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HP INC

2015-12-16

2015-10-31

ITEM 7. Management's Discussion and Analysis of Financial Condition and Results of Operations. HP INC. AND SUBSIDIARIES Management's Discussion and Analysis of Financial Condition and Results of Operations This Management's Discussion and Analysis of Financial Condition and Results of Operations ("MD&A") is organized as follows: • HP Separation Transaction. A discussion of the separation of Hewlett Packard Enterprise, Hewlett-Packard Company's former enterprise technology infrastructure, software, services and financing businesses. • Overview. A discussion of our business and overall analysis of financial and other highlights affecting the company to provide context for the remainder of MD&A. The overview analysis compares fiscal 2015 to fiscal 2014. • Critical Accounting Policies and Estimates. A discussion of accounting policies and estimates that we believe are important to understanding the assumptions and judgments incorporated in our reported financial results. • Results of Operations. An analysis of our financial results comparing fiscal 2015 to fiscal 2014 and fiscal 2014 to fiscal 2013. A discussion of the results of operations at the consolidated level is followed by a more detailed discussion of the results of operations by segment. • Liquidity and Capital Resources. An analysis of changes in our cash flows and a discussion of our financial condition and liquidity. • Contractual and Other Obligations. An overview of contractual obligations, retirement and post-retirement benefit plan funding, restructuring plans, separation costs, uncertain tax positions and off-balance sheet arrangements. We intend the discussion of our financial condition and results of operations that follows to provide information that will assist the reader in understanding our Consolidated Financial Statements, the changes in certain key items in those financial statements from year to year, and the primary factors that accounted for those changes, as well as how certain accounting principles, policies and estimates affect our Consolidated Financial Statements. This discussion should be read in conjunction with our Consolidated Financial Statements and the related notes that appear elsewhere in this document. HP Separation Transaction On November 1, 2015 (the "Distribution Date"), we completed the separation of Hewlett Packard Enterprise, Hewlett-Packard Company's former enterprise technology infrastructure, software, services and financing businesses (the "Separation"). In connection with the Separation, Hewlett-Packard Company changed its name to HP Inc. On November 1, 2015, each of our stockholders of record as of the close of business on October 21, 2015 (the "Record Date") received one share of Hewlett Packard Enterprise common stock for every one share of our common stock held as of the Record Date. We distributed a total of approximately 1.8 billion shares of Hewlett Packard Enterprise common stock to our stockholders. Hewlett Packard Enterprise is now an independent public company trading on the New York Stock Exchange ("NYSE") under the symbol "HPE". After the Separation, we do not beneficially own any shares of Hewlett Packard Enterprise common stock. HP INC. AND SUBSIDIARIES Management's Discussion and Analysis of Financial Condition and Results of Operations (Continued) The process of completing the Separation was highly complex and involved significant costs and expenses. Accordingly, we incurred separation costs and foreign tax expenses associated with separating into two companies. In fiscal 2015, we recorded nonrecurring separation costs and net foreign tax expenses of $1.6 billion, which were primarily related to third-party consulting, contractor fees and other incremental costs directly associated with the separation process. We expect total separation charges and net foreign tax expenses to be approximately $180 million in fiscal 2016. Additionally, the separation into two independent companies is expected to result in total dis-synergies of approximately $400 million to $450 million annually, which costs are primarily associated with corporate functions such as finance, legal, IT, real estate and human resources. Such dis-synergies are expected to be divided approximately equally between HP Inc. and Hewlett Packard Enterprise. We recorded a deferred tax asset on these costs and expenses as they were incurred through fiscal 2015. We expect a portion of these deferred tax assets associated with separation costs and expenses will be eliminated, given that some will be non-deductible, at the time the Separation is executed. Furthermore, we concluded on the legal form of the Separation and in May 2015 announced that Hewlett Packard Enterprise will be the spinnee company in the United States ("U.S."). Accordingly, we implemented certain internal reorganizations of, and transactions among, our wholly-owned subsidiaries and operating activities in preparation for the legal form of separation. As a result, we recognized gross incremental foreign tax expenses related to the separation of foreign legal entities of approximately $300 million and foreign tax credits of approximately $100 million in fiscal 2015 with additional tax credit amounts expected over several years. As of October 31, 2015, we also expect separation-related capital expenditures of approximately $30 million in fiscal 2016. In connection with the Separation, we and Hewlett Packard Enterprise have entered into a separation and distribution agreement as well as various other agreements that provide a framework for the relationships between the parties going forward, including among others a tax matters agreement, an employee matters agreement, a transition service agreement, a real estate matters agreement, a master commercial agreement and an information technology service agreement. In the fourth quarter of fiscal 2015, we transferred substantially all of the assets, liabilities and operations of enterprise technology infrastructure, software, services and financing businesses to Hewlett Packard Enterprise in the fourth fiscal quarter of 2015. The historical results of operations and the financial position of Hewlett Packard Enterprise are included in the consolidated financial statements of HP Inc. for each of the fiscal years included in this report and will be reported as discontinued operations beginning in the first quarter of fiscal 2016. Beginning November 1, 2015, we no longer consolidate Hewlett Packard Enterprise within our financial results or reflect the financial results of Hewlett Packard Enterprise within our continuing results of operations. OVERVIEW As of October 31, 2015, we were a leading global provider of products, technologies, software, solutions and services to individual consumers, small- and medium-sized businesses ("SMBs") and large enterprises, including customers in the government, health and education sectors. Our offerings span the following: • personal computing and other access devices; • imaging- and printing-related products and services; HP INC. AND SUBSIDIARIES Management's Discussion and Analysis of Financial Condition and Results of Operations (Continued) • enterprise IT infrastructure, including enterprise server and storage technology, networking products and solutions, technology support and maintenance; • multi-vendor customer services, including technology consulting, outsourcing and support services across infrastructure, applications and business process domains; and • software products and solutions, including application testing and delivery, big data analytics, enterprise security, information governance and IT Operations Management. As of October 31, 2015, we had seven segments for financial reporting purposes: Personal Systems, Printing, the Enterprise Group ("EG"), Enterprise Services ("ES"), Software, HP Financial Services ("HPFS") and Corporate Investments. Effective November 1, 2015, we report three segments as part of continuing operations: Personal Systems, Printing and Corporate Investments. The following provides an overview of our key financial metrics by segment for fiscal 2015: (1)HP consolidated net revenue excludes intersegment net revenue and other. (2)Segment earnings from operations exclude corporate and unallocated costs, stock-based compensation expense, amortization of intangible assets, restructuring charges, acquisition and other related charges, separation costs, defined benefit plan settlement charges and impairment of data center assets. (3)"NM" represents not meaningful. HP consolidated net revenue declined 7.3% (decreased 2.1% on a constant currency basis) in fiscal 2015 as compared to fiscal 2014. The leading contributors to the net revenue decline were unfavorable currency impacts across all major segments, key account runoff and soft demand in Infrastructure Technology Outsourcing ("ITO") in ES, lower desktop sales in Personal Systems and lower sales of printers and supplies. Partially offsetting these declines was growth within the EG segment from sales of ISS servers. Gross margin was 24.0% ($24.8 billion) and 23.9% ($26.6 billion) for fiscal 2015 and 2014, respectively. The 0.1 percentage point increase in gross margin was due primarily to service delivery efficiencies and improvements in underperforming contracts in ES. Partially offsetting the gross margin increase was the impact from a higher mix of ISS products in EG, competitive pricing pressures in Printing and the impact from the sale of intellectual property ("IP") in the prior-year period. We continue to experience gross margin pressures resulting from a competitive pricing environment across our hardware portfolio. HP's operating margin decreased by 1.1 percentage points in fiscal 2015 as compared to fiscal 2014 due primarily to separation costs, pension plan settlement charges, data center impairments and the impact from the sale of IP in the prior-year period. Partially offsetting these HP INC. AND SUBSIDIARIES Management's Discussion and Analysis of Financial Condition and Results of Operations (Continued) declines was the gross margin increase, lower selling, general and administrative ("SG&A") expenses and lower restructuring charges. As of October 31, 2015, cash and cash equivalents and short- and long-term investments were $17.7 billion, representing an increase of approximately $2.2 billion from the October 31, 2014 balance of $15.5 billion. The increase in cash and cash equivalents and short- and long-term investments in fiscal 2015 was primarily due to the following factors: cash received from operating cash flows of $6.5 billion and cash received for net issuances and repayments of debt of $5.0 billion; partially offset by investments in property, plant and equipment and business acquisitions net of divestitures of $3.2 billion and $2.4 billion, respectively, cash utilization for share repurchases of common stock of $2.9 billion and dividend payments to stockholders of $1.2 billion. We continue to experience challenges that are representative of trends and uncertainties that may affect our business and results of operations. One set of challenges relates to dynamic and accelerating market trends such as the decline in the PC market. Certain of our legacy hardware businesses face challenges as customers migrate to cloud-based offerings and reduce their purchases of hardware products. A second set of challenges relates to changes in the competitive landscape. Our major competitors are expanding their product and service offerings with integrated products and solutions, our business-specific competitors are exerting increased competitive pressure in targeted areas and are entering new markets, our emerging competitors are introducing new technologies and business models, and our alliance partners in some businesses are increasingly becoming our competitors in others. A third set of challenges relates to business model changes and our go-to-market execution. The macroeconomic weakness we have experienced has moderated in some geographic regions but remains an overall challenge. A discussion of some of these challenges at the segment level is set forth below. • In Personal Systems, we are witnessing soft demand in the Personal Computer ("PC") market as customers hold onto their PCs longer, thereby extending PC refresh cycles. Demand for PCs is being impacted by weaker macroeconomic conditions and currency devaluations in certain Asian and European markets. Additionally, industry wide, PC channels in some regions are working through excess channel inventory, which is impacting sell in. As such, we see continued market headwinds for the next several quarters. However, we are optimistic and see opportunity in the market long term given our strength in Commercial and the launch of Windows 10, combined with Intel's Skylake processor family transition, which may represent a catalyst for demand through introduction of breakthrough form factors. In Personal Systems, we are maintaining our strategic focus on profitable growth through improved market segmentation with respect to enhanced innovation in multi-operating systems, multi-architecture, geography, customer segments and other key attributes. Additionally, HP is investing significantly in premium and mobility form factors such as convertible notebooks, detachable notebooks, and commercial tablets in order to meet customer preference for mobile, thinner and lighter devices. • In Printing, we are experiencing the impact of the growth in mobility and demand challenges in consumer and commercial markets. We are also experiencing an overall competitive pricing environment due to aggressive pricing from our Japanese competitors, given the weakness of the Japanese yen. To be successful in addressing these challenges, we need to continue to execute on our key initiatives of focusing on products targeted at high usage categories and introducing new revenue delivery models to consumer customers. In the consumer market, our Ink in the Office products are driving unit volume due to our OfficeJet Pro product lines. The Ink in the Office HP INC. AND SUBSIDIARIES Management's Discussion and Analysis of Financial Condition and Results of Operations (Continued) initiative also targets shifting ink into SMBs through our OfficeJet Pro X printers which leverage our Page-Wide Array technology. In the commercial market, our focus is on placing higher value printer units which also offers a positive annuity of toner and ink and accelerating growth in graphics. We are accomplishing this in several growth areas: in multi-function and Enterprise Ink printers with recently introduced products that are increasing demand, in managed print services, which presents a strong after-market supplies opportunity, and in graphics with product innovation such as our Indigo product line. We plan to continue this focus on shifting the mix in the installed base to more value-added units, and expanding our innovative ink, laser and graphics programs. • In EG, we are experiencing challenges due to multiple market trends, including the increasing demand for hyperscale computing infrastructure products, the transition to cloud computing and a highly competitive pricing environment. In addition, demand for our Business Critical Systems ("BCS") products continues to weaken as has the overall market for UNIX products. The effect of lower BCS and traditional storage revenue along with a higher mix of ISS density optimized server products and midrange Converged Storage solutions is impacting support attach opportunities in Technology Services ("TS"). To be successful in overcoming these challenges, we must address business model shifts and go-to-market execution challenges, while continuing to pursue new product innovation that builds on our existing capabilities in areas such as cloud and data center computing, software-defined networking, storage, blade servers and wireless networking. • In ES, we are facing challenges, including managing the revenue runoff from several large contracts, pressured public sector spending, a competitive pricing environment and market pressures from a mixed economic recovery in Europe, the Middle East and Africa ("EMEA"). We are also experiencing commoditization in the IT infrastructure services market that is placing pressure on traditional ITO pricing and cost structures. There is also an industry-wide shift to highly automated, asset-light delivery of IT infrastructure and applications leading to headcount consolidation. To be successful in addressing these challenges, we must execute on the ES multi-year turnaround plan, which includes a cost reduction initiative to align our costs to our revenue trajectory, a focus on new logo wins and Strategic Enterprise Services ("SES") and initiatives to improve execution in sales performance and accountability, contracting practices and pricing. • In Software, we are facing challenges, including the market shift to SaaS and go-to-market execution challenges. To be successful in addressing these challenges, we must improve our go-to-market execution with multiple product delivery models which better address customer needs and achieve broader integration across our overall product portfolio as we work to capitalize on important market opportunities in cloud, big data and security. To address these challenges, we continue to pursue innovation with a view towards developing new products and services aligned with market demand, industry trends and the needs of our customers and partners. In addition, we need to continue to improve our operations, with a particular focus on enhancing our end-to-end processes and efficiencies. We also need to continue to optimize our sales coverage models, align our sales incentives with our strategic goals, improve channel execution, strengthen our capabilities in our areas of strategic focus, and develop and capitalize on market opportunities. HP INC. AND SUBSIDIARIES Management's Discussion and Analysis of Financial Condition and Results of Operations (Continued) For a further discussion of trends, uncertainties and other factors that could impact our operating results, see the section entitled "Risk Factors" in Item 1A, which is incorporated herein by reference. CRITICAL ACCOUNTING POLICIES AND ESTIMATES General The Consolidated Financial Statements of HP are prepared in accordance with U.S. generally accepted accounting principles ("GAAP"), which require management to make estimates, judgments and assumptions that affect the reported amounts of assets, liabilities, net revenue and expenses, and the disclosure of contingent liabilities. Management bases its estimates on historical experience and on various other assumptions that it believes to be reasonable under the circumstances, the results of which form the basis for making judgments about the carrying amount of assets and liabilities that are not readily apparent from other sources. Management has discussed the development, selection and disclosure of these estimates with the Audit Committee of HP's Board of Directors. Management believes that the accounting estimates employed and the resulting amounts are reasonable; however, actual results may differ from these estimates. Making estimates and judgments about future events is inherently unpredictable and is subject to significant uncertainties, some of which are beyond our control. Should any of these estimates and assumptions change or prove to have been incorrect, it could have a material impact on our results of operations, financial position and cash flows. A summary of significant accounting policies is included in Note 1 to the Consolidated Financial Statements in Item 8, which is incorporated herein by reference. An accounting policy is deemed to be critical if it requires an accounting estimate to be made based on assumptions about matters that are highly uncertain at the time the estimate is made, if different estimates reasonably could have been used, or if changes in the estimate that are reasonably possible could materially impact the financial statements. Management believes the following critical accounting policies reflect the significant estimates and assumptions used in the preparation of the Consolidated Financial Statements. Revenue Recognition We recognize revenue when persuasive evidence of an arrangement exists, delivery has occurred or services are rendered, the sales price or fee is fixed or determinable and collectability is reasonably assured, as well as when other revenue recognition principles are met, including industry-specific revenue recognition guidance. We enter into contracts to sell our products and services, and while many of our sales agreements contain standard terms and conditions, there are agreements we enter into which contain non-standard terms and conditions. Further, many of our arrangements include multiple elements. As a result, significant contract interpretation may be required to determine the appropriate accounting, including the identification of deliverables considered to be separate units of accounting, the allocation of the transaction price among elements in the arrangement and the timing of revenue recognition for each of those elements. We recognize revenue for delivered elements as separate units of accounting when the delivered elements have standalone value to the customer. For elements with no standalone value, we recognize revenue consistent with the pattern of the undelivered elements. If the arrangement includes a customer-negotiated refund or return right or other contingency relative to the delivered items and the delivery and performance of the undelivered items is considered probable and substantially within our control, the delivered element constitutes a separate unit of accounting. In arrangements with HP INC. AND SUBSIDIARIES Management's Discussion and Analysis of Financial Condition and Results of Operations (Continued) combined units of accounting, changes in the allocation of the transaction price among elements may impact the timing of revenue recognition for the contract but will not change the total revenue recognized for the contract. We establish the selling prices used for each deliverable based on vendor specific objective evidence ("VSOE") of selling price, if available, third-party evidence ("TPE"), if VSOE of selling price is not available, or estimated selling price ("ESP"), if neither VSOE of selling price nor TPE is available. We establish VSOE of selling price using the price charged for a deliverable when sold separately and, in rare instances, using the price established by management having the relevant authority. TPE of selling price is established by evaluating largely similar and interchangeable competitor products or services in standalone sales to similarly situated customers. ESP is established based on management's judgment considering internal factors such as margin objectives, pricing practices and controls, customer segment pricing strategies and the product life cycle. Consideration is also given to market conditions such as competitor pricing strategies and industry technology life cycles. We may modify or develop new go-to-market practices in the future, which may result in changes in selling prices, impacting both VSOE of selling price and ESP. In most arrangements with multiple elements, the transaction price is allocated to the individual units of accounting at inception of the arrangement based on their relative selling price. However, the aforementioned factors may result in a different allocation of the transaction price to deliverables in multiple element arrangements entered into in future periods. This may change the pattern and timing of revenue recognition for identical arrangements executed in future periods, but will not change the total revenue recognized for any given arrangement. We reduce revenue for customer and distributor programs and incentive offerings, including price protection, rebates, promotions, other volume-based incentives and expected returns. Future market conditions and product transitions may require us to take actions to increase customer incentive offerings, possibly resulting in an incremental reduction of revenue at the time the incentive is offered. For certain incentive programs, we estimate the number of customers expected to redeem the incentive based on historical experience and the specific terms and conditions of the incentive. For hardware products, we recognize revenue generated from direct sales to end customers and indirect sales to channel partners (including resellers, distributors and value-added solution providers) when the revenue recognition criteria are satisfied. For indirect sales to channel partners, we recognize revenue at the time of delivery when the channel partner has economic substance apart from HP and HP has completed its obligations related to the sale. For the various software products we sell (e.g., big data analytics and applications, application delivery management, enterprise security and IT Operations Management), we assess whether the software products were sold on a standalone basis or with hardware products. If the software sold with a hardware product is not essential to the functionality of the hardware product and is more-than-incidental, we treat it as a software deliverable. We recognize revenue from the sale of perpetual software licenses at inception of the license term, assuming all revenue recognition criteria have been satisfied. Term-based software license revenue is generally recognized ratably over the term of the license. We use the residual method to allocate revenue to software licenses at inception of the arrangement when VSOE of fair value for all undelivered elements, such as post-contract customer support, exists and all other revenue recognition criteria have been satisfied. Revenue from maintenance and unspecified upgrades or updates provided HP INC. AND SUBSIDIARIES Management's Discussion and Analysis of Financial Condition and Results of Operations (Continued) on a when-and-if-available basis is recognized ratably over the period during which such items are delivered. For hosting or SaaS arrangements, we recognize revenue as the service is delivered, generally on a straight-line basis, over the contractual period of performance. In hosting arrangements, we consider the rights provided to the customer (e.g. whether the customer has the contractual right to take possession of the software at any time during the hosting period without significant penalty and the feasibility of the customer to operate or contract with another vendor to operate the software) in determining whether the arrangement includes the sale of a software license. In hosting arrangements where software licenses are sold, license revenue is generally recognized according to whether perpetual or term licenses are sold, when all other revenue recognition criteria are satisfied. We recognize revenue from fixed-price support or maintenance contracts, including extended warranty contracts and software post-contract customer support agreements, ratably over the contract period. For certain fixed-price contracts, such as consulting arrangements, we recognize revenue as work progresses using a proportional performance method. We estimate the total expected labor costs in order to determine the amount of revenue earned to date. We apply a proportional performance method because reasonably dependable estimates of the labor costs applicable to various stages of a contract can be made. On fixed-price contracts for design and build projects (to design, develop and construct software infrastructure and systems), we recognize revenue as work progresses using the percentage-of-completion method. We use the cost-to-cost method to measure progress toward completion as determined by the percentage of costs incurred to date compared to the total estimated costs of the project. Total project costs are subject to revision throughout the life of a fixed-price contract. Provisions for estimated losses on fixed-price contracts are recognized in the period when such losses become known and are recorded as a component of cost of sales. In circumstances when reasonable and reliable cost estimates for a project cannot be made we recognize revenue using the completed contract method. Outsourcing services revenue is generally recognized in the period when the service is provided and the amount earned is not contingent on the occurrence of any future event. We recognize revenue using an objective measure of output for per unit-priced contracts. Revenue for fixed-price outsourcing contracts with periodic billings is recognized on a straight-line basis if the service is provided evenly over the contract term. Provisions for estimated losses on outsourcing arrangements are recognized in the period when such losses become probable and estimable and are recorded as a component of cost of sales. Warranty We accrue the estimated cost of product warranties at the time we recognize revenue. We evaluate our warranty obligations on a product group basis. Our standard product warranty terms generally include post-sales support and repairs or replacement of a product at no additional charge for a specified period of time. While we engage in extensive product quality programs and processes, including actively monitoring and evaluating the quality of our component suppliers, we base our estimated warranty obligation on contractual warranty terms, repair costs, product call rates, average cost per call, current period product shipments and ongoing product failure rates, as well as specific product class failure outside of our baseline experience. Warranty terms generally range from 90 days to three years for parts and labor, depending upon the product. Over the last three fiscal years, the annual warranty expense and actual warranty costs have averaged approximately 2.5% and 2.7% of annual net product revenue, respectively. HP INC. AND SUBSIDIARIES Management's Discussion and Analysis of Financial Condition and Results of Operations (Continued) Restructuring We have engaged in restructuring actions which require management to estimate the timing and amount of severance and other employee separation costs for workforce reduction and enhanced early retirement programs, fair value of assets made redundant or obsolete, and the fair value of lease cancellation and other exit costs. We accrue for severance and other employee separation costs under these actions when it is probable that benefits will be paid and the amount is reasonably estimable. The rates used in determining severance accruals are based on existing plans, historical experiences and negotiated settlements. For a full description of our restructuring actions, refer to our discussions of restructuring in "Results of Operations" below and in Note 3 to the Consolidated Financial Statements in Item 8, which are incorporated herein by reference. Retirement and Post-Retirement Benefits Our pension and other post-retirement benefit costs and obligations depend on various assumptions. Our major assumptions relate primarily to discount rates, mortality rates, expected increases in compensation levels and the expected long-term return on plan assets. The discount rate assumption is based on current investment yields of high-quality fixed-income securities with maturities similar to the expected benefits payment period. Mortality rates help predict the expected life of plan participants and are based on a historical demographic study of the plan. The expected increase in the compensation levels assumption reflects our long-term actual experience and future expectations. The expected long-term return on plan assets is determined based on asset allocations, historical portfolio results, historical asset correlations and management's expected returns for each asset class. We evaluate our expected return assumptions annually including reviewing current capital market assumptions to assess the reasonableness of the expected long-term return on plan assets. We update the expected long-term return on assets when we observe a sufficient level of evidence that would suggest the long-term expected return has changed. In any fiscal year, significant differences may arise between the actual return and the expected long-term return on plan assets. Historically, differences between the actual return and expected long-term return on plan assets have resulted from changes in target or actual asset allocation, short-term performance relative to expected long-term performance, and to a lesser extent, differences between target and actual investment allocations, the timing of benefit payments compared to expectations, and the use of derivatives intended to effect asset allocation changes or hedge certain investment or liability exposures. For the recognition of net periodic benefit cost, the calculation of the expected long-term return on plan assets uses the fair value of plan assets as of the beginning of the fiscal year unless updated as result of interim remeasurement. Our major assumptions vary by plan, and the weighted-average rates used are set forth in Note 4 to the Consolidated Financial Statements in Item 8, which is incorporated herein by reference. The following table provides the impact changes in the weighted-average assumptions of discount rates, the HP INC. AND SUBSIDIARIES Management's Discussion and Analysis of Financial Condition and Results of Operations (Continued) expected increase in compensation levels and the expected long-term return on plan assets would have had on our net periodic benefit cost for fiscal 2015: Taxes on Earnings We calculate our current and deferred tax provisions based on estimates and assumptions that could differ from the final positions reflected in our income tax returns. We adjust our current and deferred tax provisions based on income tax returns which are generally filed in the third or fourth quarters of the subsequent fiscal year. We recognize deferred tax assets and liabilities for the expected tax consequences of temporary differences between the tax bases of assets and liabilities and their reported amounts using enacted tax rates in effect for the year in which we expect the differences to reverse. We record a valuation allowance to reduce deferred tax assets to the amount that we are more likely than not to realize. In determining the need for a valuation allowance, we consider future market growth, forecasted earnings, future taxable income, the mix of earnings in the jurisdictions in which we operate and prudent and feasible tax planning strategies. In the event we were to determine that it is more likely than not that we will be unable to realize all or part of our deferred tax assets in the future, we would increase the valuation allowance and recognize a corresponding charge to earnings or other comprehensive income in the period in which we make such a determination. Likewise, if we later determine that we are more likely than not to realize the deferred tax assets, we would reverse the applicable portion of the previously recognized valuation allowance. In order for us to realize our deferred tax assets, we must be able to generate sufficient taxable income in the jurisdictions in which the deferred tax assets are located. Our effective tax rate includes the impact of certain undistributed foreign earnings for which we have not provided U.S. federal taxes because we plan to reinvest such earnings indefinitely outside the U.S. We plan distributions of foreign earnings based on projected cash flow needs as well as the working capital and long-term investment requirements of our foreign subsidiaries and our domestic operations. Based on these assumptions, we estimate the amount we expect to indefinitely invest outside the U.S. and the amounts we expect to distribute to the U.S. and provide the U.S. federal taxes due on amounts expected to be distributed to the U.S. Further, as a result of certain employment actions and capital investments we have undertaken, income from manufacturing activities in certain jurisdictions is subject to reduced tax rates and, in some cases, is wholly exempt from taxes for fiscal years through 2026. Material changes in our estimates of cash, working capital and long-term investment requirements in the various jurisdictions in which we do business could impact how future earnings are repatriated to the U.S., and our related future effective tax rate. We are subject to income taxes in the U.S. and approximately 105 other countries, and we are subject to routine corporate income tax audits in many of these jurisdictions. We believe that positions HP INC. AND SUBSIDIARIES Management's Discussion and Analysis of Financial Condition and Results of Operations (Continued) taken on our tax returns are fully supported, but tax authorities may challenge these positions, which may not be fully sustained on examination by the relevant tax authorities. Accordingly, our income tax provision includes amounts intended to satisfy assessments that may result from these challenges. Determining the income tax provision for these potential assessments and recording the related effects requires management judgments and estimates. The amounts ultimately paid on resolution of an audit could be materially different from the amounts previously included in our income tax provision and, therefore, could have a material impact on our income tax provision, net income and cash flows. Our accrual for uncertain tax positions is attributable primarily to uncertainties concerning the tax treatment of our international operations, including the allocation of income among different jurisdictions, intercompany transactions and related interest. For a further discussion on taxes on earnings, refer to Note 6 to the Consolidated Financial Statements in Item 8, which is incorporated herein by reference. Inventory We state our inventory at the lower of cost or market on a first-in, first-out basis. We make adjustments to reduce the cost of inventory to its net realizable value at the product group level for estimated excess or obsolescence. Factors influencing these adjustments include changes in demand, technological changes, product life cycle and development plans, component cost trends, product pricing, physical deterioration and quality issues. Business Combinations We allocate the fair value of purchase consideration to the assets acquired, including in-process research and development ("IPR&D"), liabilities assumed, and non-controlling interests in the acquiree generally based on their fair values at the acquisition date. IPR&D is initially capitalized at fair value as an intangible asset with an indefinite life and assessed for impairment thereafter. When the IPR&D project is complete, it is reclassified as an amortizable purchased intangible asset and is amortized over its estimated useful life. If an IPR&D project is abandoned, we will record a charge for the value of the related intangible asset to the Consolidated Statement of Earnings in the period it is abandoned. The excess of the fair value of purchase consideration over the fair value of these assets acquired, liabilities assumed and non-controlling interests in the acquiree is recorded as goodwill. When determining the fair values of assets acquired, liabilities assumed, and non-controlling interests in the acquiree, management makes significant estimates and assumptions, especially with respect to intangible assets. Critical estimates in valuing intangible assets include, but are not limited to, expected future cash flows, which includes consideration of future growth rates and margins, attrition rates, future changes in technology and brand awareness, loyalty and position, and discount rates. Fair value estimates are based on the assumptions management believes a market participant would use in pricing the asset or liability. Amounts recorded in a business combination may change during the measurement period, which is a period not to exceed one year from the date of acquisition, as additional information about conditions existing at the acquisition date becomes available. Goodwill We review goodwill for impairment annually and whenever events or changes in circumstances indicate the carrying amount of goodwill may not be recoverable. While we are permitted to conduct a qualitative assessment to determine whether it is necessary to perform a two-step quantitative goodwill impairment test, for our annual goodwill impairment test in the fourth quarter of fiscal 2015, we performed a quantitative test for all of our reporting units. Goodwill is tested for impairment at the HP INC. AND SUBSIDIARIES Management's Discussion and Analysis of Financial Condition and Results of Operations (Continued) reporting unit level. As of October 31, 2015, our reporting units are consistent with the reportable segments identified in Note 2, except for ES, which includes two reporting units: MphasiS Limited; and the remainder of ES. In the first step of the goodwill impairment test, we compare the fair value of each reporting unit to its carrying amount. We estimate the fair value of our reporting units using a weighting of fair values derived most significantly from the income approach and, to a lesser extent, the market approach. Under the income approach, we estimate the fair value of a reporting unit based on the present value of estimated future cash flows. Cash flow projections are based on management's estimates of revenue growth rates and operating margins, taking into consideration industry and market conditions. The discount rate used is based on the weighted-average cost of capital adjusted for the relevant risk associated with business-specific characteristics and the uncertainty related to the reporting unit's ability to execute on the projected cash flows. Under the market approach, we estimate fair value based on market multiples of revenue and earnings derived from comparable publicly-traded companies with operating and investment characteristics similar to the reporting unit. We weight the fair value derived from the market approach depending on the level of comparability of these publicly-traded companies to the reporting unit. When market comparables are not meaningful or not available, we estimate the fair value of a reporting unit using only the income approach. For the MphasiS Limited reporting unit, we utilized the quoted market price in an active market to estimate fair value. In order to assess the reasonableness of the estimated fair value of our reporting units, we compare the aggregate reporting unit fair value to HP's market capitalization and calculate an implied control premium (the excess of the sum of the reporting units' fair value over HP's market capitalization). We evaluate the control premium by comparing it to observable control premiums from recent comparable transactions. If the implied control premium is not believed to be reasonable in light of these recent transactions, we reevaluate reporting unit fair values, which may result in an adjustment to the discount rate and/or other assumptions. This reevaluation could result in a change to the estimated fair value for certain or all of our reporting units. Estimating the fair value of a reporting unit is judgmental in nature and involves the use of significant estimates and assumptions. These estimates and assumptions include revenue growth rates and operating margins used to calculate projected future cash flows, risk-adjusted discount rates, future economic and market conditions and the determination of appropriate comparable publicly-traded companies. In addition, we make certain judgments and assumptions in allocating shared assets and liabilities to individual reporting units to determine the carrying amount of each reporting unit. If the fair value of a reporting unit exceeds the carrying amount of the net assets assigned to that reporting unit, goodwill is not impaired and no further testing is required. If the fair value of the reporting unit is less than its carrying amount, then we perform the second step of the goodwill impairment test to measure the amount of impairment loss, if any. In the second step, the reporting unit's assets, including any unrecognized intangible assets, liabilities and non-controlling interests are measured at fair value in a hypothetical analysis to calculate the implied fair value of goodwill for the reporting unit in the same manner as if the reporting unit was being acquired in a business combination. If the implied fair value of the reporting unit's goodwill is less than its carrying amount, the difference is recorded as an impairment loss. Our annual goodwill impairment analysis, which we performed as of the first day of the fourth quarter of fiscal 2015, did not result in any impairment charges. The excess of fair value over carrying amount for our reporting units ranged from 19% to approximately 2,600% of carrying amounts. The Software reporting unit has the lowest excess of fair value over carrying amount at 19%. HP INC. AND SUBSIDIARIES Management's Discussion and Analysis of Financial Condition and Results of Operations (Continued) In order to evaluate the sensitivity of the estimated fair value of our reporting units in the goodwill impairment test, we applied a hypothetical 10% decrease to the fair value of each reporting unit. This hypothetical 10% decrease resulted in an excess of fair value over carrying amount for our reporting units ranging from 7% to approximately 2,400% of the carrying amounts with the Software reporting unit having the lowest excess of fair value over carrying amount of 7%. The fair value of the Software reporting unit is estimated using equal weighting of both the income and market approaches. Our Software business is facing multiple challenges including the market shift to SaaS and go-to-market execution challenges. If we are not successful in addressing these challenges, our projected revenue growth rates could decline resulting in a decrease in the fair value of the Software reporting unit. The fair value of the Software reporting unit could also be negatively impacted by declines in market multiples of revenue for comparable publicly-traded companies, changes in management's business strategy or significant and sustained declines in our stock price, which could result in an indicator of impairment. Intangible Assets We review intangible assets with finite lives for impairment whenever events or changes in circumstances indicate the carrying amount of an asset may not be recoverable. Recoverability of our finite-lived intangible assets is assessed based on the estimated undiscounted future cash flows expected to result from the use and eventual disposition of the asset. If the undiscounted future cash flows are less than the carrying amount, the finite-lived intangible assets are considered to be impaired. The amount of the impairment loss, if any, is measured as the difference between the carrying amount of the asset and its fair value. We estimate the fair value of finite-lived intangible assets by using an income approach or, when available and appropriate, using a market approach. Fair Value of Derivative Instruments We use derivative instruments to manage a variety of risks, including risks related to foreign currency exchange rates and interest rates. We use forwards, swaps and at times, options to hedge certain foreign currency and interest rate exposures. We do not use derivative instruments for speculative purposes. As of October 31, 2015, the gross notional of our derivative portfolio was $52.6 billion. Assets and liabilities related to derivative instruments are measured at fair value, and were $1.1 billion and $0.5 billion, respectively as of October 31, 2015. Fair value is the price we would receive to sell an asset or pay to transfer a liability in an orderly transaction between market participants at the measurement date. In the absence of active markets for the identical assets or liabilities, such measurements involve developing assumptions based on market observable data and, in the absence of such data, internal information that is consistent with what market participants would use in a hypothetical transaction that occurs at the measurement date. The determination of fair value often involves significant judgments about assumptions such as determining an appropriate discount rate that factors in both risk and liquidity premiums, identifying the similarities and differences in market transactions, weighting those differences accordingly and then making the appropriate adjustments to those market transactions to reflect the risks specific to the asset or liability being valued. We generally use industry standard valuation models to measure the fair value of our derivative positions. When prices in active markets are not available for the identical asset or liability, we use industry standard valuation models to measure fair value. Where applicable, these models project future cash flows and discount the future amounts to present value using market-based HP INC. AND SUBSIDIARIES Management's Discussion and Analysis of Financial Condition and Results of Operations (Continued) observable inputs, including interest rate curves, HP and counterparty credit risk, foreign currency exchange rates, and forward and spot prices. For a further discussion on fair value measurements and derivative instruments, refer to Note 11 and Note 12, respectively, to the Consolidated Financial Statements in Item 8, which are incorporated herein by reference. Loss Contingencies We are involved in various lawsuits, claims, investigations and proceedings including those consisting of IP, commercial, securities, employment, employee benefits and environmental matters that arise in the ordinary course of business. We record a liability when we believe that it is both probable that a liability has been incurred and the amount of loss can be reasonably estimated. Significant judgment is required to determine both the probability of having incurred a liability and the estimated amount of the liability. We review these matters at least quarterly and adjust these liabilities to reflect the impact of negotiations, settlements, rulings, advice of legal counsel and other updated information and events, pertaining to a particular case. Based on our experience, we believe that any damage amounts claimed in the specific litigation and contingencies matters further discussed in Note 16 to the Consolidated Financial Statements in Item 8, which is incorporated herein by reference, are not a meaningful indicator of HP's potential liability. Litigation is inherently unpredictable. However, we believe we have valid defenses with respect to legal matters pending against us. Nevertheless, cash flows or results of operations could be materially affected in any particular period by the resolution of one or more of these contingencies. We believe we have recorded adequate provisions for any such matters and, as of October 31, 2015, it was not reasonably possible that a material loss had been incurred in excess of the amounts recognized in our financial statements. ACCOUNTING PRONOUNCEMENTS For a summary of recent accounting pronouncements applicable to our consolidated financial statements see Note 1 to the Consolidated Financial Statements in Item 8, which is incorporated herein by reference. RESULTS OF OPERATIONS Revenue from our international operations has historically represented, and we expect will continue to represent, a majority of our overall net revenue. As a result, our net revenue growth has been impacted, and we expect will continue to be impacted, by fluctuations in foreign currency exchange rates. In order to provide a framework for assessing performance excluding the impact of foreign currency fluctuations, we present the year-over-year percentage change in net revenue on a constant currency basis, which assumes no change in foreign currency exchange rates from the prior-year period and doesn't adjust for any repricing or demand impacts from changes in foreign currency exchange rates. This information is provided so that net revenue can be viewed without the effect of fluctuations in foreign currency exchange rates, which is consistent with how management evaluates our net revenue results and trends. This constant currency disclosure is provided in addition to, and not as a substitute for, the year-over-year percentage change in revenue on a GAAP basis. Other companies may calculate and define similarly labeled items differently, which may limit the usefulness of this measure for comparative purposes. HP INC. AND SUBSIDIARIES Management's Discussion and Analysis of Financial Condition and Results of Operations (Continued) Results of operations in dollars and as a percentage of net revenue were as follows: (1)Cost of products, cost of services and financing interest. Net Revenue In fiscal 2015, total HP net revenue declined 7.3% (decreased 2.1% on a constant currency basis) as compared to fiscal 2014. U.S. net revenue decreased 2.9% to $37.7 billion, and net revenue from outside of the U.S. decreased 9.6% to $65.7 billion. In fiscal 2014, total HP net revenue declined 0.8% (decreased 0.4% on a constant currency basis) as compared to fiscal 2013. U.S. net revenue decreased 3.7% to $38.8 billion, while net revenue from outside of the U.S. increased 0.9% to $72.6 billion. HP INC. AND SUBSIDIARIES Management's Discussion and Analysis of Financial Condition and Results of Operations (Continued) The components of the weighted net revenue change by segment were as follows: Fiscal 2015 compared with Fiscal 2014 For fiscal 2015, total net revenue decreased 7.3 percentage points. From a segment perspective, the primary factors contributing to the change in net revenue are summarized as follows: • Personal Systems net revenue decreased due primarily to unfavorable currency impacts, particularly in EMEA, and weakening market demand; • ES net revenue decreased due primarily to unfavorable currency impacts, revenue runoff in key accounts and weak growth in new and existing accounts; • Printing net revenue decreased due primarily to unfavorable currency impacts, weak market demand and competitive pricing pressures; • HPFS net revenue decreased due primarily to unfavorable currency impacts led by weakness in the euro and lower asset management activity primarily in customer buyouts; • Corporate Investments net revenue decreased due to the sale of IP in the prior-year period; • Software net revenue decreased due primarily to unfavorable currency impacts and declines in license revenue; and • EG net revenue increased due to growth in Industry Standard Servers ("ISS") and net revenue resulting from our acquisition of Aruba Networks, Inc. ("Aruba") in May 2015. Fiscal 2014 compared with Fiscal 2013 For fiscal 2014, total net revenue decreased 0.8 percentage points. From a segment perspective, the primary factors contributing to the change in net revenue are summarized as follows: • ES net revenue declined due primarily to revenue runoff in key accounts, weak growth in new and existing accounts, particularly in EMEA, and contractual price declines; • Printing net revenue decreased due primarily to a decline in Supplies; • EG net revenue decreased due to net revenue declines in TS, BCS and Storage; HP INC. AND SUBSIDIARIES Management's Discussion and Analysis of Financial Condition and Results of Operations (Continued) • Software net revenue decreased due to lower net revenue from licenses, support and professional services; • HPFS net revenue decreased due primarily to lower portfolio revenue from lower average portfolio assets and lower asset management activity, primarily in customer buyouts; • Corporate Investments net revenue increased due to the sale of IP; and • Personal Systems net revenue increased due to growth in commercial PCs, particularly notebooks, along with growth in consumer notebooks. A more detailed discussion of segment revenue is included under "Segment Information" below. Gross Margin Fiscal 2015 compared with Fiscal 2014 HP's gross margin increased by 0.1 percentage points for fiscal year 2015 compared with fiscal 2014. From a segment perspective, the primary factors impacting gross margin performance are summarized as follows: • ES gross margin increased due primarily to service delivery efficiencies and improving profit performance in underperforming contracts; • HPFS gross margin decreased due primarily to unfavorable currency impacts, lower margin in customer buyouts, and lower portfolio margin due to competitive pricing; • EG gross margin decreased due primarily to a higher revenue mix of ISS products, unfavorable currency impacts, and competitive pricing; • Printing gross margin decreased due primarily to a competitive pricing environment in hardware and unfavorable currency impacts; • Personal Systems gross margin decreased due primarily to unfavorable currency impacts and a lower mix of commercial products, partially offset by favorable component costs and operational cost improvements; and • Software gross margin decreased due to a lower mix of license revenue. Fiscal 2014 compared with Fiscal 2013 HP's gross margin increased by 0.8 percentage points for fiscal year 2014 compared with fiscal 2013. From a segment perspective, the primary factors impacting gross margin performance are summarized as follows: • ES gross margin increased due primarily to our continued focus on service delivery efficiencies, improving profit performance in under-performing contracts and labor savings as a result of restructuring; • Printing gross margin increased due primarily to favorable currency impacts from the Japanese yen, continued cost structure improvements and a favorable mix from a higher proportion of graphics and ink supplies; • Corporate Investments gross margin increased due to the sale of IP; HP INC. AND SUBSIDIARIES Management's Discussion and Analysis of Financial Condition and Results of Operations (Continued) • Software gross margin increased due to the shift to more profitable contracts and improved workforce utilization in professional services; • HPFS gross margin increased due to a higher portfolio margin, primarily from lower bad debt expense, a lower cost of funds and improved margins in remarketing sales; • Personal Systems gross margin increased due primarily to operational cost improvements, a favorable mix of commercial products and the sale of IP; and • EG gross margin decreased due primarily to the impact of a higher mix of ISS products, lower mix of BCS products and competitive pricing pressure in ISS and Networking. A more detailed discussion of segment gross margins and operating margins is included under "Segment Information" below. Operating Expenses Research and Development R&D expense increased 2% in fiscal 2015 as compared to fiscal 2014 due primarily to expenses from the acquisition of Aruba and increases in Technology Services, cloud and HP Labs, partially offset by favorable currency impacts. R&D expense increased 10% in fiscal 2014 as compared to fiscal 2013 with increases across each of our segments as we made investments in our strategic focus areas of cloud, security, big data and mobility. Selling, General and Administrative SG&A expense decreased 9% in fiscal 2015 as compared to fiscal 2014 due primarily to favorable currency impacts and declines in go-to-market costs as a result of lower commissions and productivity initiatives. SG&A expense increased 1% in fiscal 2014 as compared to fiscal 2013 due primarily to higher compensation costs, litigation expenses and higher selling costs from investments in the areas of cloud, networking and storage, partially offset by gains from sales of real estate and lower program spending in marketing. Amortization of Intangible Assets Amortization expense decreased in fiscal 2015 and in fiscal 2014 due primarily to certain intangible assets associated with prior acquisitions reaching the end of their respective amortization periods, partially offset by amortization expense from intangible assets resulting from the acquisition of Aruba in fiscal 2015. Restructuring Charges Restructuring charges decreased 37% in fiscal 2015 due primarily to lower charges from the multi-year restructuring plan initially announced in May 2012 (the "2012 Plan"). On September 14, 2015, our Board of Directors approved a restructuring plan (the "2015 Plan") in connection with the Separation which will be implemented through fiscal 2018. As a result, HP recognized $391 million of charges related to the 2015 Plan during the fourth quarter of fiscal 2015. HP INC. AND SUBSIDIARIES Management's Discussion and Analysis of Financial Condition and Results of Operations (Continued) Restructuring charges increased in fiscal 2014 due primarily to higher charges in connection with the 2012 Plan and from increases to the 2012 Plan announced in fiscal 2014. During fiscal 2014, HP increased the total for positions expected to be eliminated under the 2012 Plan from 34,000 to 55,000 positions. In fiscal 2015, HP recognized restructuring charges of $640 million in connection with the 2012 Plan. Acquisition and Other Related Charges Acquisition and other related charges increased for fiscal 2015, due primarily to the acquisition of Aruba resulting in a non-cash inventory fair value adjustment charge and professional services and legal fees associated with the acquisition. Separation Costs Separation costs for fiscal 2015 were primarily comprised of third-party consulting, contractor fees and other related costs. Defined Benefit Plan Settlement Charges Defined benefit plan settlement charges for fiscal 2015 were related to U.S. defined benefit plan settlement expense and net periodic benefit cost resulting from the voluntary lump sum program announced in January 2015. Impairment of Data Center Assets Impairment of data center assets for fiscal 2015 was related to our exit from several ES data centers. Interest and Other, Net Interest and other, net expense increased by $111 million in fiscal 2015. The increase was in connection with $167 million of early debt settlement costs and higher foreign currency transaction losses, partially offset by lower interest expense due to lower weighted average interest rates and a decrease in miscellaneous other expenses. Interest and other, net expense increased by $7 million in fiscal 2014. The increase was due primarily to higher currency transaction losses partially offset by lower interest expense from a lower average debt balance. Provision for Taxes Our effective tax rates were 3.8%, 23.5% and 21.5% in fiscal 2015, 2014 and 2013, respectively. Our effective tax rate generally differs from the U.S. federal statutory rate of 35% due to favorable tax rates associated with certain earnings from our operations in lower tax jurisdictions throughout the world. The jurisdictions with favorable tax rates that had the most significant impact on HP's effective tax rate in the periods presented were Puerto Rico, Singapore, China, Malaysia, Ireland and Netherlands. HP plans to reinvest certain earnings of these jurisdictions indefinitely outside the U.S. and therefore has not provided U.S. taxes on those indefinitely reinvested earnings. HP INC. AND SUBSIDIARIES Management's Discussion and Analysis of Financial Condition and Results of Operations (Continued) For a reconciliation of our effective tax rate to the U.S. federal statutory rate of 35% and further explanation of our provision for taxes, see Note 6 to the Consolidated Financial Statements in Item 8, which is incorporated herein by reference. In fiscal 2015, we recorded $1.6 billion of net income tax benefits related to items unique to the year. These amounts included $1.8 billion tax benefit due to a release of valuation allowances pertaining to certain U.S. deferred tax assets and $486 million tax charge to record valuation allowances on certain foreign deferred tax assets, both related to legal entities within the ES business, $394 million of tax charges for adjustments to uncertain tax positions and the settlement of tax audit matters, inclusive of $449 million of tax charges related to pension transfers, and $3 million of tax charges for various provision to return adjustments and other adjustments. In addition, we recorded $639 million of net tax benefits on restructuring, separation-related and other charges and a tax benefit of $47 million arising from the retroactive research and development credit resulting from the Tax Increase Prevention Act of 2014, which was signed into law in December 2014. We recorded gross deferred tax assets of $12.5 billion, $14.0 billion and $13.6 billion at October 31, 2015, 2014 and 2013 which were reduced by valuation allowances of $9.9 billion, $11.9 billion and $11.4 billion respectively. Total valuation allowances decreased by $2 billion in fiscal 2015 associated with the release of a valuation allowance against deferred tax assets in the U.S., and increased by $525 million in fiscal 2014, associated primarily with foreign net operating losses. In fiscal 2014, we recorded $53 million of net income tax charges related to items unique to the year. In fiscal 2013, we recorded $471 million of net income tax charges related to items unique to the year. These amounts included $214 million of net increases to valuation allowances, $406 million of tax charges for adjustments to uncertain tax positions and the settlement of tax audit matters and $47 million of tax charges for various prior period adjustments. In addition, we recorded $146 million of tax benefits from adjustments to prior year foreign income tax accruals and a tax benefit of $50 million arising from the retroactive research and development credit resulting from the American Taxpayer Relief Act of 2012, which was signed into law in January 2013. Segment Information A description of the products and services for each segment can be found in Note 2 to the Consolidated Financial Statements in Item 8, which is incorporated herein by reference. Future changes to this organizational structure may result in changes to the segments disclosed. Effective at the beginning of its first quarter of fiscal 2015, we implemented an organizational change to align our segment financial reporting more closely with its current business structure. This organizational change resulted in the transfer of third-party multi-vendor support arrangements from the TS business unit within the EG segment to the ITO business unit within the ES segment. We have reflected this change to our segment information retrospectively to the earliest period presented, which has resulted in the removal of intersegment revenue from the TS business unit within the EG segment and the related corporate intersegment revenue eliminations, and the transfer of operating profit from the TS business unit within the EG segment to the ITO business unit within the ES segment. In connection with the Separation, effective at the beginning of its fourth quarter of fiscal 2015, we implemented an organizational change which resulted in the transfer of marketing optimization solutions business from the Software segment to the Commercial Hardware business unit within the HP INC. AND SUBSIDIARIES Management's Discussion and Analysis of Financial Condition and Results of Operations (Continued) Printing segment. We have reflected this change to our segment information in prior reporting periods on an as-if basis, which resulted in the transfer of net revenue from the Software segment to the Commercial Hardware business unit within the Printing segment. This change also resulted in the transfer of operating profit from the Software segment to the Commercial Hardware business unit within the Printing segment. In addition, this change resulted in the reclassification of $512 million of goodwill from the Software segment to the Printing segment. These changes had no impact on our previously reported consolidated net revenue, earnings from operations, net earnings or net earnings per share. Printing and Personal Systems Group The Personal Systems segment and the Printing segment are structured beneath a broader Printing and Personal Systems Group ("PPS"). We describe the results of the business segments within PPS below. Personal Systems The components of net revenue and the weighted net revenue change by business unit were as follows: HP INC. AND SUBSIDIARIES Management's Discussion and Analysis of Financial Condition and Results of Operations (Continued) Fiscal 2015 compared with Fiscal 2014 Personal Systems net revenue decreased 8.3% (decreased 3.1% on a constant currency basis) in fiscal 2015. The net revenue decline in Personal Systems was due primarily to unfavorable currency impacts, particularly in EMEA, and weakening market demand. Personal Systems net revenue decreased as a result of a 5% decline in average selling prices ("ASPs") and a 3% decline in unit volume. The decline in ASPs was due primarily to unfavorable currency impacts, a shift in consumer PCs to low end products and a lower mix of commercial PCs within Personal Systems. The unit volume decline was due primarily to a unit volume decline in desktops, partially offset by a unit volume growth in notebooks, both consumer and commercial. Net revenue for commercial clients decreased 8% due primarily to unfavorable currency impacts, a decline in commercial desktops as a result of weak market demand and higher net revenue in the prior-year period resulting from the replacement of the Windows XP operating system. Net revenue for consumer clients decreased 8% due primarily to unfavorable currency impacts and a decline in consumer desktops. Net revenue declined 17% in Desktop PCs, 2% in Notebook PCs, 9% in Workstations and 8% in Other. The net revenue decline in Other was due primarily to a decline in consumer tablets, the sale of IP in the prior-year period, and unfavorable currency impacts, the effects of which were partially offset by increased sales of extended warranties. Personal Systems earnings from operations as a percentage of net revenue decreased by 0.3 percentage points for fiscal 2015 as a result of a decline in gross margin combined with an increase in operating expenses as a percentage of net revenue. The decline in gross margin was due primarily to unfavorable currency impacts and a lower mix of commercial products, partially offset by favorable component costs and operational cost improvements. Operating expenses as a percentage of net revenue increased due primarily to the size of the net revenue decline, higher administrative expenses as a result of lower bad debt recoveries as compared to the prior-year period and higher R&D investments in commercial, mobility and immersive computing products, the effects of which were partially offset by a decline in field selling costs as a result of favorable currency impacts and operational cost improvements. Fiscal 2014 compared with Fiscal 2013 Personal Systems net revenue increased 6.6% (increased 7.2% on a constant currency basis) in fiscal 2014. While the Personal Systems business continued to be challenged by the market shift towards mobility products, the pace of the PC market decline slowed with signs of stabilization driven by growth in commercial PCs, the effects of which were partially offset by weakness in consumer PCs. The revenue increase in Personal Systems was due to growth in commercial PCs, particularly notebooks, along with growth in consumer notebooks. Personal Systems experienced revenue growth across all regions led by double digit revenue growth in EMEA, which experienced improved demand. The revenue increase was driven by an 8.2% increase in unit volume, the effects of which were partially offset by a 1.5% decline in ASPs. The unit volume increase was primarily led by growth in commercial notebooks as well as strength in commercial desktops, consumer notebooks and thin client products. The decline in ASPs was due primarily to a competitive pricing environment and unfavorable currency impacts, the effects of which were partially offset by a favorable mix of commercial PCs. Net revenue for commercial clients increased 10% due primarily to the benefits from the delayed installed base refresh cycle, the effects of customers migrating from the Windows XP operating system and growth in all product categories partly driven by new product introductions, including the HP Elite HP INC. AND SUBSIDIARIES Management's Discussion and Analysis of Financial Condition and Results of Operations (Continued) products. Net revenue for consumer clients remained flat as growth in consumer notebooks, partly driven by our new product lineup including Chromebooks and hybrid products, was offset by a decline in consumer desktops. For fiscal 2014, net revenue for Notebook PCs increased 9%, Desktop PCs increased 3%, Workstations increased 3% and Other net revenue increased 16%. The net revenue increase in Other was due to the sale of IP and growth in mobility products, primarily consumer tablets which were introduced in the second half of fiscal 2013. Personal Systems earnings from operations as a percentage of net revenue increased 0.7 percentage points for fiscal 2014. The increase was driven by an increase in gross margin and a decline in operating expenses as a percentage of net revenue. The increase in gross margin was due primarily to operational cost improvements, a favorable commercial mix and the sale of IP, the effects of which were partially offset by unfavorable currency impacts. Operating expenses as a percentage of net revenue decreased due primarily to our cost structure optimization efforts, the effects of which were partially offset by increased research and development investments for commercial, mobility and immersive computing products, as well as higher administrative expenses driven by lower bad debt recoveries as compared to fiscal 2013. Printing The components of the net revenue and weighted net revenue change by business unit were as follows: HP INC. AND SUBSIDIARIES Management's Discussion and Analysis of Financial Condition and Results of Operations (Continued) Fiscal 2015 compared with Fiscal 2014 Printing net revenue decreased 8.5% (decreased 5.1% on a constant currency basis) for fiscal 2015. The decline in net revenue was due primarily to unfavorable currency impacts, decline in Supplies, weak market demand and competitive pricing pressures, the effects of which were partially offset by growth in graphics products. From a regional perspective, Printing experienced a net revenue decline across all regions, primarily in EMEA and particularly in Russia as a result of challenges in those markets. Net revenue for Supplies decreased 6% due primarily to unfavorable currency impacts and demand weakness in toner and ink, partially offset by growth in graphics supplies. The demand weakness in toner was particularly in EMEA, led by a net revenue decline in Russia. Printer unit volumes declined 7% while average revenue per unit ("ARU") decreased 7%. Printer unit volume declined due primarily to a decline in LaserJet and home printer units, the effects of which were partially offset by growth in graphics printer units. The ARU for printers decreased due primarily to a highly competitive pricing environment and unfavorable currency impacts on Inkjet and LaserJet printers. Net revenue for Commercial Hardware decreased 10% driven by a 7% decline in printer unit volume and a 4% decline in ARU, partially offset by a net revenue increase in other peripheral solutions. In Commercial Hardware, the decline in unit volume was due primarily to an overall decline in LaserJet printer units, partially offset by growth in graphics printer units. The ARU decline in Commercial Hardware was due primarily to a competitive pricing environment and unfavorable currency impacts. Net revenue for Consumer Hardware decreased 20% driven by a 13% decline in ARU and a 7% decline in unit volume. The ARU decline in Consumer Hardware was due primarily to a competitive pricing environment and unfavorable currency impacts. The unit volume decline in Consumer Hardware was due primarily to lower sales of home and SMB printer units. Printing earnings from operations as a percentage of net revenue remained flat for fiscal 2015 due to a decline in gross margin, offset by lower operating expenses as a percentage of net revenue. The decline in gross margin was due primarily to a competitive pricing environment in hardware and unfavorable currency impacts, the effects of which were partially offset by a favorable mix of ink and graphics supplies and favorable currency impacts from the Japanese yen. Operating expenses as a percentage of net revenue decreased due primarily to our cost saving initiatives, lower marketing expenses, the impact of the divestiture of our photo printing service Snapfish and favorable currency impacts. HP INC. AND SUBSIDIARIES Management's Discussion and Analysis of Financial Condition and Results of Operations (Continued) Fiscal 2014 compared with Fiscal 2013 In fiscal 2014, Printing experienced a decline in revenue and an increase in operating profit as we continued to push our print strategies, which includes driving high value printer unit placements and expanding our graphics products and managed print services portfolio. Printing net revenue decreased 3.8% (decreased 3.3% on a constant currency basis) for fiscal 2014. The decline in net revenue was primarily driven by a decline in Supplies, the effects of which were partially offset by growth in graphics products and managed print services. Net revenue for Supplies decreased 5% driven by demand weakness in toner and ink, and a reduction in channel inventory in the fourth quarter of fiscal 2014, the effects of which were partially offset by growth in graphics supplies. Printer unit volume remained flat while ARU decreased 1%. Printer unit volume was flat due primarily to our continued efforts to target high value areas of the market, which resulted in a decline in home printer units and low value LaserJet printer units, the effects of which were offset by increased units in SMB, multifunction laser and graphics printers. The decline in ARU was due primarily to increased discounting driven by competitive pricing pressures. Net revenue for Commercial Hardware was flat as a 3% increase in printer unit volume was offset by a 3% decline in printer ARU. The unit volume in Commercial Hardware increased due primarily to growth in our multifunction laser printers and graphics printers. The ARU decline in Commercial Hardware was due primarily to a decline in LaserJet and graphics printers driven by a competitive pricing environment. Net revenue for Consumer Hardware decreased 4% driven by a 1% decline in printer unit volume and a 1% decline in ARU, along with a decline in other peripheral printing solutions. The unit volume decline in Consumer Hardware was due to lower sales of home printers, the effects of which were partially offset by growth in SMB printers. The ARU decline in Consumer Hardware was due primarily to increased discounting for SMB printers due to a competitive pricing environment, the effects of which were partially offset by a favorable mix of high value home printers. Printing earnings from operations as a percentage of net revenue increased by 1.8 percentage points for fiscal 2014 as an increase in gross margin more than offset an increase in operating expenses as a percentage of net revenue. The gross margin increase was due to favorable currency impacts primarily driven by the Japanese yen, continued cost structure improvements and a favorable mix from a higher proportion of graphics and ink supplies, the effects of which were partially offset by a competitive pricing environment. Operating expenses as a percentage of net revenue increased due primarily to higher R&D expenses as a result of our investments in enterprise products and 3-D printing, the effects of which were partially offset by reduced marketing expenses. Enterprise Group HP INC. AND SUBSIDIARIES Management's Discussion and Analysis of Financial Condition and Results of Operations (Continued) The components of the net revenue and weighted net revenue change by business unit were as follows: Fiscal 2015 compared with Fiscal 2014 EG net revenue increased 0.7% (increased 6.3% on a constant currency basis) in fiscal 2015. The increase in EG net revenue was due primarily to growth in ISS and from our acquisition of Aruba in May 2015, partially offset primarily by unfavorable currency impacts led by the euro and a net revenue decline in TS. However, we continued to experience challenges due to market trends, including the transition to cloud computing, as well as product and technology transitions, along with a highly competitive pricing environment. ISS net revenue increased 8% as a result of higher average unit prices ("AUPs) and unit volume growth. The increase in AUP's was across the server portfolio, primarily driven by higher option attach rates for memory, processors and hard drives and a mix shift to high-end new generation HP ProLiant servers. The unit volume growth was primarily due to shipment increases in rack and density optimized server products. Networking net revenue increased 8% due primarily to revenue from Aruba, which resulted in higher revenue from wireless local area network ("WLAN") products, the effect of which was partially offset by competitive pricing pressures, particularly in the China market. Storage net revenue decreased 4% as a result of a decline in traditional storage products, the effect of which was partially offset by growth in Converged Storage solutions from the 3PAR StoreServ products, HP INC. AND SUBSIDIARIES Management's Discussion and Analysis of Financial Condition and Results of Operations (Continued) particularly All-flash arrays, and StoreOnce. BCS net revenue decreased 13% largely as a result of contraction in the overall UNIX market. TS net revenue decreased 9% due primarily to a reduction in support for BCS and traditional storage products along with lower revenue from consulting services, the effects of which were partially offset by growth in HP Data Center Care and HP Proactive Care support solutions. In fiscal 2015, EG earnings from operations as a percentage of net revenue decreased by 0.1 percentage point due to a decrease in gross margin partially offset by a decrease in operating expenses as a percentage of net revenue. The decrease in gross margin was due primarily to a higher revenue mix of ISS products, unfavorable currency impacts and competitive pricing, the effects of which were partially offset by improved cost management, improved pricing in Storage and a higher gross margin contribution in Networking from Aruba. The decrease in operating expenses as a percentage of net revenue was due primarily to favorable currency impacts, partially offset by expenses during the period from Aruba. Fiscal 2014 compared with Fiscal 2013 EG net revenue decreased 1.0% (decreased 0.6% on a constant currency basis) in fiscal 2014. In EG, we continued to experience revenue challenges due to market trends, including the transition to cloud computing, as well as product and technology transitions, along with a highly competitive pricing environment. The decline in EG net revenue was due to net revenue declines in TS, BCS and Storage partially offset by net revenue growth in ISS and Networking. TS net revenue decreased 4% due primarily to a continued reduction in support for BCS, traditional storage products and lower support in networking services, partially offset by growth in support solutions for Converged Storage solutions and ISS. BCS net revenue decreased 22% as a result of ongoing pressures from the overall UNIX market contraction. Storage net revenue decreased by 5% as we continue to experience multiple challenges including product transitions from traditional storage products which include our tape, storage networking and legacy external disk products, to converged solutions, which include our 3PAR StoreServ, StoreOnce, and StoreVirtual products, other challenges include market weakness in high-end converged solutions and sales execution challenges, the effects of which were partially offset by revenue growth in our Converged Storage solutions. Networking net revenue increased 4% due to higher switching product revenue as a result of growth in our data center products, partially offset by lower revenue from WLAN products. ISS net revenue increased by 3% due primarily to higher volume and higher average unit prices in rack and blade server products driven by higher option attach rates for memory, processors and hard drives. EG earnings from operations as a percentage of net revenue decreased by 0.8 percentage points in fiscal 2014 due to a decrease in gross margin coupled with an increase in operating expenses as a percentage of net revenue. The gross margin decline was due primarily to a higher mix of ISS products, a lower mix of BCS products and competitive pricing pressure in ISS and Networking, partially offset by supply chain cost optimization and improved cost management in TS. The increase in operating expenses as a percentage of net revenue was driven by higher R&D investments in storage, networking and ISS, partially offset by continued cost savings associated with our ongoing restructuring efforts. HP INC. AND SUBSIDIARIES Management's Discussion and Analysis of Financial Condition and Results of Operations (Continued) Enterprise Services The components of the net revenue and weighted net revenue change by business unit were as follows: Fiscal 2015 compared with Fiscal 2014 ES net revenue decreased 11.6% (decreased 5.7% on a constant currency basis) in fiscal 2015. Performance in ES remained challenged by the impact of several large contracts winding down. The net revenue decrease in ES was due primarily to unfavorable currency impacts, revenue runoff in key accounts and weak growth in new and existing accounts, partially offset by growth in our SES portfolio which includes analytics and data management, security and cloud services. Net revenue in ITO decreased by 14% in fiscal 2015 due to unfavorable currency impacts, revenue runoff in key accounts and weak growth in new and existing accounts, particularly in EMEA in the first half of fiscal 2015, partially offset by growth in SES revenue in the second half of fiscal 2015. Net revenue in Application and Business Services ("ABS") declined by 8% in fiscal 2015, due to unfavorable currency impacts and weak growth in new and existing accounts particularly in the first half of fiscal 2015, partially offset by growth in SES net revenue in the second half of fiscal 2015. ES earnings from operations as a percentage of net revenue increased 1.7 percentage points in fiscal 2015. The increase in operating margin was due to an increase in gross margin and a decrease in HP INC. AND SUBSIDIARIES Management's Discussion and Analysis of Financial Condition and Results of Operations (Continued) operating expenses as a percentage of net revenue. Gross margin increased due primarily to service delivery efficiencies and improving profit performance in underperforming contracts. The decrease in operating expenses as a percentage of net revenue was primarily driven by lower field selling costs, which was due to favorable currency impacts and our sales transformation initiatives. Fiscal 2014 compared with Fiscal 2013 ES net revenue decreased 6.9% (decreased 6.8% on a constant currency basis) in fiscal 2014. Performance in ES remained challenged by the impact of several large contracts winding down and lower public sector spending in EMEA, particularly in the United Kingdom, and several other countries in EMEA. The net revenue decrease in ES was due primarily to revenue runoff in key accounts, weak growth in new and existing accounts, particularly in EMEA, and contractual price declines. These effects were partially offset by net revenue growth in our SES portfolio, which includes information management and analytics, security and cloud services. Net revenue in Infrastructure Technology Outsourcing ("ITO") decreased by 8% in fiscal 2014 due to revenue runoff in key accounts, weak growth in new and existing accounts, particularly in EMEA, and contractual price declines in ongoing contracts partially offset by growth in cloud and security revenue and favorable currency impacts. Net revenue in ABS decreased by 5% in fiscal 2014, due to revenue runoff in a key account, weak growth in new and existing accounts, particularly in EMEA, and unfavorable currency impacts, partially offset by growth in information management and analytics and cloud revenue. ES earnings from operations as a percentage of net revenue increased 0.7 percentage points in fiscal 2014. The increase in operating margin was due to an increase in gross margin, partially offset by an increase in operating expenses as a percentage of net revenue. Gross margin increased due primarily to our continued focus on service delivery efficiencies, improving profit performance in under-performing contracts and labor savings as a result of restructuring, partially offset by unfavorable impacts from revenue runoff in key accounts and weak growth in new and existing accounts. The increase in operating expenses as a percentage of net revenue was primarily driven by the size of the revenue decline and higher administrative expenses and field selling costs. The increase in administrative expenses was due to the prior-year period containing higher bad debt recoveries and insurance recoveries. The increase in selling costs was the result of expanding the sales force coverage as we transition from a reactive sales model to a more proactive approach. Software Fiscal 2015 compared with Fiscal 2014 Software net revenue decreased 6.6% (decreased 2.7% on a constant currency basis) in fiscal 2015. Revenue growth in Software is being challenged by the overall market shift to SaaS solutions and related go-to-market sales execution challenges. Additionally, these challenges are impacting growth in HP INC. AND SUBSIDIARIES Management's Discussion and Analysis of Financial Condition and Results of Operations (Continued) license and support revenue. In fiscal 2015, net revenue growth was negatively impacted by foreign currency fluctuations across all regions, led primarily by weakness in the euro. In fiscal 2015, net revenue from licenses, professional services, SaaS and support decreased by 13%, 8%, 3% and 3%, respectively. The decrease in license revenue was due primarily to the market shift to SaaS solutions and sales execution challenges and, as a result, we experienced lower revenue in IT Operations Management. Professional services net revenue decreased due primarily to unfavorable currency impacts, our continued focus on higher-margin engagements, and, as a result, we experienced a net revenue decrease in big data solutions, partially offset by net revenue growth in security products. SaaS net revenue decreased due primarily to sales execution challenges, which resulted in lower revenue from big data solutions, partially offset by net revenue growth in IT Operations Management. The decrease in support revenue was due primarily to unfavorable currency impacts and past declines in license revenue, partially offset by growth in revenue for security products. In fiscal 2015, Software earnings from operations as a percentage of net revenue decreased by 0.4 percentage points due to a decrease in gross margin and an increase in operating expenses as a percentage of net revenue. The decrease in gross margin was due primarily to a lower mix of license revenue. The increase in operating expenses as a percentage of net revenue was due to the size of the revenue decline. During the period, operating expense declined due primarily to favorable currency impacts and lower SG&A expenses as a result of lower field selling costs driven by expense management. Fiscal 2014 compared with Fiscal 2013 Software net revenue decreased 2.3% (decreased 2.2% on a constant currency basis) in fiscal 2014. Revenue growth in Software was challenged by the overall market and customer shift to SaaS solutions, which is impacting growth in license and support revenue. In fiscal 2014, net revenue from licenses, support and professional services decreased by 3%, 2% and 6% respectively, while SaaS net revenue increased by 5%. The decline in license net revenue was due to the market and customer shift to SaaS solutions, which resulted in lower revenue from IT/cloud management and information management products, partially offset by strength in some of our key focus areas of big data analytics and security. The decrease in support net revenue was due to past declines in license revenue. Professional services net revenue decreased as we continued our focus on higher-margin engagements. These declines were partially offset by higher SaaS revenue due to improving demand for our SaaS solutions in IT/cloud management products and security products. In fiscal 2014, Software earnings from operations as a percentage of net revenue remained flat in percentage points. There was an increase in gross margin, the effect of which was offset by an increase in operating expenses as a percentage of net revenue. The increase in gross margin was due to the shift to more profitable contracts and improved workforce utilization in professional services. The increase in operating expenses as a percentage of net revenue was due primarily to investments in R&D partially offset by lower SG&A expenses due to cost savings associated with our ongoing restructuring efforts and improved operational expense management. HP INC. AND SUBSIDIARIES Management's Discussion and Analysis of Financial Condition and Results of Operations (Continued) HP Financial Services Fiscal 2015 compared with Fiscal 2014 HPFS net revenue decreased by 8.1% (decreased 1.5% on a constant currency basis) in fiscal 2015 due primarily to unfavorable currency impacts led by weakness in the euro and lower asset management activity in customer buyouts. HPFS earnings from operations as a percentage of net revenue decreased by 0.2 percentage points in fiscal 2015 due primarily to decrease in gross margin while operating expense as a percentage of net revenue was flat in fiscal 2015 as compared to fiscal 2014. The decrease in gross margin was due to unfavorable currency impacts, lower margins in customer buyouts, and lower portfolio margin due to competitive pricing, the effects of which were partially offset by higher margins from asset recovery services. Operating expenses as a percentage of net revenue was flat as a result of lower SG&A expenses due primarily to lower field selling costs the effects of which were offset by size of the revenue decline. Fiscal 2014 compared with Fiscal 2013 HPFS net revenue decreased by 3.6% (decreased 3.3% on a constant currency basis) in fiscal 2014 due primarily to lower portfolio revenue from lower average portfolio assets and lower asset management activity, primarily in customer buyouts. HPFS earnings from operations as a percentage of net revenue increased by 0.1 percentage points in fiscal 2014. The increase was due primarily to an increase in gross margin, partially offset by an increase in operating expenses as a percentage of net revenue. The increase in gross margin was the result of a higher portfolio margin, primarily from lower bad debt expense and a lower cost of funds and improved margins in remarketing sales. The increase in operating expenses as a percentage of net revenue was due primarily to higher go-to-market investments. Financing Volume New financing volume, which represent the amount of financing provided to customers for equipment and related software and services, including intercompany activity, increased 1.2% in fiscal 2015 and 14.7% in fiscal 2014, respectively. The increase in both fiscal 2015 and 2014 was driven by higher financing associated with product sales and related services offerings. The increase in fiscal 2015 was partially offset by unfavorable currency impacts led by weakness in the euro. HP INC. AND SUBSIDIARIES Management's Discussion and Analysis of Financial Condition and Results of Operations (Continued) Portfolio Assets and Ratios The HPFS business model is asset intensive and uses certain internal metrics to measure its performance against other financial services companies, including a segment balance sheet that is derived from our internal management reporting system. The accounting policies used to derive HPFS amounts are substantially the same as those used by HP. However, intercompany loans and certain accounts that are reflected in the segment balances are eliminated in our Consolidated Financial Statements. The portfolio assets and ratios derived from the segment balance sheet for HPFS were as follows: (1)Intercompany activity is eliminated in consolidation. (2)Allowance for doubtful accounts for financing receivables includes both the short- and long-term portions. (3)Debt attributable to HPFS consists of intercompany equity that is treated as debt for segment reporting purposes, intercompany debt, and borrowing- and funding-related activity associated with HPFS and its subsidiaries. Debt attributable to HPFS totaled $10.7 billion at both October 31, 2015 and October 31, 2014. HPFS equity at both October 31, 2015 and October 31, 2014 was $1.5 billion. We believe the HPFS debt-to-equity ratio is comparable to that of other similar financing companies. At October 31, 2015 and October 31, 2014, HPFS cash and cash equivalents and short term investments were $589 million and $952 million, respectively. Net portfolio assets at October 31, 2015 increased 2% from October 31, 2014. The increase generally resulted from new financing volume partially offset by portfolio runoff and unfavorable currency impacts. HPFS recorded net bad debt expense and operating lease equipment reserves of $46 million, $40 million, and $50 million in fiscal 2015, 2014 and 2013, respectively. HP INC. AND SUBSIDIARIES Management's Discussion and Analysis of Financial Condition and Results of Operations (Continued) Corporate Investments (1)"NM" represents not meaningful. Fiscal 2015 compared with Fiscal 2014 The revenue decrease for fiscal 2015 was due primarily to the sale of IP related to the Palm acquisition in the prior-year period. The increase in the loss from operations for fiscal 2015 was due primarily to the sale of IP in the prior-year period and higher expenses from enterprise-related business incubation activities and HP Labs. Fiscal 2014 compared with Fiscal 2013 The revenue increase for fiscal 2014 was due primarily to the sale of IP related to the Palm acquisition. The decrease in the loss from operations for fiscal 2014 was due primarily to the sale of IP, the benefits of which were partially offset by higher expenses associated with enterprise-related business incubation activities, corporate strategy, HP Labs and global alliances. LIQUIDITY AND CAPITAL RESOURCES We use cash generated by operations as our primary source of liquidity. We believe that internally generated cash flows are generally sufficient to support our operating businesses, capital expenditures, restructuring activities, principal and interest payment of debt, income tax payments and the payment of stockholder dividends, in addition to investments and share repurchases. We are able to supplement this short-term liquidity, if necessary, with broad access to capital markets and credit facilities made available by various domestic and foreign financial institutions. Our access to capital markets may be constrained and our cost of borrowing may increase under certain business, market and economic conditions; however, our access to a variety of funding sources to meet our liquidity needs is designed to facilitate continued access to capital resources under all such conditions. Our liquidity is subject to various risks including the risks identified in the section entitled "Risk Factors" in Item 1A and market risks identified in the section entitled "Quantitative and Qualitative Disclosures about Market Risk" in Item 7A, which is incorporated herein by reference. Our cash balances are held in numerous locations throughout the world, with substantially all of those amounts held outside of the U.S. We utilize a variety of planning and financing strategies in an effort to ensure that our worldwide cash is available when and where it is needed. Our cash position remains strong, and we expect that our cash balances, anticipated cash flow generated from operations and access to capital markets will be sufficient to cover our expected near-term cash outlays. HP INC. AND SUBSIDIARIES Management's Discussion and Analysis of Financial Condition and Results of Operations (Continued) Amounts held outside of the U.S. are generally utilized to support non-U.S. liquidity needs, although a portion of those amounts may from time to time be subject to short-term intercompany loans into the U.S. Most of the amounts held outside of the U.S. could be repatriated to the U.S. but, under current law, some would be subject to U.S. federal income taxes, less applicable foreign tax credits. Repatriation of some foreign earnings is restricted by local law. Except for foreign earnings that are considered indefinitely reinvested outside of the U.S., we have provided for the U.S. federal tax liability on these earnings for financial statement purposes. Repatriation could result in additional income tax payments in future years. Where local restrictions prevent an efficient intercompany transfer of funds, our intent is that cash balances would remain outside of the U.S. and we would meet liquidity needs through ongoing cash flows, external borrowings, or both. We do not expect restrictions or potential taxes incurred on repatriation of amounts held outside of the U.S. to have a material effect on our overall liquidity, financial condition or results of operations. In connection with the Separation, we reviewed our capital structure during fiscal 2015 to ensure that each company, HP Inc. and Hewlett Packard Enterprise, would be well capitalized after the Separation. In October 2015, prior to the Separation, Hewlett Packard Enterprise completed its offering of $14.6 billion senior unsecured notes and we redeemed and paid $6.6 billion of U.S. Dollar Global Notes as a result of early extinguishment of debt. In connection with our ongoing operations and in part due to the Separation, we repaid a short-term loan of $3.5 billion, issued $18.2 billion and repaid $18.4 billion of commercial paper in fiscal 2015. On November 4, 2015, we incrementally redeemed and paid $2.1 billion U.S. Dollar Global Notes as part of the final settlement of the debt redemption issued as a part of the Separation. Liquidity Our cash and cash equivalents, total debt and available borrowing resources were as follows: (1)For more information on our available borrowing resources, see Note 13 to the Consolidated Financial Statements in Item 8, which is incorporated herein by reference. Our key cash flow metrics were as follows: HP INC. AND SUBSIDIARIES Management's Discussion and Analysis of Financial Condition and Results of Operations (Continued) Operating Activities Net cash provided by operating activities decreased by approximately $5.8 billion for fiscal 2015 as compared to fiscal 2014. The decrease was due primarily to lower cash generated from working capital management activities, payments for separation costs, lower cash receipts from contract manufacturers and financing receivables, lower net earnings in the current period, unfavorable currency impacts, as well as higher cash payments for prepaids and employee benefits. Net cash provided by operating activities increased by $0.7 billion for fiscal 2014 as compared to fiscal 2013, due primarily to improvements in working capital management. Our key working capital metrics were as follows: Days of sales outstanding in accounts receivable ("DSO") measures the average number of days our receivables are outstanding. DSO is calculated by dividing ending accounts receivable, net of allowance for doubtful accounts, by a 90-day average of net revenue. For fiscal 2015, the increase in DSO was due primarily to lower usage of cash discounts by our customers and longer standard payment terms for Aruba. For fiscal 2014, the decrease in DSO was due primarily to the impact of currency and the expansion of our factoring programs. Days of supply in inventory ("DOS") measures the average number of days from procurement to sale of our product. DOS is calculated by dividing ending inventory by a 90-day average of cost of goods sold. For fiscal 2015, the increase in DOS was due to higher inventory balance to support future sales levels. For fiscal 2014, the increase in DOS was due to a higher inventory balance in Personal Systems due in part to strategic and advanced buys. Days of purchases outstanding in accounts payable ("DPO") measures the average number of days our accounts payable balances are outstanding. DPO is calculated by dividing ending accounts payable by a 90-day average of cost of goods sold. For fiscal 2015, the increase in DPO was primarily the result of purchasing linearity and an extension of payment terms with our product suppliers. For fiscal 2014, the increase in DPO was primarily the result of an extension of payment terms with our product suppliers. The cash conversion cycle is the sum of DSO and DOS less DPO. Items which may cause the cash conversion cycle in a particular period to differ from a long-term sustainable rate include, but are not limited to, changes in business mix, changes in payment terms, extent of receivables factoring, seasonal trends and the timing of revenue recognition and inventory purchases within the period. Investing Activities Net cash used in investing activities increased by approximately $2.7 billion for fiscal 2015 as compared to fiscal 2014, due primarily to the acquisition of Aruba. Net cash used in investing activities HP INC. AND SUBSIDIARIES Management's Discussion and Analysis of Financial Condition and Results of Operations (Continued) was flat for fiscal 2014 as compared to fiscal 2013, due primarily to higher cash utilization for purchases of property, plant and equipment offset by cash generated from sales of available-for-sale securities. Financing Activities Net cash provided by financing activities was $1.3 billion in fiscal 2015 as compared to net cash used in financing activities of $6.6 billion in fiscal 2014. The change was due primarily to proceeds from the issuance of senior unsecured notes in October 2015 by Hewlett Packard Enterprise in principal amount of $14.6 billion and higher proceeds from issuance of commercial paper, partially offset by the repayment as a result of early debt extinguishment of $6.6 billion of U.S. Dollar Global Notes and higher repayment of commercial paper as compared to fiscal 2014. Net cash used in financing activities decreased by approximately $1.4 billion for fiscal 2014 as compared to fiscal 2013 due primarily to proceeds from the issuance of U.S. Dollar Global Notes in January 2014, partially offset by higher debt repayments and repurchases of common stock. For more information on our share repurchase programs, see Item 5 and Note 13 to the Consolidated Financial Statements in Item 8, which are incorporated herein by reference. Capital Resources Debt Levels We maintain debt levels that we establish through consideration of a number of factors, including cash flow expectations, cash requirements for operations, investment plans (including acquisitions), share repurchase activities, our cost of capital and targeted capital structure. Short-term debt decreased by $601 million and long-term debt increased by approximately $5.7 billion for fiscal 2015 as compared to fiscal 2014. The net increase in total debt was due primarily to issuance of senior unsecured notes in October 2015 by Hewlett Packard Enterprise in principal amount of $14.6 billion which includes of $14.0 billion fixed rate notes and $600 million of floating rate notes, partially offset by the payment as a result of early debt extinguishment of $6.6 billion in connection with the Separation, maturities of $2.5 billion of U.S. Dollar Global Notes and repayment of $3.5 billion of short-term loan. We also issued $18.2 billion and repaid $18.4 billion of commercial paper in fiscal 2015. On November 4, 2015, we paid $2.1 billion of U.S. Dollar Global Notes as part of the final settlement of the debt redemption issued as a part of the Separation. Short-term debt and long-term debt decreased by approximately $2.5 billion and $0.6 billion, respectively, for fiscal 2014 as compared to fiscal 2013. The net decrease in total debt was due primarily to maturities of debt. During fiscal 2014, we issued $2.0 billion of U.S. Dollar Global Notes under the 2012 Shelf Registration Statement which mature in 2019 and repaid $4.9 billion of U.S. Dollar Global Notes. We also issued $11.6 billion and repaid $11.5 billion of commercial paper in fiscal 2014. HP INC. AND SUBSIDIARIES Management's Discussion and Analysis of Financial Condition and Results of Operations (Continued) Our debt-to-equity ratio is calculated as the carrying amount of debt divided by total stockholders' equity. Our debt-to-equity ratio increased by 0.16x in fiscal 2015, due to an increase in total debt balances of $5.1 billion partially offset by an increase in stockholders' equity by $1.0 billion at the end of fiscal 2015. Our debt-to-equity ratio decreased by 0.10x in fiscal 2014, due to a decrease in total debt balances of $3.1 billion partially offset by a decrease in stockholders' equity by $0.5 billion at the end of fiscal 2014. Our weighted-average interest rate reflects the effective interest rate on our borrowings prevailing during the period and reflects the effect of interest rate swaps. For more information on our interest rate swaps, see Note 13 to the Consolidated Financial Statements in Item 8, which is incorporated herein by reference. Available Borrowing Resources We had the following resources available to obtain short- or long-term financing if we need additional liquidity: For more information on our available borrowings resources, see Note 13 to the Consolidated Financial Statements in Item 8, which is incorporated herein by reference. Credit Ratings Our credit risk is evaluated by major independent rating agencies based upon publicly available information as well as information obtained in our ongoing discussions with them. While we do not have any rating downgrade triggers that would accelerate the maturity of a material amount of our debt, previous downgrades have increased the cost of borrowing under our credit facilities, have reduced market capacity for our commercial paper and have required the posting of additional collateral under some of our derivative contracts. In addition, any further downgrade to our credit ratings by any rating agencies may further impact us in a similar manner, and, depending on the extent of any such downgrade, could have a negative impact on our liquidity and capital position. We can rely on alternative sources of funding, including drawdowns under our credit facilities, if necessary, to offset potential reductions in the market capacity for our commercial paper. HP INC. AND SUBSIDIARIES Management's Discussion and Analysis of Financial Condition and Results of Operations (Continued) CONTRACTUAL AND OTHER OBLIGATIONS The contractual and other obligations for HP (including Hewlett Packard Enterprise) as of October 31, 2015, were as follows: (1)Amounts represent the principal cash payments relating to our short-term and long-term debt and do not include any fair value adjustments, discounts or premiums. Subsequent to the Separation, HP Inc. expects the total future principal payments on debt to be approximately $8.7 billion. (2)Amounts represent the expected interest payments relating to our short-term and long-term debt. We have outstanding interest rate swap agreements accounted for as fair value hedges that have the economic effect of changing fixed interest rates associated with some of our U.S. Dollar Global Notes to variable interest rates. The impact of our outstanding interest rate swaps at October 31, 2015 was factored into the calculation of the future interest payments on debt. Subsequent to the Separation, HP Inc. expects the total future interest payments on debt to be approximately $2.9 billion. (3)Amounts represent the operating lease obligations net of total sublease income of $77 million. Subsequent to the Separation, HP Inc. expects the total remaining future minimum operating lease commitments to be approximately $367 million, net of sublease income of $118 million. (4)Purchase obligations include agreements to purchase goods or services that are enforceable and legally binding on us and that specify all significant terms, including fixed or minimum quantities to be purchased; fixed, minimum or variable price provisions; and the approximate timing of the transaction. These purchase obligations are related principally to inventory and other items. Purchase obligations exclude agreements that are cancelable without penalty. Purchase obligations also exclude open purchase orders that are routine arrangements entered into in the ordinary course of business as they are difficult to quantify in a meaningful way. Even though open purchase orders are considered enforceable and legally binding, the terms generally allow us the option to cancel, reschedule, and adjust terms based on our business needs prior to the delivery of goods or performance of services. Subsequent to the Separation, HP Inc. expects the total remaining future unconditional purchase obligations to be approximately $915 million. (5)Retirement and Post-Retirement Benefit Plan Contributions. As of October 31, 2015, HP (including Hewlett Packard Enterprise) expects to contribute approximately $384 million to its non-U.S. pension plans, approximately $37 million to cover benefit payments to U.S. non-qualified plan participants and approximately $46 million to cover benefit claims for HP's post-retirement benefit plans in fiscal 2016. Subsequent to the Separation, HP Inc. expects to contribute approximately HP INC. AND SUBSIDIARIES Management's Discussion and Analysis of Financial Condition and Results of Operations (Continued) $18 million to its non-U.S. pension plans, approximately $36 million to cover benefit payments to U.S. non-qualified plan participants and approximately $43 million to cover benefit claims for HP's post-retirement benefit plans. Our policy is to fund our pension plans so that we meet at least the minimum contribution requirements, as established by local government, funding and taxing authorities. Expected contributions and payments to our pension and post-retirement benefit plans are excluded from the contractual obligations table because they do not represent contractual cash outflows as they are dependent on numerous factors which may result in a wide range of outcomes. For more information on our retirement and post-retirement benefit plans, see Note 4 to the Consolidated Financial Statements in Item 8, which is incorporated herein by reference. (6)Restructuring Plans. As of October 31, 2015, HP (including Hewlett Packard Enterprise) expects future cash payments of approximately $3.2 billion in connection with our approved restructuring plans which includes $1.3 billion expected to be paid in fiscal 2016 with the remaining approximately $1.9 billion cash payments to be made through fiscal 2025. Subsequent to the Separation, HP Inc. expects future cash payments of approximately $280 million in connection with our approved restructuring plans which includes $90 million expected to be paid in fiscal 2016 with the remaining approximately $190 million cash payments to be made through fiscal 2025. Payments for restructuring have been excluded from the contractual obligations table, because they do not represent contractual cash outflows and there is uncertainty as to the timing of these payments. For more information on our restructuring activities, see Note 3 to the Consolidated Financial Statements in Item 8, which is incorporated herein by reference. (7)Separation Costs. As of October 31, 2015, HP (including Hewlett Packard Enterprise) expects future cash payments of approximately $750 million in connection with our separation charges and net foreign tax payments, which are expected to be paid in fiscal 2016, with subsequent tax credit amounts expected over later years. As of October 31, 2015, we also expect separation-related capital expenditures of approximately $60 million in fiscal 2016. Subsequent to the Separation, HP Inc. expects future cash payments of approximately $180 million in connection with our separation charges and net foreign tax payments, which are expected to be paid in fiscal 2016, with subsequent tax credit amounts expected over later years. As of October 31, 2015, HP Inc. also expects separation-related capital expenditures of approximately $30 million in fiscal 2016. Payments for separation costs have been excluded from the contractual obligations table, because they do not represent contractual cash outflows and there is uncertainty as to the timing of these payments. (8)Uncertain Tax Positions. As of October 31, 2015, we had approximately $3.7 billion of recorded liabilities and related interest and penalties pertaining to uncertain tax positions. These liabilities and related interest and penalties include $15 million expected to be paid within one year. For the remaining amount, we are unable to make a reasonable estimate as to when cash settlement with the tax authorities might occur due to the uncertainties related to these tax matters. Payments of these obligations would result from settlements with taxing authorities. For more information on our uncertain tax positions, see Note 6 to the Consolidated Financial Statements in Item 8, which is incorporated herein by reference. OFF-BALANCE SHEET ARRANGEMENTS As part of our ongoing business, we have not participated in transactions that generate material relationships with unconsolidated entities or financial partnerships, such as entities often referred to as HP INC. AND SUBSIDIARIES Management's Discussion and Analysis of Financial Condition and Results of Operations (Continued) structured finance or special purpose entities, established for the purpose of facilitating off-balance sheet arrangements or other contractually narrow or limited purposes. We have third-party short-term financing arrangements intended to facilitate the working capital requirements of certain customers. The total aggregate maximum capacity of the financing arrangements was $3.3 billion as of October 31, 2015, including an aggregate maximum capacity of $1.4 billion in non-recourse financing arrangements and an aggregate maximum capacity of $1.9 billion in partial-recourse facilities. For more information on our third-party revolving short-term financing arrangements, see Note 7 to the Consolidated Financial Statements in Item 8, which is incorporated herein by reference.

<s>[INST] Management's Discussion and Analysis of Financial Condition and Results of Operations This Management's Discussion and Analysis of Financial Condition and Results of Operations ("MD&A") is organized as follows: HP Separation Transaction. A discussion of the separation of Hewlett Packard Enterprise, HewlettPackard Company's former enterprise technology infrastructure, software, services and financing businesses. Overview. A discussion of our business and overall analysis of financial and other highlights affecting the company to provide context for the remainder of MD&A. The overview analysis compares fiscal 2015 to fiscal 2014. Critical Accounting Policies and Estimates. A discussion of accounting policies and estimates that we believe are important to understanding the assumptions and judgments incorporated in our reported financial results. Results of Operations. An analysis of our financial results comparing fiscal 2015 to fiscal 2014 and fiscal 2014 to fiscal 2013. A discussion of the results of operations at the consolidated level is followed by a more detailed discussion of the results of operations by segment. Liquidity and Capital Resources. An analysis of changes in our cash flows and a discussion of our financial condition and liquidity. Contractual and Other Obligations. An overview of contractual obligations, retirement and postretirement benefit plan funding, restructuring plans, separation costs, uncertain tax positions and offbalance sheet arrangements. We intend the discussion of our financial condition and results of operations that follows to provide information that will assist the reader in understanding our Consolidated Financial Statements, the changes in certain key items in those financial statements from year to year, and the primary factors that accounted for those changes, as well as how certain accounting principles, policies and estimates affect our Consolidated Financial Statements. This discussion should be read in conjunction with our Consolidated Financial Statements and the related notes that appear elsewhere in this document. HP Separation Transaction On November 1, 2015 (the "Distribution Date"), we completed the separation of Hewlett Packard Enterprise, HewlettPackard Company's former enterprise technology infrastructure, software, services and financing businesses (the "Separation"). In connection with the Separation, HewlettPackard Company changed its name to HP Inc. On November 1, 2015, each of our stockholders of record as of the close of business on October 21, 2015 (the "Record Date") received one share of Hewlett Packard Enterprise common stock for every one share of our common stock held as of the Record Date. We distributed a total of approximately 1.8 billion shares of Hewlett Packard Enterprise common stock to our stockholders. Hewlett Packard Enterprise is now an independent public company trading on the New York Stock Exchange ("NYSE") under the symbol "HPE". After the Separation, we do not beneficially own any shares of Hewlett Packard Enterprise common stock. HP INC. AND SUBSIDIARIES Management's Discussion and Analysis of Financial Condition and Results of Operations (Continued) The process of completing the Separation was highly complex and involved significant costs and expenses. Accordingly, we incurred separation costs and foreign tax expenses associated with separating into two companies. In fiscal 2015, we recorded nonrecurring separation costs and net foreign tax expenses of $1.6 billion, which were primarily related to thirdparty consulting, contractor fees and other incremental costs directly associated with the separation process. We expect total separation charges and net foreign tax expenses to be approximately $180 million in fiscal 2016. Additionally, the separation into two independent companies is expected to result in total dissynergies of approximately $400 million to $450 million annually, which costs are primarily associated with corporate functions such as finance, legal, IT, real estate and human resources. Such dissynergies are expected to be divided approximately equally between HP Inc. and Hewlett Packard Enterprise. We recorded a deferred tax asset on these costs and expenses as they were incurred through fiscal 2015. We expect a portion of these deferred tax assets associated with separation costs and expenses will be eliminated, [/INST] Negative. </s>

HP INC

2016-12-15

2016-10-31

ITEM 7. Management’s Discussion and Analysis of Financial Condition and Results of Operations. This Management’s Discussion and Analysis of Financial Condition and Results of Operations (“MD&A”) is organized as follows: • HP Inc. Separation Transaction. A discussion of the separation of Hewlett Packard Enterprise Company, HP Inc.’s former enterprise technology infrastructure, software, services and financing businesses. • Overview. A discussion of our business and other highlights affecting the company to provide context for the remainder of this MD&A. • Critical Accounting Policies and Estimates. A discussion of accounting policies and estimates that we believe are important to understanding the assumptions and judgments incorporated in our reported financial results. • Results of Operations. An analysis of our continuing financial results comparing fiscal year 2016 to fiscal year 2015 and fiscal year 2015 to fiscal year 2014. A discussion of the results of continuing operations is followed by a more detailed discussion of the results of operations by segment. • Liquidity and Capital Resources. An analysis of changes in our cash flows and a discussion of our liquidity and continuing financial condition. • Contractual and Other Obligations. An overview of contractual obligations, retirement and post-retirement benefit plan contributions, restructuring plans, uncertain tax positions and off-balance sheet arrangements of our continuing operations and separation costs. We intend the discussion of our continuing financial condition and results of continuing operations that follows to provide information that will assist the reader in understanding our Consolidated Financial Statements, the changes in certain key items in those financial statements from year to year, and the primary factors that accounted for those changes, as well as how certain accounting principles, policies and estimates affect our Consolidated Financial Statements. This discussion should be read in conjunction with our Consolidated Financial Statements and the related notes that appear elsewhere in this document. HP Inc. Separation Transaction On November 1, 2015 (the “Distribution Date”), we completed the separation of Hewlett Packard Enterprise Company (“Hewlett Packard Enterprise”), Hewlett-Packard Company’s former enterprise technology infrastructure, software, services and financing businesses (the “Separation”). In connection with the Separation, Hewlett-Packard Company changed its name to HP Inc. (“HP”). On the Distribution Date, each of our stockholders of record as of the close of business on October 21, 2015 (the “Record Date”) received one share of Hewlett Packard Enterprise common stock for every one share of our common stock held as of the Record Date. We distributed a total of approximately 1.8 billion shares of Hewlett Packard Enterprise common stock to our stockholders. Hewlett Packard Enterprise is an independent public company trading on the New York Stock Exchange (“NYSE”) under the symbol “HPE”. After the Separation, we do not beneficially own any shares of Hewlett Packard Enterprise common stock. In connection with the Separation, we and Hewlett Packard Enterprise have entered into a separation and distribution agreement as well as various other agreements that provide a framework for the relationships between HP and Hewlett Packard Enterprise going forward, including among others a tax matters agreement, an employee matters agreement, a transition service agreement, a real estate matters agreement, a master commercial agreement and an information technology service agreement. HP INC. AND SUBSIDIARIES Management’s Discussion and Analysis of Financial Condition and Results of Operations (Continued) OVERVIEW We are a leading global provider of personal computing and other access devices, imaging and printing products, and related technologies, solutions, and services. We sell to individual consumers, small- and medium-sized businesses and large enterprises, including customers in the government, health, and education sectors. We have three segments for financial reporting purposes: Personal Systems, Printing and Corporate Investments. The Personal Systems segment offers Commercial personal computers (“PCs”), Consumer PCs, workstations, thin clients, Commercial tablets and mobility devices, retail point-of-sale systems, displays and other related accessories, software, support, and services for the commercial and consumer markets. The Printing segment provides Consumer and Commercial printer hardware, Supplies, media, solutions and services, as well as scanning devices. Corporate Investments include HP Labs and certain business incubation projects. • In Personal Systems, our strategic focus is on profitable growth through improved market segmentation with respect to enhanced innovation in multi-operating systems, multi-architecture, geography, customer segments and other key attributes. Additionally, HP is investing in premium and mobility form factors such as convertible notebooks, detachable notebooks, and commercial tablets and mobility devices in order to meet customer preference for mobile, thinner and lighter devices. We expect a decrease in the rate of the market decline and we believe that we are well positioned due to our competitive product lineup. • In Printing, our strategic focus is on business printing, a shift to contractual solutions and graphics. Business printing includes delivering solutions to SMB and enterprise customers, such as multi-function and PageWide printers, including our JetIntelligence lineup of LaserJet printers. The shift to contractual solutions includes an increased focus on Managed Print Services and Instant Ink, which presents strong aftermarket supplies opportunities. In the graphics space, we are focused on innovations such as our Indigo and Latex product offerings. We plan to continue to focus on shifting the mix in the installed base to higher value units and expanding our innovative ink, laser and graphics and 3D printing programs. We continue to execute on our key initiatives of focusing on products targeted at high usage categories and introducing new revenue delivery models. Our Ink in the Office initiative is continuing to shift the installed base to more valuable units. In the commercial market, our focus is on placing higher value printer units which offer positive annuity of toner and ink, the design and deployment of A3 products and solutions, accelerating growth in graphic solutions products, and launching and developing our first 3D printers. During the third quarter of fiscal year 2016, we announced our decision to make a one-time investment over time to reduce the level of supplies inventory across the channels. This change in the Supplies sales model supports our strategy of maintaining a more consistent value proposition by shifting from a push model to a pull model driven by market demand, and allows for less price variability. We continue to experience challenges that are representative of trends and uncertainties that may affect our business and results of operations. One set of challenges relates to dynamic and accelerating market trends such as the decline in the PC device market and home printing. A second set of challenges relates to changes in the competitive landscape. Our primary competitors are exerting increased competitive pressure in targeted areas and are entering new markets, our emerging competitors are introducing new technologies and business models, and our alliance partners in some businesses are increasingly becoming our competitors in others. A third set of challenges relates to business model changes and our go-to-market execution. • In Personal Systems, we are witnessing soft demand in the PC market as customers hold onto their PCs longer, thereby extending PC refresh cycles. Demand for PCs is being impacted by weaker macroeconomic conditions and currency depreciation in Latin America, Canada and certain Asian and European markets. As such, we anticipate continued market headwinds. • In Printing, we are experiencing the impact of demand challenges in consumer and commercial markets. We are also experiencing an overall competitive pricing environment and have yet to see evidence of a broad move for our Japanese competitors to be less aggressive given the strength of the yen. We obtain a number of components from single sources due to technology, availability, price, quality or other considerations. For instance, we source laser printer engines and laser toner cartridges from Canon. Any decision by either party to not renew our agreement with Canon or to limit or reduce the scope of the agreement could adversely affect our net revenue from LaserJet products; however, we have a long-standing business relationship with Canon and do not anticipate non-renewal of this agreement. We may also face challenges as a result of the June 23, 2016 referendum by British voters to exit the European Union (commonly known as “Brexit”). The outcome of Brexit and its impact on our business cannot be known until the terms and HP INC. AND SUBSIDIARIES Management’s Discussion and Analysis of Financial Condition and Results of Operations (Continued) timing of the United Kingdom’s exit are clearer. Until that time, we may face various Brexit-related challenges that may include uncertainty in the markets, volatility in exchange rates and weaker macroeconomic conditions. To address these challenges, we continue to pursue innovation with a view towards developing new products and services aligned with generating market demand and meeting the needs of our customers and partners. In addition, we need to continue to improve our operations, with a particular focus on enhancing our end-to-end processes and efficiencies. We also need to continue to optimize our sales coverage models, align our sales incentives with our strategic goals, improve channel execution, strengthen our capabilities in our areas of strategic focus, and develop and capitalize on market opportunities. For a further discussion of trends, uncertainties and other factors that could impact our continuing operating results, see the section entitled “Risk Factors” in Item 1A in this Annual Report on Form 10-K. CRITICAL ACCOUNTING POLICIES AND ESTIMATES General The Consolidated Financial Statements of HP are prepared in accordance with United States (“U.S.”) generally accepted accounting principles (“GAAP”), which require management to make estimates, judgments and assumptions that affect the reported amounts of assets, liabilities, net revenue and expenses, and the disclosure of contingent liabilities. Management bases its estimates on historical experience and on various other assumptions that it believes to be reasonable under the circumstances, the results of which form the basis for making judgments about the carrying amount of assets and liabilities that are not readily apparent from other sources. Management has discussed the development, selection and disclosure of these estimates with the Audit Committee of HP’s Board of Directors. Management believes that the accounting estimates employed and the resulting amounts are reasonable; however, actual results may differ from these estimates. Making estimates and judgments about future events is inherently unpredictable and is subject to significant uncertainties, some of which are beyond our control. Should any of these estimates and assumptions change or prove to have been incorrect, it could have a material impact on our results of operations, financial position and cash flows. A summary of significant accounting policies is included in Note 1, “Overview and Summary of Significant Accounting Policies” to the Consolidated Financial Statements in Item 8, which is incorporated herein by reference. An accounting policy is deemed to be critical if it requires an accounting estimate to be made based on assumptions about matters that are highly uncertain at the time the estimate is made, if different estimates reasonably could have been used, or if changes in the estimate that are reasonably possible could materially impact the financial statements. Management believes the following critical accounting policies reflect the significant estimates and assumptions used in the preparation of the Consolidated Financial Statements. Revenue Recognition We recognize revenue when persuasive evidence of an arrangement exists, delivery has occurred or services are rendered, the sales price or fee is fixed or determinable and collectability is reasonably assured, as well as when other revenue recognition principles are met, including industry-specific revenue recognition guidance. We enter into contracts to sell our products and services, and while many of our sales agreements contain standard terms and conditions, there are agreements we enter into which contain non-standard terms and conditions. Further, many of our arrangements include multiple elements. As a result, significant contract interpretation may be required to determine the appropriate accounting, including the identification of deliverables considered to be separate units of accounting, the allocation of the transaction price among elements in the arrangement and the timing of revenue recognition for each of those elements. We recognize revenue for delivered elements as separate units of accounting when the delivered elements have standalone value to the customer. For elements with no standalone value, we recognize revenue consistent with the pattern of the delivery of the final deliverable. If the arrangement includes a customer-negotiated refund or return right or other contingency relative to the delivered items and the delivery and performance of the undelivered items is considered probable and substantially within our control, the delivered element constitutes a separate unit of accounting. In arrangements with combined units of accounting, changes in the allocation of the transaction price among elements may impact the timing of revenue recognition for the contract but will not change the total revenue recognized for the contract. HP INC. AND SUBSIDIARIES Management’s Discussion and Analysis of Financial Condition and Results of Operations (Continued) We establish the selling prices used for each deliverable based on vendor specific objective evidence (“VSOE”) of selling price, if available, third-party evidence (“TPE”), if VSOE of selling price is not available, or estimated selling price (“ESP”), if neither VSOE of selling price nor TPE is available. We establish VSOE of selling price using the price charged for a deliverable when sold separately and, in rare instances, using the price established by management having the relevant authority. We evaluate TPE of selling price by reviewing largely similar and interchangeable competitor products or services in standalone sales to similarly situated customers. ESP is established based on management’s judgment considering internal factors such as margin objectives, pricing practices and controls, customer segment pricing strategies and the product life cycle. Consideration is also given to market conditions such as competitor pricing strategies and industry technology life cycles. We may modify or develop new go-to-market practices in the future, which may result in changes in selling prices, impacting both VSOE of selling price and ESP. In most arrangements with multiple elements, the transaction price is allocated to the individual units of accounting at inception of the arrangement based on their relative selling price. However, the aforementioned factors may result in a different allocation of the transaction price to deliverables in multiple element arrangements entered into in future periods. This may change the pattern and timing of revenue recognition for identical arrangements executed in future periods, but will not change the total revenue recognized for any given arrangement. We reduce revenue for customer and distributor programs and incentive offerings, including price protection, rebates, promotions, other volume-based incentives and expected returns. Future market conditions and product transitions may require us to take actions to increase customer incentive offerings, possibly resulting in an incremental reduction of revenue at the time the incentive is offered. For certain incentive programs, we estimate the number of customers expected to redeem the incentive based on historical experience and the specific terms and conditions of the incentive. For hardware products, we recognize revenue generated from direct sales to end customers and indirect sales to channel partners (including resellers, distributors and value-added solution providers) when the revenue recognition criteria are satisfied. For indirect sales to channel partners, we recognize revenue at the time of delivery when the channel partner has economic substance apart from HP and HP has completed its obligations related to the sale. We recognize revenue from fixed-price support or maintenance contracts ratably over the contract period. Warranty We accrue the estimated cost of product warranties at the time we recognize revenue. We evaluate our warranty obligations on a product group basis. Our standard product warranty terms generally include post-sales support and repairs or replacement of a product at no additional charge for a specified period of time. While we engage in extensive product quality programs and processes, including actively monitoring and evaluating the quality of our component suppliers, we base our estimated warranty obligation on contractual warranty terms, repair costs, product call rates, average cost per call, current period product shipments and ongoing product failure rates, as well as specific product class failure outside of our baseline experience. Warranty terms generally range from 90 days to three years for parts, labor and onsite services, depending upon the product. Over the last three fiscal years, the annual warranty expense and actual warranty costs have averaged approximately 2.2% and 2.5% of annual net revenue, respectively. Restructuring and Other Charges We have engaged in restructuring actions which require management to estimate the timing and amount of severance and other employee separation costs for workforce reduction and enhanced early retirement programs, fair value of assets made redundant or obsolete, and the fair value of lease cancellation and other exit costs. We accrue for severance and other employee separation costs under these actions when it is probable that benefits will be paid and the amount is reasonably estimable. The rates used in determining severance accruals are based on existing plans, historical experiences and negotiated settlements. Other charges include non-recurring costs that are distinct from ongoing operational costs such as information technology costs incurred in connection with the Separation. For a full description of our restructuring actions, refer to our discussions of restructuring in “Results of Operations” below and in Note 4, “Restructuring and Other Charges” to the Consolidated Financial Statements in Item 8, which are incorporated herein by reference. Retirement and Post-Retirement Benefits Our pension and other post-retirement benefit costs and obligations depend on various assumptions. Our major assumptions relate primarily to discount rates, mortality rates, expected increases in compensation levels and the expected long- HP INC. AND SUBSIDIARIES Management’s Discussion and Analysis of Financial Condition and Results of Operations (Continued) term return on plan assets. The discount rate assumption is based on current investment yields of high-quality fixed-income securities with maturities similar to the expected benefits payment period. Mortality rates help predict the expected life of plan participants and are based on a historical demographic study of the plan. The expected increase in the compensation levels assumption reflects our long-term actual experience and future expectations. The expected long-term return on plan assets is determined based on asset allocations, historical portfolio results, historical asset correlations and management’s expected returns for each asset class. We evaluate our expected return assumptions annually including reviewing current capital market assumptions to assess the reasonableness of the expected long-term return on plan assets. We update the expected long-term return on assets when we observe a sufficient level of evidence that would suggest the long-term expected return has changed. In any fiscal year, significant differences may arise between the actual return and the expected long-term return on plan assets. Historically, differences between the actual return and expected long-term return on plan assets have resulted from changes in target or actual asset allocation, short-term performance relative to expected long-term performance, and to a lesser extent, differences between target and actual investment allocations, the timing of benefit payments compared to expectations, and the use of derivatives intended to effect asset allocation changes or hedge certain investment or liability exposures. For the recognition of net periodic benefit cost, the calculation of the expected long-term return on plan assets uses the fair value of plan assets as of the beginning of the fiscal year unless updated as a result of interim remeasurement. Our major assumptions vary by plan, and the weighted-average rates used are set forth in Note 5, “Retirement and Post-Retirement Benefit Plans” to the Consolidated Financial Statements in Item 8, which is incorporated herein by reference. The following table provides the impact a change of 25 basis points in each of the weighted-average assumptions of the discount rate, expected increase in compensation levels and expected long-term return on plan assets would have had on our net periodic benefit cost for fiscal year 2016: Taxes on Earnings We calculate our current and deferred tax provisions based on estimates and assumptions that could differ from the final positions reflected in our income tax returns. We adjust our current and deferred tax provisions based on income tax returns which are generally filed in the third or fourth quarters of the subsequent fiscal year. We recognize deferred tax assets and liabilities for the expected tax consequences of temporary differences between the tax bases of assets and liabilities and their reported amounts using enacted tax rates in effect for the year in which we expect the differences to reverse. We record a valuation allowance to reduce deferred tax assets to the amount that we are more likely than not to realize. In determining the need for a valuation allowance, we consider future market growth, forecasted earnings, future taxable income, the mix of earnings in the jurisdictions in which we operate and prudent and feasible tax planning strategies. In the event we were to determine that it is more likely than not that we will be unable to realize all or part of our deferred tax assets in the future, we would increase the valuation allowance and recognize a corresponding charge to earnings or other comprehensive income in the period in which we make such a determination. Likewise, if we later determine that we are more likely than not to realize the deferred tax assets, we would reverse the applicable portion of the previously recognized valuation allowance. In order for us to realize our deferred tax assets, we must be able to generate sufficient taxable income in the jurisdictions in which the deferred tax assets are located. Our effective tax rate includes the impact of certain undistributed foreign earnings for which we have not provided United States federal taxes because we plan to reinvest such earnings indefinitely outside the United States. We plan distributions of foreign earnings based on projected cash flow needs as well as the working capital and long-term investment requirements of our foreign subsidiaries and our domestic operations. Based on these assumptions, we estimate the amount we expect to indefinitely invest outside the United States and the amounts we expect to distribute to the United States and provide the United HP INC. AND SUBSIDIARIES Management’s Discussion and Analysis of Financial Condition and Results of Operations (Continued) States federal taxes due on amounts expected to be distributed to the United States. Further, as a result of certain employment actions and capital investments we have undertaken, income from manufacturing activities in certain jurisdictions is subject to reduced tax rates and, in some cases, is wholly exempt from taxes for fiscal years through 2027. Material changes in our estimates of cash, working capital and long-term investment requirements in the various jurisdictions in which we do business could impact how future earnings are repatriated to the United States, and our related future effective tax rate. We are subject to income taxes in the United States and approximately 58 other countries, and we are subject to routine corporate income tax audits in many of these jurisdictions. We believe that positions taken on our tax returns are fully supported, but tax authorities may challenge these positions, which may not be fully sustained on examination by the relevant tax authorities. Accordingly, our income tax provision includes amounts intended to satisfy assessments that may result from these challenges. Determining the income tax provision for these potential assessments and recording the related effects requires management judgments and estimates. The amounts ultimately paid on resolution of an audit could be materially different from the amounts previously included in our income tax provision and, therefore, could have a material impact on our income tax provision, net income and cash flows. Our accrual for uncertain tax positions is attributable primarily to uncertainties concerning the tax treatment of our international operations, including the allocation of income among different jurisdictions, intercompany transactions and related interest. For a further discussion on taxes on earnings, refer to Note 7, “Taxes on Earnings” to the Consolidated Financial Statements in Item 8, which is incorporated herein by reference. Inventory We state our inventory at the lower of cost or market on a first-in, first-out basis. We make adjustments to reduce the cost of inventory to its net realizable value at the product group level for estimated excess or obsolescence. Factors influencing these adjustments include changes in demand, technological changes, product life cycle and development plans, component cost trends, product pricing, physical deterioration and quality issues. Goodwill We review goodwill for impairment annually during our fourth quarter and whenever events or changes in circumstances indicate the carrying amount of goodwill may not be recoverable. We can opt to perform a qualitative assessment to test a reporting unit’s goodwill for impairment or we can directly perform the two-step impairment test. Based on the qualitative assessment, if we determine that the fair value of a reporting unit is more likely than not (i.e., a likelihood of more than 50 percent) to be less than its carrying amount, the two-step impairment test will be performed. In the first step of the impairment test, we compare the fair value of each reporting unit to its carrying amount with the fair values derived most significantly from the income approach, and to a lesser extent, the market approach. Under the income approach, we estimate the fair value of a reporting unit based on the present value of estimated future cash flows. We base cash flow projections on management’s estimates of revenue growth rates and operating margins, taking into consideration industry and market conditions. We base the discount rate on the weighted-average cost of capital adjusted for the relevant risk associated with business-specific characteristics and the uncertainty related to the reporting unit’s ability to execute on the projected cash flows. Under the market approach, we estimate fair value based on market multiples of revenue and earnings derived from comparable publicly-traded companies with similar operating and investment characteristics as the reporting unit. We weight the fair value derived from the market approach depending on the level of comparability of these publicly-traded companies to the reporting unit. When market comparables are not meaningful or not available, we estimate the fair value of a reporting unit using only the income approach. If the fair value of a reporting unit exceeds the carrying amount of the net assets assigned to that reporting unit, goodwill is not impaired and no further testing is required. If the fair value of the reporting unit is less than its carrying amount, then we perform the second step of the goodwill impairment test to measure the amount of impairment loss, if any. In the second step, we measure the reporting unit’s assets, including any unrecognized intangible assets, liabilities and non-controlling interests at fair value in a hypothetical analysis to calculate the implied fair value of goodwill for the reporting unit in the same manner as if the reporting unit was being acquired in a business combination. If the implied fair value of the reporting unit’s goodwill is less than its carrying amount, the difference is recorded as an impairment loss. Our annual goodwill impairment analysis, performed using the qualitative assessment option as of the first day of the fourth quarter of fiscal year 2016, resulted in a conclusion that it was more likely than not that the fair value of our reporting HP INC. AND SUBSIDIARIES Management’s Discussion and Analysis of Financial Condition and Results of Operations (Continued) units exceeded their respective carrying values. As a result, we concluded that the first step of the goodwill impairment test was not necessary. Fair Value of Derivative Instruments We use derivative instruments to manage a variety of risks, including risks related to foreign currency exchange rates and interest rates. We use forwards, swaps and at times, options to hedge certain foreign currency and interest rate exposures. We do not use derivative instruments for speculative purposes. As of October 31, 2016, the gross notional value of our derivative portfolio was $17.9 billion. Assets and liabilities related to derivative instruments are measured at fair value, and were $325 million and $97 million, respectively as of October 31, 2016. Fair value is the price we would receive to sell an asset or pay to transfer a liability in an orderly transaction between market participants at the measurement date. In the absence of active markets for the identical assets or liabilities, such measurements involve developing assumptions based on market observable data and, in the absence of such data, internal information that is consistent with what market participants would use in a hypothetical transaction that occurs at the measurement date. The determination of fair value often involves significant judgments about assumptions such as determining an appropriate discount rate that factors in both risk and liquidity premiums, identifying the similarities and differences in market transactions, weighting those differences accordingly and then making the appropriate adjustments to those market transactions to reflect the risks specific to the asset or liability being valued. We generally use industry standard valuation models to measure the fair value of our derivative positions. When prices in active markets are not available for the identical asset or liability, we use industry standard valuation models to measure fair value. Where applicable, these models project future cash flows and discount the future amounts to present value using market-based observable inputs, including interest rate curves, HP and counterparty credit risk, foreign currency exchange rates, and forward and spot prices. For a further discussion on fair value measurements and derivative instruments, refer to Note 10, “Fair Value” and Note 11, “Financial Instruments”, respectively, to the Consolidated Financial Statements in Item 8, which are incorporated herein by reference. Loss Contingencies We are involved in various lawsuits, claims, investigations and proceedings including those consisting of intellectual property (“IP”), commercial, securities, employment, employee benefits and environmental matters that arise in the ordinary course of business. We record a liability when we believe that it is both probable that a liability has been incurred and the amount of loss can be reasonably estimated. Significant judgment is required to determine both the probability of having incurred a liability and the estimated amount of the liability. We review these matters at least quarterly and adjust these liabilities to reflect the impact of negotiations, settlements, rulings, advice of legal counsel and other updated information and events, pertaining to a particular case. Pursuant to the separation and distribution agreement, we share responsibility with Hewlett Packard Enterprise for certain matters, as discussed in Note 15, “Litigation and Contingencies” to the Consolidated Financial Statements in Item 8, which is incorporated herein by reference, and Hewlett Packard Enterprise has agreed to indemnify us in whole or in part with respect to certain matters. Based on our experience, we believe that any damage amounts claimed in the specific litigation and contingencies matters further discussed in Note 15, “Litigation and Contingencies”, are not a meaningful indicator of HP’s potential liability. Litigation is inherently unpredictable. However, we believe we have valid defenses with respect to legal matters pending against us. Nevertheless, cash flows or results of operations could be materially affected in any particular period by the resolution of one or more of these contingencies. We believe we have recorded adequate provisions for any such matters and, as of October 31, 2016, it was not reasonably possible that a material loss had been incurred in excess of the amounts recognized in our financial statements. RECENT ACCOUNTING PRONOUNCEMENTS For a summary of recent accounting pronouncements applicable to our consolidated financial statements see Note 1, “Overview and Summary of Significant Accounting Policies” to the Consolidated Financial Statements in Item 8, which is incorporated herein by reference. RESULTS OF OPERATIONS HP INC. AND SUBSIDIARIES Management’s Discussion and Analysis of Financial Condition and Results of Operations (Continued) Revenue from our international operations has historically represented, and we expect will continue to represent, a majority of our overall net revenue. As a result, our net revenue growth has been impacted, and we expect it will continue to be impacted, by fluctuations in foreign currency exchange rates. In order to provide a framework for assessing performance excluding the impact of foreign currency fluctuations, we supplementally present the year-over-year percentage change in net revenue on a constant currency basis, which assumes no change in foreign currency exchange rates from the prior-year period and does not adjust for any repricing or demand impacts from changes in foreign currency exchange rates. This information is provided so that net revenue can be viewed with and without the effect of fluctuations in foreign currency exchange rates, which is consistent with how management evaluates our net revenue results and trends. This constant currency disclosure is provided in addition to, and not as a substitute for, the year-over-year percentage change in net revenue on a GAAP basis. Other companies may calculate and define similarly labeled items differently, which may limit the usefulness of this measure for comparative purposes. Results of operations in dollars and as a percentage of net revenue were as follows: Net Revenue In fiscal year 2016, total net revenue from continuing operations decreased 6.3% (decreased 2% on a constant currency basis) as compared with fiscal year 2015. Net revenue from the United States increased 1.7% to $18.0 billion, while net revenue from outside of the United States decreased 10.4% to $30.2 billion. The primary factors contributing to the net revenue decline were unfavorable currency impacts, weak market demand, competitive pricing pressures and the change in the Supplies sales model. The net revenue decline was driven by decline in supplies, commercial and consumer printers, commercial and consumer desktops and consumer notebooks, partially offset by growth in commercial notebooks. In fiscal year 2015, total net revenue from continuing operations decreased 9.2% (decreased 4.7% on a constant currency basis) as compared with fiscal year 2014. Net revenue from the United States decreased 2.6% to $17.7 billion, while net revenue from outside of the United States decreased 12.2% to $33.7 billion. The primary factors contributing to the net revenue decline were unfavorable currency impacts, particularly in EMEA, weak market demand and competitive pricing pressures. The net revenue decline was driven by desktops and supplies, partially offset by growth in notebooks and graphics products. A more detailed discussion of the factors contributing to the changes in segment net revenue is included under “Segment Information” below. HP INC. AND SUBSIDIARIES Management’s Discussion and Analysis of Financial Condition and Results of Operations (Continued) Gross Margin Our gross margin from continuing operations decreased to 18.7% for fiscal year 2016 compared with 19.3% for fiscal year 2015. The decline in gross margin performance was primarily due to unfavorable currency impacts, partially offset by operational improvements. Our gross margin from continuing operations decreased to 19.3% for fiscal year 2015 compared with 19.8% for fiscal year 2014. The primary factors impacting gross margin performance were competitive pricing environment and unfavorable currency impacts, partially offset by favorable component costs in Personal Systems, favorable mix of ink and graphics supplies and operational cost improvements. A more detailed discussion of the factors contributing to the changes in segment gross margins is included under “Segment Information” below. Operating Expenses Research and Development (“R&D”) R&D expense increased 2% in fiscal year 2016 as compared to fiscal year 2015 primarily due to incremental investments in A3 and 3D printing, partially offset by favorable currency impacts. R&D expense decreased 8% in fiscal year 2015 as compared to fiscal year 2014 primarily due to favorable currency impacts. Selling, General and Administrative (“SG&A”) SG&A expense decreased 19% in fiscal year 2016 as compared to fiscal year 2015 primarily due to gains from the divestiture of certain software assets to Open Text Corporation, lower corporate governance and other overhead costs related to the pre-Separation combined entity, our cost saving initiatives and favorable currency impacts. These effects were partially offset by the gain from the divestiture of Snapfish in the prior-year period. SG&A expense decreased 12% in fiscal year 2015 as compared to fiscal year 2014 primarily due to favorable currency impacts and declines in go-to-market costs as a result of lower commissions and productivity initiatives. Amortization of Intangible Assets Amortization expense decreased by $86 million and $27 million in fiscal year 2016 and in fiscal year 2015 respectively, primarily due to prior acquisitions reaching the end of their respective amortization periods. Restructuring and other Charges Restructuring and other charges increased by $142 million in fiscal year 2016 primarily due to severance pay and infrastructure related charges from our restructuring plan initially announced in September 2015 (the “Fiscal 2015 Plan”). On October 10, 2016, our Board of Directors approved a restructuring plan (the “Fiscal 2017 Plan”) which will be implemented through fiscal year 2019. HP recognized $24 million of charges related to the Fiscal 2017 Plan during the fourth quarter of fiscal year 2016. Restructuring and other charges decreased by $113 million in fiscal year 2015 primarily due to lower charges from our restructuring plan initially announced in May 2012 (the “Fiscal 2012 Plan”). HP recognized $39 million of charges related to the Fiscal 2015 Plan during the fourth quarter of fiscal year 2015. Interest and Other, Net HP INC. AND SUBSIDIARIES Management’s Discussion and Analysis of Financial Condition and Results of Operations (Continued) Interest and other, net expense decreased by $600 million in fiscal year 2016. The decrease was primarily due to changes in indemnification receivables from Hewlett Packard Enterprise for certain tax liabilities that HP is jointly and severally liable for, but for which it is indemnified by Hewlett Packard Enterprise under the tax matters agreement and lower foreign currency losses, partially offset by lower interest income. Interest and other, net expense decreased by $5 million in fiscal year 2015. The decrease was due to lower other miscellaneous expense. Provision for Taxes Our effective tax rates were 29.1%, (5.3)% and 24.3% in fiscal years 2016, 2015 and 2014, respectively. Our effective tax rate generally differs from the U.S. federal statutory rate of 35% due to favorable tax rates associated with certain earnings from our operations in lower tax jurisdictions throughout the world. The jurisdictions with favorable tax rates that had the most significant impact on our effective tax rate in the periods presented were Puerto Rico, Singapore, China, Malaysia and Ireland. We plan to reinvest certain earnings of these jurisdictions indefinitely outside the United States and therefore has not provided U.S. taxes on those indefinitely reinvested earnings. In addition to the above factors, the overall tax rates in fiscal year 2016 were impacted by adjustments to valuation allowances and uncertain tax positions. For a reconciliation of our effective tax rate to the U.S. federal statutory rate of 35% and further explanation of our provision for taxes, see Note 7, “Taxes on Earnings” to the Consolidated Financial Statements in Item 8, which is incorporated herein by reference. In fiscal 2016, we recorded $301 million of net income tax charges related to items unique to the year for continuing operations. These amounts primarily include uncertain tax position charges of $525 million related to pre-separation tax matters. In addition, we recorded $62 million of net tax benefits on restructuring and other charges, $52 million of net tax benefits related to the release of foreign valuation allowances and $41 million of net tax benefits arising from the retroactive research and development credit provided by the Consolidated Appropriations Act of 2016 signed into law in December 2015 and $70 million of other tax benefit. In fiscal year 2015, we recorded $1.2 billion of net income tax benefits related to items unique to the year. These amounts included $1.7 billion of tax benefits due to a release of valuation allowances pertaining to certain U.S. deferred tax assets, $449 million of tax charges related to uncertain tax positions on pension transfers, $70 million of tax benefits related to state tax impacts, and $6 million of income tax charges related to various other items. In addition, we recorded $33 million of income tax charges on restructuring and pension-related costs. In fiscal year 2014, we recorded $69 million of net income tax benefits related to items unique to the year. These amounts included $37 million of income tax benefits related to provision to return adjustments, $25 million of income tax charges related to state rate changes, $41 million of income tax benefits for adjustments related to uncertain tax positions, and $16 million of income tax benefits related to other items. Segment Information A description of the products and services for each segment can be found in Note 3, “Segment Information,” to the Consolidated Financial Statements in Item 8, which is incorporated herein by reference. Future changes to this organizational structure may result in changes to the segments disclosed. Personal Systems HP INC. AND SUBSIDIARIES Management’s Discussion and Analysis of Financial Condition and Results of Operations (Continued) The components of net revenue and the weighted net revenue change by business unit were as follows: Fiscal Year 2016 compared with Fiscal Year 2015 Personal systems net revenue decreased 4.9% (decreased 0.9% on a constant currency basis) in fiscal year 2016. The net revenue decline in Personal Systems was primarily due to unfavorable currency impacts and weak market demand. Personal Systems net revenue decreased as a result of a 3.5% decline in unit volume along with a 1% decline in average selling price (“ASP”) as compared to the prior-year period. The unit volume decline was primarily due to an overall decline in desktops and consumer notebooks, partially offset by unit volume growth in commercial notebooks. The decline in ASP was primarily due to competitive pricing in the commercial segment partially offset by favorable pricing in the consumer segment and favorable mix shift in consumer high-end premium products. Consumer and commercial revenue both decreased by 5%, primarily due to weak market demand, partially offset by an increase in commercial notebooks and PC services. Net revenue declined 2% in Notebooks, 9% in Desktops, 7% in Workstations and 9% in Other as compared to the prior-year period. The net revenue decline in Other was primarily due to lower sales in consumer tablets and Personal Systems options partially offset by revenue growth in PC services. Personal Systems earnings from operations as a percentage of net revenue increased by 0.6 percentage points in fiscal year 2016. The increase was primarily due to growth in gross margin driven by favorable commodity costs combined with product mix and increase in PC services, the effects of which were partially offset by unfavorable currency impacts in revenue. Operating expenses as a percentage of net revenue increased by 0.1 percentage point primarily driven by an increase in field selling cost. Fiscal Year 2015 compared with Fiscal Year 2014 Personal Systems net revenue decreased 8.3% (decreased 3.1% on a constant currency basis) in fiscal year 2015. The net revenue decline in Personal Systems was primarily due to unfavorable currency impacts, particularly in EMEA, and weakening market demand. Personal Systems net revenue decreased as a result of a 5% decline in ASP and a 3% decline in unit volume. The decline in ASP was primarily due to unfavorable currency impacts, a shift in consumer PCs to low end products and a HP INC. AND SUBSIDIARIES Management’s Discussion and Analysis of Financial Condition and Results of Operations (Continued) lower mix of commercial PCs within Personal Systems. The unit volume decline was primarily due to a unit volume decline in desktops, partially offset by a unit volume growth in notebooks, both consumer and commercial. Net revenue for commercial clients decreased 8% primarily due to unfavorable currency impacts, a decline in commercial desktops as a result of weak market demand and higher net revenue in the prior-year period resulting from the replacement of the Windows XP operating system. Net revenue for consumer clients decreased 8% primarily due to unfavorable currency impacts and a decline in consumer desktops. Net revenue declined 17% in Desktop PCs, 2% in Notebook PCs, 9% in Workstations and 10% in Other. The net revenue decline in Other was primarily due to a decline in consumer tablets, the sale of intellectual property assets in the prior-year period, and unfavorable currency impacts, the effects of which were partially offset by increased sales of extended warranties. Personal Systems earnings from operations as a percentage of net revenue decreased by 0.5 percentage points for fiscal year 2015 as a result of a decline in gross margin combined with an increase in operating expenses as a percentage of net revenue. The decline in gross margin was primarily due to unfavorable currency impacts and a lower mix of commercial products, partially offset by favorable component costs and operational cost improvements. Operating expenses as a percentage of net revenue increased primarily due to the size of the net revenue decline, higher administrative expenses as a result of lower bad debt recoveries as compared to the prior-year period and higher R&D investments in commercial, mobility and immersive computing products, the effects of which were partially offset by a decline in field selling costs as a result of favorable currency impacts and operational cost improvements. Printing The components of the net revenue and weighted net revenue change by business unit were as follows: Fiscal Year 2016 compared with Fiscal Year 2015 HP INC. AND SUBSIDIARIES Management’s Discussion and Analysis of Financial Condition and Results of Operations (Continued) Printing net revenue decreased 14.0% (decreased 9.3% on a constant currency basis) for fiscal year 2016. The decline in net revenue was primarily due to unfavorable currency impacts, weakness in demand, impact from the change in the Supplies sales model and competitive pricing pressures. These factors resulted in a net revenue decline across Supplies and Consumer and Commercial Hardware. Net revenue for Supplies decreased 15.1% as compared to the prior-year period, primarily due to unfavorable currency impacts, demand weakness combined with a competitive pricing environment and impact of the change in the Supplies sales model. Printer unit volume decreased 12% and ASP increased by 2% as compared to the prior-year period. Printer unit volume decreased due to weakness in demand, our pricing discipline and focus on placing positive NPV units. Printer ASP increased primarily due to a favorable mix shift to high-value printers, partially offset by unfavorable currency impacts. Net revenue for Commercial Hardware decreased 6% for fiscal year 2016 as compared to the prior-year period primarily driven by a 6% decline in unit volume and a decrease in other peripheral printing solutions. The unit volume in Commercial Hardware declined primarily due to a unit volume decline in LaserJet printers. The ASP in Commercial Hardware increased slightly primarily due to mix shift to high-value printer sales offset by unfavorable currency impacts. Printer unit volume in Consumer Hardware declined 15%, combined with a decline in other printing solutions largely driven by the divestiture of Snapfish in the prior-year period and a 9% decline in ASP, resulted in a 30% decline in Consumer Hardware net revenue for fiscal year 2016 as compared to the prior-year period. The unit volume decline in Consumer Hardware was primarily due to weakness in demand, our pricing discipline and our continued efforts to place positive NPV units. The ASP in Consumer Hardware decreased primarily due to unfavorable currency impacts. Printing earnings from operations as a percentage of net revenue decreased by 0.6% percentage points for fiscal year 2016 as compared to the prior-year period due to decline in gross margin, partially offset by the gains from the divestiture of certain software assets. The gross margin decline was primarily due to unfavorable currency impacts and supplies mix, partially offset by operational improvements and favorable mix of printers. Operating expenses decreased primarily due to the gains from the divestiture of certain software assets to Open Text Corporation and cost-saving initiatives. Fiscal Year 2015 compared with Fiscal Year 2014 Printing net revenue decreased 8.5% (decreased 5.1% on a constant currency basis) for fiscal year 2015. The decline in net revenue was primarily due to unfavorable currency impacts, decline in Supplies, weak market demand and competitive pricing pressures, the effects of which were partially offset by growth in graphics products. From a regional perspective, Printing experienced a net revenue decline across all regions, primarily in EMEA and particularly in Russia as a result of challenges in those markets. Net revenue for Supplies decreased 6% primarily due to unfavorable currency impacts and demand weakness in toner and ink, partially offset by growth in graphics supplies. The demand weakness in toner was particularly in EMEA, led by a net revenue decline in Russia. Printer unit volumes declined 7% while ASP decreased 7%. Printer unit volume declined primarily due to a decline in LaserJet and home printer units, the effects of which were partially offset by growth in graphics printer units. The ASP for printers decreased primarily due to a highly competitive pricing environment and unfavorable currency impacts on Inkjet and LaserJet printers. Net revenue for Commercial Hardware decreased 9% driven by a 7% decline in printer unit volume and a 4% decline in ASP, partially offset by a net revenue increase in other peripheral solutions. In Commercial Hardware, the decline in unit volume was primarily due to an overall decline in LaserJet printer units, partially offset by growth in graphics printer units. The ASP decline in Commercial Hardware was primarily due to a competitive pricing environment and unfavorable currency impacts. Net revenue for Consumer Hardware decreased 21% driven by a 13% decline in ASP, 7% decline in unit volume and a decline in other peripheral solutions. The ASP decline in Consumer Hardware was primarily due to a competitive pricing environment and unfavorable currency impacts. The unit volume decline in Consumer Hardware was primarily due to lower sales of home and SMB printer units. Printing earnings from operations as a percentage of net revenue declined 0.2 percentage points for fiscal year 2015 due to a decline in gross margin, partially offset by lower operating expenses as a percentage of net revenue. The decline in gross margin was primarily due to a competitive pricing environment in hardware and unfavorable currency impacts, the effects of which were partially offset by a favorable mix of ink and graphics supplies and favorable currency impacts from the Japanese yen. Operating expenses as a percentage of net revenue decreased primarily due to our cost saving initiatives, lower marketing expenses, the impact of the divestiture of our photo printing service Snapfish and favorable currency impacts. HP INC. AND SUBSIDIARIES Management’s Discussion and Analysis of Financial Condition and Results of Operations (Continued) Corporate Investments (1) “NM” represents not meaningful. Fiscal Year 2016 compared with Fiscal Year 2015 The loss from operations for fiscal year 2016 was primarily due to expenses associated with our incubation projects. Fiscal Year 2015 compared with Fiscal Year 2014 The net revenue decrease for fiscal year 2015 was primarily due to the sale of intellectual property assets related to the Palm acquisition in the prior-year period. The increase in the loss from operations for fiscal year 2015 was primarily due to the sale of intellectual property assets in the prior-year period and higher expenses associated with incubation projects and HP Labs. LIQUIDITY AND CAPITAL RESOURCES We use cash generated by operations as our primary source of liquidity. We believe that internally generated cash flows are generally sufficient to support our operating businesses, capital expenditures, restructuring activities, maturing debt, income tax payments and the payment of stockholder dividends, in addition to investments and share repurchases. We are able to supplement this short-term liquidity, if necessary, with broad access to capital markets and credit facilities made available by various domestic and foreign financial institutions. Our access to capital markets may be constrained and our cost of borrowing may increase under certain business, market and economic conditions; however, our access to a variety of funding sources to meet our liquidity needs is designed to facilitate continued access to capital resources under all such conditions. Our liquidity is subject to various risks including the risks identified in the section entitled “Risk Factors” in Item 1A and market risks identified in the section entitled “Quantitative and Qualitative Disclosures about Market Risk” in Item 7A, which is incorporated herein by reference. Our cash balances are held in numerous locations throughout the world, with majority of those amounts held outside of the United States. We utilize a variety of planning and financing strategies in an effort to ensure that our worldwide cash is available when and where it is needed. Our cash position remains strong, and we expect that our cash balances, anticipated cash flow generated from operations and access to capital markets will be sufficient to cover our expected near-term cash outlays. In September 2016, HP entered into a definitive agreement to acquire Samsung Electronics Co., Ltd.’s printer business for $1.05 billion. The transaction is expected to close within 12 months pending regulatory review and other customary closing conditions. Amounts held outside of the United States are generally utilized to support non-U.S. liquidity needs, although a portion of those amounts may from time to time be subject to short-term intercompany loans into the United States. Most of the amounts held outside of the United States could be repatriated to the United States but, under current law, some would be subject to U.S. federal income taxes, less applicable foreign tax credits. Repatriation of some foreign earnings is restricted by local law. Except for foreign earnings that are considered indefinitely reinvested outside of the United States, we have provided for the U.S. federal tax liability on these earnings for financial statement purposes. Repatriation could result in additional income tax payments in future years. Where local restrictions prevent an efficient intercompany transfer of funds, our intent is that cash balances would remain outside of the United States and we would meet liquidity needs through ongoing cash flows, external HP INC. AND SUBSIDIARIES Management’s Discussion and Analysis of Financial Condition and Results of Operations (Continued) borrowings, or both. We do not expect restrictions or potential taxes incurred on repatriation of amounts held outside of the United States to have a material effect on our overall liquidity, financial condition or results of operations. Liquidity Our cash and cash equivalents and total debt for continuing operations were as follows: Our historical statements of cash flows represent the combined cash flows and key cash flow metrics of HP prior to the Separation and have not been revised to reflect the effect of the Separation. For further information on discontinued operations, see Note 2, “Discontinued Operations” in the Consolidated Financial Statements and notes thereto included in Item 8, “Financial Statements and Supplementary Data”, which is incorporated herein by reference. Our key cash flow metrics were as follows: Operating Activities Net cash provided by operating activities decreased by $3.3 billion for fiscal year 2016 as compared to fiscal year 2015, since the net cash provided by operating activities for fiscal year 2015 included the impact of discontinued operations, which is not included in the net cash provided by operating activities for fiscal year 2016, as a result of the Separation. Net cash provided by operating activities decreased by approximately $5.8 billion for fiscal year 2015 as compared to fiscal year 2014. The decrease was due primarily to lower cash generated from working capital management activities, payments for Separation costs, lower cash receipts from contract manufacturers and financing receivables, lower net earnings in the current period, unfavorable currency impacts, as well as higher cash payments for prepaid expenses and employee benefits. Working Capital Metrics Management utilizes current cash conversion cycle information to manage our working capital level. The table below presents the cash conversion cycle as of October 31, 2016 and October 31, 2015. HP INC. AND SUBSIDIARIES Management’s Discussion and Analysis of Financial Condition and Results of Operations (Continued) The cash conversion cycle is the sum of days of sales outstanding in accounts receivable (“DSO”) and days of supply in inventory (“DOS”) less days of purchases outstanding in accounts payable (“DPO”). Items which may cause the cash conversion cycle in a particular period to differ from a long-term sustainable rate include, but are not limited to, changes in business mix, changes in payment terms, extent of receivables factoring, seasonal trends and the timing of revenue recognition and inventory purchases within the period. DSO measures the average number of days our receivables are outstanding. DSO is calculated by dividing ending accounts receivable, net of allowance for doubtful accounts, by a 90-day average of net revenue. For fiscal year 2016, the decrease in DSO compared to fiscal year 2015 was primarily due to favorable revenue linearity and strong collections, partially offset by unfavorable currency impacts. For fiscal year 2015, the increase in DSO compared to fiscal year 2014 was primarily due to lower usage of cash discounts by our customers. DOS measures the average number of days from procurement to sale of our product. DOS is calculated by dividing ending inventory by a 90-day average of cost of goods sold. For fiscal year 2016, the DOS was flat compared to fiscal year 2015 due to strong inventory management offset by higher inventory balance to support future sales levels. For fiscal year 2015, the increase in DOS compared to fiscal year 2014 was due to higher inventory balance to support future sales levels. DPO measures the average number of days our accounts payable balances are outstanding. DPO is calculated by dividing ending accounts payable by a 90-day average of cost of goods sold. For fiscal year 2016, the increase in DPO compared to fiscal year 2015 was primarily the result of extension of payment terms with our product suppliers and increased strategic inventory purchases. For fiscal year 2015, the increase in DPO compared to fiscal year 2014 was primarily the result of purchasing linearity and an extension of payment terms with our product suppliers. Investing Activities Net cash used in investing activities decreased by $5.6 billion for fiscal year 2016 as compared to fiscal year 2015, due to capital expenditures and payments made in connection with business acquisitions, net of cash acquired, in fiscal year 2015 by the discontinued operations. Net cash used in investing activities increased by approximately $2.7 billion for fiscal year 2015 as compared to fiscal year 2014, primarily due to the acquisition of Aruba Networks, Inc., which was transferred to Hewlett Packard Enterprise as a part of the Separation. Financing Activities Net cash used in financing activities increased by $15.8 billion in fiscal year 2016 primarily due to the cash transfer of $10.4 billion to Hewlett Packard Enterprise in connection with the Separation, the redemption of $2.1 billion of U.S. Dollar Global Notes and cash utilization of $2.0 billion for repurchases of common stock and dividends. Net cash used in financing activities decreased by approximately $7.9 billion for fiscal year 2015 as compared to net cash used in financing activities of $6.6 billion in fiscal year 2014. The change was primarily due to proceeds from the issuance of senior unsecured notes in October 2015 by Hewlett Packard Enterprise in principal amount of $14.6 billion and higher proceeds from issuance of commercial paper, partially offset by the redemption of $6.6 billion of U.S. Dollar Global Notes and higher repayment of commercial paper as compared to fiscal year 2014. Capital Resources Debt Levels HP INC. AND SUBSIDIARIES Management’s Discussion and Analysis of Financial Condition and Results of Operations (Continued) We maintain debt levels that we establish through consideration of a number of factors, including cash flow expectations, cash requirements for operations, investment plans (including acquisitions), share repurchase activities, our cost of capital and targeted capital structure. Short-term debt decreased by $2.1 billion and long-term debt increased by $0.1 billion for fiscal year 2016 as compared to fiscal year 2015. The net decrease in total debt was primarily due to redemption of $2.1 billion of fixed rate U.S. Dollar Global Notes in November 2015. Short-term debt decreased by $0.4 billion and long-term debt decreased by $8.9 billion for fiscal year 2015 as compared to fiscal year 2014. The net decrease in total debt was primarily due to the redemption of $6.6 billion of U.S. Dollar Global Notes in connection with the Separation and maturities of $2.5 billion of U.S. Dollar Global Notes in fiscal year 2015. During the month of November 2015, we paid $2.1 billion for the redemption of U.S. Dollar Global Notes as part of the final settlement of the debt redeemed as a part of the Separation. Our debt-to-equity ratio is calculated as the carrying amount of debt divided by total stockholders’ equity. Our debt-to-equity ratio decreased by 2.08x in fiscal year 2016, primarily due to negative equity resulting from the transfer of net assets of $32.5 billion to Hewlett Packard Enterprise and redemption of $2.1 billion of fixed-rate U.S. Dollar Global Notes due to the Separation. During fiscal year 2016, we generated operating cash flow of $3.2 billion. Our debt-to-equity ratio decreased by 0.35x in fiscal year 2015, due to a decrease in total debt balances of $9.3 billion coupled with an increase in total stockholders’ equity by $1.0 billion at the end of fiscal year 2015. Our weighted-average interest rate reflects the effective interest rate on our borrowings prevailing during the period and reflects the effect of interest rate swaps. For more information on our interest rate swaps, see Note 11, “Financial Instruments” in the Consolidated Financial Statements and notes thereto in Item 8, “Financial Statements and Supplementary Data”. As of October 31, 2016, we maintain a senior unsecured committed revolving credit facility with aggregate lending commitments of $4.0 billion, which will be available until April 2, 2019 and is primarily to support the issuance of commercial paper. Funds borrowed under this revolving credit facility may also be used for general corporate purposes. Available Borrowing Resources As of October 31, 2016, we had available borrowing resources of $822 million from uncommitted lines of credit in addition to our $4.0 billion senior unsecured committed revolving credit facility discussed above. For more information on our borrowings, see Note 12, “Borrowings”, to the Consolidated Financial Statements in Item 8 of Part II, which is incorporated herein by reference. Credit Ratings Our credit risk is evaluated by major independent rating agencies based upon publicly available information as well as information obtained in our ongoing discussions with them. While we do not have any rating downgrade triggers that would accelerate the maturity of a material amount of our debt, previous downgrades have increased the cost of borrowing under our credit facilities, have reduced market capacity for our commercial paper and have required the posting of additional collateral under some of our derivative contracts. In addition, any further downgrade to our credit ratings by any rating agencies may further impact us in a similar manner, and, depending on the extent of any such downgrade, could have a negative impact on our liquidity and capital position. We can access alternative sources of funding, including drawdowns under our credit facilities, if necessary, to offset potential reductions in the market capacity for our commercial paper. HP INC. AND SUBSIDIARIES Management’s Discussion and Analysis of Financial Condition and Results of Operations (Continued) CONTRACTUAL AND OTHER OBLIGATIONS Our contractual and other obligations as of October 31, 2016, were as follows: (1) Amounts represent the principal cash payments relating to our short-term and long-term debt and do not include any fair value adjustments, discounts or premiums. (2) Amounts represent the expected interest payments relating to our short-term and long-term debt. We have outstanding interest rate swap agreements accounted for as fair value hedges that have the economic effect of changing fixed interest rates associated with some of our U.S. Dollar Global Notes to variable interest rates. The impact of our outstanding interest rate swaps at October 31, 2016 was factored into the calculation of the future interest payments on debt. (3) Purchase obligations include agreements to purchase goods or services that are enforceable and legally binding on us and that specify all significant terms, including fixed or minimum quantities to be purchased; fixed, minimum or variable price provisions; and the approximate timing of the transaction. These purchase obligations are related principally to inventory and other items. Purchase obligations exclude agreements that are cancelable without penalty. Purchase obligations also exclude open purchase orders that are routine arrangements entered into in the ordinary course of business as they are difficult to quantify in a meaningful way. Even though open purchase orders are considered enforceable and legally binding, the terms generally allow us the option to cancel, reschedule, and adjust terms based on our business needs prior to the delivery of goods or performance of services. (4) Amounts represent the operating lease obligations, net of total sublease income of $218 million. (5) Amounts represent the capital lease obligations, including total capital lease interest obligations of $35 million. (6) Retirement and Post-Retirement Benefit Plan Contributions. In fiscal year 2017, we anticipate making contributions of $26 million to non-U.S. pension plans, approximately $33 million to cover benefit payments to U.S. non-qualified pension plan participants and approximately $9 million to cover benefit claims for our post-retirement benefit plans. Our policy is to fund our pension plans so that we meet at least the minimum contribution requirements, as established by local government, funding and taxing authorities. Expected contributions and payments to our pension and post-retirement benefit plans are excluded from the contractual obligations table because they do not represent contractual cash outflows as they are dependent on numerous factors which may result in a wide range of outcomes. For more information on our retirement and post-retirement benefit plans, see Note 5, “Retirement and Post-Retirement Benefit Plans”, to the Consolidated Financial Statements in Item 8, which is incorporated herein by reference. (7) Cost Savings Plans. We expect to make future cash payments of between $384 million and $534 million in connection with our cost savings plans through fiscal year 2019. These payments have been excluded from the contractual obligations table, because they do not represent contractual cash outflows and there is uncertainty as to the timing of these payments. For more information on our restructuring activities, see Note 4, “Restructuring and Other Charges”, to the Consolidated Financial Statements in Item 8, which is incorporated herein by reference. (8) Uncertain Tax Positions. As of October 31, 2016, we had approximately $1.9 billion of recorded liabilities and related interest and penalties pertaining to uncertain tax positions. We are unable to make a reasonable estimate as to when cash settlement with the tax authorities might occur due to the uncertainties related to these tax matters. Payments of these obligations would result from settlements with taxing authorities. For more information on our uncertain tax positions, HP INC. AND SUBSIDIARIES Management’s Discussion and Analysis of Financial Condition and Results of Operations (Continued) see Note 7, “Taxes on Earnings”, to the Consolidated Financial Statements in Item 8, which is incorporated herein by reference. OFF-BALANCE SHEET ARRANGEMENTS As part of our ongoing business, we have not participated in transactions that generate material relationships with unconsolidated entities or financial partnerships, such as entities often referred to as structured finance or special purpose entities, which would have been established for the purpose of facilitating off-balance sheet arrangements or other contractually narrow or limited purposes. We have third-party short-term financing arrangements intended to facilitate the working capital requirements of certain customers. For more information on our third-party short-term financing arrangements, see Note 8 “Balance Sheet Details” to the Consolidated Financial Statements in Item 8, which is incorporated herein by reference.

<s>[INST] HP Inc. Separation Transaction. A discussion of the separation of Hewlett Packard Enterprise Company, HP Inc.’s former enterprise technology infrastructure, software, services and financing businesses. Overview. A discussion of our business and other highlights affecting the company to provide context for the remainder of this MD&A. Critical Accounting Policies and Estimates. A discussion of accounting policies and estimates that we believe are important to understanding the assumptions and judgments incorporated in our reported financial results. Results of Operations. An analysis of our continuing financial results comparing fiscal year 2016 to fiscal year 2015 and fiscal year 2015 to fiscal year 2014. A discussion of the results of continuing operations is followed by a more detailed discussion of the results of operations by segment. Liquidity and Capital Resources. An analysis of changes in our cash flows and a discussion of our liquidity and continuing financial condition. Contractual and Other Obligations. An overview of contractual obligations, retirement and postretirement benefit plan contributions, restructuring plans, uncertain tax positions and offbalance sheet arrangements of our continuing operations and separation costs. We intend the discussion of our continuing financial condition and results of continuing operations that follows to provide information that will assist the reader in understanding our Consolidated Financial Statements, the changes in certain key items in those financial statements from year to year, and the primary factors that accounted for those changes, as well as how certain accounting principles, policies and estimates affect our Consolidated Financial Statements. This discussion should be read in conjunction with our Consolidated Financial Statements and the related notes that appear elsewhere in this document. HP Inc. Separation Transaction On November 1, 2015 (the “Distribution Date”), we completed the separation of Hewlett Packard Enterprise Company (“Hewlett Packard Enterprise”), HewlettPackard Company’s former enterprise technology infrastructure, software, services and financing businesses (the “Separation”). In connection with the Separation, HewlettPackard Company changed its name to HP Inc. (“HP”). On the Distribution Date, each of our stockholders of record as of the close of business on October 21, 2015 (the “Record Date”) received one share of Hewlett Packard Enterprise common stock for every one share of our common stock held as of the Record Date. We distributed a total of approximately 1.8 billion shares of Hewlett Packard Enterprise common stock to our stockholders. Hewlett Packard Enterprise is an independent public company trading on the New York Stock Exchange (“NYSE”) under the symbol “HPE”. After the Separation, we do not beneficially own any shares of Hewlett Packard Enterprise common stock. In connection with the Separation, we and Hewlett Packard Enterprise have entered into a separation and distribution agreement as well as various other agreements that provide a framework for the relationships between HP and Hewlett Packard Enterprise going forward, including among others a tax matters agreement, an employee matters agreement, a transition service agreement, a real estate matters agreement, a master commercial agreement and an information technology service agreement. HP INC. AND SUBSIDIARIES Management’s Discussion and Analysis of Financial Condition and Results of Operations (Continued) OVERVIEW We are a leading global provider of personal computing and other access devices, imaging and printing products, and related technologies, solutions, and services. We sell to individual consumers, small and mediumsized businesses and large enterprises, including customers in the government, health, and education sectors. We have three segments for financial reporting purposes: Personal Systems, Printing and Corporate Investments. The Personal Systems segment offers Commercial personal computers (“PCs”), Consumer PCs, workstations, thin clients, Commercial tablets and mobility devices, retail pointofsale systems, displays and other related accessories, software, support, and services for the commercial and consumer markets. The Printing segment provides Consumer and Commercial printer hardware, Supplies, media, solutions and services, as well as scanning devices. Corporate Investments include HP Labs and certain business incubation projects. In Personal Systems, our strategic focus is on profitable growth through improved market [/INST] Negative. </s>

HP INC

2017-12-14

2017-10-31

ITEM 7. Management’s Discussion and Analysis of Financial Condition and Results of Operations. This Management’s Discussion and Analysis of Financial Condition and Results of Operations (“MD&A”) is organized as follows: • HP Inc. Separation Transaction. A discussion of the separation of Hewlett Packard Enterprise Company, HP Inc.’s former enterprise technology infrastructure, software, services and financing businesses. • Overview. A discussion of our business and other highlights affecting the company to provide context for the remainder of this MD&A. • Critical Accounting Policies and Estimates. A discussion of accounting policies and estimates that we believe are important to understanding the assumptions and judgments incorporated in our reported financial results. • Results of Operations. An analysis of our continuing financial results comparing fiscal year 2017 to fiscal year 2016 and fiscal year 2016 to fiscal year 2015. A discussion of the results of continuing operations is followed by a more detailed discussion of the results of operations by segment. • Liquidity and Capital Resources. An analysis of changes in our cash flows and a discussion of our liquidity and continuing financial condition. • Contractual and Other Obligations. An overview of contractual obligations, retirement and post-retirement benefit plan contributions, cost-saving plans, uncertain tax positions and off-balance sheet arrangements of our continuing operations. The discussion of financial condition and results of our continuing operations that follows provides information that will assist the reader in understanding our Consolidated Financial Statements, the changes in certain key items in those financial statements from year to year, and the primary factors that accounted for those changes, as well as how certain accounting principles, policies and estimates affect our Consolidated Financial Statements. This discussion should be read in conjunction with our Consolidated Financial Statements and the related notes that appear elsewhere in this document. HP Inc. Separation Transaction On November 1, 2015, we completed the separation of Hewlett Packard Enterprise Company (“Hewlett Packard Enterprise”), Hewlett-Packard Company’s former enterprise technology infrastructure, software, services and financing businesses (the “Separation”). In connection with the Separation, Hewlett-Packard Company changed its name to HP Inc. (“HP”). In connection with the Separation, we and Hewlett Packard Enterprise have entered into a separation and distribution agreement as well as various other agreements that provide a framework for the relationships between HP and Hewlett Packard Enterprise going forward, including among others a tax matters agreement, an employee matters agreement, a real estate matters agreement and a master commercial agreement. HP INC. AND SUBSIDIARIES Management’s Discussion and Analysis of Financial Condition and Results of Operations (Continued) OVERVIEW We are a leading global provider of personal computing and other access devices, imaging and printing products, and related technologies, solutions, and services. We sell to individual consumers, small- and medium-sized businesses (“SMBs”) and large enterprises, including customers in the government, health, and education sectors. We have three segments for financial reporting purposes: Personal Systems, Printing and Corporate Investments. The Personal Systems segment offers Commercial and Consumer personal computers (“PCs”), Workstations, thin clients, Commercial tablets and mobility devices, retail point-of-sale systems, displays and other related accessories, software, support and services for the commercial and consumer markets. The Printing segment provides Consumer and Commercial printer hardware, Supplies, solutions and services, as well as scanning devices. Corporate Investments include HP Labs and certain business incubation projects. • In Personal Systems, our strategic focus is on profitable growth through hyper market segmentation with respect to enhanced innovation in multi-operating systems, multi-architecture, geography, customer segments and other key attributes. Additionally, we are investing in premium and mobility form factors such as convertible notebooks, detachable notebooks and mobility devices in order to meet customer preference for mobile, thinner and lighter devices. The beginning of a market shift to contractual solutions includes an increased focus on Device as a Service. We believe that we are well positioned due to our competitive product lineup. • In Printing, our strategic focus is on business printing, a shift to contractual solutions and Graphics, as well as expanding our footprint in the 3D printing marketplace. Business printing includes delivering solutions to SMBs and enterprise customers, such as multi-function and PageWide printers, including our JetIntelligence lineup of LaserJet printers. The shift to contractual solutions includes an increased focus on Managed Print Services and Instant Ink, which presents strong after-market supplies opportunities. In the Graphics space, we are focused on innovations such as our Indigo and Latex product offerings. We plan to continue to focus on shifting the mix in the installed base to higher value units and expanding our innovative Ink, Laser, Graphics and 3D printing programs. We continue to execute on our key initiatives of focusing on high-value products targeted at high usage categories and introducing new revenue delivery models. Our focus is on placing higher value printer units which offer strong annuity of toner and ink, the design and deployment of A3 products and solutions, accelerating growth in Graphic solutions and 3D printing. We continue to experience challenges that are representative of trends and uncertainties that may affect our business and results of operations. One set of challenges relates to dynamic market trends, such as flat PC device and home printing markets. A second set of challenges relates to changes in the competitive landscape. Our primary competitors are exerting competitive pressure in targeted areas and are entering new markets, our emerging competitors are introducing new technologies and business models, and our alliance partners in some businesses are increasingly becoming our competitors in others. A third set of challenges relates to business model changes and our go-to-market execution. • In Personal Systems, we face challenges with continued increases in commodity costs, especially in memory, and the uncertainty of the PC market’s ability to absorb price increases driven by higher commodity costs. • In Printing, we are seeing signs of stabilization of demand in consumer and commercial markets, but are still experiencing an overall competitive pricing environment. We obtained a number of components from single sources due to technology, availability, price, quality or other considerations. For instance, we source majority of our A4 and a portion of A3 portfolio of laser printer engines and laser toner cartridges from Canon. Any decision by either party to not renew our agreement with Canon or to limit or reduce the scope of the agreement could adversely affect our net revenue from LaserJet products; however, we have a long-standing business relationship with Canon and anticipate renewal of this agreement. Our business and financial performance also depend significantly on worldwide economic conditions. Accordingly, we face global macroeconomic challenges such as the June 23, 2016 referendum by British voters to exit the European Union (commonly known as “Brexit”), uncertainty in the markets and weaker macroeconomic conditions. The impact of these and other global macroeconomic challenges on our business cannot be known at this time. To address these challenges, we continue to pursue innovation with a view towards developing new products and services aligned with generating market demand and meeting the needs of our customers and partners. In addition, we need to continue to improve our operations, with a particular focus on enhancing our end-to-end processes and efficiencies. We also need to continue to optimize our sales coverage models, align our sales incentives with our strategic goals, improve channel execution, strengthen our capabilities in our areas of strategic focus, and develop and capitalize on market opportunities. HP INC. AND SUBSIDIARIES Management’s Discussion and Analysis of Financial Condition and Results of Operations (Continued) We typically experience higher net revenues in our first and fourth quarters compared to other quarters in our fiscal year due in part to seasonal holiday demand. Historical seasonal patterns should not be considered reliable indicators of our future net revenues or financial performance. For a further discussion of trends, uncertainties and other factors that could impact our continuing operating results, see the section entitled “Risk Factors” in Item 1A in this Annual Report on Form 10-K. CRITICAL ACCOUNTING POLICIES AND ESTIMATES General The Consolidated Financial Statements of HP are prepared in accordance with United States (“U.S.”) generally accepted accounting principles (“GAAP”), which require management to make estimates, judgments and assumptions that affect the reported amounts of assets, liabilities, net revenue and expenses, and the disclosure of contingent liabilities. Management bases its estimates on historical experience and on various other assumptions that it believes to be reasonable under the circumstances, the results of which form the basis for making judgments about the carrying amount of assets and liabilities that are not readily apparent from other sources. Management has discussed the development, selection and disclosure of these estimates with the Audit Committee of HP’s Board of Directors. Management believes that the accounting estimates employed and the resulting amounts are reasonable; however, actual results may differ from these estimates. Making estimates and judgments about future events is inherently unpredictable and is subject to significant uncertainties, some of which are beyond our control. Should any of these estimates and assumptions change or prove to have been incorrect, it could have a material impact on our results of operations, financial position and cash flows. A summary of significant accounting policies is included in Note 1, “Overview and Summary of Significant Accounting Policies” to the Consolidated Financial Statements in Item 8, which is incorporated herein by reference. An accounting policy is deemed to be critical if it requires an accounting estimate to be made based on assumptions about matters that are highly uncertain at the time the estimate is made, if different estimates reasonably could have been used, or if changes in the estimate that are reasonably possible could materially impact the financial statements. Management believes the following critical accounting policies reflect the significant estimates and assumptions used in the preparation of the Consolidated Financial Statements. Revenue Recognition We recognize revenue when persuasive evidence of an arrangement exists, delivery has occurred or services are rendered, the sales price or fee is fixed or determinable and collectability is reasonably assured, as well as when other revenue recognition principles are met, including industry-specific revenue recognition guidance. We enter into contracts to sell our products and services, and while many of our sales agreements contain standard terms and conditions, there are agreements we enter into which contain non-standard terms and conditions. Further, many of our arrangements include multiple elements. As a result, significant contract interpretation may be required to determine the appropriate accounting, including the identification of deliverables considered to be separate units of accounting, the allocation of the transaction price among elements in the arrangement and the timing of revenue recognition for each of those elements. We recognize revenue for delivered elements as separate units of accounting when the delivered elements have standalone value to the customer. For elements with no standalone value, we recognize revenue consistent with the pattern of the delivery of the final deliverable. If the arrangement includes a customer-negotiated refund or return right or other contingency relative to the delivered items and the delivery and performance of the undelivered items is considered probable and substantially within our control, the delivered element constitutes a separate unit of accounting. In arrangements with combined units of accounting, changes in the allocation of the transaction price among elements may impact the timing of revenue recognition for the contract but will not change the total revenue recognized for the contract. We establish the selling prices used for each deliverable based on vendor specific objective evidence (“VSOE”) of selling price, if available, third-party evidence (“TPE”), if VSOE of selling price is not available, or estimated selling price (“ESP”), if neither VSOE of selling price nor TPE is available. We establish VSOE of selling price using the price charged for a deliverable when sold separately and, in rare instances, using the price established by management having the relevant authority. We HP INC. AND SUBSIDIARIES Management’s Discussion and Analysis of Financial Condition and Results of Operations (Continued) evaluate TPE of selling price by reviewing largely similar and interchangeable competitor products or services in standalone sales to similarly situated customers. ESP is established based on management’s judgment considering internal factors such as margin objectives, pricing practices and controls, customer segment pricing strategies and the product life cycle. Consideration is also given to market conditions such as competitor pricing strategies and industry technology life cycles. We may modify or develop new go-to-market practices in the future, which may result in changes in selling prices, impacting both VSOE of selling price and ESP. In most arrangements with multiple elements, the transaction price is allocated to the individual units of accounting at inception of the arrangement based on their relative selling price. However, the aforementioned factors may result in a different allocation of the transaction price to deliverables in multiple element arrangements entered into in future periods. This may change the pattern and timing of revenue recognition for identical arrangements executed in future periods, but will not change the total revenue recognized for any given arrangement. We reduce revenue for customer and distributor programs and incentive offerings, including price protection, rebates, promotions, other volume-based incentives and expected returns. Future market conditions and product transitions may require us to take actions to increase customer incentive offerings, possibly resulting in an incremental reduction of revenue at the time the incentive is offered. For certain incentive programs, we estimate the number of customers expected to redeem the incentive based on historical experience and the specific terms and conditions of the incentive. For hardware products, we recognize revenue generated from direct sales to end customers and indirect sales to channel partners (including resellers, distributors and value-added solution providers) when the revenue recognition criteria are satisfied. For indirect sales to channel partners, we recognize revenue at the time of delivery when the channel partner has economic substance apart from HP and HP has completed its obligations related to the sale. We recognize revenue from fixed-price support or maintenance contracts ratably over the contract period. Warranty We accrue the estimated cost of product warranties at the time we recognize revenue. We evaluate our warranty obligations on a product group basis. Our standard product warranty terms generally include post-sales support and repairs or replacement of a product at no additional charge for a specified period of time. While we engage in extensive product quality programs and processes, including actively monitoring and evaluating the quality of our component suppliers, we base our estimated warranty obligation on contractual warranty terms, repair costs, product call rates, average cost per call, current period product shipments and ongoing product failure rates, as well as specific product class failure outside of our baseline experience. Warranty terms generally range from 90 days to three years for parts, labor and onsite services, depending upon the product. Over the last three fiscal years, the annual warranty expense and actual warranty costs have averaged approximately 2.0% and 2.3% of annual net revenue, respectively. Restructuring and Other Charges We have engaged in restructuring actions which require management to estimate the timing and amount of severance and other employee separation costs for workforce reduction and enhanced early retirement programs, fair value of assets made redundant or obsolete, and the fair value of lease cancellation and other exit costs. We accrue for severance and other employee separation costs under these actions when it is probable that benefits will be paid and the amount is reasonably estimable. The rates used in determining severance accruals are based on existing plans, historical experiences and negotiated settlements. Other charges include non-recurring costs that are distinct from ongoing operational costs such as information technology costs incurred in connection with the Separation. For a full description of our restructuring actions, refer to our discussions of restructuring in “Results of Operations” below and in Note 3, “Restructuring and Other Charges” to the Consolidated Financial Statements in Item 8, which are incorporated herein by reference. Retirement and Post-Retirement Benefits Our pension and other post-retirement benefit costs and obligations depend on various assumptions. Our major assumptions relate primarily to discount rates, mortality rates, expected increases in compensation levels and the expected long-term return on plan assets. The discount rate assumption is based on current investment yields of high-quality fixed-income securities with maturities similar to the expected benefits payment period. Mortality rates help predict the expected life of plan participants and are based on a historical demographic study of the plan. The expected increase in the compensation levels assumption reflects our long-term actual experience and future expectations. The expected long-term return on plan assets is HP INC. AND SUBSIDIARIES Management’s Discussion and Analysis of Financial Condition and Results of Operations (Continued) determined based on asset allocations, historical portfolio results, historical asset correlations and management’s expected returns for each asset class. We evaluate our expected return assumptions annually including reviewing current capital market assumptions to assess the reasonableness of the expected long-term return on plan assets. We update the expected long-term return on assets when we observe a sufficient level of evidence that would suggest the long-term expected return has changed. In any fiscal year, significant differences may arise between the actual return and the expected long-term return on plan assets. Historically, differences between the actual return and expected long-term return on plan assets have resulted from changes in target or actual asset allocation, short-term performance relative to expected long-term performance, and to a lesser extent, differences between target and actual investment allocations, the timing of benefit payments compared to expectations, and the use of derivatives intended to effect asset allocation changes or hedge certain investment or liability exposures. For the recognition of net periodic benefit cost, the calculation of the expected long-term return on plan assets uses the fair value of plan assets as of the beginning of the fiscal year unless updated as a result of interim re-measurement. Our major assumptions vary by plan, and the weighted-average rates used are set forth in Note 4, “Retirement and Post-Retirement Benefit Plans” to the Consolidated Financial Statements in Item 8, which is incorporated herein by reference. The following table provides the impact a change of 25 basis points in each of the weighted-average assumptions of the discount rate, expected increase in compensation levels and expected long-term return on plan assets would have had on our net periodic benefit cost for fiscal year 2017: Taxes on Earnings We calculate our current and deferred tax provisions based on estimates and assumptions that could differ from the final positions reflected in our income tax returns. We adjust our current and deferred tax provisions based on income tax returns which are generally filed in the third or fourth quarters of the subsequent fiscal year. We recognize deferred tax assets and liabilities for the expected tax consequences of temporary differences between the tax bases of assets and liabilities and their reported amounts using enacted tax rates in effect for the year in which we expect the differences to reverse. We record a valuation allowance to reduce deferred tax assets to the amount that we are more likely than not to realize. In determining the need for a valuation allowance, we consider future market growth, forecasted earnings, future taxable income, the mix of earnings in the jurisdictions in which we operate and prudent and feasible tax planning strategies. In the event we were to determine that it is more likely than not that we will be unable to realize all or part of our deferred tax assets in the future, we would increase the valuation allowance and recognize a corresponding charge to earnings or other comprehensive income in the period in which we make such a determination. Likewise, if we later determine that we are more likely than not to realize the deferred tax assets, we would reverse the applicable portion of the previously recognized valuation allowance. In order for us to realize our deferred tax assets, we must be able to generate sufficient taxable income in the jurisdictions in which the deferred tax assets are located. Our effective tax rate includes the impact of certain undistributed foreign earnings for which we have not provided United States federal taxes because we plan to reinvest such earnings indefinitely outside the United States. We plan distributions of foreign earnings based on projected cash flow needs as well as the working capital and long-term investment requirements of our foreign subsidiaries and our domestic operations. Based on these assumptions, we estimate the amount we expect to indefinitely invest outside the United States and the amounts we expect to distribute to the United States and provide the United States federal taxes due on amounts expected to be distributed to the United States. Further, as a result of certain employment actions and capital investments we have undertaken, income from manufacturing activities in certain jurisdictions is subject to reduced tax rates and, in some cases, is wholly exempt from taxes for fiscal years through 2027. Material changes in our HP INC. AND SUBSIDIARIES Management’s Discussion and Analysis of Financial Condition and Results of Operations (Continued) estimates of cash, working capital and long-term investment requirements in the various jurisdictions in which we do business could impact how future earnings are repatriated to the United States, and our related future effective tax rate. We are subject to income taxes in the United States and approximately 58 other countries, and we are subject to routine corporate income tax audits in many of these jurisdictions. We believe that positions taken on our tax returns are fully supported, but tax authorities may challenge these positions, which may not be fully sustained on examination by the relevant tax authorities. Accordingly, our income tax provision includes amounts intended to satisfy assessments that may result from these challenges. Determining the income tax provision for these potential assessments and recording the related effects requires management judgments and estimates. The amounts ultimately paid on resolution of an audit could be materially different from the amounts previously included in our income tax provision and, therefore, could have a material impact on our income tax provision, net income and cash flows. Our accrual for uncertain tax positions is attributable primarily to uncertainties concerning the tax treatment of our international operations, including the allocation of income among different jurisdictions, intercompany transactions and related interest. For a further discussion on taxes on earnings, refer to Note 6, “Taxes on Earnings” to the Consolidated Financial Statements in Item 8, which is incorporated herein by reference. Inventory We state our inventory at the lower of cost or market on a first-in, first-out basis. We make adjustments to reduce the cost of inventory to its net realizable value at the product group level for estimated excess or obsolescence. Factors influencing these adjustments include changes in demand, technological changes, product life cycle and development plans, component cost trends, product pricing, physical deterioration and quality issues. Goodwill We review goodwill for impairment annually during our fourth quarter and whenever events or changes in circumstances indicate the carrying amount of goodwill may not be recoverable. We can opt to perform a qualitative assessment to test a reporting unit’s goodwill for impairment or perform a quantitative impairment test. Based on a qualitative assessment, if we determine that the fair value of a reporting unit is more likely than not (i.e., a likelihood of more than 50 percent) to be less than its carrying amount, the quantitative impairment test will be performed. In the quantitative impairment test, we compare the fair value of each reporting unit to its carrying amount with the fair values derived most significantly from the income approach, and to a lesser extent, the market approach. Under the income approach, we estimate the fair value of a reporting unit based on the present value of estimated future cash flows. We base cash flow projections on management’s estimates of revenue growth rates and operating margins, taking into consideration industry and market conditions. We base the discount rate on the weighted-average cost of capital adjusted for the relevant risk associated with business-specific characteristics and the uncertainty related to the reporting unit’s ability to execute on the projected cash flows. Under the market approach, we estimate fair value based on market multiples of revenue and earnings derived from comparable publicly-traded companies with similar operating and investment characteristics as the reporting unit. We weight the fair value derived from the market approach depending on the level of comparability of these publicly-traded companies to the reporting unit. When market comparables are not meaningful or not available, we estimate the fair value of a reporting unit using only the income approach. If the fair value of a reporting unit exceeds the carrying amount of the net assets assigned to that reporting unit, goodwill is not impaired. If the fair value of the reporting unit is less than its carrying amount, goodwill is impaired and the excess of the reporting unit’s carrying value over the fair value is recognized as an impairment loss. Our annual goodwill impairment analysis, performed using the qualitative assessment option as of the first day of the fourth quarter of fiscal year 2017, resulted in a conclusion that it was more likely than not that the fair value of our reporting units exceeded their respective carrying values. As a result, we concluded that the first step of the goodwill impairment test was not necessary. Fair Value of Derivative Instruments We use derivative instruments to manage a variety of risks, including risks related to foreign currency exchange rates and interest rates. We use forwards, swaps and at times, options to hedge certain foreign currency and interest rate exposures. We do not use derivative instruments for speculative purposes. As of October 31, 2017, the gross notional value of our derivative portfolio was $25 billion. Assets and liabilities related to derivative instruments are measured at fair value, and were $121 million and $372 million, respectively as of October 31, 2017. HP INC. AND SUBSIDIARIES Management’s Discussion and Analysis of Financial Condition and Results of Operations (Continued) Fair value is the price we would receive to sell an asset or pay to transfer a liability in an orderly transaction between market participants at the measurement date. In the absence of active markets for the identical assets or liabilities, such measurements involve developing assumptions based on market observable data and, in the absence of such data, internal information that is consistent with what market participants would use in a hypothetical transaction that occurs at the measurement date. The determination of fair value often involves significant judgments about assumptions such as determining an appropriate discount rate that factors in both risk and liquidity premiums, identifying the similarities and differences in market transactions, weighting those differences accordingly and then making the appropriate adjustments to those market transactions to reflect the risks specific to the asset or liability being valued. We generally use industry standard valuation models to measure the fair value of our derivative positions. When prices in active markets are not available for the identical asset or liability, we use industry standard valuation models to measure fair value. Where applicable, these models project future cash flows and discount the future amounts to present value using market-based observable inputs, including interest rate curves, HP and counterparty credit risk, foreign currency exchange rates, and forward and spot prices. For a further discussion on fair value measurements and derivative instruments, refer to Note 9, “Fair Value” and Note 10, “Financial Instruments”, respectively, to the Consolidated Financial Statements in Item 8, which are incorporated herein by reference. Loss Contingencies We are involved in various lawsuits, claims, investigations and proceedings including those consisting of intellectual property (“IP”), commercial, securities, employment, employee benefits and environmental matters that arise in the ordinary course of business. We record a liability when we believe that it is both probable that a liability has been incurred and the amount of loss can be reasonably estimated. Significant judgment is required to determine both the probability of having incurred a liability and the estimated amount of the liability. We review these matters at least quarterly and adjust these liabilities to reflect the impact of negotiations, settlements, rulings, advice of legal counsel and other updated information and events, pertaining to a particular case. Pursuant to the separation and distribution agreement, we share responsibility with Hewlett Packard Enterprise for certain matters, as discussed in Note 14, “Litigation and Contingencies” to the Consolidated Financial Statements in Item 8, which is incorporated herein by reference, and Hewlett Packard Enterprise has agreed to indemnify us in whole or in part with respect to certain matters. Based on our experience, we believe that any damage amounts claimed in the specific litigation and contingencies matters further discussed in Note 14, “Litigation and Contingencies”, are not a meaningful indicator of HP’s potential liability. Litigation is inherently unpredictable. However, we believe we have valid defenses with respect to legal matters pending against us. Nevertheless, cash flows or results of operations could be materially affected in any particular period by the resolution of one or more of these contingencies. We believe we have recorded adequate provisions for any such matters and, as of October 31, 2017, it was not reasonably possible that a material loss had been incurred in excess of the amounts recognized in our financial statements. RECENT ACCOUNTING PRONOUNCEMENTS For a summary of recent accounting pronouncements applicable to our consolidated financial statements see Note 1, “Overview and Summary of Significant Accounting Policies” to the Consolidated Financial Statements in Item 8, which is incorporated herein by reference. RESULTS OF OPERATIONS Revenue from our international operations has historically represented, and we expect will continue to represent, a majority of our overall net revenue. As a result, our net revenue growth has been impacted, and we expect it will continue to be impacted, by fluctuations in foreign currency exchange rates. In order to provide a framework for assessing performance excluding the impact of foreign currency fluctuations, we supplement the year-over-year percentage change in net revenue with the year-over-year percentage change in net revenue on a constant currency basis, which excludes the change of foreign currency exchange fluctuations and hedging activities from the prior-year period and does not adjust for any repricing or demand impacts from changes in foreign currency exchange rates. This information is provided so that net revenue can be viewed with and without the effect of fluctuations in foreign currency exchange rates, which is consistent with how management evaluates our net revenue results and trends, as management does not believe that the excluded items are reflective of ongoing operating results. The constant currency measures are provided in addition to, and not as a substitute for, the year-over-year percentage change in net revenue on a GAAP basis. Other companies may calculate and define similarly labeled items differently, which may limit the usefulness of this measure for comparative purposes. HP INC. AND SUBSIDIARIES Management’s Discussion and Analysis of Financial Condition and Results of Operations (Continued) Results of operations in dollars and as a percentage of net revenue were as follows: Net Revenue In fiscal year 2017, total net revenue increased 7.9% (increased 8.7% on a constant currency basis) as compared with fiscal year 2016. Net revenue from the United States increased 7.1% to $19.3 billion and net revenue from outside of the United States increased 8.4% to $32.8 billion. The increase in net revenue was primarily driven by growth in Notebooks, Desktops and Supplies revenue, partially offset by unfavorable foreign currency impacts. In fiscal year 2016, total net revenue decreased 6.3% (decreased 2.0% on a constant currency basis) as compared with fiscal year 2015. Net revenue from the United States increased 1.7% to $18.0 billion, while net revenue from outside of the United States decreased 10.4% to $30.2 billion. The primary factors contributing to the net revenue decline were unfavorable foreign currency impacts, weak market demand, competitive pricing pressures and the change in the Supplies sales model. The net revenue decline was driven by decline in supplies, commercial and consumer printers, commercial and consumer desktops and consumer notebooks, partially offset by growth in commercial notebooks. A more detailed discussion of the factors contributing to the changes in segment net revenue is included under “Segment Information” below. Gross Margin Our gross margin was 18.4% for fiscal year 2017 compared with 18.7% for fiscal year 2016. The primary factors impacting the gross margin decrease were lower Personal System gross margin driven by higher commodity costs, unfavorable foreign currency impacts and higher mix of Personal Systems revenue, partially offset by productivity improvements in Printing. Our gross margin was 18.7% for fiscal year 2016 compared with 19.3% for fiscal year 2015. The decline in gross margin performance was primarily due to unfavorable foreign currency impacts, partially offset by operational improvements. HP INC. AND SUBSIDIARIES Management’s Discussion and Analysis of Financial Condition and Results of Operations (Continued) A more detailed discussion of the factors contributing to the changes in segment gross margins is included under “Segment Information” below. Operating Expenses Research and Development (“R&D”) R&D expense decreased 2% in fiscal year 2017 compared to fiscal year 2016, primarily due to lower spend as a result of the launch of A3 products in fiscal year 2016, partially offset by continuing investment in Printing. R&D expense increased 2% in fiscal year 2016 as compared to fiscal year 2015 primarily due to incremental investments in A3 and 3D printing, partially offset by favorable foreign currency impacts. Selling, General and Administrative (“SG&A”) SG&A expense increased 14% in fiscal year 2017 as compared to fiscal year 2016, primarily due to a gain from the divestiture of marketing optimization assets in fiscal year 2016 and an increase in field selling costs. SG&A expense decreased 19% in fiscal year 2016 as compared to fiscal year 2015 primarily due to gains from the divestiture of certain software assets to Open Text Corporation, lower corporate governance and other overhead costs related to the pre-Separation combined entity, our cost-saving initiatives and favorable foreign currency impacts. These effects were partially offset by the gain from the divestiture of Snapfish in the prior-year period. Amortization of Intangible Assets Amortization expense decreased by $15 million and $86 million in fiscal year 2017 and in fiscal year 2016 respectively, year-over-year, primarily due to assets from prior acquisitions reaching the end of their respective amortization periods. Restructuring and other Charges Restructuring and other charges increased by $157 million in fiscal year 2017 compared to the prior-year period, primarily due to the restructuring plan announced in October 2016 (the “Fiscal 2017 Plan”) and certain non-recurring costs, including those as a result of the Separation. Restructuring and other charges increased by $142 million in fiscal year 2016 compared to the prior-year period, primarily due to severance pay and infrastructure related charges from our restructuring plan initially announced in September 2015 (the “Fiscal 2015 Plan”). Interest and Other, Net Interest and other, net expense increased by $455 million in fiscal year 2017 compared to the prior-year period. The increase was primarily due to lower tax indemnification income in fiscal year 2017 from Hewlett Packard Enterprise for certain tax liabilities that HP is jointly and severally liable for, but for which it is indemnified by Hewlett Packard Enterprise under the tax matters agreement. Interest and other, net expense decreased by $600 million in fiscal year 2016 compared to the prior-year period. The decrease was primarily due to higher tax indemnification income in fiscal year 2016 from Hewlett Packard Enterprise under the tax matters agreement and lower foreign currency losses, partially offset by lower interest income. Provision for Taxes Our effective tax rates were 22.9%, 29.1% and (5.3)% in fiscal 2017, 2016 and 2015, respectively. Our effective tax rate generally differs from the U.S. federal statutory rate of 35% due to favorable tax rates associated with certain earnings from our operations in lower tax jurisdictions throughout the world. The jurisdictions with favorable tax rates that had the most significant impact on our effective tax rate in the periods presented were Puerto Rico, Singapore, China, Malaysia and Ireland. We plan to reinvest certain earnings of these jurisdictions indefinitely outside the United States and therefore have not provided HP INC. AND SUBSIDIARIES Management’s Discussion and Analysis of Financial Condition and Results of Operations (Continued) U.S. taxes on those indefinitely reinvested earnings. In addition to the above factors, the overall tax rates in fiscal year 2017 were impacted by adjustments to valuation allowances and state income taxes, and the overall tax rates in fiscal year 2016 were impacted by adjustments to valuation allowances and uncertain tax positions. For a reconciliation of our effective tax rate to the U.S. federal statutory rate of 35% and further explanation of our provision for taxes, see Note 6, “Taxes on Earnings” to the Consolidated Financial Statements in Item 8, which is incorporated herein by reference. In fiscal year 2017, we recorded $72 million of net income tax benefit related to discrete items in the provision for taxes. These amounts primarily include tax benefits of $84 million related to restructuring and other charges, $12 million related to U.S. federal provision to return adjustments, $45 million related to Samsung acquisition-related charges, and $13 million of other net tax benefits. In addition, we recorded tax charges of $11 million related to changes in state valuation allowances, $22 million of state provision to return adjustments, and $49 million related to uncertain tax positions. In fiscal year 2016, we recorded $301 million of net income tax charges related to discrete items in the provision for taxes for continuing operations. These amounts primarily include uncertain tax position charges of $525 million related to pre-separation tax matters. In addition, we recorded $62 million of net tax benefits on restructuring charges, $52 million of net tax benefits related to the release of foreign valuation allowances and $41 million of net tax benefits arising from the retroactive research and development credit provided by the Consolidated Appropriations Act of 2016 signed into law in December 2015 and $70 million of other tax benefit. In fiscal year 2015, we recorded $1.2 billion of net income tax benefits related to discrete items in the provision for taxes for continuing operations. These amounts included $1.7 billion of tax benefits due to a release of valuation allowances pertaining to certain U.S. deferred tax assets, $449 million of tax charges related to uncertain tax positions on pension transfers, $70 million of tax benefits related to state tax impacts, and $6 million of income tax charges related to various other items. In addition, we recorded $33 million of income tax charges on restructuring and pension-related costs. Segment Information A description of the products and services for each segment can be found in Note 2, “Segment Information,” to the Consolidated Financial Statements in Item 8, which is incorporated herein by reference. Future changes to this organizational structure may result in changes to the segments disclosed. Personal Systems The components of net revenue and the weighted net revenue change by business unit were as follows: HP INC. AND SUBSIDIARIES Management’s Discussion and Analysis of Financial Condition and Results of Operations (Continued) Fiscal Year 2017 compared with Fiscal Year 2016 Personal Systems net revenue increased 11.3% (increased 12.3% on a constant currency basis) in fiscal year 2017. The net revenue increase was primarily due to growth in Notebooks, Desktops and Workstations partially offset by unfavorable foreign currency impacts. The net revenue increase was driven by a 6.7% increase in unit volume combined with a 4.3% increase in average selling prices (“ASPs”) as compared to fiscal year 2016. The increase in unit volume was primarily due to growth in Notebooks and Workstations. The increase in ASPs was primarily due to favorable pricing partially offset by unfavorable foreign currency impacts. Consumer revenue increased 16% in fiscal year 2017, driven by growth in Notebooks and Desktops as a result of higher unit volume combined with higher ASPs. Commercial revenue increased 9% in fiscal year 2017, driven by growth in Notebooks and Workstations. Net revenue increased 16% in Notebooks, 9% in Workstations and 3% in Desktops in fiscal year 2017. Personal Systems earnings from operations as a percentage of net revenue decreased by 0.2 percentage points in fiscal year 2017. The decrease was primarily due to a decline in gross margin partially offset by a decrease in operating expenses. The decrease in gross margin was primarily due to an increase in commodity cost and unfavorable foreign currency impacts partially offset by higher ASPs. Operating expenses as a percentage of net revenue decreased primarily due to operating expense management. Fiscal Year 2016 compared with Fiscal Year 2015 Personal systems net revenue decreased 4.9% (decreased 0.9% on a constant currency basis) in fiscal year 2016. The net revenue decline in Personal Systems was primarily due to unfavorable foreign currency impacts and weak market demand. Personal Systems net revenue decreased as a result of a 3.5% decline in unit volume along with a 1% decline in ASPs as compared to the prior-year period. The unit volume decline was primarily due to an overall decline in desktops and consumer notebooks, partially offset by unit volume growth in commercial notebooks. The decline in ASPs was primarily due to competitive pricing in the commercial segment partially offset by favorable pricing in the consumer segment and favorable mix shift in consumer high-end premium products. HP INC. AND SUBSIDIARIES Management’s Discussion and Analysis of Financial Condition and Results of Operations (Continued) Consumer and commercial revenue both decreased by 5%, primarily due to weak market demand, partially offset by an increase in commercial notebooks and PC services. Net revenue declined 2% in Notebooks, 9% in Desktops, 7% in Workstations and 9% in Other as compared to the prior-year period. The net revenue decline in Other was primarily due to lower sales in consumer tablets and Personal Systems options partially offset by revenue growth in PC services. Personal Systems earnings from operations as a percentage of net revenue increased by 0.6 percentage points in fiscal year 2016. The increase was primarily due to growth in gross margin driven by favorable commodity costs combined with product mix and increase in PC services, the effects of which were partially offset by unfavorable foreign currency impacts in revenue. Operating expenses as a percentage of net revenue increased by 0.1 percentage point primarily driven by an increase in field selling cost. Printing The components of the net revenue and weighted net revenue change by business unit were as follows: Fiscal Year 2017 compared with Fiscal Year 2016 Printing net revenue increased 3.0% (increased 3.5% on a constant currency basis) for fiscal year 2017. The increase in net revenue was primarily driven by the increase in Supplies revenue. Net revenue for Supplies increased 4.6% as compared to the prior-year period, primarily due to the change in the Supplies sales model in the prior-year period and better discount management, partially offset by unfavorable foreign currency impacts. Printer unit volume increased 3.4% while ASPs decreased 0.9% as compared to the prior-year period. The increase in Printer unit volume was primarily driven by unit increases in Consumer Hardware and larger opportunity to place incremental units with positive net present value. Printer ASPs decreased primarily due to unfavorable foreign currency impacts. HP INC. AND SUBSIDIARIES Management’s Discussion and Analysis of Financial Condition and Results of Operations (Continued) Net revenue for Commercial Hardware decreased 2% as compared to the prior-year period, driven by a decline in other printing solutions largely due to the divestiture of marketing optimization assets in the prior-year period, partially offset by revenue from 3D printing in fiscal year 2017. ASPs decreased by 0.1% while unit volume increased by 2.0%. The unit volume increased primarily due to a larger opportunity to place incremental units with positive net present value. The decrease in ASPs was primarily due to unfavorable foreign currency impacts, partially offset by a mix shift to higher-end printers. Net revenue for Consumer Hardware increased 3% as compared to the prior-year period due to a 4% increase in printer unit volume, partially offset by 0.4% decrease in ASPs. The unit volume increase was driven by the Home business. The decrease in ASPs was primarily due to unfavorable foreign currency impacts, partially offset by better discount management. Printing earnings from operations as a percentage of net revenue decreased by 0.3 percentage points for the fiscal year 2017 as compared to the prior-year period, primarily due to an increase in operating expenses, partially offset by an improved gross margin. The gross margin increased due to operational improvements, partially offset by unfavorable foreign currency impacts. Operating expenses increased primarily due to a gain from the divestiture of marketing optimization assets in the prior-year period and an increase in marketing investments. Fiscal Year 2016 compared with Fiscal Year 2015 Printing net revenue decreased 14.0% (decreased 9.3% on a constant currency basis) for fiscal year 2016. The decline in net revenue was primarily due to unfavorable foreign currency impacts, weakness in demand, impact from the change in the Supplies sales model and competitive pricing pressures. These factors resulted in a net revenue decline across Supplies and Consumer and Commercial Hardware. Net revenue for Supplies decreased 15% as compared to the prior-year period, primarily due to unfavorable foreign currency impacts, demand weakness combined with a competitive pricing environment and impact of the change in the Supplies sales model. Printer unit volume decreased 12% and ASPs increased by 2% as compared to the prior-year period. Printer unit volume decreased due to weakness in demand, our pricing discipline and focus on placing positive NPV units. Printer ASPs increased primarily due to a favorable mix shift to high-value printers, partially offset by unfavorable foreign currency impacts. Net revenue for Commercial Hardware decreased 7% for fiscal year 2016 as compared to the prior-year period primarily driven by an 8% decline in unit volume and a decrease in other peripheral printing solutions. The unit volume in Commercial Hardware declined primarily due to a unit volume decline in LaserJet printers. The ASPs in Commercial Hardware increased by 2% primarily due to a mix shift to high-value printer sales offset by unfavorable foreign currency impacts. Printer unit volume in Consumer Hardware declined 12%, combined with a decline in other printing solutions largely driven by the divestiture of Snapfish in the prior-year period and a 2% decline in ASPs, resulted in a 19% decline in Consumer Hardware net revenue for fiscal year 2016 as compared to the prior-year period. The unit volume decline in Consumer Hardware was primarily due to weakness in demand, our pricing discipline and our continued efforts to place positive NPV units. The ASPs in Consumer Hardware decreased primarily due to unfavorable foreign currency impacts. Printing earnings from operations as a percentage of net revenue decreased by 0.6% percentage points for fiscal year 2016 as compared to the prior-year period due to decline in gross margin, partially offset by the gains from the divestiture of certain software assets. The gross margin decline was primarily due to unfavorable foreign currency impacts and supplies mix, partially offset by operational improvements and a favorable mix of printers. Operating expenses decreased primarily due to the gains from the divestiture of certain software assets to Open Text Corporation and cost-saving initiatives. Corporate Investments The loss from operations in Corporate Investments for the fiscal years 2017, 2016 and 2015 was primarily due to expenses associated with our incubation projects and HP Labs. LIQUIDITY AND CAPITAL RESOURCES We use cash generated by operations as our primary source of liquidity. We believe that internally generated cash flows are generally sufficient to support our operating businesses, capital expenditures, acquisitions, restructuring activities, maturing debt, income tax payments and the payment of stockholder dividends, in addition to investments and share repurchases. We are HP INC. AND SUBSIDIARIES Management’s Discussion and Analysis of Financial Condition and Results of Operations (Continued) able to supplement this short-term liquidity, if necessary, with broad access to capital markets and credit facilities made available by various domestic and foreign financial institutions. While our access to capital markets may be constrained and our cost of borrowing may increase under certain business, market and economic conditions, our access to a variety of funding sources to meet our liquidity needs is designed to facilitate continued access to capital resources under all such conditions. Our liquidity is subject to various risks including the risks identified in the section entitled “Risk Factors” in Item 1A and market risks identified in the section entitled “Quantitative and Qualitative Disclosures about Market Risk” in Item 7A, which is incorporated herein by reference. Our cash balances are held in numerous locations throughout the world, with the majority of those amounts held outside of the United States. We utilize a variety of planning and financing strategies in an effort to ensure that our worldwide cash is available when and where it is needed. Our cash position remains strong, and we expect that our cash balances, anticipated cash flow generated from operations and access to capital markets will be sufficient to cover our expected near-term cash outlays. On November 1, 2017, HP made a cash payment of $1.1 billion to Samsung Electronics Co., Ltd. in connection with the acquisition of its printer business. Amounts held outside of the United States are generally utilized to support non-U.S. liquidity needs, although a portion of those amounts may from time to time be subject to short-term intercompany loans into the United States. Most of the amounts held outside of the United States could be repatriated to the United States but, under current law, some would be subject to U.S. federal income taxes, less applicable foreign tax credits. Repatriation of some foreign earnings is restricted by local law. Except for foreign earnings that are considered indefinitely reinvested outside of the United States, we have provided for the U.S. federal tax liability on these earnings for financial statement purposes. Repatriation could result in additional income tax payments in future years. Where local restrictions prevent an efficient intercompany transfer of funds, our intent is that cash balances would remain outside of the United States and we would meet liquidity needs through ongoing cash flows, external borrowings, or both. We do not expect restrictions or potential taxes incurred on amounts repatriated to the United States to have a material effect on our overall liquidity, financial condition or results of operations. Liquidity Our cash and cash equivalents, marketable debt securities and total debt for continuing operations were as follows: (1) Includes highly liquid U.S. treasury notes, U.S. agency securities, non-U.S. government bonds, corporate debt securities, money market and other funds. We classify these investments within Other current assets in Consolidated Balance Sheets, including those with maturity dates beyond one year, based on their highly liquid nature and availability for use in current operations. Our historical statements of cash flows represent the combined cash flows and key cash flow metrics of HP prior to the Separation and have not been revised to reflect the effect of the Separation. For further information on discontinued operations, see Note 17, “Discontinued Operations” in the Consolidated Financial Statements and notes thereto included in Item 8, “Financial Statements and Supplementary Data”, which is incorporated herein by reference. Our key cash flow metrics were as follows: HP INC. AND SUBSIDIARIES Management’s Discussion and Analysis of Financial Condition and Results of Operations (Continued) Operating Activities Net cash provided by operating activities increased by $0.4 billion for fiscal year 2017 as compared to fiscal year 2016.The increase was primarily due to higher cash generated from working capital management activities. Net cash provided by operating activities decreased by $3.8 billion for fiscal year 2016 as compared to fiscal year 2015, since the net cash provided by operating activities for fiscal year 2015 included the impact of discontinued operations, which is not included in the net cash provided by operating activities for fiscal year 2016, as a result of the Separation. Working Capital Metrics Management utilizes current cash conversion cycle information to manage our working capital level. The table below presents the cash conversion cycle: The cash conversion cycle is the sum of days of DSO and DOS less DPO. Items which may cause the cash conversion cycle in a particular period to differ from a long-term sustainable rate include, but are not limited to, changes in business mix, changes in payment terms, extent of receivables factoring, seasonal trends and the timing of revenue recognition and inventory purchases within the period. DSO measures the average number of days our receivables are outstanding. DSO is calculated by dividing ending accounts receivable, net of allowance for doubtful accounts, by a 90-day average of net revenue. For fiscal year 2017, the decrease in DSO compared to fiscal year 2016 was primarily due to strong collections. For fiscal year 2016, the decrease in DSO compared to fiscal year 2015 was primarily due to favorable revenue linearity and strong collections, partially offset by unfavorable foreign currency impacts. DOS measures the average number of days from procurement to sale of our product. DOS is calculated by dividing ending inventory by a 90-day average of cost of goods sold. For fiscal year 2017, the DOS was higher primarily due to leveraging our balance sheet, particularly through higher strategic buys and sea shipments to better assure supply of commodities in short supply. For fiscal year 2016, the DOS was flat compared to fiscal year 2015 due to strong inventory management offset by higher inventory balance to support future sales levels. DPO measures the average number of days our accounts payable balances are outstanding. DPO is calculated by dividing ending accounts payable by a 90-day average of cost of goods sold. For fiscal year 2017, the DPO was higher primarily due to increased inventory purchases and an extension of payment terms with our product suppliers. For fiscal year 2016, the increase in DPO compared to fiscal year 2015 was primarily the result of an extension of payment terms with our product suppliers and increased strategic inventory purchases. Investing Activities Net cash used in investing activities increased by $1.8 billion for fiscal year 2017 as compared to fiscal year 2016, primarily due to net investment activity of $1.1 billion, classified as available-for-sale investments within Other current assets, collateral of $0.2 billion related to our derivatives and proceeds from a business divestiture of $0.5 billion in fiscal year 2016. Net cash used in investing activities decreased by $5.6 billion for fiscal year 2016 as compared to fiscal year 2015, due to capital expenditures and payments made in connection with business acquisitions, net of cash acquired, in fiscal year 2015 by the discontinued operations. Financing Activities Net cash used in financing activities decreased by $13.2 billion in fiscal year 2017 compared to fiscal year 2016, as the net cash used in financing activities for the fiscal year 2016 included the cash transfer of $10.4 billion to Hewlett Packard Enterprise in connection with the Separation and the redemption of $2.1 billion of U.S. Dollar Global Notes, and fiscal year 2017 included a higher outstanding of commercial paper of $0.9 billion. Net cash used in financing activities increased by $15.2 billion in fiscal year 2016 compared to fiscal year 2015, primarily due to the cash transfer of $10.4 billion to Hewlett Packard Enterprise in connection with the Separation, the redemption of $2.1 billion of U.S. Dollar Global Notes and cash utilization of $2.0 billion for repurchases of common stock and dividends. HP INC. AND SUBSIDIARIES Management’s Discussion and Analysis of Financial Condition and Results of Operations (Continued) Capital Resources Debt Levels We maintain debt levels that we establish through consideration of a number of factors, including cash flow expectations, cash requirements for operations, investment plans (including acquisitions), share repurchase activities, our cost of capital and targeted capital structure. Short-term debt increased by $1.0 billion for fiscal year 2017 as compared to fiscal year 2016. The net increase in total debt was primarily due to a higher outstanding of commercial paper of $0.9 billion. Short-term debt decreased by $2.1 billion and long-term debt increased by $0.1 billion for fiscal year 2016 as compared to fiscal year 2015. The net decrease in total debt was primarily due to the redemption of $2.1 billion of fixed rate U.S. Dollar Global Notes in November 2015. Our debt-to-equity ratio is calculated as the carrying amount of debt divided by total stockholders’ (deficit) equity. Our debt-to-equity ratio increased by 0.54x in fiscal year 2017 compared to fiscal year 2016, due to an increase in total debt balances of $1.0 billion. Our debt-to-equity ratio decreased by 2.06x in fiscal year 2016 compared to fiscal year 2015, primarily due to negative equity resulting from the transfer of net assets of $32.5 billion to Hewlett Packard Enterprise and the redemption of $2.1 billion of fixed-rate U.S. Dollar Global Notes due to the Separation. During fiscal year 2017 and 2016, we generated operating cash flow of $3.7 billion and $3.3 billion, respectively. Our weighted-average interest rate reflects the effective interest rate on our borrowings prevailing during the period and reflects the effect of interest rate swaps. For more information on our interest rate swaps, see Note 10, “Financial Instruments” in the Consolidated Financial Statements and notes thereto in Item 8, “Financial Statements and Supplementary Data”. Available Borrowing Resources We had the following resources available to obtain short or long-term financing: As of October 31, 2017, we maintain a senior unsecured committed revolving credit facility with aggregate lending commitments of $4.0 billion, which will be available until April 2, 2019 and is primarily to support the issuance of commercial paper. Funds borrowed under this revolving credit facility may also be used for general corporate purposes. We increased our issuance authorization under our commercial paper program from $4.0 billion to $6.0 billion in November 2017. In December 2017, we also entered into a revolving credit facility with certain institutional lenders that provides us with $1.5 billion of available borrowings until November 30, 2018. For more information on our borrowings, see Note 11, “Borrowings”, to the Consolidated Financial Statements in Item 8, which is incorporated herein by reference. Credit Ratings Our credit risk is evaluated by major independent rating agencies based upon publicly available information as well as information obtained in our ongoing discussions with them. While we do not have any rating downgrade triggers that would accelerate the maturity of a material amount of our debt, previous downgrades have increased the cost of borrowing under our credit facilities, have reduced market capacity for our commercial paper and have required the posting of additional collateral under some of our derivative contracts. In addition, any further downgrade to our credit ratings by any rating agencies may further impact us in a similar manner, and, depending on the extent of any such downgrade, could have a negative impact on HP INC. AND SUBSIDIARIES Management’s Discussion and Analysis of Financial Condition and Results of Operations (Continued) our liquidity and capital position. We can access alternative sources of funding, including drawdowns under our credit facilities, if necessary, to offset potential reductions in the market capacity for our commercial paper. HP INC. AND SUBSIDIARIES Management’s Discussion and Analysis of Financial Condition and Results of Operations CONTRACTUAL AND OTHER OBLIGATIONS Our contractual and other obligations as of October 31, 2017, were as follows: (1) Amounts represent the principal cash payments relating to our short-term and long-term debt and do not include any fair value adjustments, discounts or premiums. (2) Amounts represent the expected interest payments relating to our short-term and long-term debt. We have outstanding interest rate swap agreements accounted for as fair value hedges that have the economic effect of changing fixed interest rates associated with some of our U.S. Dollar Global Notes to variable interest rates. The impact of our outstanding interest rate swaps at October 31, 2017 was factored into the calculation of the future interest payments on debt. (3) Purchase obligations include agreements to purchase goods or services that are enforceable and legally binding on us and that specify all significant terms, including fixed or minimum quantities to be purchased; fixed, minimum or variable price provisions; and the approximate timing of the transaction. These purchase obligations are related principally to inventory and other items. Purchase obligations exclude agreements that are cancelable without penalty. Purchase obligations also exclude open purchase orders that are routine arrangements entered into in the ordinary course of business as they are difficult to quantify in a meaningful way. Even though open purchase orders are considered enforceable and legally binding, the terms generally allow us the option to cancel, reschedule, and adjust terms based on our business needs prior to the delivery of goods or performance of services. (4) Amounts represent the operating lease obligations, net of total sublease income of $174 million. (5) Amounts represent the capital lease obligations, including total capital lease interest obligations of $45 million. (6) Retirement and Post-Retirement Benefit Plan Contributions. In fiscal year 2018, we anticipate making contributions of approximately $24 million to non-U.S. pension plans, $33 million to cover benefit payments to U.S. non-qualified pension plan participants and $7 million to cover benefit claims for our post-retirement benefit plans. Our policy is to fund our pension plans so that we meet at least the minimum contribution requirements, as established by local government, funding and taxing authorities. Expected contributions and payments to our pension and post-retirement benefit plans are excluded from the contractual obligations table because they do not represent contractual cash outflows as they are dependent on numerous factors which may result in a wide range of outcomes. For more information on our retirement and post-retirement benefit plans, see Note 4, “Retirement and Post-Retirement Benefit Plans”, to the Consolidated Financial Statements in Item 8, which is incorporated herein by reference. (7) Cost Savings Plans. We expect to make future cash payments of between $173 million and $323 million in connection with our cost savings plans through fiscal year 2021. These payments have been excluded from the contractual obligations table, because they do not represent contractual cash outflows and there is uncertainty as to the timing of these payments. For more information on our restructuring activities that are part of our cost improvements, see Note 3, “Restructuring and Other Charges”, to the Consolidated Financial Statements in Item 8, which is incorporated herein by reference. (8) Uncertain Tax Positions. As of October 31, 2017, we had approximately $2.1 billion of recorded liabilities and related interest and penalties pertaining to uncertain tax positions. We are unable to make a reasonable estimate as to when cash settlement with the tax authorities might occur due to the uncertainties related to these tax matters. Payments of these obligations would result from settlements with taxing authorities. For more information on our uncertain tax positions, HP INC. AND SUBSIDIARIES Management’s Discussion and Analysis of Financial Condition and Results of Operations (Continued) see Note 6, “Taxes on Earnings”, to the Consolidated Financial Statements in Item 8, which is incorporated herein by reference. OFF-BALANCE SHEET ARRANGEMENTS As part of our ongoing business, we have not participated in transactions that generate material relationships with unconsolidated entities or financial partnerships, such as entities often referred to as structured finance or special purpose entities, which would have been established for the purpose of facilitating off-balance sheet arrangements or other contractually narrow or limited purposes. We have third-party short-term financing arrangements intended to facilitate the working capital requirements of certain customers. For more information on our third-party short-term financing arrangements, see Note 7 “Supplementary Financial Information” to the Consolidated Financial Statements in Item 8, which is incorporated herein by reference.

<s>[INST] HP Inc. Separation Transaction. A discussion of the separation of Hewlett Packard Enterprise Company, HP Inc.’s former enterprise technology infrastructure, software, services and financing businesses. Overview. A discussion of our business and other highlights affecting the company to provide context for the remainder of this MD&A. Critical Accounting Policies and Estimates. A discussion of accounting policies and estimates that we believe are important to understanding the assumptions and judgments incorporated in our reported financial results. Results of Operations. An analysis of our continuing financial results comparing fiscal year 2017 to fiscal year 2016 and fiscal year 2016 to fiscal year 2015. A discussion of the results of continuing operations is followed by a more detailed discussion of the results of operations by segment. Liquidity and Capital Resources. An analysis of changes in our cash flows and a discussion of our liquidity and continuing financial condition. Contractual and Other Obligations. An overview of contractual obligations, retirement and postretirement benefit plan contributions, costsaving plans, uncertain tax positions and offbalance sheet arrangements of our continuing operations. The discussion of financial condition and results of our continuing operations that follows provides information that will assist the reader in understanding our Consolidated Financial Statements, the changes in certain key items in those financial statements from year to year, and the primary factors that accounted for those changes, as well as how certain accounting principles, policies and estimates affect our Consolidated Financial Statements. This discussion should be read in conjunction with our Consolidated Financial Statements and the related notes that appear elsewhere in this document. HP Inc. Separation Transaction On November 1, 2015, we completed the separation of Hewlett Packard Enterprise Company (“Hewlett Packard Enterprise”), HewlettPackard Company’s former enterprise technology infrastructure, software, services and financing businesses (the “Separation”). In connection with the Separation, HewlettPackard Company changed its name to HP Inc. (“HP”). In connection with the Separation, we and Hewlett Packard Enterprise have entered into a separation and distribution agreement as well as various other agreements that provide a framework for the relationships between HP and Hewlett Packard Enterprise going forward, including among others a tax matters agreement, an employee matters agreement, a real estate matters agreement and a master commercial agreement. HP INC. AND SUBSIDIARIES Management’s Discussion and Analysis of Financial Condition and Results of Operations (Continued) OVERVIEW We are a leading global provider of personal computing and other access devices, imaging and printing products, and related technologies, solutions, and services. We sell to individual consumers, small and mediumsized businesses (“SMBs”) and large enterprises, including customers in the government, health, and education sectors. We have three segments for financial reporting purposes: Personal Systems, Printing and Corporate Investments. The Personal Systems segment offers Commercial and Consumer personal computers (“PCs”), Workstations, thin clients, Commercial tablets and mobility devices, retail pointofsale systems, displays and other related accessories, software, support and services for the commercial and consumer markets. The Printing segment provides Consumer and Commercial printer hardware, Supplies, solutions and services, as well as scanning devices. Corporate Investments include HP Labs and certain business incubation projects. In Personal Systems, our strategic focus is on profitable growth through hyper market segmentation with respect to enhanced innovation in multioperating systems, multiarchitecture, geography, customer segments and other key attributes. Additionally, we are investing in premium and mobility form factors such as convertible notebooks, detachable notebooks and mobility devices in order to meet customer preference for mobile, thinner and lighter devices. The beginning of a market shift to contractual solutions includes an increased focus on Device as a Service. We believe that we are well positioned due to our competitive product lineup. In Printing, our strategic focus is on business printing, a shift to contractual solutions and Graphics, as well as expanding our footprint in the 3D printing marketplace. Business printing includes delivering solutions to SMBs and enterprise customers, such as multifunction and PageWide printers [/INST] Negative. </s>

HP INC

2018-12-13

2018-10-31

ITEM 7. Management’s Discussion and Analysis of Financial Condition and Results of Operations. This Management’s Discussion and Analysis of Financial Condition and Results of Operations (“MD&A”) is organized as follows: • Overview. A discussion of our business and other highlights affecting the company to provide context for the remainder of this MD&A. • Separation Transaction. A discussion of the separation of Hewlett Packard Enterprise Company, HP Inc.’s former enterprise technology infrastructure, software, services and financing businesses. • Critical Accounting Policies and Estimates. A discussion of accounting policies and estimates that we believe are important to understanding the assumptions and judgments incorporated in our reported financial results. • Results of Operations. An analysis of our continuing financial results comparing fiscal year 2018 to fiscal year 2017 and fiscal year 2017 to fiscal year 2016. A discussion of the results of continuing operations is followed by a more detailed discussion of the results of operations by segment. • Liquidity and Capital Resources. An analysis of changes in our cash flows and a discussion of our liquidity and financial condition. • Contractual and Other Obligations. An overview of contractual obligations, retirement and post-retirement benefit plan contributions, cost-saving plans, uncertain tax positions and off-balance sheet arrangements. The discussion of financial condition and results of our continuing operations that follows provides information that will assist the reader in understanding our Consolidated Financial Statements, the changes in certain key items in those financial statements from year to year, and the primary factors that accounted for those changes, as well as how certain accounting principles, policies and estimates affect our Consolidated Financial Statements. This discussion should be read in conjunction with our Consolidated Financial Statements and the related notes that appear elsewhere in this document. HP INC. AND SUBSIDIARIES Management’s Discussion and Analysis of Financial Condition and Results of Operations (Continued) OVERVIEW We are a leading global provider of personal computing and other access devices, imaging and printing products, and related technologies, solutions, and services. We sell to individual consumers, SMBs and large enterprises, including customers in the government, health, and education sectors. We have three reportable segments: Personal Systems, Printing and Corporate Investments. The Personal Systems segment offers Commercial and Consumer desktop and notebook PCs, workstations, thin clients, Commercial mobility devices, retail POS systems, displays and other related accessories, software, support, and services. The Printing segment provides Consumer and Commercial printer hardware, Supplies, solutions and services, as well as scanning devices. Corporate Investments include HP Labs and certain business incubation projects. • In Personal Systems, our strategic focus is on profitable growth through hyper market segmentation with respect to enhanced innovation in multi-operating systems, multi-architecture, geography, customer segments and other key attributes. Additionally, we are investing in premium form factors such as convertible notebooks to meet customer preference for mobile, thinner and lighter devices. We have increased our focus on Device as a Service as the market begins to shift to contractual solutions. We believe that we are well positioned due to our competitive product lineup. • In Printing, our strategic growth focus is on shifting to contractual solutions and Graphics, as well as expanding our footprint in the 3D printing marketplace. Business printing includes delivering solutions to SMBs and enterprise customers, such as multi-function and PageWide printers, including our JetIntelligence lineup of LaserJet printers. The shift to contractual solutions includes an increased focus on Managed Print Services and Instant Ink, which presents strong after-market supplies opportunities. In the Graphics space, we are focused on innovations such as our Indigo and Latex product offerings. We plan to continue to focus on shifting the mix in the installed base to higher value units and expanding our innovative Ink, Laser, Graphics and 3D printing programs. We continue to execute on our key initiatives of focusing on high-value products targeted at high usage categories and introducing new revenue delivery models. Our focus is on placing higher value printer units which offer strong annuity of toner and ink, the design and deployment of A3 products and solutions, accelerating growth in Graphic solutions and 3D printing. We continue to experience challenges that are representative of trends and uncertainties that may affect our business and results of operations. One set of challenges relates to dynamic market trends, such as forecasted declining PC Client markets and flat home printing markets. A second set of challenges relates to changes in the competitive landscape. Our primary competitors are exerting competitive pressure in targeted areas and are entering new markets, our emerging competitors are introducing new technologies and business models, and our alliance partners in some businesses are increasingly becoming our competitors in others. A third set of challenges relates to business model changes and our go-to-market execution. • In Personal Systems, we face challenges with industry component availability. • In Printing, we are seeing signs of stabilization of demand in consumer and commercial markets, but are still experiencing an overall competitive pricing environment. We obtain many components from single sources due to technology, availability, price, quality or other considerations. For instance, we source the majority of our A4 and a portion of our A3 portfolio of laser printer engines and laser toner cartridges from Canon. Any decision by either party to not renew our agreement with Canon or to limit or reduce the scope of the agreement could adversely affect our net revenue from LaserJet products; however, we have a long-standing business relationship with Canon and anticipate renewal of this agreement. We are also seeing increases in commodity costs impacting our bill of materials. Our business and financial performance also depend significantly on worldwide economic conditions. Accordingly, we face global macroeconomic challenges, tariff-driven headwinds, uncertainty in the markets, volatility in exchange rates, weaker macroeconomic conditions and evolving dynamics in the global trade environment. The impact of these and other global macroeconomic challenges on our business cannot be known at this time. To address these challenges, we continue to pursue innovation with a view towards developing new products and services aligned with generating market demand and meeting the needs of our customers and partners. In addition, we continue to work on improving our operations, with a particular focus on enhancing our end-to-end processes and efficiencies. We also continue to work on optimizing our sales coverage models, align our sales incentives with our strategic goals, improve channel execution, strengthen our capabilities in our areas of strategic focus, and develop and capitalize on market opportunities. We typically experience higher net revenues in our fourth quarter compared to other quarters in our fiscal year due in part to seasonal holiday demand. Historical seasonal patterns should not be considered reliable indicators of our future net revenues or financial performance. For a further discussion of trends, uncertainties and other factors that could impact our continuing operating results, see the section entitled “Risk Factors” in Item 1A in this Annual Report on Form 10-K. HP INC. AND SUBSIDIARIES Management’s Discussion and Analysis of Financial Condition and Results of Operations (Continued) SEPARATION TRANSACTION On November 1, 2015, we completed the separation of Hewlett Packard Enterprise, Hewlett-Packard Company’s former enterprise technology infrastructure, software, services and financing businesses and entered into a separation and distribution agreement as well as various other agreements that provide a framework for the relationships between HP and Hewlett Packard Enterprise going forward, including among others a tax matters agreement, an employee matters agreement, a real estate matters agreement and a master commercial agreement. CRITICAL ACCOUNTING POLICIES AND ESTIMATES General The Consolidated Financial Statements of HP are prepared in accordance with United States (“U.S.”) generally accepted accounting principles (“GAAP”), which require management to make estimates, judgments and assumptions that affect the reported amounts of assets, liabilities, net revenue and expenses, and the disclosure of contingent liabilities. Management bases its estimates on historical experience and on various other assumptions that it believes to be reasonable under the circumstances, the results of which form the basis for making judgments about the carrying amount of assets and liabilities that are not readily apparent from other sources. Management has discussed the development, selection and disclosure of these estimates with the Audit Committee of HP’s Board of Directors. Management believes that the accounting estimates employed and the resulting amounts are reasonable; however, actual results may differ from these estimates. Making estimates and judgments about future events is inherently unpredictable and is subject to significant uncertainties, some of which are beyond our control. Should any of these estimates and assumptions change or prove to have been incorrect, it could have a material impact on our results of operations, financial position and cash flows. A summary of significant accounting policies is included in Note 1, “Overview and Summary of Significant Accounting Policies” to the Consolidated Financial Statements in Item 8, which is incorporated herein by reference. An accounting policy is deemed to be critical if it requires an accounting estimate to be made based on assumptions about matters that are highly uncertain at the time the estimate is made, if different estimates reasonably could have been used, or if changes in the estimate that are reasonably possible could materially impact the financial statements. Management believes the following critical accounting policies reflect the significant estimates and assumptions used in the preparation of the Consolidated Financial Statements. Revenue Recognition We recognize revenue when persuasive evidence of an arrangement exists, delivery has occurred or services are rendered, the sales price or fee is fixed or determinable and collectability is reasonably assured, as well as when other revenue recognition principles are met, including industry-specific revenue recognition guidance. We enter into contracts to sell our products and services, and while many of our sales agreements contain standard terms and conditions, there are agreements which contain non-standard terms and conditions. Further, many of our arrangements include multiple elements. As a result, significant contract interpretation may be required to determine the appropriate accounting, including the identification of deliverables considered to be separate units of accounting, the allocation of the transaction price among elements in the arrangement and the timing of revenue recognition for each of those elements. We recognize revenue for delivered elements as separate units of accounting when the delivered elements have standalone value to the customer. For elements with no standalone value, we recognize revenue consistent with the pattern of the delivery of the final deliverable. If the arrangement includes a customer-negotiated refund or return right or other contingency relative to the delivered items and the delivery and performance of the undelivered items is considered probable and substantially within our control, the delivered element constitutes a separate unit of accounting. In arrangements with combined units of accounting, changes in the allocation of the transaction price among elements may impact the timing of revenue recognition for the contract but will not change the total revenue recognized for the contract. We establish the selling prices used for each deliverable based on vendor specific objective evidence (“VSOE”) of selling price, if available, third-party evidence (“TPE”), if VSOE of selling price is not available, or estimated selling price (“ESP”), if neither VSOE of selling price nor TPE is available. We establish VSOE of selling price using the price charged for a deliverable when sold separately and, in rare instances, using the price established by management having the relevant authority. We evaluate TPE of selling price by reviewing largely similar and interchangeable competitor products or services in standalone sales to similarly situated customers. ESP is established based on management’s judgment considering internal factors such as margin objectives, pricing practices and controls, customer segment pricing strategies and the product life cycle. Consideration is also given to market conditions such as competitor pricing strategies and industry technology life cycles. We may modify or HP INC. AND SUBSIDIARIES Management’s Discussion and Analysis of Financial Condition and Results of Operations (Continued) develop new go-to-market practices in the future, which may result in changes in selling prices, impacting both VSOE of selling price and ESP. In most arrangements with multiple elements, the transaction price is allocated to the individual units of accounting at the inception of the arrangement based on their relative selling price. However, the aforementioned factors may result in a different allocation of the transaction price to deliverables in multiple element arrangements entered into in future periods. This may change the pattern and timing of revenue recognition for identical arrangements executed in future periods, but will not change the total revenue recognized for any given arrangement. We reduce revenue for customer and distributor programs and incentive offerings, including price protection, rebates, promotions, other volume-based incentives and expected returns. Future market conditions and product transitions may require us to take actions to increase customer incentive offerings, possibly resulting in an incremental reduction of revenue at the time the incentive is offered. For certain incentive programs, we estimate the number of customers expected to redeem the incentive based on historical experience and the specific terms and conditions of the incentive. For hardware products, we recognize revenue generated from direct sales to end customers and indirect sales to channel partners (including resellers, distributors and value-added solution providers) when the revenue recognition criteria are satisfied. For indirect sales to channel partners, we recognize revenue at the time of delivery when the channel partner has economic substance apart from HP and HP has completed its obligations related to the sale. We recognize revenue from fixed-price support or maintenance contracts ratably over the contract period. Warranty We accrue the estimated cost of product warranties at the time we recognize revenue. We evaluate our warranty obligations on a product group basis. Our standard product warranty terms generally include post-sales support and repairs or replacement of a product at no additional charge for a specified period. While we engage in extensive product quality programs and processes, including actively monitoring and evaluating the quality of our component suppliers, we base our estimated warranty obligation on contractual warranty terms, repair costs, product call rates, average cost per call, current period product shipments and ongoing product failure rates, as well as specific product class failure outside of our baseline experience. Warranty terms generally range from 90 days to three years for parts, labor and onsite services, depending upon the product. Over the last three fiscal years, the annual warranty expense and actual warranty costs have averaged approximately 1.8% and 2.0% of annual net revenue, respectively. Restructuring and Other Charges We have engaged in restructuring actions which require management to estimate the timing and amount of severance and other employee separation costs for workforce reduction programs, fair value of assets made redundant or obsolete, and the fair value of lease cancellation and other exit costs. We accrue for severance and other employee separation costs under these actions when it is probable that benefits will be paid and the amount is reasonably estimable. The rates used in determining severance accruals are based on existing plans, historical experiences and negotiated settlements. Other charges include non-recurring costs that are distinct from ongoing operational costs such as information technology costs incurred in connection with the Separation. For a full description of our restructuring actions, refer to our discussions of restructuring in “Results of Operations” below and in Note 3, “Restructuring and Other Charges” to the Consolidated Financial Statements in Item 8, which are incorporated herein by reference. Retirement and Post-Retirement Benefits Our pension and other post-retirement benefit costs and obligations depend on various assumptions. Our major assumptions relate primarily to discount rates, mortality rates, expected increases in compensation levels and the expected long-term return on plan assets. The discount rate assumption is based on current investment yields of high-quality fixed-income securities with maturities similar to the expected benefits payment period. Mortality rates help predict the expected life of plan participants and are based on a historical demographic study of the plan. The expected increase in the compensation levels assumption reflects our long-term actual experience and future expectations. The expected long-term return on plan assets is determined based on asset allocations, historical portfolio results, historical asset correlations and management’s expected returns for each asset class. We evaluate our expected return assumptions annually including reviewing current capital market assumptions to assess the reasonableness of the expected long-term return on plan assets. We update the expected long-term return on assets when we observe a sufficient level of evidence that would suggest the long-term expected return has changed. In any fiscal year, significant differences may arise between the actual return and the expected long-term return on plan assets. Historically, differences between the actual return and expected long-term return on plan assets have resulted from changes in target or actual asset allocation, short-term performance relative to expected long-term performance, and to a lesser extent, differences between target and actual investment allocations, the timing of benefit payments compared to expectations, and the use of derivatives intended to effect asset allocation changes or hedge certain investment or liability exposures. For the HP INC. AND SUBSIDIARIES Management’s Discussion and Analysis of Financial Condition and Results of Operations (Continued) recognition of net periodic benefit cost, the calculation of the expected long-term return on plan assets uses the fair value of plan assets as of the beginning of the fiscal year unless updated as a result of interim re-measurement. Our major assumptions vary by plan, and the weighted-average rates used are set forth in Note 4, “Retirement and Post-Retirement Benefit Plans” to the Consolidated Financial Statements in Item 8, which is incorporated herein by reference. The following table provides the impact a change of 25 basis points in each of the weighted-average assumptions of the discount rate, expected increase in compensation levels and expected long-term return on plan assets would have had on our net periodic benefit cost for fiscal year 2018: Taxes on Earnings The Tax Cuts and Jobs Act (“the TCJA”) made significant changes to the U.S. tax law. The TCJA lowered our U.S. statutory federal income tax rate from 35% to 21% effective January 1, 2018, while also imposing a one-time transition tax on accumulated foreign earnings. In fiscal year 2018, we recorded a provisional tax benefit of $760 million as a provisional estimate under the SEC Staff Accounting Bulletin (“SAB”) No. 118. In December 2017, the SEC staff issued SAB No. 118, which addresses how a company recognizes provisional estimates when a company does not have the necessary information available, prepared or analyzed (including computations) in reasonable detail to complete its accounting for the effect of the changes in the TCJA. The measurement period ends when a company has obtained, prepared, and analyzed the information necessary to finalize its accounting, but cannot extend beyond one year. The final impact of the TCJA may differ from the provisional estimates due to changes in interpretations of the TCJA, legislative action to address questions that arise because of the TCJA, changes in accounting standard for income taxes and related interpretations in response to the TCJA, and updates or changes to estimates used in the provisional amounts. In fiscal year 2018, we recorded a provisional tax benefit of $760 million related to the $5.6 billion net benefit for the decrease in our deferred tax liability on unremitted foreign earnings, partially offset by a $3.3 billion net expense for the deemed repatriation tax payable in installments over eight years, a $1.2 billion net expense for the remeasurement of our deferred tax assets and liabilities to the new U.S. statutory tax rate and a $317 million net expense related to realization on U.S. deferred taxes that are expected to be realized at a lower rate. Resolution of the provisional estimates of the TCJA effects that are different from the assumptions made by us could have a material impact on our financial condition and operating results. Prior to the enactment of the TCJA, our effective tax rate included the impact of certain undistributed foreign earnings for which we have not provided U.S. federal taxes because we had planned to reinvest such earnings indefinitely outside the United States. We plan distributions of foreign earnings based on projected cash flow needs as well as the working capital and long-term investment requirements of our foreign subsidiaries and our domestic operations. Based on these assumptions, we estimate the amount we expect to indefinitely invest outside the United States and the amounts we expect to distribute to the United States and provide the U.S. federal taxes due on amounts expected to be distributed to the United States. Further, as a result of certain employment actions and capital investments we have undertaken, income from manufacturing activities in certain jurisdictions is subject to reduced tax rates and, in some cases, is wholly exempt from taxes for fiscal years through 2027. Material changes in our estimates of cash, working capital and long-term investment requirements in the various jurisdictions in which we do business could impact how future earnings are repatriated to the United States, and our related future effective tax rate. The effects of the TCJA related to these policies are referenced and discussed in detail in Note 6, “Taxes on Earnings” to the Consolidated Financial Statements in Item 8, which is incorporated herein by reference. We calculate our current and deferred tax provisions based on estimates and assumptions that could differ from the final positions reflected in our income tax returns. We adjust our current and deferred tax provisions based on income tax returns which are generally filed in the third or fourth quarters of the subsequent fiscal year. We recognize deferred tax assets and liabilities for the expected tax consequences of temporary differences between the tax bases of assets and liabilities and their reported amounts using enacted tax rates in effect for the year in which we expect the differences to reverse. HP INC. AND SUBSIDIARIES Management’s Discussion and Analysis of Financial Condition and Results of Operations (Continued) We record a valuation allowance to reduce deferred tax assets to the amount that we are more likely than not to realize. In determining the need for a valuation allowance, we consider future market growth, forecasted earnings, future taxable income, the mix of earnings in the jurisdictions in which we operate and prudent and feasible tax planning strategies. In the event we were to determine that it is more likely than not that we will be unable to realize all or part of our deferred tax assets in the future, we would increase the valuation allowance and recognize a corresponding charge to earnings or other comprehensive income in the period in which we make such a determination. Likewise, if we later determine that we are more likely than not to realize the deferred tax assets, we would reverse the applicable portion of the previously recognized valuation allowance. In order for us to realize our deferred tax assets, we must be able to generate sufficient taxable income in the jurisdictions in which the deferred tax assets are located. We are subject to income taxes in the United States and approximately 60 other countries, and we are subject to routine corporate income tax audits in many of these jurisdictions. We believe that positions taken on our tax returns are fully supported, but tax authorities may challenge these positions, which may not be fully sustained on examination by the relevant tax authorities. Accordingly, our income tax provision includes amounts intended to satisfy assessments that may result from these challenges. Determining the income tax provision for these potential assessments and recording the related effects requires management judgments and estimates. The amounts ultimately paid on resolution of an audit could be materially different from the amounts previously included in our income tax provision and, therefore, could have a material impact on our income tax provision, net income and cash flows. Our accrual for uncertain tax positions is attributable primarily to uncertainties concerning the tax treatment of our international operations, including the allocation of income among different jurisdictions, intercompany transactions, pension and related interest. For a further discussion on taxes on earnings, refer to Note 6, “Taxes on Earnings” to the Consolidated Financial Statements in Item 8, which is incorporated herein by reference. Inventory We state our inventory at the lower of cost or market on a first-in, first-out basis. We make adjustments to reduce the cost of inventory to its net realizable value at the product group level for estimated excess or obsolescence. Factors influencing these adjustments include changes in demand, technological changes, product life cycle and development plans, component cost trends, product pricing, physical deterioration and quality issues. Business Combinations We allocate the fair value of purchase consideration to the assets acquired, liabilities assumed, and non-controlling interests in the acquiree generally based on their fair values at the acquisition date. The excess of the fair value of purchase consideration over the fair value of these assets acquired, liabilities assumed and non-controlling interests in the acquiree is recorded as goodwill and may involve engaging independent third-parties to perform an appraisal. When determining the fair values of assets acquired, liabilities assumed, and non-controlling interests in the acquiree, management makes significant estimates and assumptions, especially with respect to intangible assets. Critical estimates in valuing intangible assets include, but are not limited to, expected future cash flows, which includes consideration of future growth rates and margins, attrition rates, future changes in technology and brand awareness, loyalty and position, and discount rates. Fair value estimates are based on the assumptions management believes a market participant would use in pricing the asset or liability. Amounts recorded in a business combination may change during the measurement period, which is a period not to exceed one year from the date of acquisition, as additional information about conditions existing at the acquisition date becomes available. Goodwill We review goodwill for impairment annually during our fourth quarter and whenever events or changes in circumstances indicate the carrying amount of goodwill may not be recoverable. We can elect to perform a qualitative assessment to test a reporting unit’s goodwill for impairment or perform a quantitative impairment test. Based on a qualitative assessment, if we determine that the fair value of a reporting unit is more likely than not (i.e., a likelihood of more than 50 percent) to be less than its carrying amount, the quantitative impairment test will be performed. In the quantitative impairment test, we compare the fair value of each reporting unit to its carrying amount with the fair values derived most significantly from the income approach, and to a lesser extent, the market approach. Under the income approach, we estimate the fair value of a reporting unit based on the present value of estimated future cash flows. We base cash flow projections on management’s estimates of revenue growth rates and operating margins, taking into consideration industry and market conditions. We base the discount rate on the weighted-average cost of capital adjusted for the relevant risk associated with business-specific characteristics and the uncertainty related to the reporting unit’s ability to execute on the projected cash flows. Under the market approach, we estimate fair value based on market multiples of revenue and earnings derived from comparable publicly-traded companies with similar operating and investment characteristics as the reporting unit. We weight the fair value derived from the market approach depending on the level of comparability of these publicly-traded HP INC. AND SUBSIDIARIES Management’s Discussion and Analysis of Financial Condition and Results of Operations (Continued) companies to the reporting unit. When market comparables are not meaningful or not available, we estimate the fair value of a reporting unit using only the income approach. If the fair value of a reporting unit exceeds the carrying amount of the net assets assigned to that reporting unit, goodwill is not impaired. If the fair value of the reporting unit is less than its carrying amount, goodwill is impaired and the excess of the reporting unit’s carrying value over the fair value is recognized as an impairment loss. Our annual goodwill impairment analysis, performed using the qualitative assessment option as of the first day of the fourth quarter of fiscal year 2018, resulted in a conclusion that it was more likely than not that the fair value of our reporting units exceeded their respective carrying values. As a result, we concluded that a quantitative impairment test was not necessary. Fair Value of Derivative Instruments We use derivative instruments to manage a variety of risks, including risks related to foreign currency exchange rates and interest rates. We use forwards, swaps and at times, options to hedge certain foreign currency and interest rate exposures. We do not use derivative instruments for speculative purposes. As of October 31, 2018, the gross notional value of our derivative portfolio was $24 billion. Assets and liabilities related to derivative instruments are measured at fair value and were $515 million and $195 million, respectively, as of October 31, 2018. Fair value is the price we would receive to sell an asset or pay to transfer a liability in an orderly transaction between market participants at the measurement date. In the absence of active markets for the identical assets or liabilities, such measurements involve developing assumptions based on market observable data and, in the absence of such data, internal information that is consistent with what market participants would use in a hypothetical transaction that occurs at the measurement date. The determination of fair value often involves significant judgments about assumptions such as determining an appropriate discount rate that factors in both risk and liquidity premiums, identifying the similarities and differences in market transactions, weighting those differences accordingly and then making the appropriate adjustments to those market transactions to reflect the risks specific to the asset or liability being valued. We generally use industry standard valuation models to measure the fair value of our derivative positions. When prices in active markets are not available for the identical asset or liability, we use industry standard valuation models to measure fair value. Where applicable, these models project future cash flows and discount the future amounts to present value using market-based observable inputs, including interest rate curves, HP and counterparty credit risk, foreign currency exchange rates, and forward and spot prices. For a further discussion on fair value measurements and derivative instruments, refer to Note 9, “Fair Value” and Note 10, “Financial Instruments”, respectively, to the Consolidated Financial Statements in Item 8, which are incorporated herein by reference. Loss Contingencies We are involved in various lawsuits, claims, investigations and proceedings including those consisting of intellectual property (“IP”), commercial, securities, employment, employee benefits and environmental matters that arise in the ordinary course of business. We record a liability when we believe that it is both probable that a liability has been incurred and the amount of loss can be reasonably estimated. Significant judgment is required to determine both the probability of having incurred a liability and the estimated amount of the liability. We review these matters at least quarterly and adjust these liabilities to reflect the impact of negotiations, settlements, rulings, advice of legal counsel and other updated information and events, pertaining to a particular case. Pursuant to the separation and distribution agreement, we share responsibility with Hewlett Packard Enterprise for certain matters, as discussed in Note 14, “Litigation and Contingencies” to the Consolidated Financial Statements in Item 8, which is incorporated herein by reference, and Hewlett Packard Enterprise has agreed to indemnify us in whole or in part with respect to certain matters. Based on our experience, we believe that any damage amounts claimed in the specific litigation and contingencies matters further discussed in Note 14, “Litigation and Contingencies”, are not a meaningful indicator of HP’s potential liability. Litigation is inherently unpredictable. However, we believe we have valid defenses with respect to legal matters pending against us. Nevertheless, cash flows or results of operations could be materially affected in any particular period by the resolution of one or more of these contingencies. We believe we have recorded adequate provisions for any such matters and, as of October 31, 2018, it was not reasonably possible that a material loss had been incurred in excess of the amounts recognized in our financial statements. RECENT ACCOUNTING PRONOUNCEMENTS For a summary of recent accounting pronouncements applicable to our consolidated financial statements see Note 1, “Overview and Summary of Significant Accounting Policies” to the Consolidated Financial Statements in Item 8, which is incorporated herein by reference. HP INC. AND SUBSIDIARIES Management’s Discussion and Analysis of Financial Condition and Results of Operations (Continued) RESULTS OF OPERATIONS Revenue from our international operations has historically represented, and we expect will continue to represent, a majority of our overall net revenue. As a result, our net revenue growth has been impacted, and we expect it will continue to be impacted, by fluctuations in foreign currency exchange rates. In order to provide a framework for assessing performance excluding the impact of foreign currency fluctuations, we supplement the year-over-year percentage change in net revenue with the year-over-year percentage change in net revenue on a constant currency basis, which excludes the effect of foreign currency exchange fluctuations calculated by translating current period revenues using monthly average exchange rates from the comparative period and hedging activities from the prior-year period and does not adjust for any repricing or demand impacts from changes in foreign currency exchange rates. This information is provided so that net revenue can be viewed with and without the effect of fluctuations in foreign currency exchange rates, which is consistent with how management evaluates our net revenue results and trends, as management does not believe that the excluded items are reflective of ongoing operating results. The constant currency measures are provided in addition to, and not as a substitute for, the year-over-year percentage change in net revenue on a GAAP basis. Other companies may calculate and define similarly labeled items differently, which may limit the usefulness of this measure for comparative purposes. Results of operations in dollars and as a percentage of net revenue were as follows: Net Revenue In fiscal year 2018, total net revenue increased 12.3% (increased 10.1% on a constant currency basis) as compared with fiscal year 2017. Net revenue from the United States increased 6.6% to $20.6 billion and net revenue from outside of the United States increased 15.7% to $37.9 billion. The increase in net revenue was primarily driven by growth in Notebooks, Desktops, Supplies, Commercial Printing Hardware revenue and favorable foreign currency impacts. In fiscal year 2017, total net revenue increased 7.9% (increased 8.7% on a constant currency basis) as compared with fiscal year 2016. Net revenue from the United States increased 7.1% to $19.3 billion and net revenue from outside of the United States increased 8.4% to $32.8 billion. The increase in net revenue was primarily driven by growth in Notebooks, Desktops and Supplies revenue, partially offset by unfavorable foreign currency impacts. A detailed discussion of the factors contributing to the changes in segment net revenue is included under “Segment Information” below. Gross Margin HP INC. AND SUBSIDIARIES Management’s Discussion and Analysis of Financial Condition and Results of Operations (Continued) Our gross margin was 18.2% for fiscal year 2018 compared with 18.4% for fiscal year 2017. The decrease was primarily due to higher Commercial Hardware unit placements in Printing and an increase in commodity and logistics costs in Personal Systems, partially offset by higher pricing in Personal Systems and favorable foreign currency impacts. Our gross margin was 18.4% for fiscal year 2017 compared with 18.7% for fiscal year 2016. The primary factors impacting the gross margin decrease were lower Personal System gross margin driven by higher commodity costs, unfavorable foreign currency impacts and a higher mix of Personal Systems revenue, partially offset by productivity improvements in Printing. A detailed discussion of the factors contributing to the changes in segment gross margins is included under “Segment Information” below. Operating Expenses Research and Development (“R&D”) R&D expense increased 18% in fiscal year 2018 compared to fiscal year 2017, primarily due to continuing investment in Printing, including the acquisition of Samsung’s printer business. R&D expense decreased 2% in fiscal year 2017 compared to fiscal year 2016, primarily due to lower spend as a result of the launch of A3 products in fiscal year 2016, partially offset by continuing investment in Printing. Selling, General and Administrative (“SG&A”) SG&A expense increased 11% in fiscal year 2018 as compared to fiscal year 2017, primarily driven by incremental go-to-market investments to support revenue growth, including the acquisition of Samsung’s printer business. SG&A expense increased 14% in fiscal year 2017 as compared to fiscal year 2016, primarily due to a gain from the divestiture of marketing optimization assets in fiscal year 2016 and an increase in field selling costs. Restructuring and other Charges Restructuring and other charges decreased by $230 million in fiscal year 2018 compared to the prior-year period, primarily due to lower charges from our restructuring plan announced in October 2016 (the “Fiscal 2017 Plan”) and amended in May 2018. Restructuring and other charges increased by $157 million in fiscal year 2017 compared to the prior-year period, primarily due to the Fiscal 2017 Plan and certain non-recurring costs, including those as a result of the Separation. Acquisition-related Charges Acquisition-related charges for the fiscal years 2018, 2017 and 2016 relate primarily to third-party professional and legal fees, and integration-related costs, as well as fair value adjustments of certain acquired assets such as inventory. Amortization of Intangible Assets Amortization expense increased by $79 million in fiscal year 2018 compared to the prior-year period, due to intangible assets resulting primarily from the acquisition of Samsung’s printer business. Amortization expense decreased by $15 million in fiscal year 2017 compared to the prior-year period, primarily due to assets from prior acquisitions reaching the end of their respective amortization periods. Interest and Other, Net Interest and other, net expense increased by $808 million in fiscal year 2018 compared to the prior-year period, primarily due to the reversal of indemnification receivables from Hewlett Packard Enterprise pertaining to various income tax audit settlements, and loss on extinguishment of debt. Interest and other, net expense increased by $455 million in fiscal year 2017 compared to the prior-year period, primarily due to lower tax indemnification income in fiscal year 2017 from Hewlett Packard Enterprise for certain tax liabilities that HP is jointly and severally liable for, but for which it is indemnified by Hewlett Packard Enterprise under the tax matters agreement. Benefit from (Provision for) Taxes As a result of U.S. tax reform, a blended U.S. federal statutory rate of 23% was computed for the fiscal year ending October 31, 2018. Our effective tax rates were (76.8%), 22.9% and 29.1% in fiscal years 2018, 2017 and 2016, respectively. In fiscal year 2018, our effective tax rate generally differs from the U.S. federal statutory rate of 23.3% primarily due to transitional impacts of U.S. tax reform and resolution of various audits and tax litigation. In fiscal years 2017 and 2016, our effective tax rate generally differs from the U.S. federal statutory rate of 35% due to favorable tax rates associated with certain earnings from our operations in lower-tax jurisdictions throughout the world. The jurisdictions with favorable tax rates that had the most significant impact on our effective tax rate in the periods presented were Puerto Rico, Singapore, China, Malaysia and HP INC. AND SUBSIDIARIES Management’s Discussion and Analysis of Financial Condition and Results of Operations (Continued) Ireland. The gross income tax benefits related to these favorable tax rates are in addition to transitional impacts of U.S. tax reform and resolution of various audits and tax litigation. Additionally, the overall effective tax rate in fiscal year 2017 was impacted by adjustments to valuation allowances and state income taxes, and the overall effective tax rate in fiscal year 2016 was impacted by adjustments to valuation allowances and uncertain tax positions. For a reconciliation of our effective tax rate to the U.S. federal statutory rate of 23.3% in fiscal year 2018 and 35% in fiscal years 2017 and 2016 and further explanation of our provision for taxes, see Note 6, “Taxes on Earnings” to the Consolidated Financial Statements in Item 8, which is incorporated herein by reference. In fiscal year 2018, we recorded $2.8 billion of net income tax benefit related to discrete items in the provision for taxes which include impacts of the TCJA. As discussed in the Note 6 “Taxes on Earnings” to the Consolidated Financial Statements in Item 8 of this report, we have not yet completed our analysis of the full impact of the TCJA. However, as of October 31, 2018, we recorded a provisional tax benefit of $760 million related to $5.6 billion net benefit for the decrease in our deferred tax liability on unremitted foreign earnings, partially offset by $3.3 billion net expense for the deemed repatriation tax payable in installments over eight years, a $1.2 billion net expense for the remeasurement of our deferred assets and liabilities to the new U.S. statutory tax rate and a $317 million net expense related to realization on U.S. deferred taxes that are expected to be realized at a lower rate. Fiscal year 2018 also included tax benefits related to audit settlements of $1.5 billion and valuation allowance releases of $601 million pertaining to a change in our ability to utilize certain foreign and U.S. deferred tax assets due to a change in our geographic earnings mix. These benefits were partially offset by other net tax charges of $34 million. In fiscal year 2018, in addition to the discrete items mentioned above, we recorded excess tax benefits of $42 million on stock options, restricted stock units and performance-adjusted restricted stock units. In fiscal year 2017, we recorded $72 million of net income tax benefit related to discrete items in the provision for taxes. These amounts primarily include tax benefits of $84 million related to restructuring and other charges, $12 million related to U.S. federal provision to return adjustments, $45 million related to Samsung acquisition-related charges, and $13 million of other net tax benefits. In addition, we recorded tax charges of $11 million related to changes in state valuation allowances, $22 million of state provision to return adjustments, and $49 million related to uncertain tax positions. In fiscal year 2016, we recorded $301 million of net income tax charges related to discrete items in the provision for taxes for continuing operations. These amounts primarily include uncertain tax position charges of $525 million related to pre-Separation tax matters. In addition, we recorded $62 million of net tax benefits on restructuring charges, $52 million of net tax benefits related to the release of foreign valuation allowances and $41 million of net tax benefits arising from the retroactive research and development credit provided by the Consolidated Appropriations Act of 2016 signed into law in December 2015 and $70 million of other tax benefit. Segment Information A description of the products and services for each segment can be found in Note 2, “Segment Information,” to the Consolidated Financial Statements in Item 8, which is incorporated herein by reference. Future changes to this organizational structure may result in changes to the segments disclosed. Realignment Effective at the beginning of its first quarter of fiscal year 2018, HP implemented an organizational change to align its segment and business unit financial reporting more closely with its current business structure. The organizational change resulted in the transfer of long-life consumables from Commercial to Supplies within the Printing segment. Certain revenues related to service arrangements, which are being eliminated for the purposes of reporting HP’s consolidated net revenue, have now been reclassified from Other to segments. HP has reflected this change to its segment and business unit information in prior reporting periods on an as-if basis. The reporting change had no impact on previously reported consolidated net revenue, earnings from operations, net earnings or net EPS. Personal Systems HP INC. AND SUBSIDIARIES Management’s Discussion and Analysis of Financial Condition and Results of Operations (Continued) The components of net revenue and the weighted net revenue change by business unit were as follows: Fiscal Year 2018 compared with Fiscal Year 2017 Personal Systems net revenue increased 13.0% (increased 10.5% on a constant currency basis) in fiscal year 2018 as compared to the prior-year period. The net revenue increase was primarily due to growth in Notebooks and Desktops and favorable foreign currency impacts. The net revenue increase was driven by a 6.6% and 6.0% increase in unit volume and average selling prices (“ASPs”), respectively, as compared to the prior-year period. The increase in unit volume was primarily due to growth in Notebooks and Desktops. The increase in ASPs was primarily due to higher pricing driven by increased commodity and logistics costs, favorable foreign currency impacts and positive mix shifts. Consumer and Commercial revenue increased 11% and 14%, respectively, in fiscal year 2018 as compared to the prior-year period, driven by growth in Notebooks, Desktops and Workstations as a result of higher unit volume combined with higher ASPs. Net revenue increased 14% in Notebooks, 12% in Desktops and 10% in Workstations in fiscal year 2018. Personal Systems earnings from operations as a percentage of net revenue increased by 0.1 percentage points in fiscal year 2018. The increase was primarily due to higher ASPs, partially offset by an increase in commodity and logistics costs. Fiscal Year 2017 compared with Fiscal Year 2016 Personal Systems net revenue increased 11.3% (increased 12.2% on a constant currency basis) in fiscal year 2017. The net revenue increase was primarily due to growth in Notebooks, Desktops and Workstations partially offset by unfavorable foreign currency impacts. The net revenue increase was driven by a 6.7% and 4.3% increase in unit volume and ASPs, respectively, as compared to fiscal year 2016. The increase in unit volume was primarily due to growth in Notebooks and Workstations. The increase in ASPs was primarily due to favorable pricing partially offset by unfavorable foreign currency impacts. Consumer revenue increased 16% in fiscal year 2017, driven by growth in Notebooks and Desktops as a result of higher unit volume combined with higher ASPs. Commercial revenue increased 9% in fiscal year 2017, driven by growth in Notebooks and Workstations. Net revenue increased 16% in Notebooks, 9% in Workstations and 3% in Desktops in fiscal year 2017. Personal Systems earnings from operations as a percentage of net revenue decreased by 0.2 percentage points in fiscal year 2017. The decrease was primarily due to a decline in gross margin partially offset by a decrease in operating expenses. The decrease in gross margin was primarily due to an increase in commodity cost and unfavorable foreign currency impacts HP INC. AND SUBSIDIARIES Management’s Discussion and Analysis of Financial Condition and Results of Operations (Continued) partially offset by higher ASPs. Operating expenses as a percentage of net revenue decreased primarily due to operating expense management. Printing The components of the net revenue and weighted net revenue change by business unit were as follows: Fiscal Year 2018 compared with Fiscal Year 2017 Printing net revenue increased 11.1% (increased 9.5% on a constant currency basis) for fiscal year 2018. The increase in net revenue was primarily driven by the increase in Supplies and Hardware revenue and favorable foreign currency impacts. Net revenue for Supplies increased 8.4% as compared to the prior-year period, including the acquisition of Samsung’s printer business. Printer unit volume increased 12.7% while ASPs increased 1.6% as compared to the prior-year period. The increase in Printer unit volume was primarily driven by unit increases in Commercial and Consumer Hardware, including the Samsung-branded printers. Printer ASPs increased primarily due to favorable foreign currency impacts, partially offset by the dilution impact from Samsung-branded low-end A4 products. Net revenue for Commercial Hardware increased 23.3% as compared to the prior-year period, including revenue from Samsung branded printers, LaserJet and PageWide printers. The unit volume increased by 84.5% while the ASPs decreased by 34.2%. The unit volume increased primarily due to Samsung-branded printers. The decrease in ASPs was primarily due to the dilution impact from Samsung-branded low-end A4 products. Net revenue for Consumer Hardware increased 6.0% as compared to the prior-year period due to a 3.8% increase in printer unit volume and a 2.4% increase in ASPs. The unit volume increase was driven by InkJet and LaserJet Home business. The increase in ASPs was primarily due to favorable foreign currency impacts. Printing earnings from operations as a percentage of net revenue decreased by 0.8 percentage points for the fiscal year 2018 as compared to the prior-year period, primarily due to an increase in operating expenses and lower gross margin. The HP INC. AND SUBSIDIARIES Management’s Discussion and Analysis of Financial Condition and Results of Operations (Continued) gross margin decreased primarily due to lower Supplies mix and the dilution impact of Samsung-branded low-end products, partially offset by favorable foreign currency impacts and operational improvements. Operating expenses increased primarily driven by the acquisition of Samsung’s printer business and increases in investments in key growth initiatives and go-to-market. Fiscal Year 2017 compared with Fiscal Year 2016 Printing net revenue increased 3.3% (increased 3.9% on a constant currency basis) for fiscal year 2017. The increase in net revenue was primarily driven by the increase in Supplies revenue. Net revenue for Supplies increased 4.5% as compared to the prior-year period, primarily due to the change in the Supplies sales model in the prior-year period and better discount management, partially offset by unfavorable foreign currency impacts. Printer unit volume increased 3.4% while ASPs decreased 0.9% as compared to the prior-year period. The increase in Printer unit volume was primarily driven by unit increases in Consumer Hardware and larger opportunity to place incremental units with positive net present value. Printer ASPs decreased primarily due to unfavorable foreign currency impacts. Net revenue for Commercial Hardware is flat as compared to the prior-year period, driven by a decline in other printing solutions largely due to the divestiture of marketing optimization assets in the prior-year period, offset by revenue from Managed Print Services and 3D Printing in fiscal year 2017. ASPs decreased by 0.1% while unit volume increased by 2.0%. The unit volume increased primarily due to a larger opportunity to place incremental units with positive net present value. The decrease in ASPs was primarily due to unfavorable foreign currency impacts, partially offset by a mix shift to higher-end printers. Net revenue for Consumer Hardware increased 2.6% as compared to the prior-year period due to a 3.5% increase in printer unit volume, partially offset by a 0.4% decrease in ASPs. The unit volume increase was driven by the Home business. The decrease in ASPs was primarily due to unfavorable foreign currency impacts, partially offset by better discount management. Printing earnings from operations as a percentage of net revenue decreased by 0.4 percentage points for the fiscal year 2017 as compared to the prior-year period, primarily due to an increase in operating expenses, partially offset by an improved gross margin. The gross margin increased due to operational improvements, partially offset by unfavorable foreign currency impacts. Operating expenses increased primarily due to a gain from the divestiture of marketing optimization assets in the prior-year period and an increase in marketing investments. Corporate Investments The loss from operations in Corporate Investments for the fiscal years 2018, 2017 and 2016 was primarily due to expenses associated with HP Labs and our incubation projects. LIQUIDITY AND CAPITAL RESOURCES We use cash generated by operations as our primary source of liquidity. We believe that internally generated cash flows are generally sufficient to support our operating businesses, capital expenditures, acquisitions, restructuring activities, maturing debt, income tax payments and the payment of stockholder dividends, in addition to investments and share repurchases. We are able to supplement this short-term liquidity, if necessary, with broad access to capital markets and credit facilities made available by various domestic and foreign financial institutions. While our access to capital markets may be constrained and our cost of borrowing may increase under certain business, market and economic conditions, our access to a variety of funding sources to meet our liquidity needs is designed to facilitate continued access to capital resources under all such conditions. Our liquidity is subject to various risks including the risks identified in the section entitled “Risk Factors” in Item 1A and market risks identified in the section entitled “Quantitative and Qualitative Disclosures about Market Risk” in Item 7A, which are incorporated herein by reference. Our cash balances are held in numerous locations throughout the world, with the majority of those amounts held outside of the United States. We utilize a variety of planning and financing strategies in an effort to ensure that our worldwide cash is available when and where it is needed. Our cash position remains strong, and we expect that our cash balances, anticipated cash flow generated from operations and access to capital markets will be sufficient to cover our expected near-term cash outlays. On November 1, 2018, we made a cash payment of $422 million in connection with the acquisition of the Apogee group, a U.K. based office equipment dealer (“OED”) and provider of print, outsourced services, and document and process technology. The cash payment is subject to customary closing and other adjustments and would be finalized in future periods. Amounts held outside of the United States are generally utilized to support non-U.S. liquidity needs, and may from time to time be distributed to the United States. The TCJA made significant changes to the U.S. tax law, including a one-time transition tax on accumulated foreign earnings. The payments associated with this one-time transition tax will be paid over eight years beginning 2019. We expect a significant portion of the cash and cash equivalents held by our foreign subsidiaries will no longer be subject to U.S. income tax consequences upon a subsequent repatriation to the United States as a result of the HP INC. AND SUBSIDIARIES Management’s Discussion and Analysis of Financial Condition and Results of Operations (Continued) transition tax on accumulated foreign earnings. However, a portion of this cash may still be subject to foreign income tax or withholding tax consequences upon repatriation. As we evaluate the impact of the TCJA and the future cash needs of our operations, we may revise the amount of foreign earnings considered to be permanently reinvested in our foreign subsidiaries and how to utilize such funds, including reducing our gross debt level, or other uses. Liquidity Our cash and cash equivalents, marketable debt securities and total debt were as follows: (1) Includes highly liquid U.S. treasury notes, U.S. agency securities, non-U.S. government bonds, corporate debt securities, money market and other funds. We classify these investments within Other current assets in Consolidated Balance Sheets, including those with maturity dates beyond one year, based on their highly liquid nature and availability for use in current operations. Our key cash flow metrics were as follows: Operating Activities Net cash provided by operating activities increased by $0.9 billion for fiscal year 2018 as compared to fiscal year 2017. The increase was primarily due to higher earnings from operations and cash generated from working capital management activities. Net cash provided by operating activities increased by $0.4 billion for fiscal year 2017 as compared to fiscal year 2016. The increase was primarily due to higher cash generated from working capital management activities. Working Capital Metrics Management utilizes current cash conversion cycle information to manage our working capital level. The table below presents the cash conversion cycle: The cash conversion cycle is the sum of days of DSO and DOS less DPO. Items which may cause the cash conversion cycle in a particular period to differ from a long-term sustainable rate include, but are not limited to, changes in business mix, changes in payment terms, extent of receivables factoring, seasonal trends and the timing of revenue recognition and inventory purchases within the period. DSO measures the average number of days our receivables are outstanding. DSO is calculated by dividing ending accounts receivable, net of allowance for doubtful accounts, by a 90-day average of net revenue. For fiscal year 2018, the HP INC. AND SUBSIDIARIES Management’s Discussion and Analysis of Financial Condition and Results of Operations (Continued) increase in DSO compared to fiscal year 2017 was primarily due to unfavorable revenue linearity. For fiscal year 2017, the decrease in DSO compared to fiscal year 2016 was primarily due to strong collections. DOS measures the average number of days from procurement to sale of our product. DOS is calculated by dividing ending inventory by a 90-day average of cost of goods sold. For fiscal year 2018, the DOS was lower primarily due to a focus on inventory management. For fiscal year 2017, the DOS was higher primarily due to leveraging our balance sheet, particularly through higher strategic buys and sea shipments to better assure supply of commodities in short supply. DPO measures the average number of days our accounts payable balances are outstanding. DPO is calculated by dividing ending accounts payable by a 90-day average of cost of goods sold. For fiscal year 2018, the DPO remained flat compared to fiscal year 2017. For fiscal year 2017, the DPO was higher primarily due to increased inventory purchases and an extension of payment terms with our product suppliers. Investing Activities Net cash used in investing activities decreased by $1.0 billion for fiscal year 2018 as compared to fiscal year 2017, primarily due to a decrease in investments classified as available-for-sale investments within Other current assets by $1.6 billion and collateral related to our derivatives of $0.4 billion, partially offset by the payment of $1.0 billion for the acquisition of Samsung’s printer business. Net cash used in investing activities increased by $1.8 billion for fiscal year 2017 as compared to fiscal year 2016, primarily due to net investment activity of $1.1 billion, classified as available-for-sale investments within Other current assets, collateral of $0.2 billion related to our derivatives and proceeds from a business divestiture of $0.5 billion in fiscal year 2016. Financing Activities Net cash used in financing activities increased by $4.4 billion in fiscal year 2018 compared to fiscal year 2017, primarily due to the payment to repurchase approximately $1.85 billion of debt, higher share repurchase amount of $1.1 billion and higher outstanding commercial paper of $0.9 billion in fiscal year 2017. Net cash used in financing activities decreased by $13.2 billion in fiscal year 2017 compared to fiscal year 2016, as the net cash used in financing activities for the fiscal year 2016 included the cash transfer of $10.4 billion to Hewlett Packard Enterprise in connection with the Separation and the redemption of $2.1 billion of U.S. Dollar Global Notes, and fiscal year 2017 included a higher outstanding commercial paper of $0.9 billion. Capital Resources Debt Levels We maintain debt levels that we establish through consideration of a number of factors, including cash flow expectations, cash requirements for operations, investment plans (including acquisitions), share repurchase activities, our cost of capital and targeted capital structure. Short-term debt increased by $0.4 billion and long-term debt decreased by $2.2 billion for fiscal year 2018 as compared to fiscal year 2017. The net decrease in total debt was primarily due to the payment to repurchase approximately $1.85 billion in aggregate principal amount of U.S. Dollar Global Notes. Short-term debt increased by $1.0 billion for fiscal year 2017 as compared to fiscal year 2016. The net increase in total debt was primarily due to a higher outstanding of commercial paper of $0.9 billion. Our debt-to-equity ratio is calculated as the carrying amount of debt divided by total stockholders’ deficit. Our debt-to-equity ratio changed by 7.07x in fiscal year 2018 compared to fiscal year 2017, primarily due to a decrease in stockholders’ deficit balance of $2.8 billion. Our debt-to-equity ratio changed by 0.54x in fiscal year 2017 compared to fiscal year 2016, due to an increase in total debt balances of $1.0 billion. HP INC. AND SUBSIDIARIES Management’s Discussion and Analysis of Financial Condition and Results of Operations (Continued) Our weighted-average interest rate reflects the effective interest rate on our borrowings prevailing during the period and reflects the effect of interest rate swaps. For more information on our interest rate swaps, see Note 10, “Financial Instruments” in the Consolidated Financial Statements and notes thereto in Item 8, “Financial Statements and Supplementary Data”. Available Borrowing Resources We had the following resources available to obtain short or long-term financing: As of October 31, 2018, we maintain a senior unsecured committed revolving credit facility with aggregate lending commitments of $4.0 billion, which will be available until March 30, 2023 and is primarily to support the issuance of commercial paper. Funds borrowed under this revolving credit facility may also be used for general corporate purposes. As of October 31, 2018, we had $0.9 billion of commercial paper outstanding. We increased our issuance authorization under our commercial paper program from $4.0 billion to $6.0 billion in November 2017. In December 2017, we also entered into an additional revolving credit facility with certain institutional lenders that provided us with $1.5 billion of available borrowings until November 30, 2018. We elected to terminate this $1.5 billion revolving credit facility early, effective August 17, 2018. For more information on our borrowings, see Note 11, “Borrowings”, to the Consolidated Financial Statements in Item 8, which is incorporated herein by reference. Credit Ratings Our credit risk is evaluated by major independent rating agencies based on publicly available information as well as information obtained in our ongoing discussions with them. While we do not have any rating downgrade triggers that would accelerate the maturity of a material amount of our debt, previous downgrades have increased the cost of borrowing under our credit facilities, have reduced market capacity for our commercial paper and have required the posting of additional collateral under some of our derivative contracts. In addition, any further downgrade to our credit ratings by any rating agencies may further impact us in a similar manner, and, depending on the extent of any such downgrade, could have a negative impact on our liquidity and capital position. We can access alternative sources of funding, including drawdowns under our credit facilities, if necessary, to offset potential reductions in the market capacity for our commercial paper. HP INC. AND SUBSIDIARIES Management’s Discussion and Analysis of Financial Condition and Results of Operations (Continued) CONTRACTUAL AND OTHER OBLIGATIONS Our contractual and other obligations as of October 31, 2018, were as follows: (1) Amounts represent the principal cash payments relating to our short-term and long-term debt and do not include any fair value adjustments, discounts or premiums. (2) Amounts represent the expected interest payments relating to our short-term and long-term debt. We have outstanding interest rate swap agreements accounted for as fair value hedges that have the economic effect of changing fixed interest rates associated with some of our U.S. Dollar Global Notes to variable interest rates. The impact of our outstanding interest rate swaps at October 31, 2018 was factored into the calculation of the future interest payments on debt. (3) Purchase obligations include agreements to purchase goods or services that are enforceable and legally binding on us and that specify all significant terms, including fixed or minimum quantities to be purchased; fixed, minimum or variable price provisions; and the approximate timing of the transaction. These purchase obligations are related principally to inventory and other items. Purchase obligations exclude agreements that are cancelable without penalty. Purchase obligations also exclude open purchase orders that are routine arrangements entered into in the ordinary course of business as they are difficult to quantify in a meaningful way. Even though open purchase orders are considered enforceable and legally binding, the terms generally allow us the option to cancel, reschedule, and adjust terms based on our business needs prior to the delivery of goods or performance of services. (4) Amounts represent the operating lease obligations, net of total sublease income of $129 million. (5) Amounts represent the capital lease obligations, including total capital lease interest obligations of $58 million. (6) Retirement and Post-Retirement Benefit Plan Contributions. In fiscal year 2019, we anticipate making contributions of approximately $46 million to non-U.S. pension plans, $32 million to cover benefit payments to U.S. non-qualified pension plan participants and $6 million to cover benefit claims for our post-retirement benefit plans. Our policy is to fund our pension plans so that we meet at least the minimum contribution requirements, as established by local government, funding and taxing authorities. Expected contributions and payments to our pension and post-retirement benefit plans are excluded from the contractual obligations table because they do not represent contractual cash outflows as they are dependent on numerous factors which may result in a wide range of outcomes. For more information on our retirement and post-retirement benefit plans, see Note 4, “Retirement and Post-Retirement Benefit Plans”, to the Consolidated Financial Statements in Item 8, which is incorporated herein by reference. (7) Cost Savings Plans. We expect to make future cash payments of approximately $286 million in connection with our cost savings plans through fiscal year 2019. These payments have been excluded from the contractual obligations table because they do not represent contractual cash outflows and there is uncertainty as to the timing of these payments. For more information on our restructuring activities that are part of our cost improvements, see Note 3, “Restructuring and Other Charges”, to the Consolidated Financial Statements in Item 8, which is incorporated herein by reference. (8) Uncertain Tax Positions. As of October 31, 2018, we had approximately $1.3 billion of recorded liabilities and related interest and penalties pertaining to uncertain tax positions. We are unable to make a reasonable estimate as to when cash settlement with the tax authorities might occur due to the uncertainties related to these tax matters. Payments of these obligations would result from settlements with taxing authorities. For more information on our uncertain tax positions, see Note 6, “Taxes on Earnings”, to the Consolidated Financial Statements in Item 8, which is incorporated herein by reference. (9) Payment of one-time transition taxes under the TCJA. The TCJA made significant changes to U.S. tax law resulting in a one-time deemed repatriation transition tax on accumulated foreign earnings of approximately $3.3 billion. We expect the HP INC. AND SUBSIDIARIES Management’s Discussion and Analysis of Financial Condition and Results of Operations (Continued) actual cash payments for the tax to be much lower as we expect to reduce the overall liability by more than half once tax credits and other balance sheet tax attributes are used. OFF-BALANCE SHEET ARRANGEMENTS As part of our ongoing business, we have not participated in transactions that generate material relationships with unconsolidated entities or financial partnerships, such as entities often referred to as structured finance or special purpose entities, which would have been established for the purpose of facilitating off-balance sheet arrangements or other contractually narrow or limited purposes. We have third-party short-term financing arrangements intended to facilitate the working capital requirements of certain customers. For more information on our third-party short-term financing arrangements, see Note 7 “Supplementary Financial Information” to the Consolidated Financial Statements in Item 8, which is incorporated herein by reference.

<s>[INST] Overview. A discussion of our business and other highlights affecting the company to provide context for the remainder of this MD&A. Separation Transaction. A discussion of the separation of Hewlett Packard Enterprise Company, HP Inc.’s former enterprise technology infrastructure, software, services and financing businesses. Critical Accounting Policies and Estimates. A discussion of accounting policies and estimates that we believe are important to understanding the assumptions and judgments incorporated in our reported financial results. Results of Operations. An analysis of our continuing financial results comparing fiscal year 2018 to fiscal year 2017 and fiscal year 2017 to fiscal year 2016. A discussion of the results of continuing operations is followed by a more detailed discussion of the results of operations by segment. Liquidity and Capital Resources. An analysis of changes in our cash flows and a discussion of our liquidity and financial condition. Contractual and Other Obligations. An overview of contractual obligations, retirement and postretirement benefit plan contributions, costsaving plans, uncertain tax positions and offbalance sheet arrangements. The discussion of financial condition and results of our continuing operations that follows provides information that will assist the reader in understanding our Consolidated Financial Statements, the changes in certain key items in those financial statements from year to year, and the primary factors that accounted for those changes, as well as how certain accounting principles, policies and estimates affect our Consolidated Financial Statements. This discussion should be read in conjunction with our Consolidated Financial Statements and the related notes that appear elsewhere in this document. HP INC. AND SUBSIDIARIES Management’s Discussion and Analysis of Financial Condition and Results of Operations (Continued) OVERVIEW We are a leading global provider of personal computing and other access devices, imaging and printing products, and related technologies, solutions, and services. We sell to individual consumers, SMBs and large enterprises, including customers in the government, health, and education sectors. We have three reportable segments: Personal Systems, Printing and Corporate Investments. The Personal Systems segment offers Commercial and Consumer desktop and notebook PCs, workstations, thin clients, Commercial mobility devices, retail POS systems, displays and other related accessories, software, support, and services. The Printing segment provides Consumer and Commercial printer hardware, Supplies, solutions and services, as well as scanning devices. Corporate Investments include HP Labs and certain business incubation projects. In Personal Systems, our strategic focus is on profitable growth through hyper market segmentation with respect to enhanced innovation in multioperating systems, multiarchitecture, geography, customer segments and other key attributes. Additionally, we are investing in premium form factors such as convertible notebooks to meet customer preference for mobile, thinner and lighter devices. We have increased our focus on Device as a Service as the market begins to shift to contractual solutions. We believe that we are well positioned due to our competitive product lineup. In Printing, our strategic growth focus is on shifting to contractual solutions and Graphics, as well as expanding our footprint in the 3D printing marketplace. Business printing includes delivering solutions to SMBs and enterprise customers, such as multifunction and PageWide printers, including our JetIntelligence lineup of LaserJet printers. The shift to contractual solutions includes an increased focus on Managed Print Services and Instant Ink, which presents strong aftermarket supplies opportunities. In the Graphics space, we are focused on innovations such as our Indigo and Latex product offerings. We plan to continue to focus on shifting the mix in the installed base to higher value units and expanding our innovative Ink, Laser, Graphics and 3D printing programs. We continue to execute on our key initiatives of focusing on highvalue products targeted at high usage categories and introducing new revenue delivery models. Our focus is on placing higher value printer units which offer strong annuity of toner and ink, the design and deployment of A3 products and solutions, accelerating growth in Graphic solutions and 3D printing. We continue to experience challenges that are representative of trends and uncertainties that may affect our business and results of operations. One set of challenges relates to dynamic market trends, such as forecasted declining PC [/INST] Negative. </s>

HP INC

2019-12-12

2019-10-31

ITEM 7. Management’s Discussion and Analysis of Financial Condition and Results of Operations. This Management’s Discussion and Analysis of Financial Condition and Results of Operations (“MD&A”) is organized as follows: • Overview. A discussion of our business and other highlights affecting the company to provide context for the remainder of this MD&A. • Critical Accounting Policies and Estimates. A discussion of accounting policies and estimates that we believe are important to understanding the assumptions and judgments incorporated in our reported financial results. • Results of Operations. An analysis of our financial results comparing fiscal year 2019 to fiscal year 2018 and fiscal year 2018 to fiscal year 2017. A discussion of the results of operations is followed by a more detailed discussion of the results of operations by segment. • Liquidity and Capital Resources. An analysis of changes in our cash flows and a discussion of our liquidity and financial condition. • Contractual and Other Obligations. An overview of contractual obligations, retirement and post-retirement benefit plan contributions, cost-saving plans, uncertain tax positions and off-balance sheet arrangements. The discussion of financial condition and results of our operations that follows provides information that will assist the reader in understanding our Consolidated Financial Statements, the changes in certain key items in those financial statements from year to year, and the primary factors that accounted for those changes, as well as how certain accounting principles, policies and estimates affect our Consolidated Financial Statements. This discussion should be read in conjunction with our Consolidated Financial Statements and the related notes that appear elsewhere in this document. HP INC. AND SUBSIDIARIES Management’s Discussion and Analysis of Financial Condition and Results of Operations (Continued) OVERVIEW We are a leading global provider of personal computing and other access devices, imaging and printing products, and related technologies, solutions, and services. We sell to individual consumers, SMBs and large enterprises, including customers in the government, health, and education sectors. We have three reportable segments: Personal Systems, Printing and Corporate Investments. The Personal Systems segment offers commercial and consumer desktop and notebook PCs, workstations, thin clients, commercial mobility devices, retail POS systems, displays and other related accessories, software, support, and services. The Printing segment provides consumer and commercial printer hardware, supplies, solutions and services, as well as scanning devices. Corporate Investments include HP Labs and certain business incubation and investment projects. • In Personal Systems, our strategic focus is on profitable growth through market segmentation with respect to enhanced innovation in multi-operating systems, multi-architecture, geography, customer segments and other key attributes. Additionally, we are investing in end point services and solutions. We are focused on services including DaaS as the market begins to shift to contractual solutions. We believe that we are well positioned due to our competitive product lineup. • In Printing, our strategic focus is on Contractual solutions and Graphics, as well as expanding our footprint in the 3D printing and digital manufacturing marketplace. In Contractual solutions we have a continued focus on Managed Print Services and Instant Ink. In Graphics, we are focused on innovations such as our Indigo and Latex product offerings. We continue to experience challenges that are representative of trends and uncertainties that may affect our business and results of operations. One set of challenges relates to dynamic market trends, such as forecasted declining PC Client markets and home printing markets. A second set of challenges relates to changes in the competitive landscape. Our primary competitors are exerting competitive pressure in targeted areas and are entering new markets, our emerging competitors are introducing new technologies and business models, and our alliance partners in some businesses are increasingly becoming our competitors in others. A third set of challenges relates to business model changes and our go-to-market execution in an evolving distribution and reseller landscape, with increasing online and omnichannel presence. Additional challenges we face at the segment level are set forth below. • In Personal Systems, we face challenges with industry component availability and a competitive pricing environment. • In Printing, a competitive pricing environment, including from non-original supplies (which includes imitation, refill or remanufactured alternatives), and a weakened market in certain geographies with associated pricing sensitivity of our customers present challenges. We also face challenges in Printing due to our multi-tier distribution network, primarily in EMEA, including limiting grey marketing and the potential misuse of pricing programs. We also obtain many Printing components from single sources due to technology, availability, price, quality or other considerations. For instance, we source the majority of our A4 and a portion of our A3 portfolio of laser printer engines and laser toner cartridges from Canon. Any decision by either party to not renew our agreement with Canon or to limit or reduce the scope of the agreement could adversely affect our net revenue from LaserJet products; however, we have a long-standing business relationship with Canon and anticipate renewal of this agreement. Our business and financial performance also depend significantly on worldwide economic conditions. Accordingly, we face global macroeconomic challenges, tariff-driven headwinds, uncertainty in the markets, volatility in exchange rates, weaker macroeconomic conditions and evolving dynamics in the global trade environment. The full impact of these and other global macroeconomic challenges on our business cannot be known at this time. To address these challenges, we continue to pursue innovation with a view towards developing new products and services aligned with generating market demand and meeting the needs of our customers and partners. In addition, we continue to work on improving our operations and adapting our business models, with a particular focus on enhancing our end-to-end processes, analytics and efficiencies. We also continue to work on optimizing our sales coverage models, aligning our sales incentives with our strategic goals, improving channel execution and inventory management, strengthening our capabilities in our areas of strategic focus, strengthening our pricing discipline, and developing and capitalizing on market opportunities. Specifically, in October 2019, we announced cost-reduction and operational efficiency initiatives intended to simplify the way we work, move closer to our customers and facilitate specific investment in our business. These efforts include transforming our operating model to integrate our sales force into a single commercial organization and reducing structural costs across the company through our restructuring plan approved in September 2019 (the “Fiscal 2020 Plan”). We expect to invest some of the savings from these efforts across our businesses, including investing to build our digital capabilities. Over time, we expect these investments will make us more efficient and allow us to advance our positions in Personal Systems and Printing, while also disrupting new industries where we see attractive medium to long-term growth opportunities. However, the rate at which we are able to invest in our business and the returns that we are able to achieve from these investments will be HP INC. AND SUBSIDIARIES Management’s Discussion and Analysis of Financial Condition and Results of Operations (Continued) affected by many factors, including the efforts to address the execution, industry and macroeconomic challenges facing our business as discussed above. As a result, we may experience delays in the anticipated timing of activities related to these efforts, and the anticipated benefits of these efforts may not materialize. We typically experience higher net revenues in our fourth quarter compared to other quarters in our fiscal year due in part to seasonal holiday demand. Historical seasonal patterns should not be considered reliable indicators of our future net revenues or financial performance. For a further discussion of trends, uncertainties and other factors that could impact our operating results, see the section entitled “Risk Factors” in Item 1A in this Annual Report on Form 10-K. CRITICAL ACCOUNTING POLICIES AND ESTIMATES General The Consolidated Financial Statements of HP are prepared in accordance with United States (“U.S.”) generally accepted accounting principles (“GAAP”), which require management to make estimates, judgments and assumptions that affect the reported amounts of assets, liabilities, net revenue and expenses, and the disclosure of contingent liabilities. Management bases its estimates on historical experience and on various other assumptions that it believes to be reasonable under the circumstances, the results of which form the basis for making judgments about the carrying amount of assets and liabilities that are not readily apparent from other sources. Management has discussed the development, selection and disclosure of these estimates with the Audit Committee of HP’s Board of Directors. Management believes that the accounting estimates employed and the resulting amounts are reasonable; however, actual results may differ from these estimates. Making estimates and judgments about future events is inherently unpredictable and is subject to significant uncertainties, some of which are beyond our control. Should any of these estimates and assumptions change or prove to have been incorrect, it could have a material impact on our results of operations, financial position and cash flows. A summary of significant accounting policies is included in Note 1, “Overview and Summary of Significant Accounting Policies” to the Consolidated Financial Statements in Item 8, which is incorporated herein by reference. An accounting policy is deemed to be critical if it requires an accounting estimate to be made based on assumptions about matters that are highly uncertain at the time the estimate is made, if different estimates reasonably could have been used, or if changes in the estimate that are reasonably possible could materially impact the financial statements. Management believes the following critical accounting policies reflect the significant estimates and assumptions used in the preparation of the Consolidated Financial Statements. Revenue Recognition We recognize revenue depicting the transfer of promised goods or services to customers in an amount that reflects the consideration to which we are expected to be entitled in exchange for those goods or services. We evaluate customers’ ability to pay based on various factors like historical payment experience, financial metrics and customer credit scores. We enter into contracts to sell our products and services, and while many of our sales contracts contain standard terms and conditions, there are contracts which contain non-standard terms and conditions. Further, many of our arrangements include multiple performance obligations. As a result, significant contract interpretation may be required to determine the appropriate accounting, including the identification of performance obligations that are distinct, the allocation of the transaction price among performance obligations in the arrangement and the timing of transfer of control of promised goods or services for each of those performance obligations. We evaluate each performance obligation in an arrangement to determine whether it represents a distinct good or services. A performance obligation constitutes distinct goods or services when the customer can benefit from the goods or services either on its own or together with other resources that are readily available to the customer and the performance obligation is distinct within the context of the contract. Transaction price is the amount of consideration to which we expect to be entitled in exchange for transferring goods or services to the customer. If the transaction price includes a variable amount, we estimate the amount using either the expected value or most likely amount method. We reduce the transaction price at the time of revenue recognition for customer and distributor programs and incentive offerings, rebates, promotions, other volume-based incentives and expected returns. We use estimates to determine the expected variable consideration for such programs based on historical experience, expected consumer behavior and market conditions. When a sales arrangement contains multiple performance obligations, such as hardware and/or services, we allocate revenue to each performance obligation in proportion to their selling price. The selling price for each performance obligation is based on its standalone selling price (“SSP”). We establish SSP using the price charged for a performance obligation when sold HP INC. AND SUBSIDIARIES Management’s Discussion and Analysis of Financial Condition and Results of Operations (Continued) separately (“observable price”) and, in some instances, using the price established by management having the relevant authority. When observable price is not available, we establish SSP based on management’s judgment considering internal factors such as margin objectives, pricing practices and controls, customer segment pricing strategies and the product life-cycle. Consideration is also given to market conditions such as competitor pricing strategies and technology industry life cycles. We may modify or develop new go-to-market practices in the future, which may result in changes in selling prices, impacting standalone selling price determination applying the aforementioned management judgments and estimates. This may change the pattern and timing of revenue recognition for identical arrangements executed in future periods but will not change the total revenue recognized for any given arrangement. In most arrangements with multiple performance obligations, the transaction price is allocated to each performance obligation at the inception of the arrangement based on their relative selling price. Revenue is recognized when, or as, a performance obligation is satisfied by transferring control of a promised good or service to a customer. We generally invoice the customer upon delivery of the goods or services and the payments are due as per contract terms. For fixed price support or maintenance and other service contracts that are in the nature of stand-ready obligations, payments are generally received in advance from customers and revenue is recognized on a straight-line basis over the duration of the contract. In instances when revenue is derived from sales of third-party vendor products or services, we record revenue on a gross basis when we are a principal in the transaction and on a net basis when we are acting as an agent between the customer and the vendor. We consider several factors to determine whether we are acting as a principal or an agent, most notably whether we are the primary obligor to the customer, have established our own pricing and have inventory and credit risks. Warranty We accrue the estimated cost of product warranties at the time we recognize revenue. We evaluate our warranty obligations on a product group basis. Our standard product warranty terms generally include post-sales support and repairs or replacement of a product at no additional charge for a specified period. While we engage in extensive product quality programs and processes, including actively monitoring and evaluating the quality of our component suppliers, we base our estimated warranty obligation on contractual warranty terms, repair costs, product call rates, average cost per call, current period product shipments and ongoing product failure rates, as well as specific product class failure outside of our baseline experience. Warranty terms generally range from 90 days to three years for parts, labor and onsite services, depending upon the product. Over the last three fiscal years, the annual warranty expense and actual warranty costs have averaged approximately 1.8% of annual net revenue. Restructuring and Other Charges We have engaged in restructuring actions which require management to estimate the timing and amount of severance and other employee separation costs for workforce reduction and enhanced early retirement programs, fair value of assets made redundant or obsolete, and the fair value of lease cancellation and other exit costs. We accrue for severance and other employee separation costs under these actions when it is probable that benefits will be paid and the amount is reasonably estimable. The rates used in determining severance accruals are based on existing plans, historical experiences and negotiated settlements. Other charges include non-recurring costs that are distinct from ongoing operational costs incurred in connection with the Separation or information technology rationalization efforts. For a full description of our restructuring actions, refer to our discussions of restructuring in “Results of Operations” below and in Note 3, “Restructuring and Other Charges” to the Consolidated Financial Statements in Item 8, which are incorporated herein by reference. Retirement and Post-Retirement Benefits Our pension and other post-retirement benefit costs and obligations depend on various assumptions. Our major assumptions relate primarily to discount rates, mortality rates, expected increases in compensation levels and the expected long-term return on plan assets. The discount rate assumption is based on current investment yields of high-quality fixed-income securities with maturities similar to the expected benefits payment period. Mortality rates help predict the expected life of plan participants and are based on a historical demographic study of the plan. The expected increase in the compensation levels assumption reflects our long-term actual experience and future expectations. The expected long-term return on plan assets is determined based on asset allocations, historical portfolio results, historical asset correlations and management’s expected returns for each asset class. We evaluate our expected return assumptions annually including reviewing current capital market assumptions to assess the reasonableness of the expected long-term return on plan assets. We update the expected long-term return on assets when we observe a sufficient level of evidence that would suggest the long-term expected return has changed. In any fiscal year, significant differences may arise between the actual return and the expected long-term return on plan assets. Historically, differences between the actual return and expected long-term return on plan assets have resulted from changes in target or actual asset allocation, short-term performance relative to expected long-term performance, and to a lesser extent, differences between target and actual investment allocations, the timing of benefit payments compared to expectations, and the use of derivatives intended to effect asset allocation changes or hedge certain investment or liability exposures. For the HP INC. AND SUBSIDIARIES Management’s Discussion and Analysis of Financial Condition and Results of Operations (Continued) recognition of net periodic benefit cost, the calculation of the expected long-term return on plan assets uses the fair value of plan assets as of the beginning of the fiscal year unless updated as a result of interim re-measurement. Our major assumptions vary by plan, and the weighted-average rates used are set forth in Note 4, “Retirement and Post-Retirement Benefit Plans” to the Consolidated Financial Statements in Item 8, which is incorporated herein by reference. The following table provides the impact a change of 25 basis points in each of the weighted-average assumptions of the discount rate, expected increase in compensation levels and expected long-term return on plan assets would have had on our net periodic benefit cost for fiscal year 2019: Taxes on Earnings The Tax Cuts and Jobs Act (“TCJA”) made significant changes to the U.S. tax law. The TCJA lowered our U.S. statutory federal income tax rate from 35% to 21% effective January 1, 2018, while also imposing a one-time transition tax on accumulated foreign earnings. In December 2017, the SEC staff issued SAB No. 118, which allows registrants to record provisional amounts during a one year “measurement period”. In January 2019, we completed our accounting for the tax effects of the TCJA with no material changes to the provisional amounts recorded during the measurement period. In January 2018, the FASB released guidance on the accounting for tax on the Global Minimum Tax provisions of TCJA. The Global Minimum Tax provisions impose a tax on foreign income in excess of a deemed return on tangible assets of foreign corporations. We have elected to treat the Global Minimum Tax inclusions as period costs. As a result of certain employment actions and capital investments we have undertaken, income from manufacturing activities in certain jurisdictions is subject to reduced tax rates and, in some cases, is wholly exempt from taxes for fiscal years through 2027. Material changes in our estimates of cash, working capital and long-term investment requirements in the various jurisdictions in which we do business could impact how future earnings are repatriated to the United States, and our related future effective tax rate. The effects of the TCJA related to these policies are referenced and discussed in detail in Note 6, “Taxes on Earnings” to the Consolidated Financial Statements in Item 8, which is incorporated herein by reference. We calculate our current and deferred tax provisions based on estimates and assumptions that could differ from the final positions reflected in our income tax returns. We adjust our current and deferred tax provisions based on income tax returns which are generally filed in the third or fourth quarters of the subsequent fiscal year. We recognize deferred tax assets and liabilities for the expected tax consequences of temporary differences between the tax bases of assets and liabilities and their reported amounts using enacted tax rates in effect for the year in which we expect the differences to reverse. We record a valuation allowance to reduce deferred tax assets to the amount that we are more likely than not to realize. In determining the need for a valuation allowance, we consider future market growth, forecasted earnings, future taxable income, the mix of earnings in the jurisdictions in which we operate and prudent and feasible tax planning strategies. In the event we were to determine that it is more likely than not that we will be unable to realize all or part of our deferred tax assets in the future, we would increase the valuation allowance and recognize a corresponding charge to earnings or other comprehensive income in the period in which we make such a determination. Likewise, if we later determine that we are more likely than not to realize the deferred tax assets, we would reverse the applicable portion of the previously recognized valuation allowance. In order for us to realize our deferred tax assets, we must be able to generate sufficient taxable income in the jurisdictions in which the deferred tax assets are located. We are subject to income taxes in the United States and approximately 58 other countries, and we are subject to routine corporate income tax audits in many of these jurisdictions. We believe that positions taken on our tax returns are fully supported, but tax authorities may challenge these positions, which may not be fully sustained on examination by the relevant tax authorities. Accordingly, our income tax provision includes amounts intended to satisfy assessments that may result from these challenges. Determining the income tax provision for these potential assessments and recording the related effects HP INC. AND SUBSIDIARIES Management’s Discussion and Analysis of Financial Condition and Results of Operations (Continued) requires management judgments and estimates. The amounts ultimately paid on resolution of an audit could be materially different from the amounts previously included in our income tax provision and, therefore, could have a material impact on our income tax provision, net income and cash flows. Our accrual for uncertain tax positions is attributable primarily to uncertainties concerning the tax treatment of our domestic operations, including the allocation of income among different jurisdictions, intercompany transactions, pension and related interest. For a further discussion on taxes on earnings, refer to Note 6, “Taxes on Earnings” to the Consolidated Financial Statements in Item 8, which is incorporated herein by reference. Inventory We state our inventory at the lower of cost or market on a first-in, first-out basis. We make adjustments to reduce the cost of inventory to its net realizable value at the product group level for estimated excess or obsolescence. Factors influencing these adjustments include changes in demand, technological changes, product life cycle and development plans, component cost trends, product pricing, physical deterioration and quality issues. Business Combinations We allocate the fair value of purchase consideration to the assets acquired, liabilities assumed, and non-controlling interests in the acquiree generally based on their fair values at the acquisition date. The excess of the fair value of purchase consideration over the fair value of these assets acquired, liabilities assumed and non-controlling interests in the acquiree is recorded as goodwill and may involve engaging independent third-parties to perform an appraisal. When determining the fair values of assets acquired, liabilities assumed, and non-controlling interests in the acquiree, management makes significant estimates and assumptions, especially with respect to intangible assets. Critical estimates in valuing intangible assets include, but are not limited to, expected future cash flows, which includes consideration of future growth rates and margins, attrition rates, future changes in technology and brand awareness, loyalty and position, and discount rates. Fair value estimates are based on the assumptions management believes a market participant would use in pricing the asset or liability. Amounts recorded in a business combination may change during the measurement period, which is a period not to exceed one year from the date of acquisition, as additional information about conditions existing at the acquisition date becomes available. Goodwill We review goodwill for impairment annually during our fourth quarter and whenever events or changes in circumstances indicate the carrying amount of goodwill may not be recoverable. We can elect to perform a qualitative assessment to test a reporting unit’s goodwill for impairment or perform a quantitative impairment test. Based on a qualitative assessment, if we determine that the fair value of a reporting unit is more likely than not (i.e., a likelihood of more than 50 percent) to be less than its carrying amount, the quantitative impairment test will be performed. In the quantitative impairment test, we compare the fair value of each reporting unit to its carrying amount with the fair values derived most significantly from the income approach, and to a lesser extent, the market approach. Under the income approach, we estimate the fair value of a reporting unit based on the present value of estimated future cash flows. We base cash flow projections on management’s estimates of revenue growth rates and operating margins, taking into consideration industry and market conditions. We base the discount rate on the weighted-average cost of capital adjusted for the relevant risk associated with business-specific characteristics and the uncertainty related to the reporting unit’s ability to execute on the projected cash flows. Under the market approach, we estimate fair value based on market multiples of revenue and earnings derived from comparable publicly-traded companies with similar operating and investment characteristics as the reporting unit. We weight the fair value derived from the market approach depending on the level of comparability of these publicly-traded companies to the reporting unit. When market comparables are not meaningful or not available, we estimate the fair value of a reporting unit using only the income approach. If the fair value of a reporting unit exceeds the carrying amount of the net assets assigned to that reporting unit, goodwill is not impaired. If the fair value of the reporting unit is less than its carrying amount, goodwill is impaired and the excess of the reporting unit’s carrying value over the fair value is recognized as an impairment loss. Our annual goodwill impairment analysis, performed using the qualitative assessment option as of the first day of the fourth quarter of fiscal year 2019, resulted in a conclusion that it was more likely than not that the fair value of our reporting units exceeded their respective carrying values. As a result, we concluded that a quantitative impairment test was not necessary. Fair Value of Derivative Instruments We use derivative instruments to manage a variety of risks, including risks related to foreign currency exchange rates, interest rates and existing assets and liabilities. We use forwards, swaps and at times, options to hedge certain foreign currency, interest rate and, return on certain investments exposures. We do not use derivative instruments for speculative purposes. As of October 31, 2019, the gross notional value of our derivative portfolio was $24 billion. Assets and liabilities related to derivative instruments are measured at fair value and were $392 million and $166 million, respectively, as of October 31, 2019. HP INC. AND SUBSIDIARIES Management’s Discussion and Analysis of Financial Condition and Results of Operations (Continued) Fair value is the price we would receive to sell an asset or pay to transfer a liability in an orderly transaction between market participants at the measurement date. In the absence of active markets for the identical assets or liabilities, such measurements involve developing assumptions based on market observable data and, in the absence of such data, internal information that is consistent with what market participants would use in a hypothetical transaction that occurs at the measurement date. The determination of fair value often involves significant judgments about assumptions such as determining an appropriate discount rate that factors in both risk and liquidity premiums, identifying the similarities and differences in market transactions, weighting those differences accordingly and then making the appropriate adjustments to those market transactions to reflect the risks specific to the asset or liability being valued. We generally use industry standard valuation models to measure the fair value of our derivative positions. When prices in active markets are not available for the identical asset or liability, we use industry standard valuation models to measure fair value. Where applicable, these models project future cash flows and discount the future amounts to present value using market-based observable inputs, including interest rate curves, HP and counterparty credit risk, foreign currency exchange rates, and forward and spot prices. For a further discussion on fair value measurements and derivative instruments, refer to Note 9, “Fair Value” and Note 10, “Financial Instruments”, respectively, to the Consolidated Financial Statements in Item 8, which are incorporated herein by reference. Loss Contingencies We are involved in various lawsuits, claims, investigations and proceedings including those consisting of intellectual property (“IP”), commercial, securities, employment, employee benefits and environmental matters that arise in the ordinary course of business. We record a liability when we believe that it is both probable that a liability has been incurred and the amount of loss can be reasonably estimated. Significant judgment is required to determine both the probability of having incurred a liability and the estimated amount of the liability. We review these matters at least quarterly and adjust these liabilities to reflect the impact of negotiations, settlements, rulings, advice of legal counsel and other updated information and events, pertaining to a particular case. Pursuant to the separation and distribution agreement, we share responsibility with Hewlett Packard Enterprise for certain matters, as discussed in Note 14, “Litigation and Contingencies” to the Consolidated Financial Statements in Item 8, which is incorporated herein by reference, and Hewlett Packard Enterprise has agreed to indemnify us in whole or in part with respect to certain matters. Based on our experience, we believe that any damage amounts claimed in the specific litigation and contingencies matters further discussed in Note 14, “Litigation and Contingencies”, are not a meaningful indicator of HP’s potential liability. Litigation is inherently unpredictable. However, we believe we have valid defenses with respect to legal matters pending against us. Nevertheless, cash flows or results of operations could be materially affected in any particular period by the resolution of one or more of these contingencies. We believe we have recorded adequate provisions for any such matters and, as of October 31, 2019, it was not reasonably possible that a material loss had been incurred in excess of the amounts recognized in our financial statements. RECENT ACCOUNTING PRONOUNCEMENTS For a summary of recent accounting pronouncements applicable to our consolidated financial statements see Note 1, “Overview and Summary of Significant Accounting Policies” to the Consolidated Financial Statements in Item 8, which is incorporated herein by reference. RESULTS OF OPERATIONS Revenue from our international operations has historically represented, and we expect will continue to represent, a majority of our overall net revenue. As a result, our net revenue growth has been impacted, and we expect it will continue to be impacted, by fluctuations in foreign currency exchange rates. In order to provide a framework for assessing performance excluding the impact of foreign currency fluctuations, we supplement the year-over-year percentage change in net revenue with the year-over-year percentage change in net revenue on a constant currency basis, which excludes the effect of foreign currency exchange fluctuations calculated by translating current period revenues using monthly average exchange rates from the comparative period and hedging activities from the prior-year period and does not adjust for any repricing or demand impacts from changes in foreign currency exchange rates. This information is provided so that net revenue can be viewed with and without the effect of fluctuations in foreign currency exchange rates, which is consistent with how management evaluates our net revenue results and trends, as management does not believe that the excluded items are reflective of ongoing operating results. The constant currency measures are provided in addition to, and not as a substitute for, the year-over-year percentage change in net revenue on a GAAP basis. Other companies may calculate and define similarly labeled items differently, which may limit the usefulness of this measure for comparative purposes. HP INC. AND SUBSIDIARIES Management’s Discussion and Analysis of Financial Condition and Results of Operations (Continued) Results of operations in dollars and as a percentage of net revenue were as follows: Net Revenue In fiscal year 2019, total net revenue increased 0.5% (increased 2.0% on a constant currency basis) as compared to the prior-year period. Net revenue from the United States remained flat at $20.6 billion and net revenue from outside of the United States increased 0.7% to $38.2 billion. The increase in net revenue was primarily driven by growth in Notebooks, Desktops and Workstations in Personal Systems, partially offset by unfavorable foreign currency impacts and a decline in Printing Supplies. In fiscal year 2018, total net revenue increased 12.3% (increased 10.1% on a constant currency basis) as compared to the prior-year period. Net revenue from the United States increased 6.6% to $20.6 billion and net revenue from outside of the United States increased 15.7% to $37.9 billion. The increase in net revenue was primarily driven by growth in Notebooks, Desktops, Supplies, Commercial Printing Hardware revenue and favorable foreign currency impacts. A detailed discussion of the factors contributing to the changes in segment net revenue is included under “Segment Information” below. Gross Margin Our gross margin was 19.0% for fiscal year 2019 compared with 18.2% for fiscal year 2018. The increase was primarily due to higher rate in Personal Systems driven by lower supply chain costs. Our gross margin was 18.2% for fiscal year 2018 compared with 18.4% for fiscal year 2017. The decrease was primarily due to higher Commercial Hardware unit placements in Printing and an increase in commodity and logistics costs in Personal Systems, partially offset by higher pricing in Personal Systems and favorable foreign currency impacts. A detailed discussion of the factors contributing to the changes in segment gross margins is included under “Segment Information” below. Operating Expenses Research and Development (“R&D”) R&D expense increased 7% in fiscal year 2019 compared to the prior-year period, primarily due to continuing investments in innovation and key growth initiatives. R&D expense increased 18% in fiscal year 2018 compared to the prior-year period, primarily due to continuing investment in Printing, including the acquisition of Samsung’s printer business. Selling, General and Administrative (“SG&A”) HP INC. AND SUBSIDIARIES Management’s Discussion and Analysis of Financial Condition and Results of Operations (Continued) SG&A expense increased 5% in fiscal year 2019 as compared to the prior-year period, primarily driven by increased investments in key growth initiatives and go-to-market in Personal Systems and investment in digital infrastructure. SG&A expense increased 13% in fiscal year 2018 as compared to the prior-year period, primarily driven by incremental go-to-market investments to support revenue growth, including the acquisition of Samsung’s printer business. Restructuring and other Charges Restructuring and other charges increased by $143 million in fiscal year 2019 compared to the prior-year period, primarily due to charges from the Fiscal 2020 Plan and the restructuring plan approved in October 2016 (the “Fiscal 2017 Plan”), which was later amended in May 2018. Restructuring and other charges decreased by $230 million in fiscal year 2018 compared to the prior-year period, primarily due to lower charges from the Fiscal 2017 Plan. Acquisition-related Charges Acquisition-related charges for the fiscal years 2019, 2018 and 2017 relate primarily to third-party professional and legal fees, and integration-related costs, as well as fair value adjustments of certain acquired assets such as inventory. Amortization of Intangible Assets Amortization expense increased by $36 million in fiscal year 2019 compared to the prior-year period, due to intangible assets resulting primarily from the acquisition of the Apogee group. Amortization expense increased by $79 million in fiscal year 2018 compared to the prior-year period, due to intangible assets resulting primarily from the acquisition of Samsung’s printer business. Interest and Other, Net Interest and other, net expense increased by $536 million in fiscal year 2019 compared to the prior-year period, primarily due to tax indemnifications related to the termination of the tax matters agreement (“TMA”) with Hewlett Packard Enterprise during the fourth quarter of fiscal year 2019. Interest and other, net expense increased by $726 million in fiscal year 2018 compared to the prior-year period, primarily due to the reversal of indemnification receivables from Hewlett Packard Enterprise pertaining to various income tax audit settlements, and loss on extinguishment of debt. Benefit from (Provision for) Taxes Our effective tax rates were (24.9%), (76.8%) and 22.9% in fiscal years 2019, 2018 and 2017, respectively. In fiscal year 2019, our effective tax rate generally differs from the U.S. federal statutory rate of 21% primarily due to the resolution of various audits, changes in valuation allowances, and impacts of U.S. tax reform. In fiscal year 2018, our effective tax rate generally differs from the U.S. federal statutory rate of 23.3% primarily due to transitional impacts of U.S. tax reform and resolution of various audits and tax litigation. In fiscal year 2017, our effective tax rate generally differs from the U.S. federal statutory rate of 35% due to favorable tax rates associated with certain earnings in lower-tax jurisdictions throughout the world. The jurisdictions with favorable tax rates that had the most significant impact on our effective tax rate in the periods presented were Puerto Rico, Singapore, China, Malaysia and Ireland. Additionally, the overall effective tax rate in fiscal year 2017 was impacted by adjustments to valuation allowances and state income taxes. For a reconciliation of our effective tax rate to the U.S. federal statutory rate of 21%, 23.3% and 35% in fiscal years 2019, 2018 and 2017, respectively, and further explanation of our provision for income taxes, see Note 6, “Taxes on Earnings” to the Consolidated Financial Statements in Item 8, which is incorporated herein by reference. In fiscal year 2019, we recorded $1.3 billion of net income tax benefit related to discrete items in the provision for taxes. This amount includes tax benefits related to audit settlements of $1.0 billion, $75 million due to ability to utilize tax attributes, $57 million of restructuring benefits and net valuation allowance releases of $94 million. We also recorded benefits of $78 million related to U.S. tax reform as a result of new guidance issued by the U.S. Internal Revenue Service (“IRS”). These benefits were partially offset by uncertain tax position charges of $51 million. In fiscal year 2019, in addition to the discrete items mentioned above, we recorded excess tax benefits of $20 million associated with stock options, restricted stock units and performance-adjusted restricted stock units. In fiscal year 2018, we recorded $2.8 billion of net income tax benefit related to discrete items in the provision for taxes which include impacts of the TCJA. As discussed in the Note 6 “Taxes on Earnings” to the Consolidated Financial Statements in Item 8 of this report, we had not yet completed our analysis of the full impact of the TCJA. However, as of October 31, 2018, we recorded a provisional tax benefit of $760 million related to $5.6 billion net benefit for the decrease in our deferred tax liability on unremitted foreign earnings, partially offset by $3.3 billion net expense for the deemed repatriation tax payable in installments over eight years, a $1.2 billion net expense for the remeasurement of our deferred assets and liabilities to the new U.S. statutory tax rate and a $317 million net expense related to realization on U.S. deferred taxes that are expected to be HP INC. AND SUBSIDIARIES Management’s Discussion and Analysis of Financial Condition and Results of Operations (Continued) realized at a lower rate. Fiscal year 2018 also included tax benefits related to audit settlements of $1.5 billion and valuation allowance releases of $601 million pertaining to a change in our ability to utilize certain foreign and U.S. deferred tax assets due to a change in our geographic earnings mix. These benefits were partially offset by other net tax charges of $34 million. In fiscal year 2018, in addition to the discrete items mentioned above, we recorded excess tax benefits of $42 million associated with stock options, restricted stock units and performance-adjusted restricted stock units. In fiscal year 2017, we recorded $72 million of net income tax benefit related to discrete items in the provision for taxes. These amounts primarily include tax benefits of $84 million related to restructuring and other charges, $12 million related to U.S. federal provision to return adjustments, $45 million related to Samsung acquisition-related charges, and $13 million of other net tax benefits. In addition, we recorded tax charges of $11 million related to changes in state valuation allowances, $22 million of state provision to return adjustments, and $49 million related to uncertain tax positions. Segment Information A description of the products and services for each segment can be found in Note 2, “Segment Information,” to the Consolidated Financial Statements in Item 8, which is incorporated herein by reference. Future changes to this organizational structure may result in changes to the segments disclosed. Realignment Effective at the beginning of its first quarter of fiscal year 2019, we implemented an organizational change to align our business unit financial reporting more closely with our current business structure. The organizational change resulted in the transfer of certain Samsung-branded product categories from Commercial to Consumer within the Printing segment. We reflected this change to our business unit information in prior reporting periods on an as-if basis. The reporting change had no impact to previously reported segment net revenue, consolidated net revenue, earnings from operations, net earnings or net earnings per share (“EPS”). Personal Systems The components of net revenue and the weighted net revenue change by business unit were as follows: (1) Weighted Net Revenue Change Percentage Points measures contribution of each business unit towards overall segment revenue growth. It is calculated by dividing the change in revenue of each business unit from the prior-year period by total segment revenue for the prior-year period. Fiscal Year 2019 compared with Fiscal Year 2018 Personal Systems net revenue increased 2.7% (increased 4.9% on a constant currency basis) in fiscal year 2019 as compared to the prior-year period. The net revenue increase was primarily due to growth in Notebooks, Desktops and Workstations, partially offset by unfavorable foreign currency impacts. The net revenue increase was driven by a 2.2% increase in unit volume and 0.5% increase in average selling prices (“ASPs”) as compared to the prior-year period. The increase in unit volume was primarily due to growth in Notebooks and Desktops. The increase in ASPs was primarily due to positive mix shifts and higher pricing, partially offset by unfavorable foreign currency impacts. Commercial revenue increased 7.0% primarily HP INC. AND SUBSIDIARIES Management’s Discussion and Analysis of Financial Condition and Results of Operations (Continued) driven by higher unit volume partially offset by unfavorable foreign currency impacts, and consumer revenue decreased by 5.5% primarily driven by lower unit volume, respectively, in fiscal year 2019 as compared to the prior-year period. Net revenue increased 1.7% in Notebooks, 4.1% in Desktops and 6.4% in Workstations in fiscal year 2019 as compared to the prior-year period. Personal Systems earnings from operations as a percentage of net revenue increased by 1.2 percentage points in fiscal year 2019 as compared to the prior-year period, primarily due to in an increase in gross margin, partially offset by an increase in operating expenses. The increase in gross margin was primarily due to lower supply chain costs and higher ASPs. The increase in operating expenses was primarily due to increased investments in key growth initiatives and go-to-market. Fiscal Year 2018 compared with Fiscal Year 2017 Personal Systems net revenue increased 13.0% (increased 10.5% on a constant currency basis) in fiscal year 2018 as compared to the prior-year period. The net revenue increase was primarily due to growth in Notebooks and Desktops and favorable foreign currency impacts. The net revenue increase was driven by a 6.6% increase in unit volume and 6.0% increase in ASPs as compared to the prior-year period. The increase in unit volume was primarily due to growth in Notebooks and Desktops. The increase in ASPs was primarily due to higher pricing driven by increased commodity and logistics costs, favorable foreign currency impacts and positive mix shifts. Consumer and Commercial revenue increased 11% and 14%, respectively, in fiscal year 2018 as compared to the prior-year period, driven by growth in Notebooks, Desktops and Workstations as a result of higher unit volume combined with higher ASPs. Net revenue increased 14% in Notebooks, 12% in Desktops and 10% in Workstations in fiscal year 2018 as compared to the prior-year period. Personal Systems earnings from operations as a percentage of net revenue increased by 0.1 percentage points in fiscal year 2018 as compared to the prior-year period. The increase was primarily due to higher ASPs, partially offset by an increase in commodity and logistics costs. Printing The components of the net revenue and weighted net revenue change by business unit were as follows: (1) Weighted Net Revenue Change Percentage Points measures the contribution of each business unit towards overall segment revenue growth. It is calculated by dividing the change in revenue of each business unit from the prior period by total segment revenue for the prior-year period. Fiscal Year 2019 compared with Fiscal Year 2018 Printing net revenue decreased 3.6% (decreased 3.0% on a constant currency basis) for fiscal year 2019 as compared to prior-year period. The decline in net revenue was primarily driven by a decline in Supplies, Consumer Hardware revenue and unfavorable foreign currency impacts, partially offset by an increase in Commercial Hardware revenue. Net revenue for Supplies decreased 4.8% as compared to the prior-year period, primarily due to demand weakness. Printer unit volume HP INC. AND SUBSIDIARIES Management’s Discussion and Analysis of Financial Condition and Results of Operations (Continued) decreased 4.8% compared to the prior-year period. The decrease in printer unit volume was driven by unit decrease in Consumer Hardware. Net revenue for Commercial Hardware increased 2.2% as compared to the prior-year period, primarily due to the acquisition of the Apogee group. Net revenue for Consumer Hardware decreased 6.7% as compared to the prior-year period due to a 5.4% decrease in printer unit volume and 1.7% decrease in ASPs. The unit volume decrease was driven by InkJet Home Consumer business and LaserJet Home business. The decrease in ASPs was primarily due to unfavorable foreign currency impacts. Printing earnings from operations as a percentage of net revenue increased by 0.1 percentage points for the fiscal year 2019 as compared to the prior-year period, primarily due to higher gross margin. The gross margin increased primarily due to rate improvement in Commercial Hardware partially offset by lower Supplies revenue. Fiscal Year 2018 compared with Fiscal Year 2017 Printing net revenue increased 11.1% (increased 9.5% on a constant currency basis) for fiscal year 2018 as compared to prior-year period. The increase in net revenue was primarily driven by the increase in Supplies and Hardware revenue and favorable foreign currency impacts. Net revenue for Supplies increased 8.4% as compared to the prior-year period, including the acquisition of Samsung’s printer business. Printer unit volume increased 12.7% while ASPs increased 1.7% as compared to the prior-year period. The increase in Printer unit volume was primarily driven by unit increases in Commercial and Consumer Hardware, including the Samsung-branded printers. Printer ASPs increased primarily due to favorable foreign currency impacts, partially offset by the dilution impact from Samsung-branded low-end A4 products. Net revenue for Commercial Hardware increased 19.0% as compared to the prior-year period, including revenue from Samsung-branded printers, LaserJet and PageWide printers. The unit volume increased by 39.6% while the ASPs decreased by 17.0%. The unit volume increased primarily due to Samsung-branded printers. The decrease in ASPs was primarily due to the dilution impact from Samsung-branded low-end A4 products. Net revenue for Consumer Hardware increased 12.6% as compared to the prior-year period due to a 9.3% increase in printer unit volume and a 3.4% increase in ASPs. The unit volume increase was driven by Samsung-branded printers, InkJet and LaserJet Home business. The increase in ASPs was primarily due to favorable foreign currency impacts. Printing earnings from operations as a percentage of net revenue decreased by 0.9 percentage points for the fiscal year 2018 as compared to the prior-year period, primarily due to an increase in operating expenses and lower gross margin. The gross margin decreased primarily due to lower Supplies mix and the dilution impact of Samsung-branded low-end products, partially offset by favorable foreign currency impacts and operational improvements. Operating expenses increased primarily driven by the acquisition of Samsung’s printer business and increases in investments in key growth initiatives and go-to-market. Corporate Investments The loss from operations in Corporate Investments for the fiscal years 2019, 2018 and 2017 was primarily due to expenses associated with HP Labs and our incubation and investment projects. LIQUIDITY AND CAPITAL RESOURCES We use cash generated by operations as our primary source of liquidity. We believe that internally generated cash flows are generally sufficient to support our operating businesses, capital expenditures, acquisitions, restructuring activities, maturing debt, income tax payments and the payment of stockholder dividends, in addition to investments and share repurchases. We are able to supplement this short-term liquidity, if necessary, with broad access to capital markets and credit facilities made available by various domestic and foreign financial institutions. While our access to capital markets may be constrained and our cost of borrowing may increase under certain business, market and economic conditions, our access to a variety of funding sources to meet our liquidity needs is designed to facilitate continued access to capital resources under all such conditions. Our liquidity is subject to various risks including the risks identified in the section entitled “Risk Factors” in Item 1A and market risks identified in the section entitled “Quantitative and Qualitative Disclosures about Market Risk” in Item 7A, which are incorporated herein by reference. Our cash and cash equivalents balances are held in numerous locations throughout the world, with the majority of those amounts held outside of the United States. We utilize a variety of planning and financing strategies in an effort to ensure that our worldwide cash is available when and where it is needed. Our cash position remains strong, and we expect that our cash balances, anticipated cash flow generated from operations and access to capital markets will be sufficient to cover our expected near-term cash outlays. Amounts held outside of the United States are generally utilized to support non-U.S. liquidity needs and may from time to time be distributed to the United States. The TCJA made significant changes to the U.S. tax law, including a one-time transition tax on accumulated foreign earnings. The payments associated with this one-time transition tax will be paid over eight years and began in fiscal year 2019. We expect a significant portion of the cash and cash equivalents held by our foreign subsidiaries HP INC. AND SUBSIDIARIES Management’s Discussion and Analysis of Financial Condition and Results of Operations (Continued) will no longer be subject to U.S. income tax consequences upon a subsequent repatriation to the United States as a result of the transition tax on accumulated foreign earnings. However, a portion of this cash may still be subject to foreign income tax or withholding tax consequences upon repatriation. As we evaluate the future cash needs of our operations, we may revise the amount of foreign earnings considered to be permanently reinvested in our foreign subsidiaries and how to utilize such funds, including reducing our gross debt level, or other uses. Liquidity Our cash and cash equivalents, marketable debt securities and total debt were as follows: (1) Includes highly liquid U.S. treasury notes, U.S. agency securities, non-U.S. government bonds, corporate debt securities, money market and other funds. We classify these investments within Other current assets in Consolidated Balance Sheets, including those with maturity dates beyond one year, based on their highly liquid nature and availability for use in current operations. Our key cash flow metrics were as follows: Operating Activities Net cash provided by operating activities increased marginally by $0.1 billion for fiscal year 2019 as compared to fiscal year 2018. Net cash provided by operating activities increased by $0.9 billion for fiscal year 2018 as compared to fiscal year 2017. The increase was primarily due to higher earnings from operations and cash generated from working capital management activities. Working Capital Metrics Management utilizes current cash conversion cycle information to manage our working capital level. The table below presents the cash conversion cycle: The cash conversion cycle is the sum of days of DSO and DOS less DPO. Items which may cause the cash conversion cycle in a particular period to differ from a long-term sustainable rate include, but are not limited to, changes in business mix, changes in payment terms, extent of receivables factoring, seasonal trends and the timing of revenue recognition and inventory purchases within the period. DSO measures the average number of days our receivables are outstanding. DSO is calculated by dividing ending accounts receivable, net of allowance for doubtful accounts, by a 90-day average of net revenue. For fiscal years 2019 and HP INC. AND SUBSIDIARIES Management’s Discussion and Analysis of Financial Condition and Results of Operations (Continued) 2018, the increase in DSO compared to fiscal years 2018 and 2017, respectively, was primarily due to unfavorable revenue linearity. DOS measures the average number of days from procurement to sale of our product. DOS is calculated by dividing ending inventory by a 90-day average of cost of goods sold. For fiscal year 2019, the decrease in DOS compared to fiscal year 2018 was primarily due to reduction in inventory driven by reclassification of certain balances to other current assets pursuant to adoption of the new revenue standard in the first quarter of fiscal 2019. For fiscal year 2018, the DOS was lower primarily due to a focus on inventory management. DPO measures the average number of days our accounts payable balances are outstanding. DPO is calculated by dividing ending accounts payable by a 90-day average of cost of goods sold. For fiscal year 2019, the increase in DPO compared to fiscal year 2018 was higher primarily due to working capital management activities, partially offset by lower inventory purchasing volume. For fiscal year 2018, the DPO remained flat compared to fiscal year 2017. Investing Activities Net cash used in investing activities decreased by $0.3 billion for fiscal year 2019 as compared to fiscal year 2018, primarily due to lower net payments for acquisitions. Net cash used in investing activities decreased by $1.0 billion for fiscal year 2018 as compared to fiscal year 2017, primarily due to a decrease in investments classified as available-for-sale investments within Other current assets by $1.6 billion, and collateral related to our derivatives of $0.4 billion, partially offset by the payment of $1.0 billion for the acquisition of Samsung’s printer business. Financing Activities Net cash used in financing activities decreased by $0.8 billion in fiscal year 2019 compared to fiscal year 2018, primarily due to lower payment of debt of $1.5 billion, partially offset by a decrease in outstanding commercial paper amounts of $0.7 billion. Net cash used in financing activities increased by $4.4 billion in fiscal year 2018 compared to fiscal year 2017, primarily due to the payment to repurchase approximately $1.85 billion of debt, higher share repurchase amount of $1.1 billion and higher outstanding commercial paper of $0.9 billion in fiscal year 2017. Capital Resources Debt Levels We maintain debt levels that we establish through consideration of a number of factors, including cash flow expectations, cash requirements for operations, investment plans (including acquisitions), share repurchase activities, our cost of capital and targeted capital structure. Short-term debt decreased by $1.1 billion for fiscal year 2019 as compared to fiscal year 2018, primarily due to a decrease in outstanding commercial paper amounts of $0.9 billion. Long-term debt decreased by $2.2 billion for fiscal year 2018 as compared to fiscal year 2017 primarily due to the payment to repurchase approximately $1.85 billion in aggregate principal amount of U.S. Dollar Global Notes. Our debt-to-equity ratio is calculated as the carrying amount of debt divided by total stockholders’ deficit. Our debt-to-equity ratio changed by 5.1x in fiscal year 2019 compared to fiscal year 2018, primarily due to an increase in stockholders’ deficit balance of $0.6 billion. Our debt-to-equity ratio changed by 7.1x in fiscal year 2018 compared to fiscal year 2017, primarily due to a decrease in stockholders’ deficit balance of $2.8 billion. Our weighted-average interest rate reflects the effective interest rate on our borrowings prevailing during the period and reflects the effect of interest rate swaps. For more information on our interest rate swaps, see Note 10, “Financial Instruments” in the Consolidated Financial Statements and notes thereto in Item 8, “Financial Statements and Supplementary Data”. HP INC. AND SUBSIDIARIES Management’s Discussion and Analysis of Financial Condition and Results of Operations (Continued) Available Borrowing Resources We had the following resources available to obtain short or long-term financing: The 2016 Shelf Registration Statement will expire in December 2019, around which time we expect to file a new shelf registration statement. As of October 31, 2019, we maintain a senior unsecured committed revolving credit facility with aggregate lending commitments of $4.0 billion, that will be available until March 30, 2023 and is primarily to support the issuance of commercial paper. Funds borrowed under this revolving credit facility may also be used for general corporate purposes. For more information on our borrowings, see Note 11, “Borrowings”, to the Consolidated Financial Statements in Item 8, which is incorporated herein by reference. Credit Ratings Our credit risk is evaluated by major independent rating agencies based upon publicly available information as well as information obtained in our ongoing discussions with them. While we do not have any rating downgrade triggers that would accelerate the maturity of a material amount of our debt, previous downgrades have increased the cost of borrowing under our credit facility, have reduced market capacity for our commercial paper and have required the posting of additional collateral under some of our derivative contracts. In addition, any further downgrade to our credit ratings by any rating agencies may further impact us in a similar manner, and, depending on the extent of any such downgrade, could have a negative impact on our liquidity and capital position. We can access alternative sources of funding, including drawdowns under our credit facility, if necessary, to offset potential reductions in the market capacity for our commercial paper. HP INC. AND SUBSIDIARIES Management’s Discussion and Analysis of Financial Condition and Results of Operations (Continued) CONTRACTUAL AND OTHER OBLIGATIONS Our contractual and other obligations as of October 31, 2019, were as follows: (1) Amounts represent the principal cash payments relating to our short-term and long-term debt and do not include any fair value adjustments, discounts or premiums. (2) Amounts represent the expected interest payments relating to our short-term and long-term debt. We have outstanding interest rate swap agreements accounted for as fair value hedges that have the economic effect of changing fixed interest rates associated with some of our U.S. Dollar Global Notes to variable interest rates. The impact of our outstanding interest rate swaps at October 31, 2019 was factored into the calculation of the future interest payments on debt. (3) Purchase obligations include agreements to purchase goods or services that are enforceable and legally binding on us and that specify all significant terms, including fixed or minimum quantities to be purchased; fixed, minimum or variable price provisions; and the approximate timing of the transaction. These purchase obligations are related principally to inventory and other items. Purchase obligations exclude agreements that are cancelable without penalty. Purchase obligations also exclude open purchase orders that are routine arrangements entered into in the ordinary course of business as they are difficult to quantify in a meaningful way. Even though open purchase orders are considered enforceable and legally binding, the terms generally allow us the option to cancel, reschedule, and adjust terms based on our business needs prior to the delivery of goods or performance of services. (4) Amounts represent the operating lease obligations, net of total sublease income of $130 million. (5) Amounts represent the capital lease obligations, including total capital lease interest obligations of $64 million. (6) Retirement and Post-Retirement Benefit Plan Contributions. In fiscal year 2020, we expect to contribute approximately $76 million to non-U.S. pension plans, $36 million to cover benefit payments to U.S. non-qualified plan participants and $6 million to cover benefit claims for our post-retirement benefit plans. Our policy is to fund our pension plans so that we meet at least the minimum contribution required by local government, funding and taxing authorities. Expected contributions and payments to our pension and post-retirement benefit plans are excluded from the contractual obligations table because they do not represent contractual cash outflows as they are dependent on numerous factors which may result in a wide range of outcomes. For more information on our retirement and post-retirement benefit plans, see Note 4, “Retirement and Post-Retirement Benefit Plans”, to the Consolidated Financial Statements in Item 8, which is incorporated herein by reference. (7) Cost Savings Plans. As a result of our approved restructuring plans, including the Fiscal 2020 plan, we expect to make future cash payments of approximately $1.0 billion. We expect to make future cash payments of $418 million in fiscal year 2020 with remaining cash payments through fiscal year 2023. These payments have been excluded from the contractual obligations table because they do not represent contractual cash outflows and there is uncertainty as to the timing of these payments. For more information on our restructuring activities that are part of our cost improvements, see Note 3, “Restructuring and Other Charges”, to the Consolidated Financial Statements in Item 8, which is incorporated herein by reference. (8) Uncertain Tax Positions. As of October 31, 2019, we had approximately $509 million of recorded liabilities and related interest and penalties pertaining to uncertain tax positions. We are unable to make a reasonable estimate as to when cash settlement with the tax authorities might occur due to the uncertainties related to these tax matters. Payments of these obligations would result from settlements with taxing authorities. For more information on our uncertain tax positions, see Note 6, “Taxes on Earnings”, to the Consolidated Financial Statements in Item 8, which is incorporated herein by reference. HP INC. AND SUBSIDIARIES Management’s Discussion and Analysis of Financial Condition and Results of Operations (Continued) (9) Payment of one-time transition taxes under the TCJA. The TCJA made significant changes to U.S. tax law resulting in a one-time gross transition tax of $3.0 billion on accumulated foreign earnings. We expect the actual cash payments for the tax to be much lower as we expect to reduce the overall liability by more than half once existing and future credits and other balance sheet tax attributes are used. The payments associated with this one-time transition tax will be paid over eight years and began in fiscal year 2019. OFF-BALANCE SHEET ARRANGEMENTS As part of our ongoing business, we have not participated in transactions that generate material relationships with unconsolidated entities or financial partnerships, such as entities often referred to as structured finance or special purpose entities, which would have been established for the purpose of facilitating off-balance sheet arrangements or other contractually narrow or limited purposes. We have third-party short-term financing arrangements intended to facilitate the working capital requirements of certain customers. For more information on our third-party short-term financing arrangements, see Note 7 “Supplementary Financial Information” to the Consolidated Financial Statements in Item 8, which is incorporated herein by reference.

<s>[INST] Overview. A discussion of our business and other highlights affecting the company to provide context for the remainder of this MD&A. Critical Accounting Policies and Estimates. A discussion of accounting policies and estimates that we believe are important to understanding the assumptions and judgments incorporated in our reported financial results. Results of Operations. An analysis of our financial results comparing fiscal year 2019 to fiscal year 2018 and fiscal year 2018 to fiscal year 2017. A discussion of the results of operations is followed by a more detailed discussion of the results of operations by segment. Liquidity and Capital Resources. An analysis of changes in our cash flows and a discussion of our liquidity and financial condition. Contractual and Other Obligations. An overview of contractual obligations, retirement and postretirement benefit plan contributions, costsaving plans, uncertain tax positions and offbalance sheet arrangements. The discussion of financial condition and results of our operations that follows provides information that will assist the reader in understanding our Consolidated Financial Statements, the changes in certain key items in those financial statements from year to year, and the primary factors that accounted for those changes, as well as how certain accounting principles, policies and estimates affect our Consolidated Financial Statements. This discussion should be read in conjunction with our Consolidated Financial Statements and the related notes that appear elsewhere in this document. HP INC. AND SUBSIDIARIES Management’s Discussion and Analysis of Financial Condition and Results of Operations (Continued) OVERVIEW We are a leading global provider of personal computing and other access devices, imaging and printing products, and related technologies, solutions, and services. We sell to individual consumers, SMBs and large enterprises, including customers in the government, health, and education sectors. We have three reportable segments: Personal Systems, Printing and Corporate Investments. The Personal Systems segment offers commercial and consumer desktop and notebook PCs, workstations, thin clients, commercial mobility devices, retail POS systems, displays and other related accessories, software, support, and services. The Printing segment provides consumer and commercial printer hardware, supplies, solutions and services, as well as scanning devices. Corporate Investments include HP Labs and certain business incubation and investment projects. In Personal Systems, our strategic focus is on profitable growth through market segmentation with respect to enhanced innovation in multioperating systems, multiarchitecture, geography, customer segments and other key attributes. Additionally, we are investing in end point services and solutions. We are focused on services including DaaS as the market begins to shift to contractual solutions. We believe that we are well positioned due to our competitive product lineup. In Printing, our strategic focus is on Contractual solutions and Graphics, as well as expanding our footprint in the 3D printing and digital manufacturing marketplace. In Contractual solutions we have a continued focus on Managed Print Services and Instant Ink. In Graphics, we are focused on innovations such as our Indigo and Latex product offerings. We continue to experience challenges that are representative of trends and uncertainties that may affect our business and results of operations. One set of challenges relates to dynamic market trends, such as forecasted declining PC Client markets and home printing markets. A second set of challenges relates to changes in the competitive landscape. Our primary competitors are exerting competitive pressure in targeted areas and are entering new markets, our emerging competitors are introducing new technologies and business models, and our alliance partners in some businesses are increasingly becoming our competitors in others. A third set of challenges relates to business model changes and our gotomarket execution in an evolving distribution and reseller landscape, with increasing online and omnichannel presence. Additional challenges we face at the segment level are set forth below. In Personal Systems, we face challenges with industry component availability and a competitive pricing environment. In Printing, a competitive pricing environment, including from nonoriginal supplies (which includes imitation, refill or remanufactured alternatives), and a weakened market in certain geographies with associated pricing sensitivity of our customers present challenges. We also face challenges in Printing due to our multitier distribution network, primarily in EMEA, including limiting grey marketing and the potential [/INST] Positive. </s>

LSB INDUSTRIES INC

2015-03-02

2014-12-31

ITEM 7. MANAGEMENT’S DISCUSSION AND ANALYSIS OF FINANCIAL CONDITION AND RESULTS OF OPERATIONS The following Management’s Discussion and Analysis of Financial Condition and Results of Operations should be read in conjunction with a review of the other Items included in this Form 10-K and our December 31, 2014 Consolidated Financial Statements included elsewhere in this report. Certain statements contained in this MD&A may be deemed to be forward-looking statements. See “Special Note Regarding Forward-Looking Statements.” Overview General LSB is a manufacturing and marketing company operating through our subsidiaries. LSB and its wholly-owned subsidiaries own the following core businesses: • Chemical Business manufactures and sells nitrogen-based chemical products for the agricultural, industrial, and mining markets it produces from four facilities located in El Dorado, Arkansas; Cherokee, Alabama; Pryor, Oklahoma; and Baytown, Texas. • Climate Control Business manufactures and sells a broad range of HVAC products that include water source and geothermal heat pumps, hydronic fan coils, large custom air handlers, modular geothermal and other chillers, and other related products and services. These products are primarily used in commercial/institutional and residential new buildings construction, renovation of existing buildings and replacement of existing systems. Our Climate Control Business manufactures and distributes its products from seven facilities located in Oklahoma City, Oklahoma. Items Affecting Comparability of Results Chemical Business Property and Business Interruption Insurance Claims and Recoveries In October 2013 and January 2014, we settled claims with our insurance carriers for the aggregate amount of approximately $113.0 million and $43.5 million related to property damage and business interruption at our El Dorado Facility and Cherokee Facility, respectively. For 2013 and 2014, the impact of these claims to our operating results was $66.0 million and $5.1 million, respectively, recognized as property insurance recoveries in excess of losses incurred and $28.6 million and approximately $22.9 million, respectively, recognized as a reduction to cost of sales. Debt and Interest Expense During August 2013, in connection with a major expansion of our El Dorado Facility, LSB sold $425 million of 7.75% Senior Secured Notes. The use of proceeds included $67.2 million used to pay all outstanding borrowings including the prepayment penalty under a term loan agreement. During 2013 and 2014, interest expense was $14.0 million and $21.6 million, respectively net of capitalized interest of $4.0 million and $14.1 million, respectively. Interest was capitalized based upon construction in progress of the El Dorado expansion and certain other capital projects. Recovery of Precious Metals In 2013 during major maintenance projects, our Chemical Business performed procedures to recover precious metals, which had accumulated over time within the manufacturing equipment. As a result, a recovery of precious metals of $4.5 million was recognized as a reduction to cost of sales. Key Industry Factors Chemical Business Supply and Demand Agricultural The price at which our agricultural products are ultimately sold depends on numerous factors, including the supply and demand for nitrogen fertilizers which, in turn, depends upon, among other factors, world grain demand and production levels, the cost and availability of transportation, storage, weather conditions, competitive pricing and the availability of imports. An expansion or upgrade of competitors’ facilities, international political and economic developments and other factors are likely to continue to play an important role in nitrogen fertilizer industry economics. These factors can impact, among other things, the level of inventories in the market, resulting in price volatility and product margins. As reported in Green Markets and based upon the January USDA release of its 2014 Crop Production Summary and the WASDE Report dated February 10, 2015, for the 2014/2015 corn season, production is estimated at 14.2 billion bushels or 351 million metric tons, 3% above the prior season. Additionally, the average U. S. yield is estimated at a record 171.0 bushels per acre compared to 158.1 bushels per acre in the prior season. WASDE also estimated the ending U.S. corn stocks to be 47.7 million metric tons compared to 31.3 million metric tons last season. Due to the expectation of the abundant supply, corn prices are low relative to pricing over the last three years; most recently reported at $3.65 per bushel. The number of acres planted will drive nitrogen fertilizer consumption and demand which likely will drive ammonia, UAN and urea prices. Current WASDE estimates are for 88-89 million acres of corn to be planted in 2015 compared to approximately 91 million planted in 2014. However with fewer acres, farmers will expect better yields requiring increased nitrogen fertilizers. Notwithstanding the current conditions, the fundamentals continue to be positive for nitrogen fertilizer products we produce and sell and gross margins still continue to be favorable, with the exception of AN produced at the El Dorado Facility from purchased ammonia, which is one of the reasons for the current construction project of an ammonia plant at our El Dorado Facility. Additionally, we believe that we will see strong spring demand for nitrogen fertilizer since U.S. farmers were unable to apply normal fall ammonia amounts in 2014 due to a delayed corn harvest followed by poor weather conditions. Industrial Our industrial products sales volumes are dependent upon general economic conditions primarily in the housing, automotive, and paper industries. According to the American Chemistry Council, the U.S. economic indicators continue to be mostly positive. Our sales prices vary with the market price of our feedstock (ammonia, natural gas or sulfur, as applicable) in our pricing arrangements with customers. Mining Our mining products are industrial grade AN and AN solutions for the mining industry. The primary uses are as specialty emulsions for mining applications (primarily in surface mining of coal) and for usage in quarries and the construction industry. As reported by the U.S. Energy Information Administration, annual coal production estimates for 2014 were up 1% over 2013. EIA is forecasting 1% declines in production for both 2015 and 2016 with the Appalachia region expected to see declines of 3% or more in the coming two years, offset by stable production in the west and modest growth in the mid-west. However, we believe that growth of coal production in the U.S. will face problems competing with low cost natural gas and export demand could be lower due to the current strong U.S. currency. While we believe our plants are well-located to support the regions expected to see growth in the upcoming years, our current mining sales volumes are being impacted by lower customer demand for industrial grade AN. Farmer Economics The demand for fertilizer is affected by the aggregate crop planting decisions and fertilizer application rate decisions of individual farmers. Individual farmers make planting decisions based largely on prospective profitability of a harvest, while the specific varieties and amounts of fertilizer they apply depend on factors, such as farmers’ financial resources, soil conditions, weather patterns and the types of crops planted. Natural Gas Prices Natural gas is the primary feedstock for the production of nitrogen fertilizers at our Cherokee and Pryor Facilities. Over the last five years, U.S. natural gas reserves have increased significantly due to, among other factors, advances in extracting shale gas, which have reduced and stabilized natural gas prices, providing North America with a cost advantage over certain imports. As a result, our competitive position and that of other North American nitrogen fertilizer producers have been positively impacted. We historically have purchased natural gas in the spot market or through the use of forward purchase contracts, or a combination of both. We historically have used forward purchase contracts to lock in pricing for a portion of our natural gas requirements. These forward purchase contracts are generally either fixed-price or index-price, short-term in nature and for a fixed supply quantity. We are able to purchase natural gas at competitive prices due to our connections to large distribution systems and their proximity to interstate pipeline systems. Over the past several years, natural gas prices have experienced significant fluctuations, which has had an impact on our cost of producing nitrogen fertilizer. The following table shows the annual volume of natural gas we purchased and the average cost per MMBtu: Beginning in December 2014, Henry Hub natural gas prices have trended below $4.00, averaging at approximately $3.00 in January and at $2.65 through mid-February. Ammonia Prices Ammonia is the primary feedstock for the production of agricultural and industrial grade AN at our El Dorado Facility. Ammonia pricing is based on a published Tampa, Florida market index. The Tampa index is commonly used in annual contracts for both the agricultural and industrial sectors, and is based on the most recent major industry transactions in the Tampa market. Pricing considerations for ammonia incorporate international supply-demand, ocean freight and production factors. Additionally, the El Dorado Facility’s cost to produce agricultural grade AN from purchased ammonia at current market prices exceeds the current selling prices (a cost disadvantage as compared to producing ammonia from natural gas). Subject to availability, the El Dorado Facility has the option to source a portion of its ammonia requirements from our Pryor Facility, which cost is significantly lower than current market prices. Once our new ammonia production plant at the El Dorado Facility commences production (expected to begin in the first quarter of 2016), we believe this cost disadvantage will be eliminated. Over the past several years, ammonia prices have experienced large fluctuations. The table below shows the El Dorado Facility’s annual volume of ammonia purchased and the average cost per short ton: Based upon full plant production, the El Dorado Facility would normally purchase 200,000 to 220,000 tons per year of ammonia feedstock. In 2014 and 2013, the purchased ammonia was less than the amount required for full production due to tons paid for but not taken by Orica, lower than normal agricultural AN demand in 2013 and lower nitric acid capacity in both years due to the loss of the DSN plant in 2012. Transportation Costs Costs for transporting nitrogen based products can be significant relative to their selling price. For example, ammonia is a hazardous gas at ambient temperatures and must be transported under refrigeration in specialized equipment, which is more expensive than other forms of nitrogen fertilizers. In recent years, a significant amount of the ammonia consumed annually in the U.S was imported. Therefore, nitrogen fertilizers prices in the U.S. are influenced by the cost to transport product from exporting countries, giving domestic producers that transport shorter distances an advantage. Climate Control Business Construction Markets From a market sector perspective, our Climate Control Business serves the new and renovation commercial/institutional and residential construction sectors and we believe the majority of our business is associated with the construction of new facilities. Information available from the CMFS forecast indicates that construction activity in the commercial/institutional markets we serve is expected to increase 5% in aggregate during 2015 and is heading back towards 2007 pre-recession levels. In particular, the hospitality, education and multi-family sectors are expected to grow faster than other vertical markets we serve. On the other hand, single-family residential construction is expected to grow 15% during 2015, however, it will remain well below pre-recession levels We expect the Climate Control Business to experience moderate sales growth in the short-term. Although a part of the Climate Control Business’ commercial/institutional sales are products that are used for renovation and replacement applications, sales increases in the medium-term and long-term are expected to be primarily driven by growth in new construction, as well as the introduction of new products specifically in the hospitality, education and healthcare sectors. Our expectations for residential products are that this sector will experience minimal growth due to the higher relative purchase cost of our higher efficiency GHP product offerings as compared to traditional HVAC systems creating a longer payback period in most regions due to low natural gas prices. We continue to focus our sales and marketing efforts to increase our share of the existing market for our products as well as expand the market for and application of our products, especially utilizing high efficiency and “green” technology. Key Operational Factors Chemical Business Facility Reliability Consistent, reliable and safe operations at our chemical plants are critical to our financial performance and results of operations. Unplanned downtime of the plants typically result in lost contribution margin, increased maintenance expense and decreased inventory for sale. The financial impact of planned downtime, including Turnarounds maintenance, is mitigated through a diligent planning process that takes into the market, the availability of resources to perform the needed maintenance, feedstock logistics and other factors. Our Cherokee and Pryor Facilities have historically undergone a facility Turnaround every year. In the third quarter of 2014, our Cherokee Facility underwent an extended Turnaround replacing certain end-of-life equipment and performing additional maintenance required to move to a two-year Turnaround cycle. The extended Turnaround lasted 42 days and incurred approximately $5 million in maintenance expenses. Going forward, we anticipate that Turnarounds at our Cherokee Facility typically will be performed every two years, expecting to last 25 to 30 days. Turnarounds at our Pryor Facility currently are performed every year, and typically last between 20 to 25 days. We are currently anticipating a Turnaround at our Pryor Facility in June or July of 2015. At our El Dorado Facility, since we are able to perform Turnaround projects on individual plants without shutting down the entire facility, the impact of lost production is not significant. Upon completion of the new ammonia plant at our El Dorado Facility, that facility will begin with annual Turnarounds that will typically last between 20 to 25 days. All Turnarounds result in lost fixed overhead absorption and additional maintenance costs, which costs are expensed as incurred. Prepay Contracts We use forward sales of our fertilizer products to optimize our asset utilization, planning process and production scheduling. These sales are made by offering customers the opportunity to purchase product on a forward basis at prices and delivery dates that we propose. We use this program to varying degrees during the year depending on market conditions and depending on our view as to whether price environments will be increasing or decreasing. Fixing the selling prices of our products months in advance of their ultimate delivery to customers typically causes our reported selling prices and margins to differ from spot market prices and margins available at the time of shipment. Climate Control Business Product Orders, Sales and Ending Backlog Our Climate Control Business 2014 total bookings were $278 million, the highest level since 2008 ($306 million). Despite the loss of Carrier’s heat pump contracts discussed below, our commercial bookings increased 12% over 2013, whereas our residential product bookings declined 7%. Excluding Carrier heat pump activity, commercial and residential bookings increased 18% and 15%, respectively. Our backlog significantly improved in 2014 over 2013 due to increased orders for our larger custom air handlers and hydronic fan coils. The following table shows information relating to our product order intake level, net sales and backlog of confirmed customer product orders of our Climate Control Business: (1) Our product order level consists of confirmed purchase orders from customers that have been accepted and received credit approval. Our backlog consists of confirmed customer orders for product to be shipped at a future date. Historically, we have not experienced significant cancellations relating to our backlog of confirmed customer product orders, and we typically expect to ship substantially all of these orders within the next twelve months. However, the December 31, 2014 backlog includes two orders totaling approximately $6.9 million expected to ship from twelve to eighteen months. It is possible that some of our customers could cancel a portion of our backlog or extend the shipment terms. Product orders and backlog, as reported, generally do not include amounts relating to shipping and handling charges, service orders or service contract orders. In addition, product orders and backlog, as reported, exclude contracts related to our construction business due to the relative size of individual projects and, in some cases, extended timeframe for completion beyond a twelve-month period. For January 2015, our new orders received were approximately $24.8 million and our backlog was approximately $71.7 million at January 31, 2015. Operational Excellence Activities We are in the second year of our operational excellence initiatives to become a world class company in terms of safety, quality, delivery and cost. We believe world class performance will benefit our Climate Control Business through a high level of customer satisfaction, enhanced employee engagement, faster growth and improved margins. During the past two years, we completed value analysis/value engineering activities that are part of our operational excellence initiatives at each of our companies within our Climate Control Business. In addition, we have laid the foundation for the continuous improvement culture desired in our organization. In 2014, we completed more than 15 rapid improvement events and improvement projects across our Climate Control Business. The RIE’s covered areas throughout our entire value streams; improving our response time to customer quote requests, improving material delivery to our production lines, creating flow on our assembly lines, implementing kitting operations within sheet metal fabrication to reduce material outages on our assembly lines, improving our communication and scheduling on quick cycle orders and improving our engineering design and delivery process for special feature requests from our customers. In addition, we implemented daily improvement activities and root cause analysis/problem solving methods. We also have completed our second year of value stream analysis (“VSA”) and management alignment (“MA”) activities, which we believe sets the stage for additional improvements in 2015 and future years. Certain Heat Pump Contracts In November 2013, Carrier advised one of our subsidiaries, CM, that heat pump contracts would not be renewed between CM, as the manufacturer, and Carrier, as the purchaser. These contracts expired on May 11, 2014. During 2014, 2013 and 2012, net sales pursuant to these heat pump contracts represented approximately $15 million, $32 million and $36 million, respectively. Despite the loss of the Carrier heat pump contracts, we expect our Climate Control Business to report improved sales in 2015 due from higher sales of our LSB branded climate control products through new product introductions and forecast growth in the commercial and institutional construction markets. Results of Operations The following Results of Operations should be read in conjunction with our consolidated financial statements for the years ended December 31, 2014, 2013, and 2012 and accompanying notes and the discussions under “Overview” and “Liquidity and Capital Resources” included in this MD&A. We present the following information about our results of operations for our two core business segments: the Chemical Business and the Climate Control Business. The business operation classified as “Other” primarily sells industrial machinery and related components to machine tool dealers and end users. Net sales by business segment include net sales to unaffiliated customers as reported in the consolidated financial statements. Intersegment net sales are not significant. Gross profit by business segment represents net sales less cost of sales. In addition, our chief operating decision makers use operating income by business segment for purposes of making decisions that include resource allocations and performance evaluations. Operating income by business segment represents gross profit by business segment less SG&A incurred by each business segment plus other income and other expense earned/incurred by each business segment before general corporate expenses. General corporate expenses consist of SG&A, other income and other expense that are not allocated to one of our business segments. The following table contains certain information about our continuing operations in different business segments for each of the three years ended December 31: Year Ended December 31, 2014 Compared to Year Ended December 31, 2013 Chemical Business The following table contains certain information about our net sales, gross profit and operating income in our Chemical segment for 2014 and 2013: (1) As a percentage of net sales Net Sales - Chemical Our Chemical Business sales in the agricultural markets primarily were at the spot market price in effect at the time of sale or at a negotiated future price. Most of our Chemical Business sales in the industrial and mining markets were pursuant to sales contracts and/or pricing arrangements on terms that include the cost of raw material feedstock as a pass through component in the sales price. Our 2014 production and sales volumes were higher in all three of our primary markets due to consistent customer demand and improved on-stream production rates at the El Dorado, Pryor and Cherokee Facilities, partially offset by an extended Turnaround in the third quarter and the approximately 30 days of downtime in the fourth quarter to complete certain unplanned maintenance at our Cherokee Facility. • Agricultural products comprised approximately 47% and 44% of the Chemical Business’ net sales for 2014 and 2013, respectively. Agricultural products sales increased in 2014 as more product was available to sell resulting from the increased on-stream rates of our facilities partially offset by lower average selling prices for nitrogen fertilizers. Compared to 2013, the 2014 average agricultural products selling prices per ton were lower by 8%, 5%, and 10% for ammonia, UAN and AN, respectively. The decrease in selling prices for the nitrogen fertilizers was due largely to record exports of urea from China combined with lower commodity prices. • Industrial acids and other chemical products sales increased in 2014 as a result of more product available to sell due to the improved on-stream rates of our chemical facilities. • Mining products sales increased in 2014 primarily as a result of more product available to sell due to the improved on-stream rates of our chemical facilities. • Other products relates to natural gas sales from our working interests in certain natural gas properties acquired in 2012 and 2013 by a subsidiary within our Chemical Business. The increase in natural gas sales is primarily due to higher production volume as these properties are developed partially offset by lower net selling prices. Gross Profit - Chemical • Our gross profit increased $20.4 million in 2014 as compared to 2013. Excluding business interruption insurance recoveries of $22.9 million and $28.6 million in 2014 and 2013, respectively, and $4.5 million of precious metals recovery in 2013, the increase in gross profit was $30.6 million. The increase of $30.6 million was due to the higher sales level resulting in improved fixed overhead absorption made possible by the improved on-stream production rates of our chemical facilities. The improved gross profit was partially offset by a decline in the margin per ton of nitrogen fertilizers due to lower selling prices and higher feedstock costs. Natural gas feedstock cost increased approximately 12% partially offset by a 7% decrease in ammonia feedstock costs, while AN prices decreased 10% and UAN selling prices decreased 5%, negatively affecting gross profit margins on our nitrogen fertilizer sales. • Unrealized losses related to forward contracts on natural gas purchases decreased 2014 gross profit by $2.1 million compared to a minimal unrealized gain in 2013. • Purchased UAN that was sold at a loss to honor forward sales commitments in excess of available production due to unplanned downtime reduced gross profit by $1.2 million in 2014. Operating Income - Chemical • Our Chemical Business’ operating income was $51.3 million, a decrease of $36.5 million. In addition to the business interruption insurance recoveries included in gross profit discussed above, property insurance recoveries of $5.1 million and $66.0 million were recognized in 2014 and 2013, respectively. Excluding all insurance recoveries of $28.0 million and $94.6 million in 2014 and 2013, respectively, and excluding the precious metals recovery of $4.5 million in 2013, our adjusted operating income was $23.3 million in 2014 compared to an adjusted operating loss of $11.3 million, or an increase of $34.6 million. Additionally net other expenses were $4.0 million lower in 2014 due primarily to dismantling expenses and penalties incurred in 2013. Climate Control Business The following table contains certain information about our net sales, gross profit and operating income in our Climate Control segment for 2014 and 2013: (1) As a percentage of net sales Net Sales - Climate Control • Net sales of our water source and geothermal heat pump products decreased in 2014 primarily as a result of the loss of the Carrier heat pump contracts, which generated sales in 2014 that were $17 million lower than 2013. Excluding Carrier heat pump sales, commercial/institutional product sales were flat with 2013 while residential product sales were up nearly 6.5%. Overall, the number of units sold declined; and the unit average unit selling price increased due to lower Carrier sales. From a commercial/institutional market perspective, gains were seen in the retail and multi-family sectors with a slight decline in the education sector. In addition, 2014 had an extremely slow start due to low beginning backlog and weather related delays. Incoming orders, excluding Carrier, for commercial/institutional products and residential products increased 11% and 15%, respectively. During 2014, we continued to maintain a market share leadership position based on market data supplied by the AHRI. • Net sales of our hydronic fan coils declined in 2014 primarily due to lower than expected product orders partially offset by an increase in selling prices of approximately 8% over 2013 primarily due to product and feature mix. We experienced only minor fluctuations in the vertical markets served. During 2014, we continued to maintain a market share leadership position based on market data supplied by the AHRI. • Net sales of our other HVAC products decreased primarily due to a lower beginning backlog entering 2014, customer scheduled delivery dates shifting out for our large custom air handlers and modular chillers, partially offset by increased activity on contracts for our engineering and construction services. Gross Profit - Climate Control • The decrease in gross profit in our Climate Control Business was primarily the result of the lower net sales as discussed above and reduced overhead absorption related to fewer units sold in 2014 as compared to 2013. Operating Income - Climate Control • Operating income decreased primarily as a result of the lower gross profit discussed above, partially offset by lower operating expenses. However, variable selling expenses as a percentage of sales increased due to the change in product and customer mix with lower OEM sales at CM causing freight to increase as a percentage of sales and warranty expenses increasing due to recent claims at our fan coil operation. Fixed selling and administrative expense in 2014 declined slightly from 2013 but represented a greater percentage of net sales due to lower sales in 2014. General Corporate Expenses General corporate expenses consist of SG&A, other income and other expense that are not allocated to one of our business segments. General corporate expenses were $21.4 million during 2014 compared to $14.6 million in 2013. The increase was primarily the result of incurring approximately $4.2 million in fees and expenses related to evaluating and analyzing proposals from and settling with certain activist shareholders in the first quarter of 2014 and increases in consulting fees and services of $0.9 million, insurance and bank related expense of $0.4 million, depreciation and amortization of $0.4 and personnel costs of $0.3 million. During 2013, we recognized other income of $0.5 million relating to a litigation settlement. Interest Expense, net Interest expense for 2014 was $21.6 million compared to $14.0 million for 2013. The increase is due primarily to the issuance of the Senior Secured Notes during 2013, partially offset by $14.1 million of capitalized interest on capital projects under development and construction during 2014 compared to $4.0 million capitalized during 2013. Loss on Extinguishment of Debt As the result of the payoff of the Secured Term Loan in 2013, we incurred a loss on extinguishment of debt of $1.3 million, consisting of a prepayment premium and writing off unamortized debt issuance costs. Provision for Income Taxes The provision for income taxes for 2014 was approximately $12.4 million compared to $35.4 million for 2013. The resulting effective tax rate was 39% for 2014 and 40% for 2013 (excluding the benefit of $0.5 million associated with the retroactive tax relief on certain 2012 tax provisions that expired in 2012). The decrease in the effective tax rate was due primarily to certain expired tax credits reinstated during December 2014. Year Ended December 31, 2013 Compared to Year Ended December 31, 2012 Chemical Business The following table contains certain information about our net sales, gross profit and operating income in our Chemical segment for 2013 and 2012: (1) As a percentage of net sales Net Sales - Chemical • Agricultural products sales decreased due to the lack of available products as the result of the downtime experienced at our Cherokee and Pryor Facilities, lower sales prices for nitrogen fertilizer, and periodic adverse weather conditions during 2013. • Industrial acids and other chemical products sales decreased due to the reduction in the average Tampa ammonia price by more than $57 per metric ton in 2013 compared to 2012 and its impact to pricing to certain of our industrial acid customers, the unplanned downtime at our Cherokee Facility, the reduction in production at our El Dorado Facility, and the timing and duration of a Turnaround performed at our Baytown Facility to coincide with a significant customer’s planned maintenance outage. • Mining products sales decreased primarily due to a 44% decrease in volumes as the result of lower customer demand due to the current low cost of natural gas as an alternative fuel for utility companies and the downtime experienced at the Cherokee Facility. • Other products consist of natural gas sales relating to working interests in certain natural gas properties acquired in October 2012 and August 2013 by a subsidiary within our Chemical Business. Management considers these working interests as an economic hedge against a portion of a potential rise in natural gas prices in the future for a portion of our future natural gas production requirements. Gross Profit - Chemical • Our Chemical Business’ gross profit was $46.2 million, including $28.6 million business interruption insurance recovery recognized. Excluding the insurance recovery, the decrease in gross profit of $72.8 million was primarily attributable to lower sales volume, unabsorbed fixed overhead costs, maintenance and repair costs, and costs associated with purchased ammonia and other products to meet some of our customers’ needs, all of which are primarily attributable to the downtime experienced at certain of our facilities, partially offset by $4.5 million precious metals recoveries during 2013. Additionally, gross margin percentages were impacted as the result of lower nitrogen fertilizer sale prices and higher natural gas feedstock costs. For 2012, the estimated cumulative impact from the downtime experienced at our facilities was approximately $32 million, which included unabsorbed fixed overhead costs, losses incurred on firm sales commitments, maintenance and repair costs, and other expenses, partially offset by $7.3 million business interruption insurance recovery. Operating Income - Chemical • Our Chemical Business’ operating income was $87.8 million, including the $66.0 million property insurance recovery recognized (classified as property insurance recoveries in excess of losses incurred) during 2013 partially offset by the decrease in gross profit as discussed above. Selling, general and administrative expenses increased approximately $3.3 million primarily due to consulting and other fees related to the El Dorado Facility, professional fees incurred at our Pryor Facility in connection with improving plant reliability. Additionally, other net expenses increased approximately $5.5 million primarily as a result of dismantle and demolition costs incurred at the El Dorado Facility and other income of $2.3 million recognized in 2012 (none in 2013) relating to a litigation settlement with a certain vendor. Climate Control Business The following table contains certain information about our net sales, gross profit and operating income in our Climate Control segment for 2013 and 2012: (1) As a percentage of net sales Net Sales - Climate Control • Net sales of our geothermal and water source heat pump products increased primarily as a result of a 17% improvement in sales of our commercial/institutional products with an increase in the number of units sold and higher unit pricing associated with product mix as well as reducing the level of backlog and an increase in new product orders during the year. Residential product sales improved 3% as a result of reducing the level of backlog, increased orders and higher unit pricing. During 2013, we continued to maintain a market share leadership position of approximately 40%, based on market data supplied by the AHRI. • Net sales of our hydronic fan coils increased primarily as a result of an increase in the number of units sold, unit pricing and product mix related to reducing the level of backlog and an increase in new product orders during the year. During 2013, we continued to have a market share leadership position of approximately 32% based on market data supplied by the AHRI. • Net sales of our other HVAC products decreased primarily due to a decline in incoming orders for our large custom air handlers and for our engineering and construction services partially offset by increased sales of our modular chillers. Gross Profit - Climate Control • The increase in gross profit in our Climate Control Business was primarily the result of the higher sales volume and unit pricing and change in product mix as discussed above. Gross profit as a percentage of sales improved primarily due to an improvement in raw material costs (copper, steel and aluminum) and overhead absorption related to the higher sales volume. Operating Income - Climate Control • Operating income increased as the result of the increase in gross profit discussed above partially offset by higher variable selling expenses of $2.0 million (including commission of $0.7 million, warranty of $0.6 million, and freight of $0.6 million) primarily as the result of higher sales volume, increased consulting fees of $1.2 million primarily for services focused on future process and cost savings improvements, and increased personnel costs of $3.9 million primarily related to the increase in the number of employees and healthcare benefits. Interest Expense, net Interest expense for 2013 was $14.0 million compared to $4.2 million for 2012. The increase is due primarily to the issuance of the Senior Secured Notes as discussed above under “Loan Agreements” partially offset by $4.0 million of capitalized interest on capital projects, while under development and construction, during 2013 compared to $0.4 million capitalized during 2012. Loss on Extinguishment of Debt As the result of the payoff of the Secured Term Loan in 2013, we incurred a loss on extinguishment of debt of $1.3 million, consisting of a prepayment premium and writing off unamortized debt issuance costs. Provision for Income Taxes The provision for income taxes for 2013 was approximately $35.4 million compared to an income tax provision of $33.6 million for 2012. The resulting effective tax rate for 2013 and 2012 was 40% (excluding the benefit of $0.5 million associated with the retroactive tax relief on certain 2012 tax provisions that expired in 2012) and 36%, respectively. The increase in the effective tax rate was due primarily to the inability to take advantage of “domestic manufacturing deduction” as a result of the lower manufacturing income in 2013. Liquidity and Capital Resources Historically, our primary cash needs have been for operating expenses, working capital and capital expenditures. We have financed our cash requirements primarily through internally generated cash flow and various forms of financing. See additional discussions concerning cash flow relating to our Chemical and Climate Control Businesses under “Overview”, “Results of Operations,” and “Loan Agreements” included in this MD&A. Before discussing our capitalization and capital projects in detail, the following summarizes our cash flow activities in 2014: Cash Flow from Continuing Operating Activities For 2014, net cash provided by continuing operating activities was $66.7 million primarily as the result of net income of $19.6 million plus adjustments of $12.8 million for deferred income taxes, and $35.7 million for depreciation, depletion and amortization of PP&E. Cash Flow from Continuing Investing Activities Net cash used by continuing investing activities for 2014 of $12.0 million consisted primarily of $219.8 million used for expenditures for PP&E primarily for the benefit of our Chemical Business and net purchases of short-term investments of $14.5 million, partially offset by net proceeds of $219.6 million from restricted cash and cash equivalents and investments primarily representing cash designated by management for specific capital projects relating to our Chemical Business. Cash Flow from Continuing Financing Activities Net cash used by continuing financing activities for 2014 of $11.5 million was primarily related to payments on short-term financing and long-term debt partially offset by proceeds from short-term financing. Capitalization The following is our cash and cash equivalents, noncurrent restricted cash and investments, long-term debt and stockholders’ equity: (1) At December 31, 2014, this balance includes a certificate of deposit with an original maturity no longer than approximately 26 weeks. We have designated this balance for specific purposes relating to capital projects. All of these investments were held by financial institutions within the U.S. (2) This ratio is based on total long-term debt divided by total stockholders’ equity and excludes the use of cash or noncurrent restricted cash and investments to pay down debt. As of December 31, 2014, our current and noncurrent cash and investments totaled $272.3 million. In addition, our $100 million revolving credit facility was undrawn and available to fund operations as discussed below, if needed, subject to the amount of our eligible collateral and outstanding letters of credit. For 2015, we have extensive planned capital expenditures. Our primary cash needs for this period of time will be to fund our planned capital spending program, as well as, our operations, our general obligations, and our interest payment requirements. Based upon our projections for 2015, we expect to fund these cash needs from the noncurrent restricted cash and investments (provided from the proceeds from the Senior Secured Notes), working capital, internally generated cash flows, and third-party financing. We are currently in discussion with certain lenders to finance three separately identifiable pieces of equipment that are included in the planned expansion project. We have received a conditional commitment for $16 million to finance a natural gas pipeline being constructed at our El Dorado Facility. Additionally, we are in final discussions regarding financing $21 million related to the construction of a cogeneration facility at our El Dorado Facility. We continue to consider additional borrowing for a third piece of equipment. Subject to the terms of our existing loan agreements, including the Senior Secured Notes, these total secured borrowings being considered and under discussion is approximately $50 million. We believe that neither the Senior Secured Notes nor the Amended Working Capital Revolver Loan will preclude us from entering into the additional borrowings. See additional discussions below under “Capital Additions”. Our internally generated cash flows and liquidity have been, and could be, affected by possible declines in sales volumes resulting from the uncertainty regarding current economic conditions and production inefficiency of our facilities. We are party to an Indenture governing the Senior Secured Notes. The Indenture contains covenants that, among other things, limit LSB’s ability, with certain exceptions and as defined in the Indenture, to certain transactions. As discussed below under “Loan Agreements”, we and certain of our subsidiaries are party to an amended and restated revolving credit facility. Pursuant to the terms of the Amended Working Capital Revolver Loan, the principal amount the Borrowers may borrow is up to $100.0 million, based on specific percentages of eligible accounts receivable and inventories. At December 31, 2014, there were no outstanding borrowings under the Amended Working Capital Revolver Loan and the net credit available for borrowings was approximately $71.1 million, based on our eligible collateral, less outstanding letters of credit as of that date. Due to the overall increase in our outstanding long-term debt, our interest payment obligations have increased and will continue during future periods. A portion of our interest has been, and will be capitalized relating to major capital projects. In November 2012, we filed a universal shelf registration statement on Form S-3, with the SEC. The shelf registration statement provides that we could offer and sell up to $200 million of our securities consisting of equity (common and preferred), debt (senior and subordinated), warrants and units, or a combination thereof. The shelf registration statement expires in November 2015 unless we decide to file a post-effective amendment. This disclosure shall not constitute an offer to sell or the solicitation of an offer to buy, nor shall there be any sale of these securities in any state in which such offer, solicitation or sale would be unlawful prior to registration or qualification under the securities laws of any such state. Capital Additions Capital Additions - 2014 Capital additions during 2014 were $248.1 million, including $241.3 million for the benefit of our Chemical Business. The Chemical Business capital additions included $175.8 million for expansion projects at our El Dorado Facility, approximately $19.4 million associated with maintaining compliance with environmental laws, regulations and guidelines, approximately $23.0 million for various major renewal and improvement projects, and $6.9 million for the development of natural gas leaseholds. The capital additions were funded primarily from noncurrent restricted cash and investments and working capital. Due to the increase in the amount of capital additions incurred and planned, our depreciation, depletion and amortization expenses have increased and are expected to continue to increase during 2015 and future years. Planned Capital Additions (1) Includes cost associated with savings initiatives, new market development, and other capital projects. Included in planned capital expenditures is capitalized interest of approximately $21.7 million for 2015. The planned capital expenditures for Corporate and Other are primarily for the replacement of our enterprise resource planning, financial and operations management system. The new ERP system replaces our legacy systems, which are out-of-date and largely unsupported, and will improve our access to operational and financial information utilized to manage the business and improve our security and regulatory compliance capability. This project began in 2013 and is expected to be fully implemented in 2016 at a total cost of $24.0 million to $26.0 million. Planned capital expenditures are presented as a range to provide for engineering estimates, the status of bidding, variable material costs, unplanned delays in construction, and other contingencies. As the engineering, design, and bidding processes progress and project construction proceeds, the estimated costs are more certain and the range of estimates narrows. The planned capital expenditures include investments that we anticipate making for expansion and development projects, environmental requirements, and major renewal and improvement projects. These capital expenditures are subject to economic conditions, which are continually reviewed by us, and may increase or decrease as new information is obtained or circumstances change. We plan to fund the planned capital expenditures from working capital, noncurrent cash and investments, internally generated cash flows, and third-party financing. As discussed below, the construction of the El Dorado Expansion projects are expected to be completed by the end of 2015. Beyond 2015, specific capital projects are less identified but are expected to include approximately $40 million to $60 million per year at our chemical facilities for ongoing capital maintenance, including environmental compliance, major renewal and improvement projects, and other capital projects, and approximately $24 million from 2016-2019 to fully develop our natural gas working interests. El Dorado Facility Expansion Projects The El Dorado Facility has certain expansion projects underway. These expansion projects include an ammonia production plant; a new 65% strength nitric acid plant and concentrator; and other support infrastructure, all of which were analyzed and evaluated based on their forecasted return on investment. The expected costs of these projects are outlined below, which planned amounts are included in the table above. Our El Dorado Facility produces nitric acid and agricultural and industrial grade AN from purchased ammonia, which is currently at a cost disadvantage compared to products produced from natural gas. The El Dorado Facility historically purchased 600-700 tons of ammonia per day when operating at full capacity. We are constructing a 1,150 ton per day ammonia production plant at the El Dorado Facility, which we believe should eliminate the cost disadvantage, increase capacity, and the improve efficiency of the El Dorado Facility. The construction of this project is expected to be complete in late 2015 and operational in early 2016. In addition, we are constructing a new 1,100 ton per day, 65% strength nitric acid plant and concentrator to replace the concentrated nitric acid capacity lost in May 2012. These plants are scheduled to begin production in the third quarter of 2015 and are designed to be more efficient and provide increased nitric acid production capacity. As a result of the increased production capacity at the El Dorado Facility, it is necessary to expand and improve certain support infrastructure, including utility capacity, control room facilities, inventory storage and handling, and ammonia distribution. Also, other cost reduction and cost recovery equipment, including an electric cogeneration plant, are being added to improve efficiency and lower the cost of production. Plant Turnarounds Consistent, reliable and safe operations at our chemical plants are critical to our financial performance and results of operations. Unplanned downtime of the plants typically result in lost contribution margin, increased maintenance expense and decreased inventory for sale. The financial impact of planned downtime, such as major Turnaround maintenance, is mitigated through a diligent planning process that takes into the market, the availability of resources to perform the needed maintenance, feedstock logistics and other factors. Expenses Associated with Environmental Regulatory Compliance Our Chemical Business is subject to specific federal and state environmental compliance laws, regulations and guidelines. As a result, our Chemical Business incurred expenses of $5.5 million in 2014 in connection with environmental projects. For 2015, we expect to incur expenses ranging from $4.6 million to $5.6 million in connection with additional environmental projects. However, it is possible that the actual costs could be significantly different than our estimates. Dividends We have not paid cash dividends on our outstanding common stock in many years, and we do not currently anticipate paying cash dividends on our outstanding common stock in the near future. However, our Board of Directors has not made a decision whether or not to pay such dividends on our common stock in 2015. During the first quarter of 2014, dividends totaling $300,000 were declared on our outstanding preferred stock and subsequently paid in 2014 using funds from our working capital. Each share of preferred stock is entitled to receive an annual dividend, only when declared by our Board of Directors, payable as follows: • $0.06 per share on our outstanding non-redeemable Series D Preferred for an aggregate dividend of $60,000, and • $12.00 per share on our outstanding non-redeemable Series B Preferred for an aggregate dividend of $240,000. In January 2015, our Board of Directors declared the following dividends: • $0.06 per share on our outstanding non-redeemable Series D Preferred for an aggregate dividend of $60,000, which were paid in February 2015, and • $12.00 per share on our outstanding non-redeemable Series B Preferred for an aggregate dividend of $240,000, which were paid in February 2015. All shares of the Series D Preferred and Series B Preferred are owned by the Golsen Group. There are no optional or mandatory redemption rights with respect to the Series B Preferred or Series D Preferred. Compliance with Long - Term Debt Covenants As discussed below under “Loan Agreements”, the Amended Working Capital Revolver Loan requires, among other things, that we meet certain financial covenants. Currently, our forecast is that we will be able to meet all financial covenant requirements for the next twelve months. Loan Agreements Senior Secured Notes - On August 7, 2013, LSB sold $425 million aggregate principal amount of the 7.75% Senior Secured Notes due 2019 in a private transaction to qualified institutional buyers under Rule 144A and, outside of the U.S., pursuant to Regulation S of the Securities Act of 1933, as amended. In accordance with the registration rights agreement entered into at the time of the issuance of the Senior Secured Notes, LSB and the guarantor subsidiaries completed an exchange offer to exchange the Senior Secured Notes for substantially identical notes registered under the Securities Act. The registration statement for the exchange offer was declared effective by the SEC in May 2014, and the exchange offer was completed in June 2014. The Senior Secured Notes bear interest at the rate of 7.75% per year and mature on August 1, 2019. Interest is to be paid semiannually on February 1st and August 1st. See footnote (B) under Note 9 of Notes to Consolidated Financial Statements included in this report for additional information on these notes. Amended Working Capital Revolver Loan - Effective December 31, 2013, LSB and certain of its subsidiaries entered into an amendment to the existing senior secured revolving credit facility. Pursuant to the terms of the Amended Working Capital Revolver Loan, the Borrowers may borrow on a revolving basis up to $100.0 million, based on specific percentages of eligible accounts receivable and inventories and permits the Senior Secured Notes and the secured guarantees to be secured on a first-priority basis by the Priority Collateral and on a second-priority basis by the certain collateral securing the Amended Working Capital Revolver Loan and provides that the Amended Working Capital Revolver Loan be secured on a second-priority basis by the Priority Collateral. The Amended Working Capital Revolver Loan will mature on April 13, 2018. The Amended Working Capital Revolver Loan accrues interest at a base rate (generally equivalent to the prime rate) plus 0.50% if borrowing availability is greater than $25.0 million, otherwise plus 0.75% or, at our option, accrues interest at LIBOR plus 1.50% if borrowing availability is greater than $25.0 million, otherwise LIBOR plus 1.75%. At December 31, 2014, the interest rate was 3.75% based on LIBOR. Interest is paid monthly, if applicable. At December 31, 2014, there were no outstanding borrowings under the Amended Working Capital Revolver Loan. At December 31, 2014, the net credit available for borrowings under our Amended Working Capital Revolver Loan was approximately $71.1 million, based on our eligible collateral, less outstanding letters of credit as of that date. The Amended Working Capital Revolver Loan requires the Borrowers to meet a minimum fixed charge coverage ratio of not less than 1.10 to 1, if at any time the excess availability (as defined by the Amended Working Capital Revolver Loan), under the Amended Working Capital Revolver Loan, is less than or equal to $12.5 million. This ratio will be measured monthly on a trailing twelve month basis and as defined in the agreement. As of December 31, 2014, as defined in the agreement, the fixed charge coverage ratio was 3.5 to 1. See footnote (A) under Note 9 of Notes to Consolidated Financial Statements included in this report for additional information on this loan. Secured Promissory Note - On February 1, 2013, Zena, a subsidiary within our Chemical Business, entered into the Secured Promissory Note with a lender in the original principal amount of $35 million. The Secured Promissory Note follows the original acquisition by Zena of Working Interests in certain natural gas properties during October 2012. The proceeds of the Secured Promissory Note effectively financed $35 million of the approximately $50 million purchase price of the Working Interests previously paid out of LSB’s working capital. The Secured Promissory Note matures on February 1, 2016. Principal and interest are payable monthly based on a five-year amortization at a defined LIBOR rate plus 300 basis points with a final balloon payment of $15.3 million due at maturity. Zena currently plans to fund the final balloon payment with cash on hand. The interest rate at December 31, 2014 was 3.23%. The loan is secured by the Working Interests and related properties and proceeds. Seasonality See discussion above under “Part1-Item 1 Business” for seasonality trends. Related Party Transactions See discussion above under “Liquidity and Capital Resources-Dividends” relating to the Golsen Group. Off-Balance Sheet Arrangements We do not have any off-balance sheet arrangements as defined in Item 303(a)(4)(ii) of Regulation S-K under the Securities Exchange Act of 1934. Performance and Payment Bonds We are contingently liable to sureties in respect of insurance bonds issued by the sureties in connection with certain contracts entered into by subsidiaries in the normal course of business. These insurance bonds primarily represent guarantees of future performance of our subsidiaries. As of December 31, 2014, we have agreed to indemnify the sureties for payments, up to $10.6 million, made by them in respect of such bonds. All of these insurance bonds are expected to expire or be renewed in 2015. Aggregate Contractual Obligations Our aggregate contractual obligations as of December 31, 2014 are summarized in the following table (1) (2): (1) The table does not include amounts relating to future purchases of ammonia by EDC pursuant to a supply agreement through December 2015. The terms of this supply agreement do not include minimum volumes or take-or-pay provisions. (2) The table does not include our estimated accrued warranty costs of $8.8 million at December 31, 2014 as discussed below under “Critical Accounting Policies and Estimates”. (3) The estimated interest payments relating to variable interest rate debt are based on interest rates at December 31, 2014. (4) The estimated future cash flows are based on the estimated fair value of these contracts at December 31, 2014. (5) Capital expenditures are based on estimates (high end of range) at December 31, 2014. (6) Other capital expenditures include only the estimated committed amounts (high end of range) at December 31, 2014 but exclude amounts relating to the El Dorado facility expansion projects. (7) Our proportionate share of the minimum costs to ensure capacity relating to a gathering and pipeline system. (8) The future cash flows relating to executive and death benefits are based on estimates at December 31, 2014. Critical Accounting Policies and Estimates The preparation of financial statements requires management to make estimates and assumptions that affect the reported amount of assets, liabilities, revenues and expenses, and disclosures of contingencies and fair values. For each of the last three years ended December 31, 2014, 2013, and 2012, we did not experience a material change in accounting estimates. However, it is reasonably possible that the estimates and assumptions utilized as of December 31, 2014 could change in the near term. In addition, the more critical areas of financial reporting impacted by management’s judgment, estimates and assumptions include the following: Accrued Warranty Costs - Our Climate Control Business sells equipment that has an expected life, under normal circumstances and use, which extends over several years. As such, we provide warranties after equipment shipment/start up covering defects in materials and workmanship. Our accounting policy and methodology for warranty arrangements is to measure and recognize the expense and liability for such warranty obligations at the time of sale using a percentage of sales and cost per unit of equipment, based upon our historical and estimated future warranty costs. We also recognize the additional warranty expense and liability to cover atypical costs associated with a specific product, or component thereof, or project installation, when such costs are probable and reasonably estimable. It is reasonably possible that our estimated accrued warranty costs could change in the near and long term. Generally for commercial/institutional products, the base warranty coverage for most of the manufactured equipment in the Climate Control Business is limited to eighteen months from the date of shipment or twelve months from the date of start up, whichever is shorter, and to ninety days for spare parts. For residential products, the base warranty coverage for manufactured equipment in the Climate Control Business is limited to ten years from the date of shipment for material and to five years from the date of shipment for labor associated with the repair. The warranty provides that most equipment is required to be returned to the factory or an authorized representative and the warranty is limited to the repair and replacement of the defective product, with a maximum warranty of the refund of the purchase price. Furthermore, companies within the Climate Control Business generally disclaim and exclude warranties related to merchantability or fitness for any particular purpose and disclaim and exclude any liability for consequential or incidental damages. In some cases, the customer may purchase or a specific product may be sold with an extended warranty. The above discussion is generally applicable to such extended warranties, but variations do occur depending upon specific contractual obligations, certain system components, and local laws. Since 2003, our residential products warranty carried a ten-year standard parts warranty on the refrigerant circuit (including air coils, compressors, thermal expansion valves, water coils, and reversing valves) and five-years on the other components (motors being the major component). In 2010, the warranty policy was amended to include a full ten-year standard parts and five-year standard labor warranty. Without a full ten-year experience on the other components (motors), there is a risk we could incur higher than projected warranty costs over the next five years. At December 31, 2014 and 2013, our accrued product warranty obligations were $8.8 million and $7.3 million, respectively and are included in current and noncurrent accrued and other liabilities in the consolidated balance sheets. For 2014, 2013, and 2012, our warranty expense was $7.9 million, $7.4 million, and $6.7 million, respectively Contingencies - Certain conditions may exist which may result in a loss, but which will only be resolved when future events occur. We and our legal counsel assess such contingent liabilities (including the explosion at West, Texas) and related insurance coverage, if applicable, and such assessment inherently involves an exercise of judgment. If the assessment of a contingency indicates that it is probable that a loss has been incurred, we would accrue for such contingent losses when such losses can be reasonably estimated. If the assessment indicates that a potentially material loss contingency is not probable but reasonably possible, or is probable but cannot be estimated, the nature of the contingent liability, together with an estimate of the range of possible loss if determinable and material, would be disclosed. Estimates of potential legal fees and other directly related costs associated with contingencies are not accrued but rather are expensed as incurred. Loss contingency liabilities are included in current and noncurrent accrued and other liabilities and are based on current estimates that may be revised in the near term. In addition, we recognize contingent gains when such gains are realized or realizable and earned. We are a party to various litigation and other contingencies, the ultimate outcome of is not presently known. Should the ultimate outcome of these contingencies be adverse, such outcome could adversely impact our liquidity, capital resources and results of operations. Regulatory Compliance - Our Chemical Business is subject to specific federal and state regulatory compliance laws and guidelines. We have developed policies and procedures related to regulatory compliance. We must continually monitor whether we have maintained compliance with such laws and regulations and the operating implications, if any, and amount of penalties, fines and assessments that may result from noncompliance. We will also be obligated to manage certain discharge water outlets and monitor groundwater contaminants at our Chemical Business facilities should we discontinue the operations of a facility. However, certain conditions exist which may result in a loss but which will only be resolved when future events occur relating to these matters. At December 31, 2014, liabilities totaling $0.4 million have been accrued relating to these issues as discussed under “Environmental, Health and Safety Matters” in Item 1 of this report. This liability is included in current accrued and other liabilities and is based on current estimates that may be revised in the near term. Recognition of Insurance Recoveries - If an insurance claim relates to a recovery of our losses, we recognize the recovery when it is probable and reasonably estimable. If our insurance claim relates to a contingent gain, we recognize the recovery when it is realized or realizable and earned. An insurance recovery in excess of recoverable costs relating to a business interruption claim is a reduction to cost of sales. An insurance recovery in excess of recoverable costs relating to a property insurance claim is included in property insurance recoveries in excess of losses incurred Management’s judgment and estimates in the above areas are based on information available from internal and external resources at that time. Actual results could differ materially from these estimates and judgments, as additional information becomes known.

<s>[INST] Overview General LSB is a manufacturing and marketing company operating through our subsidiaries. LSB and its whollyowned subsidiaries own the following core businesses: Chemical Business manufactures and sells nitrogenbased chemical products for the agricultural, industrial, and mining markets it produces from four facilities located in El Dorado, Arkansas; Cherokee, Alabama; Pryor, Oklahoma; and Baytown, Texas. Climate Control Business manufactures and sells a broad range of HVAC products that include water source and geothermal heat pumps, hydronic fan coils, large custom air handlers, modular geothermal and other chillers, and other related products and services. These products are primarily used in commercial/institutional and residential new buildings construction, renovation of existing buildings and replacement of existing systems. Our Climate Control Business manufactures and distributes its products from seven facilities located in Oklahoma City, Oklahoma. Items Affecting Comparability of Results Chemical Business Property and Business Interruption Insurance Claims and Recoveries In October 2013 and January 2014, we settled claims with our insurance carriers for the aggregate amount of approximately $113.0 million and $43.5 million related to property damage and business interruption at our El Dorado Facility and Cherokee Facility, respectively. For 2013 and 2014, the impact of these claims to our operating results was $66.0 million and $5.1 million, respectively, recognized as property insurance recoveries in excess of losses incurred and $28.6 million and approximately $22.9 million, respectively, recognized as a reduction to cost of sales. Debt and Interest Expense During August 2013, in connection with a major expansion of our El Dorado Facility, LSB sold $425 million of 7.75% Senior Secured Notes. The use of proceeds included $67.2 million used to pay all outstanding borrowings including the prepayment penalty under a term loan agreement. During 2013 and 2014, interest expense was $14.0 million and $21.6 million, respectively net of capitalized interest of $4.0 million and $14.1 million, respectively. Interest was capitalized based upon construction in progress of the El Dorado expansion and certain other capital projects. Recovery of Precious Metals In 2013 during major maintenance projects, our Chemical Business performed procedures to recover precious metals, which had accumulated over time within the manufacturing equipment. As a result, a recovery of precious metals of $4.5 million was recognized as a reduction to cost of sales. Key Industry Factors Chemical Business Supply and Demand Agricultural The price at which our agricultural products are ultimately sold depends on numerous factors, including the supply and demand for nitrogen fertilizers which, in turn, depends upon, among other factors, world grain demand and production levels, the cost and availability of transportation, storage, weather conditions, competitive pricing and the availability of imports. An expansion or upgrade of competitors’ facilities, international political and economic developments and other factors are likely to continue to play an important role in nitrogen fertilizer industry economics. These factors can impact, among other things, the level of inventories in the market, resulting in price volatility and product margins. As reported in Green Markets and based upon the January USDA release of its 2014 Crop Production Summary and the WASDE Report dated February 10, 2015, for the 2014/2015 corn season, production is estimated at 14.2 billion bushels or 351 million metric tons, 3% above the prior season. Additionally, the average U. S. yield is estimated at a record 171.0 bushels per acre compared to 158.1 bushels per acre in the prior season. WASDE also estimated the ending U.S. corn stocks to be 47.7 million metric tons compared to 31.3 million metric tons last season. Due to the expectation of the abundant supply, corn prices are low relative to pricing over the last three years; most recently reported at $3.65 per bushel. The number of acres planted will drive nitrogen fertilizer consumption and demand which likely [/INST] Positive. </s>

LSB INDUSTRIES INC

2016-02-29

2015-12-31

ITEM 7. MANAGEMENT’S DISCUSSION AND ANALYSIS OF FINANCIAL CONDITION AND RESULTS OF OPERATIONS The following Management’s Discussion and Analysis of Financial Condition and Results of Operations should be read in conjunction with a review of the other Items included in this Form 10-K and our December 31, 2015 Consolidated Financial Statements included elsewhere in this report. Certain statements contained in this MD&A may be deemed to be forward-looking statements. See “Special Note Regarding Forward-Looking Statements.” Overview General LSB is a manufacturing company operating through our subsidiaries. LSB and its wholly-owned subsidiaries own the following core businesses: · Chemical Business manufactures and sells nitrogen-based chemical products for the agricultural, industrial, and mining markets it produces from four facilities located in El Dorado, Arkansas; Cherokee, Alabama; Pryor, Oklahoma; and Baytown, Texas. · Climate Control Business manufactures and sells a broad range of HVAC products that include water source and geothermal heat pumps, hydronic fan coils, large custom air handlers, modular geothermal and other chillers, and other related products and services. These products are primarily used in commercial/institutional and residential new buildings construction, renovation of existing buildings and replacement of existing systems. Our Climate Control Business manufactures and distributes its products from seven facilities located in Oklahoma City, Oklahoma. Key Expectations for 2016 The new ammonia plant at the El Dorado Facility was mechanically complete in February 2016 and should begin production early in the second quarter of 2016. We define mechanical completion as it relates to the El Dorado ammonia plant as having concluded the installation of process vessels and rotating equipment, including associated piping and valves. Additionally, utility equipment systems such as cooling water, steam generation, raw water treatment, and air systems, along with related piping, have been installed. Currently, all that remains to fully complete construction activities at the El Dorado ammonia plant is the connection of the electronic instrumentation wiring to the field instruments, along with the painting and insulation of the piping and process vessels, and the final grading and concrete containment for proper drainage of the process areas. Management and our Board, as previously announced, will continue to review strategic alternatives for our businesses in order to maximize shareholder value including asset sales and/or the separation of our two businesses. Additionally, once the El Dorado ammonia plant becomes operational, we intend to explore refinancing our capital structure. Key Capital Expenditure, Financing and Other Developments - 2015 The El Dorado Facility has certain expansion projects underway, a portion of which have been completed. These expansion projects include an ammonia production plant; a new 65% strength nitric acid plant and nitric acid concentrator; and other support infrastructure. The new nitric acid concentrator went into production in June 2015, and the new nitric acid plant went into production during November 2015. The new ammonia plant was mechanically complete in February 2016 and should begin production early in the second quarter of 2016. During 2015, management in conjunction with the owner’s representative, the engineering, procurement and construction contractor and other consultants determined that the total cost to complete the El Dorado Expansion would exceed what we previously projected at the beginning of the year, due, in part, to an under-estimation of the budgeted costs, work performed by a former subcontractor and mechanical and piping labor cost increases compared to earlier estimates. We have now determined that the total cost to complete the El Dorado Expansion is estimated to be in the range of $831 million to $855 million, of which $705 million was spent as of December 31, 2015 and $126 million to $150 million is estimated to be spent in 2016. Although we had begun seeking additional debt financing to address what were then our known costs of the El Dorado Expansion during the third quarter of 2015, the reluctance of existing bondholders to permit additional senior indebtedness unless we obtained additional equity caused us to reevaluate our financing plans and liquidity needs while we also worked to define the new cost estimates. As a result of that analysis, we concluded that our liquidity needs to complete the projects would exceed available debt financing, particularly in light of our existing debt covenants limiting the incurrence of additional indebtedness. Given that publicly offered financing would be unavailable before we had defined the cost estimates and the release of our 2015 third quarter results and would probably be unavailable even after those events, our options were either to obtain other financing solutions in order for us to continue the projects or delay or stop the projects during the fourth quarter of 2015 to preserve our liquidity for other operations, which, without the El Dorado costs, are generally self-sustaining. We also took additional steps to address our liquidity concerns, including obtaining extended payment terms, for a limited time during the fourth quarter, from Leidos our EDC contractor, for our El Dorado Expansion and by obtaining financing for discrete pieces of equipment. We considered and explored financing options including debt, equity-linked and equity as well as potential asset sales. As part of those considerations we took into account our permitted indebtedness limits, the costs and likelihood of obtaining consents to raise our permitted indebtedness limits, the sale of one or more of our significant assets or divisions, and various forms of equity issuances. We recognized that, without additional financing, some counterparties to contracts might begin changing payment terms and requiring cash payments in advance, which would further impair our liquidity and affect our business. We evaluated our choices based on timing of financing, certainty of completion, and short- and long-term costs. Ultimately, based on the choices available after analyzing and pursuing various options, we concluded that termination or delay of the El Dorado Expansion would significantly impair the long-term value of the Company compared to the costs and benefits of a private debt and equity financing solution and that a sale of significant assets was not likely to be completed in the timeframe needed at an appropriate price. Therefore during the fourth quarter of 2015, we entered into the following agreements as summarized below: 12% Senior Secured Notes On November 9, 2015, LSB sold $50 million aggregate principal amount of the 12% senior secured notes due 2019 (the “12% Senior Secured Notes”) in a private placement exempt from registration under the Securities Act. The 12% Senior Secured Notes bear interest at the annual rate of 12% and mature on August 1, 2019. Interest is to be paid semiannually on February 1st and August 1st, which began February 1, 2016. The 12% Senior Secured Notes are secured on a pari passu basis with the same collateral securing LSB’s existing $425 million aggregate principal amount of 7.75% Senior Secured Notes issued in 2013 (the “7.75% Senior Secured Notes”). The 12% Senior Secured Notes have covenants and events of default that are substantially similar to those applicable to the 7.75% Senior Secured Notes. See further discussion in Note 9 to Consolidated Financial Statements contained in this report. Securities Purchase Agreement On December 4, 2015, LSB entered into a securities purchase agreement (the “Securities Purchase Agreement”) with an unrelated third party, LSB Funding, (“LSB Funding”) pursuant to which LSB sold to LSB Funding, in a private placement exempt from registration under the Securities Act the following: · $210 million of Series E Redeemable Preferred which includes participation rights in dividends and liquidating distributions, · a warrant to purchase 4,103,746 shares of our common stock, par value $0.10, which number of shares is equal to 17.99% of the outstanding shares of our common stock before the completion of this private placement (the “Warrants”), and · one share of Series F Redeemable Preferred which has voting rights with common stock equal to 19.99% of the outstanding shares of our common stock before the completion of this private placement. See further discussion in Note 13 to Consolidated Financial Statements contained in this report. Registration Right Agreements In connection with the 12% Senior Secured Notes, LSB entered into a registration rights agreement (the “Registration Rights Agreement-Notes”). Pursuant to the Registration Rights Agreement-Notes, we have agreed to use our reasonable best efforts to file with the SEC a registration statement on an appropriate form with respect to a registered offer to exchange the 12% Senior Secured Notes for new notes with terms substantially identical in all material respects to the 12% Senior Secured Notes, cause the registration statement to be declared effective under the Securities Act, and complete the exchange within 180 days after the effective date of such registration statement. We are also obligated to update the registration statement by filing a post-effective amendment. In connection with the Securities Purchase Agreement, LSB entered into a registration rights agreement (the “Registration Rights Agreement-Warrants”) relating to the registered resale of the common stock issuable upon exercise of the Warrants and certain other common stock. Pursuant to the Registration Rights Agreement-Warrants, we are required to file a registration statement for such registered resale within nine months from December 4, 2015 (the “Closing Date”), to permit the public resale of registrable securities then outstanding from time to time as permitted by Rule 415 under the Securities Act. We are required to use commercially reasonable efforts to cause the registration statement to become effective as soon as practicable thereafter. Furthermore, the registration statement must be declared effective within twelve months after the Closing Date by filing a post-effective amendment. Board Representation and Standstill Agreement On the Closing Date, LSB and the Purchaser entered into a Board Representation and Standstill Agreement. Pursuant to the Board Representation and Standstill Agreement, we agreed to permit LSB Funding to appoint three nominees to our Board of Directors (the “Board”). Until the Board Designation Termination Date (as defined in the agreement), so long as LSB Funding or its affiliates own the Series E Redeemable Preferred or the Warrants, LSB Funding will continue to be entitled to designate three directors. In the event of redemption in full of the Series E Redeemable Preferred by LSB, LSB Funding will be entitled to designate only two directors so long as LSB Funding owns the Warrants or any shares of our common stock issuable thereunder. However, LSB Funding will be entitled to designate only one director nominee in the event LSB Funding and its affiliates collectively cease to beneficially own at least 10% (but not greater than 24.99%) of our common stock issued pursuant to the Warrants (whether owned directly or as a right to acquire upon exercise of the Warrants). LSB Funding’s rights to designate any directors will terminate when LSB Funding and its affiliates collectively cease to beneficially own at least 10% of our common stock issued pursuant to the Warrants (whether owned directly or as a right to acquire upon exercise of the Warrants). Under the Board Representation and Standstill Agreement, the Golsen Holders, collectively, have the right to designate two directors; however, if the Golsen Holders, collectively, continue to beneficially own at least 2.5% (but not 5% or more) of the then outstanding Common Stock, the Golsen Holders will be entitled to designate up to one director. These designation rights will terminate immediately on the first date on which the Golsen Holders, collectively, no longer beneficially own at least 2.5% of the then outstanding common stock. From and including the Closing Date through and including the annual meeting of stockholders to elect directors to the Board in 2016 (including any adjournments and postponements thereof), LSB Funding and the Golsen Holders have agreed that, at any meeting of the stockholders or in any other circumstances upon which a vote, consent or other approval of all or some of the stockholders is sought solely with respect to the matters described below, they will vote (or cause to be voted) or execute (or cause to be executed) consents with respect to, as applicable, all of our securities owned as of the applicable record date in favor of the election of the persons named in our proxy statement as the Board’s nominees for election as directors, and against any other nominees. During the period commencing on the Closing Date and ending on the Standstill Termination Date (as defined below), LSB Funding has agreed that it will not, and will cause its affiliates not to, directly or indirectly, among other things: · engage in any hostile or takeover activities with respect to LSB (including by means of a tender offer or soliciting proxies or written consents, other than as recommended by the Board); · acquire or propose to acquire beneficial ownership of additional LSB common stock (other than the common stock issuable upon exercise of the Warrants) or other LSB securities that in the aggregate, together with their beneficial ownership of any other units, is equal to beneficial ownership of 20% or more of the voting power of the outstanding common stock (taking into account the voting rights of our common stock underlying the Warrants and the Series F Redeemable Preferred), provided that, the foregoing will not prohibit or apply to the receipt of any common stock paid as dividends on the Series E Redeemable Preferred held by LSB Funding or any of its affiliates or any common stock issued in exchange for the redemption of the Series E Redeemable Preferred held by LSB Funding or any Purchaser affiliates, and such Series E Redeemable Preferred and common stock shall not be taken into account for purposes of establishing compliance with the foregoing; · acquire or propose to acquire any other LSB securities or any securities of any of our affiliates; · call a special meeting of the stockholders; or · propose to remove, or vote to remove, any directors, other than in accordance with the Board Representation and Standstill Agreement. “Standstill Termination Date” means the earlier of (1) 90 days after the Board Designation Termination Date and (2) the later of (A) the fifth anniversary of the Closing Date and (B) 90 days after the date on which all directors designated by LSB Funding pursuant to the Board Representation and Standstill Agreement have resigned or been removed from the Board, and LSB Funding has permanently waived and renounced its Board designation rights under the Board Representation and Standstill Agreement. Ammonia Purchase and Sale Agreement In November 2015, EDC and Koch Fertilizer entered into an ammonia purchase and sale agreement under which Koch Fertilizer agreed to purchase, with minimum purchase requirements, the ammonia that is in excess of El Dorado’s internal needs as discussed in Note 11 to Consolidated Financial Statements. Significant Financial Developments - 2015 Our financial developments during 2015 included the following items: · Our consolidated operating loss for 2015 was $50.8 million, including an operating loss of $41.8 million from our Chemical Business. The following items contributed to the Chemical Business operating loss: · a $43.2 million non-cash impairment charge primarily consisting of a $39.7 million non-cash impairment charge to reduce the carrying value of our working interest in natural gas properties in the Marcellus Shale region primarily as the result of a decline in forward prices for natural gas, large natural gas price differentials in the Marcellus Shale region and changes in the drilling plans of these natural gas properties (see discussion below under “Critical Accounting Policies and Estimates”) and a $3.5 million non-cash impairment charge recorded by our Pryor Facility to reduce the carrying value of certain plant assets related to unused ammonia production equipment; · a $19.1 million negative impact on operating results due to the planned and unplanned downtime experienced at the Pryor Facility. During the third quarter of 2015 ($15.6 million) and unplanned outage and resulting maintenance costs during the fourth quarter of 2015 ($3.5 million to $4.0 million); · a $27 million increase in operating losses at the El Dorado Facility resulting from the impact of the expiration of the Orica Agreement related to the sale of industrial grade AN (“LDAN”) and lower sales volume of agricultural grade AN (“HDAN”) primarily as the result of unfavorable weather conditions that curtailed the fall fertilizer application season, partially offset by; · a $13.0 million improvement in operating results, after adjusting for a $28 million insurance recovery in 2014, at the Cherokee Facility primarily due to overall higher on-stream rates as this facility was not required to perform major planned maintenance (a “Turnaround”) during 2015. Key Industry Factors Chemical Business Supply and Demand Agricultural The price at which our agricultural products are ultimately sold depends on numerous factors, including the supply and demand for nitrogen fertilizers which, in turn, depends upon world grain demand and production levels, the cost and availability of transportation, storage, weather conditions, competitive pricing and the availability of imports, among other factors. An expansion or upgrade of competitors’ facilities, international and domestic political and economic developments and other factors are likely to continue to play an important role in nitrogen fertilizer industry economics. These factors can impact, among other things, the level of inventories in the market, resulting in price volatility and product margins. Corn prices affect the number of acres of corn planted in a given year, and the number of acres planted will drive nitrogen fertilizer consumption, likely driving ammonia, UAN and urea prices. Weather also will have an impact on fertilizer consumption. Although the latest World Agricultural Supply and Demand Estimates Report, report dated January 12, 2016 estimates record world corn ending stocks for 2015/2016 at 208.9 million tons, more than half of these tons are estimated to be held in China. Despite the record ending stocks, the USDA is estimating the U.S. growers will plant 90.5 million acres of corn in 2016 compared to 88.0 million in 2015. At present, the overall fertilizer market continues to be under pressure as inventories of fertilizer products at distributors and producers remain high due to the contracted fall application season and farmers and dealers delaying purchases as they believe fertilizer pricing will continue to drop. However, spring nitrogen movement is expected to be stronger in 2016 compared to 2015 given the increase in estimated planted acres in 2016 and that the 2015 fall nitrogen fertilizer application was disappointing due to poor weather conditions. Along with farmer and dealers delaying purchases, the strong U.S. dollar makes the U.S. an attractive market for importers to bring in product at lower prices, which is putting further pressure on the market. With the spring application season rapidly approaching, we believe that nitrogen fertilizer prices will recover as more fertilizer will need to be applied to maintain the yield achieved over the past two seasons given the truncated fall application season and imports continuing to run below the levels set last year. Industrial Our industrial products sales volumes are dependent upon general economic conditions primarily in the housing, automotive, and paper industries. According to the American Chemistry Council, the U.S. economic indicators continue to be mostly positive for these sectors domestically. Our sales prices generally vary with the market price of our feedstock (ammonia or natural gas, as applicable) in our pricing arrangements with customers. Mining Our mining products are LDAN and AN solutions. The primary uses are as AN fuel oil and specialty emulsions for surface mining of coal and for usage in quarries and the construction industry. As reported by the EIA, annual coal production in the U.S. for 2015 is estimated to be down 11%. EIA also forecasts an additional 6% decrease in U.S. coal production in 2016. The Appalachia region drove the decline in coal production with an estimated decline of approximately 15% from 2015. The Powder River Basin and Illinois Basin are estimated to have declined approximately 9% and 11%, respectively. Although the majority of our LDAN and AN solutions are used in the Powder River Basin which has experienced a slower rate of decline, we believe that coal production in the U.S. will face significant challenges assuming natural gas prices remain at current levels and given that export demand is expected to be lower due to the current strength of U.S. currency. While we believe our plants are well-located to support the regions that are more stable in the upcoming years, our current mining sales volumes are being impacted by overall lower customer demand for LDAN. Farmer Economics The demand for fertilizer is affected by the aggregate crop planting decisions and fertilizer application rate decisions of individual farmers. Individual farmers make planting decisions based largely on prospective profitability of a harvest, while the specific varieties and amounts of fertilizer they apply depend on factors, such as farmers’ financial resources, soil conditions, weather patterns and the types of crops planted. Natural Gas Prices Natural gas is the primary feedstock for the production of nitrogen fertilizers at our Cherokee and Pryor Facilities and will be upon the completion of the construction of the ammonia plant at our El Dorado Facility. Over the last five years, U.S. natural gas reserves have increased significantly due to, among other factors, advances in extracting shale gas, which has reduced and stabilized natural gas prices, providing North America with a cost advantage over certain imports. As a result, our competitive position and that of other North American nitrogen fertilizer producers have been positively impacted. We historically have purchased natural gas in the spot market or through the use of forward purchase contracts, or a combination of both and have used forward purchase contracts to lock in pricing for a portion of our natural gas requirements. These forward purchase contracts are generally either fixed-price or index-price, short-term in nature and for a fixed supply quantity. We are able to purchase natural gas at competitive prices due to our connections to large distribution systems and their proximity to interstate pipeline systems. Over the past several years, natural gas prices have experienced significant downward fluctuations, which have had a positive impact on our cost of producing nitrogen fertilizer. The following table shows the annual volume of natural gas we purchased and the average cost per MMBtu: For 2016 we have forward purchase commitments of natural gas for approximately 3 million MMBtus for our Cherokee Facility, approximately 2 million MMBtus for our Pryor Facility and approximately 2 million MMBtus for our El Dorado Facility at an average cost of $2.76 per MMBtu. This represents approximately 30% of our exposed natural gas usage at each facility for 2016. Ammonia Prices Currently, ammonia is the primary feedstock for the production of HDAN and LDAN at our El Dorado Facility. That will continue until the new ammonia plant being constructed is operational which is expected to occur in the second quarter of 2016. Ammonia pricing is based on a published Tampa, Florida market index pursuant to an ammonia purchase agreement with Koch Nitrogen International Sarl (“Koch”), under which Koch agrees to supply certain of the El Dorado Facility’s ammonia requirements. Under an amended agreement, the El Dorado Facility will purchase a majority of its ammonia requirement from Koch through the earlier of December 31, 2016 or the date on which the new ammonia plant comes on stream at the El Dorado Facility. The Tampa index is commonly used in annual contracts for the industrial sectors, and is based on the most recent major industry transactions in the Tampa market. Pricing considerations for ammonia incorporate international supply-demand, ocean freight and production factors. Subject to availability, the El Dorado Facility has the ability to source a portion of its ammonia requirements from our Pryor Facility, which costs are significantly less than current market prices. Once our new ammonia production plant at the El Dorado Facility commences production we believe this cost disadvantage will be eliminated. Over the past several years, ammonia prices have experienced large fluctuations. Additionally, the El Dorado Facility’s cost to produce HDAN from purchased ammonia can at times exceed our selling price (a cost disadvantage as compared to producing ammonia from natural gas) as discussed below. Based upon full plant production, the El Dorado Facility would expect to require 200,000 to 220,000 tons per year of ammonia feedstock to upgrade to other products. During 2015, the purchased ammonia was less than the amount required for full production due to lower production of: · HDAN tons due to adverse weather conditions and cautious buyers resulting from falling nitrogen product selling prices and; · LDAN production caused by low natural gas prices affecting the overall demand for coal translating to lower U.S. coal production combined with EDC currently being a high cost producer causing customers to purchase LDAN from competitors. The table below shows the El Dorado Facility’s annual volume of ammonia purchased and the average cost per short ton: It is expected that this overall trend will continue into the second quarter of 2016 until we begin operating our new ammonia production plant at the El Dorado Facility and will negatively impact our operating results until that point. We have executed contracts with customers with expected purchase requirements of 150,000 tons per year of LDAN a portion of which include minimum purchase requirement volumes. With the recent downturn in the mining industry, we are unsure if we will reach these sales levels. These contracts begin in 2016. As mentioned above, our El Dorado Facility is currently at a cost disadvantage since it purchases ammonia compared to products produced with ammonia that were produced from natural gas. This cost disadvantage combined with the impact of the expiration of the Orica Agreement contributed to an operating loss for the facility during 2015 of approximately $45 million compared to an operating loss of approximately $18 million in 2014. Transportation Costs Costs for transporting nitrogen based products can be significant relative to their selling price. For example, ammonia is a hazardous gas at ambient temperatures and must be transported in specialized equipment, which is more expensive than other forms of nitrogen fertilizers. In recent years, a significant amount of the ammonia consumed annually in the U.S was imported. Therefore, nitrogen fertilizers prices in the U.S. are influenced by the cost to transport product from exporting countries, giving domestic producers who transport shorter distances an advantage. Climate Control Business Construction Markets Our Climate Control Business serves the new, renovation and replacement commercial/institutional and residential construction sectors. Over the past two years, our overall business volume has shifted from a new construction majority to a dominance in renovation and replacement projects today. Information available from the CMFS indicates that construction activity in the commercial/institutional markets we serve (including multi-family residential structures) is expected to increase 8%, 7% and 5% in the aggregate from 2016 - 2018 and has surpassed pre-recession levels collectively. In particular, the education, office and healthcare vertical end markets of the commercial/institutional sector are expected to grow faster than other vertical end markets we serve. Additionally, single-family residential construction is expected to grow 20% during 2016 to 805,000 units but still remains well below the 1.5 million unit pre-recession levels. Based on the above forecasted growth in the vertical markets we serve as well as the introduction of new products specifically targeted at the hospitality, education and healthcare vertical markets, we expect the commercial/institutional portion of the Climate Control Business to experience sales growth in the medium and long-term. We believe that our residential products, which are all geothermal heat pumps (“GHP”), will experience limited sales growth, if any, due to the higher relative total system purchase cost of our higher efficiency GHP product offerings as compared to traditional HVAC systems. The higher initial purchase cost creates a longer payback period in most regions due to current low energy costs. We continue to concentrate our product development and sales and marketing efforts on increasing our share of the existing market for our products, as well as expanding the markets for and application of our products, with a focus on utilizing high efficiency/“green” technology. Key Operational Factors Chemical Business Facility Reliability Consistent, reliable and safe operations at our chemical plants are critical to our financial performance and results of operations. Unplanned downtime of the plants typically results in lost contribution margin, increased maintenance expense and decreased inventory for sale. The financial impact of planned downtime, including Turnarounds maintenance, is mitigated through a diligent planning process that takes into account, the availability of resources to perform the needed maintenance, feedstock logistics and other factors. Our Cherokee and Pryor Facilities have historically undergone a facility Turnaround every year. In the third quarter of 2014, our Cherokee Facility underwent an extended Turnaround replacing certain end-of-life equipment and performing additional maintenance required to move to a two-year Turnaround cycle. As a result, a Turnaround was not required at this facility during 2015 and we anticipate that Turnarounds at our Cherokee Facility typically will be performed every two years, and last 25 to 30 days. For the Cherokee Facility, the next bi-annual Turnaround is scheduled in mid-2016. Currently, Turnarounds at our Pryor Facility are performed annually, and typically last between 20 to 25 days. During the third quarter of 2015, the Pryor Facility completed a Turnaround that lasted 25 days. However, subsequent to the completion of this Turnaround, this facility experienced unplanned downtime as discussed below under “Items Affecting Comparability of Results.” We are currently anticipating a Turnaround at our Pryor Facility in mid-2016. At our El Dorado Facility, since we are able to perform Turnaround projects on individual plants without shutting down the entire facility, the impact of lost production is not significant. However, upon completion of the new ammonia plant at our El Dorado Facility, the facility will begin with annual Turnarounds that are expected to last between 20 to 25 days. All Turnarounds result in lost fixed overhead absorption and additional maintenance costs, which costs are expensed as incurred. Prepay Contracts We use forward sales of our fertilizer products to optimize our asset utilization, planning process and production scheduling. These sales are made by offering customers the opportunity to purchase product on a forward basis at prices and delivery dates that we propose. We use this program to varying degrees during the year depending on market conditions and depending on our view as to whether price environments will be increasing or decreasing. Fixing the selling prices of our products months in advance of their ultimate delivery to customers typically causes our reported selling prices and margins to differ from spot market prices and margins available at the time of shipment. Climate Control Business Product Orders, Sales and Ending Backlog Our Climate Control Business had 2015 total bookings of $261 million, a 6% decline from 2014. This decline is directly related to the loss of Carrier’s water source heat pump contract that occurred in May 2014. The backlog at December 31, 2015 is approximately 4% higher than 2014 primarily driven by an increase in commercial/institutional branded water source heat pump products of our subsidiary, Climate Master, Inc. (“Climate Master”). The following table shows information relating to our product order intake level, net sales and backlog of confirmed customer product orders of our Climate Control Business: (1) Our product new order level consists of confirmed purchase orders from customers that have been accepted and received credit approval and our backlog consists of confirmed customer orders for product to be shipped at a future date. Historically, we have not experienced significant cancellations relating to our backlog of confirmed customer product orders, and we typically expect to ship substantially all of these orders within the next twelve months. At December 31, 2015 backlog includes two orders totaling approximately $1.5 million expected to ship from twelve to fifteen months. It is possible that some of our customers could cancel a portion of our backlog or extend the shipment terms. Product orders and backlog, as reported, generally do not include amounts relating to shipping and handling charges, service orders or service contract orders. In addition, product orders and backlog, as reported, exclude contracts related to our construction business due to the relative size of individual projects and, in some cases, extended timeframe for completion beyond a twelve-month period. For January 2016, our new orders received were approximately $18.8 million and our backlog was approximately $65.6 million at January 31, 2016. Operational Excellence Activities In 2013 we began our Operational Excellence (“OpEx”) initiative at each of the companies within our Climate Control Business focusing on creating a safe work environment, industry leading quality, excellent customer service and operating cost reductions. Our OpEx focus intensified throughout 2014 and 2015 at our custom air handler business and realignment of our water source and geothermal heat pump and hydronic fan coil operations. We have increased our investment through the addition of a group Director of OpEx and staffing of OpEx professionals at three of our operations to accelerate improvements in the businesses. The Climate Control Business continues to build the foundation for the continuous improvement culture desired in our organization. OpEx initiatives will drive safety, quality, delivery, and cost reductions with integration into our 2016 strategic planning activities by setting targeted goals and driving organizational development and management accountability. Savings are expected to come from increased manufacturing excellence, effective launch of new products, and synergies gained through changes in organizational structure which will leverage support across all businesses. Certain Heat Pump Contracts In November 2013, Carrier advised Climate Master that heat pump contracts would not be renewed between Climate Master, as the manufacturer, and Carrier, as the purchaser. These contracts expired in May 2014. During 2014 and 2015, net sales pursuant to these heat pump contracts represented approximately $14.7 million and $0.6 million, respectively. Consolidated Results for 2015 Our consolidated net sales for 2015 were $711.8 million compared to $761.2 million for 2014. The sales decrease of $49.4 million included a decrease of $55.5 million in our Chemical Business partially offset by an increase of $8.7 million in our Climate Control Business. Our consolidated operating loss was $50.8 million compared to a consolidated operating income of $53.4 million for 2014. The decrease in our operating results of $104.2 million included a decrease in our Chemical Business operating results of $93.1 million and a decrease of $1.8 million in operating income in our Climate Control Business. In addition, our unallocated corporate expenses increased $8.5 million. The items impacting our operating results are discussed in more detail below and under “Results of Operations.” Items Affecting Comparability of Results Property and Business Interruption Insurance Claims and Recoveries In January 2014, we settled claims with our insurance carriers related to property damage and business interruption at our Cherokee Facility. For 2014, the impact of these claims to our operating results was approximately $22.9 million recognized as a reduction to cost of sales and $5.1 million recognized as a property insurance recovery in excess of losses incurred. Impairment of Natural Gas Properties and Long Lived Assets During 2015, a subsidiary within our Chemical Business received an engineering and economic evaluation (the “Evaluation”) from our independent petroleum engineer relating to its working interest in natural gas properties in the Marcellus Shale region. The results of the Evaluation indicated that the carrying amount of these natural gas properties may not be recoverable. Therefore a review for impairment was performed on these natural gas properties. As a result of the review, our Chemical Business recognized a non-cash impairment charge of $39.7 million to write-down the carrying value of our working interest in these natural gas properties to the estimated fair value of $22.5 million at the time of the evaluation. In addition, our Chemical Business recognized a $3.5 million non-cash impairment charge to reduce the carrying value of certain plant assets related to unused ammonia production equipment at our Pryor Facility. See additional discussion below under “Critical Accounting Policies and Estimates” in this MD&A. Pryor Downtime Our Pryor Facility completed an annual Turnaround on August 4, 2015, which lasted 25 days. While restarting the plant, several mechanical issues were encountered requiring management to take the plant out of service for additional repairs. The plant was restarted and resumed production on September 23, 2015, resulting in 45 days of unplanned downtime. The Pryor facility experienced additional unplanned downtime in its Urea and UAN plants during the fourth quarter of 2015. We estimate that the period of planned and unplanned downtime at our Pryor Facility during the third quarter of 2015 resulted in reduced sales volumes of UAN and ammonia by approximately 18,300 tons and 22,200 tons, respectively and an additional reduction in UAN sales volumes of 21,000 tons in the fourth quarter. The impact from these outages increased our operating losses in 2015 by approximately $19 million, which includes unabsorbed overhead expenses, costs of repair and lost profit margin. During the first six months of 2014, Pryor incurred unplanned downtime resulting in lost ammonia and UAN production of approximately 34,000 tons and 59,000 tons respectively. The estimated negative impact to operating income resulting from these outages was approximately $15 million. In addition, Pryor incurred a short planned 8 day outage in July to perform maintenance and experienced a 10 day unplanned outage in August resulting from a power outage. Orica Agreement EDC’s LDAN sales agreement with Orica expired on April 9, 2015. The Orica Agreement included a provision for Orica to pay for fixed overhead costs and gross profit on the portion of the annual minimum of product not taken. The annual fixed overhead and gross profit associated with the 240,000 tons was approximately $20 million. As a result during 2015, our El Dorado Facility had approximately $15 million less contribution margin from this agreement compared to 2014. Subsequent to the expiration of the Orica Agreement, we continue to selling LDAN to other customers including Orica but at a lower volume given that we remain a high cost producer due to purchasing ammonia as the feedstock. We believe we will continue to experience lower volumes until the El Dorado ammonia plant construction is in production which is expected to begin early in the second quarter of 2016. We have signed contracts with customers that, beginning in January 2016, provide for the sale of LDAN for approximately 150,000 tons annually under various cost plus pricing arrangements. With the recent downturn in the mining industry, we are unsure if we will reach these sales levels. Unlike the Orica Agreement, which contained take-or-pay provisions, certain of these contracts include minimum annual volume levels with penalty payments if minimum volumes are not met. However, as discussed in more detail above under “Key Industry Factors,” our LDAN sales volumes are being impacted by the decline in coal production in the U.S. Cherokee Turnaround Expense In 2014 our Cherokee Facility underwent an extended Turnaround replacing certain end-of-life equipment and performing additional maintenance required to move to a two-year Turnaround cycle. The impact from this turnaround reduced our operating results in 2014 by approximately $5 million which includes unabsorbed overhead expenses, costs of repair and lost profit margin. Our Cherokee Facility has moved to a bi-annual turnaround schedule with the next Turnaround scheduled for third quarter of 2016. Interest Expense, net For 2015 and 2014, interest expense was $7.4 million and $21.6 million, net of capitalized interest of $30.6 million and $14.1 million, respectively. Interest was capitalized based upon construction in progress of the El Dorado Expansion and certain other capital projects. Certain Unallocated Corporate Expenses During 2015, we incurred certain one-time corporate costs relating to severance agreements with former executives of $2.0 million and we incurred stock-based compensation of $0.4 million associated with our Chief Executive Officer relating to restricted stock that vested on the date of grant, and certain Board fees of $0.2 million. Results of Operations The following Results of Operations should be read in conjunction with our consolidated financial statements for the years ended December 31, 2015, 2014, and 2013 and accompanying notes and the discussions under “Overview” and “Liquidity and Capital Resources” included in this MD&A. See discussion in Note 1 to Consolidated Financial Statements regarding the adjusted prior period amounts to classify certain shipping and handling of our Chemical Business from net sales and SG&A to cost of sales to conform to our current presentation of our consolidated statement of operations for 2015. We present the following information about our results of operations for our two core business segments: the Chemical Business and the Climate Control Business. The business operation classified as “Other” primarily sells industrial machinery and related components to machine tool dealers and end users. Net sales by business segment include net sales to unaffiliated customers as reported in the consolidated financial statements. Intersegment net sales are not significant. Gross profit by business segment represents net sales less cost of sales. Operating income (loss) by business segment represents gross profit by business segment less SG&A incurred by each business segment plus other income and other expense earned/incurred by each business segment before general corporate expenses. General corporate expenses consist of SG&A, other income and other expense that are not allocated to one of our business segments. The following table contains certain information about our continuing operations in different business segments for each of the three years ended December 31: Year Ended December 31, 2015 Compared to Year Ended December 31, 2014 Chemical Business The following table contains certain information about our net sales, gross profit and operating income in our Chemical segment for 2015 and 2014: (1) As a percentage of net sales The following tables provide key operating metrics for the agricultural products of our Chemical Business for 2015 and 2014: With respect to sales of industrial, mining and other chemical products, the following table indicates the volumes sold of our major products for 2015 and 2014: Net Sales - Chemical Our Chemical Business sales in the agricultural markets primarily were at the spot market price in effect at the time of sale or at a negotiated future price. The majority of our Chemical Business sales in the industrial and mining markets were pursuant to sales contracts and/or pricing arrangements on terms that include the cost of raw material feedstock as a pass through component in the sales price. In general, for 2015 our agricultural sales were lower due to lower sales volumes for HDAN, ammonia and our other agricultural products due to unusually wet application seasons and lower prices for HDAN and UAN partially offset by higher UAN sales volumes. Mining sales also declined primarily due to lower sales prices and volumes while sales of industrial products decreased slightly with lower prices partially offset by higher sales volumes. In addition, natural gas sales prices and volumes declined in 2015 compared to 2014. · Agricultural products comprised approximately 49% and 48% of the Chemical Business net sales for 2015 and 2014, respectively. The sales decline of 8.8% over 2014 sales was driven by a slight overall decline in sales volumes with lower HDAN, ammonia and other agricultural products sales volumes partially offset by higher UAN sales volumes. The higher UAN sales volumes were primarily due to higher production at our Cherokee and Pryor Facilities in 2015 compared to 2014 when we performed a bi-annual turnaround at the Cherokee Facility. Compounding the slight decline in sales volumes was a decrease in our average product selling prices per ton in 2015 with UAN down 9% and HDAN down 1%. These lower selling prices were attributable to lower natural gas and other commodity prices coupled with lower urea selling prices caused by the large amount of imports, placing downward pressure on selling prices. Ammonia prices were essentially unchanged for 2015 compared to 2014. · Industrial acids and other chemical products sales increased as a result of increased volumes at the Baytown Facility (which performed a Turnaround in 2014, but not in 2015) and at our Cherokee Facility, partially offset by lower prices from the pass-through of decreased ammonia costs to contractual customers and lower volumes from the El Dorado Facility due to lower customer demand. · Mining products sales decreased primarily due to lower sales of LDAN resulting from the expiration of the take-or-pay Orica Agreement in April 2015 compared to the contract being in place for the full year in 2014 and lower sales volumes for the balance of 2015 due to being a high cost producer and not competitive in the marketplace. Additionally, lower sales volumes of AN solution at our Cherokee Facility are the result from a continued decline of demand for mining products in the Appalachian region combined with lower selling prices contributed to lower mining sales. · Other products relates to natural gas sales from our working interests in certain natural gas properties. The decrease in natural gas sales is due to lower realized sales prices out of the Marcellus Shale region combined with lower production volumes in 2015 compared to 2014 as the operator of these properties has slowed development due to the decline in natural gas sales prices. Gross Profit - Chemical · Our gross profit decreased $44.4 million in 2015 when compared to 2014. Excluding the business interruption insurance recoveries of $22.9 million in 2014, the decrease in gross profit in 2015 compared to 2014 was $21.5 million. The decrease of $21.5 million was primarily due to the loss of the margin contribution relating to the expiration of the Orica Agreement, lost absorption of fixed overhead costs associated with lower production of HDAN, lower average sales prices, increased operating costs including railcar lease costs, partially offset by the higher overall on-stream rate at the Cherokee Facility and lower natural gas feedstock costs. Natural gas feedstock costs decreased approximately 25% but that was partially offset by operating losses incurred relating to our working interests in certain natural gas properties. Operating Income (Loss) - Chemical · Our Chemical Business operating loss was $41.8 million, a decrease of $93.1 million in operating results. This decrease includes the $43.2 million non-cash impairment charges consisting of an impairment charge of $39.7 million to reduce the carrying value of our working interest in natural gas properties and a $3.5 million impairment charge to reduce the carrying value of certain plant assets related to unused ammonia production equipment at our Pryor Facility during 2015. In addition to the business interruption insurance recovery included in gross profit discussed above, a property insurance recovery of $5.1 million for a total insurance recovery of $28.0 million, was recognized in 2014. Excluding the impairment charges of $43.2 million in 2015 and the total insurance recoveries of $28.0 million in 2014, operating results decreased $21.9 million primarily from the decrease in gross profit discussed above and personnel and training expenses, which are primarily related to the expansion related activities at the El Dorado Facility. Climate Control Business The following table contains certain information about our net sales, gross profit and operating income in our Climate Control segment for 2015 and 2014: (1) As a percentage of net sales The following table provides sales by market sector in our Climate Control Business for the year ended December 31: Net Sales - Climate Control · Net sales of our water source and geothermal heat pump products decreased in 2015 primarily as a result of the loss of the Carrier heat pump contract, which generated $14.7 million in sales in 2014 compared to $0.6 million in 2015. Excluding Carrier heat pump sales, commercial/institutional product sales of water source and geothermal heat pumps improved slightly over 2014 while residential product sales of water source and geothermal heat pumps declined $3.9 million, or 10.0%. Overall, the number of units sold declined and the average unit selling price decreased due to lower Carrier sales and product mix, respectively. From a commercial/institutional market perspective, gains were seen in the multi-family, healthcare and public building sectors with a slight decline in the education and office sectors. We believe during 2015, we continued to maintain a leading market share position based on market data supplied by AHRI. · Net sales of our hydronic fan coils increased in 2015 primarily due to favorable end markets as well as new product introductions and an increase in selling prices relative to 2014. Sales gains were realized in hospitality, healthcare, government buildings and multi-family offset slightly by a drop in the education market. We believe during 2015, we continued to maintain a leading market share position based on market data supplied by AHRI. · Net sales of our other HVAC products increased primarily due to increased sales of our large custom air handlers related to a higher beginning backlog entering 2015. Our backlog continues to grow. Gross Profit - Climate Control · The increase in gross profit in our Climate Control Business was primarily the result of the higher net sales as discussed above, although the gross profit as a percentage of net sales declined due to product mix and under absorbed overhead and increased expenses for contract labor, outside services, recruiting, repair and maintenance. Operating Income - Climate Control · Operating income decreased primarily as a result of higher variable selling expenses related to the increase in sales volume (freight, warranty, and commissions) partially offset by a reduction in fixed expenses in 2015 over 2014, primarily advertising. General Corporate Expenses General corporate expenses consist of SG&A, other income and other expense that are not allocated to one of our business segments. General corporate expenses were $29.9 million in 2015 compared to $21.4 million in 2014. The increase of approximately $8.5 million primarily relates to an increase of $6.4 million for personnel related expenses including; one-time severance payments of approximately $2.0 million for certain senior executives, additional compensation expense of approximately $1.0 million, discontinuance of the allocation of certain senior management costs to the Chemical and Climate Control Businesses of approximately $1.2 million and compensation related to restricted stock awards of approximately $0.4. The remaining increase of approximately $2.1 million relates primarily to an increase in professional fees for legal and investment banking services related to various financing activities, an increase in auditing and other accounting services and other consulting services. Additionally, in both 2014 and 2015 we incurred $4.8 million and $4.6 million respectively for fees and expenses related to analyzing proposals received from certain activist shareholders and in dealing, negotiating and settling with those shareholders in order to avoid a proxy fight. Interest Expense, net Interest expense for 2015 was $7.4 million compared to $21.6 million for 2014. The decrease is due primarily to capitalized interest on capital projects under development and construction, of which $30.6 million was capitalized in 2015 compared to $14.1 million during 2014. Provision (benefit) for Income Taxes The benefit for income taxes for 2015 was $23.6 million compared to a provision of $12.4 million for the same period in 2014. The effective tax rate was 40% for 2015 and 39% for 2014. Year Ended December 31, 2014 Compared to Year Ended December 31, 2013 Chemical Business The following table contains certain information about our net sales, gross profit and operating income in our Chemical segment for 2014 and 2013: (1) As a percentage of net sales Net Sales - Chemical Our Chemical Business sales in the agricultural markets primarily were at the spot market price in effect at the time of sale or at a negotiated future price. Most of our Chemical Business sales in the industrial and mining markets were pursuant to sales contracts and/or pricing arrangements on terms that include the cost of raw material feedstock as a pass through component in the sales price. Our 2014 production and sales volumes were higher in all three of our primary markets due to consistent customer demand and improved on-stream production rates at the El Dorado, Pryor and Cherokee Facilities, partially offset by an extended Turnaround in the third quarter and the approximately 30 days of downtime in the fourth quarter to complete certain unplanned maintenance at our Cherokee Facility. · Agricultural products comprised approximately 48% and 45% of the Chemical Business’ net sales for 2014 and 2013, respectively. Agricultural products sales increased in 2014 as more product was available to sell resulting from the increased on-stream rates of our facilities partially offset by lower average selling prices for nitrogen fertilizers. Compared to 2013, the 2014 average agricultural products selling prices per ton were lower by 8%, 5%, and 10% for ammonia, UAN and AN, respectively. The decrease in selling prices for the nitrogen fertilizers was due largely to record exports of urea from China combined with lower commodity prices. · Industrial acids and other chemical products sales increased in 2014 as a result of more product available to sell due to the improved on-stream rates of our chemical facilities. · Mining products sales increased in 2014 primarily as a result of more product available to sell due to the improved on-stream rates of our chemical facilities. · Other products relates to natural gas sales from our working interests in certain natural gas properties acquired in 2012 and 2013 by a subsidiary within our Chemical Business. The increase in natural gas sales is primarily due to higher production volume as these properties are developed and partially offset by lower net selling prices. Gross Profit - Chemical · Our gross profit increased $20.4 million in 2014 when compared to 2013. Excluding business interruption insurance recoveries of $22.9 million and $28.6 million in 2014 and 2013, respectively, and $4.5 million of precious metals recovery in 2013, the increase in gross profit was $30.6 million. The increase of $30.6 million was due to the higher sales level resulting in improved fixed overhead absorption made possible by the improved on-stream production rates of our chemical facilities. The improved gross profit was partially offset by a decline in the margin per ton of nitrogen fertilizers due to lower selling prices and higher feedstock costs. Natural gas feedstock cost increased approximately 12% partially offset by a 7% decrease in ammonia feedstock costs, while AN prices decreased 10% and UAN selling prices decreased 5%, negatively affecting gross profit margins on our nitrogen fertilizer sales. · Unrealized losses related to forward contracts on natural gas purchases decreased 2014 gross profit by $2.1 million compared to a minimal unrealized gain in 2013. · Purchased UAN that was sold at a loss to honor forward sales commitments in excess of available production due to unplanned downtime reduced gross profit by $1.2 million in 2014. Operating Income - Chemical · Our Chemical Business’ operating income was $51.3 million, a decrease of $36.5 million. In addition to the business interruption insurance recoveries included in gross profit discussed above, property insurance recoveries of $5.1 million and $66.0 million were recognized in 2014 and 2013, respectively. Excluding all insurance recoveries of $28.0 million and $94.6 million in 2014 and 2013, respectively, and excluding the precious metals recovery of $4.5 million in 2013, our adjusted operating income was $23.3 million in 2014 compared to an adjusted operating loss of $11.3 million, or an increase of $34.6 million. Additionally net other expenses were $4.0 million lower in 2014 due primarily to dismantling expenses and penalties incurred in 2013. Climate Control Business The following table contains certain information about our net sales, gross profit and operating income in our Climate Control segment for 2014 and 2013: (1) As a percentage of net sales Net Sales - Climate Control · Net sales of our water source and geothermal heat pump products decreased in 2014 primarily as a result of the loss of the Carrier heat pump contracts, which generated sales in 2014 that were $17 million lower than 2013. Excluding Carrier heat pump sales, commercial/institutional product sales were flat with 2013 while residential product sales were up nearly 6.5%. Overall, the number of units sold declined; and the unit average unit selling price increased due to lower Carrier sales. From a commercial/institutional market perspective, gains were seen in the retail and multi-family sectors with a slight decline in the education sector. In addition, 2014 had an extremely slow start due to low beginning backlog and weather related delays. Incoming orders, excluding Carrier, for commercial/institutional products and residential products increased 11% and 15%, respectively. During 2014, we continued to maintain a market share leadership position based on market data supplied by AHRI. · Net sales of our hydronic fan coils declined in 2014 primarily due to lower than expected product orders partially offset by an increase in selling prices of approximately 8% over 2013 primarily due to product and feature mix. We experienced only minor fluctuations in the vertical markets served. During 2014, we continued to maintain a market share leadership position based on market data supplied by AHRI. · Net sales of our other HVAC products decreased primarily due to a lower beginning backlog entering 2014, customer scheduled delivery dates shifting out for our large custom air handlers and modular chillers, partially offset by increased activity on contracts for our engineering and construction services. Gross Profit - Climate Control · The decrease in gross profit in our Climate Control Business was primarily the result of the lower net sales as discussed above and reduced overhead absorption related to fewer units sold in 2014 as compared to 2013. Operating Income - Climate Control · Operating income decreased primarily as a result of the lower gross profit discussed above, partially offset by lower operating expenses. However, variable selling expenses as a percentage of sales increased due to the change in product and customer mix with lower OEM sales at CM causing freight to increase as a percentage of sales and warranty expenses increasing due to recent claims at our fan coil operation. Fixed selling and administrative expense in 2014 declined slightly from 2013 but represented a greater percentage of net sales due to lower sales in 2014. General Corporate Expenses General corporate expenses were $21.4 million during 2014 compared to $14.6 million in 2013. The increase was primarily the result of incurring approximately $4.2 million in fees and expenses related to evaluating and analyzing proposals from and settling with certain activist shareholders in the first quarter of 2014 and increases in consulting fees and services of $0.9 million, insurance and bank related expense of $0.4 million, depreciation and amortization of $0.4 and personnel costs of $0.3 million. During 2013, we recognized other income of $0.5 million relating to a litigation settlement. Interest Expense, net Interest expense for 2014 was $21.6 million compared to $14.0 million for 2013. The increase is due primarily to the issuance of the 7.75% Senior Secured Notes during 2013, partially offset by $14.1 million of capitalized interest on capital projects under development and construction during 2014 compared to $4.0 million capitalized during 2013. Loss on Extinguishment of Debt As the result of the payoff of a secured term loan facility in 2013, we incurred a loss on extinguishment of debt of $1.3 million, consisting of a prepayment premium and writing off unamortized debt issuance costs. Provision for Income Taxes The provision for income taxes for 2014 was approximately $12.4 million compared to $35.4 million for 2013. The resulting effective tax rate was 39% for 2014 and 40% for 2013 (excluding the benefit of $0.5 million associated with the retroactive tax relief on certain 2012 tax provisions that expired in 2012). The decrease in the effective tax rate was due primarily to certain expired tax credits reinstated during December 2014. LIQUIDITY AND CAPITAL RESOURCES For 2015, our operating activities generated positive cash flows. The following summarizes our cash flow for all activities: Cash Flow from Continuing Operating Activities For 2015, net cash provided by continuing operating activities was $31.6 million primarily as the result of net loss of $34.8 million plus adjustments of $43.2 million for the impairment of long-lived assets (primarily natural gas properties), $18.5 million for deferred income taxes, and $40.5 million for depreciation, depletion and amortization of PP&E. Cash Flow from Continuing Investing Activities For 2015, net cash used by continuing investing activities was $354.0 million consisting primarily of $439.8 million used for expenditures for PP&E primarily for the benefit of our Chemical Business, partially offset by net proceeds of $85.5 million from restricted cash and cash equivalents and investments primarily representing funds designated by management for specific capital projects relating to our Chemical Business. Cash Flow from Continuing Financing Activities For 2015, net cash provided by continuing financing activities was $263.1 million and primarily consisted of net proceeds from the issuance of preferred stock and warrants of $198.6 million and net proceeds from long-term financing of $79.0 million, partially offset by net payments on short-term financing and payment of long-term debt of $16.6 million. Liquidity Needs for 2016 As discussed below under “Capitalization”, our primary cash needs relate to completing our current capital projects in addition to our scheduled debt and preferred dividend and redemption requirements. Our cash requirements are primarily dependent on credit agreements, various forms of financing, and through internally generated cash flows. See “Key Capital Expenditure, Financing and Other Developments - 2015.” During 2016, we will complete the construction of and begin operations at the new ammonia plant being constructed at our El Dorado Facility. We plan to fund our remaining cash needs to complete this project along with our annual interest payments on our outstanding debt, our dividend payments on our outstanding preferred stock and the repayment of the Secured Promissory Note due 2016 through funds received in connection with the $260 million in financing completed in December 2015, cash flow from operations, the funding of the cogeneration facility equipment at our El Dorado Facility and the use of our revolving credit facility. We have the ability to accrue the dividend payments on our preferred stock should we need to elect that option. Our Senior Secured Notes mature in 2019 and the holders of our Series E Redeemable Preferred and Series F Redeemable Preferred have the right to have the Company redeem that preferred stock in 2019, including accumulated dividends, if any. We intend to seek refinancing on or before the maturity date in 2019 of the Senior Secured Notes. If the holders of our Series E Redeemable Preferred and Series F Redeemable Preferred require us to redeem the preferred stock in 2019, we may be required to seek additional financing. Capitalization The following is our total current and noncurrent cash and investments, long-term debt and stockholders’ equity: As of December 31, 2015, our cash and cash equivalents were $127.3 million. In addition, our $100 million revolving credit facility was undrawn and available to fund operations as discussed below, if needed, subject to the amount of our eligible collateral and outstanding letters of credit. As discussed in “Key Capital Expenditure, Financing and Other Developments - 2015,” over the course of 2015, management in conjunction with the owner’s representative, the engineering, procurement and construction contractor and other consultants determined that the total cost to complete the El Dorado Expansion would exceed what we previously projected compared to earlier estimates. We have now determined that the total cost to complete the El Dorado Expansion is estimated to be in the range of $831 million to $855 million ($705 million spent as of December 31, 2015 and $126 million to $150 million to be spent in 2016). In order to finance these additional costs, and for the reasons discussed in “Key Capital Expenditure, Financing and Other Developments - 2015,” during the fourth quarter of 2015, we obtained additional financing totaling $260 million in the form of debt, preferred stock, and common stock warrants. We believe that the funding provided by the financing, together with our other sources of liquidity, will be sufficient for our anticipated liquidity needs through completion of the El Dorado Expansion. In February 2016, we received financing of $10 million related to the cogeneration facility equipment in connection with the El Dorado Expansion projects. Our agreement allows us to secure up to an additional $10 million in financing on the cogeneration facility equipment. We are party to the Senior Secured Notes Indenture governing the 7.75% Senior Secured Notes and the Senior Secured Note Purchase Agreement governing the 12% Senior Secured Notes. The Senior Secured Notes Indenture and the Senior Secured Note Purchase Agreement contain covenants that, among other things, limit LSB’s ability, with certain exceptions and as defined in the Senior Secured Notes Indenture and the Senior Secured Note Purchase Agreement, to enter certain transactions. We and certain of our subsidiaries are party to the Amended Working Capital Revolver Loan. Pursuant to the terms of the facility, the principal amount LSB and certain of its subsidiaries (“the Borrowers”) may borrow is up to $100.0 million, based on specific percentages of eligible accounts receivable and inventories. At December 31, 2015, there were no outstanding borrowings under the Amended Working Capital Revolver Loan and the net credit available for borrowings was approximately $64.4 million, based on our eligible collateral, less outstanding letter of credit as of that date. Capital Additions Capital Additions - 2015 Capital additions during 2015 were $477.0 million, including $473.4 million for the benefit of our Chemical Business. The Chemical Business capital additions included $443.0 million for expansion projects at our El Dorado Facility (which capital additions include equipment associated with maintaining compliance with environmental laws, regulations and guidelines), $19.1 million for various major renewal and improvement projects, $6.0 million relating to the new ERP system, $3.7 million for the development of natural gas leaseholds, and an additional $3.7 million associated with maintaining compliance with environmental laws, regulations and guidelines not associated with the El Dorado Expansion. The capital additions were funded primarily from noncurrent restricted cash and investments, third-party financing and working capital. Due to the increase in the amount of capital additions incurred and planned, our depreciation, depletion and amortization expenses have increased and are expected to increase in 2016. Planned Capital Additions (1) Includes cost associated with renewal and improvement projects, environmental projects and the development of natural gas leaseholds, some of which may be deferred. (2) Includes cost associated with savings initiatives, new market development, and other capital projects. Included in planned capital expenditures is capitalized interest of approximately $12 million for 2016. The planned capital expenditures for Corporate and Other are primarily for the replacement of our ERP, financial and operations management system. The new ERP system replaces our legacy systems, which are out-of-date and largely unsupported, and will improve our access to operational and financial information utilized to manage the business and improve our security and regulatory compliance capability. This project began in 2013 and is expected to be fully implemented in 2017 at a total cost of $26 million to $28 million. Planned capital expenditures are presented as a range to provide for engineering estimates, the status of bidding, variable material costs, unplanned delays in construction, and other contingencies. As the engineering, design, and bidding processes progress and project construction proceeds, the estimated costs are more certain and the range of estimates narrows. The planned capital expenditures include investments that we anticipate making for expansion and development projects, environmental requirements, and major renewal and improvement projects. Beyond the completion of the expansion projects, specific capital projects are less identified but are expected to include between $40 million to $60 million per year at our chemical facilities for ongoing capital maintenance, including environmental compliance, major renewal and improvement projects, and other capital projects, and approximately $19 million from 2016-2019 to fully develop our natural gas working interests. The El Dorado Expansion The El Dorado Facility has certain expansion projects underway, of which a portion of these have been completed. These expansion projects include an ammonia production plant; a new 65% strength nitric acid plant and concentrator; and other support infrastructure, all of which were analyzed and evaluated based on their forecasted return on investment. The expected costs of these projects are outlined below, and their planned amounts are included in the table above. Our El Dorado Facility produces nitric acid, HDAN and LDAN from purchased ammonia, which is currently at a cost disadvantage compared to products produced from natural gas. The El Dorado Facility historically purchased 600-700 tons of ammonia per day when operating at full capacity. We are constructing a 1,150 ton per day ammonia production plant at the El Dorado Facility, which we believe will eliminate the cost disadvantage, increase capacity, and improve efficiency of the El Dorado Facility. This plant is expected to be operational early in the second quarter of 2016. During 2015, we have completed the construction of a new 1,100 ton per day, 65% strength nitric acid plant and concentrator that replaces the concentrated nitric acid capacity lost in 2012. The nitric acid plant and concentrator are designed to be more efficient and provide increased nitric acid production capacity. As a result of the increased production capacity at the El Dorado Facility, it is necessary to expand and improve certain support infrastructure, including utility capacity, control room facilities, inventory storage and handling, and ammonia distribution. Also, other cost reduction and cost recovery equipment, including an electric cogeneration plant, are being added to improve efficiency and lower the cost of production. As the result of the completion/expected completion of the various capital projects included in the El Dorado Expansion (ending the capitalization of interest to these capital projects) and the issuance of the 12% Senior Secured Notes, our future operating results will be impacted by an increase in interest expense. Expenses Associated with Environmental Regulatory Compliance Our Chemical Business is subject to specific federal and state environmental compliance laws, regulations and guidelines. As a result, our Chemical Business incurred expenses of $5.5 million in 2015 in connection with environmental projects. For 2016, we expect to incur expenses ranging from $4.5 million to $5.5 million in connection with additional environmental projects. However, it is possible that the actual costs could be significantly different than our estimates. Dividends We have not paid cash dividends on our outstanding common stock in many years, and we do not currently anticipate paying cash dividends on our outstanding common stock in the near future. However, our Board has not made a decision whether or not to pay such dividends on our common stock in 2016. Also see discussion below concerning certain limitations relating to paying dividends on our common stock. During the first quarter of 2015, annual dividends totaling $300,000 were declared on our outstanding Series D 6% cumulative convertible Class C preferred stock (the “Series D Preferred”) and Series B 12% cumulative convertible Class C Preferred Stock (the “Series B Preferred”) and subsequently paid in 2015 using funds from our working capital. Each share of preferred stock is entitled to receive an annual dividend, only when declared by our Board, payable as follows: · $0.06 per share on our outstanding non-redeemable Series D Preferred for an aggregate dividend of $60,000, and · $12.00 per share on our outstanding non-redeemable Series B Preferred for an aggregate dividend of $240,000. All shares of the Series D Preferred and Series B Preferred are owned by the Golsen Holders. There are no optional or mandatory redemption rights with respect to the Series B Preferred or Series D Preferred. Dividends on the Series E Redeemable Preferred are cumulative and payable semi-annually, commencing May 1, 2016, in arrears at the annual rate of 14% of the liquidation value of $1,000 per share. Each share of Series E Redeemable Preferred is entitled to receive a semi-annual dividend, only when declared by our Board, of $70.00 per share for the aggregate semi-annual dividend of $14.7 million. In addition, dividends in arrears at the dividend date, until paid, shall compound additional dividends at the annual rate of 14%. We also must declare a dividend on the Series E Redeemable Preferred on a pro rata basis with our common stock. As long as the Purchaser holds at least 10% of the Series E Redeemable Preferred, we may not declare dividends on our common stock and other preferred stocks unless and until dividends have been declared and paid on the Series E Redeemable Preferred for the then current dividend period in cash. As of December 31, 2015, the amount of accumulated dividends on the Series E Redeemable Preferred was approximately $2.3 million. Compliance with Long - Term Debt Covenants As discussed below under “Loan Agreements”, the Amended Working Capital Revolver Loan requires, among other things, that we meet certain financial covenants. Currently, our forecast is that we will be able to meet all financial covenant requirements for the next twelve months. We plan to use our revolving credit facility to fund operational needs though out 2016 and believe that even with this additional borrowing that we will meet the minimum fixed charge coverage ratio during 2016. Loan Agreements and Redeemable Preferred Stock Senior Secured Notes - In 2013, LSB sold $425 million aggregate principal amount of the 7.75% Senior Secured Notes due 2019. The 7.75% Senior Secured Notes bear interest at the rate of 7.75% per year and mature on August 1, 2019. Interest is to be paid semiannually on February 1st and August 1st. On November 9, 2015, LSB sold $50 million aggregate principal amount of the 12% Senior Secured Notes due 2019 in a private placement exempt from registration under the Securities Act of 1933, as amended. The 12% Senior Secured Notes bear interest at the annual rate of 12% and mature on August 1, 2019. Interest is to be paid semiannually on February 1st and August 1st, which began February 1, 2016. The 12% Senior Secured Notes are secured on a pari passu basis with the same collateral securing LSB’s existing $425 million aggregate principal amount of 7.75% Senior Secured Notes issued in 2013. The 12% Senior Secured Notes have covenants and events of default that are substantially similar to those applicable to the 7.75% Senior Secured Notes. See footnote (B) under Note 9 to Consolidated Financial Statements included in this report for additional information on these Senior Secured Notes. Amended Working Capital Revolver Loan - LSB and certain of its subsidiaries are party to the Amended Working Capital Revolver Loan, by which the Borrowers may borrow on a revolving basis up to $100.0 million, based on specific percentages of eligible accounts receivable and inventories. The Amended Working Capital Revolver Loan will mature on April 13, 2018. The Amended Working Capital Revolver Loan accrues interest at a base rate (generally equivalent to the prime rate) plus 0.50% if borrowing availability is greater than $25.0 million, otherwise plus 0.75% or, at our option, accrues interest at LIBOR plus 1.50% if borrowing availability is greater than $25.0 million, otherwise LIBOR plus 1.75%. At December 31, 2015, the interest rate was 4.0% based on LIBOR. Interest is paid monthly, if applicable. At December 31, 2015, there were no outstanding borrowings under the Amended Working Capital Revolver Loan. At December 31, 2015, the net credit available for borrowings under our Amended Working Capital Revolver Loan was approximately $64.4 million, based on our eligible collateral, less outstanding letters of credit as of that date. The Amended Working Capital Revolver Loan requires the Borrowers to meet a minimum fixed charge coverage ratio of not less than 1.10 to 1, if at any time the excess availability (as defined by the Amended Working Capital Revolver Loan), under the Amended Working Capital Revolver Loan, is less than or equal to $12.5 million. If applicable, this ratio will be measured monthly on a trailing twelve month basis and as defined in the agreement. As of December 31, 2015, as defined in the agreement, the fixed charge coverage ratio was 2.3 to 1. See footnote (A) under Note 9 of Notes to Consolidated Financial Statements included in this report for additional information on this loan. Secured Promissory Note due 2016 - On February 1, 2013, Zena Energy L.L.C. (“Zena”), a subsidiary within our Chemical Business, entered into a loan (the “Secured Promissory Note”) with a lender in the original principal amount of $35 million. The Secured Promissory Note followed the original acquisition by Zena of working interests (“Working Interests”) in certain natural gas properties during October 2012. The proceeds of the Secured Promissory Note effectively financed $35 million of the approximately $50 million purchase price of the Working Interests previously paid out of LSB’s working capital. The Secured Promissory Note maturity date was amended on January 5, 2015 from February 1, 2016 to April 1, 2016. Principal and interest are payable in two monthly installments totaling approximately $1.3 million with interest based on the LIBOR rate plus 300 basis points with a final balloon payment of approximately $14.0 million due at maturity. The interest rate at December 31, 2015 was 3.42%. The loan is secured by the Working Interests and related properties and proceeds. Secured Promissory Note due 2019 - On February 5, 2016, EDC entered into a secured promissory note due 2019 for an original principal amount of $10.0 million. The secured promissory note due 2019 bears interest at the rate of 5.73% per annum and matures on June 29, 2019. Principal and interest are payable in 40 equal monthly installments with a final balloon payment of approximately $6.7 million. The Secured Promissory Note due 2019 is secured by the cogeneration facility equipment and is guaranteed by LSB. Secured Promissory Note due 2021 - On April 9, 2015, EDC and a lender entered into a secured promissory note due 2021 for an original principal amount of approximately $16.2 million. The Secured Promissory Note due 2021 bears interest at the rate of 5.25% per year and matures on March 26, 2021. Interest only is payable monthly for the first 12 months of the term. Principal and interest are payable monthly for the remaining term of the Secured Promissory Note due 2021. This Secured Promissory Note due 2021 is secured by a natural gas pipeline being constructed at the El Dorado Facility and is guaranteed by LSB. Secured Promissory Note due 2022 - On September 16, 2015, El Dorado Ammonia L.L.C. (“EDA”), a subsidiary within our Chemical Business, entered into a secured promissory note due 2022 for the construction financing of an ammonia storage tank and related systems with an initial funding received of $15.0 million and a maximum principal note amount of $19.8 million. The remainder of the funding under the Secured Promissory Note due 2022 is expected to be drawn upon completion of the ammonia storage tank, but in any event by May 2016 (the “Loan Conversion Date”). Up to the Loan Conversion Date, EDA will make monthly interest payments on the outstanding principal borrowed. On the Loan Conversion Date, the outstanding principal balance will be converted to a seven year secured term loan requiring equal monthly principal and interest payments. In addition, a final balloon payment equal to the remaining outstanding principal (or 30% of the outstanding principal balance on the Loan Conversion Date) is required on the maturity date. The Secured Promissory Note due 2022 bears interest at a rate that is based on the monthly LIBOR rate plus 4.0% and matures in May 2022. At December 31, 2015, the interest rate was 4.24%. The Secured Promissory Note due 2022 is secured by the ammonia tank and related systems and is guaranteed by LSB. Redemption of Series E Redeemable Preferred - At any time on or after August 2, 2019, each Series E Holder has the right to elect to have such holder’s shares redeemed by LSB at a redemption price per share equal to the Liquidation Preference of such share as of the redemption date. The Series E Redeemable Preferred has a liquidation preference per share of $1,000 plus accrued and unpaid dividends plus the participation rights value (the “Liquidation Preference”). Additionally, LSB, at its option, may redeem the Series E Redeemable Preferred at any time at a redemption price per share equal to the Liquidation Preference of such share as of the redemption date. Lastly, with receipt of (i) prior consent of the electing Series E holder or a majority of shares of Series E Redeemable Preferred and (ii) all other required approvals, including under any principal U.S. securities exchange on which our common stock is then listed for trading, LSB can redeem the Series E Redeemable Preferred by the issuance of shares of common stock having an aggregate common stock price equal to the amount of the aggregate Liquidation Preference of such shares being redeemed in shares of common stock in lieu of cash at the redemption date. In the event of liquidation, the Series E Redeemable Preferred is entitled to receive its Liquidation Preference before any such distribution of assets or proceeds is made to or set aside for the holders of our common stock and any other Junior Stock. In the event of a change of control, we must make an offer to purchase all of the shares of Series E Redeemable Preferred outstanding. Since carrying values of the redeemable preferred stocks are being increased by periodic accretions (including the amount for dividends earned but not yet declared or paid) so that the carrying amount will equal the redemption value as of August 2, 2019, the earliest possible redemption date by the holder, this accretion has and will continue to impact income (loss) per common share. Seasonality See discussion above under “Part I-Item 1 Business” for seasonality trends. Off-Balance Sheet Arrangements We do not have any off-balance sheet arrangements as defined in Item 303(a)(4)(ii) of Regulation S-K under the Securities Exchange Act of 1934. Performance and Payment Bonds We are contingently liable to sureties in respect of insurance bonds issued by the sureties in connection with certain contracts entered into by subsidiaries in the normal course of business. These insurance bonds primarily represent guarantees of future performance of our subsidiaries. As of December 31, 2015, we have agreed to indemnify the sureties for payments, up to $17.3 million, made by them in respect of such bonds. All of these insurance bonds are expected to expire or be renewed in 2016. Aggregate Contractual Obligations Our aggregate contractual obligations as of December 31, 2015 are summarized in the following table (1) (2): (1) The table does not include amounts relating to future purchases of ammonia by EDC pursuant to a supply agreement through the earlier of December 31, 2016 or the date on which the new ammonia plant comes on stream. The terms of this supply agreement do not include minimum volumes or take-or-pay provisions. (2) The table does not include our estimated accrued warranty costs of $10.6 million at December 31, 2015 as discussed below under “Critical Accounting Policies and Estimates”. (3) The estimated interest payments relating to variable interest rate debt are based on interest rates at December 31, 2015. (4) The dividends on our Series E redeemable preferred stock are assumed to be paid annually and redeemed on the earliest possible redemption date by the holder, August 2, 2019. (5) The estimated future cash flows are based on the estimated fair value of these contracts at December 31, 2015. (6) Capital expenditures are based on estimates (high end of range) at December 31, 2015. (7) Other capital expenditures include only the estimated committed amounts (high end of range) at December 31, 2015 but exclude amounts relating to the El Dorado Expansion. (8) Our proportionate share of the minimum costs to ensure capacity relating to a gathering and pipeline system. (9) The future cash flows relating to executive and death benefits are based on estimates at December 31, 2015. The participation rights value associated with embedded derivative of our Series E redeemable preferred stock is based the value of our common stock at December 31, 2015 and in included in the table above on the earliest possible redemption date by the holder, August 2, 2019. Critical Accounting Policies and Estimates The preparation of financial statements requires management to make estimates and assumptions that affect the reported amount of assets, liabilities, revenues and expenses, and disclosures of contingencies and fair values. It is reasonably possible that the estimates and assumptions utilized as of December 31, 2015 could change in the near term. The more critical areas of financial reporting impacted by management's judgment, estimates and assumptions include the following: Impairment of Long-Lived Assets - Long-lived assets are reviewed for impairment whenever events or changes in circumstances indicate that the carrying amount of an asset (asset group) may not be recoverable. An impairment loss would be recognized when the carrying amount of an asset (asset group) exceeds the estimated undiscounted future cash flows expected to result from the use of the asset (asset group) and its eventual disposition. If assets to be held and used are considered to be impaired, the impairment to be recognized is the amount by which the carrying amounts of the assets exceed the fair values of the assets as measured by the present value of future net cash flows expected to be generated by the assets or their appraised value. As it relates to natural gas properties, proven natural gas properties are reviewed for impairment on a field-by-field basis and nonproducing leasehold costs are reviewed for impairment on a property-by-property basis. During September 2015, our Chemical Business recognized an impairment charge of $39.7 million to write-down the carrying value of our working interest in natural gas properties in the Marcellus Shale region to their estimated fair value of $22.5 million. The impairment charge represented the amount by which the carrying value of these natural gas properties exceeded the estimated fair value and was therefore not recoverable. The estimated fair value was determined based on estimated future discounted net cash flows, a Level 3 input, using estimated production and prices at which we reasonably expect natural gas will be sold, including the Evaluation provided by our independent consulting petroleum engineer in October 2015. The impairment was due to the decline in prices for natural gas futures, large natural gas price differentials in the Marcellus Shale region and changes in the drilling plans of these natural gas properties that caused certain of these properties to be reclassified from the “proved undeveloped reserves” category to the “probable undeveloped resources” category included in the Evaluation because those properties are no longer likely to be developed within five years. In addition during December 2015, our Chemical Business recognized an impairment charge of $3.5 million to write down the carrying value of certain plant assets related to certain ammonia production equipment at our Pryor Facility. The estimated fair value was determined based on an offer received from a possible buyer less estimated costs that would be incurred if the equipment is sold (Level 3 inputs). Accrued Warranty Costs - Our Climate Control Business sells equipment that has an expected life, under normal circumstances and use, which extends over several years. As such, we provide warranties after equipment shipment/start up covering defects in materials and workmanship. Our accounting policy and methodology for warranty arrangements is to measure and recognize the expense and liability for such warranty obligations at the time of sale using a percentage of sales and cost per unit of equipment, based upon our historical and estimated future warranty costs. We also recognize the additional warranty expense and liability to cover atypical costs associated with a specific product, or component thereof, or project installation, when such costs are probable and reasonably estimable. It is reasonably possible that our estimated accrued warranty costs could change in the near and long term. Generally for commercial/institutional products, the base warranty coverage for most of the manufactured equipment in the Climate Control Business is limited to eighteen months from the date of shipment or twelve months from the date of start-up, whichever is shorter, and to ninety days for spare parts. For residential products, the base warranty coverage for manufactured equipment in the Climate Control Business is limited to ten years from the date of shipment for material and to five years from the date of shipment for labor associated with the repair. The warranty provides that most equipment is required to be returned to the factory or an authorized representative and the warranty is limited to the repair and replacement of the defective product, with a maximum warranty of the refund of the purchase price. Furthermore, companies within the Climate Control Business generally disclaim and exclude warranties related to merchantability or fitness for any particular purpose and disclaim and exclude any liability for consequential or incidental damages. In some cases, the customer may purchase or a specific product may be sold with an extended warranty. The above discussion is generally applicable to such extended warranties, but variations do occur depending upon specific contractual obligations, certain system components, and local laws. Since 2003, our residential products warranty carried a ten-year standard parts warranty on the refrigerant circuit (including air coils, compressors, thermal expansion valves, water coils, and reversing valves) and five-years on the other components (motors being the major component). In 2010, the warranty policy was amended to include a full ten-year standard parts and five-year standard labor warranty. Without a full ten-year experience on the other components (motors), there is a risk we could incur higher than projected warranty costs over the next five years. At December 31, 2015 and 2014, our accrued product warranty obligations were $10.6 million and $8.8 million, respectively and are included in current and noncurrent accrued and other liabilities in the consolidated balance sheets. For 2015, 2014, and 2013, our warranty expense was $9.6 million, $7.9 million, and $7.4 million, respectively. Contingencies - Certain conditions may exist which may result in a loss, but which will only be resolved when future events occur. We and our legal counsel assess such contingent liabilities, and such assessment inherently involves an exercise of judgment. If the assessment of a contingency indicates that it is probable that a loss has been incurred, we would accrue for such contingent losses when such losses can be reasonably estimated. If the assessment indicates that a potentially material loss contingency is not probable but reasonably possible, or is probable but cannot be estimated, the nature of the contingent liability, together with an estimate of the range of possible loss if determinable and material, would be disclosed. Estimates of potential legal fees and other directly related costs associated with contingencies are not accrued but rather are expensed as incurred. Loss contingency liabilities are included in current and noncurrent accrued and other liabilities and are based on current estimates that may be revised in the near term. In addition, we recognize contingent gains when such gains are realized or realizable and earned. We are involved in various legal matters that require management to make estimates and assumptions, including costs relating to the lawsuit styled City of West, Texas v CF Industries, Inc., et al, discussed under “Other Pending, Threatened or Settled Litigation” of Note 11 to Consolidated Financial Statements included in this report. It is possible that the actual costs could be significantly different than our estimates. Regulatory Compliance - As discussed under “Environmental, Health and Safety Matters” in Item 1 of this report, our Chemical Business is subject to specific federal and state regulatory compliance laws and guidelines. We have developed policies and procedures related to regulatory compliance. We must continually monitor whether we have maintained compliance with such laws and regulations and the operating implications, if any, and amount of penalties, fines and assessments that may result from noncompliance. We will also be obligated to manage certain discharge water outlets and monitor groundwater contaminants at our Chemical Business facilities should we discontinue the operations of a facility. However, certain conditions exist which may result in a loss but which will only be resolved when future events occur relating to these matters. We are involved in various environmental matters that require management to make estimates and assumptions, including our current inability to develop a meaningful and reliable estimate (or range of estimate) as to the costs relating to a corrective action study work plan approved by the KDHE discussed under footnote 3 - Other Environmental Matters of Note 11. At December 31, 2015, liabilities totaling $0.4 million have been accrued relating to these issues as discussed. This liability is included in current accrued and other liabilities and is based on current estimates that may be revised in the near term. At the time that cost estimates for any corrective action are received, we will adjust our accrual accordingly. It is possible that the adjustment to the accrual and the actual costs could be significantly different than our current estimates. Redeemable Preferred Stocks and Warrants - On December 4, 2015, we issued the Series E and F Redeemable Preferred and Warrants. The redeemable preferred stocks are redeemable outside of our control and are classified as temporary/mezzanine equity on our consolidated balance sheet. In addition, certain embedded features (the “embedded derivative”) included in the Series E Redeemable Preferred required bifurcation and are classified as derivative liabilities. The Warrants issued in conjunction with our redeemable preferred stocks are standalone instruments, indexed to our common stock, and do not include provisions requiring liability classification. As a result, these warrants are classified as equity. The Series E and Series F Redeemable Preferred and Warrants were recorded at fair value upon issuance, net of issuance costs or discounts. The valuations are classified as Level 3. The Warrants were valued based on a Black-Scholes-Merton option pricing model and a Finnerty model to determine the estimated discount for lack of marketability resulting in an estimated fair value of $22.3 million. The Series E Redeemable Preferred was valued at an estimated fair value of $187.7 million (before issuance costs), with discounted cash flow models that calculates the present value of future cash flows using possible redemption scenarios and using published market yields for publicly traded unsecured fixed income securities with a similar credit ratings. No valuation input adjustments were considered necessary relating to the nonperformance risk for the Warrants or Series E Redeemable Preferred. Based on the terms of the Series F Redeemable Preferred, we determined that this share had minimal economic value. For the embedded derivative, the derivative was valued at the date of issuance and at December 31, 2015, with changes in fair value recorded in our statement of operations. The embedded derivative was valued using the underlying number of shares as defined in the terms of the Series E Redeemable Preferred and included the market price of our common stock on the date of valuation. The valuation is classified as Level 2. At December 4, 2015 and December 31, 2015, the embedded derivative was valued at an estimated fair value of $2.8 million and $3.3 million, respectively. No valuation input adjustments were considered necessary relating to nonperformance risk for the embedded derivative. The carrying value of the Series E Redeemable Preferred is being increased by periodic accretions (including the amount for dividends earned but not yet declared or paid) so that the carrying amount will equal the redemption value as of August 2, 2019, the earliest possible redemption date by the holder. At December 31, 2015, the carrying value of these redeemable preferred stocks was $177.3 million. Approximately $3 million of accretion was recorded to retained earnings in 2015. Management’s judgment and estimates in the above areas are based on information available from internal and external resources at that time. Actual results could differ materially from these estimates and judgments, as additional information becomes known.

<s>[INST] Overview General LSB is a manufacturing company operating through our subsidiaries. LSB and its whollyowned subsidiaries own the following core businesses: · Chemical Business manufactures and sells nitrogenbased chemical products for the agricultural, industrial, and mining markets it produces from four facilities located in El Dorado, Arkansas; Cherokee, Alabama; Pryor, Oklahoma; and Baytown, Texas. · Climate Control Business manufactures and sells a broad range of HVAC products that include water source and geothermal heat pumps, hydronic fan coils, large custom air handlers, modular geothermal and other chillers, and other related products and services. These products are primarily used in commercial/institutional and residential new buildings construction, renovation of existing buildings and replacement of existing systems. Our Climate Control Business manufactures and distributes its products from seven facilities located in Oklahoma City, Oklahoma. Key Expectations for 2016 The new ammonia plant at the El Dorado Facility was mechanically complete in February 2016 and should begin production early in the second quarter of 2016. We define mechanical completion as it relates to the El Dorado ammonia plant as having concluded the installation of process vessels and rotating equipment, including associated piping and valves. Additionally, utility equipment systems such as cooling water, steam generation, raw water treatment, and air systems, along with related piping, have been installed. Currently, all that remains to fully complete construction activities at the El Dorado ammonia plant is the connection of the electronic instrumentation wiring to the field instruments, along with the painting and insulation of the piping and process vessels, and the final grading and concrete containment for proper drainage of the process areas. Management and our Board, as previously announced, will continue to review strategic alternatives for our businesses in order to maximize shareholder value including asset sales and/or the separation of our two businesses. Additionally, once the El Dorado ammonia plant becomes operational, we intend to explore refinancing our capital structure. Key Capital Expenditure, Financing and Other Developments 2015 The El Dorado Facility has certain expansion projects underway, a portion of which have been completed. These expansion projects include an ammonia production plant; a new 65% strength nitric acid plant and nitric acid concentrator; and other support infrastructure. The new nitric acid concentrator went into production in June 2015, and the new nitric acid plant went into production during November 2015. The new ammonia plant was mechanically complete in February 2016 and should begin production early in the second quarter of 2016. During 2015, management in conjunction with the owner’s representative, the engineering, procurement and construction contractor and other consultants determined that the total cost to complete the El Dorado Expansion would exceed what we previously projected at the beginning of the year, due, in part, to an underestimation of the budgeted costs, work performed by a former subcontractor and mechanical and piping labor cost increases compared to earlier estimates. We have now determined that the total cost to complete the El Dorado Expansion is estimated to be in the range of $831 million to $855 million, of which $705 million was spent as of December 31, 2015 and $126 million to $150 million is estimated to be spent in 2016. Although we had begun seeking additional debt financing to address what were then our known costs of the El Dorado Expansion during the third quarter of 2015, the reluctance of existing bondholders to permit additional senior indebtedness unless we obtained additional equity caused us to reevaluate our financing plans and liquidity needs while we also worked to define the new cost estimates. As a result of that analysis, we concluded that our liquidity needs to complete the projects would exceed available debt financing, particularly in light of our existing debt covenants limiting the incurrence of additional indebtedness. Given that publicly offered financing would be unavailable before we had defined the cost estimates and the release of our 2015 third quarter results and would probably be unavailable even after those events, our options were either to obtain other financing solutions in order for us to continue the projects or delay or stop the projects during the fourth quarter of 2015 to [/INST] Positive. </s>

LSB INDUSTRIES INC

2017-02-27

2016-12-31

ITEM 7. MANAGEMENT’S DISCUSSION AND ANALYSIS OF FINANCIAL CONDITION AND RESULTS OF OPERATIONS The following Management’s Discussion and Analysis of Financial Condition and Results of Operations should be read in conjunction with a review of the other Items included in this Form 10-K and our December 31, 2016 Consolidated Financial Statements included elsewhere in this report. Certain statements contained in this MD&A may be deemed to be forward-looking statements. See “Special Note Regarding Forward-Looking Statements.” Overview General LSB is headquartered in Oklahoma City, Oklahoma and through its subsidiaries, manufactures and sells chemical products for the agricultural, mining, and industrial markets. We own and operate facilities in Cherokee, Alabama, El Dorado, Arkansas and Pryor, Oklahoma, and operate a facility, for Covestro in Baytown, Texas. Our products are sold through distributors and directly to end customers throughout the U.S. Key Initiatives for 2017 We believe our future results of operations and financial condition will depend significantly on our ability to successfully implement the following key initiatives: • Improving the on-stream rates of our chemical plants. We have made and continue to make: (1) upgrades to the operations teams at our chemical facilities; (2) investments of capital to enhance the reliability of each of our plants at each facility in order to reduce unplanned outages, unplanned downtimes, and the frequency of planned Turnarounds; and (3) continued efforts to focus on safety and efficiency throughout our entire operations. • Broadening the distribution of our AN and Nitric Acid products. Given the reduction in our LDAN sales from the declining use of coal, we have expanded our overall sales of HDAN through a number of marketing initiatives that have broadened our addressable market. Those initiatives have included, storing and distributing HDAN at our Pryor and Cherokee Facilities and selling to new markets and customers out of those facilities. In addition, through our marketing efforts, we are working on expanding our market for our nitric acid products to parts of the Western U.S. and Canada. • Reducing and controlling our cost structure. In 2016, we put in place SG&A expense reductions of approximately $6 million per year that we will realize beginning in 2017. In addition, beginning in 2017 we have reduced plant costs at each manufacturing facility by approximately $6 million. We continue to review our overall costs and believe that we will be able to further reduce costs during 2017. • Selling non-core assets. In 2016, we identified assets that are no longer necessary in the operations of our business. Those assets include our working interest in the natural gas properties in the Marcellus Shale, our engineered products business, certain pieces of equipment and certain real estate. In the fourth quarter of 2016, we sold a portion of this equipment for approximately $5 million and are in the process of selling certain other non-core assets, which we believe could generate an additional approximately $15 million to $20 million of net cash proceeds (net of any debt outstanding against these assets). • Evaluate strategic initiatives for our business. We have initiated a process to explore and evaluate potential strategic alternatives for our business, which may include a sale, a merger with another party, or another strategic transaction involving some or all of our assets. We have retained Morgan Stanley & Co. LLC as our financial advisor to assist with this process. We may not successfully implement any or all of these initiatives. Even if we successfully implement the initiatives, they may not achieve the beneficial results that we expect or desire. Business and Financing Developments - 2016 Sale of Climate Control Business On July 1, 2016, we completed the sale of our Climate Control Business to a subsidiary of NIBE for a total of $364 million before the customary adjustments set forth in the Stock Purchase Agreement. As a result, we recognized a pre-tax gain on the sale of approximately $282 million. At December 31, 2016, our accounts receivable included approximately $2.7 million relating to the sale of our Climate Control Business representing an indemnity escrow balance. Our current and noncurrent accrued and other liabilities also include approximately $5.5 million related to estimated contingent liabilities, costs in connection with the Transition Services Agreement (“TSA”) and certain severance agreements associated with the sale. See additional discussion in Note 2 to Consolidated Financial Statements included in this report. El Dorado Expansion During the second quarter of 2016, the new ammonia plant at our El Dorado Facility became operational and began producing ammonia at our nameplate capacity of 1,150 tons per day. However, the ammonia plant experienced unplanned downtime from various causes including a lightning strike, heat exchanger tube leaks and required modifications to the process vent system design to improve safety and reliability. As a result, our 2016 average on-stream rate for this plant since becoming operational was only 64% but has steadily improved on a quarterly basis with the on-stream rate for fourth quarter of 2016 at 73%. Since the ammonia plant became operational, the El Dorado Facility has been a net seller of ammonia. All ammonia that the facility has not upgraded into other products is sold to Koch Fertilizer LLC via pipeline under a previously reported three-year offtake agreement. As discussed below under “Liquidity and Capital Resources,” the final cost of the El Dorado expansion project was approximately $835 million. During 2016, the El Dorado Facility’s new nitric acid plant required several warranty repairs. After attempts to repair leaks in the nitric acid plant’s nitrous oxide abatement vessel, it was determined that this abatement vessel would need to be replaced under warranty provisions. In order to operate the nitric acid plant while a permanent solution was developed, we obtained a consent administrative order from the Arkansas Department of Environmental Quality (“ADEQ”) to allow the facility to by-pass the failed nitrous oxide abatement system and continue to operate the new nitric acid plant until April 2018. We made use of our secondary nitric acid plant at the El Dorado Facility and shipped product from our other facilities to ensure that customer demands were met while we designed and installed the by-pass system. We anticipate that the design, fabrication, and installation of a new nitrous oxide abatement vessel will be complete no later than April 2018 and all costs will be covered under warranty provisions. New and Amended Contracts UAN Purchase and Sale Agreement - We entered into a new UAN purchase and sale agreement with Coffeyville Resources Nitrogen Fertilizers, LLC (“CVR”) that became effective June 1, 2016. Under the agreement, CVR is purchasing all of the UAN produced at Pryor Chemical Company (“PCC”) in excess of the needs of PCC or its affiliates, which shall be no more than 30,000 tons per year. The initial term of the contract is for three years. This agreement replaced another agreement with a different customer. LDAN Purchase and Sale Agreement - We amended a purchase and sale agreement with one of our LDAN customers. The amendment reduced the required sales volumes and overall potential shortfall charges. In return, this customer will pay us a fee of $9 million, of which $6 million was received in 2016. The remaining fee of $3 million is due by March 31, 2017. Income associated with these payments is being deferred and recognized over the contract term. Redemption of Portion of Series E Redeemable Preferred and Senior Secured Notes In September 2016, we completed a consent solicitation to effect the certain amendments to the Original 7.75% Indenture (the “Indenture Amendments”) and entered into a Supplemental Indenture (the “Supplemental Indenture”) as discussed in Note 9 to Consolidated Financial Statements included in this report. As a result, in September 2016, we redeemed 70,232 shares of the Series E Redeemable Preferred Stock for approximately $80 million, which includes $78.3 million related to the liquidation preference of $1,000 per share and accumulated dividends and $1.7 million related to the participation rights value associated with the redeemed shares. In October 2016, we called debt totaling approximately $107 million (including accrued interest) as follows: • $50 million of 12% Senior Secured Notes due 2019 at a call price of 106% plus accrued interest and; • $50 million of 7.75% Senior Secured Notes due 2019 at a call price of 103.875% plus accrued interest. Those payments, along with the Series E Redemption, were funded with proceeds from the sale of our Climate Control Business. See further discussion under “Liquidity and Capital Resources.” Key Industry Factors Supply and Demand Agricultural Sales of our agricultural products were approximately 44% of our total net sales for 2016. The price at which our agricultural products are ultimately sold depends on numerous factors, including the supply and demand for nitrogen fertilizers which, in turn, depends upon world grain demand and production levels, the cost and availability of transportation and storage, weather conditions, competitive pricing and the availability of imports. Additionally, expansions or upgrades of competitors’ facilities and international and domestic political and economic developments continue to play an important role in the global nitrogen fertilizer industry economics. These factors can affect, in addition to selling prices, the level of inventories in the market which can cause price volatility and effect product margins. One of the key factors that affects demand of our agricultural products is corn prices. Changes in corn prices can affect the number of acres of corn planted in a given year, and the number of acres planted will drive the level of nitrogen fertilizer consumption, likely effecting prices. The World Agricultural Supply and Demand Estimates Report (“WASDE”), dated January 12, 2017, estimates U.S. corn production for 2016 of 15.1 billion bushels, up 11% from 2015, reflecting an increase in planted and harvested areas, in addition to higher yields per acre. In addition, this report estimates world corn ending stocks for 2016/2017 at 220.9 million tons, an increase over 2015/2016 ending stocks of approximately 5% and U.S. corn ending stock of 59.8 million tons, an increase of approximately 36% over the prior year. Despite the increase in ending stocks, the USDA is estimating that U.S. growers will plant 90 to 91 million acres of corn in 2017, a decrease of only approximately 4 million acres from the previous year. Given the low price of natural gas in North America over the last several years, North American fertilizer producers have become the global low cost producers for delivered fertilizer products to the Midwest U.S. Several years ago, the market believed that low natural gas prices would continue. That belief, combined with favorable fertilizer pricing, led to the announcement of numerous expansions of existing nitrogen chemical facilities and the construction of new nitrogen chemical facilities. Since those announcements, fertilizer pricing has been in continuous decline and many of the announced expansions and new nitrogen chemical facilities have been cancelled. However, approximately 5 million tons of annual ammonia production capacity has either been added or are expected to be added by the end of 2017. Ammonia production in North America will increase from approximately 15 million tons annually to approximately 20 million tons annually, replacing most of the ammonia that has been imported into North America to cover the annual demand of approximately 21 million tons. Additional domestic supply of ammonia will also change the physical flow of ammonia in North America. However, since most of the added domestic ammonia production will come with additional production capacity for upgraded nitrogen products (Urea, UAN and DEF), North America will continue to import between 2 million to 3 million tons of ammonia annually. All of this has created uncertainty in the fertilizer markets and has put pressure on all fertilizer prices in North America that, we believe, will last throughout 2017. However, since the fertilizer market is seasonal, selling prices and demand will increase ahead of the spring season and remain until the end of that season with prices typically falling after the spring season. Industrial Sales of our industrial products were approximately 42% of our total net sales for 2016. Our industrial products sales volumes are dependent upon general economic conditions primarily in the housing, automotive, and paper industries. According to the American Chemistry Council, the U.S. economic indicators continue to be mostly positive for these sectors domestically. Our sales prices generally vary with the market price of our feedstock (ammonia or natural gas, as applicable) in our pricing arrangements with customers. Mining Sales of our mining products were approximately 12% of our total net sales for 2016. Our mining products are LDAN and AN solutions, which are primary used as AN fuel oil and specialty emulsions for surface mining of coal and for usage in quarries and the construction industry. As reported by the EIA, annual coal production in the U.S. for the full year of 2016 is estimated to be down 17% from 2015 and at its lowest level since 1978 continuing an eight-year decline. EIA is forecasting a 7% increase in U.S. coal production from coal-fired electricity generation in 2017 and a slight increase from 2017 to 2018. We believe that coal production in the U.S. continues to face significant challenges from competition from natural gas and renewables. While we believe, our plants are well-located to support the more stable coal-producing regions in the upcoming years, our current mining sales volumes are being affected by overall lower customer demand for LDAN. We do not expect a significant increase in our mining business in the near term. Farmer Economics The demand for fertilizer is affected by the aggregate crop planting decisions and fertilizer application rate decisions of individual farmers. Individual farmers make planting decisions based largely on prospective profitability of a harvest, while the specific varieties and amounts of fertilizer they apply depend on factors such as their financial resources, soil conditions, weather patterns and the types of crops planted. Natural Gas Prices Natural gas is the primary feedstock for the production of nitrogen fertilizers at our Cherokee and Pryor Facilities and, with the completion of the construction of the ammonia plant, at our El Dorado Facility beginning in the third quarter of 2016. In recent years, U.S. natural gas reserves have been increasing significantly due to, among other factors, advances in extracting shale gas, which has reduced and stabilized natural gas prices, providing North America with a cost advantage over certain imports. As a result, our competitive position and that of other North American nitrogen fertilizer producers have been positively affected. We historically have purchased natural gas in the spot market, through the use of forward purchase contracts, or through a combination of both and have used forward purchase contracts to lock in pricing for a portion of our natural gas requirements. These forward purchase contracts are generally either fixed-price or index-price, short-term in nature and for a fixed supply quantity. We are able to purchase natural gas at competitive prices due to our connections to large distribution systems and their proximity to interstate pipeline systems. Over the past several years, natural gas prices have experienced significant downward fluctuations, which have had a positive effect on our cost of producing nitrogen fertilizer. The following table shows the annual volume of natural gas we purchased and the average cost per MMBtu: (1) The increase in volume in 2016 is primarily attributed to the new ammonia plant at the El Dorado Facility and higher overall ammonia operating rates at our plants. As of December 31, 2016, we had volume purchase commitments with a fixed cost for natural gas of approximately 2.4 million MMBtus at an average cost of $3.20 per MMBtu. These commitments are for firm purchases during the first quarter of 2017 and represent approximately 41% of our total exposed natural gas usage required for that period. In January 2017, we increased our volume purchase commitments with a fixed cost for natural gas to approximately 3.4 million MMBtus at an average cost of $3.28 per MMBtu. With the additional commitments, which now extend through June 2017, we have approximately 53% of our total exposed natural gas usage requirements at an average price of $3.28 for the first quarter of 2017 and 20% of our total exposed natural gas usage requirements at an average price of $3.35 for the second quarter of 2017. Transportation Costs Costs for transporting nitrogen based products can be significant relative to their selling price. For example, ammonia is a hazardous gas at ambient temperatures and must be transported in specialized equipment, which is more expensive than other forms of nitrogen fertilizers. In recent years, a significant amount of the ammonia consumed annually in the U.S was imported. Therefore, nitrogen fertilizers prices in the U.S. are influenced by the cost to transport product from exporting countries, giving domestic producers who transport shorter distances an advantage. Key Operational Factors Facility Reliability Consistent, reliable and safe operations at our chemical plants are critical to our financial performance and results of operations. The financial effects of planned downtime at our plants, including Turnarounds is mitigated through a diligent planning process that takes into account the availability of resources to perform the needed maintenance, feedstock logistics and other factors. Unplanned downtime of our plants typically results in lost contribution margin from lost sales of our products, lost fixed cost absorption from lower production of our products and increased costs related to repairs and maintenance. All Turnarounds result in lost contribution margin from lost sales of our products, lost fixed cost absorption from lower production of our products, and increased costs related to repairs and maintenance, which repair and maintenance costs are expensed as incurred. Our Pryor Facility is on a one-year Turnaround cycle and we expect to perform a Turnaround in the fourth quarter of 2017. Annual Turnarounds will continue through 2019 and at that time we expect to move to a two-year Turnaround cycle. At our El Dorado Facility, historically, we were able to perform Turnaround projects on individual plants without shutting down the entire facility as we have redundancy for most of our produced products. The effect of lost production from those have not been significant. With the completion of the new ammonia plant, the facility will begin to schedule traditional Turnarounds that will require the ammonia plant to be taken out of production and will cause a financial effect from lost production. This Facility will initially be on a two-year Turnaround cycle with its initial Turnaround scheduled for 2018. Our Cherokee Facility is on a two-year Turnaround cycle, with the last Turnaround being performed in the third quarter of 2016. The next Turnaround to be performed is expected to occur in the third quarter of 2018 at which time we expect to move to a three-year Turnaround cycle. Prepay Contracts We use forward sales of our fertilizer products to optimize our asset utilization, planning process and production scheduling. These sales are made by offering customers the opportunity to purchase product on a forward basis at prices and delivery dates that are agreed upon. We use this program to varying degrees during the year depending on market conditions and our view of changing price environments. Fixing the selling prices of our products months in advance of their ultimate delivery to customers typically causes our reported selling prices and margins to differ from spot market prices and margins available at the time of shipment. Consolidated Results for 2016 Our consolidated net sales for 2016 were $374.6 million compared to $437.7 million for 2015. Our consolidated operating loss was $90.2 million compared to $71.2 million for 2015. The items affecting our operating results are discussed below and under “Results of Operations.” Items Affecting Comparability of Results On-Stream Rates The on-stream rates of our plants affect our production, the absorption of fixed costs of each plant and sales of our products. It is a key operating metric that we use to manage our business. In particular, we closely monitor the on-stream rates of our ammonia plants as that is the basic product used to produce all upgraded products. In 2016, we improved the operating rates at both our Cherokee and Pryor ammonia plants. At our Cherokee Facility, the on-stream rate (excluding the effect from its scheduled Turnaround) for 2016 for our ammonia plant increased to 96% from 94% in 2015. We expect on-stream rates to continue at this level in 2017. At our Pryor Facility, the on-stream rate (excluding the effect from its scheduled Turnaround) for 2016 for our ammonia plant increased to 86% from 83% in 2015. Although the rate increased, it fell below our expectations. We believe that the capital improvements made to the ammonia plant in 2016 will improve the on-stream rate for 2017 to between 90% and 95%. We expect on-stream rates to continue at this level in 2017. The El Dorado Facility’s ammonia plant began production in mid-2016. It is typical for newly operated plants that are in production to go through a period of optimization (Shakedown) that may require the plant to be taken out of operation for a period of time. Our reported 2016 on-stream rate for the ammonia plant at El Dorado was 64%. However, since going into operation, the on-stream rate has steadily improved on a quarterly basis with the on-stream rate for the fourth quarter of 73%. The on-stream rate has continued to improve in the first quarter of 2017 and we believe that the ammonia plant will operate at approximately a 95% on-stream rate for 2017. The plant is currently producing ammonia in excess of 1,300 tons per day, which is above its nameplate capacity of 1,150 tons per day. Selling Prices During 2016, selling prices for our agricultural products declined significantly over 2015 selling prices. Average selling prices for our ammonia, UAN and HDAN decreased 34%, 30% and 28%, respectively compared to 2015 average selling prices. The decreases in overall agricultural products selling prices were caused by lower corn prices in 2016 compares to 2015, lower natural gas prices year-over-year and the addition of nitrogen production capacity being added globally in 2016 and 2017 and this additional supply’s expected effect on the supply/demand balance in the U.S. Depreciation Expense During 2016 and 2015, depreciation expense was $59.4 million and $35.9 million, respectively. The increase is primarily due to our El Dorado expansion project being completed and placed into service during the second quarter of 2016. Certain Startup, One-Time, Warranty and Other Expenses During 2016, the El Dorado Facility’s new ammonia plant became operational. We estimate that our operating costs were $5.1 million higher during the first half of 2016, as a result of start-up and commissioning activities related to the new ammonia plant. The El Dorado Facility’s new nitric acid plant incurred certain expenses after start-up for which we believe a portion will be covered under our warranty provisions. The estimated impact on our operating results for 2016 was approximately $8 million to $9 million. During 2016, EDC incurred a one-time fee of $12.1 million related to consulting services associated with the reduction of assessed property values for the El Dorado projects real and personal property for both the nitric acid plant, nitric acid concentrator plant and the ammonia plant. We expect material property tax savings in future periods through a reduction of property taxes paid. During 2015, we incurred certain one-time corporate SG&A costs relating to severance agreements with former executives of $2.0 million. Debt and Interest Expense For 2016 and 2015, interest expense was $30.9 million and $7.4 million, net of capitalized interest of $15.0 million and $30.6 million, respectively. Interest was capitalized based upon construction in progress of the El Dorado expansion project, which was completed during the second quarter of 2016. In addition, interest expense increased $4.5 million relating to the 12% Senior Secured Notes sold in November 2015 and repaid in October 2016 and $2.2 million, as a result of the debt modification associated with the Consent Solicitation in 2016. Loss on Extinguishment of Debt As discussed above under “Business and Financing Developments - 2016”, in October 2016, we called debt totaling $106.9 million (including accrued interest) to redeem all of the outstanding $50 million of the 12% Senior Secured Notes due 2019 at the original redemption price of 106% plus accrued interest and $50 million of the 7.75% Senior Secured Notes due 2019 at the original redemption price of 103.875% plus accrued interest. As a result of this transaction, we recognized a loss on extinguishment of debt of approximately $8.7 million. Impairment of Natural Gas Properties (2015 only) As previously reported during third quarter of 2015, we recognized a non-cash impairment charge of $39.7 million to write-down the carrying value of our working interest in natural gas properties in the Marcellus Shale region to the estimated fair value. In addition, we recognized a $3.5 million non-cash impairment charge to reduce the carrying value of certain plant assets related to unused ammonia production equipment at our Pryor Facility. Results of Operations The following Results of Operations should be read in conjunction with our consolidated financial statements for the years ended December 31, 2016, 2015, and 2014 and accompanying notes and the discussions under “Overview” and “Liquidity and Capital Resources” included in this MD&A. We present the following information about our results of operations. Net sales to unaffiliated customers are reported in the consolidated financial statements and gross profit represents net sales less cost of sales. Net sales are reported on a gross basis with the cost of freight being recorded in cost of sales. Year Ended December 31, 2016 Compared to Year Ended December 31, 2015 The following table contains certain financial information relating to our continuing operations: (1) As a percentage of net sales The following tables provide key operating metrics for the Agricultural Products: With respect to sales of Industrial, Mining and Other Chemical Products, the following table indicates the volumes sold of our major products: Net Sales In general, for 2016, our agricultural sales were lower, influenced by lower selling prices for ammonia, UAN and HDAN, partially offset by higher sales volume from improved on-stream rates at our facilities in 2016 as discussed under “Items Affecting Comparability”. Industrial products sales and mining sales both decreased due primarily to lower selling prices partially offset by higher overall sales volumes. In addition, other products, which includes our natural gas working interest, decreased as natural gas sales prices and volumes declined in 2016 compared to 2015. • Agricultural products comprised approximately 44% and 48% of our net sales for 2016 and 2015, respectively. Agricultural sales decreased as our average selling prices per ton of our products were significantly lower for 2016 compared to 2015. This reduction in selling prices was partially offset by an increase in sales volumes for HDAN, UAN and Ammonia. The increase in HDAN sales volume was driven by a strong spring fertilizer season which increased our customer demand and expanded our customer base during 2016. The higher UAN and ammonia sales volumes were primarily due to higher production at our Pryor Facility in 2016 compared to 2015 partially offset by lower production and sales volumes at our Cherokee Facility due to performing a bi-annual Turnaround in 2016. • Industrial acids and other chemical products sales decreased primarily as the result of lower overall product selling prices. A majority of our sales of these products are tied to the cost of our feedstock, primarily natural gas and ammonia, which are passed through as part of the selling prices to our customers. Our feedstock costs were lower in 2016 compared to 2015. The decrease in selling prices was partially offset by higher sales volume of ammonia as our El Dorado Facility began producing ammonia during the second quarter of 2016 compared to no production in 2015. • Mining products sales decreased primarily due to lower product selling prices as a majority of our sales from these products are tied to the cost of our feedstock, primarily natural gas and ammonia, which are passed through as part of the selling prices to our customers. Our feedstock costs were lower in 2016 compared to 2015. Additionally, our Cherokee Facility performed its bi-annual Turnaround in 2016 which reduced the production of AN solution for 2016. The reduction in production at our Cherokee Facility was partially offset by an increase in sales volume of LDAN at our El Dorado Facility. • Other products consist of natural gas sales from our working interests in certain natural gas properties and sales of industrial machinery and related components. The decrease in other products is primarily due to lower realized sales prices out of the Marcellus Shale region combined with lower production volumes in 2016 compared to 2015. During 2016, the operator of these properties elected to slow well development due to the decline in natural gas sales prices. They are currently reevaluating their development program as natural gas prices have increased making certain wells economical to develop. Gross Profit As noted in the table above, we incurred a gross loss of $49.3 million in 2016 compared to gross profit of $20.0 million in 2015, or a decrease in gross profit of approximately $69.3 million. In addition to the negative effect from lower sales discussed above, 2016 includes a one-time cost of $12.1 million relating to consulting services associated with the reduction of property taxes from fixing the assessed value for our El Dorado Facility, costs incurred relating to the start-up and commissioning activities at our El Dorado expansion project, increased repair expenses associated with unplanned downtime experienced at our Cherokee, Pryor and El Dorado Facilities, an increase in overall depreciation expense partially offset by improved feedstock costs from lower average natural gas prices and our El Dorado Facility producing ammonia from natural gas compared to purchasing ammonia for a portion of the year. See discussion above under “Items Affecting Comparability of Results.” Selling General and Administrative Expense Our SG&A expenses were $40.2 million for 2016, a decrease of $9.6 million compared to 2015. The decrease includes a $4.5 million reduction in expenses related to shareholder activities, $3.8 million reduction in overall compensation related costs, and $1.5 million reduction in training expenses partially offset by an increase of $1.5 million in legal fees related primarily to our review of strategic initiatives and updates to our corporate governance practices and policies. Impairment of Long-Lived Assets and Goodwill During 2016, we recognized a non-cash impairment charge of $1.6 million to fully write-off the carrying value of goodwill. In 2015, we recognized non-cash impairment charges totaling $43.2 million, consisting of an impairment charge of $39.7 million to reduce the carrying value of our working interest in natural gas properties and a $3.5 million impairment charge to reduce the carrying value of certain plant assets related to unused ammonia production equipment at our Pryor Facility. Interest Expense, net Interest expense for 2016 was $30.9 million compared to $7.4 million for 2015. The increase is due primarily to a reduction in capitalized interest during 2016 of $15.6 million as a result of the El Dorado expansion project completion. In addition, $4.5 million of the increase in interest expense relates to the 12% Senior Secured Notes sold in November 2015 and repaid in October 2016 and $2.2 million as a result of the debt modification of the Senior Secured Notes in 2016. Loss on Extinguishment of Debt As a result of the repayment of $50 million of the 7.75% Senior Secured Notes and all of our 12% Senior Secured Notes in 2016, we incurred a loss on extinguishment of debt of $8.7 million, consisting of prepayment premiums and writing off associated unamortized debt issuance costs. Benefit for Income Taxes The benefit for income taxes for 2016 was $42 million compared to $32.5 million for the same period in 2015. The effective tax rate was 32% for 2016 and 41% for 2015. The decrease in the benefit rate is primarily related to the increased valuation allowance established on state net operating losses that we anticipate will not be able to utilized prior to expiration. Income from Discontinued Operations, net of taxes As previously reported, the results of operations of the Climate Control Business have been presented as discontinued operations. For 2016, income from discontinued operations was $200.3 million, including a gain of $282 million and net of a tax provision of $91.7 million. For 2015, income from discontinued operations was $11.4 million, net of a tax provision of $9 million. Year Ended December 31, 2015 Compared to Year Ended December 31, 2014 The following table contains certain financial information relating to our continuing operations: (1) As a percentage of net sales Net Sales Our sales in the agricultural markets primarily were at the spot market price in effect at the time of sale or at a negotiated future price. The majority of our sales in the industrial and mining markets were pursuant to sales contracts and/or pricing arrangements on terms that include the cost of raw material feedstock as a pass-through component in the sales price. In general, for 2015 our agricultural sales were lower due to lower sales volumes for HDAN, ammonia and our other agricultural products due to unusually wet application seasons and lower prices for HDAN and UAN partially offset by higher UAN sales volumes. Mining sales also declined primarily due to lower sales prices and volumes while sales of industrial products decreased slightly with lower prices partially offset by higher sales volumes. In addition, natural gas sales prices and volumes declined in 2015 compared to 2014. • Agricultural products comprised approximately 47.9% and 46.4% of our net sales for 2015 and 2014, respectively. The sales decline of 8.8% over 2014 sales was driven by a slight overall decline in sales volumes with lower HDAN, ammonia and other agricultural products sales volumes partially offset by higher UAN sales volumes. The higher UAN sales volumes were primarily due to higher production at our Cherokee and Pryor Facilities in 2015 compared to 2014 when we performed a bi-annual turnaround at the Cherokee Facility. Compounding the slight decline in sales volumes was a decrease in our average product selling prices per ton in 2015 with UAN down 9% and HDAN down 1%. These lower selling prices were attributable to lower natural gas and other commodity prices coupled with lower urea selling prices caused by the large amount of imports, placing downward pressure on selling prices. Ammonia prices were essentially unchanged for 2015 compared to 2014. • Industrial acids and other chemical products sales increased as a result of increased volumes at the Baytown Facility (which performed a Turnaround in 2014, but not in 2015) and at our Cherokee Facility, partially offset by lower prices from the pass-through of decreased ammonia costs to contractual customers and lower volumes from the El Dorado Facility due to lower customer demand. • Mining products sales decreased primarily due to lower sales of LDAN resulting from the expiration of the take-or-pay Orica Agreement in April 2015 compared to the contract being in place for the full year in 2014 and lower sales volumes for the balance of 2015 due to being a high cost producer and not competitive in the marketplace. Additionally, lower sales volumes of AN solution at our Cherokee Facility are the result from a continued decline of demand for mining products in the Appalachian region combined with lower selling prices contributed to lower mining sales. • Other products consist of natural gas sales from our working interests in certain natural gas properties and sales of industrial machinery and related components. The decrease in other products is primarily due to lower realized sales prices out of the Marcellus Shale region combined with lower production volumes in 2015 compared to 2014 as the operator of these properties has slowed development due to the decline in natural gas sales prices. Gross Profit Our gross profit decreased $45.4 million in 2015 when compared to 2014. Excluding the business interruption insurance recoveries of $22.9 million in 2014, the decrease in gross profit in 2015 compared to 2014 was $22.5 million. The decrease of $22.5 million was primarily due to the loss of the margin contribution relating to the expiration of the Orica Agreement, lost absorption of fixed overhead costs associated with lower production of HDAN, lower average sales prices, and increased operating costs including railcar lease costs, partially offset by the higher overall on-stream rate at the Cherokee Facility and lower natural gas feedstock costs. Natural gas feedstock costs decreased approximately 25% but that was partially offset by operating losses incurred relating to our working interests in certain natural gas properties. Selling General and Administrative Expense Our SG&A expenses were $49.8 million for 2015, an increase of $10.8 million compared to 2014. The increase was primarily driven by an increase in personnel related expenses of $7.4 million including one-time severance payments of approximately $2.0 million for certain senior executives and training expenses of $1.4 million primarily related to the expansion related activities at the El Dorado Facility. In addition, professional fees increased $1.3 million for legal and investment banking services related to various financing activities, auditing and other accounting services and other consulting services. Impairment of Long-Lived Assets In 2015, we recognized non-cash impairment charges totaling $43.2 million, consisting of an impairment charge of $39.7 million to reduce the carrying value of our working interest in natural gas properties and a $3.5 million impairment charge to reduce the carrying value of certain plant assets related to unused ammonia production equipment at our Pryor Facility. Other Expense (Income), net In 2015, other income was $1.8 million compared to other expense of $1.0 million in 2014. During 2015, we recognized other income of $0.9 million relating to a litigation settlement and other miscellaneous items and $0.9 million related to the sale of carbon credits. In 2014, we recognized other expense of $1.0 million primarily relating to losses on sales and disposal of PP&E. Interest Expense, net Interest expense for 2015 was $7.4 million compared to $21.6 million for 2014. The decrease is due primarily to capitalized interest on capital projects under development and construction, of which $30.6 million was capitalized in 2015 compared to $14.1 million during 2014. Provision (benefit) for Income Taxes The benefit for income taxes from continuing operations for 2015 was $32.5 million compared to a provision of $4.3 million for the same period in 2014. The effective tax rate was 41% for 2015 and 46% for 2014. Income from Discontinued Operations, net of taxes The results of operations of the Climate Control Business have been presented as discontinued operations. For 2015, income from discontinued operations was $11.4 million, net of a tax provision of $9 million. For 2014, income from discontinued operations was $14.6 million, net of a tax provision of $8.1 million. LIQUIDITY AND CAPITAL RESOURCES The following summarizes our continuing cash flow activities for 2016: Cash Flow from Continuing Operating Activities For 2016, net cash used by continuing operating activities was $22.2 million, primarily as the result of net income of $112.2 million less an adjustment of $200.3 million for net income from discontinued operations and an adjustment of deferred income taxes of $42 million, plus adjustments of $59.4 million for depreciation, depletion and amortization of PP&E, $8.7 million for a loss on extinguishment of debt, other noncash adjustments totaling approximately $12.3 million and $27.5 million net cash provided from our working capital. Cash Flow from Continuing Investing Activities For 2016, net cash provided by continuing investing activities was $153.3 million that consisting of $356.7 million of net proceeds from the sale of the Climate Control Business and $9.1 million associated with other activities partially offset by $212.5 million of cash used for expenditures for PP&E. Cash Flow from Continuing Financing Activities For 2016, net cash used by continuing financing activities was $193.6 million, primarily related to the payments on the 7.75% and 12% Senior Secured Notes totaling $100 million, the redemption of a portion of the Series E Redeemable Preferred including dividends of approximately $80 million, payments on long-term debt of $15.4 million and payments of debt and equity modification, extinguishment and issuance costs of $13.1 million partially offset by net proceeds from long-term debt financing of approximately $14.8 million. Capitalization The following is our total current cash, long-term debt, redeemable preferred stock and stockholders’ equity: (1) Liquidation preference of $161.8 million as of December 31, 2016. In July 2016, we sold our Climate Control Business for a total of $364 million before customary adjustments set forth in the Stock Purchase Agreement. In September 2016, holders of our Senior Secured Notes agreed to allow us to redeem a portion of the Series E Redeemable Preferred and to call a portion of the Senior Secured Notes and all of the 12% Senior Secured Notes. In September 2016, we used $80 million to redeem a portion of the Series E Redeemable Preferred (including accumulated dividends and participation rights value). In October 2016, we used approximately $107 million to redeem $50 million of the 7.75% Senior Secured Notes and all of the 12% Senior Secured Notes (including accrued interest and the redemption prices). We currently have a revolving credit facility, our Working Capital Revolver Loan, with a borrowing base of $50 million. As of January 31, 2017, our Working Capital Revolver Loan was undrawn and had $40.5 million of availability. As discussed below, we have planned capital additions relating to maintaining and enhancing safety and reliability at our facilities of approximately $30 million to $35 million for 2017. We believe that the combination of our cash on hand, the availability on our revolving credit facility (amended in January 2017) as discussed below under “Loan Agreements and Redeemable Preferred Stock,” and our cash from operations will be sufficient to fund our anticipated liquidity needs for the next twelve months. In addition, as discuss above under “Overview-Key Initiatives”, we have determined that certain non-core assets are not necessary in the operations of our business. In December 2016 we sold a non-core asset for approximately $5 million and are working on the sale of other assets including our working interest in the Marcellus Shale, our engineered products business and certain pieces of equipment and real estate. We believe that these assets could generate between approximately $15 million and $20 million in net cash proceeds, if sold. Compliance with Long - Term Debt Covenants As discussed below under “Loan Agreements,” the Working Capital Revolver Loan requires, among other things, that we meet certain financial covenants. The Working Capital Revolver Loan does not include financial covenant requirements unless a defined covenant trigger event has occurred and is continuing. As of December 31, 2016, no trigger event had occurred. Loan Agreements and Redeemable Preferred Stock Senior Secured Notes due 2019 - Pursuant to the terms of the Supplemental Indenture and subsequent redemption of $50 million of the 7.75% Senior Secured Notes and all of the $50 million 12% Senior Secured Notes during 2016 as discussed in Note 9 of Notes to Consolidated Financial Statements included in this report, the remaining $375 million Senior Secured Notes bears an annual interest rate of 8.5%. Interest is to be paid semiannually on February 1st and August 1st. Secured Promissory Note due 2017 - On April 1, 2016, Zena Energy L.L.C. (“Zena”), one of our subsidiaries, entered into the second amended and restated note (the “Amended Note”) with its original lender. Principal and interest are payable in 20 monthly installments with the first installment made on May 1st. Interest is based on the LIBOR rate plus 300 basis points. The terms of the promissory note were not changed by this amendment. The Amended Note matures on December 1, 2017. The Amended Note continues to be secured by certain working interests and related properties and proceeds and is guaranteed by LSB. Secured Promissory Note due 2019 - On February 5, 2016, EDC entered into a secured promissory note due 2019 for an original principal amount of $10 million. The secured promissory note due 2019 bears interest at the rate of 5.73% per annum and matures on June 29, 2019. Principal and interest are payable in 40 equal monthly installments with a final balloon payment of approximately $6.7 million. The Secured Promissory Note due 2019 is secured by the cogeneration facility equipment and is guaranteed by LSB. Secured Promissory Note due 2021 - On April 9, 2015, EDC entered into a secured promissory note due 2021 for an original principal amount of approximately $16.2 million. The Secured Promissory Note due 2021 bears interest at the rate of 5.25% per year and matures on March 26, 2021. Interest only is payable monthly for the first 12 months of the term. Principal and interest are payable monthly for the remaining term of the Secured Promissory Note due 2021. This Secured Promissory Note due 2021 is secured by a natural gas pipeline at the El Dorado Facility and is guaranteed by LSB. Secured Promissory Note due 2023 - On September 16, 2015, El Dorado Ammonia L.L.C. (“EDA”), one of our subsidiaries, entered into a secured promissory note with an initial funding of $15 million and a maximum principal note amount of $19.8 million. On May 13, 2016 (the “Loan Conversion Date”), the remainder of the funding of $4.8 million was drawn and the outstanding principal balance of $19.8 million was converted to a seven-year secured term loan requiring 83 equal monthly principal and interest payments with a final balloon payment of approximately $6.1 million. This Note bears interest at a rate that is based on the monthly LIBOR rate plus a base rate for a total of 4.87%. The Secured Promissory Note is secured by the ammonia storage tank and related systems and is guaranteed by LSB. Working Capital Revolver Loan - Effective January 17, 2017, LSB and certain of its subsidiaries entered into the Third Amended and Restated Loan and Security Agreement (the “Working Capital Revolver Loan Amendment”), which amends and restates the existing working capital revolver (as so amended and restated, the “Working Capital Revolver Loan”). Pursuant to the terms of the Working Capital Revolver Loan, borrowers may borrow on a revolving basis up to $50 million. Obligations under the Working Capital Revolver Loan are secured by a first-priority security interest in substantially all of the borrower’s current assets, including accounts receivable and inventory. The agreement provides that the Senior Secured Notes secure the Working Capital Revolver Loan on a second-priority basis. The Working Capital Revolver Loan provides for the issuances of letters of credit in an aggregate amount not to exceed to $10 million, with the outstanding amount of any such letters of credit reducing availability for borrowings under the Working Capital Revolver Loan. The maturity date of the Working Capital Revolver Loan is January 17, 2022, with a springing earlier maturity date (the “Springing Maturity Date”) that is 90 days prior to the maturity date of the currently existing senior notes (the “Senior Notes”), to the extent the Senior Notes are not refinanced or repaid prior to the Springing Maturity Date. At January 31, 2017, there were no outstanding borrowings under the Working Capital Revolver Loan. At January 31, 2017, the net credit available for borrowings under our Working Capital Revolver Loan was approximately $40.5 million, based on our eligible collateral, less outstanding letters of credit as of that date. The Working Capital Revolver Loan Amendment also provides for a springing financial covenant (the “Financial Covenant”), which requires that, if the borrowing availability is less than or equal to the greater of 10.0% of the total revolver commitments and $5 million, then the borrowers must maintain (a) with respect to relevant periods ending on or prior to September 30, 2017, a minimum EBITDA in the amount set forth in the Working Capital Revolver Loan Amendment and (b) with respect to relevant periods ending after September 30, 2017, a minimum fixed charge coverage ratio of not less than 1.00:1.00. The Financial Covenant, if triggered, is tested monthly. Also, see Note 21 of Notes to Consolidated Financial Statements included in this report for additional information on this credit facility. Redemption of Series E Redeemable Preferred - As discussed above under “Business and Financing Developments - 2016”, in September 2016, we successfully completed the consent solicitation initiated in August 2016 to affect amendments to the Original 7.75% Indenture and entered into the Supplemental Indenture. As a result, in September 2016, we redeemed 70,232 shares of the Series E Redeemable Preferred for approximately $80 million, which includes $78.3 million for the liquidation preference of $1,000 per share and accumulated dividends and $1.7 million for the participation rights value associated with the redeemed shares. At December 31, 2016, there were 139,768 outstanding shares of Series E Redeemable Preferred. At any time on or after August 2, 2019, each Series E holder has the right to elect to have such holder’s shares redeemed by us at a redemption price per share equal to the liquidation preference per share of $1,000 plus accrued and unpaid dividends plus the participation rights value (the “Liquidation Preference”). Additionally, at our option, we may redeem the Series E Redeemable Preferred at any time at a redemption price per share equal to the Liquidation Preference of such share as of the redemption date. Lastly, with receipt of (i) prior consent of the electing Series E holder or a majority of shares of Series E Redeemable Preferred and (ii) all other required approvals, including under any principal U.S. securities exchange on which our common stock is then listed for trading, we can redeem the Series E Redeemable Preferred by the issuance of shares of common stock having an aggregate common stock price equal to the amount of the aggregate Liquidation Preference of such shares being redeemed in shares of common stock in lieu of cash at the redemption date. In the event of liquidation, the Series E Redeemable Preferred is entitled to receive its Liquidation Preference before any such distribution of assets or proceeds is made to or set aside for the holders of our common stock and any other junior stock. In the event of a change of control, we must make an offer to purchase all of the shares of Series E Redeemable Preferred outstanding at the Liquidation Preference. Since carrying values of the redeemable preferred stocks are being increased by periodic accretions (including the amount for dividends earned but not yet declared or paid) using the interest method so that the carrying amount will equal the redemption value as of August 2, 2019, the earliest possible redemption date by the holder, this accretion has and will continue to affect income (loss) per common share. In addition, this accretion could accelerate if the expected redemption date is earlier than August 2, 2019. As of December 31, 2016, the aggregate liquidation preference (par value plus accrued dividends) was $161.8 million. Also, see discussion in Note 13 to Consolidated Financial Statements included in this report. Capital Additions - 2016 Capital additions during 2016 primarily related to PP&E of $165.3 million, of which most relates to the completed expansion projects at our El Dorado Facility (which additions include equipment associated with maintaining compliance with environmental laws, regulations and guidelines). Additionally, these additions include other capital costs of $0.9 million associated with maintaining compliance with environmental laws, regulations and guidelines. The capital additions were funded primarily from cash, third-party financing and working capital. Due to the increase in the amount of capital additions incurred, our depreciation, depletion and amortization expenses have increased in 2016. For 2017, we expect our annual capital expenditures (including capital expenditures in our planned Turnaround at our Pryor Facility) to range between $30 million to $35 million. Capital expenditures for 2017 include those needed for maintenance and reliability, safety and efficiency. They do not include any capital spending to increase capacity. Expenses Associated with Environmental Regulatory Compliance We are subject to specific federal and state environmental compliance laws, regulations and guidelines. As a result, we incurred expenses of $5.3 million in 2016 in connection with environmental projects. For 2017, we expect to incur expenses ranging from $3.5 million to $4.5 million in connection with additional environmental projects. However, it is possible that the actual costs could be significantly different than our estimates. Dividends We have not paid cash dividends on our outstanding common stock in many years, and we do not currently anticipate paying cash dividends on our outstanding common stock in the near future. Dividends on the Series E Redeemable Preferred are cumulative and payable semi-annually, commencing May 1, 2016, in arrears at the annual rate of 14% of the liquidation value of $1,000 per share. Each share of Series E Redeemable Preferred is entitled to receive a semi-annual dividend, only when declared by our Board, of $70.00 per share for the aggregate semi-annual dividend of $9.8 million. In addition, dividends in arrears at the dividend date, until paid, shall compound additional dividends at the annual rate of 14%. We also must declare a dividend on the Series E Redeemable Preferred on a pro rata basis with our common stock. As long as the Purchaser holds at least 10% of the Series E Redeemable Preferred, we may not declare dividends on our common stock and other preferred stocks unless and until dividends have been declared and paid on the Series E Redeemable Preferred for the then current dividend period in cash. As of December 31, 2016, the amount of accumulated dividends on the Series E Redeemable Preferred was approximately $22 million. Dividends on the Series D 6% cumulative convertible Class C preferred stock (the “Series D Preferred”) and Series B 12% cumulative convertible Class C Preferred Stock (the “Series B Preferred”) are payable annually, only when declared by our Board, as follows: • $0.06 per share on our outstanding non-redeemable Series D Preferred for an aggregate dividend of $60,000, and • $12.00 per share on our outstanding non-redeemable Series B Preferred for an aggregate dividend of $240,000. As of December 31, 2016, no dividend has been declared and the amount of accumulated dividends on the Series D Preferred and Series B Preferred totaled approximately $0.4 million. All shares of the Series D Preferred and Series B Preferred are owned by the Golsen Holders. There are no optional or mandatory redemption rights with respect to the Series B Preferred or Series D Preferred. Seasonality See discussion above under “Part I-Item 1 Business” for seasonality trends. Performance and Payment Bonds We are contingently liable to sureties in respect of insurance bonds issued by the sureties in connection with certain contracts entered into by subsidiaries in the normal course of business. These insurance bonds primarily represent guarantees of future performance of our subsidiaries. As of December 31, 2016, we have agreed to indemnify the sureties for payments, up to $10 million, made by them in respect of such bonds. All of these insurance bonds are expected to expire or be renewed in 2017. Off-Balance Sheet Arrangements We do not have any off-balance sheet arrangements as defined in Item 303(a)(4)(ii) of Regulation S-K under the Securities Exchange Act of 1934. Aggregate Contractual Obligations As of December 31, 2016, our aggregate contractual obligations are summarized in the following table: (1) The estimated interest payments relating to variable interest rate debt are based on interest rates at December 31, 2016. (2) The Series E redeemable preferred stock (including dividends) are assumed to be redeemed and paid on the earliest possible redemption date by the holder, August 2, 2019. (3) Other capital expenditures include only the estimated committed amounts (high end of range) at December 31, 2016. (4) Our proportionate share of the minimum costs to ensure capacity relating to a gathering and pipeline system. (5) The future cash flows relating to executive and death benefits are based on estimates at December 31, 2016. The participation rights value associated with embedded derivative of our Series E redeemable preferred stock is based the value of our common stock at December 31, 2016 and is based on the earliest possible redemption date by the holder, August 2, 2019. Critical Accounting Policies and Estimates The preparation of financial statements requires management to make estimates and assumptions that affect the reported amount of assets, liabilities, revenues and expenses, and disclosures of contingencies and fair values. It is reasonably possible that the estimates and assumptions utilized as of December 31, 2016, could change in the near term. The more critical areas of financial reporting affected by management's judgment, estimates and assumptions include the following: Impairment of Long-Lived Assets and Goodwill - Long-lived assets are reviewed for impairment whenever events or changes in circumstances indicate that the carrying amount of an asset (asset group) may not be recoverable. An impairment loss would be recognized when the carrying amount of an asset (asset group) exceeds the estimated undiscounted future cash flows expected to result from the use of the asset (asset group) and its eventual disposition. If assets to be held and used are considered to be impaired, the impairment to be recognized is the amount by which the carrying amounts of the assets exceed the fair values of the assets as measured by the present value of future net cash flows expected to be generated by the assets or their appraised value. In general, and depending on the event or change in circumstances, our asset groups are reviewed for impairment on a facility-by-facility basis (such as the Cherokee, El Dorado or Pryor Facility). As it relates to natural gas properties, proven natural gas properties are reviewed for impairment on a field-by-field basis and nonproducing leasehold costs are reviewed for impairment on a property-by-property basis. In addition, if the event or change in circumstance relates to the possible sale of an asset (or group of assets), the specific asset (or group of assets) is reviewed for impairment. In addition, goodwill is reviewed for impairment at least annually. An impairment loss generally would be recognized when the carrying amount of the reporting unit’s net assets exceeds the estimated fair value of the reporting unit. Our goodwill of $1.6 million related to the acquisition of our El Dorado Facility. Generally, the evaluation of goodwill for impairment involves a two-step test. Step 1 involves comparing the estimated fair value of each respective reporting unit to its carrying value, including goodwill. Our step 1 test utilized both a market approach and income approach to estimate the fair values of our reporting units. The market approach was based on enterprise value to estimated EBITDA multiples of our peer group (Level 3 inputs). If the estimated fair value exceeds the carrying value, the reporting unit’s goodwill is not considered impaired. If the carrying value exceeds the estimated fair value, step 2 must be performed to determine whether goodwill is impaired and, if so, the amount of the impairment. Step 2 involves calculating an implied fair value of goodwill by performing a hypothetical allocation of the estimated fair value of the reporting unit determined in step 1 to the respective tangible and intangible net assets of the reporting unit (Level 3 inputs). The remaining implied goodwill is then compared to the actual carrying amount of the goodwill for the reporting unit. To the extent, the carrying amount of goodwill exceeds the implied goodwill, the difference is the amount of the goodwill impairment. During 2016, pricing for our key product groups deteriorated well below expectations foreseen at December 31, 2015. Additionally, we believe the lower price environment is expected to continue throughout 2017. Thus, in accordance with ASC 350, we determined it was more likely than not that the fair value of goodwill related to our El Dorado Facility was less than its carrying amount (goodwill and other) implied under step 2 resulting in an impairment charge of $1.6 million to fully write-down the carrying value of goodwill, originally recognized upon acquisition of the El Dorado Facility during the 1980s. We also performed a recoverability test on the property, plant and equipment of the El Dorado Facility and determined that no impairment charges were necessary at December 31, 2016. As previously reported, during September 2015, we recognized an impairment charge of $39.7 million to write-down the carrying value ($62.2 million) of our working interest in natural gas properties in the Marcellus Shale region to their estimated fair value of $22.5 million. The impairment charge represented the amount by which the carrying value of these natural gas properties exceeded the estimated fair value and was therefore not recoverable. The estimated fair value was determined based on estimated future discounted net cash flows, a Level 3 input, using estimated production and prices at which we reasonably expect natural gas will be sold, including the Evaluation provided by our independent consulting petroleum engineer in October 2015. The event triggering the review for impairment related primarily from the results received from the Evaluation. The impairment was due to the decline in prices for natural gas futures, large natural gas price differentials in the Marcellus Shale region and the resulting changes in the drilling plans of these natural gas properties that caused certain of these properties to be reclassified from the “proved undeveloped reserves” category to the “probable undeveloped resources” category included in the Evaluation because those properties are no longer likely to be developed within five years. Our independent consulting petroleum engineering firm calculated our natural gas reserves using volumetric analysis of the reservoir and rate decline analysis for existing producers. The process of estimating proved reserves and future net cash flows is complex involving decisions and assumptions in evaluating the available engineering and geologic data and natural gas prices and the cost to produce these reserves and other factors, many of which are beyond our control. These assumptions include estimates of future natural gas production, commodity prices based on commodity futures price strips, operating and development costs, and a risk-adjusted discount rate of 10%, which is based on an industry standard. As a result, these estimates are imprecise and should be expected to change as future information becomes available. These changes could be significant. As a non-operator of our natural gas properties, we rely on information provided from the operator which is given to our independent consulting petroleum engineering firm for use in the preparation of our reserve estimates. The reserve estimates are reviewed by our certain members of our accounting group for accuracy and checked for consistency in its preparation along with validating the assumptions provided by the operator based on actual performance. Additionally, members of management met with the operator periodically to review our properties and discuss performance. In addition, during December 2015, we recognized an impairment charge of $3.5 million to write down the carrying value ($8.5 million) of certain plant assets related to certain ammonia production equipment at our Pryor Facility to their estimated fair value of approximately $5.0 million. The change of circumstances triggering the review for impairment related primarily to an offer received from a possible buyer on this non-core ammonia production equipment. The estimated fair value was determined based on an offer received from a possible buyer less estimated costs that would be incurred if the equipment is sold (Level 3 inputs). In 2016, this ammonia production equipment was sold to a third party for a minimal gain. In addition, and as discussed above under “Overview”, we currently own non-core assets (total net book value of approximately $44 million), and we are currently considering selling a portion of these assets. Due to the nature of some of these assets, there may be a limited market. As a result, and depending on appraisals obtained and offers received, if any, from potential buyers, it is reasonably possible we could incur impairment charges or losses on sales of assets in the near term. Contingencies - Certain conditions may exist which may result in a loss, but which will only be resolved when future events occur. We and our legal counsel assess such contingent liabilities, and such assessment inherently involves an exercise of judgment. If the assessment of a contingency indicates that it is probable that a loss has been incurred, we would accrue for such contingent losses when such losses can be reasonably estimated. If the assessment indicates that a potentially material loss contingency is not probable but reasonably possible, or is probable but cannot be estimated, the nature of the contingent liability, together with an estimate of the range of possible loss if determinable and material, would be disclosed. Estimates of potential legal fees and other directly related costs associated with contingencies are not accrued but rather are expensed as incurred. Loss contingency liabilities are included in current and noncurrent accrued and other liabilities and are based on current estimates that may be revised in the near term. In addition, we recognize contingent gains when such gains are realized or realizable and earned. We are involved in various legal matters that require management to make estimates and assumptions, including costs relating to the lawsuit styled City of West, Texas v CF Industries, Inc., et al, discussed under “Other Pending, Threatened or Settled Litigation” of Note 11 to Consolidated Financial Statements include in this report. As discussed in Note 2, in conjunction with the Climate Control Business sale in 2016, we entered into a TSA, pursuant to which, among other things, we agreed to provide certain information technology, payroll, legal, tax and other general services up through December 2017. As of December 31, 2016, our current and noncurrent accrued and other liabilities include approximately $5.5 million relating primarily to estimated contingent liabilities, costs associated with the TSA and severance agreements associated with the sale of the Climate Control Business. It is possible that the actual costs could be significantly different than our estimates. Regulatory Compliance - As discussed under “Environmental, Health and Safety Matters” in Item 1 of this report, we are subject to specific federal and state regulatory compliance laws and guidelines. We have developed policies and procedures related to regulatory compliance. We must continually monitor whether we have maintained compliance with such laws and regulations and the operating implications, if any, and amount of penalties, fines and assessments that may result from noncompliance. We will also be obligated to manage certain discharge water outlets and monitor groundwater contaminants at our chemical facilities should we discontinue the operations of a facility. However, certain conditions exist which may result in a loss but which will only be resolved when future events occur relating to these matters. We are involved in various environmental matters that require management to make estimates and assumptions, including our current inability to develop a meaningful and reliable estimate (or range of estimate) as to the costs relating to a corrective action study work plan approved by the KDHE discussed under footnote 3 - Other Environmental Matters of Note 11. At December 31, 2016 and 2015, liabilities totaling $0.3 million and $0.4 million, respectively have been accrued relating to these issues as discussed. This liability is included in current accrued and other liabilities and is based on current estimates that may be revised in the near term. At the time that cost estimates for any corrective action are received, we will adjust our accrual accordingly. It is possible that the adjustment to the accrual and the actual costs could be significantly different than our current estimates. Redeemable Preferred Stocks - On December 4, 2015, we issued the Series E and F Redeemable Preferred. The redeemable preferred stocks are redeemable outside of our control and are classified as temporary/mezzanine equity on our consolidated balance sheet. In addition, certain embedded features (the “embedded derivative”) included in the Series E Redeemable Preferred required bifurcation and are classified as derivative liabilities. Currently, the carrying values of the redeemable preferred stocks are being increased by periodic accretions (recorded to retained earnings and included in determining income or loss per share) using the interest method so that the carrying amount will equal the redemption value as of August 2, 2019, the earliest possible redemption date by the holder. However, a portion of this accretion was accelerated ($6.6 million) during the third quarter of 2016 as the result of the redemption discussed above under “Overview” and the remaining accretion could accelerate if the expected redemption date is earlier than August 2, 2019. Approximately $46 million of accretion (including the amount for earned dividends) was recorded to retained earnings in 2016. At December 31, 2016, the carrying value of these redeemable preferred stocks was $145 million. For the embedded derivative, changes in fair value are recorded in our statement of operations. As the result of the Indenture Amendments in connection with the Consent Solicitation relating to the Senior Secured Notes as above under “Overview” and in Note 9, including the redemption of the portion of Series E Redeemable Preferred discussed in Notes 9 and 13, we estimate that the contingent redemption feature has no fair value based on low probability that the remaining shares of Series E Redeemable Preferred would be redeemed prior to August 2, 2019. At December 31, 2016 and 2015, the fair value of the participation rights was $2.6 million and $3.3 million, respectively, based on the equivalent of 303,646 and 456,225 shares, respectively, of our common stock at $8.42 and $7.25 per share, respectively. No valuation input adjustments were considered necessary relating to nonperformance risk for the embedded derivative based on our current forecast. The valuation is classified as Level 3. Management’s judgment and estimates in the above areas are based on information available from internal and external resources at that time. Actual results could differ materially from these estimates and judgments, as additional information becomes known.

<s>[INST] Overview General LSB is headquartered in Oklahoma City, Oklahoma and through its subsidiaries, manufactures and sells chemical products for the agricultural, mining, and industrial markets. We own and operate facilities in Cherokee, Alabama, El Dorado, Arkansas and Pryor, Oklahoma, and operate a facility, for Covestro in Baytown, Texas. Our products are sold through distributors and directly to end customers throughout the U.S. Key Initiatives for 2017 We believe our future results of operations and financial condition will depend significantly on our ability to successfully implement the following key initiatives: Improving the onstream rates of our chemical plants. We have made and continue to make: (1) upgrades to the operations teams at our chemical facilities; (2) investments of capital to enhance the reliability of each of our plants at each facility in order to reduce unplanned outages, unplanned downtimes, and the frequency of planned Turnarounds; and (3) continued efforts to focus on safety and efficiency throughout our entire operations. Broadening the distribution of our AN and Nitric Acid products. Given the reduction in our LDAN sales from the declining use of coal, we have expanded our overall sales of HDAN through a number of marketing initiatives that have broadened our addressable market. Those initiatives have included, storing and distributing HDAN at our Pryor and Cherokee Facilities and selling to new markets and customers out of those facilities. In addition, through our marketing efforts, we are working on expanding our market for our nitric acid products to parts of the Western U.S. and Canada. Reducing and controlling our cost structure. In 2016, we put in place SG&A expense reductions of approximately $6 million per year that we will realize beginning in 2017. In addition, beginning in 2017 we have reduced plant costs at each manufacturing facility by approximately $6 million. We continue to review our overall costs and believe that we will be able to further reduce costs during 2017. Selling noncore assets. In 2016, we identified assets that are no longer necessary in the operations of our business. Those assets include our working interest in the natural gas properties in the Marcellus Shale, our engineered products business, certain pieces of equipment and certain real estate. In the fourth quarter of 2016, we sold a portion of this equipment for approximately $5 million and are in the process of selling certain other noncore assets, which we believe could generate an additional approximately $15 million to $20 million of net cash proceeds (net of any debt outstanding against these assets). Evaluate strategic initiatives for our business. We have initiated a process to explore and evaluate potential strategic alternatives for our business, which may include a sale, a merger with another party, or another strategic transaction involving some or all of our assets. We have retained Morgan Stanley & Co. LLC as our financial advisor to assist with this process. We may not successfully implement any or all of these initiatives. Even if we successfully implement the initiatives, they may not achieve the beneficial results that we expect or desire. Business and Financing Developments 2016 Sale of Climate Control Business On July 1, 2016, we completed the sale of our Climate Control Business to a subsidiary of NIBE for a total of $364 million before the customary adjustments set forth in the Stock Purchase Agreement. As a result, we recognized a pretax gain on the sale of approximately $282 million. At December 31, 2016, our accounts receivable included approximately $2.7 million relating to the sale of our Climate Control Business representing an indemnity escrow balance. Our current and noncurrent accrued and other liabilities also include approximately $5.5 million related to estimated contingent liabilities, costs in connection with the Transition Services Agreement (“TSA”) and certain severance agreements associated with the sale. See additional discussion in Note 2 to Consolidated Financial Statements included in this report. El Dorado Expansion During the second quarter of 2016, the new ammonia plant at our El Dorado Facility became operational and began producing ammonia at our nameplate capacity of 1,150 tons per day. However, the ammonia plant experienced unpl [/INST] Positive. </s>

LSB INDUSTRIES INC

2018-02-26

2017-12-31

ITEM 7. MANAGEMENT’S DISCUSSION AND ANALYSIS OF FINANCIAL CONDITION AND RESULTS OF OPERATIONS The following MD&A should be read in conjunction with a review of the other Items included in this Form 10-K and our December 31, 2017 Consolidated Financial Statements included elsewhere in this report. Certain statements contained in this MD&A may be deemed to be forward-looking statements. See “Special Note Regarding Forward-Looking Statements.” Overview General LSB is headquartered in Oklahoma City, Oklahoma and through its subsidiaries, manufactures and sells chemical products for the agricultural, mining, and industrial markets. We own and operate facilities in Cherokee, Alabama, El Dorado, Arkansas and Pryor, Oklahoma, and operate a facility for Covestro in Baytown, Texas. Our products are sold through distributors and directly to end customers throughout the U.S. Key Initiatives for 2018 We believe our future results of operations and financial condition will depend significantly on our ability to successfully implement the following key initiatives: • Improving the on-stream rates of our chemical plants. We have several initiatives underway that we believe will assist us in improving the reliability of our plants and allow us to produce more products for sale while lowering our cost of production. In 2017, we made the decision to upgrade our existing maintenance management system through technology enhancements and work processes to improve our predictive and preventative maintenance programs at our facilities. At that time, we also made the decision to engage outside maintenance experts to assist us in expediting its implementation and in its overall use. We expect that the system will be implemented by the end of the second quarter of 2018 and we will begin to see the benefits in the second half of 2018. Additionally, specific to our Pryor Facility, we engaged several outside engineering firms to assist us in an overall plant reliability study which will be used to enhance our reliability improvement plan for that facility. We expect the study to be completed during the second quarter of 2018. • Focus on the Continued Improvement of Our Safety Performance. We believe that high safety standards are critical to improved plant performance. With that in mind, we implemented enhanced safety programs at our facilities that focus on reducing risks and improving our safety culture in 2017. The implementation and training of these programs will continue in 2018 and we expect these will benefit our on-stream rates. • Continue Broadening of the distribution of our AN and Nitric Acid products. We increased our overall sales volume of HDAN in 2017 by approximately 60,000 tons or 26% to approximately 290,000 tons compared to 230,000 tons for 2016 through various marketing initiatives which include: (1) storing and distributing HDAN at our Pryor and Cherokee Facilities which allows us to sell to new markets and customers out of those facilities and; (2) educating growers on the additional applications for HDAN. In 2018, we will continue to focus on those initiatives and other initiatives in an effort to continue to grow our annual sales volumes over 2017. In addition, through increased marketing efforts, we increased our sales volumes of Nitric Acid by approximately 18,000 tons from 82,000 tons in 2016 to 100,000 tons in 2017. We will continue to focus on increasing our marketing efforts in order to expand our market for our nitric acid products in North America. • Improving the Margins on Sales of Our Products. Over the last several years, we have focused on increasing our sales volumes to produce at optimal on-stream rates and lower our manufacturing costs per ton of product. Beginning in 2018, we will undertake a review of all sales to customers to determine if there are opportunities to improve the margins on sales to those customers and to explore if there are further product upgrading opportunities. • Reducing and controlling our cost structure. We have engaged outside experts to assist us in centralizing and expanding our Company-wide procurement efforts. We expect this to be implemented by the end of the second quarter of 2018 and believe that these efforts will result in a reduction in expenses and capital spend in the aggregate of between $3 million to $5 million on an annualized basis. Over the last 18 months, we have reduced our SG&A and plant expenses over $12 million annually and believe, in addition to the procurement initiative discussed above, there is still an opportunity to further reduce those expenses. • Focus on Improving Our Capital Structure and Overall Cost of Capital. We are actively seeking ways to improve our capital structure and reduce our overall cost of capital. We believe that the improving end markets for our products combined with our improved operating performance will be a benefit. We may not successfully implement any or all of these initiatives. Even if we successfully implement the initiatives, they may not achieve the results that we expect or desire. Business Developments - 2017 Sale of Working Interests in Natural Gas Properties and Other Non-Core Assets At the end of 2016, we identified certain assets that were no longer necessary in the operations of our business. During 2017, we sold assets totaling approximately $23.8 million. We sold all of Zena Energy L.L.C. (“Zena”) assets including Zena’s right, title, and interest in all of its oil and natural gas properties (the “Properties”) located in Wyoming County, Pennsylvania for a purchase price of approximately $16.3 million, which sale was completed on June 26, 2017. Concurrently with the closing of the purchase and sale agreement, a portion of the net proceeds (approximately $3.5 million) was used to repay the remaining outstanding balance of a promissory note, which was secured by the Properties. As a result of the sale, we no longer own any working interest in oil and natural gas properties. During 2017, we also sold our engineered products business (industrial machinery and related components) and other various non-core assets for approximately $7.5 million of net proceeds. We continue to evaluate our assets in order to determine if there are additional non-core assets that we should monetize. Approval of Arkansas Incentive Tax Credit During 2017, we received notification from the State of Arkansas that incentive tax credits had been approved associated with certain capital expenditures associated with the El Dorado Facility’s expansion projects completed primarily in the fourth quarter of 2015 and the second quarter of 2016. As a result, we recognized a current and noncurrent receivable totaling approximately $8.1 million associated with these incentive tax credits with the offset reducing plant, property and equipment (“PP&E”) (covered by the tax credit) by approximately $7.4 million and the remaining balance of $0.7 million as a reduction to cost of sales (recovery of previously incurred depreciation expense related to the PP&E). As of December 31, 2017, our current and noncurrent incentive tax credits receivable totaled $7.4 million. Planned and Unplanned Downtime at our Pryor and El Dorado Facilities During 2017, we experienced an aggregate of 158 days of unplanned downtime that contributed to approximately $21 million in lost improvement to our operating results. The following were the main unplanned downtime events: In May 2017, the ammonia plant at our Pryor Facility experienced a lightning strike causing a loss of power to the facility and 16 days of unplanned downtime. In June 2017, the ammonia plant at our El Dorado Facility was taken out of service to perform proactive adjustments and heat exchanger cleaning and repairs to enable the plant to operate closer to the higher end of its operating envelope on a sustained basis. Total downtime relating to this event was 12 days. In July 2017, the Pryor Facility experienced an electrical outage shutting the facility down. As the facility was already down and considering the low selling price environment for our agricultural products, and other maintenance needing to be completed, the election was made to move forward the Turnaround previously scheduled for the fourth quarter of 2017 to the third quarter of 2017. Total downtime for the Turnaround was 17 days. On September 23, 2017, the ammonia plant at the Pryor Facility experienced a minor fire and was taken out of service to repair damage to some of the plant’s electrical controls, wiring and piping. As these repairs were being performed, we decided to replace the process gas preheat system that was originally scheduled to be included in the 2018 Turnaround. The plant resumed production on December 4, 2017. Total downtime days during 2017 relating to this event was 72 days. On October 3, 2017, the ammonia plant at our El Dorado Facility was taken out of service to make mechanical repairs to the burner refractory system on the boiler, which were completed on October 8, 2017. Following the work on the boiler, we determined that repairs on a process heat exchanger were necessary, which repairs to the heat exchanger were completed and ammonia production resumed on October 22, 2017. Total downtime of the ammonia plant related to these two events in October was 21 days. Update on Strategic Alternatives Review In July 2017, our Board of Directors terminated the formal sales process portion of its strategic review as they were not presented with a sale transaction that was in the best interest of our shareholders. Our Management and Board of Directors continues to work with its outside advisors on evaluating other strategic, financial and operational options on an ongoing basis. El Dorado Nitric Acid Plant During 2016, the El Dorado Facility’s new nitric acid plant required several warranty repairs. After attempts to repair leaks in the nitric acid plant’s nitrous oxide abatement vessel, it was determined that this abatement vessel would need to be replaced under warranty provisions. In order to operate the nitric acid plant while a permanent solution was developed, we obtained a consent administrative order from the Arkansas Department of Environmental Quality (“ADEQ”) to allow the facility to by-pass the failed nitrous oxide abatement system and continue to operate the new nitric acid plant until September 2018. We are in process of extending the consent administrative order. We made use of our secondary nitric acid plant at the El Dorado Facility and shipped product from our other facilities to ensure that customer demands were met while we designed and installed the by-pass system. We anticipate that the design, fabrication, and installation of a new nitrous oxide abatement vessel will be complete by October 2018 and all costs will be covered under warranty provisions. Key Industry Factors Supply and Demand Agricultural Sales of our agricultural products were approximately 43% of our total net sales for 2017. The price at which our agricultural products are ultimately sold depends on numerous factors, including the supply and demand for nitrogen fertilizers which, in turn, depends upon world grain demand and production levels, the cost and availability of transportation and storage, weather conditions, competitive pricing and the availability of imports. Additionally, expansions or upgrades of competitors’ facilities and international and domestic political and economic developments continue to play an important role in the global nitrogen fertilizer industry economics. These factors can affect, in addition to selling prices, the level of inventories in the market which can cause price volatility and effect product margins. Additionally, changes in corn prices can affect the number of acres of corn planted in a given year, and the number of acres planted will drive the level of nitrogen fertilizer consumption, likely effecting prices. The WASDE, dated February 8, 2018, estimates U.S. corn production for 2016/2017 (“2017 Crop”) was 15.2 billion bushels, up 11.4% from 2015/2016 (“2016 Crop”), reflecting increases in planted and harvested acres. In addition, they estimate yields per acre of 174.6 bushels per acre for the 2017 Crop compared to 168.4 bushels per acre for the 2016 Crop. This report also estimates world corn ending stocks for 2017/2018 (“2018 Crop”) at 203.1 million tons, a decrease over the 2017 Crop ending stocks of approximately 11.6% while U.S. corn ending stocks of 59.8 million tons, an increase of approximately 3% over the prior year. This has led the WASDE to estimate that U.S. growers will plant 90.2 million acres of corn in the 2018 Crop, a decrease of 3.8 million acres over the previous year, with expected yields of 176.6 bushels per acre, a 1% increase in yield from the previous year. On the supply side, given the low price of natural gas in North America over the last several years, North American fertilizer producers have become the global low-cost producers for delivered fertilizer products to the Midwest U.S. Several years ago, the market believed that low natural gas prices would continue. That belief, combined with favorable fertilizer pricing, stimulated investment in numerous expansions of existing nitrogen chemical facilities and the construction of new nitrogen chemical facilities. Since those announcements, global nitrogen fertilizer supply has outpaced global nitrogen fertilizer demand causing oversupply in the global and North American markets. The increased fertilizer supply led to lower nitrogen fertilizer selling prices during most of 2017. Also, additional domestic supply of ammonia will change the physical flow of ammonia in North America placing pressure on ammonia and other fertilizer prices until the distribution system accepts the new supply. Beginning in the fourth quarter of 2017, we have seen an increase in fertilizer prices as the imports of fertilizers has decreases significantly and the distribution of the new domestic supply has been established. That has continued into the first quarter of 2018. Industrial Sales of our industrial products were approximately 46% of our total net sales for 2017. Our industrial products sales volumes are dependent upon general economic conditions primarily in the housing, automotive, and paper industries. According to the American Chemistry Council, the U.S. economic indicators continue to be positive for these sectors domestically. Our sales prices generally vary with the market price of our feedstock (ammonia or natural gas, as applicable) in our pricing arrangements with customers. Mining Sales of our mining products were approximately 9% of our total net sales for 2017. Our mining products are LDAN and AN-solutions, which are primary used as AN fuel oil and specialty emulsions for surface mining of coal and for usage in quarries and the construction industry. As reported by the EIA, annual coal production in the U.S. for the full year of 2017 is up 6% from 2016 due to increased export demand. EIA is forecasting a 2% decrease in U.S. coal production in 2018 and another 2% decrease in 2019. U.S. coal consumption is also expected to decline over the next two years due to low natural gas prices reducing demand for coal for coal-fired electricity generation. EIA also expects U.S. coal export demand to decline in 2018 and 2019. We believe that coal production in the U.S. continues to face significant challenges from competition from natural gas and renewable sources of energy. While we believe, our plants are well-located to support the more stable coal-producing regions in the upcoming years, our current mining sales volumes are being affected by overall lower customer demand for LDAN. We do not expect a significant increase in our mining business in the near term. Farmer Economics The demand for fertilizer is affected by the aggregate crop planting decisions and fertilizer application rate decisions of individual farmers. Individual farmers make planting decisions based largely on prospective profitability of a harvest, while the specific varieties and amounts of fertilizer they apply depend on factors such as their financial resources, soil conditions, weather patterns and the types of crops planted. Natural Gas Prices Natural gas is the primary feedstock used to produce nitrogen fertilizers at our manufacturing facilities. In recent years, U.S. natural gas reserves have increased significantly due to, among other factors, advances in extracting shale gas, which has reduced and stabilized natural gas prices, providing North America with a cost advantage over certain imports. As a result, our competitive position and that of other North American nitrogen fertilizer producers has been positively affected. We historically have purchased natural gas in the spot market, using forward purchase contracts, or through a combination of both and have used forward purchase contracts to lock in pricing for a portion of our natural gas requirements. These forward purchase contracts are generally either fixed-price or index-price, short-term in nature and for a fixed supply quantity. We are able to purchase natural gas at competitive prices due to our connections to large distribution systems and their proximity to interstate pipeline systems. The following table shows the annual volume of natural gas we purchased and the average cost per MMBtu: (1) The increase in volume in 2017 is primarily attributed to the new ammonia plant at the El Dorado Facility operating for the full year compared to approximately half a year for 2016 and higher overall ammonia operating rates at our plants. As of December 31, 2017, we had volume purchase commitments with a fixed cost for natural gas of approximately 1.3 million MMBtus at an average cost of $2.42 per MMBtu. These commitments are for firm purchases during the first quarter of 2018 and represent approximately 17% of our total exposed natural gas usage required for that period. Transportation Costs Costs for transporting nitrogen-based products can be significant relative to their selling price. For example, ammonia is a hazardous gas at ambient temperatures and must be transported in specialized equipment, which is more expensive than other forms of nitrogen fertilizers. In recent years, a significant amount of the ammonia consumed annually in the U.S was imported. Therefore, nitrogen fertilizers prices in the U.S. are influenced by the cost to transport product from exporting countries, giving domestic producers who transport shorter distances an advantage. Key Operational Factors Facility Reliability Consistent, reliable and safe operations at our chemical plants are critical to our financial performance and results of operations. The financial effects of planned downtime at our plants, including Turnarounds is mitigated through a diligent planning process that considers the availability of resources to perform the needed maintenance, feedstock logistics and other factors. Unplanned downtime of our plants typically results in lost contribution margin from lost sales of our products, lost fixed cost absorption from lower production of our products and increased costs related to repairs and maintenance. All Turnarounds result in lost contribution margin from lost sales of our products, lost fixed cost absorption from lower production of our products, and increased costs related to repairs and maintenance, which repair, and maintenance costs are expensed as incurred. Also see the Turnaround costs presented in the Quarterly Financial Data of the Consolidated Financial Statements included in this report. During the unplanned outage in the fourth quarter of 2017 at our Pryor Facility, we replaced the process gas pre-heat system which was originally planned for the Turnaround in 2018. Although this extended the downtime, combined with previous maintenance work done at the facility during 2017, it allowed us to avoid a Turnaround in 2018 that had been previously planned. Following the Turnaround scheduled in 2019, we expect to move to a two-year Turnaround cycle at this facility. At our El Dorado Facility, historically, we performed Turnaround projects on individual plants without shutting down the entire facility as we have redundancy for most of our produced products. The effect of lost production from those have not been significant. With the completion of the new ammonia plant, the facility will begin to schedule traditional Turnarounds that will require the ammonia plant to be taken out of production and will cause a financial effect from lost production. This facility will perform a two-year Turnaround currently scheduled in the third quarter of 2018 and following this initial Turnaround, the facility will move to a three-year Turnaround cycle. Our Cherokee Facility is currently on a two-year Turnaround cycle, with the last Turnaround being performed in the third quarter of 2016. The next Turnaround to be performed is expected to occur in the third quarter of 2018 at which time we expect to move to a three-year Turnaround cycle. Prepay Contracts We use forward sales of our fertilizer products to optimize our asset utilization, planning process and production scheduling. These sales are made by offering customers the opportunity to purchase product on a forward basis at prices and delivery dates that are agreed upon. We use this program to varying degrees during the year depending on market conditions and our view of changing price environments. Fixing the selling prices of our products months in advance of their ultimate delivery to customers typically causes our reported selling prices and margins to differ from spot market prices and margins available at the time of shipment. Consolidated Results for 2017 Our consolidated net sales for 2017 were $427.5 million compared to $374.6 million for 2016. Our consolidated operating loss was $34.1 million compared to $90.2 million for 2016. The items affecting our operating results are discussed below and under “Results of Operations.” Items Affecting Comparability of Results On-Stream Rates The on-stream rates of our plants affect our production, the absorption of fixed costs of each plant and sales of our products. It is a key operating metric that we use to manage our business. In particular, we closely monitor the on-stream rates of our ammonia plants as that is the basic product as used to produce all upgraded products. In 2017, we improved the operating rates at our Cherokee ammonia plant. The on-stream rate (excluding the effect from its scheduled Turnaround in 2016) for 2017 for our ammonia plant increased to 99% from 96% in 2016. We believe that the ammonia plant will have a minimum on-stream rate for 2018 of 95%, excluding the planned Turnaround days out of service. The El Dorado Facility’s ammonia plant began production in mid-2016. It is typical for newly operated plants that are in production to go through a period of optimization (shakedown) that may require the plant to be taken out of operation for a period of time. Our reported 2016 on-stream rate for the ammonia plant at El Dorado was 64%. For 2017, the on-stream rate for its ammonia plant was 86%. We believe that the ammonia plant will operate at a minimum of 95% on-stream rate for 2018, excluding the planned Turnaround days out of service. The plant is currently producing ammonia in excess of 1,300 tons per day, which is above its nameplate capacity of 1,150 tons per day. At our Pryor Facility, the on-stream rate (excluding the effect from its Turnaround) for 2017 for our ammonia plant decreased to 69% from 86% in 2016, due primarily to the unplanned downtime discussed under “Business Developments - 2017.” We believe that our focus on improving on-stream rates as discussed in key initiatives for 2018 and the capital investments made to the ammonia plant to date, will improve the on-stream rate for 2018. Because of the improved ammonia production at the El Dorado Facility, during 2017, we sold approximately 200,000 tons of ammonia that were in excess of our internal needs at this facility compared to approximately 88,000 tons in excess of our internal needs in 2016. Selling Prices During 2017, selling prices for our agricultural products declined significantly over 2016 selling prices. Average selling prices for our ammonia, UAN and HDAN decreased 17%, 12% and 6%, respectively compared to 2016 average selling prices. The decrease in ammonia selling prices was impacted by several factors: (1) a wet spring that caused lower pre-plant ammonia application and resulted in ammonia inventory buildup at the end of the spring season; (2) recent facility expansion projects that started ammonia production but had not yet started planned upgraded production facilities and; (3) intended distribution systems for increased ammonia production not yet in place. We expect this excess ammonia supply will begin to be absorbed in 2018 as these upgraded production facilities begin production and the distribution systems are in place. The decrease in UAN and HDAN selling prices were caused by lower average commodity prices and the nitrogen production capacity being added globally, and in North America specifically, that, we believe, created uncertainty on the ability of producers to efficiently distribute the additional production. Depreciation Expense During 2017 and 2016, depreciation expense was $67.0 million and $59.4 million, respectively. The increase is primarily due to our El Dorado expansion project being completed and placed into service during the second quarter of 2016. Debt and Interest Expense During 2017 and 2016, interest expense was $37.3 million and $30.9 million, net of capitalized interest $15.0 million for 2016 (minimal in 2017). Interest was capitalized based upon construction in progress of the El Dorado expansion project, which was completed during the second quarter of 2016. Also, 2016 included interest expense of $5.5 million from the 12% Senior Secured Notes which were repaid in October 2016, $2.2 million as a result of the debt modification associated with the Consent Solicitation and interest expense from borrowings under our Working Capital Revolver Loan. Certain Startup, One-Time, Warranty and Other Expenses (2016 only) During 2016, the El Dorado Facility’s new ammonia plant became operational. We estimate that our operating costs were $5.1 million higher during the first half of 2016, as a result of start-up and commissioning activities related to the new ammonia plant. The El Dorado Facility’s new nitric acid plant incurred certain expenses after start-up for which we believe a portion will be covered under our warranty provisions. The estimated impact on our operating results for 2016 was approximately $8 million to $9 million. During 2016, EDC incurred a one-time fee of $12.1 million related to consulting services associated with the reduction of assessed property values for the El Dorado projects real and personal property for both the nitric acid plant, nitric acid concentrator plant and the ammonia plant. We expect material property tax savings in future periods through a reduction of property taxes paid. Loss on Extinguishment of Debt (2016 only) In October 2016, we called debt totaling $106.9 million (including accrued interest) to redeem all of the outstanding $50 million of the 12% Senior Secured Notes due 2019 at the original redemption price of 106% plus accrued interest and $50 million of the 7.75% Senior Secured Notes due 2019 at the original redemption price of 103.875% plus accrued interest. As a result of this transaction, we recognized a loss on extinguishment of debt of approximately $8.7 million. Results of Operations The following Results of Operations should be read in conjunction with our consolidated financial statements for the years ended December 31, 2017, 2016, and 2015 and accompanying notes and the discussions under “Overview” and “Liquidity and Capital Resources” included in this MD&A. We present the following information about our results of operations. Net sales to unaffiliated customers are reported in the consolidated financial statements and gross profit represents net sales less cost of sales. Net sales are reported on a gross basis with the cost of freight being recorded in cost of sales. Year Ended December 31, 2017 Compared to Year Ended December 31, 2016 The following table contains certain financial information relating to our continuing operations: (1) As a percentage of net sales (2) 2017 additions to PP&E and DD&A are net of approximately $8.1 million and approximately $0.7 million respectively, associated with the incentive tax credit recognized during 2017 as discussed above under “Business Developments - 2017.” The following tables provide key operating metrics for the Agricultural Products: With respect to sales of Industrial and Other Chemical Products, the following table indicates the volumes sold of our major products: With respect to sales of Mining Products, the following table indicates the volumes sold of our major products: Net Sales Agricultural and industrial sales for 2017 were both significantly higher due to increased sales volumes that were partially offset by decreased average selling prices while mining sales for 2017 were lower due to lower average prices and a net decrease in sales volume compared to 2016. • Agricultural products sales increased primarily from higher sales volume across all product categories. The increase in sales volume was primarily the result of overall improved on-stream and production rates at our El Dorado and Cherokee Facilities, the absence of a Cherokee Turnaround in 2017 and the broadening of our distribution of HDAN to new markets and customers. Partially offsetting the increase in sales volume was lower average selling prices, primarily due to: (1) lower average commodity prices; (2) weather in the early spring that caused less ammonia to be applied during pre-plant season which caused an inventory buildup and; (3) the nitrogen production capacity being added globally, and in North America specifically. • Industrial acids and other chemical products sales increased driven by strong industrial ammonia sales at our El Dorado Facility from higher plant on-stream rates (minimal ammonia production during the first half of 2016 from this facility). In addition, nitric acid sales from El Dorado are continuing to expand and sales volume was significantly higher compared to 2016, although at lower net prices due to longer shipping distances and stronger market competitive pressures. • Mining products sales decreased primarily as the result of both lower sales volume and lower selling prices of AN Solution partially offset by increases in LDAN sales volume from our El Dorado Facility. We continue to face lower sales volume of AN Solution from our Cherokee Facility as demand from our customers remains suppressed by overall Appalachia coal market conditions and increased competitive production capacity in our region. • Other products consist of natural gas sales from our former working interests in certain natural gas properties and sales from our former business that sold industrial machinery and related components, both of which were sold during 2017. Gross Profit As noted in the table above, we recognized a gross profit of $5.5 million in 2017 compared to a gross loss of $49.3 million in 2016, or an increase in gross profit of $54.8 million. In addition to the net positive effect from the higher sales discussed above, our gross profit improved primarily through: • a reduction in our feedstock and other operating costs at our El Dorado Facility as (i) this facility produced ammonia from natural gas during 2017 compared to purchasing ammonia during most of the first half of 2016 and (ii) costs associated with the start-up, commissioning and optimizing activities performed on the ammonia plant during 2016 that were not incurred in 2017; • a reduction in overall fixed plant expenses; • a recovery of precious metals of $2.9 million during 2017, which metals had accumulated over time within certain manufacturing equipment; and • improved absorption of fixed costs from improved on-stream and production rates at our Cherokee and El Dorado Facilities and lower Turnaround expense at the Cherokee Facility as a Turnaround was not required in 2017. The increase in gross profit was partially offset by an increase in overall depreciation expense of approximately $7.6 million primarily as a result of our new ammonia plant at our El Dorado Facility not being put into service until mid-May 2016, lower absorption of fixed costs from lower on-stream rates at our Pryor Facility and higher average natural gas feedstock cost at our Cherokee and Pryor Facilities. In addition, during 2016, we incurred a one-time cost of $12.1 million relating to consulting services associated with the reduction of property taxes from fixing the assessed value for our El Dorado Facility. Selling General and Administrative Expense Our SG&A expenses were $35.0 million for 2017, a decrease of $5.2 million compared to 2016. The decrease was driven by a $2.2 million reduction in compensation-related costs, $1.9 million reduction in insurance and other miscellaneous costs and $1.1 million reduction in professional fees. Impairment of Long-Lived Assets and Goodwill During 2016, we recognized a non-cash impairment charge of $1.6 million to fully write-off the carrying value of goodwill. Other Expense (Income), net Our net other expense for 2017 was $4.6 million compared to net other income of $0.9 million for 2016. The change primarily consists of a total net loss of $7.0 million relating to the sale of our working interest of certain natural gas properties, the sale of our engineered products business (industrial machinery and related components) and other non-core assets partially offset by the extinguishment and derecognition of a liability of approximately $1.4 million associated with a death benefit agreement as discussed in Note 17 to the Consolidated Financial Statements and $0.1 million in miscellaneous items. Interest Expense, net Interest expense for 2017 was $37.3 million compared to $30.9 million for 2016. The increase is due primarily to a reduction in capitalized interest during 2017 of $14.7 million as a result of the El Dorado expansion project completion during 2016. This increase was partially offset by a decrease of $5.5 million relating to the 12% Senior Secured Notes sold in 2015 and repaid in 2016 and $2.2 million as a result of the debt modification associated with a consent solicitation completed in 2016. Loss on Extinguishment of Debt As a result of the repayment of $50 million of the 7.75% Senior Secured Notes and all of our 12% Senior Secured Notes in 2016, we incurred a loss on extinguishment of debt of $8.7 million, consisting of prepayment premiums and writing off associated unamortized debt issuance costs. Benefit for Income Taxes The benefit for income taxes for continuing operations in 2017 was $41 million compared to $42 million for the same period in 2016. The effective tax rate, including the impact of tax reform adjustments, was 57% for 2017 compared to 32% for 2016. The increase in the benefit rate is primarily due to the adjustments on the deferred tax assets and liabilities from the newly enacted tax rate as a result of tax reform in 2017. The provisional adjustments related to tax reform resulted in recording a tax benefit of $23 million. Recently enacted tax legislation is not expected to materially impact the near-term liquidity or financial condition of the company. Further information on the impacts of tax reform in 2017 is included in Note 10 to the Consolidated Financial Statements. Historically, our effective tax rate has been driven by the federal statutory rate with notable impacts from investment tax credits and valuation allowances. Also, the adoption of ASU 2016-09 in 2017 may cause some volatility in the effective tax rate. Income from Discontinued Operations, net of taxes The results of operations of our former Climate Control Business are presented as discontinued operations. For 2017, income from discontinued operations was $1.1 million, consisting of a gain of $2.6 million relating primarily to estimate revisions to contingent obligations and net of a tax provision of $1.5 million. For 2016, income from discontinued operations was $200.3 million, including a gain of $282 million and net of a tax provision of $91.7 million. Year Ended December 31, 2016 Compared to Year Ended December 31, 2015 The following table contains certain financial information relating to our continuing operations: (1) As a percentage of net sales The following tables provide key operating metrics for the Agricultural Products: With respect to sales of Industrial and Other Chemical Products, the following table indicates the volumes sold of our major products: With respect to sales of Mining Products, the following table indicates the volumes sold of our major products: Net Sales In general, for 2016, our agricultural sales were lower, influenced by lower selling prices for ammonia, UAN and HDAN, partially offset by higher sales volume from improved on-stream rates at our facilities in 2016. Industrial products sales and mining sales both decreased due primarily to lower selling prices partially offset by higher overall sales volumes. In addition, other products, which includes our natural gas working interest, decreased as natural gas sales prices and volumes declined in 2016 compared to 2015. • Agricultural products comprised approximately 44% and 48% of our net sales for 2016 and 2015, respectively. Agricultural sales decreased as our average selling prices per ton of our products were significantly lower for 2016 compared to 2015. This reduction in selling prices was partially offset by an increase in sales volumes for HDAN, UAN and Ammonia. The increase in HDAN sales volume was driven by a strong spring fertilizer season which increased our customer demand and expanded our customer base during 2016. The higher UAN and ammonia sales volumes were primarily due to higher production at our Pryor Facility in 2016 compared to 2015 partially offset by lower production and sales volumes at our Cherokee Facility due to performing a bi-annual Turnaround in 2016. • Industrial acids and other chemical products sales decreased primarily as the result of lower overall product selling prices. A majority of our sales of these products are tied to the cost of our feedstock, primarily natural gas and ammonia, which are passed through as part of the selling prices to our customers. Our feedstock costs were lower in 2016 compared to 2015. The decrease in selling prices was partially offset by higher sales volume of ammonia as our El Dorado Facility began producing ammonia during the second quarter of 2016 compared to no production in 2015. • Mining products sales decreased primarily due to lower product selling prices as a majority of our sales from these products are tied to the cost of our feedstock, primarily natural gas and ammonia, which are passed through as part of the selling prices to our customers. Our feedstock costs were lower in 2016 compared to 2015. Additionally, our Cherokee Facility performed its bi-annual Turnaround in 2016 which reduced the production of AN solution for 2016. The reduction in production at our Cherokee Facility was partially offset by an increase in sales volume of LDAN at our El Dorado Facility. • Other products consist of natural gas sales from our working interests in certain natural gas properties and sales of industrial machinery and related components. The decrease in other products is primarily due to lower realized sales prices out of the Marcellus Shale region combined with lower production volumes in 2016 compared to 2015. During 2016, the operator of these properties elected to slow well development due to the decline in natural gas sales prices. They are currently reevaluating their development program as natural gas prices have increased making certain wells economical to develop. Gross Profit As noted in the table above, we incurred a gross loss of $49.3 million in 2016 compared to gross profit of $20.0 million in 2015, or a decrease in gross profit of approximately $69.3 million. In addition to the negative effect from lower sales discussed above, 2016 includes a one-time cost of $12.1 million relating to consulting services associated with the reduction of property taxes from fixing the assessed value for our El Dorado Facility, costs incurred relating to the start-up and commissioning activities at our El Dorado expansion project, increased repair expenses associated with unplanned downtime experienced at our Cherokee, Pryor and El Dorado Facilities, an increase in overall depreciation expense partially offset by improved feedstock costs from lower average natural gas prices and our El Dorado Facility producing ammonia from natural gas compared to purchasing ammonia for a portion of the year. Selling General and Administrative Expense Our SG&A expenses were $40.2 million for 2016, a decrease of $9.6 million compared to 2015. The decrease includes a $4.5 million reduction in expenses related to shareholder activities, $3.8 million reduction in overall compensation related costs, and $1.5 million reduction in training expenses partially offset by an increase of $1.5 million in legal fees related primarily to our review of strategic initiatives and updates to our corporate governance practices and policies. Impairment of Long-Lived Assets and Goodwill During 2016, we recognized a non-cash impairment charge of $1.6 million to fully write-off the carrying value of goodwill. In 2015, we recognized non-cash impairment charges totaling $43.2 million, consisting of an impairment charge of $39.7 million to reduce the carrying value of our working interest in natural gas properties and a $3.5 million impairment charge to reduce the carrying value of certain plant assets related to unused ammonia production equipment at our Pryor Facility. Interest Expense, net Interest expense for 2016 was $30.9 million compared to $7.4 million for 2015. The increase is due primarily to a reduction in capitalized interest during 2016 of $15.6 million as a result of the El Dorado expansion project completion. In addition, $4.5 million of the increase in interest expense relates to the 12% Senior Secured Notes sold in November 2015 and repaid in October 2016 and $2.2 million as a result of the debt modification of the Senior Secured Notes in 2016. Loss on Extinguishment of Debt As a result of the repayment of $50 million of the 7.75% Senior Secured Notes and all of our 12% Senior Secured Notes in 2016, we incurred a loss on extinguishment of debt of $8.7 million, consisting of prepayment premiums and writing off associated unamortized debt issuance costs. Benefit for Income Taxes The benefit for income taxes for 2016 was $42 million compared to $32.5 million for the same period in 2015. The effective tax rate was 32% for 2016 and 41% for 2015. The decrease in the benefit rate is primarily related to the increased valuation allowance established on state net operating losses that we anticipate will not be able to be utilized prior to expiration. Income from Discontinued Operations, net of taxes As previously reported, the results of operations of the Climate Control Business have been presented as discontinued operations. For 2016, income from discontinued operations was $200.3 million, including a gain of $282 million and net of a tax provision of $91.7 million. For 2015, income from discontinued operations was $11.4 million, net of a tax provision of $9 million. LIQUIDITY AND CAPITAL RESOURCES The following table summarizes our continuing cash flow activities for 2017 and 2016: Cash Flow from Continuing Operating Activities Net cash provided by continuing operating activities was $2.3 million for 2017 compared to net cash used of $22.0 million for 2016, an improvement of approximately $24.3 million. For 2017, the net cash provided is the result of a net loss of $29.2 million plus a noncash adjustment of $67 million for depreciation, depletion and amortization of PP&E and other noncash adjustments totaling approximately $13.7 million less an adjustment of $40.4 million for deferred income taxes and approximately $8.8 million of net cash used primarily from our working capital including an increase in our trade accounts receivable. For 2016, the net cash used is the result of net income of $112.2 million less adjustments of $200.3 million for net income from discontinued operations and $42 million for deferred income taxes, plus adjustments of $59.4 million for depreciation, depletion and amortization of PP&E, $8.7 million for a loss on extinguishment of debt, other noncash adjustments totaling approximately $12.4 million and $27.6 million of net cash provided primarily from our working capital including an increase in our trade accounts payable, and deferred income associated with an amended LDAN purchase and sales agreement. Cash Flow from Continuing Investing Activities Net cash used by continuing investing activities was $10.8 million for 2017 compared to net cash provided of $153.3 million, a change of $164.1 million. For 2017, the net cash used relates to expenditures for PP&E of $35.4 million partially offset by net proceeds of $23.8 million from the sale of our working interests in certain natural gas properties, engineered products business (industrial machinery and related components) and other property and equipment as discussed above under “Recent Developments” and in Note 1 to the Consolidated Financial Statements and $0.8 million associated with other activities. For 2016, the net cash provided consists of $362 million of net proceeds from the sale of the Climate Control Business and other property and equipment and $3.8 million associated with other activities partially offset by $212.5 million of cash used for expenditures for PP&E. Cash Flow from Continuing Financing Activities Net cash used by continuing financing activities was $16.1 million for 2017 compared to $193.7 million for 2016, a change of approximately $177.6 million. For 2017, the net cash used consists of payments on long-term debt and related costs of $14.2 million and $1.9 million of other activities. For 2016, the net cash used relates to the payments on the 7.75% and 12% Senior Secured Notes totaling $100 million, the redemption of a portion of the Series E Redeemable Preferred including dividends of approximately $80 million, payments on long-term debt of $15.4 million and payments of debt and equity modification, extinguishment and issuance costs of $13.1 million partially offset by net proceeds from long-term debt financing of approximately $14.8 million. Capitalization The following is our total current cash, long-term debt, redeemable preferred stock and stockholders’ equity: (1) During 2017, concurrently with the closing of the purchase and sale agreement relating to Zena discussed above under “Business Developments-2017” of the Overview, a portion of the net proceeds (approximately $3.5 million) from the sale was used to repay the remaining outstanding balance of this promissory note. (2) Liquidation preference of $185.2 million as of December 31, 2017. We currently have a revolving credit facility, our Working Capital Revolver Loan, with a borrowing base of $50 million. As of December 31, 2017, our Working Capital Revolver Loan was undrawn and had $41.2 million of availability. As discussed below, we have planned capital improvements relating to maintaining and enhancing safety and reliability at our facilities of approximately $35 million for 2018. We believe that the combination of our cash on hand, the availability on our revolving credit facility, and our cash flow from operations will be sufficient to fund our anticipated liquidity needs for the next twelve months. Compliance with Long - Term Debt Covenants As discussed below under “Loan Agreements,” the Working Capital Revolver Loan requires, among other things, that we meet certain financial covenants. The Working Capital Revolver Loan does not include financial covenant requirements unless a defined covenant trigger event has occurred and is continuing. As of December 31, 2017, no trigger event had occurred. Loan Agreements and Redeemable Preferred Stock Senior Secured Notes due 2019 - LSB has $375 million aggregate principal amount of the 8.5% Senior Secured Notes currently outstanding. Interest is to be paid semiannually on February 1st and August 1st. Secured Promissory Note due 2019 - EDC is party to a secured promissory note due June 29, 2019. This promissory note bears interest at the annual rate of 5.73%. Principal and interest are payable in equal monthly installments with a final balloon payment of approximately $6.7 million. This promissory note is secured by the cogeneration facility equipment and is guaranteed by LSB. Secured Promissory Note due 2021 - EDC is party to a secured promissory note due March 26, 2021. This promissory note bears interest at the annual rate of 5.25%. Principal and interest are payable in monthly installments. This promissory note is secured by a natural gas pipeline at the El Dorado Facility and is guaranteed by LSB. Secured Promissory Note due 2023 - EDA is party to a secured promissory note due in May 2023. Principal and interest are payable in equal monthly installments with a final balloon payment of approximately $6.1 million. This promissory note bears interest at a rate that is based on the monthly LIBOR rate plus a base rate for a total of 5.62%. This promissory note is secured by the ammonia storage tank and related systems and is guaranteed by LSB. Working Capital Revolver Loan - At December 31, 2017, there were no outstanding borrowings under the Working Capital Revolver Loan and the net credit available for borrowings under our Working Capital Revolver Loan was approximately $41.2 million, based on our eligible collateral, less outstanding letters of credit as of that date. The maturity date of the Working Capital Revolver Loan is January 17, 2022, with a springing earlier maturity date (the “Springing Maturity Date”) that is 90 days prior to the maturity date of the currently existing senior notes (the “Senior Notes”), to the extent the Senior Notes are not refinanced or repaid prior to the Springing Maturity Date. The Working Capital Revolver Loan Amendment also provides for a springing financial covenant (the “Financial Covenant”), which requires that, if the borrowing availability is less than or equal to the greater of 10.0% of the total revolver commitments and $5 million, then the borrowers must maintain a minimum fixed charge coverage ratio of not less than 1.00:1.00. The Financial Covenant, if triggered, is tested monthly. Also see discussion above under “Compliance with Long-Term Debt Covenants. Redemption of Series E Redeemable Preferred - At December 31, 2017, there were 139,768 outstanding shares of Series E Redeemable Preferred. At any time on or after August 2, 2019, each Series E holder has the right to elect to have such holder’s shares redeemed by us at a redemption price per share equal to the liquidation preference per share of $1,000 plus accrued and unpaid dividends plus the participation rights value (the “Liquidation Preference”). Additionally, at our option, we may redeem the Series E Redeemable Preferred at any time at a redemption price per share equal to the Liquidation Preference of such share as of the redemption date. Lastly, with receipt of (i) prior consent of the electing Series E holder or a majority of shares of Series E Redeemable Preferred and (ii) all other required approvals, including under any principal U.S. securities exchange on which our common stock is then listed for trading, we can redeem the Series E Redeemable Preferred by the issuance of shares of common stock having an aggregate common stock price equal to the amount of the aggregate Liquidation Preference of such shares being redeemed in shares of common stock in lieu of cash at the redemption date. In the event of liquidation, the Series E Redeemable Preferred is entitled to receive its Liquidation Preference before any such distribution of assets or proceeds is made to or set aside for the holders of our common stock and any other junior stock. In the event of a change of control, we must make an offer to purchase all of the shares of Series E Redeemable Preferred outstanding at the Liquidation Preference. Since carrying values of the redeemable preferred stocks are being increased by periodic accretions (including the amount for dividends earned but not yet declared or paid) using the interest method so that the carrying amount will equal the redemption value as of August 2, 2019, the earliest possible redemption date by the holder, this accretion has and will continue to affect income (loss) per common share. In addition, this accretion could accelerate if the expected redemption date is earlier than August 2, 2019. As of December 31, 2017, the aggregate liquidation preference (par value plus accrued dividends) was $185.2 million. Also, see discussion in Notes 9 and 13 to Consolidated Financial Statements included in this report. Capital Improvements - 2017 For 2017, capital improvements relating to PP&E were $37.4 million, which improvements include approximately $3.1 million associated with maintaining compliance with environmental laws, regulations and guidelines. The capital improvements were funded primarily from cash and working capital. See discussion above under “Capitalization” for our expected annual capital improvements for 2018. Expenses Associated with Environmental Regulatory Compliance We are subject to specific federal and state environmental compliance laws, regulations and guidelines. As a result, we incurred expenses of $4.1 million in 2017 in connection with environmental projects. For 2018, we expect to incur expenses ranging from $3.6 million to $4.6 million in connection with additional environmental projects. However, it is possible that the actual costs could be significantly different than our estimates. Dividends We have not paid cash dividends on our outstanding common stock in many years, and we do not currently anticipate paying cash dividends on our outstanding common stock in the near future. Dividends on the Series E Redeemable Preferred are cumulative and payable semi-annually (May 1 and November 1) in arrears at the annual rate of 14% of the liquidation value of $1,000 per share. Each share of Series E Redeemable Preferred is entitled to receive a semi-annual dividend, only when declared by our Board of Directors. In addition, dividends in arrears at the dividend date, until paid, shall compound additional dividends at the annual rate of 14%. The current semiannual compounded dividend is approximately $90.69 per share for the current aggregate semi-annual dividend of $12.7 million. We also must declare a dividend on the Series E Redeemable Preferred on a pro rata basis with our common stock. As long as the Purchaser holds at least 10% of the Series E Redeemable Preferred, we may not declare dividends on our common stock and other preferred stocks unless and until dividends have been declared and paid on the Series E Redeemable Preferred for the then current dividend period in cash. As of December 31, 2017, the amount of accumulated dividends on the Series E Redeemable Preferred was approximately $45.5 million. See discussion under “Redeemable Preferred Stocks” of Note 1 to the Consolidated Financial Statements included in this report. Dividends on the Series D 6% cumulative convertible Class C preferred stock (the “Series D Preferred”) and Series B 12% cumulative convertible Class C Preferred Stock (the “Series B Preferred”) are payable annually, only when declared by our Board of Directors, as follows: • $0.06 per share on our outstanding non-redeemable Series D Preferred for an aggregate dividend of $60,000, and • $12.00 per share on our outstanding non-redeemable Series B Preferred for an aggregate dividend of $240,000. As of December 31, 2017, no dividend has been declared and the amount of accumulated dividends on the Series D Preferred and Series B Preferred totaled approximately $0.7 million. All shares of the Series D Preferred and Series B Preferred are owned by the Golsen Holders. There are no optional or mandatory redemption rights with respect to the Series B Preferred or Series D Preferred. Seasonality See discussion above under “Part I-Item 1 Business” for seasonality trends. Performance and Payment Bonds We are contingently liable to sureties in respect of insurance bonds issued by the sureties in connection with certain contracts entered into by subsidiaries in the normal course of business. These insurance bonds primarily represent guarantees of future performance of our subsidiaries. As of December 31, 2017, we have agreed to indemnify the sureties for payments, up to $10 million, made by them in respect of such bonds. All of these insurance bonds are expected to expire or be renewed in 2018. Off-Balance Sheet Arrangements We do not have any off-balance sheet arrangements as defined in Item 303(a)(4)(ii) of Regulation S-K under the Securities Exchange Act of 1934. Aggregate Contractual Obligations As of December 31, 2017, our aggregate contractual obligations are summarized in the following table: (1) The estimated interest payments relating to variable interest rate debt are based on interest rates at December 31, 2017. (2) The Series E redeemable preferred stock (including dividends) are assumed to be redeemed and paid on the earliest possible redemption date by the holder (August 2, 2019) and that dividends are accrued until that date. (3) Other capital expenditures include only the estimated committed amounts (high end of range) at December 31, 2017. (4) Our proportionate share of the minimum costs to ensure capacity relating to a gathering and pipeline system. (5) The future cash flows relating to executive and death benefits are based on estimates at December 31, 2017. The participation rights value associated with embedded derivative of our Series E redeemable preferred stock is based the value of our common stock at December 31, 2017 and is based on the earliest possible redemption date by the holder, August 2, 2019. New Accounting Pronouncements For recently adopted and recently issued accounting standards, see discussions in Note 1 - Summary of Significant Accounting Policies to the Consolidated Financial Statements included in this report. Critical Accounting Policies and Estimates The preparation of financial statements requires management to make estimates and assumptions that affect the reported amount of assets, liabilities, revenues and expenses, and disclosures of contingencies and fair values. It is reasonably possible that the estimates and assumptions utilized as of December 31, 2017, could change in the near term. The more critical areas of financial reporting affected by management's judgment, estimates and assumptions include the following: Strategic Review of Certain Assets - As discussed above under “Overview,” one of our key initiatives for 2018 is the continued review of our cost structure with the goal of reducing our annual overall costs. In conjunction with this review, we continue to evaluate the return on investment and necessity of certain assets. As a result, we currently own certain assets (net book value of approximately $7 million) that we are considering selling. Due to the nature of some of these assets, there may be a limited market. As a result, and depending on appraisals obtained and offers received, if any, from potential buyers, it is reasonably possible we could incur impairment charges or losses on sales of assets in the near term. Contingencies - Certain conditions may exist which may result in a loss, but which will only be resolved when future events occur. We and our legal counsel assess such contingent liabilities, and such assessment inherently involves an exercise of judgment. If the assessment of a contingency indicates that it is probable that a loss has been incurred, we would accrue for such contingent losses when such losses can be reasonably estimated. If the assessment indicates that a potentially material loss contingency is not probable but reasonably possible, or is probable but cannot be estimated, the nature of the contingent liability, together with an estimate of the range of possible loss if determinable and material, would be disclosed. Estimates of potential legal fees and other directly related costs associated with contingencies are not accrued but rather are expensed as incurred. Loss contingency liabilities are included in current and noncurrent accrued and other liabilities and are based on current estimates that may be revised in the near term. In addition, we recognize contingent gains when such gains are realized or realizable and earned. We are involved in various legal matters that require management to make estimates and assumptions, including costs relating to the lawsuit styled City of West, Texas v CF Industries, Inc., et al, and BAE Systems Ordinance Systems, Inc., et al. vs. El Dorado Chemical Company, discussed under “Other Pending, Threatened or Settled Litigation” of Note 11 to Consolidated Financial Statements include in this report. It is reasonably possible that the actual costs could be significantly different than our estimates. Regulatory Compliance - As discussed under “Environmental, Health and Safety Matters” in Item 1 of this report, we are subject to specific federal and state regulatory compliance laws and guidelines. We have developed policies and procedures related to regulatory compliance. We must continually monitor whether we have maintained compliance with such laws and regulations and the operating implications, if any, and amount of penalties, fines and assessments that may result from noncompliance. We will also be obligated to manage certain discharge water outlets and monitor groundwater contaminants at our chemical facilities should we discontinue the operations of a facility. However, certain conditions exist which may result in a loss, but which will only be resolved when future events occur relating to these matters. We are involved in various environmental matters that require management to make estimates and assumptions, including our current inability to develop a meaningful and reliable estimate (or range of estimate) as to the costs relating to a corrective action study work plan approved by the Kansas Department of Health and Environment (“KDHE”) discussed under footnote 3 - Other Environmental Matters of Note 11. At December 31, 2017 and 2016, liabilities totaling $0.2 million and $0.3 million, respectively have been accrued relating to these issues as discussed. This liability is included in current accrued and other liabilities and is based on current estimates that may be revised in the near term. At the time that cost estimates for any corrective action are received, we will adjust our accrual accordingly. It is reasonably possible that the adjustment to the accrual and the actual costs could be significantly different than our current estimates. Redeemable Preferred Stocks - On December 4, 2015, we issued the Series E and F Redeemable Preferred. The redeemable preferred stocks are redeemable outside of our control and are classified as temporary/mezzanine equity on our consolidated balance sheet. In addition, certain embedded features (the “embedded derivative”) included in the Series E Redeemable Preferred required bifurcation and are classified as derivative liabilities. Currently, the carrying values of the redeemable preferred stocks are being increased by periodic accretions (recorded to retained earnings and included in determining income or loss per share) using the interest method so that the carrying amount will equal the redemption value as of August 2, 2019, the earliest possible redemption date by the holder. However, a portion of this accretion was accelerated ($6.6 million) during 2016 as the result of the redemption discussed in Note 9 and the remaining accretion could accelerate if the expected redemption date is earlier than August 2, 2019. Approximately $30 million of accretion (including the amount for earned dividends) was recorded to retained earnings in 2017. At December 31, 2017, the carrying value of these redeemable preferred stocks was $175 million. For the embedded derivative, changes in fair value are recorded in our statement of operations. As the result of the effect of certain amendments to the Senior Secured Notes indenture (“Indenture Amendments”) in connection with the consent solicitation initiated in August 2016 (“Consent Solicitation”) as discussed in Note 9, including the redemption of the portion of Series E Redeemable Preferred discussed in Notes 9 and 13, we estimate that the contingent redemption feature has no fair value based on low probability that the remaining shares of Series E Redeemable Preferred would be redeemed prior to August 2, 2019. At December 31, 2017 and 2016, the fair value of the participation rights was $2.7 million and $2.6 million, respectively, based on the equivalent of 303,646 shares of our common stock at $8.76 and $8.42 per share, respectively. No valuation input adjustments were considered necessary relating to nonperformance risk for the embedded derivative based on our current forecast. The valuation is classified as Level 3. Management’s judgment and estimates in the above areas are based on information available from internal and external resources at that time. Actual results could differ materially from these estimates and judgments, as additional information becomes known.

<s>[INST] Overview General LSB is headquartered in Oklahoma City, Oklahoma and through its subsidiaries, manufactures and sells chemical products for the agricultural, mining, and industrial markets. We own and operate facilities in Cherokee, Alabama, El Dorado, Arkansas and Pryor, Oklahoma, and operate a facility for Covestro in Baytown, Texas. Our products are sold through distributors and directly to end customers throughout the U.S. Key Initiatives for 2018 We believe our future results of operations and financial condition will depend significantly on our ability to successfully implement the following key initiatives: Improving the onstream rates of our chemical plants. We have several initiatives underway that we believe will assist us in improving the reliability of our plants and allow us to produce more products for sale while lowering our cost of production. In 2017, we made the decision to upgrade our existing maintenance management system through technology enhancements and work processes to improve our predictive and preventative maintenance programs at our facilities. At that time, we also made the decision to engage outside maintenance experts to assist us in expediting its implementation and in its overall use. We expect that the system will be implemented by the end of the second quarter of 2018 and we will begin to see the benefits in the second half of 2018. Additionally, specific to our Pryor Facility, we engaged several outside engineering firms to assist us in an overall plant reliability study which will be used to enhance our reliability improvement plan for that facility. We expect the study to be completed during the second quarter of 2018. Focus on the Continued Improvement of Our Safety Performance. We believe that high safety standards are critical to improved plant performance. With that in mind, we implemented enhanced safety programs at our facilities that focus on reducing risks and improving our safety culture in 2017. The implementation and training of these programs will continue in 2018 and we expect these will benefit our onstream rates. Continue Broadening of the distribution of our AN and Nitric Acid products. We increased our overall sales volume of HDAN in 2017 by approximately 60,000 tons or 26% to approximately 290,000 tons compared to 230,000 tons for 2016 through various marketing initiatives which include: (1) storing and distributing HDAN at our Pryor and Cherokee Facilities which allows us to sell to new markets and customers out of those facilities and; (2) educating growers on the additional applications for HDAN. In 2018, we will continue to focus on those initiatives and other initiatives in an effort to continue to grow our annual sales volumes over 2017. In addition, through increased marketing efforts, we increased our sales volumes of Nitric Acid by approximately 18,000 tons from 82,000 tons in 2016 to 100,000 tons in 2017. We will continue to focus on increasing our marketing efforts in order to expand our market for our nitric acid products in North America. Improving the Margins on Sales of Our Products. Over the last several years, we have focused on increasing our sales volumes to produce at optimal onstream rates and lower our manufacturing costs per ton of product. Beginning in 2018, we will undertake a review of all sales to customers to determine if there are opportunities to improve the margins on sales to those customers and to explore if there are further product upgrading opportunities. Reducing and controlling our cost structure. We have engaged outside experts to assist us in centralizing and expanding our Companywide procurement efforts. We expect this to be implemented by the end of the second quarter of 2018 and believe that these efforts will result in a reduction in expenses and capital spend in the aggregate of between $3 million to $5 million on an annualized basis. Over the last 18 months, we have reduced our SG&A and plant expenses over $12 million annually and believe, in addition to the procurement initiative discussed above, there is still an opportunity to further reduce those expenses. Focus on Improving Our Capital Structure and Overall Cost of Capital. We are actively seeking ways to improve our capital structure and reduce our overall cost of capital. We believe that the improving end markets for our products combined with our improved [/INST] Positive. </s>

LSB INDUSTRIES INC

2019-02-26

2018-12-31

ITEM 7. MANAGEMENT’S DISCUSSION AND ANALYSIS OF FINANCIAL CONDITION AND RESULTS OF OPERATIONS The following MD&A should be read in conjunction with a review of the other Items included in this Form 10-K and our December 31, 2018 Consolidated Financial Statements included elsewhere in this report. Certain statements contained in this MD&A may be deemed to be forward-looking statements. See “Special Note Regarding Forward-Looking Statements.” Overview General LSB is headquartered in Oklahoma City, Oklahoma and through its subsidiaries, manufactures and sells chemical products for the agricultural, mining, and industrial markets. We own and operate facilities in Cherokee, Alabama; El Dorado, Arkansas; and Pryor, Oklahoma, and operate a facility for Covestro in Baytown, Texas. Our products are sold through distributors and directly to end customers throughout the U.S. Key Operating Initiatives for 2019 We believe our future results of operations and financial condition will depend significantly on our ability to successfully implement the following key initiatives: • Improving the On-Stream Rates of our Chemical Plants. Over the past 18 months, our focus has been on upgrading our existing maintenance management system through technology enhancements and work processes to improve our predictive and preventative maintenance programs at our facilities. We engaged outside maintenance experts to assist us in expediting implementation and overall use. We have completed the initial implementation. Additionally, beginning in the third quarter of 2018, we engaged outside consultants to do a thorough review of our operating and maintenance procedures and our preventive maintenance programs at all of our facilities in an effort to determine where we may have gaps in procedures and programs and where we may need enhancements. Based on the “Gap Analysis” completed, we have several initiatives underway that we believe will improve the overall reliability of our plants and allow us to produce more products for sale while lowering our cost of production. Those initiatives are focused on operating behavior and procedure enhancements including operator training, leadership training, shift change enhancements and operating and maintenance procedures. • Focus on the Continued Improvement of Our Safety Performance. We believe that high safety standards are critical and a precursor to improved plant performance. With that in mind, we implemented enhanced safety programs at our facilities that focus on reducing risks and improving our safety culture. As a result of these programs, we significantly lowered our recordable incident rate in 2018 as compared to the prior year and we remain well below the national average for recordable safety incidents. • Continue Broadening of the Distribution of our Products. We increased our overall sales volume of HDAN over the past 24 months by approximately 30% through various marketing initiatives which include: (1) storing and distributing HDAN at our Pryor Facility which allows us to sell to new markets and customers out of that facility and; (2) educating growers on the agronomic benefits and the additional applications for HDAN. To further leverage our plants’ current production capacity, we are continuing to expand the distribution of our mining products by partnering with customers to take product further into the Western U.S. as well as markets outside the U.S. We also partnered with a current customer to position an emulsion explosives plant at our El Dorado Facility. We began selling product to that facility in the fourth quarter of 2018. We will continue to explore further guest plant opportunities at our facilities in 2019. In addition, through increased marketing efforts, we increased our sales volumes of nitric acid over the past 24 months by approximately 35%. We continue to focus our efforts to expand our market for our nitric acid products in North America and to fully utilize available nitric acid production capacity of our facilities. • Improving the Margins on Sales of Our Products. Over the last several years, we have focused on increasing our sales volumes to produce at optimal on-stream rates and lower our manufacturing costs per ton of product. In 2019, we will undertake a review of all sales to customers to determine if there are opportunities to improve the margins on sales to those customers and to explore if there are further product upgrading opportunities. • Continued Focus on Procurement and Logistics. In 2018, we engaged outside experts to assist us in centralizing and expanding our Company-wide procurement efforts. We completed our initial areas of focus during the second quarter of 2018, completed the implementation of those changes, and began to see benefits during the third quarter of 2018. We believe that these efforts along with several additional identified areas of focus, will result in an overall reduction in expenses and capital spend in the aggregate of between $3 million to $5 million on an annualized basis, which we expect to realize over the next 12 to 24 months. Additionally, we will continue to focus on improving the effectiveness and overall cost of our logistics strategy through a centrally managed team focused on building logistics partners that will help us further drive efficiencies in 2019. • Focus on Improving Our Capital Structure and Overall Cost of Capital. We are actively seeking ways to improve our capital structure and reduce our overall cost of capital. We believe that the improving end markets for our products combined with our improved operating performance will be a benefit in achieving those efforts. As a part of that, in the second quarter of 2018, we refinanced our outstanding Senior Secured Notes. We will continue to actively seek ways to improve our capital structure going forward. We may not successfully implement any or all of these initiatives. Even if we successfully implement the initiatives, they may not achieve the results that we expect or desire. Business Developments - 2018 Financing Transaction and Series E Redeemable Preferred Letter Agreement As discussed in Note 7 to the Consolidated Financial Statements, on April 25, 2018 (the date of the “Financing Transactions”), we issued $400 million aggregate principal amount of 9.625% Senior Secured Notes due 2023 (the “Senior Secured Notes”). Most of the net proceeds from the Senior Secured Notes were used to repurchase all of our senior secured notes due 2019. As discussed in Note 11, in connection with the financing transactions discussed above, we entered into a letter agreement with the holder of our Series E Redeemable Preferred to extend the date upon which a holder of Series E Redeemable Preferred has the right to elect to have such holder’s shares of Series E Redeemable Preferred redeemed by us from August 2, 2019 to October 25, 2023. The letter agreement also provides for the amendment of certain other terms relating to the Series E Redeemable Preferred, including an increase in the per annum dividend rate payable in respect of the Series E Redeemable Preferred (a) by 0.50% on the third anniversary of the financing transactions, (b) by an additional 0.50% on the fourth anniversary of the financing transactions and (c) by an additional 1.0% on the fifth anniversary of the financing transactions. Completion of a Turnaround at Cherokee During 2018, we successfully completed a 35-day Turnaround performed on our plants at our Cherokee Facility. The next Turnaround for this facility is scheduled in 2021. See additional discussion below under “Items Affecting Comparability of Results.” Sale of Certain Non-Core Assets During 2018, we sold certain non-core assets (primarily real estate properties) for approximately $6.0 million of net proceeds and recognized a net gain of approximately $2.4 million that is included in other income. We continue to evaluate our assets to determine if there are additional non-core assets that we should consider monetizing. Key Industry Factors Supply and Demand Agricultural Sales of our agricultural products were approximately 50% of our total net sales for 2018. The price at which our agricultural products are ultimately sold depends on numerous factors, including the supply and demand for nitrogen fertilizers which, in turn, depends upon world grain demand and production levels, the cost and availability of transportation and storage, weather conditions, competitive pricing and the availability of imports. Additionally, expansions or upgrades of competitors’ facilities and international and domestic political and economic developments continue to play an important role in the global nitrogen fertilizer industry economics. These factors can affect, in addition to selling prices, the level of inventories in the market which can cause price volatility and effect product margins. Additionally, changes in corn prices and those of soybean, cotton and wheat prices, can affect the number of acres of corn planted in a given year, and the number of acres planted will drive the level of nitrogen fertilizer consumption, likely effecting prices. Industry reports indicated China’s recent tariffs placed on U.S. soybeans could result in a shift of 2 to 4 million acres that will be rotated from soybeans to corn in this next planting season. The USDA also estimates an increase in 2019 corn acres that is in line with other industry reports ranging between 92 million to 93 million acres. Soybean pricing concerns may drive crop planting selection when final crop choices are made at the farm level. The following February estimates are associated with the corn market: (1) Information obtained from WASDE reports dated February 8, 2019 (February Report) for the 2018/2019 (“2019 Crop”), 2017/2018 (“2018 Crop”) and 2016/2017 (“2016”) corn marketing years. (2) Represents the percentage change between the 2019 Crop amounts compared to the 2018 Crop amounts. (3) Represents the percentage change between the 2019 Crop amounts compared to the 2017 Crop amounts. On the supply side, given the low price of natural gas in North America over the last several years, North American fertilizer producers have become the global low-cost producers for delivered fertilizer products to the Midwest U.S. Several years ago, the market believed that low natural gas prices would continue. That belief, combined with favorable fertilizer pricing, stimulated investment in numerous expansions of existing nitrogen chemical facilities and the construction of new nitrogen chemical facilities. Since those announcements, global nitrogen fertilizer supply has outpaced global nitrogen fertilizer demand causing oversupply in the global and North American markets. The increased fertilizer supply led to lower nitrogen fertilizer sale prices during most of 2017. Also, additional domestic supply of ammonia and other fertilizer products changed the physical flow of ammonia in North America placing pressure on ammonia and other fertilizer prices until the distribution system accepted the new supply. Beginning in the fourth quarter of 2017 and through 2018, we have seen an increase in fertilizer prices as imports of fertilizers have decreased significantly and the distribution of the new domestic supply of fertilizer has been established. We expect this trend to continue into 2019. Industrial Sales of our industrial products were approximately 39% of our total net sales for 2018. Our industrial products sales volumes are dependent upon general economic conditions primarily in the housing, automotive, and paper industries. According to the American Chemistry Council, the U.S. economic indicators continue to be positive for these sectors domestically. Our sales prices generally vary with the market price of ammonia or natural gas, as applicable, in our pricing arrangements with customers. Mining Sales of our mining products were approximately 11% of our total net sales for 2018. Our mining products are LDAN and AN solutions, which are primary used as AN fuel oil and specialty emulsions for surface mining of coal and for usage in quarries and the construction industry. As reported by the EIA, annual coal production in the U.S. for the full year of 2018 is down 3% from 2017 due to this market’s weak competitive position in the electrical generation sector compared with natural gas and to a lesser degree lower export demand. EIA is forecasting another 3% decrease in U.S. coal production in 2019 followed by a continued decline of 7% in 2020. This estimated decline is based on the continual shift in utility-scale electricity generation from coal to natural gas. We believe that coal production in the U.S. continues to face significant challenges from competition from natural gas and renewable sources of energy. While we believe, our plants are well located to support the more stable coal-producing regions in the upcoming years, our current mining sales volumes are being affected by overall lower customer demand for LDAN. As part of our continued effort to expand sales of our mining products, we entered into an agreement with a current customer, by which the customer has located an emulsion explosives plant at our El Dorado Facility. We will continue to explore further guest plant opportunities in 2019. Farmer Economics The demand for fertilizer is affected by the aggregate crop planting decisions and fertilizer application rate decisions of individual farmers. Individual farmers make planting decisions based largely on prospective profitability of a harvest, while the specific varieties and amounts of fertilizer they apply depend on factors such as their financial resources, soil conditions, weather patterns and the types of crops planted. Natural Gas Prices Natural gas is the primary feedstock used to produce nitrogen fertilizers at our manufacturing facilities. In recent years, U.S. natural gas reserves have increased significantly due to, among other factors, advances in extracting shale gas, which has reduced and stabilized natural gas prices, providing North America with a cost advantage over certain imports. As a result, our competitive position and that of other North American nitrogen fertilizer producers has been positively affected. We historically have purchased natural gas in the spot market, using forward purchase contracts, or through a combination of both and have used forward purchase contracts to lock in pricing for a portion of our natural gas requirements. These forward purchase contracts are generally either fixed-price or index-price, short-term in nature and for a fixed supply quantity. We are able to purchase natural gas at competitive prices due to our connections to large distribution systems and their proximity to interstate pipeline systems. The following table shows the annual volume of natural gas we purchased and the average cost per MMBtu: Transportation Costs Costs for transporting nitrogen-based products can be significant relative to their selling price. For example, ammonia is a hazardous gas at ambient temperatures and must be transported in specialized equipment, which is more expensive than other forms of nitrogen fertilizers. In recent years, a significant amount of the ammonia consumed annually in the U.S. was imported. Therefore, nitrogen fertilizers prices in the U.S. are influenced by the cost to transport product from exporting countries, giving domestic producers who transport shorter distances an advantage. However, we continue to evaluate the recent rising costs of rail and truck freight domestically. Higher transportation costs may impact our margins if we are not able to pass through these costs. As a result, we continue to evaluate supply chain efficiencies to reduce or counter the impact of higher logistics costs. Key Operational Factors Facility Reliability Consistent, reliable and safe operations at our chemical plants are critical to our financial performance and results of operations. The financial effects of planned downtime at our plants, including Turnarounds is mitigated through a diligent planning process that considers the availability of resources to perform the needed maintenance, feedstock logistics and other factors. Unplanned downtime of our plants typically results in lost contribution margin from lost sales of our products, lost fixed cost absorption from lower production of our products and increased costs related to repairs and maintenance. All Turnarounds result in lost contribution margin from lost sales of our products, lost fixed cost absorption from lower production of our products, and increased costs related to repairs and maintenance, which repair, and maintenance costs are expensed as incurred. Also see the Turnaround costs presented in the Quarterly Financial Data of the Consolidated Financial Statements included in this report. Our El Dorado Facility performed partial Turnaround activities in the second and third quarters of 2018. The remaining portion of this Turnaround activity will be performed in the third quarter of 2019. Following the completion of this work, we expect the El Dorado Facility to move to a three-year Turnaround cycle with the next Turnaround planned in the third quarter of 2022. Our Cherokee Facility is currently on a three-year Turnaround cycle, with the last Turnaround performed in the third quarter of 2018 lasting 35 days. The next Turnaround to be performed is expected to occur in the third quarter of 2021. During the unplanned outage in the fourth quarter of 2017 at our Pryor Facility, we replaced the process gas pre-heat system which was originally planned for a scheduled Turnaround in 2018. Completing the Turnaround at that time allowed us to avoid the previously planned Turnaround in 2018. A Turnaround is scheduled for the third quarter of 2019 and we expect to continue with a two-year Turnaround cycle at this facility with the next Turnaround planned for the third quarter of 2021. At that time, we will seek to move to a three-year Turnaround cycle. Prepay Contracts We use forward sales of our fertilizer products to optimize our asset utilization, planning process and production scheduling. These sales are made by offering customers the opportunity to purchase product on a forward basis at prices and delivery dates that are agreed upon. We use this program to varying degrees during the year depending on market conditions and our view of changing price environments. Fixing the selling prices of our products months in advance of their ultimate delivery to customers typically causes our reported selling prices and margins to differ from spot market prices and margins available at the time of shipment. Consolidated Results for 2018 Our consolidated net sales for 2018 were $378.2 million compared to $427.5 million for 2017. Our consolidated operating loss was $23.0 million compared to $34.1 million for 2017. The items affecting our operating results are discussed below and under “Results of Operations.” Items Affecting Comparability of Results Turnaround Expense During 2018, we incurred Turnaround costs totaling approximately $9.8 million associated with a 35-day Turnaround performed on our plants at our Cherokee Facility and a total of 12 days associated with Turnaround activity at our El Dorado Facility. During 2017, we incurred Turnaround costs of approximately $1.3 million primarily relating to a 17-day Turnaround at our Pryor Facility. Turnaround costs are included in cost of sales. The Turnaround costs noted above do not include the impact on operating results relating to lost absorption of fixed costs or the reduced margins due to the lost production and subsequent product sales from our plants being shut down during the Turnaround. On-Stream Rates The on-stream rates of our plants affect our production, the absorption of fixed costs of each plant and sales of our products. It is a key operating metric that we use to manage our business. In particular, we closely monitor the on-stream rates of our ammonia plants as ammonia is the basic product as used to produce all upgraded products. The on-stream rates noted below exclude Turnaround days, when applicable. At our Cherokee Facility, the ammonia plant on-stream rate for 2018 was 94% compared to 99% for the same period of 2017. The ammonia plant’s on-stream rate was impacted by maintenance completed on its primary reformer during the first quarter of 2018. Our target on-stream rate for this ammonia plant for 2019 is 95%. At our El Dorado Facility, the ammonia plant’s on-stream rate for 2018 was 88% compared to 86% for the same period of 2017. The ammonia plant’s on-stream rate for 2018 was impacted by maintenance completed on its boiler relating to tube failures caused by a power outage during June 2018. The El Dorado Facility’s ammonia plant operated at 93% during the second half of 2018 and we are targeting an ammonia plant average on-stream rate for 2019 of 95%. At our Pryor Facility, the on-stream rate for 2018 for our ammonia plant increased to 89% from 69% in 2017. Despite having to perform maintenance to repair leaks in the ammonia plant’s waste heat boiler during 2018, this was the Pryor Facility’s best full year performance since we brought the facility online in 2010. We view this result as an indication that the leadership changes in personnel and reliability investments made, coupled with the maintenance management systems, procedures and preventative maintenance programs being implementing are yielding positive results. While we anticipate brief periods of unscheduled downtime during 2019 as we continue to take actions to improve long-term reliability, we are targeting an ammonia plant average on-stream rate for 2019 of 90%. We believe that our focus on improving on-stream rates as discussed in key operating initiatives will continue to improve our overall on-stream rate for 2019. Selling Prices During 2018, we experienced improved selling prices for our agricultural products compared to 2017. Average selling prices for our ammonia, UAN and HDAN increased 16%, 15% and 11%, respectively compared to 2017 average selling prices. This increase reflects a more favorable alignment of demand with market capacity for these products. We expect these overall sales price levels to continue into 2019. Our 2018 average industrial selling prices for our ammonia also improved compared to 2017. 2018 average Tampa Ammonia pricing improved 12% as compared to 2017 and many of our industrial contracts are indexed to the Tampa Ammonia price. Depreciation Expense During 2018 and 2017, depreciation expense was $70.3 million and $67.0 million, respectively. For 2018, approximately $2.0 million relates to accelerated depreciation at the El Dorado Facility due to the tube failures discussed above. Interest Expense During 2018 and 2017, interest expense was $43.1 million and $37.3 million, respectively. The change primarily relates to our Senior Secured Notes, which includes approximately $0.9 million related to debt modification fees associated with the financing transactions discussed above under “Business Developments - 2018” and in Note 7 to the Consolidated Financial Statements. Loss on Extinguishment of Debt (2018 only) As the result of the financing transactions relating to the Senior Secured Notes and repurchase of the senior secured notes due 2019, we incurred a loss on extinguishment of debt of $6.0 million. Valuation Allowance on Deferred Tax Assets (2018 only) As discussed in Note 8 and below under “Critical Accounting Policies and Estimates”, during the second quarter of 2018, we established a valuation allowance on a portion of our federal deferred tax assets (resulting in an income tax provision) since we currently believe that it is more-likely-than-not that a portion of our federal deferred tax assets will not be able to be utilized. The impact from the valuation allowance in 2018 was approximately $15 million. Severance Benefits and Accelerated Stock-based Compensation (2018 only) We incurred $5.3 million associated with certain severance benefits and accelerated stock-based compensation relating to Daniel D. Greenwell, our former Chief Executive Officer (“CEO”), electing not to renew his employment agreement in December 2018. Recovery from a Settlement with a Vendor (2018 only) We and a vendor mediated a settlement relating primarily to a business interruption claim caused by defective work performed by the vendor at our Pryor Facility. As a result of the settlement, the vendor paid us $4.0 million. As part of the settlement, we paid the vendor $0.5 million to settle $1.1 million of invoices that were held in our accounts payable. As a result, we recognized a recovery from this settlement totaling $4.6 million of which $4.4 million was classified as a reduction to cost of sales (primarily relating to our business interruption claim) and the remaining balance of $0.2 million as a reduction to PP&E. Adoption of ASC 606 in 2018 See discussion concerning the impact from the adoption of ASC 606 in Note 2. Results of Operations The following Results of Operations should be read in conjunction with our consolidated financial statements for the years ended December 31, 2018, 2017, and 2016 and accompanying notes and the discussions under “Overview” and “Liquidity and Capital Resources” included in this MD&A. We present the following information about our results of operations. Net sales to unaffiliated customers are reported in the consolidated financial statements and gross profit represents net sales less cost of sales. Net sales are reported on a gross basis with the cost of freight being recorded in cost of sales. Year Ended December 31, 2018 Compared to Year Ended December 31, 2017 The following table contains certain financial information relating to our continuing operations: (1) See discussion concerning the impact from the adoption of ASC 606 in Note 2 to the Consolidated Financial Statements (2) As a percentage of net sales (3) See discussion in Note 8 to the Consolidated Financial Statements The following tables provide key operating metrics for the Agricultural Products: With respect to sales of Industrial and Other Chemical Products, the following table indicates the volumes sold of our major products: With respect to sales of Mining Products, the following table indicates the volumes sold of our major products: Net Sales • Agricultural products sales increased primarily from higher average sales prices for our major products as a result of improved commodity pricing and overall higher product selling prices. This increase was partially offset by the lost production at our Cherokee Facility resulting from a 35-day Turnaround performed during 2018. UAN volumes were also higher in 2017 due to the timing of barge shipments that crossed over year-end and landed in the first quarter of 2017. Additionally, ammonia sales volumes were lower as a result of a poor fall application season. The delayed 2018 fall harvest coupled with poor weather conditions resulted in a decline of approximately 55% of fall ammonia applications compared to the 2017 fall application season. As a result of the lower demand, a portion of our agricultural ammonia was sold into our industrial markets. HDAN sales volumes, although slightly higher than 2017, were also impacted by substantially higher rainfall amounts occurring during the last few months of 2018. • Industrial acids and other industrial chemical products sales decreased approximately 24%, due to the impact from adopting ASC 606 as discussed in Note 2. Since we adopted ASC 606 using the “modified retrospective” method, the prior periods were not restated. If we had applied ASC 606 to these specific arrangements during 2017, net sales for these products would have been reduced by approximately $65.4 million to $130.7 million representing a $17.9 million or 13.7% increase for 2018 compared to 2017. Excluding this impact, sales increased primarily due to improved average selling prices and stronger sales volumes reflecting expanded marketing efforts and the continued strength of the U.S. economy. • Mining product sales increased primarily as a result of the broadening of our AN distribution markets combined with new guest plant arrangements. • Other products consist of natural gas sales from our former working interests in certain natural gas properties and sales from our former business that sold industrial machinery and related components, both of which were sold during 2017. Gross Profit As noted in the table above, we recognized a gross profit of $15.8 million in 2018 compared to $5.5 million in 2017, or an increase in gross profit of approximately $10.3 million. In addition to the net positive effect from the higher sales discussed above, our gross profit improvement includes a net reduction of natural gas cost of approximately $1.3 million from lower average natural gas prices, partially offset by higher natural gas volumes purchased as the result of improved on-stream and production rates at our Pryor and El Dorado Facilities, which are the result of implementing our key operating initiatives to improve plant reliability. Our gross profit was also impacted by the following: • approximately $8.5 million from higher expenses associated with the Turnarounds primarily performed at our Cherokee and El Dorado Facilities and the resulting lost production during the 35-day and 12-day Turnarounds at Cherokee and El Dorado: and • approximately $3.2 million from additional consulting costs associated with our reliability and purchasing initiatives. Also, as discussed above under “Items Affecting Comparability-Recovery from a Settlement with a Vendor”, our 2018 gross profit included a recovery from a settlement with a vendor of $4.4 million classified as a reduction to cost of sales (primarily relating to our business interruption claim). In addition, 2017 gross profit included a recovery of precious metals of $2.9 million and approximately $3.3 million of gross profit associated with our former industrial machinery business and working interests in certain natural gas properties, both sold in 2017. Selling General and Administrative Expense Our SG&A expenses were $40.8 million for 2018, an increase of $5.8 million compared to 2017, of which $5.3 million associated with severance benefits and accelerated stock-based compensation relating to our former CEO electing not to renew his employment agreement in December 2018. Excluding this impact, SG&A expenses increased $0.5 million including higher professional fees of $2.6 million associated with our legal matters partially offset by a reduction in insurance and other miscellaneous expenses of $0.5 million and the impact from $1.6 million of SG&A expenses related to two former businesses that were sold in 2017. Other Expense (Income), net Other income for 2018 was $2.0 million that includes a net gain from the sales of certain non-core assets (primarily consisting of real estate). Other expense for 2017 was $4.6 million for 2017 that includes a total net loss of $7.0 million primarily from the sales of our engineered products business (industrial machinery and related components) and other non-core assets partially offset by the extinguishment and derecognition of a liability of approximately $1.4 million associated with a death benefit agreement and $1.0 million in miscellaneous items. Interest Expense, net Interest expense for 2018 was $43.1 million compared to $37.3 million for 2017. The increase relates primarily to the issuance of the Senior Secured Notes and approximately $0.9 million related to debt modification fees associated with this financing as discussed in Note 7 to the Consolidated Financial Statements. Loss on Extinguishment of Debt During 2018, we incurred a loss on extinguishment of debt of approximately $6.0 million as discussed above under “Items Affecting Comparability of Results - Loss on Extinguishment of Debt” and in Note 7. Provision (Benefit) for Income Taxes The provision for income taxes for 2018 was $1.7 million compared to a $40.8 million benefit in the same period in 2017. The effective tax rate, including the impact of tax reform adjustments, was 2.5%, as compared to a benefit rate of 57% for 2017. The 2018 effective tax rate was impacted by adjustments made to our valuation allowances during 2018 including a reversal of approximately $2.3 million of state valuation allowance related to tax law changes. The significant tax benefit in 2017 was primarily due to the adjustments recorded in 2017 on the deferred tax assets and liabilities from the decrease in the federal enacted tax rate as a result of tax reform in 2017. Income from Discontinued Operations, net of taxes The results of operations of our former Climate Control Business are presented as discontinued operations. For 2017, income from discontinued operations was $1.1 million, consisting of a gain of $2.6 million relating primarily to estimate revisions to contingent obligations and net of a tax provision of $1.5 million. Year Ended December 31, 2017 Compared to Year Ended December 31, 2016 The following table contains certain financial information relating to our continuing operations: (1) As a percentage of net sales The following tables provide key operating metrics for the Agricultural Products: With respect to sales of Industrial and Other Chemical Products, the following table indicates the volumes sold of our major products: With respect to sales of Mining Products, the following table indicates the volumes sold of our major products: Net Sales Agricultural and industrial sales for 2017 were both significantly higher due to increased sales volumes that were partially offset by decreased average selling prices while mining sales for 2017 were lower due to lower average prices and a net decrease in sales volume compared to 2016. • Agricultural products sales increased primarily from higher sales volume across all product categories. The increase in sales volume was primarily the result of overall improved on-stream and production rates at our El Dorado and Cherokee Facilities, the absence of a Cherokee Turnaround in 2017 and the broadening of our distribution of HDAN to new markets and customers. Partially offsetting the increase in sales volume was lower average selling prices, primarily due to: (1) lower average commodity prices; (2) weather in the early spring that caused less ammonia to be applied during pre-plant season which caused an inventory buildup and; (3) the nitrogen production capacity being added globally, and in North America specifically. • Industrial acids and other chemical products sales increased driven by strong industrial ammonia sales at our El Dorado Facility from higher plant on-stream rates (minimal ammonia production during the first half of 2016 from this facility). In addition, nitric acid sales from El Dorado continued to expand and sales volume was significantly higher compared to 2016, although at lower net prices due to longer shipping distances and stronger market competitive pressures. • Mining products sales decreased primarily as the result of both lower sales volume and lower selling prices of AN Solution partially offset by increases in LDAN sales volume from our El Dorado Facility. We continued to face lower sales volume of AN Solution from our Cherokee Facility as demand from our customers remained suppressed by overall Appalachia coal market conditions and increased competitive production capacity in our region. • Other products consist of natural gas sales from our former working interests in certain natural gas properties and sales from our former business that sold industrial machinery and related components, both of which were sold during 2017. Gross Profit As noted in the table above, we recognized a gross profit of $5.5 million in 2017 compared to a gross loss of $49.3 million in 2016, or an increase in gross profit of $54.8 million. In addition to the net positive effect from the higher sales discussed above, our gross profit improved primarily through: • a reduction in our feedstock and other operating costs at our El Dorado Facility as (i) this facility produced ammonia from natural gas during 2017 compared to purchasing ammonia during most of the first half of 2016 and (ii) costs associated with the start-up, commissioning and optimizing activities performed on the ammonia plant during 2016 that were not incurred in 2017; • a reduction in overall fixed plant expenses; • a recovery of precious metals of $2.9 million during 2017, which metals had accumulated over time within certain manufacturing equipment; and • improved absorption of fixed costs from improved on-stream and production rates at our Cherokee and El Dorado Facilities and lower Turnaround expense at the Cherokee Facility as a Turnaround was not required in 2017. The increase in gross profit was partially offset by an increase in overall depreciation expense of approximately $7.6 million primarily as a result of our new ammonia plant at our El Dorado Facility not being put into service until mid-May 2016, lower absorption of fixed costs from lower on-stream rates at our Pryor Facility and higher average natural gas feedstock cost at our Cherokee and Pryor Facilities. In addition, during 2016, we incurred a one-time cost of $12.1 million relating to consulting services associated with the reduction of property taxes from fixing the assessed value for our El Dorado Facility. Selling General and Administrative Expense Our SG&A expenses were $35.0 million for 2017, a decrease of $5.2 million compared to 2016. The decrease was driven by a $2.2 million reduction in compensation-related costs, $1.9 million reduction in insurance and other miscellaneous costs and $1.1 million reduction in professional fees. Impairment of Long-Lived Assets and Goodwill During 2016, we recognized a non-cash impairment charge of $1.6 million to fully write-off the carrying value of goodwill. Other Expense (Income), net Our net other expense for 2017 was $4.6 million compared to net other income of $0.9 million for 2016. The change primarily consists of a total net loss of $7.0 million relating to the sale of our working interest of certain natural gas properties, the sale of our engineered products business (industrial machinery and related components) and other non-core assets partially offset by the extinguishment and derecognition of a liability of approximately $1.4 million associated with a death benefit agreement and $0.1 million in miscellaneous items. Interest Expense, net Interest expense for 2017 was $37.3 million compared to $30.9 million for 2016. The increase is due primarily to a reduction in capitalized interest during 2017 of $14.7 million as a result of the El Dorado expansion project completion during 2016. This increase was partially offset by a decrease of $5.5 million relating to the 12% Senior Secured Notes sold in 2015 and repaid in 2016 and $2.2 million as a result of the debt modification associated with a consent solicitation completed in 2016. Loss on Extinguishment of Debt As a result of the repayment of $50 million of the 7.75% Senior Secured Notes and all of our 12% Senior Secured Notes in 2016, we incurred a loss on extinguishment of debt of $8.7 million, consisting of prepayment premiums and writing off associated unamortized debt issuance costs. Benefit for Income Taxes The benefit for income taxes for continuing operations in 2017 was $41 million compared to $42 million for the same period in 2016. The effective tax rate, including the impact of tax reform adjustments, was 57% for 2017 compared to 32% for 2016. The increase in the benefit rate is primarily due to the adjustments on the deferred tax assets and liabilities from the enacted tax rate as a result of tax reform in 2017. The provisional adjustments related to tax reform resulted in recording a tax benefit of $23 million. Income from Discontinued Operations, net of taxes The results of operations of our former Climate Control Business are presented as discontinued operations. For 2017, income from discontinued operations was $1.1 million, consisting of a gain of $2.6 million relating primarily to estimate revisions to contingent obligations and net of a tax provision of $1.5 million. For 2016, income from discontinued operations was $200.3 million, including a gain of $282 million and net of a tax provision of $91.7 million. LIQUIDITY AND CAPITAL RESOURCES The following table summarizes our continuing cash flow activities for 2018 and 2017: Cash Flow from Continuing Operating Activities Net cash provided by continuing operating activities was $17.6 million for 2018 compared to $2.3 million for 2017, an improvement of approximately $15.3 million. For 2018, the net cash provided is the result of a net loss of $72.2 million plus adjustments of $70.3 million for depreciation, depletion and amortization of PP&E, $8.4 million for stock-based compensation, $6.0 million for a loss on extinguishment of debt, $1.8 million for deferred taxes and other adjustments totaling approximately $2.8 million and net cash provided of approximately $0.5 million primarily from our working capital including an increase in inventories and accounts payables and a decrease in accrued interest. For 2017, the net cash provided is the result of a net loss of $29.2 million plus a noncash adjustment of $67 million for depreciation, depletion and amortization of PP&E and other noncash adjustments totaling approximately $13.7 million less an adjustment of $40.4 million for deferred income taxes and approximately $8.8 million of net cash used primarily from our working capital including an increase in our trade accounts receivable. Cash Flow from Continuing Investing Activities Net cash used by continuing investing activities was $25.7 million for 2018 compared to $10.8 million for 2017, a change of $14.9 million. For 2018, the net cash used is the result of $37.1 million on expenditures for PP&E partially offset by $6.7 million from net proceeds from the sale of PP&E, $2.7 million representing the remaining proceeds from an indemnity escrow account associated with the sale of the Climate Control business in 2016 and approximately $2.0 million relating to a recovery from a property insurance claim and other investing activities. For 2017, the net cash used relates to expenditures for PP&E of $35.4 million partially offset by net proceeds of $23.8 million from the sale of our working interests in certain natural gas properties, engineered products business (industrial machinery and related components) and other property and equipment and $0.8 million associated with other activities. Cash Flow from Continuing Financing Activities Net cash provided by continuing financing activities was $0.5 million for 2018 compared to net cash used $16.1 million for 2017, a change of approximately $16.6 million. For 2018, the net cash provided consists of net proceeds of $390.5 million from the Senior Secured Notes, $10.9 million from short-term financing, and $10.0 million from our Working Capital Revolver Loan partially offset by $375 million repayment of the senior secured notes due 2019, payments of $20.0 million on other long-term debt and short-term financing, payments of $11.0 million for debt related costs, payments of $2.8 million of fees associated with the modification of terms of our Series E Redeemable Preferred and approximately $2.1 million of other financing activities. For 2017, the net cash used consists of payments on long-term debt and related costs of $14.2 million and $1.9 million of other activities. Capitalization The following is our total current cash, long-term debt, redeemable preferred stock and stockholders’ equity: (1) See discussion contained in Note 7 to the Consolidated Financial Statements. (2) Liquidation preference of $212.1 million as of December 31, 2018. We currently have a revolving credit facility, our Working Capital Revolver Loan, with a borrowing base of $50 million. During the fourth quarter of 2018, we delivered product to several customers with extended short-term payment terms as a means of optimizing our inventory and storage capacity headed into the spring season. We utilized the revolver to finance normal working capital fluctuations such as these receivables. As of December 31, 2018, our Working Capital Revolver Loan had outstanding borrowings of $10.0 million and $37.2 million of availability. As discussed below, we have planned capital expenditures relating to maintaining and enhancing safety and reliability at our facilities of approximately $30 million to $35 million. This is inclusive of a new sulfuric acid converter at our El Dorado Facility that we plan to install in the fourth quarter of 2019 and estimate will cost approximately $7.5 million. We expect this investment to significantly improve the reliability of that plant while increasing the production capacity from approximately 140,000 tons to 160,000 tons allowing us to take advantage of attractive market conditions. We are finalizing the equipment financing for this capital project. We believe that the combination of our cash on hand, the availability on our revolving credit facility, and our cash flow from operations will be sufficient to fund our anticipated liquidity needs for the next twelve months. Compliance with Long - Term Debt Covenants As discussed below under “Loan Agreements,” the Working Capital Revolver Loan requires, among other things, that we meet certain financial covenants. The Working Capital Revolver Loan does not include financial covenant requirements unless a defined covenant trigger event has occurred and is continuing. As of December 31, 2018, no trigger event had occurred. Loan Agreements and Redeemable Preferred Stock Senior Secured Notes due 2019 and 2023 - See discussion contained in Note 7 to the Consolidated Financial Statements. As a result of the financing transactions, our interest expense has increased as compared to 2017. Secured Promissory Note due 2019 - EDC is party to a secured promissory note due in June 2019. This promissory note bears interest at the annual rate of 5.73%. Principal and interest are payable in equal monthly installments with a final balloon payment of approximately $6.7 million. Secured Promissory Note due 2021 - EDC is party to a secured promissory note due in March 2021. This promissory note bears interest at the annual rate of 5.25%. Principal and interest are payable in monthly installments. Secured Promissory Note due 2023 - EDA is party to a secured promissory note due in May 2023. Principal and interest are payable in equal monthly installments with a final balloon payment of approximately $6.1 million. This promissory note bears interest at a rate that is based on the monthly LIBOR rate plus a base rate for a current total rate of 6.76%. Working Capital Revolver Loan - At December 31, 2018, we had $10.0 million outstanding borrowings under the Working Capital Revolver Loan and the net credit available for borrowings under our Working Capital Revolver Loan was approximately $37.2 million, based on our eligible collateral, less outstanding letters of credit as of that date. Also see discussion above under “Compliance with Long-Term Debt Covenants. Redemption of Series E Redeemable Preferred - At December 31, 2018, there were 139,768 outstanding shares of Series E Redeemable Preferred. At any time on or after October 25, 2023, each Series E holder has the right to elect to have such holder’s shares redeemed by us at a redemption price per share equal to the liquidation preference per share of $1,000 plus accrued and unpaid dividends plus the participation rights value (the “Liquidation Preference”). Additionally, at our option, we may redeem the Series E Redeemable Preferred at any time at a redemption price per share equal to the Liquidation Preference of such share as of the redemption date. Lastly, with receipt of (i) prior consent of the electing Series E holder or a majority of shares of Series E Redeemable Preferred and (ii) all other required approvals, including under any principal U.S. securities exchange on which our common stock is then listed for trading, we can redeem the Series E Redeemable Preferred by the issuance of shares of common stock having an aggregate common stock price equal to the amount of the aggregate Liquidation Preference of such shares being redeemed in shares of common stock in lieu of cash at the redemption date. In the event of liquidation, the Series E Redeemable Preferred is entitled to receive its Liquidation Preference before any such distribution of assets or proceeds is made to or set aside for the holders of our common stock and any other junior stock. In the event of a change of control, we must make an offer to purchase all of the shares of Series E Redeemable Preferred outstanding at the Liquidation Preference. Since carrying values of the redeemable preferred stocks are being increased by periodic accretions (including the amount for dividends earned but not yet declared or paid) using the interest method so that the carrying amount will equal the redemption value as of October 25, 2023, the earliest possible redemption date by the holder, this accretion has and will continue to affect income (loss) per common share. In addition, this accretion could accelerate if the expected redemption date is earlier than October 25, 2023. As of December 31, 2018, the aggregate liquidation preference (par value plus accrued dividends) was $212.1 million. Also, see discussion in Note 11 to the Consolidated Financial Statements included in this report. Capital Expenditures - 2018 For 2018, capital expenditures relating to PP&E were $37.1 million, which expenditures include approximately $0.9 million associated with maintaining compliance with environmental laws, regulations and guidelines. The capital expenditures were funded primarily from cash and working capital. See discussion above under “Capitalization” for our expected annual capital expenditures for 2019. Expenses Associated with Environmental Regulatory Compliance We are subject to specific federal and state environmental compliance laws, regulations and guidelines. As a result, we incurred expenses of $3.2 million in 2018 in connection with environmental projects. For 2019, we expect to incur expenses ranging from $3.2 million to $4.2 million in connection with additional environmental projects. However, it is possible that the actual costs could be significantly different than our estimates. Dividends We have not paid cash dividends on our outstanding common stock in many years, and we do not currently anticipate paying cash dividends on our outstanding common stock in the near future. Dividends on the Series E Redeemable Preferred are cumulative and payable semi-annually (May 1 and November 1) in arrears at the current annual rate of 14% of the liquidation value of $1,000 per share, but such annual rate will increase beginning on April 25, 2021 as discussed in Note 11. Each share of Series E Redeemable Preferred is entitled to receive a semi-annual dividend, only when declared by our Board. In addition, dividends in arrears at the dividend date, until paid, shall compound additional dividends at the current annual rate of 14%, but such annual rate will increase beginning on April 25, 2021. The current semi-annual compounded dividend is approximately $103.83 per share for the current aggregate semi-annual dividend of $14.5 million. We also must declare a dividend on the Series E Redeemable Preferred on a pro rata basis with our common stock. As long as the Purchaser holds at least 10% of the Series E Redeemable Preferred, we may not declare dividends on our common stock and other preferred stocks unless and until dividends have been declared and paid on the Series E Redeemable Preferred for the then current dividend period in cash. As of December 31, 2018, the amount of accumulated dividends on the Series E Redeemable Preferred was approximately $72.3 million. Dividends on the Series D 6% cumulative convertible Class C preferred stock (the “Series D Preferred”) and Series B 12% cumulative convertible Class C Preferred Stock (the “Series B Preferred”) are payable annually, only when declared by our Board, as follows: • $0.06 per share on our outstanding non-redeemable Series D Preferred for an aggregate dividend of $60,000, and • $12.00 per share on our outstanding non-redeemable Series B Preferred for an aggregate dividend of $240,000. As of December 31, 2018, the amount of accumulated dividends on the Series D Preferred and Series B Preferred totaled approximately $1.0 million. All shares of the Series D Preferred and Series B Preferred are owned by the Golsen Holders. There are no optional or mandatory redemption rights with respect to the Series B Preferred or Series D Preferred. Seasonality We believe fertilizer products sold to the agricultural industry are seasonal while sales into the industrial and mining sectors generally are less susceptible. The selling seasons for agricultural products are primarily during the spring and fall planting seasons, which typically extend from March through June and from September through November in the geographical markets we distribute the majority of our agricultural products. As a result, we typically increase our inventory of fertilizer products prior to the beginning of each planting season in order to meet the demand for our products. In addition, the amount and timing of sales to the agricultural markets depend upon weather conditions and other circumstances beyond our control. Performance and Payment Bonds We are contingently liable to sureties in respect of insurance bonds issued by the sureties in connection with certain contracts entered into by subsidiaries in the normal course of business. These insurance bonds primarily represent guarantees of future performance of our subsidiaries. As of December 31, 2018, we have agreed to indemnify the sureties for payments, up to $10 million, made by them in respect of such bonds. All of these insurance bonds are expected to expire or be renewed in 2019. Off-Balance Sheet Arrangements We do not have any off-balance sheet arrangements as defined in Item 303(a)(4)(ii) of Regulation S-K under the Securities Exchange Act of 1934. Aggregate Contractual Obligations As of December 31, 2018, our aggregate contractual obligations are summarized in the following table: (1) The estimated interest payments relating to variable interest rate debt are based on interest rates at December 31, 2018. (2) The Series E redeemable preferred stock (including dividends) are assumed to be redeemed and paid on the earliest possible redemption date by the holder (October 25, 2023) and that dividends are accrued until that date. (3) Other capital expenditures include only the estimated committed amounts (high end of range) at December 31, 2018 which includes approximately $7.5 million in financing we are finalizing as discussed above under Capitalization. (4) Our proportionate share of the minimum costs to ensure capacity relating to a gathering and pipeline system. (5) The future cash flows relating to executive and death benefits are based on estimates at December 31, 2018. The participation rights value associated with embedded derivative of our Series E redeemable preferred stock is based the value of our common stock at December 31, 2018 and is based on the earliest possible redemption date by the holder, October 25, 2023. New Accounting Pronouncements For recently adopted and recently issued accounting standards, see discussions in Note 1 to the Consolidated Financial Statements included in this report. Critical Accounting Policies and Estimates The preparation of financial statements requires management to make estimates and assumptions that affect the reported amount of assets, liabilities, revenues and expenses, and disclosures of contingencies and fair values. It is reasonably possible that the estimates and assumptions utilized as of December 31, 2018, could change in the near term. The more critical areas of financial reporting affected by management's judgment, estimates and assumptions include the following: Contingencies - Certain conditions may exist which may result in a loss, but which will only be resolved when future events occur. We and our legal counsel assess such contingent liabilities, and such assessment inherently involves an exercise of judgment. If the assessment of a contingency indicates that it is probable that a loss has been incurred, we would accrue for such contingent losses when such losses can be reasonably estimated. If the assessment indicates that a potentially material loss contingency is not probable but reasonably possible, or is probable but cannot be estimated, the nature of the contingent liability, together with an estimate of the range of possible loss if determinable and material, would be disclosed. Estimates of potential legal fees and other directly related costs associated with contingencies are not accrued but rather are expensed as incurred. Loss contingency liabilities are included in current and noncurrent accrued and other liabilities and are based on current estimates that may be revised in the near term. In addition, we recognize contingent gains when such gains are realized or realizable and earned. We are involved in various legal matters that require management to make estimates and assumptions, including costs relating to the lawsuit styled City of West, Texas v CF Industries, Inc., et al, discussed under “Other Pending, Threatened or Settled Litigation” of Note 9 to the Consolidated Financial Statements include in this report. It is reasonably possible that the actual costs could be significantly different than our estimates. Regulatory Compliance - As discussed under “Environmental, Health and Safety Matters” in Item 1 of this report, we are subject to specific federal and state regulatory compliance laws and guidelines. We have developed policies and procedures related to regulatory compliance. We must continually monitor whether we have maintained compliance with such laws and regulations and the operating implications, if any, and amount of penalties, fines and assessments that may result from noncompliance. We will also be obligated to manage certain discharge water outlets and monitor groundwater contaminants at our chemical facilities should we discontinue the operations of a facility. However, certain conditions exist which may result in a loss, but which will only be resolved when future events occur relating to these matters. We are involved in various environmental matters that require management to make estimates and assumptions, including our current inability to develop a meaningful and reliable estimate (or range of estimate) as to the costs relating to a corrective action study work plan approved by the Kansas Department of Health and Environment (“KDHE”) discussed under footnote 3 - Other Environmental Matters of Note 9. At December 31, 2018 and 2017, liabilities totaling $0.2 million for both periods have been accrued relating to these issues as discussed. This liability is included in current accrued and other liabilities and is based on current estimates that may be revised in the near term. At the time that cost estimates for any corrective action are received, we will adjust our accrual accordingly. It is reasonably possible that the adjustment to the accrual and the actual costs could be significantly different than our current estimates. Income Tax - As discussed in Note 8, during the second quarter of 2018, we established a valuation allowance on a portion of our federal deferred tax assets. This valuation allowance is reflective of our quarterly analysis of the four sources of taxable income, including the calculation of the reversal of existing tax assets and liabilities, the impact of the recent financing activities and our 2018 results. Based on our analysis, we now believe that it is more-likely-than-not that a portion of our federal deferred tax assets will not be able to be utilized and the valuation allowance recorded during 2018 was approximately $15 million. Senior Secured Notes - As discussed in Note 7, LSB completed the issuance and sale of the Senior Secured Notes in April 2018. A portion of this transaction was accounted for as an extinguishment of debt and a portion was accounted for as a non-substantial debt modification. As a result, approximately $15.2 million of the fees/redemption premiums/discount was deferred and included in discount and debt issuance costs and approximately $0.9 million of fees were expensed, as incurred, and are included in interest expense. In addition, we recognized a loss on extinguishment of debt of approximately $6.0 million, primarily consisting of a portion of the redemption premiums paid and the expensing of a portion of debt issuance costs associated with the 8.5% Senior Secured Notes. The extinguishment and modification conclusion impacts the treatment of discounts and debt issuance costs. In addition, certain embedded features included in the Senior Secured Notes were evaluated to identify if those features represented a derivative and required bifurcation. Redeemable Preferred Stocks - In December 2015, we issued the Series E and F Redeemable Preferred. The redeemable preferred stocks are redeemable outside of our control and are classified as temporary/mezzanine equity on our consolidated balance sheet. In addition, certain embedded features (the “embedded derivative”) included in the Series E Redeemable Preferred required bifurcation and are classified as derivative liabilities. As discussed in Note 11, the terms of the Series E Redeemable Preferred were amended in 2018 associated with a letter agreement in connection with the issuance and sale of the Senior Secured Notes discussed above. The amended terms associated with the letter agreement were determined to result in a nonsubstantial modification, which determination included estimates regarding the probability, timing and amount of shares redeemed prior to October 25, 2023, the earliest possible redemption date by the holder. In addition, the letter agreement included a contingent redemption feature, which required bifurcation from the Series E Redeemable Preferred and is classified as a derivative liability. Currently, the carrying values of the redeemable preferred stocks are being increased by periodic accretions (recorded to retained earnings and included in determining income or loss per share) using the interest method so that the carrying amount will equal the redemption value as of October 25, 2023, the earliest possible redemption date by the holder. Approximately $30 million of accretion (including the amount for earned dividends) was recorded to retained earnings in 2018. At December 31, 2018, the carrying value of these redeemable preferred stocks was $202.1 million. For the embedded derivative, changes in fair value are recorded in our statement of operations. As the result of the financing transaction relating to the Senior Secured Notes and the letter agreement, we estimate that the contingent redemption features have fair value at December 31, 2018 since we estimate that it is probable that a portion of the shares of this preferred stock would be redeemed prior to October 25, 2023. At December 31, 2018 and 2017, the fair value of the embedded derivative was $1.6 million and $2.7 million, respectively, primarily relating to the participation rights based on the equivalent of 303,646 shares of our common stock at $5.52 and $8.76 per share, respectively. No valuation input adjustments were considered necessary relating to nonperformance risk for the embedded derivative based on our current forecast. The valuation is classified as Level 3. Management’s judgment and estimates in the above areas are based on information available from internal and external resources at that time. Actual results could differ materially from these estimates and judgments, as additional information becomes known.

<s>[INST] Overview General LSB is headquartered in Oklahoma City, Oklahoma and through its subsidiaries, manufactures and sells chemical products for the agricultural, mining, and industrial markets. We own and operate facilities in Cherokee, Alabama; El Dorado, Arkansas; and Pryor, Oklahoma, and operate a facility for Covestro in Baytown, Texas. Our products are sold through distributors and directly to end customers throughout the U.S. Key Operating Initiatives for 2019 We believe our future results of operations and financial condition will depend significantly on our ability to successfully implement the following key initiatives: Improving the OnStream Rates of our Chemical Plants. Over the past 18 months, our focus has been on upgrading our existing maintenance management system through technology enhancements and work processes to improve our predictive and preventative maintenance programs at our facilities. We engaged outside maintenance experts to assist us in expediting implementation and overall use. We have completed the initial implementation. Additionally, beginning in the third quarter of 2018, we engaged outside consultants to do a thorough review of our operating and maintenance procedures and our preventive maintenance programs at all of our facilities in an effort to determine where we may have gaps in procedures and programs and where we may need enhancements. Based on the “Gap Analysis” completed, we have several initiatives underway that we believe will improve the overall reliability of our plants and allow us to produce more products for sale while lowering our cost of production. Those initiatives are focused on operating behavior and procedure enhancements including operator training, leadership training, shift change enhancements and operating and maintenance procedures. Focus on the Continued Improvement of Our Safety Performance. We believe that high safety standards are critical and a precursor to improved plant performance. With that in mind, we implemented enhanced safety programs at our facilities that focus on reducing risks and improving our safety culture. As a result of these programs, we significantly lowered our recordable incident rate in 2018 as compared to the prior year and we remain well below the national average for recordable safety incidents. Continue Broadening of the Distribution of our Products. We increased our overall sales volume of HDAN over the past 24 months by approximately 30% through various marketing initiatives which include: (1) storing and distributing HDAN at our Pryor Facility which allows us to sell to new markets and customers out of that facility and; (2) educating growers on the agronomic benefits and the additional applications for HDAN. To further leverage our plants’ current production capacity, we are continuing to expand the distribution of our mining products by partnering with customers to take product further into the Western U.S. as well as markets outside the U.S. We also partnered with a current customer to position an emulsion explosives plant at our El Dorado Facility. We began selling product to that facility in the fourth quarter of 2018. We will continue to explore further guest plant opportunities at our facilities in 2019. In addition, through increased marketing efforts, we increased our sales volumes of nitric acid over the past 24 months by approximately 35%. We continue to focus our efforts to expand our market for our nitric acid products in North America and to fully utilize available nitric acid production capacity of our facilities. Improving the Margins on Sales of Our Products. Over the last several years, we have focused on increasing our sales volumes to produce at optimal onstream rates and lower our manufacturing costs per ton of product. In 2019, we will undertake a review of all sales to customers to determine if there are opportunities to improve the margins on sales to those customers and to explore if there are further product upgrading opportunities. Continued Focus on Procurement and Logistics. In 2018, we engaged outside experts to assist us in centralizing and expanding our Companywide procurement efforts. We completed our initial areas of focus during the second quarter of 2018, completed the implementation of those changes, and began to see benefits during the third quarter of 2018. We believe that these efforts along with several additional identified areas of focus, will result in an overall reduction in expenses and capital spend in the aggregate of between $3 million to $5 million on an annualized basis, which we expect to realize over the next 12 to 24 months. Additionally, we will continue to focus on improving the effectiveness and overall cost of our logistics strategy through [/INST] Negative. </s>

LSB INDUSTRIES INC

2020-02-25

2019-12-31

ITEM 7. MANAGEMENT’S DISCUSSION AND ANALYSIS OF FINANCIAL CONDITION AND RESULTS OF OPERATIONS The following MD&A should be read in conjunction with a review of the other Items included in this Form 10-K and our December 31, 2019 consolidated financial statements included elsewhere in this report. A reference to a “Note” relates to a note in the accompanying notes to the consolidated financial statements. Certain statements contained in this MD&A may be deemed to be forward-looking statements. See “Special Note Regarding Forward-Looking Statements.” Overview General LSB is headquartered in Oklahoma City, Oklahoma and through its subsidiaries, manufactures and sells chemical products for the agricultural, mining, and industrial markets. We own and operate facilities in Cherokee, Alabama; El Dorado, Arkansas; and Pryor, Oklahoma, and operate a facility for Covestro in Baytown, Texas. Our products are sold through distributors and directly to end customers throughout the U.S. Key Operating Initiatives for 2020 We believe our future results of operations and financial condition will depend significantly on our ability to successfully implement the following key initiatives: • Continued Focus on Becoming a “Best in Class” Chemical plant operator with respect to safe, reliable operations that produce the highest quality product. • We believe that high safety standards are critical and a precursor to improved plant performance. With that in mind, we implemented and are currently managing enhanced safety programs at our facilities that focus on improving our safety culture that will reduce risks and continuously improve our safety performance. • Additionally, over the last several years, our focus has been on upgrading our existing maintenance management system through technology enhancements and work processes to improve our predictive and preventative maintenance programs at our facilities. • We have several initiatives underway that we believe will improve the overall reliability of our plants and allow us to produce more products for sale while lowering our cost of production. Those initiatives are focused on building internal expertise to improve oversight of external contractors, operating behavior and procedure enhancements including operator training, leadership training, shift change enhancements and operating and maintenance procedures. • Continue Broadening of the Distribution of our Products. To further leverage our plants current production capacity, we are continuing to expand the distribution of our industrial and mining products by partnering with customers to take product into different markets within the U.S. as well as markets outside the U.S. Additionally, during 2019, we developed a pipeline of margin enhancement projects including product loading and unloading improvements, tank storage and capital to facilitate guest plant opportunities which, we expect will result in improved margins on the sales of our products. We expect to complete these projects over the next 12 to 18 months. • Improve Our Capital Structure and Overall Cost of Capital. We are actively seeking ways to improve our capital structure and reduce our overall cost of capital. We believe that our improved operating performance will be a benefit in achieving those efforts. We may not successfully implement any or all of these initiatives. Even if we successfully implement the initiatives, they may not achieve the results that we expect or desire. Business Developments - 2019 Financing Transaction As discussed in Note 7, in June 2019, we completed the issuance and sale of $35 million of the New Notes. The New Notes were issued at a price equal to 102.125% of their face value. We expect to use the net proceeds from the New Notes to fund approximately $20 million in anticipated capital expenditures over a 12 to 18-month period that are intended to enhance our margins as discussed above under “Key Operating Initiatives for 2020”. The remaining net proceeds have been used for general corporate purposes. Completion of Turnarounds at our El Dorado and Pryor Facilities During August 2019, we completed an 18-day Turnaround on our ammonia plant at our El Dorado Facility. Additionally, during November 2019, the ammonia plant at our El Dorado Facility was taken out of service for 16 days in order to make adjustments that improved the ammonia plant reliability and production volume. Also, during November 2019, we completed a 28-day Turnaround on our sulfuric acid plant at our El Dorado Facility, which included the installation of a new sulfuric acid converter which will increase reliability and production volume. During November 2019, we completed an extensive 67-day Turnaround at our Pryor Facility including the installation of a new, larger urea reactor. The next Turnarounds for these facilities are scheduled in 2021 for our Pryor Facility and 2022 for our El Dorado Facility. See additional discussion below under “Items Affecting Comparability of Results.” Amended Ammonia Agreement During October 2019, the ammonia purchase and sale agreement between El Dorado Chemical Company (“EDC”) and Koch Fertilizer LLC (“Koch Fertilizer”) was amended, pursuant to which Koch Fertilizer agrees to purchase, with minimum purchase requirements, a portion of the ammonia that (a) will be produced at the El Dorado Facility and (b) that is in excess of EDC’s needs. As amended, the term of the agreement expires in June 2022 but automatically continues for additional one-year terms unless terminated by either party by delivering a notice of termination at least nine months prior to the end of term in effect. Assets Held for Sale During November 2019, in conjunction with management’s review of our long-range strategy, development of the 2020 budget and the completion of the 2019 Turnarounds, certain long-lived assets were identified for sale and a plan to sell such assets was finalized by management. Based on information obtained from various potential buyers and vendors to dissemble the assets, the carrying amount of these assets held for sale was written down to a de minimis amount and the corresponding non-cash charge of $9.7 million was recognized and included in other expense. Costs to disassemble these assets, in conjunction with disposals, will be recognized as incurred. We expect the sales of these assets, which will be sold primarily for scrap value, to be completed within one year. Key Industry Factors Supply and Demand Agricultural Sales of our agricultural products were approximately 52% of our total net sales for 2019. The price at which our agricultural products are ultimately sold depends on numerous factors, including the supply and demand for nitrogen fertilizers which, in turn, depends upon world grain demand and production levels, the cost and availability of transportation and storage, weather conditions, competitive pricing and the availability of imports. Additionally, expansions or upgrades of competitors’ facilities and international and domestic political and economic developments continue to play an important role in the global nitrogen fertilizer industry economics, including the impact from the Phase 1 trade agreement between the U.S and China. These factors can affect, in addition to selling prices, the level of inventories in the market which can cause price volatility and affect product margins. From a farmers’ perspective, the demand for fertilizer is affected by the aggregate crop planting decisions and fertilizer application rate decisions of individual farmers. Individual farmers make planting decisions based largely on prospective profitability of a harvest, while the specific varieties and amounts of fertilizer they apply depend on factors such as their financial resources, soil conditions, weather patterns and the types of crops planted. Additionally, changes in corn prices and those of soybean, cotton and wheat prices, can affect the number of acres of corn planted in a given year, and the number of acres planted will drive the level of nitrogen fertilizer consumption, likely effecting prices. The USDA estimates corn production for the 2020 Crop at approximately 13.7 billion bushels, down 5 percent from the 2019 Crop. The average yield in the U.S. was estimated at 168.0 bushels per acre, 8.4 bushels below the 2019 Crop yield of 176.4 bushels per acre. The following February estimates are associated with the corn market: (1) Information obtained from WASDE reports dated February 11, 2020 (February Report) for the 2019/2020 (“2020 Crop”), 2018/2019 (“2019 Crop”) and 2017/2018 (“2018 Crop”) corn marketing years. The marketing year is the twelve-month period during which a crop normally is marketed. For example, the marketing year for a corn crop is from September 1 of the current year to August 31 of the next year. The marketing year begins at the harvest and continues until just before harvest of the following year. (2) Represents the percentage change between the 2020 Crop amounts compared to the 2019 Crop amounts. (3) Represents the percentage change between the 2020 Crop amounts compared to the 2018 Crop amounts. On the supply side, given the low price of natural gas in North America over the last several years, North American fertilizer producers have become the global low-cost producers for delivered fertilizer products to the Midwest U.S. Several years ago, the market believed that low natural gas prices would continue. That belief, combined with favorable fertilizer pricing, stimulated investment in numerous expansions of existing nitrogen chemical facilities and the construction of new nitrogen chemical facilities. Following the expansions, global nitrogen fertilizer supply outpaced global nitrogen fertilizer demand causing oversupply in the global and North American markets. In addition, the new domestic supply of ammonia and other fertilizer products changed the physical flow of ammonia in North America placing pressure on nitrogen fertilizer selling prices as the new capacity was absorbed by the market. More recently, ammonia pricing has been under pressure as a result of inordinately inclement weather in late 2018 and 2019, which led to limited fertilizer application and resultant elevated ammonia inventory levels in the domestic distribution channel. Additionally, UAN prices have pulled back in part, to European anti-dumping duties that were imposed on imports from certain countries, including the U.S which has caused imports of UAN into the U.S. to increase and exports from the U.S. to decrease increasing UAN supply in the U.S. After a challenging 2019 for U.S. corn farmers, it is expected that final harvested acres and yields for the 2019 harvest year will be lower than expected. These factors have already impacted the price of corn, which has risen to its highest level since 2014. A likely decline in the stock-to-use ratio for corn should lead to an increase in planted acres in the spring 2020 planting season. Assuming normal weather conditions, industry reports currently estimate a 5% increase in corn acres to be planted during 2020 compared to 2019. Therefore, for 2020, we expect overall stronger demand for our products somewhat tempered by continued pricing pressures on these products. Industrial Sales of our industrial products were approximately 38% of our total net sales for 2019. Our industrial products sales volumes are dependent upon general economic conditions primarily in the housing, automotive, and paper industries. According to the American Chemistry Council, the U.S. economic indicators point to modest growth in 2020 in the U.S market we serve and export weakness due to the softening global economy and trade tensions. Our sales prices generally vary with the market price of ammonia or natural gas, as applicable, in our pricing arrangements with customers. Mining Sales of our mining products were approximately 10% of our total net sales for 2019. Our mining products are LDAN and AN solution, which are primary used as AN fuel oil and specialty emulsions for usage in the quarry and the construction industries, for metals mining, and to a lesser extent, for coal. In our mining markets, our sales volumes are typically driven by changes in the overall North American consumption levels of mining products that can be impacted by weather. Additionally, recent reduction in coal mining activities is increasing competition within the other sectors of this market. While we believe our plants are well located to support the more stable quarry and construction industries and the metals mining industries, our 2019 mining sales volumes were affected by overall lower customer demand in our mining markets. Farmer Economics The demand for fertilizer is affected by the aggregate crop planting decisions and fertilizer application rate decisions of individual farmers. Individual farmers make planting decisions based largely on prospective profitability of a harvest, while the specific varieties and amounts of fertilizer they apply depend on factors such as their financial resources, soil conditions, weather patterns and the types of crops planted. Natural Gas Prices Natural gas is the primary feedstock used to produce nitrogen fertilizers at our manufacturing facilities. In recent years, U.S. natural gas reserves have increased significantly due to, among other factors, advances in extracting shale gas, which has reduced and stabilized natural gas prices, providing North America with a cost advantage over certain imports. As a result, our competitive position and that of other North American nitrogen fertilizer producers has been positively affected. We historically have purchased natural gas either on the spot market, through forward purchase contracts, or a combination of both and have used forward purchase contracts to lock in pricing for a portion of our natural gas requirements. These forward purchase contracts are generally either fixed-price or index-price, short-term in nature and for a fixed supply quantity. We are able to purchase natural gas at competitive prices due to our connections to large distribution systems and their proximity to interstate pipeline systems. The following table shows the annual volume of natural gas we purchased and the average cost per MMBtu: Transportation Costs Costs for transporting nitrogen-based products can be significant relative to their selling price. For example, ammonia is a hazardous gas at ambient temperatures and must be transported in specialized equipment, which is more expensive than other forms of nitrogen fertilizers. In recent years, a significant amount of the ammonia consumed annually in the U.S. was imported. Therefore, nitrogen fertilizers prices in the U.S. are influenced by the cost to transport product from exporting countries, giving domestic producers who transport shorter distances an advantage. However, we continue to evaluate the recent rising costs of rail and truck freight domestically. Additionally, the Magellan ammonia pipeline, which had an annual capacity to transport approximately 900,000 tons per year, most of which was produced in Oklahoma and Texas and delivered via the pipeline in the Midwest, is in the process of being permanently shut down. Pipeline closure began at the southern end of the pipeline in September of 2019 and is expected to continue on the northern end of the pipeline in early 2020. Without the pipeline in place for ammonia transport, producers will have to rely on other transportation venues, primarily by truck but will also include rail and barge transport of ammonia. Higher transportation costs may impact our margins if we are not able to pass through these costs. As a result, we continue to evaluate supply chain efficiencies to reduce or counter the impact of higher logistics costs. Key Operational Factors Facility Reliability Consistent, reliable and safe operations at our chemical plants are critical to our financial performance and results of operations. The financial effects of planned downtime at our plants, including Turnarounds, is mitigated through a diligent planning process that considers the availability of resources to perform the needed maintenance and other factors. Unplanned downtime of our plants typically results in lost contribution margin from lost sales of our products, lost fixed cost absorption from lower production of our products and increased costs related to repairs and maintenance. All Turnarounds result in lost contribution margin from lost sales of our products, lost fixed cost absorption from lower production of our products, and increased costs related to repairs and maintenance, which repair and maintenance costs are expensed as incurred. Our Pryor Facility completed an extensive Turnaround during 2019. The Pryor Facility will continue on a two-year Turnaround cycle with the next Turnaround planned for the third quarter of 2021. At that time, we will seek to move to a three-year Turnaround cycle. In addition, our El Dorado Facility completed a partial Turnaround during 2018. The remaining portion of this Turnaround was completed during 2019. The El Dorado Facility has moved to a three-year Turnaround cycle with the next Turnaround planned in the third quarter of 2022. Our Cherokee Facility is currently on a three-year Turnaround cycle with the next Turnaround to be performed in the third quarter of 2021. Prepay Contracts We use forward sales of our fertilizer products to optimize our asset utilization, planning process and production scheduling. These sales are made by offering customers the opportunity to purchase product on a forward basis at prices and delivery dates that are agreed upon. We use this program to varying degrees during the year depending on market conditions and our view of changing price environments. Fixing the selling prices of our products months in advance of their ultimate delivery to customers typically causes our reported selling prices and margins to differ from spot market prices and margins available at the time of shipment. Consolidated Results for 2019 Our consolidated net sales for 2019 were $365.1 million compared to $378.2 million for 2018. Our consolidated operating loss was $39.1 million compared to $23.0 million for 2018. The items affecting our operating results are discussed below and under “Results of Operations.” Items Affecting Comparability of Results On-Stream Rates The on-stream rates of our plants affect our production, the absorption of fixed costs of each plant and sales of our products. It is a key operating metric that we use to manage our business. In particular, we closely monitor the on-stream rates of our ammonia plants as ammonia is the basic product as used to produce all upgraded products. The on-stream rates noted below exclude Turnaround days, when applicable. Our average overall on-stream rate of our ammonia plants was 91% for 2019 compared to 89% for 2018. For 2020, we are targeting an average overall on-stream rate of 94%. We believe that our focus on improving on-stream rates as discussed in key operating initiatives will continue to improve our overall on-stream rate for 2020. Turnaround Expense During 2019, we incurred Turnaround costs totaling approximately $13.2 million associated with a 67-day Turnaround performed on our plants at our Pryor Facility and a total of 46 days associated with Turnaround activity performed on our plants at our El Dorado Facility which consisted of an 18-day Turnaround on the ammonia plant and a 28-day Turnaround on the sulfuric acid plant. During 2018, we incurred Turnaround costs totaling approximately $9.8 million associated with a 35-day Turnaround performed on our plants at our Cherokee Facility and a total of 12 days associated with Turnaround activity at our El Dorado Facility. Selling Prices During 2019, we experienced improved selling prices for our agricultural products compared to 2018. Average selling prices for our UAN, ammonia, and HDAN increased 14%, 2% and 1%, respectively compared to 2018 average selling prices. During the back half of 2019 selling prices began to decline reflecting a lowering in the Southern Plains benchmark price for ammonia resulting from elevated inventory levels from the inordinately inclement weather throughout the Midwest over the past year and the closure of the Magellan ammonia pipeline. In addition, UAN selling prices also deteriorated in the second half of 2019, as import volumes increased while export volumes declined due, in part, to European anti-dumping duties. Our 2019 average industrial selling prices for our ammonia decreased compared to the same period of 2018 as a result of the aforementioned elevated ammonia inventory levels. The 2019 average Tampa Ammonia price declined approximately 21% as compared to the same period in 2018, which led to a decrease in industrial selling prices as many of our industrial contracts are indexed to the Tampa Ammonia benchmark price. With respect to our outlook for 2020, we expect that agricultural and industrial pricing will continue to be impacted by the aforementioned factors, impacting the agricultural market coupled with excess ammonia inventories weighing on the industrial market, as was the case in the second half of 2019. Legal Fees For 2019 and 2018, legal fees were approximately $12.8 million and $8.3 million, respectively. The change primarily relates to fees incurred as we pursue our claims against Leidos to recover damages and losses associated with the construction of the ammonia plant and other assets at our El Dorado Facility as discussed in footnote B of Note 9. We expect to continue to incur legal fees associated with this matter through March 2020, the scheduled date of the trial. Depreciation Expense During 2019 and 2018, depreciation expense was $68.3 million and $70.3 million, respectively. For 2018, approximately $2.0 million relates to accelerated depreciation at the El Dorado Facility due to the boiler tube failures caused by a power outage. Charge Associated with Assets Held for Sale (2019 only) As discussed above under “Business Developments - 2019”, we recognized a non-cash charge of $9.7 million associated with assets held for sale, which amount is included in other expense. Interest Expense During 2019 and 2018, interest expense was $46.4 million and $43.1 million, respectively. The change primarily relates to our Senior Secured Notes as discussed in Note 7. Provision (benefit) for Income Taxes For 2019, the benefit for income taxes was $20.9 million compared to a provision of $1.7 million for 2018. The resulting benefit rate for 2019 was 24.8% compared to an effective tax rate of 2.5% for 2018, which includes the impact from tax reform adjustments. The increase in the benefit rate is primarily due to changes to the state deferred tax assets and liabilities resulting from state tax law changes enacted during 2019 and due to federal and state indefinite lived carryforward benefits that can be realized through the reversal of deferred tax liabilities. The 2018 effective tax rate was impacted by adjustments made to our valuation allowances including a reversal of approximately $2.3 million of state valuation allowance related to tax law changes. Loss on Extinguishment of Debt (2018 only) As the result of the financing transactions relating to the Senior Secured Notes and repurchase of the senior secured notes due 2019, we incurred a loss on extinguishment of debt of $6.0 million in 2018. Severance Benefits and Accelerated Stock-based Compensation (2018 only) During 2018, we incurred $5.3 million associated with certain severance benefits and accelerated stock-based compensation relating to Daniel D. Greenwell, our former Chief Executive Officer (“CEO”), electing not to renew his employment agreement in December 2018. Recovery from a Settlement with a Vendor (2018 only) During 2018, we and a vendor mediated a settlement relating primarily to a business interruption claim caused by defective work performed by the vendor at our Pryor Facility. As a result of the settlement, the vendor paid us $4.0 million. As part of the settlement, we paid the vendor $0.5 million to settle $1.1 million of invoices that were held in our accounts payable. As a result, we recognized a recovery from this settlement totaling $4.6 million of which $4.4 million was classified as a reduction to cost of sales (primarily relating to our business interruption claim) and the remaining balance of $0.2 million as a reduction to PP&E. Results of Operations The following Results of Operations should be read in conjunction with our consolidated financial statements for the years ended December 31, 2019 and 2018 and accompanying notes and the discussions under “Overview” and “Liquidity and Capital Resources” included in this MD&A. You should carefully review and consider the information in the MD&A of our 2018 Form 10-K, filed with the SEC on February 26, 2019, for an understanding of our results of operations and liquidity discussions and analysis comparing 2018 to 2017. We present the following information about our results of operations. Net sales to unaffiliated customers are reported in the consolidated financial statements and gross profit represents net sales less cost of sales. Net sales are reported on a gross basis with the cost of freight being recorded in cost of sales. Year Ended December 31, 2019 Compared to Year Ended December 31, 2018 The following table contains certain financial information: (1) Represents a non-GAAP measure since the amount excludes depreciation, amortization and Turnaround expenses. (2) Represents amount classified as cost of sales. (3) As a percentage of total net sales. The following table provides certain financial information by market (dollars in thousands): (1) Represents a non-GAAP measure since the amount excludes depreciation, amortization and Turnaround expenses. See reconciliation included in the financial information table above. (2) As a percentage of the respective net sales. The following tables provide key sales metrics for the agricultural products: With respect to sales of industrial products, the following tables indicate key operating metrics of our major products: With respect to sales of mining products, the following tables indicate key operating metrics of our major products: Net Sales • Agricultural products sales were slightly higher primarily from improved selling prices for all of our agricultural products in conjunction with improved sales volumes for ammonia. This improvement was partially offset by lower sales volumes of UAN and HDAN resulting from unfavorable weather conditions in the markets we serve compared to 2018, as well as an extensive 67-day turnaround at our Pryor Facility which was completed in November of 2019. • Industrial acids and other industrial chemical products sales decreased primarily from lower selling prices due to lower Tampa ammonia benchmark pricing along with lower sales volumes for nitric acid due to certain spot sales made to a customer during 2018 to meet their demand caused by a disruption of their plant operations. This decline was partially offset by improved sales volumes for ammonia from improved on-stream rates during 2019 allowing for the sale of more product. The average Tampa ammonia pricing was approximately $65 per ton lower compared to 2018 as discussed below. • Mining products sales decreased primarily as the result of overall lower sales volume and selling prices for our mining products. This decline is primarily driven by lower customer demand as the overall coal market conditions remain suppressed in conjunction with competitive pressures in our marketing region. Gross Profit As noted in the tables above, we recognized a gross profit $5.0 million for 2019 compared to $15.8 million for 2018, or a decrease of approximately $10.8 million. Overall, our gross profit percentage decreased to 1.4% for 2019 compared to 4.2% for 2018. Our agricultural products adjusted gross profit percentage increased to 15% for 2019 from 11% for 2018 due primarily to increased selling prices for all of our agricultural products along with improved production and sales volumes for ammonia, partially offset by lower UAN and HDAN sales volumes as discussed above. Industrial and mining products adjusted gross profit percentage declined for 2019 to 33% from 39% for 2018 primarily driven by lower overall Tampa ammonia pricing, which averaged approximately $248 per metric ton during 2019 compared to approximately $313 per metric ton for 2018 driven by a poor weather negatively impacting the 2018 fall and the 2019 spring and fall application seasons in the U.S. agricultural markets, combined with weather impacting the movement of ammonia from the Gulf region, which caused a build-up of ammonia inventory across the distribution channel, resulting in downward pressure on Tampa ammonia benchmark pricing and Gulf ammonia in general. The net negative effect on gross profit from sales activity discussed above was partially offset by approximately $9.9 million in lower natural gas costs per MMBtu, approximately $1.9 million decline in depreciation expense, and improved cost absorption from higher overall plant on-stream rates partially offset by approximately $3.4 million increase in turnaround costs and approximately $1.0 million of higher freight costs incurred to move product for storage as a result of the delay in the spring application season. Also, as discussed above under “Items Affecting Comparability of Results-Recovery from a Settlement with a Vendor”, our 2018 gross profit included a recovery from a settlement with a vendor of $4.4 million classified as a reduction to cost of sales (primarily relating to our business interruption claim). Selling, General and Administrative Our SG&A expenses were $34.2 million for 2019, a decrease of $6.6 million compared to 2018, of which $5.3 million was associated with severance benefits and accelerated stock-based compensation recognized in 2018 relating to our former CEO electing not to renew his employment agreement in December 2018. Excluding this impact, SG&A expenses decreased $1.3 million primarily driven by a $5.0 million reduction in compensation-related costs and $0.9 million reduction in insurance and other miscellaneous items partially offset by a $4.6 million increase in professional fees, including legal fees associated with the legal matter discussed above under “Items Affecting Comparability of Results-Legal”. Other Expense (Income), net Other expense for 2019 was $9.9 million primarily relating to a non-cash charge associated with assets held for sale discussed above under “Business Developments-2019.” Other income for 2018 was $2.0 million primarily relating to the sales of certain non-core assets (primarily consisting of real estate). Interest Expense, net Interest expense for 2019 was $46.4 million compared to $43.1 million for 2018. The net increase relates primarily to interest expense associated with the Notes issued in April 2018 and the New Notes issued in June 2019 partially offset by $0.9 million of debt modification fees incurred in 2018. Loss on Extinguishment of Debt During 2018, we incurred a loss on extinguishment of debt of approximately $6.0 million relating to the repurchase of the senior secured notes that were scheduled to mature in 2019. Provision (benefit) for Income Taxes The benefit for income taxes for 2019 was $20.9 million compared to a provision of $1.7 million for 2018. The resulting benefit rate for 2019 was 24.8% compared to an effective tax rate of 2.5% for 2018 including the impact of tax reform adjustments. The increase in the benefit rate is primarily due to changes to the state deferred tax assets and liabilities resulting from state tax law changes enacted during 2019 and due to federal and state indefinite lived carryforward benefits that can be realized through the reversal of deferred tax liabilities. The 2018 effective tax rate was impacted by adjustments made to our valuation allowances during 2018 including a reversal of approximately $2.3 million of state valuation allowance related to tax law changes. Also, see discussion in Note 8. LIQUIDITY AND CAPITAL RESOURCES The following table summarizes our continuing cash flow activities for 2019 and 2018: Net Cash Flow from Operating Activities Net cash provided by operating activities was $2.1 million for 2019 compared to $17.6 million for 2018, a decrease of $15.5 million. For 2019, net cash provided is the result of a net loss of $63.4 million plus adjustments of $69.6 million for depreciation and amortization of PP&E, non-cash charge of $9.7 million associated assets held for sale, and other adjustments of $5.7 million less an adjustment of $20.9 million for deferred taxes and net cash provided of approximately $1.4 million primarily from our working capital. For 2018, net cash provided is the result of a net loss of $72.2 million plus adjustments of $70.3 million for depreciation, depletion and amortization of PP&E, $8.4 million for stock-based compensation, $6.0 million for a loss on extinguishment of debt, $1.8 million for deferred taxes and other adjustments totaling approximately $2.8 million and net cash provided of approximately $0.5 million primarily from our working capital including an increase in inventories and accounts payables and a decrease in accrued interest. Net Cash Flow from Investing Activities Net cash used by investing activities was $35.9 million for 2019 compared to $25.7 million for 2018, a change of $10.2 million. For 2019, net cash used relates primarily to expenditures for PP&E. For 2018, net cash used is the result of $37.1 million on expenditures for PP&E partially offset by $6.7 million from net proceeds from the sale of PP&E, $2.7 million representing the remaining proceeds from an indemnity escrow account associated with the sale of our former Climate Control business in 2016 and approximately $2.0 million relating to a recovery from a property insurance claim and other investing activities. Net Cash Flow from Financing Activities Net cash provided by financing activities was $30.6 million for 2019 compared to $0.5 million for 2018, a change of approximately $30.0 million. For 2019, net cash provided primarily consists of net proceeds of $35.1 million from the New Notes, net proceeds of $7.5 million, net of payments, from other long-term debt and insurance premium short-term financing partially offset by net payments of $10 million on the Working Capital Revolver Loan, and payments of $2.0 million for other financing activities. For 2018, net cash provided consists of net proceeds of $390.5 million from the Notes, $10.9 million from insurance premium short-term financing, and $10.0 million from our Working Capital Revolver Loan partially offset by $375 million repayment of the senior secured notes due 2019, payments of $20.0 million on other long-term debt and short-term financing, payments of $11.0 million for debt related costs, payments of $2.8 million of fees associated with the modification of terms of our Series E Redeemable Preferred and approximately $2.1 million of other financing activities. Capitalization The following is our total current cash, long-term debt, redeemable preferred stock and stockholders’ equity: (1) A portion of the proceeds from the Secured Financing due in 2023 was used to pay off the secured financing due in 2019. (2) Liquidation preference of $242.8 million as of December 31, 2019. We currently have a revolving credit facility, our Working Capital Revolver Loan, with a borrowing base of $75 million. As of December 31, 2019, our Working Capital Revolver Loan was undrawn and had approximately $42.1 million of availability. We expect capital expenditures to be approximately $25 million to $30 million for 2020, which includes approximately $5 million to $10 million for margin enhancement projects. The remaining capital spending is planned for reliability and maintenance capital projects. We believe that the combination of our cash on hand, the availability on our revolving credit facility, and our cash flow from operations will be sufficient to fund our anticipated liquidity needs for the next twelve months. Compliance with Long - Term Debt Covenants As discussed below under “Loan Agreements,” the Working Capital Revolver Loan requires, among other things, that we meet certain financial covenants. The Working Capital Revolver Loan does not include financial covenant requirements unless a defined covenant trigger event has occurred and is continuing. As of December 31, 2019, no trigger event had occurred. Loan Agreements and Redeemable Preferred Stock Senior Secured Notes due 2023 - LSB has $435 million aggregate principal amount of the 9.625% Senior Secured Notes currently outstanding, including the $35 million associated with the New Notes as discussed in footnote (B) of Note 7. Interest is to be paid semiannually on May 1st and November 1st, maturing May 1, 2023. As a result of the financing transactions, our interest expense has increased as compared to 2018. Secured Promissory Note due 2021 - EDC is party to a secured promissory note due in March 2021. This promissory note bears interest at the annual rate of 5.25%. Principal and interest are payable in monthly installments. Secured Promissory Note due 2023 - EDA is party to a secured promissory note due in May 2023. Principal and interest are payable in equal monthly installments with a final balloon payment of approximately $6.1 million. This promissory note bears interest at a rate that is based on the monthly LIBOR rate plus a base rate for a current total rate of 6.03%. Secured Loan Agreement - EDC entered into a $15 million secured financing arrangement with an affiliate of LSB Funding L.L.C. (“LSB Funding”) in May 2019 with a current interest rate of 8.76%. Beginning in June 2019, principal and interest are payable in 48 equal monthly installments with a final balloon payment of approximately $3 million due on June 1, 2023. This financing arrangement is secured by the cogeneration facility equipment and is guaranteed by LSB. During 2019, EDC entered into a secured loan agreement with an affiliate of LSB Funding. Under the terms of the agreement, EDC has up to $7.5 million of available borrowings (the “Interim Loan”) during the construction of a new sulfuric acid converter (the “Interim Loan Period), subject to certain conditions. During the Interim Loan Period, interest only is payable in monthly installments. The Interim Loan will be replaced by a term loan in 2020. Principal and interest will be payable in 60 equal monthly installments under the term loan. Working Capital Revolver Loan - At December 31, 2019, the Working Capital Revolver Loan was undrawn and the net credit available for borrowings under our Working Capital Revolver Loan was approximately $42.1 million, based on our eligible collateral, less outstanding standby letters of credit as of that date. Also see discussion above under “Compliance with Long-Term Debt Covenants. Redemption of Series E Redeemable Preferred - At December 31, 2019, there were 139,768 outstanding shares of Series E Redeemable Preferred and the aggregate liquidation preference (par value plus accrued dividends) was $242.8 million. At any time on or after October 25, 2023, each Series E holder has the right to elect to have such holder’s shares redeemed by us at a redemption price per share equal to the liquidation preference per share of $1,000 plus accrued and unpaid dividends plus the participation rights value (the “Liquidation Preference”). Additionally, at our option, we may redeem the Series E Redeemable Preferred at any time at a redemption price per share equal to the Liquidation Preference of such share as of the redemption date. Lastly, with receipt of (i) prior consent of the electing Series E holder or a majority of shares of Series E Redeemable Preferred and (ii) all other required approvals, including under any principal U.S. securities exchange on which our common stock is then listed for trading, we can redeem the Series E Redeemable Preferred by the issuance of shares of common stock having an aggregate common stock price equal to the amount of the aggregate Liquidation Preference of such shares being redeemed in shares of common stock in lieu of cash at the redemption date. In the event of liquidation, the Series E Redeemable Preferred is entitled to receive its Liquidation Preference before any such distribution of assets or proceeds is made to or set aside for the holders of our common stock and any other junior stock. In the event of a change of control, we must make an offer to purchase all of the shares of Series E Redeemable Preferred outstanding at the Liquidation Preference. Since carrying values of the redeemable preferred stocks are being increased by periodic accretions (including the amount for dividends earned but not yet declared or paid) using the interest method so that the carrying amount will equal the redemption value as of October 25, 2023, the earliest possible redemption date by the holder, this accretion has and will continue to affect income (loss) per common share. However, this accretion will change if the expected redemption date changes. Also, see discussion in Note 10. Capital Expenditures - 2019 For 2019, capital expenditures relating to PP&E were $36.1 million, which expenditures include approximately $2.0 million associated with maintaining compliance with environmental laws, regulations and guidelines. Approximately $5.2 million related to the new sulfuric acid converter, which was financed, and the remaining capital expenditures were primarily funded with cash. See discussion above under “Capitalization” for our expected annual capital expenditures for 2020. Expenses Associated with Environmental Regulatory Compliance We are subject to specific federal and state environmental compliance laws, regulations and guidelines. As a result, we incurred expenses of $4.9 million in 2019 in connection with environmental projects. For 2020, we expect to incur expenses ranging from $4.5 million to $5.0 million in connection with additional environmental projects. However, it is possible that the actual costs could be significantly different than our estimates. Dividends We have not paid cash dividends on our outstanding common stock in many years, and we do not currently anticipate paying cash dividends on our outstanding common stock in the near future. Dividends on the Series E Redeemable Preferred are cumulative and payable semi-annually (May 1 and November 1) in arrears at the current annual rate of 14% of the liquidation value of $1,000 per share, but such annual rate will increase beginning on April 25, 2021 as discussed in Note 10. Each share of Series E Redeemable Preferred is entitled to receive a semi-annual dividend, only when declared by our Board. In addition, dividends in arrears at the dividend date, until paid, shall compound additional dividends at the current annual rate of 14%, but such annual rate will increase beginning on April 25, 2021. The current semi-annual compounded dividend is approximately $118.87 per share for the current aggregate semi-annual dividend of $16.6 million. We also must declare a dividend on the Series E Redeemable Preferred on a pro rata basis with our common stock. As long as the Purchaser holds at least 10% of the Series E Redeemable Preferred, we may not declare dividends on our common stock and other preferred stocks unless and until dividends have been declared and paid on the Series E Redeemable Preferred for the then current dividend period in cash. As of December 31, 2019, the amount of accumulated dividends on the Series E Redeemable Preferred was approximately $103.0 million. Dividends on the Series D 6% cumulative convertible Class C preferred stock (the “Series D Preferred”) and Series B 12% cumulative convertible Class C Preferred Stock (the “Series B Preferred”) are payable annually, only when declared by our Board, as follows: • $0.06 per share on our outstanding non-redeemable Series D Preferred for an aggregate dividend of $60,000, and • $12.00 per share on our outstanding non-redeemable Series B Preferred for an aggregate dividend of $240,000. As of December 31, 2019, the amount of accumulated dividends on the Series D Preferred and Series B Preferred totaled approximately $1.3 million. All shares of the Series D Preferred and Series B Preferred are owned by the Golsen Holders. There are no optional or mandatory redemption rights with respect to the Series B Preferred or Series D Preferred. Seasonality We believe fertilizer products sold to the agricultural industry are seasonal while sales into the industrial and mining sectors generally are less susceptible. The selling seasons for agricultural products are primarily during the spring and fall planting seasons, which typically extend from March through June and from September through November in the geographical markets we distribute the majority of our agricultural products. As a result, we typically increase our inventory of fertilizer products prior to the beginning of each planting season in order to meet the demand for our products. In addition, the amount and timing of sales to the agricultural markets depend upon weather conditions and other circumstances beyond our control. Performance and Payment Bonds We are contingently liable to sureties in respect of insurance bonds issued by the sureties in connection with certain contracts entered into by subsidiaries in the normal course of business. These insurance bonds primarily represent guarantees of future performance of our subsidiaries. As of December 31, 2019, we have agreed to indemnify the sureties for payments, up to $10 million, made by them in respect of such bonds. All of these insurance bonds are expected to expire or be renewed in 2020. Off-Balance Sheet Arrangements We do not have any off-balance sheet arrangements as defined in Item 303(a)(4)(ii) of Regulation S-K under the Securities Exchange Act of 1934. Aggregate Contractual Obligations As of December 31, 2019, our aggregate contractual obligations are summarized in the following table: (1) The estimated interest payments relating to variable interest rate debt are based on interest rates at December 31, 2019. (2) The Series E redeemable preferred stock (including dividends) are assumed to be redeemed and paid on the earliest possible redemption date by the holder (October 25, 2023) and that dividends are accrued until that date. (3) Capital expenditures include only the estimated committed amounts (high end of range) at December 31, 2019. (4) Our proportionate share of the minimum costs to ensure capacity relating to a gathering and pipeline system. (5) The future cash flows relating to executive and death benefits are based on estimates at December 31, 2019. The participation rights value associated with embedded derivative of our Series E redeemable preferred stock is based on the value of our common stock at December 31, 2019 and is based on the earliest possible redemption date by the holder, October 25, 2023. New Accounting Pronouncements Refer to Notes 1 and 2 for recently adopted and issued accounting standards. Critical Accounting Policies and Estimates The preparation of financial statements requires management to make estimates and assumptions that affect the reported amount of assets, liabilities, revenues and expenses, and disclosures of contingencies and fair values. It is reasonably possible that the estimates and assumptions utilized as of December 31, 2019, could change in the near term. The more critical areas of financial reporting affected by management's judgment, estimates and assumptions include the following: Contingencies - Certain conditions may exist which may result in a loss, but which will only be resolved when future events occur. We and our legal counsel assess such contingent liabilities, and such assessment inherently involves an exercise of judgment. If the assessment of a contingency indicates that it is probable that a loss has been incurred, we would accrue for such contingent losses when such losses can be reasonably estimated. If the assessment indicates that a potentially material loss contingency is not probable but reasonably possible, or is probable but cannot be estimated, the nature of the contingent liability, together with an estimate of the range of possible loss if determinable and material, would be disclosed. Estimates of potential legal fees and other directly related costs associated with contingencies are not accrued but rather are expensed as incurred. Loss contingency liabilities are included in current and noncurrent accrued and other liabilities and are based on current estimates that may be revised in the near term. In addition, we recognize contingent gains when such gains are realized or realizable and earned. We are involved in various legal matters that require management to make estimates and assumptions, including costs relating to the lawsuit styled City of West, Texas v CF Industries, Inc., et al, discussed under “Other Pending, Threatened or Settled Litigation” of Note 9. It is reasonably possible that the actual costs could be significantly different than our estimates. Regulatory Compliance - As discussed under “Environmental, Health and Safety Matters” in Item 1 of this report, we are subject to specific federal and state regulatory compliance laws and guidelines. We have developed policies and procedures related to regulatory compliance. We must continually monitor whether we have maintained compliance with such laws and regulations and the operating implications, if any, and amount of penalties, fines and assessments that may result from noncompliance. We will also be obligated to manage certain discharge water outlets and monitor groundwater contaminants at our chemical facilities should we discontinue the operations of a facility. However, certain conditions exist which may result in a loss, but which will only be resolved when future events occur relating to these matters. We are involved in various environmental matters that require management to make estimates and assumptions, including our current inability to develop a meaningful and reliable estimate (or range of estimate) as to the costs relating to a corrective action study work plan approved by the Kansas Department of Health and Environment (“KDHE”) discussed under footnote 3 - Other Environmental Matters of Note 9. At December 31, 2019 and 2018, liabilities totaling $0.2 million for both periods have been accrued relating to these issues as discussed. This liability is included in current accrued and other liabilities and is based on current estimates that may be revised in the near term. At the time that cost estimates for any corrective action are received, we will adjust our accrual accordingly. It is reasonably possible that the adjustment to the accrual and the actual costs could be significantly different than our current estimates. Charge Associated with Assets Held for Sale - As discussed in Note 1, assets held for sale are generally reported at the lower of the carrying amounts of the assets or fair values less costs to sell. During 2019, in conjunction with management’s review of our long-range strategy, development of the 2020 budget and the completion of the 2019 Turnarounds, certain non-core long-lived assets were identified and authorized to be sold. As a result, these assets were classified as assets held for sale. Because the estimated costs to sell these assets (primarily to dismantle) exceeds the estimated fair values, the carrying amount of these assets were written down to a de minimis amount and a non-cash charge of approximately $9.7 million was recognized and classified as other expense. We expect these assets to be sold in 2020. At December 31, 2018, we had no long-lived assets classified as held for sale. Income Tax - As discussed under “Income Taxes” in Note 1 and in Note 8, income taxes are accounted for under the asset and liability method. Deferred tax assets and liabilities are measured using enacted tax rates expected to apply to taxable income in the years in which those differences are expected to be recovered or settled. We establish valuation allowances if we believe it is more-likely-than-not that some or all of deferred tax assets will not be realized. Significant judgment is applied in evaluating the need for and the magnitude of appropriate valuation allowances against deferred tax assets. At December 31, 2019 and 2018, our valuation allowance on deferred tax assets was $51.6 million and $45.6 million, respectively. Redeemable Preferred Stocks - In December 2015, we issued the Series E and F Redeemable Preferred. The redeemable preferred stocks are redeemable outside of our control and are classified as temporary/mezzanine equity on our consolidated balance sheet. In addition, certain embedded features (the “embedded derivative”) included in the Series E Redeemable Preferred required bifurcation and are classified as derivative liabilities. Currently, the carrying values of the redeemable preferred stocks are being increased by periodic accretions (recorded to retained earnings and included in determining income or loss per share) using the interest method so that the carrying amount will equal the redemption value as of October 25, 2023, the earliest possible redemption date by the holder. Approximately $33 million of accretion (including the amount for earned dividends) was recorded to retained earnings in 2019. At December 31, 2019, the carrying value of these redeemable preferred stocks was $234.9 million. For the embedded derivative, changes in fair value are recorded in our statement of operations. At December 31, 2019 and 2018, we estimated that the embedded contingent redemption features have fair value since we estimate that it is probable that a portion of the shares of this preferred stock would be redeemed prior to October 25, 2023. At December 31, 2019 and 2018, the fair value of the embedded derivative was $1.1 million and $1.6 million, respectively, primarily relating to the participation rights based on the equivalent of 303,646 shares of our common stock at $4.20 and $5.52 per share, respectively. No valuation input adjustments were considered necessary relating to nonperformance risk for the embedded derivative based on our current forecast. The valuation is classified as Level 3. Management’s judgment and estimates in the above areas are based on information available from internal and external resources at that time. Actual results could differ materially from these estimates and judgments, as additional information becomes known.

<s>[INST] Overview General LSB is headquartered in Oklahoma City, Oklahoma and through its subsidiaries, manufactures and sells chemical products for the agricultural, mining, and industrial markets. We own and operate facilities in Cherokee, Alabama; El Dorado, Arkansas; and Pryor, Oklahoma, and operate a facility for Covestro in Baytown, Texas. Our products are sold through distributors and directly to end customers throughout the U.S. Key Operating Initiatives for 2020 We believe our future results of operations and financial condition will depend significantly on our ability to successfully implement the following key initiatives: Continued Focus on Becoming a “Best in Class” Chemical plant operator with respect to safe, reliable operations that produce the highest quality product. We believe that high safety standards are critical and a precursor to improved plant performance. With that in mind, we implemented and are currently managing enhanced safety programs at our facilities that focus on improving our safety culture that will reduce risks and continuously improve our safety performance. Additionally, over the last several years, our focus has been on upgrading our existing maintenance management system through technology enhancements and work processes to improve our predictive and preventative maintenance programs at our facilities. We have several initiatives underway that we believe will improve the overall reliability of our plants and allow us to produce more products for sale while lowering our cost of production. Those initiatives are focused on building internal expertise to improve oversight of external contractors, operating behavior and procedure enhancements including operator training, leadership training, shift change enhancements and operating and maintenance procedures. Continue Broadening of the Distribution of our Products. To further leverage our plants current production capacity, we are continuing to expand the distribution of our industrial and mining products by partnering with customers to take product into different markets within the U.S. as well as markets outside the U.S. Additionally, during 2019, we developed a pipeline of margin enhancement projects including product loading and unloading improvements, tank storage and capital to facilitate guest plant opportunities which, we expect will result in improved margins on the sales of our products. We expect to complete these projects over the next 12 to 18 months. Improve Our Capital Structure and Overall Cost of Capital. We are actively seeking ways to improve our capital structure and reduce our overall cost of capital. We believe that our improved operating performance will be a benefit in achieving those efforts. We may not successfully implement any or all of these initiatives. Even if we successfully implement the initiatives, they may not achieve the results that we expect or desire. Business Developments 2019 Financing Transaction As discussed in Note 7, in June 2019, we completed the issuance and sale of $35 million of the New Notes. The New Notes were issued at a price equal to 102.125% of their face value. We expect to use the net proceeds from the New Notes to fund approximately $20 million in anticipated capital expenditures over a 12 to 18month period that are intended to enhance our margins as discussed above under “Key Operating Initiatives for 2020”. The remaining net proceeds have been used for general corporate purposes. Completion of Turnarounds at our El Dorado and Pryor Facilities During August 2019, we completed an 18day Turnaround on our ammonia plant at our El Dorado Facility. Additionally, during November 2019, the ammonia plant at our El Dorado Facility was taken out of service for 16 days in order to make adjustments that improved the ammonia plant reliability and production volume. Also, during November 2019, we completed a 28day Turnaround on our sulfuric acid plant at our El Dorado Facility, which included the installation of a new sulfuric acid converter which will increase reliability and production volume. During November 2019, we completed an extensive 67day Turnaround at our Pryor Facility including the installation of a new, larger urea reactor. The next Turnarounds for these facilities are scheduled in 2021 for our Pryor Facility and 2022 for our El Dorado Facility. See additional discussion below under “Items Affecting Comparability of Results.” Amended Ammonia Agreement During October 2019, the ammonia purchase and sale agreement between El [/INST] Negative. </s>

FIFTH THIRD BANCORP

2019-03-01

2018-12-31

ITEM 7. MANAGEMENT’S DISCUSSION AND ANALYSIS OF FINANCIAL CONDITION AND RESULTS OF OPERATIONS (MD&A) The following is Management’s Discussion and Analysis of Financial Condition and Results of Operations of certain significant factors that have affected Fifth Third Bancorp’s (the “Bancorp” or “Fifth Third”) financial condition and results of operations during the periods included in the Consolidated Financial Statements, which are a part of this filing. Reference to the Bancorp incorporates the parent holding company and all consolidated subsidiaries. The Bancorp’s banking subsidiary is referred to as the Bank. OVERVIEW This overview of MD&A highlights selected information in the financial results of the Bancorp and may not contain all of the information that is important to you. For a more complete understanding of trends, events, commitments, uncertainties, liquidity, capital resources and critical accounting policies and estimates, you should carefully read this entire document. Each of these items could have an impact on the Bancorp’s financial condition, results of operations and cash flows. In addition, refer to the Glossary of Abbreviations and Acronyms in this report for a list of terms included as a tool for the reader of this annual report on Form 10-K. The abbreviations and acronyms identified therein are used throughout this MD&A, as well as the Consolidated Financial Statements and Notes to Consolidated Financial Statements. Net interest income, net interest margin, net interest rate spread and the efficiency ratio are presented in MD&A on an FTE basis. The FTE basis adjusts for the tax-favored status of income from certain loans and securities held by the Bancorp that are not taxable for federal income tax purposes. The Bancorp believes this presentation to be the preferred industry measurement of net interest income as it provides a relevant comparison between taxable and non-taxable amounts. The FTE basis for presenting net interest income is a non-GAAP measure. For further information, refer to the Non-GAAP Financial Measures section of MD&A. The Bancorp’s revenues are dependent on both net interest income and noninterest income. For the year ended December 31, 2018, net interest income on an FTE basis and noninterest income provided 60% and 40% of total revenue, respectively. The Bancorp derives the majority of its revenues within the U.S. from customers domiciled in the U.S. Revenue from foreign countries and external customers domiciled in foreign countries was immaterial to the Consolidated Financial Statements. Changes in interest rates, credit quality, economic trends and the capital markets are primary factors that drive the performance of the Bancorp. As discussed later in the Risk Management section of MD&A, risk identification, assessment, management, monitoring and independent governance reporting of risk are important to the management of risk and to the financial performance and capital strength of the Bancorp. Net interest income is the difference between interest income earned on assets such as loans, leases and securities, and interest expense incurred on liabilities such as deposits, other short-term borrowings and long-term debt. Net interest income is affected by the general level of interest rates, the relative level of short-term and long-term interest rates, changes in interest rates and changes in the amount and composition of interest-earning assets and interest-bearing liabilities. Generally, the rates of interest the Bancorp earns on its assets and pays on its liabilities are established for a period of time. The change in market interest rates over time exposes the Bancorp to interest rate risk through potential adverse changes to net interest income and financial position. The Bancorp manages this risk by continually analyzing and adjusting the composition of its assets and liabilities based on their payment streams and interest rates, the timing of their maturities and their sensitivity to changes in market interest rates. Additionally, in the ordinary course of business, the Bancorp enters into certain derivative transactions as part of its overall strategy to manage its interest rate and prepayment risks. The Bancorp is also exposed to the risk of loss on its loan and lease portfolio as a result of changing expected cash flows caused by borrower credit events, such as loan defaults and inadequate collateral. Noninterest income is derived from service charges on deposits, wealth and asset management revenue, corporate banking revenue, card and processing revenue, mortgage banking net revenue, net securities gains or losses and other noninterest income. Noninterest expense includes personnel costs, net occupancy expense, technology and communication costs, card and processing expense, equipment expense and other noninterest expense. Worldpay, Inc. and Worldpay Holding, LLC Transactions On January 16, 2018, Vantiv, Inc. completed its previously announced acquisition of Worldpay Group plc. with the resulting combined company named Worldpay, Inc. As a result of this transaction, the Bancorp recognized a gain of $414 million in other noninterest income during the first quarter of 2018 associated with the dilution in its ownership interest in Worldpay Holding, LLC from approximately 8.6% to approximately 4.9%. On June 27, 2018, the Bancorp completed the sale of 5 million shares of Class A common stock of Worldpay, Inc. The Bancorp had previously received these Class A shares in exchange for Class B Units of Worldpay Holding, LLC. The Bancorp recognized a gain of $205 million related to the sale. As a result of the sale, the Bancorp beneficially owns approximately 3.3% of Worldpay’s equity through its ownership of approximately 10.3 million Class B Units. At December 31, 2018, the Bancorp’s remaining interest in Worldpay Holding, LLC of $420 million continues to be accounted for as an equity method investment given the nature of Worldpay Holding, LLC’s structure as a limited liability company and contractual arrangements between Worldpay Holding, LLC and the Bancorp. GS Holdings Transaction In May 2018, GreenSky, Inc. launched an IPO and issued 38 million shares of Class A common stock for a valuation of $23 per share. In connection with this IPO, the Bancorp’s investment in GreenSky, LLC, which was comprised of 252,550 membership units, was converted to 2,525,498 units of the newly formed GreenSky Holdings, LLC (“GS Holdings”), representing a 1.4% interest in GS Holdings. The Bancorp’s units in GS Holdings are exchangeable on a one-to-one basis for Class A common stock or cash. At the time of the IPO, the Bancorp recognized a $16 million gain on its investment in GreenSky, LLC, which was included in other noninterest income in the Consolidated Statements of Income for the year ended December 31, 2018. At December 31, 2018, the investment in GS Holdings was $24 million, which was included in equity securities in the Consolidated Balance Sheets. Accelerated Share Repurchase Transactions During the years ended December 31, 2018 and 2017, the Bancorp entered into or settled a number of accelerated share repurchase transactions. As part of these transactions, the Bancorp entered into forward contracts in which the final number of shares delivered at settlement was based generally on a discount to the average daily volume weighted-average price of the Bancorp’s common stock during the term of the repurchase agreements. 44 Fifth Third Bancorp MANAGEMENT’S DISCUSSION AND ANALYSIS OF FINANCIAL CONDITION AND RESULTS OF OPERATIONS For more information on the accelerated share repurchase program, refer to Note 22 of the Notes to Consolidated Financial Statements. For a summary of the Bancorp’s accelerated share repurchase transactions that were entered into or settled during the years ended December 31, 2018 and 2017, refer to Table 1. Open Market Share Repurchase Transactions Between July 20, 2018 and August 2, 2018, the Bancorp repurchased 16,945,020 shares, or approximately $500 million, of its outstanding common stock through open market repurchase transactions, which settled between July 24, 2018 and August 6, 2018. Between October 24, 2018 and November 9, 2018, the Bancorp repurchased 14,916,332 shares, or approximately $400 million, of its outstanding common stock through open market repurchase transactions, which settled between October 26, 2018 and November 14, 2018. For more information on the open market share repurchase program, refer to Note 22 of the Notes to Consolidated Financial Statements. Senior Notes Offerings On March 14, 2018, the Bancorp issued and sold $650 million of senior notes to third-party investors. The senior notes bear a fixed-rate of interest of 3.95% per annum. The notes are unsecured, senior obligations of the Bancorp. Payment of the full principal amounts of the notes is due upon maturity on March 14, 2028. These fixed-rate senior notes will be redeemable by the Bancorp, in whole or in part, on or after the date that is 30 days prior to the maturity date at a redemption price equal to 100% of the principal amount plus accrued and unpaid interest up to, but excluding, the redemption date. On June 5, 2018, the Bancorp issued and sold $250 million of senior notes to third-party investors. The senior notes bear a floating-rate of three-month LIBOR plus 47 bps. The notes are unsecured, senior obligations of the Bancorp. Payment of the full principal amounts of the notes is due upon maturity on June 4, 2021. These floating-rate senior notes will be redeemable by the Bancorp, in whole or in part, on or after the date that is 30 days prior to the maturity date at a redemption price equal to 100% of the principal amount plus accrued and unpaid interest up to, but excluding, the redemption date. On July 26, 2018 the Bank issued and sold, under its bank notes program, $1.55 billion in aggregate principal amount of unsecured senior bank notes. The bank notes consisted of $500 million of 3.35% senior fixed-rate notes, with a maturity of three years, due on July 26, 2021; $300 million of senior floating-rate notes at three-month LIBOR plus 44 bps, with a maturity of three years, due on July 26, 2021; and $750 million of 3.95% senior fixed-rate notes, with a maturity of seven years, due July 28, 2025. The Bank entered into interest rate swaps to convert the fixed-rate notes due in 2021 and 2025 to a floating-rate, which resulted in an effective interest rate of one-month LIBOR plus 53 bps and 104 bps, respectively. These bank notes will be redeemable by the Bank, in whole or in part, on or after the date that is 30 days prior to the maturity date at a redemption price equal to 100% of the principal amount plus accrued and unpaid interest up to, but excluding, the redemption date. For additional information on these senior notes offerings, refer to Note 15 of the Notes to Consolidated Financial Statements. For further information on subsequent events related to long-term debt, refer to Note 31 of the Notes to Consolidated Financial Statements. 2018 Branch Optimization Plan Customer interactions and service and sales activity in Branch Banking continue to evolve with changing demographics and technology applications. Customers are increasingly utilizing digital tools to interact with their financial institutions in conducting their transactions while still utilizing physical branches for consultations and new product and service initiation. During the past three years, these developments and other business strategies led to a net decrease of 133 in the number of retail branches, or 11% of the Bancorp’s total branch count, through consolidations and sales. The Bancorp continues to evaluate its retail network distribution in light of changes in customer behavior while developing new analytical tools that provide enhanced capabilities to optimize the profitability and growth potential of branches. In slower growth mature markets these developments enable the Bancorp to achieve efficiencies through well-executed branch consolidations without materially impacting deposit flows and/or revenue growth while maintaining the service quality standards. While continuing to evaluate such actions, the Bancorp is also focused on achieving higher retail household and deposit growth in other parts of its footprint - mainly in markets that exhibit faster economic growth and where the Bancorp has significant opportunities to capture higher market share. To that extent, based on the strategic business evaluation that was performed during the second quarter of 2018, over the next 2-3 years, as part of the 2018 Branch Optimization Plan, the Bancorp plans to close between 100-125 branches in more mature markets and open between 100-125 new branches in higher growth markets where the Bancorp already has an existing retail branch presence. With the existing local presence and familiarity with the customer demographics, and with newly developed analytical tools, the Bancorp expects to achieve higher growth rates as a result of these actions. As of December 31, 2018, the Bancorp had closed 31 branches under the 2018 Branch Optimization Plan. The Bancorp expects to identify the remaining branches to be closed under the 2018 Branch Optimization Plan prior to December 31, 2019. As part of the adoption of the 2018 Branch Optimization Plan, the Bancorp has also elected to sell 21 parcels of land which had previously been held for future branch expansion. For further information about the 2018 Branch Optimization plan, refer to Note 7 of the Notes to Consolidated Financial Statements. Change in Accounting Policy Effective in the fourth quarter of 2018, the Bancorp changed its accounting policy for qualifying LIHTC investments from the equity method to the proportional amortization method as it was management’s determination to be the preferable method. 45 Fifth Third Bancorp MANAGEMENT’S DISCUSSION AND ANALYSIS OF FINANCIAL CONDITION AND RESULTS OF OPERATIONS The proportional amortization method provides an improved presentation for the reporting of these investments by presenting the investment performance net of taxes as a component of income tax expense, which more fairly represents the economics and provides users with a better understanding of the returns from such investments than the prior equity method. Additionally, the proportional amortization method has been elected as a preferred accounting method for LIHTC investments by many of the Bancorp’s peers. Changing the accounting policy for LIHTC investments from the equity method of accounting to the proportional amortization method will make the Bancorp’s presentation of the LIHTC investments comparable to that of its peers. The adoption of the proportional amortization method was applied retrospectively and resulted in a cumulative effect adjustment to reduce retained earnings by $134 million as of January 1, 2016. Unless otherwise noted, all prior period information has been restated to conform to the accounting policy change. Refer to Note 1 of the Notes to Consolidated Financial Statements for further information including the impact of adoption on prior period financial statements. (a) These are non-GAAP measures. For further information, refer to the Non-GAAP Financial Measures section of MD&A. Earnings Summary The Bancorp’s net income available to common shareholders for the year ended December 31, 2018 was $2.1 billion, or $3.06 per diluted share, which was net of $75 million in preferred stock dividends. The Bancorp’s net income available to common shareholders for the year ended December 31, 2017 was $2.1 billion, or $2.81 per diluted share, which was net of $75 million in preferred stock dividends. Net interest income on an FTE basis (non-GAAP) was $4.2 billion and $3.8 billion for the years ended December 31, 2018 and 2017, respectively. Net interest income was positively impacted by increases in yields on average loans and leases and average taxable securities and an increase in average taxable securities for the year ended December 31, 2018 compared to the year ended December 31, 2017. Additionally, net interest income was positively impacted by the decisions of the FOMC to raise the target range of the federal funds rate 25 bps in December 2017, March 2018, June 2018, September 2018 and December 2018. These positive impacts were partially offset by increases in the rates paid on average interest-bearing core deposits and average long-term debt during the year ended December 31, 2018 compared to the year ended December 31, 2017. Net interest margin on an FTE basis (non-GAAP) was 3.22% and 3.03% for the years ended December 31, 2018 and 2017, respectively. Noninterest income decreased $434 million for the year ended December 31, 2018 compared to the year ended December 31, 2017 primarily due to a decrease in other noninterest income, partially offset by increases in corporate banking revenue, wealth and asset management revenue and card and processing revenue. Other noninterest income decreased $470 million from the year ended December 31, 2017 primarily due to the gain on sale of Worldpay, Inc. shares recognized in the prior year, a reduction in equity method income from the Bancorp’s interest in Worldpay Holding, LLC, the impact of the net losses on disposition and impairment of bank premises and equipment and income from the TRA associated with Worldpay, Inc. recognized in the prior year. These reductions were partially offset by the gain related to Vantiv, Inc.’s acquisition of Worldpay Group plc., an increase in private equity investment income, as well as a decrease in the loss on the swap associated with the sale of Visa, Inc. Class B Shares. Corporate banking revenue increased $85 million for the year ended December 31, 2018 compared to the year ended December 31, 2017. The increase from the prior year was primarily driven by increases in lease remarketing fees, institutional sales revenue, syndication fees and contract revenue from commercial customer derivatives. Wealth and asset management revenue increased $25 million from the year ended December 31, 2017 primarily due to increases in private client service fees and brokerage fees. Card and processing revenue increased $16 million from the year ended December 31 2017 primarily due to increases in the number of actively used cards and customer spend volume. Noninterest expense increased $146 million for the year ended December 31, 2018 compared to the year ended December 31, 2017 primarily due to increases in personnel costs and technology and communications expenses, partially offset by a decrease in other noninterest expense. Personnel costs increased $126 million for the year ended December 31, 2018 compared to the year ended December 31, 2017 driven by increases in base compensation, performance-based compensation and severance costs. The increase in base compensation was primarily due to an increase in the Bancorp’s minimum wage as a result of benefits received from the TCJA and personnel additions associated with strategic investments and acquisitions. 46 Fifth Third Bancorp MANAGEMENT’S DISCUSSION AND ANALYSIS OF FINANCIAL CONDITION AND RESULTS OF OPERATIONS Technology and communications expense increased $40 million for the year ended December 31, 2018 compared to the year ended December 31, 2017 driven primarily by increased investment in regulatory, compliance and growth initiatives. Other noninterest expense decreased $17 million for the year ended December 31, 2018 compared to the year ended December 31, 2017 primarily due to an increase in the benefit from the reserve for unfunded commitments, gains on partnership investments and decreases in professional service fees and FDIC insurance and other taxes, partially offset by increases in marketing expense and loan and lease expense. For more information on net interest income, noninterest income and noninterest expense, refer to the Statements of Income Analysis section of MD&A. Credit Summary The provision for loan and lease losses was $237 million and $261 million for the years ended December 31, 2018 and 2017, respectively. Net losses charged-off as a percent of average portfolio loans and leases decreased to 0.35% during the year ended December 31, 2018 compared to 0.32% during the year ended December 31, 2017. At December 31, 2018, nonperforming portfolio assets as a percent of portfolio loans and leases and OREO decreased to 0.41% compared to 0.53% at December 31, 2017. For further discussion on credit quality, refer to the Credit Risk Management subsection of the Risk Management section of MD&A. Capital Summary The Bancorp’s capital ratios exceed the “well-capitalized” guidelines as defined by the PCA requirements of the U.S. banking agencies. As of December 31, 2018, as calculated under the Basel III standardized approach, the CET1 capital ratio was 10.24%, the Tier I risk-based capital ratio was 11.32%, the Total risk-based capital ratio was 14.48% and the Tier I leverage ratio was 9.72%. NON-GAAP FINANCIAL MEASURES The following are non-GAAP measures which provide useful insight to the reader of the Consolidated Financial Statements but should be supplemental to primary U.S. GAAP measures and should not be read in isolation or relied upon as a substitute for the primary U.S. GAAP measures. The FTE basis adjusts for the tax-favored status of income from certain loans and securities held by the Bancorp that are not taxable for federal income tax purposes. The Bancorp believes this presentation to be the preferred industry measurement of net interest income as it provides a relevant comparison between taxable and non-taxable amounts. The following table reconciles the non-GAAP financial measures of net interest income on an FTE basis, interest income on an FTE basis, net interest margin, net interest rate spread and the efficiency ratio to U.S. GAAP: The Bancorp believes return on average tangible common equity is an important measure for comparative purposes with other financial institutions, but is not defined under U.S. GAAP, and therefore is considered a non-GAAP financial measure. This measure is useful for evaluating the performance of a business as it calculates the return available to common shareholders without the impact of intangible assets and their related amortization. 47 Fifth Third Bancorp MANAGEMENT’S DISCUSSION AND ANALYSIS OF FINANCIAL CONDITION AND RESULTS OF OPERATIONS The following table reconciles the non-GAAP financial measure of return on average tangible common equity to U.S. GAAP: The Bancorp considers various measures when evaluating capital utilization and adequacy, including the tangible equity ratio and tangible common equity ratio, in addition to capital ratios defined by the U.S. banking agencies. These calculations are intended to complement the capital ratios defined by the U.S. banking agencies for both absolute and comparative purposes. Because U.S. GAAP does not include capital ratio measures, the Bancorp believes there are no comparable U.S. GAAP financial measures to these ratios. These ratios are not formally defined by U.S. GAAP or codified in the federal banking regulations and, therefore, are considered to be non-GAAP financial measures. The Bancorp encourages readers to consider its Consolidated Financial Statements in their entirety and not to rely on any single financial measure. The following table reconciles non-GAAP capital ratios to U.S. GAAP: 48 Fifth Third Bancorp MANAGEMENT’S DISCUSSION AND ANALYSIS OF FINANCIAL CONDITION AND RESULTS OF OPERATIONS RECENT ACCOUNTING STANDARDS Note 1 of the Notes to Consolidated Financial Statements provides a discussion of the significant new accounting standards applicable to the Bancorp during 2018 and the expected impact of significant accounting standards issued, but not yet required to be adopted. CRITICAL ACCOUNTING POLICIES The Bancorp’s Consolidated Financial Statements are prepared in accordance with U.S. GAAP. Certain accounting policies require management to exercise judgment in determining methodologies, economic assumptions and estimates that may materially affect the Bancorp’s financial position, results of operations and cash flows. The Bancorp’s critical accounting policies include the accounting for the ALLL, reserve for unfunded commitments, income taxes, valuation of servicing rights, fair value measurements, goodwill and legal contingencies. There have been no material changes to the valuation techniques or models described below during the year ended December 31, 2018. ALLL The Bancorp disaggregates its portfolio loans and leases into portfolio segments for purposes of determining the ALLL. The Bancorp’s portfolio segments include commercial, residential mortgage and consumer. The Bancorp further disaggregates its portfolio segments into classes for purposes of monitoring and assessing credit quality based on certain risk characteristics. For an analysis of the Bancorp’s ALLL by portfolio segment and credit quality information by class, refer to Note 6 of the Notes to Consolidated Financial Statements. The Bancorp maintains the ALLL to absorb probable loan and lease losses inherent in its portfolio segments. The ALLL is maintained at a level the Bancorp considers to be adequate and is based on ongoing quarterly assessments and evaluations of the collectability and historical loss experience of loans and leases. Credit losses are charged and recoveries are credited to the ALLL. Provisions for loan and lease losses are based on the Bancorp’s review of the historical credit loss experience and such factors that, in management’s judgment, deserve consideration under existing economic conditions in estimating probable credit losses. The Bancorp’s strategy for credit risk management includes a combination of conservative exposure limits significantly below legal lending limits and conservative underwriting, documentation and collections standards. The strategy also emphasizes diversification on a geographic, industry and customer level, regular credit examinations and quarterly management reviews of large credit exposures and loans experiencing deterioration of credit quality. The Bancorp’s methodology for determining the ALLL requires significant management judgment and is based on historical loss rates, current credit grades, specific allocation on loans modified in a TDR and impaired commercial credits above specified thresholds and other qualitative adjustments. Allowances on individual commercial loans, TDRs and historical loss rates are reviewed quarterly and adjusted as necessary based on changing borrower and/or collateral conditions and actual collection and charge-off experience. An unallocated allowance is maintained to recognize the imprecision in estimating and measuring losses when evaluating allowances for pools of loans. Larger commercial loans included within aggregate borrower relationship balances exceeding $1 million that exhibit probable or observed credit weaknesses, as well as loans that have been modified in a TDR, are subject to individual review for impairment. The Bancorp considers the current value of collateral, credit quality of any guarantees, the guarantor’s liquidity and willingness to cooperate, the loan structure and other factors when evaluating whether an individual loan is impaired. Other factors may include the industry and geographic region of the borrower, size and financial condition of the borrower, cash flow and leverage of the borrower and the Bancorp’s evaluation of the borrower’s management. When individual loans are impaired, allowances are determined based on management’s estimate of the borrower’s ability to repay the loan given the availability of collateral and other sources of cash flow, as well as an evaluation of legal options available to the Bancorp. Allowances for impaired loans are measured based on the present value of expected future cash flows discounted at the loan’s effective interest rate, fair value of the underlying collateral or readily observable secondary market values. The Bancorp evaluates the collectability of both principal and interest when assessing the need for a loss accrual. Historical credit loss rates are applied to commercial loans that are not impaired or are impaired, but smaller than the established threshold of $1 million and thus not subject to specific allowance allocations. The loss rates are derived from migration analyses for several portfolio stratifications, which track the historical net charge-off experience sustained on loans according to their internal risk grade. The risk grading system utilized for allowance analysis purposes encompasses ten categories. Homogenous loans and leases in the residential mortgage and consumer portfolio segments are not individually risk graded. Rather, standard credit scoring systems and delinquency monitoring are used to assess credit risks and allowances are established based on the expected net charge-offs. Loss rates are based on the trailing twelve month net charge-off history by loan category. Historical loss rates may be adjusted for certain prescriptive and qualitative factors that, in management’s judgment, are necessary to reflect losses inherent in the portfolio. The prescriptive loss rate factors include adjustments for delinquency trends, LTV trends, refreshed FICO score trends and product mix. The Bancorp also considers qualitative factors in determining the ALLL. These include adjustments for changes in policies or procedures in underwriting, monitoring or collections, economic conditions, portfolio mix, lending and risk management personnel, results of internal audit and quality control reviews, collateral values and geographic concentrations. The Bancorp considers home price index trends in its footprint and the volatility of collateral valuation trends when determining the collateral value qualitative factor. When evaluating the adequacy of allowances, consideration is given to regional geographic concentrations and the closely associated effect changing economic conditions have on the Bancorp’s customers. Refer to the Allowance for Credit Losses subsection of the Risk Management section of MD&A for a discussion on the Bancorp’s ALLL sensitivity analysis. Reserve for Unfunded Commitments The reserve for unfunded commitments is maintained at a level believed by management to be sufficient to absorb estimated probable losses related to unfunded credit facilities and is included in other liabilities in the Consolidated Balance Sheets. The determination of the adequacy of the reserve is based upon an evaluation of the unfunded credit facilities, including an assessment of historical commitment utilization experience, credit risk grading and historical loss rates based on credit grade migration. This process takes into consideration the same risk elements that are analyzed in the determination of the adequacy of the Bancorp’s ALLL, as previously discussed. Net adjustments to the reserve for unfunded commitments are included in other noninterest expense in the Consolidated Statements of Income. 49 Fifth Third Bancorp MANAGEMENT’S DISCUSSION AND ANALYSIS OF FINANCIAL CONDITION AND RESULTS OF OPERATIONS Income Taxes The income tax laws of the jurisdictions in which the Bancorp operates are complex and may be subject to different interpretations. The Bancorp evaluates and assesses the relative risks and appropriate tax treatment of transactions and filing positions after considering statutes, regulations, judicial precedent and other information. The Bancorp maintains tax accruals consistent with its evaluation of these items. Changes in the estimate of tax accruals occur periodically due to changes in tax rates, interpretation of tax laws and regulations and other guidance issued by tax authorities and the status of examinations conducted by tax authorities, as well as the expiration of statutes of limitations. These changes may significantly impact the Bancorp’s tax accruals, deferred taxes and income tax expense and may significantly impact the operating results of the Bancorp. Deferred taxes are determined using the balance sheet method. Under this method, the net deferred tax asset or liability is calculated based on the difference between the book and tax bases of the assets and liabilities using enacted tax rates and laws. Significant management judgment is required to determine the realizability of deferred tax assets. Deferred tax assets are recognized when management believes that it is more likely than not that the deferred tax assets will be realized. Where management has determined that it is not more likely than not that certain deferred tax assets will be realized, a valuation allowance is maintained. For additional information on income taxes, refer to Note 19 of the Notes to Consolidated Financial Statements. Valuation of Servicing Rights When the Bancorp sells loans through either securitizations or individual loan sales in accordance with its investment policies, it often obtains servicing rights. The Bancorp may also purchase servicing rights. Effective January 1, 2017, the Bancorp elected to prospectively adopt the fair value method for all existing classes of its residential mortgage servicing rights portfolio. Upon this election, all servicing rights in these classes are measured at fair value at each reporting date and changes in the fair value of servicing rights are reported in earnings in the period in which the changes occur. Servicing rights are valued using internal OAS models. Significant management judgment is necessary to identify key economic assumptions used in estimating the fair value of the servicing rights including the prepayment speeds of the underlying loans, the weighted-average life, the OAS spread and the weighted-average coupon rate, as applicable. The primary risk of material changes to the value of the servicing rights resides in the potential volatility in the economic assumptions used, particularly the prepayment speeds. In order to assist in the assessment of the fair value of servicing rights, the Bancorp obtains external valuations of the servicing rights portfolio from third parties and participates in peer surveys that provide additional confirmation of the reasonableness of key assumptions utilized in the internal OAS model. Prior to the election of the fair value method, servicing rights were initially recorded at fair value and subsequently amortized in proportion to, and over the period of, estimated net servicing revenue. Servicing rights were assessed for impairment monthly, based on fair value, with temporary impairment recognized through a valuation allowance and other-than-temporary impairment recognized through a write-off of the servicing asset and related valuation allowance. For additional information on servicing rights, refer to Note 11 of the Notes to Consolidated Financial Statements. Fair Value Measurements The Bancorp measures certain financial assets and liabilities at fair value in accordance with U.S. GAAP, which defines fair value as the price that would be received to sell an asset or paid to transfer a liability in an orderly transaction between market participants at the measurement date. The Bancorp employs various valuation approaches to measure fair value including the market, income and cost approaches. The market approach uses prices or relevant information generated by market transactions involving identical or comparable assets or liabilities. The income approach involves discounting future amounts to a single present amount and is based on current market expectations about those future amounts. The cost approach is based on the amount that currently would be required to replace the service capacity of the asset. U.S. GAAP establishes a fair value hierarchy, which prioritizes the inputs to valuation techniques used to measure fair value into three broad levels. The fair value hierarchy gives the highest priority to quoted prices in active markets for identical assets or liabilities (Level 1) and the lowest priority to unobservable inputs (Level 3). A financial instrument’s categorization within the fair value hierarchy is based upon the lowest level of input that is significant to the instrument’s fair value measurement. For additional information on the fair value hierarchy and fair value measurements, refer to Note 1 of the Notes to Consolidated Financial Statements. The Bancorp’s fair value measurements involve various valuation techniques and models, which involve inputs that are observable, when available. Valuation techniques and parameters used for measuring assets and liabilities are reviewed and validated by the Bancorp on a quarterly basis. Additionally, the Bancorp monitors the fair values of significant assets and liabilities using a variety of methods including the evaluation of pricing runs and exception reports based on certain analytical criteria, comparison to previous trades and overall review and assessments for reasonableness. The level of management judgment necessary to determine fair value varies based upon the methods used in the determination of fair value. Financial instruments that are measured at fair value using quoted prices in active markets (Level 1) require minimal judgment. The valuation of financial instruments when quoted market prices are not available (Levels 2 and 3) may require significant management judgment to assess whether quoted prices for similar instruments exist, the impact of changing market conditions including reducing liquidity in the capital markets and the use of estimates surrounding significant unobservable inputs. Table 6 provides a summary of the fair value of financial instruments carried at fair value on a recurring basis and the amounts of financial instruments valued using Level 3 inputs. 50 Fifth Third Bancorp MANAGEMENT’S DISCUSSION AND ANALYSIS OF FINANCIAL CONDITION AND RESULTS OF OPERATIONS Refer to Note 26 of the Notes to Consolidated Financial Statements for further information on fair value measurements including a description of the valuation methodologies used for significant financial instruments. Goodwill Business combinations entered into by the Bancorp typically include the acquisition of goodwill. U.S. GAAP requires goodwill to be tested for impairment at the Bancorp’s reporting unit level on an annual basis, which for the Bancorp is September 30, and more frequently if events or circumstances indicate that there may be impairment. Refer to Note 1 of the Notes to Consolidated Financial Statements for a discussion on the methodology used by the Bancorp to assess goodwill for impairment. Impairment exists when a reporting unit’s carrying amount of goodwill exceeds its implied fair value. In testing goodwill for impairment, U.S. GAAP permits the Bancorp to first assess qualitative factors to determine whether it is more likely than not that the fair value of a reporting unit is less than its carrying amount. In this qualitative assessment, the Bancorp evaluates events and circumstances which may include, but are not limited to, the general economic environment, banking industry and market conditions, the overall financial performance of the Bancorp, the performance of the Bancorp’s common stock, the key financial performance metrics of the Bancorp’s reporting units and events affecting the reporting units to determine if it is not more likely than not that the fair value of a reporting unit is less than its carrying amount. If the two-step impairment test is required or the decision to bypass the qualitative assessment is elected, the Bancorp would be required to perform the first step (Step 1) of the goodwill impairment test by comparing the fair value of a reporting unit with its carrying amount, including goodwill. If the carrying amount of the reporting unit exceeds its fair value, Step 2 of the goodwill impairment test is performed to measure the amount of impairment loss, if any. The fair value of a reporting unit is the price that would be received to sell the unit as a whole in an orderly transaction between market participants at the measurement date. As none of the Bancorp’s reporting units are publicly traded, individual reporting unit fair value determinations cannot be directly correlated to the Bancorp’s stock price. The determination of the fair value of a reporting unit is a subjective process that involves the use of estimates and judgments, particularly related to cash flows, the appropriate discount rates and an applicable control premium. The Bancorp employs an income-based approach, utilizing the reporting unit’s forecasted cash flows (including a terminal value approach to estimate cash flows beyond the final year of the forecast) and the reporting unit’s estimated cost of equity as the discount rate. Significant management judgment is necessary in the preparation of each reporting unit’s forecasted cash flows surrounding expectations for earnings projections, growth and credit loss expectations and actual results may differ from forecasted results. Additionally, the Bancorp determines its market capitalization based on the average of the closing price of the Bancorp’s stock during the month including the measurement date, incorporating an additional control premium, and compares this market-based fair value measurement to the aggregate fair value of the Bancorp’s reporting units in order to corroborate the results of the income approach. When required to perform Step 2, the Bancorp compares the implied fair value of a reporting unit’s goodwill with the carrying amount of that goodwill. If the carrying amount exceeds the implied fair value, an impairment loss equal to that excess amount is recognized. A recognized impairment loss cannot exceed the carrying amount of that goodwill and cannot be reversed in future periods even if the fair value of the reporting unit subsequently recovers. During Step 2, the Bancorp determines the implied fair value of goodwill for a reporting unit by assigning the fair value of the reporting unit to all of the assets and liabilities of that unit (including any unrecognized intangible assets) as if the reporting unit had been acquired in a business combination. Significant management judgment is necessary in the identification and valuation of unrecognized intangible assets and the valuation of the reporting unit’s recorded assets and liabilities. The excess of the fair value of the reporting unit over the amounts assigned to its assets and liabilities is the implied fair value of goodwill. This assignment process is only performed for purposes of testing goodwill for impairment. The Bancorp does not adjust the carrying values of recognized assets or liabilities (other than goodwill, if appropriate), nor does it recognize previously unrecognized intangible assets in the Consolidated Financial Statements as a result of this assignment process. Refer to Note 8 of the Notes to Consolidated Financial Statements for further information regarding the Bancorp’s goodwill. Legal Contingencies The Bancorp and its subsidiaries are parties to numerous claims and lawsuits as well as threatened or potential actions or claims concerning matters arising from the conduct of its business activities. The outcome of claims or litigation and the timing of ultimate resolution are inherently difficult to predict and significant judgment may be required in the determination of both the probability of loss and whether the amount of the loss is reasonably estimable. The Bancorp’s estimates are subjective and are based on the status of legal and regulatory proceedings, the merit of the Bancorp’s defenses and consultation with internal and external legal counsel. An accrual for a potential litigation loss is established when information related to the loss contingency indicates both that a loss is probable and that the amount of loss can be reasonably estimated. Refer to Note 17 of the Notes to Consolidated Financial Statements for further information regarding the Bancorp’s legal proceedings. 51 Fifth Third Bancorp MANAGEMENT’S DISCUSSION AND ANALYSIS OF FINANCIAL CONDITION AND RESULTS OF OPERATIONS STATEMENTS OF INCOME ANALYSIS Net Interest Income Net interest income is the interest earned on loans and leases (including yield-related fees), securities and other short-term investments less the interest paid for core deposits (includes transaction deposits and other time deposits) and wholesale funding (includes certificates $100,000 and over, other deposits, federal funds purchased, other short-term borrowings and long-term debt). The net interest margin is calculated by dividing net interest income by average interest-earning assets. Net interest rate spread is the difference between the average yield earned on interest-earning assets and the average rate paid on interest-bearing liabilities. Net interest margin is typically greater than net interest rate spread due to the interest income earned on those assets that are funded by noninterest-bearing liabilities, or free funding, such as demand deposits or shareholders’ equity. Tables 7 and 8 present the components of net interest income, net interest margin and net interest rate spread for the years ended December 31, 2018, 2017 and 2016, as well as the relative impact of changes in the average balance sheet and changes in interest rates on net interest income. Nonaccrual loans and leases and loans and leases held for sale have been included in the average loan and lease balances. Average outstanding securities balances are based on amortized cost with any unrealized gains or losses on available-for-sale debt and other securities included in average other assets. Net interest income on an FTE basis (non-GAAP) was $4.2 billion and $3.8 billion for the years ended December 31, 2018 and 2017, respectively. Net interest income was positively impacted by increases in yields on average loans and leases of 58 bps and yields on average taxable securities of 13 bps for the year ended December 31, 2018 compared to the year ended December 31, 2017. Net interest income also benefited from an increase in average taxable securities of $1.4 billion for the year ended December 31, 2018 compared to the year ended December 31, 2017. Additionally, net interest income was positively impacted by the decisions of the FOMC to raise the target range of the federal funds rate 25 bps in December 2017, March 2018, June 2018, September 2018 and December 2018. These positive impacts were partially offset by increases in the rates paid on average interest-bearing core deposits and average long-term debt for the year ended December 31, 2018 compared to the year ended December 31, 2017. The rates paid on average interest-bearing core deposits and average long-term debt increased 33 bps and 32 bps, respectively, for the year ended December 31, 2018 compared to the same period in the prior year. Net interest rate spread on an FTE basis (non-GAAP) was 2.87% during the year ended December 31, 2018 compared to 2.76% during the year ended December 31, 2017. Yields on average interest-earning assets increased 46 bps, partially offset by a 35 bps increase in rates paid on average interest-bearing liabilities for the year ended December 31, 2018 compared to the year ended December 31, 2017. Net interest margin on an FTE basis (non-GAAP) was 3.22% for the year ended December 31, 2018 compared to 3.03% for the year ended December 31, 2017. The increase for the year ended December 31, 2018 was driven primarily by the previously mentioned increase in the net interest rate spread partially offset by a decrease in average free funding balances. The decrease in average free funding balances was driven by a decrease in average demand deposits of $2.5 billion for the year ended December 31, 2018 compared to the year ended December 31, 2017. Interest income on an FTE basis from loans and leases (non-GAAP) increased $590 million compared to the year ended December 31, 2017 driven by the previously mentioned increase in yields on average loans and leases, as well as an increase in the volume of average other consumer loans and average commercial and industrial loans. For more information on the Bancorp’s loan and lease portfolio, refer to the Loans and Leases subsection of the Balance Sheet Analysis section of MD&A. Interest income from investment securities and other short-term investments increased $94 million compared to the year ended December 31, 2017 primarily as a result of the aforementioned increases in average taxable securities and yields on average taxable securities. Interest expense on core deposits increased $250 million for the year ended December 31, 2018 compared to the year ended December 31, 2017. The increase was primarily due to an increase in the cost of average interest-bearing core deposits to 70 bps for the year ended December 31, 2018 from 37 bps for the year ended December 31, 2017. The increase in the cost of average interest-bearing core deposits was primarily due to increases in the rates paid on average interest checking deposits and average money market deposits. Refer to the Deposits subsection of the Balance Sheet Analysis section of MD&A for additional information on the Bancorp’s deposits. Interest expense on wholesale funding increased $102 million for the year ended December 31, 2018 compared to the year ended December 31, 2017 primarily due to the aforementioned increase in the rates paid on average long-term debt coupled with an increase in average long-term debt. Refer to the Borrowings subsection of the Balance Sheet Analysis section of MD&A for additional information on the Bancorp’s borrowings. Average wholesale funding represented 23% and 24% of average interest-bearing liabilities during the years ended December 31, 2018 and 2017, respectively. For more information on the Bancorp’s interest rate risk management, including estimated earnings sensitivity to changes in market interest rates, see the Market Risk Management subsection of the Risk Management section of MD&A. 52 Fifth Third Bancorp MANAGEMENT’S DISCUSSION AND ANALYSIS OF FINANCIAL CONDITION AND RESULTS OF OPERATIONS (a) The FTE adjustments included in the above table were $16, $26 and $25 for the years ended December 31, 2018, 2017 and 2016, respectively. (b) Net interest income (FTE), net interest margin (FTE) and net interest rate spread (FTE) are non-GAAP measures. For further information, refer to the Non-GAAP Financial Measures section of MD&A. 53 Fifth Third Bancorp MANAGEMENT’S DISCUSSION AND ANALYSIS OF FINANCIAL CONDITION AND RESULTS OF OPERATIONS (a) Changes in interest not solely due to volume or yield/rate are allocated in proportion to the absolute dollar amount of change in volume and yield/rate. Provision for Loan and Lease Losses The Bancorp provides as an expense an amount for probable losses within the loan and lease portfolio that is based on factors previously discussed in the Critical Accounting Policies section of MD&A. The provision is recorded to bring the ALLL to a level deemed appropriate by the Bancorp to cover losses inherent in the portfolio. Actual credit losses on loans and leases are charged against the ALLL. The amount of loans and leases actually removed from the Consolidated Balance Sheets is referred to as a charge-off. Net charge-offs include current period charge-offs less recoveries on previously charged-off loans and leases. The provision for loan and lease losses was $237 million for the year ended December 31, 2018 compared to $261 million for the same period in the prior year. The decrease in provision expense for the year ended December 31, 2018 compared to the prior year was primarily due to a decrease in the level of commercial criticized assets combined with overall improved credit quality, partially offset by an increase in outstanding commercial loan balances and an increase in consumer reserve rates for certain products. The ALLL declined $93 million from December 31, 2017 to $1.1 billion at December 31, 2018. At December 31, 2018, the ALLL as a percent of portfolio loans and leases decreased to 1.16%, compared to 1.30% at December 31, 2017. Refer to the Credit Risk Management subsection of the Risk Management section of MD&A as well as Note 6 of the Notes to Consolidated Financial Statements for more detailed information on the provision for loan and lease losses, including an analysis of loan and lease portfolio composition, nonperforming assets, net charge-offs and other factors considered by the Bancorp in assessing the credit quality of the loan and lease portfolio and the ALLL. 54 Fifth Third Bancorp MANAGEMENT’S DISCUSSION AND ANALYSIS OF FINANCIAL CONDITION AND RESULTS OF OPERATIONS Noninterest Income Noninterest income decreased $434 million for the year ended December 31, 2018 compared to the year ended December 31, 2017. The following table presents the components of noninterest income: Service charges on deposits Service charges on deposits decreased $5 million for the year ended December 31, 2018 compared to the year ended December 31, 2017 primarily due to a decrease of $13 million in commercial deposit fees, partially offset by an increase of $8 million in consumer deposit fees. Wealth and asset management revenue Wealth and asset management revenue increased $25 million for the year ended December 31, 2018 compared to the year ended December 31, 2017. The increase from the prior year was primarily due to increases of $16 million and $10 million, respectively, in private client service fees and brokerage fees. These increases were driven by an increase in average assets under management as a result of market performance and increased asset inflows during the year ended December 31, 2018. The Bancorp’s trust and registered investment advisory businesses had approximately $356 billion and $362 billion in total assets under care as of December 31, 2018 and 2017, respectively, and managed $37 billion in assets for individuals, corporations and not-for-profit organizations as of both December 31, 2018 and 2017. Corporate banking revenue Corporate banking revenue increased $85 million for the year ended December 31, 2018 compared to the year ended December 31, 2017. The increase from the prior year was primarily driven by increases in lease remarketing fees, institutional sales revenue, syndication fees and contract revenue from commercial customer derivatives of $46 million, $18 million, $13 million and $11 million, respectively. The increase in lease remarketing fees for the year ended December 31, 2018 included the impact of a $52 million impairment charge related to certain operating lease assets that was recognized during the year ended December 31, 2017. These benefits were partially offset by decreases of $7 million and $6 million, respectively, in letter of credit fees and business lending fees from the year ended December 31, 2017. Card and processing revenue Card and processing revenue increased $16 million for the year ended December 31, 2018 compared to the year ended December 31, 2017 primarily driven by increases in the number of actively used cards and customer spend volume. Mortgage banking net revenue Mortgage banking net revenue decreased $12 million for the year ended December 31, 2018 compared to the year ended December 31, 2017. The following table presents the components of mortgage banking net revenue: Origination fees and gains on loan sales decreased $38 million for the year ended December 31, 2018 compared to the year ended December 31, 2017 driven by a decrease in originations and lower margins due to the interest rate environment. Residential mortgage loan originations decreased to $7.1 billion for the year ended December 31, 2018 from $8.2 billion for the year ended December 31, 2017. Net mortgage servicing revenue increased $26 million for the year ended December 31, 2018 compared to the year ended December 31, 2017 primarily due to a decrease in net negative valuation adjustments on MSRs of $16 million and an increase in gross mortgage servicing fees of $10 million. Refer to Table 11 for the components of net valuation adjustments on the MSR portfolio and the impact of the non-qualifying hedging strategy. 55 Fifth Third Bancorp MANAGEMENT’S DISCUSSION AND ANALYSIS OF FINANCIAL CONDITION AND RESULTS OF OPERATIONS Mortgage rates increased during the year ended December 31, 2018 which caused modeled prepayment speeds to slow. The fair value of the MSR portfolio increased $42 million due to changes to inputs to the valuation model including prepayment speeds and OAS spread assumptions and decreased $125 million due to the passage of time, including the impact of regularly scheduled repayments, paydowns and payoffs for the year ended December 31, 2018. Mortgage rates decreased during the year ended December 31, 2017 which caused the modeled prepayment speeds to increase, which led to fair value adjustments on servicing rights. The fair value of the MSR portfolio decreased $1 million due to changes to inputs to the valuation model including prepayment speeds and OAS spread assumptions and decreased $121 million due to passage of time, including the impact of regularly scheduled repayments, paydowns and payoffs for the year ended December 31, 2017. Further detail on the valuation of MSRs can be found in Note 11 of the Notes to Consolidated Financial Statements. The Bancorp maintains a non-qualifying hedging strategy to manage a portion of the risk associated with changes in the valuation of the MSR portfolio. Refer to Note 12 of the Notes to Consolidated Financial Statements for more information on the free-standing derivatives used to economically hedge the MSR portfolio. In addition to the derivative positions used to economically hedge the MSR portfolio, the Bancorp acquires various securities as a component of its non-qualifying hedging strategy. The Bancorp recognized net losses of $15 million during the year ended December 31, 2018, and net gains of $2 million during the year ended December 31, 2017, recorded in securities (losses) gains, net - non-qualifying hedges on MSRs in the Bancorp’s Consolidated Statements of Income. The Bancorp’s total residential mortgage loans serviced at December 31, 2018 and 2017 were $79.2 billion and $76.1 billion, respectively, with $63.2 billion and $60.0 billion, respectively, of residential mortgage loans serviced for others. Other noninterest income The following table presents the components of other noninterest income: Other noninterest income decreased $470 million for the year ended December 31, 2018 compared to the year ended December 31, 2017 primarily due to the gain on sale of Worldpay, Inc. shares recognized in the prior year, a reduction in equity method income from the Bancorp’s interest in Worldpay Holding, LLC, the impact of the net losses on disposition and impairment of bank premises and equipment and income from the TRA associated with Worldpay, Inc. recognized in the prior year. These reductions were partially offset by the gain related to Vantiv, Inc.’s acquisition of Worldpay Group plc., an increase in private equity investment income, as well as a decrease in the loss on the swap associated with the sale of Visa, Inc. Class B Shares. The Bancorp recognized a $205 million gain on the sale of Worldpay, Inc. shares for the year ended December 31, 2018 compared to a $1.0 billion gain on the sale of Worldpay, Inc. shares for the year ended December 31, 2017. The Bancorp also recognized a $414 million gain related to Vantiv, Inc.’s acquisition of Worldpay Group plc. for the year ended December 31, 2018. For more information, refer to Note 18 of the Notes to Consolidated Financial Statements. 56 Fifth Third Bancorp MANAGEMENT’S DISCUSSION AND ANALYSIS OF FINANCIAL CONDITION AND RESULTS OF OPERATIONS Equity method income from the Bancorp’s interest in Worldpay Holding, LLC decreased $46 million for the year ended December 31, 2018 compared to the same period in the prior year primarily due to a decrease in the Bancorp’s ownership percentage in Worldpay Holding, LLC from approximately 8.6% as of December 31, 2017 to approximately 3.3% as of December 31, 2018 and the impact of a reduction in Worldpay Holding, LLC’s net income for the year ended December 31, 2018 compared to the prior year. Income from the TRA associated with Worldpay Inc. was $20 million during the year ended December 31, 2018 compared to $44 million for the year ended December 31, 2017. Net losses on disposition and impairment of bank premises and equipment increased $43 million during the year ended December 31, 2018 compared to the same period in the prior year. This increase was driven by the impact of impairment charges of $45 million during the year ended December 31, 2018 compared to $7 million during the year ended December 31, 2017. For more information, refer to Note 7 of the Notes to Consolidated Financial Statements. Private equity investment income increased $27 million for the year ended December 31, 2018 compared to the same period in the prior year primarily due to valuation adjustments on certain private equity investments. For the year ended December 31, 2018, the Bancorp recognized negative valuation adjustments of $59 million related to the Visa total return swap compared to negative valuation adjustments of $80 million during the year ended December 31, 2017. The decrease from the prior period was primarily attributable to the impact of litigation developments during 2017. For additional information on the valuation of the swap associated with the sale of Visa, Inc. Class B Shares, refer to Note 16, Note 17 and Note 26 of the Notes to Consolidated Financial Statements. Noninterest Expense Noninterest expense increased $146 million for the year ended December 31, 2018 compared to the year ended December 31, 2017, primarily due to increases in personnel costs (salaries, wages and incentives plus employee benefits) and technology and communications expense, partially offset by a decrease in other noninterest expense. Additionally, the Bancorp recognized $31 million in merger-related expenses for the year ended December 31, 2018. The following table presents the components of noninterest expense: (a) This is a non-GAAP measure. For further information, refer to the Non-GAAP Financial Measures section of MD&A. Personnel costs increased $126 million for the year ended December 31, 2018 compared to the year ended December 31, 2017 driven by increases in base compensation, performance-based compensation and severance costs. The increase in base compensation was primarily due to an increase in the Bancorp’s minimum wage as a result of benefits received from the TCJA and personnel additions associated with strategic investments and acquisitions. Full-time equivalent employees totaled 17,437 at December 31, 2018 compared to 18,125 at December 31, 2017. Technology and communications expense increased $40 million for the year ended December 31, 2018 compared to the year ended December 31, 2017 driven primarily by increased investment in regulatory, compliance and growth initiatives. 57 Fifth Third Bancorp MANAGEMENT’S DISCUSSION AND ANALYSIS OF FINANCIAL CONDITION AND RESULTS OF OPERATIONS The following table presents the components of other noninterest expense: Other noninterest expense decreased $17 million for the year ended December 31, 2018 compared to the year ended December 31, 2017 primarily due to an increase in the benefit from the reserve for unfunded commitments, gains on partnership investments and decreases in professional service fees and FDIC insurance and other taxes, partially offset by increases in marketing expense and loan and lease expense. The benefit from the reserve for unfunded commitments increased $30 million for the year ended December 31, 2018 compared to the year ended December 31, 2017 primarily due to overall improved credit quality. Gains on partnership investments were $4 million for the year ended December 31, 2018 compared to losses of $14 million for the year ended December 31, 2017. Professional service fees decreased $16 million for the year ended December 31, 2018 compared to the year ended December 31, 2017 primarily due to decreases in legal and consulting fees. FDIC insurance and other taxes decreased $8 million for the year ended December 31, 2018 compared to the year ended December 31, 2017 primarily due to the elimination of the FDIC surcharge in the fourth quarter of 2018. Marketing expense increased $33 million for the year ended December 31, 2018 compared to the year ended December 31, 2017 primarily due to promotional offers during the year ended December 31, 2018. Loan and lease expense increased $10 million for the year ended December 31, 2018 compared to the year ended December 31, 2017 driven by an increase in loan servicing expenses on point-of-sale loans as a result of growth in point-of-sale originations. Applicable Income Taxes Applicable income tax expense for all periods includes the benefit from tax-exempt income, tax-advantaged investments, certain gains on sales of leveraged leases that are exempt from federal taxation and tax credits (and other related tax benefits), partially offset by the effect of proportional amortization of qualifying LIHTC investments and certain nondeductible expenses. The tax credits are associated with the Low-Income Housing Tax Credit program established under Section 42 of the IRC, the New Markets Tax Credit program established under Section 45D of the IRC, the Rehabilitation Investment Tax Credit program established under Section 47 of the IRC and the Qualified Zone Academy Bond program established under Section 1397E of the IRC. The effective tax rates for the years ended December 31, 2018 and 2017 were primarily impacted by $189 million and $206 million, respectively, of low-income housing tax credits and other tax benefits and $23 million and $34 million of tax benefits from tax exempt income in 2018 and 2017, respectively and were partially offset by $154 million and $223 million of proportional amortization related to qualifying LIHTC investments. The effective tax rate for the year ended December 31, 2017 was also impacted by a $253 million benefit from the remeasurement of deferred taxes as a result of the reduction in the federal income tax rate from 35 percent to 21 percent for years beginning after December 31, 2017. The decrease in the effective tax rate from the year ended December 31, 2016 to the year ended December 31, 2017 was primarily related to the remeasurement of deferred taxes mentioned above, partially offset by the impact of an increase in income before taxes. The U.S. government enacted comprehensive tax legislation, the TCJA, on December 22, 2017. The TCJA made broad and complex changes to the U.S. tax code including, but not limited to, reducing the federal statutory corporate tax rate from 35 percent to 21 percent effective for tax years beginning after December 31, 2017. U.S. GAAP requires the Bancorp to recognize the tax effects of changes in tax laws and rates on its deferred taxes in the period in which the law is enacted. As a result, for the year ended December 31, 2017, the Bancorp remeasured its deferred tax assets and liabilities and recognized an income tax benefit of approximately $253 million. For the year ended December 31, 2017, the Bancorp was subject to a federal statutory corporate tax rate of 35 percent. For years beginning after December 31, 2017, the Bancorp is subject to a federal statutory corporate tax rate of 21 percent. For stock-based awards, U.S. GAAP requires that the tax consequences for the difference between the expense recognized for financial reporting and the Bancorp’s actual tax deduction for the stock-based awards be recognized through income tax expense in the interim periods in which they occur. The Bancorp cannot predict its stock price or whether and when its employees will exercise stock-based awards in the future. Based on its stock price at December 31, 2018, the Bancorp estimates that it may be necessary to recognize $6 million of additional income tax benefit over the next twelve months related to the settlement of stock-based awards, primarily in the first half of 2019. However, the amount of income tax expense or benefit recognized upon settlement may vary significantly from expectations based on the Bancorp’s stock price and the number of SARs exercised by employees. 58 Fifth Third Bancorp MANAGEMENT’S DISCUSSION AND ANALYSIS OF FINANCIAL CONDITION AND RESULTS OF OPERATIONS The Bancorp’s income before income taxes, applicable income tax expense and effective tax rate are as follows: 59 Fifth Third Bancorp MANAGEMENT’S DISCUSSION AND ANALYSIS OF FINANCIAL CONDITION AND RESULTS OF OPERATIONS BUSINESS SEGMENT REVIEW The Bancorp reports on four business segments: Commercial Banking, Branch Banking, Consumer Lending and Wealth and Asset Management. Additional information on each business segment is included in Note 29 of the Notes to Consolidated Financial Statements. Results of the Bancorp’s business segments are presented based on its management structure and management accounting practices. The structure and accounting practices are specific to the Bancorp; therefore, the financial results of the Bancorp’s business segments are not necessarily comparable with similar information for other financial institutions. The Bancorp refines its methodologies from time to time as management’s accounting practices and businesses change. The Bancorp manages interest rate risk centrally at the corporate level. By employing an FTP methodology, the business segments are insulated from most benchmark interest rate volatility, enabling them to focus on serving customers through the origination of loans and acceptance of deposits. The FTP methodology assigns charge and credit rates to classes of assets and liabilities, respectively, based on the estimated amount and timing of cash flows for each transaction. Assigning the FTP rate based on matching the duration of the cash flows allocates interest income and interest expense to each business segment so its resulting net interest income is insulated from future changes in benchmark interest rates. The Bancorp’s FTP methodology also allocates the contribution to net interest income of the asset-generating and deposit-providing businesses on a duration-adjusted basis to better attribute the driver of the performance. As the asset and liability durations are not perfectly matched, the residual impact of the FTP methodology is captured in General Corporate and Other. The charge and credit rates are determined using the FTP rate curve, which is based on an estimate of Fifth Third’s marginal borrowing cost in the wholesale funding markets. The FTP curve is constructed using the U.S. swap curve, brokered CD pricing and unsecured debt pricing. The Bancorp adjusts the FTP charge and credit rates as dictated by changes in interest rates for various interest-earning assets and interest-bearing liabilities and by the review of behavioral assumptions, such as prepayment rates on interest-earning assets and the estimated durations for indeterminate-lived deposits. Key assumptions, including the credit rates provided for deposit accounts, are reviewed annually. Credit rates for deposit products and charge rates for loan products may be reset more frequently in response to changes in market conditions. The credit rates for several deposit products were reset January 1, 2018 to reflect the current market rates and updated market assumptions. These rates were generally higher than those in place during 2017, thus net interest income for deposit-providing business segments was positively impacted during 2018. FTP charge rates on assets were affected by the prevailing level of interest rates and by the duration and repricing characteristics of the portfolio. As overall market rates increased, the FTP charge increased for asset-generating business segments during 2018. The Bancorp’s methodology for allocating provision for loan and lease losses expense to the business segments includes charges or benefits associated with changes in criticized commercial loan levels in addition to actual net charge-offs experienced by the loans and leases owned by each business segment. Provision for loan and lease losses expense attributable to loan and lease growth and changes in ALLL factors is captured in General Corporate and Other. The financial results of the business segments include allocations for shared services and headquarters expenses. Additionally, the business segments form synergies by taking advantage of cross-sell opportunities and funding operations by accessing the capital markets as a collective unit. The results of operations and financial position for the years ended December 31, 2017 and 2016 were adjusted to reflect changes in internal expense allocation methodologies as well as a change in accounting policy for qualifying LIHTC investments. The following table summarizes net income (loss) by business segment: 60 Fifth Third Bancorp MANAGEMENT’S DISCUSSION AND ANALYSIS OF FINANCIAL CONDITION AND RESULTS OF OPERATIONS Commercial Banking Commercial Banking offers credit intermediation, cash management and financial services to large and middle-market businesses and government and professional customers. In addition to the traditional lending and depository offerings, Commercial Banking products and services include global cash management, foreign exchange and international trade finance, derivatives and capital markets services, asset-based lending, real estate finance, public finance, commercial leasing and syndicated finance. The following table contains selected financial data for the Commercial Banking segment: (a) Includes FTE adjustments of $16, $26 and $25 for the years ended December 31, 2018, 2017 and 2016, respectively. (b) Applicable income tax expense for all periods includes the tax benefit from tax-exempt income, tax-advantaged investments and tax credits partially offset by the effect of certain nondeductible expenses. Refer to the Applicable Income Taxes subsection of the Statements of Income Analysis section of MD&A for additional information. Comparison of the year ended 2018 with 2017 Net income was $1.1 billion for the year ended December 31, 2018 compared to net income of $827 million for the year ended December 31, 2017. The increase in net income was driven by increases in noninterest income and net interest income on an FTE basis and a decrease in the provision for loan and lease losses partially offset by an increase in noninterest expense. Net interest income on an FTE basis increased $51 million from the year ended December 31, 2017 primarily driven by increases in yields on average commercial loans and leases and increases in FTP credits on interest checking deposits. These increases were partially offset by increases in FTP charge rates on loans and leases, increases in the rates paid on core deposits and decreases in FTP credits on demand deposits driven by lower average balances. Provision for loan and lease losses decreased $64 million from the year ended December 31, 2017 primarily driven by a decrease in commercial criticized asset levels partially offset by an increase in net charge-offs. Net charge-offs as a percent of average portfolio loans and leases decreased to 18 bps for the year ended December 31, 2018 compared to 19 bps for the year ended December 31, 2017. Noninterest income increased $79 million from the year ended December 31, 2017 primarily driven by an increase in corporate banking revenue and other noninterest income partially offset by a decrease in service charges on deposits. Corporate banking revenue increased $84 million from the year ended December 31, 2017 driven by increases in lease remarketing fees, institutional sales revenue, syndication fees, contract revenue from commercial customer derivatives and foreign exchange fees partially offset by decreases in letter of credit fees and business lending fees. The increase in lease remarketing fees for the year ended December 31, 2018 included the impact of $52 million of impairment charges related to certain operating lease assets that were recognized during the year ended December 31, 2017. Other noninterest income increased $9 million from the year ended December 31, 2017 primarily due to an increase in private equity investment income. Service charges on deposits decreased $14 million from the year ended December 31, 2017. Noninterest expense increased $29 million from the year ended December 31, 2017 due to an increase in personnel costs partially offset by a decrease in other noninterest expense. Personnel costs increased $50 million from the year ended December 31, 2017 primarily due to increased incentive compensation and base compensation. Other noninterest expense decreased $21 million from the year ended December 31, 2017 primarily due to the impact of gains and losses on partnership investments and decreases in operating lease expense and consulting expense partially offset by an increase in corporate overhead allocations. Average commercial loans increased $1.0 billion from the year ended December 31, 2017 primarily due to increases in average commercial and industrial loans and average commercial construction loans partially offset by decreases in average commercial leases and average commercial mortgage loans. Average commercial and industrial loans increased $973 million from the year ended December 31, 2017 as a result of an increase in loan originations, a decrease in payoffs and an increase in drawn balances on existing revolving lines of credit. Average commercial construction loans increased $404 million from the year ended December 31, 2017 primarily due to increases in draw levels on existing commitments. 61 Fifth Third Bancorp MANAGEMENT’S DISCUSSION AND ANALYSIS OF FINANCIAL CONDITION AND RESULTS OF OPERATIONS Average commercial leases decreased $218 million from the year ended December 31, 2017 primarily as a result of a planned reduction in indirect non-relationship based lease originations. Average commercial mortgage loans decreased $154 million from the year ended December 31, 2017 due to an increase in paydowns in the fourth quarter of 2017 and lower loan origination activity through the first two quarters of 2018. Average core deposits decreased $1.1 billion from the year ended December 31, 2017. The decrease was driven by decreases in average demand deposits of $3.0 billion and average savings and money market deposits of $1.2 billion compared to the year ended December 31, 2017 primarily due to lower average balances per account. These decreases were partially offset by an increase in average interest checking deposits of $3.1 billion compared to the year ended December 31, 2017 primarily due to balance migration from demand deposit accounts and an increase in average balances per commercial customer account as well as the acquisition of new commercial customers. Comparison of the year ended 2017 with 2016 Net income was $827 million for the year ended December 31, 2017 compared to net income of $1.0 billion for the year ended December 31, 2016. The decrease in net income was driven by decreases in net interest income and noninterest income and an increase in noninterest expense partially offset by a decrease in the provision for loan and lease losses. Net interest income on an FTE basis decreased $161 million from the year ended December 31, 2016 primarily driven by increases in FTP charge rates on loans and leases and increases in the rates paid of core deposits. The decrease in net interest income was partially offset by increases in yields on average commercial loans and leases of 37 bps from the year ended December 31, 2016. Provision for loan and lease losses decreased $38 million from the year ended December 31, 2016 primarily driven by a decrease in net charge-offs on commercial and industrial loans partially offset by a reduction in the benefit from commercial criticized assets. Net charge-offs as a percent of average portfolio loans and leases decreased to 19 bps for the year ended December 31, 2017 compared to 33 bps for the year ended December 31, 2016. Noninterest income decreased $69 million from the year ended December 31, 2016 primarily driven by a decrease in corporate banking revenue partially offset by an increase in other noninterest income. Corporate banking revenue decreased $82 million from the year ended December 31, 2016 driven by a decrease in lease remarketing fees of $62 million which included $52 million of impairment charges related to certain operating lease assets for the year ended December 31, 2017 compared to $20 million during the year ended December 31, 2016. Additionally, corporate banking revenue included a $15 million decrease in foreign exchange fees and a $6 million decrease in letter of credit fees for the year ended December 31, 2017 compared to the year ended December 31, 2016. Other noninterest income increased $18 million from the year ended December 31, 2016 driven by an increase in private equity investment income primarily due to gains on the sale of certain private equity investments. Noninterest expense increased $6 million from the year ended December 31, 2016 primarily as a result of an increase in other noninterest expense driven by increases in corporate overhead allocations partially offset by decreases in losses on partnership investments. Average commercial loans decreased $854 million from the year ended December 31, 2016 primarily due to a decrease in average commercial and industrial loans partially offset by an increase in average commercial construction loans. Average commercial and industrial loans decreased $1.7 billion from the year ended December 31, 2016 primarily as a result of deliberate exits from certain loans that did not meet the Bancorp’s risk-adjusted profitability targets and softer loan demand. Average commercial construction loans increased $725 million from the year ended December 31, 2016 primarily due to increases in demand and draw levels on existing commitments. Average core deposits decreased $2.2 billion from the year ended December 31, 2016. The decrease was primarily driven by decreases in average savings and money market deposits and average demand deposits which decreased $1.3 billion and $1.2 billion, respectively, from the year ended December 31, 2016 primarily due to lower average balances per account. These decreases were partially offset by an increase in average interest checking deposits of $498 million from the year ended December 31, 2016 primarily due to the acquisition of new customers. 62 Fifth Third Bancorp MANAGEMENT’S DISCUSSION AND ANALYSIS OF FINANCIAL CONDITION AND RESULTS OF OPERATIONS Branch Banking Branch Banking provides a full range of deposit and loan products to individuals and small businesses through 1,121 full-service banking centers. Branch Banking offers depository and loan products, such as checking and savings accounts, home equity loans and lines of credit, credit cards and loans for automobiles and other personal financing needs, as well as products designed to meet the specific needs of small businesses, including cash management services. The following table contains selected financial data for the Branch Banking segment: Comparison of the year ended 2018 with 2017 Net income was $702 million for the year ended December 31, 2018 compared to net income of $455 million for the year ended December 31, 2017. The increase was driven by an increase in net interest income partially offset by increases in noninterest expense and the provision for loan and lease losses. Net interest income increased $252 million from the year ended December 31, 2017. The increase was primarily due to increases in FTP credit rates on core deposits as well as increases in interest income on other consumer loans driven by higher average balances. These benefits were partially offset by increases in FTP charge rates on loans and leases and increases in the rates paid on savings and money market deposits. In addition, the increase in net interest income was partially offset by the impact of a $12 million benefit in the first quarter of 2017 related to a revised estimate of refunds to be offered to certain bankcard customers. Provision for loan and lease losses increased $18 million from the year ended December 31, 2017 primarily due to an increase in net charge-offs on other consumer loans and credit card. Net charge-offs as a percent of average portfolio loans and leases increased to 114 bps for the year ended December 31, 2018 compared to 102 bps for the year ended December 31, 2017. Noninterest income decreased $2 million from the year ended December 31, 2017 primarily driven by a decrease in other noninterest income partially offset by increases in card and processing revenue, service charges on deposits and wealth and asset management revenue. Other noninterest income decreased $36 million from the year ended December 31, 2017 primarily due to the impact of impairments on bank premises and equipment. Card and processing revenue increased $15 million from the year ended December 31, 2017 primarily driven by increases in the number of actively used cards and customer spend volume. Service charges on deposits increased $10 million from the year ended December 31, 2017 primarily due to an increase in consumer deposit fees. Wealth and asset management revenue increased $9 million from the year ended December 31, 2017 primarily driven by increases in private client service fees and brokerage fees. Noninterest expense increased $47 million from the year ended December 31, 2017 primarily due to increases in other noninterest expense and personnel costs. Other noninterest expense increased $46 million from the year ended December 31, 2017 primarily due to increases in corporate overhead allocations and loan and lease expense. Personnel costs increased $10 million from the year ended December 31, 2017 primarily due to higher base compensation driven by an increase in the Bancorp’s minimum wage as a result of benefits received from the TCJA. Average consumer loans increased $26 million from the year ended December 31, 2017 primarily driven by an increase in average other consumer loans of $1.0 billion primarily due to growth in point-of-sale loan originations. This increase from the year ended December 31, 2017 was partially offset by decreases in average home equity loans of $530 million and average residential mortgage loans of $310 million as payoffs exceeded new loan production. Average core deposits increased $2.6 billion from the year ended December 31, 2017 primarily driven by growth in average savings and money market deposits of $1.9 billion and growth in average demand deposits of $441 million. Average savings and money market deposits increased as a result of promotional rate offers facilitated by the rising-rate environment and growth in the Fifth Third Preferred Banking program. 63 Fifth Third Bancorp MANAGEMENT’S DISCUSSION AND ANALYSIS OF FINANCIAL CONDITION AND RESULTS OF OPERATIONS Average demand deposits increased primarily due to an increase in average balances per customer account and the acquisition of new customers driven by increased marketing efforts. Other time deposits and certificates $100,000 and over increased $383 million from the year ended December 31, 2017 primarily due to shifting customer preferences as a result of the rising-rate environment. Comparison of the year ended 2017 with 2016 Net income was $455 million for the year ended December 31, 2017 compared to net income of $390 million for the year ended December 31, 2016. The increase was driven by an increase in net interest income partially offset by an increase in the provision for loan and lease losses. Net interest income increased $113 million from the year ended December 31, 2016 primarily due to an increase in FTP credits driven by an increase in average core deposits, an increase in FTP credit rates on core deposits and increases in yields on average consumer and commercial loans. These benefits to net interest income were partially offset by increases in FTP charge rates on loans and leases and increases in the rates paid on core deposits. Additionally, interest income from credit cards included the impact of a $12 million benefit related to a revised estimate of refunds offered to certain bankcard customers in the first quarter of 2017 compared to a $16 million reduction in interest income for the expected refunds in the fourth quarter of 2016. Provision for loan and lease losses increased $15 million from the year ended December 31, 2016 as net charge-offs as a percent of average portfolio loans and leases increased to 102 bps for the year ended December 31, 2017 compared to 91 bps for the year ended December 31, 2016. Noninterest income increased $1 million from the year ended December 31, 2016 primarily driven by an increase in other noninterest income partially offset by a decrease in card and processing revenue. Other noninterest income increased $2 million from the year ended December 31, 2016 primarily due to impairment charges on bank premises and equipment of $7 million recognized during the year ended December 31, 2017 compared to $32 million recognized during the year ended December 31, 2016 as well as an increase of $8 million in ATM transaction fees from the year ended December 31, 2016. These positive impacts for the year ended December 31, 2017 were partially offset by the recognition of $19 million of gains on the sales of retail branch operations in the St. Louis and Pittsburgh MSAs during the year ended December 31, 2016, as well as a gain of $11 million on the sale of the agent bankcard loan portfolio during the second quarter of 2016. Card and processing revenue decreased $2 million from the year ended December 31, 2016 primarily driven by higher rewards costs. Noninterest expense decreased $2 million from the year ended December 31, 2016 primarily due to decreases in net occupancy and equipment expense and other noninterest expense partially offset by an increase in personnel costs. Net occupancy and equipment expense decreased $6 million from the year ended December 31, 2016 primarily due to a decrease in rent expense driven by a reduction in the number of full-service banking centers and ATM locations. Other noninterest expense decreased $1 million from the year ended December 31, 2016 primarily driven by a decrease in corporate overhead allocations partially offset by increases in marketing expense and FDIC insurance and other taxes. Personnel costs increased $6 million from the year ended December 31, 2016 primarily due to an increase in incentive compensation partially offset by a decrease in base compensation. Average consumer loans decreased $564 million from the year ended December 31, 2016 primarily driven by a decrease in average home equity loans and average residential mortgage loans of $547 million and $236 million, respectively, as payoffs exceeded new loan production. These declines were partially offset by an increase in average other consumer loans of $285 million from the year ended December 31, 2016 primarily due to growth in point-of-sale loan originations. Average core deposits increased $2.5 billion from the year ended December 31, 2016 primarily driven by growth in average savings and money market deposits of $1.6 billion, growth in average interest checking deposits of $567 million and growth in average demand deposits of $563 million. The growth in average savings and money market deposits, average interest checking deposits and average demand deposits was driven by an increase in average balances per customer account and acquisition of new customers. 64 Fifth Third Bancorp MANAGEMENT’S DISCUSSION AND ANALYSIS OF FINANCIAL CONDITION AND RESULTS OF OPERATIONS Consumer Lending Consumer Lending includes the Bancorp’s residential mortgage, home equity, automobile and other indirect lending activities. Direct lending activities include the origination, retention and servicing of residential mortgage and home equity loans or lines of credit, sales and securitizations of those loans, pools of loans or lines of credit and all associated hedging activities. Indirect lending activities include extending loans to consumers through correspondent lenders and automobile dealers. The following table contains selected financial data for the Consumer Lending segment: Comparison of the year ended 2018 with 2017 Consumer Lending incurred a net loss of $1 million for the year ended December 31, 2018 compared to net income of $17 million for the year ended December 31, 2017. The decrease was driven by a decrease in noninterest income partially offset by a decrease in noninterest expense. Net interest income decreased $3 million from the year ended December 31, 2017 primarily driven by an increase in FTP charge rates on loans and leases partially offset by increases in yields on average automobile loans and average residential mortgage loans. Provision for loan and lease losses increased $2 million from the year ended December 31, 2017. Net charge-offs as a percent of average portfolio loans and leases increased to 21 bps for the year ended December 31, 2018 compared to 20 bps for the year ended December 31, 2017. Noninterest income decreased $32 million from the year ended December 31, 2017 driven by decreases in other noninterest income and mortgage banking net revenue. Other noninterest income decreased $21 million from the year ended December 31, 2017 primarily due to an increase in the loss on securities related to non-qualifying hedges on MSRs resulting from increased interest rates. Mortgage banking net revenue decreased $11 million from the year ended December 31, 2017 primarily driven by a decrease in mortgage origination fees and gains on loan sales partially offset by an increase in net mortgage servicing revenue. Refer to the Noninterest Income subsection of the Statements of Income Analysis section of MD&A for additional information on the fluctuations in mortgage banking net revenue. Noninterest expense decreased $9 million from the year ended December 31, 2017 driven by a decrease in other noninterest expense partially offset by an increase in personnel costs. Other noninterest expense decreased $12 million from the year ended December 31, 2017 primarily due to decreases in corporate overhead allocations and operational losses. Personnel costs increased $3 million from the year ended December 31, 2017 primarily due to an increase in base compensation. Average consumer loans decreased $4 million from the year ended December 31, 2017. Average automobile loans decreased $263 million from the year ended December 31, 2017 as payoffs exceeded new loan production due to a strategic shift focusing on improving risk-adjusted returns. Average home equity decreased $50 million from the year ended December 31, 2017 as the vintage portfolio continues to pay down. Average residential mortgage loans increased $309 million from the year ended December 31, 2017 primarily driven by the continued retention of certain agency conforming ARMs and certain other fixed-rate loans. Comparison of the year ended 2017 with 2016 Net income was $17 million for the year ended December 31, 2017 compared to net income of $50 million for the year ended December 31, 2016. The decrease was driven by a decrease in noninterest income partially offset by a decrease in noninterest expense. Net interest income decreased $8 million from the year ended December 31, 2016 primarily driven by an increase in FTP charges on loans and leases partially offset by an increase in yields on average automobile loans. Provision for loan and lease losses decreased $4 million from the year ended December 31, 2016. Net charge-offs as a percent of average portfolio loans and leases decreased to 20 bps for the year ended December 31, 2017 compared to 22 bps for the year ended December 31, 2016. Noninterest income decreased $66 million from the year ended December 31, 2016 driven primarily by a decrease in mortgage banking net revenue. Mortgage banking net revenue decreased $60 million from the year ended December 31, 2016 primarily driven by decreases of $48 million and $12 million in mortgage origination fees and gains on loan sales and net mortgage servicing revenue, respectively. Refer to the Noninterest Income subsection of the Statements of Income Analysis section of MD&A for additional information on the fluctuations in mortgage banking net revenue. 65 Fifth Third Bancorp MANAGEMENT’S DISCUSSION AND ANALYSIS OF FINANCIAL CONDITION AND RESULTS OF OPERATIONS Noninterest expense decreased $19 million from the year ended December 31, 2016 driven by decreases in other noninterest expense and personnel costs. Other noninterest expense decreased $13 million from the year ended December 31, 2016 primarily driven by a decrease in corporate overhead allocations. Personnel costs decreased $6 million from the year ended December 31, 2016 primarily driven by decreases in incentive and base compensation. Average consumer loans decreased $332 million from the year ended December 31, 2016 as a decrease in average automobile loans was partially offset by an increase in average residential mortgage loans. Average automobile loans decreased $1.2 billion from the year ended December 31, 2016 as payoffs exceeded new loan production due to a strategic shift focusing on improving risk-adjusted returns. Average residential mortgage loans, including held for sale, increased $964 million from the year ended December 31, 2016 primarily due to the continued retention of certain agency conforming ARMs and certain other fixed-rate loans originated during the year ended December 31, 2017. Wealth and Asset Management Wealth and Asset Management provides a full range of investment alternatives for individuals, companies and not-for-profit organizations. Wealth and Asset Management is made up of four main businesses: FTS; Fifth Third Insurance Agency; Fifth Third Private Bank; and Fifth Third Institutional Services. FTS offers full-service retail brokerage services to individual clients and broker-dealer services to the institutional marketplace. Fifth Third Insurance Agency assists clients with their financial and risk management needs. Fifth Third Private Bank offers holistic strategies to affluent clients in wealth planning, investing, insurance and wealth protection. Fifth Third Institutional Services provides advisory services for institutional clients including states and municipalities. The following table contains selected financial data for the Wealth and Asset Management segment: Comparison of the year ended 2018 with 2017 Net income was $97 million for the year ended December 31, 2018 compared to net income of $65 million for the year ended December 31, 2017. The increase in net income was driven by increases in noninterest income and net interest income partially offset by increases in noninterest expense and the provision for loan and lease losses. Net interest income increased $28 million from the year ended December 31, 2017 primarily due to increases in FTP credit rates on interest checking deposits and savings and money market deposits as well as increases in yields on average loans and leases. These positive impacts were partially offset by increases in the rates paid on interest checking deposits as well as an increase in FTP charge rates on loans and leases. Provision for loan and lease losses increased $6 million from the year ended December 31, 2017 driven by an increase in net charge-offs partially offset by the impact of the benefit of lower commercial criticized assets. Net charge-offs as a percent of average portfolio loans and leases increased to 52 bps for the year ended December 31, 2018 compared to 11 bps for the year ended December 31, 2017. Noninterest income increased $37 million from the year ended December 31, 2017 due to increases in wealth and asset management revenue and other noninterest income. Wealth and asset management revenue increased $22 million from the year ended December 31, 2017 primarily due to increases in private client service fees and brokerage fees. These increases were driven by an increase in average assets under management as a result of market performance and increased asset production. Other noninterest income increased $15 million from the year ended December 31, 2017 due to an increase in insurance income as a result of the full year impact of acquisitions from 2017. Noninterest expense increased $36 million from the year ended December 31, 2017 due to increases in personnel costs and other noninterest expense. Personnel costs increased $21 million from the year ended December 31, 2017 due to higher base compensation and incentive compensation primarily driven by the aforementioned acquisitions completed during 2017. Other noninterest expense increased $15 million from the year ended December 31, 2017 primarily driven by an increase in corporate overhead allocations. Average loans and leases increased $144 million from the year ended December 31, 2017 driven by increases in average commercial and industrial loans and average residential mortgage loans due to increases in loan origination activity. These increases were partially offset by a decline in average home equity balances. Average core deposits increased $550 million from the year ended December 31, 2017 primarily due to increases in average interest checking deposits and average savings and money market deposits. 66 Fifth Third Bancorp MANAGEMENT’S DISCUSSION AND ANALYSIS OF FINANCIAL CONDITION AND RESULTS OF OPERATIONS Comparison of the year ended 2017 with 2016 Net income was $65 million for the year ended December 31, 2017 compared to net income of $86 million for the year ended December 31, 2016. The decrease in net income was driven by an increase in noninterest expense and a decrease in net interest income partially offset by an increase in noninterest income. Net interest income decreased $14 million from the year ended December 31, 2016 primarily due to increases in FTP charge rates on loans and leases as well as increases in the rates paid on interest checking deposits. These negative impacts were partially offset by increases in interest income on loans and leases as a result of increases in yields and average balances. The decrease was also partially offset by an increase in FTP credits on interest checking deposits and savings and money market deposits. Provision for loan and lease losses increased $5 million from the year ended December 31, 2016 primarily driven by an increase in net charge-offs on commercial and industrial loans. Noninterest income increased $20 million from the year ended December 31, 2016 due to increases in wealth and asset management revenue and other noninterest income. Wealth and asset management revenue increased $16 million from the year ended December 31, 2016 primarily due to an increase in private client service fees driven by an increase in assets under management as a result of strong market performance and the impact of an acquisition in the second quarter of 2017. Other noninterest income increased $4 million from the year ended December 31, 2016 driven by an increase in insurance income as a result of acquisitions in the first and fourth quarters of 2017. Noninterest expense increased $36 million from the year ended December 31, 2016 due to increases in other noninterest expense and personnel costs. Other noninterest expense increased $23 million from the year ended December 31, 2016 driven by an increase in corporate overhead allocations. Personnel costs increased $13 million from the year ended December 31, 2016 due to higher base compensation primarily driven by the aforementioned acquisitions completed during 2017 as well as higher incentive compensation. Average loans and leases increased $142 million from the year ended December 31, 2016 driven by an increase in average residential mortgage loans due to increases in new loan origination activity. This increase was partially offset by a decline in average home equity balances. Average core deposits increased $228 million from the year ended December 31, 2016 primarily due to increases in average interest checking deposits and average savings and money market deposits. General Corporate and Other General Corporate and Other includes the unallocated portion of the investment securities portfolio, securities gains and losses, certain non-core deposit funding, unassigned equity, unallocated provision for loan and lease losses expense or a benefit from the reduction of the ALLL, the payment of preferred stock dividends and certain support activities and other items not attributed to the business segments. Comparison of the year ended 2018 with 2017 Net interest income increased $4 million from the year ended December 31, 2017 primarily driven by an increase in the benefit related to the FTP charge rates on loans and leases as well as an increase in interest income on taxable securities. These benefits were partially offset by increases in FTP credit rates on deposits allocated to the business segments and increases in interest expense on long-term debt and federal funds purchased. Provision for loan and lease losses increased $14 million from the year ended December 31, 2017 primarily due to the decrease in the allocation of provision expense to the business segments driven by a decrease in commercial criticized assets. Noninterest income decreased $510 million from the year ended December 31, 2017 primarily driven by the recognition of a $1.0 billion gain on the sale of Vantiv, Inc. (now Worldpay, Inc.) shares during the third quarter of 2017. The decrease was partially offset by the recognition of a $205 million gain on the sale of Worldpay, Inc. shares during the second quarter of 2018 and a $414 million gain related to Vantiv, Inc.’s acquisition of Worldpay Group plc. during the first quarter of 2018. Additionally, equity method earnings from the Bancorp’s interest in Worldpay Holding, LLC decreased $46 million from the year ended December 31, 2017 primarily due to a decrease in the Bancorp’s ownership interest in Worldpay Holding, LLC and the impact of a reduction in Worldpay Holding, LLC net income. Income from the TRA associated with Worldpay, Inc. decreased to $20 million during the year ended December 31, 2018 compared to $44 million for the year ended December 31, 2017. These decreases were partially offset by a decrease in the loss on the swap associated with the sale of Visa, Inc. Class B Shares. For the year ended December 31, 2018, the Bancorp recognized negative valuation adjustments of $59 million related to the Visa total return swap compared to negative valuation adjustments of $80 million during the year ended December 31, 2017. Noninterest expense increased $49 million from the year ended December 31, 2017. The increase was primarily due to increases in personnel expenses, technology and communications expense and marketing expense partially offset by an increase in corporate overhead allocations from General Corporate and Other to the other business segments and an increased benefit from the reserve for unfunded commitments from the year ended December 31, 2017. Comparison of the year ended 2017 with 2016 Net interest income increased $254 million from the year ended December 31, 2016 primarily driven by an increase in the benefit related to the FTP charges on loans and leases as well as an increase in interest income on taxable securities. These positive impacts were partially offset by increases in FTP credit rates on deposits allocated to the business segments, a decrease in interest income on loans and leases as well as an increase in interest expense on long-term debt. Provision for loan and lease losses decreased $60 million from the year ended December 31, 2016 primarily due to a reduction in the benefit for commercial criticized assets allocated to the business segments coupled with an increase in the benefit from the reduction in the ALLL. Noninterest income increased $643 million from the year ended December 31, 2016 primarily driven by the recognition of a $1.0 billion gain on the sale of Worldpay, Inc. shares during the third quarter of 2017. The increase was partially offset by the impact of a $280 million gain recognized during the third quarter of 2016 from the termination and settlement of gross cash flows from the existing Worldpay, Inc. TRA and the expected obligation to terminate and settle the remaining Worldpay, Inc. TRA cash flows upon the exercise of put or call options. This termination did not impact the TRA payments of $44 million and $33 million recognized in 2017 and 2016, respectively. The year ended December 31, 2016 also included positive valuation adjustments on the stock warrant associated with Worldpay Holding, LLC of $64 million. The stock warrant was not outstanding during 2017 as the Bancorp exercised the remaining warrant in Worldpay Holding, LLC during the fourth quarter of 2016 and recognized a gain of $9 million. 67 Fifth Third Bancorp MANAGEMENT’S DISCUSSION AND ANALYSIS OF FINANCIAL CONDITION AND RESULTS OF OPERATIONS The increase in noninterest income from December 31, 2016 was partially offset by negative valuation adjustments related to the Visa total return swap of $80 million for the year ended December 31, 2017 compared with $56 million for the prior year. Additionally, equity method earnings from the Bancorp’s interest in Worldpay Holding, LLC decreased $19 million from the year ended December 31, 2016. Noninterest income for the year ended December 31, 2016 also included a gain of $11 million on the sale-leaseback of an office complex during the third quarter of 2016. Noninterest expense increased $2 million from the year ended December 31, 2016. The increase was primarily due to increases in personnel costs and technology and communications expense partially offset by a decrease in the provision for the reserve for unfunded commitments and an increase in corporate overhead allocations from General Corporate and Other to the other business segments. 68 Fifth Third Bancorp MANAGEMENT’S DISCUSSION AND ANALYSIS OF FINANCIAL CONDITION AND RESULTS OF OPERATIONS FOURTH QUARTER REVIEW The Bancorp’s 2018 fourth quarter net income available to common shareholders was $432 million, or $0.64 per diluted share, compared to net income available to common shareholders of $421 million, or $0.61 per diluted share, for the third quarter of 2018 and net income available to common shareholders of $504 million, or $0.70 per diluted share, for the fourth quarter of 2017. Net interest income on an FTE basis was $1.1 billion for the fourth quarter of 2018, an increase of $38 million from the third quarter of 2018 and $122 million from the fourth quarter of 2017. The increase from both the previous quarter and fourth quarter of 2017 was reflective of growth in commercial and industrial loans and the securities portfolio balance as well as higher short-term market rates, partially offset by increases in the rates paid on average interest-bearing core deposits and average long-term debt. The increase in net interest income in comparison to the fourth quarter of 2017 was also impacted by a $27 million remeasurement related to the tax treatment of leveraged leases resulting from the TCJA in the fourth quarter of 2017. Noninterest income was $575 million for the fourth quarter of 2018, an increase of $12 million compared to the third quarter of 2018 and a decrease of $2 million compared to the fourth quarter of 2017. The increase from the third quarter of 2018 was primarily due to increases in corporate banking revenue and other noninterest income, partially offset by an increase in securities losses, net. The year-over-year decrease was primarily the result of an increase in securities losses, net and decreases in other noninterest income, partially offset by an increase in corporate banking revenue. Service charges on deposits were $135 million for the fourth quarter of 2018, a decrease of $4 million compared to the previous quarter and $3 million compared to the fourth quarter of 2017. The decreases from both the previous quarter and the fourth quarter of 2017 were primarily driven by a decrease in commercial deposit fees. Corporate banking revenue was $130 million for the fourth quarter of 2018, an increase of $30 million compared to the third quarter of 2018 and $53 million compared to the fourth quarter of 2017. The increases from both the previous quarter and the fourth quarter of 2017 were primarily driven by increases in institutional sales revenue and syndication fees. The increase compared to the fourth quarter of 2017 was also impacted by a $25 million lease remarketing impairment in the fourth quarter of 2017. Mortgage banking net revenue was $54 million for the fourth quarter of 2018 compared to $49 million in the third quarter of 2018 and $54 million in the fourth quarter of 2017. The increase in mortgage banking net revenue compared to the third quarter of 2018 was primarily driven by lower negative net valuation adjustments on MSRs partially offset by lower origination fees and gains on loan sales. Mortgage banking net revenue is affected by net valuation adjustments, which include MSR valuation adjustments caused by fluctuating OAS spreads, earning rates and prepayment speeds, as well as mark-to-market adjustments on free-standing derivatives used to economically hedge the MSR portfolio. Net negative valuation adjustments on MSRs were $24 million and $33 million in the fourth and third quarters of 2018, respectively, and $32 million in the fourth quarter of 2017. Originations for the fourth quarter of 2018 were $1.6 billion, compared with $1.9 billion in both the previous quarter and the fourth quarter of 2017. Originations for the fourth quarter of 2018 resulted in gains of $23 million on mortgages sold, compared with gains of $25 million for the previous quarter and $32 million for the fourth quarter of 2017. Gross mortgage servicing fees were $54 million in the fourth quarter of 2018, $56 million in the third quarter of 2018 and $54 million in the fourth quarter of 2017. Wealth and asset management revenue was $109 million for the fourth quarter of 2018, a decrease of $5 million from the previous quarter and an increase of $3 million from the fourth quarter of 2017. The decrease from the third quarter of 2018 was primarily driven by lower institutional trust and brokerage fees. The increase compared to the fourth quarter of 2017 was primarily driven by increases in private client service fees and brokerage fees. Card and processing revenue was $84 million for the fourth quarter of 2018, an increase of $2 million from the third quarter of 2018 and $4 million from the fourth quarter of 2017. The increase from both the third quarter of 2018 and the fourth quarter of 2017 reflected increased customer credit card spend volume, partially offset by higher rewards. Other noninterest income was $93 million for the fourth quarter of 2018, an increase of $7 million compared to the third quarter of 2018 and a decrease of $30 million from the fourth quarter of 2017. The increase from the third quarter of 2018 was primarily due to a benefit from the positive valuation adjustment on the Visa total return swap and revenue recognized from Worldpay, Inc. related to the TRA, partially offset by a decrease in private equity investment income and the impact of the net losses on disposition and impairment of bank premises and equipment. The decrease in other noninterest income from the fourth quarter of 2017 was primarily due to a decrease in revenues from the TRA associated with Worldpay, Inc., a reduction in equity method income from the Bancorp’s interest in Worldpay Holding, LLC and a decrease in private equity investment income. These reductions were partially offset by an increase in the benefit from the positive valuation adjustment on the Visa total return swap associated with the sale of Visa, Inc. Class B Shares. The net losses on investment securities were $32 million for the fourth quarter of 2018 compared to $6 million in the third quarter of 2018 and net gains of $1 million for the fourth quarter of 2017. The increase in losses from both the previous quarter and the fourth quarter of 2017 was primarily related to unrealized losses on equity securities. Net gains on securities held as non-qualifying hedges for MSRs were $2 million for the fourth quarter of 2018 compared to net losses of $1 million for the third quarter of 2018 and $2 million for the fourth quarter of 2017. Noninterest expense was $977 million for the fourth quarter of 2018, an increase of $7 million from the previous quarter and $2 million from the fourth quarter of 2017. The increases in noninterest expense compared to both the previous quarter and the fourth quarter of 2017 were primarily related to increases in technology and communications expense and personnel costs, partially offset by decreases in other noninterest expense. The increase in technology and communications expense was driven primarily by increased investment in regulatory, compliance and growth initiatives. The increase in personnel costs was driven by increases in base and performance-based compensation. The increase in base compensation was primarily due to an increase in the Bancorp’s minimum wage as a result of benefits received from the TCJA and personnel additions associated with strategic investments and acquisitions. The decrease in other noninterest expense from the third quarter of 2018 included a reduction in FDIC insurance and other taxes due to the elimination of the FDIC surcharge, partially offset by an increase in professional service fees. The decrease in other noninterest expense from the fourth quarter of 2017 was primarily due to a reduction in donations expense and the aforementioned decrease in FDIC insurance and other taxes, partially offset by an increase in marketing expense. Additionally, the Bancorp recognized $27 million in merger-related expenses during the fourth quarter of 2018. 69 Fifth Third Bancorp MANAGEMENT’S DISCUSSION AND ANALYSIS OF FINANCIAL CONDITION AND RESULTS OF OPERATIONS The ALLL as a percentage of portfolio loans and leases was 1.16% as of December 31, 2018, compared to 1.17% as of September 30, 2018 and 1.30% as of December 31, 2017. The provision for loan and lease losses was $95 million in the fourth quarter of 2018 compared with $86 million in the third quarter of 2018 and $67 million in the fourth quarter of 2017. Net losses charged-off were $83 million in the fourth quarter of 2018, or 35 bps of average portfolio loans and leases on an annualized basis, compared with net losses charged-off of $72 million in the third quarter of 2018 and $76 million in the fourth quarter of 2017. (a) Amounts presented on an FTE basis. The FTE adjustment was $4 for the three months ended December 31, 2018, September 30, 2018 and June 30, 2018 and $3 for the three months ended March 31, 2018. The FTE adjustment was $7 for the both the three months ended December 31, 2017 and September 30, 2017 and $6 for both the three months ended June 30, 2017 and March 31, 2017. (b) Effective in the fourth quarter of 2018, Fifth Third retrospectively applied a change in its accounting policy for investments in affordable housing projects that qualify for LIHTC in accordance with ASU 2014-01. Refer to Note 1 of the Notes to Consolidated Financial Statements for additional information. (c) Net interest income, provision for loan and lease losses and noninterest income were not impacted as a result of the Bancorp’s change in accounting policy for investments in affordable housing projects that qualify for LIHTC in accordance with ASU 2014-01. Refer to Note 1 of the Notes to Consolidated Financial Statements for additional information. COMPARISON OF THE YEAR ENDED 2017 WITH 2016 The Bancorp’s net income available to common shareholders for the year ended December 31, 2017 was $2.1 billion, or $2.81 per diluted share, which was net of $75 million in preferred stock dividends. The Bancorp’s net income available to common shareholders for the year ended December 31, 2016 was $1.5 billion, or $1.91 per diluted share, which was net of $75 million in preferred stock dividends. The provision for loan and lease losses decreased to $261 million for the year ended December 31, 2017 compared to $343 million for the year ended December 31, 2016 primarily due to the decrease in the level of commercial criticized assets, which reflected improvement in the national economy and stabilization of commodity prices, and a decrease in outstanding loan balances. Net losses charged-off as a percent of average portfolio loans and leases decreased to 0.32% for the year ended December 31, 2017 compared to 0.39% for the year ended December 31, 2016. Net interest income on an FTE basis (non-GAAP) was $3.8 billion and $3.6 billion for the years ended December 31, 2017 and 2016, respectively. Net interest income was positively impacted by an increase in yields on average loans and leases, an increase in average taxable securities and a decrease in average long-term debt for the year ended December 31, 2017 compared to the year ended December 31, 2016. Additionally, net interest income was positively impacted by the decisions of the FOMC to raise the target range of the federal funds rate 25 bps in December 2016, March 2017, June 2017 and December 2017. These positive impacts were partially offset by a decrease in average loans and leases and increases in the rates paid on average other short-term borrowings, average long-term debt and average interest-bearing core deposits for the year ended December 31, 2017. Net interest margin on an FTE basis (non-GAAP) was 3.03% and 2.88% for the years ended December 31, 2017 and 2016, respectively. Noninterest income increased $528 million for the year ended December 31, 2017 compared to the year ended December 31, 2016 primarily due to an increase in other noninterest income, partially offset by decreases in corporate banking revenue and mortgage banking net revenue. Other noninterest income increased $669 million from the year ended December 31, 2016 primarily due to the gain on sale of Worldpay, Inc. shares, an increase in private equity investment income and the impact of the net losses on disposition and impairment of bank premises and equipment for the year ended December 31, 2016. These benefits were partially offset by the impact of certain transactions that occurred during the year ended December 31, 2016 which included the impact of income from the TRA transactions associated with Worldpay, Inc., positive valuation adjustments and the gain on sale of the warrant associated with Worldpay Holding, LLC and gains on the sales of certain retail branch operations. 70 Fifth Third Bancorp MANAGEMENT’S DISCUSSION AND ANALYSIS OF FINANCIAL CONDITION AND RESULTS OF OPERATIONS The year ended December 31, 2017 also included an increase in the loss on the swap associated with the sale of Visa, Inc. Class B Shares and a reduction in equity method income from the Bancorp’s interest in Worldpay Holding, LLC. Corporate banking revenue decreased $79 million from the year ended December 31, 2016 primarily due to decreases in lease remarketing fees, foreign exchange fees and letter of credit fees. Mortgage banking net revenue decreased $61 million from the year ended December 31, 2016 primarily due to a decrease in origination fees and gains on loan sales. Noninterest expense increased $22 million for the year ended December 31, 2017 compared to the year ended December 31, 2016 primarily due to increases in personnel costs and technology and communications expense, partially offset by a decrease in other noninterest expense. Personnel costs increased $38 million for the year ended December 31, 2017 compared to the year ended December 31, 2016 driven by increases in base compensation, medical and FICA expenses and long-term incentive compensation, partially offset by a decrease in severance costs related to the Bancorp’s voluntary early retirement program in 2016. The increase in personnel costs also included the impact of one-time employee bonuses that the Bancorp paid as a result of benefits received from the TCJA. Technology and communication expense increased $11 million for the year ended December 31, 2017 compared to the year ended December 31, 2016 primarily due to increased investment in regulatory, compliance and growth initiatives. Other noninterest expense decreased $19 million for the year ended December 31, 2017 compared to the year ended December 31, 2016 primarily due to decreases in the provision for the reserve for unfunded commitments, losses and adjustments and losses on partnership investments, partially offset by increases in professional service fees and marketing expense. 71 Fifth Third Bancorp MANAGEMENT’S DISCUSSION AND ANALYSIS OF FINANCIAL CONDITION AND RESULTS OF OPERATIONS BALANCE SHEET ANALYSIS Loans and Leases The Bancorp classifies its commercial loans and leases based upon primary purpose and consumer loans based upon product or collateral. Table 22 summarizes end of period loans and leases, including loans and leases held for sale and Table 23 summarizes average total loans and leases, including loans and leases held for sale. Total loans and leases increased $3.4 billion from December 31, 2017. The increase from December 31, 2017 was the result of a $3.2 billion, or 6%, increase in commercial loans and leases as well as a $170 million increase in consumer loans. Commercial loans and leases increased from December 31, 2017 due to increases in commercial and industrial loans, commercial mortgage loans and commercial construction loans, partially offset by a decrease in commercial leases. Commercial and industrial loans increased $3.2 billion, or 8%, from December 31, 2017 primarily as a result of an increase in loan originations, a decrease in payoffs and an increase in drawn balances on existing revolving lines of credit during the year ended December 31, 2018. Commercial mortgage loans increased $367 million, or 6% from December 31, 2017 primarily due to an increase in loan originations and increases in permanent financing from the Bancorp’s commercial construction loan portfolio. Commercial construction loans increased $104 million, or 2%, from December 31, 2017 primarily due to increases in draw levels on existing commitments. Commercial leases decreased $468 million, or 12%, from December 31, 2017 primarily as a result of a planned reduction in indirect non-relationship based lease originations. Consumer loans and leases increased from December 31, 2017 primarily due to increases in other consumer loans and credit card, partially offset by a decrease in home equity and automobile loans. Other consumer loans increased $783 million, or 50%, from December 31, 2017 primarily due to growth in point-of-sale loan originations. Credit card increased $171 million, or 7%, from December 31, 2017 primarily due to an increase in balance active customers and an increase in card usage resulting in an increase in the average balance per active customer. Home equity decreased $612 million, or 9%, from December 31, 2017 as payoffs exceeded new loan production. Automobile loans decreased $136 million, or 1%, from December 31, 2017 as payoffs exceeded new loan production due to a strategic shift focusing on improving risk-adjusted returns. Total average loans and leases increased $1.1 billion, or 1%, from December 31, 2017 as a result of a $1.1 billion, or 2%, increase in average commercial loans and leases and a $34 million increase in average consumer loans. Average commercial loans and leases increased from December 31, 2017 primarily due to increases in average commercial and industrial loans and average commercial construction loans, partially offset by decreases in average commercial leases and average commercial mortgage loans. 72 Fifth Third Bancorp MANAGEMENT’S DISCUSSION AND ANALYSIS OF FINANCIAL CONDITION AND RESULTS OF OPERATIONS Average commercial and industrial loans increased $1.1 billion, or 3%, from December 31, 2017 primarily as a result of an increase in loan originations, a decrease in payoffs and an increase in drawn balances on existing revolving lines of credit. Average commercial construction loans increased $419 million, or 10%, from December 31, 2017 primarily due to increases in draw levels on existing commitments. Average commercial leases decreased $216 million, or 5%, from December 31, 2017 primarily as a result of a planned reduction in indirect non-relationship based lease originations. Average commercial mortgage loans decreased $183 million, or 3%, from December 31, 2017 primarily due to an increase in paydowns in the fourth quarter of 2017 and lower loan origination activity through the first two quarters of 2018. Average consumer loans increased from December 31, 2017 primarily due to increases in other consumer loans, credit card and residential mortgage loans, partially offset by decreases in home equity and automobile loans. Average other consumer loans increased $889 million, or 88%, from December 31, 2017 primarily due to growth in point-of-sale loan originations. Average credit card increased $139 million, or 6%, from December 31, 2017 primarily due to an increase in balance active customers and an increase in card usage resulting in an increase in the average balance per active customer. Average residential mortgage loans increased $97 million, or 1%, from December 31, 2017 primarily driven by the continued retention of certain agency conforming ARMs and certain other fixed-rate loans. Average home equity decreased $677 million, or 9%, from December 31, 2017 as payoffs exceeded new loan production. Average automobile loans decreased $414 million, or 4%, from December 31, 2017 as payoffs exceeded new loan production due to a strategic shift focusing on improving risk-adjusted returns. Investment Securities The Bancorp uses investment securities as a means of managing interest rate risk, providing collateral for pledging purposes and for liquidity to satisfy regulatory requirements. Total investment securities were $33.6 billion and $32.7 billion at December 31, 2018 and December 31, 2017, respectively. The taxable available-for-sale debt and other investment securities portfolio had an effective duration of 5.0 years at December 31, 2018 compared to 4.7 years at December 31, 2017. Debt securities are classified as available-for-sale when, in management’s judgment, they may be sold in response to, or in anticipation of, changes in market conditions. Securities that management has the intent and ability to hold to maturity are classified as held-to-maturity and reported at amortized cost. Debt securities are classified as trading when bought and held principally for the purpose of selling them in the near term. At December 31, 2018, the Bancorp’s investment portfolio consisted primarily of AAA-rated available-for-sale debt and other securities. The Bancorp held an immaterial amount in below-investment grade available-for-sale debt and other securities at both December 31, 2018 and 2017. For the year ended December 31, 2018 the Bancorp did not recognize any OTTI on its available-for-sale debt and other securities. For the year ended December 31, 2017 the Bancorp recognized $54 million of OTTI on its available-for-sale debt and other securities, included in securities (losses) gains, net, in the Consolidated Statements of Income. Refer to Note 1 of the Notes to Consolidated Financial Statements for the Bancorp’s methodology for both classifying investment securities and evaluating securities in an unrealized loss position for OTTI. The following table summarizes the end of period components of investment securities: (a) Includes interest-only mortgage-backed securities recorded at fair value with fair value changes recorded in securities (losses) gains, net in the Consolidated Statements of Income. (b) Other securities consist of FHLB, FRB and DTCC restricted stock holdings that are carried at cost. 73 Fifth Third Bancorp MANAGEMENT’S DISCUSSION AND ANALYSIS OF FINANCIAL CONDITION AND RESULTS OF OPERATIONS On an amortized cost basis, available-for-sale debt and other securities increased $1.6 billion, or 5%, from December 31, 2017 primarily due to increases in agency residential mortgage-backed securities and agency commercial mortgage-backed securities, partially offset by decreases in asset-backed securities and other debt securities. On an amortized cost basis, available-for-sale debt and other securities were 25% of total interest-earning assets at both December 31, 2018 and December 31, 2017. The estimated weighted-average life of the debt securities in the available-for-sale debt and other securities portfolio was 6.5 years at both December 31, 2018 and 2017. In addition, at December 31, 2018 and 2017 the available-for-sale debt and other securities portfolio had a weighted-average yield of 3.25% and 3.18%, respectively. Trading debt securities decreased $205 million from December 31, 2017 primarily due to a decrease in agency residential mortgage-backed securities. Information presented in Table 25 is on a weighted-average life basis, anticipating future prepayments. Yield information is presented on an FTE basis and is computed using amortized cost balances. Maturity and yield calculations for the total available-for-sale debt and other securities portfolio exclude other securities that have no stated yield or maturity. Total net unrealized losses on the available-for-sale debt and other securities portfolio were $298 million at December 31, 2018 compared to net unrealized gains of $174 million at December 31, 2017. The fair value of investment securities is impacted by interest rates, credit spreads, market volatility and liquidity conditions. The fair value of investment securities generally decreases when interest rates increase or when credit spreads expand. (a) Taxable-equivalent yield adjustments included in the above table are 0.00%, 0.48%, 0.00% and 0.03% for securities with an average life of 1 year or less, 1-5 years, 5-10 years and in total, respectively. Deposits The Bancorp’s deposit balances represent an important source of funding and revenue growth opportunity. The Bancorp continues to focus on core deposit growth in its retail and commercial franchises by improving customer satisfaction, building full relationships and offering competitive rates. Average core deposits represented 72% and 71% of the Bancorp’s average asset funding base for the years ended December 31, 2018 and 2017, respectively. 74 Fifth Third Bancorp MANAGEMENT’S DISCUSSION AND ANALYSIS OF FINANCIAL CONDITION AND RESULTS OF OPERATIONS The following table presents the end of period components of deposits: (a) Includes $1.2 billion, $1.3 billion, $1.3 billion, $1.5 billion and $1.8 billion of institutional, retail and wholesale certificates $250,000 and over at December 31, 2018, 2017, 2016, 2015 and 2014, respectively. Core deposits increased $5.6 billion, or 6%, from December 31, 2017, driven by increases of $4.9 billion and $715 million in transaction deposits and other time deposits, respectively. Transaction deposits increased from December 31, 2017 primarily due to increases in interest checking deposits and money market deposits partially offset by a decrease in demand deposits. Interest checking deposits increased $6.4 billion, or 23%, from December 31, 2017 driven primarily by balance migration from demand deposit accounts and higher balances per commercial customer account as well as the acquisition of new commercial customers. Money market deposits increased $2.5 billion, or 12%, from December 31, 2017 primarily as a result of promotional rate offers facilitated by the rising-rate environment and growth in the Fifth Third Preferred Banking program. Demand deposits decreased $3.2 billion, or 9%, from December 31, 2017 primarily as a result of the aforementioned commercial customer balance migration into interest checking deposits and lower balances per commercial customer account. Other time deposits increased from December 31, 2017 primarily due to promotional rate offers facilitated by the rising-rate environment. The following table presents the components of average deposits for the years ended December 31: (a) Includes $1.1 billion, $1.4 billion, $1.5 billion, $1.6 billion and $1.8 billion of average institutional, retail and wholesale certificates $250,000 and over during the years ended December 31, 2018, 2017, 2016, 2015 and 2014, respectively. On an average basis, core deposits increased $2.2 billion from December 31, 2017 primarily due to an increase of $1.9 billion and $335 million in average transaction deposits and average other time deposits, respectively. The increase in average transaction deposits was driven by increases in average interest checking deposits and average money market deposits partially offset by a decrease in average demand deposits. Average interest checking deposits increased $3.4 billion, or 13%, from December 31, 2017 primarily due to balance migration from demand deposit accounts and an increase in average balances per commercial customer account as well as the acquisition of new commercial customers. Average money market deposits increased $1.5 billion, or 8%, from December 31, 2017 as a result of promotional rate offers facilitated by the rising-rate environment and growth in the Fifth Third Preferred Banking program. Average demand deposits decreased $2.5 billion, or 7%, from December 31, 2017 primarily as a result of the aforementioned migration into interest checking deposits and lower average balances per commercial customer account. The increase in average other time deposits was primarily due to promotional rate offers facilitated by the rising-rate environment. 75 Fifth Third Bancorp MANAGEMENT’S DISCUSSION AND ANALYSIS OF FINANCIAL CONDITION AND RESULTS OF OPERATIONS Contractual Maturities The contractual maturities of certificates $100,000 and over as of December 31, 2018 are summarized in the following table: The contractual maturities of other time deposits and certificates $100,000 and over as of December 31, 2018 are summarized in the following table: Borrowings The Bancorp accesses a variety of short-term and long-term funding sources. Borrowings with original maturities of one year or less are classified as short-term and include federal funds purchased and other short-term borrowings. Average total borrowings as a percent of average interest-bearing liabilities were 20% at December 31, 2018 compared to 21% at December 31, 2017. The following table summarizes the end of period components of borrowings: Total borrowings decreased $2.2 billion, or 11%, from December 31, 2017 due to decreases in other short-term borrowings and long-term debt, partially offset by an increase in federal funds purchased. Other short-term borrowings decreased $3.4 billion from December 31, 2017 driven by a decrease in FHLB advances. The level of other short-term borrowings can fluctuate significantly from period to period depending on funding needs and which sources are used to satisfy those needs. For further information on the components of other short-term borrowings, refer to Note 14 of the Notes to Consolidated Financial Statements. Long-term debt decreased $478 million from December 31, 2017 primarily driven by the maturity of $1.9 billion of unsecured senior bank notes and $500 million of unsecured subordinated debt, $480 million of paydowns on long-term debt associated with automobile loan securitizations and $44 million of fair value adjustments associated with interest rate swaps hedging long-term debt during the year ended December 31, 2018. These decreases were partially offset by the issuance of $1.3 billion of unsecured fixed-rate senior bank notes, $650 million of unsecured fixed-rate senior notes, $300 million of unsecured floating-rate senior bank notes and $250 million of unsecured floating-rate senior notes since December 31, 2017. For additional information regarding long-term debt issuances, refer to Note 15 of the Notes to Consolidated Financial Statements. Federal funds purchased increased $1.8 billion from December 31, 2017 due to a reallocation of other short-term borrowings. For further information on subsequent events related to long-term debt, refer to Note 31 of the Notes to Consolidated Financial Statements. The following table summarizes the components of average borrowings: Total average borrowings increased $152 million, or 1%, compared to December 31, 2017, due to increases in average federal funds purchased and average long-term debt, partially offset by a decrease in average other short-term borrowings. Average federal funds purchased increased $952 million due to a reallocation of other short-term borrowings. 76 Fifth Third Bancorp MANAGEMENT’S DISCUSSION AND ANALYSIS OF FINANCIAL CONDITION AND RESULTS OF OPERATIONS Average long-term debt increased $747 million compared to December 31, 2017. The increase was driven primarily by the issuances of long-term debt during the second half of 2017 which consisted of $750 million of unsecured fixed-rate senior bank notes and $300 million of unsecured floating-rate senior bank notes and the issuances during the year ended December 31, 2018, as discussed above. The increase was partially offset by the maturities of unsecured senior bank notes and subordinated debt and paydowns on long-term debt associated with automobile loan securitizations, as discussed above, during the year ended December 31, 2018. Average other short-term borrowings decreased $1.5 billion compared to December 31, 2017, driven primarily by the aforementioned decrease in FHLB advances. Information on the average rates paid on borrowings is discussed in the Net Interest Income subsection of the Statements of Income Analysis section of MD&A. In addition, refer to the Liquidity Risk Management subsection of the Risk Management section of MD&A for a discussion on the role of borrowings in the Bancorp’s liquidity management. 77 Fifth Third Bancorp MANAGEMENT’S DISCUSSION AND ANALYSIS OF FINANCIAL CONDITION AND RESULTS OF OPERATIONS RISK MANAGEMENT - OVERVIEW Risk management is critical for effectively serving customers’ financial needs while protecting the Bancorp and achieving strategic goals. It is also essential to reducing the volatility of earnings and safeguarding the Bancorp’s brand and reputation. Further, risk management is integral to the Bancorp’s strategic and capital planning processes. It is essential that the Bancorp’s business strategies consistently align to its overall risk appetite and capital considerations. Maintaining risks within the Bancorp’s risk appetite requires that risks are understood by all employees across the enterprise, and appropriate risk mitigants and controls are in place to limit risk to within the risk appetite. To achieve this, the Bancorp implements a framework for managing risk that encompasses business as usual activities and the utilization of a risk process for identifying, assessing, managing, monitoring and reporting risks. Fifth Third uses a structure consisting of three lines of defense in order to clarify the roles and responsibilities for effective risk management. The risk taking functions within the lines of business comprise the first line of defense. The first line of defense originates risk through normal business as usual activities; therefore, it is essential that they monitor, assess and manage the risks being taken, implement controls necessary to mitigate those risks and take responsibility for managing their business within the Bancorp’s risk appetite. Control functions, such as the Risk Management organization, are the second line of defense and are responsible for providing challenge, oversight and governance of activities performed by the first line. The Audit division is the third line of defense and provides an independent assessment of the Bancorp’s internal control structure and related systems and processes. The Credit Risk Review division provides an independent assessment of credit risk, which includes evaluating the sufficiency of underwriting, documentation and approval processes for consumer and commercial credits, the accuracy of risk grades assigned to commercial credit exposure, nonaccrual status, specific reserves and monitoring for charge-offs. Fifth Third’s core values and culture provide a foundation for supporting sound risk management practices by setting expectations for appropriate conduct and accountability across the organization. All employees are expected to conduct themselves in alignment with Fifth Third’s core values and Code of Business Conduct & Ethics, which may be found on www.53.com, while carrying out their responsibilities. Fifth Third’s Corporate Responsibility and Reputation Committee provides oversight of business conduct policies, programs and strategies, and monitors reporting of potential misconduct, trends or themes across the enterprise. Prudent risk management is a responsibility that is expected from all employees across the first, second and third lines of defense and is a foundational element of Fifth Third’s culture. Below are the Bancorp’s core principles of risk management that are used to ensure the Bancorp is operating in a safe and sound manner: ● Understand the risks taken as a necessary part of business; however, the Bancorp ensures risks taken are in alignment with its strategy and risk appetite. ● Provide transparency and escalate risks and issues as necessary. ● Ensure Fifth Third’s products and services are designed, delivered and maintained to provide value and benefit to its customers and to Fifth Third, and that potential opportunities remain aligned to the core customer base. ● Avoid risks that cannot be understood, managed and monitored. ● Act with integrity in all activities. ● Focus on providing operational excellence by providing reliable, accurate and efficient services to meet customers’ needs. ● Maintain a strong financial position to ensure that the Bancorp meets its strategic objectives through all economic cycles and is able to access the capital markets at all times, even under stressed conditions. ● Protect the Bancorp’s reputation by thoroughly understanding the consequences of business strategies, products and processes. ● Conduct business in compliance with all applicable laws, rules and regulations and in alignment with internal policies and procedures. Fifth Third’s success is dependent on effective risk management and understanding and controlling the risks taken in order to deliver sustainable returns for employees and shareholders. The Bancorp’s goal is to ensure that aggregate risks do not exceed its risk capacity, and that risks taken are supportive of the Bancorp’s portfolio diversification and profitability objectives. Fifth Third’s Risk Management Framework states its risk appetite and the linkage to strategic and capital planning, defines and sets the tolerance for each of the eight risk types, explains the process used to manage risk across the enterprise and sets forth its risk governance structure. ● The Board of Directors (the “Board”) and executive management define the risk appetite, which is considered in the development of business strategies, and forms the basis for enterprise risk management. The Bancorp’s risk appetite is set annually in alignment with the strategic, capital and financial plans, and is reviewed by the Board on an annual basis. ● The Risk Management Process provides a consistent and integrated approach for managing risks and ensuring appropriate risk mitigants and controls are in place, and risks and issues are appropriately escalated. Five components are utilized for effective risk management; identifying, assessing, managing, monitoring and independent governance reporting of risk. ● The Board and executive management have identified eight risk types for monitoring the overall risk of the Bancorp; Credit Risk, Market Risk, Liquidity Risk, Operational Risk, Regulatory Compliance Risk, Legal Risk, Reputation Risk and Strategic Risk, and have also qualitatively established a risk tolerance, which is defined as the maximum amount of risk the Bancorp is willing to take for each of the eight risk types. These risk types are assessed on an ongoing basis and reported to the Board each quarter, or more frequently, if necessary. In addition, each business and operational function (first line of defense) is accountable for proactively identifying and managing risk using its risk management process. Risk tolerances and risk limits are also established, where appropriate, in order to ensure that business and operational functions across the enterprise are able to monitor and manage risks at a more granular level, while ensuring that aggregate risks across the enterprise do not exceed the overall risk appetite. ● The Bancorp’s risk governance structure includes management committees operating under delegation from, and providing information directly or indirectly to, the Board. 78 Fifth Third Bancorp MANAGEMENT’S DISCUSSION AND ANALYSIS OF FINANCIAL CONDITION AND RESULTS OF OPERATIONS The Bancorp Board delegates certain responsibilities to Board sub-committees, including the RCC as outlined in each respective Committee Charter, which may be found on www.53.com. The ERMC, which reports to the RCC, comprises senior management from across the Bancorp and reviews and approves risk management frameworks and policies, oversees the management of all risk types to ensure that aggregated risks remain within the Bancorp’s risk appetite and fosters a risk culture to ensure appropriate escalation and transparency of risks. CREDIT RISK MANAGEMENT The objective of the Bancorp’s credit risk management strategy is to quantify and manage credit risk on an aggregate portfolio basis, as well as to limit the risk of loss resulting from the failure of a borrower or counterparty to honor its financial or contractual obligations to the Bancorp. The Bancorp’s credit risk management strategy is based on three core principles: conservatism, diversification and monitoring. The Bancorp believes that effective credit risk management begins with conservative lending practices which are described below. These practices include the use of intentional risk-based limits for single name exposures and counterparty selection criteria designed to reduce or eliminate exposure to borrowers who have higher than average default risk and defined weaknesses in financial performance. The Bancorp carefully designed and monitors underwriting, documentation and collection standards. The Bancorp’s credit risk management strategy also emphasizes diversification on a geographic, industry and customer level as well as ongoing portfolio monitoring and timely management reviews of large credit exposures and credits experiencing deterioration of credit quality. Credit officers with the authority to extend credit are delegated specific authority amounts, the utilization of which is closely monitored. Underwriting activities are centrally managed, and ERM manages the policy and the authority delegation process directly. The Credit Risk Review function provides independent and objective assessments of the quality of underwriting and documentation, the accuracy of risk grades and the charge-off, nonaccrual and reserve analysis process. The Bancorp’s credit review process and overall assessment of the adequacy of the allowance for credit losses is based on quarterly assessments of the probable estimated losses inherent in the loan and lease portfolio. The Bancorp uses these assessments to promptly identify potential problem loans or leases within the portfolio, maintain an adequate allowance for credit losses and take any necessary charge-offs. The Bancorp defines potential problem loans and leases as those rated substandard that do not meet the definition of a nonaccrual loan or a restructured loan. Refer to Note 6 of the Notes to Consolidated Financial Statements for further information on the Bancorp’s credit grade categories, which are derived from standard regulatory rating definitions. In addition, stress testing is performed on various commercial and consumer portfolios using the CCAR model and for certain portfolios, such as real estate and leveraged lending, the stress testing is performed by Credit department personnel at the individual loan level during credit underwriting. The following tables provide a summary of potential problem portfolio loans and leases: In addition to the individual review of larger commercial loans that exhibit probable or observed credit weaknesses, the commercial credit review process includes the use of two risk grading systems. The risk grading system currently utilized for allowance for credit loss analysis purposes encompasses ten categories. The Bancorp also maintains a dual risk rating system for credit approval and pricing, portfolio monitoring and capital allocation that includes a “through-the-cycle” rating philosophy for assessing a borrower’s creditworthiness. A “through-the-cycle” rating philosophy uses a grading scale that assigns ratings based on average default rates through an entire business cycle for borrowers with similar financial performance. The dual risk rating system includes thirteen probabilities of default grade categories and an additional eleven grade categories for estimating losses given an event of default. The probability of default and loss given default evaluations are not separated in the ten-category risk rating system. The Bancorp has completed significant validation and testing of the dual risk rating system as a commercial credit risk management tool. The Bancorp is assessing the necessary modifications to the dual risk rating system outputs to develop a U.S. GAAP compliant ALLL model and will evaluate the use of modified dual risk ratings for purposes of determining the Bancorp’s ALLL as part of the Bancorp’s adoption of ASU 2016-13 “Measurement of Credit Losses on Financial Instruments,” which will be effective for the Bancorp on January 1, 2020. Scoring systems, various analytical tools and portfolio performance monitoring are used to assess the credit risk in the Bancorp’s homogenous consumer and small business loan portfolios. 79 Fifth Third Bancorp MANAGEMENT’S DISCUSSION AND ANALYSIS OF FINANCIAL CONDITION AND RESULTS OF OPERATIONS Overview Inflationary expectations have changed little and are expected to remain near 2% in the coming year. The labor market has continued to tighten and unemployment remains low. Household spending has continued to show strong growth. The FOMC stated that risks to the economic outlook are roughly balanced, but the Committee will continue to monitor global economic and financial developments and assess their implications for the economic outlook. Market professionals continue to have an increased focus on wages, interest rates, input costs, tariffs, trade negotiations and foreign exchange. During December 2018, the FOMC enacted an additional 25 bp increase in the target rate for Federal Funds. The Federal Reserve median forecast for change in 2019 real GDP is 2.41%, a slight decrease from the 3.1% rate in 2018. The Federal Reserve, in their minutes, continues to be concerned that tariffs could hurt the current economic recovery but are waiting to see evidence of any damage. Also concerning is the recent slowdown in homebuilding. There is a chance of higher interest rates in 2019 that would generally be detrimental to the Bancorp’s clients’ financial condition. Market data and vacancies remain positive. Competition for term loans on stabilized or near-stabilized assets remains highly aggressive in terms of pricing, recourse and repayment structures, as banks seek to diversify away from construction. Construction costs continue to escalate and will likely be exacerbated by the impact of tariffs. The Bancorp is also monitoring potential increased risks in the Retail sector as a result of changes in distribution models with increasing levels of online purchasing and recent weakness in certain specialty retailers. However, needs-based retail and online retailers moving to brick and mortar are supporting continued development and lease-up for mixed-use retail centers. The Bancorp has been focused on tenants that have multi-channel distribution and/or provide entertainment such as restaurants, cosmetic stores, fitness, grocery and drug. During the third quarter of 2018, the southeastern United States experienced a major hurricane impacting the eastern portions of the states of North Carolina and South Carolina. The Bancorp has limited credit exposure in the coastal regions of both states; however, temporary assistance was provided to customers that were negatively impacted. There is no expectation of any material net charge-offs as a result of the hurricane. Commercial Portfolio The Bancorp’s credit risk management strategy seeks to minimize concentrations of risk through diversification. The Bancorp has commercial loan concentration limits based on industry, lines of business within the commercial segment, geography and credit product type. The risk within the commercial loan and lease portfolio is managed and monitored through an underwriting process utilizing detailed origination policies, continuous loan level reviews, monitoring of industry concentration and product type limits and continuous portfolio risk management reporting. The Bancorp provides loans to a variety of customers ranging from large multi-national firms to middle market businesses, sole proprietors and high net worth individuals. The origination policies for commercial and industrial loans outline the risks and underwriting requirements for loans to businesses in various industries. Included in the policies are maturity and amortization terms, collateral and leverage requirements, cash flow coverage measures and hold limits. The Bancorp aligns credit and sales teams with specific industry expertise to better monitor and manage different industry segments of the portfolio. The origination policies for commercial real estate outline the risks and underwriting requirements for owner and nonowner-occupied and construction lending. Included in the policies are maturity and amortization terms, maximum LTVs, minimum debt service coverage ratios, construction loan monitoring procedures, appraisal requirements, pre-leasing requirements (as applicable), pro-forma analysis requirements and interest rate sensitivity. The Bancorp requires a valuation of real estate collateral, which may include third-party appraisals, be performed at the time of origination and renewal in accordance with regulatory requirements and on an as-needed basis when market conditions justify. Although the Bancorp does not back test these collateral value assumptions, the Bancorp maintains an appraisal review department to order and review third-party appraisals in accordance with regulatory requirements. Collateral values on criticized assets with relationships exceeding $1 million are reviewed quarterly to assess the appropriateness of the value ascribed in the assessment of charge-offs and specific reserves. The Bancorp assesses all real estate and non-real estate collateral securing a loan and considers all cross-collateralized loans in the calculation of the LTV ratio. The following tables provide detail on the most recent LTV ratios for commercial mortgage loans greater than $1 million, excluding impaired commercial mortgage loans individually evaluated. The Bancorp does not typically aggregate the LTV ratios for commercial mortgage loans less than $1 million. 80 Fifth Third Bancorp MANAGEMENT’S DISCUSSION AND ANALYSIS OF FINANCIAL CONDITION AND RESULTS OF OPERATIONS The following table provides detail on commercial loan and leases by industry classification (as defined by the North American Industry Classification System), by loan size and by state, illustrating the diversity and granularity of the Bancorp’s commercial loans and leases: The Bancorp’s nonowner-occupied commercial real estate portfolios have been identified by the Bancorp as loans which it believes represent a higher level of risk compared to the rest of the Bancorp’s commercial loan portfolio due to economic or market conditions within the Bancorp’s key lending areas. 81 Fifth Third Bancorp MANAGEMENT’S DISCUSSION AND ANALYSIS OF FINANCIAL CONDITION AND RESULTS OF OPERATIONS The following tables provide an analysis of nonowner-occupied commercial real estate loans by state (excluding loans held for sale): Consumer Portfolio Consumer credit risk management utilizes a framework that encompasses consistent processes for identifying, assessing, managing, monitoring and reporting credit risk. These processes are supported by a credit risk governance structure that includes Board oversight, policies, risk limits and risk committees. The Bancorp’s consumer portfolio is materially comprised of five categories of loans: residential mortgage loans, home equity, automobile loans, credit card and other consumer loans. The Bancorp has identified certain credit characteristics within these five categories of loans which it believes represent a higher level of risk compared to the rest of the consumer loan portfolio. The Bancorp does not update LTV ratios for the consumer portfolio subsequent to origination except as part of the charge-off process for real estate secured loans. Among consumer portfolios, legacy underwritten residential mortgage and brokered home equity portfolios exhibited the most stress during the past credit crisis. As of December 31, 2018, consumer real estate loans, consisting of residential mortgage loans and home equity loans, originated from 2005 through 2008 represent approximately 12% of the consumer real estate portfolio. These loans accounted for 47% of total consumer real estate secured losses for the year ended December 31, 2018. Current loss rates in the residential mortgage and home equity portfolios are below pre-crisis levels. In addition to the consumer real estate portfolio, credit risk management continues to closely monitor the automobile portfolio performance. The automobile market has exhibited industry-wide gradual loosening of credit standards such as lower FICOs, longer terms and higher LTVs. The Bancorp has adjusted credit standards focused on improving risk-adjusted returns while maintaining credit risk tolerance. The Bancorp actively manages the automobile portfolio through concentration limits, which mitigate credit risk through limiting the exposure to lower FICO scores, higher advance rates and extended term originations. Residential mortgage portfolio The Bancorp manages credit risk in the residential mortgage portfolio through underwriting guidelines that limit exposure to higher LTV ratios and lower FICO scores. Additionally, the portfolio is governed by concentration limits that ensure geographic, product and channel diversification. The Bancorp may also package and sell loans in the portfolio. The Bancorp does not originate residential mortgage loans that permit customers to defer principal payments or make payments that are less than the accruing interest. The Bancorp originates both fixed-rate and ARM loans. Within the ARM portfolio approximately $665 million of ARM loans will have rate resets during the next twelve months. Of these resets, 95% are expected to experience an increase in rate, with an average increase of approximately one percent. Underlying characteristics of these borrowers are relatively strong with a weighted average origination DTI of 33% and weighted average origination LTV of 74%. Certain residential mortgage products have contractual features that may increase credit exposure to the Bancorp in the event of a decline in housing values. These types of mortgage products offered by the Bancorp include loans with high LTV ratios, multiple loans on the same collateral that when combined result in an LTV greater than 80% and interest-only loans. 82 Fifth Third Bancorp MANAGEMENT’S DISCUSSION AND ANALYSIS OF FINANCIAL CONDITION AND RESULTS OF OPERATIONS The Bancorp has deemed residential mortgage loans with greater than 80% LTV ratios and no mortgage insurance as loans that represent a higher level of risk. Portfolio residential mortgage loans from 2010 and later vintages represented 92% of the portfolio as of December 31, 2018 and had a weighted-average LTV of 73% and a weighted-average origination FICO of 760. The following table provides an analysis of the residential mortgage portfolio loans outstanding by LTV at origination as of: (a) Includes loans with both borrower and lender paid mortgage insurance. The following tables provide an analysis of the residential mortgage portfolio loans outstanding with a greater than 80% LTV ratio and no mortgage insurance: Home equity portfolio The Bancorp’s home equity portfolio is primarily comprised of home equity lines of credit. Beginning in the first quarter of 2013, the Bancorp’s newly originated home equity lines of credit have a 10-year interest-only draw period followed by a 20-year amortization period. The home equity line of credit previously offered by the Bancorp was a revolving facility with a 20-year term, minimum payments of interest-only and a balloon payment of principal at maturity. Peak maturity years for the balloon home equity lines of credit are 2025 to 2028 and approximately 26% of the balances mature before 2025. The ALLL provides coverage for probable and estimable losses in the home equity portfolio. The allowance attributable to the portion of the home equity portfolio that has not been restructured in a TDR is determined on a pooled basis with senior lien and junior lien categories segmented in the determination of the probable credit losses in the home equity portfolio. The loss factor for the home equity portfolio is based on the trailing twelve month historical loss rate for each category, as adjusted for certain prescriptive loss rate factors and certain qualitative adjustment factors to reflect risks associated with current conditions and trends. The prescriptive loss rate factors include adjustments for delinquency trends, LTV trends and refreshed FICO score trends. 83 Fifth Third Bancorp MANAGEMENT’S DISCUSSION AND ANALYSIS OF FINANCIAL CONDITION AND RESULTS OF OPERATIONS The qualitative factors include adjustments for changes in policies or procedures in underwriting, monitoring or collections, economic conditions, portfolio mix, lending and risk management personnel, results of internal audit and quality control reviews, collateral values and geographic concentrations. The Bancorp considers home price index trends in its footprint and the volatility of collateral valuation trends when determining the collateral value qualitative factor. The home equity portfolio is managed in two primary groups: loans outstanding with a combined LTV greater than 80% and those loans with an LTV of 80% or less based upon appraisals at origination. For additional information on these loans, refer to Table 43 and Table 44. Of the total $6.4 billion of outstanding home equity loans: ● 89% reside within the Bancorp’s Midwest footprint of Ohio, Michigan, Kentucky, Indiana and Illinois as of December 31, 2018; ● 37% are in senior lien positions and 63% are in junior lien positions at December 31, 2018; ● 81% of non-delinquent borrowers made at least one payment greater than the minimum payment during the year ended December 31, 2018; and ● The portfolio had an average refreshed FICO score of 745 at December 31, 2018. The Bancorp actively manages lines of credit and makes adjustments in lending limits when it believes it is necessary based on FICO score deterioration and property devaluation. The Bancorp does not routinely obtain appraisals on performing loans to update LTV ratios after origination. However, the Bancorp monitors the local housing markets by reviewing various home price indices and incorporates the impact of the changing market conditions in its ongoing credit monitoring processes. For junior lien home equity loans which become 60 days or more past due, the Bancorp tracks the performance of the senior lien loans in which the Bancorp is the servicer and utilizes consumer credit bureau attributes to monitor the status of the senior lien loans that the Bancorp does not service. If the senior lien loan is found to be 120 days or more past due, the junior lien home equity loan is placed on nonaccrual status unless both loans are well-secured and in the process of collection. Additionally, if the junior lien home equity loan becomes 120 days or more past due and the senior lien loan is also 120 days or more past due, the junior lien home equity loan is assessed for charge-off. Refer to the Analysis of Nonperforming Assets subsection of the Risk Management section of MD&A for more information. 84 Fifth Third Bancorp MANAGEMENT’S DISCUSSION AND ANALYSIS OF FINANCIAL CONDITION AND RESULTS OF OPERATIONS The following table provides an analysis of home equity portfolio loans outstanding disaggregated based upon refreshed FICO score as of: The following tables provide an analysis of home equity portfolio loans by state with a combined LTV greater than 80%: 85 Fifth Third Bancorp MANAGEMENT’S DISCUSSION AND ANALYSIS OF FINANCIAL CONDITION AND RESULTS OF OPERATIONS Automobile portfolio The Bancorp’s automobile portfolio balances have declined since December 31, 2017 as payoffs exceeded new loan production due to a strategic shift focusing on improving risk-adjusted returns. Additionally, the concentration of lower FICO (£690) origination balances remained within targeted credit risk tolerance during the year ended December 31, 2018. All concentration and guideline changes are monitored monthly to ensure alignment with original credit performance and return projections. The following table provides an analysis of automobile portfolio loans outstanding disaggregated based upon FICO score as of: The automobile portfolio is characterized by direct and indirect lending products to consumers. As of December 31, 2018, 43% of the automobile loan portfolio is comprised of loans collateralized by new automobiles. It is a common industry practice to advance on automobile loans an amount in excess of the automobile value due to the inclusion of negative equity trade-in, maintenance/warranty products, taxes, title and other fees paid at closing. The Bancorp monitors its exposure to these higher risk loans. The following table provides an analysis of automobile portfolio loans outstanding by LTV at origination as of: The following table provides an analysis of the Bancorp’s automobile portfolio loans with an LTV at origination greater than 100% as of and for the years ended: Credit card portfolio The credit card portfolio consists of predominately prime accounts with 97% of loan balances existing within the Bancorp’s footprint as of December 31, 2018. At December 31, 2018 and December 31, 2017, 71% and 76%, respectively, of the outstanding balances were originated through branch-based relationships with the remainder coming from direct mail campaigns and online acquisitions. 86 Fifth Third Bancorp MANAGEMENT’S DISCUSSION AND ANALYSIS OF FINANCIAL CONDITION AND RESULTS OF OPERATIONS The following table provides an analysis of credit card portfolio loans outstanding disaggregated based upon FICO score as of: Other consumer portfolio loans The other consumer portfolio loans are comprised of secured and unsecured loans originated through the Bancorp’s branch network as well as point-of-sale loans originated in connection with third-party financial technology companies. Outstanding balances for other consumer loans increased approximately $783 million, or 50%, from December 31, 2017 primarily due to an increase in originations in connection with third-party financial technology companies. Additionally, the Bancorp has approximately $374 million in unfunded commitments associated with loans originated in connection with third-party financial technology companies as of December 31, 2018. Fifth Third closely monitors the credit performance of these point-of-sale loans which, for Fifth Third, is impacted by the credit loss protection coverage provided by the third-party financial technology companies. The following table provides an analysis of other consumer portfolio loans outstanding by product type at origination as of: Analysis of Nonperforming Assets Nonperforming assets include nonaccrual loans and leases for which ultimate collectability of the full amount of the principal and/or interest is uncertain; restructured commercial and credit card loans which have not yet met the requirements to be classified as a performing asset; restructured consumer loans which are 90 days past due based on the restructured terms unless the loan is both well-secured and in the process of collection; and certain other assets, including OREO and other repossessed property. A summary of nonperforming assets is included in Table 51. For further information on the Bancorp’s policies related to accounting for delinquent and nonperforming loans and leases, refer to the Nonaccrual Loans and Leases section of Note 1 of the Notes to Consolidated Financial Statements. Nonperforming assets were $411 million at December 31, 2018 compared to $495 million at December 31, 2017. At December 31, 2018, $16 million of nonaccrual loans were held for sale, compared to $6 million at December 31, 2017. Nonperforming portfolio assets as a percent of portfolio loans and leases and OREO were 0.41% as of December 31, 2018 compared to 0.53% as of December 31, 2017. Nonaccrual loans and leases secured by real estate were 34% of nonaccrual loans and leases as of December 31, 2018 compared to 33% as of December 31, 2017. Commercial portfolio nonaccrual loans and leases were $228 million at December 31, 2018, a decrease of $78 million from December 31, 2017. Consumer portfolio nonaccrual loans and leases were $120 million at December 31, 2018, a decrease of $11 million from December 31, 2017. Refer to Table 52 for a rollforward of the portfolio nonaccrual loans and leases. OREO and other repossessed property was $47 million at December 31, 2018, compared to $52 million at December 31, 2017. The Bancorp recognized $7 million and $10 million in losses on the transfer, sale or write-down of OREO properties during the years ended December 31, 2018 and 2017, respectively. During the years ended December 31, 2018 and 2017, approximately $30 million and $36 million, respectively, of interest income would have been recognized if the nonaccrual and renegotiated loans and leases on nonaccrual status had been current in accordance with their original terms. Although these values help demonstrate the costs of carrying nonaccrual credits, the Bancorp does not expect to recover the full amount of interest as nonaccrual loans and leases are generally carried below their principal balance. 87 Fifth Third Bancorp MANAGEMENT’S DISCUSSION AND ANALYSIS OF FINANCIAL CONDITION AND RESULTS OF OPERATIONS (a) Information for all periods presented excludes advances made pursuant to servicing agreements for GNMA mortgage pools whose repayments are insured by the FHA or guaranteed by the VA. These advances were $195, $290, $312, $335 and $373 as of December 31, 2018, 2017, 2016, 2015 and 2014, respectively. The Bancorp recognized losses of $5, $5, $6, $8 and $13 for the years ended December 31, 2018, 2017, 2016, 2015 and 2014, respectively. (b) Includes $6, $3, $4, $6 and $9 of nonaccrual government insured commercial loans whose repayments are insured by the SBA at December 31, 2018, 2017, 2016, 2015 and 2014, respectively, of which $2, $3, $1, $2 and $4 were restructured nonaccrual government insured commercial loans at December 31, 2018, 2017, 2016, 2015 and 2014, respectively. (c) Excludes $19, $20 and $21 of restructured nonaccrual loans at December 31, 2016, 2015 and 2014, respectively, associated with a consolidated VIE in which the Bancorp had no continuing credit risk due to the risk being assumed by a third party. Refer to Note 10 of the Notes to Consolidated Financial Statements for further discussion on the deconsolidation of the VIE associated with these loans in the third quarter of 2017. (d) Excludes $71 of OREO related to government insured loans at December 31, 2014. The Bancorp had historically excluded government guaranteed loans classified in OREO from its nonperforming asset disclosures. Upon the prospective adoption on January 1, 2015 of ASU 2014-14, “Classification of Certain Government-Guaranteed Mortgage Loans Upon Foreclosure,” government guaranteed loans meeting certain criteria are reclassified to other receivables rather than OREO upon foreclosure. 88 Fifth Third Bancorp MANAGEMENT’S DISCUSSION AND ANALYSIS OF FINANCIAL CONDITION AND RESULTS OF OPERATIONS The following table provides a rollforward of portfolio nonaccrual loans and leases, by portfolio segment: Troubled Debt Restructurings If a borrower is experiencing financial difficulty, the Bancorp may consider, in certain circumstances, modifying the terms of their loan to maximize collection of amounts due. Typically, these modifications reduce the loan interest rate, extend the loan term, reduce the accrued interest or in limited circumstances, reduce the principal balance of the loan. These modifications are classified as TDRs. At the time of modification, the Bancorp maintains certain consumer loan TDRs (including residential mortgage loans, home equity loans and other consumer loans) on accrual status, provided there is reasonable assurance of repayment and performance according to the modified terms based upon a current, well-documented credit evaluation. Commercial loans modified as part of a TDR are maintained on accrual status provided there is a sustained payment history of six months or greater prior to the modification in accordance with the modified terms and all remaining contractual payments under the modified terms are reasonably assured of collection. TDRs of commercial loans and credit card loans that do not have a sustained payment history of six months or greater in accordance with the modified terms remain on nonaccrual status until a six-month payment history is sustained. Consumer restructured loans on accrual status totaled $961 million and $927 million at December 31, 2018 and 2017, respectively. As of December 31, 2018, the percentage of restructured residential mortgage loans, home equity loans, and credit card loans that are past due 30 days or more were 25%, 11% and 39%, respectively. The following tables summarize portfolio TDRs by loan type and delinquency status: (a) Information includes advances made pursuant to servicing agreements for GNMA mortgage pools whose repayments are insured by the FHA or guaranteed by the VA. As of December 31, 2018, these advances represented $321 of current loans, $42 of 30-89 days past due loans and $101 of 90 days or more past due loans. (b) Excludes restructured nonaccrual loans held for sale. 89 Fifth Third Bancorp MANAGEMENT’S DISCUSSION AND ANALYSIS OF FINANCIAL CONDITION AND RESULTS OF OPERATIONS (a) Information includes advances made pursuant to servicing agreements for GNMA mortgage pools whose repayments are insured by the FHA or guaranteed by the VA. As of December 31, 2017, these advances represented $282 of current loans, $40 of 30-89 days past due loans and $108 of 90 days or more past due loans. (b) Excludes restructured nonaccrual loans held for sale. Analysis of Net Loan Charge-offs Net charge-offs were 35 bps and 32 bps of average portfolio loans and leases for the years ended December 31, 2018 and 2017, respectively. Table 55 provides a summary of credit loss experience and net charge-offs as a percentage of average portfolio loans and leases outstanding by loan category. The ratio of commercial loan and lease net charge-offs to average portfolio commercial loans and leases was 23 bps during the year ended December 31, 2018, compared to 22 bps during the year ended December 31, 2017. Consumer loan net charge-offs as a percent of average portfolio consumer loans was 56 bps for the year ended December 31, 2018 compared to 49 bps for the year ended December 31, 2017. The increase was primarily due to increases in net charge-offs on credit card of $17 million and increases in net charge-offs on other consumer loans of $12 million as a result of growth in unsecured loans. 90 Fifth Third Bancorp MANAGEMENT’S DISCUSSION AND ANALYSIS OF FINANCIAL CONDITION AND RESULTS OF OPERATIONS (a) For the year ended December 31, 2018, the Bancorp recorded $29 in both losses charged-off and recoveries of losses charged-off related to customer defaults on point-of-sale consumer loans for which the Bancorp obtained recoveries under third-party credit enhancements. Allowance for Credit Losses The allowance for credit losses is comprised of the ALLL and the reserve for unfunded commitments. The ALLL provides coverage for probable and estimable losses in the loan and lease portfolio. The Bancorp evaluates the ALLL each quarter to determine its adequacy to cover inherent losses. Several factors are taken into consideration in the determination of the overall ALLL, including an unallocated component. These factors include, but are not limited to, the overall risk profile of the loan and lease portfolios, net charge-off experience, the extent of impaired loans and leases, the level of nonaccrual loans and leases, the level of 90 days past due loans and leases and the overall level of the ALLL as a percent of portfolio loans and leases. The Bancorp also considers overall asset quality trends, credit administration and portfolio management practices, risk identification practices, credit policy and underwriting practices, overall portfolio growth, portfolio concentrations and current economic conditions that might impact the portfolio. Refer to the Critical Accounting Policies section of MD&A for more information. During the year ended December 31, 2018, the Bancorp did not substantively change any material aspect of its overall approach in the determination of the ALLL and there have been no material changes in assumptions or estimation techniques as compared to prior periods that impacted the determination of the current period allowance. In addition to the ALLL, the Bancorp maintains a reserve for unfunded commitments recorded in other liabilities in the Consolidated Balance Sheets. The methodology used to determine the adequacy of this reserve is similar to the Bancorp’s methodology for determining the ALLL. The provision for the reserve for unfunded commitments is included in other noninterest expense in the Consolidated Statements of Income. 91 Fifth Third Bancorp MANAGEMENT’S DISCUSSION AND ANALYSIS OF FINANCIAL CONDITION AND RESULTS OF OPERATIONS The ALLL attributable to the portion of the residential mortgage and consumer loan portfolios that has not been restructured in a TDR is calculated on a pooled basis with the segmentation based on the similarity of credit risk characteristics. Loss factors for consumer loans are developed for each pool based on the trailing twelve month historical loss rate, as adjusted for certain prescriptive loss rate factors and certain qualitative adjustment factors. The prescriptive loss rate factors and qualitative adjustments are designed to reflect risks associated with current conditions and trends which are not believed to be fully reflected in the trailing twelve month historical loss rate. For real estate backed consumer loans, the prescriptive loss rate factors include adjustments for delinquency trends, LTV trends, refreshed FICO score trends and product mix, and the qualitative factors include adjustments for changes in policies or procedures in underwriting, monitoring or collections, economic conditions, portfolio mix, lending and risk management personnel, results of internal audit and quality control reviews, collateral values and geographic concentrations. The Bancorp considers home price index trends in its footprint and the volatility of collateral valuation trends when determining the collateral value qualitative factor. The Bancorp’s determination of the ALLL for commercial loans is sensitive to the risk grades it assigns to these loans. In the event that 10% of commercial loans in each risk category would experience a downgrade of one risk category, the allowance for commercial loans would increase by approximately $163 million at December 31, 2018. In addition, the Bancorp’s determination of the ALLL for residential mortgage loans and consumer loans and leases is sensitive to changes in estimated loss rates. In the event that estimated loss rates would increase by 10%, the ALLL for residential mortgage loans and consumer loans and leases would increase by approximately $35 million at December 31, 2018. As several qualitative and quantitative factors are considered in determining the ALLL, these sensitivity analyses do not necessarily reflect the nature and extent of future changes in the ALLL. They are intended to provide insights into the impact of adverse changes to risk grades and estimated loss rates and do not imply any expectation of future deterioration in the risk ratings or loss rates. Given current processes employed by the Bancorp, management believes the risk grades and estimated loss rates currently assigned are appropriate. (a) For the year ended December 31, 2018, the Bancorp recorded $29 in both losses charged-off and recoveries of losses charged-off related to customer defaults on point-of-sale consumer loans for which the Bancorp obtained recoveries under third-party credit enhancements. (b) Refer to Note 10 of the Notes to Consolidated Financial Statements for further discussion on the deconsolidation of a VIE. Certain inherent but unconfirmed losses are probable within the loan and lease portfolio. The Bancorp’s current methodology for determining the level of losses is based on historical loss rates, current credit grades, specific allocation on impaired commercial credits above specified thresholds and restructured loans and other qualitative adjustments. Due to the heavy reliance on realized historical losses and the credit grade rating process, the model-derived estimate of ALLL tends to slightly lag behind the deterioration in the portfolio in a stable or deteriorating credit environment, and tends not to be as responsive when improved conditions have presented themselves. Given these model limitations, the qualitative adjustment factors may be incremental or decremental to the quantitative model results. An unallocated component of the ALLL is maintained to recognize the imprecision in estimating and measuring loss. The unallocated allowance as a percent of total portfolio loans and leases at December 31, 2018 and 2017 was 0.12% and 0.13%, respectively. The unallocated allowance was 10% of the total allowance at both December 31, 2018 and 2017. As shown in Table 57, the ALLL as a percent of portfolio loans and leases was 1.16% at December 31, 2018, compared to 1.30% at December 31, 2017. The ALLL was $1.1 billion and $1.2 billion at December 31, 2018 and 2017, respectively. 92 Fifth Third Bancorp MANAGEMENT’S DISCUSSION AND ANALYSIS OF FINANCIAL CONDITION AND RESULTS OF OPERATIONS MARKET RISK MANAGEMENT Market risk is the day-to-day potential for the value of a financial instrument to increase or decrease due to movements in market factors. The Bancorp’s market risk includes risks resulting from movements in interest rates, foreign exchange rates, equity prices and commodity prices. Interest rate risk, a component of market risk, primarily impacts the Bancorp’s NII and interest sensitive fee income categories through changes in interest income on earning assets and cost of interest-bearing liabilities, and through fee items that are related to interest sensitive activities such as mortgage origination and servicing income. Management considers interest rate risk a prominent market risk in terms of its potential impact on earnings. Interest rate risk may occur for any one or more of the following reasons: ● Assets and liabilities mature or reprice at different times; ● Short-term and long-term market interest rates change by different amounts; or ● The expected maturities of various assets or liabilities shorten or lengthen as interest rates change. In addition to the direct impact of interest rate changes on NII, interest rates can impact earnings through their effect on loan and deposit demand, credit losses, mortgage originations, the value of servicing rights and other sources of the Bancorp’s earnings. Stability of the Bancorp’s net income is largely dependent upon the effective management of interest rate risk. Management continually reviews the Bancorp’s balance sheet composition and earnings flows and models the interest rate risk, and possible actions to manage this risk, given numerous possible future interest rate scenarios. A series of Policy Limits and Key Risk Indicators are employed to ensure that this risk is managed within the Bancorp’s risk tolerance. Interest Rate Risk Management Oversight The Bancorp’s ALCO, which includes senior management representatives and is accountable to the ERMC, monitors and manages interest rate risk within Board-approved policy limits. In addition to the risk management activities of ALCO, the Bancorp has a Market Risk Management function as part of ERM that provides independent oversight of market risk activities. Net Interest Income Sensitivity The Bancorp employs a variety of measurement techniques to identify and manage its interest rate risk, including the use of an NII simulation model to analyze the sensitivity of NII to changes in interest rates. The model is based on contractual and estimated cash flows and repricing characteristics for all of the Bancorp’s assets, liabilities and off-balance sheet exposures and incorporates market-based assumptions regarding the effect of changing interest rates on the prepayment rates of certain assets and attrition rates of certain liabilities. The model also includes senior management’s projections of the future volume and pricing of each of the product lines offered by the Bancorp as well as other pertinent assumptions. Actual results may differ from simulated results due to timing, magnitude and frequency of interest rate changes, deviations from projected assumptions, as well as from changes in market conditions and management strategies. 93 Fifth Third Bancorp MANAGEMENT’S DISCUSSION AND ANALYSIS OF FINANCIAL CONDITION AND RESULTS OF OPERATIONS As of December 31, 2018, the Bancorp’s interest rate risk exposure is governed by a risk framework that utilizes the change in NII over 12-month and 24-month horizons assuming a 200 bps parallel ramped increase and a 150 bps parallel ramped decrease in interest rates. Additionally, the Bancorp routinely analyzes various potential and extreme scenarios, including ramps, shocks and twists to assess where risks to net interest income persist or develop as changes in the balance sheet and market rates evolve. In order to recognize the risk of noninterest-bearing demand deposit balance run-off in a rising interest rate environment, the Bancorp’s NII sensitivity modeling assumes that approximately $500 million of additional demand deposit balances run-off over 24 months above what is included in senior management’s baseline projections for each 100 bps increase in short-term market interest rates. Similarly, the Bancorp’s NII sensitivity modeling incorporates approximately $500 million of incremental growth in noninterest-bearing deposit balances over 24 months above senior management’s baseline projections for each 100 bps decrease in short-term market interest rates. The incremental balance run-off and growth are modeled to flow into and out of funding products that reprice in conjunction with market rate changes. Another important deposit modeling assumption is the amount by which interest-bearing deposit rates will increase or decrease when market interest rates increase or decrease. This deposit repricing sensitivity is known as the beta, and it represents the expected amount by which Bancorp deposit rates will change for a given change in short-term market rates. The Bancorp’s NII sensitivity modeling assumes a weighted-average rising rate interest-bearing deposit beta of 70% at December 31, 2018, which is approximately 10 to 20 percentage points higher than the average beta that the Bancorp experienced in the last FRB tightening cycle from June 2004 to June 2006 and higher than the most recent beta experienced in the current tightening cycle to date. The Bancorp’s NII sensitivity modeling assumes a weighted-average falling rate interest-bearing deposit beta of 40% at December 31, 2018. In addition, the modeling assumes there is no lag between the timing of changes in market rates and the timing of deposit repricing despite such timing lags having occurred for each rate move thus far in the current tightening cycle. The Bancorp continually evaluates the sensitivity of its interest rate risk measures to these important deposit modeling assumptions. The Bancorp also regularly monitors the sensitivity of other important modeling assumptions, such as loan and security prepayments and early withdrawals on fixed-rate customer liabilities. The following table shows the Bancorp’s estimated NII sensitivity profile and ALCO policy limits as of December 31: At December 31, 2018, the Bancorp’s NII sensitivity is near neutral in year one and would benefit in year two under the parallel rate ramp increases. The Bancorp’s NII would decline in both year one and year two under the parallel 150 bps ramp decrease in interest rates. The NII sensitivity profile is attributable to the combination of floating-rate assets, including the predominantly floating-rate commercial loan portfolio, and certain intermediate-term fixed-rate liabilities. As the FOMC has increased its target range for the federal funds rate, the sensitivity to declining rates has increased, which is a reflection of the balance sheet mix previously described. Reductions in the yield of the commercial loan portfolio would be expected to be only partially offset by a decline in the cost of interest-bearing deposits in this scenario. During the fourth quarter of 2018, the Bancorp executed hedges with notional amounts of $4 billion in spot starting and $1 billion in forward starting receive-fixed interest rate swaps and $3 billion in forward starting interest rate floors, which reduced the Bancorp’s exposure to falling rates while allowing the balance sheet to remain asset sensitive over the month horizon. Additionally, $3.2 billion in out of the money cash flow hedges, originally maturing in 2019, were terminated to enhance asset sensitivity over the next year and to increase the capacity for additional cash flow hedges, as warranted. The changes in the estimated NII sensitivity profile as of December 31, 2018 compared to December 31, 2017 were primarily attributable to an increase in the outstanding taxable securities balances, a net increase in outstanding receive-fixed swaps against floating-rate commercial loans, the addition of forward starting floors against one-month LIBOR, reduced noninterest-bearing deposit balances and a decrease in outstanding fixed-rate long-term debt. These items were partially offset by an overall increase in core deposit balances and a reduction in fixed-rate commercial leases and residential mortgage. Tables 59 and 60 provide the Bancorp’s estimated NII profile at December 31, 2018 with changes to certain deposit balances and deposit repricing sensitivity (betas) assumptions. 94 Fifth Third Bancorp MANAGEMENT’S DISCUSSION AND ANALYSIS OF FINANCIAL CONDITION AND RESULTS OF OPERATIONS The following table includes the Bancorp’s estimated NII sensitivity profile with an immediate $1 billion decrease and an immediate $1 billion increase in demand deposit balances as of December 31, 2018: Economic Value of Equity Sensitivity The Bancorp also uses EVE as a measurement tool in managing interest rate risk. Whereas the NII sensitivity analysis highlights the impact on forecasted NII on an FTE basis (non-GAAP) over one and two year time horizons, EVE is a point-in-time analysis of the economic sensitivity of current positions that incorporates all cash flows over their estimated remaining lives. The EVE of the balance sheet is defined as the discounted present value of all asset and net derivative cash flows less the discounted value of all liability cash flows. Due to this longer horizon, the sensitivity of EVE to changes in the level of interest rates is a measure of longer-term interest rate risk. EVE values only the current balance sheet and does not incorporate the balance growth assumptions used in the NII sensitivity analysis. As with the NII simulation model, assumptions about the timing and variability of existing balance sheet cash flows are critical in the EVE analysis. Particularly important are assumptions driving loan and security prepayments and the expected balance attrition and pricing of transaction deposits. The following table shows the Bancorp’s estimated EVE sensitivity profile as of December 31: The EVE sensitivity is moderately negative in both the +200 bps rising rate and the -200 bps falling rate scenarios at December 31, 2018. The changes in the estimated EVE sensitivity profile from December 31, 2017 are primarily related to an increase in the outstanding taxable securities balance, migration from noninterest-bearing deposits to interest-bearing deposits with higher attrition assumptions, the addition of receive-fixed swaps against floating-rate commercial loans and the addition of interest rate floors. These items were partially offset by net run-off of the fixed-rate commercial lease and residential mortgage portfolios and overall deposit growth. While an instantaneous shift in interest rates is used in this analysis to provide an estimate of exposure, the Bancorp believes that a gradual shift in interest rates would have a much more modest impact. Since EVE measures the discounted present value of cash flows over the estimated lives of instruments, the change in EVE does not directly correlate to the degree that earnings would be impacted over a shorter time horizon (e.g., the current fiscal year). Further, EVE does not take into account factors such as future balance sheet growth, changes in product mix, changes in yield curve relationships and changing product spreads that could mitigate or exacerbate the impact of changes in interest rates. The NII simulations and EVE analyses do not necessarily include certain actions that management may undertake to manage risk in response to actual changes in interest rates. The Bancorp regularly evaluates its exposures to a static balance sheet forecast, LIBOR, Prime Rate and other basis risks, yield curve twist risks and embedded options risks. 95 Fifth Third Bancorp MANAGEMENT’S DISCUSSION AND ANALYSIS OF FINANCIAL CONDITION AND RESULTS OF OPERATIONS In addition, the impacts on NII on an FTE basis and EVE of extreme changes in interest rates are modeled, wherein the Bancorp employs the use of yield curve shocks and environment-specific scenarios. Use of Derivatives to Manage Interest Rate Risk An integral component of the Bancorp’s interest rate risk management strategy is its use of derivative instruments to minimize significant fluctuations in earnings caused by changes in market interest rates. Examples of derivative instruments that the Bancorp may use as part of its interest rate risk management strategy include interest rate swaps, interest rate floors, interest rate caps, forward contracts, forward starting interest rate swaps, options, swaptions and TBA securities. As part of its overall risk management strategy relative to its residential mortgage banking activities, the Bancorp enters into forward contracts accounted for as free-standing derivatives to economically hedge IRLCs that are also considered free-standing derivatives. Additionally, the Bancorp economically hedges its exposure to residential mortgage loans held for sale through the use of forward contracts and mortgage options. The Bancorp also enters into derivative contracts with major financial institutions to economically hedge market risks assumed in interest rate derivative contracts with commercial customers. Generally, these contracts have similar terms in order to protect the Bancorp from market volatility. Credit risk arises from the possible inability of counterparties to meet the terms of their contracts, which the Bancorp minimizes through collateral arrangements, approvals, limits and monitoring procedures. The Bancorp has risk limits and internal controls in place to help ensure excessive risk is not being taken in providing this service to customers. These controls include an independent determination of interest rate volatility and credit equivalent exposure on these contracts and counterparty credit approvals performed by independent risk management. For further information including the notional amount and fair values of these derivatives, refer to Note 12 of the Notes to Consolidated Financial Statements. Portfolio Loans and Leases and Interest Rate Risk Although the Bancorp’s portfolio loans and leases contain both fixed and floating/adjustable-rate products, the rates of interest earned by the Bancorp on the outstanding balances are generally established for a period of time. The interest rate sensitivity of loans and leases is directly related to the length of time the rate earned is established. The following table summarizes the carrying value of the Bancorp’s portfolio loans and leases expected cash flows, excluding interest receivable, as of December 31, 2018: Additionally, the following table displays a summary of expected cash flows, excluding interest receivable, occurring after one year for both fixed and floating/adjustable-rate loans and leases as of December 31, 2018: Residential Mortgage Servicing Rights and Interest Rate Risk The fair value of the residential MSR portfolio was $938 million and $858 million at December 31, 2018 and December 31, 2017, respectively. The value of servicing rights can fluctuate sharply depending on changes in interest rates and other factors. Generally, as interest rates decline and loans are prepaid to take advantage of refinancing, the total value of existing servicing rights declines because no further servicing fees are collected on repaid loans. 96 Fifth Third Bancorp MANAGEMENT’S DISCUSSION AND ANALYSIS OF FINANCIAL CONDITION AND RESULTS OF OPERATIONS The Bancorp maintains a non-qualifying hedging strategy relative to its mortgage banking activity in order to manage a portion of the risk associated with changes in the value of its MSR portfolio as a result of changing interest rates. Mortgage rates increased during the year ended December 31, 2018 which caused modeled prepayment speeds to slow. The fair value of the MSR portfolio increased $42 million due to changes to inputs to the valuation model including prepayment speeds and OAS spread assumptions and decreased $125 million due to the passage of time, including the impact of regularly scheduled repayments, paydowns and payoffs for the year ended December 31, 2018. Mortgage rates decreased during the year ended December 31, 2017 which caused modeled prepayment speeds to increase, leading to fair value adjustments on servicing rights. The fair value of the MSR portfolio decreased $1 million due to changes to inputs to the valuation model including prepayment speeds and OAS spread assumptions and decreased $121 million due to the passage of time, including the impact of regularly scheduled repayments, paydowns and payoffs for the year ended December 31, 2017. The Bancorp recognized net losses of $36 million and net gains of $4 million, respectively, on its non-qualifying hedging strategy during the years ended December 31, 2018 and 2017. These amounts include net losses of $15 million and net gains of $2 million, respectively, on securities related to the Bancorp’s non-qualifying hedging strategy during the years ended December 31, 2018 and 2017. The Bancorp may adjust its hedging strategy to reflect its assessment of the composition of its MSR portfolio, the cost of hedging and the anticipated effectiveness of the hedges given the economic environment. Refer to Note 11 of the Notes to Consolidated Financial Statements for further discussion on servicing rights and the instruments used to hedge interest rate risk on MSRs. Foreign Currency Risk The Bancorp may enter into foreign exchange derivative contracts to economically hedge certain foreign denominated loans. The derivatives are classified as free-standing instruments with the revaluation gain or loss being recorded in other noninterest income in the Consolidated Statements of Income. The balance of the Bancorp’s foreign denominated loans at December 31, 2018 and 2017 was $948 million and $939 million, respectively. The Bancorp also enters into foreign exchange contracts for the benefit of commercial customers to hedge their exposure to foreign currency fluctuations. Similar to the hedging of interest rate risk from interest rate derivative contracts, the Bancorp also enters into foreign exchange contracts with major financial institutions to economically hedge a substantial portion of the exposure from client driven foreign exchange activity. The Bancorp has risk limits and internal controls in place to help ensure excessive risk is not being taken in providing this service to customers. These controls include an independent determination of currency volatility and credit equivalent exposure on these contracts, counterparty credit approvals and country limits performed by independent risk management. Commodity Risk The Bancorp also enters into commodity contracts for the benefit of commercial customers to hedge their exposure to commodity price fluctuations. Similar to the hedging of foreign exchange and interest rate risk from interest rate derivative contracts, the Bancorp also enters into commodity contracts with major financial institutions to economically hedge a substantial portion of the exposure from client driven commodity activity. The Bancorp may also offset this risk with exchange-traded commodity contracts. The Bancorp has risk limits and internal controls in place to help ensure excessive risk is not taken in providing this service to customers. These controls include an independent determination of commodity volatility and credit equivalent exposure on these contracts and counterparty credit approvals performed by independent risk management. LIQUIDITY RISK MANAGEMENT The goal of liquidity management is to provide adequate funds to meet changes in loan and lease demand, unexpected levels of deposit withdrawals and other contractual obligations. Mitigating liquidity risk is accomplished by maintaining liquid assets in the form of cash and investment securities, maintaining sufficient unused borrowing capacity in the debt markets and delivering consistent growth in core deposits. A summary of certain obligations and commitments to make future payments under contracts is included in Note 16 of the Notes to Consolidated Financial Statements. The Bancorp’s Treasury department manages funding and liquidity based on point-in-time metrics as well as forward-looking projections, which incorporate different sources and uses of funds under base and stress scenarios. Liquidity risk is monitored and managed by the Treasury department, and a series of Policy Limits and Key Risk Indicators are established to ensure risks are managed within the Bancorp’s risk tolerance. The Bancorp maintains a contingency funding plan that provides for liquidity stress testing, which assesses the liquidity needs under varying market conditions, time horizons, asset growth rates and other events. The contingency plan provides for ongoing monitoring of unused borrowing capacity and available sources of contingent liquidity to prepare for unexpected liquidity needs and to cover unanticipated events that could affect liquidity. The contingency plan also outlines the Bancorp’s response to various levels of liquidity stress and actions that should be taken during various scenarios. Liquidity Risk Management Oversight The Bancorp’s ALCO, which includes senior management representatives and is accountable to the ERMC, monitors and manages liquidity and funding risk within Board-approved policy limits. In addition to the risk management activities of ALCO, the Bancorp has a Market Risk Management function as part of ERM that provides independent oversight of liquidity risk management. Sources of Funds The Bancorp’s primary sources of funds relate to cash flows from loan and lease repayments, payments from securities related to sales and maturities, the sale or securitization of loans and leases and funds generated by core deposits, in addition to the use of public and private debt offerings. Table 62 of the Market Risk Management subsection of the Risk Management section of MD&A illustrates the expected maturities from loan and lease repayments. Of the $32.8 billion of securities in the Bancorp’s available-for-sale debt and other securities portfolio at December 31, 2018, $3.3 billion in principal and interest is expected to be received in the next 12 months and an additional $3.2 billion is expected to be received in the next 13 to 24 months. For further information on the Bancorp’s securities portfolio, refer to the Investment Securities subsection of the Balance Sheet Analysis section of MD&A. 97 Fifth Third Bancorp MANAGEMENT’S DISCUSSION AND ANALYSIS OF FINANCIAL CONDITION AND RESULTS OF OPERATIONS Asset-driven liquidity is provided by the Bancorp’s ability to sell or securitize loans and leases. In order to reduce the exposure to interest rate fluctuations and to manage liquidity, the Bancorp has developed securitization and sale procedures for several types of interest-sensitive assets. A majority of the long-term, fixed-rate single-family residential mortgage loans underwritten according to FHLMC or FNMA guidelines are sold for cash upon origination. Additional assets such as certain other residential mortgage loans, certain commercial loans, home equity loans, automobile loans and other consumer loans are also capable of being securitized or sold. The Bancorp sold or securitized loans totaling $5.5 billion during the year ended December 31, 2018 compared to $7.5 billion during the year ended December 31, 2017. For further information, refer to Note 10 and Note 11 of the Notes to Consolidated Financial Statements. Core deposits have historically provided the Bancorp with a sizeable source of relatively stable and low-cost funds. The Bancorp’s average core deposits and average shareholders’ equity funded 83% of its average total assets for both the years ended December 31, 2018 and 2017. In addition to core deposit funding, the Bancorp also accesses a variety of other short-term and long-term funding sources, which include the use of the FHLB system. Certificates $100,000 and over and deposits in the Bancorp’s foreign branch located in the Cayman Islands are wholesale funding tools utilized to fund asset growth. Management does not rely on any one source of liquidity and manages availability in response to changing balance sheet needs. As of December 31, 2018, $7.3 billion of debt or other securities were available for issuance under the current Bancorp’s Board of Directors’ authorizations and the Bancorp is authorized to file any necessary registration statements with the SEC to permit ready access to the public securities markets; however, access to these markets may depend on market conditions. During the year ended 2018, the Bancorp issued and sold $900 million of senior notes. The Bank’s global bank note program has a borrowing capacity of $25.0 billion, of which $17.0 billion was available for issuance as of December 31, 2018. During the year ended 2018, the Bank issued and sold $1.6 billion of senior bank notes. Additionally, at December 31, 2018, the Bank had approximately $45.2 billion of borrowing capacity available through secured borrowing sources including the FHLB and FRB. For further information on subsequent events related to long-term debt, refer to Note 31 of the Notes to Consolidated Financial Statements. Liquidity Coverage Ratio and Net Stable Funding Ratio The Bancorp is subject to the Modified LCR requirement, which stipulates that BHCs with at least $50 billion but less than $250 billion in total consolidated assets that are not internationally active, such as the Bancorp, maintain HQLA equal to their calculated net cash outflows over a 30 calendar-day stress period multiplied by a factor of 0.7. The Bancorp’s Modified LCR was 128% at December 31, 2018. Further, beginning with the fourth quarter of 2018, BHCs subject to the Modified LCR are required to calculate and disclose the quarterly average components used to calculate their Modified LCR. The following table presents the components of the Bancorp’s Quarterly Average Modified LCR for the three months ended: (a) Average HQLA shown after application of applicable haircuts and limits on Level 2 liquid assets. On June 1, 2016, the U.S. banking agencies published a notice of proposed rulemaking to implement a modified NSFR for certain bank holding companies with at least $50 billion but less than $250 billion in total consolidated assets and with less than $10 billion in on-balance sheet foreign exposures, including the Bancorp. Generally consistent with the BCBS’ framework, under the proposed rule banking organizations would be required to hold an amount of ASF over a one-year time horizon that equals or exceeds the institution’s amount of RSF, with the ASF representing the numerator and the RSF representing the denominator of the NSFR. Banking organizations subject to the modified NSFR would multiply the RSF amount by 70%, such that the RSF amount required for these institutions would be equivalent to 70% of the RSF amount that would be required pursuant to the full NSFR generally applicable to institutions with at least $250 billion in total consolidated assets or $10 billion or more in on-balance sheet foreign exposures under the proposed rule. The comment period for this proposal ended on August 5, 2016. On October 31, 2018, the Board of Governors of the FRB released a series of regulatory proposals to implement the Economic Growth, Regulatory Relief, and Consumer Protection Act (“Reform Act”). Among the proposals, the Board of Governors, joined by the Department of Treasury, Office of the Comptroller of the Currency and the Federal Deposit Insurance Corporation proposed to remove the application of the LCR regulations and the NSFR from certain BHCs that qualify under the proposal as “Category IV” institutions, primarily those BHCs with consolidated assets between $100 billion and $250 billion, including Fifth Third Bancorp. The NPR’s public comment period ended January 22, 2019 and could be further amended by the FRB and other financial regulators prior to adoption. As such, the ultimate impacts of the NPR to Fifth Third Bancorp, Fifth Third Bank and their respective subsidiaries and activities will be subject to the final form of these NPRs and additional rulemakings issued. Fifth Third cannot predict future changes in the applicable laws, regulations and regulatory agency policies, yet such changes may have a material effect on its business, financial condition or results of operations. Credit Ratings The cost and availability of financing to the Bancorp and Bank are impacted by its credit ratings. A downgrade to the Bancorp’s or Bank’s credit ratings could affect its ability to access the credit markets and increase its borrowing costs, thereby adversely impacting the Bancorp’s or Bank’s financial condition and liquidity. Key factors in maintaining high credit ratings include a stable and diverse earnings stream, strong credit quality, strong capital ratios and diverse funding sources, in addition to disciplined liquidity monitoring procedures. The Bancorp’s and Bank’s credit ratings are summarized in Table 65. The ratings reflect the ratings agency’s view on the Bancorp’s and Bank’s capacity to meet financial commitments.* 98 Fifth Third Bancorp MANAGEMENT’S DISCUSSION AND ANALYSIS OF FINANCIAL CONDITION AND RESULTS OF OPERATIONS * As an investor, you should be aware that a security rating is not a recommendation to buy, sell or hold securities, that it may be subject to revision or withdrawal at any time by the assigning rating organization and that each rating should be evaluated independently of any other rating. Additional information on the credit rating ranking within the overall classification system is located on the website of each credit rating agency. OPERATIONAL RISK MANAGEMENT Operational risk is the risk of loss resulting from inadequate or failed processes or systems or due to external events that are neither market nor credit-related. Operational risk is inherent in the Bancorp’s activities and can manifest itself in various ways including fraudulent acts, business interruptions, inappropriate behavior of employees, unintentional failure to comply with applicable laws and regulations, cyber-security incidents and privacy breaches or failure of vendors to perform in accordance with their arrangements. These events could result in financial losses, litigation and regulatory fines, as well as other damage to the Bancorp. The Bancorp’s risk management goal is to keep operational risk at appropriate levels consistent with the Bancorp’s risk appetite, financial strength, the characteristics of its businesses, the markets in which it operates and the competitive and regulatory environment to which it is subject. To control, monitor and govern operational risk, the Bancorp maintains an overall Risk Management Framework which comprises governance oversight, risk assessment, capital measurement, monitoring and reporting as well as a formal three lines of defense approach. ERM is responsible for prescribing the framework to the lines of business and corporate functions and providing independent oversight of its implementation (second line of defense). Business Controls groups are in place in each of the lines of business to ensure consistent implementation and execution of managing day-to-day operational risk (first line of defense). The Bancorp’s risk management framework consists of five integrated components, including identifying, assessing, managing, monitoring and independent governance reporting of risk. The corporate Operational Risk Management function within Enterprise Risk is responsible for developing and overseeing the implementation of the Bancorp’s approach to managing operational risk. This includes providing governance, awareness and training, tools, guidance and oversight to support implementation of key risk programs and systems as they relate to operational risk management, such as risk and control self-assessments, new product/initiative risk reviews, key risk indicators, Vendor Risk Management, cyber security risk management and review of operational losses. The function is also responsible for developing reports that support the proactive management of operational risk across the enterprise. The lines of business and corporate functions are responsible for managing the operational risks associated with their areas in accordance with the risk management framework. The framework is intended to enable the Bancorp to function with a sound and well-controlled operational environment. These processes support the Bancorp’s goals to minimize future operational losses and strengthen the Bancorp’s performance by maintaining sufficient capital to absorb operational losses that are incurred. The Bancorp also maintains a robust information security program to support the management of cyber security risk within the organization with a focus on prevention, detection and recovery processes. Fifth Third utilizes a wide array of techniques to secure its operations and proprietary information such as Board-approved policies and programs, network monitoring and testing, access controls and dedicated security personnel. Fifth Third has adopted the National Institute of Standards and Technology Cyber Security Framework for the management and deployment of cyber security controls and is an active participant in the financial sector information sharing organization structure, known as the Financial Services Information Sharing and Analysis Center. To ensure resiliency of key Bancorp functions, Fifth Third also employs redundancy protocols that include a robust business continuity function that works to mitigate any potential impacts to Fifth Third customers and its systems. Fifth Third also focuses on the reporting and escalation of operational control issues to senior management and the Board of Directors. The Operational Risk Committee is the key committee that oversees and supports Fifth Third in the management of operational risk across the enterprise. The Operational Risk Committee reports to the ERMC, which reports to the Risk and Compliance Joint Committee of the Board of Directors of Fifth Third Bancorp and Fifth Third Bank. COMPLIANCE RISK MANAGEMENT Regulatory compliance risk is defined as the risk of legal or regulatory sanctions, financial loss or damage to reputation as a result of noncompliance with (i) applicable laws, regulations, rules and other regulatory requirements (including but not limited to the risk of consumers experiencing economic loss or other legal harm as a result of noncompliance with consumer protection laws, regulations and requirements); (ii) internal policies and procedures, standards of best practice or codes of conduct; and (iii) principles of integrity and fair dealing applicable to Fifth Third’s activities and functions. Fifth Third focuses on managing regulatory compliance risk in accordance with the Bancorp’s integrated risk management framework, which ensures consistent processes for identifying, assessing, managing, monitoring and reporting risks. The Bancorp’s risk management goal is to keep compliance risk at appropriate levels consistent with the Bancorp’s risk appetite. 99 Fifth Third Bancorp MANAGEMENT’S DISCUSSION AND ANALYSIS OF FINANCIAL CONDITION AND RESULTS OF OPERATIONS To mitigate compliance risk, Compliance Risk Management provides independent oversight to ensure consistency and sufficiency in the execution of the program, and ensures that lines of business, regions and support functions are adequately identifying, assessing and monitoring compliance risks and adopting proper mitigation strategies. The lines of business and enterprise functions are responsible for managing the compliance risks associated with their areas. Additionally, the Chief Compliance Officer is responsible for establishing and overseeing the Compliance Risk Management program which implements key compliance processes, including but not limited to, executive- and board-level governance and reporting routines, compliance-related policies, risk assessments, key risk indicators, issues tracking, regulatory compliance testing and monitoring, anti-money laundering, privacy and, in partnership with the Community and Economic Development team, oversees the Bancorp’s compliance with the Community Reinvestment Act. Fifth Third also focuses on the reporting and escalation of compliance issues to senior management and the Board of Directors. The Management Compliance Committee, which is chaired by the Chief Compliance Officer, is the key committee that oversees and supports Fifth Third in the management of compliance risk across the enterprise. The Management Compliance Committee oversees Fifth Third-wide compliance issues, industry best practices, legislative developments, regulatory concerns and other leading indicators of compliance risk. The Management Compliance Committee reports to the ERMC, which reports to the Risk and Compliance Joint Committee of the Board of Directors of Fifth Third Bancorp and Fifth Third Bank. CAPITAL MANAGEMENT Management regularly reviews the Bancorp’s capital levels to help ensure it is appropriately positioned under various operating environments. The Bancorp has established a Capital Committee which is responsible for making capital plan recommendations to management. These recommendations are reviewed by the ERMC and the annual capital plan is approved by the Board of Directors. The Capital Committee is responsible for execution and oversight of the capital actions of the capital plan. Regulatory Capital Ratios The Basel III Final Rule was effective for the Bancorp on January 1, 2015 and set minimum regulatory capital ratios as well as defined the measure of “well-capitalized”. On January 1, 2016, the Bancorp became subject to a capital conservation buffer which will be phased in over a three-year period ending January 1, 2019. Once fully phased-in, the capital conservation buffer will be 2.5% in addition to the minimum capital ratios, in order to avoid limitations on certain capital distributions and discretionary bonus payments to executive officers. The capital conservation buffer was 0.625% in 2016, 1.25% in 2017, and is 1.875% in 2018. The Bancorp exceeded these “well-capitalized” and “capital conservation buffer” ratios for all periods presented. In April 2018, the federal banking regulators proposed transitional arrangements to permit banking organizations to phase in the day-one impact of the adoption of ASU 2016-13, referred to as the current expected credit loss model, on regulatory capital over a period of three years. For additional information on ASU 2016-13, refer to Note 1 of the Notes to Consolidated Financial Statements. The Bancorp is evaluating the impact of this proposal. The Bancorp made a one-time permanent election to not include AOCI in regulatory capital in the March 31, 2015 FFIEC 031 and FR Y-9C filings. 100 Fifth Third Bancorp MANAGEMENT’S DISCUSSION AND ANALYSIS OF FINANCIAL CONDITION AND RESULTS OF OPERATIONS The following table summarizes the Bancorp’s capital ratios as of December 31: (a) These are non-GAAP measures. For further information, refer to the Non-GAAP Financial Measures section of MD&A. (b) Under the U.S. banking agencies’ Basel III Final Rule, assets and credit equivalent amounts of off-balance sheet exposures are calculated according to the standardized approach for risk-weighted assets. The resulting values are added together resulting in the Bancorp’s total risk-weighted assets. Under the banking agencies’ Final Rule published in November 2017 pertaining to certain regulatory items for banks subject to the standardized approach, the Bancorp is no longer subject to certain transition provisions and phase-outs beyond 2017. (c) These capital amounts and ratios were calculated under the Supervisory Agencies general risk-based capital rules (Basel I) which were in effect prior to January 1, 2015. (d) Excludes unrealized gains and losses (e) The regulatory capital data and ratios have not been restated as a result of the Bancorp’s change in accounting for investments in affordable housing projects that qualify for low-income housing tax credits (LIHTC). Refer to Note 1 of the Notes to Consolidated Financial Statements for additional information. Stress Tests and CCAR In 2011 the FRB adopted the capital plan rule, which requires BHCs with consolidated assets of $50 billion or more to submit annual capital plans to the FRB for review. Under the rule, these capital plans must include detailed descriptions of the following: the BHC’s internal processes for assessing capital adequacy; the policies governing capital actions such as common stock issuances, dividends and share repurchases; and all planned capital actions over a nine-quarter planning horizon. Further, each BHC must also report to the FRB the results of stress tests conducted by the BHC under a number of scenarios that assess the sources and uses of capital under baseline and stressed economic scenarios. The FRB launched the 2018 stress testing program and CCAR on February 1, 2018, with submissions of stress test results and capital plans to the FRB due on April 5, 2018, which the Bancorp submitted as required. As a CCAR institution, the Bancorp is required to disclose the results of its company-run stress test under the supervisory adverse and supervisory severely adverse scenarios and to provide information related to the types of risk included in its stress testing, a general description of the methodologies used, estimates of certain financial results and pro forma capital ratios, and an explanation of the most significant causes of changes in regulatory capital ratios. On June 21, 2018 the Bancorp publicly disclosed the results of its company-run stress test as required by the DFA stress testing rules, which is available on Fifth Third’s website at www.53.com. With Fifth Third’s designation as a Large and Non-complex Bank, it is no longer subject to the qualitative aspects of the CCAR program. It is, however, subject to the FRB’s Horizontal Capital Review, which was conducted in the third quarter of 2018. Refer to Note 3 and Note 22 of the Notes to Consolidated Financial Statements for a discussion on the FRB’s review of the capital plan, the FRB’s non-objection to the Bancorp’s proposed capital actions and the Bancorp’s capital actions taken in 2018. On May 21, 2018, the Bancorp announced the planned acquisition of MB Financial, Inc. As a result of this transaction, the FRB required the Bancorp to resubmit its CCAR plan recognizing the pro forma impact of the combined Fifth Third/MB Financial, Inc. post-merger entity. On October 5, 2018, Fifth Third resubmitted its capital plan to the FRB. On December 27, 2018, the FRB indicated to the Bancorp that it did not object to the resubmitted capital plan. The resubmitted capital plan called for no change to the originally submitted total capital actions over the 2018 CCAR approval horizon (the third quarter of 2018 through the second quarter of 2019). However, the share repurchase authority increased from $1.651 billion to $1.81 billion as a result of after-tax gains related to the sale of Worldpay, Inc. common stock. In April 2018, the FRB proposed to introduce stress buffer requirements. Under the proposal, a SCB would replace the 2.5% capital conservation buffer. The SCB would reflect stressed losses in the supervisory severely adverse scenario of the FRB’s CCAR stress tests plus four quarters of planned common stock dividends, subject to a floor of 2.5%. The proposal would also introduce a SLB requirement, analogous to the SCB, that would apply to the Tier I leverage ratio. In addition, the proposal would require BHCs to reduce their planned capital distributions if those distributions would not be consistent with the applicable capital buffer constraints based on the BHCs’ own baseline scenario projections. The proposal is applicable for BHCs with $50 billion or more in total consolidated assets, including the Bancorp. Under the proposal, a BHC’s first SCB and SLB requirements would become effective on October 1, 2019. The Bancorp is evaluating the impact of this proposal. Dividend Policy and Stock Repurchase Program The Bancorp’s common stock dividend policy and stock repurchase program reflect its earnings outlook, desired payout ratios, the need to maintain adequate capital levels, the ability of its subsidiaries to pay dividends, the need to comply with safe and sound banking practices as well as meet regulatory requirements and expectations. The Bancorp declared dividends per common share of $0.74 and $0.60 during the years ended December 31, 2018 and 2017, respectively. The Bancorp entered into or settled a number of accelerated share repurchase and open market share repurchase transactions during the years ended December 31, 2018 and 2017. Refer to Note 22 of the Notes to Consolidated Financial Statements for additional information on the accelerated share repurchases and open market share repurchase transactions. 101 Fifth Third Bancorp MANAGEMENT’S DISCUSSION AND ANALYSIS OF FINANCIAL CONDITION AND RESULTS OF OPERATIONS The following table summarizes shares authorized for repurchase as part of publicly announced plans or programs: (a) During the first quarter of 2018, the Bancorp announced that its Board of Directors had authorized management to purchase 100 million shares of the Bancorp’s common stock through the open market or in any private transactions. The authorization does not include specific price targets or an expiration date. This share repurchase authorization replaces the Board’s previous authorization pursuant to which approximately 13 million shares remained available for repurchase by the Bancorp. (b) Excludes 2,155,189 and 2,397,589 shares repurchased during the years ended December 31, 2018 and 2017, respectively, in connection with various employee compensation plans. These purchases are not included in the calculation for average price paid per share and do not count against the maximum number of shares that may yet be repurchased under the Board of Directors’ authorization. 102 Fifth Third Bancorp MANAGEMENT’S DISCUSSION AND ANALYSIS OF FINANCIAL CONDITION AND RESULTS OF OPERATIONS OFF-BALANCE SHEET ARRANGEMENTS In the ordinary course of business, the Bancorp enters into financial transactions that are considered off-balance sheet arrangements as they involve varying elements of market, credit and liquidity risk in excess of the amounts recognized in the Bancorp’s Consolidated Balance Sheets. The Bancorp’s off-balance sheet arrangements include commitments, guarantees, contingent liabilities and transactions with non-consolidated VIEs. A brief discussion of these transactions is as follows: Commitments The Bancorp has certain commitments to make future payments under contracts, including commitments to extend credit, letters of credit, forward contracts related to residential mortgage loans held for sale, noncancelable operating lease obligations, purchase obligations, capital expenditures, capital commitments for private equity investments and capital lease obligations. Refer to Note 16 of the Notes to Consolidated Financial Statements for additional information on commitments. Guarantees and Contingent Liabilities The Bancorp has performance obligations upon the occurrence of certain events provided in certain contractual arrangements, including residential mortgage loans sold with representation and warranty provisions or credit recourse. Refer to Note 16 of the Notes to Consolidated Financial Statements for additional information on guarantees and contingent liabilities. Transactions with Non-consolidated VIEs The Bancorp engages in a variety of activities that involve VIEs, which are legal entities that lack sufficient equity to finance their activities, or the equity investors of the entities as a group lack any of the characteristics of a controlling interest. The investments in those entities in which the Bancorp was determined not to be the primary beneficiary but holds a variable interest in the entity are accounted for under the equity method of accounting or other accounting standards as appropriate and not consolidated. Refer to Note 10 of the Notes to Consolidated Financial Statements for additional information on non-consolidated VIEs. 103 Fifth Third Bancorp MANAGEMENT’S DISCUSSION AND ANALYSIS OF FINANCIAL CONDITION AND RESULTS OF OPERATIONS CONTRACTUAL OBLIGATIONS AND OTHER COMMITMENTS The Bancorp has certain obligations and commitments to make future payments under contracts. The aggregate contractual obligations and commitments at December 31, 2018 are shown in Table 69. As of December 31, 2018, the Bancorp has unrecognized tax benefits that, if recognized, would impact the effective tax rate in future periods. Due to the uncertainty of the amounts to be ultimately paid as well as the timing of such payments, all uncertain tax liabilities that have not been paid have been excluded from the following table. For further detail on the impact of income taxes, refer to Note 19 of the Notes to Consolidated Financial Statements. (a) Interest-bearing obligations are principally used to fund interest-earning assets. Interest charges on contractual obligations were excluded from reported amounts, as the potential cash outflows would have corresponding cash inflows from interest-earning assets. (b) Includes demand, interest checking, savings, money market and foreign office deposits. For additional information, refer to the Deposits subsection of the Balance Sheet Analysis section of MD&A. (c) Includes debt obligations with an original maturity of greater than one year. Refer to Note 15 of the Notes to Consolidated Financial Statements for additional information on these debt instruments. (d) Includes other time deposits and certificates $100,000 and over. For additional information, refer to the Deposits subsection of the Balance Sheet Analysis section of MD&A. (e) Includes federal funds purchased and borrowings with an original maturity of less than one year. For additional information, refer to Note 14 of the Notes to Consolidated Financial Statements. (f) Refer to Note 12 of the Notes to Consolidated Financial Statements for additional information on forward contracts to sell residential mortgage loans. (g) Includes rental commitments. (h) Includes low-income housing and historic tax investments. For additional information, refer to Note 10 of the Notes to Consolidated Financial Statements. (i) Refer to Note 20 of the Notes to Consolidated Financial Statements for additional information on pension obligations. (j) Represents agreements to purchase goods or services and includes commitments to various general contractors for work related to banking center construction. (k) Commitments to extend credit are agreements to lend, typically having fixed expiration dates or other termination clauses that may require payment of a fee. Many of the commitments to extend credit may expire without being drawn upon. The total commitment amounts include capital commitments for private equity investments and do not necessarily represent future cash flow requirements. For additional information, refer to Note 16 of the Notes to Consolidated Financial Statements. (l) Letters of credit are conditional commitments issued to guarantee the performance of a customer to a third party. For additional information, refer to Note 16 of the Notes to Consolidated Financial Statements.

<s>[INST] OVERVIEW This overview of MD&A highlights selected information in the financial results of the Bancorp and may not contain all of the information that is important to you. For a more complete understanding of trends, events, commitments, uncertainties, liquidity, capital resources and critical accounting policies and estimates, you should carefully read this entire document. Each of these items could have an impact on the Bancorp’s financial condition, results of operations and cash flows. In addition, refer to the Glossary of Abbreviations and Acronyms in this report for a list of terms included as a tool for the reader of this annual report on Form 10K. The abbreviations and acronyms identified therein are used throughout this MD&A, as well as the Consolidated Financial Statements and Notes to Consolidated Financial Statements. Net interest income, net interest margin, net interest rate spread and the efficiency ratio are presented in MD&A on an FTE basis. The FTE basis adjusts for the taxfavored status of income from certain loans and securities held by the Bancorp that are not taxable for federal income tax purposes. The Bancorp believes this presentation to be the preferred industry measurement of net interest income as it provides a relevant comparison between taxable and nontaxable amounts. The FTE basis for presenting net interest income is a nonGAAP measure. For further information, refer to the NonGAAP Financial Measures section of MD&A. The Bancorp’s revenues are dependent on both net interest income and noninterest income. For the year ended December 31, 2018, net interest income on an FTE basis and noninterest income provided 60% and 40% of total revenue, respectively. The Bancorp derives the majority of its revenues within the U.S. from customers domiciled in the U.S. Revenue from foreign countries and external customers domiciled in foreign countries was immaterial to the Consolidated Financial Statements. Changes in interest rates, credit quality, economic trends and the capital markets are primary factors that drive the performance of the Bancorp. As discussed later in the Risk Management section of MD&A, risk identification, assessment, management, monitoring and independent governance reporting of risk are important to the management of risk and to the financial performance and capital strength of the Bancorp. Net interest income is the difference between interest income earned on assets such as loans, leases and securities, and interest expense incurred on liabilities such as deposits, other shortterm borrowings and longterm debt. Net interest income is affected by the general level of interest rates, the relative level of shortterm and longterm interest rates, changes in interest rates and changes in the amount and composition of interestearning assets and interestbearing liabilities. Generally, the rates of interest the Bancorp earns on its assets and pays on its liabilities are established for a period of time. The change in market interest rates over time exposes the Bancorp to interest rate risk through potential adverse changes to net interest income and financial position. The Bancorp manages this risk by continually analyzing and adjusting the composition of its assets and liabilities based on their payment streams and interest rates, the timing of their maturities and their sensitivity to changes in market interest rates. Additionally, in the ordinary course of business, the Bancorp enters into certain derivative transactions as part of its overall strategy to manage its interest rate and prepayment risks. The Bancorp is also exposed to the risk of loss on its loan and lease portfolio as a result of changing expected cash flows caused by borrower credit events, such as loan defaults and inadequate collateral. Noninterest income is derived from service charges on deposits, wealth and asset management revenue, corporate banking revenue, card and processing revenue, mortgage banking net revenue, net securities gains or losses and other noninterest income. Noninterest expense includes personnel costs, net occupancy expense, technology and communication costs, card and processing expense, equipment expense and other noninterest expense. Worldpay, Inc. and Worldpay Holding, LLC Transactions On January 16, 2018, Vantiv, Inc. completed its previously announced acquisition of Worldpay Group plc. with the resulting combined company named Worldpay, Inc. As a result of this transaction, the Bancorp recognized a gain of $ [/INST] Negative. </s>

FIFTH THIRD BANCORP

2020-03-02

2019-12-31

ITEM 7. MANAGEMENT’S DISCUSSION AND ANALYSIS OF FINANCIAL CONDITION AND RESULTS OF OPERATIONS (MD&A) The following is Management’s Discussion and Analysis of Financial Condition and Results of Operations of certain significant factors that have affected Fifth Third Bancorp’s (the “Bancorp” or “Fifth Third”) financial condition and results of operations during the periods included in the Consolidated Financial Statements, which are a part of this filing. Reference to the Bancorp incorporates the parent holding company and all consolidated subsidiaries. The Bancorp’s banking subsidiary is referred to as the Bank. OVERVIEW This overview of MD&A highlights selected information in the financial results of the Bancorp and may not contain all of the information that is important to you. For a more complete understanding of trends, events, commitments, uncertainties, liquidity, capital resources and critical accounting policies and estimates, you should carefully read this entire document. Each of these items could have an impact on the Bancorp’s financial condition, results of operations and cash flows. In addition, refer to the Glossary of Abbreviations and Acronyms in this report for a list of terms included as a tool for the reader of this Annual Report on Form 10-K. The abbreviations and acronyms identified therein are used throughout this MD&A, as well as the Consolidated Financial Statements and Notes to Consolidated Financial Statements. Net interest income, net interest margin, net interest rate spread and the efficiency ratio are presented in MD&A on an FTE basis. The FTE basis adjusts for the tax-favored status of income from certain loans and securities held by the Bancorp that are not taxable for federal income tax purposes. The Bancorp believes this presentation to be the preferred industry measurement of net interest income as it provides a relevant comparison between taxable and non-taxable amounts. The FTE basis for presenting net interest income is a non-GAAP measure. For further information, refer to the Non-GAAP Financial Measures section of MD&A. The Bancorp’s revenues are dependent on both net interest income and noninterest income. For the year ended December 31, 2019, net interest income on an FTE basis and noninterest income provided 58% and 42% of total revenue, respectively. The Bancorp derives the majority of its revenues within the U.S. from customers domiciled in the U.S. Revenue from foreign countries and external customers domiciled in foreign countries was immaterial to the Consolidated Financial Statements. Changes in interest rates, credit quality, economic trends and the capital markets are primary factors that drive the performance of the Bancorp. As discussed later in the Risk Management section of MD&A, risk identification, assessment, management, monitoring and independent governance reporting of risk are important to the management of risk and to the financial performance and capital strength of the Bancorp. Net interest income is the difference between interest income earned on assets such as loans, leases and securities, and interest expense incurred on liabilities such as deposits, other short-term borrowings and long-term debt. Net interest income is affected by the general level of interest rates, the relative level of short-term and long-term interest rates, changes in interest rates and changes in the amount and composition of interest-earning assets and interest-bearing liabilities. Generally, the rates of interest the Bancorp earns on its assets and pays on its liabilities are established for a period of time. The change in market interest rates over time exposes the Bancorp to interest rate risk through potential adverse changes to net interest income and financial position. The Bancorp manages this risk by continually analyzing and adjusting the composition of its assets and liabilities based on their payment streams and interest rates, the timing of their maturities and their sensitivity to changes in market interest rates. Additionally, in the ordinary course of business, the Bancorp enters into certain derivative transactions as part of its overall strategy to manage its interest rate and prepayment risks. The Bancorp is also exposed to the risk of loss on its loan and lease portfolio as a result of changing expected cash flows caused by borrower credit events, such as loan defaults and inadequate collateral. Noninterest income is derived from corporate banking revenue, service charges on deposits, wealth and asset management revenue, card and processing revenue, mortgage banking net revenue, net securities gains or losses and other noninterest income. Noninterest expense includes personnel costs, technology and communication costs, net occupancy expense, card and processing expense, equipment expense and other noninterest expense. Acquisition of MB Financial, Inc. On March 22, 2019, Fifth Third Bancorp completed its acquisition of MB Financial, Inc. in a stock and cash transaction valued at approximately $3.6 billion. MB Financial, Inc. was headquartered in Chicago, Illinois with reported assets of approximately $20 billion and 86 branches (91 locations) as of December 31, 2018 and was the holding company of MB Financial Bank, N.A. The acquisition resulted in a combined company with a larger Chicago market presence and core deposit funding base while also building scale in a strategically important market. Under the terms of the agreement, the Bancorp acquired 100% of the common stock of MB Financial, Inc. In exchange, common shareholders of MB Financial, Inc. received 1.45 shares of Fifth Third Bancorp common stock and $5.54 in cash for each share of MB Financial, Inc. common stock, for a total value per share of $42.49, based on the $25.48 closing price of Fifth Third Bancorp’s common stock on March 21, 2019. Upon closing of the transaction, MB Financial, Inc. became a subsidiary of the Bancorp. However, MB Financial, Inc.’s 6.00% non-cumulative Series C perpetual preferred stock with a fair value of $197 million remained outstanding and was recognized as a noncontrolling interest on the Consolidated Balance Sheets. Through its ownership of all of the common stock, the Bancorp controlled 95% of the voting equity interests in MB Financial, Inc. with the remainder attributable to the preferred shareholders’ noncontrolling interest. On June 24, 2019, MB Financial, Inc. entered into an Agreement and Plan of Merger with the Bancorp to provide for the merger of MB Financial, Inc. with and into the Bancorp, with the Bancorp as the surviving corporation. A special meeting of MB Financial, Inc.’s stockholders was held on August 23, 2019 at which the holders of MB Financial, Inc.’s common stock and preferred stock, voting together as a single class, approved the merger. In the merger, each outstanding share of MB Financial, Inc.’s preferred stock was converted into the right to receive one share of a newly created series of preferred stock of the Bancorp having substantially the same terms as the MB Financial, Inc. preferred stock. See the Preferred Stock Transactions section for additional information. The acquisition of MB Financial, Inc. constituted a business combination and was accounted for under the acquisition method of accounting. Accordingly, the assets acquired, liabilities assumed and noncontrolling interest recognized were recorded at their estimated fair values as of the acquisition date. These fair value estimates are considered preliminary as of December 31, 2019. Fair value estimates, including loans and leases, intangible assets, bank premises and equipment, certain tax-related matters and goodwill, are subject to change for up to one year after the acquisition date as additional information becomes available. 44 Fifth Third Bancorp MANAGEMENT’S DISCUSSION AND ANALYSIS OF FINANCIAL CONDITION AND RESULTS OF OPERATIONS Bank Merger On May 3, 2019 MB Financial Bank, N.A. merged with and into Fifth Third Bank (now Fifth Third Bank, National Association), with Fifth Third Bank, National Association as the surviving entity. Fifth Third Bank, National Association is an indirect subsidiary of Fifth Third Bancorp. Worldpay Holding, LLC and Worldpay, Inc. Transactions On March 18, 2019, the Bancorp exchanged its remaining 10,252,826 Class B Units of Worldpay Holding, LLC for 10,252,826 shares of Class A common stock of Worldpay, Inc., and subsequently sold those shares. As a result of this transaction, the Bancorp recognized a gain of $562 million in other noninterest income during the first quarter of 2019. As a result of the sale, the Bancorp no longer beneficially owns any of Worldpay, Inc.’s equity securities. During the fourth quarter of 2019, the Bancorp entered into an agreement with Fidelity National Information Services, Inc. and Worldpay, Inc. under which Worldpay, Inc. may be obligated to pay up to approximately $366 million to the Bancorp to terminate and settle certain remaining TRA cash flows, totaling an estimated $720 million, upon the exercise of certain call options by Worldpay, Inc. or certain put options by the Bancorp (“Worldpay, Inc. TRA transaction”). If exercised, certain of the obligations would be settled with four quarterly payments beginning in April 2020, a second set of the obligations would be settled with four quarterly payments beginning in April 2022, and a third set of the obligations would be settled with four quarterly payments beginning in April 2023. In 2019, the Bancorp recognized a gain of approximately $345 million in other noninterest income associated with these options. This agreement did not impact the TRA payment recognized in the fourth quarter of 2019. Accelerated Share Repurchase Transactions The Bancorp entered into or settled a number of accelerated share repurchase transactions during the year ended December 31, 2019. As part of these transactions, the Bancorp entered into forward contracts in which the final number of shares delivered at settlement was based generally on a discount to the average daily volume weighted-average price of the Bancorp’s common stock during the term of the repurchase agreements. For more information on the accelerated share repurchase program, refer to Note 25 of the Notes to Consolidated Financial Statements. For a summary of the Bancorp’s accelerated share repurchase transactions that were entered into or settled during the year ended December 31, 2019, refer to Table 1. TABLE 1: SUMMARY OF ACCELERATED SHARE REPURCHASE TRANSACTIONS (a) This accelerated share repurchase transaction consisted of two supplemental confirmations each with a notional amount of $456.5 million. (b) This accelerated share repurchase transaction consisted of two supplemental confirmations each with a notional amount of $100 million. Open Market Share Repurchase Transactions Between July 29, 2019 and July 30, 2019, the Bancorp repurchased 1,667,735 shares, or approximately $50 million, of its outstanding common stock through open market repurchase transactions, which settled between July 31, 2019 and August 1, 2019. For more information on the open market share repurchase program, refer to Note 25 of the Notes to Consolidated Financial Statements. Preferred Stock Transactions On August 26, 2019, the Bancorp issued 200,000 shares of 6.00% non-cumulative perpetual Class B preferred stock, Series A. Each preferred share has a $1,000 liquidation preference. These shares were issued to the holders of MB Financial, Inc.’s 6.00% non-cumulative perpetual preferred stock, Series C, in conjunction with the merger of MB Financial, Inc. with and into Fifth Third Bancorp. This transaction resulted in the elimination of the noncontrolling interest in MB Financial, Inc. which was previously reported in the Bancorp’s Consolidated Financial Statements. The newly issued shares of Class B preferred stock, Series A were recognized by the Bancorp at the carrying value previously assigned to the MB Financial, Inc. Series C preferred stock prior to the transaction. On September 17, 2019, the Bancorp issued in a registered public offering 10,000,000 depositary shares, representing 10,000 shares of 4.95% non-cumulative perpetual preferred stock, Series K, for net proceeds of approximately $242 million. Each preferred share has a $25,000 liquidation preference. Subject to any required regulatory approval, the Bancorp may redeem the Series K preferred shares at its option (i) in whole or in part, on any dividend payment date on or after September 30, 2024 and (ii) in whole, but not in part, at any time following a regulatory capital event. The Series K preferred shares are not convertible into Bancorp common shares or any other securities. For more information on preferred stock transactions, refer to Note 25 of the Notes to Consolidated Financial Statements. Senior Notes Offerings On January 25, 2019, the Bancorp issued and sold $1.5 billion of senior notes to third-party investors. The senior notes bear a fixed-rate of interest of 3.65% per annum. The notes are unsecured, senior obligations of the Bancorp. Payment of the full principal amounts of the notes is due upon maturity on January 25, 2024. These fixed-rate senior notes will be redeemable by the Bancorp, in whole or in part, on or after the date that is 30 days prior to the maturity date at a redemption price equal to 100% of the principal amount plus accrued and unpaid interest up to, but excluding, the redemption date. On February 1, 2019, the Bank issued and sold, under its bank notes program, $300 million in unsecured senior floating-rate bank notes due on February 1, 2022. Interest on the floating-rate notes is three-month LIBOR plus 64 bps. These notes will be redeemable by the Bank, in whole or in part, on or after the date that is 30 days prior to the maturity date at a redemption price equal to 100% of the principal amount of the notes to be redeemed plus accrued and unpaid interest up to, but excluding, the redemption date. On October 28, 2019, the Bancorp issued and sold $750 million of senior notes to third-party investors. The senior notes bear a fixed-rate of interest of 2.375% per annum. 45 Fifth Third Bancorp MANAGEMENT’S DISCUSSION AND ANALYSIS OF FINANCIAL CONDITION AND RESULTS OF OPERATIONS The notes are unsecured, senior obligations of the Bancorp. Payment of the full principal amounts of the notes is due upon maturity on January 28, 2025. These notes will be redeemable at the Bancorp’s option, in whole or in part, at any time or from time to time, on or after April 25, 2020, and prior to December 29, 2024, in each case at a redemption price, plus accrued and unpaid interest thereon, if any, to, but excluding, the redemption date, equal to the greater of (i) 100% of the aggregate principal amount of the notes being redeemed on that redemption date; and (ii) the sum of the present values of the remaining scheduled payments of principal and interest on the notes being redeemed that would be due if the notes to be redeemed matured on December 29, 2024 discounted to the redemption date on a semi-annual basis at the applicable treasury rate plus 15 bps. Additionally, these notes will be redeemable by the Bancorp, in whole or in part, on or after the date that is 30 days prior to the maturity date at a redemption price equal to 100% of the principal amount of the notes to be redeemed plus accrued and unpaid interest thereon to, but excluding, the redemption date. For additional information on these senior notes offerings, refer to Note 18 of the Notes to Consolidated Financial Statements. For further information on a subsequent event related to long-term debt, refer to Note 33 of the Notes to Consolidated Financial Statements. Automobile Loan Securitization In a securitization transaction that occurred in 2019, the Bancorp transferred approximately $1.43 billion in automobile loans to a bankruptcy remote trust which subsequently issued approximately $1.37 billion of asset-backed notes, of which approximately $68 million of the asset-backed notes were retained by the Bancorp, resulting in approximately $1.3 billion of outstanding notes included in long-term debt in the Consolidated Balance Sheets. Additionally, the bankruptcy remote trust was deemed to be a VIE and the Bancorp, as the primary beneficiary, consolidated the VIE. The third-party holders of the asset-backed notes do not have recourse to the general assets of the Bancorp. GS Holdings and GreenSky, Inc. Transactions In May 2018, GreenSky, Inc. launched an IPO and issued 38 million shares of Class A common stock for a valuation of $23 per share. In connection with this IPO, the Bancorp’s investment in GreenSky, LLC, which was comprised of 252,550 membership units, was converted to 2,525,498 units of the newly formed GreenSky Holdings, LLC (“GS Holdings”), representing a 1.4% interest in GS Holdings. The Bancorp’s units in GS Holdings were exchangeable on a one-to-one basis for Class A common stock or cash. During the first quarter of 2019, all of the Bancorp’s units in GS Holdings were converted for Class A common stock on a one-to-one basis. The Bancorp sold all of its Class A common stock during 2019 and, therefore, no longer beneficially owns any of GreenSky, Inc.’s equity securities. Conversion to a National Bank Charter On September 10, 2019, Fifth Third Bancorp announced that Fifth Third Bank had received approval from the OCC to convert from an Ohio state-chartered bank to a national bank. The Bank converted to a national bank charter on November 14, 2019. As a result of the conversion, the Bank is subject to supervision and regulation by the OCC and subject to the National Bank Act and is no longer subject to supervision and regulation by the Ohio Division of Financial Institutions. Additionally, while the FRB is no longer the Bank’s primary federal regulator, the Bank remains a member of the Federal Reserve System. LIBOR Transition In July 2017, the Chief Executive of the United Kingdom Financial Conduct Authority (the “FCA”), which regulates LIBOR, announced that FCA will stop persuading or compelling banks to submit rates for the calculation of LIBOR to the administrator of LIBOR after 2021. Since then, central banks around the world, including the Federal Reserve, have commissioned working groups of market participants and official sector representatives with the goal of finding suitable replacements for LIBOR. The Bancorp has substantial exposure to LIBOR-based products within its commercial lending, commercial deposits, business banking, consumer lending, capital markets lines of business and corporate treasury function. It is expected that a transition away from the widespread use of LIBOR to alternative reference rates will occur over the course of the next few years. Although the full impact of such reforms and actions remains unclear, the Bancorp is preparing to transition from LIBOR to these alternative reference rates. The Bancorp’s transition plan includes a number of key work streams, including continued engagement with central bank and industry working groups and regulators, active client engagement, comprehensive review of legacy documentation, internal operational readiness, and risk management, among other things, to facilitate the transition to alternative reference rates. The transition away from LIBOR is expected to be gradual and complicated. There remain a number of unknown factors regarding the transition from LIBOR that could impact the Bancorp’s business, including, for example, the pace of the transition to replacement rates, including industry coalescence around an alternative benchmark, such as SOFR, our ability to identify exposures to LIBOR across our business lines, the specific terms and parameters for any potential alternative reference rates, the prices of and the liquidity of trading markets for products based on the alternative reference rates, our ability to transition to and develop appropriate systems and analytics for one or more alternative reference rates, our ability to maintain contractual continuity and our ability to identify and remediate any operational issues. For a further discussion of the various risks the Bancorp faces in connection with the expected replacement of LIBOR on its operations, see “Risk Factors-Market Risks-The replacement of LIBOR could adversely affect Fifth Third’s revenue or expenses and the value of those assets or obligations.” in Item 1A. Risk Factors of this Annual Report on Form 10-K. Legislative and Regulatory Developments On October 31, 2018, the Board of Governors of the FRB released a series of regulatory proposals to implement the Economic Growth, Regulatory Relief, and Consumer Protection Act (“Reform Act”). Among the proposals, the Board of Governors, joined by the Department of Treasury, OCC and the FDIC proposed to remove the application of the LCR regulations and the NSFR from certain BHCs that qualify under the proposal as “Category IV” institutions, primarily those BHCs with consolidated assets between $100 billion and $250 billion, including Fifth Third Bancorp. On October 10, 2019, the Board of Governors of the FRB announced it finalized the rules that tailor its regulations for banks to more closely match their risk profile. Fifth Third, as a Category IV institution, will no longer be subject to the LCR regulations and the NSFR regulations. The final rules were effective December 31, 2019. In August and September 2019, the five regulatory agencies charged with implementing the Volcker Rule released final amendments to the Volcker Rule regulations that tailor the Volcker Rule’s compliance requirements to the amount of a firm’s trading activity, revise the definition of a trading account, clarify certain key provisions in the Volcker Rule and simplify the information that covered entities are required to provide to regulatory agencies. The Bancorp believes the amendments to the Volcker Rule are not material to its business operations. 46 Fifth Third Bancorp MANAGEMENT’S DISCUSSION AND ANALYSIS OF FINANCIAL CONDITION AND RESULTS OF OPERATIONS TABLE 2: CONDENSED CONSOLIDATED STATEMENTS OF INCOME (a) These are non-GAAP measures. For further information, refer to the Non-GAAP Financial Measures section of MD&A. Earnings Summary The Bancorp’s net income available to common shareholders for the year ended December 31, 2019 was $2.4 billion, or $3.33 per diluted share, which was net of $93 million in preferred stock dividends. The Bancorp’s net income available to common shareholders for the year ended December 31, 2018 was $2.1 billion, or $3.06 per diluted share, which was net of $75 million in preferred stock dividends. Net interest income on an FTE basis (non-GAAP) was $4.8 billion and $4.2 billion for the years ended December 31, 2019 and 2018, respectively. Net interest income was positively impacted by increases in average commercial and industrial loans and average commercial mortgage loans from the year ended December 31, 2018. Additionally, net interest income benefited from an increase in yields on average loans and leases from the year ended December 31, 2018. These positive impacts were partially offset by increases in both the rates paid on and balances of average interest-bearing core deposits and average long-term debt as well as an increase in average certificates $100,000 and over for the year ended December 31, 2019 compared to the year ended December 31, 2018. Additionally, net interest income was negatively impacted by the August 2019, September 2019 and October 2019 decisions of the FOMC to lower the target range of the federal funds rate. Net interest income for the year ended December 31, 2019 included $65 million of amortization and accretion of premiums and discounts on acquired loans and leases and assumed deposits and long-term debt from acquisitions. Net interest margin on an FTE basis (non-GAAP) was 3.31% for the year ended December 31, 2019 compared to 3.22% for the year ended December 31, 2018. Noninterest income increased $746 million for the year ended December 31, 2019 compared to the year ended December 31, 2018 primarily due to increases in other noninterest income, corporate banking revenue, mortgage banking net revenue and wealth and asset management revenue. Other noninterest income increased $337 million for the year ended December 31, 2019 compared to the year ended December 31, 2018 primarily due to the recognition of gains on the sale of Worldpay Inc. shares driven by the Bancorp’s sale of shares during the first quarter of 2019, an increase in the income from the TRA associated with Worldpay, Inc., an increase in operating lease income and a decrease in the net losses on disposition and impairment of bank premises and equipment. These benefits were partially offset by the gain related to Vantiv, Inc.’s acquisition of Worldpay Group plc. recognized during the first quarter of 2018 as well as an increase in the loss on the swap associated with the sale of Visa, Inc. Class B Shares. Corporate banking revenue increased $132 million for the year ended December 31, 2019 compared to the year ended December 31, 2018. The increase from the prior year was primarily driven by increases in leasing business revenue, lease remarketing fees, institutional sales revenue and business lending fees of $50 million, $44 million, $26 million and $21 million, respectively. The increase in leasing business revenue was driven by the acquisition of MB Financial, Inc. These benefits were partially offset by a decrease of $8 million in syndication fees from the year ended December 31, 2018. Mortgage banking net revenue increased $75 million for the year ended December 31, 2019 compared to the year ended December 31, 2018 primarily due to a $75 million increase in origination fees and gains on loan sales due to the lower interest rate environment. Wealth and asset management revenue increased $43 million for the year ended December 31, 2019 compared to the year ended December 31, 2018 primarily due to an increase of $37 million in private client service fees. This increase was driven by increased sales production and strong market performance as well as the full-year benefit from acquisitions in 2018 and the acquisition of MB Financial, Inc. Noninterest expense increased $702 million for the year ended December 31, 2019 compared to the year ended December 31, 2018 primarily due to increases in personnel costs, technology and communications expense and other noninterest expense. Personnel costs increased $303 million for the year ended December 31, 2019 compared to the year ended December 31, 2018 driven by $90 million in merger-related expenses for the year ended December 31, 2019, the addition of personnel costs from the acquisition of MB Financial, Inc. and higher deferred compensation expense. Technology and communications expense increased $137 million for the year ended December 31, 2019 compared to the year ended December 31, 2018 driven by $71 million in merger-related expenses for the year ended December 31, 2019, as well as increased investment in contemporizing information technology architecture, mitigating information security risks and growth initiatives. 47 Fifth Third Bancorp MANAGEMENT’S DISCUSSION AND ANALYSIS OF FINANCIAL CONDITION AND RESULTS OF OPERATIONS Other noninterest expense increased $209 million for the year ended December 31, 2019 compared to the year ended December 31, 2018 and included the impact of an increase of $23 million in merger-related expenses related to the acquisition of MB Financial, Inc. as well as increases in operating lease expense, intangible amortization expense, losses and adjustments and loan and lease expense, partially offset by a decrease in FDIC insurance and other taxes. For more information on net interest income, noninterest income and noninterest expense, refer to the Statements of Income Analysis section of MD&A. Credit Summary The provision for credit losses was $471 million and $207 million for the years ended December 31, 2019 and 2018, respectively. Net losses charged-off as a percent of average portfolio loans and leases remained at 0.35% for both the years ended December 31, 2019 and 2018. At December 31, 2019, nonperforming portfolio assets as a percent of portfolio loans and leases and OREO increased to 0.62% compared to 0.41% at December 31, 2018. For further discussion on credit quality, refer to the Credit Risk Management subsection of the Risk Management section of MD&A. Capital Summary The Bancorp’s capital ratios exceed the “well-capitalized” guidelines as defined by the U.S. banking agencies. As of December 31, 2019, as calculated under the Basel III standardized approach, the CET1 capital ratio was 9.75%, the Tier I risk-based capital ratio was 10.99%, the Total risk-based capital ratio was 13.84% and the Tier I leverage ratio was 9.54%. NON-GAAP FINANCIAL MEASURES The following are non-GAAP measures which provide useful insight to the reader of the Consolidated Financial Statements but should be supplemental to primary U.S. GAAP measures and should not be read in isolation or relied upon as a substitute for the primary U.S. GAAP measures. The FTE basis adjusts for the tax-favored status of income from certain loans and securities held by the Bancorp that are not taxable for federal income tax purposes. The Bancorp believes this presentation to be the preferred industry measurement of net interest income as it provides a relevant comparison between taxable and non-taxable amounts. The following table reconciles the non-GAAP financial measures of net interest income on an FTE basis, interest income on an FTE basis, net interest margin, net interest rate spread and the efficiency ratio to U.S. GAAP: TABLE 3: NON-GAAP FINANCIAL MEASURES - FINANCIAL MEASURES AND RATIOS ON AN FTE BASIS The Bancorp believes return on average tangible common equity is an important measure for comparative purposes with other financial institutions, but is not defined under U.S. GAAP, and therefore is considered a non-GAAP financial measure. This measure is useful for evaluating the performance of a business as it calculates the return available to common shareholders without the impact of intangible assets and their related amortization. The Bancorp also measures average tangible common equity excluding AOCI. The Bancorp believes this is a useful return measure as it calculates the return available to common shareholders without the impact of intangible assets, their related amortization as well as the volatility primarily associated with fluctuations of unrealized gains and losses on the Bancorp’s available-for-sale debt and other securities and cash flow hedge derivatives. 48 Fifth Third Bancorp MANAGEMENT’S DISCUSSION AND ANALYSIS OF FINANCIAL CONDITION AND RESULTS OF OPERATIONS The following table reconciles the non-GAAP financial measure of return on average tangible common equity to U.S. GAAP: TABLE 4: NON-GAAP FINANCIAL MEASURE - RETURN ON AVERAGE TANGIBLE COMMON EQUITY The Bancorp considers various measures when evaluating capital utilization and adequacy, including the tangible equity ratio and tangible common equity ratio, in addition to capital ratios defined by the U.S. banking agencies. These calculations are intended to complement the capital ratios defined by the U.S. banking agencies for both absolute and comparative purposes. Because U.S. GAAP does not include capital ratio measures, the Bancorp believes there are no comparable U.S. GAAP financial measures to these ratios. These ratios are not formally defined by U.S. GAAP or codified in the federal banking regulations and, therefore, are considered to be non-GAAP financial measures. The Bancorp encourages readers to consider its Consolidated Financial Statements in their entirety and not to rely on any single financial measure. The following table reconciles non-GAAP capital ratios to U.S. GAAP: TABLE 5: NON-GAAP FINANCIAL MEASURES - CAPITAL RATIOS 49 Fifth Third Bancorp MANAGEMENT’S DISCUSSION AND ANALYSIS OF FINANCIAL CONDITION AND RESULTS OF OPERATIONS RECENT ACCOUNTING STANDARDS Note 1 of the Notes to Consolidated Financial Statements provides a discussion of the significant new accounting standards applicable to the Bancorp during 2019 and the expected impact of significant accounting standards issued, but not yet required to be adopted. CRITICAL ACCOUNTING POLICIES The Bancorp’s Consolidated Financial Statements are prepared in accordance with U.S. GAAP. Certain accounting policies require management to exercise judgment in determining methodologies, economic assumptions and estimates that may materially affect the Bancorp’s financial position, results of operations and cash flows. The Bancorp’s critical accounting policies include the accounting for the ALLL, reserve for unfunded commitments, valuation of servicing rights, fair value measurements, goodwill and legal contingencies. There have been no material changes to the valuation techniques or models described below during the year ended December 31, 2019. ALLL The Bancorp disaggregates its portfolio loans and leases into portfolio segments for purposes of determining the ALLL. The Bancorp’s portfolio segments include commercial, residential mortgage and consumer. The Bancorp further disaggregates its portfolio segments into classes for purposes of monitoring and assessing credit quality based on certain risk characteristics. For an analysis of the Bancorp’s ALLL by portfolio segment and credit quality information by class, refer to Note 7 of the Notes to Consolidated Financial Statements. The Bancorp maintains the ALLL to absorb probable loan and lease losses inherent in its portfolio segments. The ALLL is maintained at a level the Bancorp considers to be adequate and is based on ongoing quarterly assessments and evaluations of the collectability and historical loss experience of loans and leases. Credit losses are charged and recoveries are credited to the ALLL. Provisions for loan and lease losses are based on the Bancorp’s review of the historical credit loss experience and such factors that, in management’s judgment, deserve consideration under existing economic conditions in estimating probable credit losses. The Bancorp’s strategy for credit risk management includes a combination of conservative exposure limits significantly below legal lending limits and conservative underwriting, documentation and collections standards. The strategy also emphasizes diversification on a geographic, industry and customer level, regular credit examinations and quarterly management reviews of large credit exposures and loans experiencing deterioration of credit quality. The Bancorp’s methodology for determining the ALLL requires significant management judgment and is based on historical loss rates, current credit grades, specific allocation on loans modified in a TDR and impaired commercial credits above specified thresholds and other qualitative adjustments. Allowances on individual commercial loans and leases, TDRs and historical loss rates are reviewed quarterly and adjusted as necessary based on changing borrower and/or collateral conditions and actual collection and charge-off experience. An unallocated allowance is maintained to recognize the imprecision in estimating and measuring losses when evaluating allowances for pools of loans and leases. Larger commercial loans and leases included within aggregate borrower relationship balances exceeding $1 million that exhibit probable or observed credit weaknesses, as well as loans that have been modified in a TDR, are subject to individual review for impairment. The Bancorp considers the current value of collateral, credit quality of any guarantees, the guarantor’s liquidity and willingness to cooperate, the loan or lease structure and other factors when evaluating whether an individual loan or lease is impaired. Other factors may include the industry and geographic region of the borrower, size and financial condition of the borrower, cash flow and leverage of the borrower and the Bancorp’s evaluation of the borrower’s management. When individual loans and leases are impaired, allowances are determined based on management’s estimate of the borrower’s ability to repay the loan or lease given the availability of collateral and other sources of cash flow, as well as an evaluation of legal options available to the Bancorp. Allowances for impaired loans and leases are measured based on the present value of expected future cash flows discounted at the loan’s effective interest rate, fair value of the underlying collateral or readily observable secondary market values. The Bancorp evaluates the collectability of both principal and interest when assessing the need for a loss accrual. Historical credit loss rates are applied to commercial loans and leases that are not impaired or are impaired, but smaller than the established threshold of $1 million and thus not subject to specific allowance allocations. The loss rates are derived from migration analyses for several portfolio stratifications, which track the historical net charge-off experience sustained on loans and leases according to their internal risk grade. The risk grading system utilized for allowance analysis purposes encompasses ten categories. Homogenous loans in the residential mortgage and consumer portfolio segments are not individually risk graded. Rather, standard credit scoring systems and delinquency monitoring are used to assess credit risks and allowances are established based on the expected net charge-offs. Loss rates are based on the trailing twelve-month net charge-off history by loan category. Historical loss rates may be adjusted for certain prescriptive and qualitative factors that, in management’s judgment, are necessary to reflect losses inherent in the portfolio. The prescriptive loss rate factors include adjustments for delinquency trends, LTV trends, refreshed FICO score trends and product mix. The Bancorp also considers qualitative factors in determining the ALLL. These include adjustments for changes in policies or procedures in underwriting, monitoring or collections, economic conditions, portfolio mix, lending and risk management personnel, results of internal audit and quality control reviews, collateral values, geographic concentrations, estimated loss emergence period and specific portfolio loans backed by enterprise valuations and private equity sponsors. The Bancorp considers home price index trends in its footprint and the volatility of collateral valuation trends when determining the collateral value qualitative factor. When evaluating the adequacy of allowances, consideration is given to regional geographic concentrations and the closely associated effect changing economic conditions have on the Bancorp’s customers. Refer to the Allowance for Credit Losses subsection of the Risk Management section of MD&A for a discussion on the Bancorp’s ALLL sensitivity analysis. Reserve for Unfunded Commitments The reserve for unfunded commitments is maintained at a level believed by management to be sufficient to absorb estimated probable losses related to unfunded credit facilities and is included in other liabilities in the Consolidated Balance Sheets. The determination of the adequacy of the reserve is based upon an evaluation of the unfunded credit facilities, including an assessment of historical commitment utilization experience, credit risk grading and historical loss rates based on credit grade migration. 50 Fifth Third Bancorp MANAGEMENT’S DISCUSSION AND ANALYSIS OF FINANCIAL CONDITION AND RESULTS OF OPERATIONS This process takes into consideration the same risk elements that are analyzed in the determination of the adequacy of the Bancorp’s ALLL, as previously discussed. Net adjustments to the reserve for unfunded commitments are included in provision for credit losses in the Consolidated Statements of Income. Valuation of Servicing Rights When the Bancorp sells loans through either securitizations or individual loan sales in accordance with its investment policies, it often obtains servicing rights. The Bancorp may also purchase servicing rights. The Bancorp has elected to measure all existing classes of its servicing rights at fair value at each reporting date with changes in the fair value of servicing rights reported in earnings in the period in which the changes occur. Servicing rights are valued using internal OAS models. Significant management judgment is necessary to identify key economic assumptions used in estimating the fair value of the servicing rights including the prepayment speeds of the underlying loans, the weighted-average life, the OAS and the weighted-average coupon rate, as applicable. The primary risk of material changes to the value of the servicing rights resides in the potential volatility in the economic assumptions used, particularly the prepayment speeds. In order to assist in the assessment of the fair value of servicing rights, the Bancorp obtains external valuations of the servicing rights portfolio from third parties and participates in peer surveys that provide additional confirmation of the reasonableness of key assumptions utilized in the internal OAS model. For additional information on servicing rights, refer to Note 14 of the Notes to Consolidated Financial Statements. Fair Value Measurements The Bancorp measures certain financial assets and liabilities at fair value in accordance with U.S. GAAP, which defines fair value as the price that would be received to sell an asset or paid to transfer a liability in an orderly transaction between market participants at the measurement date. The Bancorp employs various valuation approaches to measure fair value including the market, income and cost approaches. The market approach uses prices or relevant information generated by market transactions involving identical or comparable assets or liabilities. The income approach involves discounting future amounts to a single present amount and is based on current market expectations about those future amounts. The cost approach is based on the amount that currently would be required to replace the service capacity of the asset. U.S. GAAP establishes a fair value hierarchy, which prioritizes the inputs to valuation techniques used to measure fair value into three broad levels. The fair value hierarchy gives the highest priority to quoted prices in active markets for identical assets or liabilities (Level 1) and the lowest priority to unobservable inputs (Level 3). A financial instrument’s categorization within the fair value hierarchy is based upon the lowest level of input that is significant to the instrument’s fair value measurement. For additional information on the fair value hierarchy and fair value measurements, refer to Note 1 of the Notes to Consolidated Financial Statements. The Bancorp’s fair value measurements involve various valuation techniques and models, which involve inputs that are observable, when available. Valuation techniques and parameters used for measuring assets and liabilities are reviewed and validated by the Bancorp on a quarterly basis. Additionally, the Bancorp monitors the fair values of significant assets and liabilities using a variety of methods including the evaluation of pricing runs and exception reports based on certain analytical criteria, comparison to previous trades and overall review and assessments for reasonableness. The level of management judgment necessary to determine fair value varies based upon the methods used in the determination of fair value. Financial instruments that are measured at fair value using quoted prices in active markets (Level 1) require minimal judgment. The valuation of financial instruments when quoted market prices are not available (Levels 2 and 3) may require significant management judgment to assess whether quoted prices for similar instruments exist, the impact of changing market conditions including reducing liquidity in the capital markets and the use of estimates surrounding significant unobservable inputs. Table 6 provides a summary of the fair value of financial instruments carried at fair value on a recurring basis and the amounts of financial instruments valued using Level 3 inputs. TABLE 6: FAIR VALUE SUMMARY Refer to Note 29 of the Notes to Consolidated Financial Statements for further information on fair value measurements including a description of the valuation methodologies used for significant financial instruments. Goodwill Business combinations entered into by the Bancorp typically include the acquisition of goodwill. U.S. GAAP requires goodwill to be tested for impairment at the Bancorp’s reporting unit level on an annual basis, which for the Bancorp is September 30, and more frequently if events or circumstances indicate that there may be impairment. Refer to Note 1 of the Notes to Consolidated Financial Statements for a discussion on the methodology used by the Bancorp to assess goodwill for impairment. Impairment exists when a reporting unit’s carrying amount of goodwill exceeds its implied fair value. In testing goodwill for impairment, U.S. GAAP permits the Bancorp to first assess qualitative factors to determine whether it is more likely than not that the fair value of a reporting unit is less than its carrying amount. In this qualitative assessment, the Bancorp evaluates events and circumstances which may include, but are not limited to, the general economic environment, banking industry and market conditions, the overall financial performance of the Bancorp, the performance of the Bancorp’s common stock, the key financial performance metrics of the Bancorp’s reporting units and events affecting the reporting units to determine if it is not more likely than not that the fair value of a reporting unit is less than its carrying amount. If the two-step impairment test is required or the decision to bypass the qualitative assessment is elected, the Bancorp would be required to perform the first step (Step 1) of the goodwill impairment test by comparing the fair value of a reporting unit with its carrying amount, including goodwill. If the carrying amount of the reporting unit exceeds its fair value, Step 2 of the goodwill impairment test is performed to measure the amount of impairment loss, if any. 51 Fifth Third Bancorp MANAGEMENT’S DISCUSSION AND ANALYSIS OF FINANCIAL CONDITION AND RESULTS OF OPERATIONS The fair value of a reporting unit is the price that would be received to sell the unit as a whole in an orderly transaction between market participants at the measurement date. As none of the Bancorp’s reporting units are publicly traded, individual reporting unit fair value determinations cannot be directly correlated to the Bancorp’s stock price. The determination of the fair value of a reporting unit is a subjective process that involves the use of estimates and judgments, particularly related to cash flows, the appropriate discount rates and an applicable control premium. The Bancorp employs an income-based approach, utilizing the reporting unit’s forecasted cash flows (including a terminal value approach to estimate cash flows beyond the final year of the forecast) and the reporting unit’s estimated cost of equity as the discount rate. Significant management judgment is necessary in the preparation of each reporting unit’s forecasted cash flows surrounding expectations for earnings projections, growth and credit loss expectations and actual results may differ from forecasted results. Additionally, the Bancorp determines its market capitalization based on the average of the closing price of the Bancorp’s stock during the month including the measurement date, incorporating an additional control premium, and compares this market-based fair value measurement to the aggregate fair value of the Bancorp’s reporting units in order to corroborate the results of the income approach. When required to perform Step 2, the Bancorp compares the implied fair value of a reporting unit’s goodwill with the carrying amount of that goodwill. If the carrying amount exceeds the implied fair value, an impairment loss equal to that excess amount is recognized. A recognized impairment loss cannot exceed the carrying amount of that goodwill and cannot be reversed in future periods even if the fair value of the reporting unit subsequently recovers. During Step 2, the Bancorp determines the implied fair value of goodwill for a reporting unit by assigning the fair value of the reporting unit to all of the assets and liabilities of that unit (including any unrecognized intangible assets) as if the reporting unit had been acquired in a business combination. Significant management judgment is necessary in the identification and valuation of unrecognized intangible assets and the valuation of the reporting unit’s recorded assets and liabilities. The excess of the fair value of the reporting unit over the amounts assigned to its assets and liabilities is the implied fair value of goodwill. This assignment process is only performed for purposes of testing goodwill for impairment. The Bancorp does not adjust the carrying values of recognized assets or liabilities (other than goodwill, if appropriate), nor does it recognize previously unrecognized intangible assets in the Consolidated Financial Statements as a result of this assignment process. Refer to Note 11 of the Notes to Consolidated Financial Statements for further information regarding the Bancorp’s goodwill. Legal Contingencies The Bancorp and its subsidiaries are parties to numerous claims and lawsuits as well as threatened or potential actions or claims concerning matters arising from the conduct of its business activities. The outcome of claims or litigation and the timing of ultimate resolution are inherently difficult to predict and significant judgment may be required in the determination of both the probability of loss and whether the amount of the loss is reasonably estimable. The Bancorp’s estimates are subjective and are based on the status of legal and regulatory proceedings, the merit of the Bancorp’s defenses and consultation with internal and external legal counsel. An accrual for a potential litigation loss is established when information related to the loss contingency indicates both that a loss is probable and that the amount of loss can be reasonably estimated. Refer to Note 20 of the Notes to Consolidated Financial Statements for further information regarding the Bancorp’s legal proceedings. 52 Fifth Third Bancorp MANAGEMENT’S DISCUSSION AND ANALYSIS OF FINANCIAL CONDITION AND RESULTS OF OPERATIONS STATEMENTS OF INCOME ANALYSIS Net Interest Income Net interest income is the interest earned on loans and leases (including yield-related fees), securities and other short-term investments less the interest paid for core deposits (includes transaction deposits and other time deposits) and wholesale funding (includes certificates $100,000 and over, other deposits, federal funds purchased, other short-term borrowings and long-term debt). The net interest margin is calculated by dividing net interest income by average interest-earning assets. Net interest rate spread is the difference between the average yield earned on interest-earning assets and the average rate paid on interest-bearing liabilities. Net interest margin is typically greater than net interest rate spread due to the interest income earned on those assets that are funded by noninterest-bearing liabilities, or free funding, such as demand deposits or shareholders’ equity. Tables 7 and 8 present the components of net interest income, net interest margin and net interest rate spread for the years ended December 31, 2019, 2018 and 2017, as well as the relative impact of changes in the average balance sheet and changes in interest rates on net interest income. Nonaccrual loans and leases and loans and leases held for sale have been included in the average loan and lease balances. Average outstanding securities balances are based on amortized cost with any unrealized gains or losses included in average other assets. Net interest income on an FTE basis (non-GAAP) was $4.8 billion and $4.2 billion for the years ended December 31, 2019 and 2018, respectively. Net interest income was positively impacted by increases in average commercial and industrial loans and average commercial mortgage loans of $7.5 billion and $3.2 billion, respectively, from the year ended December 31, 2018. Additionally, net interest income benefited from an increase in yields on average loans and leases of 34 bps from the year ended December 31, 2018. These positive impacts were partially offset by increases in both the rates paid on and balances of average interest-bearing core deposits and average long-term debt as well as an increase in average certificates $100,000 and over for the year ended December 31, 2019 compared to the year ended December 31, 2018. The rates paid on average interest-bearing core deposits increased 26 bps and average interest-bearing core deposits increased $12.9 billion from the year ended December 31, 2018. The rates paid on average long-term debt increased 24 bps and average long-term debt increased $818 million from the year ended December 31, 2018. Average certificates $100,000 and over increased $2.1 billion from the year ended December 31, 2018. Additionally, net interest income was negatively impacted by the August 2019, September 2019 and October 2019 decisions of the FOMC to lower the target range of the federal funds rate. Net interest income for the year ended December 31, 2019 included $65 million of amortization and accretion of premiums and discounts on acquired loans and leases and assumed deposits and long-term debt from acquisitions. Net interest rate spread on an FTE basis (non-GAAP) was 2.92% during the year ended December 31, 2019 compared to 2.87% during the year ended December 31, 2018. Yields on average interest-earning assets increased 28 bps, partially offset by a 23 bps increase in rates paid on average interest-bearing liabilities for the year ended December 31, 2019 compared to the year ended December 31, 2018. Net interest margin on an FTE basis (non-GAAP) was 3.31% for the year ended December 31, 2019 compared to 3.22% for the year ended December 31, 2018. The increase for the year ended December 31, 2019 was driven primarily by the previously mentioned increase in the net interest rate spread as well as an increase in average free funding balances. The increase in average free funding balances was driven by increases in average shareholders’ equity and average demand deposits of $4.0 billion and $1.7 billion, respectively, for the year ended December 31, 2019 compared to the year ended December 31, 2018. Interest income on an FTE basis (non-GAAP) from loans and leases increased $975 million compared to the year ended December 31, 2018 primarily due to the aforementioned increases in the balances of average commercial and industrial loans and average commercial mortgage loans as well as the increase in yields on average loans and leases. For more information on the Bancorp’s loan and lease portfolio, refer to the Loans and Leases subsection of the Balance Sheet Analysis section of MD&A. Interest income on an FTE basis (non-GAAP) from investment securities and other short-term investments increased $97 million from the year ended December 31, 2018 primarily as a result of an increase in average taxable securities. Interest expense on core deposits increased $301 million for the year ended December 31, 2019 compared to the year ended December 31, 2018 primarily due to the previously mentioned increases in both the cost and balances of average interest-bearing core deposits. The increases in both the cost and balances of average interest-bearing core deposits were primarily due to increases in the rates paid on and balances of both average interest checking deposits and average money market deposits. Refer to the Deposits subsection of the Balance Sheet Analysis section of MD&A for additional information on the Bancorp’s deposits. Interest expense on wholesale funding increased $113 million for the year ended December 31, 2019 compared to the year ended December 31, 2018 primarily due to the aforementioned increase in the rates paid on and balances of average long-term debt and increases in average certificates $100,000 and over. These increases were partially offset by a decrease in average other short-term borrowings of $565 million for the year ended December 31, 2019 compared to the year ended December 31, 2018. Refer to the Borrowings subsection of the Balance Sheet Analysis section of MD&A for additional information on the Bancorp’s borrowings. Average wholesale funding represented 21% and 23% of average interest-bearing liabilities during the years ended December 31, 2019 and 2018, respectively. For more information on the Bancorp’s interest rate risk management, including estimated earnings sensitivity to changes in market interest rates, see the Market Risk Management subsection of the Risk Management section of MD&A. 53 Fifth Third Bancorp MANAGEMENT’S DISCUSSION AND ANALYSIS OF FINANCIAL CONDITION AND RESULTS OF OPERATIONS TABLE 7: CONSOLIDATED AVERAGE BALANCE SHEET AND ANALYSIS OF NET INTEREST INCOME ON AN FTE BASIS (a) The FTE adjustments included in the above table were $17 , $16 and $26 for the years ended December 31, 2019 , 2018 and 2017, respectively. (b) Net interest income (FTE), net interest margin (FTE) and net interest rate spread (FTE) are non-GAAP measures. For further information, refer to the Non-GAAP Financial Measures section of MD&A. 54 Fifth Third Bancorp MANAGEMENT’S DISCUSSION AND ANALYSIS OF FINANCIAL CONDITION AND RESULTS OF OPERATIONS (a) Changes in interest not solely due to volume or yield/rate are allocated in proportion to the absolute dollar amount of change in volume and yield/rate. Provision for Credit Losses The Bancorp provides as an expense an amount for probable credit losses within the loan and lease portfolio and the portfolio of unfunded loan commitments and letters of credit that is based on factors previously discussed in the Critical Accounting Policies section of MD&A. The provision is recorded to bring the ALLL and reserve for unfunded commitments to a level deemed appropriate by the Bancorp to cover losses inherent in the portfolios. Actual credit losses on loans and leases are charged against the ALLL. The amount of loans and leases actually removed from the Consolidated Balance Sheets is referred to as a charge-off. Net charge-offs include current period charge-offs less recoveries on previously charged-off loans and leases. The provision for credit losses was $471 million for the year ended December 31, 2019 compared to $207 million for the same period in the prior year. The increase in provision expense for the year ended December 31, 2019 compared to the prior year was primarily due to increases in specific reserves on certain impaired commercial loans and the level of commercial criticized assets as well as increases in both outstanding loan balances and unfunded commitments in 2019, exclusive of loans and leases acquired in the MB Financial, Inc. acquisition. The ALLL increased $99 million from December 31, 2018 to $1.2 billion at December 31, 2019. At December 31, 2019, the ALLL as a percent of portfolio loans and leases decreased to 1.10%, compared to 1.16% at December 31, 2018. This decrease reflects the impact of the MB Financial, Inc. acquisition, which added approximately $13.4 billion in portfolio loans and leases at the acquisition date. Loans acquired by the Bancorp through a purchase business combination are recorded at fair value as of the acquisition date. The Bancorp does not carry over the acquired company’s ALLL, nor does the Bancorp add to its existing ALLL as part of purchase accounting. The reserve for unfunded commitments increased $13 million from December 31, 2018 to $144 million at December 31, 2019. This increase reflects the impact of the MB Financial, Inc. acquisition, which included approximately $8 million in reserves for unfunded commitments at the acquisition date. Refer to the Credit Risk Management subsection of the Risk Management section of MD&A as well as Note 7 of the Notes to Consolidated Financial Statements for more detailed information on the provision for credit losses, including an analysis of loan and lease portfolio composition, nonperforming assets, net charge-offs and other factors considered by the Bancorp in assessing the credit quality of the loan and lease portfolio, ALLL, and reserve for unfunded commitments. 55 Fifth Third Bancorp MANAGEMENT’S DISCUSSION AND ANALYSIS OF FINANCIAL CONDITION AND RESULTS OF OPERATIONS Noninterest Income Noninterest income increased $746 million for the year ended December 31, 2019 compared to the year ended December 31, 2018. The following table presents the components of noninterest income: TABLE 9: COMPONENTS OF NONINTEREST INCOME Corporate banking revenue Corporate banking revenue increased $132 million for the year ended December 31, 2019 compared to the year ended December 31, 2018. The increase from the prior year was primarily driven by increases in leasing business revenue, lease remarketing fees, institutional sales revenue and business lending fees of $50 million, $44 million, $26 million and $21 million, respectively. The increase in leasing business revenue was driven by the acquisition of MB Financial, Inc. These benefits were partially offset by a decrease of $8 million in syndication fees from the year ended December 31, 2018. Service charges on deposits Service charges on deposits increased $16 million for the year ended December 31, 2019 compared to the year ended December 31, 2018 primarily due to an increase of $31 million in commercial deposit fees, partially offset by a decrease of $14 million in consumer deposit fees. Wealth and asset management revenue Wealth and asset management revenue increased $43 million for the year ended December 31, 2019 compared to the year ended December 31, 2018 primarily due to an increase of $37 million in private client service fees. This increase was driven by increased sales production and strong market performance as well as the full-year benefit from acquisitions in 2018 and the acquisition of MB Financial, Inc. The Bancorp’s trust and registered investment advisory businesses had approximately $413 billion and $356 billion in total assets under care as of December 31, 2019 and 2018, respectively, and managed $49 billion and $37 billion in assets for individuals, corporations and not-for-profit organizations as of December 31, 2019 and 2018, respectively. Card and processing revenue Card and processing revenue increased $31 million for the year ended December 31, 2019 compared to the year ended December 31, 2018 primarily driven by increases in the number of actively used cards, customer spend volume and other interchange revenue. Mortgage banking net revenue Mortgage banking net revenue increased $75 million for the year ended December 31, 2019 compared to the year ended December 31, 2018. The following table presents the components of mortgage banking net revenue: TABLE 10: COMPONENTS OF MORTGAGE BANKING NET REVENUE Origination fees and gains on loan sales increased $75 million for the year ended December 31, 2019 compared to the year ended December 31, 2018 driven by an increase in originations due to the lower interest rate environment. Residential mortgage loan originations increased to $11.6 billion for the year ended December 31, 2019 from $7.1 billion for the year ended December 31, 2018. Net mortgage servicing revenue remained flat for the year ended December 31, 2019 compared to the year ended December 31, 2018 as an increase in gross mortgage servicing fees of $51 million was offset by an increase in net negative valuation adjustments of $51 million from the year ended 2018. Refer to Table 11 for the components of net valuation adjustments on the MSR portfolio and the impact of the non-qualifying hedging strategy. 56 Fifth Third Bancorp MANAGEMENT’S DISCUSSION AND ANALYSIS OF FINANCIAL CONDITION AND RESULTS OF OPERATIONS TABLE 11: COMPONENTS OF NET VALUATION ADJUSTMENTS ON MSRs Mortgage rates decreased during the year ended December 31, 2019 which caused modeled prepayment speeds to rise. The fair value of the MSR portfolio decreased $203 million due to changes to inputs to the valuation model including prepayment speeds and OAS assumptions and decreased $173 million due to the passage of time, including the impact of regularly scheduled repayments, paydowns and payoffs for the year ended December 31, 2019. Mortgage rates increased during the year ended December 31, 2018 which caused modeled prepayment speeds to slow. The fair value of the MSR portfolio increased $42 million due to changes to inputs to the valuation model including prepayment speeds and OAS assumptions and decreased $125 million due to the passage of time, including the impact of regularly scheduled repayments, paydowns and payoffs for the year ended December 31, 2018. Further detail on the valuation of MSRs can be found in Note 14 of the Notes to Consolidated Financial Statements. The Bancorp maintains a non-qualifying hedging strategy to manage a portion of the risk associated with changes in the valuation of the MSR portfolio. Refer to Note 15 of the Notes to Consolidated Financial Statements for more information on the free-standing derivatives used to economically hedge the MSR portfolio. In addition to the derivative positions used to economically hedge the MSR portfolio, the Bancorp acquires various securities as a component of its non-qualifying hedging strategy. The Bancorp recognized net gains of $3 million during the year ended December 31, 2019, and net losses of $15 million during the year ended December 31, 2018, recorded in securities gains (losses), net - non-qualifying hedges on MSRs in the Bancorp’s Consolidated Statements of Income. The Bancorp’s total residential mortgage loans serviced at December 31, 2019 and 2018 were $98.4 billion and $79.2 billion, respectively, with $80.7 billion and $63.2 billion, respectively, of residential mortgage loans serviced for others. Other noninterest income The following table presents the components of other noninterest income: TABLE 12: COMPONENTS OF OTHER NONINTEREST INCOME Other noninterest income increased $337 million for the year ended December 31, 2019 compared to the year ended December 31, 2018 primarily due to the recognition of gains on the sale of Worldpay Inc. shares driven by the Bancorp’s sale of shares during the first quarter of 2019, an increase in the income from the TRA associated with Worldpay, Inc., an increase in operating lease income and a decrease in the net losses on disposition and impairment of bank premises and equipment. These benefits were partially offset by the gain related to Vantiv, Inc.’s acquisition of Worldpay Group plc. recognized during the first quarter of 2018 as well as an increase in the loss on the swap associated with the sale of Visa, Inc. Class B Shares. The Bancorp recognized a $562 million gain on the sale of Worldpay, Inc. shares for the year ended December 31, 2019 compared to a $205 million gain on the sale of Worldpay, Inc. shares for the year ended December 31, 2018. Income from the TRA associated with Worldpay Inc. increased $326 million from the year ended December 31, 2018 primarily driven by a $345 million gain recognized in the fourth quarter of 2019 from the Worldpay, Inc. TRA transaction. For additional information, refer to Note 21 of the Notes to Consolidated Financial Statements. Operating lease income increased $67 million during the year ended December 31, 2019 compared to the year ended December 31, 2018 driven by the acquisition of MB Financial, Inc. Net losses on disposition and impairment of bank premises and equipment decreased $20 million during the year ended December 31, 2019 compared to the same period in the prior year driven by the impact of impairment charges of $28 million during the year ended December 31, 2019 compared to $45 million during the year ended December 31, 2018. For more information, refer to Note 8 of the Notes to Consolidated Financial Statements. 57 Fifth Third Bancorp MANAGEMENT’S DISCUSSION AND ANALYSIS OF FINANCIAL CONDITION AND RESULTS OF OPERATIONS The Bancorp recognized a $414 million gain related to Vantiv, Inc.’s acquisition of Worldpay Group plc. during the year ended December 31, 2018. For the year ended December 31, 2019, the Bancorp recognized negative valuation adjustments of $107 million related to the Visa total return swap compared to negative valuation adjustments of $59 million during the year ended December 31, 2018. The increase from the prior year was primarily due to the impact of litigation developments during 2019 and an increase in Visa, Inc.’s share price. For additional information on the valuation of the swap associated with the sale of Visa, Inc. Class B Shares, refer to Note 19, Note 20 and Note 29 of the Notes to Consolidated Financial Statements. Noninterest Expense Noninterest expense increased $702 million for the year ended December 31, 2019 compared to the year ended December 31, 2018, primarily due to increases in personnel costs (salaries, wages and incentives plus employee benefits), technology and communications expense and other noninterest expense. The following table presents the components of noninterest expense: TABLE 13: COMPONENTS OF NONINTEREST EXPENSE (a) This is a non-GAAP measure. For further information, refer to the Non-GAAP Financial Measures section of MD&A. The Bancorp recognized $222 million and $31 million of merger-related expenses related to the MB Financial, Inc. acquisition for the years ended December 31, 2019 and 2018, respectively. The following table provides a summary of merger-related expenses recorded in noninterest expense: TABLE 14: MERGER-RELATED EXPENSES Personnel costs increased $303 million for the year ended December 31, 2019 compared to the year ended December 31, 2018 driven by $90 million in merger-related expenses for the year ended December 31, 2019, the addition of personnel costs from the acquisition of MB Financial, Inc. and higher deferred compensation expense. Full-time equivalent employees totaled 19,869 at December 31, 2019 compared to 17,437 at December 31, 2018. Technology and communications expense increased $137 million for the year ended December 31, 2019 compared to the year ended December 31, 2018 driven by $71 million in merger-related expenses for the year ended December 31, 2019, as well as increased investment in contemporizing information technology architecture, mitigating information security risks and growth initiatives. 58 Fifth Third Bancorp MANAGEMENT’S DISCUSSION AND ANALYSIS OF FINANCIAL CONDITION AND RESULTS OF OPERATIONS The following table presents the components of other noninterest expense: TABLE 15: COMPONENTS OF OTHER NONINTEREST EXPENSE Other noninterest expense increased $209 million for the year ended December 31, 2019 compared to the year ended December 31, 2018 and included the impact of an increase of $23 million of merger-related expenses related to the acquisition of MB Financial, Inc. as well as increases in operating lease expense, intangible amortization expense, losses and adjustments, and loan and lease expense, partially offset by a decrease in FDIC insurance and other taxes. Operating lease expense and intangible amortization expense increased $48 million and $40 million, respectively, for the year ended December 31, 2019 compared to the year ended December 31, 2018 primarily driven by the acquisition of MB Financial, Inc. Losses and adjustments increased $41 million for the year ended December 31, 2019 compared to the year ended December 31, 2018 primarily driven by increases in credit valuation adjustments on derivatives as well as legal settlements. Loan and lease expense increased $30 million for the year ended December 31, 2019 compared to the year ended December 31, 2018 primarily as a result of an increase in loan closing costs due to an increase in residential mortgage loan originations. FDIC insurance and other taxes decreased $38 million for the year ended December 31, 2019 compared to the year ended December 31, 2018 primarily due to the elimination of the FDIC surcharge in the fourth quarter of 2018. Applicable Income Taxes Applicable income tax expense for all periods includes the benefit from tax-exempt income, tax-advantaged investments, certain gains on sales of leveraged leases that are exempt from federal taxation and tax credits (and other related tax benefits), partially offset by the effect of proportional amortization of qualifying LIHTC investments and certain nondeductible expenses. The tax credits are associated with the Low-Income Housing Tax Credit program established under Section 42 of the IRC, the New Markets Tax Credit program established under Section 45D of the IRC, the Rehabilitation Investment Tax Credit program established under Section 47 of the IRC and the Qualified Zone Academy Bond program established under Section 1397E of the IRC. The effective tax rates for the years ended December 31, 2019 and 2018 were primarily impacted by $160 million and $189 million, respectively, of low-income housing tax credits and other tax benefits and $40 million and $23 million, respectively, of tax benefits from tax exempt income, and were partially offset by $140 million and $154 million, respectively, of proportional amortization related to qualifying LIHTC investments. The increase in the effective tax rate for the year ended December 31, 2019 from 2018 was impacted by the increase in state income taxes. The effective tax rate for the year ended December 31, 2017 was impacted by a $253 million benefit from the remeasurement of deferred taxes as a result of the reduction in the federal income tax rate from 35 percent to 21 percent for years beginning after December 31, 2017. The U.S. government enacted comprehensive tax legislation, the TCJA, on December 22, 2017. The TCJA made broad and complex changes to the U.S. tax code including, but not limited to, reducing the federal statutory corporate tax rate from 35 percent to 21 percent effective for tax years beginning after December 31, 2017. U.S. GAAP requires the Bancorp to recognize the tax effects of changes in tax laws and rates on its deferred taxes in the period in which the law is enacted. As a result, for the year ended December 31, 2017, the Bancorp remeasured its deferred tax assets and liabilities and recognized an income tax benefit of approximately $253 million. For the year ended December 31, 2017, the Bancorp was subject to a federal statutory corporate tax rate of 35 percent. For years beginning after December 31, 2017, the Bancorp is subject to a federal statutory corporate tax rate of 21 percent. For stock-based awards, U.S. GAAP requires that the tax consequences for the difference between the expense recognized for financial reporting and the Bancorp’s actual tax deduction for the stock-based awards be recognized through income tax expense in the interim periods in which they occur. The Bancorp cannot predict its stock price or whether and when its employees will exercise stock-based awards in the future. Based on its stock price at December 31, 2019, the Bancorp estimates that it may be necessary to recognize $6 million of additional income tax benefit over the next twelve months related to the settlement of stock-based awards, primarily in the first half of 2020. However, the amount of income tax expense or benefit recognized upon settlement may vary significantly from expectations based on the Bancorp’s stock price and the number of SARs exercised by employees. 59 Fifth Third Bancorp MANAGEMENT’S DISCUSSION AND ANALYSIS OF FINANCIAL CONDITION AND RESULTS OF OPERATIONS The Bancorp’s income before income taxes, applicable income tax expense and effective tax rate are as follows: TABLE 16: APPLICABLE INCOME TAXES 60 Fifth Third Bancorp MANAGEMENT’S DISCUSSION AND ANALYSIS OF FINANCIAL CONDITION AND RESULTS OF OPERATIONS BUSINESS SEGMENT REVIEW The Bancorp reports on four business segments: Commercial Banking, Branch Banking, Consumer Lending and Wealth and Asset Management. Additional information on each business segment is included in Note 32 of the Notes to Consolidated Financial Statements. Results of the Bancorp’s business segments are presented based on its management structure and management accounting practices. The structure and accounting practices are specific to the Bancorp; therefore, the financial results of the Bancorp’s business segments are not necessarily comparable with similar information for other financial institutions. The Bancorp refines its methodologies from time to time as management’s accounting practices and businesses change. The Bancorp manages interest rate risk centrally at the corporate level. By employing an FTP methodology, the business segments are insulated from most benchmark interest rate volatility, enabling them to focus on serving customers through the origination of loans and acceptance of deposits. The FTP methodology assigns charge and credit rates to classes of assets and liabilities, respectively, based on the estimated amount and timing of cash flows for each transaction. Assigning the FTP rate based on matching the duration of cash flows allocates interest income and interest expense to each business segment so its resulting net interest income is insulated from future changes in benchmark interest rates. The Bancorp’s FTP methodology also allocates the contribution to net interest income of the asset-generating and deposit-providing businesses on a duration-adjusted basis to better attribute the driver of the performance. As the asset and liability durations are not perfectly matched, the residual impact of the FTP methodology is captured in General Corporate and Other. The charge and credit rates are determined using the FTP rate curve, which is based on an estimate of Fifth Third’s marginal borrowing cost in the wholesale funding markets. The FTP curve is constructed using the U.S. swap curve, brokered CD pricing and unsecured debt pricing. The Bancorp adjusts the FTP charge and credit rates as dictated by changes in interest rates for various interest-earning assets and interest-bearing liabilities and by the review of behavioral assumptions, such as prepayment rates on interest-earning assets and the estimated durations for indeterminate-lived deposits. Key assumptions, including the credit rates provided for deposit accounts, are reviewed annually. Credit rates for deposit products and charge rates for loan products may be reset more frequently in response to changes in market conditions. The credit rates for several deposit products were reset January 1, 2019 to reflect the current market rates and updated market assumptions. These rates were generally higher than those in place during 2018, thus net interest income for deposit-providing business segments was positively impacted during 2019. FTP charge rates on assets were affected by the prevailing level of interest rates and by the duration and repricing characteristics of the portfolio. As overall market rates increased, the FTP charge increased for asset-generating business segments during 2019. The Bancorp’s methodology for allocating provision for credit losses expense to the business segments includes charges or benefits associated with changes in criticized commercial loan levels in addition to actual net charge-offs experienced by the loans and leases owned by each business segment. Provision for credit losses expense attributable to loan and lease growth and changes in ALLL factors is captured in General Corporate and Other. The financial results of the business segments include allocations for shared services and headquarters expenses. Additionally, the business segments form synergies by taking advantage of cross-sell opportunities and funding operations by accessing the capital markets as a collective unit. The following table summarizes net income (loss) by business segment: 61 Fifth Third Bancorp MANAGEMENT’S DISCUSSION AND ANALYSIS OF FINANCIAL CONDITION AND RESULTS OF OPERATIONS Commercial Banking Commercial Banking offers credit intermediation, cash management and financial services to large and middle-market businesses and government and professional customers. In addition to the traditional lending and depository offerings, Commercial Banking products and services include global cash management, foreign exchange and international trade finance, derivatives and capital markets services, asset-based lending, real estate finance, public finance, commercial leasing and syndicated finance. The following table contains selected financial data for the Commercial Banking segment: TABLE 18: COMMERCIAL BANKING (a) Includes FTE adjustments of $17 , $16 and $26 for the years ended December 31, 2019, 2018 and 2017, respectively. (b) Applicable income tax expense for all periods includes the tax benefit from tax-exempt income, tax-advantaged investments and tax credits partially offset by the effect of certain nondeductible expenses. Refer to the Applicable Income Taxes subsection of the Statements of Income Analysis section of MD&A for additional information. Comparison of the year ended 2019 with 2018 Net income was $1.4 billion for the year ended December 31, 2019 compared to net income of $1.1 billion for the year ended December 31, 2018. The increase in net income was driven by increases in net interest income on an FTE basis and noninterest income partially offset by increases in noninterest expense and provision for credit losses. Net interest income on an FTE basis increased $648 million from the year ended December 31, 2018 primarily driven by increases in both average balances and yields on commercial loans and leases, increases in FTP credits on interest checking deposits and increases in FTP credit rates on demand deposits. These increases were partially offset by increases in FTP charges on loans and leases and increases in both average balances and rates paid on interest checking deposits. Provision for credit losses increased $209 million from the year ended December 31, 2018 driven by the impact of an increase in criticized asset levels partially offset by a decrease in net charge-offs on commercial and industrial loans. Net charge-offs as a percent of average portfolio loans and leases decreased to 14 bps for the year ended December 31, 2019 compared to 18 bps for the year ended December 31, 2018. Noninterest income increased $270 million from the year ended December 31, 2018 driven by increases in corporate banking revenue, other noninterest income and service charges on deposits. Corporate banking revenue increased $133 million from the year ended December 31, 2018 driven by increases in leasing business revenue, lease remarketing fees, institutional sales revenue and business lending fees. Other noninterest income increased $102 million from the year ended December 31, 2018 primarily due to increases in operating lease income, card and processing revenue and private equity investment income. Service charges on deposits increased $35 million from the year ended December 31, 2018 primarily driven by an increase in commercial deposit fees. Noninterest expense increased $358 million from the year ended December 31, 2018 due to increases in other noninterest expense and personnel costs. Other noninterest expense increased $236 million from the year ended December 31, 2018 primarily due to increases in corporate overhead allocations, operating lease expense, intangible amortization expense and losses and adjustments. Personnel costs increased $122 million from the year ended December 31, 2018 due to increases in base compensation and incentive compensation primarily as a result of the MB Financial, Inc. acquisition as well as an increase in employee benefits expense. Average commercial loans and leases increased $10.7 billion from the year ended December 31, 2018 primarily due to increases in average commercial and industrial loans and average commercial mortgage loans. Average commercial and industrial loans increased $7.4 billion from the year ended December 31, 2018 primarily as a result of the acquisition of MB Financial, Inc. as well as an increase in loan originations. Average commercial mortgage loans increased $3.2 billion from the year ended December 31, 2018 as a result of the acquisition of MB Financial, Inc. and increases in loan originations as well as permanent financing from the Bancorp’s commercial construction loan portfolio. Average core deposits increased $6.6 billion from the year ended December 31, 2018 primarily driven by increases in average interest checking deposits and average savings and money market deposits partially offset by decreases in average foreign office deposits and average demand deposits. 62 Fifth Third Bancorp MANAGEMENT’S DISCUSSION AND ANALYSIS OF FINANCIAL CONDITION AND RESULTS OF OPERATIONS Average interest checking deposits increased $6.1 billion from the year ended December 31, 2018 primarily due to balance migration from demand deposit accounts and an increase in average balances per commercial customer account as well as the acquisition of MB Financial, Inc. Average savings and money market deposits increased $776 million from the year ended December 31, 2018 primarily due to the acquisition of MB Financial, Inc. and an increase in average balances per commercial customer account. Average foreign office deposits decreased $153 million from the year ended December 31, 2018 driven by balance migration into interest checking deposits. Average demand deposits decreased $136 million from the year ended December 31, 2018 primarily driven by balance migration into interest checking deposits partially offset by the acquisition of MB Financial, Inc. Comparison of the year ended 2018 with 2017 Net income was $1.1 billion for the year ended December 31, 2018 compared to net income of $827 million for the year ended December 31, 2017. The increase in net income was driven by increases in noninterest income and net interest income on an FTE basis and a decrease in the provision for credit losses partially offset by an increase in noninterest expense. Net interest income on an FTE basis increased $51 million from the year ended December 31, 2017 primarily driven by increases in yields on average commercial loans and leases and increases in FTP credits on interest checking deposits. These increases were partially offset by increases in FTP charge rates on loans and leases, increases in the rates paid on core deposits and decreases in FTP credits on demand deposits driven by lower average balances. Provision for credit losses decreased $64 million from the year ended December 31, 2017 primarily driven by a decrease in commercial criticized asset levels as well as a decrease in net charge-offs. Net charge-offs as a percent of average portfolio loans and leases decreased to 18 bps for the year ended December 31, 2018 compared to 19 bps for the year ended December 31, 2017. Noninterest income increased $79 million from the year ended December 31, 2017 primarily driven by an increase in corporate banking revenue and other noninterest income partially offset by a decrease in service charges on deposits. Corporate banking revenue increased $84 million from the year ended December 31, 2017 driven by increases in lease remarketing fees, institutional sales revenue, syndication fees, contract revenue from commercial customer derivatives and foreign exchange fees partially offset by decreases in letter of credit fees and business lending fees. The increase in lease remarketing fees for the year ended December 31, 2018 included the impact of $52 million of impairment charges related to certain operating lease assets that were recognized during the year ended December 31, 2017. Other noninterest income increased $9 million from the year ended December 31, 2017 primarily due to an increase in private equity investment income. Service charges on deposits decreased $14 million from the year ended December 31, 2017. Noninterest expense increased $29 million from the year ended December 31, 2017 due to an increase in personnel costs partially offset by a decrease in other noninterest expense. Personnel costs increased $50 million from the year ended December 31, 2017 primarily due to increased incentive compensation and base compensation. Other noninterest expense decreased $21 million from the year ended December 31, 2017 primarily due to the impact of gains and losses on partnership investments and decreases in operating lease expense and consulting expense partially offset by an increase in corporate overhead allocations. Average commercial loans increased $1.0 billion from the year ended December 31, 2017 primarily due to increases in average commercial and industrial loans and average commercial construction loans partially offset by decreases in average commercial leases and average commercial mortgage loans. Average commercial and industrial loans increased $973 million from the year ended December 31, 2017 as a result of an increase in loan originations, a decrease in payoffs and an increase in drawn balances on existing revolving lines of credit. Average commercial construction loans increased $404 million from the year ended December 31, 2017 primarily due to increases in draw levels on existing commitments. Average commercial leases decreased $218 million from the year ended December 31, 2017 primarily as a result of a planned reduction in indirect non-relationship based lease originations. Average commercial mortgage loans decreased $154 million from the year ended December 31, 2017 due to an increase in paydowns in the fourth quarter of 2017 and lower loan origination activity through the first two quarters of 2018. Average core deposits decreased $1.1 billion from the year ended December 31, 2017. The decrease was driven by decreases in average demand deposits of $3.0 billion and average savings and money market deposits of $1.2 billion compared to the year ended December 31, 2017 primarily due to lower average balances per account. These decreases were partially offset by an increase in average interest checking deposits of $3.1 billion compared to the year ended December 31, 2017 primarily due to balance migration from demand deposit accounts and an increase in average balances per commercial customer account as well as the acquisition of new commercial customers. 63 Fifth Third Bancorp MANAGEMENT’S DISCUSSION AND ANALYSIS OF FINANCIAL CONDITION AND RESULTS OF OPERATIONS Branch Banking Branch Banking provides a full range of deposit and loan products to individuals and small businesses through 1,149 full-service banking centers. Branch Banking offers depository and loan products, such as checking and savings accounts, home equity loans and lines of credit, credit cards and loans for automobiles and other personal financing needs, as well as products designed to meet the specific needs of small businesses, including cash management services. The following table contains selected financial data for the Branch Banking segment: TABLE 19: BRANCH BANKING Comparison of the year ended 2019 with 2018 Net income was $860 million for the year ended December 31, 2019 compared to net income of $702 million for the year ended December 31, 2018. The increase was driven by increases in net interest income and noninterest income partially offset by increases in noninterest expense and provision for credit losses. Net interest income increased $337 million from the year ended December 31, 2018. The increase was primarily due to increases in FTP credits on core deposits and certificates $100,000 and over as well as increases in average balances of other consumer loans and credit card. These benefits were partially offset by increases in both the rates paid on and average balances of savings and money market deposits and other time deposits and certificates $100,000 and over as well as an increase in FTP charge rates on loans and leases. Provision for credit losses increased $53 million from the year ended December 31, 2018 primarily due to increases in net charge-offs on credit card and other consumer loans. Net charge-offs as a percent of average portfolio loans and leases increased to 144 bps for the year ended December 31, 2019 compared to 114 bps for the year ended December 31, 2018. Noninterest income increased $48 million from the year ended December 31, 2018 driven by increases in other noninterest income, card and processing revenue and wealth and asset management revenue partially offset by a decrease in service charges on deposits. Other noninterest income increased $36 million from the year ended December 31, 2018 primarily due to the impact of impairment on bank premises and equipment recognized during 2018. Card and processing revenue increased $19 million from the year ended December 31, 2018 primarily driven by increases in the number of actively used cards and customer spend volume. Wealth and asset management revenue increased $8 million from the year ended December 31, 2018 primarily driven by increases in brokerage fees and private client service fees. Service charges on deposits decreased $15 million from the year ended December 31, 2018 due to a decrease in consumer deposit fees partially offset by an increase in commercial deposit fees. Noninterest expense increased $132 million from the year ended December 31, 2018 primarily due to increases in other noninterest expense and personnel costs. Other noninterest expense increased $69 million from the year ended December 31, 2018 primarily due to increases in corporate overhead allocations, intangible amortization expense and loan and lease expense partially offset by a decrease in FDIC insurance and other taxes. Personnel costs increased $65 million from the year ended December 31, 2018 due to higher base compensation primarily as a result of the MB Financial, Inc. acquisition as well as increases in employee benefits expense and incentive compensation. Average consumer loans increased $166 million from the year ended December 31, 2018 primarily driven by an increase in average other consumer loans of $649 million primarily due to growth in point-of-sale loan originations. This increase was partially offset by decreases in average home equity loans of $303 million and average residential mortgage loans of $259 million as payoffs exceeded loan production. Average core deposits increased $7.0 billion from the year ended December 31, 2018 primarily driven by growth in average savings and money market deposits of $3.7 billion and growth in average demand deposits of $1.5 billion. These increases were primarily due to the acquisition of MB Financial, Inc. as well as promotional product offerings, which drove consumer customer acquisition and growth in balances from existing customers. 64 Fifth Third Bancorp MANAGEMENT’S DISCUSSION AND ANALYSIS OF FINANCIAL CONDITION AND RESULTS OF OPERATIONS The increase in average core deposits also included an increase in interest checking deposits of $529 million from the year ended December 31, 2018 primarily as a result of the acquisition of MB Financial, Inc. Average other time deposits and certificates $100,000 and over increased $2.2 billion from the year ended December 31, 2018 primarily as a result of the acquisition of MB Financial, Inc. as well as promotional product offerings, which drove increased production. Comparison of the year ended 2018 with 2017 Net income was $702 million for the year ended December 31, 2018 compared to net income of $455 million for the year ended December 31, 2017. The increase was driven by an increase in net interest income partially offset by increases in noninterest expense and provision for credit losses. Net interest income increased $252 million from the year ended December 31, 2017. The increase was primarily due to increases in FTP credit rates on core deposits as well as increases in interest income on other consumer loans driven by higher average balances. These benefits were partially offset by increases in FTP charge rates on loans and leases and increases in the rates paid on savings and money market deposits. In addition, the increase in net interest income was partially offset by the impact of a $12 million benefit in the first quarter of 2017 related to a revised estimate of refunds to be offered to certain bankcard customers. Provision for credit losses increased $18 million from the year ended December 31, 2017 primarily due to an increase in net charge-offs on other consumer loans and credit card. Net charge-offs as a percent of average portfolio loans and leases increased to 114 bps for the year ended December 31, 2018 compared to 102 bps for the year ended December 31, 2017. Noninterest income decreased $2 million from the year ended December 31, 2017 primarily driven by a decrease in other noninterest income partially offset by increases in card and processing revenue, service charges on deposits and wealth and asset management revenue. Other noninterest income decreased $36 million from the year ended December 31, 2017 primarily due to the impact of impairments on bank premises and equipment. Card and processing revenue increased $15 million from the year ended December 31, 2017 primarily driven by increases in the number of actively used cards and customer spend volume. Service charges on deposits increased $10 million from the year ended December 31, 2017 primarily due to an increase in consumer deposit fees. Wealth and asset management revenue increased $9 million from the year ended December 31, 2017 primarily driven by increases in private client service fees and brokerage fees. Noninterest expense increased $47 million from the year ended December 31, 2017 primarily due to increases in other noninterest expense and personnel costs. Other noninterest expense increased $46 million from the year ended December 31, 2017 primarily due to increases in corporate overhead allocations and loan and lease expense. Personnel costs increased $10 million from the year ended December 31, 2017 primarily due to higher base compensation driven by an increase in the Bancorp’s minimum wage as a result of benefits received from the TCJA. Average consumer loans increased $26 million from the year ended December 31, 2017 primarily driven by an increase in average other consumer loans of $1.0 billion primarily due to growth in point-of-sale loan originations. This increase from the year ended December 31, 2017 was partially offset by decreases in average home equity loans of $530 million and average residential mortgage loans of $310 million as payoffs exceeded new loan production. Average core deposits increased $2.6 billion from the year ended December 31, 2017 primarily driven by growth in average savings and money market deposits of $1.9 billion and growth in average demand deposits of $441 million. Average savings and money market deposits increased as a result of promotional rate offers facilitated by the rising-rate environment and growth in the Fifth Third Preferred Banking program. Average demand deposits increased primarily due to an increase in average balances per customer account and the acquisition of new customers driven by increased marketing efforts. Other time deposits and certificates $100,000 and over increased $383 million from the year ended December 31, 2017 primarily due to shifting customer preferences as a result of the rising-rate environment. 65 Fifth Third Bancorp MANAGEMENT’S DISCUSSION AND ANALYSIS OF FINANCIAL CONDITION AND RESULTS OF OPERATIONS Consumer Lending Consumer Lending includes the Bancorp’s residential mortgage, automobile and other indirect lending activities. Residential mortgage activities within Consumer Lending include the origination, retention and servicing of residential mortgage loans, sales and securitizations of those loans, pools of loans, and all associated hedging activities. Residential mortgages are primarily originated through a dedicated sales force and through third-party correspondent lenders. Automobile and other indirect lending activities include extending loans to consumers through automobile dealers, motorcycle dealers, powersport dealers, recreational vehicle dealers and marine dealers. The following table contains selected financial data for the Consumer Lending segment: TABLE 20: CONSUMER LENDING Comparison of the year ended 2019 with 2018 Net income was $92 million for the year ended December 31, 2019 compared to a net loss of $1 million for the year ended December 31, 2018. The increase was driven by increases in noninterest income and net interest income partially offset by increases in noninterest expense and provision for credit losses. Net interest income increased $88 million from the year ended December 31, 2018 primarily driven by increases in both yields on and average balances of indirect secured consumer loans and residential mortgage loans as well as an increase in FTP credits on demand deposits. These benefits were partially offset by increases in FTP charges on loans and leases. Provision for credit losses increased $7 million from the year ended December 31, 2018 primarily driven by an increase in net charge-offs on indirect secured consumer loans partially offset by a decrease in net charge-offs on residential mortgage loans. Net charge-offs as a percent of average portfolio loans and leases increased to 22 bps for the year ended December 31, 2019 compared to 21 bps for the year ended December 31, 2018. Noninterest income increased $91 million from the year ended December 31, 2018 driven by increases in mortgage banking net revenue and other noninterest income. Mortgage banking net revenue increased $73 million from the year ended December 31, 2018 primarily driven by an increase in origination fees and gains on loan sales. Refer to the Noninterest Income subsection of the Statements of Income Analysis section of MD&A for additional information on the fluctuations in mortgage banking net revenue. Other noninterest income increased $18 million from the year ended December 31, 2018 primarily due to the recognition of $3 million of gains on securities acquired as a component of the Bancorp’s non-qualifying hedging strategy of MSRs during the year ended December 31, 2019 compared to the recognition of $15 million of losses during the year ended December 31, 2018. Noninterest expense increased $53 million from the year ended December 31, 2018 primarily due to an increase in other noninterest expense primarily driven by increases in corporate overhead allocations, loan and lease expense and losses and adjustments. Average consumer loans increased $2.6 billion from the year ended December 31, 2018 primarily driven by increases in average indirect secured consumer loans and average residential mortgage loans. Average indirect secured consumer loans increased $1.4 billion from the year ended December 31, 2018 primarily driven by the acquisition of MB Financial, Inc. and higher loan production exceeding payoffs. Average residential mortgage loans increased $1.2 billion from the year ended December 31, 2018 primarily driven by the acquisition of MB Financial, Inc. Comparison of the year ended 2018 with 2017 Consumer Lending incurred a net loss of $1 million for the year ended December 31, 2018 compared to net income of $17 million for the year ended December 31, 2017. The decrease was driven by a decrease in noninterest income partially offset by a decrease in noninterest expense. Net interest income decreased $3 million from the year ended December 31, 2017 primarily driven by an increase in FTP charge rates on loans and leases partially offset by increases in yields on average automobile loans and average residential mortgage loans. Provision for credit losses increased $2 million from the year ended December 31, 2017. Net charge-offs as a percent of average portfolio loans and leases increased to 21 bps for the year ended December 31, 2018 compared to 20 bps for the year ended December 31, 2017. Noninterest income decreased $32 million from the year ended December 31, 2017 driven by decreases in other noninterest income and mortgage banking net revenue. Other noninterest income decreased $21 million from the year ended December 31, 2017 primarily due to an increase in the loss on securities acquired as a component of the Bancorp’s non-qualifying hedging strategy of MSRs resulting from increased interest rates. Mortgage banking net revenue decreased $11 million from the year ended December 31, 2017 primarily driven by a decrease in mortgage origination fees and gains on loan sales partially offset by an increase in net mortgage servicing revenue. 66 Fifth Third Bancorp MANAGEMENT’S DISCUSSION AND ANALYSIS OF FINANCIAL CONDITION AND RESULTS OF OPERATIONS Noninterest expense decreased $9 million from the year ended December 31, 2017 driven by a decrease in other noninterest expense partially offset by an increase in personnel costs. Other noninterest expense decreased $12 million from the year ended December 31, 2017 primarily due to decreases in corporate overhead allocations and operational losses. Personnel costs increased $3 million from the year ended December 31, 2017 primarily due to an increase in base compensation. Average consumer loans decreased $4 million from the year ended December 31, 2017. Average indirect secured consumer loans decreased $263 million from the year ended December 31, 2017 as payoffs exceeded new loan production due to a strategic shift focusing on improving risk-adjusted returns. Average home equity decreased $50 million from the year ended December 31, 2017 as the vintage portfolio continued to pay down. Average residential mortgage loans increased $309 million from the year ended December 31, 2017 primarily driven by the continued retention of certain agency conforming ARMs and certain other fixed-rate loans. Wealth and Asset Management Wealth and Asset Management provides a full range of investment alternatives for individuals, companies and not-for-profit organizations. Wealth and Asset Management is made up of four main businesses: FTS, an indirect wholly-owned subsidiary of the Bancorp; Fifth Third Insurance Agency; Fifth Third Private Bank; and Fifth Third Institutional Services. FTS offers full service retail brokerage services to individual clients and broker-dealer services to the institutional marketplace. Fifth Third Insurance Agency assists clients with their financial and risk management needs. Fifth Third Private Bank offers wealth management strategies to high net worth and ultra-high net worth clients through wealth planning, investment management, banking, insurance, trust and estate services. Fifth Third Institutional Services provides advisory services for institutional clients including middle market businesses, non-profits, states and municipalities. The following table contains selected financial data for the Wealth and Asset Management segment: TABLE 21: WEALTH AND ASSET MANAGEMENT Comparison of the year ended 2019 with 2018 Net income was $112 million for the year ended December 31, 2019 compared to net income of $97 million for the year ended December 31, 2018. The increase in net income was driven by an increase in noninterest income as well as a decrease in provision for credit losses partially offset by an increase in noninterest expense. Net interest income remained flat for the year ended December 31, 2019 compared to the year ended December 31, 2018. Net interest income was positively impacted by increases in FTP credits on interest checking deposits and savings and money market deposits as well as increases in both yields on and average balances of loans and leases. These positive impacts were offset by an increase in the rates paid on interest checking deposits as well as an increase in FTP charges on loans and leases. Provision for credit losses decreased $12 million from the year ended December 31, 2018 driven by a decrease in net charge-offs on commercial and industrial loans. This decrease was partially offset by the impact of the benefit of lower criticized asset levels for the year ended December 31, 2018. Noninterest income increased $33 million from the year ended December 31, 2018 due to an increase in wealth and asset management revenue partially offset by a decrease in other noninterest income. Wealth and asset management revenue increased $40 million from the year ended December 31, 2018 primarily due to an increase in private client service fees driven by increased sales production and strong market performance as well as the full-year benefit from acquisitions in 2018 and the acquisition of MB Financial, Inc. Other noninterest income decreased $7 million from the year ended December 31, 2018 primarily due to a loss on sale of a business recognized during the second quarter of 2019. Noninterest expense increased $25 million from the year ended December 31, 2018 due to increases in personnel costs and other noninterest expense. Personnel costs increased $15 million from the year ended December 31, 2018 primarily due to higher base compensation driven by the full-year impact from acquisitions in 2018 and the acquisition of MB Financial, Inc. Other noninterest expense increased $10 million from the year ended December 31, 2018 primarily driven by an increase in corporate overhead allocations partially offset by a decrease in FDIC insurance and other taxes. Average loans and leases increased $159 million from the year ended December 31, 2018 primarily due to an increase in average residential mortgage loans driven by the acquisition of MB Financial, Inc., partially offset by a decrease in average commercial and industrial loans as payoffs exceeded new loan production. Average core deposits increased $369 million from the year ended December 31, 2018 primarily due to an increase in average interest checking deposits primarily as a result of the acquisition of MB Financial, Inc. as well as an increase in average savings and money market deposits. 67 Fifth Third Bancorp MANAGEMENT’S DISCUSSION AND ANALYSIS OF FINANCIAL CONDITION AND RESULTS OF OPERATIONS Comparison of the year ended 2018 with 2017 Net income was $97 million for the year ended December 31, 2018 compared to net income of $65 million for the year ended December 31, 2017. The increase in net income was driven by increases in noninterest income and net interest income partially offset by increases in noninterest expense and the provision for credit losses. Net interest income increased $28 million from the year ended December 31, 2017 primarily due to increases in FTP credit rates on interest checking deposits and savings and money market deposits as well as increases in yields on average loans and leases. These positive impacts were partially offset by increases in the rates paid on interest checking deposits as well as an increase in FTP charge rates on loans and leases. Provision for credit losses increased $6 million from the year ended December 31, 2017 driven by an increase in net charge-offs partially offset by the impact of the benefit of lower commercial criticized assets. Net charge-offs as a percent of average portfolio loans and leases increased to 52 bps for the year ended December 31, 2018 compared to 11 bps for the year ended December 31, 2017. Noninterest income increased $37 million from the year ended December 31, 2017 due to increases in wealth and asset management revenue and other noninterest income. Wealth and asset management revenue increased $22 million from the year ended December 31, 2017 primarily due to increases in private client service fees and brokerage fees. These increases were driven by an increase in average assets under management as a result of market performance and increased asset production. Other noninterest income increased $15 million from the year ended December 31, 2017 due to an increase in insurance income as a result of the full year impact of acquisitions from 2017. Noninterest expense increased $36 million from the year ended December 31, 2017 due to increases in personnel costs and other noninterest expense. Personnel costs increased $21 million from the year ended December 31, 2017 due to higher base compensation and incentive compensation primarily driven by the aforementioned acquisitions completed during 2017. Other noninterest expense increased $15 million from the year ended December 31, 2017 primarily driven by an increase in corporate overhead allocations. Average loans and leases increased $144 million from the year ended December 31, 2017 driven by increases in average commercial and industrial loans and average residential mortgage loans due to increases in loan origination activity. These increases were partially offset by a decline in average home equity balances. Average core deposits increased $550 million from the year ended December 31, 2017 primarily due to increases in average interest checking deposits and average savings and money market deposits. General Corporate and Other General Corporate and Other includes the unallocated portion of the investment securities portfolio, securities gains and losses, certain non-core deposit funding, unassigned equity, unallocated provision for credit losses expense or a benefit from the reduction of the ALLL, the payment of preferred stock dividends and certain support activities and other items not attributed to the business segments. Comparison of the year ended 2019 with 2018 Net interest income decreased $415 million from the year ended December 31, 2018 primarily driven by an increase in FTP credits on deposits allocated to the business segments and increases in interest expense on long-term debt. These negative impacts were partially offset by an increase in the benefit related to FTP charges on loans and leases and an increase in interest income on taxable securities. Provision for credit losses increased $7 million from the year ended December 31, 2018 primarily due to increases in both outstanding loan balances and unfunded commitments in 2019, exclusive of loans and leases acquired in the MB Financial, Inc. acquisition. This was partially offset by an increase in the allocation of provision expense to the business segments driven by an increase in commercial criticized asset levels. Noninterest income increased $309 million from the year ended December 31, 2018 primarily driven by the recognition of a $562 million gain on the sale of Worldpay, Inc. shares for the year ended December 31, 2019 in addition to a $345 million gain recognized in the fourth quarter of 2019 from the Worldpay, Inc. TRA transaction compared to a $205 million gain on the sale of Worldpay, Inc. shares for the year ended December 31, 2018 and a $414 million gain recognized in the first quarter of 2018 related to Vantiv, Inc.’s acquisition of Worldpay Group plc. The increase from the year ended December 31, 2018 also included securities gains of $40 million during the year ended December 31, 2019 compared to securities losses of $54 million during the year ended December 31, 2018. These positive impacts were partially offset by an increase in the loss on the swap associated with the sale of Visa, Inc. Class B Shares. The Bancorp recognized negative valuation adjustments of $107 million related to the Visa total return swap for the year ended December 31, 2019 compared to negative valuation adjustments of $59 million during the year ended December 31, 2018. Noninterest expense increased $139 million from the year ended December 31, 2018. The increase was primarily due to increases in technology and communications expense, personnel costs and net occupancy expense driven by merger-related expenses as a result of the acquisition of MB Financial, Inc. partially offset by an increase in corporate overhead allocations from General Corporate and Other to the other business segments. Refer to the Noninterest Expense subsection of the Statements of Income Analysis section of MD&A for additional information on merger-related expenses. Comparison of the year ended 2018 with 2017 Net interest income increased $4 million from the year ended December 31, 2017 primarily driven by an increase in the benefit related to the FTP charge rates on loans and leases as well as an increase in interest income on taxable securities. These benefits were partially offset by increases in FTP credit rates on deposits allocated to the business segments and increases in interest expense on long-term debt and federal funds purchased. Provision for credit losses decreased $16 million from the year ended December 31, 2017 primarily due to an increased benefit from the reserve for unfunded commitments partially offset by the decrease in the allocation of provision expense to the business segments driven by a decrease in commercial criticized assets. Noninterest income decreased $510 million from the year ended December 31, 2017 primarily driven by the recognition of a $1.0 billion gain on the sale of Worldpay, Inc. shares during the third quarter of 2017. The decrease was partially offset by the recognition of a $205 million gain on the sale of Worldpay, Inc. shares during the second quarter of 2018 and a $414 million gain related to Vantiv, Inc.’s acquisition of Worldpay Group plc. during the first quarter of 2018. Additionally, equity method earnings from the Bancorp’s interest in Worldpay Holding, LLC decreased $46 million from the year ended December 31, 2017 primarily due to a decrease in the Bancorp’s ownership interest in Worldpay Holding, LLC and the impact of a reduction in Worldpay Holding, LLC net income. 68 Fifth Third Bancorp MANAGEMENT’S DISCUSSION AND ANALYSIS OF FINANCIAL CONDITION AND RESULTS OF OPERATIONS Income from the TRA associated with Worldpay, Inc. decreased to $20 million during the year ended December 31, 2018 compared to $44 million for the year ended December 31, 2017. These decreases were partially offset by a decrease in the loss on the swap associated with the sale of Visa, Inc. Class B Shares. For the year ended December 31, 2018, the Bancorp recognized negative valuation adjustments of $59 million related to the Visa total return swap compared to negative valuation adjustments of $80 million during the year ended December 31, 2017. Noninterest expense increased $79 million from the year ended December 31, 2017. The increase was primarily due to increases in personnel expenses, technology and communications expense and marketing expense partially offset by an increase in corporate overhead allocations from General Corporate and Other to the other business segments. 69 Fifth Third Bancorp MANAGEMENT’S DISCUSSION AND ANALYSIS OF FINANCIAL CONDITION AND RESULTS OF OPERATIONS FOURTH QUARTER REVIEW The Bancorp’s 2019 fourth quarter net income available to common shareholders was $701 million, or $0.96 per diluted share, compared to net income available to common shareholders of $530 million, or $0.71 per diluted share, for the third quarter of 2019 and net income available to common shareholders of $432 million, or $0.64 per diluted share, for the fourth quarter of 2018. Net interest income on an FTE basis was $1.2 billion for the fourth quarter of 2019, a decrease of $14 million from the third quarter of 2019 and an increase of $147 million from the fourth quarter of 2018. The decrease from the third quarter of 2019 was primarily driven by lower short-term market rates, partially offset by growth in the indirect secured consumer portfolio, as well as the favorable impact of previously executed cash flow hedges. The increase from the fourth quarter 2018 was primarily driven by an increase in interest-earning assets, including the impact from the MB Financial, Inc. acquisition, partially offset by the declining-rate environment. Net interest income for the fourth quarter of 2019 included $18 million of amortization and accretion of premiums and discounts on acquired loans and leases and assumed deposits and long-term debt from acquisitions compared to $28 million in the third quarter of 2019 and an immaterial amount in the fourth quarter of 2018. Noninterest income was $1.0 billion for the fourth quarter of 2019, an increase of $295 million compared to the third quarter of 2019 and $460 million compared to the fourth quarter of 2018. The increase from the third quarter of 2019 was primarily due to an increase in other noninterest income, partially offset by a decrease in mortgage banking net revenue and corporate banking revenue. The year-over-year increase was primarily the result of an increase in other noninterest income. Service charges on deposits were $149 million for the fourth quarter of 2019, an increase of $6 million compared to the previous quarter and $14 million compared to the fourth quarter of 2018. The increases from both the previous quarter and the fourth quarter of 2018 were primarily driven by higher commercial deposit fees. The increase from the third quarter of 2019 was also driven by higher consumer deposit fees. Corporate banking revenue was $153 million for the fourth quarter of 2019, a decrease of $15 million compared to the third quarter of 2019 and an increase of $23 million compared to the fourth quarter of 2018. The decrease from the previous quarter was primarily driven by a decrease in leasing business revenue, partially offset by an increase in loan syndication revenue. The increase compared to the fourth quarter of 2018 was primarily driven by an increase in leasing business revenue primarily resulting from the MB Financial, Inc. acquisition, as well as an increase in corporate bond fees. Mortgage banking net revenue was $73 million for the fourth quarter of 2019 compared to $95 million in the third quarter of 2019 and $54 million in the fourth quarter of 2018. The decrease in mortgage banking net revenue compared to the third quarter of 2019 was primarily driven by lower origination fees and gains on loan sales, partially offset by an increase in origination volumes. The increase in mortgage banking net revenue compared to the fourth quarter of 2018 was primarily driven by higher mortgage originations. Mortgage banking net revenue is affected by net valuation adjustments, which include MSR valuation adjustments caused by fluctuating OAS, earning rates and prepayment speeds, as well as mark-to-market adjustments on free-standing derivatives used to economically hedge the MSR portfolio. Net negative valuation adjustments on MSRs were $47 million and $40 million in the fourth and third quarters of 2019, respectively, and $24 million in the fourth quarter of 2018. Originations for the fourth quarter of 2019 were $3.8 billion, compared with $3.4 billion in the previous quarter and $1.6 billion the fourth quarter of 2018. Originations for the fourth quarter of 2019 resulted in gains of $49 million on mortgages sold, compared with gains of $64 million for the previous quarter and $23 million for the fourth quarter of 2018. Gross mortgage servicing fees were $72 million in the fourth quarter of 2019, $71 million in the third quarter of 2019 and $54 million in the fourth quarter of 2018. Wealth and asset management revenue was $129 million for the fourth quarter of 2019, an increase of $5 million from the previous quarter and $20 million from the fourth quarter of 2018. The increase from the third quarter of 2019 was primarily driven by higher personal asset management revenue and brokerage fees. The increase compared to the fourth quarter of 2018 was primarily driven by higher personal asset management revenue. Card and processing revenue was $95 million for the fourth quarter of 2019, an increase of $1 million from the third quarter of 2019 and $11 million from the fourth quarter of 2018. The increase from the fourth quarter of 2018 was primarily driven by increases in the number of actively used cards, customer spend volume and other interchange revenue. Other noninterest income was $427 million for the fourth quarter of 2019, an increase of $316 million compared to the third quarter of 2019 and $334 million from the fourth quarter of 2018. The increase from both the third quarter of 2019 and the fourth quarter of 2018 was primarily due to an increase in the income from the TRA associated with Worldpay, Inc. driven by the Worldpay, Inc. TRA transaction in the fourth quarter of 2019, partially offset by an increase in negative valuation adjustments related to the Visa total return swap. The net gains on investment securities were $10 million for the fourth quarter of 2019 compared to $5 million in the third quarter of 2019 and net losses of $32 million for the fourth quarter of 2018. The increase in gains from the previous quarter was primarily due to realized gains on available-for-sale debt and other securities. The increase in gains from the fourth quarter of 2018 was primarily related to unrealized losses on equity securities in the fourth quarter of 2018. Net losses on securities held as non-qualifying hedges for MSRs were $1 million for the fourth quarter of 2019 compared to immaterial net losses for the third quarter of 2019 and net gains of $2 million for the fourth quarter of 2018. Noninterest expense was $1.2 billion for the fourth quarter of 2019, an increase of $1 million from the previous quarter and $185 million from the fourth quarter of 2018. The increase in noninterest expense compared to the fourth quarter of 2018 was primarily related to increases in other noninterest expense, personnel costs and technology and communications expense. The increase in other noninterest expense was primarily driven by increases in donations expense, operating lease expense, loan and lease expense and intangible amortization. The increase in personnel costs was driven by the addition of personnel costs from the acquisition of MB Financial, Inc. and higher deferred compensation expense. The increase in technology and communications expense was driven by increased investment in contemporizing information technology architecture, mitigating information security risks and growth initiatives. The ALLL as a percentage of portfolio loans and leases was 1.10% as of December 31, 2019, compared to 1.04% as of September 30, 2019 and 1.16% as of December 31, 2018. The provision for credit losses was $162 million in the fourth quarter of 2019 compared with $134 million in the third quarter of 2019 and $97 million in the fourth quarter of 2018. Net losses charged-off were $113 million in the fourth quarter of 2019, or 41 bps of average portfolio loans and leases on an annualized basis, compared with net losses charged-off of $99 million in the third quarter of 2019 and $83 million in the fourth quarter of 2018. 70 Fifth Third Bancorp MANAGEMENT’S DISCUSSION AND ANALYSIS OF FINANCIAL CONDITION AND RESULTS OF OPERATIONS TABLE 22: QUARTERLY INFORMATION (unaudited) (a) Amounts presented on an FTE basis. The FTE adjustment was $4 for both the three months ended December 31, 2019 and September 30, 2019 , $5 for the three months ended June 30, 2019 and $4 for the three months ended March 31, 2019 . The FTE adjustment was $4 for the three months ended December 31, 2018, September 30, 2018 and June 30, 2018 and $3 for the three months ended March 31, 2018. COMPARISON OF THE YEAR ENDED 2018 WITH 2017 The Bancorp’s net income available to common shareholders for the year ended December 31, 2018 was $2.1 billion, or $3.06 per diluted share, which was net of $75 million in preferred stock dividends. The Bancorp’s net income available to common shareholders for the year ended December 31, 2017 was $2.1 billion, or $2.81 per diluted share, which was net of $75 million in preferred stock dividends. The provision for credit losses was $207 million for the year ended December 31, 2018 compared to $261 million for the same period in the prior year. The decrease in provision expense for the year ended December 31, 2018 compared to the prior year was primarily due to a decrease in the level of commercial criticized assets combined with overall improved credit quality, partially offset by an increase in outstanding commercial loan balances and an increase in consumer reserve rates for certain products. The ALLL declined $93 million from December 31, 2017 to $1.1 billion at December 31, 2018. At December 31, 2018, the ALLL as a percent of portfolio loans and leases decreased to 1.16%, compared to 1.30% at December 31, 2017. Net interest income on an FTE basis (non-GAAP) was $4.2 billion and $3.8 billion for the years ended December 31, 2018 and 2017, respectively. Net interest income was positively impacted by increases in yields on average loans and leases and average taxable securities and an increase in average taxable securities for the year ended December 31, 2018 compared to the year ended December 31, 2017. Additionally, net interest income was positively impacted by the decisions of the FOMC to raise the target range of the federal funds rate 25 bps in December 2017, March 2018, June 2018, September 2018 and December 2018. These positive impacts were partially offset by increases in the rates paid on average interest-bearing core deposits and average long-term debt during the year ended December 31, 2018 compared to the year ended December 31, 2017. Net interest margin on an FTE basis (non-GAAP) was 3.22% and 3.03% for the years ended December 31, 2018 and 2017, respectively. Noninterest income decreased $434 million for the year ended December 31, 2018 compared to the year ended December 31, 2017 primarily due to a decrease in other noninterest income, partially offset by increases in corporate banking revenue, wealth and asset management revenue and card and processing revenue. Other noninterest income decreased $470 million from the year ended December 31, 2017 primarily due to the gain on sale of Worldpay, Inc. shares recognized in the prior year, a reduction in equity method income from the Bancorp’s interest in Worldpay Holding, LLC, the impact of the net losses on disposition and impairment of bank premises and equipment and income from the TRA associated with Worldpay, Inc. recognized in the prior year. These reductions were partially offset by the gain related to Vantiv, Inc.’s acquisition of Worldpay Group plc., an increase in private equity investment income, as well as a decrease in the loss on the swap associated with the sale of Visa, Inc. Class B Shares. Corporate banking revenue increased $85 million for the year ended December 31, 2018 compared to the year ended December 31, 2017. The increase from the prior year was primarily driven by increases in lease remarketing fees, institutional sales revenue, syndication fees and contract revenue from commercial customer derivatives. Wealth and asset management revenue increased $25 million from the year ended December 31, 2017 primarily due to increases in private client service fees and brokerage fees. Card and processing revenue increased $16 million from the year ended December 31, 2017 primarily due to increases in the number of actively used cards and customer spend volume. Noninterest expense increased $176 million for the year ended December 31, 2018 compared to the year ended December 31, 2017 primarily due to increases in personnel costs, technology and communications expense and other noninterest expense. Personnel costs increased $126 million for the year ended December 31, 2018 compared to the year ended December 31, 2017 driven by increases in base compensation, performance-based compensation and severance costs. The increase in base compensation was primarily due to an increase in the Bancorp’s minimum wage as a result of benefits received from the TCJA and personnel additions associated with strategic investments and acquisitions. Technology and communications expense increased $40 million for the year ended December 31, 2018 compared to the year ended December 31, 2017 driven primarily by increased investment in regulatory, compliance and growth initiatives. Other noninterest expense increased $13 million for the year ended December 31, 2018 compared to the year ended December 31, 2017 primarily due to increases in marketing expense and loan and lease expense, partially offset by an increase in gains on partnership investments and decreases in professional service fees and FDIC insurance and other taxes. 71 Fifth Third Bancorp MANAGEMENT’S DISCUSSION AND ANALYSIS OF FINANCIAL CONDITION AND RESULTS OF OPERATIONS BALANCE SHEET ANALYSIS Loans and Leases The Bancorp classifies its commercial loans and leases based upon primary purpose and consumer loans based upon product or collateral. Table 23 summarizes end of period loans and leases, including loans and leases held for sale, Table 24 summarizes loans and leases acquired in the MB Financial, Inc. acquisition and Table 25 summarizes average total loans and leases, including loans and leases held for sale. (a) The Bancorp acquired indirect motorcycle, powersport, recreational vehicle and marine loans in the acquisition of MB Financial, Inc. These loans are included in addition to automobile loans in the line item “indirect secured consumer loans.” Total loans and leases, including loans and leases held for sale, increased $15.1 billion from December 31, 2018. The increase in total loans and leases was primarily driven by the impact of the MB Financial, Inc. acquisition, which added $13.4 billion in total loans and leases upon acquisition. Table 24 summarizes the detail of loans and leases acquired from MB Financial, Inc. on March 22, 2019. The following discussion excludes the impact of loans and leases acquired in the MB Financial, Inc. acquisition. Commercial loans and leases decreased $618 million from December 31, 2018 due to decreases in commercial leases, commercial and industrial loans and commercial construction loans, partially offset by an increase in commercial mortgage loans. Commercial leases decreased $681 million, or 19%, from December 31, 2018 primarily as a result of a planned reduction in indirect non-relationship based lease originations. Commercial and industrial loans decreased $276 million, or 1%, from December 31, 2018 primarily due to elevated payoff levels. Commercial construction loans decreased $62 million, or 1%, from December 31, 2018 primarily due to decreased draw levels on existing commitments. Commercial mortgage loans increased $401 million, or 6%, from December 31, 2018 primarily as a result of increases in loan originations and permanent financing from the Bancorp’s commercial construction loan portfolio. The following discussion excludes the impact of loans and leases acquired in the MB Financial, Inc. acquisition. Consumer loans increased $2.3 billion from December 31, 2018 due to increases in indirect secured consumer loans, residential mortgage loans, other consumer loans and credit card, partially offset by a decrease in home equity. Indirect secured consumer loans increased $1.8 billion, or 20%, from December 31, 2018 primarily as a result of loan production exceeding payoffs. Residential mortgage loans increased $628 million, or 4%, from December 31, 2018 primarily driven by the continued retention of certain agency conforming ARMs and certain other fixed-rate loans. Other consumer loans increased $337 million, or 14%, from December 31, 2018 primarily due to growth in point-of-sale loan originations. Credit card increased $43 million, or 2%, from December 31, 2018 primarily due to increases in balance-active customers and the balance per active customer. Home equity decreased $489 million, or 8%, from December 31, 2018 as payoffs exceeded new loan production. 72 Fifth Third Bancorp MANAGEMENT’S DISCUSSION AND ANALYSIS OF FINANCIAL CONDITION AND RESULTS OF OPERATIONS Average loans and leases, including loans and leases held for sale, increased $13.9 billion, or 15%, from December 31, 2018 as a result of a $10.9 billion, or 19%, increase in average commercial loans and leases as well as a $3.0 billion, or 8%, increase in average consumer loans. Average commercial loans and leases increased from December 31, 2018 due to increases in average commercial and industrial loans, average commercial mortgage loans and average commercial construction loans, partially offset by a decrease in average commercial leases. Average commercial and industrial loans increased $7.5 billion, or 18%, from December 31, 2018 primarily due to the impact of the acquisition of MB Financial, Inc. and an increase in loan originations. Average commercial mortgage loans increased $3.2 billion, or 49%, from December 31, 2018 primarily due to the impact of the acquisition of MB Financial, Inc. and increases in loan originations as well as permanent financing from the Bancorp’s commercial construction loan portfolio. Average commercial construction loans increased $381 million, or 8%, from December 31, 2018 primarily as a result of the acquisition of MB Financial, Inc. Average commercial leases decreased $217 million, or 6%, from December 31, 2018 primarily as a result of a planned reduction in indirect non-relationship based lease originations, partially offset by commercial leases acquired in the MB Financial, Inc. acquisition. Average consumer loans increased from December 31, 2018 due to increases in indirect secured consumer loans, residential mortgage loans, other consumer loans and credit card, partially offset by a decrease in home equity. Average indirect secured consumer loans increased $1.4 billion, or 15%, from December 31, 2018 primarily due to the acquisition of MB Financial, Inc. and higher loan production exceeding payoffs. Average residential mortgage loans increased $1.2 billion, or 7%, from December 31, 2018 primarily driven by the acquisition of MB Financial, Inc. Average other consumer loans increased $659 million, or 35%, from December 31, 2018 primarily due to growth in point-of-sale loan originations. Average credit card increased $157 million, or 7%, from December 31, 2018 primarily due to increases in balance-active customers and the average balance per active customer. Average home equity decreased $345 million, or 5%, from December 31, 2018 as payoffs exceeded new loan production, partially offset by home equity acquired in the MB Financial, Inc. acquisition. Investment Securities The Bancorp uses investment securities as a means of managing interest rate risk, providing collateral for pledging purposes and for liquidity to satisfy regulatory requirements. Total investment securities were $36.9 billion and $33.6 billion at December 31, 2019 and December 31, 2018, respectively. The taxable available-for-sale debt and other investment securities portfolio had an effective duration of 5.1 years at December 31, 2019 compared to 5.0 years at December 31, 2018. Debt securities are classified as available-for-sale when, in management’s judgment, they may be sold in response to, or in anticipation of, changes in market conditions. Securities that management has the intent and ability to hold to maturity are classified as held-to-maturity and reported at amortized cost. Debt securities are classified as trading when bought and held principally for the purpose of selling them in the near term. At December 31, 2019, the Bancorp’s investment portfolio consisted primarily of AAA-rated available-for-sale debt and other securities. The Bancorp held an immaterial amount in below-investment grade available-for-sale debt and other securities at both December 31, 2019 and 2018. For the year ended December 31, 2019, the Bancorp recognized $1 million of OTTI on its available-for-sale debt and other securities. For the year ended December 31, 2018, the Bancorp did not recognize any OTTI on its available-for-sale debt and other securities. Refer to Note 1 of the Notes to Consolidated Financial Statements for the Bancorp’s methodology for both classifying investment securities and evaluating securities in an unrealized loss position for OTTI. 73 Fifth Third Bancorp MANAGEMENT’S DISCUSSION AND ANALYSIS OF FINANCIAL CONDITION AND RESULTS OF OPERATIONS The following table summarizes the end of period components of investment securities: (a) Includes interest-only mortgage-backed securities recorded at fair value with fair value changes recorded in securities gains (losses), net in the Consolidated Statements of Income. (b) Other securities consist of FHLB, FRB and DTCC restricted stock holdings that are carried at cost. On an amortized cost basis, available-for-sale debt and other securities increased $1.8 billion, or 6%, from December 31, 2018 primarily due to increases in agency commercial mortgage-backed securities, partially offset by decreases in agency residential mortgage-backed securities. On an amortized cost basis, available-for-sale debt and other securities were 24% and 25% of total interest-earning assets at December 31, 2019 and December 31, 2018, respectively. The estimated weighted-average life of the debt securities in the available-for-sale debt and other securities portfolio was 6.6 and 6.5 years at December 31, 2019 and 2018, respectively. In addition, at December 31, 2019 and 2018 the available-for-sale debt and other securities portfolio had a weighted-average yield of 3.22% and 3.25%, respectively. Information presented in Table 27 is on a weighted-average life basis, anticipating future prepayments. Yield information is presented on an FTE basis and is computed using amortized cost balances. Maturity and yield calculations for the total available-for-sale debt and other securities portfolio exclude other securities that have no stated yield or maturity. Total net unrealized gains on the available-for-sale debt and other securities portfolio were $1.1 billion at December 31, 2019 compared to net unrealized losses of $298 million at December 31, 2018. The fair value of investment securities is impacted by interest rates, credit spreads, market volatility and liquidity conditions. The fair value of investment securities generally increases when interest rates decrease or when credit spreads contract. 74 Fifth Third Bancorp MANAGEMENT’S DISCUSSION AND ANALYSIS OF FINANCIAL CONDITION AND RESULTS OF OPERATIONS (a) Taxable-equivalent yield adjustments included in the above table are 1.57%, 0.00% and 0.01% for securities with an average life of 1 year or less, 1-5 years and in total, respectively. (b) Taxable-equivalent yield adjustments included in the above table are 0.00%, 0.00%, 0.00%, 0.03% and 0.01% for securities with an average life of 1 year or less, 1-5 years, 5-10 years, greater than 10 years and in total, respectively. Deposits The Bancorp’s deposit balances represent an important source of funding and revenue growth opportunity. The Bancorp continues to focus on core deposit growth in its retail and commercial franchises by improving customer satisfaction, building full relationships and offering competitive rates. Average core deposits represented 71% and 72% of the Bancorp’s average asset funding base for the years ended December 31, 2019 and 2018, respectively. The following table presents the end of period components of deposits: (a) Includes $2.1 billion, $1.2 billion, $1.3 billion, $1.3 billion and $1.5 billion of institutional, retail and wholesale certificates $250,000 and over at December 31, 2019 , 2018, 2017, 2016 and 2015, respectively. Total deposits increased $18.2 billion, or 17%, from December 31, 2018 driven by the MB Financial, Inc. acquisition as the Bancorp assumed commercial and consumer deposit balances of $14.5 billion at acquisition. Table 29 summarizes the detail of deposits assumed as a result of the MB Financial, Inc. acquisition on March 22, 2019. 75 Fifth Third Bancorp MANAGEMENT’S DISCUSSION AND ANALYSIS OF FINANCIAL CONDITION AND RESULTS OF OPERATIONS The following discussion excludes the impact of deposits assumed in the MB Financial, Inc. acquisition. Core deposits increased $4.2 billion, or 4%, from December 31, 2018, driven by an increase in transaction deposits. Transaction deposits increased $4.0 billion, or 4%, from December 31, 2018 primarily due to increases in interest checking deposits and money market deposits partially offset by a decrease in demand deposits. Interest checking deposits increased $3.9 billion, or 12%, from December 31, 2018 primarily as a result of higher balances per commercial customer account and balance migration from demand deposit accounts. Money market deposits increased $2.1 billion, or 9%, from December 31, 2018 primarily as a result of promotional product offerings, which drove consumer customer acquisition. Demand deposits decreased $2.2 billion, or 7%, from December 31, 2018 primarily as a result of balance migration into interest checking deposits and lower balances per commercial customer account. The following table presents the components of average deposits for the years ended December 31: (a) Includes $2.6 billion , $1.1 billion, $1.4 billion, $1.5 billion and $1.6 billion of average institutional, retail and wholesale certificates $250,000 and over during the years ended December 31, , 2018, 2017, 2016 and 2015, respectively. On an average basis, core deposits increased $14.6 billion, or 14%, from December 31, 2018 due to an increase of $13.2 billion and $1.4 billion in average transaction deposits and average other time deposits, respectively. The increase in average transaction deposits was driven by increases in average interest checking deposits, average money market deposits and average demand deposits. Average interest checking deposits increased $6.8 billion, or 23%, from December 31, 2018 primarily due to the MB Financial, Inc. acquisition as well as balance migration from demand deposit accounts and an increase in average balances per commercial customer account. Average money market deposits increased $4.1 billion, or 19%, from December 31, 2018 primarily due to the MB Financial, Inc. acquisition as well as promotional product offerings, which drove consumer customer acquisition. Average demand deposits increased $1.7 billion, or 5%, from December 31, 2018 primarily due to the MB Financial, Inc. acquisition, partially offset by balance migration into interest checking deposits and lower balances per commercial customer account. The increase in average other time deposits was primarily due to the MB Financial, Inc. acquisition as well as promotional rate offers. Average certificates $100,000 and over increased $2.1 billion from December 31, 2018 primarily due to the MB Financial, Inc. acquisition as well as an increase in retail brokered certificates of deposit issued since December 31, 2018. Average other deposits decreased $211 million primarily due to a decrease in average Eurodollar trade deposits. Contractual Maturities The contractual maturities of certificates $100,000 and over as of December 31, 2019 are summarized in the following table: 76 Fifth Third Bancorp MANAGEMENT’S DISCUSSION AND ANALYSIS OF FINANCIAL CONDITION AND RESULTS OF OPERATIONS The contractual maturities of other time deposits and certificates $100,000 and over as of December 31, 2019 are summarized in the following table: Borrowings The Bancorp accesses a variety of short-term and long-term funding sources. Borrowings with original maturities of one year or less are classified as short-term and include federal funds purchased and other short-term borrowings. Average total borrowings as a percent of average interest-bearing liabilities were 17% at December 31, 2019 compared to 20% at December 31, 2018. The following table summarizes the end of period components of borrowings: Total borrowings decreased $683 million, or 4%, from December 31, 2018 due to a decrease in federal funds purchased, partially offset by increases in long-term debt and other short-term borrowings. Federal funds purchased decreased $1.7 billion from December 31, 2018 primarily due to a reduction in short-term funding needs as a result of deposit growth. Long-term debt increased $544 million from December 31, 2018 primarily driven by the issuance of $2.3 billion of unsecured senior fixed-rate notes, $300 million of unsecured senior floating-rate bank notes, the issuance of asset-backed securities of $1.3 billion related to an automobile loan securitization and $148 million of fair value adjustments associated with interest rate swaps hedging long-term debt. These increases were partially offset by the maturities of $2.6 billion of unsecured senior bank notes, $500 million of unsecured senior notes and $689 million of paydowns on long-term debt associated with automobile loan securitizations during the year ended December 31, 2019. For additional information regarding the automobile loan securitization and long-term debt issuances, refer to Note 13 and Note 18, respectively, of the Notes to Consolidated Financial Statements. Other short-term borrowings increased $438 million from December 31, 2018 as a result of increases in collateral held related to certain derivatives and in securities sold under repurchase agreements driven by an increase in commercial customer activity. The level of other short-term borrowings can fluctuate significantly from period to period depending on funding needs and which sources are used to satisfy those needs. For further information on the components of other short-term borrowings, refer to Note 17 of the Notes to Consolidated Financial Statements. For further information on a subsequent event related to long-term debt, refer to Note 33 of the Notes to Consolidated Financial Statements. The following table summarizes the components of average borrowings: Total average borrowings increased $11 million compared to December 31, 2018, due to an increase in average long-term debt, partially offset by decreases in average other short-term borrowings and average federal funds purchased. Average long-term debt increased $818 million compared to December 31, 2018. The increase was driven primarily by the issuances of long-term debt during the first half of 2019 which consisted of $1.5 billion of unsecured senior fixed-rate notes, $300 million of unsecured senior floating-rate bank notes and the issuance of asset-backed securities of $1.3 billion related to an automobile loan securitization. The increase was partially offset by the maturities of unsecured senior bank notes, unsecured senior notes and paydowns on long-term debt associated with automobile loan securitizations, as discussed above, during the year ended December 31, 2019. Average other short-term borrowings decreased $565 million compared to December 31, 2018, driven primarily by a decrease in average FHLB advances. Average federal funds purchased decreased $242 million primarily due to a reduction in short-term funding needs as a result of average deposit growth. Information on the average rates paid on borrowings is discussed in the Net Interest Income subsection of the Statements of Income Analysis section of MD&A. In addition, refer to the Liquidity Risk Management subsection of the Risk Management section of MD&A for a discussion on the role of borrowings in the Bancorp’s liquidity management. 77 Fifth Third Bancorp MANAGEMENT’S DISCUSSION AND ANALYSIS OF FINANCIAL CONDITION AND RESULTS OF OPERATIONS RISK MANAGEMENT - OVERVIEW Risk management is critical to effectively serving customers’ financial needs while protecting the Bancorp and achieving strategic goals. It is also essential to reducing the volatility of earnings and safeguarding the Bancorp’s brand and reputation. Further, risk management is integral to the Bancorp’s strategic, financial, and capital planning processes. It is essential that the Bancorp’s business strategies consistently align to its overall risk appetite and capital considerations. Key elements of Fifth Third’s Risk Management Framework are as follows: ● The Bancorp ensures transparency of risk through defined risk policies, governance, and a reporting structure that includes the Risk and Compliance Committee of the Board of Directors, the Enterprise Risk Management Committee, and risk management committees. ● The Bancorp establishes a risk appetite in alignment with its strategic, financial, and capital plans. The Bancorp’s risk appetite is defined using quantitative metrics and qualitative measures to ensure prudent risk taking, drive balanced decision making, and ensure that no excessive risks are taken. ● Fifth Third’s core values and culture provide a foundation for supporting sound risk management practices by setting expectations for appropriate conduct and accountability across the organization. All employees are expected to conduct themselves in alignment with Fifth Third’s core values and Code of Business Conduct & Ethics, which may be found on www.53.com, while carrying out their responsibilities. Fifth Third’s Corporate Responsibility and Reputation Committee provides oversight of business conduct policies, programs and strategies, and monitors reporting of potential misconduct, trends or themes across the enterprise. Prudent risk management is a responsibility that is expected from all employees across the first, second and third lines of defense and is a foundational element of Fifth Third’s culture. Fifth Third drives accountability for managing risk through its Three Lines of Defense structure: ● The first line of defense is comprised of front line units that create risk and are accountable for managing risk. These groups are the Bancorp’s primary risk takers and are responsible for implementing effective internal controls and maintaining processes for identifying, assessing, controlling, and mitigating the risks associated with their activities consistent with established risk appetite and limits. The first line of defense also includes business units that provide information technology, operations, servicing, processing, or other support. ● The second line of defense, or Independent Risk Management, consists of Risk Management, Compliance, and Credit Review. The second line is responsible for developing frameworks and policies to govern risk-taking activities, overseeing risk-taking of the organization, advising on controlling that risk, and providing input on key risk decisions. Risk Management complements the front line’s management of risk taking activities through its monitoring and reporting responsibilities, including adherence to the risk appetite. Additionally, Risk Management is responsible for identifying, measuring, monitoring, and controlling aggregate and emerging risks enterprise-wide. ● The third line of defense is Internal Audit, which provides oversight of the first and second lines of defense, and independent assurance to the Board on the effectiveness of governance, risk management, and internal controls. The Bancorp has eight defined risk types and manages each to a prescribed tolerance. The risk types are as follows: ● Credit Risk ● Liquidity Risk ● Market Risk (including Interest Rate Risk and Price Risk) ● Regulatory Compliance Risk ● Legal Risk ● Operational Risk ● Reputational Risk ● Strategic Risk Fifth Third’s Risk Management processes ensure a consistent and comprehensive approach in how to identify, measure and assess, manage, monitor, and report risks. The Bancorp has also established processes and programs to manage and report concentration risks; to ensure robust talent, compensation, and performance management; and to aggregate risks across the enterprise. Below are the Bancorp’s core principles and qualitative factors that define its risk appetite and are used to ensure the Bancorp is operating in a safe and sound manner: ● Act with integrity in all activities. ● Understand the risks the Bancorp takes, and ensure that they are in alignment with its business strategies and risk appetite. ● Avoid risks that cannot be understood, managed or monitored. ● Provide transparency of risk to the Bancorp’s management and Board, and escalate risks and issues as necessary. ● Ensure Fifth Third’s products and services are aligned to its core customer base and are designed, delivered and maintained to provide value and benefit to customers and to Fifth Third. ● Do not offer products or services that are not appropriate or suitable for customers. ● Focus on providing operational excellence by providing reliable, accurate, and efficient services to meet customer’s needs. ● Maintain a strong financial position to ensure that the Bancorp meets its objectives through all economic cycles with sufficient capital and liquidity, even under stressed conditions. ● Protect the Bancorp’s reputation by thoroughly understanding the consequences of business strategies, products and processes. ● Conduct business in compliance with all applicable laws, rules and regulations and in alignment with internal policies and procedures. Risk appetite is measured and monitored to ensure: ● Risk-taking activities remain aligned with the Bancorp’s established risk appetite, tolerances, and limits; ● Business decisions are based on a holistic and forward-looking view of risk and returns, including interactions between risks and results of stress tests, leading to an efficient use of capital; ● Risk management activities are maintained through periods of economic decline, as well as periods of economic growth when risk management can be most critical and challenging. 78 Fifth Third Bancorp MANAGEMENT’S DISCUSSION AND ANALYSIS OF FINANCIAL CONDITION AND RESULTS OF OPERATIONS Quantitative metrics and limits are used to provide a view of the overall risk profile of the Bancorp, which includes monitoring top risks and areas of concentration risk. Fifth Third’s success is dependent on effective risk management and understanding and controlling the risks taken in order to deliver sustainable returns for employees and shareholders. The Bancorp’s goal is to ensure that aggregate risks do not exceed its risk capacity, and that risks taken are supportive of the Bancorp’s portfolio diversification and profitability objectives. Fifth Third’s strategic plan is approved by the Board of Directors annually. The strategic plan includes a comprehensive assessment of risks that currently have an impact on the Bancorp or risks that could have an impact to risk appetite and impact to capital, liquidity, and earnings during the time period covered by the plan. Fifth Third’s Risk Management Framework states its risk appetite and the linkage to strategic and capital planning, defines and sets the tolerance for each of the eight risk types, explains the process used to manage risk across the enterprise and sets forth its risk governance structure. ● The Board of Directors (the “Board”) and executive management define the risk appetite, which is considered in the development of business strategies, and forms the basis for enterprise risk management. The Bancorp’s risk appetite is set annually in alignment with the strategic, capital and financial plans, and is reviewed by the Board on an annual basis. ● The Risk Management Process provides a consistent and integrated approach for managing risks and ensuring appropriate risk mitigants and controls are in place, and risks and issues are appropriately escalated. Five components are utilized for effective risk management; identifying, assessing, managing, monitoring and independent governance reporting of risk. ● The Board and executive management have identified eight risk types (defined above) for monitoring the overall risk of the Bancorp, and have also qualitatively established a risk tolerance, which is defined as the maximum amount of risk the Bancorp is willing to take for each of the eight risk types. These risk types are assessed using quantitative measurements and qualitative factors on an ongoing basis and reported to the Board each quarter, or more frequently, if necessary. In addition, each business and operational function (first line of defense) is accountable for proactively identifying and managing risk using its risk management process. Risk tolerances and risk limits are also established, where appropriate, in order to ensure that business and operational functions across the enterprise are able to monitor and manage risks at a more granular level, while ensuring that aggregate risks across the enterprise do not exceed the overall risk appetite. ● The Bancorp’s risk governance structure includes management committees operating under delegation from, and providing information directly or indirectly to, the Board. The Bancorp Board delegates certain responsibilities to Board sub-committees, including the RCC as outlined in each respective Committee Charter, which may be found on www.53.com. The ERMC, which reports to the RCC, comprises senior management from across the Bancorp and reviews and approves risk management frameworks and policies, oversees the management of all risk types to ensure that aggregated risks remain within the Bancorp’s risk appetite and fosters a risk culture to ensure appropriate escalation and transparency of risks. CREDIT RISK MANAGEMENT The objective of the Bancorp’s credit risk management strategy is to quantify and manage credit risk on an aggregate portfolio basis, as well as to limit the risk of loss resulting from the failure of a borrower or counterparty to honor its financial or contractual obligations to the Bancorp. The Bancorp’s credit risk management strategy is based on three core principles: conservatism, diversification and monitoring. The Bancorp believes that effective credit risk management begins with conservative lending practices which are described below. These practices include the use of intentional risk-based limits for single name exposures and counterparty selection criteria designed to reduce or eliminate exposure to borrowers who have higher than average default risk and defined weaknesses in financial performance. The Bancorp carefully designed and monitors underwriting, documentation and collection standards. The Bancorp’s credit risk management strategy also emphasizes diversification on a geographic, industry and customer level as well as ongoing portfolio monitoring and timely management reviews of large credit exposures and credits experiencing deterioration of credit quality. Credit officers with the authority to extend credit are delegated specific authority amounts, the utilization of which is closely monitored. Underwriting activities are centrally managed, and ERM manages the policy and the authority delegation process directly. The Credit Risk Review function provides independent and objective assessments of the quality of underwriting and documentation, the accuracy of risk grades and the charge-off, nonaccrual and reserve analysis process. The Bancorp’s credit review process and overall assessment of the adequacy of the allowance for credit losses is based on quarterly assessments of the probable estimated losses inherent in the loan and lease portfolio. The Bancorp uses these assessments to promptly identify potential problem loans or leases within the portfolio, maintain an adequate allowance for credit losses and take any necessary charge-offs. The Bancorp defines potential problem loans and leases as those rated substandard that do not meet the definition of a nonaccrual loan or a restructured loan. Refer to Note 7 of the Notes to Consolidated Financial Statements for further information on the Bancorp’s credit grade categories, which are derived from standard regulatory rating definitions. In addition, stress testing is performed on various commercial and consumer portfolios using the CCAR model and for certain portfolios, such as real estate and leveraged lending, the stress testing is performed by Credit department personnel at the individual loan level during credit underwriting. 79 Fifth Third Bancorp MANAGEMENT’S DISCUSSION AND ANALYSIS OF FINANCIAL CONDITION AND RESULTS OF OPERATIONS The following tables provide a summary of potential problem portfolio loans and leases: In addition to the individual review of larger commercial loans that exhibit probable or observed credit weaknesses, the commercial credit review process includes the use of two risk grading systems. The risk grading system currently utilized for allowance for credit loss analysis purposes encompasses ten categories. The Bancorp also maintains a dual risk rating system for credit approval and pricing, portfolio monitoring and capital allocation that includes a “through-the-cycle” rating philosophy for assessing a borrower’s creditworthiness. A “through-the-cycle” rating philosophy uses a grading scale that assigns ratings based on average default rates through an entire business cycle for borrowers with similar financial performance. The dual risk rating system includes thirteen probabilities of default grade categories and an additional eleven grade categories for estimating losses given an event of default. The probability of default and loss given default evaluations are not separated in the ten-category risk rating system. The Bancorp has completed significant validation and testing of the dual risk rating system as a commercial credit risk management tool. The Bancorp has also developed U.S. GAAP compliant CECL models as part of the Bancorp’s adoption of ASU 2016-13 “Measurement of Credit Losses on Financial Instruments ,” which was adopted by the Bancorp on January 1, 2020. These validated CECL models use separate probabilities of default and loss given default ratings to estimate credit losses. Scoring systems, various analytical tools and portfolio performance monitoring are used to assess the credit risk in the Bancorp’s homogenous consumer and small business loan portfolios. Overview U.S. economic growth slowed in the fourth quarter due to weakness in the manufacturing sector and a softer trend in consumer spending. Financial conditions eased during the quarter as the expansion of the FRB’s balance sheet eased funding pressures in the overnight funding markets. Also, the phase one trade deal between the U.S. and China eased concerns around an escalation of the trade conflict. The easing in financial conditions, along with the trade agreement, supported a rally in equity and credit markets as investors upgraded their outlook for global growth and earnings in 2020. FRB officials have strongly suggested that the FOMC is expected to hold interest rates steady for 2020, indicating that observation of a sustained and significant increase in inflation would be needed before considering raising rates. The theme of slower growth was also reflected in the employment market where job growth, growth in average hourly wages and growth in hours worked slowed in 2019 when compared to 2018. Despite the softer job growth, the unemployment rate declined to 3.5% in 2019 from 3.9% in 2018 as job growth outpaced the growth in the labor force. Even though employment growth slowed in 2019, the lowest unemployment rate in a half century along with the availability of consumer credit continued to support consumer confidence and spending while lower interest rates supported a rebound in the housing market. Existing home sales reached a two-year high leaving inventories at their lowest level since 1999. Low inventories along with stronger price gains will limit the growth in home sales in 2020. Geopolitics will continue to play a significant role in the outlook for global growth. Although the U.S. and China reached a trade agreement in early January 2020, the path to a broader trade deal appears unlikely before the November U.S. election. U.S. concerns around national security, human rights, enforcement, and Chinese subsidies for state-owned enterprises remain outstanding with no clear solution. Meanwhile, geopolitical challenges outside the U.S. will continue to limit the upside potential of the global economy. Commercial Portfolio The Bancorp’s credit risk management strategy seeks to minimize concentrations of risk through diversification. The Bancorp has commercial loan concentration limits based on industry, lines of business within the commercial segment, geography and credit product type. The risk within the commercial loan and lease portfolio is managed and monitored through an underwriting process utilizing detailed origination policies, continuous loan level reviews, monitoring of industry concentration and product type limits and continuous portfolio risk management reporting. The Bancorp provides loans to a variety of customers ranging from large multi-national firms to middle market businesses, sole proprietors and high net worth individuals. The origination policies for commercial and industrial loans outline the risks and underwriting requirements for loans to businesses in various industries. Included in the policies are maturity and amortization terms, collateral and leverage requirements, cash flow coverage measures and hold limits. The Bancorp aligns credit and sales teams with specific industry expertise to better monitor and manage different industry segments of the portfolio. 80 Fifth Third Bancorp MANAGEMENT’S DISCUSSION AND ANALYSIS OF FINANCIAL CONDITION AND RESULTS OF OPERATIONS The acquired commercial and industrial portfolio is comprised primarily of small business and middle market commercial loans but also includes specialty lending products, including lease banking, small business leasing and asset-based lending. These products serve distinct client needs and broaden Fifth Third’s lending capabilities. The portfolios have been evaluated for credit quality and will be managed within Fifth Third’s credit risk framework to ensure adherence to risk appetite. The following table provides detail on commercial loans and leases by industry classification (as defined by the North American Industry Classification System), by loan size and by state, illustrating the diversity and granularity of the Bancorp’s commercial loans and leases: The origination policies for commercial real estate outline the risks and underwriting requirements for owner and nonowner-occupied and construction lending. Included in the policies are maturity and amortization terms, maximum LTVs, minimum debt service coverage ratios, construction loan monitoring procedures, appraisal requirements, pre-leasing requirements (as applicable), pro-forma analysis requirements and interest rate sensitivity. The Bancorp requires a valuation of real estate collateral, which may include third-party appraisals, be performed at the time of origination and renewal in accordance with regulatory requirements and on an as-needed basis when market conditions justify. Although the Bancorp does not back test these collateral value assumptions, the Bancorp maintains an appraisal review department to order and review third-party appraisals in accordance with regulatory requirements. Collateral values on criticized assets with relationships exceeding $1 million are reviewed quarterly to assess the appropriateness of the value ascribed in the assessment of charge-offs and specific reserves. 81 Fifth Third Bancorp MANAGEMENT’S DISCUSSION AND ANALYSIS OF FINANCIAL CONDITION AND RESULTS OF OPERATIONS The Bancorp assesses all real estate and non-real estate collateral securing a loan and considers all cross-collateralized loans in the calculation of the LTV ratio. The following tables provide detail on the most recent LTV ratios for commercial mortgage loans greater than $1 million, excluding impaired commercial mortgage loans individually evaluated. The Bancorp does not typically aggregate the LTV ratios for commercial mortgage loans less than $1 million. The Bancorp views non-owner-occupied commercial real estate as a higher credit risk product compared to some other commercial loan portfolios due to the higher volatility of the industry. The following tables provide an analysis of nonowner-occupied commercial real estate loans by state (excluding loans held for sale): (a) Included in commercial mortgage loans and commercial construction loans in the Loans and Leases subsection of the Balance Sheet Analysis section of MD&A. (a) Included in commercial mortgage loans and commercial construction loans in the Loans and Leases subsection of the Balance Sheet Analysis section of MD&A. Consumer Portfolio Consumer credit risk management utilizes a framework that encompasses consistent processes for identifying, assessing, managing, monitoring and reporting credit risk. These processes are supported by a credit risk governance structure that includes Board oversight, policies, risk limits and risk committees. The Bancorp’s consumer portfolio is materially comprised of five categories of loans: residential mortgage loans, home equity, indirect secured consumer loans, credit card and other consumer loans. The Bancorp has identified certain credit characteristics within these five categories of loans which it believes represent a higher level of risk compared to the rest of the consumer loan portfolio. The Bancorp does not update LTVs for the consumer portfolio subsequent to origination except as part of the charge-off process for real estate secured loans. Among consumer portfolios, legacy underwritten residential mortgage and brokered home equity portfolios exhibited the most stress during the past credit crisis. 82 Fifth Third Bancorp MANAGEMENT’S DISCUSSION AND ANALYSIS OF FINANCIAL CONDITION AND RESULTS OF OPERATIONS As of December 31, 2019, consumer real estate loans, consisting of residential mortgage loans and home equity loans, originated from 2005 through 2008 represent approximately 10% of the consumer real estate portfolio. These loans accounted for 50% of total consumer real estate secured net charge-offs for the year ended December 31, 2019. Current loss rates in the residential mortgage and home equity portfolios are below pre-crisis levels. In addition to the consumer real estate portfolio, credit risk management continues to closely monitor the indirect secured consumer portfolio performance, which includes automobile loans. The automobile market has exhibited industry-wide gradual loosening of credit standards such as lower FICOs, longer terms and higher LTVs. The Bancorp has adjusted credit standards focused on improving risk-adjusted returns while maintaining credit risk tolerance. The Bancorp actively manages the automobile portfolio through concentration limits, which mitigate credit risk through limiting the exposure to lower FICO scores, higher advance rates and extended term originations. Residential mortgage portfolio The Bancorp manages credit risk in the residential mortgage portfolio through underwriting guidelines that limit exposure to higher LTVs and lower FICO scores. Additionally, the portfolio is governed by concentration limits that ensure geographic, product and channel diversification. The Bancorp may also package and sell loans in the portfolio. The Bancorp does not originate residential mortgage loans that permit customers to defer principal payments or make payments that are less than the accruing interest. The Bancorp originates both fixed-rate and ARM loans. Within the ARM portfolio approximately $671 million of ARM loans will have rate resets during the next twelve months. Of these resets, 29% are expected to experience an increase in rate, with an average increase of approximately 1%. Underlying characteristics of these borrowers are relatively strong with a weighted-average origination DTI of 32% and weighted-average origination LTV of 71%. Certain residential mortgage products have contractual features that may increase credit exposure to the Bancorp in the event of a decline in housing values. These types of mortgage products offered by the Bancorp include loans with high LTVs, multiple loans secured by the same collateral that when combined result in an LTV greater than 80% and interest-only loans. The Bancorp has deemed residential mortgage loans with greater than 80% LTVs and no mortgage insurance as loans that represent a higher level of risk. Portfolio residential mortgage loans from 2010 and later vintages represented 94% of the portfolio as of December 31, 2019 and had a weighted-average origination LTV of 73% and a weighted-average origination FICO of 760. The following table provides an analysis of the residential mortgage portfolio loans outstanding by LTV at origination: (a) Includes loans with both borrower and lender paid mortgage insurance. The following tables provide an analysis of the residential mortgage portfolio loans outstanding by state with a greater than 80% LTV and no mortgage insurance: 83 Fifth Third Bancorp MANAGEMENT’S DISCUSSION AND ANALYSIS OF FINANCIAL CONDITION AND RESULTS OF OPERATIONS Home equity portfolio The Bancorp’s home equity portfolio is primarily comprised of home equity lines of credit. Beginning in the first quarter of 2013, the Bancorp’s newly originated home equity lines of credit have a 10-year interest-only draw period followed by a 20-year amortization period. The home equity line of credit previously offered by the Bancorp was a revolving facility with a 20-year term, minimum payments of interest-only and a balloon payment of principal at maturity. Peak maturity years for the balloon home equity lines of credit are 2025 to 2028 and approximately 25% of the balances mature before 2025. The ALLL provides coverage for probable and estimable losses in the home equity portfolio. The allowance attributable to the portion of the home equity portfolio that has not been restructured in a TDR is determined on a pooled basis with senior lien and junior lien categories segmented in the determination of the probable credit losses in the home equity portfolio. The loss factor for the home equity portfolio is based on the trailing twelve-month historical loss rate for each category, as adjusted for certain prescriptive loss rate factors and certain qualitative adjustment factors to reflect risks associated with current conditions and trends. The prescriptive loss rate factors include adjustments for delinquency trends, LTV trends and refreshed FICO score trends. The qualitative factors include adjustments for changes in policies or procedures in underwriting, monitoring or collections, economic conditions, portfolio mix, lending and risk management personnel, results of internal audit and quality control reviews, collateral values and geographic concentrations. The Bancorp considers home price index trends in its footprint and the volatility of collateral valuation trends when determining the collateral value qualitative factor. The home equity portfolio is managed in two primary groups: loans outstanding with a combined LTV greater than 80% and those loans with an LTV of 80% or less based upon appraisals at origination. For additional information on these loans, refer to Table 46 and Table 47. Of the total $6.1 billion of outstanding home equity loans: ● 90% reside within the Bancorp’s Midwest footprint of Ohio, Michigan, Kentucky, Indiana and Illinois as of December 31, 2019; ● 37% are in senior lien positions and 63% are in junior lien positions at December 31, 2019; ● 79% of non-delinquent borrowers made at least one payment greater than the minimum payment during the year ended December 31, 2019; and ● The portfolio had a weighted-average refreshed FICO score of 745 at December 31, 2019. The Bancorp actively manages lines of credit and makes adjustments in lending limits when it believes it is necessary based on FICO score deterioration and property devaluation. The Bancorp does not routinely obtain appraisals on performing loans to update LTVs after origination. However, the Bancorp monitors the local housing markets by reviewing various home price indices and incorporates the impact of the changing market conditions in its ongoing credit monitoring processes. For junior lien home equity loans which become 60 days or more past due, the Bancorp tracks the performance of the senior lien loans in which the Bancorp is the servicer and utilizes consumer credit bureau attributes to monitor the status of the senior lien loans that the Bancorp does not service. If the senior lien loan is found to be 120 days or more past due, the junior lien home equity loan is placed on nonaccrual status unless both loans are well-secured and in the process of collection. Additionally, if the junior lien home equity loan becomes 120 days or more past due and the senior lien loan is also 120 days or more past due, the junior lien home equity loan is assessed for charge-off. Refer to the Analysis of Nonperforming Assets subsection of the Risk Management section of MD&A for more information. 84 Fifth Third Bancorp MANAGEMENT’S DISCUSSION AND ANALYSIS OF FINANCIAL CONDITION AND RESULTS OF OPERATIONS The following table provides an analysis of home equity portfolio loans outstanding disaggregated based upon refreshed FICO score: The following tables provide an analysis of home equity portfolio loans outstanding by state with a combined LTV greater than 80%: 85 Fifth Third Bancorp MANAGEMENT’S DISCUSSION AND ANALYSIS OF FINANCIAL CONDITION AND RESULTS OF OPERATIONS Indirect secured consumer portfolio The indirect secured consumer portfolio is comprised of $10.7 billion of automobile loans and $882 million of indirect motorcycle, powersport, recreational vehicle and marine loans. The Bancorp’s indirect secured consumer portfolio balances have increased since December 31, 2018 due to the acquisition of MB Financial, Inc. and an increase in loan origination activity. Additionally, the concentration of lower FICO (≤ 690) origination balances remained within targeted credit risk tolerance during the year ended December 31, 2019. All concentration and guideline changes are monitored monthly to ensure alignment with original credit performance and return projections. The following table provides an analysis of indirect secured consumer portfolio loans outstanding disaggregated based upon FICO score: As of December 31, 2019, 95% of the indirect secured consumer loan portfolio is comprised of automobile loans, powersport loans and motorcycle loans. It is a common industry practice to advance on these types of loans an amount in excess of the collateral value due to the inclusion of negative equity trade-in, maintenance/warranty products, taxes, title and other fees paid at closing. The Bancorp monitors its exposure to these higher risk loans. The remainder of the indirect secured consumer loan portfolio is comprised of marine and recreational vehicle loans. Credit policy limits the maximum advance rate on these to 100% of collateral value. The following table provides an analysis of indirect secured consumer portfolio loans outstanding by LTV at origination: The following table provides an analysis of the Bancorp’s indirect secured consumer portfolio loans outstanding with an LTV at origination greater than 100% as of and for the years ended: Credit card portfolio The credit card portfolio consists of predominately prime accounts with 97% of balances existing within the Bancorp’s footprint as of December 31, 2019. At December 31, 2019 and 2018, 67% and 71%, respectively, of the outstanding balances were originated through branch-based relationships with the remainder coming from direct mail campaigns and online acquisitions. 86 Fifth Third Bancorp MANAGEMENT’S DISCUSSION AND ANALYSIS OF FINANCIAL CONDITION AND RESULTS OF OPERATIONS The following table provides an analysis of credit card portfolio loans outstanding disaggregated based upon FICO score at origination: Other consumer portfolio loans Other consumer portfolio loans are comprised of secured and unsecured loans originated through the Bancorp’s branch network as well as point-of-sale loans originated in connection with third-party financial technology companies. The Bancorp had $289 million in unfunded commitments associated with loans originated in connection with third-party financial technology companies as of December 31, 2019. The Bancorp closely monitors the credit performance of point-of-sale loans which, for the Bancorp, is impacted by the credit loss protection coverage provided by the third-party financial technology companies. The following table provides an analysis of other consumer portfolio loans outstanding by product type at origination: Analysis of Nonperforming Assets Nonperforming assets include nonaccrual loans and leases for which ultimate collectability of the full amount of the principal and/or interest is uncertain; restructured commercial, credit card and certain consumer loans which have not yet met the requirements to be classified as a performing asset; restructured consumer loans which are 90 days past due based on the restructured terms unless the loan is both well-secured and in the process of collection; and certain other assets, including OREO and other repossessed property. A summary of nonperforming assets is included in Table 54. For further information on the Bancorp’s policies related to accounting for delinquent and nonperforming loans and leases, refer to the Nonaccrual Loans and Leases section of Note 1 of the Notes to Consolidated Financial Statements. Nonperforming assets were $687 million at December 31, 2019 compared to $411 million at December 31, 2018. At December 31, 2019, $7 million of nonaccrual loans were held for sale, compared to $16 million at December 31, 2018. Nonperforming portfolio assets as a percent of portfolio loans and leases and OREO were 0.62% as of December 31, 2019 compared to 0.41% as of December 31, 2018. Nonaccrual loans and leases secured by real estate were 35% of nonaccrual loans and leases as of December 31, 2019 compared to 34% as of December 31, 2018. Portfolio commercial nonaccrual loans and leases were $397 million at December 31, 2019, an increase of $169 million from December 31, 2018. Portfolio consumer nonaccrual loans were $221 million at December 31, 2019, an increase of $101 million from December 31, 2018. Refer to Table 55 for a rollforward of the portfolio nonaccrual loans and leases. OREO and other repossessed property was $62 million at December 31, 2019, compared to $47 million at December 31, 2018. The Bancorp recognized $6 million and $7 million in losses on the transfer, sale or write-down of OREO properties during the years ended December 31, 2019 and 2018, respectively. During the years ended December 31, 2019 and 2018, approximately $35 million and $30 million, respectively, of interest income would have been recognized if the nonaccrual and renegotiated loans and leases on nonaccrual status had been current in accordance with their original terms. Although these values help demonstrate the costs of carrying nonaccrual credits, the Bancorp does not expect to recover the full amount of interest as nonaccrual loans and leases are generally carried below their principal balance. 87 Fifth Third Bancorp MANAGEMENT’S DISCUSSION AND ANALYSIS OF FINANCIAL CONDITION AND RESULTS OF OPERATIONS TABLE 54: SUMMARY OF NONPERFORMING ASSETS AND DELINQUENT LOANS (a) Information for all periods presented excludes advances made pursuant to servicing agreements for GNMA mortgage pools whose repayments are insured by the FHA or guaranteed by the VA. These advances were $261 , $195, $290, $312 and $335 as of December 31, 2019 , 2018, 2017, 2016 and 2015, respectively. The Bancorp recognized losses of $4 , $5, $5, $6 and $8 for the years ended December 31, 2019 , 2018, 2017, 2016 and 2015, respectively. (b) Includes $16 , $6, $3, $4 and $6 of nonaccrual government insured commercial loans whose repayments are insured by the SBA at December 31, 2019 , 2018, 2017, 2016 and 2015, respectively, of which $11, $2, $3, $1 and $2 were restructured nonaccrual government insured commercial loans at December 31, 2019 , 2018, 2017, 2016 and 2015, respectively. (c) Upon completion of Fifth Third Bank’s conversion to a national charter, the Bancorp conformed to OCC guidance with regard to branch-related real estate no longer intended to be used for banking purposes. The impact of the change resulted in an increase to OREO of approximately $30 million with an offsetting reduction to bank premises and equipment. 88 Fifth Third Bancorp MANAGEMENT’S DISCUSSION AND ANALYSIS OF FINANCIAL CONDITION AND RESULTS OF OPERATIONS The following table provides a rollforward of portfolio nonaccrual loans and leases, by portfolio segment: Troubled Debt Restructurings A loan is accounted for as a TDR if the Bancorp, for economic or legal reasons related to the borrower’s financial difficulties, grants a concession to the borrower that it would not otherwise consider. TDRs include concessions granted under reorganization, arrangement or other provisions of the Federal Bankruptcy Act. A TDR typically involves a modification of terms such as a reduction of the stated interest rate or remaining principal amount of the loan, a reduction of accrued interest or an extension of the maturity date at a stated interest rate lower than the current market rate for a new loan with similar risk. At the time of modification, the Bancorp maintains certain consumer loan TDRs (including certain residential mortgage loans, home equity loans and other consumer loans) on accrual status, provided there is reasonable assurance of repayment and performance according to the modified terms based upon a current, well-documented credit evaluation. Loans discharged in a Chapter 7 bankruptcy and not reaffirmed by the borrower are classified as collateral-dependent TDRs and placed on nonaccrual status regardless of the borrower’s payment history or capacity to repay in the future. These loans are returned to accrual status provided there is a sustained payment history of twelve months after bankruptcy and collectability is reasonably assured for all remaining contractual payments. Commercial loans modified as part of a TDR are maintained on accrual status provided there is a sustained payment history of six months or greater prior to the modification in accordance with the modified terms and all remaining contractual payments under the modified terms are reasonably assured of collection. TDRs of commercial loans and credit card loans that do not have a sustained payment history of six months or greater in accordance with the modified terms remain on nonaccrual status until a six-month payment history is sustained. Consumer restructured loans on accrual status totaled $965 million and $961 million at December 31, 2019 and 2018, respectively. As of December 31, 2019, the percentage of restructured residential mortgage loans, home equity loans, and credit card loans that are past due 30 days or more from their modified terms were 32%, 19% and 38%, respectively. The following tables summarize portfolio TDRs by loan type and delinquency status: (a) Excludes restructured nonaccrual loans held for sale. (b) Information includes advances made pursuant to servicing agreements for GNMA mortgage pools whose repayments are insured by the FHA or guaranteed by the VA. As of December 31, 2019 , these advances represented $321 of current loans, $40 of 30-89 days past due loans and $109 of 90 days or more past due loans. (c) Upon completion of Fifth Third Bank’s conversion to a national charter, the Bancorp conformed to OCC guidance with regard to non-reaffirmed loans included in Chapter 7 bankruptcy filings to be accounted for as TDRs and collateral dependent loans regardless of payment history and capacity to pay in the future. The impact of the change resulted in an increase to TDRs of approximately $105, of which $83 were transferred to nonaccrual status. 89 Fifth Third Bancorp MANAGEMENT’S DISCUSSION AND ANALYSIS OF FINANCIAL CONDITION AND RESULTS OF OPERATIONS (a) Excludes restructured nonaccrual loans held for sale. (b) Information includes advances made pursuant to servicing agreements for GNMA mortgage pools whose repayments are insured by the FHA or guaranteed by the VA. As of December 31, 2018, these advances represented $321 of current loans, $42 of 30-89 days past due loans and $101 of 90 days or more past due loans. Analysis of Net Loan Charge-offs Net charge-offs were 35 bps of average portfolio loans and leases for both the years ended December 31, 2019 and 2018. Table 58 provides a summary of credit loss experience and net charge-offs as a percentage of average portfolio loans and leases outstanding by loan category. The ratio of commercial loan and lease net charge-offs to average portfolio commercial loans and leases was 16 bps during the year ended December 31, 2019, compared to 23 bps during the year ended December 31, 2018. The decrease was primarily due to an increase in average commercial loans and leases as a result of the MB Financial, Inc. acquisition as well as a decrease in net charge-offs on commercial and industrial loans of $29 million. The ratio of consumer loan net charge-offs to average portfolio consumer loans was 68 bps for the year ended December 31, 2019 compared to 56 bps for the year ended December 31, 2018. The increase was primarily due to increases in net charge-offs on credit card and other consumer loans of $33 million and $17 million, respectively. 90 Fifth Third Bancorp MANAGEMENT’S DISCUSSION AND ANALYSIS OF FINANCIAL CONDITION AND RESULTS OF OPERATIONS (a) For the years ended December 31, 2019 and 2018, the Bancorp recorded $48 and $29, respectively, in both losses charged-off and recoveries of losses charged-off related to customer defaults on point-of-sale consumer loans for which the Bancorp obtained recoveries under third-party credit enhancements. Allowance for Credit Losses The allowance for credit losses is comprised of the ALLL and the reserve for unfunded commitments. The ALLL provides coverage for probable and estimable losses in the loan and lease portfolio. The Bancorp evaluates the ALLL each quarter to determine its adequacy to cover inherent losses. Several factors are taken into consideration in the determination of the overall ALLL, including an unallocated component. These factors include, but are not limited to, the overall risk profile of the loan and lease portfolios, net charge-off experience, the extent of impaired loans and leases, the level of nonaccrual loans and leases, the level of 90 days past due loans and leases and the overall level of the ALLL as a percent of portfolio loans and leases. The Bancorp also considers overall asset quality trends, credit administration and portfolio management practices, risk identification practices, credit policy and underwriting practices, overall portfolio growth, portfolio concentrations and current economic conditions that might impact the portfolio. Refer to the Critical Accounting Policies section of MD&A for more information. During the year ended December 31, 2019, the Bancorp did not substantively change any material aspect of its overall approach in the determination of the ALLL and there have been no material changes in assumptions or estimation techniques as compared to prior periods that impacted the determination of the current period allowance. In addition to the ALLL, the Bancorp maintains a reserve for unfunded commitments recorded in other liabilities in the Consolidated Balance Sheets. 91 Fifth Third Bancorp MANAGEMENT’S DISCUSSION AND ANALYSIS OF FINANCIAL CONDITION AND RESULTS OF OPERATIONS The methodology used to determine the adequacy of this reserve is similar to the Bancorp’s methodology for determining the ALLL. The provision for the reserve for unfunded commitments is included in provision for credit losses in the Consolidated Statements of Income. The ALLL attributable to the portion of the residential mortgage and consumer loan portfolios that has not been restructured in a TDR is calculated on a pooled basis with the segmentation based on the similarity of credit risk characteristics. Loss factors for consumer loans are developed for each pool based on the trailing twelve-month historical loss rate, as adjusted for certain prescriptive loss rate factors and certain qualitative adjustment factors. The prescriptive loss rate factors and qualitative adjustments are designed to reflect risks associated with current conditions and trends which are not believed to be fully reflected in the trailing twelve-month historical loss rate. For real estate backed consumer loans, the prescriptive loss rate factors include adjustments for delinquency trends, LTV trends, refreshed FICO score trends and product mix, and the qualitative factors include adjustments for changes in policies or procedures in underwriting, monitoring or collections, economic conditions, portfolio mix, lending and risk management personnel, results of internal audit and quality control reviews, collateral values and geographic concentrations. The Bancorp considers home price index trends in its footprint and the volatility of collateral valuation trends when determining the collateral value qualitative factor. The Bancorp’s determination of the ALLL for commercial loans and leases is sensitive to the risk grades it assigns to these loans and leases. In the event that 10% of commercial loans and leases in each risk category would experience a downgrade of one risk category, the allowance for commercial loans and leases would increase by approximately $171 million at December 31, 2019. In addition, the Bancorp’s determination of the ALLL for residential mortgage loans and consumer loans is sensitive to changes in estimated loss rates. In the event that estimated loss rates would increase by 10%, the ALLL for residential mortgage loans and consumer loans would increase by approximately $37 million at December 31, 2019. As several qualitative and quantitative factors are considered in determining the ALLL, these sensitivity analyses do not necessarily reflect the nature and extent of future changes in the ALLL. They are intended to provide insights into the impact of adverse changes to risk grades and estimated loss rates and do not imply any expectation of future deterioration in the risk ratings or loss rates. Given current processes employed by the Bancorp, management believes the risk grades and estimated loss rates currently assigned are appropriate. (a) For the years ended December 31, 2019 and 2018, the Bancorp recorded $48 and $29, respectively, in both losses charged-off and recoveries of losses charged-off related to customer defaults on point-of-sale consumer loans for which the Bancorp obtained recoveries under third-party credit enhancements. Certain inherent but unconfirmed losses are probable within the loan and lease portfolio. The Bancorp’s current methodology for determining the level of losses is based on historical loss rates, current credit grades, specific allocation on impaired commercial credits above specified thresholds and restructured loans and other qualitative adjustments. Due to the heavy reliance on realized historical losses and the credit grade rating process, the model-derived estimate of the ALLL tends to slightly lag behind the deterioration in the portfolio in a stable or deteriorating credit environment, and tends not to be as responsive when improved conditions have presented themselves. Given these model limitations, the qualitative adjustment factors may be incremental or decremental to the quantitative model results. An unallocated component of the ALLL is maintained to recognize the imprecision in estimating and measuring loss. The unallocated allowance as a percent of total portfolio loans and leases at December 31, 2019 and 2018 was 0.11% and 0.12%, respectively. The unallocated allowance was approximately 10% of the total allowance at both December 31, 2019 and 2018. As shown in Table 60, the ALLL as a percent of portfolio loans and leases was 1.10% at December 31, 2019, compared to 1.16% at December 31, 2018. This decrease reflects the impact of the MB Financial, Inc. acquisition, which added approximately $13.4 billion in portfolio loans and leases at the acquisition date. Loans acquired by the Bancorp through a purchase business combination are recorded at fair value as of the acquisition date. The Bancorp does not carry over the acquired company’s ALLL, nor does the Bancorp add to its existing ALLL as part of purchase accounting. The ALLL was $1.2 billion and $1.1 billion at December 31, 2019 and 2018, respectively. 92 Fifth Third Bancorp MANAGEMENT’S DISCUSSION AND ANALYSIS OF FINANCIAL CONDITION AND RESULTS OF OPERATIONS In June 2016, the FASB issued ASU 2016-13 which establishes a new approach to estimate credit losses on certain types of financial instruments. The new approach changes the impairment model for most financial assets, and will require the use of an “expected credit loss” model for financial instruments measured at amortized cost and certain other instruments. The ASU is effective for the Bancorp on January 1, 2020. Based on portfolio characteristics and economic conditions and expectations as of January 1, 2020, the Bancorp recorded a combined increase to the ALLL and reserve for unfunded commitments on January 1, 2020 of approximately $650 million upon the adoption of ASU 2016-13. The increase is based on economic forecasts that the Bancorp considers reasonable and supportable for a period of three years followed by a reversion to long-term historical loss rates for the remaining contractual life (adjusted for expected prepayments) phased in over a period of two years. The estimated increase in the ALLL is primarily attributable to longer duration consumer loans. This increase includes the differences between the purchase accounting treatment of loans and leases acquired in the MB Financial, Inc. acquisition and the treatment under ASU 2016-13. In the legacy portfolio, excluding the MB Financial, Inc. loans and leases, the Bancorp recognized an increase to the ALLL of approximately $475 million. The impact on the Bancorp’s ALLL in future periods may vary significantly from the adoption date as it will be based on changes in economic conditions, economic forecasts and the composition and credit quality of the Bancorp’s loan and lease portfolio. The adoption of ASU 2016-13 will also have an impact on the provision for credit losses in periods after adoption, which could differ materially from historical trends. For additional information on ASU 2016-13, refer to Note 1 of the Notes to Consolidated Financial Statements. MARKET RISK MANAGEMENT Market risk is the day-to-day potential for the value of a financial instrument to fluctuate due to movements in market factors. The Bancorp’s market risk includes risks resulting from movements in interest rates, foreign exchange rates, equity prices and commodity prices. Interest rate risk, a component of market risk, primarily impacts the Bancorp’s income categories through changes in interest income on earning assets and the cost of interest-bearing liabilities, and through fee items that are related to interest sensitive activities such as mortgage origination and servicing income and through earnings credits earned on commercial deposits that offset commercial deposit fees. Management considers interest rate risk a prominent market risk in terms of its potential impact on earnings. Interest rate risk may occur for any one or more of the following reasons: ● Assets and liabilities mature or reprice at different times; ● Short-term and long-term market interest rates change by different amounts; or ● The expected maturities of various assets or liabilities shorten or lengthen as interest rates change. 93 Fifth Third Bancorp MANAGEMENT’S DISCUSSION AND ANALYSIS OF FINANCIAL CONDITION AND RESULTS OF OPERATIONS In addition to the direct impact of interest rate changes on NII and interest-sensitive fees, interest rates can impact earnings through their effect on loan and deposit demand, credit losses, mortgage origination volumes, the value of servicing rights and other sources of the Bancorp’s earnings. Stability of the Bancorp’s net income is largely dependent upon the effective management of interest rate risk. Management continually reviews the Bancorp’s balance sheet composition and earnings flows and models the interest rate risk, and possible actions to manage this risk, given numerous possible future interest rate scenarios. A series of Policy Limits and Key Risk Indicators are employed to ensure that this risk is managed within the Bancorp’s risk tolerance. In addition to the traditional forms of interest rate risk discussed in this section, the Bancorp is exposed to interest rate risk associated with the retirement and replacement of LIBOR. For more information on the LIBOR transition, refer to the Overview section of MD&A. Interest Rate Risk Management Oversight The Bancorp’s ALCO, which includes senior management representatives and is accountable to the ERMC, monitors and manages interest rate risk within Board-approved policy limits. In addition to the risk management activities of ALCO, the Bancorp has a Market Risk Management function as part of ERM that provides independent oversight of market risk activities. Net Interest Income Sensitivity The Bancorp employs a variety of measurement techniques to identify and manage its interest rate risk, including the use of an NII simulation model to analyze the sensitivity of NII to changes in interest rates. The model is based on contractual and estimated cash flows and repricing characteristics for all of the Bancorp’s assets, liabilities and off-balance sheet exposures and incorporates market-based assumptions regarding the effect of changing interest rates on the prepayment rates of certain assets and attrition rates of certain liabilities. The model also includes senior management’s projections of the future volume and pricing of each of the product lines offered by the Bancorp as well as other pertinent assumptions. Actual results may differ from simulated results due to timing, magnitude and frequency of interest rate changes, deviations from projected assumptions, as well as from changes in market conditions and management strategies. As of December 31, 2019, the Bancorp’s interest rate risk exposure is governed by a risk framework that utilizes the change in NII over 12-month and 24-month horizons assuming a 200 bps parallel ramped increase and a 100 bps parallel ramped decrease in interest rates. Additionally, the Bancorp routinely analyzes various potential and extreme scenarios, including ramps, shocks and non-parallel shifts in rates to assess where risks to net interest income persist or develop as changes in the balance sheet and market rates evolve. In order to recognize the risk of noninterest-bearing demand deposit balance run-off in a rising interest rate environment, the Bancorp’s NII sensitivity modeling assumes that approximately $750 million of additional demand deposit balances run-off over 24 months above what is included in senior management’s baseline projections for each 100 bps increase in short-term market interest rates. Similarly, the Bancorp’s NII sensitivity modeling incorporates approximately $750 million of incremental growth in noninterest-bearing deposit balances over 24 months above senior management’s baseline projections for each 100 bps decrease in short-term market interest rates. The incremental balance run-off and growth are modeled to flow into and out of funding products that reprice in conjunction with short-term market rate changes. Another important deposit modeling assumption is the amount by which interest-bearing deposit rates will increase or decrease when market interest rates increase or decrease. This deposit repricing sensitivity is known as the beta, and it represents the expected amount by which Bancorp deposit rates will change for a given change in short-term market rates. The Bancorp’s NII sensitivity modeling assumes a weighted-average rising-rate interest-bearing deposit beta of 71% at December 31, 2019, which is approximately 10 to 30 percentage points higher than the average beta that the Bancorp experienced in the FRB tightening cycles from June 2004 to June 2006 and from December 2015 to December 2018. The Bancorp’s NII sensitivity modeling assumes a weighted-average falling-rate interest-bearing deposit beta of 41% at December 31, 2019. In addition, the modeling assumes there is no lag between the timing of changes in market rates and the timing of deposit repricing despite such timing lags having occurred in prior rate cycles. The Bancorp continually evaluates the sensitivity of its interest rate risk measures to these important deposit modeling assumptions. The Bancorp also regularly monitors the sensitivity of other important modeling assumptions, such as loan and security prepayments and early withdrawals on fixed-rate customer liabilities. The following table shows the Bancorp’s estimated NII sensitivity profile and ALCO policy limits as of December 31: At December 31, 2019, the Bancorp’s NII sensitivity under the parallel rate ramp increases is near neutral in the first year and would benefit in the second year. Under the parallel 100 bps ramp decrease in interest rates, the Bancorp’s NII would decline in both the first and second years. The asymmetric NII sensitivity profile is attributable to the combination of floating-rate assets, including the predominantly floating-rate commercial loan portfolio, and certain intermediate-term fixed-rate liabilities and managed-rate deposits. Reductions in the yield of the commercial loan portfolio would be expected to be only partially offset by a decline in the cost of interest-bearing deposits in this scenario. However, proactive management of the securities and derivatives portfolios has reduced the near-term risk to declining market rates. 94 Fifth Third Bancorp MANAGEMENT’S DISCUSSION AND ANALYSIS OF FINANCIAL CONDITION AND RESULTS OF OPERATIONS The changes in the estimated NII sensitivity profile as of December 31, 2019 compared to December 31, 2018 were primarily attributable to the acquisition of MB Financial, Inc., which had a more asset-sensitive balance sheet. The down rate scenarios were also impacted by lower market interest rates and a higher composition of low-cost deposits, which results in deposits hitting their floor rates more quickly in the current year scenarios. However, the strategic repositioning of the investment portfolio into securities that are less callable in the near term more than offset the impact of the MB Financial, Inc. acquisition on NII at risk in year one and partially offset the impact in year two. Tables 62 and 63 provide the sensitivity of the Bancorp’s estimated NII profile at December 31, 2019 to changes to certain deposit balance and deposit repricing sensitivity (betas) assumptions. The following table includes the Bancorp’s estimated NII sensitivity profile with an immediate $1 billion decrease and an immediate $1 billion increase in demand deposit balances as of December 31, 2019: Economic Value of Equity Sensitivity The Bancorp also uses EVE as a measurement tool in managing interest rate risk. Whereas the NII sensitivity analysis highlights the impact on forecasted NII on an FTE basis (non-GAAP) over one and two-year time horizons, EVE is a point-in-time analysis of the economic sensitivity of current positions that incorporates all cash flows over their estimated remaining lives. The EVE of the balance sheet is defined as the discounted present value of all asset and net derivative cash flows less the discounted value of all liability cash flows. Due to this longer horizon, the sensitivity of EVE to changes in the level of interest rates is a measure of longer-term interest rate risk. EVE values only the current balance sheet and does not incorporate the balance growth assumptions used in the NII sensitivity analysis. As with the NII simulation model, assumptions about the timing and variability of existing balance sheet cash flows are critical in the EVE analysis. Particularly important are assumptions driving loan and security prepayments and the expected balance attrition and pricing of indeterminate-lived deposits. The following table shows the Bancorp’s estimated EVE sensitivity profile as of December 31: The EVE sensitivity is moderately negative in both a +200 bps rising-rate and a -150 bps declining-rate market rate scenario at December 31, 2019. The changes in the estimated EVE sensitivity profile from December 31, 2018 were primarily related to noninterest-bearing deposits growth from the acquisition of MB Financial, Inc. and a decrease in market interest rates. These items were partially offset by strategic repositioning of the investment portfolio into securities that are less callable in the near term. While an instantaneous shift in interest rates is used in this analysis to provide an estimate of exposure, the Bancorp believes that a gradual shift in interest rates would have a much more modest impact. 95 Fifth Third Bancorp MANAGEMENT’S DISCUSSION AND ANALYSIS OF FINANCIAL CONDITION AND RESULTS OF OPERATIONS Since EVE measures the discounted present value of cash flows over the estimated lives of instruments, the change in EVE does not directly correlate to the degree that earnings would be impacted over a shorter time horizon (e.g., the current fiscal year). Further, EVE does not take into account factors such as future balance sheet growth, changes in product mix, changes in yield curve relationships and changing product spreads that could mitigate or exacerbate the impact of changes in interest rates. The NII simulations and EVE analyses do not necessarily include certain actions that management may undertake to manage risk in response to actual changes in interest rates. The Bancorp regularly evaluates its exposures to a static balance sheet forecast, LIBOR, Prime Rate and other basis risks, yield curve twist risks and embedded options risks. In addition, the impacts on NII on an FTE basis and EVE of extreme changes in interest rates are modeled, wherein the Bancorp employs the use of yield curve shocks and environment-specific scenarios. Use of Derivatives to Manage Interest Rate Risk An integral component of the Bancorp’s interest rate risk management strategy is its use of derivative instruments to minimize significant fluctuations in earnings caused by changes in market interest rates. Examples of derivative instruments that the Bancorp may use as part of its interest rate risk management strategy include interest rate swaps, interest rate floors, interest rate caps, forward contracts, forward starting interest rate swaps, options, swaptions and TBA securities. Tables 65 and 66 show all swap and floor positions that are utilized for purposes of managing the Bancorp’s exposures to the variability of interest rates. These positions are used to convert the contractual interest rate index of agreed-upon amounts of assets and liabilities (i.e., notional amounts) to another interest rate index or to hedge forecasted transactions for the variability in cash flows attributable to the contractually specified interest rate. The volume, maturity and mix of portfolio swaps change frequently as the Bancorp adjusts its broader interest rate risk management objectives and the balance sheet positions to be hedged. For further information, including the notional amount and fair values of these derivatives, refer to Note 15 of the Notes to Consolidated Financial Statements. The following tables present additional information about the interest rate swaps and floors used in Fifth Third’s asset and liability management activities: (a) Forward starting swaps will become effective January 2, 2020. (b) Forward starting floors became effective December 16, 2019. Additionally, as part of its overall risk management strategy relative to its residential mortgage banking activities. The Bancorp enters into forward contracts accounted for as free-standing derivatives to economically hedge IRLCs that are also considered free-standing derivatives. The Bancorp economically hedges its exposure to residential mortgage loans held for sale through the use of forward contracts and mortgage options as well. See the Residential Mortgage Servicing Rights and Interest Rate Risk section for the discussion of the use of derivatives to economically hedge this exposure. The Bancorp also enters into derivative contracts with major financial institutions to economically hedge market risks assumed in interest rate derivative contracts with commercial customers. Generally, these contracts have similar terms in order to protect the Bancorp from market volatility. Credit risk arises from the possible inability of the counterparties to meet the terms of their contracts, which the Bancorp minimizes through collateral arrangements, approvals, limits and monitoring procedures. The Bancorp has risk limits and internal controls in place to help ensure excessive risk is not being taken in providing this service to customers. These controls include an independent determination of interest rate volatility and credit equivalent exposure on these contracts and counterparty credit approvals performed by independent risk management. For further information, including the notional amount and fair values of these derivatives, refer to Note 15 of the Notes to Consolidated Financial Statements. Portfolio Loans and Leases and Interest Rate Risk Although the Bancorp’s portfolio loans and leases contain both fixed and floating/adjustable-rate products, the rates of interest earned by the Bancorp on the outstanding balances are generally established for a period of time. The interest rate sensitivity of loans and leases is directly related to the length of time the rate earned is established. 96 Fifth Third Bancorp MANAGEMENT’S DISCUSSION AND ANALYSIS OF FINANCIAL CONDITION AND RESULTS OF OPERATIONS The following table summarizes the carrying value of the Bancorp’s portfolio loans and leases expected cash flows, excluding interest receivable, as of December 31, 2019: Additionally, the following table displays a summary of expected cash flows, excluding interest receivable, occurring after one year for both fixed and floating/adjustable-rate loans and leases as of December 31, 2019: Residential Mortgage Servicing Rights and Interest Rate Risk The fair value of the residential MSR portfolio was $993 million and $938 million at December 31, 2019 and December 31, 2018, respectively. The portfolio of servicing rights included $263 million of servicing rights acquired in the acquisition of MB Financial, Inc. on March 22, 2019. The value of servicing rights can fluctuate sharply depending on changes in interest rates and other factors. Generally, as interest rates decline and loans are prepaid to take advantage of refinancing, the total value of existing servicing rights declines because no further servicing fees are collected on repaid loans. The Bancorp maintains a non-qualifying hedging strategy relative to its mortgage banking activity in order to manage a portion of the risk associated with changes in the value of its MSR portfolio as a result of changing interest rates. Mortgage rates decreased during the year ended December 31, 2019 which caused modeled prepayment speeds to rise. The fair value of the MSR portfolio decreased $203 million due to changes to inputs to the valuation model including prepayment speeds and OAS assumptions and decreased $173 million due to the passage of time, including the impact of regularly scheduled repayments, paydowns and payoffs for the year ended December 31, 2019. Mortgage rates increased during the year ended December 31, 2018 which caused modeled prepayment speeds to slow. The fair value of the MSR portfolio increased $42 million due to changes to inputs to the valuation model including prepayment speeds and OAS assumptions and decreased $125 million due to the passage of time, including the impact of regularly scheduled repayments, paydowns and payoffs for the year ended December 31, 2018. The Bancorp recognized net gains of $224 million and net losses of $36 million, respectively, on its non-qualifying hedging strategy during the years ended December 31, 2019 and 2018. These amounts include net gains of $3 million and net losses of $15 million, respectively, on securities related to the Bancorp’s non-qualifying hedging strategy during the years ended December 31, 2019 and 2018. The Bancorp may adjust its hedging strategy to reflect its assessment of the composition of its MSR portfolio, the cost of hedging and the anticipated effectiveness of the hedges given the economic environment. Refer to Note 14 of the Notes to Consolidated Financial Statements for further discussion on servicing rights and the instruments used to hedge interest rate risk on MSRs. Foreign Currency Risk The Bancorp may enter into foreign exchange derivative contracts to economically hedge certain foreign denominated loans. The derivatives are classified as free-standing instruments with the revaluation gain or loss being recorded in other noninterest income in the Consolidated Statements of Income. The balance of the Bancorp’s foreign denominated loans at December 31, 2019 and 2018 was $880 million and $948 million, respectively. The Bancorp also enters into foreign exchange contracts for the benefit of commercial customers to hedge their exposure to foreign currency fluctuations. Similar to the hedging of interest rate risk from interest rate derivative contracts entered into with commercial customers, the Bancorp also enters into foreign exchange contracts with major financial institutions to economically hedge a substantial portion of the exposure from client driven foreign exchange activity. 97 Fifth Third Bancorp MANAGEMENT’S DISCUSSION AND ANALYSIS OF FINANCIAL CONDITION AND RESULTS OF OPERATIONS The Bancorp has risk limits and internal controls in place to help ensure excessive risk is not being taken in providing this service to customers. These controls include an independent determination of currency volatility and credit equivalent exposure on these contracts, counterparty credit approvals and country limits performed by independent risk management. Commodity Risk The Bancorp also enters into commodity contracts for the benefit of commercial customers to hedge their exposure to commodity price fluctuations. Similar to the hedging of foreign exchange and interest rate risk from interest rate derivative contracts, the Bancorp also enters into commodity contracts with major financial institutions to economically hedge a substantial portion of the exposure from client driven commodity activity. The Bancorp may also offset this risk with exchange-traded commodity contracts. The Bancorp has risk limits and internal controls in place to help ensure excessive risk is not taken in providing this service to customers. These controls include an independent determination of commodity volatility and credit equivalent exposure on these contracts and counterparty credit approvals performed by independent risk management. LIQUIDITY RISK MANAGEMENT The goal of liquidity management is to provide adequate funds to meet changes in loan and lease demand, unexpected levels of deposit withdrawals and other contractual obligations. Mitigating liquidity risk is accomplished by maintaining liquid assets in the form of cash and investment securities, maintaining sufficient unused borrowing capacity in the debt markets and delivering consistent growth in core deposits. A summary of certain obligations and commitments to make future payments under contracts is included in Note 19 of the Notes to Consolidated Financial Statements. The Bancorp’s Treasury department manages funding and liquidity based on point-in-time metrics as well as forward-looking projections, which incorporate different sources and uses of funds under base and stress scenarios. Liquidity risk is monitored and managed by the Treasury department with independent oversight provided by ERM, and a series of Policy Limits and Key Risk Indicators are established to ensure risks are managed within the Bancorp’s risk tolerance. The Bancorp maintains a contingency funding plan that provides for liquidity stress testing, which assesses the liquidity needs under varying market conditions, time horizons, asset growth rates and other events. The contingency plan provides for ongoing monitoring of unused borrowing capacity and available sources of contingent liquidity to prepare for unexpected liquidity needs and to cover unanticipated events that could affect liquidity. The contingency plan also outlines the Bancorp’s response to various levels of liquidity stress and actions that should be taken during various scenarios. Liquidity risk is monitored and managed for both Fifth Third Bancorp and its subsidiaries. The Bancorp receives substantially all of its liquidity from dividends from its subsidiaries, primarily Fifth Third Bank, National Association. Subsidiary dividends are supplemented with term debt to enable the Bancorp to maintain sufficient liquidity to meet its cash obligations, including debt service and scheduled maturities, common and preferred dividends, unfunded commitments to subsidiaries and other planned capital actions in the form of share repurchases. Liquidity resources are more limited at the Bancorp, making its liquidity position more susceptible to market disruptions. Bancorp liquidity is assessed using a cash coverage horizon, ensuring the entity maintains sufficient liquidity to withstand a period of sustained market disruption while meeting its anticipated obligations over an extended stressed horizon. The Bancorp’s ALCO, which includes senior management representatives and is accountable to the ERMC, monitors and manages liquidity and funding risk within Board-approved policy limits. In addition to the risk management activities of ALCO, the Bancorp has a Market Risk Management function as part of ERM that provides independent oversight of liquidity risk management. Sources of Funds The Bancorp’s primary sources of funds relate to cash flows from loan and lease repayments, payments from securities related to sales and maturities, the sale or securitization of loans and leases and funds generated by core deposits, in addition to the use of public and private debt offerings. Table 67 of the Market Risk Management subsection of the Risk Management section of MD&A illustrates the expected maturities from loan and lease repayments. Of the $36.0 billion of securities in the Bancorp’s available-for-sale debt and other securities portfolio at December 31, 2019, $3.4 billion in principal and interest is expected to be received in the next 12 months and an additional $3.8 billion is expected to be received in the next 13 to 24 months. For further information on the Bancorp’s securities portfolio, refer to the Investment Securities subsection of the Balance Sheet Analysis section of MD&A. Asset-driven liquidity is provided by the Bancorp’s ability to sell or securitize loans and leases. In order to reduce the exposure to interest rate fluctuations and to manage liquidity, the Bancorp has developed securitization and sale procedures for several types of interest-sensitive assets. A majority of the long-term, fixed-rate single-family residential mortgage loans underwritten according to FHLMC or FNMA guidelines are sold for cash upon origination. Additional assets such as certain other residential mortgage loans, certain commercial loans, home equity loans, automobile loans and other consumer loans are also capable of being securitized or sold. The Bancorp sold or securitized loans and leases totaling $9.7 billion during the year ended December 31, 2019 compared to $5.5 billion during the year ended December 31, 2018. For further information, refer to Note 13 and Note 14 of the Notes to Consolidated Financial Statements. Core deposits have historically provided the Bancorp with a sizeable source of relatively stable and low-cost funds. The Bancorp’s average core deposits and average shareholders’ equity funded 83% of its average total assets for both the years ended December 31, 2019 and 2018. In addition to core deposit funding, the Bancorp also accesses a variety of other short-term and long-term funding sources, which include the use of the FHLB system. Certificates $100,000 and over and certain deposits in the Bancorp’s foreign branch located in the Cayman Islands are wholesale funding tools utilized to fund asset growth. Management does not rely on any one source of liquidity and manages availability in response to changing balance sheet needs. As of December 31, 2019, $4.8 billion of debt or other securities were available for issuance under the current Bancorp’s Board of Directors’ authorizations and the Bancorp is authorized to file any necessary registration statements with the SEC to permit ready access to the public securities markets; however, access to these markets may depend on market conditions. During the year ended December 31, 2019, the Bancorp issued and sold $1.5 billion of 3.65% senior fixed-rate notes and $750 million of 2.375% senior fixed-rate notes. 98 Fifth Third Bancorp MANAGEMENT’S DISCUSSION AND ANALYSIS OF FINANCIAL CONDITION AND RESULTS OF OPERATIONS Additionally, during the year ended December 31, 2019, the Bancorp issued in a registered public offering 10,000,000 depositary shares, representing 10,000 shares of 4.95% non-cumulative Series K perpetual preferred stock, for net proceeds of approximately $242 million. As of December 31, 2019, the Bank’s global bank note program had a borrowing capacity of $25.0 billion, of which $19.3 billion was available for issuance. During the year ended 2019, the Bank issued and sold $300 million of senior floating-rate bank notes. For further information on a subsequent event related to long-term debt, refer to Note 33 of the Notes to Consolidated Financial Statements. Additionally, at December 31, 2019, the Bank had approximately $48.3 billion of borrowing capacity available through secured borrowing sources including the FRB and FHLB. In a securitization transaction that occurred in 2019, the Bancorp transferred approximately $1.43 billion in automobile loans to a bankruptcy remote trust which subsequently issued approximately $1.37 billion of asset-backed notes, of which approximately $68 million of the asset-backed notes were retained by the Bancorp, and resulted in approximately $1.3 billion of outstanding notes included in long-term debt in the Consolidated Balance Sheets. The bankruptcy remote trust was deemed to be a VIE and the Bancorp, as the primary beneficiary, consolidated the VIE. The third-party holders of the asset-backed notes do not have recourse to the general assets of the Bancorp. Refer to Note 18 of the Notes to Consolidated Financial Statements for additional information. Liquidity Coverage Ratio and Net Stable Funding Ratio On October 31, 2018, the Board of Governors of the FRB released a series of regulatory proposals to implement the Economic Growth, Regulatory Relief, and Consumer Protection Act (“Reform Act”). Among the proposals, the Board of Governors, joined by the Department of Treasury, OCC and the FDIC proposed to remove the application of the LCR regulations and the NSFR from certain BHCs that qualify under the proposal as “Category IV” institutions, primarily those BHCs with consolidated assets between $100 billion and $250 billion. On October 10, 2019, the Board of Governors of the FRB announced it finalized the rules that tailor its regulations for banks to more closely match their risk profile. Fifth Third, as a Category IV institution, is no longer subject to the LCR regulations and the NSFR regulations, effective December 31, 2019. Credit Ratings The cost and availability of financing to the Bancorp and Bank are impacted by its credit ratings. A downgrade to the Bancorp’s or Bank’s credit ratings could affect its ability to access the credit markets and increase its borrowing costs, thereby adversely impacting the Bancorp’s or Bank’s financial condition and liquidity. Key factors in maintaining high credit ratings include a stable and diverse earnings stream, strong credit quality, strong capital ratios and diverse funding sources, in addition to disciplined liquidity monitoring procedures. The Bancorp’s and Bank’s credit ratings are summarized in Table 69. The ratings reflect the ratings agency’s view on the Bancorp’s and Bank’s capacity to meet financial commitments.* *As an investor, you should be aware that a security rating is not a recommendation to buy, sell or hold securities, that it may be subject to revision or withdrawal at any time by the assigning rating organization and that each rating should be evaluated independently of any other rating. Additional information on the credit rating ranking within the overall classification system is located on the website of each credit rating agency. TABLE 69: AGENCY RATINGS OPERATIONAL RISK MANAGEMENT Operational risk is the risk to current or projected financial condition and resilience arising from inadequate or failed internal processes or systems, human errors or misconduct, or adverse external events that are neither market nor credit-related. Operational risk is inherent in the Bancorp’s activities and can manifest itself in various ways including fraudulent acts, business interruptions, inappropriate behavior of employees, unintentional failure to comply with applicable laws and regulations, poor design or delivery of products and services, cyber security or physical security incidents and privacy breaches or failure of vendors to perform in accordance with their arrangements. These events could result in financial losses, litigation and regulatory fines, as well as other damage to the Bancorp. The Bancorp’s risk management goal is to keep operational risk at appropriate levels consistent with the Bancorp’s risk appetite, financial strength, the characteristics of its businesses, the markets in which it operates and the competitive and regulatory environment to which it is subject. To control, monitor and govern operational risk, the Bancorp maintains an overall Risk Management Framework which comprises governance oversight, risk assessment, capital measurement, monitoring and reporting as well as a formal three lines of defense approach. ERM is responsible for prescribing the framework to the lines of business and corporate functions and providing independent oversight of its implementation (second line of defense). Business Controls groups are in place in each of the lines of business to ensure consistent implementation and execution of managing day-to-day operational risk (first line of defense). The Bancorp’s risk management framework consists of five integrated components, including identifying, assessing, managing, monitoring and independent governance reporting of risk. The corporate Operational Risk Management function within Enterprise Risk is responsible for developing and overseeing the implementation of the Bancorp’s approach to managing operational risk. 99 Fifth Third Bancorp MANAGEMENT’S DISCUSSION AND ANALYSIS OF FINANCIAL CONDITION AND RESULTS OF OPERATIONS This includes providing governance, awareness and training, tools, guidance and oversight to support implementation of key risk programs and systems as they relate to operational risk management, such as risk and control self-assessments, new product/initiative risk reviews, key risk indicators, Vendor Risk Management, cyber security risk management and review of operational losses. The function is also responsible for developing reports that support the proactive management of operational risk across the enterprise. The lines of business and corporate functions are responsible for managing the operational risks associated with their areas in accordance with the risk management framework. The framework is intended to enable the Bancorp to function with a sound and well-controlled operational environment. These processes support the Bancorp’s goals to minimize future operational losses and strengthen the Bancorp’s performance by maintaining sufficient capital to absorb operational losses that are incurred. The Bancorp also maintains a robust information security program to support the management of cyber security risk within the organization with a focus on prevention, detection and recovery processes. Fifth Third utilizes a wide array of techniques to secure its operations and proprietary information such as Board-approved policies and programs, network monitoring and testing, access controls and dedicated security personnel. Fifth Third has adopted the National Institute of Standards and Technology Cybersecurity Framework for the management and deployment of cyber security controls and is an active participant in the financial sector information sharing organization structure, known as the Financial Services Information Sharing and Analysis Center. To ensure resiliency of key Bancorp functions, Fifth Third also employs redundancy protocols that include a robust business continuity function that works to mitigate any potential impacts to Fifth Third customers and its systems. Fifth Third also focuses on the reporting and escalation of operational control issues to senior management and the Board of Directors. The Operational Risk Committee is the key committee that oversees and supports Fifth Third in the management of operational risk across the enterprise. The Operational Risk Committee reports to the ERMC, which reports to the Risk and Compliance Joint Committee of the Board of Directors of Fifth Third Bancorp and Fifth Third Bank, National Association. Fifth Third’s operational risk management and information security programs have been actively engaged to evaluate and oversee MB Financial, Inc.’s products and processes to ensure risks are understood, well managed and in alignment with the Bancorp’s risk appetite. COMPLIANCE RISK MANAGEMENT Regulatory compliance risk is defined as the risk of legal or regulatory sanctions, financial loss or damage to reputation as a result of noncompliance with (i) applicable laws, regulations, rules and other regulatory requirements (including but not limited to the risk of consumers experiencing economic loss or other legal harm as a result of noncompliance with consumer protection laws, regulations and requirements); (ii) internal policies and procedures, standards of best practice or codes of conduct; and (iii) principles of integrity and fair dealing applicable to Fifth Third’s activities and functions. Fifth Third focuses on managing regulatory compliance risk in accordance with the Bancorp’s integrated risk management framework, which ensures consistent processes for identifying, assessing, managing, monitoring and reporting risks. The Bancorp’s risk management goal is to keep compliance risk at appropriate levels consistent with the Bancorp’s risk appetite. To mitigate compliance risk, Compliance Risk Management provides independent oversight to ensure consistency and sufficiency in the execution of the program, and ensures that lines of business, regions and support functions are adequately identifying, assessing and monitoring compliance risks and adopting proper mitigation strategies. The lines of business and enterprise functions are responsible for managing the compliance risks associated with their areas. Additionally, the Chief Compliance Officer is responsible for establishing and overseeing the Compliance Risk Management program which implements key compliance processes, including but not limited to, executive- and board-level governance and reporting routines, compliance-related policies, risk assessments, key risk indicators, issues tracking, regulatory compliance testing and monitoring and privacy. The Chief Compliance Officer also partners with the Financial Crimes Division to oversee anti-money laundering processes and partners with the Community and Economic Development team to oversee the Bancorp’s compliance with the Community Reinvestment Act. Fifth Third also focuses on the reporting and escalation of compliance issues to senior management and the Board of Directors. The Management Compliance Committee, which is chaired by the Chief Compliance Officer, is the key committee that oversees and supports Fifth Third in the management of compliance risk across the enterprise. The Management Compliance Committee oversees Fifth Third-wide compliance issues, industry best practices, legislative developments, regulatory concerns and other leading indicators of compliance risk. The Management Compliance Committee reports to the ERMC, which reports to the Risk and Compliance Joint Committee of the Board of Directors of Fifth Third Bancorp and Fifth Third Bank, National Association. Fifth Third’s compliance risk management and anti-money laundering programs have been actively engaged to evaluate and oversee MB Financial, Inc.’s products and processes to ensure risks are understood, well managed and in alignment with the Bancorp’s risk appetite. 100 Fifth Third Bancorp MANAGEMENT’S DISCUSSION AND ANALYSIS OF FINANCIAL CONDITION AND RESULTS OF OPERATIONS CAPITAL MANAGEMENT Management regularly reviews the Bancorp’s capital levels to help ensure it is appropriately positioned under various operating environments. The Bancorp has established a Capital Committee which is responsible for making capital plan recommendations to management. These recommendations are reviewed by the ERMC and the annual capital plan is approved by the Board of Directors. The Capital Committee is responsible for execution and oversight of the capital actions of the capital plan. Regulatory Capital Ratios The Basel III Final Rule sets minimum regulatory capital ratios as well as defines the measure of “well-capitalized” for insured depository institutions. The Bancorp is subject to a capital conservation buffer of 2.5%, in addition to the minimum capital ratios, in order to avoid limitations on certain capital distributions and discretionary bonus payments to executive officers. The capital conservation buffer was phased-in over a three-year period beginning on January 1, 2016 at 0.625%, increasing by an additional 0.625% each year, culminating on January 1, 2019 at the fully phased-in rate of 2.5%. The Bancorp exceeded these “well-capitalized” and “capital conservation buffer” ratios for all periods presented. In April 2018, the federal banking regulators proposed transitional arrangements to permit banking organizations to phase in the day-one impact of the adoption of ASU 2016-13, referred to as the current expected credit loss model, on regulatory capital over a period of three years. The proposed rule was adopted as final effective July 1, 2019. The phase-in provisions of the final rule are optional for a banking organization that experiences a reduction in retained earnings due to CECL adoption as of the beginning of the fiscal year in which the banking organization adopts CECL. A banking organization that elects the phase-in provisions of the final rule for regulatory capital purposes must phase in 25% of the transitional amounts impacting regulatory capital in the first year of adoption of CECL, 50% in the second year, 75% in the third year, with full impact beginning in the fourth year. The Bancorp adopted ASU 2016-13 on January 1, 2020 and plans to elect the phase-in option for the impact of CECL on regulatory capital with its regulatory filings as of March 31, 2020. For additional information on ASU 2016-13, refer to Note 1 of the Notes to Consolidated Financial Statements. On July 22, 2019, the federal banking regulators published the Regulatory Capital Simplification final rule in the Federal Register. Under the final rule, non-advanced approach banks, such as the Bancorp, will be subject to simpler regulatory capital requirements for mortgage servicing assets, certain deferred tax assets arising from temporary differences and investments in the capital of unconsolidated financial institutions than those currently applied. The final rule increases the deduction threshold for mortgage servicing assets, certain deferred tax assets arising from temporary differences and investments in the capital of unconsolidated financial institutions from 10% to 25% of CET1, but increases the risk-weighted assets percentage for the non-deducted elements from 100% to 250%. The final rule pertaining to these regulatory capital elements is effective on April 1, 2020. The following table summarizes the Bancorp’s capital ratios as of December 31: (a) These are non-GAAP measures. For further information, refer to the Non-GAAP Financial Measures section of MD&A. (b) Under the U.S. banking agencies’ Basel III Final Rule, assets and credit equivalent amounts of off-balance sheet exposures are calculated according to the standardized approach for risk-weighted assets. The resulting values are added together resulting in the Bancorp’s total risk-weighted assets. (c) Excludes AOCI. 101 Fifth Third Bancorp MANAGEMENT’S DISCUSSION AND ANALYSIS OF FINANCIAL CONDITION AND RESULTS OF OPERATIONS Capital Planning In 2011 the FRB adopted the capital plan rule, which requires BHCs with consolidated assets of $50 billion or more to submit annual capital plans to the FRB for review. Under the rule, these capital plans must include detailed descriptions of the following: the BHC’s internal processes for assessing capital adequacy; the policies governing capital actions such as common stock issuances, dividends and share repurchases; and all planned capital actions over a nine-quarter planning horizon. Furthermore, each BHC must report to the FRB the results of stress tests conducted by the BHC under a number of scenarios that assess the sources and uses of capital under baseline and stressed economic conditions. During the first quarter of 2019, the FRB provided relief from certain regulatory requirements related to supervisory stress testing and company-run stress testing for the 2019 stress test cycle, including disclosure requirements. As a result, the Bancorp was not required to submit a capital plan or participate in CCAR 2019. The requirement for the Bancorp to submit an annual capital plan to the FRB has been extended until April 5, 2020. However, the Bancorp remains subject to the requirement to develop and maintain a capital plan, and the Board of Directors of the Bancorp must review and approve the capital plan. The FRB further clarified that relief from the 2019 stress test cycle should not be construed as relief from any regulatory capital requirements and that the Bancorp will be subject to the full CCAR 2020 stress test requirements. In June of 2019, the Bancorp announced its capital distribution capacity of approximately $2 billion for the period of July 1, 2019 through June 30, 2020. This includes the ability to execute share repurchases up to $1.24 billion as well as increase quarterly common stock dividends by up to $0.03 per share. These distributions will be governed under the FRB’s 2019 extended stress test process for BHCs with less than $250 billion of total consolidated assets. Preferred Stock Transactions On August 26, 2019, the Bancorp issued 200,000 shares of 6.00% non-cumulative perpetual Class B preferred stock, Series A. Each preferred share has a $1,000 liquidation preference. These shares were issued to the holders of MB Financial, Inc.’s 6.00% non-cumulative perpetual preferred stock, Series C, in conjunction with the merger of MB Financial, Inc. with and into Fifth Third Bancorp. This transaction resulted in the elimination of the noncontrolling interest in MB Financial, Inc. which was previously reported in the Bancorp’s Consolidated Financial Statements. The newly issued shares of Class B preferred stock, Series A were recognized by the Bancorp at the carrying value previously assigned to the MB Financial, Inc. Series C preferred stock prior to the transaction. On September 17, 2019, the Bancorp issued in a registered public offering 10,000,000 depositary shares, representing 10,000 shares of 4.95% non-cumulative perpetual preferred stock, Series K, for net proceeds of approximately $242 million. Each preferred share has a $25,000 liquidation preference. Subject to any required regulatory approval, the Bancorp may redeem the Series K preferred shares at its option (i) in whole or in part, on any dividend payment date on or after September 30, 2024 and (ii) in whole, but not in part, at any time following a regulatory capital event. The Series K preferred shares are not convertible into Bancorp common shares or any other securities. Dividend Policy and Stock Repurchase Program The Bancorp’s common stock dividend policy and stock repurchase program reflect its earnings outlook, desired payout ratios, the need to maintain adequate capital levels, the ability of its subsidiaries to pay dividends, the need to comply with safe and sound banking practices as well as meet regulatory requirements and expectations. The Bancorp declared dividends per common share of $0.94 and $0.74 during the years ended December 31, 2019 and 2018, respectively. The Bancorp entered into or settled a number of accelerated share repurchase and open market share repurchase transactions during the years ended December 31, 2019 and 2018. Refer to Note 25 of the Notes to Consolidated Financial Statements for additional information on the accelerated share repurchase and open market share repurchase transactions. The following table summarizes shares authorized for repurchase as part of publicly announced plans or programs: (a) During the second quarter of 2019, the Bancorp announced that its Board of Directors had authorized management to purchase 100 million shares of the Bancorp’s common stock through the open market or in any private party transactions. The authorization does not include specific price targets or an expiration date. This share repurchase authorization replaces the Board’s previous authorization pursuant to which approximately 20 million shares remained available for repurchase by the Bancorp. (b) Excludes 2,693,318 and 2,155,189 shares repurchased during the years ended December 31, 2019 and 2018, respectively, in connection with various employee compensation plans. These purchases are not included in the calculation for average price paid per share and do not count against the maximum number of shares that may yet be repurchased under the Board of Directors’ authorization. 102 Fifth Third Bancorp MANAGEMENT’S DISCUSSION AND ANALYSIS OF FINANCIAL CONDITION AND RESULTS OF OPERATIONS OFF-BALANCE SHEET ARRANGEMENTS In the ordinary course of business, the Bancorp enters into financial transactions that are considered off-balance sheet arrangements as they involve varying elements of market, credit and liquidity risk in excess of the amounts recognized in the Bancorp’s Consolidated Balance Sheets. The Bancorp’s off-balance sheet arrangements include commitments, guarantees, contingent liabilities and transactions with non-consolidated VIEs. A brief discussion of these transactions is as follows: Commitments The Bancorp has certain commitments to make future payments under contracts, including commitments to extend credit, letters of credit, forward contracts related to residential mortgage loans held for sale, purchase obligations, capital commitments for private equity investments and capital expenditures. Refer to Note 19 of the Notes to Consolidated Financial Statements for additional information on commitments. Guarantees and Contingent Liabilities The Bancorp has performance obligations upon the occurrence of certain events provided in certain contractual arrangements, including residential mortgage loans sold with representation and warranty provisions or credit recourse. Refer to Note 19 of the Notes to Consolidated Financial Statements for additional information on guarantees and contingent liabilities. Transactions with Non-consolidated VIEs The Bancorp engages in a variety of activities that involve VIEs, which are legal entities that lack sufficient equity to finance their activities, or the equity investors of the entities as a group lack any of the characteristics of a controlling interest. The investments in those entities in which the Bancorp was determined not to be the primary beneficiary but holds a variable interest in the entity are accounted for under the equity method of accounting or other accounting standards as appropriate and not consolidated. Refer to Note 13 of the Notes to Consolidated Financial Statements for additional information on non-consolidated VIEs. 103 Fifth Third Bancorp MANAGEMENT’S DISCUSSION AND ANALYSIS OF FINANCIAL CONDITION AND RESULTS OF OPERATIONS Contractual Obligations and Other Commitments The Bancorp has certain obligations and commitments to make future payments under contracts. The aggregate contractual obligations and commitments at December 31, 2019 are shown in Table 73. As of December 31, 2019, the Bancorp had unrecognized tax benefits that, if recognized, would impact the effective tax rate in future periods. Due to the uncertainty of the amounts to be ultimately paid as well as the timing of such payments, all uncertain tax liabilities that have not been paid have been excluded from the following table. For further detail on the impact of income taxes, refer to Note 22 of the Notes to Consolidated Financial Statements. (a) Interest-bearing obligations are principally used to fund interest-earning assets. Interest charges on contractual obligations were excluded from reported amounts, as the potential cash outflows would have corresponding cash inflows from interest-earning assets. (b) Includes demand, interest checking, savings, money market and foreign office deposits. For additional information, refer to the Deposits subsection of the Balance Sheet Analysis section of MD&A. (c) Includes debt obligations with an original maturity of greater than one year. Refer to Note 18 of the Notes to Consolidated Financial Statements for additional information on these debt instruments. (d) Includes other time deposits and certificates $100,000 and over. For additional information, refer to the Deposits subsection of the Balance Sheet Analysis section of MD&A. (e) Includes federal funds purchased and borrowings with an original maturity of less than one year. For additional information, refer to Note 17 of the Notes to Consolidated Financial Statements. (f) Refer to Note 15 of the Notes to Consolidated Financial Statements for additional information on forward contracts to sell residential mortgage loans. (g) Refer to Note 10 of the Notes to Consolidated Financial Statements for additional information on lease obligations. (h) Includes LIHTC and New Markets Tax Credit investments. For additional information, refer to Note 13 of the Notes to Consolidated Financial Statements. (i) Refer to Note 23 of the Notes to Consolidated Financial Statements for additional information on pension obligations. (j) Represents agreements to purchase goods or services and includes commitments to various general contractors for work related to banking center construction. (k) Commitments to extend credit are agreements to lend, typically having fixed expiration dates or other termination clauses that may require payment of a fee. Many of the commitments to extend credit may expire without being drawn upon. The total commitment amounts include capital commitments for private equity investments and do not necessarily represent future cash flow requirements. For additional information, refer to Note 19 of the Notes to Consolidated Financial Statements. (l) Letters of credit are conditional commitments issued to guarantee the performance of a customer to a third party. For additional information, refer to Note 19 of the Notes to Consolidated Financial Statements.

<s>[INST] OVERVIEW This overview of MD&A highlights selected information in the financial results of the Bancorp and may not contain all of the information that is important to you. For a more complete understanding of trends, events, commitments, uncertainties, liquidity, capital resources and critical accounting policies and estimates, you should carefully read this entire document. Each of these items could have an impact on the Bancorp’s financial condition, results of operations and cash flows. In addition, refer to the Glossary of Abbreviations and Acronyms in this report for a list of terms included as a tool for the reader of this Annual Report on Form 10K. The abbreviations and acronyms identified therein are used throughout this MD&A, as well as the Consolidated Financial Statements and Notes to Consolidated Financial Statements. Net interest income, net interest margin, net interest rate spread and the efficiency ratio are presented in MD&A on an FTE basis. The FTE basis adjusts for the taxfavored status of income from certain loans and securities held by the Bancorp that are not taxable for federal income tax purposes. The Bancorp believes this presentation to be the preferred industry measurement of net interest income as it provides a relevant comparison between taxable and nontaxable amounts. The FTE basis for presenting net interest income is a nonGAAP measure. For further information, refer to the NonGAAP Financial Measures section of MD&A. The Bancorp’s revenues are dependent on both net interest income and noninterest income. For the year ended December 31, 2019, net interest income on an FTE basis and noninterest income provided 58% and 42% of total revenue, respectively. The Bancorp derives the majority of its revenues within the U.S. from customers domiciled in the U.S. Revenue from foreign countries and external customers domiciled in foreign countries was immaterial to the Consolidated Financial Statements. Changes in interest rates, credit quality, economic trends and the capital markets are primary factors that drive the performance of the Bancorp. As discussed later in the Risk Management section of MD&A, risk identification, assessment, management, monitoring and independent governance reporting of risk are important to the management of risk and to the financial performance and capital strength of the Bancorp. Net interest income is the difference between interest income earned on assets such as loans, leases and securities, and interest expense incurred on liabilities such as deposits, other shortterm borrowings and longterm debt. Net interest income is affected by the general level of interest rates, the relative level of shortterm and longterm interest rates, changes in interest rates and changes in the amount and composition of interestearning assets and interestbearing liabilities. Generally, the rates of interest the Bancorp earns on its assets and pays on its liabilities are established for a period of time. The change in market interest rates over time exposes the Bancorp to interest rate risk through potential adverse changes to net interest income and financial position. The Bancorp manages this risk by continually analyzing and adjusting the composition of its assets and liabilities based on their payment streams and interest rates, the timing of their maturities and their sensitivity to changes in market interest rates. Additionally, in the ordinary course of business, the Bancorp enters into certain derivative transactions as part of its overall strategy to manage its interest rate and prepayment risks. The Bancorp is also exposed to the risk of loss on its loan and lease portfolio as a result of changing expected cash flows caused by borrower credit events, such as loan defaults and inadequate collateral. Noninterest income is derived from corporate banking revenue, service charges on deposits, wealth and asset management revenue, card and processing revenue, mortgage banking net revenue, net securities gains or losses and other noninterest income. Noninterest expense includes personnel costs, technology and communication costs, net occupancy expense, card and processing expense, equipment expense and other noninterest expense. Acquisition of MB Financial, Inc. On March 22, 2019, Fifth Third Bancorp completed its acquisition of MB Financial, Inc. in a stock and cash transaction valued at approximately $3.6 billion. MB Financial, Inc. was [/INST] Negative. </s>

CHEMUNG FINANCIAL CORP

2015-03-13

2014-12-31

ITEM 7. MANAGEMENT'S DISCUSSION AND ANALYSIS OF FINANCIAL CONDITION AND RESULTS OF OPERATION To assist the reader, the Corporation has provided the following list of commonly used acronyms and abbreviations included in Management’s Discussion and Analysis of Financial Condition and Results of Operations. ASU: Accounting Standards Update FRBNY: Federal Reserve Bank of New York Bank: Chemung Canal Trust Company Freddie Mac: Federal Home Loan Mortgage Corporation CDO: Collateralized Debt Obligation GAAP: U.S. generally accepted accounting principles Corporation: Chemung Financial Corporation OTTI: Other-than-temporary impairment FASB: Financial Accounting Standards Board PCI: Purchased credit impaired FDIC: Federal Deposit Insurance Corporation SEC: Securities and Exchange Commission FHLBNY: Federal Home Loan Bank of New York TDRs: Troubled debt restructurings FRB: Board of Governors of the Federal Reserve System The purpose of this discussion is to focus on information about the financial condition and results of operations of the Corporation. Reference should be made to the accompanying consolidated financial statements and footnotes, and the selected financial data appearing elsewhere in this report for an understanding of the following discussion and analysis. This discussion contains forward-looking statements within the meaning of Section 27A of the Securities Act and Section 21E of the Exchange Act. The Corporation intends its forward-looking statements to be covered by the safe harbor provisions for forward-looking statements in these sections. All statements regarding the Corporation's expected financial position and operating results, the Corporation's business strategy, the Corporation's financial plans, forecasted demographic and economic trends relating to the Corporation's industry and similar matters are forward-looking statements. These statements can sometimes be identified by the Corporation's use of forward-looking words such as "may," "will," "anticipate," "estimate," "expect," or "intend." The Corporation cannot promise that its expectations in such forward-looking statements will turn out to be correct. The Corporation's actual results could be materially different from expectations because of various factors, including changes in economic conditions or interest rates, credit risk, difficulties in managing the Corporation’s growth, competition, changes in law or the regulatory environment, including the Dodd-Frank Act, and changes in general business and economic trends. Information concerning these and other factors can be found in the Corporation’s periodic filings with the SEC, including the discussion under the heading “Item 1A. Risk Factors” in this form 10-K. These filings are available publicly on the SEC’s web site at http://www.sec.gov, on the Corporation's web site at http://www.chemungcanal.com or upon request from the Corporate Secretary at (607) 737-3746. Except as otherwise required by law, the Corporation undertakes no obligation to publicly update or revise its forward-looking statements, whether as a result of new information, future events or otherwise. Use of Non-GAAP Financial Measures The SEC has adopted Regulation G, which applies to all public disclosures, including earnings releases, made by registered companies that contain “non-GAAP financial measures.” Under Regulation G, companies making public disclosures containing non-GAAP financial measures must also disclose, along with each non-GAAP financial measure, certain additional information, including a reconciliation of the non-GAAP financial measure to the closest comparable GAAP financial measure and a statement of the Corporation’s reasons for utilizing the non-GAAP financial measure as part of its financial disclosures. The SEC has exempted from the definition of “non-GAAP financial measures” certain commonly used financial measures that are not based on GAAP. When these exempted measures are included in public disclosures, supplemental information is not required. The following measures used in this Report, which are commonly utilized by financial institutions, have not been specifically exempted by the SEC and may constitute "non-GAAP financial measures" within the meaning of the SEC's new rules, although we are unable to state with certainty that the SEC would so regard them. Tax-Equivalent Net Interest Income and Net Interest Margin Net interest income is commonly presented on a tax-equivalent basis. That is, to the extent that some component of the institution's net interest income, which is presented on a before-tax basis, is exempt from taxation (e.g., is received by the institution as a result of its holdings of state or municipal obligations), an amount equal to the tax benefit derived from that component is added to the actual before-tax net interest income total. This adjustment is considered helpful in comparing one financial institution's net interest income to that of other institutions or in analyzing any institution’s net interest income trend line over time, to correct any analytical distortion that might otherwise arise from the fact that financial institutions vary widely in the proportions of their portfolios that are invested in tax-exempt securities, and that even a single institution may significantly alter over time the proportion of its own portfolio that is invested in tax-exempt obligations. Moreover, net interest income is itself a component of a second financial measure commonly used by financial institutions, net interest margin, which is the ratio of net interest income to average interest-earning assets. For purposes of this measure as well, fully taxable equivalent net interest income is generally used by financial institutions, as opposed to actual net interest income, again to provide a better basis of comparison from institution to institution and to better demonstrate a single institution’s performance over time. The Corporation follows these practices. Tangible Book Value per Share Tangible equity is total shareholders’ equity less intangible assets. Tangible book value per share is tangible equity divided by total shares issued and outstanding. Tangible book value per share is often regarded as a more meaningful comparative ratio than book value per share as calculated under GAAP, that is, total shareholders’ equity including intangible assets divided by total shares issued and outstanding. Intangible assets include goodwill and other intangible assets resulting from business combinations. Adjustments for Certain Items of Income or Expense In addition to disclosures of certain GAAP financial measures, including net income, earnings per share (“EPS”), return on average assets (“ROA”), and return on average equity (“ROE”), we may also provide comparative disclosures that adjust these GAAP financial measures for a particular period by removing from the calculation thereof the impact of certain transactions or other material items of income or expense occurring during the period, including certain nonrecurring items. The Corporation believes that the resulting non-GAAP financial measures may improve an understanding of its results of operations by separating out any such transactions or items that may have had a disproportionate positive or negative impact on the Corporation’s financial results during the particular period in question. In the Corporation’s presentation of any such non-GAAP (adjusted) financial measures not specifically discussed in the preceding paragraphs, the Corporation supplies the supplemental financial information and explanations required under Regulation G. The Corporation believes that the non-GAAP financial measures disclosed by it from time-to-time are useful in evaluating the Corporation’s performance and that such information should be considered as supplemental in nature and not as a substitute for or superior to the related financial information prepared in accordance with GAAP. The Corporation’s non-GAAP financial measures may differ from similar measures presented by other companies. Overview The Corporation has been a financial holding company since 2000, and the Bank was established in 1833 and CFS Group, Inc. in 2001. Through the Bank and CFS Group, Inc., the Corporation provides a wide range of financial services, including demand, savings and time deposits, commercial, residential and consumer loans, letters of credit, wealth management services, employee benefit plans, securities and insurance brokerage services. The Bank relies substantially on a foundation of locally generated deposits. The Corporation, on a stand-alone basis, has minimal results of operations. The Bank derives its income primarily from interest and fees on loans, interest on investment securities, Wealth Management Group fee income and fees received in connection with deposit and other services. The Bank’s operating expenses are interest expense paid on deposits and borrowings, salaries and employee benefit plans and general operating expenses. Highlights Below are highlights of the Corporation’s operations for the year ended December 31, 2014: · Net income for 2014 was $8.2 million, or $1.74 per share, compared with $8.7 million, or $1.87 per share, for 2013, a decrease of $0.5 million, or 6.6%. · Returns on average assets and average equity for 2014 were 0.54% and 5.74%, respectively, compared with 0.67% and 6.50%, respectively, for 2013. · Net interest margin (fully taxable equivalent) for 2014 was 3.59%, down from 3.91% for 2013. · The non-performing assets to total assets ratio was 0.71% at December 31, 2014 compared with 0.61% at December 31, 2013. · Book value per share was $28.44 at December 31, 2014 compared with $29.67 at December 31, 2013, a decrease of $1.23, or 4.1%. Tangible book value per share was $22.71 at December 31, 2014 compared with $23.63 at December 31, 2013, a decrease of $0.92 or 3.9%. · Tangible equity to tangible assets ratio decreased to 7.13% at December 31, 2014 compared with 7.62% at December 31, 2013. · The Corporation’s January 29, 2015 earnings release did not reflect an additional provision for loan losses of $0.7 million due to the impairment of a commercial loan, as we were unable to reasonably estimate the provision as of the date of the earnings release. The additional provision changed the previously reported full year net income of $8.6 million to $8.2 million, income tax expense of $4.0 million to $3.7 million, provision for loan losses of $3.3 million to $4.0 million, basic and diluted earnings per share of $1.83 to $1.74 and total shareholders’ equity of $134.0 million to $133.6 million. The Corporation’s earnings release also did not include a $7.9 million gross-up of the accrual for legal settlement, which had no income statement impact, to reflect the receivable for insurance proceeds. The provision for loan loss and the gross-up of the accrual for legal settlement adjustments changed the previously reported total assets of $1.517 billion to $1.524 billion and total liabilities of $1.383 billion to $1.391 billion. Critical Accounting Policies, Estimates and Risks and Uncertainties Critical accounting policies include the areas where the Corporation has made what it considers to be particularly difficult, subjective or complex judgments concerning estimates, and where these estimates can significantly affect the Corporation's financial results under different assumptions and conditions. The Corporation prepares its financial statements in conformity with GAAP. As a result, the Corporation is required to make certain estimates, judgments and assumptions that it believes are reasonable based upon the information available at that time. These estimates, judgments and assumptions affect the reported amounts of assets and liabilities at the date of the financial statements and the reported amounts of revenue and expenses during the periods presented. Actual results could be different from these estimates. Management considers the accounting policy relating to the allowance for loan losses to be a critical accounting policy given the uncertainty in evaluating the level of the allowance required to cover probable incurred credit losses inherent in the loan portfolio, and the material effect that such judgments can have on the Corporation's results of operations. While management's current evaluation of the allowance for loan losses indicates that the allowance is adequate, under adversely different conditions or assumptions the allowance would need to be increased. For example, if historical loan loss experience significantly worsened or if current economic conditions significantly deteriorated, additional provisions for loan losses would be required to increase the allowance. In addition, the assumptions and estimates used in the internal reviews of the Corporation's non-performing loans and potential problem loans, and the associated evaluation of the related collateral coverage for these loans, has a significant impact on the overall analysis of the adequacy of the allowance for loan losses. Real estate values in the Corporation’s market area did not increase dramatically in the prior several years, and, as a result, any declines in real estate values have been modest. While management has concluded that the current evaluation of collateral values is reasonable under the circumstances, if collateral evaluations were significantly lowered, the Corporation's allowance for loan losses policy would also require additional provisions for loan losses. Management also considers the accounting policy relating to the valuation of goodwill and other intangible assets to be a critical accounting policy. The initial carrying value of goodwill and other intangible assets is determined using estimated fair values developed from various sources and other generally accepted valuation techniques. Estimates are based upon financial, economic, market and other conditions as they existed as of the date of a particular acquisition. These estimates of fair value are the results of judgments made by the Corporation based upon estimates that are inherently uncertain and changes in the assumptions upon which the estimates were based may have a significant impact on the resulting estimates. In addition to the initial determination of the carrying value, on an ongoing basis management must assess whether there is any impairment of goodwill and other intangible assets that would require an adjustment in carrying value and recognition of a loss in the consolidated statement of income. Financial Condition Summary Consolidated assets at December 31, 2014 totaled $1.525 billion, an increase of $48.4 million or 3.3% since December 31, 2013. The growth was due primarily to increases of $125.7 million, in total portfolio loans. The increase in portfolio loans was due to strong growth of $100.5 million in commercial loans and $19.9 million in indirect consumer loans. Total shareholders’ equity was $133.6 million at December 31, 2014, a decrease of $5.0 million from December 31, 2013, due primarily to the Corporation’s $8.9 million reduction in accumulated other comprehensive income, declared dividends of $4.8 million and partially offset by net income of $8.2 million and a reduction of $0.7 million in treasury stock. The market value of total assets under management or administration in the Corporation’s Wealth Management Group was $1.956 billion at December 31, 2014 compared with $1.888 billion at December 31, 2013, an increase of $68.0 million, or 3.6%. Balance Sheet Comparisons Table 1 contains selected average balance sheet information for each year in the six-year period ended December 31, 2014 (amounts in millions): TABLE 1. SELECTED AVERAGE BALANCE SHEET INFORMATION (1) Average earning assets include securities available for sale and securities held to maturity based on amortized cost, loans and loans held for sale net of deferred loan fees, interest-bearing deposits, FHLBNY stock, FRBNY stock and federal funds sold. (2) Average loans and loans held for sale, net of deferred loan fees. (3) Average balances for investments include securities available for sale and securities held to maturity, based on amortized cost, FHLBNY stock, FRBNY stock, federal funds sold and interest-bearing deposits. (4) Average borrowings include FHLBNY advances, securities sold under agreements to repurchase and capitalized lease obligations. Table 2 contains selected period-end balance sheet information for each year in the six-year period ended December 31, 2014 (amounts in millions): TABLE 2. SELECTED PERIOD-END BALANCE SHEET INFORMATION (1) Earning assets include securities available for sale, at estimated fair value and securities held to maturity based on amortized cost, loans and loans held for sale net of deferred loan fees, interest-bearing deposits, FHLBNY stock, FRBNY stock and federal funds sold. (2) Loans and loans held for sale, net of deferred loan fees. (3) Investments include securities available for sale, at estimated fair value, securities held to maturity, at amortized cost, FHLBNY stock, FRBNY stock, federal funds sold and interest-bearing deposits. (4) Borrowings include FHLBNY advances, securities sold under agreements to repurchase and capitalized lease obligations. Cash and Cash Equivalents Total cash and cash equivalents decreased $22.4 million since December 31, 2013, due primarily to decreases of $19.0 million in interest-bearing deposits in other financial institutions and $3.4 million in cash and due from financial institutions. Securities The Corporation’s Funds Management Policy includes an investment policy that in general, requires debt securities purchased for the bond portfolio to carry a minimum agency rating of "A". After an independent credit analysis is performed, the policy also allows the Corporation to purchase local municipal obligations that are not rated. The Corporation intends to maintain a reasonable level of securities to provide adequate liquidity and in order to have securities available to pledge to secure public deposits, repurchase agreements and other types of transactions. Fluctuations in the fair value of the Corporation’s securities relate primarily to changes in interest rates. Marketable securities are classified as Available for Sale, while investments in local municipal obligations are generally classified as Held to Maturity. The composition of the available for sale segment of the securities portfolio is summarized in Table 3 as follows (amounts in thousands): TABLE 3. SECURITIES AVAILABLE FOR SALE The available for sale segment of the securities portfolio totaled $280.5 million at December 31, 2014, a decrease of $65.5 million, or 18.9%, from $346.0 million at December 31, 2013. The decrease resulted primarily from sales and calls of $62.7 million, and maturities and principal collected of $24.2 million, partially offset by purchases of $23.6 million. The proceeds from the sales, calls, maturities and principal collected of securities were used to help fund the growth of the loan portfolio. The held to maturity segment of the securities portfolio consists of obligations of political subdivisions in the Corporation’s market areas. These securities totaled $5.8 million at December 31, 2014, a decrease of $0.7 million, or 10.2%, from $6.5 million at December 31, 2013. The decrease was due primarily to maturities and principal collected of $3.2 million, partially offset by purchases of $2.5 million. Non-marketable equity securities at December 31, 2014 include shares of FRBNY stock and FHLBNY stock, carried at their cost of $1.7 million and $3.8 million, respectively. The fair value of these securities is assumed to approximate their cost. The investment in these stocks is regulated by regulatory policies of the respective institutions. Table 4 sets forth the carrying amounts and maturities of available for sale and held to maturity debt securities at December 31, 2014 and the weighted average yields of such securities (all yields are calculated on the basis of the amortized cost and weighted for the scheduled maturity of each security, except mortgage-backed securities which are based on the average life at the projected prepayment speed of each security). Federal tax equivalent adjustments have been made in calculating yields on municipal obligations (amounts in thousands): TABLE 4. MATURIES AND YIELDS OF AVAILABLE FOR SALE AND HELD TO MATURITY SECURITIES Management evaluates securities for OTTI on a quarterly basis, and more frequently when economic or market conditions warrant such an evaluation. For the year ended December 31, 2014, the Corporation had no OTTI charges. For the year ended December 31, 2013, the Corporation had less than $0.1 million in OTTI charges. During the fourth quarter of 2013, the Corporation sold one CDO consisting of a pool of trust preferred securities that had an amortized cost of $0.6 million. The CDO was sold for $0.6 million, resulting in a slight loss. The CDO was sold in light of the uncertainty surrounding the recently released rules contained in the “Volcker Rule” provision of the Dodd-Frank Act regarding the ability of banks to hold these types of securities and based on current market conditions. In addition to the CDO that was sold in the fourth quarter of 2013, the remaining CDO was liquidated and the Corporation recorded $0.5 million in other income during the first quarter of 2014. The Corporation does not own any other CDOs in its investment securities portfolio. For more detailed information on OTTI, see Footnote (3), “Securities” in the Notes to Consolidated Financial Statements. Loans The Corporation has reporting systems to monitor: (i) loan originations and concentrations, (ii) delinquent loans, (iii) non-performing assets, including non-performing loans, troubled debt restructurings, other real estate owned, (iv) impaired loans, and (v) potential problem loans. Management reviews these systems on a regular basis. Table 5 shows the Corporation's loan composition by segment and percentage of total loans at the end of each of the last five years (amounts in thousands): Portfolio loans totaled $1.122 billion at December 31, 2014, an increase of $125.7 million, or 12.6%, from $995.9 million at December 31, 2013. The increase in portfolio loans was due to strong growth of $100.5 million, or 19.4%, in commercial loans and $19.9 million, or 12.1%, in indirect consumer loans. The growth in commercial loans was due primarily to an increase in commercial loans in the Capital Bank division in the Albany, New York region. The growth in indirect consumer loans was a result of the Corporation’s extension into the first nine months of 2014 its loan program with reduced pricing on high quality indirect auto loans. Residential mortgage loans totaled $196.8 million at December 31, 2014, an increase of $0.8 million, or 0.4%, from December 31, 2013. In addition, during 2014, $13.6 million of residential mortgages were sold in the secondary market to Freddie Mac, with an additional $0.1 million of residential mortgages sold to the State of New York Mortgage Agency. The Corporation anticipates that future growth in portfolio loans will continue to be in the commercial mortgage and commercial and agricultural loan segments. Loan concentrations are considered to exist when there are amounts loaned to a multiple number of borrowers engaged in similar activities which would cause them to be similarly impacted by economic or other conditions. The Corporation’s concentration policy limits the volume of commercial loans to any one specific industry. Specific industries are identified using the North American Industry Classification System (“NAICS”) codes. The volume of commercial loans, with the exception of commercial mortgages, to any one specific industry is limited to Tier 1 capital plus the allowance for loan losses. The volume of commercial mortgages is limited to three times the total of Tier 1 capital plus the allowance for loan losses. The Corporation is in compliance with the concentration policy limits. The Corporation also monitors specific NAICS industry classifications of commercial loans to identify concentrations greater than 10.0% of total loans. At December 31, 2014 and 2013, commercial loans to borrowers involved in the real estate, and real estate rental and lending businesses were 36.1% and 31.1% of total loans, respectively. No other concentration of loans existed in the commercial loan portfolio in excess of 10.0% of total loans as of December 31, 2014 and 2013. Table 6 shows the maturity of only commercial and agricultural loans and commercial mortgages outstanding as of December 31, 2014. Also provided are the amounts due after one year, classified according to the sensitivity to changes in interest rates (amounts in thousands): Non-Performing Assets Non-performing assets consist of non-accrual loans, non-accrual troubled debt restructurings and other real estate owned that has been acquired in partial or full satisfaction of loan obligations or upon foreclosure. Past due status on all loans is based on the contractual terms of the loan. It is generally the Corporation's policy that a loan 90 days past due be placed in non-accrual status unless factors exist that would eliminate the need to place a loan in this status. A loan may also be designated as non-accrual at any time if payment of principal or interest in full is not expected due to deterioration in the financial condition of the borrower. At the time loans are placed in non-accrual status, the accrual of interest is discontinued and previously accrued interest is reversed. All payments received on non-accrual loans are applied to principal. Loans are considered for return to accrual status when they become current as to principal and interest and remain current for a period of six consecutive months or when, in the opinion of management, the Corporation expects to receive all of its contractual principal and interest. In the case of non-accrual loans where a portion of the loan has been charged off, the remaining balance is kept in non-accrual status until the entire principal balance has been recovered. Table 7 summarizes the Corporation's non-performing assets, excluding purchased credit impaired loans (amounts in thousands): TABLE 7. NON-PERFORMING ASSETS (1) These loans are not included in nonperforming assets above. Table 8 shows interest income on non-accrual and troubled debt restructured loans for the indicated years ended December 31 (amounts in thousands): TABLE 8. INTEREST INCOME ON NON-ACCRUAL AND TROUBLED DEBT RESTRUCTURED LOANS Non-Performing Loans The recorded investment in non-performing loans at December 31, 2014, totaled $7.8 million compared to $8.5 million at year-end 2013, a decrease of $0.7 million. The decrease in non-performing loans was due to decreases of $0.6 million in non-accrual loans and $0.1 million in non-accrual TDRs. Non-performing commercial loans decreased $0.9 million while non-performing residential mortgages increased $0.3 million. The recorded investment in accruing loans 90 days or more past due totaled $1.5 million at December 31, 2014, level with the recorded investment at December, 31, 2013. At December 31, 2014, the recorded investment in accruing loans 90 days or more past due included $1.4 million in acquired construction loans not considered by management to be PCI loans, which for a variety of reasons are 90 days or more past their stated maturity dates. However, the borrowers continue to make required interest payments. Additionally, these loans carry third party credit enhancements, and based on the strength of those credit enhancements, the Corporation has not identified these loans as PCI loans and expects to incur no losses on these loans. Not included in the non-performing loan totals are loans acquired in the April 2011 acquisition of Fort Orange Financial Corp. and its wholly-owned subsidiary, Capital Bank, which the Corporation had identified as PCI loans totaled $2.6 million and $9.7 million at December 31, 2014 and 2013, respectively. The PCI loans are accounted for under separate accounting guidance, Accounting Standards Codification (“ASC”) Subtopic 310-30, “Receivables - Loans and Debt Securities Acquired with Deteriorated Credit Quality” as disclosed in Note 4 of the financial statements. Troubled Debt Restructurings The Corporation works closely with borrowers that have financial difficulties to identify viable solutions that minimize the potential for loss. In that regard, the Corporation has modified the terms of select loans to maximize their collectability. These modifications may be considered TDRs under current accounting guidance. The Corporation offers various types of modifications which may involve a change in the schedule of payments, a reduction in the interest rate, an extension of the maturity date, extending the maturity date at an interest rate lower than the current market rate for new debt with similar risk, requesting additional collateral, releasing collateral for consideration, substituting or adding a new borrower or guarantor, a permanent reduction of the recorded investment in the loan or a permanent reduction of the interest on the loan. As of December 31, 2014, the Corporation had $1.0 million of non-accrual TDRs compared with $1.1 million as of December 31, 2013. The decrease in non-accrual TDRs was in the commercial loan segment of the loan portfolio. As of December 31, 2014, the Corporation had $8.7 million of accruing TDRs compared with $6.8 million as of December 31, 2013. The increase in accruing TDRs was primarily in the commercial loan segment of the loan portfolio. Impaired Loans A loan is classified as impaired when, based on current information and events, it is probable that the Corporation will be unable to collect both the principal and interest due under the contractual terms of the loan agreement. Impaired loans at December 31, 2014 totaled $15.9 million, including TDRs of $9.7 million, compared to $13.9 million at December 31, 2013, including TDRs of $7.9 million. The increase in impaired loans was in the commercial loan segment of the loan portfolio. Not included in the impaired loan totals are acquired loans which the Corporation has identified as PCI loans, as these loans are accounted for under ASC Subtopic 310-30 as noted under the above discussion of non-performing loans. Included in the impaired loan total at December 31, 2014, are loans totaling $4.9 million for which impairment allowances of $1.2 million have been specifically allocated to the allowance for loan losses. As of December 31, 2013, the impaired loan total included $2.0 million of loans for which specific impairment allowances of $1.0 million were allocated to the allowance for loan losses. The increase in the amount of impaired loans for which specific allowances were allocated to the allowance for loan losses was due to an increase of $3.1 million in impaired commercial mortgages, partially offset by a decrease of $0.9 million in commercial and industrial loans. The majority of the Corporation's impaired loans are secured and measured for impairment based on collateral evaluations. It is the Corporation's policy to obtain updated appraisals, by independent third parties, on loans secured by real estate at the time a loan is determined to be impaired. An impairment measurement is performed based upon the most recent appraisal on file to determine the amount of any specific allocation or charge-off. In determining the amount of any specific allocation or charge-off, the Corporation will make adjustments to reflect the estimated costs to sell the property. Upon receipt and review of the updated appraisal, an additional measurement is performed to determine if any adjustments are necessary to reflect the proper provisioning or charge-off. Impaired loans are reviewed on a quarterly basis to determine if any changes in credit quality or market conditions would require any additional allocation or recognition of additional charge-offs. Real estate values in the Corporation's market area have been holding steady. Non-real estate collateral may be valued using (i) an appraisal, (ii) net book value of the collateral per the borrower’s financial statements, or (iii) accounts receivable aging reports, that may be adjusted based on management’s knowledge of the client and client’s business. If market conditions warrant, future appraisals are obtained for both real estate and non-real estate collateral. Allowance for Loan Losses The allowance is an amount that management believes will be adequate to absorb probable incurred losses on existing loans. The allowance is established based on management’s evaluation of the probable inherent losses in our portfolio in accordance with GAAP, and is comprised of both specific valuation allowances and general valuation allowances. Specific valuation allowances are established based on management’s analyses of individually impaired loans. Factors considered by management in determining impairment include payment status, evaluations of the underlying collateral, expected cash flows, and the probability of collecting scheduled principal and interest payments when due. Loans that experience insignificant payment delays and payment shortfalls generally are not classified as impaired. Management determines the significance of payment delays and payment shortfalls on a case-by-case basis, taking into consideration all of the circumstances surrounding the loan and the borrower, including the length of the delay, the reasons for the delay, the borrower’s prior payment record, and the amount of the shortfall in relation to the principal and interest owed. If a loan is determined to be impaired and is placed on nonaccrual status, all future payments received are applied to principal and a portion of the allowance is allocated so that the loan is reported, net, at the present value of estimated future cash flows using the loan’s existing rate or at the fair value of collateral if repayment is expected solely from the collateral. The general component covers non-impaired loans and is based on historical loss experience adjusted for current factors. Loans not impaired but classified as substandard and special mention use a historical loss factor on a rolling five year history of net losses. For all other unclassified loans, the historical loss experience is determined by portfolio class and is based on the actual loss history experienced by the Corporation over the most recent two years. This actual loss experience is supplemented with other qualitative factors based on the risks present for each portfolio class. These qualitative factors include consideration of the following: (1) lending policies and procedures, including underwriting standards and collection, charge-off and recovery policies, (2) national and local economic and business conditions and developments, including the condition of various market segments, (3) loan profiles and volume of the portfolio, (4) the experience, ability, and depth of lending management and staff, (5) the volume and severity of past due, classified and watch-list loans, non-accrual loans, troubled debt restructurings, and other modifications (6) the quality of the Bank’s loan review system and the degree of oversight by the Bank’s Board of Directors, (7) collateral related issues: secured vs. unsecured, type, declining valuation environment and trend of other related factors, (8) the existence and effect of any concentrations of credit, and changes in the level of such concentrations, (9) the effect of external factors, such as competition and legal and regulatory requirements, on the level of estimated credit losses in the Bank’s current portfolio and (10) the impact of the global economy. The allowance for loan losses is increased through a provision for loan losses charged to operations. Loans are charged against the allowance for loan losses when management believes that the collectability of all or a portion of the principal is unlikely. Management's evaluation of the adequacy of the allowance for loan losses is performed on a periodic basis and takes into consideration such factors as the credit risk grade assigned to the loan, historical loan loss experience and review of specific impaired loans. While management uses available information to recognize losses on loans, future additions to the allowance may be necessary based on changes in economic conditions. In addition, various regulatory agencies, as an integral part of their examination process, periodically review the Corporation's allowance for loan losses. Such agencies may require the Corporation to recognize additions to the allowance based on their judgments about information available to them at the time of their examination. Prior to December 31, 2012, the Corporation utilized the sum of all allowance amounts derived as described above, combined with a reasonable unallocated allowance, as the primary indicator of the appropriate level of allowance for loan losses. During the fourth quarter of 2012, the Corporation refined its allowance calculation whereby it “allocated” the portion of the allowance that was previously deemed to be unallocated allowance. This refined allowance calculation included specific allowance allocations for qualitative factors including (i) concentrations of credit, (ii) general economic and business conditions, (iii) trends that could affect collateral values and (iv) expectations regarding the current business cycle. The Corporation may also consider other qualitative factors in future periods for additional allowance allocations, including, among other factors, (1) credit quality trends (including trends in non-performing loans expected to result from existing conditions), (2) seasoning of the loan portfolio, (3) specific industry conditions affecting portfolio segments, (4) the Corporation’s expansion into new markets and (5) the offering of new loan products. Table 9 summarizes the Corporation’s allocation of the allowance for loan losses and percent of loans by category to total loans for each year in the five-year period ended December 31, 2014 (amounts in thousands): TABLE 9. ALLOCATION OF ALLOWANCE FOR LOAN LOSSES Table 10 summarizes the Corporation's loan loss experience for each year in the five-year period ended December 31, 2014 (amounts in thousands, except ratio data): TABLE 10. SUMMARY OF LOAN LOSS EXPERIENCE Net charge-offs for 2014 were $3.1 million compared with $0.4 million for 2013. The ratio of net charge-offs to average loans outstanding was 0.29% for 2014 compared to 0.04% for 2013. The increase in net charge-offs was due primarily to increases of $2.1 million in commercial mortgage and $0.4 million in commercial and agricultural net charge-offs. Other Real Estate Owned At December 31, 2014, other real estate owned (“OREO”) totaled $3.1 million compared to $0.5 million at December 31, 2013. The increase in other real estate owned was due primarily to the transfer of two acquired PCI commercial loans. Other Assets The $10.1 million increase in other assets was due primarily to the recording of a receivable from the Corporation’s insurance carrier related to the settlement of the two legal proceedings involving its Wealth Management Group and the increase in other real estate owned. Deposits Deposits totaled $1.280 billion at December 31, 2014, compared with $1.266 billion at December 31, 2013, an increase of $13.8 million, or 1.1%. At December 31, 2014, demand deposit and money market accounts comprised 68.0% of total deposits compared with 65.3% at December 31, 2013. Sorted by public, commercial, consumer and broker sources, the growth in deposits was due primarily to increases of $38.3 million in brokered and $5.7 million in commercial deposits, partially offset by decreases of $25.2 million in consumer and $5.0 million in public deposits accounts. Brokered deposits include funds obtained through brokers, and the Bank’s participation in the Certificate of Deposit Account Registry Service (“CDARS”) and Insured Cash Sweep Service (“ICS”) programs. The CDARS and ICS programs involve a network of financial institutions that exchange funds among members in order to ensure FDIC insurance coverage on customer deposits above the single institution limit. Using a sophisticated matching system, funds are exchanged on a dollar-for-dollar basis, so that the equivalent of an original deposit comes back to the originating institution. Deposits obtained through brokers were $2.3 million and $5.0 million as of December 31, 2014 and 2013, respectively. Deposits obtained through the CDARS and ICS programs were $76.7 million and $35.7 million as of December 31, 2014 and 2013, respectively. The increase in CDARS and ICS deposits was due to the Corporation offering the programs to local municipalities. The Corporation’s deposit strategy is to fund the Bank with stable, low-cost deposits, primarily checking account deposits and other low interest-bearing deposit accounts. A checking account is the driver of a banking relationship and consumers consider the bank where they have their checking account as their primary bank. These customers will typically turn to their primary bank first when in need of other financial services. Strategies that have been developed and implemented to generate these deposits include: (i) acquire deposits by entering new markets through de novo branching, (ii) an annual checking account marketing campaign, (iii) training branch employees to identify and meet client financial needs with Bank products and services, (iv) link business and consumer loans to a primary checking account at the Bank, (v) aggressively promote direct deposit of client’s payroll checks or benefit checks and (vi) constantly monitor the Corporation’s pricing strategies to ensure competitive products and services. The Corporation also considers brokered deposits to be an element of its deposit strategy and anticipates that it will continue using brokered deposits as a secondary source of funding to support growth. Information regarding deposits is included in Note 7 to the consolidated financial statements appearing elsewhere in this report. Borrowings FHLBNY advances increased $24.9 million to $50.1 million at December 31, 2014 from $25.2 million at December 31, 2013. FHLBNY overnight advances increased $30.8 million during 2014 while FHLBNY term advances decreased $5.9 million. For each of the three years ended December 31, 2014, 2013 and 2012, respectively, the average outstanding balance of borrowings that mature in one year or less did not exceed 30% of shareholders' equity. Information regarding securities sold under agreements to repurchase and FHLBNY advances is included in notes 8 and 9 to the consolidated financial statements appearing elsewhere in this report. Liquidity and Capital Resources Liquidity management involves the ability to meet the cash flow requirements of deposit clients, borrowers, and the operating, investing and financing activities of the Corporation. The Corporation uses a variety of resources to meet its liquidity needs. These include short term investments, cash flow from lending and investing activities, core-deposit growth and non-core funding sources, such as time deposits of $100,000 or more, securities sold under agreements to repurchase and other borrowings. The Corporation is a member of the FHLBNY which allows it to access borrowings which enhance management's ability to satisfy future liquidity needs. Based on available collateral and current advances outstanding, the Corporation was eligible to borrow up to a total of $86.0 million and $73.1 million at December 31, 2014 and 2013, respectively. The Corporation also had a total of $27.8 million of unsecured lines of credit with four different financial institutions, all of which was available at December 31, 2014 and 2013. During 2014, cash and cash equivalents decreased $22.4 million. The major sources of cash during 2014 included $18.4 million provided by operating activities, $90.2 million in proceeds from sales, maturities, calls and principal reductions on securities, $13.8 million in deposits and $24.9 million in FHLBNY advances. These proceeds were used primarily to fund purchases of securities totaling $27.2 million, a $131.9 million net increase in loans, payment of cash dividends in the amount of $4.8 million and purchases of fixed assets totaling $2.6 million. During 2013, cash and cash equivalents increased $11.4 million. The major sources of cash during 2013 included $170.9 million received from the branch acquisition, $22.8 million provided by operating activities, $67.9 million in proceeds from sales, maturities, calls and principal reductions on securities and $40.9 million in organic deposit growth. These proceeds were used primarily to fund purchases of securities totaling $180.5 million, a $101.5 million net increase in loans, payment of cash dividends in the amount of $3.6 million and purchases of fixed assets totaling $3.7 million. Shareholders’ Equity Total shareholders’ equity was $133.6 million at December 31, 2014, compared with $138.6 million at December 31, 2013, a decrease of $5.0 million, or 3.6%. The decrease was due primarily to an $8.9 million decrease in accumulated other comprehensive income and declared dividends of $4.8 million, partially offset by net income of $8.2 million and a reduction of $0.7 million in treasury stock. The total shareholders’ equity to total assets ratio was 8.77% at December 31, 2014 compared with 9.39% at December 31, 2013. Tangible equity to tangible assets ratio decreased to 7.13% at December 31, 2014, from 7.62% at December 31, 2013. The Corporation and the Bank are subject to capital adequacy guidelines of the Federal Reserve which establish a framework for the classification of financial holding companies and financial institutions into five categories: well-capitalized, adequately capitalized, undercapitalized, significantly undercapitalized and critically undercapitalized. As of December 31, 2014, both the Corporation’s and the Bank’s capital ratios were in excess of those required to be considered well-capitalized under regulatory capital guidelines. A comparison of the Corporation’s and the Bank’s actual capital ratios to the ratios required to be adequately or well-capitalized at December 31, 2014 and 2013, is included in note 17 to the consolidated financial statements appearing elsewhere in this report. For more information regarding current capital regulations see Part I-“Business-Supervision and Regulation-Regulatory Capital.” Cash dividends declared during 2014 totaled $4.8 million or $1.04 per share compared to $4.8 million or $1.04 per share in 2013 and $4.6 million or $1.00 per share in 2012. Dividends declared during 2014 amounted to 58.8% of net income compared to 54.7% and 41.5% of net income for 2013 and 2012, respectively. Management seeks to continue generating sufficient capital internally, while continuing to pay adequate dividends to the Corporation’s shareholders. When shares of the Corporation become available in the market, the Corporation may purchase them after careful consideration of the Corporation’s liquidity and capital positions. Purchases may be made from time to time on the open market or in privately negotiated transactions at the discretion of management. On December 19, 2012, the Board of Directors approved a new stock repurchase plan under which the Corporation may repurchase up to 125,000 shares. No shares were purchased under the new plan in 2014. During 2013, the Corporation purchased 3,094 shares at a total cost of $93 thousand under the new plan. Under the previous plan, the Corporation purchased 68,564 shares. Off-Balance Sheet Arrangements In the normal course of operations, the Corporation engages in a variety of financial transactions that, in accordance with GAAP are not recorded in the financial statements. The Corporation is also a party to certain financial instruments with off balance sheet risk such as commitments under standby letters of credit, unused portions of lines of credit and commitments to fund new loans. The Corporation's policy is to record such instruments when funded. These transactions involve, to varying degrees, elements of credit, interest rate and liquidity risk. Such transactions are generally used by the Corporation to manage clients' requests for funding and other client needs. Table 11 shows the Corporation’s off-balance sheet arrangements as of December 31, 2014 (amounts in thousands): TABLE 12. COMMITMENT MATURITY BY PERIOD (1) Not included in this total are unused portions of home equity lines of credit, credit card lines and consumer overdraft protection lines of credit, since no contractual maturity dates exist for these types of loans. Commitments to outside parties under these lines of credit were $41,261, $13,405 and $4,921, respectively, at December 31, 2014. Contractual Obligations Table 13 shows the Corporation’s contractual obligations under long-term agreements as of December 31, 2014 (amounts in thousands). Note references are to the Notes of the Consolidated Financial Statements: TABLE 13. CONTRACTUAL OBLIGATIONS (1) Not included in the above total is the Corporation's obligation regarding the Pension Plan and Other Benefit Plans. Please refer to Part IV Item 15 Note 11 for information regarding these obligations at December 31, 2014. Results of Operations 2014 vs. 2013 Net Income Net income for 2014 was $8.2 million, a decrease of $0.5 million, or 6.6%, compared with $8.7 million for 2013. Earnings per share for 2014 was $1.74 compared with $1.87 for 2013. Return on average assets and return on average equity for 2014 were 0.54% and 5.74%, respectively, compared with 0.67% and 6.50%, respectively, for 2013. The decline in 2014 earnings was due primarily to increases of $11.1 million in non-interest expense and $1.2 million in the provision for loan losses, partially offset by increases of $8.7 million in non-interest income and $2.9 million in net interest income. The increase in non-interest expense was due to a $4.3 million accrual for legal settlement regarding two legal proceedings involving the Bank’s Wealth Management Group, along with increases of $2.0 million in salaries and wages, $1.6 million in net occupancy expense, $1.6 million in data processing expense, $0.7 million in professional services, $0.6 million in furniture and equipment expense and $0.4 million in amortization of intangible assets. A portion of the increase in non-interest expense was due to operating expenses directly related to the branch offices acquired in the fourth quarter of 2013, along with upgrades for ATMs and software. The increase in non-interest income was due primarily to $6.9 million in net gains on security transactions, along with increases of $0.4 million in Wealth Management Group fee income and $0.6 million in service charges on deposit accounts. Net Interest Income Net interest income, which is the difference between the income we receive on interest-earning assets, such as loans and securities and the interest we pay on interest-bearing liabilities, such as deposits and borrowings, is the largest contributor to our earnings. For 2014, net interest income totaled $49.6 million, an increase of $3.0 million, or 6.3%, compared with $46.6 for 2013, and the net interest margin was 3.59% for 2014 compared with 3.91% for 2013. The decline in net interest income was due primarily to margin compression evidenced by a 40 basis point decrease in the yield on interest-earning assets, partially offset by a 10 basis point decline in the cost of funds and an increase of $189.6 million in average interest-earning assets. The decline in net interest margin was due primarily to yields on interest-earning assets decreasing at a faster rate than the cost of interest-bearing liabilities. The decrease in yield on interest-earning assets was attributable to lower loan yields as loans continue to adjust to current market rates and the investment of cash from the acquired branch offices into investment securities. For 2014, total average funding liabilities, including non-interest-bearing demand deposits, increased $191.7 million, or 16.5%, to $1.354 billion. The growth was primarily due to increases of $120.7 million in average savings and money market deposits, $59.3 million in non-interest-bearing demand deposits and $30.2 million in interest-bearing demand deposits. These items were partially offset by decreases of $12.9 million in borrowings and $5.6 million in time deposits. While average interest-bearing liabilities increased $132.4 million, or 15.4%, interest expense decreased $0.4 million, or 9.6%, as the average cost of interest-bearing liabilities decreased 10 basis points to 0.37%. Provision for Loan Losses For 2014 the provision for loan loss expense totaled $4.0 million compared to $2.8 million for 2013. The increase was due primarily to additional impairments on commercial loans and growth in the loan portfolio. Non-Interest Income Non-interest income for 2014 was $26.8 million compared with $18.1 million for 2013, an increase of $8.7 million, or 48.0%. The increase was due primarily to $6.9 million in net gains on security transactions, and increases of $0.4 million in Wealth Management Group fee income and $0.6 million in service charges on deposit accounts. Current assets under management or administration of the Corporation’s Wealth Management Group include investment, trust and retirement-related business lines. The market value of total assets under management or administration in the Wealth Management Group were $1.956 billion at December 31, 2014, compared with $1.888 billion at December 31, 2013, an increase of $68.0 million, or 3.6%. As a result, Wealth Management Group fee income increased for 2014. Wealth Management Group’s efforts in 2014 were focused on programs that include a private banking program with financial planning capabilities to serve the financial needs of high net worth individuals and an enhanced retirement services program to increase the number of plans under management and fee income. Non-Interest Expense Non-interest expense for 2014 was $60.5 million compared with $49.4 million for 2013, an increase of $11.1 million, or 22.4%. Excluding a $4.3 million pre-tax legal settlement from 2014, non-interest expense increased $6.8 million, or 13.8%, for 2014. The accrual for legal settlement was the result of two legal proceedings involving the Bank’s Wealth Management Group. The $6.8 million increase in non-interest expense, excluding the accrual for legal settlement, was due primarily to increases of $2.0 million in salaries and wages, $1.6 million in net occupancy expense, $0.6 million in furniture and equipment expense, $1.6 million in data processing costs, $0.7 million in professional fees, $0.4 million in amortization of intangible assets and $1.0 million in other non-interest expenses. These items were partially offset by a decrease of $1.3 million in merger and acquisition expense. A portion of the increase in non-interest expense was due to operating expenses directly related to the branch offices acquired in the fourth quarter of 2013, along with upgrades for ATMs and software. Income Taxes Income tax expense for 2014 was $3.7 million compared with $3.8 million for 2013, a decrease of $0.1 million, or 3.0%. Income tax expense reflects an effective tax rate of 31.3% for 2014 compared with 30.4% for 2013, due primarily to a decrease in the relative percentage of tax exempt income to pre-tax income. Results of Operations 2013 vs. 2012 Net Income Net income for 2013 was $8.7 million, a decrease of $2.3 million, or 20.8%, compared with $11.0 million for 2012. Earnings per share for 2013 was $1.87 compared with $2.38 for 2012. Return on average assets and return on average equity for 2013 were 0.67% and 6.50%, respectively, compared with 0.88% and 8.41%, respectively, for 2012. The decline in 2013 earnings was due primarily to increases of $1.9 million in the provision for loan losses and $2.6 million in non-interest expense, which included $1.4 million in pre-tax branch acquisition costs. Net interest income decreased $0.2 million in 2013. These items were partially offset by a reduction of $1.6 million in income taxes and an increase of $0.9 million in non-interest income. The increase in non-interest income was due primarily to increases of $0.5 million in Wealth Management Group fee income, $0.5 million in services charges on deposit accounts and a gain of $0.5 million from the branch acquisition. These items were offset by the 2012 pre-tax casualty gain of $0.8 million from insurance reimbursements related to the September 2011 flooding of the Owego and Tioga offices. Net Interest Income Net interest income, which is the difference between the income we receive on interest-earning assets, such as loans and securities and the interest we pay on interest-bearing liabilities, such as deposits and borrowings, is the largest contributor to our earnings. For 2013, net interest income totaled $46.6 million, a slight decrease of $0.2 million, or 0.5%, compared with $46.8 for 2012, and the net interest margin was 3.85% for 2013 compared with 4.07% for 2012. The decline in net interest income was due primarily to margin compression evidenced by a 34 basis point decrease in the yield on interest-earning assets, partially offset by a 16 basis point decline in the cost of funds and an increase of $59.3 million in average earning assets. The decline in net interest margin was due primarily to yields on interest-earning assets decreasing at a faster rate than the cost of interest-bearing liabilities. The decrease in yield on interest-earning assets was attributable to lower loan yields as loans continue to reprice at current market rates. In addition, the Corporation anticipated a decline in the yield on interest-earning assets due in part to its investment of cash from the branch acquisition into investment securities. For 2013, total average funding liabilities, including non-interest-bearing demand deposits, increased $46.5 million, or 4.2%, to $1.160 billion compared to 2012. The growth was primarily due to increases of $49.6 million in average savings and money market deposits and $18.4 million in demand deposits, partially offset by a decrease of $26.9 million in time deposits. While average interest-bearing liabilities increased $28.1 million, or 3.4%, interest expense decreased $1.2 million, or 22.9%, as the average cost of interest-bearing liabilities decreased 16 basis points to 0.47%. Provision for Loan Losses For 2013 the provision for loan loss expense totaled $2.8 million compared to $0.8 million for 2012. The increase was due principally to the establishment of $0.9 million in additional specific reserves on three commercial loans, loan portfolio growth and net charge-offs. Non-Interest Income Non-interest income for 2013 was $18.1 million compared with $17.2 million for 2012, an increase of $0.9 million, or 5.2%. The increase was due primarily to a gain of $0.5 million from the branch acquisition and increases of $0.5 million in Wealth Management Group fee income and $0.5 million in service charges on deposit accounts. These items were partially offset by reductions of $0.8 million in casualty gains from insurance reimbursements related to the September 2011 flooding of the Owego and Tioga offices and $0.3 million in net gain on securities transactions. Current assets under management or administration of the Corporation’s Wealth Management Group include investment, trust and retirement-related business lines. The market value of total assets under management or administration in the Wealth Management Group were $1.888 billion at December 31, 2013, compared with $1.735 billion at December 31, 2012, an increase of $153.0 million, or 8.8%. As a result, Wealth Management Group fee income increased for 2013, as the Wealth Management Group’s efforts were focused on programs that include a private banking program with financial planning capabilities, to serve the financial needs of high net worth individuals, and an enhanced retirement services program to increase the number of plans under management and fee income. Non-Interest Expense Non-interest expense for 2013 was $49.4 million compared with $46.8 million for 2012, an increase of $2.6 million, or 5.6%. Excluding $1.4 million in pre-tax branch acquisition costs from 2013, non-interest expense increased $1.2 million, or 2.7% for 2013. This increase was due primarily to increases of $0.4 million in salaries and wages, $0.3 million in pension and other employee benefits, $0.3 million in net occupancy expense and $0.3 million in data processing costs. These items were partially offset by a decrease of $0.5 million in professional services related to consultant fees. Included in the increase in salaries and wages was $0.1 million related to the branch acquisition, and the remainder to compensation expense related to merit increases and incentive compensation. The increase in pension and other employee benefits was primarily due to higher pension and retirement costs. The increase in net occupancy was due primarily to higher depreciation and rent expense, both related to the Bank of America branch acquisition. The increase in data processing expenses was primarily due to higher software maintenance fees and telephone data lines related to the branch acquisition. Income Taxes Income tax expense for 2013 was $3.8 million compared with $5.4 million for 2012, a decrease of $1.6 million, or 29.0%. Income tax expense reflects an effective tax rate of 30.4% for 2013 compared with 32.8% for 2012, due primarily to lower pre-tax income and an increase in the relative percentage of tax exempt income to pre-tax income. Table 14 sets forth certain information related to the Corporation’s average consolidated balance sheets and its consolidated statements of income for the years indicated and reflects the average yield on assets and average cost of liabilities for the years indicated. For the purpose of the table below, non-accruing loans are included in the daily average loan amounts outstanding. Daily balances were used for average balance computations. Investment securities are stated at amortized cost. Tax equivalent adjustments have been made in calculating yields on obligations of states and political subdivisions, tax-free commercial loans and dividends on equity securities. TABLE 14. AVERAGE BALANCES AND YIELDS Distribution of Assets, Liabilities and Shareholders' Equity, Interest Rates and Interest Differential Year Ended December 31, CHANGES DUE TO VOLUME AND RATE Net interest income can be analyzed in terms of the impact of changes in rates and volumes. Table 15 illustrates the extent to which changes in interest rates and in the volume of average interest-earning assets and interest-bearing liabilities have affected the Corporation’s interest income and interest expense during the periods indicated. Information is provided in each category with respect to (i) changes attributable to changes in volume (changes in volume multiplied by prior rate); (ii) changes attributable to changes in rates (changes in rates multiplied by prior volume); and (iii) the net changes. For purposes of this table, changes that are not due solely to volume or rate changes have been allocated to these categories based on the respective percentage changes in average volume and rate. Due to the numerous simultaneous volume and rate changes during the periods analyzed, it is not possible to precisely allocate changes between volume and rates. In addition, average earning assets include non-accrual loans and taxable equivalent adjustments were made. TABLE 15. RATE/VOLUME ANALYSIS OF NET INTEREST INCOME ADOPTION OF NEW ACCOUNTING STANDARDS There are no recently issued accounting standards that the Corporation feels will have a material impact on its consolidated financial statements.

<s>[INST] ASU: Accounting Standards Update FRBNY: Federal Reserve Bank of New York Bank: Chemung Canal Trust Company Freddie Mac: Federal Home Loan Mortgage Corporation CDO: Collateralized Debt Obligation GAAP: U.S. generally accepted accounting principles Corporation: Chemung Financial Corporation OTTI: Otherthantemporary impairment FASB: Financial Accounting Standards Board PCI: Purchased credit impaired FDIC: Federal Deposit Insurance Corporation SEC: Securities and Exchange Commission FHLBNY: Federal Home Loan Bank of New York TDRs: Troubled debt restructurings FRB: Board of Governors of the Federal Reserve System The purpose of this discussion is to focus on information about the financial condition and results of operations of the Corporation. Reference should be made to the accompanying consolidated financial statements and footnotes, and the selected financial data appearing elsewhere in this report for an understanding of the following discussion and analysis. This discussion contains forwardlooking statements within the meaning of Section 27A of the Securities Act and Section 21E of the Exchange Act. The Corporation intends its forwardlooking statements to be covered by the safe harbor provisions for forwardlooking statements in these sections. All statements regarding the Corporation's expected financial position and operating results, the Corporation's business strategy, the Corporation's financial plans, forecasted demographic and economic trends relating to the Corporation's industry and similar matters are forwardlooking statements. These statements can sometimes be identified by the Corporation's use of forwardlooking words such as "may," "will," "anticipate," "estimate," "expect," or "intend." The Corporation cannot promise that its expectations in such forwardlooking statements will turn out to be correct. The Corporation's actual results could be materially different from expectations because of various factors, including changes in economic conditions or interest rates, credit risk, difficulties in managing the Corporation’s growth, competition, changes in law or the regulatory environment, including the DoddFrank Act, and changes in general business and economic trends. Information concerning these and other factors can be found in the Corporation’s periodic filings with the SEC, including the discussion under the heading “Item 1A. Risk Factors” in this form 10K. These filings are available publicly on the SEC’s web site at http://www.sec.gov, on the Corporation's web site at http://www.chemungcanal.com or upon request from the Corporate Secretary at (607) 7373746. Except as otherwise required by law, the Corporation undertakes no obligation to publicly update or revise its forwardlooking statements, whether as a result of new information, future events or otherwise. Use of NonGAAP Financial Measures The SEC has adopted Regulation G, which applies to all public disclosures, including earnings releases, made by registered companies that contain “nonGAAP financial measures.” Under Regulation G, companies making public disclosures containing nonGAAP financial measures must also disclose, along with each nonGAAP financial measure, certain additional information, including a reconciliation of the nonGAAP financial measure to the closest comparable GAAP financial measure and a statement of the Corporation’s reasons for utilizing the nonGAAP financial measure as part of its financial disclosures. The SEC has exempted from the definition of “nonGAAP financial measures” certain commonly used financial measures that are not based on GAAP. When these exempted measures are included in public disclosures, supplemental information is not required. The following measures used in this Report, which are commonly utilized by financial institutions, have not been specifically exempted by the SEC and may constitute "nonGAAP financial measures" within the meaning of the SEC's new rules, although we are unable to state with certainty that the SEC would so regard them. TaxEquivalent Net Interest Income and Net Interest Margin Net interest income is commonly presented on a taxequivalent basis. That is, to the extent that some component of the institution's net interest income, which is presented on a beforetax basis, is exempt from taxation (e.g., is received by the institution as a result of its holdings of state or municipal obligations), an amount equal to the tax benefit derived from that component is added to the actual beforetax net interest income total. This adjustment is considered helpful [/INST] Positive. </s>

CHEMUNG FINANCIAL CORP

2016-03-11

2015-12-31

ITEM 7. MANAGEMENT'S DISCUSSION AND ANALYSIS OF FINANCIAL CONDITION AND RESULTS OF OPERATION The following is the MD&A of the Corporation in this Form 10-K for the years ended December 31, 2015 and 2014. The purpose of this discussion is to focus on information about the financial condition and results of operations of the Corporation. Reference should be made to the accompanying audited consolidated financial statements and footnotes, for an understanding of the following discussion and analysis. See the list of commonly used abbreviations and terms on pages 1-4. The MD&A included in this Form 10-K contains statements that are forward-looking within the meaning of the Private Securities Litigation Reform Act of 1995. These statements are based on the current beliefs and expectations of the Corporations’ management and are subject to significant risks and uncertainties. Actual results may differ from those set forth in the forward-looking statements. For a discussion of those risks and uncertainties and the factors that could cause the Corporation’s actual results to differ materially from those risks and uncertainties, see Forward-looking Statements below. The Corporation has been a financial holding company since 2000, and the Bank was established in 1833 and CFS in 2001. Through the Bank and CFS, the Corporation provides a wide range of financial services, including demand, savings and time deposits, commercial, residential and consumer loans, interest rate swaps, letters of credit, wealth management services, employee benefit plans, insurance products, mutual funds and brokerage services. The Bank relies substantially on a foundation of locally generated deposits. The Corporation, on a stand-alone basis, has minimal results of operations. The Bank derives its income primarily from interest and fees on loans, interest on investment securities, WMG fee income and fees received in connection with deposit and other services. The Bank’s operating expenses are interest expense paid on deposits and borrowings, salaries and employee benefit plans and general operating expenses. Forward-looking Statements This discussion contains forward-looking statements within the meaning of Section 27A of the Securities Act, Section 21E of the Exchange Act, and the Private Securities Litigation Reform Act of 1995. The Corporation intends its forward-looking statements to be covered by the safe harbor provisions for forward-looking statements in these sections. All statements regarding the Corporation's expected financial position and operating results, the Corporation's business strategy, the Corporation's financial plans, forecasted demographic and economic trends relating to the Corporation's industry and similar matters are forward-looking statements. These statements can sometimes be identified by the Corporation's use of forward-looking words such as "may," "will," "anticipate," "estimate," "expect," or "intend." The Corporation cannot promise that its expectations in such forward-looking statements will turn out to be correct. The Corporation's actual results could be materially different from expectations because of various factors, including changes in economic conditions or interest rates, credit risk, difficulties in managing the Corporation’s growth, competition, changes in law or the regulatory environment, including the Dodd-Frank Act, and changes in general business and economic trends. Information concerning these and other factors can be found in the Corporation’s periodic filings with the SEC, including the discussion under the heading “Item 1A. Risk Factors” in the Corporation’s 2015 Annual Report on Form 10-K. These filings are available publicly on the SEC’s web site at http://www.sec.gov, on the Corporation's web site at http://www.chemungcanal.com or upon request from the Corporate Secretary at (607) 737-3746. Except as otherwise required by law, the Corporation undertakes no obligation to publicly update or revise its forward-looking statements, whether as a result of new information, future events or otherwise. Consolidated Financial Highlights Executive Summary This executive summary of the MD&A includes selected information and may not contain all of the information that is important to readers of this Form 10-K. For a complete description of the trends and uncertainties, as well as the risks and critical accounting estimates affecting the Corporation, this Form 10-K should be read in its entirety. The following table presents selected financial information for the periods indicated, and the dollar and percent change (in thousands, except per share and ratio data): Net income for the year ended December 31, 2015 was $9.4 million, or $2.00 per share, compared with net income of $8.2 million, or $1.74 per share, for the prior year. Return on equity for the year was 6.84%, compared with 5.74% for the prior year. The increase in net income from the prior year was driven by a reduction in non-interest expense, mostly due to the $4.3 million WMG legal settlement in 2014, and higher net interest income and a reduction in the provision for loan losses, partially offset by a reduction in non-interest income, mostly due to the gain on the sale of securities, and an increase in income tax expense. Net interest income Net interest income increased $1.1 million, or 2.2%, compared with the prior year. The increase was due primarily to an increase of $78.2 million in average interest-earning assets, offset by a 13 basis point decline in net interest margin. Non-interest income Non-interest income decreased $6.3 million, or 23.6%, compared to the prior year. The decrease was due primarily to decreases in net gains on securities transactions, service charges on deposit accounts and other non-interest income, offset by an increase in WMG fee income. Non-interest expense Non-interest expense decreased $5.1 million million, or 8.4%, compared to the prior year. The decrease was due primarily to the $4.3 million legal settlement that occurred in 2014, relating to WMG, and a decline in professional services, amortization of intangibles, marketing and advertising, and other non-interest expense. These items were offset by increases in pension and other employee benefits, data processing expense and other real estate owned expenses. For the years ended December 31, 2015 and 2014, non-interest expense to average assets was 3.51% and 3.73%, respectively. Provision for loan losses The provision for loan losses decreased $2.4 million, or 60.5%, compared to the prior year. The decrease was the result of lower specific allocations for PCI loans and lower net charge-offs during the year. Net charge-offs were $1.0 million, compared with $3.1 million for the prior year. The following table presents selected financial information for the periods indicated, and the dollar and percent change (in thousands, except per share and ratio data): Net income for the year ended December 31, 2014 was $8.2 million, or $1.74 per share, compared with $8.7 million, or $1.87 per share, for the same period in the prior year. Return on equity for the year ended December 31, 2014 was 5.74%, compared with 6.50% for the same period in the prior year. The decrease in net income from the same period in the prior year was driven by an increase in non-interest expense and provision for loan losses, offset by increases in net interest income and non-interest income, along with a reduction in income tax expense. Net interest income Net interest income increased $2.9 million, or 6.3%, compared with the same period in the prior year. The increase was due primarily to an increase of $189.6 million in average interest-earning assets, offset by a 32 basis point decline in net interest margin. Non-interest income Non-interest income increased $8.7 million, or 48.0%, compared to the same period in the prior year. The increase was due to increases in WMG fee income, service charges on deposit accounts, net gains on securities transactions, and other non-interest income, offset by a decrease in net gain on sales of loans held for sale. Non-interest expense Non-interest expense increased $11.1 million, or 22.4%, compared to the same period in the prior year. The increase was primarily due to a legal settlement of $4.3 million in 2014, salaries and wages, net occupancy expenses, furniture and equipment expenses, data processing expense, professional services, amortization of intangible assets, FDIC insurance and other non-interest expense. These items were offset by decreases in pension and other employee benefits and merger and acquisition related expenses. Provision for loan losses The provision for loan losses increased $1.2 million, or 44.5%, compared to the same period in the prior year. The increase was the result of additional impairments on commercial loans and growth in the loan portfolio. Net charge-offs were $3.1 million, compared with $0.4 million for the same period in the prior year. Consolidated Results of Operations The following section of the MD&A provides a comparative discussion of the Corporation’s Consolidated Results of Operations on a reported basis for the years ended December 31, 2015 and 2014. For a discussion of the Critical Accounting Policies, Estimates and Risks and Uncertainties that affect the Consolidated Results of Operations, see pages 16-21. Net Interest Income The following table presents net interest income for the periods indicated, and the dollar and percent change (in thousands): Net interest income, which is the difference between the interest income earned on interest-earning assets, such as loans and securities and the interest expense accrued on interest-bearing liabilities, such as deposits and borrowings, is the largest contributor to the Corporation’s earnings. Net interest income for the year ended December 31, 2015 totaled $50.6 million, an increase of $1.1 million, or 2.2%, compared with $49.6 million for the same period in the prior year. Fully taxable equivalent net interest margin was 3.46% for the year ended December 31, 2015 compared with 3.59% for the same period in the prior year. The increase in net interest income was due primarily to interest income from the commercial loan portfolio, as the year-to-date average commercial loan balance increased $88.6 million when compared to the prior year. The decline in interest margin was a result of the commercial loan portfolio repricing to current market rates. The yield on average interest-earning assets and cost of average interest-bearing liabilities decreased 14 and two basis points, respectively. Average interest-earning assets increased $78.2 million compared to the prior year, primarily in commercial loans. The following table presents net interest income for the periods indicated, and the dollar and percent change (in thousands): Net interest income for the year ended December 31, 2014 totaled $49.6 million, an increase of $2.9 million, or 6.3%, compared with $46.6 million for the same period in the prior year. Fully taxable equivalent net interest margin was 3.59% for the year ended December 31, 2014 compared with 3.91% for the same period in the prior year. The increase in net interest income was due primarily to an increase of $189.6 million in average interest-earning assets. The decline in net interest margin was due in part to a 40 basis point decline in the yield on average interest-earning assets, partially offset by a ten basis point decline in the cost of average interest-bearing liabilities. The decrease in yield on average interest-earning assets was attributable to a 37 basis point decrease in yield on loans, a result of loans continuing to reprice at current historically low market rates, primarily in the commercial loan portfolio. Average Consolidated Balance Sheet and Interest Analysis The following tables present certain information related to the Corporation’s average consolidated balance sheets and its consolidated statements of income for the years ended December 31, 2015, 2014 and 2013. It also reflects the average yield on interest-earning assets and average cost of interest-bearing liabilities for the years ended December 31, 2015, 2014 and 2013. For the purpose of the table below, non-accruing loans are included in the daily average loan amounts outstanding. Daily balances were used for average balance computations. Investment securities are stated at amortized cost. Tax equivalent adjustments have been made in calculating yields on obligations of states and political subdivisions, tax-free commercial loans and dividends on equity investments. (1) Net interest rate spread is the difference in the average yield on interest-earning assets less the average rate on interest-bearing liabilities. (2) Net interest margin is the ratio of fully taxable equivalent net interest income divided by average interest-earning assets. Changes Due to Rate and Volume Net interest income can be analyzed in terms of the impact of changes in rates and volumes. The table belows illustrates the extent to which changes in interest rates and in the volume of average interest-earning assets and interest-bearing liabilities have affected the Corporation’s interest income and interest expense during the periods indicated. Information is provided in each category with respect to (i) changes attributable to changes in volume (changes in volume multiplied by prior rate); (ii) changes attributable to changes in rates (changes in rates multiplied by prior volume); and (iii) the net changes. For purposes of this table, changes that are not due solely to volume or rate changes have been allocated to these categories based on the respective percentage changes in average volume and rate. Due to the numerous simultaneous volume and rate changes during the periods analyzed, it is not possible to precisely allocate changes between volume and rates. In addition, average earning assets include non-accrual loans and taxable equivalent adjustments were made. Provision for loan losses Management performs an ongoing assessment of the adequacy of the allowance for loan losses based upon a number of factors including an analysis of historical loss factors, collateral evaluations, recent charge-off experience, credit quality of the loan portfolio, current economic conditions and loan growth. Based on this analysis, the provision for loan losses for the years ended December 31, 2015, 2014 and 2013 were $1.6 million, $4.0 million and $2.8 million, respectively. Net charge-offs for the years ended December 31, 2015, 2014 and 2013 were $1.0 million, $3.1 million and $0.4 million, respectively. Non-interest income The following table presents non-interest income for the periods indicated, and the dollar and percent change (in thousands): Total non-interest income for the year ended December 31, 2015 decreased $6.3 million compared to the same period in the prior year. The decrease was due to decreases in service charges on deposit accounts, net gains on securities transactions, and other non-interest income, offset by an increase in WMG fee income and net gains on sales of other real estate owned. WMG fee income WMG fee income increased compared to the same period in the prior year due to an increase in fee levels, as fees were adjusted to reflect current market fee levels, offset by a decline in total assets under management or administration. Service charges on deposit accounts Service charges on deposit accounts decreased compared to the same period in the prior year due to a decline in overdraft fees. Net gains (losses) on securities transactions Net gains (losses) on securities transactions decreased compared to the same period in the prior year due to the $6.4 million gain on the sale of equity securities during the prior year. CFS fee and commission income CFS fee and commission income increased compared to the same period in the prior year due to an increase in commissions from insurance annuity products. Other Other non-interest income decreased due to a decline in gains on stock donations to charitable organizations and other non-interest income, offset by additional rental income in 2015 from properties included within OREO. The following table presents non-interest income for the periods indicated, and the dollar and percent change (in thousands): Total non-interest income for year ended December 31, 2014 increased $8.7 million compared with the same period in the prior year. The increase was mostly due to increases in WMG fee income, services charges, net gains on securities transactions, CFS fee and commission income, check card interchange income, and other non-interest income, offset by decreases in net gains on sales of loans held for sale and gain from bargain purchase. WMG fee income WMG fee income increased compared to the same period in the prior year due to an increase in assets under management or administration. Service charges on deposit accounts Service charges on deposit accounts increased compared to the same period in the prior year due the acquisition of six branches during the fourth quarter of 2013. Interchange from debit card transactions Interchange from debit card transactions increased compared to the same period in the prior year due the acquisition of six branches during the fourth quarter of 2013. Net gains on securities transactions Net gains on securities transactions increased compared to the same period in the prior year due to the $6.4 million gain on the sale of equity securities during the fourth quarter of 2014. Gain on bargain purchase The Bank recognized a $0.5 million gain from bargain purchase from the acquisition of six Bank of America branches in 2013. CFS fee and commission income CFS fee and commission income increased compared to the same period in the prior year due to an increase in the volume of insurance annuity products and mutual funds sold. Other Other non-interest income increased due to a gain on the liquidation of the Corporation’s investment in a pool of trust preferred securities recognized during the year. Non-interest expense The following table presents non-interest expense for the periods indicated, and the dollar and percent change (in thousands): Total non-interest expense for the year ended December 31, 2015 decreased $5.1 million compared with the prior year. The decrease was primarily due to a decrease in non-compensation expense related to the $4.3 million legal settlement in the the prior year. Compensation expense Compensation expense increased compared to the same period in the prior year due to an increase in pension and other employee benefits, offset by a decrease in salaries and wages. The $0.2 million increase in pension and other employee benefits was due to the adoption of updated mortality tables in 2015, which reflected improved life expectancies of employees and a reduced discount rate for determining pension costs. The decrease in salaries and wages was due to a reduction in full-time equivalent employees. Non-compensation expense Non-compensation expense decreased compared to the same period in the prior year primarily due to the legal settlement that occurred in 2014, related to the Bank's WMG, offset by an increase in data processing expense and OREO expenses. The increase in data processing expense was primarily due to check card expense and data communication lines expense, while the increase in OREO expenses was due to two properties being carried in OREO for the entire year, along with a fair market value adjustment to one property. The following table presents non-interest expense for the periods indicated, and the dollar and percent change (in thousands): Total non-interest expense for the year ended December 31, 2014 increased $11.1 million compared with the same period in the prior year. The increase was due to increases in both compensation, due to additional full-time equivalent employees from the acquisition of six branches in the fourth quarter of 2013, and non-compensation expense, mostly related to the $4.3 million legal settlement in 2014 and additional operating expenses associated with the additional six branches acquired in the fourth quarter of 2013. Compensation expense Compensation expense increased compared to the same period in the prior year due to an increase in salaries and wages. The $2.0 million increase in salaries and wages was due to the acquisition of six branches from Bank of America in the fourth quarter of 2013, which impacted 2014 for the entire year. Non-compensation expense Non-compensation expense increased compared to the same period in the prior year primarily due to the legal settlement that occurred in 2014, related to the Bank's WMG, along with increases in net occupancy, furniture and equipment, data processing, professional services, amortization of intangible assets, FDIC insurance, and other non-interest expense. Offsetting these increases was a decline in merger and acquisition expenses, due to the acquisition of six Bank of America branches in 2013. The increases in net occupancy, furniture and equipment , data processing, and FDIC insurance can be attributed to the acquisition of six branches. Professional services increased due to consulting costs associated with the rebranding of the Bank's debit cards from Visa to Mastercard. Income tax expense The following table presents income tax expense and the effective tax rate for the periods indicated, and the dollar and percent change (in thousands): The increase in the effective tax rate can be attributed to higher pre-tax income and changes in the mix of income and expense subject to U.S. federal, state, and local income taxes. The following table presents income tax expense and the effective tax rate for the periods indicated, and the dollar and percent change (in thousands): The increase in the effective tax rate can be attributed to higher pre-tax income and changes in the mix of income and expense subject to U.S. federal, state, and local income taxes. Financial Condition The following table presents selected financial information for the periods indicated, and the dollar and percent change (in thousands): Cash and cash equivalents The decrease in cash and cash equivalents can be attributed to the use of cash to purchase investment securities, fund new loans, and pay-down FHLBNY advances, offset primarily by the inflow of municipal deposits. Investment securities The increase in investment securities can be mostly attributed to the investment of excess cash primarily from municipal client deposits into higher yielding mortgage-backed securities. During the year, mortgage-backed securities and municipal securities increased $136.7 million and $13.0 million, respectively, while obligations of U.S. Government and U.S. Government sponsored enterprises decreased $81.5 million. Loans, net The increase in loans can be attributed to an increase of $79.7 million in commercial loans, offset by decreases of $1.0 million in mortgages and $32.6 million in consumer loans, which was mostly attributed to the indirect loan portfolio. The increase in the commercial loan portfolio is primarily from the Capital Bank Division, while the decline in the indirect loan portfolio can be attributed to the run off of promotional interest rates. The increase in the allowance for loan losses can be primarily attributed to growth in the commercial loan portfolio. Goodwill and other intangible assets, net The decrease in goodwill and other intangible assets, net can be attributed to amortization of other intangible assets. There were no impairments of goodwill or other intangible assets during the years ended December 31, 2015 and 2014. Other assets The decrease in other assets can be mostly attributed to depreciation of premises and equipment, the sale of two commercial properties from other real estate owned and the receipt of insurance proceeds from the WMG legal settlement during the second quarter of 2015, which was accrued in 2014. See footnote 15 for further discussion. Deposits The increase in deposits can be attributed to increases of $104.8 million in money market accounts, $35.9 million in non-interest-bearing demand deposits, $19.8 million in interest-bearing demand deposits and $5.6 million in savings deposits. These items were offset by a $45.8 million decrease in time deposits. The changes in money market accounts and demand deposits can be attributed to the net inflow of deposits from municipal clients, as well as new municipal client relationships. FHLBNY advances and other debt FHLBNY term advances were reduced by normal scheduled payments. FHLBNY overnight advances were reduced with the large increase in deposits received from municipal clients. Other liabilities The decrease in other liabilities can be attributed to the $12.1 million payment from the WMG legal settlement during the second quarter of 2015, which was accrued for in 2014. See Note 15 for further discussion. Shareholders’ equity The increase in shareholders’ equity was primarily due to earnings of $9.4 million and a reduction of $1.0 million in treasury stock, offset by an increase of $2.2 million in accumulated other comprehensive loss and $4.8 million in dividends declared. Assets under management or administration The market value of total assets under management or administration in our WMG was $1.856 billion, including $304.1 million of assets held under management or administration for the Corporation, at December 31, 2015 compared with $1.956 billion, including $287.1 million of assets held under management or administration for the Corporation, at December 31, 2014, a decrease of $100.2 million, or 5.1%. The decrease in market value can be mostly attributed to a decline in the market value of assets during 2015. Balance Sheet Comparisons The table below contains selected average balance sheet information for each year in the six-year period ended December 31, 2015 (in millions): (1) Average earning assets include securities available for sale and securities held to maturity based on amortized cost, loans and loans held for sale net of deferred loan fees, interest-bearing deposits, FHLBNY stock, FRBNY stock and federal funds sold. (2) Average loans and loans held for sale, net of deferred loan fees. (3) Average balances for investments include securities available for sale and securities held to maturity, based on amortized cost, FHLBNY stock, FRBNY stock, federal funds sold and interest-bearing deposits. (4) Average borrowings include FHLBNY advances, securities sold under agreements to repurchase and capitalized lease obligations. The table below contains selected period-end balance sheet information for each year in the six-year period ended December 31, 2015 (in millions): (1) Earning assets include securities available for sale, at estimated fair value and securities held to maturity based on amortized cost, loans and loans held for sale net of deferred loan fees, interest-bearing deposits, FHLBNY stock, FRBNY stock and federal funds sold. (2) Loans and loans held for sale, net of deferred loan fees. (3) Investments include securities available for sale, at estimated fair value, securities held to maturity, at amortized cost, FHLBNY stock, FRBNY stock, federal funds sold and interest-bearing deposits. (4) Borrowings include FHLBNY advances, securities sold under agreements to repurchase and capitalized lease obligations. Cash and Cash Equivalents Total cash and cash equivalents decreased $3.0 million since December 31, 2014, due primarily to a $3.2 million decrease in cash and due from financial institutions, offset by a $0.3 million increase in interest-bearing deposits in other financial institutions. Securities The Corporation’s Funds Management Policy includes an investment policy that in general, requires debt securities purchased for the bond portfolio to carry a minimum agency rating of "A". After an independent credit analysis is performed, the policy also allows the Corporation to purchase local municipal obligations that are not rated. The Corporation intends to maintain a reasonable level of securities to provide adequate liquidity and in order to have securities available to pledge to secure public deposits, repurchase agreements and other types of transactions. Fluctuations in the fair value of the Corporation’s securities relate primarily to changes in interest rates. Marketable securities are classified as Available for Sale, while investments in local municipal obligations are generally classified as Held to Maturity. The composition of the available for sale segment of the securities portfolio is summarized in the table as follows (in thousands): The available for sale segment of the securities portfolio totaled $344.8 million at December 31, 2015, an increase of $64.3 million, or 22.9%, from $280.5 million at December 31, 2014. The increase resulted primarily from purchases of mortgage-backed securities and obligations of states and political subdivisions, offset by sales, calls, and maturities of obligations of U.S. Government and U.S. Government sponsored enterprises. The held to maturity segment of the securities portfolio consists of obligations of political subdivisions in the Corporation’s market areas. These securities totaled $4.6 million at December 31, 2015, a decrease of $1.3 million from December 31, 2014, due primarily to maturities and principal collected, offset by additional purchases. Non-marketable equity securities at December 31, 2015 include shares of FRBNY stock and FHLBNY stock, carried at their cost of $1.7 million and $3.1 million, respectively. The fair value of thee securities is assumed to approximate their cost. The investment in these stocks is regulated by regulatory policies of the respective institutions. The table below sets forth the carrying amounts and maturities of available for sale and held to maturity debt securities at December 31, 2015 and the weighted average yields of such securities (all yields are calculated on the basis of the amortized cost and weighted for the scheduled maturity of each security, except mortgage-backed securities which are based on the average life at the projected prepayment speed of each security). Federal tax equivalent adjustments have been made in calculating yields on municipal obligations (in thousands): Management evaluates securities for OTTI on a quarterly basis, and more frequently when economic or market conditions warrant such an evaluation. For the years ended December 31, 2015 and 2014, the Corporation had no OTTI charges. For the year ended December 31, 2013, the Corporation had less than $0.1 million in OTTI charges. During the fourth quarter of 2013, the Corporation sold one CDO consisting of a pool of trust preferred securities that had an amortized cost of $0.6 million. The CDO was sold for $0.6 million, resulting in a slight loss. In addition to the CDO that was sold in the fourth quarter of 2013, the remaining CDO was liquidated and the Corporation recorded $0.5 million in other income during the first quarter of 2014. The Corporation does not own any other CDOs in its investment securities portfolio. For more detailed information on OTTI, see Footnote 3, “Securities” in the Notes to Consolidated Financial Statements. Loans The Corporation has reporting systems to monitor: (i) loan originations and concentrations, (ii) delinquent loans, (iii) non-performing assets, including non-performing loans, troubled debt restructurings, other real estate owned, (iv) impaired loans, and (v) potential problem loans. Management reviews these systems on a regular basis. The table below presents the Corporation’s loan composition by segment and percentage of total loans at the end of each of the last five years (in thousands): Portfolio loans totaled $1.169 billion at December 31, 2015, an increase of $47.1 million, or 4.2%, from $1.122 billion at December 31, 2014. The increase in portfolio loans was due to strong growth of $80.7 million, or 13.0%, in commercial loans, offset by a decrease of $33.4 million, or 18.1%, in indirect consumer loans. The growth in commercial loans was due primarily to an increase in commercial loans in the Capital Bank division in the Albany, New York region. The decline in indirect consumer loans was a result of the Corporation's decision to end its reduced pricing loan program during the fourth quarter of 2014. Residential mortgage loans totaled $195.8 million at December 31, 2015, a decrease of $1.0 million, or 0.5%, from December 31, 2014. In addition, during 2015, $12.8 million of residential mortgages were sold in the secondary market to Freddie Mac, with an additional $0.5 million of residential mortgages sold to the State of New York Mortgage Agency. The Corporation anticipates that future growth in portfolio loans will continue to be in commercial mortgages and commercial and industrial loans, especially within the Capital Bank division of the Bank. The table below presents the Corporation’s outstanding loan balance by bank division (in thousands): Loan concentrations are considered to exist when there are amounts loaned to a multiple number of borrowers engaged in similar activities which would cause them to be similarly impacted by economic or other conditions. The Corporation’s concentration policy limits the volume of commercial loans to any one specific industry. Specific industries are identified using NAICS codes. The volume of commercial loans, with the exception of commercial mortgages, to any one specific industry is limited to Tier 1 capital plus the allowance for loan losses. The volume of commercial mortgages is limited to three times the total of Tier 1 capital plus the allowance for loan losses. The Corporation is in compliance with the concentration policy limits. The Corporation also monitors specific NAICS industry classifications of commercial loans to identify concentrations greater than 10.0% of total loans. At December 31, 2015 and 2014, commercial loans to borrowers involved in the real estate, and real estate rental and lending businesses were 40.6% and 36.1% of total loans, respectively. No other concentration of loans existed in the commercial loan portfolio in excess of 10.0% of total loans as of December 31, 2015 and 2014. The table below shows the maturity of only commercial and agricultural loans and commercial mortgages outstanding as of December 31, 2015. Also provided are the amounts due after one year, classified according to the sensitivity to changes in interest rates (in thousands): Non-Performing Assets Non-performing assets consist of non-accrual loans, non-accrual troubled debt restructurings and other real estate owned that has been acquired in partial or full satisfaction of loan obligations or upon foreclosure. Past due status on all loans is based on the contractual terms of the loan. It is generally the Corporation's policy that a loan 90 days past due be placed in non-accrual status unless factors exist that would eliminate the need to place a loan in this status. A loan may also be designated as non-accrual at any time if payment of principal or interest in full is not expected due to deterioration in the financial condition of the borrower. At the time loans are placed in non-accrual status, the accrual of interest is discontinued and previously accrued interest is reversed. All payments received on non-accrual loans are applied to principal. Loans are considered for return to accrual status when they become current as to principal and interest and remain current for a period of six consecutive months or when, in the opinion of management, the Corporation expects to receive all of its contractual principal and interest. In the case of non-accrual loans where a portion of the loan has been charged off, the remaining balance is kept in non-accrual status until the entire principal balance has been recovered. The following table summarizes the Corporation's non-performing assets, excluding purchased credit impaired loans (in thousands): NON-PERFORMING ASSETS (1) These loans are not included in nonperforming assets above. The table below shows interest income on non-accrual and troubled debt restructured loans for the indicated years ended December 31 (in thousands): Non-Performing Loans Non-performing loans totaled $12.2 million at December 31, 2015, or 1.05% of total loans, compared with $7.8 million at December 31, 2014, or 0.69% of total loans. The increase in non-performing loans at December 31, 2015 was primarily due to two commercial real estate loans that were place in non-accrual status during the year. Non-performing assets, which are comprised of non-performing loans and other real estate owned, was $13.8 million, or 0.85% of total assets, at December 31, 2015, compared with $10.8 million, or 0.71% of total assets, at December 31, 2014. The recorded investment in accruing loans past due 90 days or more totaled less than $0.1 million at December 31, 2015, a decrease of $1.5 million from December 31, 2014. The decline in accruing loans past due 90 days or more can be attributed to payoffs. Not included in non-performing loan totals are $2.1 million and $2.6 million of acquired loans which the Corporation has identified as PCI loans at December 31, 2015 and 2014, respectively. The PCI loans are accounted for under separate accounting guidance, Accounting Standards Codification (“ASC”) Subtopic 310-30, “Receivables - Loans and Debt Securities Acquired with Deteriorated Credit Quality” as disclosed in Note 4 of the financial statements. Troubled Debt Restructurings The Corporation works closely with borrowers that have financial difficulties to identify viable solutions that minimize the potential for loss. In that regard, the Corporation modified the terms of select loans to maximize their collectability. The modified loans are considered TDRs under current accounting guidance. Modifications generally involve short-term deferrals of principal and/or interest payments, reductions of scheduled payment amounts, interest rates or principal of the loan, and forgiveness of accrued interest. As of December 31, 2015, the Corporation had $4.4 million of non-accrual TDRs compared with $1.0 million as of December 31, 2014. As of December 31, 2015, the Corporation had $7.6 million of accruing TDRs compared with $8.7 million as of December 31, 2014. The increase in non-accrual TDRs was primarily due to commercial loans moving to non-accrual status. Impaired Loans A loan is classified as impaired when, based on current information and events, it is probable that the Corporation will be unable to collect both the principal and interest due under the contractual terms of the loan agreement. Impaired loans at December 31, 2015 totaled $15.0 million, including TDRs of $12.0 million, compared to $15.9 million at December 31, 2014, including TDRs of $9.7 million. Not included in the impaired loan totals are acquired loans which the Corporation has identified as PCI loans, as these loans are accounted for under ASC Subtopic 310-30 as noted under the above discussion of non-performing loans. The decrease in impaired loans was primarily in the commercial loan segment of the loan portfolio. Included in the recorded investment of impaired loans at December 31, 2015, are loans totaling $5.2 million for which impairment allowances of $1.6 million have been specifically allocated to the allowance for loan losses. As of December 31, 2014, the impaired loan total included $4.2 million of loans for which specific impairment allowances of $1.2 million were allocated to the allowance for loan losses. The increase in the amount of impaired loans for which specific allowances were allocated to the allowance for loan losses was due primarily to an increase in impaired commercial loans. The majority of the Corporation's impaired loans are secured and measured for impairment based on collateral evaluations. It is the Corporation's policy to obtain updated appraisals, by independent third parties, on loans secured by real estate at the time a loan is determined to be impaired. An impairment measurement is performed based upon the most recent appraisal on file to determine the amount of any specific allocation or charge-off. In determining the amount of any specific allocation or charge-off, the Corporation will make adjustments to reflect the estimated costs to sell the property. Upon receipt and review of the updated appraisal, an additional measurement is performed to determine if any adjustments are necessary to reflect the proper provisioning or charge-off. Impaired loans are reviewed on a quarterly basis to determine if any changes in credit quality or market conditions would require any additional allocation or recognition of additional charge-offs. Real estate values in the Corporation's market area have been holding steady. Non-real estate collateral may be valued using (i) an appraisal, (ii) net book value of the collateral per the borrower’s financial statements, or (iii) accounts receivable aging reports, that may be adjusted based on management’s knowledge of the client and client’s business. If market conditions warrant, future appraisals are obtained for both real estate and non-real estate collateral. Allowance for Loan Losses The allowance is an amount that management believes will be adequate to absorb probable incurred losses on existing loans. The allowance is established based on management’s evaluation of the probable inherent losses in our portfolio in accordance with GAAP, and is comprised of both specific valuation allowances and general valuation allowances. A loan is classified as impaired when, based on current information and events, it is probable that the Corporation will be unable to collect both the principal and interest due under the contractual terms of the loan agreement. Specific valuation allowances are established based on management’s analyses of individually impaired loans. Factors considered by management in determining impairment include payment status, evaluations of the underlying collateral, expected cash flows, and the probability of collecting scheduled principal and interest payments when due. Loans that experience insignificant payment delays and payment shortfalls generally are not classified as impaired. Management determines the significance of payment delays and payment shortfalls on a case-by-case basis, taking into consideration all of the circumstances surrounding the loan and the borrower, including the length of the delay, the reasons for the delay, the borrower’s prior payment record, and the amount of the shortfall in relation to the principal and interest owed. If a loan is determined to be impaired and is placed on non-accrual status, all future payments received are applied to principal and a portion of the allowance is allocated so that the loan is reported, net, at the present value of estimated future cash flows using the loan’s existing rate or at the fair value of collateral if repayment is expected solely from the collateral. The general component covers non-impaired loans and is based on historical loss experience adjusted for current factors. Loans not impaired but classified as substandard and special mention use a historical loss factor on a rolling five year history of net losses. For all other unclassified loans, the historical loss experience is determined by portfolio class and is based on the actual loss history experienced by the Corporation over the most recent two years. This actual loss experience is supplemented with other qualitative factors based on the risks present for each portfolio class. These qualitative factors include consideration of the following: (1) lending policies and procedures, including underwriting standards and collection, charge-off and recovery policies, (2) national and local economic and business conditions and developments, including the condition of various market segments, (3) loan profiles and volume of the portfolio, (4) the experience, ability, and depth of lending management and staff, (5) the volume and severity of past due, classified and watch-list loans, non-accrual loans, troubled debt restructurings, and other modifications (6) the quality of the Bank’s loan review system and the degree of oversight by the Bank’s Board of Directors, (7) collateral related issues: secured vs. unsecured, type, declining valuation environment and trend of other related factors, (8) the existence and effect of any concentrations of credit, and changes in the level of such concentrations, (9) the effect of external factors, such as competition and legal and regulatory requirements, on the level of estimated credit losses in the Bank’s current portfolio and (10) the impact of the global economy. The allowance for loan losses is increased through a provision for loan losses charged to operations. Loans are charged against the allowance for loan losses when management believes that the collectability of all or a portion of the principal is unlikely. Management's evaluation of the adequacy of the allowance for loan losses is performed on a periodic basis and takes into consideration such factors as the credit risk grade assigned to the loan, historical loan loss experience and review of specific impaired loans. While management uses available information to recognize losses on loans, future additions to the allowance may be necessary based on changes in economic conditions. In addition, various regulatory agencies, as an integral part of their examination process, periodically review the Corporation's allowance for loan losses. Such agencies may require the Corporation to recognize additions to the allowance based on their judgments about information available to them at the time of their examination. The allowance for loan losses was $14.3 million at December 31, 2015, up from $13.7 million at December 31, 2014. The ratio of allowance for loan losses to total loans was 1.22% at December 31, 2015 and 2014, respectively. Net charge-offs for the years ended December 31, 2015 and 2014 were $1.0 million and $3.1 million. The table below summarizes the Corporation’s allocation of the allowance for loan losses and percent of loans by category to total loans for each year in the five-year period ended December 31, 2015 (in thousands): The table below summarizes the Corporation's loan loss experience for each year in the five-year period ended December 31, 2015 (in thousands, except ratio data): Net charge-offs for December 31, 2015 were $1.0 million compared with $3.1 million for December 31, 2014. The ratio of net charge-offs to average loans outstanding was 0.09% for 2015 compared to 0.29% for 2014. The decrease in net charge-offs was due primarily to a $2.1 million decrease in commercial loan net charge-offs. Other Real Estate Owned At December 31, 2015, OREO totaled $1.5 million compared to $3.1 million at December 31, 2014. The decrease in other real estate owned was due primarily to the sale of two commercial properties and a fair market value adjustment, based upon an accepted offer on a commercial property. Other Assets The $7.0 million decrease in other assets was due primarily to the receipt of insurance proceeds from the WMG legal settlement, which was accrued in the prior year, and sale of two commercial properties in other real estate owned. Deposits The table below summarizes the Corporation’s deposit composition by segment for the periods indicated, and the dollar and percent change from December 31, 2014 to December 31, 2015 (in thousands): Deposits totaled $1.400 billion at December 31, 2015, compared with $1.280 billion at December 31, 2014, an increase of $120.3 million, or 9.4%. At December 31, 2015, demand deposit and money market accounts comprised 73.6% of total deposits compared with 68.0% at December 31, 2014. Sorted by public, commercial, consumer and broker sources, the growth in deposits was due primarily to increases of $86.0 million in brokered, $16.7 million in commercial deposits, $9.0 million in consumer and $8.6 million in public deposit accounts. The table below presents the Corporation's deposits balance by bank division (in thousands): Brokered deposits include funds obtained through brokers, and the Bank’s participation in CDARS and ICS programs. The CDARS and ICS programs involve a network of financial institutions that exchange funds among members in order to ensure FDIC insurance coverage on customer deposits above the single institution limit. Using a sophisticated matching system, funds are exchanged on a dollar-for-dollar basis, so that the equivalent of an original deposit comes back to the originating institution. The Corporation had no deposits obtained through brokers as of December 31, 2015, compared with $2.3 million as of December 31, 2014, respectively. Deposits obtained through the CDARS and ICS programs were $165.0 million and $76.7 million as of December 31, 2015 and 2014, respectively. The increase in CDARS and ICS deposits was due to the Corporation offering the programs to local municipalities. The Corporation’s deposit strategy is to fund the Bank with stable, low-cost deposits, primarily checking account deposits and other low interest-bearing deposit accounts. A checking account is the driver of a banking relationship and consumers consider the bank where they have their checking account as their primary bank. These customers will typically turn to their primary bank first when in need of other financial services. Strategies that have been developed and implemented to generate these deposits include: (i) acquire deposits by entering new markets through de novo branching, (ii) an annual checking account marketing campaign, (iii) training branch employees to identify and meet client financial needs with Bank products and services, (iv) link business and consumer loans to a primary checking account at the Bank, (v) aggressively promote direct deposit of client’s payroll checks or benefit checks and (vi) constantly monitor the Corporation’s pricing strategies to ensure competitive products and services. The Corporation also considers brokered deposits to be an element of its deposit strategy and anticipates that it will continue using brokered deposits as a secondary source of funding to support growth. Information regarding deposits is included in Note 7 to the consolidated financial statements appearing elsewhere in this report. Borrowings FHLBNY advances decreased $17.0 million to $33.1 million at December 31, 2015 from $50.1 million at December 31, 2014. FHLBNY overnight advances decreased $16.9 million million during 2015 while FHLBNY term advances decreased $0.1 million. For each of the three years ended December 31, 2015, 2014 and 2013, respectively, the average outstanding balance of borrowings that mature in one year or less did not exceed 30% of shareholders' equity. Information regarding securities sold under agreements to repurchase and FHLBNY advances is included in notes 8 and 9 to the consolidated financial statements appearing elsewhere in this report. Derivatives The Corporation offers interest rate swap agreements to qualified commercial loan customers. These agreements allow the Corporation’s customers to effectively fix the interest rate on a variable rate loan by entering into a separate agreement. Simultaneous with the execution of such an agreement with a customer, the Corporation enters into a matching interest rate swap agreement with an unrelated third party provider, which allows the Corporation to continue to receive the variable rate under the loan agreement with the customer. The agreement with the third party is not designated as a hedge contract, therefore changes in fair value are recorded through other non-interest income. Assets and liabilities associated with the agreements are recorded in other assets and other liabilities on the balance sheet. Gains and losses are recorded as other non-interest income. The Corporation is exposed to credit loss equal to the fair value of the interest rate swaps, not the notional amount of the derivatives, in the event of nonperformance by the counterparty to the interest rate swap agreements. Additionally, the swap agreements are free-standing derivatives and are recorded at fair value in the Corporation's consolidated balance sheets, which typically involves a day one gain. Since the terms of the two interest rate swap agreements are identical, the income statement impact to the Corporation is limited to the day one gain and an allowance for credit loss exposure, in the event of nonperformance. The Corporation recognized $0.1 million in swap fee income for the years ended in December 31, 2015 and 2014. The Corporation also participates in the credit exposure of certain interest rate swaps in which it participates in the related commercial loan. The Corporation receives an upfront fee for participating in the credit exposure of the interest rate swap and recognizes the fee to other non-interest income immediately. The Corporation is exposed to its share of the credit loss equal to the fair value of the derivatives in the event of nonperformance by the counter-party of the interest rate swap. The Corporation determines the fair value of the credit loss exposure using historical losses of the loan category associated with the credit exposure. Information regarding derivatives is included in Note 10 to the consolidated financial statements appearing elsewhere in this report. Shareholders’ Equity Total shareholders’ equity was $137.2 million at December 31, 2015, compared with $133.6 million at December 31, 2014, a increase of $3.6 million, or 2.7%. The increase was due primarily to earnings of $9.4 million and a reduction of $1.0 million in treasury stock, offset by an increase of $2.2 million in accumulated other comprehensive loss and $4.8 million in dividends declared. The total shareholders’ equity to total assets ratio was 8.47% at December 31, 2015 compared with 8.77% at December 31, 2014. Tangible equity to tangible assets ratio decreased to 6.99% at December 31, 2015, from 7.13% at December 31, 2014. The Corporation and the Bank are subject to capital adequacy guidelines of the Federal Reserve which establish a framework for the classification of financial holding companies and financial institutions into five categories: well-capitalized, adequately capitalized, undercapitalized, significantly undercapitalized and critically undercapitalized. As of December 31, 2015, both the Corporation’s and the Bank’s capital ratios were in excess of those required to be considered well-capitalized under regulatory capital guidelines. A comparison of the Corporation’s and the Bank’s actual capital ratios to the ratios required to be adequately or well-capitalized at December 31, 2015 and 2014, is included in note 18 to the consolidated financial statements appearing elsewhere in this report. For more information regarding current capital regulations see Part I-“Business-Supervision and Regulation-Regulatory Capital.” Cash dividends declared during 2015, 2014, and 2013 totaled $4.8 million or $1.04 per share, respectively. Dividends declared during 2015 amounted to 51.34% of net income compared to 58.80% and 41.04% of net income for 2014 and 2013, respectively. Management seeks to continue generating sufficient capital internally, while continuing to pay dividends to the Corporation’s shareholders. When shares of the Corporation become available in the market, the Corporation may purchase them after careful consideration of the Corporation’s liquidity and capital positions. Purchases may be made from time to time on the open market or in privately negotiated transactions at the discretion of management. On December 19, 2012, the Board of Directors approved a new stock repurchase plan under which the Corporation may repurchase up to 125,000 shares. No shares were purchased under the new plan in 2015 and 2014. The Corporation purchased 3,094 shares at a total cost of $93 thousand under the new plan since its inception. Off-balance Sheet Arrangements In the normal course of operations, the Corporation engages in a variety of financial transactions that, in accordance with GAAP are not recorded in the financial statements. The Corporation is also a party to certain financial instruments with off balance sheet risk such as commitments under standby letters of credit, unused portions of lines of credit, commitments to fund new loans, interest rate swaps, and risk participation agreements. The Corporation's policy is to record such instruments when funded. These transactions involve, to varying degrees, elements of credit, interest rate and liquidity risk. Such transactions are generally used by the Corporation to manage clients' requests for funding and other client needs. The table below shows the Corporation’s off-balance sheet arrangements as of December 31, 2015 (in thousands): (1) Not included in this total are unused portions of home equity lines of credit, credit card lines and consumer overdraft protection lines of credit, since no contractual maturity dates exist for these types of loans. Commitments to outside parties under these lines of credit were $44,521, $12,508 and $6,663, respectively, at December 31, 2015. Contractual Obligations The table below shows the Corporation’s contractual obligations under long-term agreements as of December 31, 2015 (in thousands). Note references are to the Notes of the Consolidated Financial Statements: (1) Not included in the above total is the Corporation's obligation regarding the Pension Plan and Other Benefit Plans. Please refer to Part IV Item 15 Note 12 for information regarding these obligations at December 31, 2015. Liquidity Liquidity management involves the ability to meet the cash flow requirements of deposit clients, borrowers, and the operating, investing and financing activities of the Corporation. The Corporation uses a variety of resources to meet its liquidity needs. These include short term investments, cash flow from lending and investing activities, core-deposit growth and non-core funding sources, such as time deposits of $100,000 or more, securities sold under agreements to repurchase and other borrowings. The Corporation is a member of the FHLBNY which allows it to access borrowings which enhance management's ability to satisfy future liquidity needs. Based on available collateral and current advances outstanding, the Corporation was eligible to borrow up to a total of $106.2 million and $86.0 million at December 31, 2015 and 2014, respectively. The Corporation also had a total of $28.0 million of unsecured lines of credit with four different financial institutions, all of which was available at December 31, 2015 and 2014. Consolidated Cash Flows Analysis The table below summarizes the Corporation's cash flows for the periods indicated (in thousands): Operating activities The Corporation believes cash flows from operations, available cash balances and its ability to generate cash through short- and long-term borrowings are sufficient to fund the Corporation’s operating liquidity needs. Cash provided by operating activities in years ended 2015 and 2014 predominantly resulted from net income after non-cash operating adjustments. Investing activities Cash used in investing activities during the years ended 2015 and 2014 predominantly resulted from purchases of securities available for sale and a net increase in loans, offset by sales, calls, maturities, and principal collected on securities available for sale. Financing activities Cash provided by financing activities during the years ended 2015 and 2014 predominantly resulted from an increase in deposits. The increase in deposits reflected the seasonable inflow of funds from municipal clients into demand and money market accounts. Cash inflows in 2015 were offset by a reduction of FHLBNY overnight advances. Capital Resources Basel III Capital Rules On October 11, 2013, the FRB approved a final rule that amends the regulatory capital rules for state member banks effective January 1, 2015. The FRB approved the new capital rules in coordination with substantially identical final rules approved by the FDIC and the Office of the Comptroller of the Currency for other types of banking organizations. The revisions make the capital rules consistent with agreements that were reached by Basel III and certain provisions of the Dodd-Frank Act. In general, the new capital rules revise regulatory capital definitions and minimum ratios; redefine Tier 1 Capital as two components (common equity Tier 1 capital and additional Tier 1 capital); create a new “common equity Tier 1 risk-based capital ratio”; implement a capital conservation buffer; revise prompt corrective action thresholds; and change risk weights for certain assets and off-balance sheet exposures. The new capital rules implement a revised definition of regulatory capital, a new common equity Tier 1 minimum capital requirement of 4.5%, and a higher minimum Tier 1 capital requirement of 6.0% (which is an increase from 4.0%). Under the new rules, the total capital ratio remains at 8.0%, and the minimum leverage ratio (Tier 1 capital to total assets) for all banking organizations, regardless of supervisory rating, is 4.0%. Additionally, under the new capital rules, in order to avoid limitations on capital distributions, including dividend payments and certain discretionary bonus payments to executive officers, a banking organization must hold a capital conservation buffer composed of common equity Tier 1 capital above its minimum risk-based capital requirements. The buffer is measured relative to risk-weighted assets. The final rules also enhance risk sensitivity and address weaknesses identified by the regulators over recent years with the measure of risk-weighted assets, including through new measures of creditworthiness to replace references to credit ratings, consistent with the requirements of the Dodd-Frank Act. The new capital requirements also include changes in the risk-weights of assets to better reflect credit risk and other risk exposures. These include a 150% risk weight (up from 100%) for certain high volatility commercial real estate acquisition, development and construction loans and the unsecured portion of non-residential mortgage loans that are 90 days past due or otherwise on non-accrual status; a 20% (up from 0%) credit conversion factor for the unused portion of a commitment with an original maturity of one year or less that is not unconditionally cancellable; a 250% risk weight (up from 100%) for mortgage servicing rights and deferred tax assets that are not deducted from capital; and increased risk weights (from 0% to up to 600%) for equity exposures. The new minimum capital requirements became effective for all banking organizations (except for the largest internationally active banking organizations) on January 1, 2015, whereas the capital conservation buffer and the deductions from common equity Tier 1 capital phase in over time, beginning on January 1, 2016. The Corporation is subject to FRB capital requirements applicable to bank holding companies, which are similar to those applicable to the Bank. In assessing a state member bank’s capital adequacy, the FRB takes into consideration not only these numeric factors but also qualitative factors, and has the authority to establish higher capital requirements for individual banks where necessary. The Bank, in accordance with its internal prudential standards, targets as its goal the maintenance of capital ratios which exceed these minimum requirements and that are consistent with its risk profile. As of December 31, 2015, the Bank exceeded all regulatory capital ratios necessary to be considered well capitalized. The new capital rules maintain the general structure of the current prompt corrective action framework while increasing some of the thresholds for the prompt corrective action capital categories. For example, an adequately capitalized bank is required to maintain a Tier 1 risk-based capital ratio of 6.0% (increased from the current level of 4.0%). The rule also introduces the common equity Tier 1 capital ratio as a new prompt corrective action capital category threshold. As an institution’s capital decreases within the three undercapitalized categories listed above, the severity of the action that is authorized or required to be taken by the FRB for state member banks under the prompt corrective action regulations increases. All banks are prohibited from paying dividends or other capital distributions or paying management fees to any controlling person if, following such distribution, the bank would be undercapitalized. The FRB is required to monitor closely the condition of an undercapitalized institution and to restrict the growth of its assets. An undercapitalized state member bank is required to file a capital restoration plan with the FRB within 45 days (or other time frame prescribed by the FRB) of the date the bank receives notice that it is within any of the three undercapitalized categories, and the plan must be guaranteed by its parent holding company, subject to a cap on the guarantee that is the lesser of: (i) an amount equal to 5.0% of the bank’s total assets at the time it was notified that it became undercapitalized; and (ii) the amount that is necessary to restore the bank’s capital ratios to the levels required to be classified as “adequately classified,” as those ratios and levels are defined as of the time the bank failed to comply with the plan. If the bank fails to submit an acceptable plan, it is treated as if it were “significantly undercapitalized.” Banks that are significantly or critically undercapitalized are subject to a wider range of regulatory requirements and restrictions. The regulatory capital ratios as of December 31, 2015 were calculated under Basel III rules and the regulatory capital ratios as of December 31, 2014 were calculated under Basel I rules. There is no threshold for well-capitalized status for bank holding companies. The Corporation’s and the Bank’s actual and required regulatory capital ratios were as follows (in thousands, except ratio data): Dividend Restrictions The Corporation’s principal source of funds for dividend payments is dividends received from the Bank. Banking regulations limit the amount of dividends that may be paid without prior approval of regulatory agencies. Under these regulations, the amount of dividends that may be paid in any calendar year is limited to the current year’s net income, combined with the retained net income of the preceding two years, subject to the capital requirements in the table below. At December 31, 2015, the Bank could, without prior approval, declare dividends of approximately $14.2 million million. Adoption of New Accounting Standards For a discussion of the impact of recently issued accounting standards, please see Note 1 to the Corporation's consolidated financial statements which begins on page. Critical Accounting Policies, Estimates and Risks and Uncertainties Critical accounting policies include the areas where the Corporation has made what it considers to be particularly difficult, subjective or complex judgments concerning estimates, and where these estimates can significantly affect the Corporation's financial results under different assumptions and conditions. The Corporation prepares its financial statements in conformity with GAAP. As a result, the Corporation is required to make certain estimates, judgments and assumptions that it believes are reasonable based upon the information available at that time. These estimates, judgments and assumptions affect the reported amounts of assets and liabilities at the date of the financial statements and the reported amounts of revenue and expenses during the periods presented. Actual results could be different from these estimates. Management considers the accounting policy relating to the allowance for loan losses to be a critical accounting policy given the uncertainty in evaluating the level of the allowance required to cover probable incurred credit losses inherent in the loan portfolio, and the material effect that such judgments can have on the Corporation's results of operations. While management's current evaluation of the allowance for loan losses indicates that the allowance is adequate, under adversely different conditions or assumptions the allowance would need to be increased. For example, if historical loan loss experience significantly worsened or if current economic conditions significantly deteriorated, additional provisions for loan losses would be required to increase the allowance. In addition, the assumptions and estimates used in the internal reviews of the Corporation's non-performing loans and potential problem loans, and the associated evaluation of the related collateral coverage for these loans, has a significant impact on the overall analysis of the adequacy of the allowance for loan losses. Real estate values in the Corporation’s market area did not increase dramatically in the prior several years, and, as a result, any declines in real estate values have been modest. While management has concluded that the current evaluation of collateral values is reasonable under the circumstances, if collateral evaluations were significantly lowered, the Corporation's allowance for loan losses policy would also require additional provisions for loan losses. Management also considers the accounting policy relating to the valuation of goodwill and other intangible assets to be a critical accounting policy. The initial carrying value of goodwill and other intangible assets is determined using estimated fair values developed from various sources and other generally accepted valuation techniques. Estimates are based upon financial, economic, market and other conditions as they existed as of the date of a particular acquisition. These estimates of fair value are the results of judgments made by the Corporation based upon estimates that are inherently uncertain and changes in the assumptions upon which the estimates were based may have a significant impact on the resulting estimates. In addition to the initial determination of the carrying value, on an ongoing basis management must assess whether there is any impairment of goodwill and other intangible assets that would require an adjustment in carrying value and recognition of a loss in the consolidated statement of income. Explanation and Reconciliation of the Corporation’s Use of Non-GAAP Measures The Corporation prepares its Consolidated Financial Statements in accordance with GAAP; these financial statements appear on pages through. That presentation provides the reader with an understanding of the Corporation’s results that can be tracked consistently from year-to-year and enables a comparison of the Corporation’s performance with other companies’ GAAP financial statements. In addition to analyzing the Corporation’s results on a reported basis, management uses certain non-GAAP financial measures, because it believes these non-GAAP financial measures provide information to investors about the underlying operational performance and trends of the Corporation and, therefore, facilitate a comparison of the Corporation with the performance of its competitors. Non-GAAP financial measures used by the Corporation may not be comparable to similarly named non-GAAP financial measures used by other companies. The SEC has adopted Regulation G, which applies to all public disclosures, including earnings releases, made by registered companies that contain “non-GAAP financial measures.” Under Regulation G, companies making public disclosures containing non-GAAP financial measures must also disclose, along with each non-GAAP financial measure, certain additional information, including a reconciliation of the non-GAAP financial measure to the closest comparable GAAP financial measure and a statement of the Corporation’s reasons for utilizing the non-GAAP financial measure as part of its financial disclosures. The SEC has exempted from the definition of “non-GAAP financial measures” certain commonly used financial measures that are not based on GAAP. When these exempted measures are included in public disclosures, supplemental information is not required. The following measures used in this Report, which are commonly utilized by financial institutions, have not been specifically exempted by the SEC and may constitute "non-GAAP financial measures" within the meaning of the SEC's new rules, although we are unable to state with certainty that the SEC would so regard them. Fully Taxable Equivalent Net Interest Income, Net Interest Margin, and Efficiency Ratio Net interest income is commonly presented on a tax-equivalent basis. That is, to the extent that some component of the institution's net interest income, which is presented on a before-tax basis, is exempt from taxation (e.g., is received by the institution as a result of its holdings of state or municipal obligations), an amount equal to the tax benefit derived from that component is added to the actual before-tax net interest income total. This adjustment is considered helpful in comparing one financial institution's net interest income to that of other institutions or in analyzing any institution’s net interest income trend line over time, to correct any analytical distortion that might otherwise arise from the fact that financial institutions vary widely in the proportions of their portfolios that are invested in tax-exempt securities, and that even a single institution may significantly alter over time the proportion of its own portfolio that is invested in tax-exempt obligations. Moreover, net interest income is itself a component of a second financial measure commonly used by financial institutions, net interest margin, which is the ratio of net interest income to average interest-earning assets. For purposes of this measure as well, fully taxable equivalent net interest income is generally used by financial institutions, as opposed to actual net interest income, again to provide a better basis of comparison from institution to institution and to better demonstrate a single institution’s performance over time. The Corporation follows these practices. The efficiency ratio is a non-GAAP financial measures which represents the Corporation’s ability to turn resources into revenue and is calculated as non-interest expense divided by total revenue (fully taxable equivalent net interest income and non-interest income), adjusted for one-time occurrences and amortization. This measure is meaningful to the Corporation, as well as investors and analysts, in assessing the Corporation’s productivity measured by the amount of revenue generated for each dollar spent. Tangible Equity and Tangible Assets (Period-End) Tangible equity, tangible assets, and tangible book value per share are each non-GAAP financial measures. Tangible equity represents the Corporation’s stockholders’ equity, less goodwill and intangible assets. Tangible assets represents the Corporation’s total assets, less goodwill and other intangible assets. Tangible book value per share represents the Corporation’s equity divided by common shares at period-end. These measures are meaningful to the Corporation, as well as investors and analysts, in assessing the Corporation’s use of equity. Tangible Equity (Average) Average tangible equity and return on average tangible equity are each non-GAAP financial measures. Average tangible equity represents the Corporation’s average stockholders’ equity, less average goodwill and intangible assets for the period. Return on average tangible equity measures the Corporation’s earnings as a percentage of average tangible equity. These measures are meaningful to the Corporation, as well as investors and analysts, in assessing the Corporation’s use of equity. Adjustments for Certain Items of Income or Expense In addition to disclosures of certain GAAP financial measures, including net income, EPS, ROA, and ROE, we may also provide comparative disclosures that adjust these GAAP financial measures for a particular period by removing from the calculation thereof the impact of certain transactions or other material items of income or expense occurring during the period, including certain nonrecurring items. The Corporation believes that the resulting non-GAAP financial measures may improve an understanding of its results of operations by separating out any such transactions or items that may have had a disproportionate positive or negative impact on the Corporation’s financial results during the particular period in question. In the Corporation’s presentation of any such non-GAAP (adjusted) financial measures not specifically discussed in the preceding paragraphs, the Corporation supplies the supplemental financial information and explanations required under Regulation G.

<s>[INST] The MD&A included in this Form 10K contains statements that are forwardlooking within the meaning of the Private Securities Litigation Reform Act of 1995. These statements are based on the current beliefs and expectations of the Corporations’ management and are subject to significant risks and uncertainties. Actual results may differ from those set forth in the forwardlooking statements. For a discussion of those risks and uncertainties and the factors that could cause the Corporation’s actual results to differ materially from those risks and uncertainties, see Forwardlooking Statements below. The Corporation has been a financial holding company since 2000, and the Bank was established in 1833 and CFS in 2001. Through the Bank and CFS, the Corporation provides a wide range of financial services, including demand, savings and time deposits, commercial, residential and consumer loans, interest rate swaps, letters of credit, wealth management services, employee benefit plans, insurance products, mutual funds and brokerage services. The Bank relies substantially on a foundation of locally generated deposits. The Corporation, on a standalone basis, has minimal results of operations. The Bank derives its income primarily from interest and fees on loans, interest on investment securities, WMG fee income and fees received in connection with deposit and other services. The Bank’s operating expenses are interest expense paid on deposits and borrowings, salaries and employee benefit plans and general operating expenses. Forwardlooking Statements This discussion contains forwardlooking statements within the meaning of Section 27A of the Securities Act, Section 21E of the Exchange Act, and the Private Securities Litigation Reform Act of 1995. The Corporation intends its forwardlooking statements to be covered by the safe harbor provisions for forwardlooking statements in these sections. All statements regarding the Corporation's expected financial position and operating results, the Corporation's business strategy, the Corporation's financial plans, forecasted demographic and economic trends relating to the Corporation's industry and similar matters are forwardlooking statements. These statements can sometimes be identified by the Corporation's use of forwardlooking words such as "may," "will," "anticipate," "estimate," "expect," or "intend." The Corporation cannot promise that its expectations in such forwardlooking statements will turn out to be correct. The Corporation's actual results could be materially different from expectations because of various factors, including changes in economic conditions or interest rates, credit risk, difficulties in managing the Corporation’s growth, competition, changes in law or the regulatory environment, including the DoddFrank Act, and changes in general business and economic trends. Information concerning these and other factors can be found in the Corporation’s periodic filings with the SEC, including the discussion under the heading “Item 1A. Risk Factors” in the Corporation’s 2015 Annual Report on Form 10K. These filings are available publicly on the SEC’s web site at http://www.sec.gov, on the Corporation's web site at http://www.chemungcanal.com or upon request from the Corporate Secretary at (607) 7373746. Except as otherwise required by law, the Corporation undertakes no obligation to publicly update or revise its forwardlooking statements, whether as a result of new information, future events or otherwise. Consolidated Financial Highlights Executive Summary This executive summary of the MD&A includes selected information and may not contain all of the information that is important to readers of this Form 10K. For a complete description of the trends and uncertainties, as well as the risks and critical accounting estimates affecting the Corporation, this Form 10K should be read in its entirety. The following table presents selected financial information for the periods indicated, and the dollar and percent change (in thousands, except per share and ratio data): Net income for the year ended December 31, 2015 was $9.4 million, or $2.00 per share, compared with net income of $8.2 million, or $1.74 per share, for the prior year. Return on equity for the year was 6.84%, compared with 5.74% for the prior year. The increase in net income from the prior year was driven by a reduction in noninterest expense, mostly due to the $4.3 million WMG legal settlement in [/INST] Positive. </s>

CHEMUNG FINANCIAL CORP

2017-03-08

2016-12-31

ITEM 7. MANAGEMENT'S DISCUSSION AND ANALYSIS OF FINANCIAL CONDITION AND RESULTS OF OPERATION The following is the MD&A of the Corporation in this Form 10-K for the years ended December 31, 2016 and 2015. The purpose of this discussion is to focus on information about the financial condition and results of operations of the Corporation. Reference should be made to the accompanying audited consolidated financial statements and footnotes for an understanding of the following discussion and analysis. See the list of commonly used abbreviations and terms on pages 1-4. The MD&A included in this Form 10-K contains statements that are forward-looking within the meaning of the Private Securities Litigation Reform Act of 1995. These statements are based on the current beliefs and expectations of the Corporation's management and are subject to significant risks and uncertainties. Actual results may differ from those set forth in the forward-looking statements. For a discussion of those risks and uncertainties and the factors that could cause the Corporation’s actual results to differ materially from those risks and uncertainties, see Forward-looking Statements below. The Corporation has been a financial holding company since 2000, and the Bank was established in 1833, CFS in 2001, and CRM in 2016. Through the Bank and CFS, the Corporation provides a wide range of financial services, including demand, savings and time deposits, commercial, residential and consumer loans, interest rate swaps, letters of credit, wealth management services, employee benefit plans, insurance products, mutual funds and brokerage services. The Bank relies substantially on a foundation of locally generated deposits. The Corporation, on a stand-alone basis, has minimal results of operations. The Bank derives its income primarily from interest and fees on loans, interest on investment securities, WMG fee income and fees received in connection with deposit and other services. The Bank’s operating expenses are interest expense paid on deposits and borrowings, salaries and employee benefit plans and general operating expenses. CRM, a wholly-owned subsidiary of the Corporation which was formed and began operations on May 31, 2016, is a Nevada-based captive insurance company that insures against certain risks unique to the operations of the Corporation and its subsidiaries and for which insurance may not be currently available or economically feasible in today's insurance marketplace. CRM pools resources with several other similar insurance company subsidiaries of financial institutions to spread a limited amount of risk among themselves. CRM is subject to regulations of the State of Nevada and undergoes periodic examinations by the Nevada Division of Insurance. Forward-looking Statements This discussion contains forward-looking statements within the meaning of Section 27A of the Securities Act, Section 21E of the Exchange Act, and the Private Securities Litigation Reform Act of 1995. The Corporation intends its forward-looking statements to be covered by the safe harbor provisions for forward-looking statements in these sections. All statements regarding the Corporation's expected financial position and operating results, the Corporation's business strategy, the Corporation's financial plans, forecasted demographic and economic trends relating to the Corporation's industry and similar matters are forward-looking statements. These statements can sometimes be identified by the Corporation's use of forward-looking words such as "may," "will," "anticipate," "estimate," "expect," or "intend." The Corporation cannot promise that its expectations in such forward-looking statements will turn out to be correct. The Corporation's actual results could be materially different from expectations because of various factors, including changes in economic conditions or interest rates, credit risk, difficulties in managing the Corporation’s growth, competition, changes in law or the regulatory environment, including the Dodd-Frank Act, and changes in general business and economic trends. Information concerning these and other factors can be found in the Corporation’s periodic filings with the SEC, including the discussion under the heading “Item 1A. Risk Factors” of this Form 10-K. The Corporation's quarterly filings are available publicly on the SEC’s web site at http://www.sec.gov, on the Corporation's web site at http://www.chemungcanal.com or by written request to: Kathleen S. McKillip, Corporate Secretary, Chemung Financial Corporation, One Chemung Canal Plaza, Elmira, NY 14901. Except as otherwise required by law, the Corporation undertakes no obligation to publicly update or revise its forward-looking statements, whether as a result of new information, future events or otherwise. Consolidated Financial Highlights Executive Summary This executive summary of the MD&A includes selected information and may not contain all of the information that is important to readers of this Form 10-K. For a complete description of the trends and uncertainties, as well as the risks and critical accounting estimates affecting the Corporation, this Form 10-K should be read in its entirety. The following table presents selected financial information for the periods indicated, and the dollar and percent change (in thousands, except per share and ratio data): Net income for the year ended December 31, 2016 was $10.0 million, or $2.11 per share, compared with net income of $9.4 million, or $2.00 per share, for the prior year. Return on equity for the year was 7.02%, compared with 6.84% for the prior year. The increase in net income from the prior year was driven by increases in net interest income and non-interest income and a reduction in income tax expense, partially offset by a increases in non-interest expense and the provision for loan losses. Net interest income Net interest income increased $1.7 million, or 3.3%, compared with the prior year. The increase was due primarily to an increase of $94.0 million in average interest-earning assets, offset by a nine basis point decline in net interest margin. Non-interest income Non-interest income increased $0.7 million, or 3.4%, compared to the prior year. The increase was due primarily to increases in service charges on deposit accounts, interchange revenue from debit card transactions, and net gains on security transactions, offset by decreases in WMG fee income and other non-interest income. Non-interest expense Non-interest expense increased $1.2 million, or 2.1%, compared to the prior year. The increase was due primarily to the establishment of a $1.2 million legal reserve associated with the Fane v. Chemung Canal Trust Company case, along with increases in pension and other employee benefits and professional services, offset by decreases in salaries and wages, net occupancy expenses, amortization of intangible assets, and other real estate owned expenses. Please refer to Footnote 15 for further discussion of the Fane v. Chemung Canal case. For the years ended December 31, 2016 and 2015, non-interest expense to average assets was 3.32% and 3.51%, respectively. Provision for loan losses The provision for loan losses increased $0.9 million, or 55.1%, compared to the prior year. The increase was the result of an increase in net charge-offs and growth in the commercial loan portfolio, compared to the prior year. Net charge-offs were $2.4 million, compared with $1.0 million for the prior year. The following table presents selected financial information for the periods indicated, and the dollar and percent change (in thousands, except per share and ratio data): Net income for the year ended December 31, 2015 was $9.4 million, or $2.00 per share, compared with $8.2 million, or $1.74 per share, for the same period in the prior year. Return on equity for the year ended December 31, 2015 was 6.84%, compared with 5.74% for the same period in the prior year. The increase in net income from the prior year was driven by a reduction in non-interest expense, mostly due to the $4.3 million WMG legal settlement in 2014, and higher net interest income and a reduction in the provision for loan losses, partially offset by a reduction in non-interest income, mostly due to the gain on the sale of securities, and an increase in income tax expense. Net interest income Net interest income increased $1.1 million, or 2.2%, compared with the same period in the prior year. The increase was due primarily to an increase of $78.2 million in average interest-earning assets, offset by a 13 basis point decline in net interest margin. Non-interest income Non-interest income decreased $6.3 million, or 23.6%, compared to the same period in the prior year. The decrease was due primarily to decreases in net gains on securities transactions, service charges on deposit accounts and other non-interest income, offset by an increase in WMG fee income. Non-interest expense Non-interest expense decreased $5.1 million, or 8.4%, compared to the same period in the prior year. The decrease was due primarily to the $4.3 million legal settlement that occurred in 2014, relating to WMG, and a decline in professional services, amortization of intangibles, marketing and advertising, and other non-interest expense. These items were offset by increases in pension and other employee benefits, data processing expense and other real estate owned expenses. For the years ended December 31, 2015 and 2014, non-interest expense to average assets was 3.51% and 3.73%, respectively. Provision for loan losses The provision for loan losses decreased $2.4 million, or 60.5%, compared to the same period in the prior year. The decrease was the result of lower specific allocations for PCI loans and lower net charge-offs during the year. Net charge-offs were $1.0 million, compared with $3.1 million for the same period in the prior year. Consolidated Results of Operations The following section of the MD&A provides a comparative discussion of the Corporation’s Consolidated Results of Operations on a reported basis for the years ended December 31, 2016 and 2015. For a discussion of the Critical Accounting Policies, Estimates and Risks and Uncertainties that affect the Consolidated Results of Operations, see page 60. Net Interest Income The following table presents net interest income for the periods indicated, and the dollar and percent change (in thousands): Net interest income, which is the difference between the interest income earned on interest-earning assets, such as loans and securities and the interest expense accrued on interest-bearing liabilities, such as deposits and borrowings, is the largest contributor to the Corporation’s earnings. Net interest income for the year ended December 31, 2016 totaled $52.3 million, an increase of $1.7 million, or 3.3%, compared with $50.6 million for the same period in the prior year. Fully taxable equivalent net interest margin was 3.37% for the year ended December 31, 2016 compared with 3.46% for the same period in the prior year. The increase in net interest income was due primarily to interest income from the loan portfolio, as the year-to-date average commercial loan balance increased $77.6 million when compared to the prior year. The decline in interest margin was a result of the commercial loan portfolio repricing to current market rates. The yield on average interest-earning assets decreased 10 basis points, while the cost of interest-bearing deposits remained flat. The decline in the yield of interest-earning assets can be mostly attributed to declines of 23 basis points in the yield of commercial loans and 17 basis points in the yield of mortgage loans, due to new production at lower competitive rates, offset by a 33 basis point increase in consumer loans, due to the indirect loan portfolio and increasing the portfolio toward higher yielding used car loans. Average interest-earning assets increased $94.0 million compared to the prior year, primarily in commercial loans. The following table presents net interest income for the periods indicated, and the dollar and percent change (in thousands): Net interest income for the year ended December 31, 2015 totaled $50.6 million, an increase of $1.1 million, or 2.2%, compared with $49.6 million for the same period in the prior year. Fully taxable equivalent net interest margin was 3.46% for the year ended December 31, 2015 compared with 3.59% for the same period in the prior year. The increase in net interest income was due primarily to interest income from the commercial loan portfolio, as the year-to-date average commercial loan balance increased $88.6 million when compared to the prior year. The decline in interest margin was a result of the commercial loan portfolio repricing to current market rates. The yield on average interest-earning assets and cost of average interest-bearing liabilities decreased 14 and two basis points, respectively. Average interest-earning assets increased $78.2 million compared to the prior year, primarily in commercial loans. Average Consolidated Balance Sheet and Interest Analysis The following tables present certain information related to the Corporation’s average consolidated balance sheets and its consolidated statements of income for the years ended December 31, 2016, 2015 and 2014. It also reflects the average yield on interest-earning assets and average cost of interest-bearing liabilities for the years ended December 31, 2016, 2015 and 2014. For the purpose of the table below, non-accruing loans are included in the daily average loan amounts outstanding. Daily balances were used for average balance computations. Investment securities are stated at amortized cost. Tax equivalent adjustments have been made in calculating yields on obligations of states and political subdivisions, tax-free commercial loans and dividends on equity investments. (1) Net interest rate spread is the difference in the average yield on interest-earning assets less the average rate on interest-bearing liabilities. (2) Net interest margin is the ratio of fully taxable equivalent net interest income divided by average interest-earning assets. Changes Due to Rate and Volume Net interest income can be analyzed in terms of the impact of changes in rates and volumes. The table belows illustrates the extent to which changes in interest rates and in the volume of average interest-earning assets and interest-bearing liabilities have affected the Corporation’s interest income and interest expense during the periods indicated. Information is provided in each category with respect to (i) changes attributable to changes in volume (changes in volume multiplied by prior rate); (ii) changes attributable to changes in rates (changes in rates multiplied by prior volume); and (iii) the net changes. For purposes of this table, changes that are not due solely to volume or rate changes have been allocated to these categories based on the respective percentage changes in average volume and rate. Due to the numerous simultaneous volume and rate changes during the periods analyzed, it is not possible to precisely allocate changes between volume and rates. In addition, average earning assets include non-accrual loans and taxable equivalent adjustments were made. Provision for loan losses Management performs an ongoing assessment of the adequacy of the allowance for loan losses based upon a number of factors including an analysis of historical loss factors, collateral evaluations, recent charge-off experience, credit quality of the loan portfolio, current economic conditions and loan growth. Based on this analysis, the provision for loan losses for the years ended December 31, 2016, 2015 and 2014 were $2.4 million, $1.6 million and $4.0 million, respectively. Net charge-offs for the years ended December 31, 2016, 2015 and 2014 were $2.4 million, $1.0 million and $3.1 million, respectively. Non-interest income The following table presents non-interest income for the periods indicated, and the dollar and percent change (in thousands): Total non-interest income for the year ended December 31, 2016 increased $0.7 million compared to the same period in the prior year. The increase was primarily due to increases in services charges on deposit accounts, interchange revenue from debit card transactions, and net gains on securities transactions, offset by decreases in WMG fee income, CFS fee and commission income, and other non-interest income. WMG fee income WMG fee income decreased compared to the same period in the prior year due to a decline in assets under management or administration from the loss of one large non-profit customer during 2016. Service charges on deposit accounts Service charges on deposit accounts increased compared to the same period in the prior year due to an increase in overdraft fees. Net gains (losses) on securities transactions Net gains (losses) on securities transactions increased compared to the same period in the prior year due to the sale of $14.5 million in U.S. Treasuries and $25.0 million in obligations of U.S. Government sponsored enterprises. CFS fee and commission income CFS fee and commission income decreased compared to the same period in the prior year due to a decrease in commissions from insurance annuity products. Other Other non-interest income decreased due to rental income from OREO properties, which were sold in 2016. The following table presents non-interest income for the periods indicated, and the dollar and percent change (in thousands): Total non-interest income for year ended December 31, 2015 decreased $6.3 million compared with the same period in the prior year. The decrease was primarily due to decreases in service charges on deposit accounts, net gains on securities transactions, and other non-interest income, offset by an increase in WMG fee income and net gains on sales of other real estate owned. WMG fee income WMG fee income increased compared to the same period in the prior year due to an increase in fee levels, as fees were adjusted to reflect current market fee levels, offset by a decline in total assets under management or administration. Service charges on deposit accounts Service charges on deposit accounts decreased compared to the same period in the prior year due to a decline in overdraft fees. Net gains (losses) on securities transactions Net gains (losses) on securities transactions decreased compared to the same period in the prior year due to the $6.4 million gain on the sale of equity securities during the prior year. CFS fee and commission income CFS fee and commission income increased compared to the same period in the prior year due to an increase in commissions from insurance annuity products. Other Other non-interest income decreased due to a decline in gains on stock donations to charitable organizations and other non-interest income, offset by additional rental income in 2015 from properties included within OREO. Non-interest expense The following table presents non-interest expense for the periods indicated, and the dollar and percent change (in thousands): Total non-interest expense for the year ended December 31, 2016 increased $1.2 million compared with the prior year. The increase was primarily due to an increase in non-compensation expense related to the establishment of a $1.2 million legal reserve in the current year. Compensation expense Compensation expense decreased compared to the same period in the prior year due to a decrease in salaries and wages, offset by an increase in pension and other employee benefits. The decrease in salaries and wages was primarily due to a reduction in full-time equivalent employees. The $0.2 million increase in pension and other employee benefits was primarily due to an increase in health insurance costs, offset by a $0.3 million curtailment gain related to the amendment of the defined benefit health care plan during the fourth quarter of the current year. Non-compensation expense Non-compensation expense increased compared to the same period in the prior year primarily due increases in professional services and legal accruals and settlements, offset by decreases in net occupancy expenses, amortization of intangible assets, and other real estate owned expenses. The increase in professional services can be mostly attributed to expenses incurred related to the feasibility and implementation of CRM, consulting costs associated with the conversion of the Corporation's debit cards to MasterCard, and legal costs associated with the appeal of the Fane v. Chemung Canal Trust Company decision. The increase in legal accruals and settlements can be attributed to the establishment of a $1.2 million legal reserve associated with the Fane v. Chemung Canal Trust Company case. Please refer to Footnote 15 for further discussion of the Fane v. Chemung Canal case. The decrease in net occupancy expenses can be attributed to the closure of the branch office at 202 East State Street in Ithaca, NY during the second quarter of 2016. The decrease in other real estate owned expenses can be attributed to the sale of properties in 2016. The following table presents non-interest expense for the periods indicated, and the dollar and percent change (in thousands): Total non-interest expense for the year ended December 31, 2015 decreased $5.1 million compared with the same period in the prior year. The decrease was primarily due to a decrease in non-compensation expense related to the $4.3 million legal settlement in the the prior year. Compensation expense Compensation expense increased compared to the same period in the prior year due to an increase in pension and other employee benefits, offset by a decrease in salaries and wages. The $0.2 million increase in pension and other employee benefits was due to the adoption of updated mortality tables in 2015, which reflected improved life expectancies of employees and a reduced discount rate for determining pension costs. The decrease in salaries and wages was due to a reduction in full-time equivalent employees. Non-compensation expense Non-compensation expense decreased compared to the same period in the prior year primarily due to the legal settlement that occurred in 2014, related to the Bank's WMG, offset by increases in data processing expense and OREO expenses. The increase in data processing expense was primarily due to check card expense and data communication lines expense, while the increase in OREO expenses was due to two properties being carried in OREO for the entire year, along with a fair market value adjustment to one property. Income tax expense The following table presents income tax expense and the effective tax rate for the periods indicated, and the dollar and percent change (in thousands): The decrease in the effective tax rate can be attributed to the formation of CRM in 2016 and increasing the utilization of the the Bank's real estate investment trust during the current year. The following table presents income tax expense and the effective tax rate for the periods indicated, and the dollar and percent change (in thousands): The increase in the effective tax rate can be attributed to higher pre-tax income and changes in the mix of income and expense subject to U.S. federal, state, and local income taxes. Financial Condition The following table presents selected financial information for the periods indicated, and the dollar and percent change (in thousands): Cash and cash equivalents The increase in cash and cash equivalents can be attributed to maturities, pay-downs, and the sale of available for sale securities and an increase in deposits, offset by an increase in total loans and the pay down of FHLB overnight advances. Investment securities The decrease in investment securities can be mostly attributed to the sale of $14.5 million in U.S. treasuries in the first quarter and $25.0 million obligations of U.S. Government sponsored enterprises in the third and fourth quarters, along with $89.8 million in calls and maturities of U.S. Government sponsored enterprises and pay-downs on mortgage-backed securities, and an unrealized loss of $7.2 million for year-to-date 2016, offset by additional purchases of $1.8 million in obligations of states and political subdivisions and $94.7 million in mortgaged-backed securities. Loans, net The increase in total loans can be attributed to increases of $62.2 million in commercial mortgages and $2.7 million in residential mortgages, offset by decreases in commercial and agriculture of $16.7 million, indirect consumer of $11.8 million, and other consumer of $4.8 million. The increase in the commercial loan portfolio is primarily from the Capital Bank Division, while the decline in the indirect loan portfolio can be attributed to the run off of promotional interest rates. Goodwill and other intangible assets, net The decrease in goodwill and other intangible assets, net can be attributed to amortization of other intangible assets. There were no impairments of goodwill or other intangible assets during the years ended December 31, 2016 and 2015. Other assets The increase in other assets can be mostly attributed to the amendment of the noncontributory defined benefit pension plan and defined benefit health care plan, which resulted in a pension asset of $1.8 million, compared to a pension liability of $3.8 million in the prior year, offset by the sale of one OREO property in 2016 for $1.5 million. Deposits The increase in deposits can be attributed to increases of $51.3 million in money market accounts, $15.6 million in non-interest-bearing demand deposits, $6.2 million in interest-bearing demand deposits, and $4.9 million in savings deposits. These items were offset by a $22.0 million decrease in time deposits. The changes in money market accounts and demand deposits can be attributed to the net inflow of deposits from municipal clients, as well as new municipal client relationships. FHLBNY advances and other debt FHLBNY overnight advances were paid off with the increase in deposits received from municipal clients and FHLBNY term advances were reduced by normal scheduled payments. Offsetting the reduction in advances was an additional capital lease obligation related to the relocation of the Clifton Park, NY branch to a new location. Other liabilities The decrease in other liabilities can be mostly attributed to the amendment of the noncontributory defined benefit pension plan and defined benefit health care plan, which resulted in a pension asset of $1.8 million, compared to a pension liability of $3.8 million in the prior year, offset by the establishment of a $1.2 million legal reserve associated with the Fane v. Chemung Canal Trust Company case. Please refer to Footnote 15 for further discussion of the Fane v. Chemung Canal case. Shareholders’ equity The increase in shareholders’ equity was primarily due to earnings of $10.0 million, a reduction of $1.1 million in treasury stock, and a decrease of $0.2 million in accumulated other comprehensive loss, offset by $4.9 million in dividends declared. Assets under management or administration The market value of total assets under management or administration in our WMG was $1.721 billion, including $294.9 million of assets held under management or administration for the Corporation, at December 31, 2016 compared with $1.856 billion, including $304.1 million of assets held under management or administration for the Corporation, at December 31, 2015, a decrease of $134.5 million, or 7.3%. The decrease in market value can be mostly attributed to the loss of one large non-profit customer during the first quarter of 2016. Balance Sheet Comparisons The table below contains selected average balance sheet information for each year in the six-year period ended December 31, 2016 (in millions): (1) Average earning assets include securities available for sale and securities held to maturity based on amortized cost, loans and loans held for sale net of deferred loan fees, interest-bearing deposits, FHLBNY stock, FRBNY stock and federal funds sold. (2) Average loans and loans held for sale, net of deferred loan fees. (3) Average balances for investments include securities available for sale and securities held to maturity, based on amortized cost, FHLBNY stock, FRBNY stock, federal funds sold and interest-bearing deposits. (4) Average borrowings include FHLBNY advances, securities sold under agreements to repurchase and capitalized lease obligations. The table below contains selected period-end balance sheet information for each year in the six-year period ended December 31, 2016 (in millions): (1) Earning assets include securities available for sale, at estimated fair value and securities held to maturity based on amortized cost, loans and loans held for sale net of deferred loan fees, interest-bearing deposits, FHLBNY stock, FRBNY stock and federal funds sold. (2) Loans and loans held for sale, net of deferred loan fees. (3) Investments include securities available for sale, at estimated fair value, securities held to maturity, at amortized cost, FHLBNY stock, FRBNY stock, federal funds sold and interest-bearing deposits. (4) Borrowings include FHLBNY advances, securities sold under agreements to repurchase and capitalized lease obligations. Cash and Cash Equivalents Total cash and cash equivalents increased $48.0 million since December 31, 2015, due to increases of $3.3 million in cash and due from financial institutions and $44.7 million in interest-bearing deposits in other financial institutions. Securities The Corporation’s Funds Management Policy includes an investment policy that in general, requires debt securities purchased for the bond portfolio to carry a minimum agency rating of "A". After an independent credit analysis is performed, the policy also allows the Corporation to purchase local municipal obligations that are not rated. The Corporation intends to maintain a reasonable level of securities to provide adequate liquidity and in order to have securities available to pledge to secure public deposits, repurchase agreements and other types of transactions. Fluctuations in the fair value of the Corporation’s securities relate primarily to changes in interest rates. Marketable securities are classified as Available for Sale, while investments in local municipal obligations are generally classified as Held to Maturity. The composition of the available for sale segment of the securities portfolio is summarized in the table as follows (in thousands): The available for sale segment of the securities portfolio totaled $303.4 million at December 31, 2016, a decrease of $41.4 million, or 12.0%, from $344.8 million at December 31, 2015. The decrease resulted primarily from the sale of $14.5 million in U.S. treasuries in the first quarter and $25.0 million obligations of U.S. Government sponsored enterprises in the third and fourth quarters, along with $89.8 million in calls and maturities of U.S. Government sponsored enterprises and pay-downs on mortgage-backed securities, and an unrealized loss of $7.2 million for year-to-date 2016, offset by additional purchases of $1.8 million in obligations of states and political subdivisions and $94.7 million in mortgaged-backed securities. The held to maturity segment of the securities portfolio consists of obligations of political subdivisions in the Corporation’s market areas. These securities totaled $4.7 million at December 31, 2016, an increase of $0.1 million from December 31, 2015, due primarily to additional purchases, offset by maturities and principal collected. Non-marketable equity securities at December 31, 2016 include shares of FRBNY stock and FHLBNY stock, carried at their cost of $1.7 million and $2.3 million, respectively. The fair value of these securities is assumed to approximate their cost. The investment in these stocks is regulated by regulatory policies of the respective institutions. The table below sets forth the carrying amounts and maturities of available for sale and held to maturity debt securities at December 31, 2016 and the weighted average yields of such securities (all yields are calculated on the basis of the amortized cost and weighted for the scheduled maturity of each security, except mortgage-backed securities which are based on the average life at the projected prepayment speed of each security) (in thousands): Management evaluates securities for OTTI on a quarterly basis, and more frequently when economic or market conditions warrant such an evaluation. For the years ended December 31, 2016 and 2015, the Corporation had no OTTI charges. For the year ended December 31, 2013, the Corporation had less than $0.1 million in OTTI charges. During the fourth quarter of 2013, the Corporation sold one CDO consisting of a pool of trust preferred securities that had an amortized cost of $0.6 million. The CDO was sold for $0.6 million, resulting in a slight loss. In addition to the CDO that was sold in the fourth quarter of 2013, the remaining CDO was liquidated and the Corporation recorded $0.5 million in other income during the first quarter of 2014. The Corporation does not own any other CDOs in its investment securities portfolio. For more detailed information on OTTI, see Footnote 3, “Securities” in the Notes to Consolidated Financial Statements. Loans The Corporation has reporting systems to monitor: (i) loan originations and concentrations, (ii) delinquent loans, (iii) non-performing assets, including non-performing loans, troubled debt restructurings, other real estate owned, (iv) impaired loans, and (v) potential problem loans. Management reviews these systems on a regular basis. The table below presents the Corporation’s loan composition by segment and percentage of total loans at the end of each of the last five years (in thousands): Portfolio loans totaled $1.200 billion at December 31, 2016, an increase of $31.7 million, or 2.7%, from $1.169 billion at December 31, 2015. The increase in portfolio loans was due to strong growth of $45.5 million, or 6.5%, in commercial loans, offset by a decrease of $11.8 million, or 7.8%, in indirect consumer loans. The growth in commercial loans was due primarily to an increase in commercial mortgages in the Capital Bank division in the Albany, New York region. The decline in indirect consumer loans was a result of the Corporation's decision to focus the portfolio toward higher yielding indirect used car loans. Residential mortgage loans totaled $198.5 million at December 31, 2016, an increase of $2.7 million, or 1.4%, from December 31, 2015. In addition, during 2016, $13.9 million of residential mortgages were sold in the secondary market to Freddie Mac, with an additional $1.3 million of residential mortgages sold to the State of New York Mortgage Agency. The Corporation anticipates that future growth in portfolio loans will continue to be in commercial mortgages and commercial and industrial loans, especially within the Capital Bank division of the Bank. The table below presents the Corporation’s outstanding loan balance by bank division (in thousands): Loan concentrations are considered to exist when there are amounts loaned to a multiple number of borrowers engaged in similar activities which would cause them to be similarly impacted by changes in economic or other conditions. The Corporation’s concentration policy limits consider the volume of commercial loans to any one specific industry, sponsor, and by collateral type and location. In addition, the Corporation’s policy limits the volume of non-owner occupied commercial mortgages to four times total risk based capital. At December 31, 2016 and 2015, total non-owner occupied commercial real estate loans divided by total risk based capital was 351.1% and 334.7% respectively. The Corporation also monitors specific NAICS industry classifications of commercial loans to identify concentrations greater than 10.0% of total loans. At December 31, 2016 and 2015, commercial loans to borrowers involved in the real estate, and real estate rental and leasing businesses were 43.9% and 40.6% of total loans, respectively. No other concentration of loans existed in the commercial loan portfolio in excess of 10.0% of total loans as of December 31, 2016 and 2015. The table below shows the maturity of only commercial and agricultural loans and commercial mortgages outstanding as of December 31, 2016. Also provided are the amounts due after one year, classified according to the sensitivity to changes in interest rates (in thousands): Non-Performing Assets Non-performing assets consist of non-accrual loans, non-accrual troubled debt restructurings and other real estate owned that has been acquired in partial or full satisfaction of loan obligations or upon foreclosure. Past due status on all loans is based on the contractual terms of the loan. It is generally the Corporation's policy that a loan 90 days past due be placed in non-accrual status unless factors exist that would eliminate the need to place a loan in this status. A loan may also be designated as non-accrual at any time if payment of principal or interest in full is not expected due to deterioration in the financial condition of the borrower. At the time loans are placed in non-accrual status, the accrual of interest is discontinued and previously accrued interest is reversed. All payments received on non-accrual loans are applied to principal. Loans are considered for return to accrual status when they become current as to principal and interest and remain current for a period of six consecutive months or when, in the opinion of management, the Corporation expects to receive all of its contractual principal and interest. In the case of non-accrual loans where a portion of the loan has been charged off, the remaining balance is kept in non-accrual status until the entire principal balance has been recovered. The following table summarizes the Corporation's non-performing assets, excluding purchased credit impaired loans (in thousands): NON-PERFORMING ASSETS (1) These loans are not included in nonperforming assets above. The table below shows interest income on non-accrual and troubled debt restructured loans for the indicated years ended December 31 (in thousands): Non-Performing Loans Non-performing loans totaled $12.0 million at December 31, 2016, or 1.00% of total loans, compared with $12.2 million at December 31, 2015, or 1.05% of total loans. The decrease in non-performing loans at December 31, 2016 was primarily due to a $1.8 million decrease in non-accruing commercial mortgages, offset by increases of $1.0 million in non-accruing consumer loans and $0.6 million in non-accruing residential mortgages. Non-performing assets, which are comprised of non-performing loans and other real estate owned, was $12.4 million, or 0.75% of total assets, at December 31, 2016, compared with $13.8 million, or 0.85% of total assets, at December 31, 2015. The recorded investment in accruing loans past due 90 days or more totaled less than $0.1 million at December 31, 2016, consistent with the prior year. Not included in non-performing loan totals are $1.4 million and $2.1 million of acquired loans which the Corporation has identified as PCI loans at December 31, 2016 and 2015, respectively. The PCI loans are accounted for under separate accounting guidance, Accounting Standards Codification (“ASC”) Subtopic 310-30, “Receivables - Loans and Debt Securities Acquired with Deteriorated Credit Quality” as disclosed in Note 4 of the financial statements. Troubled Debt Restructurings The Corporation works closely with borrowers that have financial difficulties to identify viable solutions that minimize the potential for loss. In that regard, the Corporation modified the terms of select loans to maximize their collectability. The modified loans are considered TDRs under current accounting guidance. Modifications generally involve short-term deferrals of principal and/or interest payments, reductions of scheduled payment amounts, interest rates or principal of the loan, and forgiveness of accrued interest. As of December 31, 2016, the Corporation had $4.4 million of non-accrual TDRs compared with $4.4 million as of December 31, 2015. As of December 31, 2016, the Corporation had $5.8 million of accruing TDRs compared with $7.6 million as of December 31, 2015. Impaired Loans A loan is classified as impaired when, based on current information and events, it is probable that the Corporation will be unable to collect both the principal and interest due under the contractual terms of the loan agreement. Impaired loans at December 31, 2016 totaled $12.9 million, including TDRs of $10.2 million, compared to $15.0 million at December 31, 2015, including TDRs of $12.0 million. Not included in the impaired loan totals are acquired loans which the Corporation has identified as PCI loans, as these loans are accounted for under ASC Subtopic 310-30 as noted under the above discussion of non-performing loans. The decrease in impaired loans was primarily in the commercial loan segment of the loan portfolio. Included in the recorded investment of impaired loans at December 31, 2016, are loans totaling $2.6 million for which impairment allowances of $0.9 million have been specifically allocated to the allowance for loan losses. As of December 31, 2015, the impaired loan total included $5.2 million of loans for which specific impairment allowances of $1.6 million were allocated to the allowance for loan losses. The decrease in the amount of impaired loans for which specific allowances were allocated to the allowance for loan losses was due primarily to a decrease in impaired commercial loans. The majority of the Corporation's impaired loans are secured and measured for impairment based on collateral evaluations. It is the Corporation's policy to obtain updated appraisals, by independent third parties, on loans secured by real estate at the time a loan is determined to be impaired. An impairment measurement is performed based upon the most recent appraisal on file to determine the amount of any specific allocation or charge-off. In determining the amount of any specific allocation or charge-off, the Corporation will make adjustments to reflect the estimated costs to sell the property. Upon receipt and review of the updated appraisal, an additional measurement is performed to determine if any adjustments are necessary to reflect the proper provisioning or charge-off. Impaired loans are reviewed on a quarterly basis to determine if any changes in credit quality or market conditions would require any additional allocation or recognition of additional charge-offs. Real estate values in the Corporation's market area have been holding steady. Non-real estate collateral may be valued using (i) an appraisal, (ii) net book value of the collateral per the borrower’s financial statements, or (iii) accounts receivable aging reports, that may be adjusted based on management’s knowledge of the client and client’s business. If market conditions warrant, future appraisals are obtained for both real estate and non-real estate collateral. Allowance for Loan Losses The allowance is an amount that management believes will be adequate to absorb probable incurred losses on existing loans. The allowance is established based on management’s evaluation of the probable inherent losses in our portfolio in accordance with GAAP, and is comprised of both specific valuation allowances and general valuation allowances. A loan is classified as impaired when, based on current information and events, it is probable that the Corporation will be unable to collect both the principal and interest due under the contractual terms of the loan agreement. Specific valuation allowances are established based on management’s analyses of individually impaired loans. Factors considered by management in determining impairment include payment status, evaluations of the underlying collateral, expected cash flows, and the probability of collecting scheduled principal and interest payments when due. Loans that experience insignificant payment delays and payment shortfalls generally are not classified as impaired. Management determines the significance of payment delays and payment shortfalls on a case-by-case basis, taking into consideration all of the circumstances surrounding the loan and the borrower, including the length of the delay, the reasons for the delay, the borrower’s prior payment record, and the amount of the shortfall in relation to the principal and interest owed. If a loan is determined to be impaired and is placed on non-accrual status, all future payments received are applied to principal and a portion of the allowance is allocated so that the loan is reported, net, at the present value of estimated future cash flows using the loan’s existing rate or at the fair value of collateral if repayment is expected solely from the collateral. The general component covers non-impaired loans and is based on historical loss experience adjusted for current factors. Loans not impaired but classified as substandard and special mention use a historical loss factor on a rolling five year history of net losses. For all other unclassified loans, the historical loss experience is determined by portfolio class and is based on the actual loss history experienced by the Corporation over the most recent two years. This actual loss experience is supplemented with other qualitative factors based on the risks present for each portfolio class. These qualitative factors include consideration of the following: (1) lending policies and procedures, including underwriting standards and collection, charge-off and recovery policies, (2) national and local economic and business conditions and developments, including the condition of various market segments, (3) loan profiles and volume of the portfolio, (4) the experience, ability, and depth of lending management and staff, (5) the volume and severity of past due, classified and watch-list loans, non-accrual loans, troubled debt restructurings, and other modifications (6) the quality of the Bank’s loan review system and the degree of oversight by the Bank’s Board of Directors, (7) collateral related issues: secured vs. unsecured, type, declining valuation environment and trend of other related factors, (8) the existence and effect of any concentrations of credit, and changes in the level of such concentrations, (9) the effect of external factors, such as competition and legal and regulatory requirements, on the level of estimated credit losses in the Bank’s current portfolio and (10) the impact of the global economy. The allowance for loan losses is increased through a provision for loan losses charged to operations. Loans are charged against the allowance for loan losses when management believes that the collectability of all or a portion of the principal is unlikely. Management's evaluation of the adequacy of the allowance for loan losses is performed on a periodic basis and takes into consideration such factors as the credit risk grade assigned to the loan, historical loan loss experience and review of specific impaired loans. While management uses available information to recognize losses on loans, future additions to the allowance may be necessary based on changes in economic conditions. In addition, various regulatory agencies, as an integral part of their examination process, periodically review the Corporation's allowance for loan losses. Such agencies may require the Corporation to recognize additions to the allowance based on their judgments about information available to them at the time of their examination. The allowance for loan losses was $14.3 million at December 31, 2016, compared to $14.3 million at December 31, 2015. The ratio of allowance for loan losses to total loans was 1.19% at December 31, 2016 and 1.22% at December 31, 2015, respectively. Net charge-offs for the years ended December 31, 2016 and 2015 were $2.4 million and $1.0 million, respectively. The table below summarizes the Corporation’s allocation of the allowance for loan losses and percent of loans by category to total loans for each year in the five-year period ended December 31, 2016 (in thousands): The table below summarizes the Corporation's loan loss experience for each year in the five-year period ended December 31, 2016 (in thousands, except ratio data): Net charge-offs for December 31, 2016 were $2.4 million compared with $1.0 million for December 31, 2015. The ratio of net charge-offs to average loans outstanding was 0.20% for 2016 compared to 0.09% for 2015. The increase in net charge-offs can be attributed to the write-off of specifically reserved commercial loans during the current year. Other Real Estate Owned At December 31, 2016, OREO totaled $0.4 million compared to $1.5 million at December 31, 2015. The decrease in other real estate owned was due primarily to the sale of one commercial property for $1.5 million. Other Assets The $0.6 million increase in other assets was due primarily to the amendment of the noncontributory defined benefit pension plan and defined benefit health care plan, which resulted in a pension asset of $1.8 million, compared to a pension liability of $3.8 million in the prior year, offset by the sale of one OREO property in 2016 for $1.5 million. Deposits The table below summarizes the Corporation’s deposit composition by segment for the periods indicated, and the dollar and percent change from December 31, 2015 to December 31, 2016 (in thousands): Deposits totaled $1.456 billion at December 31, 2016, compared with $1.400 billion at December 31, 2015, an increase of $56.0 million, or 4.0%. At December 31, 2016, demand deposit and money market accounts comprised 75.8% of total deposits compared with 73.6% at December 31, 2015. Sorted by public, commercial, consumer and broker sources, the growth in deposits was due primarily to increases of $38.7 million in brokered, $5.0 million in commercial deposits, and $25.5 million in consumer, offset by a decrease of $13.2 million in public deposit accounts. The table below presents the Corporation's deposits balance by bank division (in thousands): Brokered deposits include funds obtained through brokers, and the Bank’s participation in CDARS and ICS programs. The CDARS and ICS programs involve a network of financial institutions that exchange funds among members in order to ensure FDIC insurance coverage on customer deposits above the single institution limit. Using a sophisticated matching system, funds are exchanged on a dollar-for-dollar basis, so that the equivalent of an original deposit comes back to the originating institution. The Corporation had no deposits obtained through brokers as of December 31, 2016 and 2015. Deposits obtained through the CDARS and ICS programs were $203.7 million and $165.0 million as of December 31, 2016 and 2015, respectively. The increase in CDARS and ICS deposits was due to the Corporation offering the programs to local municipalities. The Corporation’s deposit strategy is to fund the Bank with stable, low-cost deposits, primarily checking account deposits and other low interest-bearing deposit accounts. A checking account is the driver of a banking relationship and consumers consider the bank where they have their checking account as their primary bank. These customers will typically turn to their primary bank first when in need of other financial services. Strategies that have been developed and implemented to generate these deposits include: (i) acquire deposits by entering new markets through de novo branching, (ii) an annual checking account marketing campaign, (iii) training branch employees to identify and meet client financial needs with Bank products and services, (iv) link business and consumer loans to a primary checking account at the Bank, (v) aggressively promote direct deposit of client’s payroll checks or benefit checks and (vi) constantly monitor the Corporation’s pricing strategies to ensure competitive products and services. The Corporation also considers brokered deposits to be an element of its deposit strategy and anticipates that it will continue using brokered deposits as a secondary source of funding to support growth. Information regarding deposits is included in Note 7 to the consolidated financial statements appearing elsewhere in this report. Borrowings FHLBNY advances decreased $24.0 million to $9.1 million at December 31, 2016 from $33.1 million at December 31, 2015. FHLBNY overnight advances decreased $13.9 million million during 2016 while FHLBNY term advances decreased $10.1 million. For each of the three years ended December 31, 2016, 2015 and 2014, respectively, the average outstanding balance of borrowings that mature in one year or less did not exceed 30% of shareholders' equity. Information regarding securities sold under agreements to repurchase and FHLBNY advances is included in Foonotes 8 and 9 to the consolidated financial statements appearing elsewhere in this report. Derivatives The Corporation offers interest rate swap agreements to qualified commercial loan customers. These agreements allow the Corporation’s customers to effectively fix the interest rate on a variable rate loan by entering into a separate agreement. Simultaneous with the execution of such an agreement with a customer, the Corporation enters into a matching interest rate swap agreement with an unrelated third party provider, which allows the Corporation to continue to receive the variable rate under the loan agreement with the customer. The agreement with the third party is not designated as a hedge contract, therefore changes in fair value are recorded through other non-interest income. Assets and liabilities associated with the agreements are recorded in other assets and other liabilities on the balance sheet. Gains and losses are recorded as other non-interest income. The Corporation is exposed to credit loss equal to the fair value of the interest rate swaps, not the notional amount of the derivatives, in the event of nonperformance by the counterparty to the interest rate swap agreements. Additionally, the swap agreements are free-standing derivatives and are recorded at fair value in the Corporation's consolidated balance sheets, which typically involves a day one gain. Since the terms of the two interest rate swap agreements are identical, the income statement impact to the Corporation is limited to the day one gain and an allowance for credit loss exposure, in the event of nonperformance. The Corporation recognized $0.1 million in swap fee income for the years ended in December 31, 2016 and 2015. The Corporation also participates in the credit exposure of certain interest rate swaps in which it participates in the related commercial loan. The Corporation receives an upfront fee for participating in the credit exposure of the interest rate swap and recognizes the fee to other non-interest income immediately. The Corporation is exposed to its share of the credit loss equal to the fair value of the derivatives in the event of nonperformance by the counter-party of the interest rate swap. The Corporation determines the fair value of the credit loss exposure using historical losses of the loan category associated with the credit exposure. Information regarding derivatives is included in Note 10 to the consolidated financial statements appearing elsewhere in this report. Shareholders’ Equity Total shareholders’ equity was $143.7 million at December 31, 2016, compared with $137.2 million at December 31, 2015, a increase of $6.5 million, or 4.7%. The increase was due primarily to earnings of $10.0 million, a reduction of $1.1 million in treasury stock, and a decrease of $0.2 million in accumulated other comprehensive income, offset $4.9 million in dividends declared. The total shareholders’ equity to total assets ratio was 8.67% at December 31, 2016 compared with 8.47% at December 31, 2015. Tangible equity to tangible assets ratio increased to 7.29% at December 31, 2016, from 6.99% at December 31, 2015. The Corporation and the Bank are subject to capital adequacy guidelines of the Federal Reserve which establish a framework for the classification of financial holding companies and financial institutions into five categories: well-capitalized, adequately capitalized, undercapitalized, significantly undercapitalized and critically undercapitalized. As of December 31, 2016, both the Corporation’s and the Bank’s capital ratios were in excess of those required to be considered well-capitalized under regulatory capital guidelines. A comparison of the Corporation’s and the Bank’s actual capital ratios to the ratios required to be adequately or well-capitalized at December 31, 2016 and 2015, is included in Footnote 18 to the consolidated financial statements appearing elsewhere in this report. For more information regarding current capital regulations see Part I-“Business-Supervision and Regulation-Regulatory Capital Requirements.” Cash dividends declared during 2016 totaled $4.9 million or $1.04 per share, and cash dividends declared during both 2015 and 2014 totaled $4.8 million, or $1.04 per share. Dividends declared during 2016 amounted to 48.76% of net income compared to 51.34%, and 58.80% of net income for 2015 and 2014, respectively. Management seeks to continue generating sufficient capital internally, while continuing to pay dividends to the Corporation’s shareholders. When shares of the Corporation become available in the market, the Corporation may purchase them after careful consideration of the Corporation’s liquidity and capital positions. Purchases may be made from time to time on the open market or in privately negotiated transactions at the discretion of management. On December 19, 2012, the Board of Directors approved a new stock repurchase plan under which the Corporation may repurchase up to 125,000 shares. No shares were purchased under the new plan in 2016 and 2015. The Corporation has purchased 3,094 shares at a total cost of $93 thousand under the new plan since its inception. Off-balance Sheet Arrangements In the normal course of operations, the Corporation engages in a variety of financial transactions that, in accordance with GAAP are not recorded in the financial statements. The Corporation is also a party to certain financial instruments with off balance sheet risk such as commitments under standby letters of credit, unused portions of lines of credit, commitments to fund new loans, interest rate swaps, and risk participation agreements. The Corporation's policy is to record such instruments when funded. These transactions involve, to varying degrees, elements of credit, interest rate and liquidity risk. Such transactions are generally used by the Corporation to manage clients' requests for funding and other client needs. The table below shows the Corporation’s off-balance sheet arrangements as of December 31, 2016 (in thousands): (1) Not included in this total are unused portions of home equity lines of credit, credit card lines and consumer overdraft protection lines of credit, since no contractual maturity dates exist for these types of loans. Commitments to outside parties under these lines of credit were $46.3 million, $12.5 million and $6.3 million, respectively, at December 31, 2016. Contractual Obligations The table below shows the Corporation’s contractual obligations under long-term agreements as of December 31, 2016 (in thousands). Note references are to the Notes of the Consolidated Financial Statements: (1) Not included in the above total is the Corporation's obligation regarding the Pension Plan and Other Benefit Plans. Please refer to Part IV Item 15 Note 12 for information regarding these obligations at December 31, 2016. Liquidity Liquidity management involves the ability to meet the cash flow requirements of deposit clients, borrowers, and the operating, investing and financing activities of the Corporation. The Corporation uses a variety of resources to meet its liquidity needs. These include short term investments, cash flow from lending and investing activities, core-deposit growth and non-core funding sources, such as time deposits of $100,000 or more, securities sold under agreements to repurchase and oth+er borrowings. The Corporation is a member of the FHLBNY which allows it to access borrowings which enhance management's ability to satisfy future liquidity needs. Based on available collateral and current advances outstanding, the Corporation was eligible to borrow up to a total of $131.6 million and $106.2 million at December 31, 2016 and 2015, respectively. The Corporation also had a total of $28.0 million of unsecured lines of credit with four different financial institutions, all of which was available at December 31, 2016 and 2015. Consolidated Cash Flows Analysis The table below summarizes the Corporation's cash flows for the periods indicated (in thousands): Operating activities The Corporation believes cash flows from operations, available cash balances and its ability to generate cash through short- and long-term borrowings are sufficient to fund the Corporation’s operating liquidity needs. Cash provided by operating activities in years ended 2016 and 2015 predominantly resulted from net income after non-cash operating adjustments. Investing activities Cash used in investing activities during the years ended 2016 and 2015 predominantly resulted from purchases of securities available for sale and a net increase in loans, offset by sales, calls, maturities, and principal collected on securities available for sale. Financing activities Cash provided by financing activities during the years ended 2016 and 2015 predominantly resulted from an increase in deposits. The increase in deposits reflected the seasonable inflow of funds from municipal clients into demand and money market accounts. Cash inflows in 2016 were offset by a reduction of FHLBNY overnight advances and repayment of FHLB advances. Capital Resources The Corporation and the Bank are subject to regulatory capital requirements administered by federal banking agencies. Capital adequacy guidelines and, additionally for banks, prompt corrective action regulations, involve quantitative measures of assets, liabilities, and certain off-balance-sheet items calculated under regulatory accounting practices. Capital amounts and classifications are also subject to qualitative judgments by regulators. Failure to meet capital requirements can initiate regulatory action. The final rules implementing Basel III rules became effective for the Corporation on January 1, 2015 with full compliance with all of the requirements being phased in over a multi-year schedule, and fully phased in by January 1, 2019. Under Basel III rules, the Corporation must hold a capital conservation buffer above the adequately capitalized risk-based capital ratios. The capital conservation buffer is being phased in from 0.0% for 2015 to 2.50% by 2019. The capital conservation buffer for 2016 is 0.625%. The net unrealized gain or loss on available for sale securities and changes in the funded status of the defined benefit pension plan and other benefit plans are not included in computing regulatory capital. Management believes as of December 31, 2016, the Corporation and the Bank meet all capital adequacy requirements to which they are subject. Prompt corrective action regulations provide five classifications: well capitalized, adequately capitalized, undercapitalized, significantly undercapitalized, and critically undercapitalized, although these terms are not used to represent overall financial condition. If adequately capitalized, regulatory approval is required to accept brokered deposits. If undercapitalized, capital distributions are limited, as is asset growth and expansion, and capital restoration plans are required. Management believes that, as of December 31, 2016 and 2015, the Corporation and the Bank met all capital adequacy requirements to which they were subject. As of December 31, 2016, the most recent notification from the Federal Reserve Bank of New York categorized the Bank as well capitalized under the regulatory framework for prompt corrective action. To be categorized as well capitalized the Bank must maintain minimum total risk-based, Tier 1 risk-based, common equity Tier 1 risk-based and Tier 1 leverage ratios as set forth in the table below. There have been no conditions or events since that notification that management believes have changed the Bank's or the Corporation's capital category. The regulatory capital ratios as of December 31, 2016 and 2015 were calculated under Basel III rules. There is no threshold for well-capitalized status for bank holding companies. The Corporation’s and the Bank’s actual and required regulatory capital ratios were as follows (in thousands, except ratio data): Dividend Restrictions The Corporation’s principal source of funds for dividend payments is dividends received from the Bank. Banking regulations limit the amount of dividends that may be paid without prior approval of regulatory agencies. Under these regulations, the amount of dividends that may be paid in any calendar year is limited to the current year’s net income, combined with the retained net income of the preceding two years, subject to the capital requirements in the table above. At December 31, 2016, the Bank could, without prior approval, declare dividends of approximately $15.2 million. Adoption of New Accounting Standards For a discussion of the impact of recently issued accounting standards, please see Note 1 to the Corporation's consolidated financial statements which begins on page. Critical Accounting Policies, Estimates and Risks and Uncertainties Critical accounting policies include the areas where the Corporation has made what it considers to be particularly difficult, subjective or complex judgments concerning estimates, and where these estimates can significantly affect the Corporation's financial results under different assumptions and conditions. The Corporation prepares its financial statements in conformity with GAAP. As a result, the Corporation is required to make certain estimates, judgments and assumptions that it believes are reasonable based upon the information available at that time. These estimates, judgments and assumptions affect the reported amounts of assets and liabilities at the date of the financial statements and the reported amounts of revenue and expenses during the periods presented. Actual results could be different from these estimates. Management considers the accounting policy relating to the allowance for loan losses to be a critical accounting policy given the uncertainty in evaluating the level of the allowance required to cover probable incurred credit losses inherent in the loan portfolio, and the material effect that such judgments can have on the Corporation's results of operations. While management's current evaluation of the allowance for loan losses indicates that the allowance is adequate, under adversely different conditions or assumptions the allowance would need to be increased. For example, if historical loan loss experience significantly worsened or if current economic conditions significantly deteriorated, additional provisions for loan losses would be required to increase the allowance. In addition, the assumptions and estimates used in the internal reviews of the Corporation's non-performing loans and potential problem loans, and the associated evaluation of the related collateral coverage for these loans, has a significant impact on the overall analysis of the adequacy of the allowance for loan losses. Real estate values in the Corporation’s market area did not increase dramatically in the prior several years, and, as a result, any declines in real estate values have been modest. While management has concluded that the current evaluation of collateral values is reasonable under the circumstances, if collateral evaluations were significantly lowered, the Corporation's allowance for loan losses policy would also require additional provisions for loan losses. Explanation and Reconciliation of the Corporation’s Use of Non-GAAP Measures The Corporation prepares its Consolidated Financial Statements in accordance with GAAP; these financial statements appear on pages through. That presentation provides the reader with an understanding of the Corporation’s results that can be tracked consistently from year-to-year and enables a comparison of the Corporation’s performance with other companies’ GAAP financial statements. In addition to analyzing the Corporation’s results on a reported basis, management uses certain non-GAAP financial measures, because it believes these non-GAAP financial measures provide information to investors about the underlying operational performance and trends of the Corporation and, therefore, facilitate a comparison of the Corporation with the performance of its competitors. Non-GAAP financial measures used by the Corporation may not be comparable to similarly named non-GAAP financial measures used by other companies. The SEC has adopted Regulation G, which applies to all public disclosures, including earnings releases, made by registered companies that contain “non-GAAP financial measures.” Under Regulation G, companies making public disclosures containing non-GAAP financial measures must also disclose, along with each non-GAAP financial measure, certain additional information, including a reconciliation of the non-GAAP financial measure to the closest comparable GAAP financial measure and a statement of the Corporation’s reasons for utilizing the non-GAAP financial measure as part of its financial disclosures. The SEC has exempted from the definition of “non-GAAP financial measures” certain commonly used financial measures that are not based on GAAP. When these exempted measures are included in public disclosures, supplemental information is not required. The following measures used in this Report, which are commonly utilized by financial institutions, have not been specifically exempted by the SEC and may constitute "non-GAAP financial measures" within the meaning of the SEC's new rules, although we are unable to state with certainty that the SEC would so regard them. Fully Taxable Equivalent Net Interest Income, Net Interest Margin, and Efficiency Ratio Net interest income is commonly presented on a tax-equivalent basis. That is, to the extent that some component of the institution's net interest income, which is presented on a before-tax basis, is exempt from taxation (e.g., is received by the institution as a result of its holdings of state or municipal obligations), an amount equal to the tax benefit derived from that component is added to the actual before-tax net interest income total. This adjustment is considered helpful in comparing one financial institution's net interest income to that of other institutions or in analyzing any institution’s net interest income trend line over time, to correct any analytical distortion that might otherwise arise from the fact that financial institutions vary widely in the proportions of their portfolios that are invested in tax-exempt securities, and that even a single institution may significantly alter over time the proportion of its own portfolio that is invested in tax-exempt obligations. Moreover, net interest income is itself a component of a second financial measure commonly used by financial institutions, net interest margin, which is the ratio of net interest income to average interest-earning assets. For purposes of this measure as well, fully taxable equivalent net interest income is generally used by financial institutions, as opposed to actual net interest income, again to provide a better basis of comparison from institution to institution and to better demonstrate a single institution’s performance over time. The Corporation follows these practices. The efficiency ratio is a non-GAAP financial measures which represents the Corporation’s ability to turn resources into revenue and is calculated as non-interest expense divided by total revenue (fully taxable equivalent net interest income and non-interest income), adjusted for one-time occurrences and amortization. This measure is meaningful to the Corporation, as well as investors and analysts, in assessing the Corporation’s productivity measured by the amount of revenue generated for each dollar spent. Tangible Equity and Tangible Assets (Period-End) Tangible equity, tangible assets, and tangible book value per share are each non-GAAP financial measures. Tangible equity represents the Corporation’s stockholders’ equity, less goodwill and intangible assets. Tangible assets represents the Corporation’s total assets, less goodwill and other intangible assets. Tangible book value per share represents the Corporation’s equity divided by common shares at period-end. These measures are meaningful to the Corporation, as well as investors and analysts, in assessing the Corporation’s use of equity. Tangible Equity (Average) Average tangible equity and return on average tangible equity are each non-GAAP financial measures. Average tangible equity represents the Corporation’s average stockholders’ equity, less average goodwill and intangible assets for the period. Return on average tangible equity measures the Corporation’s earnings as a percentage of average tangible equity. These measures are meaningful to the Corporation, as well as investors and analysts, in assessing the Corporation’s use of equity. Adjustments for Certain Items of Income or Expense In addition to disclosures of certain GAAP financial measures, including net income, EPS, ROA, and ROE, we may also provide comparative disclosures that adjust these GAAP financial measures for a particular period by removing from the calculation thereof the impact of certain transactions or other material items of income or expense occurring during the period, including certain nonrecurring items. The Corporation believes that the resulting non-GAAP financial measures may improve an understanding of its results of operations by separating out any such transactions or items that may have had a disproportionate positive or negative impact on the Corporation’s financial results during the particular period in question. In the Corporation’s presentation of any such non-GAAP (adjusted) financial measures not specifically discussed in the preceding paragraphs, the Corporation supplies the supplemental financial information and explanations required under Regulation G.

<s>[INST] The MD&A included in this Form 10K contains statements that are forwardlooking within the meaning of the Private Securities Litigation Reform Act of 1995. These statements are based on the current beliefs and expectations of the Corporation's management and are subject to significant risks and uncertainties. Actual results may differ from those set forth in the forwardlooking statements. For a discussion of those risks and uncertainties and the factors that could cause the Corporation’s actual results to differ materially from those risks and uncertainties, see Forwardlooking Statements below. The Corporation has been a financial holding company since 2000, and the Bank was established in 1833, CFS in 2001, and CRM in 2016. Through the Bank and CFS, the Corporation provides a wide range of financial services, including demand, savings and time deposits, commercial, residential and consumer loans, interest rate swaps, letters of credit, wealth management services, employee benefit plans, insurance products, mutual funds and brokerage services. The Bank relies substantially on a foundation of locally generated deposits. The Corporation, on a standalone basis, has minimal results of operations. The Bank derives its income primarily from interest and fees on loans, interest on investment securities, WMG fee income and fees received in connection with deposit and other services. The Bank’s operating expenses are interest expense paid on deposits and borrowings, salaries and employee benefit plans and general operating expenses. CRM, a whollyowned subsidiary of the Corporation which was formed and began operations on May 31, 2016, is a Nevadabased captive insurance company that insures against certain risks unique to the operations of the Corporation and its subsidiaries and for which insurance may not be currently available or economically feasible in today's insurance marketplace. CRM pools resources with several other similar insurance company subsidiaries of financial institutions to spread a limited amount of risk among themselves. CRM is subject to regulations of the State of Nevada and undergoes periodic examinations by the Nevada Division of Insurance. Forwardlooking Statements This discussion contains forwardlooking statements within the meaning of Section 27A of the Securities Act, Section 21E of the Exchange Act, and the Private Securities Litigation Reform Act of 1995. The Corporation intends its forwardlooking statements to be covered by the safe harbor provisions for forwardlooking statements in these sections. All statements regarding the Corporation's expected financial position and operating results, the Corporation's business strategy, the Corporation's financial plans, forecasted demographic and economic trends relating to the Corporation's industry and similar matters are forwardlooking statements. These statements can sometimes be identified by the Corporation's use of forwardlooking words such as "may," "will," "anticipate," "estimate," "expect," or "intend." The Corporation cannot promise that its expectations in such forwardlooking statements will turn out to be correct. The Corporation's actual results could be materially different from expectations because of various factors, including changes in economic conditions or interest rates, credit risk, difficulties in managing the Corporation’s growth, competition, changes in law or the regulatory environment, including the DoddFrank Act, and changes in general business and economic trends. Information concerning these and other factors can be found in the Corporation’s periodic filings with the SEC, including the discussion under the heading “Item 1A. Risk Factors” of this Form 10K. The Corporation's quarterly filings are available publicly on the SEC’s web site at http://www.sec.gov, on the Corporation's web site at http://www.chemungcanal.com or by written request to: Kathleen S. McKillip, Corporate Secretary, Chemung Financial Corporation, One Chemung Canal Plaza, Elmira, NY 14901. Except as otherwise required by law, the Corporation undertakes no obligation to publicly update or revise its forwardlooking statements, whether as a result of new information, future events or otherwise. Consolidated Financial Highlights Executive Summary This executive summary of the MD&A includes selected information and may not contain all of the information that is important to readers of this Form 10K. For a complete description of the trends and uncertainties, as well as the risks and critical accounting estimates [/INST] Positive. </s>

CHEMUNG FINANCIAL CORP

2018-03-08

2017-12-31

ITEM 7. MANAGEMENT'S DISCUSSION AND ANALYSIS OF FINANCIAL CONDITION AND RESULTS OF OPERATION The following is the MD&A of the Corporation in this Form 10-K at December 31, 2017 and 2016, and for the years ended December 31, 2017, 2016, and 2015. The purpose of this discussion is to focus on information about the financial condition and results of operations of the Corporation. Reference should be made to the accompanying audited consolidated financial statements and footnotes for an understanding of the following discussion and analysis. See the list of commonly used abbreviations and terms on pages 1-4. The MD&A included in this Form 10-K contains statements that are forward-looking within the meaning of the Private Securities Litigation Reform Act of 1995. These statements are based on the current beliefs and expectations of the Corporation's management and are subject to significant risks and uncertainties. Actual results may differ from those set forth in the forward-looking statements. For a discussion of those risks and uncertainties and the factors that could cause the Corporation’s actual results to differ materially from those risks and uncertainties, see Forward-looking Statements below. The Corporation has been a financial holding company since 2000, and the Bank was established in 1833, CFS in 2001, and CRM in 2016. Through the Bank and CFS, the Corporation provides a wide range of financial services, including demand, savings and time deposits, commercial, residential and consumer loans, interest rate swaps, letters of credit, wealth management services, employee benefit plans, insurance products, mutual funds and brokerage services. The Bank relies substantially on a foundation of locally generated deposits. The Corporation, on a stand-alone basis, has minimal results of operations. The Bank derives its income primarily from interest and fees on loans, interest on investment securities, WMG fee income and fees received in connection with deposit and other services. The Bank’s operating expenses are interest expense paid on deposits and borrowings, salaries and employee benefit plans and general operating expenses. CRM, a wholly-owned subsidiary of the Corporation which was formed and began operations on May 31, 2016, is a Nevada-based captive insurance company that insures against certain risks unique to the operations of the Corporation and its subsidiaries and for which insurance may not be currently available or economically feasible in today's insurance marketplace. CRM pools resources with several other similar insurance company subsidiaries of financial institutions to spread a limited amount of risk among themselves. CRM is subject to regulations of the State of Nevada and undergoes periodic examinations by the Nevada Division of Insurance. Forward-looking Statements This discussion contains forward-looking statements within the meaning of Section 27A of the Securities Act, Section 21E of the Exchange Act, and the Private Securities Litigation Reform Act of 1995. The Corporation intends its forward-looking statements to be covered by the safe harbor provisions for forward-looking statements in these sections. All statements regarding the Corporation's expected financial position and operating results, the Corporation's business strategy, the Corporation's financial plans, forecasted demographic and economic trends relating to the Corporation's industry and similar matters are forward-looking statements. These statements can sometimes be identified by the Corporation's use of forward-looking words such as "may," "will," "anticipate," "estimate," "expect," or "intend." The Corporation cannot promise that its expectations in such forward-looking statements will turn out to be correct. The Corporation's actual results could be materially different from expectations because of various factors, including changes in economic conditions or interest rates, credit risk, difficulties in managing the Corporation’s growth, competition, changes in law or the regulatory environment, including the Dodd-Frank Act, and changes in general business and economic trends. Information concerning these and other factors can be found in the Corporation’s periodic filings with the SEC, including the discussion under the heading “Item 1A. Risk Factors” of this Form 10-K. The Corporation's quarterly filings are available publicly on the SEC’s web site at http://www.sec.gov, on the Corporation's web site at http://www.chemungcanal.com or by written request to: Kathleen S. McKillip, Corporate Secretary, Chemung Financial Corporation, One Chemung Canal Plaza, Elmira, NY 14901. Except as otherwise required by law, the Corporation undertakes no obligation to publicly update or revise its forward-looking statements, whether as a result of new information, future events or otherwise. Consolidated Financial Highlights Executive Summary This executive summary of the MD&A includes selected information and may not contain all of the information that is important to readers of this Form 10-K. For a complete description of the trends and uncertainties, as well as the risks and critical accounting estimates affecting the Corporation, this Form 10-K should be read in its entirety. The following table presents selected financial information for the years indicated, and the dollar and percent change (in thousands, except per share and ratio data): (a) See the GAAP to Non-GAAP reconciliations on pages 64-67. Net income for the year ended December 31, 2017 was $7.4 million, or $1.55 per share, compared with net income of $10.0 million, or $2.11 per share, for the prior year. Return on equity for the year was 4.91%, compared with 7.02% for the prior year. The decrease in net income for the year ended December 31, 2017, compared to the prior year, was driven by increases in the provision for loan losses and income tax expenses, partially offset by an increase in net interest income and a reduction in non-interest expenses. Net income in 2017 was impacted by a one-time $2.9 million reduction of the net deferred tax asset as a result of a revaluation required under GAAP due to the reduction in the corporation Federal income tax rate from 35% to 21% due to the Tax Act. Net interest income Net interest income increased $4.7 million, or 8.9% in 2017, compared with the prior year. The increase was due primarily to an increase of $52.4 million in average interest-earning assets and a 19 basis points increase in net interest margin. Non-interest income Non-interest income decreased $0.7 million, or 3.1% in 2017, compared to the prior year. The decrease was due primarily to decreases in service charges on deposit accounts, interchange revenue from debit card transactions, and net gains on securities transactions, partially offset by increases in WMG fee income and other non-interest income. Non-interest expenses Non-interest expense decreased $2.8 million, or 5.0% in 2017, compared to the prior year. The decrease was due primarily to the decreases in pension and other employee benefits, net occupancy, furniture and equipment, professional services, and legal accruals and settlements, partially offset by increases in salaries and wages and other non-interest expense. For the years ended December 31, 2017 and 2016, non-interest expense to average assets was 3.14% and 3.32%, respectively. Provision for loan losses The provision for loan losses increased $6.6 million, or 270.2% in 2017, compared to the prior year. The increase was the result of specific impairments in loans identified as impaired, including $4.9 million in specific reserves for eight commercial loans to two long-standing relationships in the Southern Tier of New York, volume increases in the commercial and indirect consumer loan portfolios, and an increase in loss factors relating to the indirect and consumer portfolios. Net charge-offs were $2.1 million in 2017, compared with $2.4 million for the prior year. Income tax expense Income tax expense increased $2.9 million, or 64.9% in 2017, compared to the prior year. The increase was the the result of a $2.9 million one-time reduction in the Corporation's net deferred asset. GAAP required a tax remeasurement of the Corporation's net deferred tax asset in the period of enactment of the Tax Act. The Tax Act was enacted on December 22, 2017, reducing the corporate Federal income tax rate from 35% to 21% and making other changes to the Federal corporate income tax laws. The additional expense was attributable to the reduction in the carrying value of net deferred tax assets reflecting lower future tax benefits resulting from the lower enacted corporate tax rate. The following table presents selected financial information for the periods indicated, and the dollar and percent change (in thousands, except per share and ratio data): (a) See the GAAP to Non-GAAP reconciliations on pages 64-67. Net income for the year ended December 31, 2016 was $10.0 million, or $2.11 per share, compared with $9.4 million, or $2.00 per share, for the prior year. Return on equity for the year ended December 31, 2016 was 7.02%, compared with 6.84% for the prior year. The increase in net income for the year ended December 31, 2016, compared to the prior year, was driven by increases in net interest income and non-interest income and a reduction in income tax expense, partially offset by increases in non-interest expense and the provision for loan losses. Net interest income Net interest income increased $1.7 million, or 3.3% in 2016, compared with the prior year. The increase was due primarily to an increase of $94.0 million in average interest-earning assets, offset by a nine basis points decline in net interest margin. Non-interest income Non-interest income increased $0.7 million, or 3.4% in 2016, compared to the prior year. The increase was due primarily to increases in service charges on deposit accounts, interchange revenue from debit card transactions, and net gains on securities transactions, offset by decreases in WMG fee income and other non-interest income. Non-interest expense Non-interest expense increased $1.2 million, or 2.1% in 2016, compared to the same period in the prior year. The increase was due primarily to the establishment of a $1.2 million legal reserve associated with the Fane v. Chemung Canal Trust Company case, along with increases in pension and other employee benefits and professional services, offset by decreases in salaries and wages, net occupancy expenses, amortization of intangible assets, and other real estate owned expenses. Please refer to Footnote 15 of the audited consolidated financial statements for further discussion of the Fane v. Chemung Canal case. For the years ended December 31, 2016 and 2015, non-interest expense to average assets was 3.32% and 3.51%, respectively. Provision for loan losses The provision for loan losses increased $0.9 million, or 55.1% in 2016, compared to the prior year. The increase was the result of an increase in net charge-offs and growth in the commercial loan portfolio, compared to the prior year. Net charge-offs were $2.4 million in 2016, compared with $1.0 million for the prior year. Income tax expense Income tax expense decreased $0.3 million, or 5.5% in 2016, compared to the prior year. The decrease in income tax expense can be attributed to the formation of CRM and increasing the utilization of the Bank's real estate investment trust in 2016. Consolidated Results of Operations The following section of the MD&A provides a comparative discussion of the Corporation’s Consolidated Results of Operations on a reported basis for the years ended December 31, 2017 and 2016 and for the years ended December 31, 2016 and 2015. For a discussion of the Critical Accounting Policies, Estimates and Risks and Uncertainties that affect the Consolidated Results of Operations, see page 64. Net Interest Income The following table presents net interest income for the years indicated, and the dollar and percent change (in thousands): Net interest income, which is the difference between the interest income earned on interest-earning assets, such as loans and securities and the interest expense accrued on interest-bearing liabilities, such as deposits and borrowings, is the largest contributor to the Corporation’s earnings. Net interest income for the year ended December 31, 2017 totaled $57.0 million, an increase of $4.7 million, or 8.9%, compared with $52.3 million for the prior year. Fully taxable equivalent net interest margin was 3.56% for the year ended December 31, 2017 compared with 3.37% for the prior year. The increase in net interest income was due primarily to an increase in interest income from the loan portfolio, primarily from the commercial loan portfolio, as average loan balances increased $56.6 million in 2017 when compared to the prior year. The increase in net interest margin was a result of the loan and securities portfolios repricing to current market rates as interest rates increased in 2017. The average yield on average interest-earning assets increased 14 basis points, while the average cost of interest-bearing liabilities decreased seven basis points. The increase in the average yield of interest-earning assets can be mostly attributed to increases of six and 20 basis points in the average yields of commercial loans and consumer loans, respectively, 13 and 18 basis points in the average yields of taxable and tax-exempt securities, respectively, and 59 basis points in the average yield of interest-earning deposits, partially offset by an 11 basis points decrease in mortgage loans. The decline in the average cost of interest-bearing liabilities can be attributed to a 23 basis points decline in the average cost of borrowings due to the maturity of one $10.0 million FHLB term advance (4.60% rate) in December 2016 and one $10.0 million repurchase agreement (4.54% rate) in March 2017. The following table presents net interest income for the years indicated, and the dollar and percent change (in thousands): Net interest income for the year ended December 31, 2016 totaled $52.3 million, an increase of $1.7 million, or 3.3%, compared with $50.6 million for the prior year. Fully taxable equivalent net interest margin was 3.37% for the year ended December 31, 2016 compared with 3.46% for the prior year. The increase in net interest income was due primarily to interest income from the loan portfolio, as the average commercial loan balance increased $77.6 million in 2016 when compared to the prior year. The decline in interest margin was a result of the commercial loan portfolio repricing to current market rates. The average yield on average interest-earning assets decreased 10 basis points, while the average cost of interest-bearing liabilities remained flat. The decline in the average yield of interest-earning assets can be mostly attributed to declines of 23 basis points in the average yield of commercial loans and 17 basis points in the average yield of mortgage loans, due to new production at lower competitive rates, offset by a 33 basis points increase in consumer loans, due to the indirect loan portfolio and increasing the portfolio toward higher yielding used automobile loans. Average interest-earning assets increased $94.0 million in 2016 compared to the prior year, primarily in commercial loans. Average Consolidated Balance Sheet and Interest Analysis The following table presents certain information related to the Corporation’s average consolidated balance sheets and its consolidated statements of income for the years ended December 31, 2017, 2016 and 2015. It also reflects the average yield on interest-earning assets and average cost of interest-bearing liabilities for the years ended December 31, 2017, 2016 and 2015. For the purpose of the table below, non-accruing loans are included in the daily average loan amounts outstanding. Daily balances were used for average balance computations. Investment securities are stated at amortized cost. Tax equivalent adjustments have been made in calculating yields on obligations of states and political subdivisions, tax-free commercial loans and dividends on equity investments. With the new 21% statutory federal tax rate effective January 1, 2018, the conversion factor to a fully taxable equivalent basis will decrease in 2018. The decline will have no impact on net income, but will cause the net interest margin on a fully taxable equivalent basis to decrease. (1) Net interest rate spread is the difference in the average yield on interest-earning assets less the average rate on interest-bearing liabilities. (2) Net interest margin is the ratio of fully taxable equivalent net interest income divided by average interest-earning assets. Changes Due to Rate and Volume Net interest income can be analyzed in terms of the impact of changes in rates and volumes. The table belows illustrates the extent to which changes in interest rates and in the volume of average interest-earning assets and interest-bearing liabilities have affected the Corporation’s interest income and interest expense during the years indicated. Information is provided in each category with respect to (i) changes attributable to changes in volume (changes in volume multiplied by prior rate); (ii) changes attributable to changes in rates (changes in rates multiplied by prior volume); and (iii) the net changes. For purposes of this table, changes that are not due solely to volume or rate changes have been allocated to these categories based on the respective percentage changes in average volume and rate. Due to the numerous simultaneous volume and rate changes during the years analyzed, it is not possible to precisely allocate changes between volume and rates. In addition, average interest-earning assets include non-accrual loans and taxable equivalent adjustments were made. Provision for loan losses Management performs an ongoing assessment of the adequacy of the allowance for loan losses based upon a number of factors including an analysis of historical loss factors, collateral evaluations, recent charge-off experience, credit quality of the loan portfolio, current economic conditions and loan growth. Based on this analysis, the provision for loan losses for the years ended December 31, 2017, 2016 and 2015 were $9.0 million, $2.4 million and $1.6 million, respectively. The increase in provision for loan losses in 2017 was due primarily to $4.9 million in specific reserves for eight commercial loans to two long-standing relationships in the Southern Tier of New York. Net charge-offs for the years ended December 31, 2017, 2016 and 2015 were $2.1 million, $2.4 million and $1.0 million, respectively. Non-interest income The following table presents non-interest income for the years indicated, and the dollar and percent change (in thousands): Total non-interest income for the year ended December 31, 2017 decreased $0.7 million compared to the prior year. The decrease was primarily due to decreases in service charges on deposit accounts, interchange revenue from debit card transactions, and net gains on securities transactions, offset by increases in WMG fee income and CFS fee and commission income. WMG fee income WMG fee income increased in 2017 compared to the prior year due to an increase in assets under management or administration. Service charges on deposit accounts Service charges on deposit accounts decreased in 2017 compared to the prior year due to an decrease in overdraft fees. Interchange revenue from debit card transactions Interchange revenue from debit card transactions decreased in 2017 compared to the prior year due to the recognition of an incremental volume bonus related to the rebranding of the Bank's credit cards recognized in 2016. Net gains on securities transactions Net gains on securities transactions decreased in 2017 compared to the prior year due to the sale of $14.5 million in U.S. Treasuries and $25.0 million in obligations of U.S. Government sponsored enterprises in 2016. CFS fee and commission income CFS fee and commission income increased in 2017 compared to the prior year due to an increase in fee income. The following table presents non-interest income for the years indicated, and the dollar and percent change (in thousands): Total non-interest income for year ended December 31, 2016 increased $0.7 million compared to the prior year. The increase was primarily due to increases in service charges on deposit accounts, interchange revenue from debit card transactions, and net gains on securities transactions, offset by decreases in WMG fee income, CFS fee and commission income, and other non-interest income. WMG fee income WMG fee income decreased in 2016 compared to the prior year due to a decline in assets under management or administration from the loss of one large non-profit customer during 2016. Service charges on deposit accounts Service charges on deposit accounts increased in 2016 compared to the prior year due to an increase in overdraft fees. Interchange revenue from debit card transactions Interchange revenue from debit card transactions increased in 2016 compared to the prior year due to the recognition of an incremental volume bonus related to the rebranding of the Bank's credit cards recognized in 2016. Net gains on securities transactions Net gains on securities transactions increased in 2016 compared to the prior year due to the sale of $14.5 million in U.S. Treasuries and $25.0 million in obligations of U.S. Government sponsored enterprises. CFS fee and commission income CFS fee and commission income decreased in 2016 compared to the prior year due to a decrease in commissions from insurance annuity products. Other Other non-interest income decreased in 2016 compared to the prior year due to rental income from OREO properties in 2015, which were sold in 2016. Non-interest expenses The following table presents non-interest expenses for the years indicated, and the dollar and percent change (in thousands): Total non-interest expenses for the year ended December 31, 2017 decreased $2.8 million compared with the prior year. The decrease was primarily due to decreases in compensation and non-compensation expenses. Compensation expenses Compensation expenses decreased in 2017 compared to the prior year due to a decrease in pension and other employee benefits, offset by an increase in salaries and wages. The decrease in pension and other employee benefits can be mostly attributed to the freezing of accruals for the pension and post-retirement healthcare plans, offset by an increase in healthcare and 401(k) plan contributions. The increase in salaries and wages can be attributed to annual merit increases. Non-compensation expenses Non-compensation expense decreased in 2017 compared to the prior year primarily due to decreases in net occupancy, furniture and equipment, professional services and legal accruals and settlements, partially offset by an increase in other non-interest expense. The decrease in net occupancy and furniture and equipment expenses can be attributed to the closure of the branch at 202 East State Street in Ithaca, NY during the second quarter of 2016, offset by exit costs for the branch at 120 Genesee Street in Auburn, NY recognized during the second quarter of 2017. The decrease in professional services can be attributed to professional fees incurred during the formation of CRM in 2016 and legal costs associated with the Fane v. Chemung Canal Trust Company case. The decrease in legal accruals and settlements can be attributed to the creation of a $1.2 million legal accrual for the Fane v. Chemung Canal Trust Company case in 2016, compared to a $0.9 million legal accrual for the same case in 2017. Please refer to Footnote 15 of the audited consolidated financial statements for further discussion of the Fane v. Chemung Canal case. The following table presents non-interest expense for the years indicated, and the dollar and percent change (in thousands): Total non-interest expenses for the year ended December 31, 2016 increased $1.2 million compared with the same period in the prior year. The increase was primarily due to an increase in non-compensation expense related to the establishment of a $1.2 million legal reserve in 2016. Compensation expenses Compensation expense decreased in 2016 compared to the prior year due to a decrease in salaries and wages, offset by an increase in pension and other employee benefits. The decrease in salaries and wages was primarily due to a reduction in full-time equivalent employees. The $0.2 million increase in pension and other employee benefits was primarily due to an increase in health insurance costs, offset by a $0.3 million curtailment gain related to the amendment of the defined benefit health care plan during the fourth quarter of 2015. Non-compensation expenses Non-compensation expense increased in 2016 compared to the prior year primarily due to increases in professional services and legal accruals and settlements, offset by decreases in net occupancy expenses, amortization of intangible assets, and other real estate owned expenses. The increase in professional services can be mostly attributed to expenses incurred related to the feasibility and implementation of CRM, consulting costs associated with the conversion of the Corporation's debit cards to MasterCard, and legal costs associated with the appeal of the Fane v. Chemung Canal Trust Company decision. The increase in legal accruals and settlements can be attributed to the establishment of a $1.2 million legal reserve associated with the Fane v. Chemung Canal Trust Company case. Please refer to Footnote 15 of the audited consolidated financial statements for further discussion of the Fane v. Chemung Canal case. The decrease in net occupancy expenses can be attributed to the closure of the branch office at 202 East State Street in Ithaca, NY during the second quarter of 2016. The decrease in other real estate owned expenses can be attributed to the sale of properties in 2016. Income tax expense The following table presents income tax expense and the effective tax rate for the years indicated, and the dollar and percent change (in thousands): The effective tax rate increased to 49.4% for the year ended December 31, 2017 compared with 30.5% for the same period in the prior year. The increase in the effective tax rate can be attributed to the $2.9 million one-time reduction in the net deferred tax asset as a result of the remeasurement required under GAAP due to the enactment of the Tax Act. The effective tax rate for the year ended December 31, 2017, excluding the one-time net deferred tax asset revaluation, was 29.5%1. The following table presents income tax expense and the effective tax rate for the years indicated, and the dollar and percent change (in thousands): The decrease in the effective tax rate can be attributed to the formation of CRM in 2016 and increasing the utilization of the Bank's real estate investment trust during 2016. 1 ($7,262 income tax expense - $2,927 revaluation of net deferred tax expense) / $14,692 income before income tax expense. Financial Condition The following table presents selected financial information at December 31, 2017 and 2016, and the dollar and percent change (in thousands): Cash and cash equivalents The decrease in cash and cash equivalents can be mostly attributed to an increase in total loans, offset by increases in deposits and FHLBNY advances. Investment securities The decrease in securities available for sale and held to maturity can be mostly attributed to maturities and calls exceeding new purchases of investment securities. Loans, net The increase in total loans can be mostly attributed to increases of $98.1 million in commercial loans and $17.5 million in consumer loans, offset by a $4.1 million decrease in residential mortgages. The increase in the commercial loan portfolio was primarily from the Capital Bank Division and the increase in consumer loans can be mostly attributed to an increase in the indirect automobile loan portfolio. Goodwill and other intangible assets, net The decrease in goodwill and other intangible assets, net can be attributed to amortization of other intangible assets. There were no impairments of goodwill or other intangible assets during the years ended December 31, 2017 and 2016. Other assets The decrease in other assets can be mostly attributed to the $2.9 million one-time reduction in the net deferred tax asset, as a result of a remeasurement required under GAAP due to the enactment of the Tax Act. Deposits The increase in deposits can be attributed to increases of $49.8 million in non-interest bearing demand deposits, $12.2 million in interest-bearing demand deposits, and $10.0 million in savings deposits. Partially offsetting the increases noted above were decreases of $35.2 million in money market accounts and $25.7 million in time deposits. FHLBNY advances and other debt FHLBNY overnight advances increased due to loan growth increasing faster than deposit growth during the current year, offset by the maturity of one $10.0 million repurchase agreement during the first quarter of 2017 and discontinuation of the Bank's customer repurchase agreement product during 2017. Shareholders’ equity The increase in shareholders' equity was primarily due to an increase in retained earnings of $4.3 million, which was a result of earnings of $7.4 million and a $1.8 million re-class of the stranded accumulated other comprehensive loss associated with the revaluation of the net deferred tax asset from accumulated other comprehensive loss to retained earnings, offset by $4.9 million in dividends declared during the current year. The decrease in accumulated other comprehensive loss of $0.4 million can be attributed to the increase in the fair market value of the securities portfolio, offset by the $1.8 million re-class of the stranded accumulated other comprehensive loss associated with the revaluation of the net deferred tax asset to retained earnings. Also, additional-paid-in capital and treasury stock increased $0.4 million and $0.9 million, respectively, due to the issuance of shares to the Corporation’s employee benefit stock plans. Assets under management or administration The market value of total assets under management or administration in our WMG was $1.952 billion, including $346.8 million of assets held under management or administration for the Corporation, at December 31, 2017 compared with $1.721 billion, including $294.9 million of assets held under management or administration for the Corporation, at December 31, 2016, an increase of $230.4 million, or 13.4%. Balance Sheet Comparisons The table below contains selected average balance sheet information for each year in the five-year period ended December 31, 2017 (in millions): (1) Average interest-earning assets include securities available for sale and securities held to maturity based on amortized cost, loans and loans held for sale net of deferred loan fees, interest-earning deposits, FHLBNY stock, FRBNY stock and federal funds sold. (2) Average loans and loans held for sale, net of deferred loan fees. (3) Average balances for investments include securities available for sale and securities held to maturity, based on amortized cost, FHLBNY stock, FRBNY stock, federal funds sold and interest-earning deposits. (4) Average borrowings include FHLBNY advances, securities sold under agreements to repurchase and capitalized lease obligations. The table below contains selected year-end balance sheet information for each year in the five-year period ended December 31, 2017 (in millions): (1) Interest-earning assets include securities available for sale, at estimated fair value and securities held to maturity based on amortized cost, loans and loans held for sale net of deferred loan fees, interest-earning deposits, FHLBNY stock, FRBNY stock and federal funds sold. (2) Loans and loans held for sale, net of deferred loan fees. (3) Investments include securities available for sale, at estimated fair value, securities held to maturity, at amortized cost, FHLBNY stock, FRBNY stock, federal funds sold and interest-earning deposits. (4) Borrowings include FHLBNY overnight and term advances, securities sold under agreements to repurchase and capitalized lease obligations. Cash and Cash Equivalents Total cash and cash equivalents decreased $43.4 million since December 31, 2016, due to decreases of $0.2 million in cash and due from financial institutions and $43.2 million in interest-earning deposits in other financial institutions in order to fund loan growth in 2017. Securities The Corporation’s Funds Management Policy includes an investment policy that in general, requires debt securities purchased for the bond portfolio to carry a minimum agency rating of "A". After an independent credit analysis is performed, the policy also allows the Corporation to purchase local municipal obligations that are not rated. The Corporation intends to maintain a reasonable level of securities to provide adequate liquidity and in order to have securities available to pledge to secure public deposits, repurchase agreements and other types of transactions. Fluctuations in the fair value of the Corporation’s securities relate primarily to changes in interest rates. Marketable securities are classified as Available for Sale, while investments in local municipal obligations are generally classified as Held to Maturity. The composition of the available for sale segment of the securities portfolio is summarized in the table as follows (in thousands): (a) Other securities consists of corporate bonds, SBA loan pools, and equity securities. The available for sale segment of the securities portfolio totaled $293.6 million at December 31, 2017, a decrease of $9.8 million, or 3.2%, from $303.4 million at December 31, 2016. The decrease resulted primarily from maturities and calls, which exeeded new purchases. The held to maturity segment of the securities portfolio consists of obligations of political subdivisions in the Corporation’s market areas. These securities totaled $3.8 million at December 31, 2017, a decrease of $0.9 million from December 31, 2016, due primarily to maturities and principal collected. Non-marketable equity securities at December 31, 2017 include shares of FRBNY stock and FHLBNY stock, carried at their cost of $1.8 million and $4.0 million, respectively. The fair value of these securities is assumed to approximate their cost. The investment in these stocks is regulated by regulatory policies of the respective institutions. The table below sets forth the carrying amounts and maturities of available for sale and held to maturity debt securities at December 31, 2017 and the weighted average yields of such securities (all yields are calculated on the basis of the amortized cost and weighted for the scheduled maturity of each security, except mortgage-backed securities which are based on the average life at the projected prepayment speed of each security) (in thousands): Management evaluates securities for OTTI on a quarterly basis, and more frequently when economic or market conditions warrant such an evaluation. For the years ended December 31, 2017 and 2016, the Corporation had no OTTI charges. Loans The Corporation has reporting systems to monitor: (i) loan originations and concentrations, (ii) delinquent loans, (iii) non-performing assets, including non-performing loans, troubled debt restructurings, other real estate owned, (iv) impaired loans, and (v) potential problem loans. Management reviews these systems on a regular basis. The table below presents the Corporation’s loan composition by type and percentage of total loans at the end of each of the last five years (in thousands): Portfolio loans totaled $1.312 billion at December 31, 2017, an increase of $111.5 million, or 9.3%, from $1.200 billion at December 31, 2016. The increase in portfolio loans was due to strong growth of $98.1 million, or 13.2%, in commercial loans and $13.5 million, or 9.7%, in indirect consumer loans. The growth in commercial loans was due primarily to an increase in commercial mortgages in the Capital Bank division in the Albany, New York region. The increase in indirect consumer loans was a result of the Corporation's decision to focus efforts into expanding its indirect automobile loan portfolio. Residential mortgage loans totaled $194.4 million at December 31, 2017, a decrease of $4.1 million, or 2.0%, from December 31, 2016. In addition, during 2017, $12.5 million of residential mortgages were sold in the secondary market to Freddie Mac, with an additional $0.6 million of residential mortgages sold to the State of New York Mortgage Agency. The Corporation anticipates that future growth in portfolio loans will continue to be in commercial mortgages and commercial and industrial loans, especially within the Capital Bank division of the Bank. The table below presents the Corporation’s outstanding loan balance by bank division (in thousands): Loan concentrations are considered to exist when there are amounts loaned to a multiple number of borrowers engaged in similar activities which would cause them to be similarly impacted by changes in economic or other conditions. The Corporation’s concentration policy limits consider the volume of commercial loans to any one specific industry, sponsor, and by collateral type and location. In addition, the Corporation’s policy limits the volume of non-owner occupied commercial mortgages to four times total risk based capital. At December 31, 2017 and 2016, total non-owner occupied commercial real estate loans divided by total risk based capital was 386.7% and 351.1% respectively. The Corporation also monitors specific NAICS industry classifications of commercial loans to identify concentrations greater than 10.0% of total loans. At December 31, 2017 and 2016, commercial loans to borrowers involved in the real estate, and real estate rental and leasing businesses were 48.1% and 43.9% of total loans, respectively. No other concentration of loans existed in the commercial loan portfolio in excess of 10.0% of total loans as of December 31, 2017 and 2016. The table below shows the maturity of only commercial and agricultural loans and commercial mortgages outstanding as of December 31, 2017. Also provided are the amounts due after one year, classified according to fixed interest rates and variable interest rates (in thousands): Non-Performing Assets Non-performing assets consist of non-accrual loans, non-accrual troubled debt restructurings and other real estate owned that has been acquired in partial or full satisfaction of loan obligations or upon foreclosure. Past due status on all loans is based on the contractual terms of the loan. It is generally the Corporation's policy that a loan 90 days past due be placed in non-accrual status unless factors exist that would eliminate the need to place a loan in this status. A loan may also be designated as non-accrual at any time if payment of principal or interest in full is not expected due to deterioration in the financial condition of the borrower. At the time loans are placed in non-accrual status, the accrual of interest is discontinued and previously accrued interest is reversed. All payments received on non-accrual loans are applied to principal. Loans are considered for return to accrual status when they become current as to principal and interest and remain current for a period of six consecutive months or when, in the opinion of management, the Corporation expects to receive all of its contractual principal and interest. In the case of non-accrual loans where a portion of the loan has been charged off, the remaining balance is kept in non-accrual status until the entire principal balance has been recovered. The following table summarizes the Corporation's non-performing assets, excluding purchased credit impaired loans (in thousands): NON-PERFORMING ASSETS (1) These loans are not included in nonperforming assets above. The table below shows interest income on non-accrual and troubled debt restructured loans for the indicated years ended December 31 (in thousands): Non-Performing Loans Non-performing loans totaled $17.3 million at December 31, 2017, or 1.32% of total loans, compared with $12.0 million at December 31, 2016, or 1.00% of total loans. The increase in non-performing loans at December 31, 2017 was primarily due to increases of $5.3 million in non-accruing commercial and industrial loans and $1.2 million in non-accruing commercial mortgages, offset by a decrease of $1.0 million in non-accruing residential mortgages. The increase in non-accruing commercial and industrial loans was due primarily to two long-standing relationships in the Southern Tier of New York. Non-performing assets, which are comprised of non-performing loans and other real estate owned, was $19.3 million, or 1.13% of total assets, at December 31, 2017, compared with $12.4 million, or 0.75% of total assets, at December 31, 2016. The recorded investment in accruing loans past due 90 days or more totaled less than $0.1 million at December 31, 2017, consistent with the prior year. Not included in non-performing loan totals are $0.8 million and $1.4 million of acquired loans which the Corporation has identified as PCI loans at December 31, 2017 and 2016, respectively. The PCI loans are accounted for under separate accounting guidance, ASC Subtopic 310-30, “Receivables - Loans and Debt Securities Acquired with Deteriorated Credit Quality” as disclosed in Note 4 of the financial statements. Troubled Debt Restructurings The Corporation works closely with borrowers that have financial difficulties to identify viable solutions that minimize the potential for loss. In that regard, the Corporation modified the terms of select loans to maximize their collectability. The modified loans are considered TDRs under current accounting guidance. Modifications generally involve short-term deferrals of principal and/or interest payments, reductions of scheduled payment amounts, interest rates or principal of the loan, and forgiveness of accrued interest. As of December 31, 2017, the Corporation had $6.0 million of non-accrual TDRs compared with $4.4 million as of December 31, 2016. As of December 31, 2017, the Corporation had $1.7 million of accruing TDRs compared with $5.8 million as of December 31, 2016. Impaired Loans A loan is classified as impaired when, based on current information and events, it is probable that the Corporation will be unable to collect both the principal and interest due under the contractual terms of the loan agreement. The unpaid principal balance of impaired loans at December 31, 2017 totaled $14.1 million, including TDRs of $7.7 million, compared to $12.9 million at December 31, 2016, including TDRs of $10.2 million. Not included in the impaired loan totals are acquired loans which the Corporation has identified as PCI loans, as these loans are accounted for under ASC Subtopic 310-30 as noted under the above discussion of non-performing loans. The increase in impaired loans was primarily in the commercial loan segment of the loan portfolio related to two long-standing relationships in the Southern Tier of New York, partially offset by the transfer of eight commercial properties from impaired loans to OREO. Included in the recorded investment of impaired loans at December 31, 2017, are loans totaling $8.1 million for which impairment allowances of $5.9 million have been specifically allocated to the allowance for loan losses. As of December 31, 2016, the impaired loan total included $2.6 million of loans for which specific impairment allowances of $0.9 million were allocated to the allowance for loan losses. The increase in the amount of impaired loans for which specific allowances were allocated to the allowance for loan losses was due primarily to an increase in impaired commercial loans. The majority of the Corporation's impaired loans are secured and measured for impairment based on collateral evaluations. It is the Corporation's policy to obtain updated appraisals, by independent third parties, on loans secured by real estate at the time a loan is determined to be impaired. An impairment measurement is performed based upon the most recent appraisal on file to determine the amount of any specific allocation or charge-off. In determining the amount of any specific allocation or charge-off, the Corporation will make adjustments to reflect the estimated costs to sell the property. Upon receipt and review of the updated appraisal, an additional measurement is performed to determine if any adjustments are necessary to reflect the proper provisioning or charge-off. Impaired loans are reviewed on a quarterly basis to determine if any changes in credit quality or market conditions would require any additional allocation or recognition of additional charge-offs. Real estate values in the Corporation's market area have been holding steady. Non-real estate collateral may be valued using (i) an appraisal, (ii) net book value of the collateral per the borrower’s financial statements, or (iii) accounts receivable aging reports, that may be adjusted based on management’s knowledge of the client and client’s business. If market conditions warrant, future appraisals are obtained for both real estate and non-real estate collateral. Allowance for Loan Losses The allowance is an amount that management believes will be adequate to absorb probable incurred losses on existing loans. The allowance is established based on management’s evaluation of the probable inherent losses in our portfolio in accordance with GAAP, and is comprised of both specific valuation allowances and general valuation allowances. A loan is classified as impaired when, based on current information and events, it is probable that the Corporation will be unable to collect both the principal and interest due under the contractual terms of the loan agreement. Specific valuation allowances are established based on management’s analyses of individually impaired loans. Factors considered by management in determining impairment include payment status, evaluations of the underlying collateral, expected cash flows, and the probability of collecting scheduled principal and interest payments when due. Loans that experience insignificant payment delays and payment shortfalls generally are not classified as impaired. Management determines the significance of payment delays and payment shortfalls on a case-by-case basis, taking into consideration all of the circumstances surrounding the loan and the borrower, including the length of the delay, the reasons for the delay, the borrower’s prior payment record, and the amount of the shortfall in relation to the principal and interest owed. If a loan is determined to be impaired and is placed on non-accrual status, all future payments received are applied to principal and a portion of the allowance is allocated so that the loan is reported, net, at the present value of estimated future cash flows using the loan’s existing rate or at the fair value of collateral if repayment is expected solely from the collateral. The general component covers non-impaired loans and is based on historical loss experience adjusted for current factors. Loans not impaired but classified as substandard and special mention use a historical loss factor on a rolling five year history of net losses. For all other unclassified loans, the historical loss experience is determined by portfolio class and is based on the actual loss history experienced by the Corporation over the most recent two years. This actual loss experience is supplemented with other qualitative factors based on the risks present for each portfolio class. These qualitative factors include consideration of the following: (1) lending policies and procedures, including underwriting standards and collection, charge-off and recovery policies, (2) national and local economic and business conditions and developments, including the condition of various market segments, (3) loan profiles and volume of the portfolio, (4) the experience, ability, and depth of lending management and staff, (5) the volume and severity of past due, classified and watch-list loans, non-accrual loans, troubled debt restructurings, and other modifications (6) the quality of the Bank’s loan review system and the degree of oversight by the Bank’s Board of Directors, (7) collateral related issues: secured vs. unsecured, type, declining valuation environment and trend of other related factors, (8) the existence and effect of any concentrations of credit, and changes in the level of such concentrations, (9) the effect of external factors, such as competition and legal and regulatory requirements, on the level of estimated credit losses in the Bank’s current portfolio and (10) the impact of the global economy. The allowance for loan losses is increased through a provision for loan losses charged to operations. Loans are charged against the allowance for loan losses when management believes that the collectability of all or a portion of the principal is unlikely. Management's evaluation of the adequacy of the allowance for loan losses is performed on a periodic basis and takes into consideration such factors as the credit risk grade assigned to the loan, historical loan loss experience and review of specific impaired loans. While management uses available information to recognize losses on loans, future additions to the allowance may be necessary based on changes in economic conditions. In addition, various regulatory agencies, as an integral part of their examination process, periodically review the Corporation's allowance for loan losses. Such agencies may require the Corporation to recognize additions to the allowance based on their judgments about information available to them at the time of their examination. The allowance for loan losses was $21.2 million at December 31, 2017, compared to $14.3 million at December 31, 2016. The increase in the allowance for loan losses can be mostly attributed to an increase in the commercial and consumer loans portfolios, an increase in impaired loans, and an increase in loss factors relating to the indirect and consumer loan portfolios. The ratio of allowance for loan losses to total loans was 1.61% at December 31, 2017 and 1.19% at December 31, 2016, respectively. Net charge-offs for the years ended December 31, 2017 and 2016 were $2.1 million and $2.4 million, respectively. The table below summarizes the Corporation’s allocation of the allowance for loan losses and percent of loans by category to total loans for each year in the five-year period ended December 31, 2017 (in thousands): The table below summarizes the Corporation's loan loss experience for each year in the five-year period ended December 31, 2017 (in thousands, except ratio data): Net charge-offs for the year ended December 31, 2017 were $2.1 million compared with $2.4 million for the year ended December 31, 2016. The ratio of net charge-offs to average loans outstanding was 0.17% for 2017 compared to 0.20% for 2016. The decrease in net charge-offs can be attributed to a decline in write-offs in commercial loans, offset by increases in write-offs in residential mortgages and consumer loans. Other Real Estate Owned At December 31, 2017, OREO totaled $1.9 million compared to $0.4 million at December 31, 2016. The increase in other real estate owned was due primarily to eight commercial properties added during the fourth quarter of 2017 in the amount of $1.6 million . Deposits The table below summarizes the Corporation’s deposit composition by segment at December 31, 2017, 2016, and 2015, and the dollar and percent change from December 31, 2016 to December 31, 2017 and December 31, 2015 to December 31, 2016 (in thousands): Deposits totaled $1.467 billion at December 31, 2017, compared with $1.456 billion at December 31, 2016, an increase of $11.1 million, or 0.8%. At December 31, 2017, demand deposit and money market accounts comprised 77.0% of total deposits compared with 75.8% at December 31, 2016. Sorted by public, commercial, consumer and broker sources, the growth in deposits was due primarily to increases of $43.0 million in commercial deposits and $0.9 million in public deposits, offset by decreases of $16.9 million in consumer deposits and $15.9 million in brokered deposits. At December 31, 2017, public funds deposits totaled $299.5 million compared to $306.3 million at December 31, 2016. The Corporation has developed a program for the retention and management of public funds deposits. These deposits are from public entities, such as school districts and municipalities. There is a seasonal component to public deposit levels associated with annual tax collections. Public funds deposits will increase at the end of the first and third quarters. Public funds deposit accounts above the FDIC insured limit are collateralized by municipal bonds and eligible government and government agency securities such as those issued by the FHLB, Fannie Mae, and Freddie Mac. The table below summarizes the Corporation’s public funds deposit composition by segment (in thousands): As of December 31, 2017, the aggregate amount of the Corporation's outstanding certificates of deposit in amounts greater than or equal to $100 thousand was $31.3 million. The table below presents the Corporation's scheduled maturity of those certificates as of December 31, 2017 (in thousands): The table below presents the Corporation's deposits balance by bank division (in thousands): Brokered deposits include funds obtained through brokers, and the Bank’s participation in CDARS and ICS programs. The CDARS and ICS programs involve a network of financial institutions that exchange funds among members in order to ensure FDIC insurance coverage on customer deposits above the single institution limit. Using a sophisticated matching system, funds are exchanged on a dollar-for-dollar basis, so that the equivalent of an original deposit comes back to the originating institution. The Corporation had no deposits obtained through brokers as of December 31, 2017 and 2016. Deposits obtained through the CDARS and ICS programs were $187.7 million and $203.7 million as of December 31, 2017 and 2016, respectively. The Corporation’s deposit strategy is to fund the Bank with stable, low-cost deposits, primarily checking account deposits and other low interest-bearing deposit accounts. A checking account is the driver of a banking relationship and consumers consider the bank where they have their checking account as their primary bank. These customers will typically turn to their primary bank first when in need of other financial services. Strategies that have been developed and implemented to generate these deposits include: (i) acquire deposits by entering new markets through de novo branching, (ii) an annual checking account marketing campaign, (iii) training branch employees to identify and meet client financial needs with Bank products and services, (iv) link business and consumer loans to a primary checking account at the Bank, (v) aggressively promote direct deposit of client’s payroll checks or benefit checks and (vi) constantly monitor the Corporation’s pricing strategies to ensure competitive products and services. The Corporation also considers brokered deposits to be an element of its deposit strategy and anticipates that it will continue using brokered deposits as a secondary source of funding to support growth. Information regarding deposits is included in Note 7 to the consolidated financial statements appearing elsewhere in this report. Borrowings FHLBNY advances increased $50.6 million to $59.7 million at December 31, 2017 from $9.1 million at December 31, 2016. FHLBNY overnight advances increased $57.7 million during 2017 while FHLBNY term advances decreased $7.1 million. FHLBNY overnight advances increased due to loan growth increasing faster than deposit growth during the year. For each of the three years ended December 31, 2017, 2016 and 2015, respectively, the average outstanding balance of borrowings that mature in one year or less did not exceed 30% of shareholders' equity. Information regarding securities sold under agreements to repurchase and FHLBNY advances is included in Foonotes 8 and 9 to the audited consolidated financial statements appearing elsewhere in this report. The following is a summary of securities sold under agreements to repurchase as of and for the years ended December 31, 2017, 2016 and 2015 (in thousands): The following is a summary of FHLBNY overnight advances as of and for the years ended December 31, 2017, 2016, and 2015 (in thousands): The following is a summary of FHLBNY term advances as of and for the years ended December 31, 2017, 2016, and 2015. The carrying amount includes the advance plus purchase accounting adjustments that are amortized over the term of the advance (in thousands): Derivatives The Corporation offers interest rate swap agreements to qualified commercial loan customers. These agreements allow the Corporation’s customers to effectively fix the interest rate on a variable rate loan by entering into a separate agreement. Simultaneous with the execution of such an agreement with a customer, the Corporation enters into a matching interest rate swap agreement with an unrelated third party provider, which allows the Corporation to continue to receive the variable rate under the loan agreement with the customer. The agreement with the third party is not designated as a hedge contract, therefore changes in fair value are recorded through other non-interest income. Assets and liabilities associated with the agreements are recorded in other assets and other liabilities on the balance sheet. Gains and losses are recorded as other non-interest income. The Corporation is exposed to credit loss equal to the fair value of the interest rate swaps, not the notional amount of the derivatives, in the event of nonperformance by the counterparty to the interest rate swap agreements. Additionally, the swap agreements are free-standing derivatives and are recorded at fair value in the Corporation's consolidated balance sheets, which typically involves a day one gain. Since the terms of the two interest rate swap agreements are identical, the income statement impact to the Corporation is limited to the day one gain and an allowance for credit loss exposure, in the event of nonperformance. The Corporation recognized $0.2 million and $0.1 million in swap fee income for the years ended December 31, 2017 and 2016, respectively. The Corporation also participates in the credit exposure of certain interest rate swaps in which it participates in the related commercial loan. The Corporation receives an upfront fee for participating in the credit exposure of the interest rate swap and recognizes the fee to other non-interest income immediately. The Corporation is exposed to its share of the credit loss equal to the fair value of the derivatives in the event of nonperformance by the counter-party of the interest rate swap. The Corporation determines the fair value of the credit loss exposure using historical losses of the loan category associated with the credit exposure. Information regarding derivatives is included in Note 10 to the consolidated financial statements appearing elsewhere in this report. Shareholders’ Equity Total shareholders’ equity was $149.8 million at December 31, 2017, compared with $143.7 million at December 31, 2016, an increase of $6.1 million, or 4.2%. The increase in retained earnings of $4.3 million was due primarily to earnings of $7.4 million and a $1.8 million re-class of the stranded accumulated other comprehensive loss associated with the revaluation of the net deferred tax asset from accumulated other comprehensive loss to retained earnings, offset by $4.9 million in dividends declared during the year. The decrease in accumulated other comprehensive loss of $0.4 million can be attributed to the increase in the fair market value of the securities portfolio, offset by the $1.8 million re-class of the stranded accumulated other comprehensive loss associated with the revaluation of the net deferred tax asset to retained earnings. Also, additional-paid-in capital and treasury stock increased $0.4 million and $0.9 million, respectively, due to the issuance of shares to the Corporation’s employee benefit stock plans. The total shareholders’ equity to total assets ratio was 8.77% at December 31, 2017 compared with 8.67% at December 31, 2016. Tangible equity to tangible assets ratio increased to 7.48% at December 31, 2017, from 7.29% at December 31, 2016. The Corporation and the Bank are subject to capital adequacy guidelines of the Federal Reserve which establish a framework for the classification of financial holding companies and financial institutions into five categories: well-capitalized, adequately capitalized, undercapitalized, significantly undercapitalized and critically undercapitalized. As of December 31, 2017, both the Corporation’s and the Bank’s capital ratios were in excess of those required to be considered well-capitalized under regulatory capital guidelines. A comparison of the Corporation’s and the Bank’s actual capital ratios to the ratios required to be adequately or well-capitalized at December 31, 2017 and 2016, is included in Footnote 18 to the consolidated financial statements appearing elsewhere in this report. For more information regarding current capital regulations see Part I-“Business-Supervision and Regulation-Regulatory Capital Requirements.” Cash dividends declared during 2017 and 2016 totaled $4.9 million or $1.04 per share, and cash dividends declared during 2015 totaled $4.8 million, or $1.04 per share. Dividends declared during 2017 amounted to 66.30% of net income compared to 48.76%, and 51.34% of net income for 2016 and 2015, respectively. Management seeks to continue generating sufficient capital internally, while continuing to pay dividends to the Corporation’s shareholders. When shares of the Corporation become available in the market, the Corporation may purchase them after careful consideration of the Corporation’s liquidity and capital positions. Purchases may be made from time to time on the open market or in privately negotiated transactions at the discretion of management. On December 19, 2012, the Board of Directors approved a new stock repurchase plan under which the Corporation may repurchase up to 125,000 shares. No shares were purchased under the plan in 2017 and 2016. The Corporation has purchased 3,094 shares at a total cost of $93 thousand under the plan since its inception. Off-balance Sheet Arrangements In the normal course of operations, the Corporation engages in a variety of financial transactions that, in accordance with GAAP are not recorded in the financial statements. The Corporation is also a party to certain financial instruments with off balance sheet risk such as commitments under standby letters of credit, unused portions of lines of credit, commitments to fund new loans, interest rate swaps, and risk participation agreements. The Corporation's policy is to record such instruments when funded. These transactions involve, to varying degrees, elements of credit, interest rate and liquidity risk. Such transactions are generally used by the Corporation to manage clients' requests for funding and other client needs. The table below shows the Corporation’s off-balance sheet arrangements as of December 31, 2017 (in thousands): (1) Not included in this total are unused portions of home equity lines of credit, credit card lines and consumer overdraft protection lines of credit, since no contractual maturity dates exist for these types of loans. Commitments to outside parties under these lines of credit were $48.3 million, $12.9 million and $5.5 million, respectively, at December 31, 2017. Contractual Obligations The table below shows the Corporation’s contractual obligations under long-term agreements as of December 31, 2017 (in thousands). Note references are to the Notes of the Consolidated Financial Statements: (1) Not included in the above total is the Corporation's obligation regarding the Pension Plan and Other Benefit Plans. Please refer to Part IV Item 15 Note 12 for information regarding these obligations at December 31, 2017. Liquidity Liquidity management involves the ability to meet the cash flow requirements of deposit clients, borrowers, and the operating, investing and financing activities of the Corporation. The Corporation uses a variety of resources to meet its liquidity needs. These include short term investments, cash flow from lending and investing activities, core-deposit growth and non-core funding sources, such as time deposits of $100,000 or more, securities sold under agreements to repurchase and other borrowings. The Corporation is a member of the FHLBNY which allows it to access borrowings which enhance management's ability to satisfy future liquidity needs. Based on available collateral and current advances outstanding, the Corporation was eligible to borrow up to a total of $73.5 million and $131.6 million at December 31, 2017 and 2016, respectively. The Corporation also had a total of $38.0 million of unsecured lines of credit with five different financial institutions, all of which were available at December 31, 2017. The Corporation had a total of $28.0 million of unsecured lines of credit with four different financial institutions, all of which was available at December 31, 2016. Consolidated Cash Flows Analysis The table below summarizes the Corporation's cash flows for the years indicated (in thousands): Operating activities The Corporation believes cash flows from operations, available cash balances and its ability to generate cash through short- and long-term borrowings are sufficient to fund the Corporation’s operating liquidity needs. Cash provided by operating activities in years ended 2017 and 2016 predominantly resulted from net income after non-cash operating adjustments. Investing activities Cash used in investing activities during the years ended 2017 and 2016 predominantly resulted from purchases of securities available for sale and a net increase in loans, offset by sales, calls, maturities, and principal collected on securities available for sale. Financing activities Cash provided by financing activities during the years ended 2017 and 2016 predominantly resulted from an increase in deposits and FHLBNY overnight advances, offset by the repayment of FHLBNY term advances and securities sold under agreements to repurchase. Capital Resources The Corporation and the Bank are subject to regulatory capital requirements administered by federal banking agencies. Capital adequacy guidelines and, additionally for banks, prompt corrective action regulations, involve quantitative measures of assets, liabilities, and certain off-balance-sheet items calculated under regulatory accounting practices. Capital amounts and classifications are also subject to qualitative judgments by regulators. Failure to meet capital requirements can initiate regulatory action. The final rules implementing Basel III rules became effective for the Corporation and the Bank on January 1, 2015 with full compliance with all of the requirements being phased in over a multi-year schedule, and fully phased in by January 1, 2019. Under Basel III rules, the Corporation must hold a capital conservation buffer above the adequately capitalized risk-based capital ratios. The capital conservation buffer is being phased in from 0.0% for 2015 to 2.50% by 2019. The capital conservation buffer for 2017 was 1.250%. The net unrealized gain or loss on available for sale securities and changes in the funded status of the defined benefit pension plan and other benefit plans are not included in computing regulatory capital. Prompt corrective action regulations provide five classifications: well capitalized, adequately capitalized, undercapitalized, significantly undercapitalized, and critically undercapitalized, although these terms are not used to represent overall financial condition. If adequately capitalized, regulatory approval is required to accept brokered deposits. If undercapitalized, capital distributions are limited, as is asset growth and expansion, and capital restoration plans are required. Management believes that, as of December 31, 2017 and 2016, the Corporation and the Bank met all capital adequacy requirements to which they were subject. As of December 31, 2017, the most recent notification from the Federal Reserve Bank of New York categorized the Bank as well capitalized under the regulatory framework for prompt corrective action. To be categorized as well capitalized the Bank must maintain minimum total risk-based, Tier 1 risk-based, common equity Tier 1 risk-based and Tier 1 leverage ratios as set forth in the table below. There have been no conditions or events since that notification that management believes have changed the Bank's or the Corporation's capital category. The regulatory capital ratios as of December 31, 2017 and 2016 were calculated under Basel III rules. There is no threshold for well-capitalized status for bank holding companies. The Corporation’s and the Bank’s actual and required regulatory capital ratios were as follows (in thousands, except ratio data): Dividend Restrictions The Corporation’s principal source of funds for dividend payments is dividends received from the Bank. Banking regulations limit the amount of dividends that may be paid without prior approval of regulatory agencies. Under these regulations, the amount of dividends that may be paid in any calendar year is limited to the current year’s net income, combined with the retained net income of the preceding two years, subject to the capital requirements in the table above. At December 31, 2017, the Bank could, without prior approval, declare dividends of approximately $13.8 million. Adoption of New Accounting Standards For a discussion of the impact of recently issued accounting standards, please see Note 1 to the Corporation's consolidated financial statements which begins on page. Critical Accounting Policies, Estimates and Risks and Uncertainties Critical accounting policies include the areas where the Corporation has made what it considers to be particularly difficult, subjective or complex judgments concerning estimates, and where these estimates can significantly affect the Corporation's financial results under different assumptions and conditions. The Corporation prepares its financial statements in conformity with GAAP. As a result, the Corporation is required to make certain estimates, judgments and assumptions that it believes are reasonable based upon the information available at that time. These estimates, judgments and assumptions affect the reported amounts of assets and liabilities at the date of the financial statements and the reported amounts of revenue and expenses during the years presented. Actual results could be different from these estimates. Management considers the accounting policy relating to the allowance for loan losses to be a critical accounting policy given the uncertainty in evaluating the level of the allowance required to cover probable incurred credit losses inherent in the loan portfolio, and the material effect that such judgments can have on the Corporation's results of operations. While management's current evaluation of the allowance for loan losses indicates that the allowance is adequate, under adversely different conditions or assumptions the allowance would need to be increased. For example, if historical loan loss experience significantly worsened or if current economic conditions significantly deteriorated, additional provisions for loan losses would be required to increase the allowance. In addition, the assumptions and estimates used in the internal reviews of the Corporation's non-performing loans and potential problem loans, and the associated evaluation of the related collateral coverage for these loans, has a significant impact on the overall analysis of the adequacy of the allowance for loan losses. Real estate values in the Corporation’s market area did not increase dramatically in the prior several years, and, as a result, any declines in real estate values have been modest. While management has concluded that the current evaluation of collateral values is reasonable under the circumstances, if collateral evaluations were significantly lowered, the Corporation's allowance for loan losses policy would also require additional provisions for loan losses. Explanation and Reconciliation of the Corporation’s Use of Non-GAAP Measures The Corporation prepares its Consolidated Financial Statements in accordance with GAAP; these financial statements appear on pages through. That presentation provides the reader with an understanding of the Corporation’s results that can be tracked consistently from year-to-year and enables a comparison of the Corporation’s performance with other companies’ GAAP financial statements. In addition to analyzing the Corporation’s results on a reported basis, management uses certain non-GAAP financial measures, because it believes these non-GAAP financial measures provide information to investors about the underlying operational performance and trends of the Corporation and, therefore, facilitate a comparison of the Corporation with the performance of its competitors. Non-GAAP financial measures used by the Corporation may not be comparable to similarly named non-GAAP financial measures used by other companies. The SEC has adopted Regulation G, which applies to all public disclosures, including earnings releases, made by registered companies that contain “non-GAAP financial measures.” Under Regulation G, companies making public disclosures containing non-GAAP financial measures must also disclose, along with each non-GAAP financial measure, certain additional information, including a reconciliation of the non-GAAP financial measure to the closest comparable GAAP financial measure and a statement of the Corporation’s reasons for utilizing the non-GAAP financial measure as part of its financial disclosures. The SEC has exempted from the definition of “non-GAAP financial measures” certain commonly used financial measures that are not based on GAAP. When these exempted measures are included in public disclosures, supplemental information is not required. The following measures used in this Report, which are commonly utilized by financial institutions, have not been specifically exempted by the SEC and may constitute "non-GAAP financial measures" within the meaning of the SEC's rules, although we are unable to state with certainty that the SEC would so regard them. Fully Taxable Equivalent Net Interest Income, Net Interest Margin, and Efficiency Ratio Net interest income is commonly presented on a tax-equivalent basis. That is, to the extent that some component of the institution's net interest income, which is presented on a before-tax basis, is exempt from taxation (e.g., is received by the institution as a result of its holdings of state or municipal obligations), an amount equal to the tax benefit derived from that component is added to the actual before-tax net interest income total. This adjustment is considered helpful in comparing one financial institution's net interest income to that of other institutions or in analyzing any institution’s net interest income trend line over time, to correct any analytical distortion that might otherwise arise from the fact that financial institutions vary widely in the proportions of their portfolios that are invested in tax-exempt securities, and that even a single institution may significantly alter over time the proportion of its own portfolio that is invested in tax-exempt obligations. Moreover, net interest income is itself a component of a second financial measure commonly used by financial institutions, net interest margin, which is the ratio of net interest income to average interest-earning assets. For purposes of this measure as well, fully taxable equivalent net interest income is generally used by financial institutions, as opposed to actual net interest income, again to provide a better basis of comparison from institution to institution and to better demonstrate a single institution’s performance over time. The Corporation follows these practices. The efficiency ratio is a non-GAAP financial measures which represents the Corporation’s ability to turn resources into revenue and is calculated as non-interest expense divided by total revenue (fully taxable equivalent net interest income and non-interest income), adjusted for one-time occurrences and amortization. This measure is meaningful to the Corporation, as well as investors and analysts, in assessing the Corporation’s productivity measured by the amount of revenue generated for each dollar spent. Tangible Equity and Tangible Assets (Year-End) Tangible equity, tangible assets, and tangible book value per share are each non-GAAP financial measures. Tangible equity represents the Corporation’s stockholders’ equity, less goodwill and intangible assets. Tangible assets represents the Corporation’s total assets, less goodwill and other intangible assets. Tangible book value per share represents the Corporation’s equity divided by common shares at year-end. These measures are meaningful to the Corporation, as well as investors and analysts, in assessing the Corporation’s use of equity. Tangible Equity (Average) Average tangible equity and return on average tangible equity are each non-GAAP financial measures. Average tangible equity represents the Corporation’s average stockholders’ equity, less average goodwill and intangible assets for the year. Return on average tangible equity measures the Corporation’s earnings as a percentage of average tangible equity. These measures are meaningful to the Corporation, as well as investors and analysts, in assessing the Corporation’s use of equity. Adjustments for Certain Items of Income or Expense In addition to disclosures of certain GAAP financial measures, including net income, EPS, ROA, and ROE, we may also provide comparative disclosures that adjust these GAAP financial measures for a particular year by removing from the calculation thereof the impact of certain transactions or other material items of income or expense occurring during the year, including certain nonrecurring items. The Corporation believes that the resulting non-GAAP financial measures may improve an understanding of its results of operations by separating out any such transactions or items that may have had a disproportionate positive or negative impact on the Corporation’s financial results during the particular year in question. In the Corporation’s presentation of any such non-GAAP (adjusted) financial measures not specifically discussed in the preceding paragraphs, the Corporation supplies the supplemental financial information and explanations required under Regulation G.

<s>[INST] The MD&A included in this Form 10K contains statements that are forwardlooking within the meaning of the Private Securities Litigation Reform Act of 1995. These statements are based on the current beliefs and expectations of the Corporation's management and are subject to significant risks and uncertainties. Actual results may differ from those set forth in the forwardlooking statements. For a discussion of those risks and uncertainties and the factors that could cause the Corporation’s actual results to differ materially from those risks and uncertainties, see Forwardlooking Statements below. The Corporation has been a financial holding company since 2000, and the Bank was established in 1833, CFS in 2001, and CRM in 2016. Through the Bank and CFS, the Corporation provides a wide range of financial services, including demand, savings and time deposits, commercial, residential and consumer loans, interest rate swaps, letters of credit, wealth management services, employee benefit plans, insurance products, mutual funds and brokerage services. The Bank relies substantially on a foundation of locally generated deposits. The Corporation, on a standalone basis, has minimal results of operations. The Bank derives its income primarily from interest and fees on loans, interest on investment securities, WMG fee income and fees received in connection with deposit and other services. The Bank’s operating expenses are interest expense paid on deposits and borrowings, salaries and employee benefit plans and general operating expenses. CRM, a whollyowned subsidiary of the Corporation which was formed and began operations on May 31, 2016, is a Nevadabased captive insurance company that insures against certain risks unique to the operations of the Corporation and its subsidiaries and for which insurance may not be currently available or economically feasible in today's insurance marketplace. CRM pools resources with several other similar insurance company subsidiaries of financial institutions to spread a limited amount of risk among themselves. CRM is subject to regulations of the State of Nevada and undergoes periodic examinations by the Nevada Division of Insurance. Forwardlooking Statements This discussion contains forwardlooking statements within the meaning of Section 27A of the Securities Act, Section 21E of the Exchange Act, and the Private Securities Litigation Reform Act of 1995. The Corporation intends its forwardlooking statements to be covered by the safe harbor provisions for forwardlooking statements in these sections. All statements regarding the Corporation's expected financial position and operating results, the Corporation's business strategy, the Corporation's financial plans, forecasted demographic and economic trends relating to the Corporation's industry and similar matters are forwardlooking statements. These statements can sometimes be identified by the Corporation's use of forwardlooking words such as "may," "will," "anticipate," "estimate," "expect," or "intend." The Corporation cannot promise that its expectations in such forwardlooking statements will turn out to be correct. The Corporation's actual results could be materially different from expectations because of various factors, including changes in economic conditions or interest rates, credit risk, difficulties in managing the Corporation’s growth, competition, changes in law or the regulatory environment, including the DoddFrank Act, and changes in general business and economic trends. Information concerning these and other factors can be found in the Corporation’s periodic filings with the SEC, including the discussion under the heading “Item 1A. Risk Factors” of this Form 10K. The Corporation's quarterly filings are available publicly on the SEC’s web site at http://www.sec.gov, on the Corporation's web site at http://www.chemungcanal.com or by written request to: Kathleen S. McKillip, Corporate Secretary, Chemung Financial Corporation, One Chemung Canal Plaza, Elmira, NY 14901. Except as otherwise required by law, the Corporation undertakes no obligation to publicly update or revise its forwardlooking statements, whether as a result of new information, future events or otherwise. Consolidated Financial Highlights Executive Summary This executive summary of the MD&A includes selected information and may not contain all of the information that is important to readers of this Form 10K. For a complete description of the trends and uncertainties, as well as the risks and critical accounting estimates [/INST] Negative. </s>

CHEMUNG FINANCIAL CORP

2019-03-13

2018-12-31

ITEM 7. MANAGEMENT'S DISCUSSION AND ANALYSIS OF FINANCIAL CONDITION AND RESULTS OF OPERATION Overview The following is the MD&A of the Corporation in this Form 10-K at December 31, 2018 and 2017, and for the years ended December 31, 2018, 2017, and 2016. The purpose of this discussion is to focus on information about the financial condition and results of operations of the Corporation. Reference should be made to the accompanying audited consolidated financial statements and footnotes for an understanding of the following discussion and analysis. See the list of commonly used abbreviations and terms on pages 1-4. The MD&A included in this Form 10-K contains statements that are forward-looking within the meaning of the Private Securities Litigation Reform Act of 1995. These statements are based on the current beliefs and expectations of the Corporation's management and are subject to significant risks and uncertainties. Actual results may differ from those set forth in the forward-looking statements. For a discussion of those risks and uncertainties and the factors that could cause the Corporation’s actual results to differ materially from those risks and uncertainties, see Forward-looking Statements below. The Corporation has been a financial holding company since 2000, and the Bank was established in 1833, CFS in 2001, and CRM in 2016. Through the Bank and CFS, the Corporation provides a wide range of financial services, including demand, savings and time deposits, commercial, residential and consumer loans, interest rate swaps, letters of credit, wealth management services, employee benefit plans, insurance products, mutual funds and brokerage services. The Bank relies substantially on a foundation of locally generated deposits. The Corporation, on a stand-alone basis, has minimal results of operations. The Bank derives its income primarily from interest and fees on loans, interest on investment securities, WMG fee income and fees received in connection with deposit and other services. The Bank’s operating expenses are interest expense paid on deposits and borrowings, salaries and employee benefit plans and general operating expenses. CRM, a wholly-owned subsidiary of the Corporation which was formed and began operations on May 31, 2016, is a Nevada-based captive insurance company that insures against certain risks unique to the operations of the Corporation and its subsidiaries and for which insurance may not be currently available or economically feasible in today's insurance marketplace. CRM pools resources with several other similar insurance company subsidiaries of financial institutions to spread a limited amount of risk among themselves. CRM is subject to regulations of the State of Nevada and undergoes periodic examinations by the Nevada Division of Insurance. Forward-looking Statements This discussion contains forward-looking statements within the meaning of Section 27A of the Securities Act, Section 21E of the Exchange Act, and the Private Securities Litigation Reform Act of 1995. The Corporation intends its forward-looking statements to be covered by the safe harbor provisions for forward-looking statements in these sections. All statements regarding the Corporation's expected financial position and operating results, the Corporation's business strategy, the Corporation's financial plans, forecasted demographic and economic trends relating to the Corporation's industry and similar matters are forward-looking statements. These statements can sometimes be identified by the Corporation's use of forward-looking words such as "may," "will," "anticipate," "estimate," "expect," or "intend." The Corporation cannot promise that its expectations in such forward-looking statements will turn out to be correct. The Corporation's actual results could be materially different from expectations because of various factors, including changes in economic conditions or interest rates, credit risk, difficulties in managing the Corporation’s growth, competition, changes in law or the regulatory environment, including the Dodd-Frank Act, and changes in general business and economic trends. Information concerning these and other factors can be found in the Corporation’s periodic filings with the SEC, including the discussion under the heading “Item 1A. Risk Factors” of this Form 10-K. The Corporation's quarterly filings are available publicly on the SEC’s web site at http://www.sec.gov, on the Corporation's web site at http://www.chemungcanal.com or by written request to: Kathleen S. McKillip, Corporate Secretary, Chemung Financial Corporation, One Chemung Canal Plaza, Elmira, NY 14901. Except as otherwise required by law, the Corporation undertakes no obligation to publicly update or revise its forward-looking statements, whether as a result of new information, future events or otherwise. Consolidated Financial Highlights Executive Summary This executive summary of the MD&A includes selected information and may not contain all of the information that is important to readers of this Form 10-K. For a complete description of the trends and uncertainties, as well as the risks and critical accounting estimates affecting the Corporation, this Form 10-K should be read in its entirety. The following table presents selected financial information for the years indicated, and the dollar and percent change (in thousands, except per share and ratio data): (a) See the GAAP to Non-GAAP reconciliations on pages 67-70. Net income for the year ended December 31, 2018 was $19.6 million, or $4.06 per share, compared with net income of $7.4 million, or $1.55 per share, for the prior year. Return on equity for the year ended December 31, 2018 was 12.76%, compared with 4.91% for the prior year. The increase in net income for the year ended December 31, 2018, compared to the prior year, was driven by increases in net interest income and non-interest income, and decreases in the provision for loan losses and income tax expense, partially offset by an increase in non-interest expenses. Net interest income Net interest income increased $3.5 million, or 6.1% in 2018, compared with the prior year. The increase was due primarily to an increase of $14.9 million in average interest-earning assets and a 16 basis points increase in net interest margin. Non-interest income Non-interest income increased $2.6 million, or 12.6% in 2018, compared to the prior year. The increase was due primarily to an increase in the fair value of equity investments as a result of the sale of Visa Class B shares, WMG fee income, and interchange revenue from debit card transactions, partially offset by a decrease in service charges on deposit accounts. Non-interest expenses Non-interest expense increased $3.0 million, or 5.6% in 2018, compared to the prior year. The increase was due primarily to increases in salaries and wages, net occupancy expenses, data processing expenses, professional services, marketing and advertising expenses, and other real estate owned expenses and a decrease in other components of net periodic pension cost (benefits). For the years ended December 31, 2018 and 2017, non-interest expense to average assets was 3.31% and 3.14%, respectively. Provision for loan losses The provision for loan losses decreased $5.9 million, or 65.1% in 2018, compared to the prior year. The decrease was primarily the result of specific impairments in loans identified as impaired, including $4.9 million in specific reserves for eight commercial loans to two long-standing relationships in the Southern Tier of New York recorded in 2017, a decrease in volume and loss factors relating to the residential, home equity, and the indirect and consumer portfolios, partially offset by an increase in volume and loss factors in the commercial loan portfolio. Net charge-offs were $5.4 million in 2018, compared with $2.1 million for the prior year. The increase in net charge-offs was due primarily to the charge-off of multiple large commercial loans to one borrower for $3.6 million during the second quarter of 2018. Income tax expense Income tax expense decreased $3.3 million, or 44.8% in 2018, compared to the prior year. The effective tax rate for 2018 decreased to 17.0% compared with 49.4% for the prior year. The decreases in income tax expense the effective tax rate can be attributed to a tax benefit of $0.4 million recorded in December 2018 and to the estimated $2.9 million one-time net deferred tax revaluation expense recorded in December 2017, both due to the enactment of the Tax Act. Additionally, the Corporation increased income generated from CCTC Funding Corp., a real estate investment trust subsidiary of the Bank, reducing the Corporation's state income tax expense. The following table presents selected financial information for the years indicated, and the dollar and percent change (in thousands, except per share and ratio data): (a) See the GAAP to Non-GAAP reconciliations on pages 67-70. Net income for the year ended December 31, 2017 was $7.4 million, or $1.55 per share, compared with $10.0 million, or $2.11 per share, for the prior year. Return on equity for the year ended December 31, 2017 was 4.91%, compared with 7.02% for the prior year. The decrease in net income for the year ended December 31, 2017, compared to the prior year, was driven by increases in provision for loan losses and income tax expenses, partially offset by an increase in net interest income and a reduction in non-interest expenses. Net income in 2017 was impacted by a one-time $2.9 million reduction of the net deferred tax asset as a result of a revaluation required under GAAP due to the reduction in the corporation Federal income tax rate from 35% to 21% due to the Tax Act. Net interest income Net interest income increased $4.7 million, or 8.9% in 2017, compared with the prior year. The decrease was due primarily to an increase of $52.4 million in average interest-earning assets, offset by a 19 basis points decline in net interest margin. Non-interest income Non-interest income decreased $0.7 million, or 3.1% in 2017, compared to the prior year. The decrease was due primarily to decreases in service charges on deposit accounts, interchange revenue from debit card transactions, and net gains on securities transactions, offset by increases in WMG fee income and other non-interest income. Non-interest expense Non-interest expense decreased $2.8 million, or 5.0% in 2017, compared to the prior year. The decrease was due primarily to the decreases in pension and other employee benefits, net occupancy, furniture and equipment, professional services, and legal accruals and settlements, partially offset by increases in salaries and other non-interest expense. For the years ended December 31, 2017 and 2016, non-interest expense to average assets was 3.14% and 3.32%, respectively. Provision for loan losses The provision for loan losses increased $6.6 million, or 270.2% in 2017, compared to the prior year. The increase was the result of specific impairments in loans identified as impaired, including $4.9 million in specific reserves for eight commercial loans to two long-standing relationships in the Southern Tier of New York, volume increases in the commercial and indirect consumer loan portfolios, and an increase in loss factors relating to the indirect and consumer portfolios. Net charge-offs were $2.1 million in 2017, compared with $2.4 million for the prior year. Income tax expense Income tax expense increased $2.9 million, or 64.9% in 2017, compared to the prior year. The increase was the result of a $2.9 million one-time reduction in the Corporation's net deferred asset. GAAP required a tax remeasurement of the Corporation's net deferred tax asset in the period of enactment of the Tax Act. The Tax Act was enacted on December 22, 2017, reducing the corporate Federal income tax rate from 35% to 21% and making other changes to the Federal corporate income tax laws. The additional expense was attributable to the reduction in the carrying value of net deferred tax assets reflecting lower future tax benefits resulting from the lower enacted corporate tax rate. Consolidated Results of Operations The following section of the MD&A provides a comparative discussion of the Corporation’s Consolidated Results of Operations on a reported basis for the years ended December 31, 2018 and 2017 and for the years ended December 31, 2017 and 2016. For a discussion of the Critical Accounting Policies, Estimates and Risks and Uncertainties that affect the Consolidated Results of Operations, see page 67. Net Interest Income The following table presents net interest income for the years indicated, and the dollar and percent change (in thousands): Net interest income, which is the difference between the interest income earned on interest-earning assets, such as loans and securities and the interest expense accrued on interest-bearing liabilities, such as deposits and borrowings, is the largest contributor to the Corporation’s earnings. Net interest income for the year ended December 31, 2018 totaled $60.5 million, an increase of $3.5 million, or 6.1%, compared with $57.0 million for the prior year. Fully taxable equivalent net interest margin was 3.72% for the year ended December 31, 2018 compared with 3.56% for the prior year. The increase in total interest and dividend income in 2018 was due primarily to increases in interest and fees of $5.0 million from loans and interest income of $0.2 million from interest-earning deposits, while interest and dividend income from securities decreased $0.7 million compared to the prior year. The increase in total interest expense in 2018 was due primarily to increases in interest expense of $1.2 million on deposits and $0.2 million on borrowed funds, while interest expense on securities sold under agreements to repurchase decreased $0.3 million, compared to the prior year. Average interest-earning assets increased $14.9 million in 2018 when compared to the prior year. The average yield on average interest-earning assets increased 21 basis points, while the average cost of interest-bearing liabilities increased nine basis points, as compared to the prior year. The increase in interest and dividend income in 2018 was due primarily to a $61.6 million increase in the average balance of commercial loans, primarily commercial mortgages, along with a 22 basis points increase in the average yield on commercial loans as a result of the rising interest rate environment, and a $14.3 million increase in the average balance of consumer loans, compared to the prior year. The increase in interest expense in 2018 was due primarily to an increase in interest rates on interest-bearing deposit accounts, including promotional interest rates on time deposits, offset by a 41 basis points decrease in the average cost on borrowed funds due to the maturity of one $2.0 million FHLB term advance (3.05% rate) in January and one $10.0 million repurchase agreement (3.72% rate) in May 2018, as compared to the prior year. The following table presents net interest income for the years indicated, and the dollar and percent change (in thousands): Net interest income for the year ended December 31, 2017 totaled $57.0 million, an increase of $4.7 million, or 8.9%, compared with $52.3 million for the prior year. Fully taxable equivalent net interest margin was 3.56% for the year ended December 31, 2017 compared with 3.37% for the prior year. The increase in net interest income was due primarily to an increase in interest income form the loan portfolio, primarily from the commercial loan portfolio, as average loan balances increased $56.6 million in 2017 when compared to the prior year. The increase in net interest margin was a result of the loan and securities portfolios repricing to current markets as interest rates increased in 2017. The average yield on average interest-earning assets increased 14 basis points, while the average cost of interest-bearing liabilities decreased seven basis points. The increase in the average yield of interest-earning assets can be mostly attributed to increases of six and 20 basis points in the average yields of commercial loans and consumer loans, respectively, 13 and 18 basis points in the average yields of taxable and tax-exempt securities, respectively, and 59 basis points in the average yield of interest-earning deposits, partially offset by an 11 basis points decrease in mortgage loans. The decline in the average cost of interest-bearing liabilities can be attributed to a 23 basis points decline in the average cost of borrowings due to the maturity of one $10.0 million FHLB term advance (4.60% rate) in December 2016 and one $10.0 million repurchase agreement (4.54% rate) in March 2017. Average Consolidated Balance Sheet and Interest Analysis The following table presents certain information related to the Corporation’s average consolidated balance sheets and its consolidated statements of income for the years ended December 31, 2018, 2017 and 2016. It also reflects the average yield on interest-earning assets and average cost of interest-bearing liabilities for the years ended December 31, 2018, 2017 and 2016. For the purpose of the table below, non-accruing loans are included in the daily average loan amounts outstanding. Daily balances were used for average balance computations. Investment securities are stated at amortized cost. Tax equivalent adjustments have been made in calculating yields on obligations of states and political subdivisions, tax-free commercial loans and dividends on equity investments. With the new 21% statutory federal tax rate effective January 1, 2018, the conversion factor to a fully taxable equivalent basis decreased in 2018. The decline had no impact on net income, but caused the net interest margin on a fully taxable equivalent basis to decrease. (1) Net interest rate spread is the difference in the average yield on interest-earning assets less the average cost of interest-bearing liabilities. (2) Net interest margin is the ratio of fully taxable equivalent net interest income divided by average interest-earning assets. Changes Due to Rate and Volume Net interest income can be analyzed in terms of the impact of changes in rates and volumes. The table below illustrates the extent to which changes in interest rates and in the volume of average interest-earning assets and interest-bearing liabilities have affected the Corporation’s interest income and interest expense during the years indicated. Information is provided in each category with respect to (i) changes attributable to changes in volume (changes in volume multiplied by prior rate); (ii) changes attributable to changes in rates (changes in rates multiplied by prior volume); and (iii) the net changes. For purposes of this table, changes that are not due solely to volume or rate changes have been allocated to these categories based on the respective percentage changes in average volume and rate. Due to the numerous simultaneous volume and rate changes during the years analyzed, it is not possible to precisely allocate changes between volume and rates. In addition, average interest-earning assets include non-accrual loans and taxable equivalent adjustments were made. Provision for loan losses Management performs an ongoing assessment of the adequacy of the allowance for loan losses based upon a number of factors including an analysis of historical loss factors, collateral evaluations, recent charge-off experience, credit quality of the loan portfolio, current economic conditions and loan growth. Based on this analysis, the provision for loan losses for the years ended December 31, 2018, 2017 and 2016 were $3.2 million, $9.0 million and $2.4 million, respectively. The decrease in provision for loan losses in 2018, as compared to 2017, was due to $4.9 million in specific reserves for eight commercial loans to two long-standing relationships in the Southern Tier of New York recorded in 2017, a decrease in volume and loss factors relating to the residential, home equity, and the indirect and consumer portfolios, partially offset by an increase in volume and loss factors in the commercial loan portfolio. The increase in provision for loan losses in 2017 as compared to 2016 was due primarily to the $4.9 million in specific reserves for eight commercial loans to two long-standing relationships in the Southern Tier of New York noted above. Net charge-offs for the years ended December 31, 2018, 2017 and 2016 were $5.4 million, $2.1 million and $2.4 million, respectively. Non-interest income The following table presents non-interest income for the years indicated, and the dollar and percent change (in thousands): Total non-interest income for the year ended December 31, 2018 increased $2.6 million compared to the prior year. The increase was due primarily to increases in the fair value of equity investments, WMG fee income and interchange revenue from debit card transactions, partially offset by a decrease in service charges on deposits accounts. WMG fee income WMG fee income increased in 2018 compared to the prior year due to an increase in average assets under management or administration. Service charges on deposit accounts Service charges on deposit accounts decreased in 2018 compared to the prior year due to a decrease in overdraft fee income. Interchange revenue from debit card transactions Interchange revenue from debit card transactions increased in 2018 compared to the prior year due to an increase in the volume of transactions. Net gains on securities transactions Net gains on securities transactions decreased in 2018 compared to the prior year due to there being no sales of securities in 2018. Change in fair value of equity investments Change in fair value of equity investments increased in 2018 compared to the prior year due primarily to the increase in the fair value of Visa Class B shares. Subsequent to the change in fair value, the Visa Class B shares were sold during the third quarter of 2018. CFS fee and commission income CFS fee and commission income decreased in 2018 compared to the prior year due to a decrease in transaction activity. The following table presents non-interest income for the years indicated, and the dollar and percent change (in thousands): Total non-interest income for year ended December 31, 2017 decreased $0.7 million compared to the prior year. The decrease was primarily due to decreases in service charges on deposit accounts, interchange revenue from debit card transactions, and net gains on securities transactions, offset by increases in WMG fee income and CFS fee and commission income. WMG fee income WMG fee income decreased in 2017 compared to the prior year due to an increase in assets under management or administration. Service charges on deposit accounts Service charges on deposit accounts decreased in 2017 compared to the prior year due to a decrease in overdraft fees. Interchange revenue from debit card transactions Interchange revenue from debit card transactions decreased in 2017 compared to the prior year due to the recognition of an incremental volume bonus related to the rebranding of the Bank's credit cards recognized in 2016. Net gains on securities transactions Net gains on securities transactions decreased in 2017 compared to the prior year due to the sale of $14.5 million in U.S. Treasuries and $25.0 million in obligations of U.S. Government sponsored enterprises in 2016. CFS fee and commission income CFS fee and commission income increased in 2017 compared to the prior year due to an increase in fee income. Non-interest expenses The following table presents non-interest expenses for the years indicated, and the dollar and percent change (in thousands): Total non-interest expenses for the year ended December 31, 2018 increased $3.0 million compared with the prior year. The increase was primarily due to increases in compensation and non-compensation expenses. Compensation expenses Compensation expenses increased in 2018 compared to the prior year due to an increase in salaries and wages and a decrease in other components of net periodic pension and postretirement cost (benefits). The increase in salaries and wages can be attributed to annual merit increases and an increase in headcount with two denovo branches which opened in 2018. The decrease in other components of net periodic pension cost (benefits) was due primarily to a $0.8 million charge related to a lump sum settlement to terminated, vested employees in 2018. Non-compensation expenses Non-compensation expense increased in 2018 compared to the prior year primarily due to increases in net occupancy, data processing, professional services, marketing and advertising, and other real estate owned expense, offset by a decrease in furniture and equipment expenses. The increase in net occupancy and data processing expenses can be attributed to the two new denovo branches, along with the timing of various projects. The increase in marketing and advertising can be attributed to advertising campaigns related to the opening of the two denovo branches. The increase in other real estate owned expense can be attributed to additional OREO properties acquired during 2017 and 2018. The following table presents non-interest expense for the years indicated, and the dollar and percent change (in thousands): Total non-interest expenses for the year ended December 31, 2017 decreased $2.8 million compared with the prior year. The decrease was primarily due to decreases in compensation and non-compensation expenses. Compensation expenses Compensation expenses decreased in 2017 compared to the prior year due to a decrease in other components of net periodic pension cost (benefits), offset by increases in salaries and wages and pension and other employee benefits. The decrease in other components of net periodic pension cost (benefits) can be mostly attributed to the freezing of accruals for the pension and post-retirement healthcare plans. The increase in salaries and wages can be attributed to annual merit increases. The increase in pension and other employee benefits can be attributed to increases in healthcare and 401(k) contributions. Non-compensation expenses Non-compensation expenses decreased in 2017 compared to the prior year primarily due to decreases in net occupancy, furniture and equipment, professional services and legal accruals and settlements, partially offset by an increase in other non-interest expense. The decrease in net occupancy and furniture and equipment expenses can be attributed to the closure of the branch at 202 East State Street in Ithaca, NY during the second quarter of 2016, offset by exit costs for the branch at 120 Genesee Street in Auburn, NY recognized during the second quarter of 2017. The decrease in professional services can attributed to professional fees incurred during the formation of CRM in 2016 and legal costs associated with the Fane v. Chemung Canal Trust Company case. The decrease in legal accruals and settlements can be attributed to the creation of a $1.2 million legal accrual for the Fane v. Chemung Canal Trust Company case in 2016, compared to a $0.9 million legal accrual for the same case in 2017. Please refer to Footnote 16 of the audited consolidated financial statements for further discussion of the Fane v. Chemung Canal Trust Company case. Income tax expense The following table presents income tax expense and the effective tax rate for the years indicated, and the dollar and percent change (in thousands): The effective tax rate decreased to 17.0% for the year ended December 31, 2018 compared with 49.4% for the prior year. The decrease in the effective tax rate can be attributed to a tax benefit of $0.4 million recorded in December 2018 and to the estimated $2.9 million one-time net deferred tax revaluation expense recorded in December 2017, both due to the enactment of the Tax Act. The effective tax rates for the years ended December 31, 2018 and 2017, excluding the tax benefit and one-time net deferred tax revaluation, were 18.8%1 and 29.5%2, respectively. The following table presents income tax expense and the effective tax rate for the years indicated, and the dollar and percent change (in thousands): The effective tax rate increased to 49.4% for the year ended December 31, 2017 compared with 30.5% for the prior year. The increase in the effective tax rate can be attributed to the $2.9 million one-time reduction in the net deferred tax asset as a result of the remeasurement required under GAAP due to the enactment of the Tax Act. The effective tax rate for the year ended December 31, 2017, excluding one-time net deferred tax asset revaluation, was 29.5%2. 1 ($4,009 income tax expense + 445 revaluation of net deferred tax expense) / $23,635 income before income tax expense. 2 ($7,262 income tax expense - $2,927 revaluation of net deferred tax expense) / $14,692 income before income tax expense. Financial Condition The following table presents selected financial information at December 31, 2018 and 2017, and the dollar and percent change (in thousands): Cash and cash equivalents The increase in cash and cash equivalents can be mostly attributed to an increase in deposits and a decrease in securities, offset by a decrease in FHLBNY advances and other debt. Investment securities The decrease in securities available for sale and held to maturity can be mostly attributed to maturities and calls exceeding new purchases of investment securities. Loans, net Total loans remained level with the prior year, however, changes included increases of $16.1 million in commercial mortgages and $4.6 million in commercial and agricultural loans, offset by decreases of $11.7 million in residential mortgages, $3.7 million in indirect consumer loans, and $5.2 million in other consumer loans. The increase in the commercial loan portfolio was primarily from the Capital Bank Division and the decrease in other consumer loans can be mostly attributed to a decrease in the indirect automobile loan portfolio. Goodwill and other intangible assets, net The decrease in goodwill and other intangible assets, net can be attributed to amortization of other intangible assets. There were no impairments of goodwill or other intangible assets during the years ended December 31, 2018 and 2017. Other assets The decrease in other assets can be mostly attributed to depreciation in premises and equipment and a decrease in the net deferred tax asset, offset by purchases in premises and equipment and an increase in interest rate swap assets. Deposits The increase in deposits can be attributed to increases of $16.8 million in non-interest bearing demand deposit accounts, $30.6 million in interest-bearing demand deposit accounts, $24.2 million in money market accounts, and $31.9 million in time deposits, due to a rate promotion, offset by a decrease of $1.6 million in savings accounts. The increase in interest-bearing demand deposits was mainly attributable to the Corporation converting its off balance sheet sweep agreement accounts into interest-bearing demand deposits in 2018 which resulted in the onboarding of approximately $30.0 million in deposits. FHLBNY advances and other debt The decrease in FHLBNY advances and other debt can be mostly attributed to an increase in deposits and a decline in securities. Shareholders’ equity The increase in shareholders' equity was due primarily to an increase in retained earnings of $14.6 million, which was a result of earnings of $19.6 million, offset by $5.0 million in dividends declared during the current year. The increase in accumulated other comprehensive loss of $1.1 million can be attributed to the decline in the fair market value of the securities portfolio due to rising interest rates. Also, treasury stock decreased $1.8 million, due to the issuance of shares to the Corporation's employee benefit stock plans and directors' stock plans. Assets under management or administration The market value of total assets under management or administration in our WMG was $1.768 billion, including $283.0 million of assets held under management or administration for the Corporation, at December 31, 2018 compared with $1.952 billion, including $346.8 million of assets held under management or administration for the Corporation, at December 31, 2017, a decrease of $183.4 million, or 9.4%. Balance Sheet Comparisons The table below contains selected average balance sheet information for each year in the five-year period ended December 31, 2018 (in millions): (1) Average interest-earning assets include securities available for sale and securities held to maturity based on amortized cost, loans and loans held for sale net of deferred loan fees, interest-earning deposits, FHLBNY stock, FRBNY stock and federal funds sold. For 2018 and 2017, average interest-earning assets also include equity investments. (2) Average loans and loans held for sale, net of deferred loan fees. (3) Average balances for investments include securities available for sale and securities held to maturity, based on amortized cost, FHLBNY stock, FRBNY stock, federal funds sold and interest-earning deposits. For 2018 and 2017, average balances for investments securities also include equity investments. (4) Average borrowings include FHLBNY advances, securities sold under agreements to repurchase and capitalized lease obligations. The table below contains selected year-end balance sheet information for each year in the five-year period ended December 31, 2018 (in millions): (1) Interest-earning assets include securities available for sale, at estimated fair value and securities held to maturity based on amortized cost, equity investments, loans and loans held for sale net of deferred loan fees, interest-earning deposits, FHLBNY stock, FRBNY stock and federal funds sold. (2) Loans and loans held for sale, net of deferred loan fees. (3) Investments include securities available for sale, at estimated fair value, securities held to maturity, at amortized cost, equity investments, FHLBNY stock, FRBNY stock, federal funds sold and interest-earning deposits. (4) Borrowings include FHLBNY overnight and term advances, securities sold under agreements to repurchase and capitalized lease obligations. Cash and Cash Equivalents Total cash and cash equivalents increased $99.2 million since December 31, 2017, due to increases of $5.1 million in cash and due from financial institutions and $94.1 million in interest-earning deposits in other financial institutions. Securities The Corporation’s Funds Management Policy includes an investment policy that in general, requires debt securities purchased for the bond portfolio to carry a minimum agency rating of "A". After an independent credit analysis is performed, the policy also allows the Corporation to purchase local municipal obligations that are not rated. The Corporation intends to maintain a reasonable level of securities to provide adequate liquidity and in order to have securities available to pledge to secure public deposits, repurchase agreements and other types of transactions. Fluctuations in the fair value of the Corporation’s securities relate primarily to changes in interest rates. Marketable securities are classified as Available for Sale, while investments in local municipal obligations are generally classified as Held to Maturity. The composition of the available for sale and held to maturity securities portfolios are summarized in the tables below (in thousands): (a) Other securities consists of corporate bonds and SBA loan pools. The available for sale segment of the securities portfolio totaled $242.3 million at December 31, 2018, a decrease of $50.8 million, or 17.3%, from $293.1 million at December 31, 2017. The decrease resulted primarily from maturities and calls, which exceeded new purchases. The held to maturity segment of the securities portfolio consists of obligations of political subdivisions in the Corporation’s market areas. These securities totaled $4.9 million at December 31, 2018, an increase of $1.1 million or 28.9%, from $3.8 million at December 31, 2017, due primarily to new purchases. Non-marketable equity securities at December 31, 2018 include shares of FRBNY stock and FHLBNY stock, carried at their cost of $1.7 million and $1.4 million, respectively. The fair value of these securities is assumed to approximate their cost. The investment in these stocks is regulated by regulatory policies of the respective institutions. The table below sets forth the carrying amounts and maturities of available for sale and held to maturity debt securities at December 31, 2018 and the weighted average yields of such securities (all yields are calculated on the basis of the amortized cost and weighted for the scheduled maturity of each security, except mortgage-backed securities which are based on the average life at the projected prepayment speed of each security) (in thousands): Management evaluates securities for OTTI on a quarterly basis, and more frequently when economic or market conditions warrant such an evaluation. For the years ended December 31, 2018 and 2017, the Corporation had no OTTI charges. Loans The Corporation has reporting systems to monitor: (i) loan originations and concentrations, (ii) delinquent loans, (iii) non-performing assets, including non-performing loans, troubled debt restructurings, other real estate owned, (iv) impaired loans, and (v) potential problem loans. Management reviews these systems on a regular basis. The table below presents the Corporation’s loan composition by type and percentage of total loans at the end of each of the last five years (in thousands): Portfolio loans totaled $1.312 billion at December 31, 2018 and December 31, 2017, however, changes included an increase of $20.7 million, or 2.5%, in total commercial loans, offset by decreases in residential mortgages of $11.7 million or 6.0%, indirect consumer loans of $3.7 million or 2.4%, and consumer loans of $5.2 million or 4.3%. The growth in commercial loans was due primarily to an increase in commercial mortgages in the Capital Bank division in the Albany, New York region. The decrease in indirect consumer loans was a result of the Corporation's decision to control the growth of the indirect consumer loan portfolio, primarily automobile loans. Residential mortgage loans totaled $182.7 million at December 31, 2018, a decrease of $11.7 million, or 6.0%, from December 31, 2017. The decrease in residential mortgages was mainly due to the Corporation selling a majority of its originated loans in the fourth quarter of 2018 in the secondary market. In addition, during 2018, $17.5 million of residential mortgages were sold in the secondary market to Freddie Mac, with an additional $0.4 million of residential mortgages sold to the State of New York Mortgage Agency. The Corporation anticipates that future growth in portfolio loans will continue to be in commercial loans, especially within the Capital Bank division of the Bank. The table below presents the Corporation’s outstanding loan balance by bank division (in thousands): Loan concentrations are considered to exist when there are amounts loaned to a multiple number of borrowers engaged in similar activities which would cause them to be similarly impacted by changes in economic or other conditions. The Corporation’s concentration policy limits consider the volume of commercial loans to any one specific industry, sponsor, and by collateral type and location. In addition, the Corporation’s policy limits the volume of non-owner occupied commercial mortgages to four times total risk based capital. At December 31, 2018 and 2017, total non-owner occupied commercial real estate loans divided by total risk based capital was 362.00% and 386.7% respectively. The Corporation also monitors specific NAICS industry classifications of commercial loans to identify concentrations greater than 10.0% of total loans. At December 31, 2018 and 2017, commercial loans to borrowers involved in the real estate, and real estate rental and leasing businesses were 47.2% and 48.1% of total loans, respectively. No other concentration of loans existed in the commercial loan portfolio in excess of 10.0% of total loans as of December 31, 2018 and 2017. The table below shows the maturity of only commercial and agricultural loans and commercial mortgages outstanding as of December 31, 2018. Also provided are the amounts due after one year, classified according to fixed interest rates and variable interest rates (in thousands): Non-Performing Assets Non-performing assets consist of non-accrual loans, non-accrual troubled debt restructurings and other real estate owned that has been acquired in partial or full satisfaction of loan obligations or upon foreclosure. Past due status on all loans is based on the contractual terms of the loan. It is generally the Corporation's policy that a loan 90 days past due be placed on non-accrual status unless factors exist that would eliminate the need to place a loan in this status. A loan may also be designated as non-accrual at any time if payment of principal or interest in full is not expected due to deterioration in the financial condition of the borrower. At the time loans are placed on non-accrual status, the accrual of interest is discontinued and previously accrued interest is reversed. All payments received on non-accrual loans are applied to principal. Loans are considered for return to accrual status when they become current as to principal and interest and remain current for a period of six consecutive months or when, in the opinion of management, the Corporation expects to receive all of its contractual principal and interest. In the case of non-accrual loans where a portion of the loan has been charged off, the remaining balance is kept in non-accrual status until the entire principal balance has been recovered. The following table summarizes the Corporation's non-performing assets, excluding purchased credit impaired loans (in thousands): NON-PERFORMING ASSETS (1) These loans are not included in nonperforming assets above. The table below shows interest income on non-accrual and troubled debt restructured loans for the indicated years ended December 31 (in thousands): Non-Performing Loans Non-performing loans totaled $12.3 million at December 31, 2018, or 0.93% of total loans, compared with $17.3 million at December 31, 2017, or 1.32% of total loans. The decrease in non-performing loans at December 31, 2018 as compared to December 31, 2017 was primarily due to decreases of $3.2 million in non-accruing commercial and industrial loans, $1.0 million in non-accruing commercial mortgages and $0.5 million in non-accruing residential mortgages. The decrease in non-accruing commercial and industrial loans was due primarily to the charge-off of multiple large commercial loans to one borrower for $3.6 million during the second quarter of 2018. Non-performing assets, which are comprised of non-performing loans and other real estate owned, was $12.8 million, or 0.73% of total assets, at December 31, 2018, compared with $19.3 million, or 1.13% of total assets, at December 31, 2017. The recorded investment in accruing loans past due 90 days or more totaled less than $0.1 million at December 31, 2018, consistent with the prior year. There were no PCI loans as of December 31, 2018. Not included in non-performing loan totals are $0.8 million of acquired loans which the Corporation has identified as PCI loans at December 31, 2017. The PCI loans are accounted for under separate accounting guidance, ASC Subtopic 310-30, “Receivables - Loans and Debt Securities Acquired with Deteriorated Credit Quality”. Troubled Debt Restructurings The Corporation works closely with borrowers that have financial difficulties to identify viable solutions that minimize the potential for loss. In that regard, the Corporation modified the terms of select loans to maximize their collectability. The modified loans are considered TDRs under current accounting guidance. Modifications generally involve short-term deferrals of principal and/or interest payments, reductions of scheduled payment amounts, interest rates or principal of the loan, and forgiveness of accrued interest. As of December 31, 2018 and 2017, the Corporation had $6.0 million of non-accrual TDRs. As of December 31, 2018, the Corporation had $0.8 million of accruing TDRs compared with $1.7 million as of December 31, 2017. Impaired Loans A loan is classified as impaired when, based on current information and events, it is probable that the Corporation will be unable to collect both the principal and interest due under the contractual terms of the loan agreement. The unpaid principal balance of impaired loans at December 31, 2018 totaled $8.8 million, including TDRs of $6.8 million, compared to $14.1 million at December 31, 2017, including TDRs of $7.7 million. Not included in the impaired loan totals at December 31, 2017, are acquired loans which the Corporation has identified as PCI loans, as these loans are accounted for under ASC Subtopic 310-30 as noted under the above discussion of non-performing loans. The decrease in impaired loans was primarily in the commercial loan segment of the loan portfolio related to the charge-off of multiple large commercial loans to one borrower for $3.6 million during the second quarter of 2018. Included in the recorded investment of impaired loans at December 31, 2018, are loans totaling $3.7 million for which impairment allowances of $2.2 million have been specifically allocated to the allowance for loan losses. As of December 31, 2017, the impaired loan total included $8.1 million of loans for which specific impairment allowances of $5.9 million were allocated to the allowance for loan losses. The decrease in the amount of impaired loans for which specific allowances were allocated to the allowance for loan losses was due primarily to the charge-off of multiple large commercial loans to one borrower for $3.6 million during the second quarter of 2018. The majority of the Corporation's impaired loans are secured and measured for impairment based on collateral evaluations. It is the Corporation's policy to obtain updated appraisals, by independent third parties, on loans secured by real estate at the time a loan is determined to be impaired. An impairment measurement is performed based upon the most recent appraisal on file to determine the amount of any specific allocation or charge-off. In determining the amount of any specific allocation or charge-off, the Corporation will make adjustments to reflect the estimated costs to sell the property. Upon receipt and review of the updated appraisal, an additional measurement is performed to determine if any adjustments are necessary to reflect the proper provisioning or charge-off. Impaired loans are reviewed on a quarterly basis to determine if any changes in credit quality or market conditions would require any additional allocation or recognition of additional charge-offs. Real estate values in the Corporation's market area have been holding steady. Non-real estate collateral may be valued using (i) an appraisal, (ii) net book value of the collateral per the borrower’s financial statements, or (iii) accounts receivable aging reports, that may be adjusted based on management’s knowledge of the client and client’s business. If market conditions warrant, future appraisals are obtained for both real estate and non-real estate collateral. Allowance for Loan Losses The allowance is an amount that management believes will be adequate to absorb probable incurred losses on existing loans. The allowance is established based on management’s evaluation of the probable inherent losses in our portfolio in accordance with GAAP, and is comprised of both specific valuation allowances and general valuation allowances. A loan is classified as impaired when, based on current information and events, it is probable that the Corporation will be unable to collect both the principal and interest due under the contractual terms of the loan agreement. Specific valuation allowances are established based on management’s analyses of individually impaired loans. Factors considered by management in determining impairment include payment status, evaluations of the underlying collateral, expected cash flows, and the probability of collecting scheduled principal and interest payments when due. Loans that experience insignificant payment delays and payment shortfalls generally are not classified as impaired. Management determines the significance of payment delays and payment shortfalls on a case-by-case basis, taking into consideration all of the circumstances surrounding the loan and the borrower, including the length of the delay, the reasons for the delay, the borrower’s prior payment record, and the amount of the shortfall in relation to the principal and interest owed. If a loan is determined to be impaired and is placed on non-accrual status, all future payments received are applied to principal and a portion of the allowance is allocated so that the loan is reported, net, at the present value of estimated future cash flows using the loan’s existing rate or at the fair value of collateral if repayment is expected solely from the collateral. The general component covers non-impaired loans and is based on historical loss experience adjusted for current factors. Loans not impaired but classified as substandard and special mention use a historical loss factor on a rolling five year history of net losses. For all other unclassified loans, the historical loss experience is determined by portfolio class and is based on the actual loss history experienced by the Corporation over the most recent two years. This actual loss experience is supplemented with other qualitative factors based on the risks present for each portfolio class. These qualitative factors include consideration of the following: (1) lending policies and procedures, including underwriting standards and collection, charge-off and recovery policies, (2) national and local economic and business conditions and developments, including the condition of various market segments, (3) loan profiles and volume of the portfolio, (4) the experience, ability, and depth of lending management and staff, (5) the volume and severity of past due, classified and watch-list loans, non-accrual loans, troubled debt restructurings, and other modifications (6) the quality of the Bank’s loan review system and the degree of oversight by the Bank’s Board of Directors, (7) collateral related issues: secured vs. unsecured, type, declining valuation environment and trend of other related factors, (8) the existence and effect of any concentrations of credit, and changes in the level of such concentrations, (9) the effect of external factors, such as competition and legal and regulatory requirements, on the level of estimated credit losses in the Bank’s current portfolio and (10) the impact of the global economy. The allowance for loan losses is increased through a provision for loan losses charged to operations. Loans are charged against the allowance for loan losses when management believes that the collectability of all or a portion of the principal is unlikely. Management's evaluation of the adequacy of the allowance for loan losses is performed on a quarterly basis and takes into consideration such factors as the credit risk grade assigned to the loan, historical loan loss experience and review of specific impaired loans. While management uses available information to recognize losses on loans, future additions to the allowance may be necessary based on changes in economic conditions. In addition, various regulatory agencies, as an integral part of their examination process, periodically review the Corporation's allowance for loan losses. Such agencies may require the Corporation to recognize additions to the allowance based on their judgments about information available to them at the time of their examination. The allowance for loan losses was $18.9 million at December 31, 2018, compared to $21.2 million at December 31, 2017. The decrease in the allowance for loan losses can be mostly attributed to a decrease in specific impairments related to the charge-off of multiple commercial loans to one borrower for $3.6 million, offset by an increase in volume and loss factors relating to the commercial loan portfolio. The ratio of allowance for loan losses to total loans was 1.44% at December 31, 2018 and 1.61% at December 31, 2017, respectively. Net charge-offs for the years ended December 31, 2018 and 2017 were $5.4 million and $2.1 million, respectively. The table below summarizes the Corporation’s allocation of the allowance for loan losses and percent of loans by category to total loans for each year in the five-year period ended December 31, 2018 (in thousands): The table below summarizes the Corporation's loan loss experience for each year in the five-year period ended December 31, 2018 (in thousands, except ratio data): Net charge-offs for the year ended December 31, 2018 were $5.4 million compared with $2.1 million for the year ended December 31, 2017. The ratio of net charge-offs to average loans outstanding was 0.41% for 2018 compared to 0.17% for 2017. The increase in net charge-offs can be attributed to the charge-off of multiple large commercial loans to one borrower for $3.6 million during the second quarter of 2018. Other Real Estate Owned At December 31, 2018, OREO totaled $0.6 million compared to $1.9 million at December 31, 2017. The decrease in other real estate owned was due primarily to nine commercial properties being sold throughout 2018 in the amount of $1.6 million. Deposits The table below summarizes the Corporation’s deposit composition by segment at December 31, 2018, 2017, and 2016, and the dollar and percent change from December 31, 2017 to December 31, 2018 and December 31, 2016 to December 31, 2017 (in thousands): Deposits totaled $1.569 billion at December 31, 2018, compared with $1.467 billion at December 31, 2017, an increase of $101.8 million, or 6.9%. At December 31, 2018, demand deposit and money market accounts comprised 76.6% of total deposits compared with 77.0% at December 31, 2017. The growth in deposits was attributable to increases of $16.8 million in non-interest bearing demand deposits, $30.6 million in interest-bearing demand deposits, $24.2 million in money market accounts, and $31.9 million in time deposits, due to a rate promotion, offset by a decrease of $1.6 million in savings accounts. The increase in interest-bearing demand deposits was mainly attributable to the Corporation converting its off balance sheet sweep agreement accounts into interest-bearing demand deposits during 2018 which resulted in the onboarding of approximately $30.0 million in deposits. At December 31, 2018, public funds deposits totaled $306.5 million compared to $299.5 million at December 31, 2017. The Corporation has developed a program for the retention and management of public funds deposits. These deposits are from public entities, such as school districts and municipalities. There is a seasonal component to public deposit levels associated with annual tax collections. Public funds deposits will increase at the end of the first and third quarters. Public funds deposit accounts above the FDIC insured limit are collateralized by municipal bonds and eligible government and government agency securities such as those issued by the FHLB, Fannie Mae, and Freddie Mac. The table below summarizes the Corporation’s public funds deposit composition by segment (in thousands): As of December 31, 2018, the aggregate amount of the Corporation's outstanding certificates of deposit in amounts greater than or equal to $100,000 was $58.8 million. The table below presents the Corporation's scheduled maturity of those certificates as of December 31, 2018 (in thousands): The table below presents the Corporation's deposits balance by bank division (in thousands): In addition to consumer, commercial and public deposits, other sources of funds include brokered deposits. The recently enacted Regulatory Relief Act changed the definition of brokered deposits, such that subject to certain conditions, reciprocal deposits of another depository institution obtained through a deposit placement network for purposes of obtaining maximum deposit insurance would not be considered brokered deposits subject to the FDIC's brokered-deposit regulations. This will apply to the Corporation's participation in the CDARS and ICS programs. The CDARS and ICS programs involve a network of financial institutions that exchange funds among members in order to ensure FDIC insurance coverage on customer deposits above the single institution limit. Using a sophisticated matching system, funds are exchanged on a dollar-for-dollar basis, so that the equivalent of an original deposit comes back to the originating institution. The Corporation had no deposits obtained through brokers as of December 31, 2018 and 2017. Deposits obtained through the CDARS and ICS programs were $193.6 million and $187.7 million as of December 31, 2018 and 2017, respectively. The Corporation’s deposit strategy is to fund the Bank with stable, low-cost deposits, primarily checking account deposits and other low interest-bearing deposit accounts. A checking account is the driver of a banking relationship and consumers consider the bank where they have their checking account as their primary bank. These customers will typically turn to their primary bank first when in need of other financial services. Strategies that have been developed and implemented to generate these deposits include: (i) acquire deposits by entering new markets through denovo branching, (ii) an annual checking account marketing campaign, (iii) training branch employees to identify and meet client financial needs with Bank products and services, (iv) link business and consumer loans to a primary checking account at the Bank, (v) aggressively promote direct deposit of client’s payroll checks or benefit checks and (vi) constantly monitor the Corporation’s pricing strategies to ensure competitive products and services. The Corporation also considers brokered deposits to be an element of its deposit strategy and anticipates that it will use brokered deposits as a secondary source of funding to support growth. Information regarding deposits is included in Note 7 to the consolidated financial statements appearing elsewhere in this report. Borrowings There were no outstanding FHLBNY advances at December 31, 2018 compared with $59.7 million at December 31, 2017. During 2018, FHLBNY overnight advances decreased $57.7 million and FHLBNY term advances decreased $2.0 million. FHLBNY overnight advances decreased due to an increase in deposits and a decrease in securities available for sale. For each of the three years ended December 31, 2018, 2017 and 2016, respectively, the average outstanding balance of borrowings that mature in one year or less did not exceed 30% of shareholders' equity. Information regarding securities sold under agreements to repurchase and FHLBNY advances is included in Footnotes 8 and 9 to the audited consolidated financial statements appearing elsewhere in this report. The following is a summary of securities sold under agreements to repurchase as of and for the years ended December 31, 2018, 2017 and 2016 (in thousands): The following is a summary of FHLBNY overnight advances as of and for the years ended December 31, 2018, 2017, and 2016 (in thousands): The following is a summary of FHLBNY term advances as of and for the years ended December 31, 2018, 2017, and 2016. The carrying amount includes the advance plus purchase accounting adjustments that are amortized over the term of the advance (in thousands): Derivatives The Corporation offers interest rate swap agreements to qualified commercial loan customers. These agreements allow the Corporation’s customers to effectively fix the interest rate on a variable rate loan by entering into a separate agreement. Simultaneous with the execution of such an agreement with a customer, the Corporation enters into a matching interest rate swap agreement with an unrelated third party provider, which allows the Corporation to continue to receive the variable rate under the loan agreement with the customer. The agreement with the third party is not designated as a hedge contract, therefore changes in fair value are recorded through other non-interest income. Assets and liabilities associated with the agreements are recorded in other assets and other liabilities on the balance sheet. Gains and losses are recorded as other non-interest income. The Corporation is exposed to credit loss equal to the fair value of the interest rate swaps, not the notional amount of the derivatives, in the event of nonperformance by the counterparty to the interest rate swap agreements. Additionally, the swap agreements are free-standing derivatives and are recorded at fair value in the Corporation's consolidated balance sheets, which typically involves a day one gain. Since the terms of the two interest rate swap agreements are identical, the income statement impact to the Corporation is limited to the day one gain and an allowance for credit loss exposure, in the event of nonperformance. The Corporation recognized $0.2 million for both the years ended December 31, 2018 and 2017. The Corporation also participates in the credit exposure of certain interest rate swaps in which it participates in the related commercial loan. The Corporation receives an upfront fee for participating in the credit exposure of the interest rate swap and recognizes the fee to other non-interest income immediately. The Corporation is exposed to its share of the credit loss equal to the fair value of the derivatives in the event of nonperformance by the counter-party of the interest rate swap. The Corporation determines the fair value of the credit loss exposure using historical losses of the loan category associated with the credit exposure. Information regarding derivatives is included in Note 11 to the consolidated financial statements appearing elsewhere in this report. Shareholders’ Equity Total shareholders’ equity was $165.0 million at December 31, 2018, compared with $149.8 million at December 31, 2017, an increase of $15.2 million, or 10.2%. The increase in retained earnings of $14.6 million was due primarily to earnings of $19.6 million offset by $5.0 million in dividends declared during the year. The increase in accumulated other comprehensive loss of $1.1 million can be attributed to the decrease in the fair market value of the securities portfolio as a result of an increase in interest rates. Also, treasury stock decreased $1.8 million, due to the issuance of shares to the Corporation's employee benefit stock plans and directors' stock plans. Total shareholders’ equity to total assets ratio was 9.40% at December 31, 2018 compared with 8.77% at December 31, 2017. Tangible equity to tangible assets ratio increased to 8.19% at December 31, 2018, from 7.48% at December 31, 2017. The Bank is subject to capital adequacy guidelines of the Federal Reserve which establish a framework for the classification of financial institutions into five categories: well-capitalized, adequately capitalized, undercapitalized, significantly undercapitalized and critically undercapitalized. As of December 31, 2018, the Bank’s capital ratios were in excess of those required to be considered well-capitalized under regulatory capital guidelines. A comparison the Bank’s actual capital ratios to the ratios required to be adequately or well-capitalized at December 31, 2018 and 2017, is included in Footnote 19 to the consolidated financial statements appearing elsewhere in this report. For more information regarding current capital regulations see Part I-“Business-Supervision and Regulation-Regulatory Capital Requirements.” Cash dividends declared during 2018 totaled $5.0 million, or $1.04 per share, and cash dividends declared during 2017 and 2016 totaled $4.9 million, or $1.04 per share. Dividends declared during 2018 amounted to 25.42% of net income compared to 66.30%, and 48.76% of net income for 2017 and 2016, respectively. Management seeks to continue generating sufficient capital internally, while continuing to pay dividends to the Corporation’s shareholders. When shares of the Corporation become available in the market, the Corporation may purchase them after careful consideration of the Corporation’s liquidity and capital positions. Purchases may be made from time to time on the open market or in privately negotiated transactions at the discretion of management. On December 19, 2012, the Board of Directors approved a stock repurchase plan under which the Corporation may repurchase up to 125,000 shares. No shares were purchased under the plan in 2018 and 2017. The Corporation has purchased 3,094 shares at a total cost of $93,000 under the plan since its inception. Off-balance Sheet Arrangements In the normal course of operations, the Corporation engages in a variety of financial transactions that, in accordance with GAAP are not recorded in the financial statements. The Corporation is also a party to certain financial instruments with off balance sheet risk such as commitments under standby letters of credit, unused portions of lines of credit, commitments to fund new loans, interest rate swaps, and risk participation agreements. The Corporation's policy is to record such instruments when funded. These transactions involve, to varying degrees, elements of credit, interest rate and liquidity risk. Such transactions are generally used by the Corporation to manage clients' requests for funding and other client needs. The table below shows the Corporation’s off-balance sheet arrangements as of December 31, 2018 (in thousands): (1) Not included in this total are unused portions of home equity lines of credit, credit card lines and consumer overdraft protection lines of credit, since no contractual maturity dates exist for these types of loans. Commitments to outside parties under these lines of credit were $50.2 million, $13.1 million and $7.5 million, respectively, at December 31, 2018. Contractual Obligations The table below shows the Corporation’s contractual obligations under long-term agreements as of December 31, 2018 (in thousands). Note references are to the Notes of the Consolidated Financial Statements: (1) Not included in the above total is the Corporation's obligation regarding the Pension Plan and Other Benefit Plans. Please refer to Part IV Item 15 Note 13 for information regarding these obligations at December 31, 2018. Liquidity Liquidity management involves the ability to meet the cash flow requirements of deposit clients, borrowers, and the operating, investing and financing activities of the Corporation. The Corporation uses a variety of resources to meet its liquidity needs. These include short term investments, cash flow from lending and investing activities, core-deposit growth and non-core funding sources, such as time deposits of $100,000 or more, securities sold under agreements to repurchase and other borrowings. The Corporation is a member of the FHLBNY which allows it to access borrowings which enhance management's ability to satisfy future liquidity needs. Based on available collateral and current advances outstanding, the Corporation was eligible to borrow up to a total of $112.6 million and $73.5 million at December 31, 2018 and 2017, respectively. The Corporation also had a total of $28.0 million of unsecured lines of credit with four different financial institutions, all of which were available at December 31, 2018. The Corporation had a total of $38.0 million of unsecured lines of credit with five different financial institutions, all of which was available at December 31, 2017. Consolidated Cash Flows Analysis The table below summarizes the Corporation's cash flows for the years indicated (in thousands): Operating activities The Corporation believes cash flows from operations, available cash balances and its ability to generate cash through short- and long-term borrowings are sufficient to fund the Corporation’s operating liquidity needs. Cash provided by operating activities in years ended December 31, 2018 and 2017 predominantly resulted from net income after non-cash operating adjustments. Investing activities Cash provided by investing activities during the year ended December 31, 2018 predominantly resulted from calls, maturities, and principal collected on securities available for sale, offset by purchases of securities available for sale and a net increase in loans. Cash used in investing activities during the year ended December 31, 2017 predominantly resulted from purchases of securities available for sale and a net increase in loans, offset by sales, calls, maturities, and principal collected on securities available for sale. Financing activities Cash provided by financing activities during the year ended December 31, 2018 resulted from an increase in deposits, offset by the repayment of FHLBNY overnight advances, FHLBNY term advances and securities sold under agreements to repurchase. Cash provided by financing activities during the year ended December 31, 2017 predominantly resulted from an increase in deposits and FHLBNY overnight advances, offset by the repayment of FHLBNY term advances and securities sold under agreements to repurchase. Capital Resources The Bank is subject to regulatory capital requirements administered by federal banking agencies. Capital adequacy guidelines and prompt corrective action regulations, involve quantitative measures of assets, liabilities, and certain off-balance-sheet items calculated under regulatory accounting practices. Capital amounts and classifications are also subject to qualitative judgments by regulators. Failure to meet capital requirements can initiate regulatory action. The final rules implementing Basel III rules became effective for the Bank on January 1, 2015 with full compliance with all of the requirements being phased in over a multi-year schedule, and fully phased in by January 1, 2019. Under Basel III rules, the Bank must hold a capital conservation buffer above the adequately capitalized risk-based capital ratios. The capital conservation buffer was phased in from 0.0% for 2015 to 2.50% by 2019. The capital conservation buffer for 2018 was 1.875%. The net unrealized gain or loss on available for sale securities and changes in the funded status of the defined benefit pension plan and other benefit plans are not included in computing regulatory capital. Pursuant to the Regulatory Relief Act, the FRB proposed a rule that establishes a community bank leverage ratio (tangible equity to average consolidated assets) at 9% for institutions under $10 billion in assets that such institutions may elect to utilize in lieu of the general applicable risk-based capital requirements under Basel III. Such institutions that meet the community bank leverage ratio and certain other qualifying criteria will automatically be deemed to be well-capitalized. Until the FRB’s proposed rule is finalized, the Basel III risk-based and leverage ratios remain in effect. Prompt corrective action regulations provide five classifications: well capitalized, adequately capitalized, undercapitalized, significantly undercapitalized, and critically undercapitalized, although these terms are not used to represent overall financial condition. If adequately capitalized, regulatory approval is required to accept brokered deposits. If undercapitalized, capital distributions are limited, as is asset growth and expansion, and capital restoration plans are required. Management believes that, as of December 31, 2017, the Corporation and the Bank met all capital adequacy requirements to which they were subject. Management believes that, as of December 31, 2018, the Bank met all capital adequacy requirements to which it was subject. At December 31, 2018, the Corporation is no longer subject to FRB consolidated capital requirements applicable to bank holding companies, which are similar to those applicable to the Bank, until it reaches $3.0 billion in assets. As of December 31, 2018, the most recent notification from the Federal Reserve Bank of New York categorized the Bank as well capitalized under the regulatory framework for prompt corrective action. To be categorized as well capitalized the Bank must maintain minimum total risk-based, Tier 1 risk-based, common equity Tier 1 risk-based and Tier 1 leverage ratios as set forth in the table below. There have been no conditions or events since that notification that management believes have changed the Bank's capital category. The regulatory capital ratios as of December 31, 2018 and 2017 were calculated under Basel III rules. There is no threshold for well-capitalized status for bank holding companies. The Corporation’s and the Bank’s actual and required regulatory capital ratios were as follows (in thousands, except ratio data): Dividend Restrictions The Corporation’s principal source of funds for dividend payments is dividends received from the Bank. Banking regulations limit the amount of dividends that may be paid without prior approval of regulatory agencies. Under these regulations, the amount of dividends that may be paid in any calendar year is limited to the current year’s net income, combined with the retained net income of the preceding two years, subject to the capital requirements in the table above. At December 31, 2018, the Bank could, without prior approval, declare dividends of approximately $23.5 million. Adoption of New Accounting Standards For a discussion of the impact of recently issued accounting standards, please see Note 1 to the Corporation's consolidated financial statements which begins on page. Critical Accounting Policies, Estimates and Risks and Uncertainties Critical accounting policies include the areas where the Corporation has made what it considers to be particularly difficult, subjective or complex judgments concerning estimates, and where these estimates can significantly affect the Corporation's financial results under different assumptions and conditions. The Corporation prepares its financial statements in conformity with GAAP. As a result, the Corporation is required to make certain estimates, judgments and assumptions that it believes are reasonable based upon the information available at that time. These estimates, judgments and assumptions affect the reported amounts of assets and liabilities at the date of the financial statements and the reported amounts of revenue and expenses during the years presented. Actual results could be different from these estimates. Management considers the accounting policy relating to the allowance for loan losses to be a critical accounting policy given the uncertainty in evaluating the level of the allowance required to cover probable incurred credit losses inherent in the loan portfolio, and the material effect that such judgments can have on the Corporation's results of operations. While management's current evaluation of the allowance for loan losses indicates that the allowance is adequate, under adversely different conditions or assumptions the allowance would need to be increased. For example, if historical loan loss experience significantly worsened or if current economic conditions significantly deteriorated, additional provisions for loan losses would be required to increase the allowance. In addition, the assumptions and estimates used in the internal reviews of the Corporation's non-performing loans and potential problem loans, and the associated evaluation of the related collateral coverage for these loans, has a significant impact on the overall analysis of the adequacy of the allowance for loan losses. Real estate values in the Corporation’s market area did not increase dramatically in the prior several years, and, as a result, any declines in real estate values have been modest. While management has concluded that the current evaluation of collateral values is reasonable under the circumstances, if collateral evaluations were significantly lowered, the Corporation's allowance for loan losses policy would also require additional provisions for loan losses. Explanation and Reconciliation of the Corporation’s Use of Non-GAAP Measures The Corporation prepares its Consolidated Financial Statements in accordance with GAAP; these financial statements appear on pages through. That presentation provides the reader with an understanding of the Corporation’s results that can be tracked consistently from year-to-year and enables a comparison of the Corporation’s performance with other companies’ GAAP financial statements. In addition to analyzing the Corporation’s results on a reported basis, management uses certain non-GAAP financial measures, because it believes these non-GAAP financial measures provide information to investors about the underlying operational performance and trends of the Corporation and, therefore, facilitate a comparison of the Corporation with the performance of its competitors. Non-GAAP financial measures used by the Corporation may not be comparable to similarly named non-GAAP financial measures used by other companies. The SEC has adopted Regulation G, which applies to all public disclosures, including earnings releases, made by registered companies that contain “non-GAAP financial measures.” Under Regulation G, companies making public disclosures containing non-GAAP financial measures must also disclose, along with each non-GAAP financial measure, certain additional information, including a reconciliation of the non-GAAP financial measure to the closest comparable GAAP financial measure and a statement of the Corporation’s reasons for utilizing the non-GAAP financial measure as part of its financial disclosures. The SEC has exempted from the definition of “non-GAAP financial measures” certain commonly used financial measures that are not based on GAAP. When these exempted measures are included in public disclosures, supplemental information is not required. The following measures used in this Report, which are commonly utilized by financial institutions, have not been specifically exempted by the SEC and may constitute "non-GAAP financial measures" within the meaning of the SEC's rules, although we are unable to state with certainty that the SEC would so regard them. Fully Taxable Equivalent Net Interest Income and Net Interest Margin Net interest income is commonly presented on a tax-equivalent basis. That is, to the extent that some component of the institution's net interest income, which is presented on a before-tax basis, is exempt from taxation (e.g., is received by the institution as a result of its holdings of state or municipal obligations), an amount equal to the tax benefit derived from that component is added to the actual before-tax net interest income total. This adjustment is considered helpful in comparing one financial institution's net interest income to that of other institutions or in analyzing any institution’s net interest income trend line over time, to correct any analytical distortion that might otherwise arise from the fact that financial institutions vary widely in the proportions of their portfolios that are invested in tax-exempt securities, and that even a single institution may significantly alter over time the proportion of its own portfolio that is invested in tax-exempt obligations. Moreover, net interest income is itself a component of a second financial measure commonly used by financial institutions, net interest margin, which is the ratio of net interest income to average interest-earning assets. For purposes of this measure as well, fully taxable equivalent net interest income is generally used by financial institutions, as opposed to actual net interest income, again to provide a better basis of comparison from institution to institution and to better demonstrate a single institution’s performance over time. The Corporation follows these practices. Efficiency Ratio The unadjusted efficiency ratio is calculated as non-interest expense divided by total revenue (net interest income and non-interest income). The adjusted efficiency ratio is a non-GAAP financial measure which represents the Corporation’s ability to turn resources into revenue and is calculated as non-interest expense divided by total revenue (fully taxable equivalent net interest income and non-interest income), adjusted for one-time occurrences and amortization. This measure is meaningful to the Corporation, as well as investors and analysts, in assessing the Corporation’s productivity measured by the amount of revenue generated for each dollar spent. Tangible Equity and Tangible Assets (Year-End) Tangible equity, tangible assets, and tangible book value per share are each non-GAAP financial measures. Tangible equity represents the Corporation’s stockholders’ equity, less goodwill and intangible assets. Tangible assets represents the Corporation’s total assets, less goodwill and other intangible assets. Tangible book value per share represents the Corporation’s equity divided by common shares at year-end. These measures are meaningful to the Corporation, as well as investors and analysts, in assessing the Corporation’s use of equity. Tangible Equity (Average) Average tangible equity and return on average tangible equity are each non-GAAP financial measures. Average tangible equity represents the Corporation’s average stockholders’ equity, less average goodwill and intangible assets for the year. Return on average tangible equity measures the Corporation’s earnings as a percentage of average tangible equity. These measures are meaningful to the Corporation, as well as investors and analysts, in assessing the Corporation’s use of equity. Adjustments for Certain Items of Income or Expense In addition to disclosures of certain GAAP financial measures, including net income, EPS, ROA, and ROE, we may also provide comparative disclosures that adjust these GAAP financial measures for a particular year by removing from the calculation thereof the impact of certain transactions or other material items of income or expense occurring during the year, including certain nonrecurring items. The Corporation believes that the resulting non-GAAP financial measures may improve an understanding of its results of operations by separating out any such transactions or items that may have had a disproportionate positive or negative impact on the Corporation’s financial results during the particular year in question. In the Corporation’s presentation of any such non-GAAP (adjusted) financial measures not specifically discussed in the preceding paragraphs, the Corporation supplies the supplemental financial information and explanations required under Regulation G.

<s>[INST] The following is the MD&A of the Corporation in this Form 10K at December 31, 2018 and 2017, and for the years ended December 31, 2018, 2017, and 2016. The purpose of this discussion is to focus on information about the financial condition and results of operations of the Corporation. Reference should be made to the accompanying audited consolidated financial statements and footnotes for an understanding of the following discussion and analysis. See the list of commonly used abbreviations and terms on pages 14. The MD&A included in this Form 10K contains statements that are forwardlooking within the meaning of the Private Securities Litigation Reform Act of 1995. These statements are based on the current beliefs and expectations of the Corporation's management and are subject to significant risks and uncertainties. Actual results may differ from those set forth in the forwardlooking statements. For a discussion of those risks and uncertainties and the factors that could cause the Corporation’s actual results to differ materially from those risks and uncertainties, see Forwardlooking Statements below. The Corporation has been a financial holding company since 2000, and the Bank was established in 1833, CFS in 2001, and CRM in 2016. Through the Bank and CFS, the Corporation provides a wide range of financial services, including demand, savings and time deposits, commercial, residential and consumer loans, interest rate swaps, letters of credit, wealth management services, employee benefit plans, insurance products, mutual funds and brokerage services. The Bank relies substantially on a foundation of locally generated deposits. The Corporation, on a standalone basis, has minimal results of operations. The Bank derives its income primarily from interest and fees on loans, interest on investment securities, WMG fee income and fees received in connection with deposit and other services. The Bank’s operating expenses are interest expense paid on deposits and borrowings, salaries and employee benefit plans and general operating expenses. CRM, a whollyowned subsidiary of the Corporation which was formed and began operations on May 31, 2016, is a Nevadabased captive insurance company that insures against certain risks unique to the operations of the Corporation and its subsidiaries and for which insurance may not be currently available or economically feasible in today's insurance marketplace. CRM pools resources with several other similar insurance company subsidiaries of financial institutions to spread a limited amount of risk among themselves. CRM is subject to regulations of the State of Nevada and undergoes periodic examinations by the Nevada Division of Insurance. Forwardlooking Statements This discussion contains forwardlooking statements within the meaning of Section 27A of the Securities Act, Section 21E of the Exchange Act, and the Private Securities Litigation Reform Act of 1995. The Corporation intends its forwardlooking statements to be covered by the safe harbor provisions for forwardlooking statements in these sections. All statements regarding the Corporation's expected financial position and operating results, the Corporation's business strategy, the Corporation's financial plans, forecasted demographic and economic trends relating to the Corporation's industry and similar matters are forwardlooking statements. These statements can sometimes be identified by the Corporation's use of forwardlooking words such as "may," "will," "anticipate," "estimate," "expect," or "intend." The Corporation cannot promise that its expectations in such forwardlooking statements will turn out to be correct. The Corporation's actual results could be materially different from expectations because of various factors, including changes in economic conditions or interest rates, credit risk, difficulties in managing the Corporation’s growth, competition, changes in law or the regulatory environment, including the DoddFrank Act, and changes in general business and economic trends. Information concerning these and other factors can be found in the Corporation’s periodic filings with the SEC, including the discussion under the heading “Item 1A. Risk Factors” of this Form 10K. The Corporation's quarterly filings are available publicly on the SEC’s web site at http://www.sec.gov, on the Corporation's web site at http://www.chemungcanal.com or by written request to: Kathleen S. McKillip, Corporate Secretary, Chemung Financial Corporation [/INST] Negative. </s>

CHEMUNG FINANCIAL CORP

2020-03-12

2019-12-31

ITEM 7. MANAGEMENT'S DISCUSSION AND ANALYSIS OF FINANCIAL CONDITION AND RESULTS OF OPERATION Overview The following is the MD&A of the Corporation in this Form 10-K at December 31, 2019 and 2018, and for the years ended December 31, 2019, 2018, and 2017. The purpose of this discussion is to focus on information about the financial condition and results of operations of the Corporation. Reference should be made to the accompanying audited consolidated financial statements and footnotes for an understanding of the following discussion and analysis. See the list of commonly used abbreviations and terms on pages 1-4. The MD&A included in this Form 10-K contains statements that are forward-looking within the meaning of the Private Securities Litigation Reform Act of 1995. These statements are based on the current beliefs and expectations of the Corporation's management and are subject to significant risks and uncertainties. Actual results may differ from those set forth in the forward-looking statements. For a discussion of those risks and uncertainties and the factors that could cause the Corporation’s actual results to differ materially from those risks and uncertainties, see Forward-looking Statements below. The Corporation has been a financial holding company since 2000, and the Bank was established in 1833, CFS in 2001, and CRM in 2016. Through the Bank and CFS, the Corporation provides a wide range of financial services, including demand, savings and time deposits, commercial, residential and consumer loans, interest rate swaps, letters of credit, wealth management services, employee benefit plans, insurance products, mutual funds and brokerage services. The Bank relies substantially on a foundation of locally generated deposits. The Corporation, on a stand-alone basis, has minimal results of operations. The Bank derives its income primarily from interest and fees on loans, interest on investment securities, WMG fee income and fees received in connection with deposit and other services. The Bank’s operating expenses are interest expense paid on deposits and borrowings, salaries and employee benefit plans and general operating expenses. CRM, a wholly-owned subsidiary of the Corporation which was formed and began operations on May 31, 2016, is a Nevada-based captive insurance company that insures against certain risks unique to the operations of the Corporation and its subsidiaries and for which insurance may not be currently available or economically feasible in today's insurance marketplace. CRM pools resources with several other similar insurance company subsidiaries of financial institutions to spread a limited amount of risk among themselves. CRM is subject to regulations of the State of Nevada and undergoes periodic examinations by the Nevada Division of Insurance. Forward-looking Statements This discussion contains forward-looking statements within the meaning of Section 27A of the Securities Act, Section 21E of the Exchange Act, and the Private Securities Litigation Reform Act of 1995. The Corporation intends its forward-looking statements to be covered by the safe harbor provisions for forward-looking statements in these sections. All statements regarding the Corporation's expected financial position and operating results, the Corporation's business strategy, the Corporation's financial plans, forecasted demographic and economic trends relating to the Corporation's industry and similar matters are forward-looking statements. These statements can sometimes be identified by the Corporation's use of forward-looking words such as "may," "will," "anticipate," "estimate," "expect," or "intend." The Corporation cannot guarantee that its expectations in such forward-looking statements will turn out to be correct. The Corporation's actual results could be materially different from expectations because of various factors, including changes in economic conditions or interest rates, credit risk, difficulties in managing the Corporation’s growth, competition, changes in law or the regulatory environment, including the Dodd-Frank Act, and changes in general business and economic trends. Information concerning these and other factors can be found in the Corporation’s periodic filings with the SEC, including the discussion under the heading “Item 1A. Risk Factors” of this annual report on Form 10-K. The Corporation's quarterly filings are available publicly on the SEC’s web site at http://www.sec.gov, on the Corporation's web site at http://www.chemungcanal.com or by written request to: Kathleen S. McKillip, Corporate Secretary, Chemung Financial Corporation, One Chemung Canal Plaza, Elmira, NY 14901. Except as otherwise required by law, the Corporation undertakes no obligation to publicly update or revise its forward-looking statements, whether as a result of new information, future events or otherwise. Consolidated Financial Highlights Executive Summary This executive summary of the MD&A includes selected information and may not contain all of the information that is important to readers of this annual report on Form 10-K. For a complete description of the trends and uncertainties, as well as the risks and critical accounting estimates affecting the Corporation, this annual report on Form 10-K should be read in its entirety. The following table presents selected financial information for the years indicated, and the dollar and percent change (in thousands, except per share and ratio data): (a) See the GAAP to Non-GAAP reconciliations on pages 68-71. Net income for the year ended December 31, 2019 was $15.6 million, or $3.21 per share, compared with net income of $19.6 million, or $4.06 per share, for the prior year. Return on average equity for the year ended December 31, 2019 was 8.86%, compared with 12.76% for the prior year. The decrease in net income for the year ended December 31, 2019, compared to the prior year, was driven by a decrease in non-interest income and an increase in the provision for loan losses, partially offset by an increase in net interest income and decreases in non-interest expenses and income tax expense. Net interest income Net interest income increased $0.1 million, or 0.2% in 2019, compared with the prior year. The increase was due primarily to the impact of an increase of $35.9 million in average interest-earning assets, offset by the impact of an eight basis points decline in net interest margin. Non-interest income Non-interest income decreased $3.0 million, or 13.0% in 2019, compared to the prior year. The decrease was due primarily to decreases of $1.9 million in the change in fair value of equity investments, $0.9 million in other non-interest income, $0.2 million in net gains (losses) on sales of other real estate owned, and $0.3 million in service charges on deposit accounts, offset by an increase of $0.2 million in WMG fee income and an increase of $0.2 million in CFS fee and commission income. The decrease in the change in fair value of equity investments was due primarily to the $2.1 million increase in the fair value of Visa Class B shares in the prior year, and a $0.1 million loss related to an investment in a limited partnership in the current year. Subsequent to the change in fair value, the Visa Class B shares were sold during the third quarter of 2018. The decrease in other non-interest income was due to a $0.4 million state sales tax refund in the prior year, a decrease of $0.1 million in rental income from other property owned in the prior year, and a decrease of $0.1 million in interest rate swap income primarily due to changes in market value in the current year. The increase in WMG fee income can be mostly attributed to an increase in the market value of assets under management and additional fee income from terminating trusts. CFS fee and commission income increased in 2019 compared to the prior year due to an increase in transaction activity. Non-interest expenses Non-interest expenses decreased $1.1 million, or 1.9% in 2019. The decrease was due primarily to decreases of $1.0 million in legal accruals and settlements, $0.6 million in net occupancy expenses, $0.6 million in FDIC insurance expense, $0.3 million in professional services, $0.3 million in other real estate owned expenses, and $0.2 in marketing and advertising expenses. These items were partially offset by increases of $1.1 million in salaries and wages, $0.4 million in pension and other employee benefits, $0.4 million in data processing expenses, and $0.1 million in other non-interest expenses. The decrease in legal accruals and settlements was due to the resolution by way of a settlement agreement in the matter of Fane v. Chemung Canal Trust Company. This matter was settled in March 2018. Additional information can be found in Footnote 17 of the attached Financial Statements. The decrease in net occupancy and furniture and equipment expenses was mostly attributable to a reduction in depreciation expense related to mechanical equipment, the closing of two branches in 2019, and the reduction in non-capitalizable fixed asset purchases as compared to the prior year due to the opening of two new branches in 2018. The decrease in FDIC insurance expense was primarily due to the receipt of a $0.4 million credit related to the Deposit Insurance Fund’s (DIF) minimum reserve ratio assessment. The decrease in professional services was due to consulting fees incurred in the prior year associated with a sales tax refund in the prior year. The decrease in other real estate owned expenses can be attributed to a reduction in the number of OREO properties in 2019 as compared to 2018. The decrease in marketing and advertising expenses was due to an increased marketing effort in 2018 to support the opening of two denovo branches during the year. The increase in salaries and wages can be attributed to annual merit increases and a lower vacancy rate in 2019. The increase in pension and other employee benefits can be attributed to full vesting of stock awards related to an executive retirement and an increase in payroll tax and health insurance expenses. The increase in other non-interest expense can be attributed to a $0.3 million charge taken to recognize the impairment of a fixed asset. For the years ended December 31, 2019 and 2018, the ratio of non-interest expense to average assets was 3.16% and 3.31%, respectively. Provision for loan losses The provision for loan losses increased $2.8 million, or 88.6% in 2019, compared to the prior year. The increase was primarily the result of specific impairments in loans identified as impaired, including $1.8 million in specific reserves related to a commercial real estate loan and $4.2 million in specific reserves related to a participating interest in a commercial and industrial credit, offset by a decline in volume and loss factors on commercial and consumer unclassified pooled loans. Net charge-offs were $1.4 million in 2019, compared with $5.4 million for the prior year. The decrease in net charge-offs was due primarily to the charge-off of multiple large commercial loans to one borrower for $3.6 million during the second quarter of 2018. Income tax expense Income tax expense decreased $0.6 million, or 14.3% in 2019, compared to the prior year. The effective tax rate for 2019 increased to 18.0% compared with 17.0% for the prior year. The decrease in income tax expense was primarily due to a decrease in pretax income. The following table presents selected financial information for the years indicated, and the dollar and percent change (in thousands, except per share and ratio data): (a) See the GAAP to Non-GAAP reconciliations on pages 69-72. Net income for the year ended December 31, 2018 was $19.6 million, or $4.06 per share, compared with $7.4 million, or $1.55 per share, for the prior year. Return on equity for the year ended December 31, 2018 was 12.76%, compared with 4.91% for the prior year. The increase in net income for the year ended December 31, 2018, compared to the prior year, was driven by increases in net interest income and non-interest income, and decreases in the provision for loan losses and income tax expense, partially offset by an increase in non-interest expenses. Net interest income Net interest income increased $3.5 million, or 6.1% in 2018, compared with the prior year. The increase was due primarily to an increase of $14.9 million in average interest-earning assets, and a 16 basis points increase in net interest margin. Non-interest income Non-interest income increased $2.6 million, or 12.6% in 2018, compared to the prior year. The increase was due primarily to an increase in the fair value of equity investments as a result of the sale of Visa Class B shares, WMG fee income, and interchange revenue from debit card transactions, partially offset by a decrease in service charges on deposit accounts. Non-interest expense Non-interest expense increased $3.0 million, or 5.6% in 2018, compared to the prior year. The increase was due primarily to the increases in salaries and wages, net occupancy expenses, data processing expenses, professional services, marketing and advertising expenses, and other real estate owned expenses and a decrease in other components of net periodic pension cost (benefits). For the years ended December 31, 2018 and 2017, non-interest expense to average assets was 3.31% and 3.14%, respectively. Provision for loan losses The provision for loan losses decreased $5.9 million, or 65.1% in 2018, compared to the prior year. The decrease was primarily the result of specific impairments in loans identified as impaired, including $4.9 million in specific reserves for eight commercial loans to two long-standing relationships in the Southern Tier of New York recorded in 2017, a decrease in volume and loss factors relating to the residential, home equity, and the indirect and consumer portfolios, partially offset by an increase in volume and loss factors in the commercial loan portfolio. Net charge-offs were $5.4 million in 2018, compared with $2.1 million for the prior year. The increase in the net charge-offs was due primarily to the charge-off of multiple large commercial loans to one borrower for $3.6 million during the second quarter of 2018. Income tax expense Income tax expense decreased $3.3 million, or 44.8% in 2018, compared to the prior year. The effective tax rate for 2018 decreased to 17.0% compared with 49.4% for the prior year. The decreases in income tax expense the effective tax rate can be attributed to a tax benefit of $0.4 million recorded in December 2018 and to the estimated $2.9 million one-time net deferred tax revaluation expense recorded in December 2017, both due to the enactment of the Tax Act. Additionally, the Corporation increased income generated from CCTC Funding Corp., a real estate investment trust subsidiary of the Bank, reducing the Corporation's state income tax expense. Consolidated Results of Operations The following section of the MD&A provides a comparative discussion of the Corporation’s Consolidated Results of Operations on a reported basis for the years ended December 31, 2019 and 2018 and for the years ended December 31, 2018 and 2017. For a discussion of the Critical Accounting Policies, Estimates and Risks and Uncertainties that affect the Consolidated Results of Operations, see page 68. Net Interest Income The following table presents net interest income for the years indicated, and the dollar and percent change (in thousands): Net interest income, which is the difference between the interest income earned on interest-earning assets, such as loans and securities and the interest expense accrued on interest-bearing liabilities, such as deposits and borrowings, is the largest contributor to the Corporation’s earnings. Net interest income for the year ended December 31, 2019 totaled $60.6 million, an increase of $0.1 million, or 0.2%, compared with $60.5 million for the prior year. Fully taxable equivalent net interest margin was 3.64% for the year ended December 31, 2019 compared with 3.72% for the prior year. The increase in total interest and dividend income in 2019 was due primarily to increases in interest income on interest-earning deposits of $1.5 million, interest and fees from loans of $0.4 million, and interest income from taxable securities of $0.5 million, compared to the prior year. The increase in total interest expense in 2019 was due primarily to an increase in interest expense on deposits of $2.9 million, offset by decreases in interest expense on securities sold under agreements to repurchase of $0.1 million, and interest expense on borrowed funds of $0.5 million, compared to the prior year. Average interest-earning assets increased $35.9 million in 2019 when compared to the prior year. The average yield on average interest-earning assets increased 6 basis points, while the average cost of interest-bearing liabilities increased 20 basis points, as compared to the prior year. As compared to 2018, total interest income increased by $2.4 million. Interest income on interest-earning deposits was up $1.5 million due to a $67 million increase in average balances, and income on taxable securities increased by $0.5 million mainly due to an increase in average yield of 24 basis points. The increase in average interest-earning deposits was primarily driven by decreases in average total loan balances and increases in average total deposits. Additionally, interest on Commercial loans increased by $1.1 million due to an increase in average balances as well as an increase in average rates. This was offset by a decline of $0.5 million in consumer loan income, which declined mainly due to a decrease in average volume, and a decline of $0.2 million in mortgage loan income. Total interest expense increased by $2.2 million. This was mostly driven by interest on savings and money market deposits, time deposits, and interest-bearing demand deposits, which increased by $1.0 million, $1.4 million, and $0.4 million respectively, mainly due to increases in average rates due to competitive factors. This increase in expense was offset by a decrease in borrowing expense of $0.6 million, which was driven mainly due to a decrease in average volume due to a decline in average overnight FHLBNY advances. The following table presents net interest income for the years indicated, and the dollar and percent change (in thousands): Net interest income for the year ended December 31, 2018 totaled $60.5 million, an increase of $3.5 million, or 6.1%, compared with $57.0 million for the prior year. Fully taxable equivalent net interest margin was 3.72% for the year ended December 31, 2018 compared with 3.56% for the prior year. The increase in total interest and dividend income in 2018 was due primarily to increases in interest and fees of $5.0 million from loans and interest income of $0.2 million from interest-earning deposits, while interest and dividend income from securities decreased $0.7 million compared to the prior year. The increase in total interest expense in 2018 was due primarily to increases in interest expense of $1.2 million on deposits and $0.2 million on borrowed funds, while interest expense on securities sold under agreements to repurchase decreased $0.3 million, compared to the prior year. Average interest-earning assets increased $14.9 million in 2018 when compared to the prior year. The average yield on average interest-earning assets increased 21 basis points, while the average cost of interest-bearing liabilities increased nine basis points, as compared to the prior year. The increase in interest and dividend income in 2018 was due primarily to a $61.6 million increase in the average balance of commercial loans, primarily commercial mortgages, along with a 22 basis points increase in the average yield on commercial loans as a result of the rising interest rate environment, and a $14.3 million increase in the average balance of consumer loans, compared to the prior year. The increase in interest expense in 2018 was due primarily to an increase in interest rates on interest-bearing deposit accounts, including promotional interest rates on time deposits, offset by a 41 basis points decrease in the average cost on borrowed funds due to the maturity of one $2.0 million FHLB term advance (3.05% rate) in January and one $10.0 million repurchase agreement (3.72% rate) in May 2018, as compared to the prior year. Average Consolidated Balance Sheet and Interest Analysis The following table presents certain information related to the Corporation’s average consolidated balance sheets and its consolidated statements of income for the years ended December 31, 2019, 2018 and 2017. It also reflects the average yield on interest-earning assets and average cost of interest-bearing liabilities for the years ended December 31, 2019, 2018 and 2017. For the purpose of the table below, non-accruing loans are included in the daily average loan amounts outstanding. Daily balances were used for average balance computations. Investment securities are stated at amortized cost. Tax equivalent adjustments have been made in calculating yields on obligations of states and political subdivisions, tax-free commercial loans and dividends on equity investments. With the new 21% statutory federal tax rate effective January 1, 2018, the conversion factor to a fully taxable equivalent basis decreased in 2018. The decline had no impact on net income, but caused the net interest margin on a fully taxable equivalent basis to decrease. (1) Net interest rate spread is the difference in the average yield on interest-earning assets less the average cost of interest-bearing liabilities. (2) Net interest margin is the ratio of fully taxable equivalent net interest income divided by average interest-earning assets. Changes Due to Rate and Volume Net interest income can be analyzed in terms of the impact of changes in rates and volumes. The table below illustrates the extent to which changes in interest rates and in the volume of average interest-earning assets and interest-bearing liabilities have affected the Corporation’s interest income and interest expense during the years indicated. Information is provided in each category with respect to (i) changes attributable to changes in volume (changes in volume multiplied by prior rate); (ii) changes attributable to changes in rates (changes in rates multiplied by prior volume); and (iii) the net changes. For purposes of this table, changes that are not due solely to volume or rate changes have been allocated to these categories based on the respective percentage changes in average volume and rate. Due to the numerous simultaneous volume and rate changes during the years analyzed, it is not possible to precisely allocate changes between volume and rates. In addition, average interest-earning assets include non-accrual loans and taxable equivalent adjustments were made. Provision for loan losses Management performs an ongoing assessment of the adequacy of the allowance for loan losses based upon a number of factors including an analysis of historical loss factors, collateral evaluations, recent charge-off experience, credit quality of the loan portfolio, current economic conditions and loan growth. Based on this analysis, the provision for loan losses for the years ended December 31, 2019, 2018 and 2017 were $5.9 million, $3.2 million and $9.0 million, respectively. The increase in provision for loan losses in 2019, as compared to 2018, was primarily the result of specific impairments in loans identified as impaired, including $1.8 million in specific reserves related to a commercial real estate loan and $4.2 million in specific reserves related to a participating interest in a commercial and industrial credit, offset by a decline in volume and loss factors on commercial and consumer unclassified pooled loans. The decrease in provision for loan losses in 2018, as compared to 2017, was due primarily to $4.9 million in specific reserves for commercial loans to two long-standing relationships in the Southern Tier of New York recorded in 2017, a decrease in volume and loss factors relating to the residential, home equity, and the indirect and consumer portfolios, partially offset by an increase in volume and loss factors in the commercial loan portfolio. Net charge-offs for the years ended December 31, 2019, 2018 and 2017 were $1.4 million, $5.4 million and $2.1 million, respectively. Non-interest income The following table presents non-interest income for the years indicated, and the dollar and percent change (in thousands): Non-interest income for the year ended December 31, 2019 was $20.1 million compared with $23.1 million for the prior year, a decrease of $3.0 million, or 13.0%. The decrease was due primarily to decreases of $1.9 million in the change in fair value of equity investments, $0.9 million in other non-interest income, $0.2 million in net gains (losses) on sales of other real estate owned, and $0.3 million in service charges on deposit accounts, offset by an increase of $0.2 million in WMG fee income and an increase of $0.2 million in CFS fee and commission income. WMG fee income WMG fee income increased in 2019 compared to the prior year primarily due to an increase in average assets under management and additional fee income from terminating trusts. Service charges on deposit accounts Service charges on deposit accounts decreased in 2019 compared to the prior year due to a decrease in overdraft fee income. Net gains (losses) on sales of other real estate owned Net losses on sales of other real estate owned was due to losses on properties sold. Change in fair value of equity investments Change in fair value of equity investments decreased in 2019 compared to the prior year due primarily to the increase in the fair value of Visa Class B shares in the prior year. Subsequent to the change in fair value, the Visa Class B shares were sold during the third quarter of 2018. CFS fee and commission income CFS fee and commission income increased in 2019 compared to the prior year due to an increase in transaction activity. Other non-interest income Other non-interest income decreased in 2019 compared to the prior year due primarily to a one time refund in sales tax in 2018, a decrease in swap fees and a decline in rental income on OREO properties. The following table presents non-interest income for the years indicated, and the dollar and percent change (in thousands): Total non-interest income for year ended December 31, 2018 increased $2.6 million compared to the prior year. The increase was due primarily to increases in the fair value of equity investments, WMG fee income and interchange revenue from debit card transactions, partially offset by a decrease in service charges on deposits accounts. WMG fee income WMG fee income increased in 2018 compared to the prior year due to an increase in average assets under management or administration. Service charges on deposit accounts Service charges on deposit accounts decreased in 2018 compared to the prior year due to a decrease in overdraft fees. Interchange revenue from debit card transactions Interchange revenue from debit card transactions increased in 2018 compared to the prior year due to an increase in the volume of transactions. Net gains on securities transactions Net gains on securities transactions decreased in 2018 compared to the prior year due to there being no sales of securities in 2018. Change in fair value of equity investments Change in fair value of equity investments increased in 2018 compared to the prior year due primarily to the increase in the fair value of Visa Class B shares. Subsequent to the change in fair value, the Visa Class B shares were sold during the third quarter of 2018. CFS fee and commission income CFS fee and commission income decreased in 2018 compared to the prior year due to a decrease in transaction activity. Non-interest expenses The following table presents non-interest expenses for the years indicated, and the dollar and percent change (in thousands): Non-interest expense decreased $1.1 million, or 1.9% in 2019. The decrease was due primarily to decreases of $1.0 million in legal accruals and settlements, $0.6 million in net occupancy expenses, $0.6 million in FDIC insurance expense, $0.3 million in professional services, $0.3 million in other real estate owned expenses, and $0.2 in marketing and advertising expenses. These items were partially offset by increases of $1.1 million in salaries and wages, $0.4 million in pension and other employee benefits, $0.4 million in data processing expenses, and $0.1 million in other non-interest expenses. Compensation expenses Compensation expenses increased in 2019 compared to the prior year due to increases in salaries and wages, and pension and other employee benefit expense. The increase in salaries and wages can be attributed to annual merit increases and a lower vacancy rate in 2019. The increase in pension and other employee benefits can be partially attributed to full vesting of stock awards related to an executive retirement and increases in payroll tax and health insurance expenses. Non-compensation expenses The decrease in legal accruals and settlements was due to the resolution by way of a settlement agreement in the matter of Fane v. Chemung Canal Trust Company. This matter was settled in March 2018. Additional information can be found in Footnote 17 of the attached Financial Statements. The decrease in net occupancy and furniture and equipment expenses was mostly attributable to a reduction in depreciation expense related to mechanical equipment, the closing of two branches in 2019, and the reduction in non-capitalizable fixed asset purchases as compared to the prior year due to the opening of two new branches in 2018. The decrease in FDIC insurance expense was primarily due to the receipt of a $0.4 million credit related to the Deposit Insurance Fund’s (DIF) minimum reserve ratio assessment. The decrease in professional services was due to consulting fees incurred in the prior year associated with a sales tax refund in the prior year. The decrease in other real estate owned expenses can be attributed to a reduction in the number of OREO properties in 2019 as compared to 2018. The decrease in marketing and advertising expenses was due to an increased marketing effort in 2018 to support the opening of two denovo branches during the year. The increase in other non-interest expense can be attributed to a $0.3 million charge taken to recognize the impairment of a fixed asset. The following table presents non-interest expense for the years indicated, and the dollar and percent change (in thousands): Total non-interest expenses for the year ended December 31, 2018 increased $3.0 million compared with the prior year. The decrease was primarily due to decreases in compensation and non-compensation expenses. Compensation expenses Compensation expenses increased in 2018 compared to the prior year due to an increase in salaries and wages and a decrease in other components of net periodic pension and postretirement cost (benefits). The increase in salaries and wages can be attributed to annual merit increases and an increase in headcount with two denovo branches which opened in 2018. The decrease in other components of net periodic pension cost (benefits) was due primarily to a $0.8 million charge related to a lump sum settlement to terminated, vested employees in 2018. Non-compensation expenses Non-compensation expenses increased in 2018 compared to the prior year primarily due to increases in net occupancy, data processing, professional services, marketing and advertising, and other real estate owned expense, offset by a decrease in furniture and equipment expenses. The increase in net occupancy and data processing expenses can be attributed to the two new denovo branches, along with the timing of various projects. The increase in marketing and advertising can be attributed to advertising campaigns related to the opening of the two denovo branches. The increase in other real estate owned expense can be attributed to additional OREO properties acquired during 2017 and 2018. Income tax expense The following table presents income tax expense and the effective tax rate for the years indicated, and the dollar and percent change (in thousands): The effective tax rate increased to 18.0% for the year ended December 31, 2019 compared with 17.0% for the prior year. The increase in the effective tax rate can be attributed to a tax benefit of $0.4 million recorded in December 2018 due to the enactment of the Tax Act. The decrease in income tax expense can be attributed to a decrease in pre-tax income. The following table presents income tax expense and the effective tax rate for the years indicated, and the dollar and percent change (in thousands): The effective tax rate decreased to 17.0% for the year ended December 31, 2018 compared with 49.4% for the prior year. The decrease in the effective tax rate can be attributed to a tax benefit of $0.4 million recorded in December 2018 and to the estimated $2.9 million one-time net deferred tax revaluation expense recorded in December 2017, both due to the enactment of the Tax Act. The effective tax rates for the years ended December 31, 2018 and 2017, excluding the tax benefit and one-time net deferred tax revaluation, were 18.8%1 and 29.5%2, respectively. 1 ($4,009 income tax expense + 445 revaluation of net deferred tax expense) / $23,635 income before income tax expense. 2 ($7,262 income tax expense - $2,927 revaluation of net deferred tax expense) / $14,692 income before income tax expense. Financial Condition The following table presents selected financial information at December 31, 2019 and 2018, and the dollar and percent change (in thousands): Cash and cash equivalents The decrease in cash and cash equivalents can be mostly attributed to changes in securities, loans, deposits, and borrowings, offset by net income. Investment securities The increase in securities available for sale and held to maturity can be mostly attributed to purchases of investment securities exceeding sales, maturities and calls. Loans, net The decrease in total loans, net, can be mostly attributed to decreases of $14.4 million in indirect consumer loans, $12.4 million in commercial mortgages, and $9.0 million in other consumer loans, offset by increases of $27.4 million in commercial and agriculture loans and $5.6 million in residential mortgages. Goodwill and other intangible assets, net The decrease in goodwill and other intangible assets, net can be attributed to amortization of other intangible assets. There were no impairments of goodwill or other intangible assets during the years ended December 31, 2019 and 2018. Other assets The increase in other assets can be mostly attributed to an increase of $8.7 million in operating lease right-of-use assets related to the adoption of ASU No. 2016-02 Leases as of January 1, 2019. Deposits The increase in deposits can be attributed to increases of $20.5 million in interest-bearing demand deposits and $11.0 million in time deposits, offset by decreases of $7.7 million in money market accounts and $16.2 million in non-interest bearing demand deposits. The increase in interest-bearing demand deposits was due primarily to commercial deposits and the increase in time deposits was primarily due to increases in personal municipal certificates of deposits. The decrease in non-interest-bearing demand deposits was mostly attributable to a decrease in personal customer deposits. The decrease in money market accounts can mostly be attributed to a decrease in ICS deposits, offset by an increase in personal customer deposits. FHLBNY advances and other debt The decrease in FHLBNY advances and other debt can be attributed to a decrease in long term capital lease obligations. Other Liabilities The increase in other liabilities can be mostly attributed to an increase in operating lease liabilities related to the January 1, 2019 adoption of ASU No. 2016-02 Leases. Shareholders’ equity The increase in shareholders' equity was due primarily to an increase in retained earnings of $10.6 million, which was a result of earnings of $15.6 million, offset by $5.0 million in dividends declared during the current year. The decrease in accumulated other comprehensive loss of $5.6 million can be attributed to the increase in the fair value of the securities portfolio. Also, treasury stock decreased $0.9 million, due to the issuance of shares to the Corporation's employee benefit stock plans and directors' stock plans. Assets under management or administration The market value of total assets under management or administration in our WMG was $1.915 billion, including $289.7 million of assets held under management or administration for the Corporation, at December 31, 2019 compared with $1.768 billion, including $283.0 million of assets held under management or administration for the Corporation, at December 31, 2018, an increase of $147.1 million, or 8.3%. Balance Sheet Comparisons The table below contains selected average balance sheet information for each year in the five-year period ended December 31, 2019 (in millions): (1) Average interest-earning assets include securities available for sale and securities held to maturity based on amortized cost, loans and loans held for sale net of deferred loan fees, interest-earning deposits, FHLBNY stock, FRBNY stock and federal funds sold. For 2019, 2018 and 2017, average interest-earning assets also include equity investments. (2) Average loans and loans held for sale, net of deferred loan fees. (3) Average balances for investments include securities available for sale and securities held to maturity, based on amortized cost, FHLBNY stock, FRBNY stock, federal funds sold and interest-earning deposits. For 2019, 2018 and 2017, average balances for investments securities also include equity investments. (4) Average borrowings include FHLBNY advances, securities sold under agreements to repurchase and capitalized lease obligations. The table below contains selected year-end balance sheet information for each year in the five-year period ended December 31, 2019 (in millions): (1) Interest-earning assets include securities available for sale, at estimated fair value and securities held to maturity based on amortized cost, equity investments, loans and loans held for sale net of deferred loan fees, interest-earning deposits, FHLBNY stock, FRBNY stock and federal funds sold. (2) Loans and loans held for sale, net of deferred loan fees. (3) Investments include securities available for sale, at estimated fair value, securities held to maturity, at amortized cost, equity investments, FHLBNY stock, FRBNY stock, federal funds sold and interest-earning deposits. (4) Borrowings include FHLBNY overnight and term advances, securities sold under agreements to repurchase and capitalized lease obligations. Cash and Cash Equivalents Total cash and cash equivalents decreased $8.1 million since December 31, 2018, due to decreases of $7.8 million in cash and due from financial institutions and $0.2 million in interest-earning deposits in other financial institutions. Securities The Corporation’s Funds Management Policy includes an investment policy that in general, requires debt securities purchased for the bond portfolio to carry a minimum agency rating of "A". After an independent credit analysis is performed, the policy also allows the Corporation to purchase local municipal obligations that are not rated. The Corporation intends to maintain a reasonable level of securities to provide adequate liquidity and in order to have securities available to pledge to secure public deposits, repurchase agreements and other types of transactions. Fluctuations in the fair value of the Corporation’s securities relate primarily to changes in interest rates. Marketable securities are classified as Available for Sale, while investments in local municipal obligations are generally classified as Held to Maturity. The composition of the available for sale and held to maturity securities portfolios are summarized in the tables below (in thousands): (a) Other securities consists of corporate bonds and SBA loan pools. The available for sale segment of the securities portfolio totaled $284.1 million at December 31, 2019, an increase of $41.8 million, or 17.3%, from $242.3 million at December 31, 2018. The increase resulted primarily from new purchases which exceeded maturities and calls. The held to maturity segment of the securities portfolio consists of obligations of political subdivisions in the Corporation’s market areas. These securities totaled $3.1 million at December 31, 2019, a decrease of $1.8 million or (36.1)%, from $4.9 million at December 31, 2018, due primarily to maturities. Non-marketable equity securities at December 31, 2019 include shares of FRBNY stock and FHLBNY stock, carried at their cost of $1.8 million and $1.3 million, respectively. The fair value of these securities is assumed to approximate their cost. The investment in these stocks is regulated by regulatory policies of the respective institutions. The table below sets forth the carrying amounts and maturities of available for sale and held to maturity debt securities at December 31, 2019 and the weighted average yields of such securities (all yields are calculated on the basis of the amortized cost and weighted for the scheduled maturity of each security, except mortgage-backed securities which are based on the average life at the projected prepayment speed of each security) (in thousands): Management evaluates securities for OTTI on a quarterly basis, and more frequently when economic or market conditions warrant such an evaluation. For the years ended December 31, 2019 and 2018, the Corporation had no OTTI charges. Loans The Corporation has reporting systems to monitor: (i) loan originations and concentrations, (ii) delinquent loans, (iii) non-performing assets, including non-performing loans, troubled debt restructurings, other real estate owned, (iv) impaired loans, and (v) potential problem loans. Management reviews these systems on a regular basis. The table below presents the Corporation’s loan composition by type and percentage of total loans at the end of each of the last five years (in thousands): Portfolio loans totaled $1.309 billion at December 31, 2019 and $1.312 billion at December 31, 2018. Changes included an increase of $15.1 million, or 1.7%, in total commercial loans, an increase in residential mortgages of $5.6 million or 3.1%, offset by decreases in indirect consumer loans of $14.4 million or 9.6%, and consumer loans of $9.0 million or 7.7%. The growth in commercial loans was due primarily to an increase in commercial and agricultural loans. The decrease in indirect consumer loans was a result of the Corporation's decision to control the growth of the indirect consumer loan portfolio, primarily automobile loans, and the decrease in consumer loans was primarily due to a decrease in home equity lines and loans. Residential mortgage loans totaled $188.3 million at December 31, 2019, an increase of $5.6 million, or 3.1%, from December 31, 2018. The increase in residential mortgages was mainly due to new originations retained in the portfolio. The Corporation anticipates that future growth in portfolio loans will continue to be in commercial loans, especially within the Capital Bank division of the Bank. Based on this growth and the increased complexity of the loans that the Bank originates, the position of Chief Credit Officer was added to Corporation's Executive Management team. The table below presents the Corporation’s outstanding loan balance by bank division (in thousands): Loan concentrations are considered to exist when there are amounts loaned to a multiple number of borrowers engaged in similar activities which would cause them to be similarly impacted by changes in economic or other conditions. The Corporation’s concentration policy limits consider the volume of commercial loans to any one specific industry, sponsor, and by collateral type and location. In addition, the Corporation’s policy limits the volume of non-owner occupied commercial mortgages to four times total risk based capital. At December 31, 2019 and 2018, total non-owner occupied commercial real estate loans divided by total risk based capital was 330.5% and 362.0% respectively. The Corporation also monitors specific NAICS industry classifications of commercial loans to identify concentrations greater than 10.0% of total loans. At December 31, 2019 and 2018, commercial loans to borrowers involved in the real estate, and real estate rental and leasing businesses were 45.0% and 47.2% of total loans, respectively. No other concentration of loans existed in the commercial loan portfolio in excess of 10.0% of total loans as of December 31, 2019 and 2018. The table below shows the maturity of only commercial and agricultural loans and commercial mortgages outstanding as of December 31, 2019. Also provided are the amounts due after one year, classified according to fixed interest rates and variable interest rates (in thousands): Non-Performing Assets Non-performing assets consist of non-accrual loans, non-accrual troubled debt restructurings and other real estate owned that has been acquired in partial or full satisfaction of loan obligations or upon foreclosure. Past due status on all loans is based on the contractual terms of the loan. It is generally the Corporation's policy that a loan 90 days past due be placed on non-accrual status unless factors exist that would eliminate the need to place a loan in this status. A loan may also be designated as non-accrual at any time if payment of principal or interest in full is not expected due to deterioration in the financial condition of the borrower. At the time loans are placed on non-accrual status, the accrual of interest is discontinued and previously accrued interest is reversed. All payments received on non-accrual loans are applied to principal. Loans are considered for return to accrual status when they become current as to principal and interest and remain current for a period of six consecutive months or when, in the opinion of management, the Corporation expects to receive all of its contractual principal and interest. In the case of non-accrual loans where a portion of the loan has been charged off, the remaining balance is kept in non-accrual status until the entire principal balance has been recovered. The following table summarizes the Corporation's non-performing assets, excluding purchased credit impaired loans (in thousands): NON-PERFORMING ASSETS (1) These loans are not included in nonperforming assets above. The table below shows interest income on non-accrual and troubled debt restructured loans for the indicated years ended December 31 (in thousands): Non-Performing Loans Non-performing loans totaled $18.0 million at December 31, 2019, or 1.38% of total loans, compared with $12.3 million at December 31, 2018, or 0.93% of total loans. The increase in non-performing loans at December 31, 2019 as compared to December 31, 2018 was primarily due to increases of $4.1 million in non-accruing commercial and industrial loans and $2.9 million in non-accruing commercial mortgages, offset by decreases of $0.5 million in non-accruing residential mortgages and $0.5 million in non-accruing home equity lines and loans. The increase in non-accruing commercial and industrial loans was due primarily to the impairment of a commercial and industrial participation loan to one borrower for $4.2 million during the third quarter of 2019. The increase in non-accruing commercial mortgages was due to the impairment of a commercial loan to one borrower in the amount of $1.9 million in the first quarter of 2019. Non-performing assets, which are comprised of non-performing loans and other real estate owned, was $18.5 million, or 1.04% of total assets, at December 31, 2019, compared with $12.8 million, or 0.73% of total assets, at December 31, 2018. The recorded investment in accruing loans past due 90 days or more totaled less than $0.1 million at December 31, 2019, consistent with the prior year. There were no PCI loans as of December 31, 2019 and 2018. Not included in non-performing loan totals are $0.8 million of acquired loans which the Corporation has identified as PCI loans at December 31, 2017. The PCI loans are accounted for under separate accounting guidance, ASC Subtopic 310-30, “Receivables - Loans and Debt Securities Acquired with Deteriorated Credit Quality”. Troubled Debt Restructurings The Corporation works closely with borrowers that have financial difficulties to identify viable solutions that minimize the potential for loss. In that regard, the Corporation modified the terms of select loans to maximize their collectability. The modified loans are considered TDRs under current accounting guidance. Modifications generally involve short-term deferrals of principal and/or interest payments, reductions of scheduled payment amounts, interest rates or principal of the loan, and forgiveness of accrued interest. As of December 31, 2019 and 2018, the Corporation had $8.1 million and $6.0 million of non-accrual TDRs, respectively. As of December 31, 2019, the Corporation had $0.9 million of accruing TDRs compared with $0.8 million as of December 31, 2018. Impaired Loans A loan is classified as impaired when, based on current information and events, it is probable that the Corporation will be unable to collect both the principal and interest due under the contractual terms of the loan agreement. The unpaid principal balance of impaired loans at December 31, 2019 totaled $15.7 million, including TDRs of $9.0 million, compared to $8.8 million at December 31, 2018, including TDRs of $6.8 million. Included in the recorded investment of impaired loans at December 31, 2019, were loans totaling $11.1 million for which impairment allowances of $8.1 million have been specifically allocated to the allowance for loan losses. The increase in impaired loans was primarily in the commercial loan segment of the loan portfolio related to the recognition of impairment for a commercial real estate loan to one borrower in the amount of $1.9 million in the first quarter and the recognition of impairment for a commercial and industrial participation loan to one borrower for $4.2 million during the third quarter of 2019. As of December 31, 2018, the impaired loan total included $3.7 million of loans for which specific impairment allowances of $2.2 million were allocated to the allowance for loan losses. The decrease in the amount of impaired loans for which specific allowances were allocated to the allowance for loan losses was due primarily to the charge-off of multiple large commercial loans to one borrower for $3.6 million during the second quarter of 2018. The majority of the Corporation's impaired loans are secured and measured for impairment based on collateral evaluations. It is the Corporation's policy to obtain updated appraisals, by independent third parties, on loans secured by real estate at the time a loan is determined to be impaired. An impairment measurement is performed based upon the most recent appraisal on file to determine the amount of any specific allocation or charge-off. In determining the amount of any specific allocation or charge-off, the Corporation will make adjustments to reflect the estimated costs to sell the property. Upon receipt and review of the updated appraisal, an additional measurement is performed to determine if any adjustments are necessary to reflect the proper provisioning or charge-off. Impaired loans are reviewed on a quarterly basis to determine if any changes in credit quality or market conditions would require any additional allocation or recognition of additional charge-offs. Real estate values in the Corporation's market area have been holding steady. Non-real estate collateral may be valued using (i) an appraisal, (ii) net book value of the collateral per the borrower’s financial statements, or (iii) accounts receivable aging reports, that may be adjusted based on management’s knowledge of the client and client’s business. If market conditions warrant, future appraisals are obtained for both real estate and non-real estate collateral. Allowance for Loan Losses The allowance is an amount that management believes will be adequate to absorb probable incurred losses on existing loans. The allowance is established based on management’s evaluation of the probable inherent losses in our portfolio in accordance with GAAP, and is comprised of both specific valuation allowances and general valuation allowances. A loan is classified as impaired when, based on current information and events, it is probable that the Corporation will be unable to collect both the principal and interest due under the contractual terms of the loan agreement. Specific valuation allowances are established based on management’s analyses of individually impaired loans. Factors considered by management in determining impairment include payment status, evaluations of the underlying collateral, expected cash flows, and the probability of collecting scheduled principal and interest payments when due. Loans that experience insignificant payment delays and payment shortfalls generally are not classified as impaired. Management determines the significance of payment delays and payment shortfalls on a case-by-case basis, taking into consideration all of the circumstances surrounding the loan and the borrower, including the length of the delay, the reasons for the delay, the borrower’s prior payment record, and the amount of the shortfall in relation to the principal and interest owed. If a loan is determined to be impaired and is placed on non-accrual status, all future payments received are applied to principal and a portion of the allowance is allocated so that the loan is reported, net, at the present value of estimated future cash flows using the loan’s existing rate or at the fair value of collateral if repayment is expected solely from the collateral. The general component covers non-impaired loans and is based on historical loss experience adjusted for current factors. Loans not impaired but classified as substandard and special mention use a historical loss factor on a rolling five year history of net losses. For all other unclassified loans, the historical loss experience is determined by portfolio class and is based on the actual loss history experienced by the Corporation over the most recent two years. This actual loss experience is supplemented with other qualitative factors based on the risks present for each portfolio class. These qualitative factors include consideration of the following: (1) lending policies and procedures, including underwriting standards and collection, charge-off and recovery policies, (2) national and local economic and business conditions and developments, including the condition of various market segments, (3) loan profiles and volume of the portfolio, (4) the experience, ability, and depth of lending management and staff, (5) the volume and severity of past due, classified and watch-list loans, non-accrual loans, troubled debt restructurings, and other modifications (6) the quality of the Bank’s loan review system and the degree of oversight by the Bank’s Board of Directors, (7) collateral related issues: secured vs. unsecured, type, declining valuation environment and trend of other related factors, (8) the existence and effect of any concentrations of credit, and changes in the level of such concentrations, (9) the effect of external factors, such as competition and legal and regulatory requirements, on the level of estimated credit losses in the Bank’s current portfolio and (10) the impact of the global economy. The allowance for loan losses is increased through a provision for loan losses charged to operations. Loans are charged against the allowance for loan losses when management believes that the collectability of all or a portion of the principal is unlikely. Management's evaluation of the adequacy of the allowance for loan losses is performed on a quarterly basis and takes into consideration such factors as the credit risk grade assigned to the loan, historical loan loss experience and review of specific impaired loans. While management uses available information to recognize losses on loans, future additions to the allowance may be necessary based on changes in economic conditions. In addition, various regulatory agencies, as an integral part of their examination process, periodically review the Corporation's allowance for loan losses. Such agencies may require the Corporation to recognize additions to the allowance based on their judgments about information available to them at the time of their examination. The allowance for loan losses was $23.5 million at December 31, 2019, compared to $18.9 million at December 31, 2018. The increase in the allowance for loan losses can be mostly attributed to an increase in specific impairment related to a $1.9 million non-performing commercial mortgage relationship and a participating interest in a $4.2 million commercial credit. The ratio of allowance for loan losses to total loans was 1.79% at December 31, 2019 and 1.44% at December 31, 2018, respectively. Net charge-offs for the years ended December 31, 2019 and 2018 were $1.4 million and $5.4 million, respectively. The table below summarizes the Corporation’s allocation of the allowance for loan losses and percent of loans by category to total loans for each year in the five-year period ended December 31, 2019 (in thousands): The table below summarizes the Corporation's loan loss experience for each year in the five-year period ended December 31, 2019 (in thousands, except ratio data): Net charge-offs for the year ended December 31, 2019 were $1.4 million compared with $5.4 million for the year ended December 31, 2018. The ratio of net charge-offs to average loans outstanding was 0.11% for 2019 compared to 0.41% for 2018. The decrease in net charge-offs in 2019 can be attributed to the charge-off of multiple large commercial loans to one borrower for $3.6 million during the second quarter of 2018. Other Real Estate Owned At December 31, 2019, OREO totaled $0.5 million compared to $0.6 million at December 31, 2018. The decrease in other real estate owned was due primarily to twelve commercial properties being sold throughout 2019 in the amount of $0.6 million. Deposits The table below summarizes the Corporation’s deposit composition by segment at December 31, 2019, 2018, and 2017, and the dollar and percent change from December 31, 2018 to December 31, 2019 and December 31, 2017 to December 31, 2018 (in thousands): Deposits totaled $1.572 billion at December 31, 2019, compared with $1.569 billion at December 31, 2018, an increase of $2.9 million, or 0.2%. At December 31, 2019, demand deposit and money market accounts comprised 76.2% of total deposits compared with 76.6% at December 31, 2018. The growth in deposits was attributable to increases of $20.5 million in interest-bearing demand deposits and $11.0 million of time deposits, offset by decreases of $7.7 million in money market accounts and $16.2 million in non-interest bearing demand deposits. The increase in interest-bearing demand deposits was due primarily to commercial deposits and the increase in time deposits was primarily due to increases in personal and municipal certificates of deposits. The decrease in non-interest-bearing demand deposits was mainly attributable to a decrease in personal customer deposits. The decrease in money market accounts can be mostly attributed to a decrease on ICS deposits, offset by an increase in personal customer deposits. At December 31, 2019, public funds deposits totaled $299.2 million compared to $306.5 million at December 31, 2018. The Corporation has developed a program for the retention and management of public funds deposits. These deposits are from public entities, such as school districts and municipalities. There is a seasonal component to public deposit levels associated with annual tax collections. Public funds deposits will increase at the end of the first and third quarters. Public funds deposit accounts above the FDIC insured limit are collateralized by municipal bonds and eligible government and government agency securities such as those issued by the FHLB, Fannie Mae, and Freddie Mac. The table below summarizes the Corporation’s public funds deposit composition by segment (in thousands): As of December 31, 2019, the aggregate amount of the Corporation's outstanding certificates of deposit in amounts greater than or equal to $100,000 was $74.5 million. The table below presents the Corporation's scheduled maturity of those certificates as of December 31, 2019 (in thousands): The table below presents the Corporation's deposits balance by bank division (in thousands): In addition to consumer, commercial and public deposits, other sources of funds include brokered deposits. The recently enacted Regulatory Relief Act changed the definition of brokered deposits, such that subject to certain conditions, reciprocal deposits of another depository institution obtained through a deposit placement network for purposes of obtaining maximum deposit insurance would not be considered brokered deposits subject to the FDIC's brokered-deposit regulations. This will apply to the Corporation's participation in the CDARS and ICS programs. The CDARS and ICS programs involve a network of financial institutions that exchange funds among members in order to ensure FDIC insurance coverage on customer deposits above the single institution limit. Using a sophisticated matching system, funds are exchanged on a dollar-for-dollar basis, so that the equivalent of an original deposit comes back to the originating institution. The Corporation had no deposits obtained through brokers as of December 31, 2019 and 2018. Deposits obtained through the CDARS and ICS programs were $180.4 million and $193.6 million as of December 31, 2019 and 2018, respectively. The Corporation’s deposit strategy is to fund the Bank with stable, low-cost deposits, primarily checking account deposits and other low interest-bearing deposit accounts. A checking account is the driver of a banking relationship and consumers consider the bank where they have their checking account as their primary bank. These customers will typically turn to their primary bank first when in need of other financial services. Strategies that have been developed and implemented to generate these deposits include: (i) acquire deposits by entering new markets through denovo branching, (ii) an annual checking account marketing campaign, (iii) training branch employees to identify and meet client financial needs with Bank products and services, (iv) link business and consumer loans to a primary checking account at the Bank, (v) aggressively promote direct deposit of client’s payroll checks or benefit checks and (vi) constantly monitor the Corporation’s pricing strategies to ensure competitive products and services. The Corporation also considers brokered deposits to be an element of its deposit strategy and anticipates that it will use brokered deposits as a secondary source of funding to support growth. Information regarding deposits is included in Note 8 to the consolidated financial statements appearing elsewhere in this report. Borrowings There were no outstanding FHLBNY advances at December 31, 2019 and 2018 respectively. For each of the three years ended December 31, 2019, 2018 and 2017, respectively, the average outstanding balance of borrowings that mature in one year or less did not exceed 30% of shareholders' equity. Information regarding securities sold under agreements to repurchase and FHLBNY advances is included in Footnotes 9 and 10 to the audited consolidated financial statements appearing elsewhere in this report. The following is a summary of securities sold under agreements to repurchase as of and for the years ended December 31, 2019, 2018 and 2017 (in thousands): The following is a summary of FHLBNY overnight advances as of and for the years ended December 31, 2019, 2018, and 2017 (in thousands): The following is a summary of FHLBNY term advances as of and for the years ended December 31, 2019, 2018, and 2017. The carrying amount includes the advance plus purchase accounting adjustments that are amortized over the term of the advance (in thousands): Derivatives The Corporation offers interest rate swap agreements to qualified commercial loan customers. These agreements allow the Corporation’s customers to effectively fix the interest rate on a variable rate loan by entering into a separate agreement. Simultaneous with the execution of such an agreement with a customer, the Corporation enters into a matching interest rate swap agreement with an unrelated third party provider, which allows the Corporation to continue to receive the variable rate under the loan agreement with the customer. The agreement with the third party is not designated as a hedge contract, therefore changes in fair value are recorded through other non-interest income. Assets and liabilities associated with the agreements are recorded in other assets and other liabilities on the balance sheet. Gains and losses are recorded as other non-interest income. The Corporation is exposed to credit loss equal to the fair value of the interest rate swaps, not the notional amount of the derivatives, in the event of nonperformance by the counterparty to the interest rate swap agreements. Additionally, the swap agreements are free-standing derivatives and are recorded at fair value in the Corporation's consolidated balance sheets, which typically involves a day one gain. Since the terms of the two interest rate swap agreements are identical, the income statement impact to the Corporation is limited to the day one gain and an allowance for credit loss exposure, in the event of nonperformance. The Corporation recognized $0.1 million and $0.2 million for the years ended December 31, 2019 and 2018, respectively. The Corporation also participates in the credit exposure of certain interest rate swaps in which it participates in the related commercial loan. The Corporation receives an upfront fee for participating in the credit exposure of the interest rate swap and recognizes the fee to other non-interest income immediately. The Corporation is exposed to its share of the credit loss equal to the fair value of the derivatives in the event of nonperformance by the counter-party of the interest rate swap. The Corporation determines the fair value of the credit loss exposure using historical losses of the loan category associated with the credit exposure. Information regarding derivatives is included in Note 12 to the consolidated financial statements appearing elsewhere in this report. Shareholders’ Equity Total shareholders’ equity was $182.6 million at December 31, 2019, compared with $165.0 million at December 31, 2018, an increase of $17.6 million, or 10.7%. The increase in retained earnings of $10.6 million was due primarily to earnings of $15.6 million offset by $5.0 million in dividends declared during the year. The decrease in accumulated other comprehensive loss of $5.6 million can be attributed to the increase in the fair market value of the securities portfolio as a result of a decrease in interest rates. Also, treasury stock decreased $0.9 million, due to the issuance of shares to the Corporation's employee benefit stock plans and directors' stock plans. Total shareholders’ equity to total assets ratio was 10.22% at December 31, 2019 compared with 9.4% at December 31, 2018. Tangible equity to tangible assets ratio increased to 9.07% at December 31, 2019, from 8.19% at December 31, 2018. The Bank is subject to capital adequacy guidelines of the Federal Reserve which establish a framework for the classification of financial institutions into five categories: well-capitalized, adequately capitalized, undercapitalized, significantly undercapitalized and critically undercapitalized. As of December 31, 2019, the Bank’s capital ratios were in excess of those required to be considered well-capitalized under regulatory capital guidelines. A comparison of the Bank’s actual capital ratios to the ratios required to be adequately or well-capitalized at December 31, 2019 and 2018, is included in Footnote 20 to the consolidated financial statements appearing elsewhere in this report. For more information regarding current capital regulations see Part I-“Business-Supervision and Regulation-Regulatory Capital Requirements.” Cash dividends declared during 2019 and 2018, each totaled $5.0 million respectively, and $4.9 million in 2017, or $1.04 per share. Dividends declared during 2019 amounted to 32.28% of net income compared to 25.42%, and 66.30% of net income for 2018 and 2017, respectively. Management seeks to continue generating sufficient capital internally, while continuing to pay dividends to the Corporation’s shareholders. When shares of the Corporation become available in the market, the Corporation may purchase them after careful consideration of the Corporation’s liquidity and capital positions. Purchases may be made from time to time on the open market or in privately negotiated transactions at the discretion of management. On December 19, 2012, the Board of Directors approved a stock repurchase plan under which the Corporation may repurchase up to 125,000 shares. No shares were purchased under the plan in 2019 and 2018. The Corporation has purchased 3,094 shares at a total cost of $93,000 under the plan since its inception. Off-balance Sheet Arrangements In the normal course of operations, the Corporation engages in a variety of financial transactions that, in accordance with GAAP are not recorded in the financial statements. The Corporation is also a party to certain financial instruments with off balance sheet risk such as commitments under standby letters of credit, unused portions of lines of credit, commitments to fund new loans, interest rate swaps, and risk participation agreements. The Corporation's policy is to record such instruments when funded. These transactions involve, to varying degrees, elements of credit, interest rate and liquidity risk. Such transactions are generally used by the Corporation to manage clients' requests for funding and other client needs. The table below shows the Corporation’s off-balance sheet arrangements as of December 31, 2019 (in thousands): (1) Not included in this total are unused portions of home equity lines of credit, credit card lines and consumer overdraft protection lines of credit, since no contractual maturity dates exist for these types of loans. Commitments to outside parties under these lines of credit were $52.0 million, $5.1 million and $7.7 million, respectively, at December 31, 2019. Contractual Obligations The table below shows the Corporation’s contractual obligations under long-term agreements as of December 31, 2019 (in thousands). Note references are to the Notes of the Consolidated Financial Statements: (1) Not included in the above total is the Corporation's obligation regarding the Pension Plan and Other Benefit Plans. Please refer to Part IV Item 15 Note 14 for information regarding these obligations at December 31, 2019. Liquidity Liquidity management involves the ability to meet the cash flow requirements of deposit clients, borrowers, and the operating, investing and financing activities of the Corporation. The Corporation uses a variety of resources to meet its liquidity needs. These include short term investments, cash flow from lending and investing activities, core-deposit growth and non-core funding sources, such as time deposits of $100,000 or more, securities sold under agreements to repurchase and other borrowings. The Corporation is a member of the FHLBNY which allows it to access borrowings which enhance management's ability to satisfy future liquidity needs. Based on available collateral and current advances outstanding, the Corporation was eligible to borrow up to a total of $141.8 million and $112.6 million at December 31, 2019 and 2018, respectively. The Corporation also had a total of $58.0 million of unsecured lines of credit with 5 different financial institutions, all of which were available at December 31, 2019. The Corporation had a total of $28.0 million of unsecured lines of credit with 4 different financial institutions, all of which was available at December 31, 2018. Consolidated Cash Flows Analysis The table below summarizes the Corporation's cash flows for the years indicated (in thousands): Operating activities The Corporation believes cash flows from operations, available cash balances and its ability to generate cash through short- and long-term borrowings are sufficient to fund the Corporation’s operating liquidity needs. Cash provided by operating activities in the years ended December 31, 2019 and 2018 predominantly resulted from net income after non-cash operating adjustments. Investing activities Cash provided by investing activities during the year ended December 31, 2019 predominantly resulted from calls, maturities, and principal collected on securities available for sale, offset by purchases of securities available for sale and a net increase in loans. Cash used in investing activities during the year ended December 31, 2018 predominantly resulted from purchases of securities available for sale and a net increase in loans, offset by sales, calls, maturities, and principal collected on securities available for sale. Financing activities Cash provided by financing activities during the year ended December 31, 2019 resulted from an increase in deposits, offset by the payment of dividends to shareholders. Cash provided by financing activities during the year ended December 31, 2018 predominantly resulted from an increase in deposits and FHLBNY overnight advances, offset by the repayment of FHLBNY term advances and securities sold under agreements to repurchase and the payment of dividends to shareholders. Capital Resources The Bank is subject to regulatory capital requirements administered by federal banking agencies. Capital adequacy guidelines and prompt corrective action regulations, involve quantitative measures of assets, liabilities, and certain off-balance-sheet items calculated under regulatory accounting practices. Capital amounts and classifications are also subject to qualitative judgments by regulators. Failure to meet capital requirements can initiate regulatory action. The final rules implementing Basel III rules became effective for the Bank on January 1, 2015 with full compliance with all of the requirements being phased in over a multi-year schedule, and fully phased in by January 1, 2019. Under Basel III rules, the Bank must hold a capital conservation buffer above the adequately capitalized risk-based capital ratios. The capital conservation buffer was phased in from 0.0% for 2015 to 2.50% by 2019. The capital conservation buffer for 2019 was 2.50%. The net unrealized gain or loss on available for sale securities and changes in the funded status of the defined benefit pension plan and other benefit plans are not included in computing regulatory capital. Pursuant to the Regulatory Relief Act, the FRB finalized a rule that established a community bank leverage ratio (tier 1 capital to average consolidated assets) at 9% for institutions under $10 billion in assets that such institutions may elect to utilize in lieu of the general applicable risk-based capital requirements under Basel III. Such institutions that meet the community bank leverage ratio and certain other qualifying criteria will automatically be deemed to be well-capitalized. The new rule took effect on January 1, 2020. Prompt corrective action regulations provide five classifications: well capitalized, adequately capitalized, undercapitalized, significantly undercapitalized, and critically undercapitalized, although these terms are not used to represent overall financial condition. If adequately capitalized, regulatory approval is required to accept brokered deposits. If undercapitalized, capital distributions are limited, as is asset growth and expansion, and capital restoration plans are required. Management believes that, as of December 31, 2019, the Corporation and the Bank met all capital adequacy requirements to which they were subject. Management believes that, as of December 31, 2018, the Bank met all capital adequacy requirements to which it was subject. As of December 31, 2018, the Corporation is no longer subject to FRB consolidated capital requirements applicable to bank holding companies, which are similar to those applicable to the Bank, until it reaches $3.0 billion in assets. As of December 31, 2019, the most recent notification from the Federal Reserve Bank of New York categorized the Bank as well capitalized under the regulatory framework for prompt corrective action. To be categorized as well capitalized the Bank must maintain minimum total risk-based, Tier 1 risk-based, common equity Tier 1 risk-based and Tier 1 leverage ratios as set forth in the table below. There have been no conditions or events since that notification that management believes have changed the Bank's capital category. The regulatory capital ratios as of December 31, 2019 and 2018 were calculated under Basel III rules. There is no threshold for well-capitalized status for bank holding companies. The Corporation’s and the Bank’s actual and required regulatory capital ratios were as follows (in thousands, except ratio data): Dividend Restrictions The Corporation’s principal source of funds for dividend payments is dividends received from the Bank. Banking regulations limit the amount of dividends that may be paid without prior approval of regulatory agencies. Under these regulations, the amount of dividends that may be paid in any calendar year is limited to the current year’s net income, combined with the retained net income of the preceding two years, subject to the capital requirements in the table above. At December 31, 2019, the Bank could, without prior approval, declare dividends of approximately $29.8 million. Adoption of New Accounting Standards For a discussion of the impact of recently issued accounting standards, please see Note 1 to the Corporation's consolidated financial statements which begins on page. Critical Accounting Policies, Estimates and Risks and Uncertainties Critical accounting policies include the areas where the Corporation has made what it considers to be particularly difficult, subjective or complex judgments concerning estimates, and where these estimates can significantly affect the Corporation's financial results under different assumptions and conditions. The Corporation prepares its financial statements in conformity with GAAP. As a result, the Corporation is required to make certain estimates, judgments and assumptions that it believes are reasonable based upon the information available at that time. These estimates, judgments and assumptions affect the reported amounts of assets and liabilities at the date of the financial statements and the reported amounts of revenue and expenses during the years presented. Actual results could be different from these estimates. Management considers the accounting policy relating to the allowance for loan losses to be a critical accounting policy given the uncertainty in evaluating the level of the allowance required to cover probable incurred credit losses inherent in the loan portfolio, and the material effect that such judgments can have on the Corporation's results of operations. While management's current evaluation of the allowance for loan losses indicates that the allowance is adequate, under adversely different conditions or assumptions the allowance would need to be increased. For example, if historical loan loss experience significantly worsened or if current economic conditions significantly deteriorated, additional provisions for loan losses would be required to increase the allowance. In addition, the assumptions and estimates used in the internal reviews of the Corporation's non-performing loans and potential problem loans, and the associated evaluation of the related collateral coverage for these loans, has a significant impact on the overall analysis of the adequacy of the allowance for loan losses. Real estate values in the Corporation’s market area did not increase dramatically in the prior several years, and, as a result, any declines in real estate values have been modest. While management has concluded that the current evaluation of collateral values is reasonable under the circumstances, if collateral evaluations were significantly lowered, the Corporation's allowance for loan losses policy would also require additional provisions for loan losses. Explanation and Reconciliation of the Corporation’s Use of Non-GAAP Measures The Corporation prepares its Consolidated Financial Statements in accordance with GAAP; these financial statements appear on pages through. That presentation provides the reader with an understanding of the Corporation’s results that can be tracked consistently from year-to-year and enables a comparison of the Corporation’s performance with other companies’ GAAP financial statements. In addition to analyzing the Corporation’s results on a reported basis, management uses certain non-GAAP financial measures, because it believes these non-GAAP financial measures provide information to investors about the underlying operational performance and trends of the Corporation and, therefore, facilitate a comparison of the Corporation with the performance of its competitors. Non-GAAP financial measures used by the Corporation may not be comparable to similarly named non-GAAP financial measures used by other companies. The SEC has adopted Regulation G, which applies to all public disclosures, including earnings releases, made by registered companies that contain “non-GAAP financial measures.” Under Regulation G, companies making public disclosures containing non-GAAP financial measures must also disclose, along with each non-GAAP financial measure, certain additional information, including a reconciliation of the non-GAAP financial measure to the closest comparable GAAP financial measure and a statement of the Corporation’s reasons for utilizing the non-GAAP financial measure as part of its financial disclosures. The SEC has exempted from the definition of “non-GAAP financial measures” certain commonly used financial measures that are not based on GAAP. When these exempted measures are included in public disclosures, supplemental information is not required. The following measures used in this Report, which are commonly utilized by financial institutions, have not been specifically exempted by the SEC and may constitute "non-GAAP financial measures" within the meaning of the SEC's rules, although we are unable to state with certainty that the SEC would so regard them. Fully Taxable Equivalent Net Interest Income and Net Interest Margin Net interest income is commonly presented on a tax-equivalent basis. That is, to the extent that some component of the institution's net interest income, which is presented on a before-tax basis, is exempt from taxation (e.g., is received by the institution as a result of its holdings of state or municipal obligations), an amount equal to the tax benefit derived from that component is added to the actual before-tax net interest income total. This adjustment is considered helpful in comparing one financial institution's net interest income to that of other institutions or in analyzing any institution’s net interest income trend line over time, to correct any analytical distortion that might otherwise arise from the fact that financial institutions vary widely in the proportions of their portfolios that are invested in tax-exempt securities, and that even a single institution may significantly alter over time the proportion of its own portfolio that is invested in tax-exempt obligations. Moreover, net interest income is itself a component of a second financial measure commonly used by financial institutions, net interest margin, which is the ratio of net interest income to average interest-earning assets. For purposes of this measure as well, fully taxable equivalent net interest income is generally used by financial institutions, as opposed to actual net interest income, again to provide a better basis of comparison from institution to institution and to better demonstrate a single institution’s performance over time. The Corporation follows these practices. Efficiency Ratio The unadjusted efficiency ratio is calculated as non-interest expense divided by total revenue (net interest income and non-interest income). The adjusted efficiency ratio is a non-GAAP financial measure which represents the Corporation’s ability to turn resources into revenue and is calculated as non-interest expense divided by total revenue (fully taxable equivalent net interest income and non-interest income), adjusted for one-time occurrences and amortization. This measure is meaningful to the Corporation, as well as investors and analysts, in assessing the Corporation’s productivity measured by the amount of revenue generated for each dollar spent. Tangible Equity and Tangible Assets (Year-End) Tangible equity, tangible assets, and tangible book value per share are each non-GAAP financial measures. Tangible equity represents the Corporation’s stockholders’ equity, less goodwill and intangible assets. Tangible assets represents the Corporation’s total assets, less goodwill and other intangible assets. Tangible book value per share represents the Corporation’s equity divided by common shares at year-end. These measures are meaningful to the Corporation, as well as investors and analysts, in assessing the Corporation’s use of equity. Tangible Equity (Average) Average tangible equity and return on average tangible equity are each non-GAAP financial measures. Average tangible equity represents the Corporation’s average stockholders’ equity, less average goodwill and intangible assets for the year. Return on average tangible equity measures the Corporation’s earnings as a percentage of average tangible equity. These measures are meaningful to the Corporation, as well as investors and analysts, in assessing the Corporation’s use of equity. Adjustments for Certain Items of Income or Expense In addition to disclosures of certain GAAP financial measures, including net income, EPS, ROA, and ROE, we may also provide comparative disclosures that adjust these GAAP financial measures for a particular year by removing from the calculation thereof the impact of certain transactions or other material items of income or expense occurring during the year, including certain nonrecurring items. The Corporation believes that the resulting non-GAAP financial measures may improve an understanding of its results of operations by separating out any such transactions or items that may have had a disproportionate positive or negative impact on the Corporation’s financial results during the particular year in question. In the Corporation’s presentation of any such non-GAAP (adjusted) financial measures not specifically discussed in the preceding paragraphs, the Corporation supplies the supplemental financial information and explanations required under Regulation G.

<s>[INST] The following is the MD&A of the Corporation in this Form 10K at December 31, 2019 and 2018, and for the years ended December 31, 2019, 2018, and 2017. The purpose of this discussion is to focus on information about the financial condition and results of operations of the Corporation. Reference should be made to the accompanying audited consolidated financial statements and footnotes for an understanding of the following discussion and analysis. See the list of commonly used abbreviations and terms on pages 14. The MD&A included in this Form 10K contains statements that are forwardlooking within the meaning of the Private Securities Litigation Reform Act of 1995. These statements are based on the current beliefs and expectations of the Corporation's management and are subject to significant risks and uncertainties. Actual results may differ from those set forth in the forwardlooking statements. For a discussion of those risks and uncertainties and the factors that could cause the Corporation’s actual results to differ materially from those risks and uncertainties, see Forwardlooking Statements below. The Corporation has been a financial holding company since 2000, and the Bank was established in 1833, CFS in 2001, and CRM in 2016. Through the Bank and CFS, the Corporation provides a wide range of financial services, including demand, savings and time deposits, commercial, residential and consumer loans, interest rate swaps, letters of credit, wealth management services, employee benefit plans, insurance products, mutual funds and brokerage services. The Bank relies substantially on a foundation of locally generated deposits. The Corporation, on a standalone basis, has minimal results of operations. The Bank derives its income primarily from interest and fees on loans, interest on investment securities, WMG fee income and fees received in connection with deposit and other services. The Bank’s operating expenses are interest expense paid on deposits and borrowings, salaries and employee benefit plans and general operating expenses. CRM, a whollyowned subsidiary of the Corporation which was formed and began operations on May 31, 2016, is a Nevadabased captive insurance company that insures against certain risks unique to the operations of the Corporation and its subsidiaries and for which insurance may not be currently available or economically feasible in today's insurance marketplace. CRM pools resources with several other similar insurance company subsidiaries of financial institutions to spread a limited amount of risk among themselves. CRM is subject to regulations of the State of Nevada and undergoes periodic examinations by the Nevada Division of Insurance. Forwardlooking Statements This discussion contains forwardlooking statements within the meaning of Section 27A of the Securities Act, Section 21E of the Exchange Act, and the Private Securities Litigation Reform Act of 1995. The Corporation intends its forwardlooking statements to be covered by the safe harbor provisions for forwardlooking statements in these sections. All statements regarding the Corporation's expected financial position and operating results, the Corporation's business strategy, the Corporation's financial plans, forecasted demographic and economic trends relating to the Corporation's industry and similar matters are forwardlooking statements. These statements can sometimes be identified by the Corporation's use of forwardlooking words such as "may," "will," "anticipate," "estimate," "expect," or "intend." The Corporation cannot guarantee that its expectations in such forwardlooking statements will turn out to be correct. The Corporation's actual results could be materially different from expectations because of various factors, including changes in economic conditions or interest rates, credit risk, difficulties in managing the Corporation’s growth, competition, changes in law or the regulatory environment, including the DoddFrank Act, and changes in general business and economic trends. Information concerning these and other factors can be found in the Corporation’s periodic filings with the SEC, including the discussion under the heading “Item 1A. Risk Factors” of this annual report on Form 10K. The Corporation's quarterly filings are available publicly on the SEC’s web site at http://www.sec.gov, on the Corporation's web site at http://www.chemungcanal.com or by written request to: Kathleen S. McKillip, Corporate Secretary, Chemung Fin [/INST] Positive. </s>

WEIS MARKETS INC

2015-03-13

2014-12-27

Item 7. Management's Discussion and Analysis of Financial Condition and Results of Operations: Overview The following Management’s Discussion and Analysis of Financial Condition and Results of Operations (MD&A) is intended to help the reader understand Weis Markets, Inc., its operations and its present business environment. The MD&A is provided as a supplement to and should be read in conjunction with the consolidated financial statements and the accompanying notes thereto contained in “Item 8. Financial Statements and Supplementary Data” of this report. The following analysis should also be read in conjunction with the Financial Statements included in the Quarterly Reports on Form 10-Q and the Annual Report on Form 10-K filed with the U.S. Securities and Exchange Commission, as well as the cautionary statement captioned “Forward-Looking Statements” immediately following this analysis. This overview summarizes the MD&A, which includes the following sections: • Company Overview - a general description of the Company’s business and strategic imperatives. • Results of Operations - an analysis of the Company’s consolidated results of operations for the three years presented in the Company’s consolidated financial statements. • Liquidity and Capital Resources - an analysis of cash flows, aggregate contractual obligations, and off-balance sheet arrangements. • Critical Accounting Policies and Estimates - a discussion of accounting policies that require critical judgments and estimates. Company Overview General Weis Markets, Inc. was founded in 1912 by Harry and Sigmund Weis in Sunbury, Pennsylvania. Today, the Company ranks among the top 50 food and drug retailers in the United States in revenues generated. As of December 27, 2014, the Company operated 163 retail food stores in Pennsylvania and four surrounding states: Maryland, New Jersey, New York and West Virginia. Company revenues are generated in its retail food stores from the sale of a wide variety of consumer products including groceries, dairy products, frozen foods, meats, seafood, fresh produce, floral, pharmacy services, deli products, prepared foods, bakery products, beer and wine, fuel, and general merchandise items, such as health and beauty care and household products. The Company supports its retail operations through a centrally located distribution facility, its own transportation fleet, three manufacturing facilities and its administrative offices. The Company's operations are reported as a single reportable segment. WEIS MARKETS, INC. Item 7. Management's Discussion and Analysis of Financial Condition and Results of Operations: (continued) Company Overview, (continued) Strategic Imperatives The following strategic imperatives will be focused upon by the Company to attempt to ensure the success of the Company in the coming years: · Establish a Sales Driven Culture - The Company continues to focus on sales and profits growth, improved operating practices, increased productivity and positive cash flow. The Company believes disciplined growth will increase its market share and operating profits, resulting in enhanced shareholder value. The Company’s method of driving sales includes focused preparation and execution of sales programs, investing in new stores and remodels, and strategic acquisitions. Communicating clear executable standards and aligning performance measures across the organization will help to instill a sales-driven operating environment. · Continuously Upgrade Organizational Talent Pool - In support of the Company’s growth and sales building strategies, the Company is committed to growing leaders at every level throughout the organization through enhanced leadership development programs, succession planning, and establishing rewarding career paths. The Company believes that improved associate talent directly impacts the ability to execute strategic plans and views this as a strategic imperative for future growth. · Become More Relevant to Consumers - Understanding the consumer is crucial to the Company’s strategic plan. Research can be done by studying the wants and needs of core consumers and casual consumers. Measuring customer satisfaction and sharing insights across the organization will help communication between management and its consumers. The Company strives to build customer loyalty by purchasing produce from local growers and supporting organizations within the communities it serves. It will continue to invest in new stores, remodels and additions and strategic acquisitions, to help retain and attract new consumers. · Create Meaningful Differentiation - The Company has identified product pricing, locally focused store assortments, shopping experience, overall convenience and customer service as critical components of future success. The strategy includes developing improved customer service training and setting customer service measurements and goals. As part of this strategy, management is committed to offering its customers a strong combination of quality, service and value. It will continue to offer competitive prices on name brand and private brand products to exceed customers’ expectations. · Significantly Improve Decision Support and Measurement - The Company will continue to make investments in its information technology systems and distribution network. This will help improve associate productivity, store conditions and the overall customer experience with user-friendly, support driven systems. These systems will also continue to play a key role in the measurement of the Company’s strategic decisions and provide valuable insight into customer behavior, shopping trends, and financial returns. Management will continue to streamline its supply chain by focusing on improving inventory turns, cost per case, in-stock position and overall service levels, which will help to improve in-store conditions and result in increased sales and profits. · Focus on Sustainability Strategies - The Company views being good stewards in the communities in which we operate as an important component of overall success. The Company’s sustainability program operates under a structure of four key pillars: green design, natural resource conservation, food and agricultural impact and social responsibility. The goal of the sustainability strategy is to reduce the Company’s overall carbon footprint by reducing greenhouse gas emissions and reducing the impact on climate change. The Company is seeking to reduce its carbon footprint by 20% by the year 2020. To accomplish this, the Company intends to institute new sustainability programs and to improve existing sustainability programs. Since 2008, the Company has been measuring the carbon footprint of the entire enterprise and has reduced the carbon emissions by a total of 14.8%. WEIS MARKETS, INC. Item 7. Management's Discussion and Analysis of Financial Condition and Results of Operations: (continued) Results of Operations Analysis of Consolidated Statements of Income Income is earned by selling merchandise at price levels that produce revenues in excess of cost of merchandise sold and operating and administrative expenses. Although the Company may experience short term fluctuations in its earnings due to unforeseen short-term operating cost increases, it historically has been able to increase revenues and maintain stable earnings from year to year. Net Sales The Company's revenues are earned and cash is generated as merchandise is sold to customers at the point of sale. Discounts provided to customers by the Company at the point of sale are recognized as a reduction in sales as products are sold or over the life of a promotional program if redeemable in the future. Discounts provided by vendors, usually in the form of paper coupons, are not recognized as a reduction in sales provided the coupons are redeemable at any retailer that accepts coupons. Total store sales increased 3.1% in 2014 compared to 2013. Excluding fuel sales, total store sales increased 2.8%. Total store sales decreased 0.3% in 2013 compared to 2012. Excluding fuel sales, total store sales decreased 0.4% in 2013 compared to 2012. When calculating the percentage change in comparable store sales, the Company defines a new store to be comparable when it has been in operation for five full quarters. Relocated stores and stores with expanded square footage are included in comparable store sales since these units are located in existing markets and are open during construction. Planned store dispositions are excluded from the calculation. The Company only includes retail food stores in the calculation. WEIS MARKETS, INC. Item 7. Management's Discussion and Analysis of Financial Condition and Results of Operations: (continued) Results of Operations (continued) Comparable store sales increased 2.0% in 2014 compared to 2013. Excluding fuel sales, comparable store sales increased 1.7%. The 2014 sales increase is attributed to the Company’s current pricing initiatives and sales building programs. Comparable store sales decreased 2.6% in 2013 compared to 2012. Excluding fuel sales, comparable store sales decreased 2.7% in 2013 compared to 2012. The 2013 sales decline is attributed to increased competition, cycling the 2012 sales impact of Hurricane Sandy and a decline in food stamp/SNAP (the United States Department of Agriculture’s Supplemental Nutrition Assistance Program) spending in its stores, which accelerated in the fourth quarter of 2013 with the reduction in SNAP benefits that went into effect on November 1, 2013. The Company continues to make progress in a market impacted by a slowly recovering economy. It attributes the 2014 sales increase to its continued investments in lower pricing and disciplined sales building programs. In addition to targeted promotional activity in key regional markets, the Company started an aggressive sales building program in 2014, notably its “Three Ways to Save” sales initiative, which included the seasonal “Price Freeze” or “Get Grillin’” promotional program, Everyday Lower Prices (EDLP) and Lowest Price Guarantee program. On December 29, 2013, the Company launched a twelfth round of its "Price Freeze" program. This program froze prices on more than 2,000 products for a thirteen-week period. On March 30, 2014, the Company entered into another "Get Grillin'" promotional program. The "Get Grillin'" promotional program was a fifteen-week reduced pricing program on top items throughout the store that our customers found to be the most seasonally relevant. This program lowered prices on approximately 1,200 items. The EDLP program lowered prices on more than 1,000 regularly purchased items. The Lowest Price Guarantee program offers discounts on four items every week that the Company guarantees to be the lowest compared to local competitors. Compared to 2013, the Company generated a 1.5% increase in average sales per customer transaction in 2014, while identical customer store visits increased by 0.6%. Compared to 2012, the Company generated a 0.7% increase in average sales per customer transaction in 2013, while the number of identical customer store visits declined by 3.3%. The Company’s results also benefited from increased operational efficiencies and improved in-stock conditions at store level. In addition, the Company’s Gold Card program, an extension of its existing Preferred Club Shopper program, continues to target the Company’s best shoppers with personalized offers and strong values to help them save money. The Company also continues to offer its "Gas Rewards" program in most markets. The "Gas Rewards" program allows Weis Preferred Shoppers club card members to earn gas discounts resulting from their in-store purchases. Customers can redeem these gas discounts at Sheetz convenience stores, located in most of the Company's markets, at Manley's Mighty Mart Valero locations, in the Binghamton, NY market or at any of the twenty-seven Weis Gas-n-Go locations. Comparable center store sales decreased by 0.2% in 2014 compared to 2013. Comparable center store sales decreased 3.4% in 2013 compared to 2012. Center store was impacted by stagnant sales performance in key center store categories, increased competition and a decline in food stamp/SNAP spending in its stores, which accelerated in the fourth quarter of 2013 with the reduction in SNAP benefits that went into effect on November 1, 2013. Comparable dairy sales increased 3.4% in 2014 compared to 2013. These increases are mainly attributed to commodity price inflation throughout the dairy category, with milk, cheese and butter seeing the largest increases. Despite the significant commodity price inflation, the Company was able to grow unit sales ahead of remaining market in 2014 as compared to 2013, through the continual promotion of dairy products in the EDLP and Lowest Price Guarantee programs. Comparable fresh sales increased 3.0% in 2014 compared to 2013. This increase was primarily driven by the meat, seafood, deli and food service departments. Comparable meat sales increased 3.8% in 2014 compared to 2013. In January 2014, the Company introduced the “Great Meals Start Here” program, which focuses on superior customer service along with educating our customers about our quality and our ability to cut fresh meat within the stores. This program coupled with price inflation; more strategic meat advertising; and a focus on improving store conditions and resetting the stores to better serve our customers’ needs has contributed to the increase in meat sales. Comparable meat sales decreased 2.5% in 2013 compared to 2012. With the cost of meat rising, the Company made the strategic decision to reduce retail prices in order to encourage meat sales. The Company sold 256,084 more pounds of meat in 2013, compared to 2012. Although total tonnage of meat sold increased, comparable meat sales decreased over the previous fiscal year due to the retail price reduction strategy. Comparable seafood sales increased 5.1% in 2014 compared to 2013. The increase is credited to the Company’s renewed attention to promoting fresh seafood items, enhancing product variety and the Company’s ongoing commitment to the EDLP program. WEIS MARKETS, INC. Item 7. Management's Discussion and Analysis of Financial Condition and Results of Operations: (continued) Results of Operations (continued) Comparable deli sales increased 2.8% in 2014 compared to 2013. The sales increase is attributed to the EDLP program, particularly in slicing meats and cheeses, an increased focus on customer service and an expanded variety in the dips and spreads category. Comparable deli sales decreased 4.6% in 2013 compared to 2012. Sales declined in 2013 as a result of emergency sales surges in October 2012, which was caused by flooding due to Hurricane Sandy, which impacted regions of Pennsylvania and southern New York, where the majority of the Company's stores are located. Customers were unable to prepare meals at home for extended periods of time in 2012, resulting in increased deli sales. Additionally, 2013 sales were negatively affected by deli salad recalls occurring in September and which continued to impact the fourth quarter of 2013, due to a disruption in supply. Comparable food service sales increased 6.6% in 2014 compared to 2013. This increase is due to increased promotional activity on key items within the department, partially through the EDLP program; an emphasis on delivering consistent product quality; the successful launch of new items within the department; and the conversion to “fresh” fried chicken in 48 stores. Comparable pharmacy sales increased 8.5% in 2014 compared to 2013. Pharmacy sales experienced significant price inflation in 2014 but were negatively affected in 2013 due to the conversion of brand to generic drugs. In addition to price inflation, the sales increase is also attributable to an increased number of prescriptions being filled, partially due to the Company’s in-store pet medication and medication synchronization programs. Also contributing to the increase, are some of the Company’s stores having expanded pharmacy hours and more individuals are eligible for healthcare benefits under the Affordable Care Act. Comparable pharmacy sales decreased 2.2% in 2013 compared to 2012. Pharmacy sales were impacted by a $15.3 million and a $10.4 million decline in 2013 and 2012, respectively, due to the conversion of brand drugs to generic. Generics are sold at lower retail prices, decreasing total pharmacy sales. While sales dropped significantly in dollars because of the increased utilization of generic pharmaceuticals, the number of units sold in comparable stores also decreased 0.4% in 2013 compared to 2012. As part of management's strategy to offset this decline, the Company emphasized a continued focus on immunization while implementing in-store pet medications and a medication synchronization program. Comparable fuel sales increased 0.4% in 2014 compared to 2013. Comparable fuel sales declined 8.3% in 2013 compared to 2012. Sales were affected by fuel price deflation in 2013, which resulted in lower retail gas sales. Management remains confident in its ability to generate sales growth in a highly competitive environment, but also understands some competitors have greater financial resources and could use these resources to take measures which could adversely affect the Company's competitive position. Cost of Sales and Gross Profit Cost of sales consists of direct product costs (net of discounts and allowances), distribution center and transportation costs, as well as manufacturing facility operations. According to the latest U.S. Bureau of Labor Statistics’ report, the annual Seasonally Adjusted Food-at-Home Consumer Price Index increased 2.4% in 2014, 0.9% in 2013 and 2.4% in 2012. Even though the U.S. Bureau of Labor Statistics’ index rates may be reflective of a trend, it will not necessarily be indicative of the Company’s actual results. Despite the fluctuation of retail and wholesale prices, the Company maintained a gross profit rate of 27.1% in 2014, 27.7% in 2013 and 27.5% in 2012. The gross profit rate declined in 2014 as a result of the implementation of the Company’s Three Ways to Save sales initiative, which consisted of the EDLP and Lowest Price Guarantee programs throughout the year, the “Price Freeze” program in the first quarter and the “Get Grillin’” program in the second quarter. The Company experienced a LIFO charge of $911,000 for 2014, compared to a charge of $692,000 for 2013 and a charge of $1.2 million for 2012. With the exception of pharmacy, the Company expects wholesale price inflation to increase slightly in 2015. The Company's profitability is impacted by the cost of oil. Fluctuating fuel prices affect the delivered cost of product and the cost of other petroleum-based supplies. As a percentage of sales, the cost of diesel fuel used by the Company to deliver goods from its distribution center to its stores decreased by 0.02% in 2014 compared to 2013 and remained unchanged in 2013 compared to 2012. According to the U.S. Department of Energy, the 52-week average diesel fuel price for the Central Atlantic States decreased $0.01 per gallon to $4.00 per gallon as of December 22, 2014, compared to $4.01 per gallon as of December 23, 2013. Diesel fuel prices for the Central Atlantic States peaked in February 2014 at $4.36 and steadily fell to $3.39 as of December 22, 2014. Based upon the U.S. Energy Information Administration’s current projections, the Company is expecting diesel fuel prices to remain below $3.00 during 2015. WEIS MARKETS, INC. Item 7. Management's Discussion and Analysis of Financial Condition and Results of Operations: (continued) Results of Operations (continued) Although the Company experienced product cost inflation and deflation in various commodities in 2014, 2013 and 2012, management cannot accurately measure the full impact of inflation or deflation on retail pricing due to changes in the types of merchandise sold between periods, shifts in customer buying patterns and the fluctuation of competitive factors. Operating, General and Administrative Expenses Business operating costs including expenses generated from administration and purchasing functions, are recorded in "Operating, general and administrative expenses." Business operating costs include items such as wages, benefits, utilities, repairs and maintenance, advertising costs and credits, rent, insurance, equipment depreciation, leasehold amortization and costs for outside provided services. The Company may not be able to recover rising expenses through increased prices charged to its customers. Any delay in the Company's response to unforeseen cost increases or competitive pressures that prevent its ability to raise prices may cause earnings to suffer. A majority of our associates are paid hourly rates related to federal and state minimum wage laws. Although we have and will continue to attempt to pass along any increased labor costs through food price increases, there can be no assurance that all such increased labor costs can be reflected in our prices or that increased prices will be absorbed by consumers without diminishing consumer spending to some degree. However, to date, we have not experienced a significant reduction in profit margins as a result of changes in such laws, and management does not anticipate any significant related future reductions in gross profit margins. Employee-related costs such as wages, employer paid taxes, health care benefits and retirement plans, comprise approximately 60% of the total “Operating, general and administrative expenses.” Employee-related costs increased $7.7 million or 2.0% in 2014 compared to 2013 and increased $4.6 million or 1.2% in 2013 compared to 2012. As a percent of sales, employee-related costs decreased 0.2% in 2014 compared to 2013 but increased 0.2% in 2013 compared to 2012. As a percent of sales, direct store labor decreased 0.2% in 2014 compared to 2013 but increased 0.3% in 2013 compared to 2012. The Company expensed $1.1 million, $2.0 million and $1.1 million in 2014, 2013 and 2012, respectively, due to adjustments made to the non-qualified supplemental executive retirement plan resulting from a rise in the equity market. See Note 6 Retirement Plans, of Notes to the Consolidated Financial Statements included in this Annual Report on Form 10-K for more information on the Company’s retirement plans. The Company’s self-insured health care benefit expenses decreased 0.5% in 2014 compared to 2013 and decreased 14.9% in 2013 compared to 2012. During 2013, the Company incurred less expensive health care claims, compared to 2012. The Company remains concerned about the potential impact that The Patient Protection and Affordable Care Act will have on its future operating expenses. On September 21, 2013, the Company entered into a separation agreement with the former President and Chief Executive Officer. The Company's "Operating, general and administrative expenses" were negatively impacted by the charge of $6.1 million worth of estimated expenses related to the separation agreement. See Exhibit 10, filed with the quarterly report on Form 10-Q filed on November 7, 2013, for more information pertaining to the separation agreement. Depreciation and amortization expense was $66.9 million, or 2.4% of net sales, for 2014 compared to $58.3 million, or 2.2% of net sales, for 2013 and $50.7 million, or 1.9% of net sales, for 2012. The increase in depreciation and amortization expense in 2014 compared to 2013 and in 2013 compared to 2012 was the result of additional capital expenditures as the Company implements its capital expansion program. In the first quarter of 2012, the Company changed its accounting policy for property and equipment and switched the depreciation method for this group of assets from accelerated methods to straight-line. See Note 1 (j) to the Consolidated Financial Statements included in this Annual Report on Form 10-K for more information on the Company’s change in accounting estimate related to depreciation expense. See the Liquidity and Capital Resources section for further information regarding the Company’s capital expansion program. WEIS MARKETS, INC. Item 7. Management's Discussion and Analysis of Financial Condition and Results of Operations: (continued) Results of Operations (continued) The Company recognized pre-tax gains of $2.6 million, $2.9 million and $1.7 million in 2014, 2013 and 2012, respectively, from the sale of two properties in 2014 and 2013 and one property in 2012. In 2013, the Company determined that the asset value of four properties was impaired. As a result, the Company recognized a pre-tax impairment loss of $2.1 million. See Note 1(l) to the Consolidated Financial Statements included in this Annual Report on Form 10-K for more information on the Company's impairment charges. Earnings were further impacted in 2013 by a $680,000 adjustment to liabilities for future expenses on closed stores. Retail store profitability is sensitive to volatility in utility costs due to the amount of electricity and gas required to operate the Company's stores and facilities. The Company is responding to this volatility in operating costs by employing conservation technologies, procurement strategies and associate energy awareness programs to manage and reduce consumption. The Company continues to be a member of the EPA GreenChill program for advancing environmentally beneficial refrigerant management systems. The Company was awarded the GreenChill Distinguished Partner Award for leadership in refrigerant management due to the demonstrated extraordinary leadership and initiative in achieving GreenChill’s mission in 2013. This past year, the Company received three additional Gold Level Certified Stores. In total, the Company has twelve stores registered under the EPA GreenChill program. In 2012, the Company replaced its existing lighting system at its 1.1 million square-foot distribution center with low watt fluorescent and LED lighting, reducing energy consumption by 80% and operating costs by 30%. Its new store prototypes contain skylights that harvest natural daylight to reduce lighting costs, LED lighting and motion sensors in its frozen departments and energy management systems. All Company stores have an assigned Green Leader to promote in-store energy conservation. Despite these initiatives, the Company’s utility expense increased by $2.1 million or 5.3% in 2014 compared to 2013. The increase is primarily due to higher capacity charges and below average temperatures in the Mid-Atlantic States, the Company’s operating region, in the first quarter of 2014. However, the Company’s utility expense decreased by $1.0 million or 2.6% in 2013 compared to 2012, through the aforementioned initiatives, with the added benefit of clement weather and a declining market in electricity costs. Investment Income The Company’s investment portfolio consists of marketable securities, which currently includes municipal bonds and equity securities, as well as the Company’s SERP investment, which is comprised of mutual funds that are maintained within the Company’s non-qualified supplemental executive retirement plan and the non-qualified pharmacist deferred compensation plan. The Company classifies all of its municipal bonds and equity securities as available-for-sale. Investment income declined $2.4 million in 2014 compared to 2013. This decrease is primarily attributed to fewer sales of equity securities and a decline in the Company’s SERP investment. The Company experienced a $1.4 million decrease in gains recognized on the sale of equity securities in 2014 compared to 2013 and the Company’s SERP investment decreased by $797,000 in 2014 compared to 2013. Investment income increased by $1.2 million in 2013 compared to 2012, primarily resulting from the $868,000 increase in gains recognized on the sale of equity securities in 2013 compared to 2012. Other Income Upon completion, the Company recognized a gain of $414,000 on the bargain purchase of three former Genuardi locations in the Delaware Valley region of Pennsylvania, from Safeway Inc., in the second quarter of 2012. Provision for Income Taxes The effective income tax rate was 35.1%, 38.1% and 37.0% in 2014, 2013 and 2012, respectively. In 2014, pre-tax book income decreased significantly. Tax exempt interest and dividends eligible for a dividends received deduction increased, causing an increase to the net favorable permanent differences. The combination of the decrease to net income before taxes and increase to the net favorable permanent differences resulted in a drop in the effective rate for 2014. The rate increased starting in 2012 due to the decrease in the domestic production deduction also referred to as the Section 199 deduction. The qualifying manufacturing sales decreased during 2012 resulting in a sizeable provision to return adjustment which results in a higher effective tax rate. The effective income tax rate differs from the federal statutory rate of 35% primarily due to the effect of state taxes, net of permanent differences. WEIS MARKETS, INC. Item 7. Management's Discussion and Analysis of Financial Condition and Results of Operations: (continued) Liquidity and Capital Resources Net cash provided by operating activities was $123.1 million in 2014, compared to $142.6 million in 2013 and $124.0 million in 2012. In 2013, management implemented new inventory control buying procedures that increased distribution center efficiencies. Under these new buying procedures, the distribution center inventory level decreased an average of $9.8 million per period during 2014 compared to 2013 and $7.0 million during the last nine fiscal months of 2013 compared to the same period in 2012. The Company's overall inventory level only decreased by $811,000 in 2014 compared to 2013 and $4.8 million in 2013 compared to 2012 as a result of holding more inventory at year end for the holidays and the addition of larger stores during each year. Working capital increased 5.8% in 2014, decreased 7.9% in 2013 and increased 2.7% in 2012, in each case compared to the prior year. The 2014 working capital increase is primarily attributed to the lower investment in the Company’s capital expansion program during 2014 compared to the previous years. Whereas, the 2013 decrease in working capital is primarily due to the utilization of marketable securities to fund the Company’s capital expansion program. Net cash used in investing activities was $85.8 million in 2014 compared to $106.8 million in 2013 and $107.8 million in 2012. These funds were used primarily to purchase marketable securities and property and equipment in the three fiscal years presented. While the Company purchased marketable securities in all three years presented, the Company’s net marketable securities transactions resulted in the purchase of $8.4 million in 2014, compared to the disposal of $18.7 million in 2013 and the sale of $6.2 million in 2012. Property and equipment purchases totaled $79.2 million in 2014, compared to $128.1 million in 2013 and $115.9 million in 2012, which included the acquisition of a business in 2012. The Company acquired three former Genuardi stores for $6.1 million in 2012. As a percentage of sales, capital expenditures including the acquisition were 2.9%, 4.8% and 4.3% in 2014, 2013 and 2012, respectively. Proceeds from the sale of property and equipment decreased $837,000 in 2014 compared to 2013 despite the sale of properties in each of the first and third quarters of 2014 for a total of $2.8 million. Proceeds from the sale of property and equipment increased $1.9 million in 2013 compared to 2012, primarily due to the sale of two properties for $3.2 million in the second quarter of 2013. The Company’s capital expansion program includes the construction of new superstores, the expansion and remodeling of existing units, the acquisition of sites for future expansion, new technology purchases and the continued upgrade of the Company’s distribution facilities and transportation fleet. Management estimates that its current development plans will require an investment of approximately $91.8 million in 2015. Net cash used in financing activities was $32.3 million in 2014, 2013 and 2012, which solely consisted of dividend payments to shareholders. At December 27, 2014, the Company had outstanding letters of credit of $19.9 million. The letters of credit are maintained primarily to support performance, payment, deposit or surety obligations of the Company. The Company does not anticipate drawing on any of them. Total cash dividend payments on common stock, on a per share basis, amounted to $1.20 in 2014, 2013 and 2012. No treasury stock was purchased in 2014, 2013 or 2012. The Board of Directors’ 2004 resolution authorizing the repurchase of up to one million shares of the Company’s common stock has a remaining balance of 752,468 shares. The Company has no other commitment of capital resources as of December 27, 2014, other than the lease commitments on its store facilities under operating leases that expire at various dates through 2029. The Company anticipates funding its working capital requirements and its $91.8 million capital expansion program through cash and investment reserves and future internally generated cash flows from operations. WEIS MARKETS, INC. Item 7. Management's Discussion and Analysis of Financial Condition and Results of Operations: (continued) Liquidity and Capital Resources (continued) The Company’s earnings and cash flows are subject to fluctuations due to changes in interest rates as they relate to available-for-sale securities and any future long-term debt borrowings. The Company’s marketable securities portfolio currently consists of municipal bonds and equity securities. Other short-term investments are classified as cash equivalents on the Consolidated Balance Sheets. Under its current policies, the Company invests in high-grade marketable debt securities and does not use interest rate derivative instruments to manage exposure to interest rate fluctuations. Currently, the Company’s investment strategy of obtaining marketable debt securities with maturity dates between one and ten years helps to minimize market risk and to maintain a balance between risk and return. The equity securities owned by the Company consist primarily of stock held in large capitalized companies trading on public security exchange markets. The Company’s management continually monitors the risk associated with its marketable securities. A quantitative tabular presentation of risk exposure is located in “

<s>[INST] The following Management’s Discussion and Analysis of Financial Condition and Results of Operations (MD&A) is intended to help the reader understand Weis Markets, Inc., its operations and its present business environment. The MD&A is provided as a supplement to and should be read in conjunction with the consolidated financial statements and the accompanying notes thereto contained in “Item 8. Financial Statements and Supplementary Data” of this report. The following analysis should also be read in conjunction with the Financial Statements included in the Quarterly Reports on Form 10Q and the Annual Report on Form 10K filed with the U.S. Securities and Exchange Commission, as well as the cautionary statement captioned “ForwardLooking Statements” immediately following this analysis. This overview summarizes the MD&A, which includes the following sections: Company Overview a general description of the Company’s business and strategic imperatives. Results of Operations an analysis of the Company’s consolidated results of operations for the three years presented in the Company’s consolidated financial statements. Liquidity and Capital Resources an analysis of cash flows, aggregate contractual obligations, and offbalance sheet arrangements. Critical Accounting Policies and Estimates a discussion of accounting policies that require critical judgments and estimates. Company Overview General Weis Markets, Inc. was founded in 1912 by Harry and Sigmund Weis in Sunbury, Pennsylvania. Today, the Company ranks among the top 50 food and drug retailers in the United States in revenues generated. As of December 27, 2014, the Company operated 163 retail food stores in Pennsylvania and four surrounding states: Maryland, New Jersey, New York and West Virginia. Company revenues are generated in its retail food stores from the sale of a wide variety of consumer products including groceries, dairy products, frozen foods, meats, seafood, fresh produce, floral, pharmacy services, deli products, prepared foods, bakery products, beer and wine, fuel, and general merchandise items, such as health and beauty care and household products. The Company supports its retail operations through a centrally located distribution facility, its own transportation fleet, three manufacturing facilities and its administrative offices. The Company's operations are reported as a single reportable segment. WEIS MARKETS, INC. Item 7. Management's Discussion and Analysis of Financial Condition and Results of Operations: (continued) Company Overview, (continued) Strategic Imperatives The following strategic imperatives will be focused upon by the Company to attempt to ensure the success of the Company in the coming years: · Establish a Sales Driven Culture The Company continues to focus on sales and profits growth, improved operating practices, increased productivity and positive cash flow. The Company believes disciplined growth will increase its market share and operating profits, resulting in enhanced shareholder value. The Company’s method of driving sales includes focused preparation and execution of sales programs, investing in new stores and remodels, and strategic acquisitions. Communicating clear executable standards and aligning performance measures across the organization will help to instill a salesdriven operating environment. · Continuously Upgrade Organizational Talent Pool In support of the Company’s growth and sales building strategies, the Company is committed to growing leaders at every level throughout the organization through enhanced leadership development programs, succession planning, and establishing rewarding career paths. The Company believes that improved associate talent directly impacts the ability to execute strategic plans and views this as a strategic imperative for future growth. · Become More Relevant to Consumers Understanding the consumer is crucial to the Company’s strategic plan. Research can be done by studying the wants and needs of core consumers and casual consumers. Measuring customer satisfaction and sharing insights across the organization will help communication between management and its consumers. The Company strives to build customer loyalty by purchasing produce from local growers and supporting organizations within the communities it serves. It will continue to invest in new stores, remodels and additions and strategic acquisitions, to help retain and attract new consumers. · Create Meaningful Differentiation The Company has identified product pricing, [/INST] Negative. </s>

WEIS MARKETS INC

2017-03-16

2016-12-31

Item 7. Management's Discussion and Analysis of Financial Condition and Results of Operations:  Overview  The following Management’s Discussion and Analysis of Financial Condition and Results of Operations (MD&A) is intended to help the reader understand Weis Markets, Inc., its operations and its present business environment. The MD&A is provided as a supplement to and should be read in conjunction with the Consolidated Financial Statements and the accompanying notes thereto contained in “Item 8. Financial Statements and Supplementary Data” of this report. The following analysis should also be read in conjunction with the Financial Statements included in the Quarterly Reports on Form 10-Q and the Annual Report on Form 10-K filed with the U.S. Securities and Exchange Commission, as well as the cautionary statement captioned “Forward-Looking Statements” immediately following this analysis. This overview summarizes the MD&A, which includes the following sections:  • Company Overview - a general description of the Company’s business and strategic imperatives.  • Results of Operations - an analysis of the Company’s consolidated results of operations for the three years presented in the Company’s Consolidated Financial Statements.  • Liquidity and Capital Resources - an analysis of cash flows, aggregate contractual obligations, and off-balance sheet arrangements.  • Critical Accounting Policies and Estimates - a discussion of accounting policies that require critical judgments and estimates.  Company Overview  General  Weis Markets, Inc. was founded in 1912 by Harry and Sigmund Weis in Sunbury, Pennsylvania. Today, the Company ranks among the top 50 United States and Canadian Food Retailers and Wholesalers in revenues generated. As of December 31, 2016, the Company operated 204 retail food stores in Pennsylvania and six surrounding states: Delaware, Maryland, New Jersey, New York, Virginia and West Virginia.  Company revenues are generated in its retail food stores from the sale of a wide variety of consumer products including groceries, dairy products, frozen foods, meats, seafood, fresh produce, floral, pharmacy services, deli products, prepared foods, bakery products, beer and wine, fuel, and general merchandise items, such as health and beauty care and household products. The Company supports its retail operations through a centrally located distribution facility, its own transportation fleet, three manufacturing facilities and its administrative offices. The Company's operations are reported as a single reportable segment.   WEIS MARKETS, INC.  Item 7. Management's Discussion and Analysis of Financial Condition and Results of Operations: (continued)  Company Overview, (continued)  Strategic Imperatives  The following strategic imperatives continue to be focused upon by the Company to attempt to ensure the success of the Company in the coming years:  · Establish a Sales Driven Culture - The Company continues to focus on sales and profits growth, improved operating practices, increased productivity and positive cash flow. The Company believes disciplined growth will increase its market share and operating profits, resulting in enhanced shareholder value. The Company’s method of driving sales includes focused preparation and execution of sales programs, investing in new stores and remodels, and strategic acquisitions. Communicating clear executable standards and aligning performance measures across the organization will help to instill a sales-driven operating environment.  · Continuously Upgrade Organizational Talent Pool - In support of the Company’s growth and sales building strategies, the Company is committed to growing leaders at every level throughout the organization through enhanced leadership development programs, succession planning, and establishing rewarding career paths. The Company believes that continuing to build associate engagement and develop associate talent directly impacts its ability to compete and execute strategic plans. The Company views this as a strategic imperative for future growth.  · Become More Relevant to Consumers - Understanding the consumer is crucial to the Company’s strategic plan. Research can be done by studying the wants and needs of core consumers and casual consumers. Measuring customer satisfaction and sharing insights across the organization will help communication between management and its consumers. The Company strives to build customer loyalty by purchasing produce from local growers and supporting organizations within the communities it serves. It will continue to invest in new stores, remodels and additions and strategic acquisitions, to help retain and attract new consumers.  · Create Meaningful Differentiation - The Company has identified product pricing, locally focused store assortments, shopping experience, overall convenience and customer service as critical components of future success. The strategy includes developing improved customer service training and setting customer service measurements and goals. As part of this strategy, management is committed to offering its customers a strong combination of quality, service and value. It will continue to offer competitive prices on name brand and private brand products to exceed customers’ expectations.  · Significantly Improve Decision Support and Measurement - The Company will continue to make investments in its information technology systems and distribution network. This will help improve associate productivity, store conditions and the overall customer experience with user-friendly, support driven systems. These systems will also continue to play a key role in the measurement of the Company’s strategic decisions and provide valuable insight into customer behavior, shopping trends, and financial returns. Management will continue to streamline its supply chain by focusing on improving inventory turns, cost per case, in-stock position and overall service levels, which will help to improve in-store conditions and result in increased sales and profits.  · Focus on Sustainability Strategies - The Company strives to be good stewards of the environment and makes this an important part of its overall mission. Its sustainability strategy operates under four key pillars: green design, natural resource conservation, food and agricultural impact and social responsibility. The goal of the sustainability strategy is to reduce the Company’s overall carbon footprint by reducing greenhouse gas emissions and reducing the impact on climate change. WEIS MARKETS, INC. Table of Contents  Item 7. Management's Discussion and Analysis of Financial Condition and Results of Operations: (continued)  Results of Operations  Analysis of Consolidated Statements of Income  Income is earned by selling merchandise at price levels that produce revenues in excess of cost of merchandise sold and operating and administrative expenses. Although the Company may experience short term fluctuations in its earnings due to unforeseen short-term operating cost increases, it historically has been able to increase revenues and maintain stable earnings from year to year.  Net Sales  The Company's revenues are earned and cash is generated as merchandise is sold to customers at the point of sale. Discounts provided to customers by the Company at the point of sale are recognized as a reduction in sales as products are sold or over the life of a promotional program if redeemable in the future. Discounts provided by vendors, usually in the form of paper coupons, are not recognized as a reduction in sales provided the coupons are redeemable at any retailer that accepts coupons.  Total store sales increased 9.0% in 2016, a 53-week period, compared to 2015, a 52-week period. The Company’s total store sales, adjusting for the additional week in 2016, increased 6.9% compared to 2015. Total store sales, excluding fuel sales and adjusting for the additional week in 2016, increased 7.0% in 2016 compared to 2015. Total store sales increased 3.6% in 2015 compared to 2014. Excluding fuel sales, total store sales increased 4.3% in 2015 compared to 2014.  When calculating the percentage change in comparable store sales, the Company defines a new store to be comparable when it has been in operation for five full quarters. Relocated stores and stores with expanded square footage are included in comparable store sales since these units are located in existing markets and are open during construction. Planned store dispositions are excluded from the calculation. The Company only includes retail food stores in the calculation. WEIS MARKETS, INC. Table of Contents  Item 7. Management's Discussion and Analysis of Financial Condition and Results of Operations: (continued)  Results of Operations (continued)  Net Sales (continued)  Comparable store sales, adjusted for the additional week in 2016, increased 2.9% compared to 2015. Comparable store sales, excluding fuel sales, also increased 2.9% in 2016 compared to 2015. Comparable store sales increased 3.7% in 2015 compared to 2014. Excluding fuel sales, comparable store sales increased 4.4% in 2015 compared to 2014.  The Company attributes the increased net sales primarily to the acquisition of 44 locations. In addition, the Company continued to invest in lower pricing and disciplined sales building programs. This includes targeted promotional activity in key regional markets and its Everyday Lower Prices (EDLP) and Lowest Price Guarantee promotional programs. The EDLP program lowered prices on more than 1,000 regularly purchased items. The Lowest Price Guarantee program offers discounts on four items every week that the Company guarantees to be the lowest compared to local competitors. The Company’s Weis Preferred Club Shopper program continues to target customer members with personalized offers and digital coupons to help them save money. As part of this loyalty marketing program, the Company continues to offers its “Gas Rewards” program in most markets. The “Gas Rewards” program allows Weis Preferred Shoppers club card members to earn gas discounts resulting from their in-store purchases. Customers can redeem these gas discounts at any of the thirty-three Weis Gas-n-Go locations, as well as participating third-party gas retail locations such as Sheetz convenience stores, which are located in most of the Company’s markets. Compared to 2015, the Company experienced a 2.0% decrease in the average sales per customer transaction in 2016. Compared to 2014, the Company experienced a 0.2% decrease in the average sales per customer transaction in 2015.  Comparable dairy sales, adjusted for the additional week in 2016, decreased 2.0% compared to 2015. The decrease in 2016 is attributed to deflation in the cost of eggs and milk.  Comparable meat sales, adjusted for the additional week in 2016, decreased 0.2% compared to 2015. In 2016, the Company saw deflation in costs causing a substantial reduction in retail prices to remain competitive. The Company introduced certified angus beef, a higher priced product, in order to offset the deflation. Comparable meat sales increased 4.3% in 2015 compared to 2014. In addition to increased costs of commodities which led to retail inflation in the first half of 2015, the Company continued to build the meat department’s base business through aggressive advertising, the introduction of new programs and expanded variety and display space for All Natural and organic products.  Comparable produce sales, adjusting for the additional week in 2016, increased 4.8% compared to 2015. The Company continued driving sales through aggressive advertising and merchandising campaigns, solid in-store execution teams and associate training classes. Comparable produce sales increased 5.9% in 2015 compared to 2014. The 2015 sales increase was driven by the factors identified above as well as, product inflation, an increased variety in key categories of produce and store remodeling projects.  Comparable pharmacy sales, adjusted for the additional week in 2016, increased 8.4% compared to 2015. Comparable pharmacy sales increased 7.4% in 2015 compared to 2014. The pharmacy sales increase in both years was driven by an increased number of filled prescriptions caused by an increase in individuals eligible for healthcare benefits under the Affordable Care Act (ACA) and the acceptance of more third-party insurance plans.  Comparable fuel sales, adjusted for the additional week in 2016, decreased 7.7% in 2016 compared to 2015. Comparable fuel sales decreased 25.4% in 2015 compared to 2014. Fuel sales decreased as a result of the decline in retail fuel prices from 2014 through 2016. According to the U.S. Department of Energy, the weekly average price of gasoline in the Central Atlantic States decreased 10.1%, or $0.26 per gallon, in 2016. The 52-week average price of gasoline in the Central Atlantic States, according to the U.S. Department of Energy, decreased 27.1%, or $0.98 per gallon, in 2015 compared to 2014.  Management remains confident in its ability to generate sales growth in a highly competitive environment, but also understands some competitors have greater financial resources and could use these resources to take measures which could adversely affect the Company's competitive position. WEIS MARKETS, INC. Table of Contents  Item 7. Management's Discussion and Analysis of Financial Condition and Results of Operations: (continued)  Results of Operations (continued)  Cost of Sales and Gross Profit  Cost of sales consists of direct product costs (net of discounts and allowances), distribution center and transportation costs, as well as manufacturing facility operations. Almost all of the increase in cost of sales in 2016 as compares to 2015 is due to the increased sales volume in 2016. Both direct product cost and distribution cost increase when sales volume increases.  According to the latest U.S. Bureau of Labor Statistics’ report, the annual Seasonally Adjusted Food-at-Home Consumer Price Index decreased 1.3% in 2016 but increased 1.1% in 2015 and 2.4% in 2014. Even though the U.S. Bureau of Labor Statistics’ index rates may be reflective of a trend, it will not necessarily be indicative of the Company’s actual results. Even with the fluctuation of retail and wholesale prices, the Company has achieved a gross profit rate of 27.8% in 2016, 27.3% in 2015 and 27.1% in 2014. The increase in gross profit rate was driven by a shift in sales mix from fuel to grocery sales which carry a higher profit margin.  The Company experienced a LIFO credit of $2.2 million for 2016, compared to a charge of $1.4 million for 2015 and a charge of $911,000 for 2014. The Company expects wholesale price inflation to increase slightly in 2017.  The Company's profitability is impacted by the cost of oil. Fluctuating fuel prices affect the delivered cost of product and the cost of other petroleum-based supplies. As a percentage of sales, the cost of diesel fuel used by the Company to deliver goods from its distribution center to its stores decreased by 0.03% in 2016 compared to 2015 and decreased by 0.07% in 2015 compared to 2014. Although the Company experienced a decrease in these costs, the decline in expense was minimized due to higher fuel usage resulting from more store deliveries to meet the higher sales demand. According to the U.S. Department of Energy, the weekly average diesel fuel price for the Central Atlantic States decreased $0.50 per gallon to $2.44 per gallon as of December 26, 2016, compared to $2.94 per gallon as of December 21, 2015. Based upon the U.S. Energy Information Administration’s current projections, the Company is expecting diesel fuel prices to increase slightly to approximately $2.75 during 2017.  Although the Company experienced product cost inflation and deflation in various commodities in 2016, 2015 and 2014, management cannot accurately measure the full impact of inflation or deflation on retail pricing due to changes in the types of merchandise sold between periods, shifts in customer buying patterns and the fluctuation of competitive factors. WEIS MARKETS, INC. Table of Contents  Item 7. Management's Discussion and Analysis of Financial Condition and Results of Operations: (continued)  Results of Operations (continued)  Operating, General and Administrative Expenses  Business operating costs, including expenses generated from administration and purchasing functions, are recorded in "Operating, general and administrative expenses." Business operating costs include items such as wages, benefits, utilities, repairs and maintenance, advertising costs and credits, rent, insurance, depreciation, leasehold amortization and costs for outside provided services. The majority of the expenses were driven by increased sales.  The Company may not be able to recover rising expenses through increased prices charged to its customers. A majority of our associates are paid hourly rates related to federal and state minimum wage laws. The Company increased the base hourly rate for associates to $9 per hour as of August 2, 2015, in order to attract and retain talented associates with a goal of delivering best-in-class customer service. The Company has decided not to increase prices to offset this hourly wage rate increase.  Employee-related costs such as wages, employer paid taxes, health care benefits and retirement plans, comprise approximately 60% of the total “Operating, general and administrative expenses.” As a percent of sales, direct store labor increased 0.2% in 2016 compared to 2015 but decreased 0.1% in 2015 compared to 2014. The increase in the base hourly rate for associates to $9 per hour and related wage compression had an estimated cost of $6.6 million in 2016. Increases in employee related expenses were offset by savings realized from a store labor efficiency project.  The Company’s self-insured health care benefit expenses increased by 15.4% in 2016 compared to 2015 and increased by 0.4% in 2015 compared to 2014. The increase from 2015 to 2016 is mainly attributed to an increase in participants from the acquired locations as well as overall group health costs. The Company remains concerned about the impact that The Patient Protection and Affordable Care Act (ACA) will have on its future operating expenses.  Depreciation and amortization expense was $76.8 million, or 2.4% of net sales, for 2016 compared to $70.1 million, or 2.4% of net sales, for 2015 and $66.9 million, or 2.4% of net sales, for 2014. The increase in depreciation and amortization expense in 2016 compared to 2015 and in 2015 compared to 2014 was the result of additional capital expenditures as the Company implements its capital expansion program, including the acquisition of 44 locations. See the Liquidity and Capital Resources section for further information regarding the Company’s capital expansion program.  The Company recognized pre-tax gains of $751,000 and $2.6 million in 2015 and 2014, respectively, from the sale of two properties in each year. In 2016, the Company determined that the asset value of one property was impaired. As a result, the Company recognized a pre-tax impairment loss of $894,000. See Note 1(l) to the Consolidated Financial Statements included in this Annual Report on Form 10-K for more information on the Company's impairment charges. Retail store profitability is sensitive to volatility in utility costs due to the amount of electricity and gas required to operate the Company's stores and facilities. The Company is responding to this volatility in operating costs by employing conservation technologies, procurement strategies and associate energy awareness programs to manage and reduce consumption. The Company continues to be a member of the EPA GreenChill program for advancing environmentally beneficial refrigerant management systems and has ten stores registered under this program. In 2016, the Company exceeded its corporate carbon reduction goal of 20% by 2020. The Company realized a 22% reduction in the overall carbon footprint versus a base year of 2008. Additional corporate sustainability goals are: reducing energy usage by 2% each year, replacing 50% of the truck fleet with fuel efficient tractors within three years and increasing recycling 5% each year. In 2016, the Company recycled 43,000 tons of materials, representing a corporate wide recycling rate of 54%. WEIS MARKETS, INC. Table of Contents  Item 7. Management's Discussion and Analysis of Financial Condition and Results of Operations: (continued)  Results of Operations (continued)  Operating, General and Administrative Expense (continued)  Employee related expenses increased in 2016 for the reasons noted above and due to a 25% increase in associates related the acquisition of 5 former Mars stores, 38 former Food Lion stores and a former Nell’s Family Market store. This increase in associates contributed to increased wages, benefits and retirement expenses.  Acquisition-related expenses, excluding the expenses mentioned above, primarily consisted of store operating expenses, travel expenses and contracted labor for store resets.  Employee-related expenses increased in 2015 for the reasons noted above, primarily related to increases in the basic hourly rate, management incentives and increases in sales volume. Hourly employees, particularly part time employees, are required to work increased hours when there is growth in sales volume. Increases in employee related expenses were offset by savings realized from a store labor efficiency project in 2015.  Store advertising expense decreased in 2015 due to reduced spending on direct mail and weekly ads.  Depreciation and amortization increased in 2015 as a result of the Company’s store capital expenditure program and technology investments.  Utility expense decreased in 2015 for the reasons noted above related to energy conservation efforts and procurement strategies, along with reduced electricity costs and usage and a reduction in the use of natural gas.  Rent expense decreased in 2015 primarily due to adjustments to accrued closed store liability estimates and purchasing a previously leased location. WEIS MARKETS, INC. Table of Contents  Item 7. Management's Discussion and Analysis of Financial Condition and Results of Operations: (continued)  Results of Operations (continued)  Investment Income  The Company’s investment portfolio consists of marketable securities, which currently includes municipal bonds and equity securities, as well as the Company’s SERP investment, which is comprised of mutual funds that are maintained within the Company’s non-qualified supplemental executive retirement plan and the non-qualified pharmacist deferred compensation plan. The Company classifies all of its municipal bonds and equity securities as available-for-sale. The SERP investments are classified as trading securities.    Equity income decreased in 2015 as a result of the Company receiving a stock dividend in 2014 which was not repeated in 2015.  SERP investment was impacted by market adjustments in both 2016 and 2015 and experienced a gain in 2016.  Provision for Income Taxes  The effective income tax rate was 30.1%, 35.7% and 35.0% in 2016, 2015 and 2014, respectively. The effective income tax rate decreased in 2016 due to the impact of the bargain purchase gain on the 38 locations being included in the overall gain calculation and not in income tax expense. The effective tax rate excluding the bargain purchase gain was 37.2%. The increase in the effective tax rate excluding the bargain purchase gain as compared to the 2015’s effective tax rate was driven by an increase in state tax expense. The effective income tax rate differs from the federal statutory rate of 35% primarily due to the effect of the bargain purchase gain, state income taxes and net permanent differences. The effective income tax rate rose in 2015 due to an increase in state tax expense.  Liquidity and Capital Resources Net cash provided by operating activities was $151.6 million in 2016, compared to $136.7 million in 2015 and $123.1 million in 2014. Working capital decreased 10.8% in 2016, increased 1.4% in 2015 and increased 6.4% in 2014, in each case compared to the prior year. The working capital decrease in 2016 was caused by the increased investment in the Company’s capital expansion program, specifically the acquisitions summarized in Note 9 of the Notes to the Consolidated Financial Statements included in this Annual Report on Form 10-K. Working capital increases in 2015 and 2014 are primarily attributed to a reduced investment in the Company’s capital expansion program compared to previous years.  Net cash used in investing activities was $186.7 million in 2016 compared to $109.8 million in 2015 and $85.8 million in 2014. These funds were used primarily to purchase property and equipment in the three fiscal years presented. Property and equipment purchases totaled $142.1 million in 2016, compared to $90.2 million in 2015 and $79.2 million in 2014. In 2016, the Company paid $24.6 million for the purchase of 5 former Mars Super Market locations in the Baltimore County, MD region; $29.4 million for the purchase of 38 former Food Lion Supermarket locations throughout Virginia, Maryland and Delaware and $9.6 million for the purchase of a former Nell’s Family Market location in East Berlin, PA. The Company paid $7.9 million for the property and equipment related to the purchase of a store in Hanover, Pennsylvania in the third quarter of 2015. As a percentage of sales, capital expenditures were 7.0%, 3.1% and 2.9% in 2016, 2015 and 2014, respectively.  The Company’s capital expansion program includes store acquisitions, the construction of new superstores, the expansion and remodeling of existing units, the acquisition of sites for future expansion, new technology purchases and the continued upgrade of the Company’s distribution facilities and transportation fleet. Management currently plans to invest approximately $90 million in its capital expansion program in 2017.    WEIS MARKETS, INC. Table of Contents  Item 7. Management's Discussion and Analysis of Financial Condition and Results of Operations: (continued)  Liquidity and Capital Resources (continued)  Net cash generated from financing activities was $32.2 million in 2016. In 2016, the Company entered into a revolving credit agreement and borrowed a total of $64.5 million of the available $100.0 million from Wells Fargo Bank, National Association, increasing the cash flow from financing activities compared to 2015. In addition, the company issued $32.3 million of cash dividend payments in 2016. The net cash flows used in 2015 and 2014 consisted solely of the $32.3 million cash dividend payments.  At December 31, 2016, the Company had $16.7 million committed to outstanding letters of credit. The letters of credit are maintained primarily to support performance, payment, deposit or surety obligations of the Company. The Company does not anticipate drawing on any of them and has committed to not draw any additional amounts from the line of credit.  Total cash dividend payments on common stock, on a per share basis, amounted to $1.20 in 2016, 2015 and 2014. No treasury stock was purchased in 2016, 2015 or 2014. The Board of Directors’ 2004 resolution authorizing the repurchase of up to one million shares of the Company’s common stock has a remaining balance of 752,468 shares.  The Company has no other commitment of capital resources as of December 31, 2016, other than the lease commitments on its store facilities and transportation equipment under operating leases that expire at various dates through 2033. The Company anticipates funding its working capital requirements and its $90 million 2017 capital expansion program through cash and future internally generated cash flows from operations, as well as the revolving credit facility agreement the Company entered into on September 1, 2016 with Wells Fargo Bank, National Association. The remaining balance as of December 31, 2016 is $18.8 million, which is the net amount of the original $100.0 million available through the revolving credit facility agreement, less the $64.5 million borrowed and the $16.7 million dollars of outstanding letters of credit. On March 13, 2017, the line of credit available through the revolving credit facility was increased to $120.0 million.  The Company’s marketable securities portfolio currently consists of municipal bonds and equity securities. Other short-term investments are classified as cash equivalents on the Consolidated Balance Sheets.  Under its current policies, the Company invests in high-grade marketable debt securities and does not use interest rate derivative instruments to manage exposure to interest rate fluctuations. Currently, the Company’s investment strategy of obtaining marketable debt securities with maturity dates between one and ten years helps to minimize market risk and to maintain a balance between risk and return. The equity securities owned by the Company consist primarily of stock held in large capitalized companies trading on public security exchange markets. The Company’s management continually monitors the risk associated with its marketable securities. A quantitative tabular presentation of risk exposure is located in “

<s>[INST] Overview  The following Management’s Discussion and Analysis of Financial Condition and Results of Operations (MD&A) is intended to help the reader understand Weis Markets, Inc., its operations and its present business environment. The MD&A is provided as a supplement to and should be read in conjunction with the Consolidated Financial Statements and the accompanying notes thereto contained in “Item 8. Financial Statements and Supplementary Data” of this report. The following analysis should also be read in conjunction with the Financial Statements included in the Quarterly Reports on Form 10Q and the Annual Report on Form 10K filed with the U.S. Securities and Exchange Commission, as well as the cautionary statement captioned “ForwardLooking Statements” immediately following this analysis. This overview summarizes the MD&A, which includes the following sections:  Company Overview a general description of the Company’s business and strategic imperatives.  Results of Operations an analysis of the Company’s consolidated results of operations for the three years presented in the Company’s Consolidated Financial Statements.  Liquidity and Capital Resources an analysis of cash flows, aggregate contractual obligations, and offbalance sheet arrangements.  Critical Accounting Policies and Estimates a discussion of accounting policies that require critical judgments and estimates.  Company Overview  General  Weis Markets, Inc. was founded in 1912 by Harry and Sigmund Weis in Sunbury, Pennsylvania. Today, the Company ranks among the top 50 United States and Canadian Food Retailers and Wholesalers in revenues generated. As of December 31, 2016, the Company operated 204 retail food stores in Pennsylvania and six surrounding states: Delaware, Maryland, New Jersey, New York, Virginia and West Virginia.  Company revenues are generated in its retail food stores from the sale of a wide variety of consumer products including groceries, dairy products, frozen foods, meats, seafood, fresh produce, floral, pharmacy services, deli products, prepared foods, bakery products, beer and wine, fuel, and general merchandise items, such as health and beauty care and household products. The Company supports its retail operations through a centrally located distribution facility, its own transportation fleet, three manufacturing facilities and its administrative offices. The Company's operations are reported as a single reportable segment.   WEIS MARKETS, INC.  Item 7. Management's Discussion and Analysis of Financial Condition and Results of Operations: (continued)  Company Overview, (continued)  Strategic Imperatives  The following strategic imperatives continue to be focused upon by the Company to attempt to ensure the success of the Company in the coming years:  · Establish a Sales Driven Culture The Company continues to focus on sales and profits growth, improved operating practices, increased productivity and positive cash flow. The Company believes disciplined growth will increase its market share and operating profits, resulting in enhanced shareholder value. The Company’s method of driving sales includes focused preparation and execution of sales programs, investing in new stores and remodels, and strategic acquisitions. Communicating clear executable standards and aligning performance measures across the organization will help to instill a salesdriven operating environment.  · Continuously Upgrade Organizational Talent Pool In support of the Company’s growth and sales building strategies, the Company is committed to growing leaders at every level throughout the organization through enhanced leadership development programs, succession planning, and establishing rewarding career paths. The Company believes that continuing to build associate engagement and develop associate talent directly impacts its ability to compete and execute strategic plans. The Company views this as a strategic imperative for future growth.  · Become More Relevant to Consumers Understanding the consumer is crucial to the Company’s strategic plan. Research can be done by studying the wants and needs of core consumers and casual consumers. Measuring customer satisfaction and sharing insights across the organization will help communication between management and its consumers. The Company strives to build customer loyalty by [/INST] Positive. </s>

WEIS MARKETS INC

2018-03-15

2017-12-30

Item 7. Management's Discussion and Analysis of Financial Condition and Results of Operations:  Overview  The following Management’s Discussion and Analysis of Financial Condition and Results of Operations (MD&A) is intended to help the reader understand Weis Markets, Inc., its operations and its present business environment. The MD&A is provided as a supplement to and should be read in conjunction with the Consolidated Financial Statements and the accompanying notes thereto contained in “Item 8. Financial Statements and Supplementary Data” of this report. The following analysis should also be read in conjunction with the Financial Statements included in the Quarterly Reports on Form 10-Q and the Annual Report on Form 10-K filed with the U.S. Securities and Exchange Commission, as well as the cautionary statement captioned “Forward-Looking Statements” immediately following this analysis. This overview summarizes the MD&A, which includes the following sections:  • Company Overview - a general description of the Company’s business and strategic imperatives.  • Results of Operations - an analysis of the Company’s consolidated results of operations for the three years presented in the Company’s Consolidated Financial Statements.  • Liquidity and Capital Resources - an analysis of cash flows, aggregate contractual obligations, and off-balance sheet arrangements.  • Critical Accounting Policies and Estimates - a discussion of accounting policies that require critical judgments and estimates.  Company Overview  General  Weis Markets is a conventional supermarket chain that operates 205 retail stores with over 23,000 associates located in Pennsylvania and six surrounding states: Delaware, Maryland, New Jersey, New York, Virginia, and West Virginia. Its products sold include groceries, dairy products, frozen foods, meats, seafood, fresh produce, floral, pharmacy services, deli products, prepared foods, bakery products, beer and wine, fuel, and general merchandise items, such as health and beauty care and household products. The store product selection includes national, local and private brands and the Company promotes by using Everyday Lower Price, Low Price Guarantee and Loyalty programs. The Loyalty program includes fuel rewards that may be redeemed at the Company’s fuel stations or one of its third-party fuel station partners.  Utilizing its own centrally located distribution center and transportation fleet, Weis Markets self distributes approximately 67% of product with the remaining being supplied by direct store vendors. In addition, the Company has three manufacturing facilities which process milk, ice cream and fresh meat products. The corporate offices are located in Sunbury, PA where the Company was founded in 1912. The Company’s operations are reported as a single reportable segment. WEIS MARKETS, INC. Item 7. Management's Discussion and Analysis of Financial Condition and Results of Operations: (continued)  Company Overview, (continued)  Strategic Imperatives  The following strategic imperatives continue to be focused upon by the Company to attempt to ensure the success of the Company in the coming years:  · Establish a Sales Driven Culture - The Company continues to focus on sales and profits growth, improved operating practices, increased productivity and positive cash flow. The Company believes disciplined growth will increase its market share and operating profits, resulting in enhanced shareholder value. The Company’s method of driving sales includes focused preparation and execution of sales programs, investing in new stores and remodels, and strategic acquisitions. Communicating clear executable standards and aligning performance measures across the organization will help to instill a sales-driven operating environment.  · Build and Support Human Resources - The Company is committed to creating a sustainable competitive advantage through the selection, development and promotion of the best people. The Company believes that establishing a learning culture will both support its commitment to be an employer of choice and will drive customer engagement with its associates. Improvements in the Company’s human capital communication and support structures will facilitate internal career opportunities which will improve retention of top talent. The Company continues to grow leaders at every level throughout the organization by creating a culture of mentoring, coaching and leveraging on-the-job assignments for continued development. The Company believes that a strong employment brand is necessary to build associate engagement and directly impacts its ability to compete and execute strategic plans. The Company will continue to assess and upgrade underlying technologies to support human capital development as a strategic imperative for future growth.  · Become More Relevant to Consumers - Understanding the consumer is crucial to the Company’s strategic plan. The Company will develop and cultivate a culture where it’s continually “on trend” with its consumers at the current time and where they are going next. The Company researches and studies the wants and needs of core consumers and casual consumers. It measures customer satisfaction and shares insights across the organization to improve communication between management and its consumers. The Company uses consumer data to measure the value of programs offered and support consumer attraction and retention. The Company believes that private brand products exceed consumer expectations and will focus on the value and attribute messaging to drive organic growth.  · Create Meaningful Differentiation - The Company recognizes the need to offer a compelling reason for customers to choose them over other channels. The Company has identified product pricing and promotion, customer shopping experience, and merchandising strategies as critical components of future success. The Company recognizes that the core of the strategy will focus on alignment of merchandising programs that foster customer engagement supported by a shopping experience that delivers the customer’s needs. As part of this strategy, management is committed to offering its customers a strong combination of quality, service and value.  · Develop and Align Organizational Capabilities - The Company will elevate organizational capacity to support decision effectiveness and deliver consistent execution. To support this strategy the Company will assess organizational capacity to support the Company’s strategic direction. The Company will align business functions and processes to enhance key capabilities and to support scalability of operations. Continued investments in information technology systems to improve associate engagement, increase productivity, and provide valuable insight into customer behavior/shopping trends will remain a focus of the Company. The Company believes these systems will continue to play a key role in the measurement of the Company’s strategic decisions and financial returns.  · Focus on Sustainability Strategies - The Company strives to be good stewards of the environment and makes this an important part of its overall mission. Its sustainability strategy operates under four key pillars: green design, natural resource conservation, food and agricultural impact and social responsibility. The goal of the sustainability strategy is to reduce the Company’s overall carbon footprint by reducing greenhouse gas emissions and reducing the impact on climate change. WEIS MARKETS, INC. Item 7. Management's Discussion and Analysis of Financial Condition and Results of Operations: (continued)  Results of Operations   Net Sales   ____________________ (1) The 2017 and 2015 years were comprised of 52 weeks where the 2016 year was comprised of 53 weeks. Due to the Company’s 2016 fiscal year being comprised of 53 weeks, the first quarter of 2017 did not include a New Year holiday sales week. Management estimates the incremental holiday sales impact was approximately $3.0 million in 2016. The $3.0 million holiday impact has been removed from the 2016 comparable sales numbers above.  When calculating the percentage change in comparable store sales, the Company defines a new store to be comparable when it has been in operation for five full quarters. Relocated stores and stores with expanded square footage are included in comparable store sales since these units are located in existing markets and are open during construction. Planned store dispositions are excluded from the calculation. The Company only includes retail food stores in the calculation. WEIS MARKETS, INC. Item 7. Management's Discussion and Analysis of Financial Condition and Results of Operations: (continued)  Results of Operations (continued)  Net Sales (continued)  According to the latest U.S. Bureau of Labor Statistics’ report, the annual Seasonally Adjusted Food-at-Home Consumer Price Index decreased 0.2% and 1.3% in 2017 and 2016 respectively but increased 1.1% in 2015. Even though the U.S. Bureau of Labor Statistics’ index rates may be reflective of a trend, it will not necessarily be indicative of the Company’s actual results. According to the U.S. Department of Energy, the 52-week average price of gasoline in the Central Atlantic States increased 13.1%, or $0.31 per gallon, in 2017 compared to the 53-week average in 2016. The 53-week average price of gasoline in the Central Atlantic States, according to the U.S. Department of Energy, decreased 10.1%, or $0.26 per gallon, in 2016 compared to the 52-week average in 2015.  The Company attributes the increased net sales primarily to the acquisition of 44 locations in the second half of 2016. Comparable store sales increased for all years presented. The Company was able to achieve this through targeted, tactical marketing programs in key regional markets along with its chain wide sales-driving promotional programs such as its loyalty card. In conjunction with its marketing initiatives the Company continues to add additional product offerings and customer conveniences such as “Click and Collect.” “Click and Collect” allows the customer to order on-line and then pick their order up at a drive thru location at the store. With the aforementioned offerings and programs, the Company was able to offset substantial deflationary pressures in its fresh departments most notably meat and produce. Pharmacy sales volume increased as a result of the Affordable Care Act and increased immunizations. Fuel sales benefited from inflation as comparable fuel sales rose 12.2% during 2017.  Although the Company experienced retail inflation and deflation in various commodities for the years presented, management cannot accurately measure the full impact of inflation or deflation on retail pricing due to changes in the types of merchandise sold between periods, shifts in customer buying patterns and the fluctuation of competitive factors. Management remains confident in its ability to generate sales growth in a highly competitive environment, but also understands some competitors have greater financial resources and could use these resources to take measures which could adversely affect the Company's competitive position.  Cost of Sales and Gross Profit  Cost of sales consists of direct product costs (net of discounts and allowances), distribution center and transportation costs, as well as manufacturing facility operations. Almost all of the increase in cost of sales in 2017 as compares to 2016 is due to the increased sales volume in 2017. Both direct product cost and distribution cost increase when sales volume increases.  Gross profit rate was 26.7% in 2017, 27.8% in 2016 and 27.3% in 2015. The decline in gross profit margin in 2017 can be attributed to lower than average winter sales volume due to lack of winter weather events in the first quarter of 2017. Decreased sales volume negatively impacts the gross profit margin by increasing inventory shrinkage and fixed distribution costs comparative rates. In the third quarter of 2017 retail deflation combined with cost inflation, decreased sales volume, competitive pricing and inventory management challenges in some of the recently acquired stores significantly reduced profits as a percent of sales for the produce, deli/food service, bakery, seafood and floral departments. The 2016 increase in gross profit rate as compared to 2015 was driven by a shift in sales mix from fuel to grocery sales which carry a higher profit margin.  The Company experienced non-cash LIFO inventory valuation adjustment income of $1.1 million and $2.2 million for 2017 and 2016, respectively, and adjustment expense of $1.4 million for 2015.  Although the Company experienced product cost inflation and deflation in various commodities in 2017, 2016 and 2015, management cannot accurately measure the full impact of inflation or deflation on retail pricing due to changes in the types of merchandise sold between periods, shifts in customer buying patterns and the fluctuation of competitive factors. WEIS MARKETS, INC. Item 7. Management's Discussion and Analysis of Financial Condition and Results of Operations: (continued)  Results of Operations (continued)  Operating, General and Administrative Expenses  The majority of the expenses were driven by increased sales volume.  Employee-related costs such as wages, employer paid taxes, health care benefits and retirement plans, comprise approximately 60% of the total “Operating, general and administrative expenses.” As a percent of sales, direct store labor decreased 0.2% in 2017 compared to 2016 and increased 0.2% in 2016 compared to 2015. The percent of sales increase in 2016 is due to the labor involved in opening the 44 acquisition stores in the second half of 2016. State and local minimum wage laws continue to be a challenge for the Company however, management continues to monitor store labor efficiencies and develop labor standards to reduce costs while maintaining the Company’s customer service expectations to offset their impact.  The Company’s self-insured health care benefit expenses increased by 4.2% in 2017 compared to 2016 and increased by 15.4% in 2016 compared to 2015 and as a percent of sales were 0.9%, 1.0% and 0.9% for 2017, 2016 and 2015, respectively. The increase in 2017 from 2016 is mainly attributed to the increase in participants for a full year from the acquired stores. The increase in 2016 from 2015 is mainly attributed to an increase in participants from the acquired locations as well as overall group health costs. The Company remains concerned about the impact that The Patient Protection and Affordable Care Act (ACA) will have on its future operating expenses.  Depreciation and amortization expense charged to “Operating, general and administrative expenses” was $77.4 million, or 2.2% of net sales, for 2017 compared to $69.8 million, or 2.2% of net sales, for 2016 and $63.3 million, or 2.2% of net sales, for 2015. The decrease in depreciation and amortization expense in 2017 compared to 2016 and increase in 2016 compared to 2015 was the impact of opening the 44 acquisition stores in the second half of 2016. See the Liquidity and Capital Resources section for further information regarding the Company’s capital expansion program.  In 2016, the Company determined that the asset value of one property was impaired. As a result, the Company recognized a pre-tax impairment loss of $894,000. See Note 1(l) to the Consolidated Financial Statements included in this Annual Report on Form 10-K for more information on the Company's impairment charges. The Company recognized pre-tax gains of $751,000 in 2015 from the sale of two properties.  The dollar amount increase in rent is primarily driven by the acquisition of five former Mars Super Market stores, 38 former Food Lion stores and a former Nell’s Family Market store in the second half of 2016. The Company expects the percent of sales to decrease over time as it develops the acquisition stores’ sales.  Employee related expenses increased in 2016 for the reasons noted above and due to a 25% increase in associates related the acquisition of five former Mars stores, 38 former Food Lion stores and a former Nell’s Family Market store. This increase in associates contributed to increased wages, benefits and retirement expenses.  Acquisition-related expenses, excluding the expenses mentioned above, primarily consisted of store operating expenses, travel expenses and contracted labor for store resets. WEIS MARKETS, INC. Item 7. Management's Discussion and Analysis of Financial Condition and Results of Operations: (continued)  Results of Operations (continued)  Provision for Income Taxes  The effective income tax rate was (24.5)%, 30.1% and 35.7% in 2017, 2016 and 2015, respectively. On December 22, 2017, the U.S. Government enacted the Tax Cuts and Jobs Act (the ”Tax Reform”). The Tax Reform significantly impacted the Company’s effective income tax rate by reducing the U.S. federal corporate tax rate from 35% to 21% effective January 1, 2018 and allowing immediate expensing of qualified assets placed into service after September 27, 2017. Other elements of the Tax Reform have minor impacts, however the above mentioned decreased deferred income tax by $49.3 million. The effective income tax rate decreased in 2016 due to the impact of the bargain purchase gain on the 38 locations being included in the overall gain calculation and not in income tax expense. The effective tax rate excluding the bargain purchase gain was 37.2%.  Liquidity and Capital Resources  The primary sources of cash are cash flows generated from operations and borrowings under the revolving credit agreement the Company entered into on September 1, 2016 with Wells Fargo Bank, NA. The Company’s revolving credit agreement has a principal amount of $100.0 million with an additional discretionary availability of $50.0 million. As of December 30, 2017, the Company’s unused availability under the revolving credit agreement was $46.8 million with $35.0 million of borrowings outstanding and $18.2 million of letters of credit outstanding. The letters of credit are maintained primarily to support performance, payment, deposit or surety obligations of the Company. The Company does not anticipate drawing on any of them.  The Company’s investment portfolio consists of high grade municipal bonds with maturity dates between one and 10 years and large capitalized public company equity securities. The portfolio totaled $63.7 million as of December 30, 2017. Management anticipates maintaining the investment portfolio, but has the ability to liquidate if needed. See “

<s>[INST] Overview  The following Management’s Discussion and Analysis of Financial Condition and Results of Operations (MD&A) is intended to help the reader understand Weis Markets, Inc., its operations and its present business environment. The MD&A is provided as a supplement to and should be read in conjunction with the Consolidated Financial Statements and the accompanying notes thereto contained in “Item 8. Financial Statements and Supplementary Data” of this report. The following analysis should also be read in conjunction with the Financial Statements included in the Quarterly Reports on Form 10Q and the Annual Report on Form 10K filed with the U.S. Securities and Exchange Commission, as well as the cautionary statement captioned “ForwardLooking Statements” immediately following this analysis. This overview summarizes the MD&A, which includes the following sections:  Company Overview a general description of the Company’s business and strategic imperatives.  Results of Operations an analysis of the Company’s consolidated results of operations for the three years presented in the Company’s Consolidated Financial Statements.  Liquidity and Capital Resources an analysis of cash flows, aggregate contractual obligations, and offbalance sheet arrangements.  Critical Accounting Policies and Estimates a discussion of accounting policies that require critical judgments and estimates.  Company Overview  General  Weis Markets is a conventional supermarket chain that operates 205 retail stores with over 23,000 associates located in Pennsylvania and six surrounding states: Delaware, Maryland, New Jersey, New York, Virginia, and West Virginia. Its products sold include groceries, dairy products, frozen foods, meats, seafood, fresh produce, floral, pharmacy services, deli products, prepared foods, bakery products, beer and wine, fuel, and general merchandise items, such as health and beauty care and household products. The store product selection includes national, local and private brands and the Company promotes by using Everyday Lower Price, Low Price Guarantee and Loyalty programs. The Loyalty program includes fuel rewards that may be redeemed at the Company’s fuel stations or one of its thirdparty fuel station partners.  Utilizing its own centrally located distribution center and transportation fleet, Weis Markets self distributes approximately 67% of product with the remaining being supplied by direct store vendors. In addition, the Company has three manufacturing facilities which process milk, ice cream and fresh meat products. The corporate offices are located in Sunbury, PA where the Company was founded in 1912. The Company’s operations are reported as a single reportable segment. WEIS MARKETS, INC. Item 7. Management's Discussion and Analysis of Financial Condition and Results of Operations: (continued)  Company Overview, (continued)  Strategic Imperatives  The following strategic imperatives continue to be focused upon by the Company to attempt to ensure the success of the Company in the coming years:  · Establish a Sales Driven Culture The Company continues to focus on sales and profits growth, improved operating practices, increased productivity and positive cash flow. The Company believes disciplined growth will increase its market share and operating profits, resulting in enhanced shareholder value. The Company’s method of driving sales includes focused preparation and execution of sales programs, investing in new stores and remodels, and strategic acquisitions. Communicating clear executable standards and aligning performance measures across the organization will help to instill a salesdriven operating environment.  · Build and Support Human Resources The Company is committed to creating a sustainable competitive advantage through the selection, development and promotion of the best people. The Company believes that establishing a learning culture will both support its commitment to be an employer of choice and will drive customer engagement with its associates. Improvements in the Company’s human capital communication and support structures will facilitate internal career opportunities which will improve retention of top talent. The Company continues to grow leaders at every level throughout the organization by creating a culture of mentoring, coaching and leveraging onthejob assignments for continued development. The Company believes that a strong employment brand is necessary to build associate eng [/INST] Positive. </s>

WEIS MARKETS INC

2019-03-14

2018-12-29

Item 7. Management's Discussion and Analysis of Financial Condition and Results of Operations:  Overview  The following Management’s Discussion and Analysis of Financial Condition and Results of Operations (MD&A) is intended to help the reader understand Weis Markets, Inc., its operations and its present business environment. The MD&A is provided as a supplement to and should be read in conjunction with the Consolidated Financial Statements and the accompanying notes thereto contained in “Item 8. Financial Statements and Supplementary Data” of this report. The following analysis should also be read in conjunction with the Financial Statements included in the Quarterly Reports on Form 10-Q and the Annual Report on Form 10-K filed with the U.S. Securities and Exchange Commission, as well as the cautionary statement captioned “Forward-Looking Statements” immediately following this analysis. This overview summarizes the MD&A, which includes the following sections:  · Company Overview - a general description of the Company’s business and strategic imperatives.  · Results of Operations - an analysis of the Company’s consolidated results of operations for the three years presented in the Company’s Consolidated Financial Statements.  · Liquidity and Capital Resources - an analysis of cash flows, aggregate contractual obligations, and off-balance sheet arrangements.  · Critical Accounting Policies and Estimates - a discussion of accounting policies that require critical judgments and estimates.  Company Overview  General  Weis Markets is a conventional supermarket chain that operates 200 retail stores with over 23,000 associates located in Pennsylvania and six surrounding states: Delaware, Maryland, New Jersey, New York, Virginia, and West Virginia. Its products sold include groceries, dairy products, frozen foods, meats, seafood, fresh produce, floral, pharmacy services, deli products, prepared foods, bakery products, beer and wine, fuel, and general merchandise items, such as health and beauty care and household products. The store product selection includes national, local and private brands and the Company promotes by using Everyday Lower Price, Low Price Guarantee, Low, Low Price, and Loyalty programs. The Loyalty program includes fuel rewards that may be redeemed at the Company’s fuel stations or one of its third-party fuel station partners. On January 17, 2019 the Company announced a new pricing strategy for its private brand products named Low, Low Price. The move takes the Company’s private brand products from a high, low pricing strategy to everyday low cost.  Utilizing its own centrally located distribution center and transportation fleet, Weis Markets self distributes approximately 65% of product with the remaining being supplied by direct store vendors. In addition, the Company has three manufacturing facilities which process milk, ice cream and fresh meat products. The corporate offices are located in Sunbury, PA where the Company was founded in 1912. The Company’s operations are reported as a single reportable segment.  In 2016, Weis Markets acquired five Mars Super Market locations in Baltimore County, MD, 38 Food Lion stores throughout Maryland, Virginia and Delaware, and a Nell's Family Market in East Berlin, PA. The completion of these individual acquisitions expanded the Company's footprint into Virginia and Delaware, and increased its store count by 25 percent. The Food Lion acquisition resulted in a 2016 Gain on Bargain Purchase Net of Tax being recorded of $23.8 million. To date the acquired store group is providing a positive cash flow for the Company at a greater return on the fair value investment than if stores had been organically established. As the acquired stores assimilate, management anticipates the adverse impact of these stores on Company margins to lessen. During 2018, the Company closed two former Food Lion stores from the acquired store group. Although there are no pending acquisitions, the Company continues to actively investigate acquisition opportunities as well as grow its existing store base organically.  The Company continues to innovate and remain relevant to industry trends and offer customer convenience by presenting programs like “Weis 2 Go Online” and home delivery. In 2018 the Company offered Weis 2 Go Online in 89 of its locations. Weis 2 Go Online allows the customer to order on-line and then pick up their order at a drive-thru location at the store. The Company began offering home delivery during the third quarter of 2018 and currently offers this convenience to customers in 173 different locations. WEIS MARKETS, INC. Item 7. Management's Discussion and Analysis of Financial Condition and Results of Operations: (continued)  Company Overview, (continued)  Strategic Imperatives  The following strategic imperatives continue to be focused upon by the Company to attempt to ensure the success of the Company in the coming years:  · Establish a Sales Driven Culture - The Company continues to focus on sales and profits growth, improved operating practices, increased productivity and positive cash flow. The Company believes disciplined growth will increase its market share and operating profits, resulting in enhanced shareholder value. The Company’s method of driving sales includes focused preparation and execution of sales programs, investing in new stores and remodels, and strategic acquisitions. Communicating clear executable standards and aligning performance measures across the organization will help to instill a sales-driven operating environment.  · Build and Support Human Capital - The Company believes that talent is a business differentiator and is committed to creating a sustainable competitive advantage through the selection, development and promotion of talented, highly motivated people. The Company believes that establishing a learning culture supports its commitment to be an employer of choice and helps drive customer engagement with its associates. Improvements in the Company’s talent management and development will help drive business impact while providing internal career opportunities. The Company continues to grow leaders at every level throughout the organization by creating a culture of mentoring, coaching and leveraging on-the-job assignments for continued development. The Company believes that a strong employment brand is necessary to attract and retain top talent and affects its ability to compete and execute strategic plans. The Company will continue to assess and upgrade underlying technologies to support human capital development as a strategic imperative for future growth.  · Become More Relevant to Consumers - Understanding the consumer is crucial to the Company’s strategic plan. The Company will develop and cultivate a culture where it’s continually “on trend” with its consumers at the current time and where they are going next. The Company researches and studies the wants and needs of core consumers and casual consumers. It measures customer satisfaction and shares insights across the organization to improve communication between management and its consumers. The Company uses consumer data to measure the value of programs offered and support consumer attraction and retention. The Company believes that its private brand products exceed consumer expectations and will continue to focus on the value and attribute messaging to drive organic growth.  · Create Meaningful Differentiation - The Company recognizes the need to offer a compelling reason for customers to choose them over other channels. The Company has identified product pricing and promotion, customer shopping experience, and merchandising strategies as critical components of future success. The Company recognizes that the core of the strategy will focus on alignment of merchandising programs that foster customer engagement supported by a shopping experience that surpasses customers’ expectations. As part of this strategy, management is committed to offering its customers a strong combination of quality, service and value.  · Develop and Align Organizational Capabilities - The Company will elevate organizational capacity to support decision effectiveness and deliver consistent execution. To support this strategy the Company will assess organizational capacity to support the Company’s strategic direction. The Company will align business functions and processes to enhance key capabilities and to support scalability of operations. Continued investments in information technology systems to improve associate engagement, increase productivity, and provide valuable insight into customer behavior/shopping trends will remain a focus of the Company. The Company believes these systems will continue to play a key role in the measurement of the Company’s strategic decisions and financial returns.  · Focus on Sustainability Strategies - The Company strives to be good stewards of the environment and makes this an important part of its overall mission. Its sustainability strategy operates under four key pillars: green design, natural resource conservation, food and agricultural impact and social responsibility. The goal of the sustainability strategy is to reduce the Company’s overall carbon footprint by reducing greenhouse gas emissions and reducing the impact on climate change. WEIS MARKETS, INC. Item 7. Management's Discussion and Analysis of Financial Condition and Results of Operations: (continued)  Results of Operations     Net Sales   ____________________ (1) The 2018 and 2017 years were comprised of 52 weeks where the 2016 year was comprised of 53 weeks. Due to the Company’s 2016 fiscal year being comprised of 53 weeks, the first quarter of 2017 did not include a New Year holiday sales week. Management estimates the incremental holiday sales impact was approximately $3.0 million in 2016. The $3.0 million holiday impact has been removed from the 2016 comparable sales numbers above.  When calculating the percentage change in comparable store sales, the Company defines a new store to be comparable when it has been in operation after five full quarters. Relocated stores and stores with expanded square footage are included in comparable store sales since these units are located in existing markets and are open during construction. Planned store dispositions are excluded from the calculation. The Company only includes retail food stores in the calculation. WEIS MARKETS, INC. Item 7. Management's Discussion and Analysis of Financial Condition and Results of Operations: (continued)  Results of Operations (continued)  Net Sales (continued)  According to the latest U.S. Bureau of Labor Statistics’ report, the annual Seasonally Adjusted Food-at-Home Consumer Price Index increased 0.7% in 2018 but decreased 0.2% and 1.3% in 2017 and 2016, respectively. Even though the U.S. Bureau of Labor Statistics’ index rates may be reflective of a trend, it will not necessarily be indicative of the Company’s actual results. According to the U.S. Department of Energy, the 52-week average price of gasoline in the Central Atlantic States increased 9.8%, or $0.26 per gallon, in 2018 compared to the 52-week average in 2017. The 52-week average price of gasoline in the Central Atlantic States, according to the U.S. Department of Energy, increased 13.1%, or $0.31 per gallon, in 2017 compared to the 53-week average in 2016.  Comparable store sales increased for all years presented. The Company was able to achieve this through targeted, tactical marketing programs in key regional markets along with its chain wide sales-driving promotional programs such as its loyalty card. In conjunction with its marketing initiatives the Company continues to add additional product offerings and customer conveniences such as “Weis 2 Go Online” currently offered in 89 store locations. “Weis 2 Go Online” allows the customer to order on-line and then pick their order up at a drive-thru location at the store. The Company continues to expand this offering, as well as home delivery offered in 173 stores. In addition to the aforementioned offerings and programs, the Company experienced inflation in some of its fresh categories, most notably eggs, fruits, and vegetables. Fuel sales benefited from inflation as comparable fuel sales rose 10.2% during 2018.  Although the Company experienced retail inflation and deflation in various commodities for the years presented, management cannot accurately measure the full impact of inflation or deflation on retail pricing due to changes in the types of merchandise sold between periods, shifts in customer buying patterns and the fluctuation of competitive factors. Management remains confident in its ability to generate sales growth in a highly competitive environment, but also understands some competitors have greater financial resources and could use these resources to take measures which could adversely affect the Company's competitive position.  Cost of Sales and Gross Profit  Cost of sales consists of direct product costs (net of discounts and allowances), net advertising costs, distribution center and transportation costs, as well as manufacturing facility operations. Almost all the increase in cost of sales in 2018 as compares to 2017 is due to the increased sales volume in 2018. Both direct product cost and distribution cost increase when sales volume increases.  Gross profit rate was 26.6% in 2018, 26.3% in 2017 and 27.5% in 2016. The increase in gross profit margin in 2018 can be attributed to improved price optimization, the Company’s private brand initiative, and inventory management. The majority of the increase in profit margin occurred in the summer months, where fresh department sell-through during the summer vacation season much improved results to that of 2017.  The Company experienced non-cash LIFO inventory valuation adjustment income of $1.5 million, $1.1 million and $2.2 million for 2018, 2017, and 2016, respectively.  Although the Company experienced product cost inflation and deflation in various commodities in 2018, 2017 and 2016, management cannot accurately measure the full impact of inflation or deflation on retail pricing due to changes in the types of merchandise sold between periods, shifts in customer buying patterns and the fluctuation of competitive factors. WEIS MARKETS, INC. Item 7. Management's Discussion and Analysis of Financial Condition and Results of Operations: (continued)  Results of Operations (continued)  Operating, General and Administrative Expenses  The majority of the expenses were driven by increased sales volume.  Employee-related costs such as wages, employer paid taxes, health care benefits and retirement plans, comprise approximately 67% of the total “Operating, general and administrative expenses.” As a percent of sales, direct store labor increased 0.2% in 2018 compared to 2017 and decreased 0.2% in 2017 compared to 2016. State and local minimum wage laws continue to be a challenge for the Company however, management continues to monitor store labor efficiencies and develop labor standards to reduce costs while maintaining the Company’s customer service expectations to offset their impact.  The Company’s self-insured health care benefit expenses increased by 6.6% in 2018 compared to 2017 and increased by 4.2% in 2017 compared to 2016. The Company saw a higher than average amount of high dollar claims in 2018. The Company does not expect this trend to continue.  Depreciation and amortization expense charged to “Operating, general and administrative expenses” was $84.4 million, or 2.4% of net sales, for 2018 compared to $77.4 million, or 2.2% of net sales, for 2017 and $69.8 million, or 2.2% of net sales, for 2016. The increase in depreciation and amortization expense in 2018 compared to 2017 was due to the impact of opening two locations and a significant investment in stores equipment in 2018. The increase in depreciation and amortization expense in 2017 compared to 2016 was due to the impact of opening the 44 acquisition stores in the second half of 2016. See the Liquidity and Capital Resources section for further information regarding the Company’s capital expansion program.  In 2018, the Company determined that the asset value of one store property was impaired. As a result, the Company recognized a pre-tax impairment loss of $1.5 million. Similarly, in 2016, the Company determined that the asset value of one store property was impaired and recognized a pre-tax impairment loss of $894,000. See Note 1(l) to the Consolidated Financial Statements included in this Annual Report on Form 10-K for more information on the Company's impairment charges.  As Company incentive goals were not met in 2017, expense from annually accrued incentive programs decreased from 2016, then increased as 2018 goals were met.  The dollar amount increase in rent in 2017 is primarily driven by the acquisition of five former Mars Super Market stores, 38 former Food Lion stores and a former Nell’s Family Market store in the second half of 2016. The Company expects the percent of sales to decrease over time as it develops the acquisition stores’ sales.  WEIS MARKETS, INC. Item 7. Management's Discussion and Analysis of Financial Condition and Results of Operations: (continued)  Results of Operations (continued)  Provision for Income Taxes  The effective income tax rate was 23.6%, negative 24.5% and 30.1% in 2018, 2017 and 2016, respectively. The effective income tax rate differs from the federal statutory rate of 21% primarily due nondeductible employee expenses. On December 22, 2017, the U.S. Government enacted the Tax Cuts and Jobs Act (the ”Tax Reform”). The Tax Reform significantly impacted the Company’s effective income tax rate by reducing the U.S. federal corporate tax rate from 35% to 21% effective January 1, 2018 and allowing immediate expensing of qualified assets placed into service after September 27, 2017. Other elements of the Tax Reform have minor impacts, however the above mentioned decreased deferred income tax by $ 49.3 million. The effective income tax rate decreased in 2016 due to the impact of the bargain purchase gain on the 38 locations being included in the overall gain calculation and not in income tax expense. The effective tax rate excluding the bargain purchase gain was 37.2%  Liquidity and Capital Resources  The primary sources of cash are cash flows generated from operations and borrowings under the revolving credit agreement the Company entered into on September 1, 2016 with Wells Fargo Bank, NA (the “Credit Agreement”). The Credit Agreement provides for an unsecured revolving credit facility with an aggregate principal amount not to exceed $100.0 million with an additional discretionary amount available of $50.0 million. On October 24, 2018, the credit agreement was amended to reduce the available revolving credit amount from $100.0 million to $50.0 million, with an additional discretionary availability of $50.0 million. As of December 29, 2018, the availability under the revolving credit agreement was $87.1 million with $12.9 million of letters of credit outstanding. The revolving credit agreement matures on September 1, 2019. The letters of credit are maintained primarily to support performance, payment, deposit or surety obligations of the Company. The Company does not anticipate drawing on any of them.  The Company’s investment portfolio consists of high grade municipal bonds with maturity dates between one and 10 years and large capitalized public company equity securities. The portfolio totaled $54.3 million as of December 29, 2018. Management anticipates maintaining the investment portfolio, but has the ability to liquidate if needed. See “

<s>[INST] Overview  The following Management’s Discussion and Analysis of Financial Condition and Results of Operations (MD&A) is intended to help the reader understand Weis Markets, Inc., its operations and its present business environment. The MD&A is provided as a supplement to and should be read in conjunction with the Consolidated Financial Statements and the accompanying notes thereto contained in “Item 8. Financial Statements and Supplementary Data” of this report. The following analysis should also be read in conjunction with the Financial Statements included in the Quarterly Reports on Form 10Q and the Annual Report on Form 10K filed with the U.S. Securities and Exchange Commission, as well as the cautionary statement captioned “ForwardLooking Statements” immediately following this analysis. This overview summarizes the MD&A, which includes the following sections:  · Company Overview a general description of the Company’s business and strategic imperatives.  · Results of Operations an analysis of the Company’s consolidated results of operations for the three years presented in the Company’s Consolidated Financial Statements.  · Liquidity and Capital Resources an analysis of cash flows, aggregate contractual obligations, and offbalance sheet arrangements.  · Critical Accounting Policies and Estimates a discussion of accounting policies that require critical judgments and estimates.  Company Overview  General  Weis Markets is a conventional supermarket chain that operates 200 retail stores with over 23,000 associates located in Pennsylvania and six surrounding states: Delaware, Maryland, New Jersey, New York, Virginia, and West Virginia. Its products sold include groceries, dairy products, frozen foods, meats, seafood, fresh produce, floral, pharmacy services, deli products, prepared foods, bakery products, beer and wine, fuel, and general merchandise items, such as health and beauty care and household products. The store product selection includes national, local and private brands and the Company promotes by using Everyday Lower Price, Low Price Guarantee, Low, Low Price, and Loyalty programs. The Loyalty program includes fuel rewards that may be redeemed at the Company’s fuel stations or one of its thirdparty fuel station partners. On January 17, 2019 the Company announced a new pricing strategy for its private brand products named Low, Low Price. The move takes the Company’s private brand products from a high, low pricing strategy to everyday low cost.  Utilizing its own centrally located distribution center and transportation fleet, Weis Markets self distributes approximately 65% of product with the remaining being supplied by direct store vendors. In addition, the Company has three manufacturing facilities which process milk, ice cream and fresh meat products. The corporate offices are located in Sunbury, PA where the Company was founded in 1912. The Company’s operations are reported as a single reportable segment.  In 2016, Weis Markets acquired five Mars Super Market locations in Baltimore County, MD, 38 Food Lion stores throughout Maryland, Virginia and Delaware, and a Nell's Family Market in East Berlin, PA. The completion of these individual acquisitions expanded the Company's footprint into Virginia and Delaware, and increased its store count by 25 percent. The Food Lion acquisition resulted in a 2016 Gain on Bargain Purchase Net of Tax being recorded of $23.8 million. To date the acquired store group is providing a positive cash flow for the Company at a greater return on the fair value investment than if stores had been organically established. As the acquired stores assimilate, management anticipates the adverse impact of these stores on Company margins to lessen. During 2018, the Company closed two former Food Lion stores from the acquired store group. Although there are no pending acquisitions, the Company continues to actively investigate acquisition opportunities as well as grow its existing store base organically.  The Company continues to innovate and remain relevant to industry trends and offer customer convenience by presenting programs like “Weis 2 Go Online” and home delivery. In 2018 the Company offered Weis 2 Go Online in 89 of its locations. Weis 2 [/INST] Negative. </s>

WEIS MARKETS INC

2020-03-12

2019-12-28

Item 7. Management's Discussion and Analysis of Financial Condition and Results of Operations:  Overview  The following Management’s Discussion and Analysis of Financial Condition and Results of Operations (MD&A) is intended to help the reader understand Weis Markets, Inc., its operations and its present business environment. The MD&A is provided as a supplement to and should be read in conjunction with the Consolidated Financial Statements and the accompanying notes thereto contained in “Item 8. Financial Statements and Supplementary Data” of this report. The following analysis should also be read in conjunction with the Financial Statements included in the Quarterly Reports on Form 10-Q and the Annual Report on Form 10-K filed with the U.S. Securities and Exchange Commission, as well as the cautionary statement captioned “Forward-Looking Statements” immediately following this analysis. This overview summarizes the MD&A, which includes the following sections:  · Company Overview - a general description of the Company’s business and strategic imperatives.  · Results of Operations - an analysis of the Company’s consolidated results of operations for the three years presented in the Company’s Consolidated Financial Statements.  · Liquidity and Capital Resources - an analysis of cash flows, aggregate contractual obligations, and off-balance sheet arrangements.  · Critical Accounting Policies and Estimates - a discussion of accounting policies that require critical judgments and estimates.  Company Overview  General  Weis Markets is a conventional supermarket chain that operates 197 retail stores with approximately 23 thousand associates located in Pennsylvania and six surrounding states: Delaware, Maryland, New Jersey, New York, Virginia, and West Virginia. Its products sold include groceries, dairy products, frozen foods, meats, seafood, fresh produce, floral, pharmacy services, deli products, prepared foods, bakery products, beer and wine, fuel, and general merchandise items, such as health and beauty care and household products. The store product selection includes national, local and private brands and the Company promotes by using Everyday Lower Price, Low Price Guarantee, Low, Low Price, and Loyalty programs. The Loyalty program includes fuel rewards that may be redeemed at the Company’s fuel stations or one of its third-party fuel station partners. On January 17, 2019 the Company announced a new pricing strategy for its private brand products named Low, Low Price. The move took the Company’s private brand products from a high, low pricing strategy to everyday low price.  Utilizing its own centrally located distribution center and transportation fleet, Weis Markets self distributes approximately 66% of product with the remaining being supplied by direct store vendors. In addition, the Company has three manufacturing facilities which process milk, ice cream and fresh meat products. The corporate offices are located in Sunbury, PA where the Company was founded in 1912.  The Company continues to innovate and remain relevant to industry trends and offer customer convenience by presenting programs like “Weis 2 Go Online” and home delivery. In 2019 the Company offered Weis 2 Go Online in 154 of its locations, adding 65 stores since the end of 2018. Weis 2 Go Online allows the customer to order on-line and then pick up their order at a drive-thru location at the store. The Company began offering home delivery during the third quarter of 2018 and currently offers this convenience to customers in 175 different locations. WEIS MARKETS, INC. Item 7. Management's Discussion and Analysis of Financial Condition and Results of Operations: (continued)  Company Overview (continued)  Strategic Imperatives  The following strategic imperatives continue to be focused upon by the Company to attempt to ensure the success of the Company in the coming years:  · Establish a Sales Driven Culture - The Company continues to focus on sales and profits growth, improved operating practices, increased productivity and positive cash flow. The Company believes disciplined growth will increase its market share and operating profits, resulting in enhanced shareholder value. The Company’s method of driving sales includes focused preparation and execution of sales programs, investing in new stores and remodels, and strategic acquisitions. Communicating clear executable standards and aligning performance measures across the organization will help to instill a sales-driven operating environment.  · Build and Support Human Capital - The Company believes that talent is a business differentiator and is committed to creating a sustainable competitive advantage through the selection, development and promotion of talented, highly motivated people. The Company believes that establishing a learning culture supports its commitment to be an employer of choice and helps drive customer engagement with its associates. Improvements in the Company’s talent management and development will help drive business impact while providing internal career opportunities. The Company continues to grow leaders at every level throughout the organization by creating a culture of mentoring, coaching and leveraging on-the-job assignments for continued development. The Company believes that a strong employment brand is necessary to attract and retain top talent and affects its ability to compete and execute strategic plans. The Company will continue to assess and upgrade underlying technologies to support human capital development as a strategic imperative for future growth.  · Become More Relevant to Consumers - Understanding the consumer is crucial to the Company’s strategic plan. The Company will develop and cultivate a culture where it’s continually “on trend” with its consumers at the current time and where they are going next. The Company researches and studies the wants and needs of core consumers and casual consumers. It measures customer satisfaction and shares insights across the organization to improve communication between management and its consumers. The Company uses consumer data to measure the value of programs offered and support consumer attraction and retention. The Company believes that its private brand products exceed consumer expectations and will continue to focus on the value and attribute messaging to drive organic growth.  · Create Meaningful Differentiation - The Company recognizes the need to offer a compelling reason for customers to choose them over other channels. The Company has identified product pricing and promotion, customer shopping experience, and merchandising strategies as critical components of future success. The Company recognizes that the core of the strategy will focus on alignment of merchandising programs that foster customer engagement supported by a shopping experience that surpasses customers’ expectations. As part of this strategy, management is committed to offering its customers a strong combination of quality, service and value.  · Develop and Align Organizational Capabilities - The Company will elevate organizational capacity to support decision effectiveness and deliver consistent execution. To support this strategy the Company will assess organizational capacity to support the Company’s strategic direction. The Company will align business functions and processes to enhance key capabilities and to support scalability of operations. Continued investments in information technology systems to improve associate engagement, increase productivity, and provide valuable insight into customer behavior/shopping trends will remain a focus of the Company. The Company believes these systems will continue to play a key role in the measurement of the Company’s strategic decisions and financial returns.  · Focus on Sustainability Strategies - The Company strives to be good stewards of the environment and makes this an important part of its overall mission. Its sustainability strategy operates under four key pillars: green design, natural resource conservation, food and agricultural impact and social responsibility. The goal of the sustainability strategy is to reduce the Company’s overall carbon footprint by reducing greenhouse gas emissions and reducing the impact on climate change. WEIS MARKETS, INC. Item 7. Management's Discussion and Analysis of Financial Condition and Results of Operations: (continued)  Results of Operations     Net Sales     When calculating the percentage change in comparable store sales, the Company defines a new store to be comparable when it has been in operation after five full quarters. Relocated stores and stores with expanded square footage are included in comparable store sales since these units are located in existing markets and are open during construction. Planned store dispositions are excluded from the calculation. The Company only includes retail food stores in the calculation. WEIS MARKETS, INC. Item 7. Management's Discussion and Analysis of Financial Condition and Results of Operations: (continued)  Results of Operations (continued)  Net Sales (continued)  According to the latest U.S. Bureau of Labor Statistics’ report, the annual Seasonally Adjusted Food-at-Home Consumer Price Index increased 0.9% in 2019 and 0.7% in 2018, but decreased 0.2% in 2017. Even though the U.S. Bureau of Labor Statistics’ index rates may be reflective of a trend, it will not necessarily be indicative of the Company’s actual results. According to the U.S. Department of Energy, the 52-week average price of gasoline in the Central Atlantic States decreased 5.7%, or $0.17 per gallon, in 2019 compared to the 52-week average in 2018. The 52-week average price of gasoline in the Central Atlantic States, according to the U.S. Department of Energy, increased 9.8%, or $0.26 per gallon, in 2018 compared to the 52-week average in 2017.  Comparable store sales increased for all years presented. On a comparable store sales basis all product categories, Center Store, Fresh, Pharmacy Services, and Fuel, increased in sales. In 2019, customer acceptance of the new Low, Low Price private brand program has augmented sales, as has additional product offerings and customer conveniences such as “Weis 2 Go Online,” currently offered at 175 store locations. “Weis 2 Go Online” allows the customer to order on-line and have their order delivered or, at 154 locations, pick up their order at an expedient store drive-thru.  Although the Company experienced retail inflation and deflation in various commodities for the years presented, management cannot accurately measure the full impact of inflation or deflation on retail pricing due to changes in the types of merchandise sold between periods, shifts in customer buying patterns and the fluctuation of competitive factors. Management remains confident in its ability to generate sales growth in a highly competitive environment, but also understands some competitors have greater financial resources and could use these resources to take measures which could adversely affect the Company's competitive position.  Cost of Sales and Gross Profit  Cost of sales consists of direct product costs (net of discounts and allowances), net advertising costs, distribution center and transportation costs, as well as manufacturing facility operations. Increased sales volume resulted in an increase in cost of sales. Both direct product cost and distribution cost increase when sales volume increases.  Gross profit rate was 26.5% in 2019, 26.6% in 2018 and 26.3% in 2017. Declining retails and costs in the first two quarters of 2019 in fuel, fruits, vegetables and eggs had a negative impact on gross profit rates, while year to date pharmacy gross profits are being pressured by recent changes in industry practices. While the various commodities’ retails and costs are cyclical in nature, the Company cannot predict whether the pharmacy industry practices will change favorably.  The Company experienced favorable non-cash LIFO inventory valuation adjustments, increasing gross profit by $5.8 million, $1.5 million and $1.1 million for 2019, 2018 and 2017, respectively.  Although the Company experienced product cost inflation and deflation in various commodities in 2019, 2018 and 2017, management cannot accurately measure the full impact of inflation or deflation on retail pricing due to changes in the types of merchandise sold between periods, shifts in customer buying patterns and the fluctuation of competitive factors. WEIS MARKETS, INC. Item 7. Management's Discussion and Analysis of Financial Condition and Results of Operations: (continued)  Results of Operations (continued)  Operating, General and Administrative Expenses  The majority of the expenses were driven by increased sales volume.  Employee-related costs such as wages, employer paid taxes, health care benefits and retirement plans, comprise approximately 61% of the total “Operating, general and administrative expenses.” As a percent of sales, direct store labor decreased 0.1% in 2019 compared to 2018 and increased 0.2% in 2018 compared to 2017. Management continues to monitor store labor efficiencies and develop labor standards to reduce costs while maintaining the Company’s customer service expectations. Currently, the Company is undergoing an initiative to install or upgrade self-checkouts in its stores in response to customer preference and labor rates and supply.  The Company’s self-insured health care benefit expenses increased by 1.0% in 2019 compared to 2018 and increased by 6.6% in 2018 compared to 2017.  Depreciation and amortization expense charged to “Operating, general and administrative expenses” was $85.2 million, or 2.4% of net sales, for 2019 compared to $84.4 million, or 2.4% of net sales, for 2018 and $77.4 million, or 2.2% of net sales, for 2017. There was no change in depreciation and amortization expense as a percent of sales in 2019 when compared to 2018, however when 2018 is compared to 2017 there is an increase of 0.2%. The increase in depreciation and amortization expense in 2018 compared to 2017 was due to the impact of opening two locations and a significant investment in store equipment in 2018. See the Liquidity and Capital Resources section for further information regarding the Company’s capital expansion program.        All expenses as a percent of sales presented for the 2019 fiscal year have benefited in comparison with the 2018 percent of sales due to the closure of unprofitable stores. The Company is benefiting from cost saving initiatives in various areas of its operations and is saving in utilities with a combination of purchasing, associate sustainability and capital investments such as its LED lighting program.  The Company’s 2018 sustainability report my be found at: https://www.weismarkets.com/sites/default/files/documents/weis_2018_9_ada.pdf?27 As Company incentive goals were not met in 2017, expense from annually accrued incentive programs increased in 2018 as goals were met.  WEIS MARKETS, INC. Item 7. Management's Discussion and Analysis of Financial Condition and Results of Operations: (continued)  Results of Operations (continued)  Provision for Income Taxes  The effective income tax rate was 23.3%, 23.6% and negative 24.5% in 2019, 2018 and 2017, respectively. The effective income tax rate differs from the federal statutory rate of 21% primarily due to state taxes. On December 22, 2017, the U.S. Government enacted the Tax Cuts and Jobs Act (the ”Tax Reform”). The Tax Reform significantly impacted the Company’s effective income tax rate by reducing the U.S. federal corporate tax rate from 35% to 21% effective January 1, 2018 and allowing immediate expensing of qualified assets placed into service after September 27, 2017. Other elements of the Tax Reform have minor impacts, however the above mentioned decreased deferred income tax by $49.3 million.  Liquidity and Capital Resources  The primary source of cash is cash flows generated from operations. In addition, the Company has access to a revolving credit agreement entered into on September 1, 2016, and amended on August 21, 2019, with Wells Fargo Bank, NA (the “Credit Agreement”). The Credit Agreement matures on September 1, 2022 and provides for an unsecured revolving credit facility with an aggregate principal amount not to exceed $30.0 million with an additional discretionary amount available of $70.0 million. As of December 28, 2019, the availability under the revolving credit agreement was $18.8 million with $11.2 million of letters of credit outstanding. The letters of credit are maintained primarily to support performance, payment, deposit or surety obligations of the Company.  The Company’s investment portfolio consists of high-grade bonds with maturity dates between one and 10 years and three long-held high yield, large capitalized public company equity securities. The portfolio totaled $63.5 million as of December 28, 2019. Management anticipates maintaining the investment portfolio, but has the ability to liquidate if needed. See “

<s>[INST] Overview  The following Management’s Discussion and Analysis of Financial Condition and Results of Operations (MD&A) is intended to help the reader understand Weis Markets, Inc., its operations and its present business environment. The MD&A is provided as a supplement to and should be read in conjunction with the Consolidated Financial Statements and the accompanying notes thereto contained in “Item 8. Financial Statements and Supplementary Data” of this report. The following analysis should also be read in conjunction with the Financial Statements included in the Quarterly Reports on Form 10Q and the Annual Report on Form 10K filed with the U.S. Securities and Exchange Commission, as well as the cautionary statement captioned “ForwardLooking Statements” immediately following this analysis. This overview summarizes the MD&A, which includes the following sections:  · Company Overview a general description of the Company’s business and strategic imperatives.  · Results of Operations an analysis of the Company’s consolidated results of operations for the three years presented in the Company’s Consolidated Financial Statements.  · Liquidity and Capital Resources an analysis of cash flows, aggregate contractual obligations, and offbalance sheet arrangements.  · Critical Accounting Policies and Estimates a discussion of accounting policies that require critical judgments and estimates.  Company Overview  General  Weis Markets is a conventional supermarket chain that operates 197 retail stores with approximately 23 thousand associates located in Pennsylvania and six surrounding states: Delaware, Maryland, New Jersey, New York, Virginia, and West Virginia. Its products sold include groceries, dairy products, frozen foods, meats, seafood, fresh produce, floral, pharmacy services, deli products, prepared foods, bakery products, beer and wine, fuel, and general merchandise items, such as health and beauty care and household products. The store product selection includes national, local and private brands and the Company promotes by using Everyday Lower Price, Low Price Guarantee, Low, Low Price, and Loyalty programs. The Loyalty program includes fuel rewards that may be redeemed at the Company’s fuel stations or one of its thirdparty fuel station partners. On January 17, 2019 the Company announced a new pricing strategy for its private brand products named Low, Low Price. The move took the Company’s private brand products from a high, low pricing strategy to everyday low price.  Utilizing its own centrally located distribution center and transportation fleet, Weis Markets self distributes approximately 66% of product with the remaining being supplied by direct store vendors. In addition, the Company has three manufacturing facilities which process milk, ice cream and fresh meat products. The corporate offices are located in Sunbury, PA where the Company was founded in 1912.  The Company continues to innovate and remain relevant to industry trends and offer customer convenience by presenting programs like “Weis 2 Go Online” and home delivery. In 2019 the Company offered Weis 2 Go Online in 154 of its locations, adding 65 stores since the end of 2018. Weis 2 Go Online allows the customer to order online and then pick up their order at a drivethru location at the store. The Company began offering home delivery during the third quarter of 2018 and currently offers this convenience to customers in 175 different locations. WEIS MARKETS, INC. Item 7. Management's Discussion and Analysis of Financial Condition and Results of Operations: (continued)  Company Overview (continued)  Strategic Imperatives  The following strategic imperatives continue to be focused upon by the Company to attempt to ensure the success of the Company in the coming years:  · Establish a Sales Driven Culture The Company continues to focus on sales and profits growth, improved operating practices, increased productivity and positive cash flow. The Company believes disciplined growth will increase its market share and operating profits, resulting in enhanced shareholder value. The Company’s method of driving sales includes focused preparation and execution of sales programs, investing in new [/INST] Positive. </s>

AVISTA CORP

2015-02-25

2014-12-31

ITEM 7. MANAGEMENT'S DISCUSSION AND ANALYSIS OF FINANCIAL CONDITION AND RESULTS OF OPERATIONS Business Segments As of December 31, 2014, we have two reportable business segments, Avista Utilities and AEL&P. We also have other businesses which do not represent a reportable business segment and are conducted by various direct and indirect subsidiaries of Avista Corp. See "Part I, Item 1. Business - Company Overview" for further discussion of our business segments. The following table presents net income (loss) attributable to Avista Corp. shareholders for each of our business segments (and the other businesses) for the year ended December 31 (dollars in thousands): (1) The results for the year ended December 31, 2014 include the net gain on sale of Ecova of $69.7 million. Executive Level Summary Overall Results Net income attributable to Avista Corporation shareholders was $192.0 million for 2014, an increase from $111.1 million for 2013. The increase was primarily due to the disposition of Ecova, which resulted in the recognition of a $69.7 million net gain. In addition, we recognized a $15.0 million pre-tax gain during the second quarter related to the settlement of the California power markets litigation involving Avista Energy. The gain from the litigation settlement was partially offset by a pre-tax contribution of $6.4 million of the proceeds to the Avista Foundation, a charitable organization funded by Avista Corp. Earnings at Avista Utilities increased due to the implementation of general rate increases in each of our jurisdictions, lower net power supply costs and a decrease in interest expense, partially offset by the provision for earnings sharing in Idaho. There were also expected increases in other operating expenses, depreciation and amortization and taxes other than income taxes. Utility results for 2013 also included the net benefit from the settlement with the BPA. Avista Utilities Avista Utilities is our most significant business segment. Our utility financial performance is dependent upon, among other things: • weather conditions (temperatures, precipitation levels and wind patterns) which affect energy demand and electric generation, including the effect of precipitation and temperature on hydroelectric resources, the effect of wind patterns on wind-generated power, weather-sensitive customer demand, and similar impacts on supply and demand in the wholesale energy markets, • regulatory decisions, allowing our utility to recover costs, including purchased power and fuel costs, on a timely basis, and to earn a reasonable return on investment, • the price of natural gas in the wholesale market, including the effect on the price of fuel for generation, and • the price of electricity in the wholesale market, including the effects of weather conditions, natural gas prices and other factors affecting supply and demand. Forecasted Customer and Load Growth Based on our forecast for 2015 through 2018 for Avista Utilities' service area, we expect annual electric customer growth to average 1.2 percent, within a forecast range of 0.8 percent to 1.6 percent. We expect annual natural gas customer growth to average 1.0 percent, within a forecast range of 0.5 percent to 1.5 percent. We anticipate retail electric load growth to average 0.8 percent, within a forecast range of 0.5 percent and 1.1 percent. We expect natural gas load growth to average 1.3 percent, within a forecast range of 0.8 percent and 1.8 percent. The forecast ranges reflect (1) the inherent uncertainty associated with the economic assumptions on which forecasts are based and (2) natural gas customer and load growth has been historically more volatile. AVISTA CORPORATION In AEL&P's service area, we expect annual residential customer growth to be in a narrow range around 0.4 percent for 2015 through 2018. We expect no significant growth in commercial and government customers over the same period. We anticipate that average annual total load growth will be in a narrow range around 0.9 percent, with residential load growth averaging about 0.6 percent; commercial about 1.2 percent; and government about 1.0 percent. For further discussion regarding utility customer growth, load growth, and the general economic conditions in our service territory, see "Economic Conditions and Utility Load Growth." See also "Competition" for a discussion of competitive factors that could affect our results of operations in the future. General Rate Cases (GRC) In our utility operations (both Avista Utilities and AEL&P), we regularly review the need for rate changes in each jurisdiction to improve the recovery of costs and capital investments in our generation, transmission and distribution systems. See further discussion under "Regulatory Matters." Capital Expenditures We are making significant capital investments in generation, transmission and distribution systems to preserve and enhance service reliability for our customers and replace aging infrastructure. Avista Utilities' cash-basis capital expenditures (per the Consolidated Statement of Cash Flows) were $323.9 million for 2014. Our accrual-basis capital expenditures were $352.3 million for 2014. We expect Avista Utilities' capital expenditures to be about $375 million for 2015 and $350 million in 2016. AEL&P's capital expenditures were $1.6 million for the six month period July 1, 2014 to December 31, 2014. We expect to spend approximately $15 million for each of 2015 and 2016 related to capital expenditures at AEL&P. These estimates of capital expenditures are subject to continuing review and adjustment (see further discussion under “Capital Expenditures”). Alaska Energy and Resources Company Acquisition On July 1, 2014, we completed our acquisition of AERC, located in Juneau, Alaska, of which AEL&P is a wholly-owned subsidiary. As of July 1, 2014 AERC is a wholly-owned subsidiary of Avista Corp. In connection with the closing, we issued 4,501,441 new shares of common stock to the shareholders of AERC based on a contractual formula that resulted in a price of $32.46 per share, reflecting a purchase price of $170.0 million, plus acquired cash, less outstanding debt and other closing adjustments. This transaction resulted in the recording of $52.7 million in goodwill during 2014. Also, our acquisition of AERC provides us a platform to explore strategic opportunities to bring natural gas to Southeast Alaska. For additional information regarding the AERC transaction, see “Note 4 of the Notes to Consolidated Financial Statements.” Ecova Disposition On May 29, 2014, Avista Capital, Inc., our non-regulated subsidiary, entered into a definitive agreement to sell its interest in Ecova to Cofely USA Inc., an indirect subsidiary of GDF SUEZ, a French multinational utility company. The sales transaction was completed on June 30, 2014, for a sales price of $335.0 million in cash, less the payment of debt and other customary closing adjustments. At the closing of the transaction on June 30, 2014, Ecova became a wholly-owned subsidiary of Cofely USA Inc. The purchase price of $335.0 million, as adjusted, was divided among the security holders of Ecova, including minority shareholders and option holders, pro rata based on ownership. Approximately $16.8 million (5 percent of the purchase price) will be held in escrow for 15 months from the closing of the transaction to satisfy certain indemnification obligations under the merger agreement, and an additional $1.0 million is being held in escrow pending resolution of adjustments to working capital, which is expected to be completed in early 2015. Avista Capital and Cofely USA Inc. agreed to make an election under Code Section 338(h)(10) with respect to the purchase and sale of Ecova to allocate the merger consideration among the assets of Ecova acquired in the merger. When all remaining escrow amounts are released, the sales transaction is expected to provide cash proceeds to Avista Corp., net of debt, payment to option and minority holders, income taxes and transaction expenses, of $143.5 million and result in a net gain of $69.7 million. The Company expects to receive the full amount of its portion of the remaining escrow accounts; therefore, these amounts are included in the gain calculation. On July 1, 2014, we utilized a portion of the proceeds from the Ecova sales transaction to pay off the outstanding balance owed on our committed line of credit and we initiated a common stock share repurchase program. AVISTA CORPORATION Stock Repurchase Programs During 2014, Avista Corp. repurchased 2,529,615 shares of our outstanding common stock at a total cost of $79.9 million and an average cost of $31.57 per share through our 2014 stock repurchase program. We did not make any repurchases under this program subsequent to October 2014. Avista Corp. initiated a second stock repurchase program commencing on January 2, 2015 which will continue through March 31, 2015 for the repurchase of up to 800,000 shares of our outstanding common stock. We have not repurchased any shares under this program through January 31, 2015. See "Item 5. Market for Registrant’s Common Equity, Related Stockholder Matters and Issuer Purchases of Equity Securities" for further discussion of these stock repurchase programs. California Power Markets Litigation Settlement and Avista Foundation Charitable Contribution On June 23, 2014, Avista Energy (an unregulated indirect subsidiary of Avista Corp.) received $15.0 million in settlement proceeds from the completion of a litigation settlement with various California parties. The litigation was related to the prices paid for power in the California spot markets during the years 2000 and 2001. This resulted in Avista Energy recognizing an increase in pre-tax earnings of approximately $15.0 million, which was recorded as a reduction to other operating expenses within the non-utility operating expenses section of the Consolidated Statements of Income. See "Note 20 of the Notes to the Consolidated Financial Statements" for further information regarding this litigation settlement. Subsequent to the receipt of the settlement proceeds, we contributed approximately $6.4 million of the proceeds to the Avista Foundation. The remainder of the proceeds were used to fund current operations and decrease reliance on short-term debt. Liquidity and Capital Resources During 2014, Avista Corp. received net cash proceeds of $205.4 million from the Ecova sale (prior to tax payments of $74.8 million made in 2014) and we expect to receive additional proceeds of $13.1 million from the escrow accounts related to the sale. We used the funds to pay off $151.5 million owed on our committed line of credit, we paid $79.9 million in a share repurchase program in the second half of 2014 and we initiated a second share repurchase program for the first quarter of 2015. Avista Corp. has a committed line of credit with various financial institutions in the total amount of $400.0 million. In April 2014, we amended this committed line of credit agreement to extend the expiration to April 2019. The amendment also provides us with the option to request an extension for an additional one or two years beyond April 2019, provided, 1) there are no default events prior to the requested extension and 2) the remaining term of agreement, including the requested extension period, does not exceed five years. The amendment did not change the amount of the committed line of credit. As of December 31, 2014, there were $105.0 million of cash borrowings and $32.6 million in letters of credit outstanding leaving $262.4 million of available liquidity under this line of credit. The Avista Corp. facility contains customary covenants and default provisions, including a covenant which does not permit our ratio of “consolidated total debt” to “consolidated total capitalization” to be greater than 65 percent at any time. As of December 31, 2014, we were in compliance with this covenant with a ratio of 52.8 percent. In December 2014, we issued $60.0 million of first mortgage bonds to three institutional investors in a private placement transaction. The first mortgage bonds bear an interest rate of 4.11 percent and mature in 2044. In 2014, we issued $154.2 million (net of issuance costs) of common stock, which includes $150.1 million associated with the acquisition of AERC and the remainder under the dividend reinvestment and direct stock purchase plan, and employee plans. With respect to the acquisition of AERC on July 1, 2014 and the subsequent rebalancing of the capital structure at AERC and its primary subsidiary AEL&P, the following transactions occurred: • Avista Corp. issued 4,501,441 shares of common stock for a total fair value of $150.1 million to acquire AERC. • In September 2014, AEL&P issued $75.0 million of 4.54 percent first mortgage bonds due in 2044 to two institutional investors in a private placement transaction. The proceeds from the AEL&P bonds were used to repay approximately $38.0 million of existing AEL&P debt, with the remainder of the proceeds and cash on-hand being paid as a cash dividend of $50.0 million to Avista Corp. • In December 2014, AERC entered into a 3.85 percent $15.0 million term loan agreement which matures in December 2019. The proceeds from this term loan were paid as a cash dividend to Avista Corp. In November 2014, AEL&P entered into a committed line of credit in the amount of $25.0 million which expires in November 2019. AEL&P terminated its previous $14.5 million committed line of credit. As of December 31, 2014, there were no borrowings or letters of credit outstanding under this committed line of credit. AEL&P did not borrow under its current or previous committed lines of credit during the second half of 2014. AVISTA CORPORATION The AEL&P committed line of credit agreement contains customary covenants and default provisions including a covenant which does not permit the ratio of “consolidated total debt at AEL&P” to “consolidated total capitalization at AEL&P,” (including the impact of the Snettisham obligation) to be greater than 67.5 percent at any time. As of December 31, 2014, AEL&P was in compliance with this covenant with a ratio of 59.6 percent. For 2015, we expect to issue approximately $125.0 million of long-term debt in order to maintain an appropriate capital structure and to fund planned capital expenditures. Through January 31, 2015, we repurchased less common stock through our stock repurchase programs than anticipated. If current market conditions continue through the end of the first quarter, we do not anticipate purchasing any of the 800,000 shares authorized under the first quarter 2015 program. If this occurs, we do not expect to issue any common stock during 2015 other than shares under the employee plans, which we estimate to be approximately $1.2 million. After considering the expected issuances of long-term debt and common stock during 2015, we expect net cash flows from operating activities, together with cash available under our $400.0 million committed line of credit agreement, to provide adequate resources to fund capital expenditures, dividends, and other contractual commitments. Regulatory Matters General Rate Cases We regularly review the need for electric and natural gas rate changes in each state in which we provide service. We will continue to file for rate adjustments to: • seek recovery of operating costs and capital investments, and • seek the opportunity to earn reasonable returns as allowed by regulators. With regards to the timing and plans for future filings, the assessment of our need for rate relief and the development of rate case plans takes into consideration short-term and long-term needs, as well as specific factors that can affect the timing of rate filings. Such factors include, but are not limited to, in-service dates of major capital investments and the timing of changes in major revenue and expense items. Washington General Rate Cases 2012 General Rate Cases In December 2012, the UTC approved a settlement agreement in Avista Utilities' electric and natural gas general rate cases filed in April 2012. The settlement, effective January 1, 2013 provided that base rates for our Washington electric customers increase by an overall 3.0 percent (designed to increase annual revenues by $13.6 million), and base rates for our Washington natural gas customers increased by an overall 3.6 percent (designed to increase annual revenues by $5.3 million). Under the settlement, there was a one-year credit designed to return $4.4 million to electric customers from the ERM deferral balance so the net average electric rate increase to our customers in 2013 was 2.0 percent. The credit to customers from the ERM balance did not impact our earnings. The approved settlement also provided that, effective January 1, 2014, base rates increased for our Washington electric customers by an overall 3.0 percent (designed to increase annual revenues by $14.0 million), and for our Washington natural gas customers by an overall 0.9 percent (designed to increase annual revenues by $1.4 million). The settlement provided for a one-year credit designed to return $9.0 million to electric customers from the ERM deferral balance, so the net average electric rate increase to our customers effective January 1, 2014 was 2.0 percent. The credit to customers from the ERM balance did not impact our earnings. The ERM balance as of December 31, 2014 was a liability of $14.2 million. The settlement agreement provided for an authorized return on equity (ROE) of 9.8 percent and an equity ratio of 47 percent, resulting in an overall rate of return on rate base of 7.64 percent. The December 2012 UTC Order approving the settlement agreement included certain conditions. (1) The new retail rates that became effective on January 1, 2014 were temporary rates, and on January 1, 2015, electric and natural gas base rates were scheduled to revert back to 2013 levels absent any intervening action from the UTC. The original settlement agreement had a provision that we would not file a general rate case in Washington seeking new rates to take effect before January 1, 2015. In November 2014, the UTC approved a settlement agreement to our Washington general rate cases which were originally filed in February 2014 with rates effective on January 1, 2015 (see further discussion below). (2) In its Order, the UTC found that much of the approved base rate increase was justified by the planned capital expenditures necessary to upgrade and maintain our utility facilities. If these capital projects are not completed to a AVISTA CORPORATION level that was contemplated in the settlement agreement, this could result in base rates which are considered too high by the UTC. We are required to file capital expenditure progress reports with the UTC on a periodic basis so that the UTC can monitor the capital expenditures and ensure they are in line with those contemplated in the settlement agreement. Total utility capital expenditures among all jurisdictions were $294.4 million and $323.9 million for 2013 and 2014 respectively. We expect utility capital expenditures to be about $375 million for 2015 and $350 million in 2016, which are above the capital expenditures contemplated in the settlement agreement. 2014 General Rate Cases In November 2014, the UTC approved an all-party settlement agreement related to Avista Utilities' electric and natural gas general rate cases filed in February 2014 and new rates became effective on January 1, 2015. The settlement is designed to increase annual electric base revenues by $12.3 million, or 2.5 percent, inclusive of a $5.3 million power supply update as required in the settlement agreement (explained below). The settlement is designed to increase annual natural gas base revenues by $8.5 million, or 5.6 percent. Expiring and New Rebates and Energy Recovery Mechanism (ERM) The parties agreed in the settlement that a credit of $8.3 million from the ERM deferral balance will be returned to electric customers to help offset the 2015 rate increase. This ERM balance represents lower net power supply costs in recent years than the costs embedded in base retail rates, which are being returned to customers in the form of a rebate. This rebate will not increase or decrease our net income. Total net deferred power costs under the ERM were a liability of $14.2 million as of December 31, 2014, compared to a liability of $17.9 million as of December 31, 2013, and these deferred power cost balances represent amounts due to customers. In addition, our electric customers were receiving benefits from two rebates that expired at the end of 2014 and which reduced monthly energy bills by 2.8 percent during 2014. The parties agreed in the settlement that we will provide a rebate to customers of $8.6 million over an 18 month period related to our sale of renewable energy credits, which will partially replace the expiring rebates and reduce customers’ monthly bills by 1.2 percent, beginning January 1, 2015. The net effect of the expiring rebates and the new rebate will result in an increase of approximately 1.6 percent beginning January 1, 2015. These rebates are passed through to customers and do not increase or decrease our net income. The overall change in customer billing rates from the approved settlement agreement, including the expiring and new rebates, is 2.5 percent for electric customers and 5.6 percent for natural gas customers effective January 1, 2015. Power Supply Update and Customer Information and Work Management Systems Deferral The settlement agreement included a provision that required Avista Utilities to update base power supply costs on November 1, 2014. This update to power supply costs was reflected in the overall electric revenue increase effective January 1, 2015, and reset the base power supply costs for the ERM calculations effective January 1, 2015. The amount of the updated power supply costs was a $5.3 million increase. The increase to customers from the power supply update was offset with the available ERM deferral balance for the calendar year 2015. The use of the ERM deferral balance for the offset will not increase or decrease our net income. The parties also agreed that the natural gas revenue requirement associated with our investment in the Customer Information and Work Management Systems capital project (Project Compass) for 2015 will be deferred for regulatory purposes for recovery in retail rates through a future general rate case, based on the actual costs of the project at the time it goes into service. Project Compass went into service in February 2015. The net income from the future recovery of these costs and return on investment, estimated to be $2.0 million on a pre-tax basis, will be recognized in the future recovery period. Decoupling The parties agreed that Avista Utilities will implement electric and natural gas decoupling mechanisms for a five-year period beginning January 1, 2015. Decoupling is a mechanism designed to sever the link between a utility's revenues and consumers' energy usage. Our actual revenue, based on kilowatt hour and therm sales will vary, up or down, from the level included in a general rate case. This could be due to changes in weather, conservation or the economy. Per the terms of the settlement agreement and the decoupling mechanisms included therein, generally, our electric and natural gas revenues will be adjusted each month to be based on the number of customers, rather than kilowatt hour and therm sales. The difference between revenues based on sales and revenues based on the number of customers will be deferred and either surcharged or rebated to customers beginning in the following year. Electric and natural gas decoupling surcharge rate adjustments to customers are limited to 3 percent on an annual basis, with any remaining surcharge balance carried forward for recovery in a future period. There is no limit on the level of rebate rate adjustments. AVISTA CORPORATION The decoupling mechanisms each include an after-the-fact earnings test. At the end of each calendar year, separate electric and natural gas earnings calculations will be made for the prior calendar year. These earnings tests will reflect actual decoupled revenues, normalized power supply costs, and other normalizing adjustments. • If we have a decoupling rebate balance for the prior year and earn in excess of a 7.32 percent rate of return (ROR), the rebate to customers would be increased by 50 percent of the earnings in excess of the 7.32 percent ROR. • If we have a decoupling rebate balance for the prior year and earn a 7.32 percent ROR or less, only the base amount of the rebate to customers would be made. • If we have a decoupling surcharge balance for the prior year and earn in excess of a 7.32 percent ROR, the surcharge to customers would be reduced by 50 percent of the earnings in excess of the 7.32 percent ROR (or eliminated). • If we have a decoupling surcharge balance for the prior year and earn a 7.32 percent ROR or less, the base amount of the surcharge to customers would be made. Original Request Our original request filed with the UTC in February 2014 included a base electric rate increase of 3.8 percent (designed to increase annual electric revenues by $18.2 million). We also requested a base natural gas rate increase of 8.1 percent (designed to increase annual natural gas revenues by $12.1 million). Specific capital structure ratios and the cost of capital components were not agreed to in the settlement agreement, and the revenue increases in the settlement were not tied to the 7.32 percent ROR referenced above. The electric and natural gas revenue increases were negotiated numbers, with each party using its own set of assumptions underlying its agreement to the revenue increases. The parties agreed that the 7.32 percent ROR will be used to calculate the Allowance for Funds Used During Construction (AFUDC) and other purposes. 2015 General Rate Cases In February 2015, we filed electric and natural gas general rates cases with the UTC. We have requested an overall increase in base electric rates of 6.6 percent (designed to increase annual electric revenues by $33.2 million) and an overall increase in base natural gas rates of 7.0 percent (designed to increase annual natural gas revenues by $12.0 million). Our requests are based on a proposed ROR on rate base of 7.46 percent with a common equity ratio of 48 percent and a 9.9 percent return on equity. The major driver of these general rate case requests is to recover the costs associated with the ongoing need to maintain, replace and invest in our facilities and equipment. Several significant capital investments we have made and are currently making, that are included in the filing are: • the ongoing and multi-year redevelopment of the Little Falls hydroelectric plant on the Spokane River, • the continuing rehabilitation of the Nine Mile hydroelectric plant on the Spokane River, • information technology upgrades that include the replacement of our customer information and work management systems (which were implemented in February 2015), • the ongoing project to systematically replace portions of Aldyl-A natural gas distribution pipe, and • technology investments for deploying Advanced Metering Infrastructure in Washington, including installation of advanced meters, beginning in 2016. The UTC has up to 11 months to review the filings and issue a decision. Idaho General Rate Cases 2012 General Rate Cases In March 2013, the IPUC approved a settlement agreement in Avista Utilities' electric and natural gas general rate cases filed in October 2012. As agreed to in the settlement, new rates were implemented in two phases: April 1, 2013 and October 1, 2013. Effective April 1, 2013, base rates increased for our Idaho natural gas customers by an overall 4.9 percent (designed to increase annual revenues by $3.1 million). There was no change in base electric rates on April 1, 2013. However, the settlement agreement provided for the recovery of the costs of the Palouse Wind Project through the PCA mechanism, subject to the 90 percent customers/10 percent Company sharing ratio, until these costs are reflected in base retail rates in our next general rate case. The settlement also provided that, effective October 1, 2013, base rates increased for our Idaho natural gas customers by an overall 2.0 percent (designed to increase annual revenues by $1.3 million). A credit resulting from deferred natural gas costs of AVISTA CORPORATION $1.6 million was returned to our Idaho natural gas customers from October 1, 2013 through December 31, 2014, so the net annual average natural gas rate increase to natural gas customers effective October 1, 2013 was 0.3 percent. Further, the settlement provided that, effective October 1, 2013, base rates increased for our Idaho electric customers by an overall 3.1 percent (designed to increase annual revenues by $7.8 million). A $3.9 million credit resulting from a payment made to us by the BPA relating to its prior use of our transmission system was returned to Idaho electric customers from October 1, 2013 through December 31, 2014, so the net annual average electric rate increase to electric customers effective October 1, 2013 was 1.9 percent. The $1.6 million credit to Idaho natural gas customers and the $3.9 million credit to Idaho electric customers did not impact our net income. The settlement agreement provided for an authorized return on equity of 9.8 percent and an equity ratio of 50.0 percent. The settlement also included an after-the-fact earnings test for 2013 and 2014, such that if Avista Corp., on a consolidated basis for electric and natural gas operations in Idaho, earns more than a 9.8 percent return on equity, we will share with customers 50 percent of any earnings above the 9.8 percent. In 2013, our returns exceeded this level and we deferred for future ratemaking treatment $3.9 million for Idaho electric customers and $0.4 million for Idaho natural gas customers. Of the electric deferral amount, $2.0 million was recorded in 2013 and $1.9 million was recorded in the first quarter of 2014 based on a revision of the allocation of costs between Idaho and Washington for regulatory purposes. The ratemaking treatment for these deferrals is addressed in the 2014 rate plan extension request explained below. There is no provision for a surcharge to customers if our return on equity is less than 9.8 percent. In 2014, our returns exceeded a 9.8 percent return on equity and we deferred for future ratemaking treatment $5.6 million for Idaho electric customers, exclusive of the $1.9 million related to 2013 that was recorded in 2014, and $0.2 million for Idaho natural gas customers. 2014 Rate Plan Extension Avista Utilities did not file new general rate cases in Idaho in 2014, instead, we developed an extension to the 2013 and 2014 rate plan and reached a settlement agreement with all interested parties. In September 2014, the IPUC approved our settlement, which reflects agreement among all interested parties, for a one-year extension to our current rate plan, which was set to expire on December 31, 2014. Under the approved extension, base retail rates will remain unchanged through December 31, 2015. The settlement will provide an estimated $3.7 million increase in pre-tax income by reducing planned expenses in 2015 for our Idaho operations, resulting from: • the delay of the beginning of the amortization of the 2013 previously deferred operations and maintenance costs pertaining to the Colstrip and Coyote Springs 2 thermal generating facilities from 2015 to 2016, and • deferred accounting, for later review and recovery, of the majority of the costs associated with Project Compass, which was implemented in February 2015. The settlement agreement establishes an ROE deadband between the currently authorized ROE of 9.8 percent and a 9.5 percent ROE. Under the settlement agreement, we will be allowed to use any 2014 Idaho after-the-fact earnings test deferral (described above under "2012 General Rate Cases") to support an actual earned ROE in 2015 up to 9.5 percent. For 2014, we deferred a total of $7.7 million for the 2014 after-the-fact earnings test, which includes the $1.9 million recorded in 2014 related to the 2013 earnings test. During 2015, if we earn more than the 9.8 percent ROE, 50 percent of the earnings above 9.8 percent will be shared with customers through future ratemaking. As part of the settlement, we agreed not to file a general rate case in 2014, and would file no earlier than May 31, 2015 for new electric or natural gas base retail rates to become effective on or after January 1, 2016. In addition, the settlement replaced two rebates, which expired on January 1, 2015, that were reducing customers' monthly energy bills by 1.3 percent for electric and 1.7 percent for natural gas. The rebates were replaced for a one-year period, through December 31, 2015, using existing deferral balances due to customers, which will have no impact on our net income. This provision does not preclude us from filing other rate adjustments such as the PGA. In addition to the GRCs above, we are evaluating the need to file electric and natural gas GRCs with the IPUC sometime during 2015. AVISTA CORPORATION Oregon General Rate Cases 2013 General Rate Case In January 2014, the OPUC approved a settlement agreement to Avista Utilities' natural gas general rate case (originally filed in August 2013). As agreed to in the settlement, new rates were implemented in two phases: February 1, 2014 and November 1, 2014. Effective February 1, 2014, rates increased for Oregon natural gas customers on a billed basis by an overall 4.4 percent (designed to increase annual revenues by $3.8 million). Effective November 1, 2014, rates for Oregon natural gas customers were to increase on a billed basis by an overall 1.6 percent (designed to increase annual revenues by $1.4 million). The billed rate increase on November 1, 2014 was dependent upon the completion of Project Compass and the actual costs incurred through September 30, 2014, and the actual costs incurred through June 30, 2014 related to the Company's Aldyl A distribution pipeline replacement program. As noted elsewhere, Project Compass was completed in February 2015. The November 1, 2014 rate increase was reduced from $1.4 million to $0.3 million due to the delay of Project Compass. The approved settlement agreement provides for an overall authorized rate of return of 7.47 percent, with a common equity ratio of 48 percent and a 9.65 percent return on equity. 2014 General Rate Case In January 2015, Avista Utilities filed an all-party settlement agreement with the OPUC related to our natural gas general rate case, which was originally filed in September 2014. The settlement agreement was designed to increase base natural gas revenues by 6.1 percent or $6.1 million. This base rate increase was offset by $0.3 million for a separate rate adjustment that we are already receiving from customers and it was offset by a $0.8 million credit to customers related to having an early implementation date for the revenue increase (prior to the full 10 months allowed in Oregon for the OPUC to make a decision on the case and new rates to take effect). The net increase to revenue after the two offsets was $5.0 million. The parties to the settlement had requested a decision by the OPUC prior to March 1, 2015, such that new retail rates could be effective on March 1, 2015. This settlement agreement provided for an overall authorized rate of return of 7.52 percent with a common equity ratio of 51 percent and a 9.5 percent return on equity. The original request was for an overall increase in base natural gas rates of 9.3 percent (designed to increase annual natural gas revenues by $9.1 million) and it was based on a proposed rate of return of 7.77 percent with a common equity ratio of 51 percent and a 9.9 percent return on equity. On February 23, 2015, the OPUC issued an order rejecting the all-party settlement agreement filed with the OPUC by the parties on January 21, 2015. The OPUC expressed concerns related to three issues: 1) the proposed early rate implementation credit; 2) the combination of proposed rate increases and rate decreases across the customer classes (rate spread); and 3) the customer count tracking mechanism. With regard to the early rate implementation credit, the order stated, among other things, that there was no evidence in the record that explains the derivation of the rate credit amount, or why the credit would be applied to all customer classes. On rate spread, the OPUC’s order expressed concern about proposed increases to rates for some customer classes, and decreases for other customer classes, absent more compelling evidence. And finally, the OPUC expressed concern that the customer count tracking mechanism is contrary to standard ratemaking. The OPUC’s order directed the Administrative Law Judge to convene a prehearing conference to schedule further proceedings in a manner that will allow for the timely completion of the case. The OPUC’s order also encouraged the parties to come back with a partial stipulation that encompasses these issues. Furthermore, the OPUC stated that its order does not preclude the parties from reaching a global settlement of all issues that addresses the concerns identified by the OPUC. In addition to the GRCs above, we are evaluating the need to file a natural gas GRC with the OPUC sometime during 2015. Alaska General Rate Case AEL&P's last GRC was filed in 2010 and approved by the RCA in 2011. Bonneville Power Administration Reimbursement and Reardan Wind Generation Project In May 2013, the UTC approved Avista Utilities' Petition for an order authorizing certain accounting and ratemaking treatment related to two issues. The first issue related to transmission revenues associated with a settlement between Avista Corp. and the BPA, whereby the BPA reimbursed us $11.7 million in the first quarter of 2013 for the BPA's past use of our transmission system. The second issue related to $4.3 million of costs we incurred for the development of a wind generation project site near Reardan, Washington, which was terminated. The UTC authorized us to retain $7.6 million of the BPA settlement payment in 2013, representing the entire portion of the settlement allocable to our Washington business. However, this amount was deemed AVISTA CORPORATION to first reimburse the Company for the $2.5 million of Reardan project costs that were allocable to our Washington business, leaving $5.1 million which was retained for the benefit of shareholders in 2013. The BPA agreed to pay $3.2 million annually for the future use of our transmission system. We separately tracked and deferred for the customers' benefit, the Washington portion of these revenue payments in 2013 and 2014 ($2.1 million annually). We implemented a one-year $4.2 million rate decrease for customers effective January 1, 2014 to partially offset our electric general rate increase effective January 1, 2014. To the extent actual revenues from the BPA in 2013 and 2014 differ from those refunded to customers in 2014, the difference will be added to or subtracted from the ERM balance. In Idaho, under the terms of the approved rate case settlement, 90 percent of the portion of the BPA settlement allocable to our Idaho business ($4.1 million) was credited back to customers over 15 months, beginning October 2013, and we are amortizing the Idaho portion of Reardan costs ($1.7 million, including $1.3 million of incurred costs and $0.4 million of equity-related AFUDC) over a two-year period, beginning April 2013. Purchased Gas Adjustments PGAs are designed to pass through changes in natural gas costs to Avista Utilities' customers with no change in gross margin (operating revenues less resource costs) or net income. In Oregon, we absorb (cost or benefit) 10 percent of the difference between actual and projected gas costs included in retail rates for supply that is not hedged. Total net deferred natural gas costs among all jurisdictions were a liability of $3.9 million as of December 31, 2014 and a liability of $12.1 million as of December 31, 2013. The following PGAs went into effect in our various jurisdictions during 2012, 2013 and 2014: (1) As it relates to the 2012 Oregon PGA, we requested that the PGA be implemented in two steps. The first step, implemented on November 1, 2012, was a decrease of 7.5 percent. The second step was an additional decrease of 0.8 percent, effective on January 1, 2013, to provide customers the net savings related to our purchase of the Klamath Falls Lateral transmission pipeline. Power Cost Deferrals and Recovery Mechanisms The ERM is an accounting method used to track certain differences between Avista Utilities' actual power supply costs, net of wholesale sales and sales of fuel, and the amount included in base retail rates for our Washington customers. Total net deferred power costs under the ERM were a liability of $14.2 million as of December 31, 2014 compared to $17.9 million as of December 31, 2013, and these deferred power cost balances represent amounts due to customers. As part of the approved Washington general rate case settlement in December 2012, during 2013 there was a one-year credit designed to return $4.4 million to electric customers from the existing ERM deferral balance to reduce the net average electric rate increase impact to customers in 2013. Additionally, during 2014 there was a one-year credit designed to return $9.0 million to electric customers from the ERM deferral balance, so the net average electric rate increase impact to customers effective January 1, 2014 was also reduced. The credits to customers from the ERM balances do not impact our net income. The difference in net power supply costs under the ERM primarily results from changes in: • short-term wholesale market prices and sales and purchase volumes, AVISTA CORPORATION • the level and availability of hydroelectric generation, • the level and availability of thermal generation (including changes in fuel prices), and • retail loads. Under the ERM, Avista Utilities absorbs the cost or receives the benefit from the initial amount of power supply costs in excess of or below the level in retail rates, which is referred to as the deadband. The annual (calendar year) deadband amount is $4.0 million. We incur the cost of, or receive the benefit from, 100 percent of this initial power supply cost variance. We share annual power supply cost variances between $4.0 million and $10.0 million with customers. There is a 50 percent customers/50 percent Company sharing ratio when actual power supply expenses are higher (surcharge to customers) than the amount included in base retail rates within this band. There is a 75 percent customers/25 percent Company sharing ratio when actual power supply expenses are lower (rebate to customers) than the amount included in base retail rates within this band. To the extent that the annual power supply cost variance from the amount included in base rates exceeds $10.0 million, there is 90 percent customers/10 percent Company sharing ratio of the cost variance. The following is a summary of the ERM: Under the ERM, Avista Utilities makes an annual filing on or before April 1 of each year to provide the opportunity for the UTC staff and other interested parties to review the prudence of and audit the ERM deferred power cost transactions for the prior calendar year. We made our annual filing on March 31, 2014, and as part of the UTC staff's review of the filing, the staff reviewed the prudence of the Colstrip outage from July 2013 through January 2014. UTC staff found no imprudence by Avista Corp. related to the Colstrip outage and recommended approval of all the ERM related transactions for 2013. The ERM provides for a 90-day review period for the filing; however, the period may be extended by agreement of the parties or by UTC order. The 2013 ERM deferred power costs transactions were approved by an order from the UTC. Avista Utilities has a PCA mechanism in Idaho that allows us to modify electric rates on October 1 of each year with IPUC approval. Under the PCA mechanism, we defer 90 percent of the difference between certain actual net power supply expenses and the amount included in base retail rates for our Idaho customers. The October 1 rate adjustments recover or rebate power supply costs deferred during the preceding July-June twelve-month period. Total net power supply costs deferred under the PCA mechanism were an asset of $8.3 million as of December 31, 2014 compared to an asset of $5.1 million as of December 31, 2013. Results of Operations - Overall The following provides an overview of changes in our Consolidated Statements of Income. More detailed explanations are provided, particularly for operating revenues and operating expenses, in the business segment discussions (Avista Utilities, AEL&P, Ecova - Discontinued Operations and the other businesses) that follow this section. As discussed in "Item 7. Management's Discussion and Analysis: Executive Level Summary," Ecova was disposed of as of June 30, 2014. As a result, in accordance with Generally Accepted Accounting Principles (GAAP), all of Ecova's operating results were removed from each line item on the Consolidated Statements of Income and reclassified into discontinued operations for all periods presented. The discussion of continuing operations below does not include any Ecova amounts. For our discussion of discontinued operations and Ecova, see "Item 7. Management's Discussion and Analysis: Ecova - Discontinued Operations." The balances included below for utility operations reconcile to the Consolidated Statements of Income. Beginning on July 1, 2014, AEL&P is included in the overall utility results. 2014 compared to 2013 Utility revenues increased $31.1 million, after elimination of intracompany revenues (within Avista Utilities) of $142.2 million for 2014 and $151.9 million for 2013. Avista Utilities' portion of utility revenues increased $9.5 million and AEL&P had electric revenues of $21.6 million, representing its revenues for the six months ended December 31, 2014. Including intracompany revenues, Avista Utilities' electric revenues decreased $31.6 million and natural gas revenues increased $31.4 million. Total retail electric revenues increased $14.8 million primarily due to general rate increases and a change in revenue AVISTA CORPORATION mix, with a greater percentage of retail revenue from residential and commercial customers. This was partially offset by a decrease in retail sales volumes. Wholesale electric revenues increased $10.6 million due to an increase in sales prices partially offset by a decrease in sales volumes, while sales of fuel decreased $42.9 million. Other electric revenues decreased $8.6 million primarily due to the receipt of $11.7 million of revenue from the BPA in the first quarter of 2013 for past use of our electric transmission system. In 2014, we estimated a provision for earnings sharing of $7.5 million for Idaho electric customers with $5.6 million representing our estimate for 2014 and $1.9 million representing an adjustment of our 2013 estimate. In 2013, we recorded a provision for earnings sharing of $2.0 million for Idaho electric customers. Retail natural gas revenues decreased $1.3 million due to a decrease in volumes caused by warmer than normal weather during the fourth quarter, partially offset by an increase in retail rates. Wholesale natural gas revenues increased $33.5 million due to an increase in prices and volumes. Utility resource costs decreased $11.3 million, after elimination of intracompany resource costs of $142.2 million for 2014 and $151.9 million for 2013. Avista Utilities' portion of resource costs decreased $17.2 million and this was offset by utility resource costs at AEL&P of $5.9 million, representing its resource costs for the six months ended December 31, 2014. Including intracompany resource costs, Avista Utilities' electric resource costs decreased $57.7 million and natural gas resource costs increased $30.7 million. The decrease in Avista Utilities' electric resource costs was due to the Colstrip outage in 2013 and increased hydroelectric generation in 2014. Specifically, there were decreases in purchased power, fuel for generation and other fuel costs (represents fuel that was purchased for generation but was later sold when conditions indicated that it was not economical to use the fuel for generation as part of the resource optimization process). The increase in natural gas resource costs was primarily due to an increase in natural gas purchased, partially offset by a decrease in natural gas cost amortizations. Utility other operating expenses increased $10.6 million and was partially the result of AEL&P being included for the six months ended December 31, 2014, which added $5.9 million to other operating expenses. Avista Utilities incurred increased generation, transmission and distribution operating and maintenance expenses and increased outside services. There were also transaction fees associated with the AERC acquisition of $1.3 million in 2014 compared to $1.6 million in 2013. These were partially offset by a decrease in pension and other post-retirement benefits expense. Utility depreciation and amortization increased $12.4 million driven by additions to utility plant and the inclusion of $2.6 million related to AEL&P for the second half of the year. Taxes other than income taxes increased $5.9 million primarily due to increased production, distribution and transmission property taxes. Also, 2014 included $1.1 million related to AEL&P for the second half of the year. Other non-utility operating expenses decreased $8.2 million primarily due to the receipt of $15.0 million related to the settlement of the California power markets litigation (which was recorded as a reduction to operating expenses), partially offset by a $6.4 million contribution to the Avista Foundation. Interest expense decreased $1.8 million primarily due to the long-term debt outstanding during 2014 having a lower interest rate than the long-term debt outstanding during 2013. This includes recent issuances at low interest rates. This was partially offset by the acquisition of AERC, which added $1.4 million for the second half of 2014. Other income-net increased $6.2 million primarily due to net income from investments of $0.3 million compared to net losses of $3.4 million in 2013. The net losses in 2013 were the result of impairment losses associated with our investment in an energy storage company and our investment in a fuel cell business. There was also an increase in equity-related AFUDC of $2.7 million during 2014. Income taxes increased $14.2 million and our effective tax rate was 37.6 percent for 2014 compared to 35.7 percent for 2013. The increase in expense was primarily due to an increase in income before income taxes. The increase in the effective tax rate was primarily the result of the Section 199 Domestic Manufacturing Deduction not being available to the Company due to limitations on taxable qualified production activities income. 2013 compared to 2012 Utility revenues increased $49.8 million, after elimination of intracompany revenues of $151.9 million for 2013 and $88.2 million for 2012. Including intracompany revenues, electric revenues increased $62.4 million and natural gas revenues increased $51.1 million. Total retail electric revenues increased $13.8 million due to general rate increases and an increase in volumes sold, which was primarily the result of warmer than normal weather during the cooling season and colder than normal weather during the fourth quarter heating season. Wholesale electric revenues increased $24.8 million and sales of fuel increased $10.8 million. Other electric revenues increased $15.0 million primarily due to the receipt of revenue from the BPA for past use of our electric transmission system. Retail natural gas revenues increased $13.3 million due to an increase in volumes caused by colder than normal weather during the fourth quarter, partially offset by a decrease in retail rates. Wholesale natural gas revenues increased $36.1 million due to an increase in prices, partially offset by a decrease in volumes. Utility resource costs decreased $3.5 million, after elimination of intracompany resource costs of $151.9 million for 2013 and $88.2 million for 2012. Including intracompany resource costs, electric resource costs increased $24.8 million and natural gas AVISTA CORPORATION resource costs increased $35.4 million. The increase in electric resource costs was primarily due to an increase in fuel costs (due to higher natural gas generation and higher natural gas fuel prices), other fuel costs (represents fuel that was purchased for generation but was later sold when conditions indicated that it was not economical to use the fuel for generation as part of the resource optimization process) and the write-off of $2.5 million of Reardan project costs that are allocable to our Washington business. The increase in natural gas resource costs was primarily due to an increase in natural gas prices, partially offset by a decrease in volumes (primarily attributable to wholesale sales). Utility other operating expenses decreased $0.6 million primarily as a result of a decrease in administrative and general labor expenses (which included $7.3 million of costs to implement the voluntary severance incentive plan in 2012 only) and a decrease in generation maintenance expenses. These decreases were partially offset by increases in pension and other postretirement benefit expenses and electric, production and gas distribution related operating and maintenance expenses. Utility depreciation and amortization increased $5.1 million driven by additions to utility plant. Taxes other than income taxes increased $5.0 million primarily due to increased franchise, municipal, and property related taxes. Interest expense increased $2.0 million primarily due to the issuance of long-term debt in November 2012 that increased the amount of long-term debt outstanding. Capitalized interest increased $1.3 million primarily due to higher average construction work in progress balances. Other income-net increased $2.5 million primarily due to an increase in equity-related AFUDC of $2.0 million. In addition, during 2013 we incurred impairment losses of $3.4 million ($2.2 million after-tax) associated with our investment in an energy storage company and our investment in a fuel cell business. During 2012, we incurred total losses on investments of $3.3 million, which included impairment losses of $2.4 million ($1.5 million after-tax) related to our investment in a fuel cell business and the write-off of our investment in a solar energy company. Income taxes increased $18.3 million and our effective tax rate was 35.7 percent for 2013 compared to 34.1 percent for 2012. The increase in expense was primarily due to an increase in income before income taxes. The change in the effective tax rate was primarily related to a reduction in the amount of our pension contribution deduction. Results of Operations - Avista Utilities Non-GAAP Financial Measures The following discussion includes two financial measures that are considered “non-GAAP financial measures,” electric gross margin and natural gas gross margin. Generally, a non-GAAP financial measure is a numerical measure of financial performance, financial position or cash flows that excludes (or includes) amounts that are included (excluded) in the most directly comparable measure calculated and presented in accordance with GAAP. The presentation of electric gross margin and natural gas gross margin is intended to supplement an understanding of Avista Utilities' operating performance. We use these measures to determine whether the appropriate amount of energy costs are being collected from our customers to allow for recovery of operating costs, as well as to analyze how changes in loads (due to weather, economic or other conditions), rates, supply costs and other factors impact our results of operations. These measures are not intended to replace income from operations as determined in accordance with GAAP as an indicator of operating performance. The calculations of electric and natural gas gross margins are presented below. 2014 compared to 2013 Net income for Avista Utilities was $113.3 million for 2014, an increase from $108.6 million for 2013. Avista Utilities’ income from operations was $240.0 million for 2014 compared to $232.6 million for 2013. Earnings at Avista Utilities increased primarily due to the implementation of general rate increases, lower net power supply costs and a decrease in interest expense. These were partially offset by a provision for earnings sharing in Idaho, and expected increases in other operating expenses, depreciation and amortization and taxes other than income taxes. The following table presents our operating revenues, resource costs and resulting gross margin for the year ended December 31 (dollars in thousands): AVISTA CORPORATION Avista Utilities’ operating revenues increased $9.5 million and resource costs decreased $17.2 million, which resulted in an increase of $26.7 million in gross margin. The gross margin on electric sales increased $26.0 million and the gross margin on natural gas sales increased $0.7 million. The increase in electric gross margin was primarily due to general rate increases in Washington and Idaho and lower net power supply costs (due to the Colstrip outage in 2013 and increased hydroelectric generation in 2014). This was partially offset by a $7.5 million provision for earnings sharing in Idaho in 2014, compared to $2.0 million in 2013. For 2014, we recognized a pre-tax benefit of $5.4 million under the ERM in Washington compared to a pre-tax expense of $4.7 million for 2013. This change represents a decrease in net power supply costs due to the Colstrip outage in 2013 and increased hydroelectric generation in 2014. Electric gross margin for 2013 included the net benefit from the settlement with the BPA of $5.1 million. The increase in natural gas gross margin was primarily due to general rates increases, mostly offset by warmer weather during the fourth quarter of 2014. Intracompany revenues and resource costs represent purchases and sales of natural gas between our natural gas distribution operations and our electric generation operations (as fuel for our generation plants). These transactions are eliminated in the presentation of total results for Avista Utilities and in the consolidated financial statements but are reflected in the presentation of the separate results for electric and natural gas below. The following table presents our utility electric operating revenues and megawatt-hour (MWh) sales for the year ended December 31 (dollars and MWhs in thousands): Retail electric revenues increased $14.8 million due to an increase in revenue per MWh (increased revenues $25.2 million), partially offset by a decrease in total MWhs sold (decreased revenues $10.4 million). The increase in revenue per MWh was primarily due to general rate increases and a change in revenue mix, with a greater percentage of retail revenue from residential and commercial customers. The decrease in total MWhs sold to residential customers was primarily due to warmer weather in the fourth quarter, partially offset by customer growth. Compared to 2013, residential electric use per customer decreased 2.3 percent, while commercial use per customer decreased 0.6 percent. Cooling degree days at Spokane were 60 percent above historical average for 2014, but 11 percent below 2013. Heating degree days at Spokane were 9 percent below historical average for 2014, and 7 percent below 2013. The decrease in total MWhs sold to industrial customers was primarily due to the expiration and replacement of a contract with one of our largest industrial customers, effective July 1, 2013. Under the new contract, we expect a decrease in revenues from annual power sales to this customer of approximately $21 million and a resulting decrease in resource costs of approximately $19 million. Any change in revenues and expenses associated with the new agreement, as compared with the revenues and expenses included in the last general rate case for this customer, are tracked through the PCA in Idaho at 100 percent, until such time as the contract is included in the Company’s base rates, so that we expect no impact on our gross margin or net income from the new agreement. Wholesale electric revenues increased $10.6 million due to an increase in sales prices (increased revenues $17.6 million), partially offset by a decrease in sales volumes (decreased revenues $7.0 million). The fluctuation in volumes and prices was primarily the result of our optimization activities during the period. When current and forward electric wholesale market prices are below the cost of operating our natural gas-fired thermal generating units, we sell the related natural gas purchased for generation in the wholesale market rather than operate the generating units. The revenues from sales of fuel decreased $42.9 million due to a decrease in sales of natural gas fuel as part of thermal generation resource optimization activities. These thermal optimization transactions also include forward hedges using AVISTA CORPORATION derivative instruments for electricity and natural gas. As relative power and natural gas prices vary, our volume of thermal optimization also varies. For 2014, $67.4 million of these sales were made to our natural gas operations and are included as intracompany revenues and resource costs. For 2013, $102.4 million of these sales were made to our natural gas operations. The net margin on wholesale sales and sales of fuel is applied to reduce or increase resource costs as accounted for under the ERM, the PCA mechanism, and in general rate cases as part of base power supply costs. Other electric revenues decreased $8.6 million primarily due to the receipt of $11.7 million of revenue from the BPA in 2013 for past use of our electric transmission system. See further information above at "Bonneville Power Administration Reimbursement and Reardan Wind Generation Project." The 2013 Idaho general rate case settlement included an after-the-fact earnings test for 2013 and 2014, such that if Avista Corp., on a consolidated basis for electric and natural gas operations in Idaho, earned more than a 9.8 percent return on equity, we would share with customers 50 percent of any earnings above the 9.8 percent. In 2014, we estimated a provision for earnings sharing of $7.5 million for Idaho electric customers with $5.6 million representing our estimate for 2014 and $1.9 million representing an adjustment of our 2013 estimate. In 2013, we recorded a provision for earnings sharing of $2.0 million for Idaho electric customers. There is no provision for a surcharge to customers if our return on equity is less than 9.8 percent. The following table presents our utility natural gas operating revenues and therms delivered for the year ended December 31 (dollars and therms in thousands): Retail natural gas revenues decreased $1.3 million due to a decrease in volumes (decreased revenues $20.0 million), partially offset by higher retail rates (increased revenues $18.7 million). Higher retail rates were due to PGAs, which passed through higher costs of natural gas, and general rate cases. We sold less retail natural gas in 2014 as compared to 2013 primarily due to weather that was warmer than normal and warmer than the prior year during the fourth quarter. Compared to 2013, residential use per customer decreased 8 percent and commercial use per customer decreased 5 percent. Heating degree days at Spokane were 9 percent below historical average for 2014, and 7 percent below 2013. Heating degree days at Medford were 25 percent below historical average for 2014, and 26 percent below 2013. For the fourth quarter of 2014, heating degree days at Spokane were 13 percent below historical average and 16 percent below 2013. Heating degree days at Medford were 29 percent below historical average and 36 percent below 2013. Wholesale natural gas revenues increased $33.5 million due to an increase in prices (increased revenues $24.8 million) and an increase in volumes (increased revenues $8.7 million). We plan for sufficient natural gas capacity to serve our retail customers on a theoretical peak day. As such, on nonpeak days we generally have more pipeline and storage capacity than what is needed for retail loads. We engage in optimization of available interstate pipeline transportation and storage capacity through wholesale purchases and sales of natural gas to generate economic value that partially offsets net natural gas costs. In some situations, customer demand is below the amount hedged and we sell natural gas in excess of load requirements. In 2014, $74.7 million of these sales were made to our electric generation operations and are included as intracompany revenues and resource costs. In 2013, $49.5 million of these sales were made to our electric generation operations. Differences between revenues and costs from sales of resources in excess of retail load requirements and from resource optimization are accounted for through the PGA mechanisms. Based on the after-the-fact earnings test related to the 2013 Idaho general rate case settlement discussed above, our 2014 consolidated earnings exceeded the 9.8 percent return on equity for Idaho and we recorded a provision for earnings sharing of $0.2 million for Idaho natural gas customers. AVISTA CORPORATION The following table presents our average number of electric and natural gas retail customers for the year ended December 31: The following table presents our utility resource costs for the year ended December 31 (dollars in thousands): Power purchased decreased $5.0 million due to a decrease in the volume of power purchases (decreased costs $25.4 million), partially offset by an increase in wholesale prices (increased costs $20.4 million). The fluctuation in volumes and prices was primarily the result of our overall optimization activities during the year. The decrease in volumes purchased was also due to increased hydroelectric generation. Amortizations and deferrals of power costs decreased electric resource costs by $6.5 million for 2014 compared to a decrease of $14.2 million for 2013. During 2014, we refunded to customers $2.3 million of previously deferred power costs in Idaho through the PCA rebate. We also refunded to Washington customers $8.5 million through an ERM rebate. During 2014, actual power supply costs were below the amount included in base retail rates in Washington and we deferred $4.2 million for probable future benefit to customers. We deferred $1.6 million in Idaho for probable future surcharge to customers. In Washington, we also deferred $1.6 million of renewable energy credits for probable future benefit to customers. Fuel for generation decreased $17.2 million primarily due to a decrease in natural gas generation (due in part to increased hydroelectric generation). Other fuel costs decreased $39.6 million. This represents fuel and the related derivative instruments that were purchased for generation but were later sold when conditions indicated that it was not economical to use the fuel for generation, as part of the resource optimization process. When the fuel or related derivative instruments are sold, that revenue is included in sales of fuel. The expense for natural gas purchased increased $44.6 million due to an increase in the price of natural gas (increased costs $44.3 million) and a slight increase in total therms purchased (increased costs $0.3 million). Total therms purchased increased due to an increase in wholesale sales which are used to balance loads and resources as part of the natural gas procurement and resource optimization process, mostly offset by a decrease in retail sales. We engage in optimization of available interstate pipeline transportation and storage capacity through wholesale purchases and sales of natural gas to generate economic value that offsets net natural gas costs. AVISTA CORPORATION 2013 compared to 2012 Net income for Avista Utilities was $108.6 million for 2013, an increase from $81.7 million for 2012. Avista Utilities’ income from operations was $232.6 million for 2013 compared to $188.8 million for 2012. Earnings at Avista Utilities increased primarily due to the implementation of general rate increases, favorable weather, the net benefit from the settlement with the BPA and a slight reduction in other operating expenses. These were partially offset by expected increases in depreciation and amortization and taxes other than income taxes. The following table presents our operating revenues, resource costs and resulting gross margin for the year ended December 31 (dollars in thousands): Avista Utilities’ operating revenues increased $49.8 million and resource costs decreased $3.5 million, which resulted in an increase of $53.3 million in gross margin. The gross margin on electric sales increased $37.6 million and the gross margin on natural gas sales increased $15.7 million. The increase in both electric and natural gas gross margin was due in part to general rate increases. The increase in electric gross margin was also due to warmer than normal weather and increased cooling loads during the summer, as well as colder than normal weather and increased heating loads during the fourth quarter. This is compared to milder weather in the prior year, particularly warmer than normal weather during the fourth quarter, which reduced loads during that period. In addition, electric gross margin increased due to the net benefit from the settlement with the BPA of $5.1 million. For 2013, we recognized a pre-tax expense of $4.7 million under the ERM in Washington compared to pre-tax benefit of $6.0 million for 2012. This change, which reduced electric gross margin, was primarily due to the Colstrip outage and partially due to lower hydroelectric generation and higher natural gas fuel prices as compared to 2012. The increase in natural gas gross margin was also due to colder than normal weather during the fourth quarter of 2013 as compared to the fourth quarter of 2012 and the increased heating loads. In addition to the above, our combined electric and natural gas earnings in Idaho for 2013 exceeded the 9.8 percent allowed return on equity as specified in the 2013 general rate case settlement, and, as a result, we recorded a provision for earnings sharing of $2.0 million for Idaho electric customers and $0.4 million for Idaho natural gas customers. The following table presents our utility electric operating revenues and megawatt-hour (MWh) sales for the year ended December 31 (dollars and MWhs in thousands): Retail electric revenues increased $13.8 million due to an increase in revenue per MWh (increased revenues $10.8 million) and an increase in total MWhs sold (increased revenues $3.0 million). The increase in total MWhs sold was primarily the result of warmer than normal weather during the cooling season, as well as colder than normal weather during the fourth quarter heating season. Compared to 2012, residential electric use per customer increased 3 percent. Cooling degree days at Spokane were 80 percent above historical average for 2013 and were 33 percent above 2012. Heating degree days at Spokane were 1 percent below historical average for 2013, and 7 percent above 2012. AVISTA CORPORATION The decrease in total MWhs sold to industrial customers was primarily due to a renewed contract which replaced an expired contract at one of our largest industrial customers which became effective July 1, 2013, partially offset by increased usage at certain industrial customers that had temporary operational challenges in 2012. Any change in revenues and expenses associated with the new agreement, as compared with the revenues and expenses included in the last general rate case for this customer, are tracked through the PCA in Idaho at 100 percent, until such time as the contract is included in the Company’s base rates, so that there was no impact on our gross margin or net income from the new agreement. The increase in revenue per MWh was primarily due to a change in revenue mix, with a greater percentage of retail revenue from residential and commercial customers, and the Washington general rate increase, partially offset by other rate changes that do not impact gross margin (including the ERM rebate). Wholesale electric revenues increased $24.8 million due to an increase in sales volumes (increased revenues $4.7 million) and an increase in sales prices (increased revenues $20.1 million), which were related to an increase in optimization activities. When current and forward electric wholesale market prices are below the cost of operating our natural gas-fired thermal generating units, we sell the related natural gas purchased for generation in the wholesale market rather than operate the generating units. The revenues from sales of fuel increased $10.8 million due to an increase in sales of natural gas fuel as part of thermal generation resource optimization activities, as well as an increase in natural gas prices. These thermal optimization transactions also include forward hedges using derivative instruments for electricity and natural gas. As relative power and natural gas prices vary, our volume of thermal optimization also varies. For 2013, $102.4 million of these sales were made to our natural gas operations and are included as intracompany revenues and resource costs. For 2012, $45.3 million of these sales were made to our natural gas operations. The net margin on wholesale sales and sales of fuel is applied to reduce or increase resource costs as accounted for under the ERM, the PCA mechanism, and in general rate cases as part of base power supply costs. Other electric revenues increased $15.0 million primarily due to the receipt of $11.7 million of revenue from the BPA for past use of our electric transmission system. In 2013, our returns exceeded the 9.8 percent return on equity that was allowed in the 2013 Idaho general rate case settlement (discussed above) and we recorded a provision for earnings sharing of $2.0 million for Idaho electric customers. The following table presents our utility natural gas operating revenues and therms delivered for the year ended December 31 (dollars and therms in thousands): Retail natural gas revenues increased $13.3 million due to an increase in volumes (increased revenues $22.5 million), partially offset by lower retail rates (decreased revenues $9.2 million). We sold more retail natural gas in 2013 as compared to 2012 primarily due to colder than normal weather during the fourth quarter. Compared to 2012, residential use per customer increased 7 percent and commercial use per customer increased 6 percent. Heating degree days at Spokane were 1 percent below historical average for 2013, and 7 percent above 2012. Heating degree days at Medford were 1 percent above historical average for 2013, and 9 percent above 2012. For the fourth quarter of 2013, heating degree days at Spokane were 3 percent above historical average and 16 percent above 2012. Heating degree days at Medford were 12 percent above historical average and 29 percent above 2012. Wholesale natural gas revenues increased $36.1 million due to an increase in prices (increased revenues $58.9 million), partially offset by a decrease in volumes (decreased revenues $22.8 million). We plan for sufficient natural gas capacity to serve AVISTA CORPORATION our retail customers on a theoretical peak day. As such, on nonpeak days we generally have more pipeline and storage capacity than what is needed for retail loads. We engage in optimization of available interstate pipeline transportation and storage capacity through wholesale purchases and sales of natural gas to generate economic value that partially offsets net natural gas costs. In some situations, customer demand is below the amount hedged and we sell natural gas in excess of load requirements. In 2013, $49.5 million of these sales were made to our electric generation operations and are included as intracompany revenues and resource costs. In 2012, $42.9 million of these sales were made to our electric generation operations. Differences between revenues and costs from sales of resources in excess of retail load requirements and from resource optimization are accounted for through the PGA mechanisms. Based on the after-the-fact earnings test related to the 2013 Idaho general rate case settlement discussed above, our 2013 consolidated earnings exceeded the allowed return on equity for Idaho and we recorded a provision for earnings sharing of $0.4 million for Idaho natural gas customers. The following table presents our average number of electric and natural gas retail customers for the year ended December 31: The following table presents our utility resource costs for the year ended December 31 (dollars in thousands): Power purchased decreased $4.2 million due to a decrease in wholesale prices (decreased costs $6.6 million), partially offset by an increase in the volume of power purchases (increased costs $2.4 million). Amortization and deferrals of power costs decreased electric resource costs by $14.2 million for 2013 compared to an increase of $12.8 million for 2012. During 2013, we refunded to customers $3.3 million of previously deferred power costs in Idaho through the PCA rebate. As part of the Washington general rate case settlement implemented on January 1, 2013, we refunded to customers $4.0 million through an ERM rebate. During 2013, actual power supply costs were above the amount included in base retail rates and we deferred $1.2 million in Washington and $6.9 million in Idaho for probable future surcharge to customers. In Washington, we also deferred $1.2 million of renewable energy credits for probable future rebate to customers. AVISTA CORPORATION Fuel for generation increased $43.6 million due to an increase in natural gas generation and an increase in natural gas fuel prices. Generation at Colstrip decreased due to an outage at Unit 4. Other fuel costs increased $1.9 million. This represents fuel and the related derivative instruments that were purchased for generation but were later sold when conditions indicated that it was not economical to use the fuel for generation, as part of the resource optimization process. When the fuel or related derivative instruments are sold, that revenue is included in sales of fuel. The expense for natural gas purchased increased $25.6 million due to an increase in the price of natural gas (increased costs $40.8 million), partially offset by a decrease in total therms purchased (decreased costs $15.2 million). Total therms purchased decreased due to a decrease in wholesale sales volumes which are used to balance loads and resources as part of the natural gas procurement and resource optimization process, partially offset by a slight increase in retail sales. We engage in optimization of available interstate pipeline transportation and storage capacity through wholesale purchases and sales of natural gas to generate economic value that offsets net natural gas costs. Results of Operations - Alaska Electric Light and Power Company As noted above, AEL&P was acquired on July 1, 2014 and only the results for the second half of 2014 are included in the actual overall results of Avista Corp. The discussion below is only for AEL&P's earnings that were included in Avista Corp.'s overall earnings in 2014. Net income for AEL&P was $3.2 million for the second half of 2014. The following table presents AEL&P's operating revenues, resource costs and resulting gross margin for the second half of 2014 (dollars in thousands): The following table presents AEL&P's utility electric operating revenues and megawatt-hour (MWh) sales for the second half of 2014 (dollars and MWhs in thousands): AEL&P’s operating revenues were $21.6 million and its resource costs were $5.9 million, which resulted in gross margin of $15.7 million, all related to electric sales. Retail revenues for the current period were derived from weather that was warmer than normal with heating degree days that were 9 percent below normal. There were no cooling degree days during the second half of 2014. AEL&P is winter peaking and does not have significant cooling loads during the summer. Government sales are similar to commercial sales in that they are primarily firm customers, but are government entities. Commercial and government revenues from interruptible or non-firm customers were $4.1 million, including $3.5 million from AEL&P's largest customer. These non-firm revenues reduce firm revenues, either through base rates or a cost of power adjustment. For the second half of 2014, the cost of power adjustment was a net rebate to firm customers of $0.6 million (included in resource costs). AVISTA CORPORATION The following table presents AEL&P's average number of electric retail customers for the second half of 2014: The following table presents AEL&P's utility resource costs for the second half of 2014 (dollars in thousands): Snettisham power expenses represent costs associated with operating the Snettisham hydroelectric project, including amounts paid under the take-or-pay power purchase agreement for the full capacity of this plant. This agreement is recorded as a capital lease on AEL&P's balance sheet, but reflected as an operating lease in the income statement. See "Note 14 of the Notes to Consolidated Financial Statements" for further information regarding this capital lease obligation. The cost of power adjustment is primarily derived from certain revenues from interruptible or non-firm customers that are deferred and passed on for the benefit of firm customers in future periods. For instance, all cruise ship revenue is passed back to firm customers at 100 percent. The amortization of these deferred balances flows through this account along with the original deferral. Results of Operations - Ecova - Discontinued Operations As discussed in "Item 7. Management's Discussion and Analysis: Executive Level Summary," Ecova was disposed of as of June 30, 2014. As a result, in accordance with GAAP, all of Ecova's operating results were removed from each line item on the Consolidated Statements of Income and reclassified into discontinued operations for all periods presented. In addition, since Ecova was a subsidiary of Avista Capital, the net gain recognized on the sale of Ecova was attributable to our other businesses. However, in accordance with GAAP, this gain is included in discontinued operations; therefore, we included the analysis of the gain in the Ecova discontinued operations section rather than in the other businesses section. 2014 compared to 2013 Ecova's net income attributable to Avista Corp. shareholders was $72.4 million for 2014 compared to net income of $7.1 million for 2013. The increase was primarily attributable to the net gain recognized on the sale of Ecova of $69.7 million. Excluding the net gain, net income from Ecova's regular operations through the date of the sale were flat compared to the same period in 2013 and were the result of a decrease in depreciation and amortization expense, an increase in operating revenues, offset by an increase in operating expenses. 2013 compared to 2012 Ecova's net income attributable to Avista Corp. shareholders was $7.1 million for 2013 compared to net income of $1.8 million for 2012. The increase was primarily attributable to increased revenues from new services that were performed by Ecova during 2013, growth in existing services (expense and data management services and energy management services) and the recognition of a $2.3 million rebate in 2013 associated with achieving certain milestones on a five-year contract related to expense and data management services. The increased revenues were partially offset by an increase in other operating expenses resulting from new services and increased costs associated with fulfilling higher volumes from existing services and an increase in depreciation and amortization expense. Results of Operations - Other Businesses 2014 compared to 2013 The net income from these operations was $3.2 million for 2014 compared to a net loss of $4.7 million for 2013. The net income for 2014 was primarily the result of the settlement of the California power markets litigation, where Avista Energy received settlement proceeds and recognized an increase in pre-tax earnings of approximately $15.0 million. This was partially AVISTA CORPORATION offset by a pre-tax contribution of $6.4 million of the proceeds to the Avista Foundation. See "Note 20 of the Notes to the Consolidated Financial Statements" for further information regarding this litigation settlement. METALfx had net income of $0.9 million for 2014, compared to net income of $1.2 million for 2013. We also incurred $2.4 million (net of tax) of corporate costs, including costs associated with exploring strategic opportunities. 2013 compared to 2012 The net loss from these operations was $4.7 million for 2013 compared to a net loss of $5.3 million for 2012. The net loss for 2013 was primarily the result of $2.1 million (net of tax) of corporate costs, including costs associated with exploring strategic opportunities and litigation costs incurred related to our previous operations at Avista Energy of $1.0 million (net of tax). Additionally, during 2013 we incurred impairment losses of $2.2 million (net of tax) associated with our investment in an energy storage company and our investment in a fuel cell business. During 2012 we incurred impairment losses of $1.5 million (net of taxes) related to the impairment of our investment in a fuel cell business and the write-off of our investment in a solar energy company. The losses above were partially offset by METALfx, which had net income of $1.2 million for each of 2013 and 2012. Accounting Standards to be Adopted in 2015 At this time, we are not expecting the adoption of accounting standards to have a material impact on our financial condition, results of operations and cash flows in 2015. For information on accounting standards adopted in 2014 and earlier periods, see “Note 2 of the Notes to Consolidated Financial Statements.” Critical Accounting Policies and Estimates The preparation of our consolidated financial statements in conformity with GAAP requires us to make estimates and assumptions that affect amounts reported in the consolidated financial statements. Changes in these estimates and assumptions are considered reasonably possible and may have a material effect on our consolidated financial statements and thus actual results could differ from the amounts reported and disclosed herein. The following accounting policies represent those that our management believes are particularly important to the consolidated financial statements and require the use of estimates and assumptions: • Utility operating revenues, which are generally recorded when service is rendered or energy is delivered to customers. Each month-end we estimate the amount of energy delivered to customers since the date of the last meter reading and a corresponding unbilled revenue amount is estimated and recorded. The critical estimates and assumptions in this calculation include a daily estimated allocation between billed and unbilled revenues for that day's energy usage based on our meter reading schedule and billing cycle day schedule, estimated adjustments due to variances in the meter reading schedule and estimates of electric line losses and natural gas system losses due to leakage. Changes to any one of these assumptions and estimates can result in material differences in the amount of unbilled revenue. See "Note 1 of the Notes to Consolidated Financial Statements" for further discussion of our utility operating revenue policy. • Regulatory accounting, which requires that certain costs and/or obligations be reflected as deferred charges on our Consolidated Balance Sheets and are not reflected in our Consolidated Statements of Income until the period during which matching revenues are recognized. We make the assumption that there are regulatory precedents for many of our regulatory items and that we will be allowed recovery of these costs via retail rates in future periods. If we were no longer allowed to apply regulatory accounting or no longer allowed recovery of these costs, we could be required to recognize significant write-offs of regulatory assets and liabilities in the Consolidated Statements of Income. See "Notes 1 and 22 of the Notes to Consolidated Financial Statements" for further discussion of our regulatory accounting policy. • Utility energy commodity derivative asset and liability accounting, where we estimate the fair value of outstanding commodity derivatives and we offset energy commodity derivative assets or liabilities with a regulatory asset or liability. This accounting treatment is intended to defer the recognition of mark-to-market gains and losses on energy commodity transactions until the period of delivery. This accounting treatment is supported by accounting orders issued by the UTC and IPUC. If we were no longer allowed to apply regulatory accounting or no longer allowed recovery of these costs, we could be required to recognize significant changes in fair value of these energy commodity derivatives on a regular basis in the Consolidated Statements of Income, which could lead to significant fluctuations in net income. See "Notes 1 and 6 of the Notes to Consolidated Financial Statements" for further discussion of our energy derivative accounting policy. AVISTA CORPORATION • Interest rate derivative asset and liability accounting, where we estimate the fair value of outstanding interest rate swaps, and U.S. Treasury lock agreements and offset the derivative asset or liability with a regulatory asset or liability. This is similar to the treatment of energy commodity derivatives described above. Upon settlement of interest rate swaps, the regulatory asset or liability (included as part of long-term debt) is amortized as a component of interest expense over the term of the associated debt. If we no longer applied regulatory accounting or were no longer allowed recovery of these costs, we could be required to recognize significant changes in fair value of these interest rate derivatives on a regular basis in the Consolidated Statements of Income, which could lead to significant fluctuations in net income. • Pension Plans and Other Postretirement Benefit Plans, discussed in further detail below. • Goodwill, discussed in further detail below. • Contingencies, related to unresolved regulatory, legal and tax issues for which there is inherent uncertainty for the ultimate outcome of the respective matter. We accrue a loss contingency if it is probable that an asset is impaired or a liability has been incurred and the amount of the loss or impairment can be reasonably estimated. We also disclose losses that do not meet these conditions for accrual, if there is a reasonable possibility that a potential loss may be incurred. For all material contingencies, we have made a judgment as to the probability of a loss occurring and as to whether or not the amount of the loss can be reasonably estimated. If the loss recognition criteria are met, liabilities are accrued or assets are reduced. However, no assurance can be given to the ultimate outcome of any particular contingency. See "Notes 1 and 20 of the Notes to Consolidated Financial Statements" for further discussion of our commitments and contingencies. • Discontinued operations, related to the accounting and financial statement presentation for Ecova following its disposition in 2014. In accordance with GAAP, this transaction caused Ecova to be accounted for as a discontinued operation. Ecova's revenues and expenses are included in the Consolidated Statements of Income in discontinued operations (as a single line item, net of tax). The gain, net of tax, recognized on the sale of Ecova is also included in discontinued operations. All tables throughout the Notes to Consolidated Financial Statements that present Consolidated Statements of Income information were revised to only include amounts from continuing operations. In addition, we are presenting earnings per share calculations for continuing and discontinued operations. Pension Plans and Other Postretirement Benefit Plans - Avista Utilities We have a defined benefit pension plan covering substantially all regular full-time employees at Avista Utilities that were hired prior to January 1, 2014. For substantially all regular non-union full-time employees at Avista Utilities that were hired on or after January 1, 2014, a defined contribution 401(k) plan replaced the defined benefit pension plan. The Finance Committee of the Board of Directors approves investment policies, objectives and strategies that seek an appropriate return for the pension plan and it reviews and approves changes to the investment and funding policies. We have contracted with an independent investment consultant who is responsible for managing/monitoring the individual investment managers. The investment managers’ performance and related individual fund performance is reviewed at least quarterly by an internal benefits committee and by the Finance Committee to monitor compliance with our established investment policy objectives and strategies. Our pension plan assets are invested in debt securities and mutual funds, trusts and partnerships that hold marketable debt and equity securities, real estate and absolute return. In seeking to obtain the desired return to fund the pension plan, the investment consultant recommends allocation percentages by asset classes. These recommendations are reviewed by the internal benefits committee, which then recommends their adoption by the Finance Committee. The Finance Committee has established target investment allocation percentages by asset classes and also investment ranges for each asset class. The target investment allocation percentages are typically the midpoint of the established range and are disclosed in “Note 10 of the Notes to Consolidated Financial Statements.” We also have a Supplemental Executive Retirement Plan (SERP) that provides additional pension benefits to our executive officers and others whose benefits under the pension plan are reduced due to the application of Section 415 of the Internal Revenue Code of 1986 and the deferral of salary under deferred compensation plans. Pension costs (including the SERP) were $14.6 million for 2014, $28.8 million for 2013 and $28.1 million for 2012. Of our pension costs, approximately 60 percent are expensed and 40 percent are capitalized consistent with labor charges. The costs related to the SERP are expensed. Our costs for the pension plan are determined in part by actuarial formulas that are dependent upon numerous factors resulting from actual plan experience and assumptions of future experience. AVISTA CORPORATION Pension costs are affected by among other things: • employee demographics (including age, compensation and length of service by employees), • the amount of cash contributions we make to the pension plan, and • the return on pension plan assets. Changes made to the provisions of our pension plan may also affect current and future pension costs. Pension plan costs may also be significantly affected by changes in key actuarial assumptions, including the: • expected return on pension plan assets, • discount rate used in determining the projected benefit obligation and pension costs, • assumed rate of increase in employee compensation, • life expectancy of participants and other beneficiaries, and • expected method of payment (lump sum or annuity) of pension benefits. The change in pension plan obligations associated with these factors may not be immediately recognized as pension costs in our Consolidated Statement of Income, but we generally recognize the change in future years over the remaining average service period of pension plan participants. As such, our costs recorded in any period may not reflect the actual level of cash benefits provided to pension plan participants. We revised the key assumption of the discount rate in 2014, 2013 and 2012. Such changes had an effect on our pension costs and projected benefit obligation in 2014, 2013 and 2012 and may affect future years, given the cost recognition approach described above. However, in determining pension obligation and cost amounts, our assumptions can change from period to period, and such changes could result in material changes to our future pension costs and funding requirements. In selecting a discount rate, we consider yield rates for highly rated corporate bond portfolios with cash flows from interest and maturities similar to that of the expected payout of pension benefits. In 2014, we decreased the pension plan discount rate (exclusive of the SERP) to 4.21 percent from 5.1 percent in 2013. We used a discount rate of 4.15 percent in 2012. These changes in the discount rate increased the projected benefit obligation (exclusive of the SERP) by approximately $66.3 million in 2014 and decreased the obligation by $68.2 million in 2013. The expected long-term rate of return on plan assets is based on past performance and economic forecasts for the types of investments held by our plan. We used an expected long-term rate of return of 6.60 percent in 2014, 6.60 percent in 2013 and 6.95 percent in 2012. This change increased pension costs by approximately $1.5 million in 2013. The actual return on plan assets, net of fees, was a gain of $56.0 million (or 11.6 percent) for 2014, a gain of $52.5 million (or 12.5 percent) for 2013 and a gain of $54.3 million (or 15.9 percent) for 2012. We periodically analyze the estimated long-term rate of return on assets based upon updated economic forecasts and revisions to the investment portfolio. The following chart reflects the sensitivities associated with a change in certain actuarial assumptions by the indicated percentage (dollars in thousands): * Changes in the expected return on plan assets would not have an effect on our total pension liability. We provide certain health care and life insurance benefits for substantially all of our retired employees. We accrue the estimated cost of postretirement benefit obligations during the years that employees provide service. Assumed health care cost trend rates have a significant effect on the amounts reported for our postretirement plans. A one-percentage-point increase in the assumed health care cost trend rate for each year would increase our accumulated postretirement benefit obligation as of December 31, 2014 by $5.2 million and the service and interest cost by $0.4 million. A one-percentage-point decrease in the assumed health AVISTA CORPORATION care cost trend rate for each year would decrease our accumulated postretirement benefit obligation as of December 31, 2014 by $4.1 million and the service and interest cost by $0.3 million. For the estimated pension liability and pension costs as of December 31, 2014, we adopted the Society of Actuaries’ mortality table that was published in 2014 as our base table, which reflects improved longevity of plan participants based on studies of wide populations through 2007 (RP-2014). We also adopted a modified form of the Society of Actuaries’ MP-2014 mortality improvement scale, which projects improvements to life expectancies after the RP-2014 historic period that ended in 2007. For years subsequent to 2007, we reviewed data from other sources, including the Human Mortality Database, maintained by the University of California, Berkley and the Max Planck Institute for Demographic Research, and the Trustee's Report provided by the Social Security Administration. Based on data subsequent to 2007, the mortality improvement scale included in the MP-2014 for the three-year period immediately following its inception (2007) was shown to significantly overstate the actual mortality improvement for those years. As such, the mortality improvement scale we adopted assumes a lower rate of improved life expectancy than the MP-2014 scale as published. The updated mortality table resulted in an increase to the projected benefit obligation of $30.0 million. Goodwill We evaluate goodwill for impairment using a combination of a discounted cash flow model and a market approach on at least an annual basis or more frequently if impairment indicators arise. Examples of impairment indicators include: a deterioration in general economic conditions, market considerations such as a deterioration in the environment in which the entity operates, a decline in market-dependent multiples or metrics, increases in costs, overall financial performance such as a decline in earnings or cash flows, or a loss of key customers. The annual evaluation of goodwill for potential impairment is completed as of November 30 for AEL&P and our other businesses. As of December 31, 2014, we had goodwill of $52.7 million related to AEL&P and $5.2 million related to our other businesses. Application of the goodwill impairment test requires judgment and the use of significant estimates, including the identification of reporting units, assignment of assets and liabilities to reporting units, and the estimation of the fair value of reporting units. The goodwill impairment test is a two-step process performed at the reporting unit level. The first step involves comparing the carrying amount of the reporting unit to its estimated fair value. If the estimated fair value of the reporting unit is greater than its carrying value, the goodwill impairment test is complete and no impairment is recorded. If the estimated fair value of the reporting unit is less than its carrying value, the second step of the test is performed to determine the amount of impairment loss, if any. This would result in a full valuation of the reporting unit's assets and liabilities and comparing the valuation to its carrying amounts, with the aggregate difference indicating the amount of impairment. In 2014, each reporting unit that was evaluated for impairment had a fair value that exceeded its book value, and no impairment losses were recorded. Liquidity and Capital Resources Overall Liquidity Historically, Avista Corp.'s consolidated operating cash flows are primarily derived from the operations of Avista Utilities. The primary source of operating cash flows for Avista Utilities is revenues from sales of electricity and natural gas. Significant uses of cash flows from Avista Utilities include the purchase of power, fuel and natural gas, and payment of other operating expenses, taxes and interest, with any excess being available for other corporate uses such as capital expenditures and dividends. During 2014, the sale of Ecova and the settlement of the California energy markets litigation at Avista Energy also provided significant cash flows. We design operating and capital budgets to control operating costs and to direct capital expenditures to choices that support immediate and long-term strategies, particularly for our regulated utility operations. In addition to operating expenses, we have continuing commitments for capital expenditures for construction, improvement and maintenance of utility facilities. Our annual net cash flows from operating activities usually do not fully support the amount required for annual utility capital expenditures. As such, from time to time, we need to access long-term capital markets in order to fund these needs as well as fund maturing debt. See further discussion at “Capital Resources.” We periodically file for rate adjustments for recovery of operating costs and capital investments and to seek the opportunity to earn reasonable returns as allowed by regulators. See further details in the section “Item 7: Management's Discussion and Analysis: Regulatory Matters.” AVISTA CORPORATION For Avista Utilities, when power and natural gas costs exceed the levels currently recovered from retail customers, net cash flows are negatively affected. Factors that could cause purchased power and natural gas costs to exceed the levels currently recovered from our customers include, but are not limited to, higher prices in wholesale markets when we buy energy or an increased need to purchase power in the wholesale markets. Factors beyond our control that could result in an increased need to purchase power in the wholesale markets include, but are not limited to: • increases in demand (due to either weather or customer growth), • low availability of streamflows for hydroelectric generation, • unplanned outages at generating facilities, and • failure of third parties to deliver on energy or capacity contracts. Avista Utilities has regulatory mechanisms in place that provide for the deferral and recovery of the majority of power and natural gas supply costs. However, if prices rise above the level currently allowed in retail rates in periods when we are buying energy, deferral balances would increase, negatively affecting our cash flow and liquidity until such time as these costs, with interest, are recovered from customers. In addition to the above, Avista Utilities enters into derivative instruments to hedge our exposure to certain risks, including fluctuations in commodity market prices, foreign exchange rates and interest rates (for purposes of issuing long-term debt in the future). These derivative instruments often require collateral (in the form of cash or letters of credit) or other credit enhancements, or reductions or terminations of a portion of the contract through cash settlement, in the event of a downgrade in the Company's credit ratings or changes in market prices. In periods of price volatility, the level of exposure can change significantly. As a result, sudden and significant demands may be made against the Company's credit facilities and cash. See "Collateral Requirements" below. We monitor the potential liquidity impacts of changes to energy commodity prices and other increased operating costs for our utility operations. We believe that we have adequate liquidity to meet such potential needs through Avista Corp.'s $400.0 million committed line of credit. As of December 31, 2014, we had $262.4 million of available liquidity under the Avista Corp. committed line of credit. With our $400.0 million credit facility that expires in April 2019, we believe that we have adequate liquidity to meet our needs for the next 12 months. Review of Consolidated Cash Flow Statement Overall During 2014, cash flows from operating activities were $267.3 million, proceeds from the issuance of long-term debt were $150.0 million and we received $229.9 million from the sale of Ecova. Cash requirements included utility capital expenditures of $325.5 million, the net repayment of short-term borrowings of $66.0 million, the redemption of long-term debt of $40.0 million, defined benefit pension plan contributions of $32.0 million, dividends of $78.3 million and the repurchase of common stock of $79.9 million. 2014 compared to 2013 Consolidated Operating Activities Net cash provided by operating activities was $267.3 million for 2014 compared to $242.6 million for 2013. Net cash used by the changes in certain current assets and liabilities components was $50.0 million for 2014, compared to net cash used of $48.2 million for 2013. The net cash used during 2014 primarily reflects cash outflows from changes in accounts payable, natural gas stored and income taxes receivable. These were partially offset by cash inflows from changes in other current liabilities (primarily related to accrued taxes and interest) and accounts receivable. The net cash used during 2013 primarily reflects cash outflows from changes in accounts receivable, accounts payable and other current assets (primarily related to miscellaneous current assets and income taxes receivable). These were partially offset by cash inflows from other current liabilities (primarily related to accrued taxes and interest). The gross gain on the sale of Ecova of $160.6 million for 2014 is deducted in reconciling net income to net cash provided by operating activities. The cash proceeds from the sale (which includes the gross gain) is included in investing activities Net amortizations of power and natural gas costs were $14.8 million for 2014 compared to $9.4 million for 2013. The provision for deferred income taxes was $144.3 million for 2014 compared to $23.5 million for 2013. The increase for 2014 was primarily due to the combination of implementation by the Company of updated federal tax tangible property regulations and increased deductions related to bonus depreciation. AVISTA CORPORATION Contributions to our defined benefit pension plan were $32.0 million for 2014 compared to $44.3 million in 2013. Collateral posted for derivative instruments increased by $23.3 million in 2014 compared to an increase of $16.1 million in 2013. We had cash collateral posted of $49.4 million as of December 31, 2014 and $26.1 million as of December 31, 2013. Net cash paid for income taxes was $45.4 million for 2014 compared to $44.8 million for 2013. Cash paid for interest was $73.5 million for 2014 compared to $75.4 million for 2013. Consolidated Investing Activities Net cash used in investing activities was $103.7 million for 2014, a decrease compared to $312.2 million for 2013. During 2014, we received cash proceeds (net of cash sold and escrow amounts) of $229.9 million related to the sale of Ecova. A portion of the proceeds from the Ecova sale was used to pay off the balance of Ecova's long-term borrowings and make payments to option holders and noncontrolling interests (included in financing activities). We also used a portion of these proceeds to pay our $74.8 million tax liability associated with the gain on sale. Utility property capital expenditures increased by $31.2 million for 2014 as compared to 2013. A significant portion of Ecova's funds held for clients were held as securities available for sale with purchases of $12.3 million and sales and maturities of $14.6 million in 2014. For 2013, Ecova had purchases of $35.9 million and sales and maturities of $23.0 million. The fluctuation in the balance of funds held for customers resulted in a decrease to cash of $18.9 million for 2014 as compared to an increase to cash of $1.8 million for 2013. We received $15.0 million in cash (net of cash paid) related to the acquisition of AERC during 2014. Consolidated Financing Activities Net cash used in financing activities was $224.0 million for 2014 compared to net cash provided of $76.8 million for 2013. During 2014, short-term borrowings on Avista Corp.’s committed line of credit decreased $66.0 million. Net borrowings on Ecova's committed line of credit decreased $46.0 million during the period with $6.0 million in payments throughout the year and $40.0 million related to the close of the Ecova sale. In September 2014, AEL&P issued $75.0 million of first mortgage bonds. In December 2014, Avista Corp. issued $60.0 million of first mortgage bonds and AERC issued a $15.0 million unsecured note representing a term loan. We cash settled interest rate swaps in conjunction with the pricing of the $60.0 million of Avista Corp. first mortgage bonds and received $5.4 million. The majority of the $40.0 million of retirements of long-term debt in 2014 relates to AEL&P paying off its existing debt. In connection with the closing of the Ecova sale, we made cash payments of $54.2 million to noncontrolling interests and $20.9 million to stock option holders and redeemable noncontrolling interests of Ecova. Cash dividends paid increased to $78.3 million (or $1.27 per share) for 2014 from $73.3 million (or $1.22 per share) for 2013. Excluding issuances related to the acquisition of AERC, we issued $4.1 million of common stock during 2014. We issued $150.1 million of common stock to AERC shareholders, and this is reflected as a non-cash financing activity. The fluctuation in the balance of customer fund obligations at Ecova increased cash by $16.2 million. During 2014, we repurchased $79.9 million of common stock. Cash inflows during 2013 were from a $119.0 million increase in short-term borrowings on Avista Corp.’s committed line of credit, the issuance of $90.0 million of long-term debt and the issuance of $4.6 million of common stock. We also cash settled interest rate swap agreements for $2.9 million related to the pricing of the $90.0 million of long-term debt. Cash outflows during 2013 were from the maturity of long-term debt of $50.5 million and a net decrease in borrowings on Ecova's committed line of credit of $8.0 million (borrowings of $3.0 million and repayments of $11.0 million). 2013 compared to 2012 Consolidated Operating Activities Net cash provided by operating activities was $242.6 million for 2013 compared to $316.6 million for 2012. Net cash used by changes in certain current assets and liabilities components was $48.2 million for 2013, compared to net cash provided of $63.6 million for 2012. The net cash used during 2013 primarily reflects net cash outflows from accounts receivable, accounts payable and income taxes receivable. These were partially offset by cash inflows from changes in other current liabilities (primarily related to accrued taxes and interest). The net cash provided during 2012 primarily reflects positive cash flows from other current assets (primarily related to a decrease in deposits with counterparties), income taxes receivable and net cash inflows related to accounts payable. AVISTA CORPORATION Net deferrals of power and natural gas costs were $9.4 million for 2013 compared to net amortizations of $6.7 million for 2012. The provision for deferred income taxes was $23.5 million for 2013 compared to $21.4 million for 2012. Contributions to our defined benefit pension plan were $44.3 million for 2013 compared to $44.0 million in 2012. Cash paid for interest was $75.4 million for 2013, compared to $74.9 million for 2012. Consolidated Investing Activities Net cash used in investing activities was $312.2 million for 2013, an increase compared to $294.7 million for 2012. Utility property capital expenditures increased by $23.2 million for 2013 compared to 2012. A significant portion of Ecova's funds held for clients are held as securities available for sale with purchases of $35.9 million and sales and maturities of $23.0 million in 2013. For 2012, Ecova had purchases of $100.4 million and sales and maturities of $138.0 million. In 2012, Ecova paid $50.3 million for the acquisition of LPB. Consolidated Financing Activities Net cash provided by financing activities was $76.8 million for 2013 compared to net cash used of $21.1 million for 2012. Cash inflows during 2013 were from a $119.0 million increase in short-term borrowings on Avista Corp.’s committed line of credit, the issuance of $90.0 million of long-term debt and the issuance of $4.6 million of common stock. We also cash settled interest rate swap agreements for $2.9 million related to the pricing of the $90.0 million of long-term debt. Cash outflows during 2013 were from the maturity of long-term debt of $50.5 million and a net decrease in borrowings on Ecova's committed line of credit of $8.0 million (borrowings of $3.0 million and repayments of $11.0 million). Cash dividends paid increased to $73.3 million (or $1.22 per share) for 2013 from $68.6 million (or $1.16 per share) for 2012. During 2012, short-term borrowings on Avista Corp.'s committed line of credit decreased $9.0 million. Net borrowings on Ecova's committed line of credit increased $19.0 million and these proceeds were used to fund the acquisition of LPB. We issued $29.1 million of common stock during 2012. We cash settled interest rate swap agreements for $18.5 million related to the pricing of $80.0 million of long-term debt issued in November 2012. Customer fund obligations at Ecova decreased $31.0 million. Collateral Requirements Avista Utilities' contracts for the purchase and sale of energy commodities can require collateral in the form of cash or letters of credit. As of December 31, 2014, we had cash deposited as collateral of $20.6 million and letters of credit of $14.5 million outstanding related to our energy derivative contracts. Price movements and/or a downgrade in our credit ratings could impact further the amount of collateral required. See “Credit Ratings” for further information. For example, in addition to limiting our ability to conduct transactions, if our credit ratings were lowered to below “investment grade” based on our positions outstanding at December 31, 2014, we would potentially be required to post additional collateral of up to $11.9 million. This amount is different from the amount disclosed in “Note 6 of the Notes to Consolidated Financial Statements” because, while this analysis includes contracts that are not considered derivatives in addition to the contracts considered in Note 6, this analysis also takes into account contractual threshold limits that are not considered in Note 6. Without contractual threshold limits, we would potentially be required to post additional collateral of $26.1 million. Under the terms of interest rate swap agreements that we enter into periodically, we may be required to post cash or letters of credit as collateral depending on fluctuations in the fair value of the instrument. As of December 31, 2014, we had interest rate swap agreements outstanding with a notional amount totaling $420.0 million and we had deposited cash in the amount of $28.9 million and letters of credit of $10.9 million as collateral for these interest rate swap derivative contracts. If our credit ratings were lowered to below “investment grade” based on our interest rate swap agreements outstanding at December 31, 2014, we would have to post $19.4 million of additional collateral. AVISTA CORPORATION Capital Resources Our consolidated capital structure, including the current portion of long-term debt and short-term borrowings, and excluding noncontrolling interests, consisted of the following as of December 31, 2014 and 2013 (dollars in thousands): Our shareholders’ equity increased $185.4 million during 2014 primarily due to net income, which included the net gain on the sale of Ecova, and the issuance of common stock to AERC shareholders, partially offset by the repurchase of common stock and dividends. Our long-term debt increased $219.6 million during 2014 due to the issuance of debt at Avista Corp., AEL&P and AERC and also because of the Snettisham capital lease obligation that was acquired with the acquisition of AERC. See "Note 14 of the Notes to Consolidated Financial Statements" for further information regarding the debt issuances and the Snettisham capital lease obligation. The Snettisham capital lease obligation is treated differently for regulatory purposes than other long-term debt. All debt service obligations (principal and interest) related to this power purchase agreement are paid on a regular basis and are included in utility resource costs and included in AEL&P's retail revenue requirements, whereas the principal of other long-term debt is typically paid in a lump sum at maturity. We need to finance capital expenditures and acquire additional funds for operations from time to time. The cash requirements needed to service our indebtedness, both short-term and long-term, reduce the amount of cash flow available to fund capital expenditures, purchased power, fuel and natural gas costs, dividends and other requirements. See "Item 7: Management's Discussion and Analysis, Executive Level Summary" for a detailed discussion of the liquidity and capital resource transactions which occurred during 2014 and our anticipated needs for 2015. Balances outstanding and interest rates of borrowings (excluding letters of credit) under our committed line of credit were as follows as of and for the year ended December 31 (dollars in thousands): Any default on the line of credit or other financing arrangements of Avista Corp. or any of our “significant subsidiaries,” if any, could result in cross-defaults to other agreements of such entity, and/or to the line of credit or other financing arrangements of any other of such entities. Any defaults could also induce vendors and other counterparties to demand collateral. In the event of any such default, it would be difficult for us to obtain financing on reasonable terms to pay creditors or fund operations. We would also likely be prohibited from paying dividends on our common stock. Avista Corp. does not guarantee the indebtedness of any of its subsidiaries. As of December 31, 2014, Avista Corp. and its subsidiaries were in compliance with all of the covenants of their financing agreements, and none of Avista Corp.'s subsidiaries constituted a “significant subsidiary” as defined in Avista Corp.'s committed line of credit. AVISTA CORPORATION We are restricted under our Restated Articles of Incorporation, as amended, as to the additional preferred stock we can issue. As of December 31, 2014, we could issue $2.2 billion of additional preferred stock at an assumed dividend rate of 5.8 percent. We are not planning to issue preferred stock. Under the Avista Corp. and the AEL&P Mortgages and Deeds of Trust securing Avista Corp.'s and AEL&P's first mortgage bonds (including Secured Medium-Term Notes), respectively, each entity may issue additional first mortgage bonds in an aggregate principal amount equal to the sum of: • 66-2/3 percent of the cost or fair value (whichever is lower) of property additions at each entity which have not previously been made the basis of any application under the Mortgages, or • an equal principal amount of retired first mortgage bonds at each entity which have not previously been made the basis of any application under the Mortgages, or • deposit of cash. However, Avista Corp. and AEL&P may not individually issue any additional first mortgage bonds (with certain exceptions in the case of bonds issued on the basis of retired bonds) unless the particular entity issuing the bonds has “net earnings” (as defined in the Mortgages) for any period of 12 consecutive calendar months out of the preceding 18 calendar months that were at least twice the annual interest requirements on all mortgage securities at the time outstanding, including the first mortgage bonds to be issued, and on all indebtedness of prior rank. As of December 31, 2014, property additions and retired bonds would have allowed, and the net earnings test would not have prohibited, the issuance of $1.0 billion in aggregate principal amount of additional first mortgage bonds at Avista Corp. and $3.5 million at AEL&P. We believe that we have adequate capacity to issue first mortgage bonds to meet our financing needs over the next several years. Capital Expenditures Utility cash-basis capital expenditures were $891.1 million for the years 2012 through 2014 including $1.6 million at AEL&P for 2014. We expect Avista Utilities' capital expenditures to be about $375 million for 2015 and $350 million for each of 2016 and 2017. Most of the capital expenditures at Avista Utilities are for upgrading and maintenance of our existing facilities, and not for construction of new facilities and we expect all of these capital expenditures to be included in rate base in future years. Our capital budget at Avista Utilities for 2015 includes the following (dollars in millions): Avista Utilities' estimated capital expenditures for the next few years include several significant capital investments we are expecting to make, including: • the ongoing and multi-year redevelopment of the Little Falls hydroelectric plant on the Spokane River, • the continuing rehabilitation of the Nine Mile hydroelectric plant on the Spokane River, • information technology upgrades that include the replacement of our customer information and work management systems (which were implemented in February 2015), • the ongoing project to systematically replace portions of Aldyl-A natural gas distribution pipe, and • technology investments for deploying Advanced Metering Infrastructure in Washington, including installation of advanced meters, beginning in 2016. At AEL&P, we expect to spend approximately $15 million for each of 2015 and 2016. A significant portion of these capital expenditures are for the construction of an additional back-up generation plant. AVISTA CORPORATION These estimates of capital expenditures are subject to continuing review and adjustment. Actual capital expenditures may vary from our estimates due to factors such as changes in business conditions, construction schedules and environmental requirements. Future generation resource decisions may be further impacted by legislation for restrictions on greenhouse gas (GHG) emissions and renewable energy requirements as discussed at “Environmental Issues and Other Contingencies.” Off-Balance Sheet Arrangements As of December 31, 2014, we had $32.6 million in letters of credit outstanding under our $400.0 million committed line of credit, compared to $27.4 million as of December 31, 2013. Pension Plan We contributed $32.0 million to the pension plan in 2014. We expect to contribute a total of $60.0 million to the pension plan in the period 2015 through 2019, with an annual contribution of $12.0 million over that period. The final determination of pension plan contributions for future periods is subject to multiple variables, most of which are beyond our control, including changes to the fair value of pension plan assets, changes in actuarial assumptions (in particular the discount rate used in determining the benefit obligation), or changes in federal legislation. We may change our pension plan contributions in the future depending on changes to any variables, including those listed above. See "Note 10 of the Notes to Consolidated Financial Statements" for additional information regarding the pension plan. Credit Ratings Our access to capital markets and our cost of capital are directly affected by our credit ratings. In addition, many of our contracts for the purchase and sale of energy commodities contain terms dependent upon our credit ratings. See “Collateral Requirements” and “Note 6 of the Notes to Consolidated Financial Statements.” The following table summarizes our credit ratings as of February 25, 2015: Standard & Poor’s (1) Moody’s (2) Corporate/Issuer rating BBB Baa1 Senior secured debt A- A2 Senior unsecured debt BBB Baa1 (1) Standard & Poor’s lowest “investment grade” credit rating is BBB-. (2) Moody’s lowest “investment grade” credit rating is Baa3. A security rating is not a recommendation to buy, sell or hold securities. Each security rating is subject to revision or withdrawal at any time by the assigning rating organization. Each security rating agency has its own methodology for assigning ratings, and, accordingly, each rating should be considered in the context of the applicable methodology, independent of all other ratings. The rating agencies provide ratings at the request of Avista Corp. and charge fees for their services. Dividends On February 6, 2015, Avista Corp.’s Board of Directors declared a quarterly dividend of $0.33 per share on the Company’s common stock. This was an increase of $0.0125 per share, or 4 percent from the previous quarterly dividend of $0.3175 per share. See "Item 5. Market for Registrant’s Common Equity, Related Stockholder Matters and Issuer Purchases of Equity Securities" for a detailed discussion of our dividend policy and the factors which could limit the payment of dividends. AVISTA CORPORATION Contractual Obligations The following table provides a summary of our future contractual obligations as of December 31, 2014 (dollars in millions): (1) Represents our estimate of interest payments on long-term debt, which is calculated based on the assumption that all debt is outstanding until maturity. Interest on variable rate debt is calculated using the rate in effect at December 31, 2014. (2) Energy purchase contracts were entered into as part of the obligation to serve our retail electric and natural gas customers’ energy requirements. As a result, costs are generally recovered either through base retail rates or adjustments to retail rates as part of the power and natural gas cost adjustment mechanisms. (3) Includes the interest component of the lease obligation. (4) Represents operational agreements, settlements and other contractual obligations for our generation, transmission and distribution facilities. These costs are generally recovered through base retail rates. (5) Includes information service contracts which are recorded to other operating expenses in the Consolidated Statements of Income as well as information technology contracts associated with the replacement of our customer information and work management systems, which are capital expenditures and were completed in February 2015. (6) Represents our estimated cash contributions to pension plans and other postretirement benefit plans through 2019. We cannot reasonably estimate pension plan contributions beyond 2019 at this time and have excluded them from the table above. (7) Represents the contractually required capital project funding associated with the Snettisham hydroelectric project. These costs are generally recovered through base retail rates. (8) Represents a commitment to fund a limited liability company in exchange for equity ownership, made by a subsidiary of Avista Capital. The above contractual obligations do not include income tax payments. Also, asset retirement obligations are not included above and payments associated with these have historically been less than $1 million per year. There are approximately $3.0 million remaining asset retirement obligations as of December 31, 2014. AVISTA CORPORATION In addition to the contractual obligations disclosed above, we will incur additional operating costs and capital expenditures in future periods for which we are not contractually obligated as part of our normal business operations. Competition Our utility electric and natural gas distribution business has historically been recognized as a natural monopoly. In each regulatory jurisdiction, our rates for retail electric and natural gas services (other than specially negotiated retail rates for industrial or large commercial customers, which are subject to regulatory review and approval) are generally determined on a “cost of service” basis. Rates are designed to provide, after recovery of allowable operating expenses and capital investments, an opportunity for us to earn a reasonable return on investment as allowed by our regulators. In retail markets, we compete with various rural electric cooperatives and public utility districts in and adjacent to our service territories in the provision of service to new electric customers. Alternative energy technologies, including solar, wind or geothermal generation, may also compete with us for sales to existing customers. While the risk is currently small in our service territory given the small numbers of customers utilizing these technologies, advances in power generation, energy efficiency and other alternative energy technologies could lead to more wide-spread usage of these technologies, thereby reducing customer demand for the energy supplied by us. This reduction in usage and demand would reduce our revenue and negatively impact our financial condition including possibly leading to our inability to fully recover our investments in generation, transmission and distribution assets. Similarly, our natural gas distribution operations compete with other energy sources including heating oil, propane and other fuels. Certain natural gas customers could bypass our natural gas system, reducing both revenues and recovery of fixed costs. To reduce the potential for such bypass, we price natural gas services, including transportation contracts, competitively and have varying degrees of flexibility to price transportation and delivery rates by means of individual contracts. These individual contracts are subject to state regulatory review and approval. We have long-term transportation contracts with several of our largest industrial customers under which the customer acquires its own commodity while using our infrastructure for delivery. Such contracts reduce the risk of these customers bypassing our system in the foreseeable future and minimizes the impact on our earnings. Also, non-utility businesses are developing new technologies and services to help energy consumers manage energy in new ways that may improve productivity and could alter demand for the energy we sell. In wholesale markets, competition for available electric supply is influenced by the: • localized and system-wide demand for energy, • type, capacity, location and availability of generation resources, and • variety and circumstances of market participants. These wholesale markets are regulated by the FERC, which requires electric utilities to: • transmit power and energy to or for wholesale purchasers and sellers, • enlarge or construct additional transmission capacity for the purpose of providing these services, and • transparently price and offer transmission services without favor to any party, including the merchant functions of the utility. Participants in the wholesale energy markets include: • other utilities, • federal power marketing agencies, • energy marketing and trading companies, • independent power producers, • financial institutions, and • commodity brokers. Economic Conditions and Utility Load Growth The general economic data, on both national and local levels, contained in this section is based, in part, on independent government and industry publications, reports by market research firms or other independent sources. While we believe that AVISTA CORPORATION these publications and other sources are reliable, we have not independently verified such data and can make no representation as to its accuracy. We track multiple economic indicators affecting three distinct metropolitan statistical areas in our Avista Utilities service area: Spokane, Washington, Coeur d'Alene, Idaho, and Medford, Oregon. Several key indicators are employment change, unemployment rates and foreclosure rates. On a year-over-year basis, December 2014 showed positive job growth, and lower unemployment rates in all three metropolitan areas. However, the unemployment rates in Spokane and Medford are still above the national average. Foreclosure rates are in line with or below the U.S rate in all three area, and key leading indicators, initial unemployment claims and residential building permits, continue to signal modest growth over the next 12 months. Therefore, in 2015, we continue to expect economic growth in our service area to be somewhat slower than the U.S. as a whole. Seasonally adjusted nonfarm employment in our eastern Washington, northern Idaho, and southwestern Oregon metropolitan service areas exhibited moderate growth between December 2013 and December 2014. In Spokane, Washington employment growth was 2.1 percent with gains in financial activities; professional and business services; education and health services; and leisure and hospitality. Employment increased by 3.0 percent in Coeur d'Alene, Idaho, reflecting gains in construction; manufacturing; professional and business services; leisure and hospitality; and other services. In Medford, Oregon, employment growth was 0.9 percent, with gains in manufacturing; education and health services; and government. U.S. nonfarm sector jobs grew by 2.1 percent in the same 12-month period. Seasonally adjusted unemployment rates went down in December 2014 from the year earlier in Spokane, Coeur d'Alene, and Medford. In Spokane the rate was 7.4 percent in December 2013 and declined to 7.2 percent in December 2014; in Coeur d'Alene the rate went from 6.6 percent to 4.3 percent; and in Medford the rate declined from 9.1 percent to 8.4 percent. The U.S. rate declined from 6.7 percent to 5.6 percent in the same period. The housing market in our Avista Utilities service area continues to experience foreclosure rates in line with or lower than the national average. The December 2014 national rate was 0.09 percent, compared to 0.08 percent in Spokane County, Washington; 0.04 percent in Kootenai County (Coeur d'Alene), Idaho; and 0.1 percent in Jackson County (Medford), Oregon. Our AEL&P service area is centered in Juneau. Although Juneau is Alaska’s state capital, it is not a metropolitan statistical area. This means breadth and frequency of economic data is more limited. Therefore, the dates of Juneau's economic data may significantly lag the period of this filing. The Quarterly Census of Employment and Wages for Juneau shows employment declined 1.3 percent between second quarter 2013 and second quarter 2014. A significant portion of this decline was due to a contraction in government employment, which is Juneau's largest single sector. Government (including active duty military personnel) accounts for approximately 37 percent of total employment. Employment declines also occurred in manufacturing; trade, transportation, and utilities; financial activities; and education and health services. Employment gains did occur in construction; information; professional and business services; and leisure and hospitality. Between December 2013 and December 2014 the non-seasonally adjusted unemployment rate increased from 4.6 percent to 4.8 percent. The Juneau foreclosure rate is below the U.S. rate. The December 2014 rate was 0.03 percent compared to 0.09 percent for the U.S. Based on our forecast for 2015 through 2018 for Avista Utilities' service area, we expect annual electric customer growth to average 1.2 percent, within a forecast range of 0.8 percent to 1.6 percent. We expect annual natural gas customer growth to average 1.0 percent, within a forecast range of 0.5 percent to 1.5 percent. We anticipate retail electric load growth to average 0.8 percent, within a forecast range of 0.5 percent and 1.1 percent. We expect natural gas load growth to average 1.3 percent, within a forecast range of 0.8 percent and 1.8 percent. The forecast ranges reflect (1) the inherent uncertainty associated with the economic assumptions on which forecasts are based and (2) natural gas customer and load growth has been historically more volatile. In AEL&P's service area, we expect annual residential customer growth to be in a narrow range around 0.4 percent for 2015 through 2018. We expect no significant growth in commercial and government customers over the same period. We anticipate that average annual total load growth will be in a narrow range around 0.9 percent, with residential load growth averaging about 0.6 percent; commercial about 1.2 percent; and government about 1.0 percent. The forward-looking statements set forth above regarding retail load growth are based, in part, upon purchased economic forecasts and publicly available population and demographic studies. The expectations regarding retail load growth are also based upon various assumptions, including: • assumptions relating to weather and economic and competitive conditions, • internal analysis of company-specific data, such as energy consumption patterns, • internal business plans, AVISTA CORPORATION • an assumption that we will incur no material loss of retail customers due to self-generation or retail wheeling, and • an assumption that demand for electricity and natural gas as a fuel for mobility will for now be immaterial. Changes in actual experience can vary significantly from our projections. Environmental Issues and Contingencies We are subject to environmental regulation by federal, state and local authorities. The generation, transmission, distribution, service and storage facilities in which we have ownership interests are designed and operated in compliance with applicable environmental laws. Furthermore, we conduct periodic reviews and audits of pertinent facilities and operations to ensure compliance and to respond to or anticipate emerging environmental issues. The Company's Board of Directors has established a committee to oversee environmental issues. We monitor legislative and regulatory developments at all levels of government for environmental issues, particularly those with the potential to impact the operation and productivity of our generating plants and other assets. Environmental laws and regulations may: • increase the operating costs of generating plants; • increase the lead time and capital costs for the construction of new generating plants; • require modification of our existing generating plants; • require existing generating plant operations to be curtailed or shut down; • reduce the amount of energy available from our generating plants; • restrict the types of generating plants that can be built or contracted with; and • require construction of specific types of generation plants at higher cost. Compliance with environmental laws and regulations could result in increases to capital expenditures and operating expenses. We intend to seek recovery of any such costs through the ratemaking process. Clean Air Act We must comply with the requirements under the Clean Air Act (CAA) in operating our thermal generating plants. The CAA currently requires a Title V operating permit for Colstrip (expires in 2017), Coyote Springs 2 (expires in 2018), the Kettle Falls GS (renewal expected in 2015), and the Rathdrum CT (expires in 2016). Boulder Park GS, Northeast CT, and other activities only require minor source operating or registration permits based on their limited operation and emissions. The Title V operating permits are renewed every five years and updated to include newly applicable CAA requirements. We actively monitor legislative, regulatory and program developments within the CAA that may impact our facilities. On March 6, 2013, the Sierra Club and Montana Environmental Information Center, filed a Complaint (Complaint) in the United States District Court for the District of Montana, Billings Division, against the owners of the Colstrip. The Complaint alleges certain violations of the CAA. See “Sierra Club and Montana Environmental Information Center Complaint Against the Owners of Colstrip” in “Note 20 of the Notes to Consolidated Financial Statements” for further information on this matter. Hazardous Air Pollutants (HAPs) The EPA regulates hazardous air pollutants from a published list of industrial sources referred to as "source categories" which must meet control technology requirements if they emit one or more of the pollutants in significant quantities. In 2012, the EPA finalized the Mercury Air Toxic Standards (MATS) for the coal and oil-fired source category. For Colstrip Units 3 & 4, the only units in which we are a minority owner, the existing emission control systems should be sufficient to meet mercury limits. For the remaining portion of the rule that utilizes Particulate Matter as a surrogate for air toxics (including metals and acid gases), the Colstrip owners have reviewed recent stack testing data and expect that no additional emission control systems will be needed for Units 3 & 4 MATS compliance. However, Units 1 & 2 (which we do not have ownership interest in) will require a pollution control enhancement for MATS compliance which has resulted in a request of an extension to the compliance deadline. The new MATS compliance deadline for Colstrip in now April, 16, 2016. We will continue to monitor future testing results but currently we do not believe there will be any material effect on Colstrip Units 3 & 4. AVISTA CORPORATION Regional Haze Program The EPA set a national goal of eliminating man-made visibility degradation in Class I areas by the year 2064. States are expected to take actions to make “reasonable progress” through 10-year plans, including application of Best Available Retrofit Technology (BART) requirements. BART is a retrofit program applied to large emission sources, including electric generating units built between 1962 and 1977. In the case where a State opts out of implementing the Regional Haze program, the EPA may act directly. On September 18, 2012, the EPA finalized the Regional Haze federal implementation plan (FIP) for Montana. The FIP includes both emission limitations and pollution controls for Colstrip Units 1 & 2. Colstrip Units 3 & 4, the only units of which we are a minority owner, are not currently affected, but will be evaluated for Reasonable Progress at the next review period in September 2017. We do not anticipate any material impacts on Units 3 & 4 at this time. In November 2012, the National Parks Conservation Association, MEIC and Sierra Club filed a petition for review of the EPA's Montana FIP in the U.S. Court of Appeals for the Ninth Circuit. We continue to monitor, but are unable to predict the outcome of this matter or estimate the effect thereof. Climate Change Concerns about long-term global climate changes could have a significant effect on our business. Our operations could also be affected by changes in laws and regulations intended to mitigate the risk of or alter global climate changes, including restrictions on the operation of our power generation resources and obligations imposed on the sale of natural gas. Changing temperatures and precipitation, including snowpack conditions, affect the availability and timing of streamflows, which impact hydroelectric generation. Extreme weather events could increase service interruptions, outages and maintenance costs. Changing temperatures could also increase or decrease customer demand. Our Climate Policy Council (an interdisciplinary team of management and other employees): • facilitates internal and external communications regarding climate change issues, • analyzes policy effects, anticipates opportunities and evaluates strategies for Avista Corp., and • develops recommendations on climate related policy positions and action plans. Federal Legislation The U.S. Congress has considered many proposals to reduce greenhouse gas (GHG) emissions and mandate renewable or clean energy. The financial and operational impacts of climate or energy legislation, if enacted, would depend on a variety of factors, including the specific provisions and timing of any legislation that might ultimately be adopted. Federal legislative proposals that would impose mandatory requirements related to greenhouse gas emissions, renewable or clean energy standards, and/or energy efficiency standards are expected to continue to be considered by the U.S. Congress. Federal Regulatory Actions The U.S. Supreme Court ruled in 2007 that the EPA had authority under the CAA to regulate GHG emissions from new motor vehicles; subsequently, the EPA issued regulations on tailpipe emissions of GHG. When these regulations became effective, GHG became regulated pollutants under the Prevention of Significant Deterioration (PSD) preconstruction permit program and the Title V operating permit program, both of which apply to power plants and other commercial and industrial facilities. In June 2013, President Obama released his Climate Action Plan which reiterates the goal of reducing GHG emissions in the U.S. "in the range of" 17 percent below 2005 levels by 2020 through such actions as regulating power plant emissions, promoting increased use of renewables and clean energy technology and establishing tighter energy efficiency standards. In keeping with a Presidential Memorandum also issued in June 2013, the EPA issued a new proposal to limit carbon dioxide emissions from new and modified coal-fired and natural gas-fueled electrical generating units in late 2013. The EPA also announced its intention to issue GHG guidelines for existing sources. The rule for new sources has not been finalized, and the proposed rule for existing sources was released on June 2, 2014. The existing source proposal aims to reduce GHG emissions from covered existing generation sources by 30 percent nationally by 2030 from a 2005 baseline. The proposal establishes individual state emission reduction goals based upon assumptions upon the potential for (1) heat rate improvements at coal-fired units, (2) increased utilization of natural gas-fired combined cycle plants up to a 70 percent capacity factor, (3) utilize more low or zero carbon emitting generation resources, and (4) increase demand side efficiency by 1.5 percent per year. States can rely on these four elements, or “building blocks,” as policy mechanisms to meet their respective goals, or they could adopt market mechanisms as an alternative, subject to the EPA's approval. The EPA is expected to finalize both rules in the summer of 2015. The states are scheduled to submit compliance plans regarding the existing source rule to the EPA by June 2016, with a potential for an extension until June 2017, or June 2018 if the state will be part of a regional approach. AVISTA CORPORATION GHG emission standards could result in significant compliance costs. Such standards could also preclude us from developing, operating or contracting with certain types of generating plants. Our thermal generation facilities (including natural gas fired facilities) may be impacted by the promulgated PSD permitting rules in the future. These rules can impact the time to obtain permits for new generation and major modifications to existing generating units as well as the final permit limitations. Additionally, the Climate Action Plan requirements related to preparing the U.S. for the impacts of climate change could affect us and others in the industry as transmission system modifications to improve resiliency may be needed in order to meet those requirements. The promulgated and proposed GHG rulemakings mentioned above also have been legally challenged in multiple venues, so we cannot fully predict the outcome or estimate the extent to which our facilities may be impacted by these regulations at this time. We intend to seek recovery of any costs related to compliance with these requirements through the ratemaking process. EPA Mandatory Reporting Rule (MRR) Any facility emitting over 25,000 metric tons of GHGs per year must report its emissions. We currently report under this requirement for Colstrip, Coyote Springs 2, and Rathdrum CT. MRR also requires GHG reporting for natural gas distribution system throughput, fugitive emissions from electric power transmission and distribution systems, fugitive emissions from natural gas distribution systems, and from natural gas storage facilities. State Legislation and State Regulatory Activities The states of Washington and Oregon have adopted non-binding targets to reduce GHG emissions. Both states enacted their targets with an expectation of reaching the targets through a combination of renewable energy standards, and assorted “complementary policies,” but no specific reductions are mandated. Washington State's Department of Ecology has adopted regulations to update its State Implementation Plan relative to the EPA's regulation of GHG emissions. We will continue to monitor actions by the Department as it may proceed to adopt additional regulations under its CAA authorities, and cannot estimate any material impact at this time. Washington and Oregon apply a GHG emissions performance standard (EPS) to electric generation facilities used to serve retail loads in their jurisdictions. The EPS prevents utilities from constructing or purchasing generation facilities, or entering into power purchase agreements of five years or longer duration, to purchase energy produced by plants that have emission levels higher than 1,100 pounds of GHG per MWh. The Washington State Department of Commerce (Commerce) initiated a process to adopt a lower emissions performance standard in 2012, any new standard will be applicable until at least 2017. Commerce published a supplemental notice of proposed rulemaking on January 16, 2013 with a new EPS of 970 pounds of GHG per MWh. We will continue to monitor this rulemaking and cannot estimate any material impact at this time. The Energy Independence Act (EIA), in Washington requires electric utilities with over 25,000 customers to acquire qualified renewable energy resources and/or renewable energy credits equal to 15 percent of the utility's total retail load in 2020. I-937 also requires these utilities to meet biennial energy conservation targets beginning in 2012. Furthermore, by January 1, 2012, electric utilities subject to EIA's mandates were required to acquire enough qualified renewable energy and/or renewable energy credits to meet three percent of their retail load. This renewable energy standard increases to nine percent in 2016. Failure to comply with renewable energy and efficiency standards could result in penalties of $50 per MWh or greater assessed against a utility for each MWh it is deficient in meeting a standard. We have met, and will continue to meet, the requirements of EIA through a variety of renewable energy generating means, including, but not limited to, some combination of hydro upgrades, wind and biomass. In 2012, EIA was amended in such a way that our Kettle Falls GS and certain other biomass energy facilities which commenced operation before March 31, 1999, are considered resources that may be used to meet the renewable energy standards beginning in 2016. On April 29, 2014, Washington State Governor Jay Inslee issued Executive Order 14-04, “Washington Carbon Pollution Reduction and Clean Energy Action.” The order created a “Climate Emissions Reduction Task Force” to provide recommendations to the Governor on design and implementation of a market-based carbon pollution program to inform possible legislative proposals in 2015. The order also called on the program to “establish a cap on carbon pollution emissions, with binding requirements to meet our statutory emission limits.” The order also states that the Governor’s Legislative Affairs and Policy Office “will seek negotiated agreements with key utilities and others to reduce and eliminate over time the use of electrical power produced from coal.” The Task Force issued a report summarizing its efforts, which included a range of potential carbon-reducing proposals. Subsequently, in January 2015, at Washington Governor Jay Inslee’s request, the Carbon Pollution Accountability Act was introduced as a bill in the Washington legislature. The bill includes a proposed cap and trade system for carbon emissions from a wide range of sources, including fossil-fired electrical generation, “imported” power generated by fossil fuels, natural gas sales and use, and certain uses of biomass for AVISTA CORPORATION electrical generation. While we cannot predict the outcome of actions arising out of proposed legislation at this time or estimate the effect thereof, we will continue to seek recovery, through the ratemaking process, of all operating and capitalized costs related to our generation assets. On February 6, 2014, the UTC issued a letter finding that Puget Sound Energy’s (PSE’s) 2013 Electric Integrated Resource Plan meets the requirements of the Revised Code of Washington and the Washington Administrative Code. In its letter, however, the UTC expressed concern regarding the continued operation of the Colstrip plant as a resource to serve retail customers. Although the UTC recognized that the results of the analyses presented by PSE “differed significantly between [Colstrip] Units 1 and 2 and Units 3 and 4,” the UTC did not limit its concerns solely to Colstrip Units 1 and 2. The UTC recommended that PSE “consult with UTC staff to consider a Colstrip Proceeding to determine the prudency of any new investment in Colstrip before it is made or, in the alternative, a closure or partial-closure plan.” As a 15 percent owner of Colstrip Units 3 and 4, we cannot estimate the effect of such proceeding, should it occur, on the future ownership and operation of our share of Colstrip Units 3 and 4. Our remaining investment in Colstrip Units 3 and 4 as of December 31, 2014 was $110.7 million. In 2013, the Oregon Legislature enacted Senate Bill 306, directing the Legislative Revenue Office to examine the feasibility of imposing a carbon tax on a statewide basis. A report prepared by Portland State University’s Northwest Economic Research Center was submitted to the Legislature in December 2014 and it analyzed, broadly, potential economic impacts of enacting a carbon tax. Any future proposal to tax natural gas as a fuel for electricity generation and to tax the carbon content of electricity produced in, but exported from, Oregon could have implications for the cost of operating Coyote Springs II. We will monitor further developments from the study, but we cannot estimate any actual material impact at this time. Coal Ash Management/Disposal On December 19, 2014, the EPA issued a final rule regarding coal combustion residuals (CCRs), also termed coal combustion byproducts or coal ash. Colstrip, of which Avista Corp. is a minority owner, produces this byproduct. The rule establishes technical requirements for CCR landfills and surface impoundments under Subtitle D of the Resource Conservation and Recovery Act (RCRA), the nation's primary law for regulating solid waste. The final rule has not yet been published in the Federal Register. We continue to review the potential costs of complying with the new CCR standards. We cannot currently estimate the operational or financial impact of CCR regulation, but we believe this rule will have an impact on Colstrip. If we were to incur incremental costs as a result of these regulations, we would seek recovery in customer rates. We do not expect these rules to have a material impact to the operations of Colstrip. Threatened and Endangered Species and Wildlife A number of species of fish in the Northwest are listed as threatened or endangered under the Federal Endangered Species Act. Efforts to protect these and other species have not directly impacted generation levels at any of our hydroelectric facilities. We are implementing fish protection measures at our hydroelectric project on the Clark Fork River under a 45-year FERC operating license for Cabinet Gorge and Noxon Rapids (issued March 2001) that incorporates a comprehensive settlement agreement. The restoration of native salmonid fish, including bull trout, is a key part of the agreement. The result is a collaborative native salmonid restoration program with the U.S. Fish and Wildlife Service, Native American tribes and the states of Idaho and Montana on the lower Clark Fork River, consistent with requirements of the FERC license. The U.S. Fish & Wildlife Service issued an updated Critical Habitat Designation for bull trout in 2010 that includes the lower Clark Fork River, as well as portions of the Coeur d'Alene basin within our Spokane River Project area, and is currently developing a final Bull Trout Recovery Plan under the ESA. Issues related to these activities are expected to be resolved through the ongoing collaborative effort of our Clark Fork and Spokane River FERC licenses. See “Spokane River Licensing” and “Fish Passage at Cabinet Gorge and Noxon Rapids” in “Note 20 of the Notes to Consolidated Financial Statements” for further information. Various statutory authorities, including the Migratory Bird Treaty Act, have established penalties for the unauthorized take of migratory birds. Because we operate facilities that can pose risks to a variety of such birds, we have developed and follow an avian protection plan. Kettle Falls Generation Station - Diesel Spill Investigation and Remediation In December 2013, our operations staff at the Kettle Falls Generation Station discovered that approximately 10,000 gallons of diesel fuel had leaked underground from the piping system used to fuel heavy equipment. We made all proper agency notifications and worked closely with the Washington State Department of Ecology during the spill response and investigation phase. We installed ground water monitoring wells, and there is no indication that ground or surface water is threatened by the spill. We initiated a voluntary cleanup action with the installation of a recovery system which is now fully operational. See "Note 20 of the Notes to Consolidated Financial Statements" for further discussion of this issue. AVISTA CORPORATION Other For other environmental issues and other contingencies see “Note 20 of the Notes to Consolidated Financial Statements.”

<s>[INST] As of December 31, 2014, we have two reportable business segments, Avista Utilities and AEL&P. We also have other businesses which do not represent a reportable business segment and are conducted by various direct and indirect subsidiaries of Avista Corp. See "Part I, Item 1. Business Company Overview" for further discussion of our business segments. The following table presents net income (loss) attributable to Avista Corp. shareholders for each of our business segments (and the other businesses) for the year ended December 31 (dollars in thousands): (1) The results for the year ended December 31, 2014 include the net gain on sale of Ecova of $69.7 million. Executive Level Summary Overall Results Net income attributable to Avista Corporation shareholders was $192.0 million for 2014, an increase from $111.1 million for 2013. The increase was primarily due to the disposition of Ecova, which resulted in the recognition of a $69.7 million net gain. In addition, we recognized a $15.0 million pretax gain during the second quarter related to the settlement of the California power markets litigation involving Avista Energy. The gain from the litigation settlement was partially offset by a pretax contribution of $6.4 million of the proceeds to the Avista Foundation, a charitable organization funded by Avista Corp. Earnings at Avista Utilities increased due to the implementation of general rate increases in each of our jurisdictions, lower net power supply costs and a decrease in interest expense, partially offset by the provision for earnings sharing in Idaho. There were also expected increases in other operating expenses, depreciation and amortization and taxes other than income taxes. Utility results for 2013 also included the net benefit from the settlement with the BPA. Avista Utilities Avista Utilities is our most significant business segment. Our utility financial performance is dependent upon, among other things: weather conditions (temperatures, precipitation levels and wind patterns) which affect energy demand and electric generation, including the effect of precipitation and temperature on hydroelectric resources, the effect of wind patterns on windgenerated power, weathersensitive customer demand, and similar impacts on supply and demand in the wholesale energy markets, regulatory decisions, allowing our utility to recover costs, including purchased power and fuel costs, on a timely basis, and to earn a reasonable return on investment, the price of natural gas in the wholesale market, including the effect on the price of fuel for generation, and the price of electricity in the wholesale market, including the effects of weather conditions, natural gas prices and other factors affecting supply and demand. Forecasted Customer and Load Growth Based on our forecast for 2015 through 2018 for Avista Utilities' service area, we expect annual electric customer growth to average 1.2 percent, within a forecast range of 0.8 percent to 1.6 percent. We expect annual natural gas customer growth to average 1.0 percent, within a forecast range of 0.5 percent to 1.5 percent. We anticipate retail electric load growth to average 0.8 percent, within a forecast range of 0.5 percent and 1.1 percent. We expect natural gas load growth to average 1.3 percent, within a forecast range of 0.8 percent and 1.8 percent. The forecast ranges reflect (1) the inherent uncertainty associated with the economic assumptions on which forecasts are based and (2) natural gas customer and load growth has been historically more volatile. AVISTA CORPORATION In AEL&P's service area, we expect annual residential customer growth to be in a narrow range around 0.4 percent for 2015 through 2018. We expect no significant growth in commercial and government customers over the same period. We anticipate that average annual total load growth will be in a narrow range around 0.9 percent, with residential load growth averaging about 0.6 percent; commercial about 1.2 percent; and government about 1.0 percent. For further discussion regarding utility customer growth, load growth, and the general economic conditions in our service territory, see "Economic Conditions and Utility Load Growth." See also "Compet [/INST] Negative. </s>

AVISTA CORP

2016-02-24

2015-12-31

ITEM 7. MANAGEMENT'S DISCUSSION AND ANALYSIS OF FINANCIAL CONDITION AND RESULTS OF OPERATIONS Business Segments As of December 31, 2015, we have two reportable business segments, Avista Utilities and AEL&P. We also have other businesses which do not represent a reportable business segment and are conducted by various direct and indirect subsidiaries of Avista Corp. See "Part I, Item 1. Business - Company Overview" for further discussion of our business segments. The following table presents net income (loss) attributable to Avista Corp. shareholders for each of our business segments (and the other businesses) for the year ended December 31 (dollars in thousands): (1) The results for the year ended December 31, 2014 include the net gain on sale of Ecova of $69.7 million. Executive Level Summary Overall Results Net income attributable to Avista Corp. shareholders was $123.2 million for 2015, a decrease from $192.0 million for 2014. The decrease was primarily due to the disposition of Ecova during 2014, which resulted in the recognition of a $74.8 million net gain, with $69.7 million being recognized in 2014 and the remainder being recognized in 2015. Avista Utilities' earnings increased slightly primarily due to the implementation of a general rate increase in Washington, lower net power supply costs, a decrease in the provision for earnings sharing in Idaho and increased cooling loads during the summer. This was mostly offset by weather that was significantly warmer than normal and warmer than the prior year in the first quarter, which reduced heating loads, which was partially offset by the new decoupling mechanism in Washington (implemented January 1, 2015). Also, we AVISTA CORPORATION experienced expected increases in other operating expenses, depreciation and amortization, taxes other than income taxes, and interest expense. Results for 2015 also include earnings at AEL&P for the full period, whereas 2014 results only include AEL&P for the third and fourth quarters. Results for 2014 include a $9.8 million net gain at Avista Energy related to the settlement of the California power markets litigation. The net gain from the litigation settlement was partially offset by a pre-tax contribution of $6.4 million of the proceeds to the Avista Foundation, a charitable organization funded by Avista Corp. Both of these transactions are reflected in the results of the other businesses. Avista Utilities Avista Utilities is our most significant business segment. Our utility financial performance is dependent upon, among other things: • weather conditions (temperatures, precipitation levels and wind patterns) which affect energy demand and electric generation, including the effect of precipitation and temperature on hydroelectric resources, the effect of wind patterns on wind-generated power, weather-sensitive customer demand, and similar impacts on supply and demand in the wholesale energy markets, • regulatory decisions, allowing our utility to recover costs, including purchased power and fuel costs, on a timely basis, and to earn a reasonable return on investment, • the price of natural gas in the wholesale market, including the effect on the price of fuel for generation, and • the price of electricity in the wholesale market, including the effects of weather conditions, natural gas prices and other factors affecting supply and demand. Forecasted Customer and Load Growth Based on our forecast for 2016 through 2019 for Avista Utilities' service area, we expect annual electric customer growth to average 1.0 percent, within a forecast range of 0.6 percent to 1.4 percent. We expect annual natural gas customer growth to average 1.1 percent, within a forecast range of 0.6 percent to 1.6 percent. We anticipate retail electric load growth to average 0.7 percent, within a forecast range of 0.4 percent and 1.0 percent. We expect natural gas load growth to average 1.1 percent, within a forecast range of 0.6 percent and 1.6 percent. The forecast ranges reflect (1) the inherent uncertainty associated with the economic assumptions on which forecasts are based and (2) the historic variability of natural gas customer and load growth. In AEL&P's service area, we expect annual residential customer growth to be in a narrow range around 0.4 percent for 2016 through 2019. We expect no significant growth in commercial and government customers over the same period. We anticipate that average annual total load growth will be in a narrow range around 0.6 percent, with residential load growth averaging 0.6 percent; commercial 0.8 percent; and government 0 percent (no load growth). For further discussion regarding utility customer growth, load growth, and the general economic conditions in our service territory, see "Economic Conditions and Utility Load Growth." See also "Competition" for a discussion of competitive factors that could affect our results of operations in the future. Capital Expenditures We are making significant capital investments in generation, transmission and distribution systems to preserve and enhance service reliability for our customers and replace aging infrastructure. The following table summarizes our actual and expected capital expenditures as of and for the year ended December 31, 2015 (in thousands): AVISTA CORPORATION Avista Utilities' 2015 calendar year capital costs, including capital costs of approximately $35.2 million that was unpaid for and accrued in accounts payable as of December 31, 2015, were $415.9 million. These estimates of capital expenditures are subject to continuing review and adjustment. Alaska Energy and Resources Company Acquisition On July 1, 2014, we acquired AERC, based in Juneau, Alaska. The completion of this transaction makes the financial results for 2015 and 2014 incomparable since the first half of 2014 does not contain any financial results from AERC. This transaction resulted in the recording of $52.4 million in goodwill. For additional information regarding the AERC transaction, including pro forma financial comparisons, see “Note 4 of the Notes to Consolidated Financial Statements.” Ecova Disposition On June 30, 2014, Avista Capital completed the sale of its interest in Ecova to Cofely USA Inc., an indirect subsidiary of GDF SUEZ, a French multinational utility company, for a sales price of $335.0 million in cash, less the payment of debt and other customary closing adjustments. The sale of Ecova provided total cash proceeds to Avista Corp., net of debt, payment to option and minority holders, income taxes and transaction expenses, of $143.7 million and resulted in a net gain of $74.8 million. Almost all of the net gain was recognized in 2014 with some minor true-ups during 2015. The completion of this transaction makes the financial results for 2015 and 2014 incomparable since the first half of 2014 contains the financial results of Ecova (in discontinued operations) and 2015 does not have any material results from Ecova. For additional information regarding the Ecova disposition, see “Note 5 of the Notes to Consolidated Financial Statements.” Stock Repurchase Programs During 2014, Avista Corp. repurchased 2,529,615 shares of our outstanding common stock at a total cost of $79.9 million and an average cost of $31.57 per share through our 2014 stock repurchase program. We did not make any repurchases under this program subsequent to October 2014 and the program expired on December 31, 2014. In the first quarter of 2015, Avista Corp. repurchased 89,400 shares of our outstanding common stock at a total cost of $2.9 million and an average cost of $32.66 per share under a second stock repurchase program that expired on March 31, 2015. All repurchased shares reverted to the status of authorized but unissued shares. Wind Storm On November 17, 2015, a historic wind storm occurred in our service territory. The storm had wind speeds exceeding 70 miles per hour which knocked down numerous trees and power poles and caused severe damage to our electrical system. Most of the damage occurred in Spokane County. The storm resulted in significant customer power outages and at the height of the storm approximately 180,000 customers (about 48 percent of our total retail electric customers) were without power, causing the most significant damage and the highest number of customer outages Avista Utilities has ever experienced. It took Avista Utilities crews from throughout the region, along with contract and mutual aid crews, approximately 10 days to fully restore power to all affected customers. Most of the storm-related costs incurred were capital costs (labor and materials) to repair the electrical system, but there were also operating and maintenance costs. The capital repair costs for power restoration were $22.9 million and $2.9 million for incremental utility operating and maintenance costs. In addition, there was approximately $0.4 million of incremental nonutility operating and maintenance costs. The damage and restoration costs were primarily incurred in Washington state and we plan to include the incremental operating and maintenance costs in the calculations for earnings sharing (see "Regulatory Matters - Decoupling and Earnings Sharing Mechanisms" for further discussion of the earnings sharing mechanisms). Liquidity and Capital Resources Avista Corp. has a $400.0 million committed line of credit with various financial institutions that expires in April 2019. We have an option to request an extension for an additional one or two years beyond April 2019, provided, 1) that no event of default has occurred and is continuing prior to the requested extension and 2) the remaining term of agreement, including the requested extension period, does not exceed five years. As of December 31, 2015, there were $105.0 million of cash borrowings and $44.6 million in letters of credit outstanding, leaving $250.4 million of available liquidity under this line of credit. The Avista Corp. facility contains customary covenants and default provisions, including a covenant which does not permit our ratio of “consolidated total debt” to “consolidated total capitalization” to be greater than 65 percent at any time. As of December 31, 2015, we were in compliance with this covenant with a ratio of 53.1 percent. AEL&P has a $25.0 million committed line of credit which expires in November 2019. As of December 31, 2015, there were no borrowings or letters of credit outstanding under this committed line of credit. AVISTA CORPORATION The AEL&P committed line of credit agreement contains customary covenants and default provisions including a covenant which does not permit the ratio of “consolidated total debt at AEL&P” to “consolidated total capitalization at AEL&P,” (including the impact of the Snettisham obligation) to be greater than 67.5 percent at any time. As of December 31, 2015, AEL&P was in compliance with this covenant with a ratio of 57.2 percent. In December 2015, we issued $100.0 million of first mortgage bonds to five institutional investors in a private placement transaction. The first mortgage bonds bear an interest rate of 4.37 percent and mature in 2045. In connection with this pricing, we cash-settled five interest rate swap contracts (notional aggregate amount of $75.0 million) and paid a total of $9.3 million. Upon settlement of interest rate swaps, the regulatory asset or liability (included as part of long-term debt) is amortized as a component of interest expense over the term of the associated debt. In 2015, we issued $1.6 million (net of issuance costs) of common stock under the employee plans. For 2016, we expect to issue approximately $155.0 million of long-term debt and $55.0 million of common stock in order to maintain an appropriate capital structure and to fund planned capital expenditures. After considering the expected issuances of long-term debt and common stock during 2016, we expect net cash flows from operating activities, together with cash available under our committed line of credit agreements, to provide adequate resources to fund capital expenditures, dividends, and other contractual commitments. Regulatory Matters General Rate Cases We regularly review the need for electric and natural gas rate changes in each state in which we provide service. We will continue to file for rate adjustments to: • seek recovery of operating costs and capital investments, and • seek the opportunity to earn reasonable returns as allowed by regulators. With regards to the timing and plans for future filings, the assessment of our need for rate relief and the development of rate case plans takes into consideration short-term and long-term needs, as well as specific factors that can affect the timing of rate filings. Such factors include, but are not limited to, in-service dates of major capital investments and the timing of changes in major revenue and expense items. Washington General Rate Cases 2012 General Rate Cases In December 2012, the UTC approved a settlement agreement in Avista Utilities' electric and natural gas general rate cases filed in April 2012. The settlement, effective January 1, 2013 provided that base rates for our Washington electric customers increase by an overall 3.0 percent (designed to increase annual revenues by $13.6 million), and base rates for our Washington natural gas customers increased by an overall 3.6 percent (designed to increase annual revenues by $5.3 million). The approved settlement also provided that, effective January 1, 2014, base rates increase for our Washington electric customers by an overall 3.0 percent (designed to increase annual revenues by $14.0 million), and increase for our Washington natural gas customers by an overall 0.9 percent (designed to increase annual revenues by $1.4 million). The settlement agreement provided for an authorized return on equity (ROE) of 9.8 percent and an equity ratio of 47 percent, resulting in an overall rate of return on rate base (ROR) of 7.64 percent. 2014 General Rate Cases In November 2014, the UTC approved an all-party settlement agreement related to Avista Utilities' electric and natural gas general rate cases filed in February 2014 and new rates became effective on January 1, 2015. The settlement was designed to increase annual electric base revenues by $12.3 million, or 2.5 percent, inclusive of a $5.3 million power supply update as required in the settlement agreement (explained below). The settlement was designed to increase annual natural gas base revenues by $8.5 million, or 5.6 percent. The settlement agreement also included the implementation of decoupling mechanisms for electric and natural gas and a related after-the-fact earnings test. See "Decoupling and Earnings Sharing Mechanisms" below for further discussion of these mechanisms. Specific capital structure ratios and the cost of capital components were not agreed to in the settlement agreement. The revenue increases in the settlement were not tied to the 7.32 percent ROR used in conjunction with the after-the fact earnings test discussed under "Decoupling and Earnings Sharing Mechanisms" below. The electric and natural gas revenue increases were negotiated numbers, with each party using its own set of assumptions underlying its agreement to the revenue increases. The parties agreed that the 7.32 percent ROR will be used to calculate the AFUDC and other purposes. AVISTA CORPORATION 2015 General Rate Cases In January 2016, we received an order that concluded our electric and natural gas general rate cases that were originally filed with the UTC in February 2015. New electric and natural gas rates were effective on January 11, 2016. The UTC approved rates designed to provide a 1.6 percent, or $8.1 million decrease in electric base revenue, and a 7.4 percent, or $10.8 million increase in natural gas base revenue. The UTC also approved an ROR on rate base of 7.29 percent, with a common equity ratio of 48.5 percent and a 9.5 percent ROE. Throughout the rate case process, certain circumstances and costs changed, causing us to revise our overall proposed rate requests downward, especially for our electric operations. Our need for electric rate relief was reduced primarily due to the following: • a decrease in power supply costs of approximately $24.0 million caused by the continuing decline in the price of natural gas used to run our natural gas-fired generation and lower contract costs associated with a new PPA from Chelan PUD, • updated information related to federal tax adjustments and state allocations, • the delay in the expected completion date of the Nine Mile hydroelectric generation project upgrade from late 2015 to late 2016, and • a delay of the start date to begin amortization of existing electric meters from 2016 to a future year, associated with our proposed AMI project. The natural gas revenue increase approved by the UTC is related to our ownership and operating costs to run the natural gas business. Changes in the commodity costs of natural gas for natural gas customers are reflected in our annual PGA, which is generally effective November 1st each year. On November 1, 2015 natural gas customers’ bills were reduced approximately 15 percent related to the decline in the market price of natural gas. In responsive testimony filed by the UTC Staff in July 2015 in our electric and natural gas general rate cases, they recommended a disallowance of $12.7 million (Washington's share) of the costs associated with the replacement of our customer information and work management systems (Project Compass) primarily related to the delay in the completion of the project. In the January 6, 2016 UTC order, they approved the full recovery of Washington's portion of Project Compass costs. UTC issues Order denying Industrial Customers of Northwest Utilities / Public Counsel Joint Motion for Clarification, UTC Staff Motion to Reconsider and UTC Staff Motion to Reopen Record On February 19, 2016, the UTC issued an order denying the Motions summarized below and affirmed their original January 2016 order of an $8.1 million decrease in electric base revenue, thus finalizing our 2015 electric and natural gas general rate cases. On January 19, 2016, the Industrial Customers of Northwest Utilities (ICNU) and the Public Counsel Unit of the Washington State Office of the Attorney General (PC) filed a Joint Motion for Clarification with the UTC. In its Motion for Clarification, ICNU and PC requested that the UTC clarify the calculation of the electric attrition adjustment and the end-result revenue decrease of $8.1 million. ICNU and PC provided their own calculations in their Motion, and suggested that the revenue decrease should have been $19.8 million based on their reading of the UTC’s Order. On January 19, 2016, the UTC Staff, which is a separate party in the general rate case proceedings from the UTC Advisory Staff that supports the Commissioners, filed a Motion to Reconsider with the UTC. In its Motion to Reconsider, the Staff provided calculations and explanations that suggested that the electric revenue decrease should have been a revenue decrease of $27.4 million instead of $8.1 million, based on its reading of the UTC's Order. Further, on February 4, 2016, the UTC Staff filed a Motion to Reopen Record for the Limited Purpose of Receiving into Evidence Instruction on Use and Application of Staff’s Attrition Model, and sought to supplement the record “to incorporate all aspects of the Company’ Power Cost Update.” Within this Motion, UTC Staff updated its suggested electric revenue decrease to $19.6 million. None of the parties in their Motions raised issues with the UTC’s decision on the natural gas revenue increase of $10.8 million. AVISTA CORPORATION Petition for an Accounting Order to Defer Existing Washington Electric Meters In January 2016, we filed a Petition with the UTC for an Accounting Order to defer and include in a regulatory asset the undepreciated value of our existing Washington electric meters for later recovery. This requested accounting treatment is related to our plans to replace approximately 253,000 of our existing electric meters with new two-way digital meters through our Advanced Metering Infrastructure (AMI) project in Washington state. The petition requests that the UTC allow the deferral, with prudence of the overall AMI project and ultimate recovery, to be addressed in a future regulatory proceeding. The undepreciated value estimated for this deferred accounting treatment is approximately $18.6 million. We have requested recovery of this regulatory asset, with a full rate of return, over fifteen years starting in January 2017, within our February 19, 2016 general rate case filing. 2016 General Rate Cases On February 19, 2016, we filed electric and natural gas general rates cases with the UTC. Our proposal includes an 18-month rate plan, with new rates taking effect on January 1, 2017 and January 1, 2018. Under this plan, we would not file a future rate case for new rates to be effective prior to July 1, 2018. The 2017 increase, if approved, would increase overall base electric rates 7.8 percent (designed to increase annual electric revenues by $38.6 million) and overall base natural gas rates 5.0 percent (designed to increase annual natural gas revenues by $4.4 million). In addition, we have requested a second step increase effective January 1, 2018, which would increase overall base electric rates by 3.9 percent (designed to increase annual electric revenues by $10.3 million) and overall base natural gas rates by 1.8 percent (designed to increase annual natural gas revenues by $0.9 million). We have proposed to offset the electric increase, for the period January through June 2018, with available ERM dollars. As a result, customers would not see an electric general rate case bill increase in 2018 prior to July 1, 2018. Our requests are based on a proposed ROR on rate base of 7.64 percent with a common equity ratio of 48.5 percent and a 9.9 percent ROE. The UTC has up to 11 months to review the filings and issue a decision. Idaho General Rate Cases 2012 General Rate Cases In March 2013, the IPUC approved a settlement agreement in Avista Utilities' electric and natural gas general rate cases filed in October 2012. As agreed to in the settlement, new rates were implemented in two phases: April 1, 2013 and October 1, 2013. Effective April 1, 2013, base rates increased for our Idaho natural gas customers by an overall 4.9 percent (designed to increase annual revenues by $3.1 million). There was no change in base electric rates on April 1, 2013. The settlement also provided that, effective October 1, 2013, base rates increased for our Idaho natural gas customers by an overall 2.0 percent (designed to increase annual revenues by $1.3 million). Further, the settlement provided that, effective October 1, 2013, base rates increased for our Idaho electric customers by an overall 3.1 percent (designed to increase annual revenues by $7.8 million). The settlement agreement provided for an authorized ROE of 9.8 percent and an equity ratio of 50.0 percent. 2014 Rate Plan Extension Avista Utilities did not file new general rate cases in Idaho in 2014; instead, we developed an extension to the 2013 and 2014 rate plan and reached a settlement agreement with all interested parties. In September 2014, the IPUC approved the settlement, which reflected agreement among all interested parties, for a one-year extension to our current rate plan, which was set to expire on December 31, 2014. Under the approved extension, base retail rates remained unchanged through December 31, 2015. The settlement provided an estimated $3.7 million increase in pre-tax income by reducing planned expenses in 2015 for our Idaho operations. AVISTA CORPORATION 2015 General Rate Cases In December 2015, the IPUC approved a settlement agreement between Avista Utilities and all interested parties related to our electric and natural gas general rate cases, which were originally filed with the IPUC on June 1, 2015. New rates were effective on January 1, 2016. The settlement agreement is designed to increase annual electric base revenues by $1.7 million or 0.7 percent and annual natural gas base revenues by $2.5 million or 3.5 percent. The settlement is based on a ROR of 7.42 percent with a common equity ratio of 50 percent and a 9.5 percent ROE. The settlement agreement also reflects the following: • the discontinuation of the after-the-fact earnings test (provision for earnings sharing) that was originally agreed to as part of the settlement of our 2012 electric and natural gas general rate cases, and • the implementation of electric and natural gas Fixed Cost Adjustment mechanisms, as discussed below. 2016 General Rate Cases We expect to file electric and natural gas general rate cases in Idaho during the first half of 2016. Oregon General Rate Cases 2013 General Rate Case In January 2014, the OPUC approved a settlement agreement in Avista Utilities' natural gas general rate case (originally filed in August 2013). As agreed to in the settlement, new rates were implemented in two phases: February 1, 2014 and November 1, 2014. Effective February 1, 2014, rates increased for Oregon natural gas customers on a billed basis by an overall 4.4 percent (designed to increase annual revenues by $3.8 million). Effective November 1, 2014, rates for Oregon natural gas customers were to increase on a billed basis by an overall 1.6 percent (designed to increase annual revenues by $1.4 million). The billed rate increase on November 1, 2014 was dependent upon the completion of Project Compass and the actual costs incurred through September 30, 2014, and the actual costs incurred through June 30, 2014 related to the Company's Aldyl A distribution pipeline replacement program. Project Compass was completed in February 2015. The November 1, 2014 rate increase was reduced from $1.4 million to $0.3 million due to the delay of Project Compass. The approved settlement agreement provides for an overall authorized ROR of 7.47 percent, with a common equity ratio of 48 percent and a 9.65 percent ROE. 2014 General Rate Case In January 2015, Avista Utilities filed an all-party settlement agreement with the OPUC related to our natural gas general rate case, which was originally filed in September 2014. On February 23, 2015, the OPUC issued an order rejecting the all-party settlement agreement. The OPUC expressed concerns related to, among other things, various rate design issues. In March 2015, Avista Utilities filed an amended all-party settlement agreement with the OPUC which addressed the OPUC's concerns regarding the initial settlement agreement. The amended settlement agreement was designed to increase base natural gas revenues by $5.3 million. Included in this base rate increase is $0.3 million in base revenues that we are already receiving from customers through a separate rate adjustment. Therefore, the net increase in base revenues was $5.0 million, or 4.9 percent on a billed basis. The parties requested that new retail rates become effective on April 16, 2015. On April 9, 2015, the OPUC issued an Order approving the amended settlement agreement as filed. This settlement agreement provided for an overall authorized ROR of 7.516 percent with a common equity ratio of 51 percent and a 9.5 percent ROE. 2015 General Rate Case On May 1, 2015, we filed a natural gas general rate case with the OPUC. We have requested an overall increase in base natural gas rates of 8 percent (designed to increase annual natural gas revenues by $8.6 million). Our request is based on a proposed ROR on rate base of 7.72 percent with a common equity ratio of 50 percent and a 9.9 percent ROE. Avista Corp. and all parties to our natural gas general rate case reached agreement on certain issues, and a partial settlement agreement was filed with the OPUC in November 2015. The partial settlement agreement reduced our requested natural gas revenue increase from $8.6 million to $6.7 million or 6.3 percent. The partial settlement, if approved by the OPUC, would resolve a number of issues including the calculation of state income taxes for rate-making purposes, wages and salaries, the revenue forecast for the rate period, and working capital. The agreement does not resolve other issues including the appropriate ROE and capital structure, the appropriate level of additions to rate base, and medical and pension expenses. In January 2016, AVISTA CORPORATION we entered into an additional all-party partial settlement to further reduce our revenue increase request to $6.1 million, related to updated information related to deferred taxes and its effect on rate base. The agreement includes a provision for the implementation of a decoupling mechanism, similar to the Washington and Idaho mechanisms described above. In addition to the partial settlement agreements above, the OPUC staff filed testimony which included a recommendation to disallow $1.2 million (Oregon's share) of Project Compass costs primarily related to the delay in the full completion of the project. In January 2016, following the January 6, 2016 UTC order approving the full recovery of Washington's portion of Project Compass costs, the OPUC staff withdrew its proposal for a disallowance, with the exception of an inconsequential amount which is still open for discussion. The procedural schedule includes an expected decision from the OPUC by February 29, 2016. Alaska General Rate Case AEL&P's last general rate case was filed in 2010 and approved by the RCA in 2011. We are evaluating the need to file an electric general rate case with the RCA in 2016. Purchased Gas Adjustments PGAs are designed to pass through changes in natural gas costs to Avista Utilities' customers with no change in gross margin (operating revenues less resource costs) or net income. In Oregon, we absorb (cost or benefit) 10 percent of the difference between actual and projected natural gas costs included in retail rates for supply that is not hedged. Total net deferred natural gas costs among all jurisdictions were a liability of $17.9 million as of December 31, 2015 and a liability of $3.9 million as of December 31, 2014. The following PGAs went into effect in our various jurisdictions during 2013, 2014 and 2015: Power Cost Deferrals and Recovery Mechanisms The ERM is an accounting method used to track certain differences between Avista Utilities' actual power supply costs, net of wholesale sales and sales of fuel, and the amount included in base retail rates for our Washington customers. Total net deferred power costs under the ERM were a liability of $18.0 million as of December 31, 2015 compared to a liability $14.2 million as of December 31, 2014, and these deferred power cost balances represent amounts due to customers. The difference in net power supply costs under the ERM primarily results from changes in: • short-term wholesale market prices and sales and purchase volumes, • the level and availability of hydroelectric generation, • the level and availability of thermal generation (including changes in fuel prices), and • retail loads. Under the ERM, Avista Utilities absorbs the cost or receives the benefit from the initial amount of power supply costs in excess of or below the level in retail rates, which is referred to as the deadband. The annual (calendar year) deadband amount is $4.0 million. AVISTA CORPORATION The following is a summary of the ERM: Under the ERM, Avista Utilities makes an annual filing on or before April 1 of each year to provide the opportunity for the UTC staff and other interested parties to review the prudence of and audit the ERM deferred power cost transactions for the prior calendar year. We made our annual filing on March 31, 2015. The ERM provides for a 90-day review period for the filing; however, the period may be extended by agreement of the parties or by UTC order. The 2014 ERM deferred power costs transactions were approved by an order from the UTC. Avista Utilities has a PCA mechanism in Idaho that allows us to modify electric rates on October 1 of each year with IPUC approval. Under the PCA mechanism, we defer 90 percent of the difference between certain actual net power supply expenses and the amount included in base retail rates for our Idaho customers. The October 1 rate adjustments recover or rebate power supply costs deferred during the preceding July-June twelve-month period. Total net power supply costs deferred under the PCA mechanism were an asset of $0.2 million as of December 31, 2015 compared to an asset of $8.3 million as of December 31, 2014. Decoupling and Earnings Sharing Mechanisms Decoupling is a mechanism designed to sever the link between a utility's revenues and consumers' energy usage. Our actual revenue, based on kilowatt hour and therm sales will vary, up or down, from the level included in a general rate case, which could be caused by changes in weather, energy conservation or the economy. Generally, our electric and natural gas revenues will be adjusted each month to be based on the number of customers, rather than kilowatt hour and therm sales. The difference between revenues based on sales and revenues based on the number of customers will be deferred and either surcharged or rebated to customers beginning in the following year. Washington Decoupling and Earnings Sharing In Washington, the UTC approved our decoupling mechanisms for electric and natural gas for a five-year period that commenced January 1, 2015. Electric and natural gas decoupling surcharge rate adjustments to customers are limited to 3 percent on an annual basis, with any remaining surcharge balance carried forward for recovery in a future period. There is no limit on the level of rebate rate adjustments. The decoupling mechanisms each include an after-the-fact earnings test. At the end of each calendar year, separate electric and natural gas earnings calculations will be made for the prior calendar year. These earnings tests will reflect actual decoupled revenues, normalized power supply costs and other normalizing adjustments. • If we have a decoupling rebate balance for the prior year and earn in excess of a 7.32 percent ROR, the rebate to customers would be increased by 50 percent of the earnings in excess of the 7.32 percent ROR. • If we have a decoupling rebate balance for the prior year and earn a 7.32 percent ROR or less, only the base amount of the rebate to customers would be made. • If we have a decoupling surcharge balance for the prior year and earn in excess of a 7.32 percent ROR, the surcharge to customers would be reduced by 50 percent of the earnings in excess of the 7.32 percent ROR (or eliminated). If 50 percent of the earnings in excess of the 7.32 percent ROR exceeds the decoupling surcharge balance, the dollar amount that exceeds the surcharge balance would create a rebate balance for customers. • If we have a decoupling surcharge balance for the prior year and earn a 7.32 percent ROR or less, the base amount of the surcharge to customers would be made. As of December 31, 2015, we had a total net decoupling surcharge (asset) of $10.9 million for Washington electric and natural gas customers and a liability (rebate to customers) for earnings sharing of $3.4 million for Washington electric customers. Idaho Fixed Cost Adjustment (FCA) and Earnings Sharing Mechanisms In Idaho, the IPUC approved the implementation of FCAs for electric and natural gas (similar in operation and effect to the Washington decoupling mechanisms) for an initial term of three years, commencing on January 1, 2016. AVISTA CORPORATION For the period 2013 through 2015, we had an after-the-fact earnings test, such that if Avista Corp., on a consolidated basis for electric and natural gas operations in Idaho, earned more than a 9.8 percent ROE, we were required to share with customers 50 percent of any earnings above the 9.8 percent. There was no provision for a surcharge to customers if our ROE was less than 9.8 percent. This after-the-fact earnings test was discontinued as part of the settlement of our 2015 Idaho electric and natural gas general rates cases (discussed in further detail above). As of December 31, 2015 and December 31, 2014, we had total cumulative earnings sharing liabilities (rebates to customers) of $8.8 million and $10.1 million, respectively for electric and natural gas customers. Of the total rebate balance as of December 31, 2015, approximately $5.8 million will be returned to customers during January 1, 2016 through December 31, 2017 and the remainder of the balance will be addressed at a future date. See "Results of Operations - Avista Utilities'" for further discussion of the amounts recorded to operating revenues in 2013 through 2015 related to the decoupling and earnings sharing mechanisms. Results of Operations - Overall The following provides an overview of changes in our Consolidated Statements of Income. More detailed explanations are provided, particularly for operating revenues and operating expenses, in the business segment discussions (Avista Utilities, AEL&P, Ecova - Discontinued Operations and the other businesses) that follow this section. As discussed in "Executive Level Summary," Ecova was disposed of as of June 30, 2014. As a result, in accordance with GAAP, all of Ecova's operating results were removed from each line item on the Consolidated Statements of Income and reclassified into discontinued operations for all periods presented. The discussion of continuing operations below does not include any Ecova amounts. For our discussion of discontinued operations and Ecova, see "Ecova - Discontinued Operations." The balances included below for utility operations reconcile to the Consolidated Statements of Income. Beginning on July 1, 2014, AEL&P is included in the overall utility results. 2015 compared to 2014 Utility revenues increased $22.7 million, after elimination of intracompany revenues (within Avista Utilities) of $107.0 million for 2015 and $142.2 million for 2014. Avista Utilities' portion of utility revenues increased $1.6 million and AEL&P's revenues increased $23.1 million due to a full year of AEL&P results in 2015 as compared to six months in 2014. Including intracompany revenues, Avista Utilities' electric revenues decreased $1.1 million and natural gas revenues decreased $35.7 million. Other non-utility revenues decreased $10.5 million primarily due to the long-term fixed rate electric capacity contract that was previously held by Spokane Energy being transferred to Avista Corp. during the second quarter of 2015. The capacity revenue from this contract was included in non-utility revenues when it was held by Spokane Energy. Utility resource costs decreased $21.3 million, after elimination of intracompany resource costs of $107.0 million for 2015 and $142.2 million for 2014. Avista Utilities' portion of resource costs decreased $27.4 million and AEL&P's resource costs increased $6.1 million due to a full year of AEL&P results in 2015 as compared to six months in 2014. Including intracompany resource costs, Avista Utilities' electric resource costs decreased $17.6 million and natural gas resource costs decreased $44.9 million. Utility other operating expenses increased $16.4 million. Avista Utilities' portion of other operating expenses increased $11.1 million and AEL&P's other operating expenses increased $5.3 million due to a full year of AEL&P results in 2015 as compared to six months in 2014. Avista Utilities incurred increased generation, transmission and distribution operating expenses of $5.7 million, increased administrative and general wages of $9.8 million and increased pension and other post-retirement benefit expenses of $10.0 million. In addition, Avista Utilities incurred incremental storm restoration costs associated with the November 2015 wind storm of approximately $2.9 million. These increases were partially offset by decreases in outside services and generation maintenance of $7.8 million and decreases in other various accounts. Utility depreciation and amortization increased $13.9 million driven by additions to utility plant and the inclusion of a full year of AEL&P depreciation as compared to only six months of AEL&P in 2014. Income taxes decreased $4.8 million and our effective tax rate was 36.3 percent for 2015 compared to 37.6 percent for 2014. The decrease in expense was primarily due to a decrease in income before income taxes. There were not material changes in any other account balances on the Consolidated Statement of Income for the year ended December 31, 2015 as compared to the year ended December 31, 2014. 2014 compared to 2013 Utility revenues increased $31.1 million, after elimination of intracompany revenues (within Avista Utilities) of $142.2 million for 2014 and $151.9 million for 2013. Avista Utilities' portion of utility revenues increased $9.5 million and AEL&P had AVISTA CORPORATION electric revenues of $21.6 million, representing its revenues for the six months ended December 31, 2014. Including intracompany revenues, Avista Utilities' electric revenues decreased $31.6 million and natural gas revenues increased $31.4 million. Utility resource costs decreased $11.3 million, after elimination of intracompany resource costs of $142.2 million for 2014 and $151.9 million for 2013. Avista Utilities' portion of resource costs decreased $17.2 million and this was offset by utility resource costs at AEL&P of $5.9 million, representing its resource costs for the six months ended December 31, 2014. Including intracompany resource costs, Avista Utilities' electric resource costs decreased $57.7 million and natural gas resource costs increased $30.7 million. Utility other operating expenses increased $10.6 million and was partially the result of AEL&P being included for the six months ended December 31, 2014, which added $5.9 million to other operating expenses. Avista Utilities incurred increased generation, transmission and distribution operating and maintenance expenses and increased outside services. There were also transaction fees associated with the AERC acquisition of $1.3 million in 2014 compared to $1.6 million in 2013. These were partially offset by a decrease in pension and other post-retirement benefits expense. The remainder of the change resulted from various smaller changes in other accounts. Utility depreciation and amortization increased $12.4 million driven by additions to utility plant and the inclusion of $2.6 million related to AEL&P for the second half of the year. Other non-utility operating expenses decreased $8.2 million primarily due to the receipt of $15.0 million related to the settlement of the California power markets litigation (which was recorded as a reduction to operating expenses), partially offset by a $6.4 million contribution to the Avista Foundation. Income taxes increased $14.2 million and our effective tax rate was 37.6 percent for 2014 compared to 35.7 percent for 2013. The increase in expense was primarily due to an increase in income before income taxes. The increase in the effective tax rate was primarily the result of the Section 199 Domestic Manufacturing Deduction not being available to the Company due to limitations on taxable qualified production activities income. There were not material changes in any other account balances on the Consolidated Statement of Income for the year ended December 31, 2014 as compared to the year ended December 31, 2013. Results of Operations - Avista Utilities Non-GAAP Financial Measures The following discussion for Avista Utilities includes two financial measures that are considered “non-GAAP financial measures,” electric gross margin and natural gas gross margin. In the AEL&P section, we include a discussion of electric gross margin. Generally, a non-GAAP financial measure is a numerical measure of a company's financial performance, financial position or cash flows that excludes (or includes) amounts that are included (excluded) in the most directly comparable measure calculated and presented in accordance with GAAP. The presentation of electric gross margin and natural gas gross margin for Avista Utilities and electric gross margin for AEL&P is intended to supplement an understanding of Avista Utilities' and AEL&P's operating performance. We use these measures to determine whether the appropriate amount of energy costs are being collected from our customers to allow for recovery of operating costs, as well as to analyze how changes in loads (due to weather, economic or other conditions), rates, supply costs and other factors impact our results of operations. These measures are not intended to replace income from operations as determined in accordance with GAAP as an indicator of operating performance. The calculations of electric and natural gas gross margins are presented below. AVISTA CORPORATION 2015 compared to 2014 The following graphs presents Avista Utilities' operating revenues, resource costs and resulting gross margin for the year ended December 31 (dollars in millions): Total results of operations for electric and natural gas in the graphs above include intracompany revenues and resource costs of $107.0 million and $142.2 million for the years ended December 31, 2015 and December 31, 2014, respectively. The gross margin on electric sales increased $16.5 million and the gross margin on natural gas sales increased $9.2 million. The increase in electric gross margin was primarily due to a general rate increase in Washington, lower net power supply costs and a $1.9 million decrease in the provision for earnings sharing (which is an offset to revenue). We experienced weather that was significantly warmer than normal and warmer than the prior year, which decreased heating loads in the first quarter and increased cooling loads in the second quarter. Loads in the third quarter were slightly higher than the prior year. Loads for the fourth quarter were lower than the prior year, particularly for residential and industrial customers. For 2015, the decoupling mechanism in Washington had a positive effect on each of electric revenues and gross margin as did the decrease in the overall provision for earnings sharing (see the details by jurisdiction in the table below). For 2015, we recognized a pre-tax benefit of AVISTA CORPORATION $6.3 million under the ERM in Washington compared to a benefit of $5.4 million for 2014. This change represents a decrease in net power supply costs primarily due to lower natural gas fuel and purchased power prices in 2015, partially offset by lower hydroelectric generation (due to warm and dry conditions in the second and third quarters). The increase in natural gas gross margin was primarily due to a decrease in natural gas resources costs and a decrease in the provision for earnings sharing, partially offset by a decrease in natural gas revenues. The decrease in natural gas revenues resulted from lower heating loads from significantly warmer weather that was partially offset by general rate increases. The earnings impact of the decrease in heating loads was partially offset by the decoupling mechanism in Washington, which had a positive effect on natural gas revenues and gross margin (see the details by jurisdiction in the table below). Intracompany revenues and resource costs represent purchases and sales of natural gas between our natural gas distribution operations and our electric generation operations (as fuel for our generation plants). These transactions are eliminated in the presentation of total results for Avista Utilities and in the consolidated financial statements but are reflected in the presentation of the separate results for electric and natural gas below. The following graphs present Avista Utilities' electric operating revenues and megawatt-hour (MWh) sales for the year ended December 31 (dollars in millions and MWhs in thousands): AVISTA CORPORATION The following table presents Avista Utilities' decoupling and customer earnings sharing mechanisms by jurisdiction that are included in utility electric operating revenues for the year ended December 31 (dollars in thousands): Total electric revenues decreased $1.1 million for 2015 as compared to 2014 due to the following: • a $5.7 million increase in retail electric revenues due to an increase in revenue per MWh (increased revenues $21.0 million), partially offset by a decrease in total MWhs sold (decreased revenues $15.3 million). The increase in revenue per MWh was primarily due to a general rate increase in Washington. The decrease in total MWhs sold was primarily the result of weather that was significantly warmer than normal and warmer than the prior year, which decreased the electric heating load in the first quarter. Compared to 2014, residential electric use per customer decreased 5 percent and commercial use per customer decreased 2 percent. Heating degree days in Spokane were 14 percent below normal and 10 percent below 2014. The impact from reduced heating loads was partially offset by increased cooling loads in the summer. Year-to-date cooling degree days were 141 percent above normal and 28 percent above the prior year. • a $10.9 million decrease in wholesale electric revenues due to a decrease in sales volumes (decreased revenues $21.9 million), partially offset by an increase in sales prices (increased revenues $11.0 million). The fluctuation in volumes and prices was primarily the result of our optimization activities. • a $0.9 million decrease in sales of fuel due to a decrease in sales of natural gas fuel as part of thermal generation resource optimization activities. For 2015, $50.0 million of these sales were made to our natural gas operations and are included as intracompany revenues and resource costs. For 2014, $67.4 million of these sales were made to our natural gas operations. • a $4.7 million increase in electric revenue due to decoupling, which reflected decreased heating loads in the first and fourth quarters, partially offset by increased cooling loads in the second and third quarters. AVISTA CORPORATION • a $1.9 million decrease in the provision for earnings sharing, primarily due to a decrease of $5.3 million for our Idaho electric operations, partially offset by an increase of $3.4 million for our Washington electric operations. In 2014, we recorded a provision for earnings sharing of $7.5 million for Idaho electric customers with $5.6 million representing our estimate for 2014 and $1.9 million representing an adjustment of our 2013 estimate. The following graphs present Avista Utilities' natural gas operating revenues and therms delivered for the year ended December 31 (dollars in millions and therms in thousands): AVISTA CORPORATION The following table presents Avista Utilities' decoupling and customer earnings sharing mechanisms by jurisdiction that are included in utility natural gas operating revenues for the year ended December 31 (dollars in thousands): Total natural gas revenues decreased $35.7 million for 2015 as compared to 2014 due to the following: • a $16.4 million decrease in retail natural gas revenues due to a decrease in volumes (decreased revenues $23.6 million), partially offset by higher retail rates (increased revenues $7.2 million). Higher retail rates were due to PGAs implemented in November 2014, which passed through higher costs of natural gas, and general rate cases. This was partially offset by PGA rate decreases implemented in November 2015, which passed through lower costs. We sold less retail natural gas in 2015 as compared to 2014 primarily due to weather that was warmer than normal and warmer than the prior year. Compared to 2014, residential use per customer decreased 9 percent and commercial use per customer decreased 9 percent. Heating degree days in Spokane were 14 percent below historical average for 2015, and 10 percent below 2014. Heating degree days in Medford were 15 percent below historical average for 2015, and 4 percent above 2014. • a $23.9 million decrease in wholesale natural gas revenues due to a decrease in prices (decreased revenues $90.4 million), partially offset by an increase in volumes (increased revenues $66.5 million). In 2015, $57.0 million of these sales were made to our electric generation operations and are included as intracompany revenues and resource costs. In 2014, $74.7 million of these sales were made to our electric generation operations. Differences between revenues and costs from sales of resources in excess of retail load requirements and from resource optimization are accounted for through the PGA mechanisms. • a $6.0 million increase for natural gas decoupling revenues due primarily to significantly warmer than normal weather and the impact on heating loads. The following table presents Avista Utilities' average number of electric and natural gas retail customers for the year ended December 31: AVISTA CORPORATION The following graphs present Avista Utilities' resource costs for the year ended December 31 (dollars in millions): Total resource costs in the graphs above include intracompany resource costs of $107.0 million and $142.2 million for the years ended December 31, 2015 and December 31, 2014, respectively. Total resource costs decreased $27.4 million for 2015 as compared to 2014 primarily due to the following: • a $18.3 million decrease in power purchased due to a decrease in the volume of power purchases (decreased costs $23.6 million), partially offset by an increase in wholesale prices (increased costs $5.3 million). The fluctuation in volumes and prices was primarily the result of our overall optimization activities. • a $14.2 million increase from amortizations and deferrals of power costs due to the following. • increases to expense in 2015: • a $5.8 million surcharge to customers of previously deferred power costs in Idaho through the PCA. • an $11.3 million deferral in Washington and a $2.0 million deferral in Idaho for probable future benefit to customers due to actual power supply costs being below the amount included in base retail rates. AVISTA CORPORATION • a $2.0 million deferral in Washington of RECs for probable future benefit to customers. • decreases to expense in 2015: • an $8.0 million refund to Washington customers through an ERM rebate. • a $5.4 million refund to Washington customers through a REC rebate. • a $4.4 million increase in fuel for generation primarily due to an increase in thermal generation (due in part to decreased hydroelectric generation), partially offset by a decrease in natural gas fuel prices. • a $10.0 million decrease in other fuel costs. This represents fuel and the related derivative instruments that were purchased for generation but were later sold when conditions indicated that it was more economical to sell the fuel as part of the resource optimization process. When the fuel or related derivative instruments are sold, that revenue is included in sales of fuel. • a $7.7 million decrease in other electric resource costs primarily due to the benefit from a capacity contract of Spokane Energy, which was mostly deferred for probable future benefit to customers through the ERM and PCA. • a $66.1 million decrease in natural gas purchased due to a decrease in the price of natural gas (decreased costs $138.3 million), partially offset by an increase in total therms purchased (increased costs $72.2 million). Total therms purchased increased due to an increase in wholesale sales, partially offset by a decrease in retail sales. • a $21.8 million increase from amortizations and deferrals of natural gas costs. This reflects lower natural gas prices and the deferral of lower costs for future rebate to customers. • a $35.1 million decrease in intracompany resource costs (which has the effect of increasing overall net resource costs). 2014 compared to 2013 The following graphs present Avista Utilities' operating revenues, resource costs and resulting gross margin for the year ended December 31 (dollars in millions): Total results of operations for electric and natural gas in the graphs above include intracompany revenues and resource costs of $142.2 million and $151.9 million for the years ended December 31, 2014 and December 31, 2013, respectively. AVISTA CORPORATION The gross margin on electric sales increased $26.0 million and the gross margin on natural gas sales increased $0.7 million. Electric gross margin for 2014 included a pre-tax benefit of $5.4 million under the ERM in Washington compared to a pre-tax expense of $4.7 million for 2013. This change represents a decrease in net power supply costs due to the Colstrip outage in 2013 and increased hydroelectric generation in 2014. Electric gross margin for 2013 included the net benefit from the settlement with the BPA of $5.1 million. The following graphs present Avista Utilities' electric operating revenues and megawatt-hour (MWh) sales for the year ended December 31 (dollars in millions and MWhs in thousands): AVISTA CORPORATION Total electric revenues decreased $31.6 million for 2014 as compared to 2013 due to the following: • a $14.8 million increase in retail electric revenue primarily due to general rate increases and a change in revenue mix (which increased revenue by $25.2 million), partially offset by a decrease in volumes (which decreased revenue by $10.4 million). The decrease in residential volumes was primarily due to warmer weather in the fourth quarter, partially offset by customer growth. The decrease in total MWhs sold to industrial customers was primarily due to the expiration and replacement of a contract with one of our largest industrial customers in Idaho, effective July 1, 2013. The change resulting from this new contract did not impact gross margin because any change in revenues and expenses was tracked through the PCA in Idaho at 100 percent until such time as the contract was included in the Company’s base rates, • a $10.6 million increase in wholesale electric revenues due to an increase in sales prices (increased revenues $17.6 million), partially offset by a decrease in sales volumes (decreased revenues $7.0 million). The fluctuation in volumes and prices was primarily the result of our optimization activities during the period, • a decrease of $42.9 million in sales of natural gas fuel as part of thermal generation resource optimization activities. For 2014, $67.4 million of these sales were made to our natural gas operations and are included as intracompany revenues and resource costs. For 2013, $102.4 million of these sales were made to our natural gas operations, • an $8.6 million decrease in other electric revenues primarily due to the receipt of $11.7 million of revenue from the Bonneville Power Administration in 2013 for past use of our electric transmission system, and • a $5.5 million increase in the provision for earnings sharing for Idaho electric customers primarily due to the 2014 provision for earnings sharing including a $1.9 million adjustment of our 2013 estimate. AVISTA CORPORATION The following graphs present Avista Utilities' natural gas operating revenues and therms delivered for the year ended December 31 (dollars in millions and therms in thousands): Natural gas revenues increased $31.4 million for 2014 as compared to 2013 due to the following: • a $1.3 million decrease in retail natural gas revenues due to a decrease in volumes (decreased revenues by $20.0 million), partially offset by general rate increases and higher PGA rates, which passed through costs of natural gas (increased revenues by $18.7 million). We had decreased volumes primarily due to weather that was warmer than normal and warmer than the prior year during the fourth quarter, • an increase of $33.5 million in wholesale natural gas revenues due to an increase in prices (increased revenues by $24.8 million) and an increase in volumes (increased revenues by $8.7 million). In 2014, $74.7 million of wholesale sales were made to our electric generation operations and are included as intracompany revenues and resource costs. In 2013, $49.5 million of these sales were made to our electric generation operations, and • a $0.2 million reduction to revenue in 2014 for the provision for earnings sharing for Idaho natural gas customers, compared to a reduction to revenue of $0.4 million in 2013. AVISTA CORPORATION The following table presents Avista Utilities' average number of electric and natural gas retail customers for the year ended December 31: The following graphs present Avista Utilities' resource costs for the year ended December 31 (dollars in millions): AVISTA CORPORATION Total resource costs in the graphs above include intracompany resource costs of $142.2 million and $151.9 million for the years ended December 31, 2014 and December 31, 2013, respectively. Total resource costs decreased $31.4 million for 2014 as compared to 2013 primarily due to the following: • a decrease of $5.0 million in power purchased due to a decrease in the volume of power purchases, partially offset by an increase in wholesale prices. The fluctuation in volumes and prices was primarily the result of our overall optimization activities during the year. The decrease in volumes purchased was also due to increased hydroelectric generation, • a decrease to 2014 electric resource costs of $6.5 million for amortizations and deferrals of power costs, compared to a decrease of $14.2 million for 2013. • increases to expense in 2014: • a $1.6 million deferral in Idaho and a $4.2 million deferral in Washington for probable future benefit to customers due to actual power supply costs being below the amount included in retail rates. • decreases to expense in 2014: • a $2.3 million refund to Idaho customers of previously deferred power costs through the PCA rebate. • an $8.5 million refund to Washington customers through an ERM rebate. • a $1.6 million deferral of RECs for probable future benefit to Washington customers. • a decrease of $17.2 million for fuel for generation primarily due to a decrease in natural gas generation, • a decrease of $39.6 million in other fuel costs due to the resource optimization process, and • an increase of $44.6 million in natural gas purchased due to an increase in the price of natural gas and a slight increase in total therms purchased. Total therms purchased increased due to an increase in wholesale sales as part of the natural gas procurement and resource optimization process, mostly offset by a decrease in retail sales. Results of Operations - Alaska Electric Light and Power Company AEL&P was acquired on July 1, 2014 and only the results for the second half of 2014 are included in the actual overall results of Avista Corp. The discussion below is only for AEL&P's earnings that were included in Avista Corp.'s overall earnings. AVISTA CORPORATION 2015 compared to 2014 Net income for AEL&P was $6.6 million for the year ended December 31, 2015, compared to $3.2 million for the second half of 2014. The following table presents AEL&P's operating revenues, resource costs and resulting gross margin for the year ended December 31, 2015 and the second half of 2014 (dollars in thousands): The following table presents AEL&P's electric operating revenues and megawatt-hour (MWh) sales for the year ended December 31, 2015 and the second half of 2014 (dollars and MWhs in thousands): AEL&P has a relatively stable load profile as it does not have a large population of customers in its service territory with electric heating and cooling requirements; therefore, their revenues are not as sensitive to weather fluctuations as Avista Utilities. However, AEL&P does have higher winter rates for its customers during the peak period of November through May of each year, which drives higher revenues during those periods. Government sales are similar to commercial sales in that they are primarily firm customers, but are government entities. Commercial and government revenues from interruptible or non-firm customers were $8.3 million for 2015, including $7.2 million from AEL&P's largest customer. These revenues from non-firm customers are deferred and passed on for the benefit of firm customers in future periods either through base rates or a cost of power adjustment. As noted at "Item 7. Management's Discussion and Analysis of Financial Condition and Results of Operations - Economic Conditions," one of AEL&P's largest commercial customers (a retailer), which accounts for approximately 1 percent of AEL&P's annual firm revenues, is permanently closing in early 2016. It is unknown whether a new business will occupy the building that was occupied by this retailer. The following table presents AEL&P's average number of electric retail customers for the year ended December 31, 2015 and the second half of 2014: AVISTA CORPORATION The following table presents AEL&P's resource costs for the year ended December 31, 2015 and the second half of 2014 (dollars in thousands): Snettisham power expenses represent costs associated with operating the Snettisham hydroelectric project, including amounts paid under the take-or-pay PPA for the full capacity of this plant. This agreement is recorded as a capital lease on AEL&P's balance sheet, but reflected as an operating lease in the income statement. See "Note 14 of the Notes to Consolidated Financial Statements" for further information regarding this capital lease obligation. Cost of power adjustments are primarily derived from certain revenues from interruptible or non-firm customers that are deferred and passed on for the benefit of firm customers in future periods. For instance, revenues from electric sales to cruise ships are passed back to firm customers at 100 percent. The amortization of these deferred balances flows through this account along with the original deferral. Results of Operations - Ecova - Discontinued Operations Ecova was disposed of as of June 30, 2014. As a result, in accordance with GAAP, all of Ecova's operating results were removed from each line item on the Consolidated Statements of Income and reclassified into discontinued operations for all periods presented. In addition, since Ecova was a subsidiary of Avista Capital, the net gain recognized on the sale of Ecova was attributable to our other businesses. However, in accordance with GAAP, this gain is included in discontinued operations; therefore, we included the analysis of the gain in the Ecova discontinued operations section rather than in the other businesses section. 2015 compared to 2014 Ecova's net income was $5.1 million for 2015, compared to net income of $72.4 million for 2014. The net income for 2015 was primarily related to a tax benefit during 2015 that resulted from the reversal of a valuation allowance against net operating losses at Ecova because the net operating losses were deemed realizable under the current tax code. Additionally, there were some minor true-ups to the gain recognized on the sale due to the settlement of the working capital and indemnification escrow accounts during 2015. The results for 2014 included $69.7 million of the net gain recognized on the sale of Ecova. 2014 compared to 2013 Ecova's net income was $72.4 million for 2014 compared to net income of $7.1 million for 2013. The increase was primarily attributable to the net gain recognized on the sale of Ecova of $69.7 million. Excluding the net gain, net income from Ecova's regular operations through the date of the sale were flat compared to the same period in 2013 and were the result of a decrease in depreciation and amortization expense and an increase in operating revenues, offset by an increase in operating expenses. Results of Operations - Other Businesses 2015 compared to 2014 The net loss from these operations was $1.9 million for 2015 compared to net income of $3.2 million for 2014. The decrease in net income compared to 2014 was primarily due to the settlement of the California power markets litigation in 2014, which is described in further detail below. In addition, the net loss for 2015 was primarily related to: • $2.3 million (net of tax) of corporate costs, including costs associated with exploring strategic opportunities, compared to $2.4 million in 2014, • net losses on investments (net of tax) of $0.4 million for 2015, compared to net gains of $0.2 million for 2014, • net income at METALfx of $1.5 million for 2015, compared to net income of $0.9 million for 2014. 2014 compared to 2013 The net income from these operations was $3.2 million for 2014 compared to a net loss of $4.7 million for 2013. The net income for 2014 was primarily the result of the settlement of the California power markets litigation, where Avista Energy received settlement proceeds from a litigation with various California parties related to the prices paid for power in the AVISTA CORPORATION California spot markets during the years 2000 and 2001. This settlement resulted in an increase in pre-tax earnings of approximately $15.0 million. This was partially offset by a pre-tax contribution of $6.4 million of the proceeds to the Avista Foundation. METALfx had net income of $0.9 million for 2014, compared to net income of $1.2 million for 2013. In 2014, we also incurred $2.4 million (net of tax) of corporate costs, including costs associated with exploring strategic opportunities. Accounting Standards to be Adopted in 2016 At this time, we are not expecting the adoption of accounting standards to have a material impact on our financial condition, results of operations and cash flows in 2016. For information on accounting standards adopted in 2015 and earlier periods, see “Note 2 of the Notes to Consolidated Financial Statements.” Critical Accounting Policies and Estimates The preparation of our consolidated financial statements in conformity with GAAP requires us to make estimates and assumptions that affect amounts reported in the consolidated financial statements. Changes in these estimates and assumptions are considered reasonably possible and may have a material effect on our consolidated financial statements and thus actual results could differ from the amounts reported and disclosed herein. The following accounting policies represent those that our management believes are particularly important to the consolidated financial statements and require the use of estimates and assumptions: • Regulatory accounting, which requires that certain costs and/or obligations be reflected as deferred charges on our Consolidated Balance Sheets and are not reflected in our Consolidated Statements of Income until the period during which matching revenues are recognized. We also have decoupling revenue deferrals. As opposed to cost deferrals which are not recognized in the Consolidated Statements of Income until they are included in rates, decoupling revenue is recognized in the Consolidated Statements of Income during the period in which it occurs (i.e. during the period of revenue shortfall or excess due to fluctuations in customer usage), subject to certain limitations, and a regulatory asset/liability is established which will be surcharged or rebated to customers in future periods. GAAP requires that for any alternative regulatory revenue program, like decoupling, the revenue must be collected from customers within 24 months of the deferral to qualify for recognition in the current period Consolidated Statement of Income. Any amounts included in the Company's decoupling program that won't be collected from customers within 24 months are not recorded in the financial statements until the period in which revenue recognition criteria are met. This could ultimately result in more decoupling revenue being collected from customers over the life of the decoupling program than what is deferred and recognized in the current period financial statements. We make estimates regarding the amount of revenue that will be collected with 24 months of deferral. We also make the assumption that there are regulatory precedents for many of our regulatory items and that we will be allowed recovery of these costs via retail rates in future periods. If we were no longer allowed to apply regulatory accounting or no longer allowed recovery of these costs, we could be required to recognize significant write-offs of regulatory assets and liabilities in the Consolidated Statements of Income. See "Notes 1 and 20 of the Notes to Consolidated Financial Statements" for further discussion of our regulatory accounting policy. • Utility energy commodity derivative asset and liability accounting, where we estimate the fair value of outstanding commodity derivatives and we offset energy commodity derivative assets or liabilities with a regulatory asset or liability. This accounting treatment is intended to defer the recognition of mark-to-market gains and losses on energy commodity transactions until the period of delivery. This accounting treatment is supported by accounting orders issued by the UTC and IPUC. If we were no longer allowed to apply regulatory accounting or no longer allowed recovery of these costs, we could be required to recognize significant changes in fair value of these energy commodity derivatives on a regular basis in the Consolidated Statements of Income, which could lead to significant fluctuations in net income. See "Notes 1 and 6 of the Notes to Consolidated Financial Statements" for further discussion of our energy derivative accounting policy. • Interest rate derivative asset and liability accounting, where we estimate the fair value of outstanding interest rate swaps, and U.S. Treasury lock agreements and offset the derivative asset or liability with a regulatory asset or liability. This is similar to the treatment of energy commodity derivatives described above. Upon settlement of interest rate swaps, the regulatory asset or liability (included as part of long-term debt) is amortized as a component of interest expense over the term of the associated debt. If we no longer applied regulatory accounting or were no longer allowed recovery of these costs, we could be required to recognize significant changes in fair value of these interest rate AVISTA CORPORATION derivatives on a regular basis in the Consolidated Statements of Income, which could lead to significant fluctuations in net income. • Pension Plans and Other Postretirement Benefit Plans, discussed in further detail below. • Contingencies, related to unresolved regulatory, legal and tax issues for which there is inherent uncertainty for the ultimate outcome of the respective matter. We accrue a loss contingency if it is probable that an asset is impaired or a liability has been incurred and the amount of the loss or impairment can be reasonably estimated. We also disclose losses that do not meet these conditions for accrual, if there is a reasonable possibility that a potential loss may be incurred. For all material contingencies, we have made a judgment as to the probability of a loss occurring and as to whether or not the amount of the loss can be reasonably estimated. If the loss recognition criteria are met, liabilities are accrued or assets are reduced. However, no assurance can be given to the ultimate outcome of any particular contingency. See "Notes 1 and 19 of the Notes to Consolidated Financial Statements" for further discussion of our commitments and contingencies. • Discontinued operations, related to the accounting and financial statement presentation for Ecova following its disposition in 2014. In accordance with GAAP, this transaction caused Ecova to be accounted for as a discontinued operation. Ecova's revenues and expenses are included in the Consolidated Statements of Income in discontinued operations (as a single line item, net of tax). The gain, net of tax, recognized on the sale of Ecova is also included in discontinued operations. All tables throughout the Notes to Consolidated Financial Statements that present Consolidated Statements of Income information were revised to only include amounts from continuing operations. In addition, we are presenting earnings per share calculations for continuing and discontinued operations. Pension Plans and Other Postretirement Benefit Plans - Avista Utilities We have a defined benefit pension plan covering substantially all regular full-time employees at Avista Utilities that were hired prior to January 1, 2014. For substantially all regular non-union full-time employees at Avista Utilities that were hired on or after January 1, 2014, a defined contribution 401(k) plan replaced the defined benefit pension plan. The Finance Committee of the Board of Directors approves investment policies, objectives and strategies that seek an appropriate return for the pension plan and it reviews and approves changes to the investment and funding policies. We have contracted with an independent investment consultant who is responsible for managing/monitoring the individual investment managers. The investment managers’ performance and related individual fund performance is reviewed at least quarterly by an internal benefits committee and by the Finance Committee to monitor compliance with our established investment policy objectives and strategies. Our pension plan assets are invested in debt securities and mutual funds, trusts and partnerships that hold marketable debt and equity securities, real estate and absolute return funds. In seeking to obtain the desired return to fund the pension plan, the investment consultant recommends allocation percentages by asset classes. These recommendations are reviewed by the internal benefits committee, which then recommends their adoption by the Finance Committee. The Finance Committee has established target investment allocation percentages by asset classes and also investment ranges for each asset class. The target investment allocation percentages are typically the midpoint of the established range and are disclosed in “Note 10 of the Notes to Consolidated Financial Statements.” We also have a Supplemental Executive Retirement Plan (SERP) that provides additional pension benefits to our executive officers and others whose benefits under the pension plan are reduced due to the application of Section 415 of the Internal Revenue Code of 1986 and the deferral of salary under deferred compensation plans. Pension costs (including the SERP) were $27.1 million for 2015, $14.6 million for 2014 and $28.8 million for 2013. Of our pension costs, approximately 60 percent are expensed and 40 percent are capitalized consistent with labor charges. The costs related to the SERP are expensed. Our costs for the pension plan are determined in part by actuarial formulas that are dependent upon numerous factors resulting from actual plan experience and assumptions of future experience. Pension costs are affected by among other things: • employee demographics (including age, compensation and length of service by employees), • the amount of cash contributions we make to the pension plan, and • the actual return on pension plan assets, • expected return on pension plan assets, AVISTA CORPORATION • discount rate used in determining the projected benefit obligation and pension costs, • assumed rate of increase in employee compensation, • life expectancy of participants and other beneficiaries, and • expected method of payment (lump sum or annuity) of pension benefits. Any changes in pension plan obligations associated with these factors may not be immediately recognized as pension costs in our Consolidated Statement of Income, but we generally recognize the change in future years over the remaining average service period of pension plan participants. As such, our costs recorded in any period may not reflect the actual level of cash benefits provided to pension plan participants. We revise the key assumption of the discount rate each year. In selecting a discount rate, we consider yield rates at the end of the year for highly rated corporate bond portfolios with cash flows from interest and maturities similar to that of the expected payout of pension benefits. In 2015, the pension plan discount rate (exclusive of the SERP) was 4.58 percent compared to 4.21 percent in 2014 and 5.10 percent in 2013. These changes in the discount rate decreased the projected benefit obligation (exclusive of the SERP) by approximately $31.0 million in 2015 and increased the obligation by $66.3 million in 2014. The expected long-term rate of return on plan assets is reset or confirmed annually based on past performance and economic forecasts for the types of investments held by our plan. We used an expected long-term rate of return of 5.30 percent in 2015, 6.60 percent in 2014 and 6.60 percent in 2013. This change increased pension costs by approximately $6.9 million in 2015. The actual return on plan assets, net of fees, was a loss of $4.3 million (or 0.8 percent) for 2015, a gain of $56.0 million (or 11.6 percent) for 2014 and a gain of $52.5 million (or 12.5 percent) for 2013. The following chart reflects the sensitivities associated with a change in certain actuarial assumptions by the indicated percentage (dollars in thousands): * Changes in the expected return on plan assets would not affect our projected benefit obligation. We provide certain health care and life insurance benefits for substantially all of our retired employees. We accrue the estimated cost of postretirement benefit obligations during the years that employees provide service. Assumed health care cost trend rates have a significant effect on the amounts reported for our postretirement plans. A one-percentage-point increase in the assumed health care cost trend rate for each year would increase our accumulated postretirement benefit obligation as of December 31, 2015 by $9.7 million and the service and interest cost by $0.5 million. A one-percentage-point decrease in the assumed health care cost trend rate for each year would decrease our accumulated postretirement benefit obligation as of December 31, 2015 by $7.5 million and the service and interest cost by $0.4 million. As of December 31, 2015, for the estimated retiree medical plan liability and costs, which are included as part of other post-retirement benefits, our actuaries adopted an updated method of calculation. For the updated method, the assumed average per-capita claim costs for pre-65 participants and post-65 participants were age-adjusted into 5-year bands as prescribed by the Actuarial Standards of Practice. This change in method resulted in an increase to the accumulated post-retirement benefit obligation of approximately $4.6 million in 2015. Liquidity and Capital Resources Overall Liquidity Avista Corp.'s consolidated operating cash flows are primarily derived from the operations of Avista Utilities. The primary source of operating cash flows for Avista Utilities is revenues from sales of electricity and natural gas. Significant uses of cash flows from Avista Utilities include the purchase of power, fuel and natural gas, and payment of other operating expenses, taxes and interest, with any excess being available for other corporate uses such as capital expenditures and dividends. AVISTA CORPORATION We design operating and capital budgets to control operating costs and to direct capital expenditures to choices that support immediate and long-term strategies, particularly for our regulated utility operations. In addition to operating expenses, we have continuing commitments for capital expenditures for construction and improvement of utility facilities. Our annual net cash flows from operating activities usually do not fully support the amount required for annual utility capital expenditures. As such, from time to time, we need to access long-term capital markets in order to fund these needs as well as fund maturing debt. See further discussion at “Capital Resources.” We periodically file for rate adjustments for recovery of operating costs and capital investments and to seek the opportunity to earn reasonable returns as allowed by regulators. See further details in the section “Regulatory Matters.” For Avista Utilities, when power and natural gas costs exceed the levels currently recovered from retail customers, net cash flows are negatively affected. Factors that could cause purchased power and natural gas costs to exceed the levels currently recovered from our customers include, but are not limited to, higher prices in wholesale markets when we buy energy or an increased need to purchase power in the wholesale markets. Factors beyond our control that could result in an increased need to purchase power in the wholesale markets include, but are not limited to: • increases in demand (due to either weather or customer growth), • low availability of streamflows for hydroelectric generation, • unplanned outages at generating facilities, and • failure of third parties to deliver on energy or capacity contracts. Avista Utilities has regulatory mechanisms in place that provide for the deferral and recovery of the majority of power and natural gas supply costs. However, if prices rise above the level currently allowed in retail rates in periods when we are buying energy, deferral balances would increase, negatively affecting our cash flow and liquidity until such time as these costs, with interest, are recovered from customers. In addition to the above, Avista Utilities enters into derivative instruments to hedge our exposure to certain risks, including fluctuations in commodity market prices, foreign exchange rates and interest rates (for purposes of issuing long-term debt in the future). These derivative instruments often require collateral (in the form of cash or letters of credit) or other credit enhancements, or reductions or terminations of a portion of the contract through cash settlement, in the event of a downgrade in the Company's credit ratings or changes in market prices. In periods of price volatility, the level of exposure can change significantly. As a result, sudden and significant demands may be made against the Company's credit facilities and cash. See “Enterprise Risk Management - Demands for Collateral” below. We monitor the potential liquidity impacts of changes to energy commodity prices and other increased operating costs for our utility operations. We believe that we have adequate liquidity to meet such potential needs through our committed lines of credit. As of December 31, 2015, we had $250.4 million of available liquidity under the Avista Corp. committed line of credit and $25.0 million under the AEL&P committed line of credit. With our $400.0 million credit facility that expires in April 2019 and AEL&P's $25.0 million credit facility that expires in November 2019, we believe that we have adequate liquidity to meet our needs for the next 12 months. Review of Consolidated Cash Flow Statement Overall During 2015, cash flows from operating activities were $375.6 million, proceeds from the issuance of long-term debt were $100.0 million and we received $13.9 million from the settlement of the Ecova escrow receivable. Cash requirements included utility capital expenditures of $393.4 million, the redemption of long-term debt of $2.9 million, defined benefit pension plan contributions of $12.0 million, dividends of $82.4 million and the repurchase of common stock of $2.9 million. 2015 compared to 2014 Consolidated Operating Activities Net cash provided by operating activities was $375.6 million for 2015 compared to $267.3 million for 2014. Net cash used by the changes in certain current assets and liabilities components was $4.1 million for 2015, compared to net cash used of $50.0 million for 2014. The net cash used during 2015 primarily reflects cash outflows from changes in accounts payable, collateral posted for derivative instruments and accounts receivable. This was partially offset by inflows from changes in natural gas stored and income taxes receivable. AVISTA CORPORATION The gross gain on the sale of Ecova of $0.8 million for 2015 is deducted in reconciling net income to net cash provided by operating activities. The cash proceeds from the sale (which includes the gross gain) is included in investing activities. This is compared to the gross gain recognized in 2014 of $160.6 million. Net amortizations of power and natural gas costs were $21.4 million for 2015 compared to net deferrals of $14.8 million for 2014. The provision for deferred income taxes was $51.8 million for 2015 compared to $144.3 million for 2014. The decrease in 2015 was primarily due to the combination of implementation by the Company of updated federal tax tangible property regulations and increased deductions related to bonus depreciation in 2014. Contributions to our defined benefit pension plan were $12.0 million for 2015 compared to $32.0 million in 2014. Net cash received for income taxes was $10.0 million for 2015 compared to net cash paid of $45.4 million for 2014. Consolidated Investing Activities Net cash used in investing activities was $387.8 million for 2015, an increase compared to $103.7 million for 2014. During 2015, we received cash proceeds (related to the settlement of the escrow accounts) of $13.9 million for the sale of Ecova. We received the majority of the proceeds ($229.9 million) from the sale of Ecova during 2014. The proceeds received in 2014 were used to pay off the balance of Ecova's long-term borrowings and make payments to option holders and noncontrolling interests (included in financing activities). We also used a portion of these proceeds to pay our $74.8 million tax liability associated with the gain on sale and to fund common stock repurchases. Utility property capital expenditures increased by $67.9 million for 2015 as compared to 2014. During 2014, we received $15.0 million in cash (net of cash paid) related to the acquisition of AERC. Consolidated Financing Activities Net cash provided by financing activities was $0.5 million for 2015 compared to net cash used of $224.0 million for 2014. In 2015 we had the following significant transactions: • issuance and sale of $100.0 million of Avista Corp. first mortgage bonds in December 2015, • cash settlement of interest rate swaps in conjunction with the execution of the purchase agreement for the Avista Corp. first mortgage bonds which resulted in the payment of $9.3 million, • payment of $2.9 million for the redemption and maturity of long-term debt, • cash dividends paid increased to $82.4 million (or $1.32 per share) for 2015 from $78.3 million (or $1.27 per share) for 2014, • issuance of $1.6 million of common stock (net of issuance costs), and • repurchase of $2.9 million of our common stock. In 2014, we had the following significant transactions: • issuance of $150.0 million of long-term debt ($60.0 million of Avista Corp. first mortgage bonds, $75.0 million of AEL&P first mortgage bonds and a $15.0 million AERC unsecured note representing a term loan), • a decrease of $66.0 million in short-term borrowings on Avista Corp.’s committed line of credit, • a decrease of $46.0 million on Ecova's committed line of credit with $6.0 million in payments throughout the year and $40.0 million related to the close of the Ecova sale, • payment of $40.0 million for the redemption and maturity of long-term debt (primarily related to AEL&P paying off its existing debt), • cash payments of $54.2 million to noncontrolling interests and $20.9 million to stock option holders and redeemable noncontrolling interests of Ecova related to the Ecova sale in 2014, • issuance of $4.1 million of common stock (net of issuance costs) excluding issuances related to the acquisition of AERC. We issued $150.1 million of common stock to AERC shareholders, and this is reflected as a non-cash financing activity, • repurchase of $79.9 million of our common stock during 2014 using the proceeds from our sale of Ecova, and • a $16.2 million increase in cash related to the fluctuation in the balance of customer fund obligations at Ecova. AVISTA CORPORATION 2014 compared to 2013 Consolidated Operating Activities Net cash provided by operating activities was $267.3 million for 2014 compared to $242.6 million for 2013. Net cash used by the changes in certain current assets and liabilities components was $50.0 million for 2014, compared to net cash used of $48.2 million for 2013. The net cash used during 2014 primarily reflects cash outflows from changes in accounts payable, natural gas stored and income taxes receivable. These were partially offset by cash inflows from changes in other current liabilities (primarily related to accrued taxes and interest) and accounts receivable. The net cash used during 2013 primarily reflects cash outflows from changes in accounts receivable, accounts payable and other current assets (primarily related to miscellaneous current assets and income taxes receivable). These were partially offset by cash inflows from other current liabilities (primarily related to accrued taxes and interest). The gross gain on the sale of Ecova of $160.6 million for 2014 is deducted in reconciling net income to net cash provided by operating activities. The cash proceeds from the sale (which includes the gross gain) is included in investing activities. Net amortizations of power and natural gas costs were $14.8 million for 2014 compared to $9.4 million for 2013. The provision for deferred income taxes was $144.3 million for 2014 compared to $23.5 million for 2013. The increase for 2014 was primarily due to the combination of implementation by the Company of updated federal tax tangible property regulations and increased deductions related to bonus depreciation. Contributions to our defined benefit pension plan were $32.0 million for 2014 compared to $44.3 million in 2013. Collateral posted for derivative instruments increased by $23.3 million in 2014 compared to an increase of $16.1 million in 2013. We had cash collateral posted of $49.4 million as of December 31, 2014 and $26.1 million as of December 31, 2013. Net cash paid for income taxes was $45.4 million for 2014 compared to $44.8 million for 2013. Cash paid for interest was $73.5 million for 2014 compared to $75.4 million for 2013. Consolidated Investing Activities Net cash used in investing activities was $103.7 million for 2014, a decrease compared to $312.2 million for 2013. During 2014, we received cash proceeds (net of cash sold and escrow amounts) of $229.9 million related to the sale of Ecova. A portion of the proceeds from the Ecova sale was used to pay off the balance of Ecova's long-term borrowings and make payments to option holders and noncontrolling interests (included in financing activities). We also used a portion of these proceeds to pay our $74.8 million tax liability associated with the gain on sale. Utility property capital expenditures increased by $31.2 million for 2014 as compared to 2013. A significant portion of Ecova's funds held for clients were held as securities available for sale with purchases of $12.3 million and sales and maturities of $14.6 million in 2014. For 2013, Ecova had purchases of $35.9 million and sales and maturities of $23.0 million. The fluctuation in the balance of funds held for customers resulted in a decrease to cash of $18.9 million for 2014 as compared to an increase to cash of $1.8 million for 2013. We received $15.0 million in cash (net of cash paid) related to the acquisition of AERC during 2014. Consolidated Financing Activities Net cash used in financing activities was $224.0 million for 2014 compared to net cash provided of $76.8 million for 2013. During 2014, short-term borrowings on Avista Corp.’s committed line of credit decreased $66.0 million. Net borrowings on Ecova's committed line of credit decreased $46.0 million during the period with $6.0 million in payments throughout the year and $40.0 million related to the close of the Ecova sale. In September 2014, AEL&P issued $75.0 million of first mortgage bonds. In December 2014, Avista Corp. issued $60.0 million of first mortgage bonds and AERC issued a $15.0 million unsecured note representing a term loan. We cash settled interest rate swaps in conjunction with the pricing of the $60.0 million of Avista Corp. first mortgage bonds and received $5.4 million. The majority of the $40.0 million of retirements of long-term debt in 2014 relates to AEL&P paying off its existing debt. In connection with the closing of the Ecova sale, we made cash payments of $54.2 million to noncontrolling interests and $20.9 million to stock option holders and redeemable noncontrolling interests of Ecova. Cash dividends paid increased to $78.3 million (or $1.27 per share) for 2014 from $73.3 million (or $1.22 per share) for 2013. Excluding issuances related to the acquisition of AERC, we issued $4.1 million of common stock during 2014. We issued $150.1 million of common stock to AERC shareholders, and this is reflected as a non-cash financing activity. The fluctuation in AVISTA CORPORATION the balance of customer fund obligations at Ecova increased cash by $16.2 million. During 2014, we repurchased $79.9 million of common stock. Cash inflows during 2013 were from a $119.0 million increase in short-term borrowings on Avista Corp.’s committed line of credit, the issuance of $90.0 million of long-term debt and the issuance of $4.6 million of common stock. We also cash settled interest rate swap agreements for $2.9 million related to the pricing of the $90.0 million of long-term debt. Cash outflows during 2013 were from the maturity of long-term debt of $50.5 million and a net decrease in borrowings on Ecova's committed line of credit of $8.0 million (borrowings of $3.0 million and repayments of $11.0 million). Capital Resources Our consolidated capital structure, including the current portion of long-term debt and short-term borrowings, and excluding noncontrolling interests, consisted of the following as of December 31, 2015 and 2014 (dollars in thousands): Our shareholders’ equity increased $45.0 million during 2015 primarily due to net income, partially offset by the repurchase of common stock and dividends. We need to finance capital expenditures and acquire additional funds for operations from time to time. The cash requirements needed to service our indebtedness, both short-term and long-term, reduce the amount of cash flow available to fund capital expenditures, purchased power, fuel and natural gas costs, dividends and other requirements. See "Executive Level Summary" for a detailed discussion of the liquidity and capital resource transactions which occurred during 2015 and our anticipated needs for 2016. Balances outstanding and interest rates of borrowings (excluding letters of credit) under Avista Corp.'s committed line of credit were as follows as of and for the year ended December 31 (dollars in thousands): Any default on the line of credit or other financing arrangements of Avista Corp. or any of our “significant subsidiaries,” if any, could result in cross-defaults to other agreements of such entity, and/or to the line of credit or other financing arrangements of any other of such entities. Any defaults could also induce vendors and other counterparties to demand collateral. In the event of any such default, it would be difficult for us to obtain financing on reasonable terms to pay creditors or fund operations. We would also likely be prohibited from paying dividends on our common stock. Avista Corp. does not guarantee the indebtedness of any of its subsidiaries. As of December 31, 2015, Avista Corp. and its subsidiaries were in compliance with all of the covenants of their financing agreements, and none of Avista Corp.'s subsidiaries constituted a “significant subsidiary” as defined in Avista Corp.'s committed line of credit. We are restricted under our Restated Articles of Incorporation, as amended, as to the additional preferred stock we can issue. As of December 31, 2015, we could issue $1.3 billion of additional preferred stock at an assumed dividend rate of 6.3 percent. We are not planning to issue preferred stock. AVISTA CORPORATION Under the Avista Corp. and the AEL&P Mortgages and Deeds of Trust securing Avista Corp.'s and AEL&P's first mortgage bonds (including Secured Medium-Term Notes), respectively, each entity may issue additional first mortgage bonds in an aggregate principal amount equal to the sum of: • 66-2/3 percent of the cost or fair value (whichever is lower) of property additions at each entity which have not previously been made the basis of any application under the Mortgages, or • an equal principal amount of retired first mortgage bonds at each entity which have not previously been made the basis of any application under the Mortgages, or • deposit of cash. However, Avista Corp. and AEL&P may not individually issue any additional first mortgage bonds (with certain exceptions in the case of bonds issued on the basis of retired bonds) unless the particular entity issuing the bonds has “net earnings” (as defined in the Mortgages) for any period of 12 consecutive calendar months out of the preceding 18 calendar months that were at least twice the annual interest requirements on all mortgage securities at the time outstanding, including the first mortgage bonds to be issued, and on all indebtedness of prior rank. As of December 31, 2015, property additions and retired bonds would have allowed, and the net earnings test would not have prohibited, the issuance of $1.1 billion in aggregate principal amount of additional first mortgage bonds at Avista Corp. and $5.0 million at AEL&P. We believe that we have adequate capacity to issue first mortgage bonds to meet our financing needs over the next several years. Capital Expenditures Utility cash-basis capital expenditures were $1,013.3 million for the years 2013 through 2015 including $13.8 million at AEL&P for 2014 and 2015. The following table summarizes our expected future capital expenditures by year (in thousands): Most of the capital expenditures at Avista Utilities are for upgrading our existing facilities and technology, and not for construction of new facilities. A significant portion of the capital expenditures at AEL&P are for the construction of an additional back-up generation plant planned to be completed in 2016 and a new hydroelectric generation project in 2017 and 2018. AVISTA CORPORATION The following graph shows the Avista Utilities' capital budget for 2016: These estimates of capital expenditures are subject to continuing review and adjustment. Actual capital expenditures may vary from our estimates due to factors such as changes in business conditions, construction schedules and environmental requirements. Off-Balance Sheet Arrangements As of December 31, 2015, we had $44.6 million in letters of credit outstanding under our $400.0 million committed line of credit, compared to $32.6 million as of December 31, 2014. Pension Plan We contributed $12.0 million to the pension plan in 2015. We expect to contribute a total of $60.0 million to the pension plan in the period 2016 through 2020, with an annual contribution of $12.0 million over that period. The final determination of pension plan contributions for future periods is subject to multiple variables, most of which are beyond our control, including changes to the fair value of pension plan assets, changes in actuarial assumptions (in particular the discount rate used in determining the benefit obligation), or changes in federal legislation. We may change our pension plan contributions in the future depending on changes to any variables, including those listed above. See "Note 10 of the Notes to Consolidated Financial Statements" for additional information regarding the pension plan. Credit Ratings Our access to capital markets and our cost of capital are directly affected by our credit ratings. In addition, many of our contracts for the purchase and sale of energy commodities contain terms dependent upon our credit ratings. See “Enterprise Risk Management - Demands for Collateral” and “Note 6 of the Notes to Consolidated Financial Statements.” The following table summarizes our credit ratings as of February 23, 2016: Standard & Poor’s (1) Moody’s (2) Corporate/Issuer rating BBB Baa1 Senior secured debt A- A2 Senior unsecured debt BBB Baa1 (1) Standard & Poor’s lowest “investment grade” credit rating is BBB-. (2) Moody’s lowest “investment grade” credit rating is Baa3. AVISTA CORPORATION A security rating is not a recommendation to buy, sell or hold securities. Each security rating is subject to revision or withdrawal at any time by the assigning rating organization. Each security rating agency has its own methodology for assigning ratings, and, accordingly, each rating should be considered in the context of the applicable methodology, independent of all other ratings. The rating agencies provide ratings at the request of Avista Corp. and charge fees for their services. Dividends On February 5, 2016, Avista Corp.’s Board of Directors declared a quarterly dividend of $0.3425 per share on the Company’s common stock. This was an increase of $0.0125 per share, or 3.8 percent from the previous quarterly dividend of $0.3300 per share. See "Item 5. Market for Registrant’s Common Equity, Related Stockholder Matters and Issuer Purchases of Equity Securities" for a detailed discussion of our dividend policy and the factors which could limit the payment of dividends. Contractual Obligations The following table provides a summary of our future contractual obligations as of December 31, 2015 (dollars in millions): (1) Represents our estimate of interest payments on long-term debt, which is calculated based on the assumption that all debt is outstanding until maturity. Interest on variable rate debt is calculated using the rate in effect at December 31, 2015. (2) Energy purchase contracts were entered into as part of the obligation to serve our retail electric and natural gas customers’ energy requirements. As a result, costs are generally recovered either through base retail rates or adjustments to retail rates as part of the power and natural gas cost adjustment mechanisms. (3) Includes the interest component of the lease obligation. (4) Represents operational agreements, settlements and other contractual obligations for our generation, transmission and distribution facilities. These costs are generally recovered through base retail rates. (5) Includes information service contracts which are recorded to other operating expenses in the Consolidated Statements of Income. On March 30, 2015, Avista Corp. provided a cancellation notice, effective May 31, 2015, to one of its information technology service providers. New contracts were entered into to replace the cancelled contract. The replacement contracts result in similar amount of expense each year; however, this resulted in a significant decrease in future information technology contractual commitments because the new contracts do not have minimum committed spending in them and are primarily time and materials contracts. (6) Represents our estimated cash contributions to pension plans and other postretirement benefit plans through 2020. We cannot reasonably estimate pension plan contributions beyond 2020 at this time and have excluded them from the table above. (7) Primarily relates to long-term debt and capital lease maturities and the related interest. AERC contractual commitments also include contractually required capital project funding and operating and maintenance costs associated with the Snettisham hydroelectric project. These costs are generally recovered through base retail rates. AVISTA CORPORATION (8) Primarily relates to operating lease commitments and a commitment to fund a limited liability company in exchange for equity ownership, made by a subsidiary of Avista Capital. The above contractual obligations do not include income tax payments. Also, asset retirement obligations are not included above and payments associated with these have historically been less than $1 million per year. There are approximately $16.0 million remaining asset retirement obligations as of December 31, 2015. In addition to the contractual obligations disclosed above, we will incur additional operating costs and capital expenditures in future periods for which we are not contractually obligated as part of our normal business operations. Competition Our utility electric and natural gas distribution business has historically been recognized as a natural monopoly. In each regulatory jurisdiction, our rates for retail electric and natural gas services (other than specially negotiated retail rates for industrial or large commercial customers, which are subject to regulatory review and approval) are generally determined on a “cost of service” basis. Rates are designed to provide, after recovery of allowable operating expenses and capital investments, an opportunity for us to earn a reasonable return on investment as allowed by our regulators. In retail markets, we compete with various rural electric cooperatives and public utility districts in and adjacent to our service territories in the provision of service to new electric customers. Alternative energy technologies, including customer-sited solar, wind or geothermal generation, may also compete with us for sales to existing customers. While the risk is currently small in our service territory given the small numbers of customers utilizing these technologies, advances in power generation, energy efficiency and other alternative energy technologies could lead to more wide-spread usage of these technologies, thereby reducing customer demand for the energy supplied by us. This reduction in usage and demand would reduce our revenue and negatively impact our financial condition including possibly leading to our inability to fully recover our investments in generation, transmission and distribution assets. Similarly, our natural gas distribution operations compete with other energy sources including heating oil, propane and other fuels. Certain natural gas customers could bypass our natural gas system, reducing both revenues and recovery of fixed costs. To reduce the potential for such bypass, we price natural gas services, including transportation contracts, competitively and have varying degrees of flexibility to price transportation and delivery rates by means of individual contracts. These individual contracts are subject to state regulatory review and approval. We have long-term transportation contracts with several of our largest industrial customers under which the customer acquires its own commodity while using our infrastructure for delivery. Such contracts reduce the risk of these customers bypassing our system in the foreseeable future and minimizes the impact on our earnings. Also, non-utility businesses are developing new technologies and services to help energy consumers manage energy in new ways that may improve productivity and could alter demand for the energy we sell. In wholesale markets, competition for available electric supply is influenced by the: • localized and system-wide demand for energy, • type, capacity, location and availability of generation resources, and • variety and circumstances of market participants. These wholesale markets are regulated by the FERC, which requires electric utilities to: • transmit power and energy to or for wholesale purchasers and sellers, • enlarge or construct additional transmission capacity for the purpose of providing these services, and • transparently price and offer transmission services without favor to any party, including the merchant functions of the utility. Participants in the wholesale energy markets include: • other utilities, • federal power marketing agencies, • energy marketing and trading companies, • independent power producers, • financial institutions, and AVISTA CORPORATION • commodity brokers. Economic Conditions and Utility Load Growth The general economic data, on both national and local levels, contained in this section is based, in part, on independent government and industry publications, reports by market research firms or other independent sources. While we believe that these publications and other sources are reliable, we have not independently verified such data and can make no representation as to its accuracy. We track multiple economic indicators affecting three distinct metropolitan statistical areas in our Avista Utilities service area: Spokane, Washington, Coeur d'Alene, Idaho, and Medford, Oregon. Several key indicators are employment change, unemployment rates and foreclosure rates. On a year-over-year basis, December 2015 showed positive job growth, and lower unemployment rates in all three metropolitan areas. However, the unemployment rates in Spokane and Medford are still above the national average. Except for Medford, foreclosure rates are in line with or below the U.S rate in all areas, and key leading indicators, initial unemployment claims and residential building permits, continue to signal modest growth over the next 12 months. Therefore, in 2016, we expect economic growth in our service area to be somewhat stronger than the U.S. as a whole. Nonfarm employment (non-seasonally adjusted) in our eastern Washington, northern Idaho, and southwestern Oregon metropolitan service areas exhibited moderate growth between December 2014 and December 2015. In Spokane, Washington employment growth was 2.5 percent with gains in all major sectors except leisure and hospitality. Employment increased by 4.4 percent in Coeur d'Alene, Idaho, reflecting gains in all major sectors except information and leisure and hospitality. In Medford, Oregon, employment growth was 3.3 percent, with gains in all major sectors except construction. U.S. nonfarm sector jobs grew by 1.9 percent in the same 12-month period. Seasonally adjusted unemployment rates went down in December 2015 from the year earlier in Spokane, Coeur d'Alene, and Medford. In Spokane the rate was 7.7 percent in December 2014 and declined to 6.3 percent in December 2015; in Coeur d'Alene the rate went from 5.1 percent to 4.7 percent; and in Medford the rate declined from 8.2 percent to 6.5 percent. The U.S. rate declined from 5.6 percent to 5.0 percent in the same period. Except for the Medford area, the housing market in our Avista Utilities service area continues to experience foreclosure rates in line with the national average. The December 2015 national rate was 0.08 percent, compared to 0.08 percent in Spokane County, Washington; 0.04 percent in Kootenai County (Coeur d'Alene), Idaho; and 0.1 percent in Jackson County (Medford), Oregon. Our AEL&P service area is centered in Juneau. Although Juneau is Alaska’s state capital, it is not a metropolitan statistical area. This means breadth and frequency of economic data is more limited. Therefore, the dates of Juneau's economic data may significantly lag the period of this filing. The Quarterly Census of Employment and Wages for Juneau shows employment increased 0.5 percent between second quarter 2014 and second quarter 2015. The modest growth in employment was largely due to gains in construction; manufacturing; trade, transportation, and utilities; information; professional and business services; and leisure and hospitality, mostly offset by a contraction in government employment, which is Juneau's largest single sector. Government (including active duty military personnel) accounts for approximately 37 percent of total employment. Employment declines also occurred in natural resources and mining; financial activities; education and health services; and other services. Between December 2014 and December 2015 the non-seasonally adjusted unemployment rate decreased from 5.0 percent to 4.7 percent. The Juneau foreclosure rate is below the U.S. rate. The December 2015 rate was 0.02 percent compared to 0.08 percent for the U.S. Based on our forecast for 2016 through 2019 for Avista Utilities' service area, we expect annual electric customer growth to average 1.0 percent, within a forecast range of 0.6 percent to 1.4 percent. We expect annual natural gas customer growth to average 1.1 percent, within a forecast range of 0.6 percent to 1.6 percent. We anticipate retail electric load growth to average 0.7 percent, within a forecast range of 0.4 percent and 1.0 percent. We expect natural gas load growth to average 1.1 percent, within a forecast range of 0.6 percent and 1.6 percent. The forecast ranges reflect (1) the inherent uncertainty associated with the economic assumptions on which forecasts are based and (2) natural gas customer and load growth has been historically volatile. In AEL&P's service area, we expect annual residential customer growth to be in a narrow range around 0.4 percent for 2016 through 2019. We expect no significant growth in commercial and government customers over the same period. We anticipate that average annual total load growth will be in a narrow range around 0.6 percent, with residential load growth averaging 0.6 percent; commercial 0.8 percent; and government 0 percent (no load growth). AVISTA CORPORATION The forward-looking statements set forth above regarding retail load growth are based, in part, upon purchased economic forecasts and publicly available population and demographic studies. The expectations regarding retail load growth are also based upon various assumptions, including: • assumptions relating to weather and economic and competitive conditions, • internal analysis of company-specific data, such as energy consumption patterns, • internal business plans, • an assumption that we will incur no material loss of retail customers due to self-generation or retail wheeling, and • an assumption that demand for electricity and natural gas as a fuel for mobility will for now be immaterial. Changes in actual experience can vary significantly from our projections. Environmental Issues and Contingencies We are subject to environmental regulation by federal, state and local authorities. The generation, transmission, distribution, service and storage facilities in which we have ownership interests are designed and operated in compliance with applicable environmental laws. Furthermore, we conduct periodic reviews and audits of pertinent facilities and operations to ensure compliance and to respond to or anticipate emerging environmental issues. The Company's Board of Directors has established a committee to oversee environmental issues. We monitor legislative and regulatory developments at all levels of government for environmental issues, particularly those with the potential to impact the operation and productivity of our generating plants and other assets. Environmental laws and regulations may: • increase the operating costs of generating plants; • increase the lead time and capital costs for the construction of new generating plants; • require modification of our existing generating plants; • require existing generating plant operations to be curtailed or shut down; • reduce the amount of energy available from our generating plants; • restrict the types of generating plants that can be built or contracted with; and • require construction of specific types of generation plants at higher cost. Compliance with environmental laws and regulations could result in increases to capital expenditures and operating expenses. We intend to seek recovery of any such costs through the ratemaking process. Clean Air Act We must comply with the requirements under the Clean Air Act (CAA) in operating our thermal generating plants. The CAA currently requires a Title V operating permit for Colstrip (expires in 2017), Coyote Springs 2 (expires in 2018), the Kettle Falls GS (application has been made for a new permit), and the Rathdrum CT (application has been made for a new permit). Boulder Park GS, Northeast CT, and other activities only require minor source operating or registration permits based on their limited operation and emissions. The Title V operating permits are renewed every five years and updated to include newly applicable CAA requirements. We actively monitor legislative, regulatory and program developments within the CAA that may impact our facilities. On March 6, 2013, the Sierra Club and Montana Environmental Information Center, filed a Complaint (Complaint) in the United States District Court for the District of Montana, Billings Division, against the owners of Colstrip. The Complaint alleges certain violations of the CAA. See “Sierra Club and Montana Environmental Information Center Complaint Against the Owners of Colstrip” in “Note 19 of the Notes to Consolidated Financial Statements” for further information on this matter. Hazardous Air Pollutants (HAPs) The EPA regulates hazardous air pollutants from a published list of industrial sources referred to as "source categories" which must meet control technology requirements if they emit one or more of the pollutants in significant quantities. In 2012, the EPA finalized the Mercury Air Toxic Standards (MATS) for the coal and oil-fired source category. At the time of issuance in 2012, we examined the existing emission control systems of Colstrip Units 3 & 4, the only units in which we are a minority owner, and concluded that the existing emission control systems should be sufficient to meet mercury limits. AVISTA CORPORATION For the remaining portion of the rule that utilized Particulate Matter as a surrogate for air toxics (including metals and acid gases), the Colstrip owners reviewed recent stack testing data and expected that no additional emission control systems would be needed for Units 3 & 4 MATS compliance. On June 29, 2015, the Supreme Court held that the EPA's interpretation of MATS was unreasonable when it deemed cost irrelevant for MATS regulation. The EPA's interpretation of MATS has been reversed and remanded. Regional Haze Program The EPA set a national goal of eliminating man-made visibility degradation in Class I areas by the year 2064. States are expected to take actions to make “reasonable progress” through 10-year plans, including application of Best Available Retrofit Technology (BART) requirements. BART is a retrofit program applied to large emission sources, including electric generating units built between 1962 and 1977. In the case where a State opts out of implementing the Regional Haze program, the EPA may act directly. On September 18, 2012, the EPA finalized the Regional Haze federal implementation plan (FIP) for Montana. The FIP includes both emission limitations and pollution controls for Colstrip Units 1 & 2. Colstrip Units 3 & 4, the only units of which we are a minority owner, are not currently affected, but will be evaluated for Reasonable Progress at the next review period in September 2017. We do not anticipate any material impacts on Units 3 & 4 at this time. Coal Ash Management/Disposal On April 17, 2015, the EPA published a final rule regarding coal combustion residuals (CCRs), also termed coal combustion byproducts or coal ash in the Federal Register, and this rule became effective on October 15, 2015. Colstrip, of which we are a 15 percent owner of Units 3 and 4, produces this byproduct. The rule establishes technical requirements for CCR landfills and surface impoundments under Subtitle D of the Resource Conservation and Recovery Act, the nation's primary law for regulating solid waste. We, in conjunction with the other owners, are developing a multi-year compliance plan to strategically address the new CCR requirements and existing state obligations while maintaining operational stability. During the second quarter of 2015, the operator of Colstrip provided an initial cost estimate of the expected retirement costs associated with complying with the new CCR rule and this estimate was subsequently updated during the fourth quarter of 2015. Based on the initial assessments, Avista Corp. recorded an increase to its asset retirement obligations of $12.5 million with a corresponding increase in the cost basis of the utility plant. In addition to an increase to our ARO, there are expected to be significant compliance costs at Colstrip in the future, both operating and capital costs, due to a series of incremental infrastructure improvements which are separate from any retirement obligations. Due to the preliminary nature of available data, we cannot reasonably estimate the future compliance costs; however, we will update our ARO and compliance cost estimates when data becomes available. The actual asset retirement costs and future compliance costs related to the CCR Rule requirements may vary substantially from the estimates used to record the increased obligation due to uncertainty about the compliance strategies that will be used and the preliminary nature of available data used to estimate costs, such as the quantity of coal ash present at certain sites and the volume of fill that will be needed to cap and cover certain impoundments. We will coordinate with the plant operators and continue to gather additional data in future periods to make decisions about compliance strategies and the timing of closure activities. As additional information becomes available, we will update the ARO and future nonretirement compliance costs for these changes in estimates, which could be material. We expect to seek recovery of any increased costs related to complying with the new rule through customer rates. Climate Change Concerns about long-term global climate changes could have a significant effect on our business. Our operations could also be affected by changes in laws and regulations intended to mitigate the risk of or alter global climate changes, including restrictions on the operation of our power generation resources and obligations imposed on the sale of natural gas. Changing temperatures and precipitation, including snowpack conditions, affect the availability and timing of streamflows, which impact hydroelectric generation. Extreme weather events could increase service interruptions, outages and maintenance costs. Changing temperatures could also increase or decrease customer demand. Our Climate Policy Council (an interdisciplinary team of management and other employees): • facilitates internal and external communications regarding climate change issues, • analyzes policy effects, anticipates opportunities and evaluates strategies for Avista Corp., and • develops recommendations on climate related policy positions and action plans. AVISTA CORPORATION Climate Change - Federal Regulatory Actions The EPA released the final rules for the Clean Power Plan (Final CPP) and the Carbon Pollution Standards (Final CPS) on August 3, 2015. The Final CPP and the Final CPS are both intended to reduce the carbon dioxide (CO2) emissions from certain coal-fired and natural gas electric generating units (EGUs). These rules were published in the Federal Register on October 23, 2015 and were immediately challenged via lawsuits by other parties. The Final CPP was promulgated pursuant to Section 111(d) of the CAA and applies to CO2 emissions from existing EGUs. The Final CPP is intended to reduce national CO2 emissions by approximately 32 percent below 2005 levels by 2030. The Final CPS rule was issued pursuant to Section 111(b) of the CAA and applies to the emissions of new, modified and reconstructed EGUs. The two rules are the first rules ever adopted by the U.S. federal government to comprehensively control and reduce CO2 emissions from the power sector. The EPA also issued a proposed Federal Implementation Plan (Proposed FIP) for the Final CPP. The Final FIP that the EPA adopts could be imposed on states by the EPA, should a state decide not to develop its own plan. The Final CPP establishes individual state emission reduction goals based upon the assumed potential for (1) heat rate improvements at coal-fired units, (2) increased utilization of natural gas-fired combined cycle plants, and (3) increased utilization of low or zero carbon emitting generation resources. As expressed in the final rule, states have until September 2016 to submit state compliance plans, with a potential for two-year extensions. Avista Corp. owns two EGUs that are subject to the Final CPP: its portion (15 percent of Units 3 & 4) of Colstrip in Montana and Coyote Springs 2 in Oregon. States may adopt rate-based or mass-based plans, and may choose to focus compliance on specific EGUs or adopt broader measures to reduce carbon emissions from this sector. The states in which Avista Utilities generates or delivers electricity, Washington, Idaho, Montana and Oregon, are all evaluating options for developing state plans, which will define compliance approaches and obligations. Alaska was exempted in the Final CPP. The EPA may consider rulemaking for Alaska and Hawaii, both states which lack regional grid connections, in the future. In a separate but related rulemaking, the EPA finalized CO2 new source performance standards (NSPS) for new, modified and reconstructed fossil fuel-fired EGUs under CAA section 111(b). These EGUs fall into the same two categories of sources regulated by the Final CPP: steam generating units (also known as “utility boilers and IGCC units”), which primarily burn coal, and stationary combustion turbines, which primarily burn natural gas. GHG emission standards could result in significant compliance costs. Such standards could also preclude us from developing, operating or contracting with certain types of generating plants. Additionally, the Climate Action Plan requirements related to preparing the U.S. for the impacts of climate change could affect us and others in the industry as transmission system modifications to improve resiliency may be needed in order to meet those requirements. The promulgated and proposed GHG rulemakings mentioned above have been legally challenged in multiple venues. On February 9, 2016, the U.S. Supreme Court granted a request for stay, halting implementation of the CPP. Given this development and the ongoing legal challenges, we cannot fully predict the outcome or estimate the extent to which our facilities may be impacted by these regulations at this time. We intend to seek recovery of any costs related to compliance with these requirements through the ratemaking process. Climate Change - State Legislation and State Regulatory Activities The states of Washington and Oregon have adopted non-binding targets to reduce GHG emissions. Both states enacted their targets with an expectation of reaching the targets through a combination of renewable energy standards, and assorted “complementary policies,” but no specific reductions are mandated. Washington and Oregon apply a GHG emissions performance standard (EPS) to electric generation facilities used to serve retail loads in their jurisdictions. The EPS prevents utilities from constructing or purchasing generation facilities, or entering into power purchase agreements of five years or longer duration, to purchase energy produced by plants that have emission levels higher than 1,100 pounds of GHG per MWh. The Washington State Department of Commerce (Commerce) initiated a process to adopt a lower emissions performance standard in 2012, any new standard will be applicable until at least 2017. Commerce published a supplemental notice of proposed rulemaking on January 16, 2013 with a new EPS of 970 pounds of GHG per MWh. We will engage in the next process to revise the EPS, which should occur in 2017. The Energy Independence Act (EIA) in Washington requires electric utilities with over 25,000 customers to acquire qualified renewable energy resources and/or renewable energy credits equal to 15 percent of the utility's total retail load in 2020. I-937 also requires these utilities to meet biennial energy conservation targets beginning in 2012. The renewable energy standard increases from three percent in 2012 to nine percent in 2016. Failure to comply with renewable energy and efficiency standards could result in penalties of $50 per MWh or greater assessed against a utility for each MWh it is deficient in meeting a standard. We have met, and will continue to meet, the requirements of EIA through a variety of AVISTA CORPORATION renewable energy generating means, including, but not limited to, some combination of hydro upgrades, wind and biomass. In 2012, EIA was amended in such a way that our Kettle Falls GS and certain other biomass energy facilities, which commenced operation before March 31, 1999, are considered resources that may be used to meet the renewable energy standards beginning in 2016. The Washington State Department of Ecology (Ecology) has commenced rulemaking, using its existing authorities, to cap and reduce carbon emissions across the State of Washington in pursuit of the State’s carbon goals, which were enacted in 2008 by the Washington State Legislature (Legislature). The rule applies to sources of annual greenhouse emissions in excess of 100,000 tons for the first compliance period of 2017 through 2019; this threshold incrementally decreases to 70,000 metric tons beginning in 2035. The rule affects stationary sources and transportation fuel suppliers, as well as natural gas distribution companies. Ecology has identified approximately 30 entities responsible for 60 percent of the state’s emission sources that would be regulated under the proposed rule. The proposed rule would only apply to Avista Corp. as a natural gas distribution company, for the emissions associated with the use of the gas we provide our customers. The Governor of Washington ordered Ecology to finalize the rule by June 2016. An Initiative to the Legislature (I-732), which would impose a carbon tax on fossil-fueled generation and natural gas distribution, as well as on transportation fuels, has qualified for submittal to the Legislature. The Legislature may enact the measure into law, pass an alternative, in which case the original initiative and the alternative will be referred to the voters in November, or allow the measure to go onto the ballot in its original form. In addition, a coalition of environmental and labor groups in Washington announced its intent to file an initiative at the start of 2016 that would apply cap and trade regulation to sources of greenhouse gas emissions, with proceeds from the State's sale of compliance instruments (allowances) dedicated to clean-energy investments and other government programs. If filed and if it gains sufficient signatures, this initiative would go on the general ballot in 2016. While we cannot predict the eventual outcome of actions arising out of initiatives, proposed legislation and regulatory actions at this time nor estimate the effect thereof, we will continue to seek recovery, through the ratemaking process, of all operating and capitalized costs related to our utility operations. On February 6, 2014, the UTC issued a letter finding that Puget Sound Energy’s (PSE’s) 2013 Electric Integrated Resource Plan meets the requirements of the Revised Code of Washington and the Washington Administrative Code. In its letter, however, the UTC expressed concern regarding the continued operation of the Colstrip plant as a resource to serve retail customers. Although the UTC recognized that the results of the analyses presented by PSE “differed significantly between [Colstrip] Units 1 and 2 and Units 3 and 4,” the UTC did not limit its concerns solely to Colstrip Units 1 and 2. The UTC recommended that PSE “consult with UTC staff to consider a Colstrip Proceeding to determine the prudency of any new investment in Colstrip before it is made or, in the alternative, a closure or partial-closure plan.” As a 15 percent owner of Colstrip Units 3 and 4, we cannot estimate the effect of such proceeding, should it occur, on the future ownership and operation of our share of Colstrip Units 3 and 4. Our remaining investment in Colstrip Units 3 and 4 as of December 31, 2015 was $118.8 million. In Oregon, legislation has been introduced which would require Portland General Electric and Pacificorp to remove coal-fired generation from their rate-base by 2030. Because these two utilities, along with Avista Utilities, hold minority interests in Colstrip, the legislation could indirectly impact Avista Utilities, though specific impacts cannot be identified at this time. While the legislation requires the two utilities to eliminate Colstrip from their rates, they would be permitted to sell the output of their shares of Colstrip into the wholesale market or, as is the case with Pacificorp, reallocate the plant to other states. We cannot predict the eventual outcome of actions arising from this legislation at this time or estimate the effect thereof; however, we will continue to seek recovery, through the ratemaking process, of all operating and capitalized costs related to our generation assets. Threatened and Endangered Species and Wildlife A number of species of fish in the Northwest are listed as threatened or endangered under the Federal Endangered Species Act (ESA). Efforts to protect these and other species have not significantly impacted generation levels at any of our hydroelectric facilities. We are implementing fish protection measures at our hydroelectric project on the Clark Fork River under a 45-year FERC operating license for Cabinet Gorge and Noxon Rapids (issued March 2001) that incorporates a comprehensive settlement agreement. The restoration of native salmonid fish, including bull trout, is a key part of the agreement. The result is a collaborative native salmonid restoration program with the U.S. Fish and Wildlife Service, Native American tribes and the states of Idaho and Montana on the lower Clark Fork River, consistent with requirements of the FERC license. The U.S. Fish & Wildlife Service issued an updated Critical Habitat Designation for bull trout in 2010 that includes the lower Clark Fork River, as well as portions of the Coeur d'Alene basin within our Spokane River Project area, and issued a final Bull Trout Recovery Plan under the ESA. Issues related to these activities are expected to be resolved through the ongoing collaborative effort of our AVISTA CORPORATION Clark Fork and Spokane River FERC licenses. See “Fish Passage at Cabinet Gorge and Noxon Rapids” in “Note 19 of the Notes to Consolidated Financial Statements” for further information. Various statutory authorities, including the Migratory Bird Treaty Act, have established penalties for the unauthorized take of migratory birds. Because we operate facilities that can pose risks to a variety of such birds, we have developed and follow an avian protection plan. Other For other environmental issues and other contingencies see “Note 19 of the Notes to Consolidated Financial Statements.” Enterprise Risk Management The material risks to our businesses are discussed in "Item 1A. Risk Factors," "Forward-Looking Statements," as well as "Environmental Issues and Contingencies." The following discussion focuses on our mitigation processes and procedures to address these risks. We consider the management of these risks an integral part of managing our core businesses and a key element of our approach to corporate governance. Risk management includes identifying and measuring various forms of risk that may affect the Company. We have an enterprise risk management process for managing risks throughout our organization. Our Board of Directors and its Committees take an active role in the oversight of risk affecting the Company. Our risk management department facilitates the collection of risk information across the Company, providing senior management with a consolidated view of the Company’s major risks and risk mitigation measures. Each area identifies risks and implements the related mitigation measures. The enterprise risk process supports management in identifying, assessing, quantifying, managing and mitigating the risks. Despite all risk mitigation measures, however, risks are not eliminated. Our primary identified categories of risk exposure are: • Financial • Compliance • Utility regulatory • Technology • Energy commodity • Strategic • Operational • External Mandates Financial Risk Financial risk is any risk that could have a direct material impact on the financial performance or financial viability of the Company. Broadly, financial risks involve variation of earnings and liquidity. Underlying risks include, but are not limited to, those described in "Item 1A. Risk Factors." We mitigate financial risk in a variety of ways including through oversight from the Finance Committee of our Board of Directors and from senior management. Our Regulatory department is also critical in risk mitigation as they have regular communications with state commission regulators and staff and they monitor and develop rate strategies for the Company. Rate strategies, such as decoupling, help mitigate the impacts of revenue fluctuations due to weather, conservation or the economy. We also have a Treasury department that monitors our daily cash position and future cash flow needs, as well as monitoring market conditions to determine the appropriate course of action for capital financing and/or hedging strategies. Weather Risk To partially mitigate the risk of financial underperformance due to weather-related factors, we developed decoupling rate mechanisms that were approved by the Washington and Idaho commissions. Decoupling mechanisms are designed to break the link between a utility's revenues and consumers' energy usage and instead provide revenue based on the number of customers, thus mitigating a large portion of the risk associated with lower customer loads. See "Regulatory Matters" for further discussion of our decoupling mechanisms. Access to Capital Markets Our capital requirements rely to a significant degree on regular access to capital markets. We actively engage with rating agencies, banks, investors and state public utility commissions to understand and address the factors that support access to capital markets on reasonable terms. We manage our capital structure to maintain a financial risk profile that these parties will deem prudent. We forecast cash requirements to determine liquidity needs, including sources and variability of cash flows that may arise from our spending plans or from external forces, such as changes in energy prices or interest rates. Our financial and AVISTA CORPORATION operating forecasts consider various metrics that affect credit ratings. Our regulatory strategies include working with state public utility commissions and filing for rate changes as appropriate to meet financial performance expectations. Interest Rate Risk Uncertainty about future interest rates causes risk related to a portion of our existing debt, our future borrowing requirements, and our pension and other post-retirement benefit obligations. We manage debt interest rate exposure by limiting our variable rate debt to a percentage of total capitalization of the Company. We hedge a portion of our interest rate risk on forecasted debt issuances with financial derivative instruments, which may include interest rate swaps and U.S. Treasury lock agreements. The Finance Committee of our Board of Directors periodically reviews and discusses interest rate risk management processes and the steps management has undertaken to control interest rate risk. Our Risk Management Committee, which is comprised of certain officers and other management personnel, also reviews our interest rate risk management plan. Additionally, interest rate risk is managed by monitoring market conditions when timing the issuance of long-term debt and optional debt redemptions and establishing fixed rate long-term debt with varying maturities. Our interest rate swap agreements are considered economic hedges against fluctuations in future cash flows associated with anticipated debt issuances. Interest rates on our long-term debt are generally set based on underlying U.S. Treasury rates plus credit spreads, which are based on our credit ratings and prevailing market prices for debt. The swap agreements hedge against changes in the U.S. Treasury rates but do not hedge the credit spread. Even though we work to manage our exposure to interest rate risk by locking in certain long-term interest rates through interest rate swap agreements, if market interest rates decrease below the interest rates we have locked in, this will result in a liability related to our interest rate swap agreements, which can be significant. However, through our regulatory accounting practices similar to our energy commodity derivatives, any interim mark-to-market gains or losses are offset by regulatory assets and liabilities. Upon settlement of interest rate swaps, the regulatory asset or liability (included as part of long-term debt) is amortized as a component of interest expense over the term of the associated debt. The following table summarizes our interest rate swap agreements outstanding as of December 31, 2015 and December 31, 2014 (dollars in thousands): (1) There are offsetting regulatory assets and liabilities for these items on the Consolidated Balance Sheets in accordance with regulatory accounting practices. (2) The balance as of December 31, 2015 and December 31, 2014 reflects the offsetting of $34.0 million and $28.9 million, respectively of cash collateral against the net derivative positions where a legal right of offset exists. In anticipation of issuing long-term debt in future years, we entered into three interest rate swap agreements in January 2016, hedging an aggregate notional amount of $30.0 million with mandatory cash settlement dates in 2018 and 2022. The following table shows our outstanding interest rate swaps as of February 23, 2016 (dollars in thousands): AVISTA CORPORATION We estimate that a 10-basis-point increase in forward LIBOR interest rates as of December 31, 2015 would decrease the interest rate swap derivative net liability by $9.8 million, while a 10-basis-point decrease would increase the interest rate swap net liability by $10.1 million. We estimated that a 10-basis-point increase in forward LIBOR interest rates as of December 31, 2014 would have decreased the interest rate swap derivative net liability by $9.0 million, while a 10-basis-point decrease would increase the interest rate swap net liability by $9.3 million. The interest rate on $51.5 million of long-term debt to affiliated trusts is adjusted quarterly, reflecting current market rates. Amounts borrowed under our committed line of credit agreements have variable interest rates. Historically, during years where we have long-term debt that is maturing, we have to issue long-term debt to replace the maturing debt. To hedge our interest rate risk associated with these expected long-term debt issuances, we enter into interest rate swap agreements (discussed above). The following table shows our long-term debt (including current portion) and related weighted average interest rates, by expected maturity dates as of December 31, 2015 (dollars in thousands): (1) These balances include the fixed rate long-term debt of Avista Corp., AEL&P and AERC. Our pension plan is exposed to interest rate risk because the value of pension obligations and other post-retirement obligations vary directly with changes in the discount rates, which are derived from end-of-year market interest rates. In addition, the value of pension investments and potential income on pension investments is partially affected by interest rates because a significant portion of pension investments are in fixed income securities. The Finance Committee of the Board of Directors approves investment policies, objectives and strategies that seek an appropriate return for the pension plan and it reviews and approves changes to the investment and funding policies. We manage interest rate risk associated with our pension and other post-retirement benefit plans by investing a targeted amount of pension plan assets in fixed income investments that have maturities with similar profiles to future projected benefit obligations. We have implemented a liability-driven investment process for the pension plan with the objective of enhancing the match between changes in pension investments and changes in pension obligations and reducing volatility of annual pension expense arising from changes in interest rates. Credit Risk Counterparty non-performance risk relates to potential losses that we would incur as a result of non-performance of contractual obligations by counterparties to deliver energy or make financial settlements. Changes in market prices may dramatically alter the size of credit risk with counterparties, even when we establish conservative credit limits. Should a counterparty fail to perform, we may be required to honor the underlying commitment or to replace existing contracts with contracts at then-current market prices. We enter into bilateral transactions with various counterparties. We also trade energy and related derivative instruments through clearinghouse exchanges. We seek to mitigate credit risk by: • transacting through clearinghouse exchanges, • entering into bilateral contracts that specify credit terms and protections against default, • applying credit limits and duration criteria to existing and prospective counterparties, • actively monitoring current credit exposures, AVISTA CORPORATION • asserting our collateral rights with counterparties, and • carrying out transaction settlements timely and effectively. The extent of transactions conducted through exchanges has increased as many market participants have shown a preference toward exchange trading and have reduced bilateral transactions. We actively monitor the collateral required by such exchanges to effectively manage our capital requirements. To address the impact on our operations of energy market price volatility, our hedging practices for electricity (including fuel for generation) and natural gas extend beyond the current operating year. Executing this extended hedging program may increase credit risk and demands for collateral. Our credit risk management process is designed to mitigate such credit risks through limit setting, contract protections and counterparty diversification, among other practices. Credit risk affects demands on our capital. We are subject to limits and credit terms that counterparties may assert to allow us to enter into transactions with them and maintain acceptable credit exposures. Many of our counterparties allow unsecured credit at limits prescribed by agreements or their discretion. Capital requirements for certain transaction types involve a combination of initial margin and market value margins without any unsecured credit threshold. Counterparties may seek assurances of performance from us in the form of letters of credit, prepayment or cash deposits. Credit exposure can change significantly in periods of commodity price and interest rate volatility. As a result, sudden and significant demands may be made against our credit facilities and cash. We actively monitor the exposure to possible collateral calls and take steps to minimize capital requirements. Counterparties’ credit exposure to us is dynamic in normal markets and may change significantly in more volatile markets. The amount of potential default risk to us from each counterparty depends on the extent of forward contracts, unsettled transactions, interest rates and market prices. There is a risk that we do not obtain sufficient additional collateral from counterparties that are unable or unwilling to provide it. As of December 31, 2015, we had cash deposited as collateral of $28.7 million and letters of credit of $28.2 million outstanding related to our energy derivative contracts. Price movements and/or a downgrade in our credit ratings could impact further the amount of collateral required. See “Credit Ratings” for further information. For example, in addition to limiting our ability to conduct transactions, if our credit ratings were lowered to below “investment grade” based on our positions outstanding at December 31, 2015, we would potentially be required to post additional collateral of up to $9.0 million. This amount is different from the amount disclosed in “Note 6 of the Notes to Consolidated Financial Statements” because, while this analysis includes contracts that are not considered derivatives in addition to the contracts considered in Note 6, this analysis also takes into account contractual threshold limits that are not considered in Note 6. Without contractual threshold limits, we would potentially be required to post additional collateral of $18.4 million. Under the terms of interest rate swap agreements that we enter into periodically, we may be required to post cash or letters of credit as collateral depending on fluctuations in the fair value of the instrument. As of December 31, 2015, we had interest rate swap agreements outstanding with a notional amount totaling $455.0 million and we had deposited cash in the amount of $34.0 million and letters of credit of $9.6 million as collateral for these interest rate swap derivative contracts. If our credit ratings were lowered to below “investment grade” based on our interest rate swap agreements outstanding at December 31, 2015, we would have to post $18.8 million of additional collateral. Foreign Currency Risk A significant portion of our utility natural gas supply (including fuel for electric generation) is obtained from Canadian sources. Most of those transactions are executed in U.S. dollars, which avoids foreign currency risk. A portion of our short-term natural gas transactions and long-term Canadian transportation contracts are committed based on Canadian currency prices. The short-term natural gas transactions are typically settled within sixty days with U.S. dollars. We economically hedge a portion of the foreign currency risk by purchasing Canadian currency exchange contracts when such commodity transactions are initiated. This risk has not had a material effect on our financial condition, results of operations or cash flows and these differences in cost related to currency fluctuations are included with natural gas supply costs for ratemaking. Further information for derivatives and fair values is disclosed at “Note 6 of the Notes to Consolidated Financial Statements” and “Note 16 of the Notes to Consolidated Financial Statements.” AVISTA CORPORATION Utility Regulatory Risk Because we are primarily a regulated utility, we face the risk that regulators may not grant rates that provide timely or sufficient recovery of our costs or allow a reasonable rate of return for our shareholders. This includes costs associated with our investment in rate base, as well as commodity costs and other operating and financing expenses. We mitigate regulatory risk through oversight from our Board of Directors and from senior management. We have a separate regulatory group which communicates with commission regulators and staff regarding the Company’s business plans and concerns. The regulatory group also considers the regulator’s priorities and rate policies and makes recommendations to senior management on regulatory strategy for the Company. See “Regulatory Matters” for further discussion of regulatory matters affecting our Company. Energy Commodity Risk Energy commodity risks are associated with fulfilling our obligation to serve customers, managing variability of energy facilities, rights and obligations and fulfilling the terms of our energy commodity agreements with counterparties. These risks include, among other things, those described in "Item 1A. Risk Factors." We mitigate energy commodity risk primarily through our energy resources risk policy, which includes oversight from the Risk Management Committee, which is comprised of certain officers and other management and oversight from the Audit Committee and the Environmental, Technology and Operations Committee of our Board of Directors. In conjunction with the oversight committees, our management team develops hedging strategies, detailed resource procurement plans, resource optimization strategies and long-term integrated resource planning to mitigate some of the risk associated with energy commodities. The various plans and strategies are monitored daily and developed with quantitative methods. Our energy resources risk policy, which includes our wholesale energy markets credit policy and control procedures to manage energy commodity price and credit risks. Nonetheless, adverse changes in commodity prices, generating capacity, customer loads, regulation and other factors may result in losses of earnings, cash flows and/or fair values. We measure the volume of monthly, quarterly and annual energy imbalances between projected power loads and resources. The measurement process is based on expected loads at fixed prices (including those subject to retail rates) and expected resources to the extent that costs are essentially fixed by virtue of known fuel supply costs or projected hydroelectric conditions. To the extent that expected costs are not fixed, either because of volume mismatches between loads and resources or because fuel cost is not locked in through fixed price contracts or derivative instruments, our risk policy guides the process to manage this open forward position over a period of time. Normal operations result in seasonal mismatches between power loads and available resources. We are able to vary the operation of generating resources to match parts of intra-hour, hourly, daily and weekly load fluctuations. We use the wholesale power markets, including the natural gas market as it relates to power generation fuel, to sell projected resource surpluses and obtain resources when deficits are projected. We buy and sell fuel for thermal generation facilities based on comparative power market prices and marginal costs of fueling and operating available generating facilities and the relative economics of substitute market purchases for generating plant operation. To address the impact on our operations of energy market price volatility, our hedging practices for electricity (including fuel for generation) and natural gas extend beyond the current operating year. Executing this extended hedging program may increase our credit risks. Our credit risk management process is designed to mitigate such credit risks through limit setting, contract protections and counterparty diversification, among other practices. Our projected retail natural gas loads and resources are regularly reviewed by operating management and the Risk Management Committee. To manage the impacts of volatile natural gas prices, we seek to procure natural gas through a diversified mix of spot market purchases and forward fixed price purchases from various supply basins and time periods. We have an active hedging program that extends several years into the future with the goal of reducing price volatility in our natural gas supply costs. We use natural gas storage capacity to support high demand periods and to procure natural gas when prices are likely to be seasonally lower. Securing prices throughout the year and even into subsequent years mitigates potential adverse impacts of significant purchase requirements in a volatile price environment. AVISTA CORPORATION The following table presents energy commodity derivative fair values as a net asset or (liability) as of December 31, 2015 that are expected to settle in each respective year (dollars in thousands): The following table presents energy commodity derivative fair values as a net asset or (liability) as of December 31, 2014 that are expected to settle in each respective year (dollars in thousands): (1) Physical transactions represent commodity transactions where we will take delivery of either electricity or natural gas and financial transactions represent derivative instruments with no physical delivery, such as futures, swaps, options, or forward contracts. The above electric and natural gas derivative contracts will be included in either power supply costs or natural gas supply costs during the period they are delivered and will be included in the various recovery mechanisms (ERM, PCA, and PGAs), or in the general rate case process, and are expected to eventually be collected through retail rates from customers. See "Item 1. Business - Electric Operations," "Item 1. Business - Natural Gas Operations," and "Item 1A. Risk Factors" for additional discussion of the risks associated with Energy Commodities. Operational Risk Operational risk involves potential disruption, losses, or excess costs arising from external events or inadequate or failed internal processes, people and systems. Our operations are subject to operational and event risks that include, but are not limited to, those described in "Item 1A. Risk Factors." To manage operational and event risks, we maintain emergency operating plans, business continuity and disaster recovery plans, maintain insurance coverage against some, but not all, potential losses and seek to negotiate indemnification arrangements with contractors for certain event risks. In addition, we design and follow detailed vegetation management and asset management inspection plans, which help mitigate wildfire and storm event risks, as well as identify utility assets which may be failing and in need of repair or replacement. We also have an Emergency Operating Center, which is a team of employees that plan for and train to deal with potential emergencies or unplanned outages at our facilities, resulting from natural disasters or other events. To prevent unauthorized access to our facilities, we have both physical and cyber security in place. To address the risk related to fuel cost, availability and delivery restraints, we have an energy resources risk policy, which includes our wholesale energy markets credit policy and control procedures to manage energy commodity price and credit risks. Development of the energy resources risk policy includes planning for sufficient capacity to meet our customer and wholesale energy delivery obligations. See further discussion of the energy resources risk policy above. Oversight of the operational risk management process is performed by the Environmental, Technology and Operations Committee of our Board of Directors and from senior management with input from each operating department. AVISTA CORPORATION Compliance Risk Compliance risk is the potential consequences of legal or regulatory sanctions or penalties arising from the failure of the Company to comply with requirements of applicable laws, rules and regulations. We have extensive compliance obligations. Our primary compliance risks and obligations include, among others, those described in "Item 1A. Risk Factors." We mitigate compliance risk through oversight from the Environmental, Technology and Operations Committee and the Audit Committee of our Board of Directors and from senior management. We also have separate Regulatory and Environmental Compliance departments that monitor legislation, regulatory orders and actions to determine the overall potential impact to our Company and develop strategies for complying with the various rules and regulations. We also engage outside attorneys, and consultants, when necessary, to help ensure compliance with laws and regulations. See "Item 1. Business, Regulatory Issues" through "Item 1. Business, Reliability Standards" and “Environmental Issues and Contingencies” for further discussion of compliance issues that impact our Company. Technology Risk Our primary technology risks are described in "Item 1A. Risk Factors." We mitigate technology risk through trainings and exercises at all levels of the Company. The Environmental, Technology and Operations Committee of our Board of Directors along with senior management are regularly briefed on security policy, programs and incidents. Annual cyber and physical training and testing of employees are included in our enterprise security program as is business continuity testing and a data breach response exercises. Technology governance is led by senior management, which includes new technology strategy, risk planning and major project planning and approval. The technology project management office and enterprise capital planning group provide project cost, timeline and schedule oversight. In addition, there are independent third party audits of our critical infrastructure security program and our business risk security controls. We have a Technology department dedicated to securing, maintaining, evaluating and developing our information technology systems. There is regular training of the technology and security team. This group also evaluates the Company's technology for obsolescence and makes recommendations for upgrading or replacing systems as necessary. This group also monitors for intrusion and security events that may include a data breach. Strategic Risk Strategic risk relates to the potential impacts resulting from incorrect assumptions about external and internal factors, inappropriate business plans, ineffective business strategy execution, or the failure to respond in a timely manner to changes in the regulatory, macroeconomic or competitive environments. Our primary strategic risks include, among others, those described in "Item 1A. Risk Factors." We mitigate strategic risk through detailed oversight from the Board of Directors and from senior management. We also have a Chief Strategy Officer that heads a Strategic Initiatives department, to search for and evaluate opportunities for the Company and makes recommendations to senior management. The Strategic Initiatives department not only focuses on whether opportunities are financially viable, but also considers whether these opportunities fall within our core policies and our core business strategies. We mitigate our reputational risk primarily through a focus on adherence to our core policies, including our Code of Conduct, maintaining an appropriate Company culture and tone at the top, and through communication and engagement of our external stakeholders. External Mandates Risk External mandate risk involves forces outside the Company, which may include significant changes in customer expectations, disruptive technologies that result in obsolescence of our business model and government action that could impact the Company. See "Environmental Issues and Contingencies" and "Forward-Looking Statements" for a discussion of or reference to our external mandates risks. We mitigate external mandate risk through detailed oversight from the Environmental, Technology and Operations Committee of our Board of Directors and from senior management. We have a Climate Council which meets internally to assess the potential impacts of climate policy to our business and to identify strategies to plan for change. We also have employees dedicated to actively engage and monitor federal, state and local government positions and legislative actions that may affect us or our customers. AVISTA CORPORATION To prevent the threat of municipalization, we work to build strong relationships with the communities we serve through, among other things: • communication and involvement with local business leaders and community organizations, • providing customers with a multitude of limited income initiatives, including energy fairs, senior outreach and low income workshops, mobile outreach strategy and a Low Income Rate Assistance Plan, • tailoring our internal company initiatives to focus on choices for our customers, to increase their overall satisfaction with the Company, and • engaging in the legislative process in a manner that fosters the interests of our customers and the communities we serve.

<s>[INST] As of December 31, 2015, we have two reportable business segments, Avista Utilities and AEL&P. We also have other businesses which do not represent a reportable business segment and are conducted by various direct and indirect subsidiaries of Avista Corp. See "Part I, Item 1. Business Company Overview" for further discussion of our business segments. The following table presents net income (loss) attributable to Avista Corp. shareholders for each of our business segments (and the other businesses) for the year ended December 31 (dollars in thousands): (1) The results for the year ended December 31, 2014 include the net gain on sale of Ecova of $69.7 million. Executive Level Summary Overall Results Net income attributable to Avista Corp. shareholders was $123.2 million for 2015, a decrease from $192.0 million for 2014. The decrease was primarily due to the disposition of Ecova during 2014, which resulted in the recognition of a $74.8 million net gain, with $69.7 million being recognized in 2014 and the remainder being recognized in 2015. Avista Utilities' earnings increased slightly primarily due to the implementation of a general rate increase in Washington, lower net power supply costs, a decrease in the provision for earnings sharing in Idaho and increased cooling loads during the summer. This was mostly offset by weather that was significantly warmer than normal and warmer than the prior year in the first quarter, which reduced heating loads, which was partially offset by the new decoupling mechanism in Washington (implemented January 1, 2015). Also, we AVISTA CORPORATION experienced expected increases in other operating expenses, depreciation and amortization, taxes other than income taxes, and interest expense. Results for 2015 also include earnings at AEL&P for the full period, whereas 2014 results only include AEL&P for the third and fourth quarters. Results for 2014 include a $9.8 million net gain at Avista Energy related to the settlement of the California power markets litigation. The net gain from the litigation settlement was partially offset by a pretax contribution of $6.4 million of the proceeds to the Avista Foundation, a charitable organization funded by Avista Corp. Both of these transactions are reflected in the results of the other businesses. Avista Utilities Avista Utilities is our most significant business segment. Our utility financial performance is dependent upon, among other things: weather conditions (temperatures, precipitation levels and wind patterns) which affect energy demand and electric generation, including the effect of precipitation and temperature on hydroelectric resources, the effect of wind patterns on windgenerated power, weathersensitive customer demand, and similar impacts on supply and demand in the wholesale energy markets, regulatory decisions, allowing our utility to recover costs, including purchased power and fuel costs, on a timely basis, and to earn a reasonable return on investment, the price of natural gas in the wholesale market, including the effect on the price of fuel for generation, and the price of electricity in the wholesale market, including the effects of weather conditions, natural gas prices and other factors affecting supply and demand. Forecasted Customer and Load Growth Based on our forecast for 2016 through 2019 for Avista Utilities' service area, we expect annual electric customer growth to average 1.0 percent, within a forecast range of 0.6 percent to 1.4 percent. We expect annual natural gas customer growth to average 1.1 percent, within a forecast range of 0.6 percent to 1.6 percent. We anticipate retail electric load growth to average 0.7 percent, within a forecast range of 0.4 percent and 1.0 percent. We expect natural gas load growth to average 1.1 percent, within a forecast range of 0.6 percent and 1.6 percent. The forecast ranges reflect (1) the inherent uncertainty associated with the economic assumptions on which forecasts are based and (2) the historic variability of natural gas customer and load growth. In AEL&P's service area, we expect annual residential customer growth to be [/INST] Positive. </s>

AVISTA CORP

2017-02-22

2016-12-31

ITEM 7. MANAGEMENT'S DISCUSSION AND ANALYSIS OF FINANCIAL CONDITION AND RESULTS OF OPERATIONS Business Segments As of December 31, 2016, we have two reportable business segments, Avista Utilities and AEL&P. We also have other businesses which do not represent a reportable business segment and are conducted by various direct and indirect subsidiaries of Avista Corp. See "Part I, Item 1. Business - Company Overview" for further discussion of our business segments. The following table presents net income (loss) attributable to Avista Corp. shareholders for each of our business segments (and the other businesses) for the year ended December 31 (dollars in thousands): (1) The results for the year ended December 31, 2014 include the net gain on sale of Ecova of $69.7 million. Executive Level Summary Overall Results Net income attributable to Avista Corp. shareholders was $137.2 million for 2016, an increase from $123.2 million for 2015. Avista Utilities' earnings increased primarily due to an increase in electric and natural gas gross margin as a result of general rate increases and the implementation of decoupling mechanisms in Idaho and Oregon. See "Results of Operations - Avista Utilities - Non-GAAP Financial Measures" for further discussion of gross margin. Also, there was a reduction in the electric provision for earnings sharing (which is an offset to revenue). Retail electric loads decreased as compared to prior year and retail natural gas loads increased as compared to prior year, but the impact of changes in load as compared to normal for electric and natural gas was mostly offset by decoupling mechanisms. In addition to the fluctuations in gross margin, there were increases in other operating expenses, depreciation, and interest expense. There was also an increase in earnings at AEL&P offset by an increase in the net loss at the other businesses. More detailed explanations of the fluctuations are provided in the results of operations and business segment discussions (Avista Utilities, AEL&P, and the other businesses) that follow this section. AVISTA CORPORATION 2016 Washington General Rate Cases In December 2016, the UTC issued an order related to our Washington electric and natural gas general rate cases that were originally filed with the UTC in February 2016. The UTC order denied the Company's proposed electric and natural gas rate increase requests totaling $43.0 million. Accordingly, our current electric and natural gas retail rates will remain unchanged in Washington State. In December 2016, we filed a Petition for Reconsideration or, in the alternative, Rehearing (Petition) with the UTC. The UTC provided notice inviting parties to respond to our Petition, stating that it expects to rule on the Petition on or before March 16, 2017. If our efforts to obtain rates that are fair, just, reasonable and sufficient are not successful, our 2017 earnings will suffer a significant adverse impact. We believe the UTC order will not allow us to earn a reasonable return on investments that we have already made in our infrastructure. In addition, the order will provide no opportunity for us to earn the return on equity authorized by the UTC or a fair return for shareholders. In the order, the UTC did not specifically disallow any of our capital projects, and we continue to believe these investments are necessary and will be recoverable in rates in the future. In 2017, we expect our operating costs to continue to grow along the same trend we have been experiencing recently; however, if our current Washington rates remain in effect, we expect to earn below our currently authorized return on equity (ROE). The order will result in regulatory lag, and, accordingly, we expect to experience earnings contraction in 2017 of $0.20 to $0.30 per diluted share as compared to 2016 actual results. See "Item 7. Management's Discussion and Analysis - Regulatory Matters" for additional discussion surrounding this general rate case and all of our other outstanding general rate cases. Alaska Energy and Resources Company Acquisition On July 1, 2014, we acquired AERC, based in Juneau, Alaska. The completion of this transaction limits the comparability of the financial results for 2016 and 2015 to those for 2014 since the first half of 2014 does not contain any financial results from AERC. This transaction resulted in the recording of $52.4 million in goodwill. For additional information regarding the AERC transaction, including pro forma financial comparisons, see “Note 4 of the Notes to Consolidated Financial Statements.” Ecova Disposition On June 30, 2014, Avista Capital completed the sale of its interest in Ecova for a sales price of $335.0 million in cash, less the payment of debt and other customary closing adjustments. The sale of Ecova provided total cash proceeds to Avista Corp., net of debt, payment to option and minority holders, income taxes and transaction expenses, of $143.7 million and resulted in a net gain of $74.8 million. Most of the net gain was recognized in 2014 with some minor true-ups during 2015. The completion of this transaction limits the comparability of the financial results for 2016 and 2015 to those for 2014 since the first half of 2014 contains the financial results of Ecova (in discontinued operations) and 2015 and 2016 do not have any material results from Ecova. For additional information regarding the Ecova disposition, see “Note 5 of the Notes to Consolidated Financial Statements.” Regulatory Matters General Rate Cases We regularly review the need for electric and natural gas rate changes in each state in which we provide service. We will continue to file for rate adjustments to: • seek recovery of operating costs and capital investments, and • seek the opportunity to earn reasonable returns as allowed by regulators. With regards to the timing and plans for future filings, the assessment of our need for rate relief and the development of rate case plans takes into consideration short-term and long-term needs, as well as specific factors that can affect the timing of rate filings. Such factors include, but are not limited to, in-service dates of major capital investments and the timing of changes in major revenue and expense items. Avista Utilities Washington General Rate Cases 2014 General Rate Cases In November 2014, the UTC approved an all-party settlement agreement related to our electric and natural gas general rate cases filed in February 2014 and new rates became effective on January 1, 2015. The settlement was designed to increase annual electric base revenues by $12.3 million, or 2.5 percent. The settlement was designed to increase annual natural gas base AVISTA CORPORATION revenues by $8.5 million, or 5.6 percent. The settlement agreement also included the implementation of decoupling mechanisms for electric and natural gas and a related after-the-fact earnings test. See "Decoupling and Earnings Sharing Mechanisms" below for further discussion of these mechanisms. Specific capital structure ratios and the cost of capital components were not agreed to in the settlement agreement. The revenue increases in the settlement were not tied to the 7.32 percent rate of return on rate base (ROR) used in conjunction with the after-the fact earnings test discussed under "Decoupling and Earnings Sharing Mechanisms" below. The electric and natural gas revenue increases were negotiated numbers, with each party using its own set of assumptions underlying its agreement to the revenue increases. The parties agreed that the 7.32 percent ROR will be used to calculate the AFUDC and will be used for other purposes. 2015 General Rate Cases In January 2016, we received an order (Order 05) that concluded our electric and natural gas general rate cases that were originally filed with the UTC in February 2015. New electric and natural gas rates were effective on January 11, 2016. The UTC-approved rates are designed to provide a 1.6 percent, or $8.1 million decrease in electric base revenue, and a 7.4 percent, or $10.8 million increase in natural gas base revenue. The UTC also approved an ROR of 7.29 percent, with a common equity ratio of 48.5 percent and a 9.5 percent ROE. UTC Order Denying Industrial Customers of Northwest Utilities / Public Counsel Joint Motion for Clarification, UTC Staff Motion to Reconsider and UTC Staff Motion to Reopen Record On January 19, 2016, the Industrial Customers of Northwest Utilities (ICNU) and the Public Counsel Unit of the Washington State Office of the Attorney General (PC) filed a Joint Motion for Clarification with the UTC. In the Motion for Clarification, ICNU and PC requested that the UTC clarify the calculation of the electric attrition adjustment and the end-result revenue decrease of $8.1 million. ICNU and PC provided their own calculations in their Motion, and suggested that the revenue decrease should have been $19.8 million based on their reading of the UTC’s Order. On January 19, 2016, the UTC Staff, which is a separate party in the general rate case proceedings from the UTC Advisory Staff, filed a Motion to Reconsider with the UTC. In its Motion to Reconsider, the Staff provided calculations and explanations that suggested that the electric revenue decrease should have been a revenue decrease of $27.4 million instead of $8.1 million, based on its reading of the UTC's Order. Further, on February 4, 2016, the UTC Staff filed a Motion to Reopen Record for the Limited Purpose of Receiving into Evidence Instruction on Use and Application of Staff’s Attrition Model, and sought to supplement the record “to incorporate all aspects of the Company’ Power Cost Update.” Within this Motion, UTC Staff updated its suggested electric revenue decrease to $19.6 million. None of the parties in their Motions raised issues with the UTC’s decision on the natural gas revenue increase of $10.8 million. On February 19, 2016, the UTC issued an order (Order 06) denying the Motions summarized above and affirmed Order 05 including an $8.1 million decrease in electric base revenue. PC Petition for Judicial Review On March 18, 2016, PC filed in Thurston County Superior Court a Petition for Judicial Review of the UTC's Order 05 and Order 06 described above that concluded our 2015 electric and natural gas general rate cases. In its Petition for Judicial Review, PC seeks judicial review of five aspects of Order 05 and Order 06, alleging, among other things, that (1) the UTC exceeded its statutory authority by setting rates for our natural gas and electric services based on amounts for utility plant and facilities that are not "used and useful" in providing utility service to customers; (2) the UTC acted arbitrarily and capriciously in granting an attrition adjustment for our electric operations after finding that the we did not meet the newly articulated standard regarding attrition adjustments; (3) the UTC erred in applying the "end results test" to set rates for our electric operations that are not supported by the record; (4) the UTC did not correct its calculation of our electric rates after significant errors were brought to its attention; and (5) the UTC's calculation of our electric rates lacks substantial evidence. PC is requesting that the Court (1) vacate or set aside portions of the UTC’s orders; (2) identify the errors contained in the UTC’s orders; (3) find that the rates approved in Order 05 and reaffirmed in Order 06 are unlawful and not fair, just and reasonable; (4) remand the matter to the UTC for further proceedings consistent with these rulings, including a determination of our revenue requirement for electric and natural gas services; and (5) find the customers are entitled to a refund. AVISTA CORPORATION On April 18, 2016, PC filed an application with the Thurston County Superior Court to certify this matter for review directly by the Court of Appeals, an intermediate appellate court in the State of Washington. After briefing and argument, the matter was certified on April 29, 2016 and accepted by the Court of Appeals on July 29, 2016. The parties are providing briefs to the Court, after which the Court will set the matter for argument. A decision from the Court is not expected until late 2017, at the earliest. The new rates established by Order 05 will continue in effect while the Petition for Judicial Review is being considered. We believe the UTC's Order 05 and Order 06 finalizing the electric and natural gas general rate cases provide a reasonable end result for all parties. If the outcome of the judicial review were to result in an electric rate reduction greater than the decrease ordered by the UTC, it may not provide us with a reasonable opportunity to earn the rate of return authorized by the UTC. 2016 General Rate Cases On December 15, 2016, the UTC issued an order related to our Washington electric and natural gas general rate cases that were originally filed with the UTC in February 2016. The UTC order denied the Company's proposed electric and natural gas rate increase requests of $38.6 million and $4.4 million, respectively. Accordingly, our current electric and natural gas retail rates will remain unchanged in Washington State. Our original requests were based on a proposed ROR of 7.64 percent with a common equity ratio of 48.5 percent and a 9.9 percent ROE. On December 23, 2016 we filed a Petition for Reconsideration or, in the alternative, Rehearing (Petition) with the UTC related to our 2016 general rate cases. The UTC’s Order and Avista Corp.’s Response The primary reason given by the UTC in reaching its conclusion is that, in our request, we did not follow an “appropriate methodology” to show the existence of attrition, as between historical data and current and projected data. Further, the order states that, among other things, we did not demonstrate, as a necessary condition to being allowed an attrition adjustment, that we have suffered from chronic under-earning caused by circumstances beyond our ability to control. We disagree with the UTC as to various questions of fact and law. In support of its decision, the UTC stated that we did not demonstrate that our current revenue is insufficient for covering costs and providing the opportunity to earn a reasonable return during the 2017 rate period. The UTC also stated that we did not demonstrate that our capital expenditures and increased operating costs are both necessary and immediate. Our Petition responding to the UTC's order points to evidence in the case that demonstrates, contrary to the UTC’s findings, the following: • Current retail rates are not sufficient for the 2017 rate period, and therefore a revenue increase is necessary. In previously filed testimony, UTC Staff agreed that current rates were not sufficient. • The costs associated with the growth in rate base and operating expenses are growing at a faster pace than revenue from retail sales, and therefore a revenue adjustment is necessary to close this gap. The revenue adjustment to close this gap is sometimes called an attrition adjustment. In previously filed testimony, UTC Staff agreed that a revenue adjustment is necessary to close this gap. • All of the capital projects and operating expenses we included in the case are necessary in the time frame proposed in order for us to continue to provide safe, reliable service to customers. No party in the case identified a single capital project that should not be completed in the time frame we proposed (other than Public Counsel’s general opposition to AMI). • We presented all of the studies and analyses in this case, consistent with our previous filings with the UTC, and the UTC Staff acknowledged in previously filed testimony, that we provided such studies. • We earned close to our allowed return on equity during each of the years 2013 through 2015, and into 2016. This opportunity was possible only with the revenue increases related to attrition adjustments, and an attrition adjustment is also necessary for 2017. In previously filed testimony, the UTC Staff supported electric and natural gas revenue increases totaling $28.4 million. Commissioner Jones dissented and did not support the decision. In his dissent, Commissioner Jones supported an electric revenue increase of $26.0 million, and a natural gas increase of $2.4 million, based on UTC Staff's analysis. AVISTA CORPORATION In response to our Petition, on December 27, 2016 the UTC issued a “Notice of Opportunity to File Answers to Petition for Reconsideration or Rehearing.” In its Notice the UTC requested parties to the case to file written answers to our Petition and all interested parties filed written answers to the Petition in January 2017. The UTC's notice indicated that it expects to enter an order resolving the Petition no later than March 16, 2017. In UTC Staff’s Answer to our Petition, UTC Staff essentially abandoned its previous recommendations to the UTC, and supported no electric and natural gas revenue increases. In our Motion to Respond, and Response Comments, to the Answers of the parties, filed January 20, 2017, we noted the inappropriateness of UTC Staff’s changed position, which was without any basis in new or changed facts or circumstances. The other parties generally supported the UTC decision in their Answers to our Petition. Future General Rate Case Filings We plan to file new electric and natural gas general rate cases in Washington in the second quarter of 2017. We will address the issues raised by the UTC in the most recent rate order, including, but not limited to, multi-year rate plans to address the concerns over frequency of filings, the necessity of an attrition adjustment for the opportunity to earn our allowed return in a period when growth rates in investment in plant and operating expenses outpace growth in energy sales, and whether our current spending levels are both necessary and immediate to provide safe and reliable service to our customers. We may also seek an order from the UTC allowing for the deferral for later recovery of ongoing costs associated with AMI. Accounting Order to Defer Existing Washington Electric Meters In March 2016, the UTC granted our Petition for an Accounting Order to defer and include in a regulatory asset the undepreciated value of our existing Washington electric meters for the opportunity for later recovery. This accounting treatment is related to our plans to replace approximately 253,000 of our existing electric meters with new two-way digital meters and the related software and support services through our AMI project in Washington State. Replacement of the meters is expected to begin in the second half of 2017. The prudence of the overall AMI project and ultimate recovery of the regulatory assets and the costs of the new meters will be addressed in a future regulatory proceeding. The undepreciated value estimated for the existing meters is approximately $19.1 million. For ratemaking purposes, the existing electric meters won't be recorded as regulatory assets until they are physically removed from service, but for GAAP purposes, they are regulatory assets upon the commitment by management to retire the meters. Idaho General Rate Cases 2015 General Rate Cases In December 2015, the IPUC approved a settlement agreement between Avista Utilities and all interested parties related to our electric and natural gas general rate cases, which were originally filed with the IPUC on June 1, 2015. New rates were effective on January 1, 2016. The settlement agreement is designed to increase annual electric base revenues by $1.7 million or 0.7 percent and annual natural gas base revenues by $2.5 million or 3.5 percent. The settlement is based on an ROR of 7.42 percent with a common equity ratio of 50 percent and a 9.5 percent ROE. The settlement agreement also reflects the following: • the discontinuation of the after-the-fact earnings test (provision for earnings sharing) that was originally agreed to as part of the settlement of our 2012 electric and natural gas general rate cases, and • the implementation of electric and natural gas Fixed Cost Adjustment mechanisms, as discussed below. 2016 General Rate Cases In December 2016, the IPUC approved a settlement agreement between us and other parties in our electric general rate case, concluding our Idaho electric general rate case originally filed in May 2016. New rates took effect on January 1, 2017 under the settlement agreement. We did not file a natural gas general rate case in 2016. The settlement agreement increases annual electric base rates by 2.6 percent (designed to increase annual electric revenues by $6.3 million). The settlement revenue increase is based on a ROR of 7.58 percent with a common equity ratio of 50 percent and a 9.5 percent ROE. AVISTA CORPORATION In addition to the agreed upon increase in electric revenues to recover costs primarily driven by our increased capital investments in infrastructure to serve customers, the settlement agreement includes the continued recovery of approximately $4.1 million in costs related to the Palouse Wind Project through the PCA mechanism rather than through base rates. In our original request we requested an overall increase in base electric rates of 6.3 percent (designed to increase annual electric revenues by $15.4 million), effective January 1, 2017. Our original request was based on a proposed ROR of 7.78 percent with a common equity ratio of 50 percent and a 9.9 percent ROE. Oregon General Rate Cases 2013 General Rate Case In January 2014, the OPUC approved a settlement agreement in our natural gas general rate case (originally filed in August 2013). As agreed to in the settlement, new rates were implemented in two phases: February 1, 2014 and November 1, 2014. Effective February 1, 2014, rates increased for Oregon natural gas customers on a billed basis by an overall 4.4 percent (designed to increase annual revenues by $3.8 million). Effective November 1, 2014, rates for Oregon natural gas customers were to increase on a billed basis by an overall 1.6 percent (designed to increase annual revenues by $1.4 million). The billed rate increase on November 1, 2014 was dependent upon the completion of Project Compass and the actual costs incurred through September 30, 2014, and the actual costs incurred through June 30, 2014 related to the Company's Aldyl A distribution pipeline replacement program. Project Compass was completed in February 2015. The November 1, 2014 rate increase was reduced from $1.4 million to $0.3 million due to the delay of Project Compass. The approved settlement agreement provided an authorized ROR of 7.47 percent, with a common equity ratio of 48 percent and a 9.65 percent ROE. 2014 General Rate Case In March 2015, we filed an all-party settlement agreement with the OPUC related to our natural gas general rate case, which was originally filed in September 2014. The settlement agreement was designed to increase base natural gas revenues by $5.3 million. Included in this base rate increase is $0.3 million in base revenues that we were already receiving from customers through a separate rate adjustment. Therefore, the net increase in base revenues was $5.0 million, or 4.9 percent on a billed basis. The parties requested that new retail rates become effective on April 16, 2015. On April 9, 2015, the OPUC issued an Order approving the settlement agreement as filed. This settlement agreement provided for an overall authorized ROR of 7.516 percent with a common equity ratio of 51 percent and a 9.5 percent ROE. 2015 General Rate Case On February 29, 2016, the OPUC issued a preliminary order (and a final order on March 15, 2016) concluding our natural gas general rate case, which was originally filed with OPUC in May 2015. The OPUC order approved rates designed to increase overall billed natural gas rates by 4.9 percent (designed to increase annual natural gas revenues by $4.5 million). New rates went into effect on March 1, 2016. The final OPUC order incorporated two partial settlement agreements which were entered into during November 2015 and January 2016. The OPUC order provided an authorized ROR of 7.46 percent with a common equity ratio of 50 percent and a 9.4 percent ROE. The November 2015 partial settlement agreement, approved by the OPUC, included a provision for the implementation of a decoupling mechanism, similar to the Washington and Idaho mechanisms described below. See further description and a summary of the balances recorded under this mechanism below. 2016 General Rate Case On November 30, 2016 we filed a natural gas general rate case with the OPUC. We have requested an overall increase in base natural gas rates of 14.5 percent (designed to increase annual natural gas revenues by $8.5 million). Our request is based on a proposed ROR of 7.83 percent with a common equity ratio of 50 percent and a 9.9 percent ROE. The OPUC has up to 10 months to review our request and issue a decision. Alaska Electric Light and Power Company Alaska General Rate Case In September 2016, AEL&P filed an electric general rate case with the RCA. AEL&P was granted a refundable interim base rate increase of 3.86 percent (designed to increase electric revenues by $1.3 million), that took effect in November 2016. AVISTA CORPORATION AEL&P has also requested a permanent base rate increase of an additional 4.24 percent (designed to increase electric revenues by $1.5 million), which, if approved, could take effect in February 2018. This represents a combined total rate increase of 8.1 percent (designed to increase electric revenues by $2.8 million). Included in the general rate case are additional annual revenues of $2.9 million from the Greens Creek Mine, which offsets a portion of the rate increase to retail customers that would otherwise occur. The RCA must rule on permanent rate increase requests within 450 days (approximately 15 months) from the date of filing, unless otherwise extended by consent of the parties. The statutory timeline for the AEL&P GRC, with the consent of the parties, has been extended to February 8, 2018. The rate request is based largely on the addition of a new backup generation plant (Industrial Blvd. Plant) to rate base. Avista Utilities Purchased Gas Adjustments PGAs are designed to pass through changes in natural gas costs to Avista Utilities' customers with no change in gross margin (operating revenues less resource costs) or net income. In Oregon, we absorb (cost or benefit) 10 percent of the difference between actual and projected natural gas costs included in retail rates for supply that is not hedged. Total net deferred natural gas costs among all jurisdictions were a liability of $30.8 million as of December 31, 2016 and a liability of $17.9 million as of December 31, 2015, and these deferred natural gas costs balances represent amounts due to customers. The following PGAs went into effect in our various jurisdictions during 2014, 2015 and 2016: Power Cost Deferrals and Recovery Mechanisms The ERM is an accounting method used to track certain differences between Avista Utilities' actual power supply costs, net of wholesale sales and sales of fuel, and the amount included in base retail rates for our Washington customers. Total net deferred power costs under the ERM were a liability of $21.3 million as of December 31, 2016 compared to a liability $18.0 million as of December 31, 2015, and these deferred power cost balances represent amounts due to customers. The difference in net power supply costs under the ERM primarily results from changes in: • short-term wholesale market prices and sales and purchase volumes, • the level and availability of hydroelectric generation, • the level and availability of thermal generation (including changes in fuel prices), and • retail loads. Under the ERM, Avista Utilities absorbs the cost or receives the benefit from the initial amount of power supply costs in excess of or below the level in retail rates, which is referred to as the deadband. The annual (calendar year) deadband amount is $4.0 million. AVISTA CORPORATION The following is a summary of the ERM: Under the ERM, Avista Utilities makes an annual filing on or before April 1 of each year to provide the opportunity for the UTC staff and other interested parties to review the prudence of and audit the ERM deferred power cost transactions for the prior calendar year. We made our annual filing on March 31, 2016. The ERM provides for a 90-day review period for the filing; however, the period may be extended by agreement of the parties or by UTC order. The 2015 ERM deferred power costs transactions were approved by an order from the UTC. Avista Utilities has a PCA mechanism in Idaho that allows us to modify electric rates on October 1 of each year with IPUC approval. Under the PCA mechanism, we defer 90 percent of the difference between certain actual net power supply expenses and the amount included in base retail rates for our Idaho customers. The October 1 rate adjustments recover or rebate power supply costs deferred during the preceding July-June twelve-month period. Total net power supply costs deferred under the PCA mechanism were a liability of $2.2 million as of December 31, 2016 compared to an asset of $0.2 million as of December 31, 2015. Decoupling and Earnings Sharing Mechanisms Decoupling is a mechanism designed to sever the link between a utility's revenues and consumers' energy usage. In each of Avista Utilities' jurisdictions, each month Avista Utilities' electric and natural gas revenues are adjusted so as to be based on the number of customers in certain customer rate classes, rather than kilowatt hour and therm sales. The difference between revenues based on the number of customers and revenues based on actual usage is deferred and either surcharged or rebated to customers beginning in the following year. Washington Decoupling and Earnings Sharing In Washington, the UTC approved our decoupling mechanisms for electric and natural gas for a five-year period beginning January 1, 2015. Electric and natural gas decoupling surcharge rate adjustments to customers are limited to 3 percent on an annual basis, with any remaining surcharge balance carried forward for recovery in a future period. There is no limit on the level of rebate rate adjustments. The decoupling mechanisms each include an after-the-fact earnings test. At the end of each calendar year, separate electric and natural gas earnings calculations are made for the prior calendar year. These earnings tests reflect actual decoupled revenues, normalized power supply costs and other normalizing adjustments. • If we have a decoupling rebate balance for the prior year and earn in excess of the authorized ROR (7.32 percent for 2015 and 7.29 percent for 2016), the rebate to customers would be increased by 50 percent of the earnings in excess of the authorized ROR. • If we have a decoupling rebate balance for the prior year and our earnings are equal to or less than the authorized ROR, only the base amount of the rebate to customers would be made. • If we have a decoupling surcharge balance for the prior year and earn in excess of the authorized ROR, the surcharge to customers would be reduced by 50 percent of the earnings in excess of the authorized ROR (or eliminated). If 50 percent of the earnings in excess of the authorized ROR exceeds the decoupling surcharge balance, the dollar amount that exceeds the surcharge balance would create a rebate balance for customers. • If we have a decoupling surcharge balance for the prior year and our earnings are equal to or less than the authorized ROR, the base amount of the surcharge to customers would be made. See below for a summary of cumulative balances under the decoupling and earnings sharing mechanisms. Idaho FCA and Earnings Sharing Mechanisms In Idaho, the IPUC approved the implementation of FCAs for electric and natural gas (similar in operation and effect to the Washington decoupling mechanisms) for an initial term of three years, beginning January 1, 2016. AVISTA CORPORATION For the period 2013 through 2015, we had an after-the-fact earnings test, such that if Avista Corp., on a consolidated basis for electric and natural gas operations in Idaho, earned more than a 9.8 percent ROE, we were required to share with customers 50 percent of any earnings above the 9.8 percent. There was no provision for a surcharge to customers if our ROE was less than 9.8 percent. This after-the-fact earnings test was discontinued as part of the settlement of our 2015 Idaho electric and natural gas general rates cases (discussed in further detail above). See below for a summary of cumulative balances under the decoupling and earnings sharing mechanisms. Oregon Decoupling Mechanism In February 2016, the OPUC approved the implementation of a decoupling mechanism for natural gas, similar to the Washington and Idaho mechanisms described above. The decoupling mechanism became effective on March 1, 2016. There will be an opportunity for interested parties to review the mechanism and recommend changes, if any, by September 2019. An earnings review is conducted on an annual basis, which is filed by us with the OPUC on or before June 1 of each year for the prior calendar year. In the annual earnings review, if we earn more than 100 basis points above our allowed return on equity, one-third of the earnings above the 100 basis points would be deferred and later returned to customers. See below for a summary of cumulative balances under the decoupling and earnings sharing mechanisms. Cumulative Decoupling and Earnings Sharing Mechanism Balances As of December 31, 2016 and December 31, 2015, we had the following cumulative balances outstanding related to decoupling and earnings sharing mechanisms in our various jurisdictions (dollars in thousands): (n/a) This mechanism did not exist during this time period. See "Results of Operations - Avista Utilities" for further discussion of the amounts recorded to operating revenues in 2015 and 2016 related to the decoupling and earnings sharing mechanisms. Results of Operations - Overall The following provides an overview of changes in our Consolidated Statements of Income. More detailed explanations are provided, particularly for operating revenues and operating expenses, in the business segment discussions (Avista Utilities, AEL&P, Ecova - Discontinued Operations and the other businesses) that follow this section. As discussed in "Executive Level Summary," Ecova was disposed of as of June 30, 2014. As a result, in accordance with GAAP, all of Ecova's operating results were removed from each line item on the Consolidated Statements of Income and reclassified into discontinued operations for all periods presented. The discussion of continuing operations below does not include any Ecova amounts. For our discussion of discontinued operations and Ecova, see "Ecova - Discontinued Operations." The balances included below for utility operations reconcile to the Consolidated Statements of Income. Beginning on July 1, 2014, AEL&P is included in the overall utility results. AVISTA CORPORATION 2016 compared to 2015 The following graph shows the total change in net income from continuing operations for the year ended December 31, 2015 to the year ended December 31, 2016, as well as the various factors that caused such change (dollars in millions): Utility revenues decreased due to a decrease at Avista Utilities, partially offset by a slight increase in AEL&P's revenues. Avista Utilities' electric revenues decreased primarily due to lower retail electric loads caused by weather fluctuations throughout the period, a general rate decrease in Washington and lower wholesale revenues resulting from lower volumes and lower wholesale prices. These revenue decreases were partially offset by a general rate increase in Idaho, the expiration of the ERM rebate to customers in Washington, increased decoupling revenues and a lower provision for earnings sharing. Natural gas revenues decreased primarily due to a decrease in wholesale activity (both a decrease in volumes and prices) and lower retail revenues due to lower prices, partially offset by higher natural gas heating volumes. The decreases in natural gas revenues were partially offset by general rate increases and higher decoupling revenues. Non-utility revenues decreased due to the long-term fixed rate electric capacity contract that was previously held by Spokane Energy being transferred to Avista Corp. during the second quarter of 2015. The capacity revenue from this contract was included in non-utility revenues when it was held by Spokane Energy during the first quarter of 2015. After the transfer, the revenue is included in Avista Utilities' revenues. The contract expired during December 2016. Utility resource costs decreased due to a decrease at Avista Utilities. Avista Utilities' electric resource costs decreased primarily due to a decrease in purchased power (from lower volumes purchased and lower wholesale prices) and a decrease in fuel for generation (due in part to increased hydroelectric generation). Natural gas resource costs decreased due to a decrease in natural gas purchased resulting from lower volumes and lower prices. Utility operating expenses increased due to an increase at Avista Utilities and a slight increase at AEL&P. Avista Utilities' portion of other operating expenses increased due to an increase in medical costs of $3.0 million, electric generation operating and maintenance expenses of $6.8 million, natural gas distribution expenses of $2.2 million and other postretirement benefit expenses of $2.0 million. Utility depreciation and amortization increased $17.0 million driven by additions to utility plant. Income tax expense increased primarily due to an increase in income before income taxes, partially offset by excess tax benefits of $1.6 million during 2016 relating to the settlement of share-based payment awards. See "Note 2 of the Notes to Consolidated Financial Statements" for further discussion of the excess tax benefits. Our effective tax rate was 36.3 percent for both 2016 and 2015. Other was primarily related to an increase in interest expense, due to additional debt being outstanding during 2016 as compared to 2015 and partially due to an increase in the overall interest rate. Also, there were losses on investments at our subsidiaries, mainly due to initial organization costs and management fees associated with a new investment. AVISTA CORPORATION 2015 compared to 2014 The following graph shows the total change in net income from continuing operations for the year ended December 31, 2014 to the year ended December 31, 2015, as well as the various factors that caused such change (dollars in millions): Utility revenues increased due to an increase at AEL&P, partially offset by a decrease at Avista Utilities. AEL&P's revenues increased $23.1 million due to a full year of AEL&P results in 2015 as compared to six months in 2014. Avista Utilities' electric revenues decreased due to lower loads from warmer weather, which were partially offset by the decoupling mechanism in Washington, a general rate increase in Washington and a decrease in the provision for earnings sharing (which is an offset to revenue). Avista Utilities' natural gas revenues decreased due to lower heating loads from significantly warmer weather that was partially offset by the decoupling mechanism in Washington and general rate increases. Other non-utility revenues decreased primarily due to the long-term fixed rate electric capacity contract that was previously held by Spokane Energy being transferred to Avista Corp. during the second quarter of 2015. The capacity revenue from this contract was included in non-utility revenues when it was held by Spokane Energy. After the transfer, the revenue is included in Avista Utilities' revenues. Utility resource costs decreased due to a decrease at Avista Utilities, partially offset by an increase at AEL&P. AEL&P's resource costs increased $6.1 million due to a full year of AEL&P results in 2015 as compared to six months in 2014. Avista Utilities' electric resource costs decreased primarily due to a decrease in purchased power (from lower volumes purchased, partially offset by higher wholesale prices) and a decrease in other fuel costs. Natural gas resource costs decreased due to a decrease in natural gas purchased resulting from lower prices, partially offset by higher volumes. Utility operating expenses increased due to an increase at Avista Utilities and at AEL&P. Avista Utilities' portion of other operating expenses increased $11.1 million and AEL&P's other operating expenses increased $5.3 million due to a full year of AEL&P results in 2015 as compared to six months in 2014. Avista Utilities incurred increased generation, transmission and distribution operating expenses of $5.7 million, increased administrative and general wages of $9.8 million and increased pension and other post-retirement benefit expenses of $10.0 million. In addition, Avista Utilities incurred incremental storm restoration costs associated with the November 2015 wind storm of approximately $2.9 million. These increases were partially offset by decreases in outside services and generation maintenance of $7.8 million. Utility depreciation and amortization increased due to additions to utility plant and the inclusion of a full year of AEL&P depreciation as compared to only six months of AEL&P in 2014. Income tax expense decreased and our effective tax rate was 36.3 percent for 2015 compared to 37.6 percent for 2014. The decrease in expense was primarily due to a decrease in income before income taxes. Other was primarily related to an increase in interest expense, due to additional debt being outstanding during 2015 as compared to 2014. Also, there were losses on investments at our subsidiaries. AVISTA CORPORATION Non-GAAP Financial Measures The following discussion for Avista Utilities includes two financial measures that are considered “non-GAAP financial measures,” electric gross margin and natural gas gross margin. In the AEL&P section, we include a discussion of electric gross margin, which is also a non-GAAP financial measure. Generally, a non-GAAP financial measure is a numerical measure of a company's financial performance, financial position or cash flows that excludes (or includes) amounts that are included (excluded) in the most directly comparable measure calculated and presented in accordance with GAAP. The presentation of electric gross margin and natural gas gross margin is intended to supplement an understanding of operating performance. We use these measures to determine whether the appropriate amount of revenue is being collected from our customers to allow for the recovery of energy resource costs and operating costs, as well as to analyze how changes in loads (due to weather, economic or other conditions), rates, supply costs and other factors impact our results of operations. In addition, we present electric and natural gas gross margin separately below for Avista Utilities since each business has different cost sources, cost recovery mechanisms and jurisdictions, such that separate analysis is beneficial. These measures are not intended to replace income from operations as determined in accordance with GAAP as an indicator of operating performance. The calculations of electric and natural gas gross margins are presented below. Results of Operations - Avista Utilities 2016 compared to 2015 The following table presents Avista Utilities' operating revenues, resource costs and resulting gross margin for the years ended December 31 (dollars in millions): The gross margin on electric sales increased $39.4 million and the gross margin on natural gas sales increased $27.0 million. The increase in electric gross margin was primarily due to general rate increases, lower resource costs, the implementation of decoupling in Idaho and a $6.6 million decrease in the provision for earnings sharing (which is an offset to revenue), partially offset by lower electric loads. The weather was warmer than the prior year in April and May (which decreased electric heating loads) and cooler than the prior year June through August (which decreased electric cooling loads). This was partially offset by the effect of weather that was cooler than the prior year in the first and fourth quarters (which increased electric heating loads). Overall, weather was warmer than normal for most of the year. Retail electric loads decreased as compared to prior year and the impact as compared to normal was mostly offset by decoupling mechanisms. See the table below for a comparison of the amounts recorded for decoupling by jurisdiction. For 2016, we recognized a pre-tax benefit of $5.1 million under the ERM in Washington compared to a benefit of $6.3 million for 2015. The increase in natural gas gross margin was primarily due to general rate increases in each of our jurisdictions, lower natural gas resources costs, the implementation of decoupling mechanisms in Idaho and Oregon, and higher natural gas retail loads. Weather was cooler in the first quarter (which increased natural gas heating loads), warmer in April and May (which reduced natural gas heating loads) and cooler in the fourth quarter (which increased natural gas heating loads) as compared to the prior year. The period June through September typically does not have significant natural gas retail loads. Overall, retail natural gas loads increased as compared to prior year and the impact as compared to normal (lower loads) was mostly offset by decoupling mechanisms. See the table below for a comparison of the amounts recorded for decoupling by jurisdiction. Intracompany revenues and resource costs represent purchases and sales of natural gas between our natural gas distribution operations and our electric generation operations (as fuel for our generation plants). These transactions are eliminated in the presentation of total results for Avista Utilities and in the condensed consolidated financial statements but are included in the separate results for electric and natural gas presented below. AVISTA CORPORATION The following graphs present Avista Utilities' electric operating revenues and megawatt-hour (MWh) sales for the years ended December 31 (dollars in millions and MWhs in thousands): (1) Other electric revenues in the graph above includes public street and highway lighting, which is considered part of retail electric revenues. AVISTA CORPORATION The following table presents Avista Utilities' decoupling and customer earnings sharing mechanisms by jurisdiction that are included in utility electric operating revenues for the years ended December 31 (dollars in thousands): (1) The provision for earnings sharing in Washington in 2016 resulted from a $2.5 million reduction in the 2015 provision for earnings sharing (which increased 2016 revenues) offset by a $2.3 million provision for earnings sharing for 2016 electric operations. (2) The provision for earnings sharing in Idaho in 2016 resulted from a reduction in the 2015 provision for earnings sharing (which increased 2016 revenues). Beginning in 2016 there is no longer an earnings sharing mechanism in Idaho. (n/a) This mechanism did not exist during this time period. Total electric revenues decreased $0.9 million for 2016 as compared to 2015, affected by the following: • a $3.0 million decrease in retail electric revenues due to a decrease in total MWhs sold (decreased revenues $9.5 million), partially offset by an increase in revenue per MWh (increased revenues $6.5 million). ◦ The increase in revenue per MWh was primarily due to a general rate increase in Idaho and the expiration of the ERM rebate to customers in Washington, partially offset by a general rate decrease in Washington. ◦ The decrease in total retail MWhs sold was the result of weather that was cooler in the first quarter (higher electric heating loads), warmer in April and May (lower electric heating loads), cooler June through August (lower electric cooling loads) and cooler in the fourth quarter (higher electric heating loads) as compared to the prior year (which overall decreased electric loads). Compared to 2015, residential electric use per customer decreased 1 percent and commercial use per customer decreased 1 percent. Heating degree days in Spokane were 11 percent below normal and 3 percent above 2015. The impact from increased heating loads was offset by decreased cooling loads in the summer. 2016 cooling degree days were 29 percent above normal (mostly in June). However, cooling degree days were 41 percent below the prior year. The overall decrease in use per customer was partially offset by growth in the number of customers. ◦ There has been a decline in residential use per customer during the last three years and is primarily due to weather fluctuations but also due in part to energy efficiency measures adopted by customers. See "Item 1. Business - Avista Utilities Operating Statistics" for the three-year summary of residential use per customer. • a $15.2 million decrease in wholesale electric revenues due to a decrease in sales volumes (decreased revenues $5.5 million) and a decrease in sales prices (decreased revenues $9.7 million). The fluctuation in volumes and prices was primarily the result of our optimization activities. • a $4.6 million decrease in sales of fuel due to a decrease in sales of natural gas fuel as part of thermal generation resource optimization activities. For 2016, $44.0 million of these sales were made to our natural gas operations and are included as intracompany revenues and resource costs. For 2015, $50.0 million of these sales were made to our natural gas operations. • a $12.6 million increase in electric revenue due to decoupling, which reflected the implementation of a decoupling mechanism in Idaho effective January 1, 2016 and lower retail revenues in 2016 as compared to 2015. • a $6.6 million decrease in the electric provision for earnings sharing (which increases revenues) due to a $2.5 million reduction in the 2015 provision for earnings sharing in Washington and a $0.7 million reduction in the 2015 provision for earnings sharing in Idaho recorded in 2016. For 2016 electric operations, we recorded a $2.3 million provision for earnings sharing. AVISTA CORPORATION The following graphs present Avista Utilities' natural gas operating revenues and therms delivered for the years ended December 31 (dollars in millions and therms in thousands): (1) Other natural gas revenues in the graph above includes interruptible and industrial revenues, which are considered part of retail natural gas revenues. AVISTA CORPORATION The following table presents Avista Utilities' decoupling and customer earnings sharing mechanisms by jurisdiction that are included in utility natural gas operating revenues for the years ended December 31 (dollars in thousands): (n/a) This mechanism did not exist during this time period. Total natural gas revenues decreased $50.1 million for 2016 as compared to 2015 due to the following: • a $3.4 million decrease in retail natural gas revenues due to lower retail rates (decreased revenues $18.4 million), partially offset by an increase in volumes (increased revenues $15.0 million). ◦ Lower retail rates were due to PGAs, which passed through lower costs of natural gas, partially offset by general rate increases. ◦ We sold more retail natural gas in 2016 as compared to 2015 primarily due to cooler weather in the first and fourth quarters, as well as customer growth. Compared to 2015, residential use per customer increased 5 percent and commercial use per customer increased 3 percent. Heating degree days in Spokane were 11 percent below historical average for 2016, and 3 percent above 2015. Heating degree days in Medford were 12 percent below historical average for 2016, and 3 percent above 2015. • a $50.8 million decrease in wholesale natural gas revenues due to a decrease in prices (decreased revenues $22.8 million) and a decrease in volumes (decreased revenues $28.0 million). In 2016, $51.2 million of these sales were made to our electric generation operations and are included as intracompany revenues and resource costs. In 2015, $57.0 million of these sales were made to our electric generation operations. Differences between revenues and costs from sales of resources in excess of retail load requirements and from resource optimization are accounted for through the PGA mechanisms. • a $6.3 million increase for natural gas decoupling revenues due primarily to the implementation of decoupling mechanisms in Idaho and Oregon, as well as an increase in the decoupling surcharge in Washington. • a $2.8 million increase in the provision for earnings sharing (which decreases revenues) representing the 2016 provision for Washington natural gas operations. The following table presents Avista Utilities' average number of electric and natural gas retail customers for the years ended December 31: AVISTA CORPORATION The following graphs present Avista Utilities' resource costs for the years ended December 31 (dollars in millions): Total resource costs in the graphs above include intracompany resource costs of $95.2 million and $107.0 million for 2016 and 2015, respectively. Total electric resource costs decreased $40.3 million for 2016 as compared to 2015 due to the following: • a $26.1 million decrease in power purchased due to a decrease in the volume of power purchases (decreased costs $9.3 million) and a decrease in wholesale prices (decreased costs $16.8 million). The fluctuation in volumes and prices was primarily the result of our optimization activities. • a $14.8 million decrease in fuel for generation primarily due to a decrease in thermal generation (due in part to increased hydroelectric generation) and a decrease in natural gas fuel prices. • a $7.5 million decrease in other fuel costs. • a $3.0 million decrease from amortizations and deferrals of power costs. • a $5.6 million increase in other electric resource costs primarily due to a benefit that was recorded during 2015 related AVISTA CORPORATION to a capacity contract of Spokane Energy. This benefit was mostly deferred for probable future benefit to customers through the ERM and PCA. • a $5.4 million increase in other regulatory amortizations. Total natural gas resource costs decreased $77.1 million for 2016 as compared to 2015 due to following: • an $80.1 million decrease in natural gas purchased due to a decrease in the price of natural gas (decreased costs $52.6 million) and a decrease in total therms purchased (decreased costs $27.5 million). Total therms purchased decreased due to a decrease in wholesale sales, partially offset by an increase in retail sales. • a $1.6 million decrease from amortizations and deferrals of natural gas costs. This reflects lower natural gas prices and the deferral of lower costs for future rebate to customers, as well as current rebates to customers through PGAs. • a $4.6 million increase in other regulatory amortizations. 2015 compared to 2014 The following graphs presents Avista Utilities' operating revenues, resource costs and resulting gross margin for the years ended December 31 (dollars in millions): The gross margin on electric sales increased $16.5 million and the gross margin on natural gas sales increased $9.2 million. The increase in electric gross margin was primarily due to a general rate increase in Washington, lower net power supply costs and a $1.9 million decrease in the provision for earnings sharing (which is an offset to revenue). We experienced weather that was significantly warmer than normal and warmer than the prior year, which decreased heating loads in the first quarter and increased cooling loads in the second quarter. Loads in the third quarter were slightly higher than the prior year. Loads for the fourth quarter were lower than the prior year, particularly for residential and industrial customers. For 2015, the decoupling mechanism in Washington had a positive effect on each of electric revenues and gross margin as did the decrease in the overall provision for earnings sharing (see the details by jurisdiction in the table below). For 2015, we recognized a pre-tax benefit of $6.3 million under the ERM in Washington compared to a benefit of $5.4 million for 2014. This change represents a decrease in net power supply costs primarily due to lower natural gas fuel and purchased power prices in 2015, partially offset by lower hydroelectric generation (due to warm and dry conditions in the second and third quarters). The increase in natural gas gross margin was primarily due to a decrease in natural gas resource costs and a decrease in the provision for earnings sharing, partially offset by a decrease in natural gas revenues. The decrease in natural gas revenues resulted from lower heating loads primarily from significantly warmer weather that was partially offset by general rate increases. The earnings impact of the decrease in heating loads was partially offset by the decoupling mechanism in Washington, which had a positive effect on natural gas revenues and gross margin (see the details by jurisdiction in the table below). Intracompany revenues and resource costs represent purchases and sales of natural gas between our natural gas distribution operations and our electric generation operations (as fuel for our generation plants). These transactions are eliminated in the presentation of total results for Avista Utilities and in the consolidated financial statements but are reflected in the presentation of the separate results for electric and natural gas below. AVISTA CORPORATION The following graphs present Avista Utilities' electric operating revenues and megawatt-hour (MWh) sales for the years ended December 31 (dollars in millions and MWhs in thousands): (1) Other electric revenues in the graph above includes public street and highway lighting, which is considered part of retail electric revenues. AVISTA CORPORATION The following table presents Avista Utilities' decoupling and customer earnings sharing mechanisms by jurisdiction that are included in utility electric operating revenues for the years ended December 31 (dollars in thousands): (n/a) This mechanism did not exist during this time period. Total electric revenues decreased $1.1 million for 2015 as compared to 2014, affected by the following: • a $5.7 million increase in retail electric revenues due to an increase in revenue per MWh (increased revenues $21.0 million), partially offset by a decrease in total MWhs sold (decreased revenues $15.3 million). The increase in revenue per MWh was primarily due to a general rate increase in Washington. The decrease in total MWhs sold was primarily the result of weather that was significantly warmer than normal and warmer than the prior year, which decreased the electric heating load in the first quarter. Compared to 2014, residential electric use per customer decreased 5 percent and commercial use per customer decreased 2 percent. Heating degree days in Spokane were 14 percent below normal and 10 percent below 2014. The impact from reduced heating loads was partially offset by increased cooling loads in the summer. Year-to-date cooling degree days were 141 percent above normal and 28 percent above the prior year. • a $10.9 million decrease in wholesale electric revenues due to a decrease in sales volumes (decreased revenues $21.9 million), partially offset by an increase in sales prices (increased revenues $11.0 million). The fluctuation in volumes and prices was primarily the result of our optimization activities. • a $0.9 million decrease in sales of fuel due to a decrease in sales of natural gas fuel as part of thermal generation resource optimization activities. For 2015, $50.0 million of these sales were made to our natural gas operations and are included as intracompany revenues and resource costs. For 2014, $67.4 million of these sales were made to our natural gas operations. • a $4.7 million increase in electric revenue due to decoupling, which reflected decreased heating loads in the first and fourth quarters, partially offset by increased cooling loads in the second and third quarters. • a $1.9 million decrease in the provision for earnings sharing, primarily due to a decrease of $5.3 million for our Idaho electric operations, partially offset by an increase of $3.4 million for our Washington electric operations. In 2014, we recorded a provision for earnings sharing of $7.5 million for Idaho electric customers with $5.6 million representing our estimate for 2014 and $1.9 million representing an adjustment to our 2013 estimate. AVISTA CORPORATION The following graphs present Avista Utilities' natural gas operating revenues and therms delivered for the years ended December 31 (dollars in millions and therms in thousands): (1) Other natural gas revenues in the graph above includes interruptible and industrial revenues, which are considered part of retail natural gas revenues. AVISTA CORPORATION The following table presents Avista Utilities' decoupling and customer earnings sharing mechanisms by jurisdiction that are included in utility natural gas operating revenues for the years ended December 31 (dollars in thousands): (n/a) This mechanism did not exist during this time period. Total natural gas revenues decreased $35.7 million for 2015 as compared to 2014 due to the following: • a $16.4 million decrease in retail natural gas revenues due to a decrease in volumes (decreased revenues $23.6 million), partially offset by higher retail rates (increased revenues $7.2 million). Higher retail rates were due to PGAs implemented in November 2014, which passed through higher costs of natural gas, and general rate cases. This was partially offset by PGA rate decreases implemented in November 2015, which passed through lower costs. We sold less retail natural gas in 2015 as compared to 2014 primarily due to weather that was warmer than normal and warmer than the prior year. Compared to 2014, residential use per customer decreased 9 percent and commercial use per customer decreased 9 percent. Heating degree days in Spokane were 14 percent below historical average for 2015, and 10 percent below 2014. Heating degree days in Medford were 15 percent below historical average for 2015, and 4 percent above 2014. • a $23.9 million decrease in wholesale natural gas revenues due to a decrease in prices (decreased revenues $90.4 million), partially offset by an increase in volumes (increased revenues $66.5 million). In 2015, $57.0 million of these sales were made to our electric generation operations and are included as intracompany revenues and resource costs. In 2014, $74.7 million of these sales were made to our electric generation operations. Differences between revenues and costs from sales of resources in excess of retail load requirements and from resource optimization are accounted for through the PGA mechanisms. • a $6.0 million increase for natural gas decoupling revenues due primarily to significantly warmer than normal weather and the impact on heating loads. The following table presents Avista Utilities' average number of electric and natural gas retail customers for the years ended December 31: AVISTA CORPORATION The following graphs present Avista Utilities' resource costs for the years ended December 31 (dollars in millions): Total resource costs in the graphs above include intracompany resource costs of $107.0 million and $142.2 million for 2015 and 2014, respectively. Total electric resource costs decreased $17.6 million for 2015 as compared to 2014 due to the following: • an $18.3 million decrease in power purchased due to a decrease in the volume of power purchases (decreased costs $23.6 million), partially offset by an increase in wholesale prices (increased costs $5.3 million). The fluctuation in volumes and prices was primarily the result of our overall optimization activities. • a $4.4 million increase in fuel for generation primarily due to an increase in thermal generation (due in part to decreased hydroelectric generation), partially offset by a decrease in natural gas fuel prices. • a $10.0 million decrease in other fuel costs. • a $14.2 million increase from amortizations and deferrals of power costs. • a $7.7 million decrease in other electric resource costs primarily due to the benefit from a capacity contract of Spokane AVISTA CORPORATION Energy, which was mostly deferred for probable future benefit to customers through the ERM and PCA. Total natural gas resource costs decreased $44.9 million for 2015 as compared to 2014 due to the following: • a $66.1 million decrease in natural gas purchased due to a decrease in the price of natural gas (decreased costs $138.3 million), partially offset by an increase in total therms purchased (increased costs $72.2 million). Total therms purchased increased due to an increase in wholesale sales, partially offset by a decrease in retail sales. • a $21.8 million increase from amortizations and deferrals of natural gas costs. This reflects lower natural gas prices and the deferral of lower costs for future rebate to customers. Results of Operations - Alaska Electric Light and Power Company AEL&P was acquired on July 1, 2014 and only the results for the second half of 2014 are included in the actual overall results of Avista Corp. The discussion below is only for AEL&P's earnings that were included in Avista Corp.'s overall earnings. 2016 compared to 2015 Net income for AEL&P was $8.0 million for the year ended December 31, 2016, compared to $6.6 million for 2015. The increase in earnings for 2016 was primarily due to an increase in gross margin and an increase in equity-related AFUDC (increased earnings) due to the construction of an additional back-up generation plant which was completed during the fourth quarter of 2016. The increase in gross margin was primarily related to a decrease in costs associated with the Snettisham hydroelectric project (due to a refinancing transaction during the second half of 2015 which lowered interest costs under the take-or-pay power purchase agreement), as well as an interim rate increase effective in November 2016. These were partially offset by a slight decrease in sales volumes to commercial and government customers and an increase in other resource costs. AEL&P has a relatively stable load profile as it does not have a large population of customers in its service territory with electric heating and cooling requirements; therefore, its revenues are not as sensitive to weather fluctuations as Avista Utilities. However, AEL&P does have higher winter rates for its customers during the peak period of November through May of each year, which drives higher revenues during those periods. 2015 compared to 2014 Net income for AEL&P was $6.6 million for the year ended December 31, 2015, compared to $3.2 million for the second half of 2014. Since AEL&P was acquired on July 1, 2014, the results for 2015 are not comparable to 2014 as 2014 only includes results for the second half of the year. Results of Operations - Ecova - Discontinued Operations Ecova was disposed of as of June 30, 2014. As a result, in accordance with GAAP, all of Ecova's operating results were removed from each line item on the Consolidated Statements of Income and reclassified into discontinued operations for all periods presented. In addition, since Ecova was a subsidiary of Avista Capital, the net gain recognized on the sale of Ecova was attributable to our other businesses. However, in accordance with GAAP, this gain is included in discontinued operations; therefore, we included the analysis of the gain in the Ecova discontinued operations section rather than in the other businesses section. 2016 compared to 2015 and 2014 There was zero net income or loss for 2016. Ecova's net income was $5.1 million for 2015, compared to net income of $72.4 million for 2014. The net income for 2015 was primarily related to a tax benefit during 2015 that resulted from the reversal of a valuation allowance against net operating losses at Ecova because the net operating losses were deemed realizable under the current tax code. Additionally, there were some minor true-ups to the gain recognized on the sale due to the settlement of the working capital and indemnification escrow accounts during 2015. The results for 2014 included $69.7 million of the net gain recognized on the sale of Ecova. Results of Operations - Other Businesses 2016 compared to 2015 The net loss from these operations was $3.2 million for 2016 compared to a net loss of $1.9 million for 2015. Net losses for 2016 were primarily related an increase in losses on investments due to initial organization costs and management fees associated with a new investment, as well as an impairment recorded on a building we own. This was partially offset by a slight decrease in corporate costs (including costs associated with exploring strategic opportunities) and a slight increase in net income at METALfx for the year-to-date. AVISTA CORPORATION 2015 compared to 2014 The net loss from these operations was $1.9 million for 2015 compared to net income of $3.2 million for 2014. The decrease in net income compared to 2014 was primarily due to the settlement of the California power markets litigation in 2014, where Avista Energy received settlement proceeds from a litigation with various California parties related to the prices paid for power in the California spot markets during the years 2000 and 2001. This settlement resulted in an increase in pre-tax earnings of approximately $15.0 million. This was partially offset by a pre-tax contribution of $6.4 million of the proceeds to the Avista Foundation. In addition, the decrease in earnings for 2015 related to an increase in net losses on investments, partially offset by an increase in net income at METALfx and a slight decrease in corporate costs, including costs associated with exploring strategic opportunities. Accounting Standards to be Adopted in 2017 At this time, we are not expecting the adoption of accounting standards to have a material impact on our financial condition, results of operations and cash flows in 2017. However, we will be adopting ASU No. 2014-09 "Revenue from Contracts with Customers (Topic 606)" in 2018 upon its effective date. This is a significant new accounting standard that requires an extensive amount of time and effort to implement. We currently expect to use a modified retrospective method of adoption, which would require a cumulative adjustment to opening retained earnings, as opposed to a full retrospective application. The Company is not far enough along in the adoption process to determine the amount, if any, of cumulative adjustment necessary. Since the vast majority of Avista Corp.’s revenue is from rate regulated sales of electricity and natural gas to retail customers and revenue is recognized as energy is delivered to these customers, we do not expect a significant change in operating revenues or net income due to adopting this standard. The Company is in the process of reviewing and analyzing certain contracts with customers (most of which are related to wholesale sales of power and natural gas) but has not yet identified any significant differences in revenue recognition between current GAAP and the new revenue recognition standard. There are unresolved issues associated with implementing this standard, including the presentation of CIACs, the presentation of utility taxes on a gross basis and determining collectibility of sales to low income customers. We are monitoring utility industry implementation guidance as it relates to unresolved issues to determine if there will be an industry consensus regarding accounting and presentation of these items. For information on accounting standards adopted in 2016 and accounting standards expected to be adopted in future periods, see “Note 2 of the Notes to Consolidated Financial Statements.” Critical Accounting Policies and Estimates The preparation of our consolidated financial statements in conformity with GAAP requires us to make estimates and assumptions that affect amounts reported in the consolidated financial statements. Changes in these estimates and assumptions are considered reasonably possible and may have a material effect on our consolidated financial statements and thus actual results could differ from the amounts reported and disclosed herein. The following accounting policies represent those that our management believes are particularly important to the consolidated financial statements and require the use of estimates and assumptions: • Regulatory accounting, which requires that certain costs and/or obligations be reflected as deferred charges on our Consolidated Balance Sheets and are not reflected in our Consolidated Statements of Income until the period during which matching revenues are recognized. We also have decoupling revenue deferrals. As opposed to cost deferrals which are not recognized in the Consolidated Statements of Income until they are included in rates, decoupling revenue is recognized in the Consolidated Statements of Income during the period in which it occurs (i.e. during the period of revenue shortfall or excess due to fluctuations in customer usage), subject to certain limitations, and a regulatory asset/liability is established which will be surcharged or rebated to customers in future periods. GAAP requires that for any alternative regulatory revenue program, like decoupling, the revenue must be expected to be collected from customers within 24 months of the deferral to qualify for recognition in the current period Consolidated Statement of Income. Any amounts included in the Company's decoupling program that are not expected to be collected from customers within 24 months are not recorded in the financial statements until the period in which revenue recognition criteria are met. This could ultimately result in more decoupling revenue being collected from customers over the life of the decoupling program than what is deferred and recognized in the current period financial statements. We make estimates regarding the amount of revenue that will be collected within 24 months of deferral. We also make the assumption that there are regulatory precedents for many of our regulatory items and that we will be AVISTA CORPORATION allowed recovery of these costs via retail rates in future periods. If we were no longer allowed to apply regulatory accounting or no longer allowed recovery of these costs, we could be required to recognize significant write-offs of regulatory assets and liabilities in the Consolidated Statements of Income. See "Notes 1 and 20 of the Notes to Consolidated Financial Statements" for further discussion of our regulatory accounting policy. • Utility energy commodity derivative asset and liability accounting, where we estimate the fair value of outstanding commodity derivatives and we offset energy commodity derivative assets or liabilities with a regulatory asset or liability. This accounting treatment is intended to defer the recognition of mark-to-market gains and losses on energy commodity transactions until the period of delivery. This accounting treatment is supported by accounting orders issued by the UTC and IPUC. If we were no longer allowed to apply regulatory accounting or no longer allowed recovery of these costs, we could be required to recognize significant changes in fair value of these energy commodity derivatives on a regular basis in the Consolidated Statements of Income, which could lead to significant fluctuations in net income. See "Notes 1 and 6 of the Notes to Consolidated Financial Statements" for further discussion of our energy derivative accounting policy. • Interest rate swap derivative asset and liability accounting, where we estimate the fair value of outstanding interest rate swap derivatives, and U.S. Treasury lock agreements and offset the derivative asset or liability with a regulatory asset or liability. This is similar to the treatment of energy commodity derivatives described above. Upon settlement of interest rate swap derivatives, the regulatory asset or liability is amortized as a component of interest expense over the term of the associated debt. If we no longer applied regulatory accounting or were no longer allowed recovery of these costs, we could be required to recognize significant changes in fair value of these interest rate swap derivatives on a regular basis in the Consolidated Statements of Income, which could lead to significant fluctuations in net income. • Pension Plans and Other Postretirement Benefit Plans, discussed in further detail below. • Contingencies, related to unresolved regulatory, legal and tax issues for which there is inherent uncertainty for the ultimate outcome of the respective matter. We accrue a loss contingency if it is probable that an asset is impaired or a liability has been incurred and the amount of the loss or impairment can be reasonably estimated. We also disclose losses that do not meet these conditions for accrual, if there is a reasonable possibility that a potential loss may be incurred. For all material contingencies, we have made a judgment as to the probability of a loss occurring and as to whether or not the amount of the loss can be reasonably estimated. If the loss recognition criteria are met, liabilities are accrued or assets are reduced. However, no assurance can be given to the ultimate outcome of any particular contingency. See "Notes 1 and 19 of the Notes to Consolidated Financial Statements" for further discussion of our commitments and contingencies. Pension Plans and Other Postretirement Benefit Plans - Avista Utilities We have a defined benefit pension plan covering substantially all regular full-time employees at Avista Utilities that were hired prior to January 1, 2014. For substantially all regular non-union full-time employees at Avista Utilities who were hired on or after January 1, 2014, a defined contribution 401(k) plan replaced the defined benefit pension plan. The Finance Committee of the Board of Directors approves investment policies, objectives and strategies that seek an appropriate return for the pension plan and it reviews and approves changes to the investment and funding policies. We have contracted with an independent investment consultant who is responsible for managing/monitoring the individual investment managers. The investment managers’ performance and related individual fund performance is reviewed at least quarterly by an internal benefits committee and by the Finance Committee to monitor compliance with our established investment policy objectives and strategies. Our pension plan assets are invested in debt securities and mutual funds, trusts and partnerships that hold marketable debt and equity securities, real estate and absolute return funds. In seeking to obtain the desired return to fund the pension plan, the investment consultant recommends allocation percentages by asset classes. These recommendations are reviewed by the internal benefits committee, which then recommends their adoption by the Finance Committee. The Finance Committee has established target investment allocation percentages by asset classes and also investment ranges for each asset class. The target investment allocation percentages are typically the midpoint of the established range. During 2016, we revised the target investment allocation percentages. See “Note 10 of the Notes to Consolidated Financial Statements” for the target investment allocation percentages and further discussion of the revision. AVISTA CORPORATION We also have a Supplemental Executive Retirement Plan (SERP) that provides additional pension benefits to our executive officers and others whose benefits under the pension plan are reduced due to the application of Section 415 of the Internal Revenue Code of 1986 and the deferral of salary under deferred compensation plans. Pension costs (including the SERP) were $26.8 million for 2016, $27.1 million for 2015 and $14.6 million for 2014. Of our pension costs, approximately 60 percent are expensed and 40 percent are capitalized consistent with labor charges. The costs related to the SERP are expensed. Our costs for the pension plan are determined in part by actuarial formulas that are dependent upon numerous factors resulting from actual plan experience and assumptions of future experience. Pension costs are affected by among other things: • employee demographics (including age, compensation and length of service by employees), • the amount of cash contributions we make to the pension plan, • the actual return on pension plan assets, • expected return on pension plan assets, • discount rate used in determining the projected benefit obligation and pension costs, • assumed rate of increase in employee compensation, • life expectancy of participants and other beneficiaries, and • expected method of payment (lump sum or annuity) of pension benefits. Any changes in pension plan obligations associated with these factors may not be immediately recognized as pension costs in our Consolidated Statement of Income, but we generally recognize the change in future years over the remaining average service period of pension plan participants. As such, our costs recorded in any period may not reflect the actual level of cash benefits provided to pension plan participants. We revise the key assumption of the discount rate each year. In selecting a discount rate, we consider yield rates at the end of the year for highly rated corporate bond portfolios with cash flows from interest and maturities similar to that of the expected payout of pension benefits. In 2016, the pension plan discount rate (exclusive of the SERP) was 4.26 percent compared to 4.58 percent in 2015 and 4.21 percent in 2014. These changes in the discount rate increased the projected benefit obligation (exclusive of the SERP) by approximately $27.7 million in 2016 and decreased the obligation by $31.0 million in 2015. The expected long-term rate of return on plan assets is reset or confirmed annually based on past performance and economic forecasts for the types of investments held by our plan. We used an expected long-term rate of return of 5.40 percent in 2016, 5.30 percent in 2015 and 6.60 percent in 2014. This change decreased pension costs by approximately $0.5 million in 2016. The actual return on plan assets, net of fees, was a gain of $43.2 million (or 8.1 percent) for 2016, a loss of $4.3 million (or 0.8 percent) for 2015 and a gain of $56.0 million (or 11.6 percent) for 2014. The following chart reflects the sensitivities associated with a change in certain actuarial assumptions by the indicated percentage (dollars in thousands): * Changes in the expected return on plan assets would not affect our projected benefit obligation. We provide certain health care and life insurance benefits for substantially all of our retired employees. We accrue the estimated cost of postretirement benefit obligations during the years that employees provide service. Assumed health care cost trend rates have a significant effect on the amounts reported for our postretirement plans. A one-percentage-point increase in the assumed health care cost trend rate for each year would increase our accumulated postretirement benefit obligation as of December 31, 2016 by $8.6 million and the service and interest cost by $1.0 million. A one-percentage-point decrease in the assumed health AVISTA CORPORATION care cost trend rate for each year would decrease our accumulated postretirement benefit obligation as of December 31, 2016 by $6.7 million and the service and interest cost by $0.7 million. Liquidity and Capital Resources Overall Liquidity Avista Corp.'s consolidated operating cash flows are primarily derived from the operations of Avista Utilities. The primary source of operating cash flows for Avista Utilities is revenues from sales of electricity and natural gas. Significant uses of cash flows from Avista Utilities include the purchase of power, fuel and natural gas, and payment of other operating expenses, taxes and interest, with any excess being available for other corporate uses such as capital expenditures and dividends. We design operating and capital budgets to control operating costs and to direct capital expenditures to choices that support immediate and long-term strategies, particularly for our regulated utility operations. In addition to operating expenses, we have continuing commitments for capital expenditures for construction and improvement of utility facilities. Our annual net cash flows from operating activities usually do not fully support the amount required for annual utility capital expenditures. As such, from time-to-time, we need to access long-term capital markets in order to fund these needs as well as fund maturing debt. See further discussion at “Capital Resources.” We periodically file for rate adjustments for recovery of operating costs and capital investments and to seek the opportunity to earn reasonable returns as allowed by regulators. In December 2016, the UTC issued an order related to our Washington electric and natural gas general rate cases that were originally filed with the UTC in February 2016. The UTC order denied the Company's proposed electric and natural gas rate increase requests totaling $43.0 million. If this order is not changed as a result of reconsideration, rehearing or judicial review, we expect it will have a negative impact on our net income in 2017. See further details in the section “Regulatory Matters.” For Avista Utilities, when power and natural gas costs exceed the levels currently recovered from retail customers, net cash flows are negatively affected. Factors that could cause purchased power and natural gas costs to exceed the levels currently recovered from our customers include, but are not limited to, higher prices in wholesale markets when we buy energy or an increased need to purchase power in the wholesale markets, and a lack of regulatory approval for higher authorized net power supply costs through general rate case decisions. Factors beyond our control that could result in an increased need to purchase power in the wholesale markets include, but are not limited to: • increases in demand (due to either weather or customer growth), • low availability of streamflows for hydroelectric generation, • unplanned outages at generating facilities, and • failure of third parties to deliver on energy or capacity contracts. Avista Utilities has regulatory mechanisms in place that provide for the deferral and recovery of the majority of power and natural gas supply costs. However, if prices rise above the level currently allowed in retail rates in periods when we are buying energy, deferral balances would increase, negatively affecting our cash flow and liquidity until such time as these costs, with interest, are recovered from customers. In addition to the above, Avista Utilities enters into derivative instruments to hedge our exposure to certain risks, including fluctuations in commodity market prices, foreign exchange rates and interest rates (for purposes of issuing long-term debt in the future). These derivative instruments often require collateral (in the form of cash or letters of credit) or other credit enhancements, or reductions or terminations of a portion of the contract through cash settlement, in the event of a downgrade in the Company's credit ratings or changes in market prices. In periods of price volatility, the level of exposure can change significantly. As a result, sudden and significant demands may be made against the Company's credit facilities and cash. See “Enterprise Risk Management - Demands for Collateral” below. We monitor the potential liquidity impacts of changes to energy commodity prices and other increased operating costs for our utility operations. We believe that we have adequate liquidity to meet such potential needs through our committed lines of credit. As of December 31, 2016, we had $245.6 million of available liquidity under the Avista Corp. committed line of credit and $25.0 million under the AEL&P committed line of credit. With our $400.0 million credit facility that expires in April 2021 and AEL&P's $25.0 million credit facility that expires in November 2019, we believe that we have adequate liquidity to meet our needs for the next 12 months. AVISTA CORPORATION Review of Consolidated Cash Flow Statement Overall During 2016, cash flows from operating activities were $358.3 million, proceeds from the issuance of long-term debt were $245.0 million (including a $70.0 million bridge loan that was repaid in December 2016), net proceeds from our committed line of credit were $15.0 million and we received $67.0 million from the issuance of common stock. Cash requirements included utility capital expenditures of $406.6 million, the payment of long-term debt of $163.2 million (including the $70.0 million bridge loan), dividends of $87.2 million and cash paid for the settlement of interest rate swap derivatives of $54.0 million. 2016 compared to 2015 Consolidated Operating Activities Net cash provided by operating activities was $358.3 million for 2016 compared to $375.6 million for 2015. The decrease in net cash provided by operating activities was primarily related to the cash settlement of interest rate swap derivatives in the third quarter of 2016 totaling $54.0 million. The interest rate swap derivatives were settled in connection with the pricing of first mortgage bonds that were issued in December 2016. In addition, our accounts receivable balances increased during 2016 (which reduces operating cash flow), due to higher sales during the fourth quarter of 2016 due to colder weather as compared to the fourth quarter of 2015 and due to the timing of collections. The cash flow decreases were partially offset by higher net income after non-cash adjustments of $446.4 million in 2016, compared to $392.3 million in 2015. There was also a decrease in collateral posted for derivative instruments in 2016 (primarily due to an increase in the fair value of outstanding energy commodity derivatives, which required less collateral) as compared to an increase in collateral posted during 2015. Pension contributions were $12.0 million for both 2016 and 2015. Net cash received from income tax refunds increased to $13.5 million for 2016 compared to $10.0 million for 2015. In addition, the income tax receivable increased $33.9 million in 2016. We are in a refund position with regards to income taxes because the Company generated a net operating loss for tax purposes in 2016 primarily due to bonus depreciation on utility plant placed in service during the year and the settlement of interest rate swaps. The Company intends to carryback the net operating loss against prior year tax returns and expects the net operating loss to be fully utilized through the carryback. Additionally, the Company generated $19.4 million of federal investment income tax credits in 2016; $9.6 million will be carried back against a prior tax return with the remaining $9.8 million to be carried forward to future federal tax periods. The provision for deferred income taxes was $124.5 million for 2016, compared to $51.8 million for 2015. The change in the provision for deferred income taxes was primarily related to deferred taxes on property, plant and equipment, investment tax credits associated with our capital projects, deferred taxes on the decoupling regulatory assets and deferred taxes on interest rate swap derivatives. Consolidated Investing Activities Net cash used in investing activities was $432.5 million for 2016, an increase compared to $387.8 million for 2015. During 2016, we paid $406.6 million for utility capital expenditures, compared to $393.4 million for 2015. In addition, during 2016, our subsidiaries disbursed $10.1 million for notes receivable to third parties and received $5.0 million in repayments on these notes receivable. Our subsidiaries also made $7.8 million in investments and purchased buildings and other property as investments for $5.3 million. During 2015, we received cash proceeds (related to the settlement of the escrow accounts) of $13.9 million from the sale of Ecova. Consolidated Financing Activities Net cash provided by financing activities was $72.2 million for 2016 compared to net cash provided of $0.5 million for 2015. In 2016 we had the following significant transactions: • borrowing of $70.0 million pursuant to a term loan agreement in August, which was used to repay a portion of the $90.0 million in first mortgage bonds that matured in August 2016, AVISTA CORPORATION • issuance and sale of $175.0 million of Avista Corp. first mortgage bonds in December 2016, the proceeds of which were used to repay the $70.0 million term loan, with the remainder being used to pay down a portion of our committed line of credit, • payment of $163.2 million for the redemption and maturity of long-term debt (including the $70.0 million term loan), • increase in cash dividends paid to $87.2 million (or $1.37 per share) for 2016 from $82.4 million (or $1.32 per share) for 2015, • $15.0 million net increase in the balance of our committed line of credit, and • issuance of $67.0 million of common stock (net of issuance costs). See below for a list of significant financing transactions occurring in 2015. 2015 compared to 2014 Consolidated Operating Activities Net cash provided by operating activities was $375.6 million for 2015 compared to $267.3 million for 2014. The increase in cash provided by operating activities was due to higher net income after non-cash adjustments of $392.3 million in 2015, compared to $348.2 million in 2014. The gross gain on the sale of Ecova of $0.8 million for 2015 is deducted in reconciling net income to net cash provided by operating activities. The cash proceeds from the sale (which includes the gross gain) is included in investing activities. This is compared to the gross gain recognized in 2014 of $160.6 million. Net cash used by certain current assets and liabilities was $4.1 million for 2015, compared to net cash used of $50.0 million for 2014. The net cash used during 2015 primarily reflects cash outflows from changes in accounts payable, collateral posted for derivative instruments and accounts receivable. This was partially offset by inflows from changes in natural gas stored and income taxes receivable. The provision for deferred income taxes was $51.8 million for 2015 compared to $144.3 million for 2014. The decrease in 2015 was primarily due to the combination of implementation by the Company of updated federal tax tangible property regulations and increased deductions related to bonus depreciation in 2014. Contributions to our defined benefit pension plan were $12.0 million for 2015 compared to $32.0 million in 2014. Net cash received for income taxes was $10.0 million for 2015 compared to net cash paid of $45.4 million for 2014. Consolidated Investing Activities Net cash used in investing activities was $387.8 million for 2015, an increase compared to $103.7 million for 2014. During 2015, we received cash proceeds (related to the settlement of the escrow accounts) of $13.9 million for the sale of Ecova. We received the majority of the proceeds ($229.9 million) from the sale of Ecova during 2014. The proceeds received in 2014 were used to pay off the balance of Ecova's long-term borrowings and make payments to option holders and noncontrolling interests (included in financing activities). We also used a portion of these proceeds to pay our $74.8 million tax liability associated with the gain on sale and to fund common stock repurchases. Utility property capital expenditures increased by $67.9 million for 2015 as compared to 2014. During 2014, we received $15.0 million in cash (net of cash paid) related to the acquisition of AERC. Consolidated Financing Activities Net cash provided by financing activities was $0.5 million for 2015 compared to net cash used of $224.0 million for 2014. In 2015 we had the following significant transactions: • issuance and sale of $100.0 million of Avista Corp. first mortgage bonds in December 2015, • payment of $2.9 million for the redemption and maturity of long-term debt, • cash dividends paid increased to $82.4 million (or $1.32 per share) for 2015 from $78.3 million (or $1.27 per share) for 2014, • issuance of $1.6 million of common stock (net of issuance costs), and • repurchase of $2.9 million of our common stock. In 2014, we had the following significant transactions: AVISTA CORPORATION • issuance of $150.0 million of long-term debt ($60.0 million of Avista Corp. first mortgage bonds, $75.0 million of AEL&P first mortgage bonds and a $15.0 million AERC unsecured note representing a term loan), • a decrease of $66.0 million in short-term borrowings on Avista Corp.’s committed line of credit, • a decrease of $46.0 million on Ecova's committed line of credit with $6.0 million in payments throughout the year and $40.0 million related to the close of the Ecova sale, • payment of $40.0 million for the redemption and maturity of long-term debt (primarily related to AEL&P paying off its existing debt), • cash payments of $54.2 million to noncontrolling interests and $20.9 million to stock option holders and redeemable noncontrolling interests of Ecova related to the Ecova sale in 2014, • issuance of $4.1 million of common stock (net of issuance costs) excluding issuances related to the acquisition of AERC. We issued $150.1 million of common stock to AERC shareholders, and this is reflected as a non-cash financing activity, • repurchase of $79.9 million of our common stock during 2014 using the proceeds from our sale of Ecova, and • a $16.2 million increase in cash related to the fluctuation in the balance of customer fund obligations at Ecova. Capital Resources Our consolidated capital structure, including the current portion of long-term debt and short-term borrowings, and excluding noncontrolling interests, consisted of the following as of December 31, 2016 and 2015 (dollars in thousands): Our shareholders’ equity increased $120.1 million during 2016 primarily due to net income, the issuance of common stock and stock compensation net of minimum tax withholdings, partially offset by dividends. We need to finance capital expenditures and acquire additional funds for operations from time to time. The cash requirements needed to service our indebtedness, both short-term and long-term, reduce the amount of cash flow available to fund capital expenditures, purchased power, fuel and natural gas costs, dividends and other requirements. Committed Lines of Credit Avista Corp. has a committed line of credit with various financial institutions in the total amount of $400.0 million. We exercised a two-year option in May 2016 to extend the maturity of the credit facility agreement to April 2021. As of December 31, 2016, we had $245.6 million of available liquidity under this line of credit. The Avista Corp. credit facility contains customary covenants and default provisions, including a covenant which does not permit our ratio of “consolidated total debt” to “consolidated total capitalization” to be greater than 65 percent at any time. As of December 31, 2016, we were in compliance with this covenant with a ratio of 52.9 percent. AEL&P has a $25.0 million committed line of credit that expires in November 2019. As of December 31, 2016, there were no borrowings or letters of credit outstanding under this credit facility. The AEL&P credit facility contains customary covenants and default provisions including a covenant which does not permit the ratio of “consolidated total debt at AEL&P” to “consolidated total capitalization at AEL&P,” (including the impact of the Snettisham obligation) to be greater than 67.5 percent at any time. As of December 31, 2016, AEL&P was in compliance with this covenant with a ratio of 55.6 percent. AVISTA CORPORATION Balances outstanding and interest rates of borrowings (excluding letters of credit) under Avista Corp.'s committed line of credit were as follows as of and for the year ended December 31 (dollars in thousands): As of December 31, 2016, Avista Corp. and its subsidiaries were in compliance with all of the covenants of their financing agreements, and none of Avista Corp.'s subsidiaries constituted a “significant subsidiary” as defined in Avista Corp.'s committed line of credit. Long-Term Debt Borrowings In August 2016, we entered into a term loan agreement with a commercial bank in the amount of $70.0 million with a maturity date of December 30, 2016. We borrowed the entire $70.0 million available under this agreement, which was used to repay a portion of the $90.0 million of first mortgage bonds that matured in August 2016. We repaid this term loan in its entirety in December using the proceeds from first mortgage bonds that were issued in December 2016. In December 2016, we issued and sold $175.0 million of 3.54 percent first mortgage bonds due in 2051 pursuant to a bond purchase agreement with institutional investors in the private placement market. In connection with the pricing of the first mortgage bonds in August 2016, the Company cash-settled seven interest rate swap derivatives (notional aggregate amount of $125.0 million) and paid a total of $54.0 million, which will be amortized as a component of interest expense over the life of the debt. The effective interest rate of the first mortgage bonds is 5.6 percent, including the effects of the settled interest rate swap derivatives and estimated issuance costs. The total net proceeds from the sale of the new bonds was used to repay the $70.0 million term loan and to repay a portion of the borrowings outstanding under our $400.0 million committed line of credit. Equity Transactions Stock Repurchase Programs During 2014 and 2015, Avista Corp.'s Board of Directors approved programs to repurchase shares of our outstanding common stock. The number of shares repurchased and the total cost of repurchases are disclosed in the Consolidated Statements of Equity and Redeemable Noncontrolling Interests. The average repurchase price was $31.57 in 2014 and $32.66 in 2015. All repurchased shares reverted to the status of authorized but unissued shares. We did not repurchase any of our outstanding common stock during 2016. Equity Issuances In March 2016, we entered into four separate sales agency agreements under which Avista Corp.’s sales agents may offer and sell up to 3.8 million new shares of Avista Corp.'s common stock, no par value, from time to time. The sales agency agreements expire on February 29, 2020. In 2016, 1.6 million shares were issued under these agreements resulting in total net proceeds of $65.3 million, leaving 2.2 million shares remaining to be issued. In 2016, we also issued $1.7 million (net of issuance costs) of common stock under the employee plans. 2017 Liquidity Expectations In the second half of 2017, we expect to issue approximately $110.0 million of long-term debt and up to $70.0 million of common stock in order to fund planned capital expenditures and maintain an appropriate capital structure. After considering the expected issuances of long-term debt and common stock during 2017, we expect net cash flows from operating activities, together with cash available under our committed line of credit agreements, to provide adequate resources to fund capital expenditures, dividends, and other contractual commitments. AVISTA CORPORATION Limitations on Issuances of Preferred Stock and First Mortgage Bonds We are restricted under our Restated Articles of Incorporation, as amended, as to the additional preferred stock we can issue. As of December 31, 2016, we could issue $1.5 billion of additional preferred stock at an assumed dividend rate of 6.3 percent. We are not planning to issue preferred stock. Under the Avista Corp. and the AEL&P Mortgages and Deeds of Trust securing Avista Corp.'s and AEL&P's first mortgage bonds (including Secured Medium-Term Notes), respectively, each entity may issue additional first mortgage bonds in an aggregate principal amount equal to the sum of: • 66-2/3 percent of the cost or fair value (whichever is lower) of property additions of that entity which have not previously been made the basis of any application under that entity's Mortgage, or • an equal principal amount of retired first mortgage bonds of that entity which have not previously been made the basis of any application under that entity's Mortgage, or • deposit of cash. However, Avista Corp. and AEL&P may not individually issue any additional first mortgage bonds (with certain exceptions in the case of bonds issued on the basis of retired bonds) unless the particular entity issuing the bonds has “net earnings” (as defined in the respective Mortgages) for any period of 12 consecutive calendar months out of the preceding 18 calendar months that were at least twice the annual interest requirements on that entity's mortgage securities at the time outstanding, including the first mortgage bonds to be issued, and on all indebtedness of prior rank. As of December 31, 2016, property additions and retired bonds would have allowed, and the net earnings test would not have prohibited, the issuance of $1.2 billion in aggregate principal amount of additional first mortgage bonds at Avista Corp. and $20.8 million at AEL&P. We believe that we have adequate capacity to issue first mortgage bonds to meet our financing needs over the next several years. Capital Expenditures We are making capital investments in generation, transmission and distribution systems to preserve and enhance service reliability for our customers and replace aging infrastructure. The following table summarizes our actual and expected capital expenditures as of and for the year ended December 31, 2016 (in thousands): (1) Actual annual capital expenditures per the Consolidated Statement of Cash Flows may differ from our expected annual accrual-basis capital expenditures due to the timing of cash payments, the capital expenditure amounts accrued in accounts payable at the end of each period and the inclusion of AFUDC in our expected amounts, but excluded from the cash flow amounts. Most of the capital expenditures at Avista Utilities are for upgrading our existing facilities and technology, and not for construction of new facilities. AVISTA CORPORATION The following graph shows the Avista Utilities' capital budget for 2017: These estimates of capital expenditures are subject to continuing review and adjustment. Actual capital expenditures may vary from our estimates due to factors such as changes in business conditions, construction schedules and environmental requirements. Off-Balance Sheet Arrangements As of December 31, 2016, we had $34.4 million in letters of credit outstanding under our $400.0 million committed line of credit, compared to $44.6 million as of December 31, 2015. Pension Plan We contributed $12.0 million to the pension plan in 2016. We expect to contribute a total of $110.0 million to the pension plan in the period 2017 through 2021, with an annual contribution of $22.0 million over that period. The final determination of pension plan contributions for future periods is subject to multiple variables, most of which are beyond our control, including changes to the fair value of pension plan assets, changes in actuarial assumptions (in particular the discount rate used in determining the benefit obligation), or changes in federal legislation. We may change our pension plan contributions in the future depending on changes to any variables, including those listed above. See "Note 10 of the Notes to Consolidated Financial Statements" for additional information regarding the pension plan. Credit Ratings Our access to capital markets and our cost of capital are directly affected by our credit ratings. In addition, many of our contracts for the purchase and sale of energy commodities contain terms dependent upon our credit ratings. See “Enterprise Risk Management - Credit Risk Liquidity Considerations” and “Note 6 of the Notes to Consolidated Financial Statements.” The following table summarizes our credit ratings as of February 21, 2017: Standard & Poor’s (1) Moody’s (2) Corporate/Issuer rating BBB Baa1 Senior secured debt A- A2 Senior unsecured debt BBB Baa1 (1) Standard & Poor’s lowest “investment grade” credit rating is BBB-. (2) Moody’s lowest “investment grade” credit rating is Baa3. AVISTA CORPORATION A security rating is not a recommendation to buy, sell or hold securities. Each security rating is subject to revision or withdrawal at any time by the assigning rating organization. Each security rating agency has its own methodology for assigning ratings, and, accordingly, each rating should be considered in the context of the applicable methodology, independent of all other ratings. The rating agencies provide ratings at the request of Avista Corp. and charge fees for their services. Dividends On February 3, 2017, Avista Corp.’s Board of Directors declared a quarterly dividend of $0.3575 per share on the Company’s common stock. This was an increase of $0.015 per share, or 4.4 percent from the previous quarterly dividend of $0.3425 per share. See "Item 5. Market for Registrant’s Common Equity, Related Stockholder Matters and Issuer Purchases of Equity Securities" for a detailed discussion of our dividend policy and the factors which could limit the payment of dividends. Contractual Obligations The following table provides a summary of our future contractual obligations as of December 31, 2016 (dollars in millions): (1) Represents our estimate of interest payments on long-term debt, which is calculated based on the assumption that all debt is outstanding until maturity. Interest on variable rate debt is calculated using the rate in effect at December 31, 2016. (2) Energy purchase contracts were entered into as part of the obligation to serve our retail electric and natural gas customers’ energy requirements. As a result, costs are generally recovered either through base retail rates or adjustments to retail rates as part of the power and natural gas cost adjustment mechanisms. (3) Includes the interest component of the lease obligation. (4) Represents operational agreements, settlements and other contractual obligations for our generation, transmission and distribution facilities. These costs are generally recovered through base retail rates. (5) Includes information service contracts which are recorded to other operating expenses in the Consolidated Statements of Income. (6) Represents our estimated cash contributions to pension plans and other postretirement benefit plans through 2021. We cannot reasonably estimate pension plan contributions beyond 2021 at this time and have excluded them from the table above. (7) Represents the net mark-to-market fair value of outstanding unsettled interest rate swap derivatives as of December 31, 2016. Negative values in the table above represent contractual amounts that are owed to Avista Corp. by the counterparties. The values in the table above will change each period depending on fluctuations in market interest rates and could become either assets or liabilities. Also, the amounts in the table above are not reflective of cash collateral of $34.9 million and letters of credit of $3.6 million that are already posted with counterparties against the outstanding interest rate swap derivatives. AVISTA CORPORATION (8) Primarily relates to long-term debt and capital lease maturities and the related interest. AERC contractual commitments also include contractually required capital project funding and operating and maintenance costs associated with the Snettisham hydroelectric project. These costs are generally recovered through base retail rates. (9) Primarily relates to operating lease commitments and a commitment to fund a limited liability company in exchange for equity ownership, made by a subsidiary of Avista Capital. The above contractual obligations do not include income tax payments. Also, asset retirement obligations are not included above and payments associated with these have historically been less than $1 million per year. There are approximately $15.5 million remaining asset retirement obligations as of December 31, 2016. In addition to the contractual obligations disclosed above, we will incur additional operating costs and capital expenditures in future periods for which we are not contractually obligated as part of our normal business operations. Competition Our utility electric and natural gas distribution business has historically been recognized as a natural monopoly. In each regulatory jurisdiction, our rates for retail electric and natural gas services (other than specially negotiated retail rates for industrial or large commercial customers, which are subject to regulatory review and approval) are generally determined on a “cost of service” basis. Rates are designed to provide, after recovery of allowable operating expenses and capital investments, an opportunity for us to earn a reasonable return on investment as allowed by our regulators. In retail markets, we compete with various rural electric cooperatives and public utility districts in and adjacent to our service territories in the provision of service to new electric customers. Alternative energy technologies, including customer-sited solar, wind or geothermal generation, may also compete with us for sales to existing customers. While the risk is currently small in our service territory given the small numbers of customers utilizing these technologies, advances in power generation, energy efficiency, energy storage and other alternative energy technologies could lead to more wide-spread usage of these technologies, thereby reducing customer demand for the energy supplied by us. This reduction in usage and demand would reduce our revenue and negatively impact our financial condition including possibly leading to our inability to fully recover our investments in generation, transmission and distribution assets. Similarly, our natural gas distribution operations compete with other energy sources including heating oil, propane and other fuels. Certain natural gas customers could bypass our natural gas system, reducing both revenues and recovery of fixed costs. To reduce the potential for such bypass, we price natural gas services, including transportation contracts, competitively and have varying degrees of flexibility to price transportation and delivery rates by means of individual contracts. These individual contracts are subject to state regulatory review and approval. We have long-term transportation contracts with several of our largest industrial customers under which the customer acquires its own commodity while using our infrastructure for delivery. Such contracts reduce the risk of these customers bypassing our system in the foreseeable future and minimizes the impact on our earnings. Also, non-utility businesses are developing new technologies and services to help energy consumers manage energy in new ways that may improve productivity and could alter demand for the energy we sell. In wholesale markets, competition for available electric supply is influenced by the: • localized and system-wide demand for energy, • type, capacity, location and availability of generation resources, and • variety and circumstances of market participants. These wholesale markets are regulated by the FERC, which requires electric utilities to: • transmit power and energy to or for wholesale purchasers and sellers, • enlarge or construct additional transmission capacity for the purpose of providing these services, and • transparently price and offer transmission services without favor to any party, including the merchant functions of the utility. Participants in the wholesale energy markets include: • other utilities, • federal power marketing agencies, • energy marketing and trading companies, AVISTA CORPORATION • independent power producers, • financial institutions, and • commodity brokers. Economic Conditions and Utility Load Growth The general economic data, on both national and local levels, contained in this section is based, in part, on independent government and industry publications, reports by market research firms or other independent sources. While we believe that these publications and other sources are reliable, we have not independently verified such data and can make no representation as to its accuracy. Avista Utilities We track multiple economic indicators affecting the three largest metropolitan statistical areas in our Avista Utilities service area: Spokane, Washington, Coeur d'Alene, Idaho, and Medford, Oregon. Several key indicators are employment change, unemployment rates and foreclosure rates. On a year-over-year basis, December 2016 showed positive job growth and lower unemployment rates in all three metropolitan areas. However, the unemployment rates in Spokane and Medford are still above the national average. Except for Medford, foreclosure rates are in line with or below the U.S rate in all areas, and key leading indicators, initial unemployment claims and residential building permits signal continued growth over the next 12 months. Therefore, in 2017, we expect economic growth in our service area to be somewhat stronger than the U.S. as a whole. Nonfarm employment (seasonally adjusted) in our eastern Washington, northern Idaho, and southwestern Oregon metropolitan service areas exhibited moderate growth between December 2015 and December 2016. In Spokane, Washington employment growth was 3.6 percent with gains in all major sectors except manufacturing and leisure and hospitality. Employment increased by 2.5 percent in Coeur d'Alene, Idaho, reflecting gains in all major sectors except mining and logging and professional and business services. In Medford, Oregon, employment growth was 3.8 percent, with gains in all major sectors except mining and logging. U.S. nonfarm sector jobs grew by 1.5 percent in the same 12-month period. Seasonally adjusted unemployment rates went down in December 2016 from the year earlier in Spokane, Coeur d'Alene, and Medford. In Spokane the rate was 6.5 percent in December 2015 and declined to 6.3 percent in December 2016; in Coeur d'Alene the rate went from 4.9 percent to 4.5 percent; and in Medford the rate declined from 6.7 percent to 5.3 percent. The U.S. rate declined from 5.0 percent to 4.7 percent in the same period. Except for the Medford area, the housing market in our Avista Utilities service area continues to experience foreclosure rates in line with the national average. The December 2016 national rate was 0.07 percent, compared to 0.07 percent in Spokane County, Washington; 0.02 percent in Kootenai County (Coeur d'Alene), Idaho; and 0.13 percent in Jackson County (Medford), Oregon. Alaska Electric Light and Power Company Our AEL&P service area is centered in Juneau. Although Juneau is Alaska’s state capital, it is not a metropolitan statistical area. This means breadth and frequency of economic data is more limited. Therefore, the dates of Juneau's economic data may significantly lag the period of this filing. The Quarterly Census of Employment and Wages for Juneau shows employment declined 1.2 percent between second quarter 2015 and second quarter 2016. The employment decline was centered in government; construction; manufacturing; financial activities; and professional and business services. Government (including active duty military personnel) accounts for approximately 37 percent of total employment. Employment declines also occurred in natural resources and mining; education and health services; and other services. Between December 2015 and December 2016 the non-seasonally adjusted unemployment rate decreased from 4.7 percent to 4.5 percent. The Juneau foreclosure rate is below the U.S. rate. The December 2016 rate was 0.02 percent compared to 0.07 percent for the U.S. Forecasted Customer and Load Growth Based on our forecast for 2017 through 2020 for Avista Utilities' service area, we expect annual electric customer growth to average 1.1 percent, within a forecast range of 0.7 percent to 1.5 percent. We expect annual natural gas customer growth to average 1.3 percent, within a forecast range of 0.8 percent to 1.8 percent. We anticipate retail electric load growth to average 0.6 percent, within a forecast range of 0.3 percent and 0.9 percent. We expect natural gas load growth to average 1.2 percent, within a forecast range of 0.7 percent and 1.7 percent. The forecast ranges reflect (1) the inherent uncertainty associated with the economic assumptions on which forecasts are based and (2) the historic variability of natural gas customer and load growth. AVISTA CORPORATION In AEL&P's service area, we expect residential customer growth near 0 percent (no residential customer growth) for 2017 through 2020. We also expect no significant growth in commercial and government customers over the same period. We anticipate average annual total load growth will be in a narrow range around 0.3 percent, with residential load growth averaging 0.6 percent, commercial growth near 0 percent (no load growth); and government growth near 0 percent. The forward-looking statements set forth above regarding retail load growth are based, in part, upon purchased economic forecasts and publicly available population and demographic studies. The expectations regarding retail load growth are also based upon various assumptions, including: • assumptions relating to weather and economic and competitive conditions, • internal analysis of company-specific data, such as energy consumption patterns, • internal business plans, • an assumption that we will incur no material loss of retail customers due to self-generation or retail wheeling, and • an assumption that demand for electricity and natural gas as a fuel for mobility will for now be immaterial. Changes in actual experience can vary significantly from our projections. See also "Competition" above for a discussion of competitive factors that could affect our results of operations in the future. Environmental Issues and Contingencies We are subject to environmental regulation by federal, state and local authorities. The generation, transmission, distribution, service and storage facilities in which we have ownership interests are designed and operated in compliance with applicable environmental laws. Furthermore, we conduct periodic reviews and audits of pertinent facilities and operations to ensure compliance and to respond to or anticipate emerging environmental issues. The Company's Board of Directors has established a committee to oversee environmental issues. We monitor legislative and regulatory developments at all levels of government for environmental issues, particularly those with the potential to impact the operation and productivity of our generating plants and other assets. Environmental laws and regulations may: • increase the operating costs of generating plants; • increase the lead time and capital costs for the construction of new generating plants; • require modification of our existing generating plants; • require existing generating plant operations to be curtailed or shut down; • reduce the amount of energy available from our generating plants; • restrict the types of generating plants that can be built or contracted with; • require construction of specific types of generation plants at higher cost; and • increase costs of distributing natural gas. Compliance with environmental laws and regulations could result in increases to capital expenditures and operating expenses. We intend to seek recovery of any such costs through the ratemaking process. Clean Air Act (CAA) We must comply with the requirements under the CAA in operating our thermal generating plants. The CAA currently requires a Title V operating permit for Colstrip (expires in 2017), Coyote Springs 2 (expires in 2018), the Kettle Falls GS (application has been made for a new permit), and the Rathdrum CT (application has been made for a new permit). Boulder Park GS, Northeast CT, and other activities only require minor source operating or registration permits based on their limited operation and emissions. The Title V operating permits are renewed every five years and updated to include newly applicable CAA requirements. We actively monitor legislative, regulatory and program developments within the CAA that may impact our facilities. On March 6, 2013, the Sierra Club and Montana Environmental Information Center, filed a Complaint (Complaint) in the United States District Court for the District of Montana, Billings Division, against the owners of Colstrip. The Complaint alleged certain violations of the Clean Air Act. On July 12, 2016, all of the parties to this action filed a Consent Decree with the AVISTA CORPORATION Court settling all claims contained in the Complaint. See “Sierra Club and Montana Environmental Information Center Litigation” in “Note 19 of the Notes to Consolidated Financial Statements” for further information on this matter. Hazardous Air Pollutants (HAPs) The EPA regulates hazardous air pollutants from a published list of industrial sources referred to as "source categories" which must meet control technology requirements if they emit one or more of the pollutants in significant quantities. In 2012, the EPA finalized the Mercury Air Toxic Standards (MATS) for the coal and oil-fired source category. At the time of issuance in 2012, we examined the existing emission control systems of Colstrip Units 3 & 4, the only units in which we are a minority owner, and concluded that the existing emission control systems should be sufficient to meet mercury limits. For the remaining portion of the rule that utilized Particulate Matter as a surrogate for air toxics (including metals and acid gases), the Colstrip owners reviewed recent stack testing data and expected that no additional emission control systems would be needed for Units 3 & 4 MATS compliance. Regional Haze Program The EPA set a national goal of eliminating man-made visibility degradation in Class I areas by the year 2064. States are expected to take actions to make “reasonable progress” through 10-year plans, including application of Best Available Retrofit Technology (BART) requirements. BART is a retrofit program applied to large emission sources, including electric generating units built between 1962 and 1977. In the case where a State opts out of implementing the Regional Haze program, the EPA may act directly. On September 18, 2012, the EPA finalized the Regional Haze federal implementation plan (FIP) for Montana. The FIP includes both emission limitations and pollution controls for Colstrip Units 1 & 2. Colstrip Units 3 & 4, the only units of which we are a minority owner, are not currently affected, but will be evaluated for Reasonable Progress at the next review period. We do not anticipate any material impacts on Units 3 & 4 at this time. Coal Ash Management/Disposal On April 17, 2015, the EPA published a final rule regarding coal combustion residuals (CCRs), also termed coal combustion byproducts or coal ash in the Federal Register, and this rule became effective on October 15, 2015. Colstrip, of which we are a 15 percent owner of Units 3 & 4, produces this byproduct. The rule establishes technical requirements for CCR landfills and surface impoundments under Subtitle D of the Resource Conservation and Recovery Act, the nation's primary law for regulating solid waste. We, in conjunction with the other owners, are developing a multi-year compliance plan to strategically address the new CCR requirements and existing state obligations while maintaining operational stability. During 2015, the operator of Colstrip provided an initial cost estimate of the expected retirement costs associated with complying with the new CCR rule and based on the initial assessments, Avista Corp. recorded an increase to its asset retirement obligations of $12.5 million with a corresponding increase in the cost basis of the utility plant. During 2016, due to additional information and updated estimates, we increased the asset retirement obligation (ARO) to $13.6 million (including accretion of $0.7 million). See "Note 9 of the Notes to Consolidated Financial Statements" for additional information regarding AROs. In addition to an increase to our ARO, it is expected that there will be significant compliance costs at Colstrip in the future, both operating and capital costs, due to a series of incremental infrastructure improvements which are separate from the ARO. Due to the preliminary nature of available data, we cannot reasonably estimate the future compliance costs; however, we will update our ARO and compliance cost estimates when data becomes available. The actual asset retirement costs and future compliance costs related to the CCR Rule requirements may vary substantially from the estimates used to record the increased ARO due to uncertainty about the compliance strategies that will be used and the preliminary nature of available data used to estimate costs, such as the quantity of coal ash present at certain sites and the volume of fill that will be needed to cap and cover certain impoundments. We will coordinate with the plant operators and continue to gather additional data in future periods to make decisions about compliance strategies and the timing of closure activities. As additional information becomes available, we will update the ARO and future nonretirement compliance costs for these changes in estimates, which could be material. We expect to seek recovery of any increased costs related to complying with the new rule through customer rates. Climate Change Concerns about long-term global climate changes could have a significant effect on our business. Our operations could also be affected by changes in laws and regulations intended to mitigate the risk of, or alter global climate changes, including restrictions on the operation of our power generation resources and obligations imposed on the sale of natural gas. Changing temperatures and precipitation, including snowpack conditions, affect the availability and timing of streamflows, which impact hydroelectric generation. Extreme weather events could increase service interruptions, outages and maintenance costs. Changing temperatures could also increase or decrease customer demand. AVISTA CORPORATION Our Climate Policy Council (an interdisciplinary team of management and other employees): • facilitates internal and external communications regarding climate change issues, • analyzes policy effects, anticipates opportunities and evaluates strategies for Avista Corp., and • develops recommendations on climate related policy positions and action plans. Climate Change - Federal Regulatory Actions The EPA released the final rules for the Clean Power Plan (Final CPP) and the Carbon Pollution Standards (Final CPS) on August 3, 2015. The Final CPP and the Final CPS are both intended to reduce the carbon dioxide (CO2) emissions from certain coal-fired and natural gas electric generating units (EGUs). These rules were published in the Federal Register on October 23, 2015 and were immediately challenged via lawsuits by other parties. The Final CPP was promulgated pursuant to Section 111(d) of the CAA and applies to CO2 emissions from existing EGUs. The Final CPP is intended to reduce national CO2 emissions by approximately 32 percent below 2005 levels by 2030. The Final CPS rule was issued pursuant to Section 111(b) of the CAA and applies to the emissions of new, modified and reconstructed EGUs. The two rules are the first rules ever adopted by the U.S. federal government to comprehensively control and reduce CO2 emissions from the power sector. The EPA also issued a proposed Federal Implementation Plan (Proposed FIP) for the Final CPP. The Final FIP that the EPA adopts could be imposed on states by the EPA, should a state decide not to develop its own plan. The Final CPP establishes individual state emission reduction goals based upon the assumed potential for (1) heat rate improvements at coal-fired units, (2) increased utilization of natural gas-fired combined cycle plants, and (3) increased utilization of low or zero carbon emitting generation resources. As expressed in the final rule, states had until September 2016 to submit state compliance plans, with a potential for two-year extensions. A stay granted by the U.S. Supreme Court, and described below, pushed this date out pending the results of the case. Avista Corp. owns two EGUs that are subject to the Final CPP: its portion (15 percent of Units 3 & 4) of Colstrip in Montana and Coyote Springs 2 in Oregon. States may adopt rate-based or mass-based plans, and may choose to focus compliance on specific EGUs or adopt broader measures to reduce carbon emissions from this sector. The states in which Avista Utilities generates or delivers electricity, Washington, Idaho, Montana and Oregon, are at differing stages of evaluating options for developing state plans, which will define compliance approaches and obligations. Alaska was exempted in the Final CPP. The EPA may consider rulemaking for Alaska and Hawaii, both states which lack regional grid connections in the future. In a separate but related rulemaking, the EPA finalized CO2 new source performance standards (NSPS) for new, modified and reconstructed fossil fuel-fired EGUs under CAA section 111(b). These EGUs fall into the same two categories of sources regulated by the Final CPP: steam generating units (also known as “utility boilers and IGCC units”), which primarily burn coal, and stationary combustion turbines, which primarily burn natural gas. GHG emission standards could result in significant compliance costs. Such standards could also preclude us from developing, operating or contracting with certain types of generating plants. Additionally, the Climate Action Plan requirements related to preparing the U.S. for the impacts of climate change could affect us and others in the industry as transmission system modifications to improve resiliency may be needed in order to meet those requirements. The promulgated and proposed GHG rulemakings mentioned above have been legally challenged in multiple venues. On February 9, 2016, the U.S. Supreme Court granted a request for stay, halting implementation of the CPP. Given this development and related ongoing legal challenges, we cannot fully predict the outcome or estimate the extent to which our facilities may be impacted by these regulations at this time. We intend to seek recovery of any costs related to compliance with these requirements through the ratemaking process. Climate Change - State Legislation and State Regulatory Activities The states of Washington and Oregon have adopted non-binding targets to reduce GHG emissions. Both states enacted their targets with an expectation of reaching the targets through a combination of renewable energy standards, and assorted “complementary policies,” but no specific reductions are mandated. Washington and Oregon apply a GHG emissions performance standard (EPS) to electric generation facilities used to serve retail loads in their jurisdictions. The EPS prevents utilities from constructing or purchasing generation facilities, or entering into power purchase agreements of five years or longer duration to purchase energy produced by plants, that in any case, have emission levels higher than 1,100 pounds of GHG per MWh. The Washington State Department of Commerce (Commerce) initiated a process to adopt a lower emissions performance standard in 2012; any new standard will be applicable until at least 2017. Commerce published a supplemental notice of proposed rulemaking on January 16, AVISTA CORPORATION 2013 with a new EPS of 970 pounds of GHG per MWh. We will engage in the next process to revise the EPS, which should occur in 2017. Washington Energy Independence Act (EIA) The EIA in Washington requires electric utilities with over 25,000 customers to acquire qualified renewable energy resources and/or renewable energy credits equal to 15 percent of the utility's total retail load in Washington in 2020. I-937 also requires these utilities to meet biennial energy conservation targets beginning in 2012. The renewable energy standard increased from three percent in 2012 to nine percent in 2016. Failure to comply with renewable energy and efficiency standards could result in penalties of $50 per MWh or greater assessed against a utility for each MWh it is deficient in meeting a standard. We have met, and will continue to meet, the requirements of EIA through a variety of renewable energy generating means, including, but not limited to, some combination of hydro upgrades, wind, biomass and renewable energy credits. In 2012, EIA was amended in such a way that our Kettle Falls GS and certain other biomass energy facilities, which commenced operation before March 31, 1999, are considered resources that may be used to meet the renewable energy standards. Clean Air Rule In September 2016, the Washington State Department of Ecology (Ecology) adopted the Clean Air Rule (CAR) to cap and reduce GHG emissions across the State of Washington in pursuit of the State’s GHG goals, which were enacted in 2008 by the Washington State Legislature (Legislature). The CAR applies to sources of annual GHG emissions in excess of 100,000 tons for the first compliance period of 2017 through 2019; this threshold incrementally decreases to 70,000 metric tons beginning in 2035. The rule affects stationary sources and transportation fuel suppliers, as well as natural gas distribution companies. Ecology has identified approximately 30 entities that would be regulated under the CAR. Parties covered by the regulation must reduce emissions by 1.7 percent annually until 2035. Compliance can be demonstrated by achieving emission reductions and/or surrendering Emission Reduction Units (ERU), which are generated by parties that achieve reductions greater than required by the rule. ERUs can also take the form of renewable energy credits from renewable resources located in Washington, carbon emission offsets, and allowances acquired from an organized cap and trade market, such as that operating in California. In addition to the CAR's applicability to our burning of fuel as an electric utility, the CAR applies to us as a natural gas distribution company, for the emissions associated with the use of the natural gas we provide our customers who are not already covered under the regulation. In September 2016, Avista Corp., Cascade Natural Gas Corp., NW Natural and Puget Sound Energy (PSE) (collectively, Petitioners) jointly filed an action in the U.S. District Court for the Eastern District of Washington challenging Ecology’s recently promulgated CAR. The four companies also filed litigation in Thurston County Superior Court. Petitioners believe that the reduction of GHG emissions is a matter that needs to be addressed, but the CAR is not the solution. Each utility represented in this case provided feedback and public comment to improve the rule, but ideas put forward were not incorporated in the final rule. They are asking the U.S District Court and the Thurston County Superior Court to find that the CAR is invalid. In their State claim, Petitioners assert that: • Ecology lacks statutory authority to regulate natural gas utilities because the CAR holds them responsible for the indirect emissions of their customers; • Ecology does not have the authority to create an emission reduction trading program (ERUs); • Ecology failed to comply with the requirements of the State Environmental Policy Act; and • the CAR is arbitrary and capricious. Petitioners' Federal claim asserts that the CAR violates the dormant Commerce Clause of the U.S. Constitution by discriminating against interstate commerce, regulating extraterritorially and unduly burdening interstate commerce by restricting the use of ERU’s (allowances) generated from outside Washington State for compliance purposes. The case in U.S. District Court has been tolled while the state court case proceeds, with oral arguments scheduled for the spring of 2017. Initiative I-732 An Initiative to the Legislature (I-732) to impose a carbon tax on fossil-fueled generation and natural gas distribution, as well as on transportation fuels, was submitted to the Legislature in January 2016. The Legislature failed to act upon the AVISTA CORPORATION measure and I-732 was referred to the November 2016 General Election ballot, where it failed to gain enough votes for enactment. Colstrip 3 & 4 Considerations On February 6, 2014, the UTC issued a letter finding that PSE’s 2013 Electric Integrated Resource Plan meets the requirements of the Revised Code of Washington and the Washington Administrative Code. In its letter, however, the UTC expressed concern regarding the continued operation of the Colstrip plant as a resource to serve retail customers. Although the UTC recognized that the results of the analyses presented by PSE “differed significantly between [Colstrip] Units 1 & 2 and Units 3 & 4,” the UTC did not limit its concerns solely to Colstrip Units 1 & 2. The UTC recommended that PSE “consult with UTC staff to consider a Colstrip Proceeding to determine the prudency of any new investment in Colstrip before it is made or, alternatively, a closure or partial-closure plan.” As part of the Sierra Club litigation that was settled in 2016, Units 1 & 2 are scheduled to close by July 2022. See "Note 19 of the Notes to Consolidated Financial Statements" for further discussion of the Sierra Club litigation. As a 15 percent owner of Colstrip Units 3 & 4, we cannot estimate the effect of such proceeding, should it occur, on the future ownership, operation and operating costs of our share of Colstrip Units 3 & 4. Our remaining investment in Colstrip Units 3 & 4 as of December 31, 2016 was $131.0 million. In Oregon, legislation was enacted in 2016 which requires Portland General Electric and PacifiCorp to remove coal-fired generation from their Oregon rate base by 2030. This legislation does not directly relate to Avista Corp. because Avista Corp. is not an electric utility in Oregon. However, because these two utilities, along with Avista Corp., hold minority interests in Colstrip, the legislation could indirectly impact Avista Corp., though specific impacts cannot be identified at this time. While the legislation requires Portland General Electric and PacifiCorp to eliminate Colstrip from their rates, they would be permitted to sell the output of their shares of Colstrip into the wholesale market or, as is the case with PacifiCorp, reallocate the plant to other states. We cannot predict the eventual outcome of actions arising from this legislation at this time or estimate the effect thereof on Avista Corp.; however, we will continue to seek recovery, through the ratemaking process, of all operating and capitalized costs related to our generation assets. Threatened and Endangered Species and Wildlife A number of species of fish in the Northwest are listed as threatened or endangered under the Federal Endangered Species Act (ESA). Efforts to protect these and other species have not significantly impacted generation levels at any of our hydroelectric facilities, nor operations of our thermal plants or electrical distribution and transmission system. We are implementing fish protection measures at our hydroelectric project on the Clark Fork River under a 45-year FERC operating license for Cabinet Gorge and Noxon Rapids (issued March 2001) that incorporates a comprehensive settlement agreement. The restoration of native salmonid fish, including bull trout, is a key part of the agreement. The result is a collaborative native salmonid restoration program with the U.S. Fish and Wildlife Service, Native American tribes and the states of Idaho and Montana on the lower Clark Fork River, consistent with requirements of the FERC license. The U.S. Fish & Wildlife Service issued an updated Critical Habitat Designation for bull trout in 2010 that includes the lower Clark Fork River, as well as portions of the Coeur d'Alene basin within our Spokane River Project area, and issued a final Bull Trout Recovery Plan under the ESA. Issues related to these activities are expected to be resolved through the ongoing collaborative effort of our Clark Fork and Spokane River FERC licenses. See “Fish Passage at Cabinet Gorge and Noxon Rapids” in “Note 19 of the Notes to Consolidated Financial Statements” for further information. Various statutory authorities, including the Migratory Bird Treaty Act, have established penalties for the unauthorized take of migratory birds. Because we operate facilities that can pose risks to a variety of such birds, we have developed and follow an avian protection plan. We are also aware of other threatened and endangered species and issues related to them that could be impacted by our operations and we make every effort to comply with all laws and regulations relating to these threatened and endangered species. We expect all costs associated with these compliance efforts to be recovered through the future ratemaking process. Other For other environmental issues and other contingencies see “Note 19 of the Notes to Consolidated Financial Statements.” Enterprise Risk Management The material risks to our businesses are discussed in "Item 1A. Risk Factors," "Forward-Looking Statements," as well as "Environmental Issues and Contingencies." The following discussion focuses on our mitigation processes and procedures to address these risks. AVISTA CORPORATION We consider the management of these risks an integral part of managing our core businesses and a key element of our approach to corporate governance. Risk management includes identifying and measuring various forms of risk that may affect the Company. We have an enterprise risk management process for managing risks throughout our organization. Our Board of Directors and its Committees take an active role in the oversight of risk affecting the Company. Our risk management department facilitates the collection of risk information across the Company, providing senior management with a consolidated view of the Company’s major risks and risk mitigation measures. Each area identifies risks and implements the related mitigation measures. The enterprise risk process supports management in identifying, assessing, quantifying, managing and mitigating the risks. Despite all risk mitigation measures, however, risks are not eliminated. Our primary identified categories of risk exposure are: • Financial • Compliance • Utility regulatory • Technology • Energy commodity • Strategic • Operational • External Mandates Financial Risk Financial risk is any risk that could have a direct material impact on the financial performance or financial viability of the Company. Broadly, financial risks involve variation of earnings and liquidity. Underlying risks include, but are not limited to, those described in "Item 1A. Risk Factors." We mitigate financial risk in a variety of ways including through oversight from the Finance Committee of our Board of Directors and from senior management. Our Regulatory department is also critical in risk mitigation as they have regular communications with state commission regulators and staff and they monitor and develop rate strategies for the Company. Rate strategies, such as decoupling, help mitigate the impacts of revenue fluctuations due to weather, conservation or the economy. We also have a Treasury department that monitors our daily cash position and future cash flow needs, as well as monitoring market conditions to determine the appropriate course of action for capital financing and/or hedging strategies. Weather Risk To partially mitigate the risk of financial underperformance due to weather-related factors, we developed decoupling rate mechanisms that were approved by the Washington, Idaho and Oregon commissions. Decoupling mechanisms are designed to break the link between a utility's revenues and consumers' energy usage and instead provide revenue based on the number of customers, thus mitigating a large portion of the risk associated with lower customer loads. See "Regulatory Matters" for further discussion of our decoupling mechanisms. Access to Capital Markets Our capital requirements rely to a significant degree on regular access to capital markets. We actively engage with rating agencies, banks, investors and state public utility commissions to understand and address the factors that support access to capital markets on reasonable terms. We manage our capital structure to maintain a financial risk profile that we believe these parties will deem prudent. We forecast cash requirements to determine liquidity needs, including sources and variability of cash flows that may arise from our spending plans or from external forces, such as changes in energy prices or interest rates. Our financial and operating forecasts consider various metrics that affect credit ratings. Our regulatory strategies include working with state public utility commissions and filing for rate changes as appropriate to meet financial performance expectations. Interest Rate Risk Uncertainty about future interest rates causes risk related to a portion of our existing debt, our future borrowing requirements, and our pension and other post-retirement benefit obligations. We manage debt interest rate exposure by limiting our variable rate debt to a percentage of total capitalization of the Company. We hedge a portion of our interest rate risk on forecasted debt issuances with financial derivative instruments, which may include interest rate swaps and U.S. Treasury lock agreements. The Finance Committee of our Board of Directors periodically reviews and discusses interest rate risk management processes and the steps management has undertaken to control interest rate risk. Our RMC also reviews our interest rate risk management plan. Additionally, interest rate risk is managed by monitoring market conditions when timing the issuance of long-term debt and optional debt redemptions and establishing fixed rate long-term debt with varying maturities. Our interest rate swap derivatives are considered economic hedges against the future forecasted interest rate payments of our long-term debt. Interest rates on our long-term debt are generally set based on underlying U.S. Treasury rates plus credit AVISTA CORPORATION spreads, which are based on our credit ratings and prevailing market prices for debt. The interest rate swap derivatives hedge against changes in the U.S. Treasury rates but do not hedge the credit spread. Even though we work to manage our exposure to interest rate risk by locking in certain long-term interest rates through interest rate swap derivatives, if market interest rates decrease below the interest rates we have locked in, this will result in a liability related to our interest rate swap derivatives, which can be significant. However, through our regulatory accounting practices similar to our energy commodity derivatives, any interim mark-to-market gains or losses are offset by regulatory assets and liabilities. Upon settlement of interest rate swap derivatives, the regulatory asset or liability is amortized as a component of interest expense over the term of the associated debt. The following table summarizes our interest rate swap derivatives outstanding as of December 31, 2016 and December 31, 2015 (dollars in thousands): (1) There are offsetting regulatory assets and liabilities for these items on the Consolidated Balance Sheets in accordance with regulatory accounting practices. (2) The balance as of December 31, 2016 and December 31, 2015 reflects the offsetting of $34.9 million and $34.0 million, respectively, of cash collateral against the net derivative positions where a legal right of offset exists. We estimate that a 10-basis-point increase in forward LIBOR interest rates as of December 31, 2016 would decrease the interest rate swap derivative net liability by $10.4 million, while a 10-basis-point decrease would increase the interest rate swap derivative net liability by $10.7 million. We estimated that a 10-basis-point increase in forward LIBOR interest rates as of December 31, 2015 would have decreased the interest rate swap derivative net liability by $9.8 million, while a 10-basis-point decrease would increase the interest rate swap derivative net liability by $10.1 million. The interest rate on $51.5 million of long-term debt to affiliated trusts is adjusted quarterly, reflecting current market rates. Amounts borrowed under our committed line of credit agreements have variable interest rates. The following table shows our long-term debt (including current portion) and related weighted-average interest rates, by expected maturity dates as of December 31, 2016 (dollars in thousands): (1) These balances include the fixed rate long-term debt of Avista Corp., AEL&P and AERC. Our pension plan is exposed to interest rate risk because the value of pension obligations and other post-retirement obligations vary directly with changes in the discount rates, which are derived from end-of-year market interest rates. In addition, the value of pension investments and potential income on pension investments is partially affected by interest rates because a portion of pension investments are in fixed income securities. The Finance Committee of the Board of Directors approves investment AVISTA CORPORATION policies, objectives and strategies that seek an appropriate return for the pension plan and it reviews and approves changes to the investment and funding policies. We manage interest rate risk associated with our pension and other post-retirement benefit plans by investing a targeted amount of pension plan assets in fixed income investments that have maturities with similar profiles to future projected benefit obligations. See "Note 10 of the Notes to Consolidated Financial Statements" for further discussion of our investment policy associated with the pension assets. Credit Risk Counterparty Non-Performance Risk Counterparty non-performance risk relates to potential losses that we would incur as a result of non-performance of contractual obligations by counterparties to deliver energy or make financial settlements. Changes in market prices may dramatically alter the size of credit risk with counterparties, even when we establish conservative credit limits. Should a counterparty fail to perform, we may be required to honor the underlying commitment or to replace existing contracts with contracts at then-current market prices. We enter into bilateral transactions with various counterparties. We also trade energy and related derivative instruments through clearinghouse exchanges. We seek to mitigate credit risk by: • transacting through clearinghouse exchanges, • entering into bilateral contracts that specify credit terms and protections against default, • applying credit limits and duration criteria to existing and prospective counterparties, • actively monitoring current credit exposures, • asserting our collateral rights with counterparties, and • carrying out transaction settlements timely and effectively. The extent of transactions conducted through exchanges has increased as many market participants have shown a preference toward exchange trading and have reduced bilateral transactions. We actively monitor the collateral required by such exchanges to effectively manage our capital requirements. Counterparties’ credit exposure to us is dynamic in normal markets and may change significantly in more volatile markets. The amount of potential default risk to us from each counterparty depends on the extent of forward contracts, unsettled transactions, interest rates and market prices. There is a risk that we do not obtain sufficient additional collateral from counterparties that are unable or unwilling to provide it. Credit Risk Liquidity Considerations To address the impact on our operations of energy market price volatility, our hedging practices for electricity (including fuel for generation) and natural gas extend beyond the current operating year. Executing this extended hedging program may increase credit risk and demands for collateral. Our credit risk management process is designed to mitigate such credit risks through limit setting, contract protections and counterparty diversification, among other practices. Credit risk affects demands on our capital. We are subject to limits and credit terms that counterparties may assert to allow us to enter into transactions with them and maintain acceptable credit exposures. Many of our counterparties allow unsecured credit at limits prescribed by agreements or their discretion. Capital requirements for certain transaction types involve a combination of initial margin and market value margins without any unsecured credit threshold. Counterparties may seek assurances of performance from us in the form of letters of credit, prepayment or cash deposits. Credit exposure can change significantly in periods of commodity price and interest rate volatility. As a result, sudden and significant demands may be made against our credit facilities and cash. We actively monitor the exposure to possible collateral calls and take steps to minimize capital requirements. As of December 31, 2016, we had cash deposited as collateral of $17.1 million and letters of credit of $24.4 million outstanding related to our energy derivative contracts. Price movements and/or a downgrade in our credit ratings could impact further the amount of collateral required. See “Credit Ratings” for further information. For example, in addition to limiting our ability to conduct transactions, if our credit ratings were lowered to below “investment grade” based on our positions outstanding at December 31, 2016, we would potentially be required to post additional collateral of up to $6.0 million. This amount is AVISTA CORPORATION different from the amount disclosed in “Note 6 of the Notes to Consolidated Financial Statements” because, while this analysis includes contracts that are not considered derivatives in addition to the contracts considered in Note 6, this analysis also takes into account contractual threshold limits that are not considered in Note 6. Without contractual threshold limits, we would potentially be required to post additional collateral of $8.2 million. Under the terms of interest rate swap derivatives that we enter into periodically, we may be required to post cash or letters of credit as collateral depending on fluctuations in the fair value of the instrument. As of December 31, 2016, we had interest rate swap agreements outstanding with a notional amount totaling $500.0 million and we had deposited cash in the amount of $34.9 million and letters of credit of $3.6 million as collateral for these interest rate swap derivatives. If our credit ratings were lowered to below “investment grade” based on our interest rate swap derivatives outstanding at December 31, 2016, we would have to post $21.1 million of additional collateral. Foreign Currency Risk A significant portion of our utility natural gas supply (including fuel for electric generation) is obtained from Canadian sources. Most of those transactions are executed in U.S. dollars, which avoids foreign currency risk. A portion of our short-term natural gas transactions and long-term Canadian transportation contracts are committed based on Canadian currency prices. The short-term natural gas transactions are typically settled within sixty days with U.S. dollars. We economically hedge a portion of the foreign currency risk by purchasing Canadian currency exchange contracts when such commodity transactions are initiated. This risk has not had a material effect on our financial condition, results of operations or cash flows and these differences in cost related to currency fluctuations are included with natural gas supply costs for ratemaking. Further information for derivatives and fair values is disclosed at “Note 6 of the Notes to Consolidated Financial Statements” and “Note 16 of the Notes to Consolidated Financial Statements.” Utility Regulatory Risk Because we are primarily a regulated utility, we face the risk that regulators may not grant rates that provide timely or sufficient recovery of our costs or allow a reasonable rate of return for our shareholders. This includes costs associated with our investment in rate base, as well as commodity costs and other operating and financing expenses. During December 2016, the UTC denied our most recent electric and natural gas general rate requests and granted zero rate relief. We are currently in the process of pursuing remedies toward a reasonable end result. If our efforts to obtain rates that are fair, just, reasonable and sufficient are not successful, we expect our 2017 earnings will be adversely impacted. See further discussion at "Item 7. Management's Discussion and Analysis of Financial Condition and Results of Operations - Regulatory Matters." We mitigate regulatory risk through oversight from our Board of Directors and from senior management. We have a separate regulatory group which communicates with commission regulators and staff regarding the Company’s business plans and concerns. The regulatory group also considers the regulator’s priorities and rate policies and makes recommendations to senior management on regulatory strategy for the Company. See “Regulatory Matters” for further discussion of regulatory matters affecting our Company. Energy Commodity Risk Energy commodity risks are associated with fulfilling our obligation to serve customers, managing variability of energy facilities, rights and obligations and fulfilling the terms of our energy commodity agreements with counterparties. These risks include, among other things, those described in "Item 1A. Risk Factors." We mitigate energy commodity risk primarily through our energy resources risk policy, which includes oversight from the RMC and oversight from the Audit Committee and the Environmental, Technology and Operations Committee of our Board of Directors. In conjunction with the oversight committees, our management team develops hedging strategies, detailed resource procurement plans, resource optimization strategies and long-term integrated resource planning to mitigate some of the risk associated with energy commodities. The various plans and strategies are monitored daily and developed with quantitative methods. Our energy resources risk policy includes our wholesale energy markets credit policy and control procedures to manage energy commodity price and credit risks. Nonetheless, adverse changes in commodity prices, generating capacity, customer loads, regulation and other factors may result in losses of earnings, cash flows and/or fair values. We measure the volume of monthly, quarterly and annual energy imbalances between projected power loads and resources. The measurement process is based on expected loads at fixed prices (including those subject to retail rates) and expected resources to the extent that costs are essentially fixed by virtue of known fuel supply costs or projected hydroelectric conditions. To the extent that expected costs are not fixed, either because of volume mismatches between loads and resources or because fuel cost is not locked in through fixed price contracts or derivative instruments, our risk policy guides the process to manage this open AVISTA CORPORATION forward position over a period of time. Normal operations result in seasonal mismatches between power loads and available resources. We are able to vary the operation of generating resources to match parts of intra-hour, hourly, daily and weekly load fluctuations. We use the wholesale power markets, including the natural gas market as it relates to power generation fuel, to sell projected resource surpluses and obtain resources when deficits are projected. We buy and sell fuel for thermal generation facilities based on comparative power market prices and marginal costs of fueling and operating available generating facilities and the relative economics of substitute market purchases for generating plant operation. To address the impact on our operations of energy market price volatility, our hedging practices for electricity (including fuel for generation) and natural gas extend beyond the current operating year. Executing this extended hedging program may increase our credit risks. Our credit risk management process is designed to mitigate such credit risks through limit setting, contract protections and counterparty diversification, among other practices. Our projected retail natural gas loads and resources are regularly reviewed by operating management and the RMC. To manage the impacts of volatile natural gas prices, we seek to procure natural gas through a diversified mix of spot market purchases and forward fixed price purchases from various supply basins and time periods. We have an active hedging program that extends into future years with the goal of reducing price volatility in our natural gas supply costs. We use natural gas storage capacity to support high demand periods and to procure natural gas when price spreads are favorable. Securing prices throughout the year and even into subsequent years mitigates potential adverse impacts of significant purchase requirements in a volatile price environment. The following table presents energy commodity derivative fair values as a net asset or (liability) as of December 31, 2016 that are expected to settle in each respective year (dollars in thousands): The following table presents energy commodity derivative fair values as a net asset or (liability) as of December 31, 2015 that were expected to settle in each respective year (dollars in thousands): (1) Physical transactions represent commodity transactions where we will take delivery of either electricity or natural gas and financial transactions represent derivative instruments with no physical delivery, such as futures, swaps, options, or forward contracts. The above electric and natural gas derivative contracts will be included in either power supply costs or natural gas supply costs during the period they are delivered and will be included in the various recovery mechanisms (ERM, PCA, and PGAs), or in the general rate case process, and are expected to eventually be collected through retail rates from customers. See "Item 1. Business - Electric Operations," "Item 1. Business - Natural Gas Operations," and "Item 1A. Risk Factors" for additional discussion of the risks associated with Energy Commodities. AVISTA CORPORATION Operational Risk Operational risk involves potential disruption, losses, or excess costs arising from external events or inadequate or failed internal processes, people and systems. Our operations are subject to operational and event risks that include, but are not limited to, those described in "Item 1A. Risk Factors." To manage operational and event risks, we maintain emergency operating plans, business continuity and disaster recovery plans, maintain insurance coverage against some, but not all, potential losses and seek to negotiate indemnification arrangements with contractors for certain event risks. In addition, we design and follow detailed vegetation management and asset management inspection plans, which help mitigate wildfire and storm event risks, as well as identify utility assets which may be failing and in need of repair or replacement. We also have an Emergency Operating Center, which is a team of employees that plan for and train to deal with potential emergencies or unplanned outages at our facilities, resulting from natural disasters or other events. To prevent unauthorized access to our facilities, we have both physical and cyber security in place. To address the risk related to fuel cost, availability and delivery restraints, we have an energy resources risk policy, which includes our wholesale energy markets credit policy and control procedures to manage energy commodity price and credit risks. Development of the energy resources risk policy includes planning for sufficient capacity to meet our customer and wholesale energy delivery obligations. See further discussion of the energy resources risk policy above. Oversight of the operational risk management process is performed by the Environmental, Technology and Operations Committee of our Board of Directors and from senior management with input from each operating department. Compliance Risk Compliance risk is the potential consequences of legal or regulatory sanctions or penalties arising from the failure of the Company to comply with requirements of applicable laws, rules and regulations. We have extensive compliance obligations. Our primary compliance risks and obligations include, among others, those described in "Item 1A. Risk Factors." We mitigate compliance risk through oversight from the Environmental, Technology and Operations Committee and the Audit Committee of our Board of Directors and from senior management. We also have separate Regulatory and Environmental Compliance departments that monitor legislation, regulatory orders and actions to determine the overall potential impact to our Company and develop strategies for complying with the various rules and regulations. We also engage outside attorneys, and consultants, when necessary, to help ensure compliance with laws and regulations. See "Item 1. Business, Regulatory Issues" through "Item 1. Business, Reliability Standards" and “Environmental Issues and Contingencies” for further discussion of compliance issues that impact our Company. Technology Risk Our primary technology risks are described in "Item 1A. Risk Factors." We mitigate technology risk through trainings and exercises at all levels of the Company. The Environmental, Technology and Operations Committee of our Board of Directors along with senior management are regularly briefed on security policy, programs and incidents. Annual cyber and physical training and testing of employees are included in our enterprise security program as are business continuity testing and data breach response exercises. Technology governance is led by senior management, which includes new technology strategy, risk planning and major project planning and approval. The technology project management office and enterprise capital planning group provide project cost, timeline and schedule oversight. In addition, there are independent third party audits of our critical infrastructure security program and our business risk security controls. We have a Technology department dedicated to securing, maintaining, evaluating and developing our information technology systems. There are regular training sessions for the technology and security team. This group also evaluates the Company's technology for obsolescence and makes recommendations for upgrading or replacing systems as necessary. Additionally, this group monitors for intrusion and security events that may include a data breach. Strategic Risk Strategic risk relates to the potential impacts resulting from incorrect assumptions about external and internal factors, inappropriate business plans, ineffective business strategy execution, or the failure to respond in a timely manner to changes in the regulatory, macroeconomic or competitive environments. Our primary strategic risks include, among others, those described in "Item 1A. Risk Factors." AVISTA CORPORATION We mitigate strategic risk through detailed oversight from the Board of Directors and from senior management. We also have a Chief Strategy Officer that leads strategic initiatives, to search for and evaluate opportunities for the Company and makes recommendations to senior management. We not only focus on whether opportunities are financially viable, but also consider whether these opportunities fall within our core policies and our core business strategies. We mitigate our reputational risk primarily through a focus on adherence to our core policies, including our Code of Conduct, maintaining an appropriate Company culture and tone at the top, and through communication and engagement of our external stakeholders. External Mandates Risk External mandate risk involves forces outside the Company, which may include significant changes in customer expectations, disruptive technologies that result in obsolescence of our business model and government action that could impact the Company. See "Environmental Issues and Contingencies" and "Forward-Looking Statements" for a discussion of or reference to our external mandates risks. We mitigate external mandate risk through detailed oversight from the Environmental, Technology and Operations Committee of our Board of Directors and from senior management. We have a Climate Council which meets internally to assess the potential impacts of climate policy to our business and to identify strategies to plan for change. We also have employees dedicated to actively engage and monitor federal, state and local government positions and legislative actions that may affect us or our customers. To prevent the threat of municipalization, we work to build strong relationships with the communities we serve through, among other things: • communication and involvement with local business leaders and community organizations, • providing customers with a multitude of limited income initiatives, including energy fairs, senior outreach and low income workshops, mobile outreach strategy and a Low Income Rate Assistance Plan, • tailoring our internal company initiatives to focus on choices for our customers, to increase their overall satisfaction with the Company, and • engaging in the legislative process in a manner that fosters the interests of our customers and the communities we serve.

<s>[INST] As of December 31, 2016, we have two reportable business segments, Avista Utilities and AEL&P. We also have other businesses which do not represent a reportable business segment and are conducted by various direct and indirect subsidiaries of Avista Corp. See "Part I, Item 1. Business Company Overview" for further discussion of our business segments. The following table presents net income (loss) attributable to Avista Corp. shareholders for each of our business segments (and the other businesses) for the year ended December 31 (dollars in thousands): (1) The results for the year ended December 31, 2014 include the net gain on sale of Ecova of $69.7 million. Executive Level Summary Overall Results Net income attributable to Avista Corp. shareholders was $137.2 million for 2016, an increase from $123.2 million for 2015. Avista Utilities' earnings increased primarily due to an increase in electric and natural gas gross margin as a result of general rate increases and the implementation of decoupling mechanisms in Idaho and Oregon. See "Results of Operations Avista Utilities NonGAAP Financial Measures" for further discussion of gross margin. Also, there was a reduction in the electric provision for earnings sharing (which is an offset to revenue). Retail electric loads decreased as compared to prior year and retail natural gas loads increased as compared to prior year, but the impact of changes in load as compared to normal for electric and natural gas was mostly offset by decoupling mechanisms. In addition to the fluctuations in gross margin, there were increases in other operating expenses, depreciation, and interest expense. There was also an increase in earnings at AEL&P offset by an increase in the net loss at the other businesses. More detailed explanations of the fluctuations are provided in the results of operations and business segment discussions (Avista Utilities, AEL&P, and the other businesses) that follow this section. AVISTA CORPORATION 2016 Washington General Rate Cases In December 2016, the UTC issued an order related to our Washington electric and natural gas general rate cases that were originally filed with the UTC in February 2016. The UTC order denied the Company's proposed electric and natural gas rate increase requests totaling $43.0 million. Accordingly, our current electric and natural gas retail rates will remain unchanged in Washington State. In December 2016, we filed a Petition for Reconsideration or, in the alternative, Rehearing (Petition) with the UTC. The UTC provided notice inviting parties to respond to our Petition, stating that it expects to rule on the Petition on or before March 16, 2017. If our efforts to obtain rates that are fair, just, reasonable and sufficient are not successful, our 2017 earnings will suffer a significant adverse impact. We believe the UTC order will not allow us to earn a reasonable return on investments that we have already made in our infrastructure. In addition, the order will provide no opportunity for us to earn the return on equity authorized by the UTC or a fair return for shareholders. In the order, the UTC did not specifically disallow any of our capital projects, and we continue to believe these investments are necessary and will be recoverable in rates in the future. In 2017, we expect our operating costs to continue to grow along the same trend we have been experiencing recently; however, if our current Washington rates remain in effect, we expect to earn below our currently authorized return on equity (ROE). The order will result in regulatory lag, and, accordingly, we expect to experience earnings contraction in 2017 of $0.20 to $0.30 per diluted share as compared to 2016 actual results. See "Item 7. Management's Discussion and Analysis Regulatory Matters" for additional discussion surrounding this general rate case and all of our other outstanding general rate cases. Alaska Energy and Resources Company Acquisition On July 1, 2014, we acquired AERC, based in Juneau, Alaska. The completion of this transaction limits the comparability of the financial results for 2016 and 2015 to those [/INST] Positive. </s>

AVISTA CORP

2018-02-21

2017-12-31

ITEM 7. MANAGEMENT'S DISCUSSION AND ANALYSIS OF FINANCIAL CONDITION AND RESULTS OF OPERATIONS Business Segments As of December 31, 2017, we have two reportable business segments, Avista Utilities and AEL&P. We also have other businesses which do not represent a reportable business segment and are conducted by various direct and indirect subsidiaries of Avista Corp. See "Part I, Item 1. Business - Company Overview" for further discussion of our business segments. The following table presents net income (loss) attributable to Avista Corp. shareholders for each of our business segments (and the other businesses) for the year ended December 31 (dollars in thousands): Executive Level Summary Overall Results Net income attributable to Avista Corp. shareholders was $115.9 million for 2017, a decrease from $137.2 million for 2016. The decrease in earnings was due to a decrease in earnings at Avista Utilities and an increase in losses at our other businesses. These were partially offset by an increase in earnings at AEL&P for 2017. Avista Utilities' earnings decreased for 2017 primarily due to costs related to the pending acquisition by Hydro One (see further discussion at "Pending Acquisition by Hydro One" below), which are not being passed through to customers. Further, since a significant portion of these acquisition costs are not deductible for income tax purposes, earnings reflect the full amount of such costs. Excluding acquisition costs, there was a slight increase in other operating expenses, primarily due to an increase in generation and distribution maintenance costs and transmission operating costs. In addition, there were increases in depreciation and amortization and interest expense. Our 2016 requests for general rate increases in Washington were denied. See further discussion at "2016 Washington General Rate Cases" below and "Regulatory Matters" for additional discussion surrounding these requests and all of our other general rate cases. In addition to the increases in costs described above, there was an increase in income tax expense during 2017, primarily due to recent changes in the federal income tax law, which is discussed at "Federal Income Tax Law Changes" below. The increase in costs was partially offset by an increase in gross margin (operating revenues less resource costs) as a result of general rate AVISTA CORPORATION increases in Idaho and Oregon, customer growth and lower electric resource costs. See "Results of Operations - Overall - Non-GAAP Financial Measures" for further discussion of gross margin. AEL&P earnings increased for 2017 resulting from an increase in revenue due to a general rate increase, higher electric loads and a slight increase in residential and commercial customers. During 2017, there was a customer refund charge related to a settlement agreement in AEL&P's electric general rate case which partially offset the increased revenues. There was also an increase in operating expenses for 2017 and a decrease in AFUDC and capitalized interest due to the construction of an additional back-up generation plant completed in 2016. The increase in losses at our other businesses for 2017 was primarily related to an increase in income tax expense resulting from the new federal income tax law. There were also renovation expenses and increased compliance costs at one of our subsidiaries as well as impairment charges associated with two of our equity investments. More detailed explanations of the fluctuations are provided in the results of operations and business segment discussions (Avista Utilities, AEL&P, and the other businesses). 2016 Washington General Rate Cases In December 2016, the WUTC issued an order related to our Washington electric and natural gas general rate cases that were originally filed in February 2016. The WUTC order denied the Company's proposed electric and natural gas rate increase requests totaling $43.0 million. Accordingly, our electric and natural gas retail rates remained unchanged in Washington State for 2017. As a result of the above WUTC decision, for 2017 we expected to earn below our authorized return on equity (ROE) and we expected to experience earnings contraction of $0.20 to $0.30 per diluted share as compared to 2016 actual results. However, our actual 2017 earnings were not as negatively affected as we anticipated primarily due to lower resource costs, which resulted from higher than normal hydroelectric generation and lower than forecasted natural gas prices. Our resource optimization activities also contributed to lower resource costs. Our original expectation for the Energy Recovery Mechanism (ERM) in Washington was to be in an expense position within the 90 percent customers/10 percent shareholders sharing band, whereas actual results were a benefit position within the 75 percent customers/25 percent shareholders sharing band. This represented a change of approximately $12 million for our portion of the ERM. In addition to lower resource costs, we had lower than expected other operating expenses (not including the Hydro One acquisition costs) due to lower pension and medical expenses, lower labor costs due to more of the workforce being utilized for capital projects versus non-capital projects, and lower hardware and software information technology maintenance resulting from the timing of capital projects. We also had lower than expected depreciation expense and net financing expenses. The lower costs described above were offset during 2017 by the Hydro One acquisition costs and the effect of federal income tax law changes, which were not contemplated in our original expectations for 2017. Pending Acquisition by Hydro One On July 19, 2017, Avista Corp. entered into a Merger Agreement that provides for Avista Corp. to become an indirect, wholly-owned subsidiary of Hydro One. Subject to the satisfaction or waiver of specified closing conditions, including approval by regulatory agencies, the transaction is expected to close during the second half of 2018. At the effective time of the acquisition, each share of Avista Corp. common stock issued and outstanding other than shares of Avista Corp. common stock that are owned by Hydro One, Olympus Holding Corp., a wholly owned subsidiary of Hydro One (US parent), and Olympus Corp., a wholly owned subsidiary of US parent (Merger Sub) or any of their respective subsidiaries, will be converted automatically into the right to receive an amount in cash equal to $53, without interest. For further information, see Notes 4 and 19 of the "Notes to Consolidated Financial Statements.” Federal Income Tax Law Changes On December 22, 2017, the TCJA was signed into law. The legislation includes substantial changes to the taxation of individuals as well as U.S. businesses, multi-national enterprises, and other types of taxpayers. Highlights of provisions most relevant to Avista Corp. include: • A permanent reduction in the statutory corporate tax rate from 35 percent to 21 percent, beginning with tax years after 2017; • Statutory provisions requiring that excess deferred taxes associated with public utility property be normalized using the average rate assumption method (ARAM) for determining the timing of the return of excess deferred taxes to customers. Excess deferred taxes result from revaluing deferred tax assets and liabilities based on the newly enacted tax rate instead of the previous tax rate, which, for most rate-regulated utilities like Avista Utilities and AEL&P, results AVISTA CORPORATION in a net benefit to customers that will be deferred as a regulatory liability and passed through to customers over future periods; • Repeal of the corporate alternative minimum tax (AMT); • Bonus depreciation (expensing of capital investment on an accelerated basis) was removed as a deduction for property predominantly used in certain rate-regulated businesses (like Avista Utilities and AEL&P), but is still allowed for our non-regulated businesses; • The deduction for interest expense that is properly allocable to certain rate-regulated trades or businesses is still allowed under the new law, but the deduction is now limited for our non-regulated businesses; and • Net operating loss (NOL) carryback deductions were eliminated, but carryforward deductions are allowed indefinitely with some annual limitations versus the previous 20-year limitation. Our analysis and interpretation of this legislation is complete as it relates to amounts recorded as of December 31, 2017 and based on our evaluation, the reduction of the U.S. corporate income tax rate required a revaluation of our deferred income tax assets and liabilities (including the value of our net operating loss carryforwards) during the fourth quarter of 2017, the period in which the tax legislation was enacted. Because we are predominantly a rate-regulated entity, the net effect of the legislation was recorded as a regulatory liability on the Consolidated Balance Sheets and it will be returned to customers through the ratemaking process in future periods. The total net amount of the regulatory liability associated with the TCJA was $442.3 million as of December 31, 2017, which is made up of $339.9 million in excess deferred taxes and $102.4 million for the income tax gross-up of those excess deferred taxes (which, together with the excess deferred tax amount, reflects the revenue amounts to be refunded to customers through the regulatory process). We expect the Avista Utilities plant related amounts will be returned to customers over a period of approximately 36 years using the ARAM. We expect the AEL&P plant related amounts to be returned to customers over a period of approximately 40 years. We do not currently have an estimate for the amortization period for the regulatory liability attributable to non-plant excess deferred taxes items as we are waiting for additional implementation guidance from various regulatory agencies. We estimate that customers could see a benefit going forward of approximately $50 to $60 million annually, excluding amounts that are currently being deferred for 2018 which will be returned to customers at a later date, due to the return of the excess deferred taxes along with lower federal income tax rates which will be reflected in future rates. Because we have deferred income tax assets and liabilities related to our unregulated subsidiaries and certain utility expenses which are not passed through to our customers, the impact of the revaluation of our deferred income tax assets and liabilities was recorded as a $10.2 million (net) discrete adjustment to income tax expense in the fourth quarter of 2017. Of this income tax expense amount, $7.5 million related to Avista Utilities and $2.7 million related to our other businesses. We expect an annual reduction to net earnings going forward of approximately $0.05 to $0.06 per diluted share due to expenses that are not passed through to our customers at Avista Utilities that will be ongoing into the future. These expenses will reduce earnings in future periods because we will receive a smaller tax deduction for these expenses than we did prior to the enactment of the TCJA. These expenses include SERP expenses, executive stock compensation and charitable donations (including the additional donations that are required as part of the Merger Agreement with Hydro One). The impact of the tax law changes going forward may differ from the amounts above due to, among other things, changes in interpretations and assumptions the Company has made; federal tax regulations, guidance or orders that may be issued by the U.S. Department of the Treasury, Internal Revenue Service, and our regulatory commissions; and actions the Company may take as a result of the tax law changes. Overall, we expect a net benefit to our customers as a result of tax law changes; however, because of the TCJA and the changes to our accumulated deferred income tax balances, our net utility property for regulatory purposes (rate base) is likely to increase in future periods, which would increase our annual revenue requirements and offset some of the benefits to customers from tax rate reductions. Rate base is likely to increase because, for ratemaking purposes, net deferred tax liabilities are netted against our rate base. Because most of the provisions of the TCJA are effective as of January 1, 2018 (including a reduction of the income tax rate to 21 percent), but our customers' rates continue to have the 35 percent corporate tax rate built in from prior general rate cases, we filed Petitions in December 2017 with the WUTC and OPUC requesting orders authorizing the deferral of the accounting impact of the change in federal income tax expense caused by the enactment of the TCJA. The IPUC on its own ordered deferred accounting for all jurisdictional utilities in January 2018. We are requesting to defer the impact of the change in federal income tax expense beginning in January 2018 forward until all benefits are properly captured through the deferral process and refunded to customers through tariffs to be reviewed and implemented in future rate proceedings. The IPUC has requested a report on the estimated overall benefit to customers related to the impacts of the TCJA by March 30, 2018. The WUTC has issued a bench request in our 2017 electric and natural gas general rate cases requesting such information by February 28, 2018. AVISTA CORPORATION Although it is unclear when or how capital markets, credit rating agencies, the FERC or state public utility commissions may respond to this legislation, we expect that certain financial metrics used by credit rating agencies to evaluate the Company will be negatively impacted as a result of the TCJA. This is primarily due to our expectation that future cash flows from operations will be negatively impacted going forward for the following reasons: • Because of accelerated depreciation, including bonus depreciation, and other tax deductions, we have paid less in actual cash taxes than what was being collected from customers. The temporary timing differences between cash paid as income taxes and tax expense recorded for GAAP resulted in the recording of a net deferred tax liability. This temporary timing difference from prior years will ultimately reverse with taxable income and corresponding income taxes increasing in future years; • Lowering the corporate tax rate to 21 percent resulted in excess deferred taxes, which must be returned to customers using the ARAM discussed above. This will result in a reduction of future revenue as we refund the excess deferred taxes to customers; • Lowering the tax rate to 21 percent will result in customers' future rates having an embedded 21 percent tax rate rather than the 35 percent tax rate, which will result in lower future revenue (which will be offset by lower actual tax expenses); and • The loss of the bonus depreciation tax deduction for 2018 and 2019 results in less depreciation as a tax deduction in those years, which will increase our taxable income and result in us having to pay taxes earlier than we had projected under the old tax law. There may be other material adverse effects resulting from the legislation that we have not yet identified. These effects have resulted in Moody's placing a negative outlook on our crdedit rating and could result in Moody's taking further negative action or other credit rating agencies taking similar action. These actions by credit rating agencies may make it more difficult and costly for us to issue future debt securities and could increase borrowing costs under our credit facilities. See "Note 11 of the Notes to Consolidated Financial Statements" and "Risk Factors" for additional information regarding the TCJA and its specific impacts to our financial statements. Regulatory Matters General Rate Cases We regularly review the need for electric and natural gas rate changes in each state in which we provide service. We will continue to file for rate adjustments to: • seek recovery of operating costs and capital investments, and • seek the opportunity to earn reasonable returns as allowed by regulators. With regards to the timing and plans for future filings, the assessment of our need for rate relief and the development of rate case plans takes into consideration short-term and long-term needs, as well as specific factors that can affect the timing of rate filings. Such factors include, but are not limited to, in-service dates of major capital investments and the timing of changes in major revenue and expense items. Avista Utilities Washington General Rate Cases 2015 General Rate Cases In January 2016, we received an order (Order 05) that concluded our electric and natural gas general rate cases that were originally filed with the WUTC in February 2015. New electric and natural gas rates were effective on January 11, 2016. The WUTC-approved rates were designed to provide a 1.6 percent, or $8.1 million decrease in electric base revenue, and a 7.4 percent, or $10.8 million increase in natural gas base revenue. The WUTC also approved a rate of return (ROR) on rate base of 7.29 percent, with a common equity ratio of 48.5 percent and a 9.5 percent ROE. WUTC Order Denying Industrial Customers of Northwest Utilities / Public Counsel Joint Motion for Clarification, WUTC Staff Motion to Reconsider and WUTC Staff Motion to Reopen Record On January 19, 2016, the Industrial Customers of Northwest Utilities (ICNU) and the Public Counsel Unit of the Washington State Office of the Attorney General (PC) filed a Joint Motion for Clarification with the WUTC. In the Motion for Clarification, ICNU and PC requested that the WUTC clarify the calculation of the electric attrition AVISTA CORPORATION adjustment and the end-result revenue decrease of $8.1 million. ICNU and PC provided their own calculations in their Motion, and suggested that the revenue decrease should have been $19.8 million based on their reading of the WUTC’s Order. On January 19, 2016, the WUTC Staff, which is a separate party in the general rate case proceedings from the WUTC Advisory Staff, filed a Motion to Reconsider with the WUTC. In its Motion to Reconsider, the Staff provided calculations and explanations that suggested that the electric revenue decrease should have been $27.4 million instead of $8.1 million, based on its reading of the WUTC's Order. Further, on February 4, 2016, the WUTC Staff filed a Motion to Reopen Record for the Limited Purpose of Receiving into Evidence Instruction on Use and Application of Staff’s Attrition Model, and sought to supplement the record “to incorporate all aspects of the Company’s Power Cost Update.” Within this Motion, WUTC Staff updated its suggested electric revenue decrease to $19.6 million. None of the parties in their Motions raised issues with the WUTC’s decision on the natural gas revenue increase of $10.8 million. On February 19, 2016, the WUTC issued an order (Order 06) denying the Motions summarized above and affirming Order 05, including an $8.1 million decrease in electric base revenue. PC Petition for Judicial Review On March 18, 2016, PC filed in Thurston County Superior Court a Petition for Judicial Review of the WUTC's Order 05 and Order 06 described above that concluded our 2015 electric and natural gas general rate cases. In its Petition for Judicial Review, PC seeks judicial review of five aspects of Order 05 and Order 06, alleging, among other things, that (1) the WUTC exceeded its statutory authority by setting rates for our natural gas and electric services based on amounts for utility plant and facilities that are not "used and useful" in providing utility service to customers; (2) the WUTC acted arbitrarily and capriciously in granting an attrition adjustment for our electric operations after finding that the we did not meet the newly articulated standard regarding attrition adjustments; (3) the WUTC erred in applying the "end results test" to set rates for our electric operations that are not supported by the record; (4) the WUTC did not correct its calculation of our electric rates after significant errors were brought to its attention; and (5) the WUTC's calculation of our electric rates lacks substantial evidence. PC is requesting that the Court (1) vacate or set aside portions of the WUTC’s orders; (2) identify the errors contained in the WUTC’s orders; (3) find that the rates approved in Order 05 and reaffirmed in Order 06 are unlawful and not fair, just and reasonable; (4) remand the matter to the WUTC for further proceedings consistent with these rulings, including a determination of our revenue requirement for electric and natural gas services; and (5) find the customers are entitled to a refund. On April 18, 2016, PC filed an application with the Thurston County Superior Court to certify this matter for review directly by the Court of Appeals, an intermediate appellate court in the State of Washington. The matter was certified on April 29, 2016 and accepted by the Court of Appeals on July 29, 2016. On July 7, 2017, ICNU filed a brief in support of PC and the WUTC and Avista Corp. responded. Oral argument was held on October 24, 2017 before the court. A decision from the Court is expected sometime in 2018. In its brief to the Court, the WUTC, while defending the use of its attrition adjustment, nevertheless requested a partial remand back to the WUTC to reevaluate its implementation of our power cost update as part of the 2015 general rate case, doing so by means of a supplemental evidentiary hearing. The power cost update at issue represents approximately $12.0 million of costs. The new rates established by Order 05 will continue in effect while the Petition for Judicial Review is being considered. We believe the WUTC's Order 05 and Order 06 finalizing the electric and natural gas general rate cases provide a reasonable end result for all parties. If the outcome of the judicial review were to result in an electric rate reduction greater than the decrease ordered by the WUTC, it may result in a refund liability to customers of up to $9.5 million, which is net of a refund for Washington electric customers of approximately $2.5 million related to the 2016 provision for earnings sharing that we have already accrued. The potential refund liability amount is limited to 2016 revenues and would not impact 2017 revenues collected from customers. 2016 General Rate Cases In December 2016, the WUTC issued an order related to our Washington electric and natural gas general rate cases that were originally filed with the WUTC in February 2016. The WUTC order denied the Company's proposed electric and natural gas AVISTA CORPORATION rate increase requests of $38.6 million and $4.4 million, respectively. Accordingly, our electric and natural gas retail rates remained unchanged in Washington State following the order. The primary reason given by the WUTC in reaching its conclusion was that, in our request, we did not follow an “appropriate methodology” to show the existence of attrition, as between historical data and current and projected data. In support of its decision, the WUTC stated that we did not demonstrate that our current revenue was insufficient for covering costs and providing the opportunity to earn a reasonable return during the 2017 rate period. The WUTC also stated that we did not demonstrate that our capital expenditures and increased operating costs are both necessary and immediate. We determined that an appeal of the WUTC’s decision to the courts would involve a significant amount of uncertainty regarding the level of success of such an appeal, as well as the timing of any value that might come following a process that would take between one and two years. The Company concluded greater long-term value could be achieved through focusing on new general rate cases than through appealing the WUTC's decision in the courts. 2017 General Rate Cases On May 26, 2017, we filed two requests with the WUTC to recover costs related to power supply and operating costs as well as capital investments made since the last determination of our rate base in the 2015 Washington general rate cases. The two filings are summarized as follows: Power Cost Rate Adjustment The first filing was an electric only power cost rate adjustment (PCRA) that was designed to update and reset power supply costs, effective September 1, 2017. We requested an overall increase in billed electric rates of 2.9 percent (designed to increase annual electric revenues by $15.0 million). On August 10, 2017, the PCRA filing was denied by the WUTC. An increased level of power supply costs is included in our pending general rate case in Washington, which is scheduled to conclude by April 26, 2018. The denial of the PCRA by the WUTC does not affect our general rate requests discussed below. General Rate Requests The second request related to electric and natural gas general rate cases. We filed three-year rate plans for electric and natural gas and have requested the following for each year (dollars in millions): (1) The revenue and base rate increases in the table above reflect reductions from what was originally filed primarily due to changes in the timing of planned capital projects. (2) As a part of the electric rate plan, we have proposed to update power supply costs through a Power Supply Update, the effects of which would also go into effect on May 1, 2019 and May 1, 2020. The requested revenue increases for 2019 and 2020 do not include any power supply adjustments. Our request is based on a proposed ROR of 7.76 percent with a common equity ratio of 50.0 percent and a 9.9 percent ROE. As a part of the three-year rate plan, if approved, we would not file another general rate case until June 1, 2020, with new rates effective no earlier than May 1, 2021. The major drivers of these general rate case requests is to recover the costs associated with our capital investments to replace infrastructure that has reached the end of its useful life, as well as respond to the need for reliability and technology investments required to maintain our integrated energy services grid. Among the capital investments included in the filings are: • Major hydroelectric investments at the Little Falls and Nine Mile hydroelectric plants. AVISTA CORPORATION • Generator maintenance at the Kettle Falls biomass plant that will ensure efficient generation and operations. • The ongoing project to systematically replace portions of natural gas distribution pipe in our service area that were installed prior to 1987, as well as replacement of other natural gas service equipment. • Transmission and distribution system and asset maintenance, such as wood pole replacements, feeder upgrades, and substation and transmission line rebuilds to maintain reliability for our customers. • Technology upgrades that support necessary business processes and operational efficiencies that allow us to effectively manage the utility and serve customers. • A refresh of the customer-facing website, providing relevant information, greater accessibility on mobile devices, easier navigation, and a streamlined payment experience. The WUTC has up to 11 months to review the general rate case filings and issue a decision, which is scheduled to be issued by April 26, 2018. On October 27, 2017, WUTC Staff and other parties to our electric and natural gas general rate cases filed their testimony. These parties recommended lower revenue requirements than what we proposed in our original filings. WUTC Staff also recommended that our power cost adjustment of approximately $16 million be denied, and that the existing level of power supply costs included in base rates be continued until either (a) our next general rate case or (b) the cumulative deferral balance in the ERM drops below $10 million. Additionally, the WUTC Staff recommended the exclusion of our 2016 settlement costs of interest rate swaps from the cost of capital calculation. The total amount of 2016 settlement costs was $54.0 million, with approximately 60 percent of this total being allocable to Washington. In addition to our 2016 settlement costs of interest rate swaps, we have a net regulatory asset of $8.8 million for interest rate swaps settled during 2017, and a net regulatory asset of $66.0 million for unsettled interest rate swaps as of December 31, 2017 related to forecasted debt issuances. Of those amounts, approximately 60 percent are allocable to Washington. If recovery of the 2016 settlement costs referenced above are not approved by the WUTC, this could change our current conclusion that 2017 settlement costs of interest rate swaps and the unsettled interest rate swaps are probable of recovery through rates. If we concluded that recovery of these swap settlement costs was no longer probable, we would be required to derecognize the related regulatory assets and liabilities with an adjustment through the income statement, and any subsequent gains and losses would be recognized through the income statement rather than being recorded as a regulatory asset or liability. Interest rate swaps are a tool used throughout multiple industries to manage interest rate risk. They also provide certainty for future cash flows associated with future borrowings. Since interest costs are included in our costs of service to be recovered from our customers, we have used this tool to manage these costs for the benefit of our customers. The settlement of interest rate swaps results in either a benefit or a cost to us which, in either case, has historically been reflected in rates authorized by the WUTC in general rate cases. Accordingly, we still believe the interest rate swap payments are probable of recovery and will continue to work through the rate case process. Depending on the outcome of this proceeding, we could determine to not manage interest rate risk through swap transactions in the future. Idaho General Rate Cases 2015 General Rate Cases In December 2015, the IPUC approved a settlement agreement between Avista Utilities and all interested parties, concluding our electric and natural gas general rate cases originally filed in June 2015. New rates were effective on January 1, 2016. The settlement agreement increased annual electric base revenues by 0.7 percent (designed to increase annual electric revenues by $1.7 million) and annual natural gas base revenues by 3.5 percent (designed to increase annual natural gas revenues by $2.5 million). The settlement was based on a ROR of 7.42 percent with a common equity ratio of 50 percent and a 9.5 percent ROE. The settlement agreement also reflects the following: • the discontinuation of the after-the-fact earnings test (provision for earnings sharing) that was originally agreed to as part of the settlement of our 2012 electric and natural gas general rate cases, and • the implementation of electric and natural gas Fixed Cost Adjustment mechanisms. AVISTA CORPORATION 2016 General Rate Cases In December 2016, the IPUC approved a settlement agreement between us and other parties, concluding our electric general rate case originally filed in May 2016. New rates were effective on January 1, 2017. We did not file a natural gas general rate case in 2016. The settlement agreement increased annual electric base rates by 2.6 percent (designed to increase annual electric revenues by $6.3 million). The settlement was based on a ROR of 7.58 percent with a common equity ratio of 50 percent and a 9.5 percent ROE. 2017 General Rate Cases On December 28, 2017, the IPUC approved a settlement agreement between us and other parties to our electric and natural gas general rate cases. New rates were effective on January 1, 2018 and additional rate changes will take effect on January 1, 2019. The settlement agreement is a two-year rate plan and has the following electric and natural gas base rate changes each year, which are designed to result in the following increases in annual revenues (dollars in millions): The settlement agreement is based on a ROR of 7.61 percent with a common equity ratio of 50.0 percent and a 9.5 percent ROE. As a part of the two-year rate plan the Company will not file a new general rate case for a new rate plan to be effective prior to January 1, 2020. Oregon General Rate Cases 2015 General Rate Case In February 2016, the OPUC issued a preliminary order (and a final order in March 2016) concluding our natural gas general rate case, which was originally filed with OPUC in May 2015. The OPUC order approved rates designed to increase overall billed natural gas rates by 4.9 percent (designed to increase annual natural gas revenues by $4.5 million). New rates went into effect on March 1, 2016. The final OPUC order incorporated two partial settlement agreements which were entered into during November 2015 and January 2016. The OPUC order provided an authorized ROR of 7.46 percent with a common equity ratio of 50 percent and a 9.4 percent ROE. The November 2015 partial settlement agreement, approved by the OPUC, included a provision for the implementation of a decoupling mechanism, similar to the Washington and Idaho mechanisms described below. See further description and a summary of the balances recorded under this mechanism below. 2016 General Rate Case In September 2017, the OPUC approved a settlement agreement between us and other parties to our natural gas general rate case that was filed with the OPUC in November 2016, which resolved all issues in the case. The OPUC approved rates designed to increase annual base revenues by 5.9 percent or $3.5 million. A rate adjustment of $2.6 million became effective October 1, 2017, and a second adjustment of $0.9 million became effective on November 1, 2017 to cover specific capital projects identified in the settlement agreement, which were completed in October. In addition, in the settlement agreement, we agreed to non-recovery of certain utility plant expenditures, which resulted in a write-off of $0.8 million in the second quarter of 2017. The settlement agreement reflects a 7.35 percent ROR with a common equity ratio of 50 percent and a 9.4 percent ROE. AMI Project In March 2016, the WUTC granted our Petition for an Accounting Order to defer and include in a regulatory asset the undepreciated value of our existing Washington electric meters for the opportunity for later recovery. This accounting treatment is related to our plans to replace approximately 253,000 of our existing electric meters with new two-way digital meters and the AVISTA CORPORATION related software and support services through our AMI project in Washington State. Replacement of the meters is expected to begin in the second half of 2018. As of December 31, 2017, the estimated undepreciated value for the existing meters is $24.3 million. In May 2017, we filed a Petition with the WUTC requesting deferred accounting treatment for the investment costs associated with the Washington AMI project, including components such as meter communication networks, information management systems and natural gas encoder receiver transmitters (ERT). The Petition requested the deferral and inclusion in a regulatory asset of all AMI investment costs over the multi-year implementation period, until the costs could be reviewed for prudence in a future regulatory proceeding and recovered through retail rates. Through discussions with WUTC staff, we developed an alternative proposal to our original Petition and in September 2017, the WUTC approved our alternative proposal to defer the depreciation expense associated with AMI, along with a carrying charge, and to seek recovery of the deferral and carrying charge in a future general rate case. Cost savings, such as reduced meter reading costs, will occur during the implementation period which will offset a portion of the AMI costs not being deferred. The WUTC also approved our request to defer the undepreciated net book value of existing natural gas ERTs (consistent with the accounting treatment we obtained on our existing electric meters) that will be retired as part of the AMI project. In May 2017, we filed Petitions with the IPUC and the OPUC requesting a depreciable life of 12.5 years for the meter data management system (MDM) related to the AMI project and both the IPUC and the OPUC approved the depreciable life. In addition, in connection with the recently completed Idaho electric general rate case (discussed above), the settling parties agreed to cost recovery of Idaho's share of the MDM system, effective January 1, 2019. In connection with the approval of the Oregon general rate case settlement (discussed above), the OPUC approved cost recovery of Oregon's share of the MDM system, effective November 1, 2017. Alaska Electric Light and Power Company Alaska General Rate Case In November 2017, the RCA approved an all-party settlement agreement related to AEL&P's electric general rate case, which was originally filed in September 2016. The settlement agreement is designed to increase base electric revenue by 3.86 percent or $1.3 million, making permanent the interim rate increase approved by the RCA in 2016. In addition, AEL&P agreed to retain $0.9 million less revenue from the Greens Creek Mine than what was included in the original general rate case request. As such, in 2017, AEL&P recorded a refund liability to customers of $1.0 million (with $0.9 million related to 2017 revenues and $0.1 million related to 2016 revenues), which will be refunded to customers during the first quarter of 2018. The amount of revenue from Greens Creek Mine that is retained by AEL&P is used to offset revenue requirements that would otherwise be required from retail customers. The agreement reflects an 8.91 percent ROR with a common equity ratio of 58.18 percent and an 11.95 percent ROE. Avista Utilities Purchased Gas Adjustments PGAs are designed to pass through changes in natural gas costs to Avista Utilities' customers with no change in gross margin (operating revenues less resource costs) or net income. In Oregon, we absorb (cost or benefit) 10 percent of the difference between actual and projected natural gas costs included in retail rates for supply that is not hedged. Total net deferred natural gas costs among all jurisdictions were a liability of $37.5 million as of December 31, 2017 and a liability of $30.8 million as of December 31, 2016. These deferred natural gas costs balances represent amounts due to customers. AVISTA CORPORATION The following PGAs went into effect in our various jurisdictions during 2015 through 2018: (1) Due to declining wholesale natural gas prices that have occurred since the 2017 PGAs were filed and went into effect, we filed, and the respective commissions approved, out of cycle PGAs to reduce customer rates and pass through expected lower costs during the winter heating months, rather than waiting until the next regular PGA cycle. Power Cost Deferrals and Recovery Mechanisms Deferred power supply costs are recorded as a deferred charge or liability on the Consolidated Balance Sheets for future prudence review and recovery or rebate through retail rates. The power supply costs deferred include certain differences between actual net power supply costs incurred by Avista Utilities and the costs included in base retail rates. This difference in net power supply costs primarily results from changes in: • short-term wholesale market prices and sales and purchase volumes, • the level, availability and optimization of hydroelectric generation, • the level and availability of thermal generation (including changes in fuel prices), • retail loads, and • sales of surplus transmission capacity. The ERM is an accounting method used to track certain differences between Avista Utilities' actual power supply costs, net of wholesale sales and sales of fuel, and the amount included in base retail rates for our Washington customers. Total net deferred power costs under the ERM were a liability of $23.7 million as of December 31, 2017 and a liability $21.3 million as of December 31, 2016. These deferred power cost balances represent amounts due to customers. Under the ERM, Avista Utilities absorbs the cost or receives the benefit from the initial amount of power supply costs in excess of or below the level in retail rates, which is referred to as the deadband. The annual (calendar year) deadband amount is $4.0 million. The following is a summary of the ERM: AVISTA CORPORATION Under the ERM, Avista Utilities makes an annual filing on or before April 1 of each year to provide the opportunity for the WUTC staff and other interested parties to review the prudence of and audit the ERM deferred power cost transactions for the prior calendar year. Avista Utilities has a PCA mechanism in Idaho that allows us to modify electric rates on October 1 of each year with IPUC approval. Under the PCA mechanism, we defer 90 percent of the difference between certain actual net power supply expenses and the amount included in base retail rates for our Idaho customers. The October 1 rate adjustments recover or rebate power supply costs deferred during the preceding July-June twelve-month period. Total net power supply costs deferred under the PCA mechanism were a liability of $6.1 million as of December 31, 2017 and a liability of $2.2 million as of December 31, 2016. These deferred power cost balances represent amounts due to customers. Decoupling and Earnings Sharing Mechanisms Decoupling (also known as a FCA in Idaho) is a mechanism designed to sever the link between a utility's revenues and consumers' energy usage. In each of our jurisdictions, Avista Utilities' electric and natural gas revenues are adjusted so as to be based on the number of customers in certain customer rate classes and assumed "normal" kilowatt hour and therm sales, rather than being based on actual kilowatt hour and therm sales. The difference between revenues based on the number of customers and "normal" sales and revenues based on actual usage is deferred and either surcharged or rebated to customers beginning in the following year. Only residential and certain commercial customer classes are included in our decoupling mechanisms. Washington Decoupling and Earnings Sharing In Washington, the WUTC approved our decoupling mechanisms for electric and natural gas for a five-year period beginning January 1, 2015. Electric and natural gas decoupling surcharge rate adjustments to customers are limited to a 3 percent increase on an annual basis, with any remaining surcharge balance carried forward for recovery in a future period. There is no limit on the level of rebate rate adjustments. The decoupling mechanisms each include an after-the-fact earnings test. At the end of each calendar year, separate electric and natural gas earnings calculations are made for the calendar year just ended. These earnings tests reflect actual decoupled revenues, normalized power supply costs and other normalizing adjustments. If we earn more than our authorized ROR in Washington, 50 percent of excess earnings are rebated to customers through adjustments to existing decoupling surcharge or rebate balances. See below for a summary of cumulative balances under the decoupling and earnings sharing mechanisms. Idaho FCA and Earnings Sharing Mechanisms In Idaho, the IPUC approved the implementation of FCAs for electric and natural gas (similar in operation and effect to the Washington decoupling mechanisms) for an initial term of three years, beginning January 1, 2016. For the period 2013 through 2015, we had an after-the-fact earnings test, such that if Avista Corp., on a consolidated basis for electric and natural gas operations in Idaho, earned more than a 9.8 percent ROE, we were required to share with customers 50 percent of any earnings above the 9.8 percent. This after-the-fact earnings test was discontinued as part of the settlement of our 2015 Idaho electric and natural gas general rates cases (discussed in further detail above). See below for a summary of cumulative balances under the decoupling and earnings sharing mechanisms. Oregon Decoupling Mechanism In February 2016, the OPUC approved the implementation of a decoupling mechanism for natural gas, similar to the Washington and Idaho mechanisms described above. The decoupling mechanism became effective on March 1, 2016. There will be an opportunity for interested parties to review the mechanism and recommend changes, if any, by September 2019. In Oregon, an earnings review is conducted on an annual basis. In the annual earnings review, if we earn more than 100 basis points above our allowed return on equity, one-third of the earnings above the 100 basis points would be deferred and later rebated to customers. See below for a summary of cumulative balances under the decoupling and earnings sharing mechanisms. AVISTA CORPORATION Cumulative Decoupling and Earnings Sharing Mechanism Balances As of December 31, 2017 and December 31, 2016, we had the following cumulative balances outstanding related to decoupling and earnings sharing mechanisms in our various jurisdictions (dollars in thousands): See "Results of Operations - Avista Utilities" for further discussion of the amounts recorded to operating revenues in 2015 through 2017 related to the decoupling and earnings sharing mechanisms. State Regulatory Approval Requirements Related to the Pending Acquisition by Hydro One The following is a brief summary of the state regulatory approvals that are required for the proposed acquisition of the Company by Hydro One. On September 14, 2017, Avista Corp. and Hydro One filed applications for approval of the acquisition with the WUTC, the IPUC, the MPSC and the OPUC, requesting approval of the transaction on or before August 14, 2018. However, the OPUC has set a procedural schedule with an end date no later than September 14, 2018. On November 21, 2017, applications for approval of the acquisition were filed with the RCA, with a statutory deadline of May 20, 2018. The principal issue before the WUTC in the proceeding for approval of the proposed transaction will be whether the transaction is consistent with the public interest, per Washington Administrative Code 480-143-170. In addition, under the Revised Code of Washington 80.12.020, the WUTC must determine that the transaction provides a “net benefit” to the customers of the Company. Before the IPUC may authorize such a transaction, the utility must prove that the transaction is consistent with the public interest, that the cost and rates for the utility’s service will not increase as a result of the transaction, and that the new owner “has the bona fide intent and financial ability to operate and maintain said property in the public service.” In addition, because the transaction includes hydropower water rights used in the generation of electric power, the director of the Idaho Department of Water Resources must issue conditions protecting the public interest and existing water rights holders with respect to the hydropower water right to be transferred, and the IPUC must include any such conditions in its approval of the transfer. The MPSC generally applies any of three standards to evaluate transfers of public utilities: the public interest standard, the no-harm-to-consumers standard, or the net-benefit-to-consumers standard (see Order No. 6754e in Docket. No. 02006.6.82). The MPSC seeks to assure that utility customers will receive adequate service and facilities, that utility rates will not increase as a result of the sale or transfer, and that the acquiring entity is fit, willing, and able to assume the service responsibilities of a public utility, though it has not enunciated a specific standard for approval because of the variety of situations that arise. The OPUC must determine that the transaction “will serve the public utility’s customers and is in the public interest.” The OPUC interprets Oregon Revised Statute § 757.511 to impose a “net benefits” test (see Order No. 06-082, at p.3 (Docket. No. UM 1209)). This analysis must include consideration of the effect of the transaction on the amount of income taxes paid by the utility and its affiliates and the approval must adjust the utility’s rates accordingly. On February 12, 2018, OPUC Staff and other interested parties in Oregon filed their initial recommendations regarding the proposed acquisition by Hydro One. In their initial recommendation, the OPUC Staff recommended that the Commission deny the application as it was originally filed. OPUC Staff believes the application does not provide a net benefit to Avista Corp.’s customers, nor are the ring-fencing commitments adequate to protect those customers from harm. However, the OPUC Staff indicated they would not issue a final opinion until after receiving and reviewing additional testimony from us and Hydro One and they indicated they would consider a more comprehensive and functional set of interlocking, reinforcing conditions designed to help ensure that Avista Corp. customers are not harmed by the proposed merger, accompanied by a proposal with incremental benefits to customers. AVISTA CORPORATION The RCA will examine whether the entity seeking to acquire the controlling interest is “fit, willing, and able and whether the proposed transfer is consistent with the public interest under the criteria set forth in Alaska Statute 42.05.” Avista Corp. and Hydro One intend to work with the various commissions, their staff and other parties to try and satisfy any concerns associated with the proposed transaction. Results of Operations - Overall The following provides an overview of changes in our Consolidated Statements of Income. More detailed explanations are provided, particularly for operating revenues and operating expenses, in the business segment discussions (Avista Utilities, AEL&P, Ecova - Discontinued Operations and the other businesses) that follow this section. The balances included below for utility operations reconcile to the Consolidated Statements of Income. 2017 compared to 2016 The following graph shows the total change in net income from continuing operations for 2016 to 2017, as well as the various factors that caused such change (dollars in millions): Utility revenues increased due to an increase at AEL&P, partially offset by a decrease at Avista Utilities. AEL&P's revenues increased primarily due to a general rate increase and higher retail heating loads due to weather that was cooler than the prior year. There was also a slight increase in the number of customers at AEL&P. Avista Utilities' revenues decreased primarily due to a decrease in electric and natural gas wholesale revenues and revenues from sales of fuel, mostly offset by an increase in electric and natural gas retail revenues. Retail revenues increased due to an increase in volumes and an electric general rate increase in Idaho and a natural gas general rate increase in Oregon. The higher retail sales volumes resulted from increased heating loads during the heating season, increased electric cooling loads during the summer and due to customer growth. The increased utility revenues were partially offset by decoupling rebates during 2017 due to weather that fluctuated from normal. This compares to decoupling surcharges during 2016. Utility resource costs decreased due to a decrease at Avista Utilities. Avista Utilities' electric resource costs decreased primarily due to a decrease in purchased power (from lower wholesale prices) and a decrease in fuel for generation (due in part to increased hydroelectric generation). Natural gas resource costs decreased due to a decrease in natural gas purchased resulting from lower wholesale sales volumes. Utility operating expenses increased due to an increase at Avista Utilities and a slight increase at AEL&P. The increase at Avista Utilities' was the result of an increase in generation and distribution maintenance costs and transmission operating costs. There was also a write-off in Oregon of utility plant associated with a general rate case settlement. The increased costs were partially offset by decreases in pension, other postretirement benefit and medical expenses. The acquisition costs are related to the pending acquisition by Hydro One and consist primarily of consulting, banking fees, legal fees and employee time and are not being passed through to customers. Utility depreciation and amortization increased due to additions to utility plant. Income tax expense increased primarily due to the enactment of the TCJA in December 2017, which resulted in a non-cash charge to income tax expense of $10.2 million during 2017 from revaluing our deferred income tax assets and liabilities based AVISTA CORPORATION on the new federal tax rate. This was partially offset by the effect of a decrease in income before income taxes. Our effective tax rate was 41.7 percent for 2017 and 36.3 percent for 2016. The effective tax rate increased due to federal income tax law changes and due to acquisition costs. The acquisition costs reduce income before income taxes, but a significant portion of these costs are not deductible for tax purposes and thus do not reduce income tax expense. See "Note 11 of the Notes to Consolidated Financial Statements" for a reconciliation of our effective income tax rate. Other was primarily related to an increase in interest expense, due to additional debt being outstanding during 2017 as compared to 2016 and partially due to an increase in the overall interest rate. There was also an increase in utility taxes other than income taxes primarily due to revenue-related taxes, which resulted from an increase in electric and natural gas retail revenue. Lastly, there were impairments recorded during 2017 on two of our equity investments. 2016 compared to 2015 The following graph shows the total change in net income from continuing operations for 2015 to 2016, as well as the various factors that caused such change (dollars in millions): Utility revenues decreased due to a decrease at Avista Utilities, partially offset by a slight increase in AEL&P's revenues. Avista Utilities' electric revenues decreased primarily due to lower retail electric loads caused by weather fluctuations throughout the period, a general rate decrease in Washington and lower wholesale revenues resulting from lower volumes and lower wholesale prices. These revenue decreases were partially offset by a general rate increase in Idaho, the expiration of the ERM rebate to customers in Washington, increased decoupling revenues and a lower provision for earnings sharing. Natural gas revenues decreased primarily due to a decrease in wholesale activity (both a decrease in volumes and prices) and lower retail revenues due to lower prices, partially offset by higher natural gas heating volumes. The decreases in natural gas revenues were partially offset by general rate increases and higher decoupling revenues. Non-utility revenues decreased due to the long-term fixed rate electric capacity contract that was previously held by Spokane Energy being transferred to Avista Corp. during the second quarter of 2015. The capacity revenue from this contract was included in non-utility revenues when it was held by Spokane Energy during the first quarter of 2015. After the transfer, the revenue is included in Avista Utilities' revenues. The contract expired during December 2016. Utility resource costs decreased due to a decrease at Avista Utilities. Avista Utilities' electric resource costs decreased primarily due to a decrease in purchased power (from lower volumes purchased and lower wholesale prices) and a decrease in fuel for generation (due in part to increased hydroelectric generation). Natural gas resource costs decreased due to a decrease in natural gas purchased resulting from lower volumes and lower prices. Utility operating expenses increased due to an increase at Avista Utilities and a slight increase at AEL&P. Avista Utilities' portion of other operating expenses increased due to an increase in medical costs, electric generation operating and maintenance expenses, natural gas distribution expenses and other postretirement benefit expenses. Utility depreciation and amortization increased due to additions to utility plant. AVISTA CORPORATION Income tax expense increased primarily due to an increase in income before income taxes, partially offset by excess tax benefits of $1.6 million during 2016 relating to the settlement of share-based payment awards. See "Note 2 of the Notes to Consolidated Financial Statements" for further discussion of the excess tax benefits. Our effective tax rate was 36.3 percent for both 2016 and 2015. Other was primarily related to an increase in interest expense, due to additional debt being outstanding during 2016 as compared to 2015 and partially due to an increase in the overall interest rate. Also, there were losses on investments at our subsidiaries, mainly due to initial organization costs and management fees associated with a new investment. Non-GAAP Financial Measures The following discussion for Avista Utilities includes two financial measures that are considered “non-GAAP financial measures,” electric gross margin and natural gas gross margin. In the AEL&P section, we include a discussion of electric gross margin, which is also a non-GAAP financial measure. Generally, a non-GAAP financial measure is a numerical measure of a company's financial performance, financial position or cash flows that excludes (or includes) amounts that are included (excluded) in the most directly comparable measure calculated and presented in accordance with GAAP. The presentation of electric gross margin and natural gas gross margin is intended to supplement an understanding of operating performance. We use these measures to determine whether the appropriate amount of revenue is being collected from our customers to allow for the recovery of energy resource costs and operating costs, as well as to analyze how changes in loads (due to weather, economic or other conditions), rates, supply costs and other factors impact our results of operations. In addition, we present electric and natural gas gross margin separately below for Avista Utilities since each business has different cost sources, cost recovery mechanisms and jurisdictions, such that separate analysis is beneficial. These measures are not intended to replace income from operations as determined in accordance with GAAP as an indicator of operating performance. The calculations of electric and natural gas gross margins are presented below. Results of Operations - Avista Utilities 2017 compared to 2016 The following table presents Avista Utilities' operating revenues, resource costs and resulting gross margin for the years ended December 31 (dollars in millions): The gross margin on electric sales increased $12.8 million and the gross margin on natural gas sales increased $13.1 million. The increase in electric gross margin was primarily due to a general rate increase in Idaho, customer growth, increases in loads not subject to decoupling and lower resource costs. For 2017, we recognized a pre-tax benefit of $4.6 million under the ERM in Washington compared to a benefit of $5.1 million for 2016. The increase in natural gas gross margin was primarily due to a general rate increase in Oregon, customer growth and increases in loads not subject to decoupling. Intracompany revenues and resource costs represent purchases and sales of natural gas between our natural gas distribution operations and our electric generation operations (as fuel for our generation plants). These transactions are eliminated in the presentation of total results for Avista Utilities and in the consolidated financial statements but are included in the separate results for electric and natural gas presented below. AVISTA CORPORATION The following graphs present Avista Utilities' electric operating revenues and megawatt-hour (MWh) sales for the years ended December 31 (dollars in millions and MWhs in thousands): (1) This balance includes public street and highway lighting, which is considered part of retail electric revenues and it also includes revenues and rebates from decoupling. AVISTA CORPORATION The following table presents Avista Utilities' decoupling and customer earnings sharing mechanisms by jurisdiction that are reflected in utility electric operating revenues for the years ended December 31 (dollars in thousands): (1) The provision for earnings sharing in Washington for 2017 represents a $0.2 million adjustment for the 2016 provision for earnings sharing and $1.0 million relating to 2017 earnings. The provision for earnings sharing in Washington in 2016 resulted from a $2.5 million reduction in the 2015 provision for earnings sharing (which increased 2016 revenues) offset by a $2.3 million provision for earnings sharing for 2016 electric operations. (2) The provision for earnings sharing in Idaho in 2016 resulted from a reduction in the 2015 provision for earnings sharing (which increased 2016 revenues). Beginning in 2016 there is no longer an earnings sharing mechanism in Idaho. (n/a) This mechanism did not exist during this time period. Total electric revenues decreased $16.6 million for 2017 as compared to 2016, primarily reflecting the following: • a $52.0 million increase in retail electric revenues due to an increase in total MWhs sold (increased revenues $36.6 million) and an increase in revenue per MWh (increased revenues $15.4 million). ◦ The increase in total retail MWhs sold was the result of weather that was cooler than the prior year during the heating season (which increased electric heating loads) and warmer than the prior year during the cooling season (which increased electric cooling loads), as well as customer growth. Compared to 2016, residential electric use per customer increased 8 percent and commercial use per customer did not change materially. Heating degree days in Spokane were 3 percent above normal and 17 percent above 2016. Cooling degree days in Spokane were 40 percent above normal and 57 percent above the prior year. ◦ The increase in revenue per MWh was primarily due to a general rate increase in Idaho and a greater portion of retail revenues from residential customers in 2017. • a $30.6 million decrease in wholesale electric revenues due to a decrease in sales prices (decreased revenues $27.3 million) and a decrease in sales volumes (decreased revenues $3.3 million). The fluctuation in volumes and prices was primarily the result of our optimization activities. • a $13.4 million decrease in sales of fuel due to a decrease in sales of natural gas fuel as part of thermal generation resource optimization activities. For 2017, $35.3 million of these sales were made to our natural gas operations and are included as intracompany revenues and resource costs. For 2016, $44.0 million of these sales were made to our natural gas operations. • a $25.6 million decrease in electric revenue due to decoupling. Weather was cooler than normal during the heating season and warmer than normal during the cooling season in 2017, which resulted in decoupling rebates for 2017. Weather was warmer than normal during the heating season in 2016, which resulted in significant decoupling surcharges. Decoupling mechanisms are not affected by fluctuations in weather compared to prior year; rather, they are only affected by weather fluctuations as compared to normal weather. AVISTA CORPORATION The following graphs present Avista Utilities' natural gas operating revenues and therms delivered for the years ended December 31 (dollars in millions and therms in thousands): (1) This balance includes interruptible and industrial revenues, which are considered part of retail natural gas revenues and it also includes revenues and rebates from decoupling. AVISTA CORPORATION The following table presents Avista Utilities' decoupling and customer earnings sharing mechanisms by jurisdiction that are reflected in utility natural gas operating revenues for the years ended December 31 (dollars in thousands): Total natural gas revenues increased $3.8 million for 2017 as compared to 2016, primarily reflecting the following: • a $36.3 million increase in retail natural gas revenues due to an increase in volumes (increased revenues $51.2 million), partially offset by lower retail rates (decreased revenues $14.9 million). ◦ We sold more retail natural gas in 2017 as compared to 2016 primarily due to cooler weather in the first and fourth quarters, as well as customer growth. Compared to 2016, residential use per customer increased 16 percent and commercial use per customer increased 17 percent. Heating degree days in Spokane were 3 percent above normal for 2017, and 17 percent above 2016. Heating degree days in Medford were 1 percent below normal for 2017, and 17 percent above 2016. ◦ Lower retail rates were due to PGAs, partially offset by a general rate increase in Oregon. • a $10.7 million decrease in wholesale natural gas revenues due to a decrease in volumes (decreased revenues $36.4 million), partially offset by an increase in prices (increased revenues $25.7 million). In 2017, $49.3 million of these sales were made to our electric generation operations and are included as intracompany revenues and resource costs. In 2016, $51.2 million of these sales were made to our electric generation operations. Differences between revenues and costs from sales of resources in excess of retail load requirements and from resource optimization are accounted for through the PGA mechanisms. • a $23.7 million decrease in natural gas revenue due to decoupling. Weather was overall cooler than normal during the heating season in 2017, which resulted in decoupling rebates. Weather was warmer than normal during the heating season in 2016, which resulted in decoupling surcharges. Decoupling mechanisms are not impacted by fluctuations in weather compared to prior year; rather, they are only impacted by weather fluctuations as compared to normal weather. The following table presents Avista Utilities' average number of electric and natural gas retail customers for the years ended December 31: AVISTA CORPORATION The following graphs present Avista Utilities' resource costs for the years ended December 31 (dollars in millions): Total electric resource costs in the graph above include intracompany resource costs of $49.3 million and $51.2 million for 2017 and 2016, respectively. Total natural gas resource costs in the graphs above include intracompany resource costs of $35.3 million and $44.0 million for 2017 and 2016, respectively. Total electric resource costs decreased $29.3 million for 2017 as compared to 2016 primarily reflecting the following: • a $17.1 million decrease in power purchased due to a decrease in wholesale prices (decreased costs $22.5 million), partially offset by an increase in the volume of power purchases (increased costs $5.4 million). The fluctuation in volumes and prices was primarily the result of our optimization activities. • a $10.2 million decrease in fuel for generation primarily due to a decrease in thermal generation (due in part to increased hydroelectric generation) as well as a decrease in fuel prices. • a $6.0 million decrease in other fuel costs. AVISTA CORPORATION • a $1.5 million increase from amortizations and deferrals of power costs. • a $0.5 million decrease in other electric resource costs. • a $3.0 million increase in other regulatory amortizations. Total natural gas resource costs decreased $9.4 million for 2017 as compared to 2016 primarily reflecting the following: • a $5.4 million decrease in natural gas purchased due to a decrease in total therms purchased (decreased costs $22.1 million), partially offset by an increase in the price of natural gas (increased costs $16.7 million). Total therms purchased decreased due to a decrease in wholesale sales, partially offset by an increase in retail sales. • a $6.6 million decrease from amortizations and deferrals of natural gas costs. • a $2.6 million increase in other regulatory amortizations. 2016 compared to 2015 The following table presents Avista Utilities' operating revenues, resource costs and resulting gross margin for the years ended December 31 (dollars in millions): The gross margin on electric sales increased $39.4 million and the gross margin on natural gas sales increased $27.0 million. The increase in electric gross margin was primarily due to general rate increases, lower resource costs, the implementation of decoupling in Idaho and a $6.6 million decrease in the provision for earnings sharing (which is an offset to revenue), partially offset by lower electric loads. For 2016, we recognized a pre-tax benefit of $5.1 million under the ERM in Washington compared to a benefit of $6.3 million for 2015. The increase in natural gas gross margin was primarily due to general rate increases in each of our jurisdictions, lower natural gas resources costs, the implementation of decoupling mechanisms in Idaho and Oregon, and higher natural gas retail loads. Intracompany revenues and resource costs represent purchases and sales of natural gas between our natural gas distribution operations and our electric generation operations (as fuel for our generation plants). These transactions are eliminated in the presentation of total results for Avista Utilities and in the consolidated financial statements but are included in the separate results for electric and natural gas presented below. AVISTA CORPORATION The following graphs present Avista Utilities' electric operating revenues and megawatt-hour (MWh) sales for the years ended December 31 (dollars in millions and MWhs in thousands): (1) This balance includes public street and highway lighting, which is considered part of retail electric revenues and it also includes revenues and rebates from decoupling. AVISTA CORPORATION The following table presents Avista Utilities' decoupling and customer earnings sharing mechanisms by jurisdiction that are included in utility electric operating revenues for the years ended December 31 (dollars in thousands): (1) The provision for earnings sharing in Washington in 2016 resulted from a $2.5 million reduction in the 2015 provision for earnings sharing (which increased 2016 revenues) offset by a $2.3 million provision for earnings sharing for 2016 electric operations. (2) The provision for earnings sharing in Idaho in 2016 resulted from a reduction in the 2015 provision for earnings sharing (which increased 2016 revenues). Beginning in 2016 there is no longer an earnings sharing mechanism in Idaho. (n/a) This mechanism did not exist during this time period. Total electric revenues decreased $0.9 million for 2016 as compared to 2015, primarily reflecting the following: • a $3.0 million decrease in retail electric revenues due to a decrease in total MWhs sold (decreased revenues $9.5 million), partially offset by an increase in revenue per MWh (increased revenues $6.5 million). ◦ The increase in revenue per MWh was primarily due to a general rate increase in Idaho and the expiration of the ERM rebate to customers in Washington, partially offset by a general rate decrease in Washington. ◦ The decrease in total retail MWhs sold was the result of weather that was cooler in the first quarter (higher electric heating loads), warmer in April and May (lower electric heating loads), cooler June through August (lower electric cooling loads) and cooler in the fourth quarter (higher electric heating loads) as compared to the prior year (which overall decreased electric loads). Compared to 2015, residential electric use per customer decreased 1 percent and commercial use per customer decreased 1 percent. Heating degree days in Spokane were 13 percent below normal and 3 percent above 2015. The impact from increased heating loads was offset by decreased cooling loads in the summer. 2016 cooling degree days were 13 percent below normal and 41 percent below the prior year. The overall decrease in use per customer was partially offset by growth in the number of customers. • a $15.2 million decrease in wholesale electric revenues due to a decrease in sales volumes (decreased revenues $5.5 million) and a decrease in sales prices (decreased revenues $9.7 million). The fluctuation in volumes and prices was primarily the result of our optimization activities. • a $4.6 million decrease in sales of fuel due to a decrease in sales of natural gas fuel as part of thermal generation resource optimization activities. For 2016, $44.0 million of these sales were made to our natural gas operations and are included as intracompany revenues and resource costs. For 2015, $50.0 million of these sales were made to our natural gas operations. • a $12.6 million increase in electric revenue due to decoupling, which reflected the implementation of a decoupling mechanism in Idaho effective January 1, 2016 and lower retail revenues in 2016 as compared to 2015. • a $6.6 million decrease in the electric provision for earnings sharing (which increases revenues) due to a $2.5 million reduction in the 2015 provision for earnings sharing in Washington and a $0.7 million reduction in the 2015 provision for earnings sharing in Idaho recorded in 2016. For 2016 electric operations, we recorded a $2.3 million provision for earnings sharing. AVISTA CORPORATION The following graphs present Avista Utilities' natural gas operating revenues and therms delivered for the years ended December 31 (dollars in millions and therms in thousands): (1) This balance includes interruptible and industrial revenues, which are considered part of retail natural gas revenues and it also includes revenues and rebates from decoupling. AVISTA CORPORATION The following table presents Avista Utilities' decoupling and customer earnings sharing mechanisms by jurisdiction that are included in utility natural gas operating revenues for the years ended December 31 (dollars in thousands): (n/a) This mechanism did not exist during this time period. Total natural gas revenues decreased $50.1 million for 2016 as compared to 2015 primarily reflecting the following: • a $3.4 million decrease in retail natural gas revenues due to lower retail rates (decreased revenues $18.4 million), partially offset by an increase in volumes (increased revenues $15.0 million). ◦ Lower retail rates were due to PGAs, which passed through lower costs of natural gas, partially offset by general rate increases. ◦ We sold more retail natural gas in 2016 as compared to 2015 primarily due to cooler weather in the first and fourth quarters, as well as customer growth. Compared to 2015, residential use per customer increased 5 percent and commercial use per customer increased 3 percent. Heating degree days in Spokane were 13 percent below historical average for 2016, and 3 percent above 2015. Heating degree days in Medford were 16 percent below historical average for 2016, and 3 percent above 2015. • a $50.8 million decrease in wholesale natural gas revenues due to a decrease in prices (decreased revenues $22.8 million) and a decrease in volumes (decreased revenues $28.0 million). In 2016, $51.2 million of these sales were made to our electric generation operations and are included as intracompany revenues and resource costs. In 2015, $57.0 million of these sales were made to our electric generation operations. Differences between revenues and costs from sales of resources in excess of retail load requirements and from resource optimization are accounted for through the PGA mechanisms. • a $6.3 million increase in natural gas revenues due to decoupling, which reflected the implementation of decoupling mechanisms in Idaho and Oregon, as well as an increase in the decoupling surcharge in Washington. • a $2.8 million increase in the provision for earnings sharing (which decreases revenues) representing the 2016 provision for Washington natural gas operations. The following table presents Avista Utilities' average number of electric and natural gas retail customers for the years ended December 31: AVISTA CORPORATION The following graphs present Avista Utilities' resource costs for the years ended December 31 (dollars in millions): Total electric resource costs in the graph above include intracompany resource costs of $51.2 million and $57.0 million for 2016 and 2015, respectively. Total natural gas resource costs in the graphs above include intracompany resource costs of $44.0 million and $50.0 million for 2016 and 2015, respectively. Total electric resource costs decreased $40.3 million for 2016 as compared to 2015 primarily reflecting the following: • a $26.1 million decrease in power purchased due to a decrease in the volume of power purchases (decreased costs $9.3 million) and a decrease in wholesale prices (decreased costs $16.8 million). The fluctuation in volumes and prices was primarily the result of our optimization activities. • a $14.8 million decrease in fuel for generation primarily due to a decrease in thermal generation (due in part to increased hydroelectric generation) and a decrease in natural gas fuel prices. • a $7.5 million decrease in other fuel costs. AVISTA CORPORATION • a $3.0 million decrease from amortizations and deferrals of power costs. • a $5.6 million increase in other electric resource costs primarily due to a benefit that was recorded during 2015 related to a capacity contract of Spokane Energy. This benefit was mostly deferred for probable future benefit to customers through the ERM and PCA. • a $5.4 million increase in other regulatory amortizations. Total natural gas resource costs decreased $77.1 million for 2016 as compared to 2015 primarily reflecting the following: • an $80.1 million decrease in natural gas purchased due to a decrease in the price of natural gas (decreased costs $52.6 million) and a decrease in total therms purchased (decreased costs $27.5 million). Total therms purchased decreased due to a decrease in wholesale sales, partially offset by an increase in retail sales. • a $1.6 million decrease from amortizations and deferrals of natural gas costs. This reflects lower natural gas prices and the deferral of lower costs for future rebate to customers, as well as current rebates to customers through PGAs. • a $4.6 million increase in other regulatory amortizations. Results of Operations - Alaska Electric Light and Power Company 2017 compared to 2016 Net income for AEL&P was $9.1 million for the year ended December 31, 2017, compared to $8.0 million for 2016. The following table presents AEL&P's operating revenues, resource costs and resulting gross margin for the years ended December 31 (dollars in millions): In 2017, there was an increase in electric gross margin which was primarily related to a general rate increase, effective in November 2016, and increases in electric heating loads due to weather that was cooler than the prior year. There were also slight increases in residential and commercial customers. This was partially offset by an increase in resource costs primarily due to purchased power and the general rate case settlement. An increase in resource costs of $1.0 million related to a settlement agreement for AEL&P's 2016 electric general rate case is included in electric gross margin for 2017. See "Regulatory Matters" for further discussion of the settlement agreement. The increase in electric gross margin was partially offset by an increase in operating expenses and a decrease in equity-related AFUDC due to the construction of an additional back-up generation plant completed in 2016. While the cooler weather did have some effect on AEL&P revenues during 2017, AEL&P has a relatively stable load profile as it does not have a large population of customers in its service territory with electric heating and cooling requirements; therefore, its revenues are not as sensitive to weather fluctuations as Avista Utilities. However, AEL&P does have higher winter rates for its customers during the peak period of November through May of each year, which drives higher revenues during those periods. Operating expenses increased primarily due to supplies expense for the new back-up generation plant, which went into service in the fourth quarter of 2016. 2016 compared to 2015 Net income for AEL&P was $8.0 million for the year ended December 31, 2016, compared to $6.6 million for 2015. The increase in earnings for 2016 was primarily due to an increase in electric gross margin and an increase in equity-related AFUDC (increased earnings) due to the construction of an additional back-up generation plant which was completed during the fourth quarter of 2016. AVISTA CORPORATION The following table presents AEL&P's operating revenues, resource costs and resulting gross margin for the years ended December 31 (dollars in millions): The increase in electric gross margin was primarily related to a decrease in costs associated with the Snettisham hydroelectric project (due to a refinancing transaction during the second half of 2015 which lowered interest costs under the take-or-pay power purchase agreement), as well as an interim rate increase effective in November 2016. These were partially offset by a slight decrease in sales volumes to commercial and government customers and an increase in other resource costs. Results of Operations - Ecova - Discontinued Operations Ecova was disposed of as of June 30, 2014. As a result, in accordance with GAAP, all of Ecova's operating results were removed from each line item on the Consolidated Statements of Income and reclassified into discontinued operations for all periods presented. 2017 and 2016 compared to 2015 There was zero net income or loss for 2017 and 2016. Ecova's net income was $5.1 million for 2015. The net income for 2015 was primarily related to a tax benefit during 2015 that resulted from the reversal of a valuation allowance against net operating losses at Ecova because the net operating losses were deemed realizable under the current tax code. Results of Operations - Other Businesses 2017 compared to 2016 The net loss from these operations was $7.9 million for 2017 compared to a net loss of $3.2 million for 2016. Net losses for 2017 were partially related to federal income tax law changes, which resulted in the revaluing of net deferred income tax assets to reflect the reduction in the corporate income tax rate from 35 percent to 21 percent, causing a non-cash increase in income tax expense. Also, there were renovation expenses and increased compliance costs at one of our subsidiaries, the recognition of our portion of net losses from our equity investments, corporate costs (including costs associated with exploring strategic opportunities) and impairment charges associated with two of our equity investments. 2016 compared to 2015 The net loss from these operations was $3.2 million for 2016 compared to a net loss of $1.9 million for 2015. Net losses for 2016 were primarily related to an increase in losses on investments due to initial organization costs and management fees associated with a new investment, as well as an impairment recorded on a building we own. This was partially offset by a slight decrease in corporate costs (including costs associated with exploring strategic opportunities) and a slight increase in net income at METALfx. Accounting Standards to be Adopted in 2018 At this time, we are not expecting the adoption of accounting standards to have a material impact on our financial condition, results of operations and cash flows in 2018. For information on accounting standards adopted in 2017 and accounting standards expected to be adopted in future periods, see “Note 2 of the Notes to Consolidated Financial Statements.” Critical Accounting Policies and Estimates The preparation of our consolidated financial statements in conformity with GAAP requires us to make estimates and assumptions that affect amounts reported in the consolidated financial statements. Changes in these estimates and assumptions are considered reasonably possible and may have a material effect on our consolidated financial statements and thus actual results could differ from the amounts reported and disclosed herein. The following accounting policies represent those that our management believes are particularly important to the consolidated financial statements and require the use of estimates and assumptions: • Regulatory accounting, which requires that certain costs and/or obligations be reflected as deferred charges on our Consolidated Balance Sheets and are not reflected in our Consolidated Statements of Income until the period during which matching revenues are recognized. We also have decoupling revenue deferrals. As opposed to cost deferrals which are not recognized in the Consolidated Statements of Income until they are included in rates, decoupling revenue is recognized in the Consolidated Statements of Income during the period in which it occurs (i.e. during the AVISTA CORPORATION period of revenue shortfall or excess due to fluctuations in customer usage), subject to certain limitations, and a regulatory asset/liability is established which will be surcharged or rebated to customers in future periods. GAAP requires that for any alternative revenue program, like decoupling, the revenue must be expected to be collected from customers within 24 months of the deferral to qualify for recognition in the current period. Any amounts included in the Company's decoupling program that are not expected to be collected from customers within 24 months are not recorded in the financial statements until the period in which revenue recognition criteria are met. This could ultimately result in more decoupling revenue being collected from customers over the life of the decoupling program than what is deferred and recognized in the current period financial statements. We make estimates regarding the amount of revenue that will be collected within 24 months of deferral. We also make the assumption that there are regulatory precedents for many of our regulatory items and that we will be allowed recovery of these costs via retail rates in future periods. If we were no longer allowed to apply regulatory accounting or no longer allowed recovery of these costs, we could be required to recognize significant write-offs of regulatory assets and liabilities in the Consolidated Statements of Income. See "Notes 1 and 20 of the Notes to Consolidated Financial Statements" for further discussion of our regulatory accounting policy and mechanisms. In addition to the above, while accounting for income taxes is not a critical policy or estimate, the interpretation of the TCJA requires many judgments, and the regulatory treatment of the changes in deferred income tax assets and liabilities (excess deferred taxes) resulting from the TCJA does involve certain regulatory assumptions and calculations for determining the amortization period over which to return excess deferred taxes to customers. For instance, excess deferred taxes associated with utility plant items will be returned to customers using the ARAM, which is a prescribed calculation. However, there is not clear guidance on how or when to return excess deferred taxes for non-plant items. We do not currently have an estimate for the amortization period of the non-plant items as we are waiting for additional implementation guidance from various regulatory agencies. If new guidance were to be issued regarding how to return excess deferred taxes to customers, it could significantly impact our financial results and future cash flows. See the "Executive Level Summary" for additional discussion of the federal income tax law changes. • Utility energy commodity derivative asset and liability accounting, where we estimate the fair value of outstanding commodity derivatives and we offset energy commodity derivative assets or liabilities with a regulatory asset or liability. This accounting treatment is intended to defer the recognition of mark-to-market gains and losses on energy commodity transactions until the period of delivery. This accounting treatment is supported by accounting orders issued by the WUTC and the IPUC. If we were no longer allowed to apply regulatory accounting or no longer allowed recovery of these costs, we could be required to recognize significant changes in fair value of these energy commodity derivatives on a regular basis in the Consolidated Statements of Income, which could lead to significant fluctuations in net income. See "Notes 1 and 6 of the Notes to Consolidated Financial Statements" for further discussion of our energy commodity derivative accounting policy and amounts recorded in the financial statements. • Interest rate swap derivative asset and liability accounting, where we estimate the fair value of outstanding interest rate swap derivatives, and U.S. Treasury lock agreements and offset the derivative asset or liability with a regulatory asset or liability. This is similar to the treatment of energy commodity derivatives described above. Upon settlement of interest rate swap derivatives, the regulatory asset or liability is amortized as a component of interest expense over the term of the associated debt. During the fourth quarter of 2017, WUTC Staff and other parties to our 2017 electric and natural gas general rate cases filed their testimony in which the WUTC Staff recommended the exclusion of the Washington portion of our 2016 settled interest rate swaps. The total amount of the 2016 settled interest rate swaps was $54.0 million, with approximately 60 percent of this total being allocated to Washington. If recovery of the 2016 settled interest rate swap payments is not approved by the WUTC, this could change our current conclusion that settlement payments related to the 2017 settled interest rate swaps and the unsettled interest rate swaps are probable of recovery through rates. If we concluded that recovery of these swap related payments were no longer probable, we may be required to derecognize the related regulatory assets and liabilities and we could be required to recognize significant changes in fair value or settlements of these interest rate swap derivatives on a regular basis in the Consolidated Statements of Income, which could lead to significant fluctuations in net income. See "Regulatory Matters - Washington General Rate Cases" for further discussion of this matter. • Pension Plans and Other Postretirement Benefit Plans, discussed in further detail below. AVISTA CORPORATION • Contingencies, related to unresolved regulatory, legal and tax issues for which there is inherent uncertainty for the ultimate outcome of the respective matter. We accrue a loss contingency if it is probable that an asset is impaired or a liability has been incurred and the amount of the loss or impairment can be reasonably estimated. We also disclose losses that do not meet these conditions for accrual, if there is a reasonable possibility that a potential loss may be incurred. For all material contingencies, we have made a judgment as to the probability of a loss occurring and as to whether or not the amount of the loss can be reasonably estimated. If the loss recognition criteria are met, liabilities are accrued or assets are reduced. However, no assurance can be given to the ultimate outcome of any particular contingency. See "Notes 1 and 19 of the Notes to Consolidated Financial Statements" for further discussion of our commitments and contingencies. Pension Plans and Other Postretirement Benefit Plans - Avista Utilities We have a defined benefit pension plan covering substantially all regular full-time employees at Avista Utilities that were hired prior to January 1, 2014. For substantially all regular non-union full-time employees at Avista Utilities who were hired on or after January 1, 2014, a defined contribution 401(k) plan replaced the defined benefit pension plan. The Finance Committee of the Board of Directors approves investment policies, objectives and strategies that seek an appropriate return for the pension plan and it reviews and approves changes to the investment and funding policies. We have contracted with an independent investment consultant who is responsible for monitoring the individual investment managers. The investment managers’ performance and related individual fund performance is reviewed at least quarterly by an internal benefits committee and by the Finance Committee to monitor compliance with our established investment policy objectives and strategies. Our pension plan assets are invested in debt securities and mutual funds, trusts and partnerships that hold marketable debt and equity securities, real estate and absolute return funds. In seeking to obtain a return that aligns with the funded status of the pension plan, the investment consultant recommends allocation percentages by asset classes. These recommendations are reviewed by the internal benefits committee, which then recommends their adoption by the Finance Committee. The Finance Committee has established target investment allocation percentages by asset classes and also investment ranges for each asset class. The target investment allocation percentages are typically the midpoint of the established range. See “Note 10 of the Notes to Consolidated Financial Statements” for the target investment allocation percentages. We also have a Supplemental Executive Retirement Plan (SERP) that provides additional pension benefits to certain executive officers and others whose benefits under the pension plan are reduced due to the application of Section 415 of the Internal Revenue Code of 1986 and the deferral of salary under deferred compensation plans. Pension costs (including the SERP) were $26.5 million for 2017, $26.8 million for 2016 and $27.1 million for 2015. Of our pension costs, approximately 60 percent are expensed and 40 percent are capitalized consistent with labor charges. The costs related to the SERP are expensed. Our costs for the pension plan are determined in part by actuarial formulas that are dependent upon numerous factors resulting from actual plan experience and assumptions of future experience. Pension costs are affected by among other things: • employee demographics (including age, compensation and length of service by employees), • the amount of cash contributions we make to the pension plan, • the actual return on pension plan assets, • expected return on pension plan assets, • discount rate used in determining the projected benefit obligation and pension costs, • assumed rate of increase in employee compensation, • life expectancy of participants and other beneficiaries, and • expected method of payment (lump sum or annuity) of pension benefits. Any changes in pension plan obligations associated with these factors may not be immediately recognized as pension costs in our Consolidated Statement of Income, but we generally recognize the change in future years over the remaining average service period of pension plan participants. As such, our costs recorded in any period may not reflect the actual level of cash benefits provided to pension plan participants. AVISTA CORPORATION We revise the key assumption of the discount rate each year. In selecting a discount rate, we consider yield rates at the end of the year for highly rated corporate bond portfolios with cash flows from interest and maturities similar to that of the expected payout of pension benefits. The expected long-term rate of return on plan assets is reset or confirmed annually based on past performance and economic forecasts for the types of investments held by our plan. The following chart reflects the assumptions used each year for the pension discount rate (exclusive of the SERP), the expected long-term return on plan assets and the actual return on plan assets and their impacts to the pension plan associated with the change in assumption (dollars in millions): The following chart reflects the sensitivities associated with a change in certain actuarial assumptions by the indicated percentage (dollars in millions): * Changes in the expected return on plan assets would not affect our projected benefit obligation. We provide certain health care and life insurance benefits for substantially all of our retired employees. We accrue the estimated cost of postretirement benefit obligations during the years that employees provide service. Assumed health care cost trend rates have a significant effect on the amounts reported for our postretirement plans. A one-percentage-point increase in the assumed health care cost trend rate for each year would increase our accumulated postretirement benefit obligation as of December 31, 2017 by $6.6 million and the service and interest cost by $0.8 million. A one-percentage-point decrease in the assumed health care cost trend rate for each year would decrease our accumulated postretirement benefit obligation as of December 31, 2017 by $5.2 million and the service and interest cost by $0.6 million. Liquidity and Capital Resources Overall Liquidity Avista Corp.'s consolidated operating cash flows are primarily derived from the operations of Avista Utilities. The primary source of operating cash flows for Avista Utilities is revenues from sales of electricity and natural gas. Significant uses of cash flows from Avista Utilities include the purchase of power, fuel and natural gas, and payment of other operating expenses, taxes and interest, with any excess being available for other corporate uses such as capital expenditures and dividends. We design operating and capital budgets to control operating costs and to direct capital expenditures to choices that support immediate and long-term strategies, particularly for our regulated utility operations. In addition to operating expenses, we have continuing commitments for capital expenditures for construction and improvement of utility facilities. Our annual net cash flows from operating activities usually do not fully support the amount required for annual utility capital expenditures. As such, from time-to-time, we need to access long-term capital markets in order to fund these needs as well as fund maturing debt. See further discussion at “Capital Resources.” AVISTA CORPORATION We periodically file for rate adjustments for recovery of operating costs and capital investments and to seek the opportunity to earn reasonable returns as allowed by regulators. Avista Utilities has regulatory mechanisms in place that provide for the deferral and recovery of the majority of power and natural gas supply costs. However, when power and natural gas costs exceed the levels currently recovered from retail customers, net cash flows are negatively affected. Factors that could cause purchased power and natural gas costs to exceed the levels currently recovered from our customers include, but are not limited to, higher prices in wholesale markets when we buy energy or an increased need to purchase power in the wholesale markets, and a lack of regulatory approval for higher authorized net power supply costs through general rate case decisions. Factors beyond our control that could result in an increased need to purchase power in the wholesale markets include, but are not limited to: • increases in demand (due to either weather or customer growth), • low availability of streamflows for hydroelectric generation, • unplanned outages at generating facilities, and • failure of third parties to deliver on energy or capacity contracts. In addition to the above, Avista Utilities enters into derivative instruments to hedge our exposure to certain risks, including fluctuations in commodity market prices, foreign exchange rates and interest rates (for purposes of issuing long-term debt in the future). These derivative instruments often require collateral (in the form of cash or letters of credit) or other credit enhancements, or reductions or terminations of a portion of the contract through cash settlement, in the event of a downgrade in the Company's credit ratings or changes in market prices. In periods of price volatility, the level of exposure can change significantly. As a result, sudden and significant demands may be made against the Company's credit facilities and cash. See “Enterprise Risk Management - Demands for Collateral” below. We monitor the potential liquidity impacts of changes to energy commodity prices and other increased operating costs for our utility operations. We believe that we have adequate liquidity to meet such potential needs through our committed lines of credit. As of December 31, 2017, we had $260.6 million of available liquidity under the Avista Corp. committed line of credit and $25.0 million under the AEL&P committed line of credit. With our $400.0 million credit facility that expires in April 2021 and AEL&P's $25.0 million credit facility that expires in November 2019, we believe that we have adequate liquidity to meet our needs for the next 12 months. Review of Consolidated Cash Flow Statement Overall During 2017, cash flows from operating activities were $410.3 million, proceeds from the issuance of long-term debt were $90.0 million and we received $56.4 million from the issuance of common stock. Cash requirements included utility capital expenditures of $412.3 million, the repayment of borrowings under our committed line of credit of $15.0 million, dividends of $92.5 million and net cash paid for the settlement of interest rate swap derivatives of $8.8 million. 2017 compared to 2016 Consolidated Operating Activities Net cash provided by operating activities was $410.3 million for 2017 compared to $358.3 million for 2016. The increase in net cash provided by operating activities was due in part to income tax refund claims in 2017 related to 2014 and 2015 tax years to utilize net operating losses and investment tax credits. We received an income tax refund of approximately $41.7 million during the fourth quarter of 2017 compared to an increase in income tax receivables of $33.9 million in 2016. In addition, during 2017 our net payments for the settlement of outstanding interest rate swaps decreased by $45.1 million, from $54.0 million in 2016 to $8.8 million for 2017. The increases above were partially offset by an increase in pension contributions from $12.0 million in 2016 to $22.0 million in 2017 and an increase in collateral posted for derivative instruments of $22.4 million in 2017, compared to a decrease in collateral posted of $10.7 million in 2016. The increase in collateral posted during 2017 was due to a decrease in the fair value of energy commodity derivatives which required additional collateral. In addition, most of our energy commodity derivatives are transacted on clearinghouse exchanges, which require initial margin collateral and additional cash collateral when derivatives are in liability positions. AVISTA CORPORATION Consolidated Investing Activities Net cash used in investing activities was $434.1 million for 2017, an increase compared to $432.5 million for 2016. During 2017, we paid $412.3 million for utility capital expenditures, compared to $406.6 million for 2016. In addition, during 2017, our subsidiaries disbursed net cash of $15.5 million for notes receivable to third parties, equity investments and property investments, compared to $18.2 million in 2016. Consolidated Financing Activities Net cash provided by financing activities was $31.5 million for 2017 compared to net cash provided of $72.2 million for 2016. In 2017 we had the following significant transactions: • issuance and sale of $90.0 million of Avista Corp. first mortgage bonds in December 2017, the proceeds of which were used to pay down a portion of our committed line of credit, • payment of $3.3 million for the maturity of long-term debt, • increase in cash dividends paid to $92.5 million (or $1.43 per share) for 2017 from $87.2 million (or $1.37 per share) for 2016, • $15.0 million net decrease in the balance of our committed line of credit, and • issuance of $56.4 million of common stock (net of issuance costs). 2016 compared to 2015 Consolidated Operating Activities Net cash provided by operating activities was $358.3 million for 2016 compared to $375.6 million for 2015. The decrease in net cash provided by operating activities was primarily related to the cash settlement of interest rate swap derivatives in the third quarter of 2016 totaling $54.0 million. The interest rate swap derivatives were settled in connection with the pricing of first mortgage bonds that were issued in December 2016. In addition, our accounts receivable balances increased during 2016 (which reduces operating cash flow), due to higher sales during the fourth quarter of 2016 due to colder weather as compared to the fourth quarter of 2015 and due to the timing of collections. There was a decrease in collateral posted for derivative instruments in 2016 (primarily due to an increase in the fair value of outstanding energy commodity derivatives, which required less collateral) as compared to an increase in collateral posted during 2015. Pension contributions were $12.0 million for both 2016 and 2015. Net cash received from income tax refunds increased to $13.5 million for 2016 compared to $10.0 million for 2015. In addition, the income tax receivable increased $33.9 million in 2016. We were in a refund position as of December 31, 2016 with regards to income taxes because the Company generated a net operating loss for tax purposes in 2016 primarily due to bonus depreciation on utility plant placed in service during the year and the settlement of interest rate swaps. The Company carried back the net operating loss against prior year tax returns and fully utilized the net operating loss through the carryback. Additionally, the Company generated $19.4 million of federal investment income tax credits in 2016; $9.6 million of which was carried back against a prior tax return with the remaining $9.8 million to be carried forward to future federal tax periods. The provision for deferred income taxes was $124.5 million for 2016, compared to $51.8 million for 2015. The change in the provision for deferred income taxes was primarily related to deferred taxes on property, plant and equipment, investment tax credits associated with our capital projects, deferred taxes on the decoupling regulatory assets and deferred taxes on interest rate swap derivatives. Consolidated Investing Activities Net cash used in investing activities was $432.5 million for 2016, an increase compared to $387.8 million for 2015. During 2016, we paid $406.6 million for utility capital expenditures, compared to $393.4 million for 2015. In addition, during 2016, our subsidiaries disbursed $10.1 million for notes receivable to third parties and received $5.0 million in repayments on these notes receivable. Our subsidiaries also made $7.8 million in investments and purchased buildings and other property as investments for $5.3 million. During 2015, we received cash proceeds (related to the settlement of the escrow accounts) of $13.9 million from the sale of Ecova. AVISTA CORPORATION Consolidated Financing Activities Net cash provided by financing activities was $72.2 million for 2016 compared to net cash provided of $0.5 million for 2015. In 2016 we had the following significant transactions: • borrowing of $70.0 million pursuant to a term loan agreement in August, which was used to repay a portion of the $90.0 million in first mortgage bonds that matured in August 2016, • issuance and sale of $175.0 million of Avista Corp. first mortgage bonds in December 2016, the proceeds of which were used to repay the $70.0 million term loan, with the remainder being used to pay down a portion of our committed line of credit, • payment of $163.2 million for the maturity of long-term debt (including the $70.0 million term loan), • increase in cash dividends paid to $87.2 million (or $1.37 per share) for 2016 from $82.4 million (or $1.32 per share) for 2015, • $15.0 million net increase in the balance of our committed line of credit, and • issuance of $67.0 million of common stock (net of issuance costs). In 2015 we had the following significant transactions: • issuance and sale of $100.0 million of Avista Corp. first mortgage bonds in December 2015, • payment of $2.9 million for the maturity of long-term debt, • cash dividends paid were $82.4 million (or $1.32 per share) for 2015, • issuance of $1.6 million of common stock (net of issuance costs), and • repurchase of $2.9 million of our common stock. Capital Resources Our consolidated capital structure, including the current portion of long-term debt and short-term borrowings, and excluding noncontrolling interests, consisted of the following as of December 31, 2017 and 2016 (dollars in thousands): Our shareholders’ equity increased $81.1 million during 2017 primarily due to net income, the issuance of common stock and stock compensation net of minimum tax withholdings, partially offset by dividends. We need to finance capital expenditures and acquire additional funds for operations from time to time. The cash requirements needed to service our indebtedness, both short-term and long-term, reduce the amount of cash flow available to fund capital expenditures, purchased power, fuel and natural gas costs, dividends and other requirements. Committed Lines of Credit Avista Corp. has a committed line of credit with various financial institutions in the total amount of $400.0 million that expires in April 2021. As of December 31, 2017, we had $260.6 million of available liquidity under this line of credit. The Avista Corp. credit facility contains customary covenants and default provisions, including a covenant which does not permit our ratio of “consolidated total debt” to “consolidated total capitalization” to be greater than 65 percent at any time. As of December 31, 2017, we were in compliance with this covenant with a ratio of 52.7 percent. AEL&P has a $25.0 million committed line of credit that expires in November 2019. As of December 31, 2017, there were no borrowings or letters of credit outstanding under this credit facility. The AEL&P credit facility contains customary covenants and default provisions including a covenant which does not permit the ratio of “consolidated total debt at AEL&P” to “consolidated total capitalization at AEL&P,” (including the impact of the AVISTA CORPORATION Snettisham obligation) to be greater than 67.5 percent at any time. As of December 31, 2017, AEL&P was in compliance with this covenant with a ratio of 53.7 percent. Balances outstanding and interest rates of borrowings (excluding letters of credit) under Avista Corp.'s committed line of credit were as follows as of and for the year ended December 31 (dollars in thousands): As of December 31, 2017, Avista Corp. and its subsidiaries were in compliance with all of the covenants of their financing agreements, and none of Avista Corp.'s subsidiaries constituted a “significant subsidiary” as defined in Avista Corp.'s committed line of credit. Long-Term Debt Borrowings In December 2017, we issued and sold $90.0 million of 3.91 percent first mortgage bonds due in 2047 pursuant to a bond purchase agreement with institutional investors in the private placement market. In connection with the pricing of the first mortgage bonds, the Company cash-settled five interest rate swap derivatives (notional aggregate amount of $60.0 million) and paid a net amount of $8.8 million, which will be amortized as a component of interest expense over the life of the debt. The effective interest rate of the first mortgage bonds is 4.55 percent, including the effects of the settled interest rate swap derivatives and issuance costs. We used the proceeds, less issuance costs, to repay a portion of the borrowings outstanding under our $400.0 million committed line of credit. Equity Issuances In March 2016, we entered into four separate sales agency agreements under which Avista Corp.’s sales agents may offer and sell up to 3.8 million new shares of Avista Corp.'s common stock, no par value, from time to time. The sales agency agreements expire on February 29, 2020. Through December 31, 2017, 2.7 million shares were issued under these agreements resulting in total net proceeds of $120.0 million, leaving 1.1 million shares remaining to be issued. Other Transactions During 2017, we filed income tax refund claims related to 2014 and 2015 to utilize net operating losses and investment tax credits and we received an income tax refund of approximately $41.7 million during the fourth quarter of 2017. 2018 Liquidity Expectations During 2018, we expect to issue approximately $375.0 million of long-term debt and up to $85.0 million of equity in order to refinance maturing long-term debt, fund planned capital expenditures, fund the impacts of the federal income tax law changes and maintain an appropriate capital structure. The $85.0 million of equity in 2018 may come through the sale of shares through our sales agency agreements or from an equity contribution from Hydro One upon consummation of the acquisition or from a combination of those sources. After considering the expected issuances of long-term debt and equity during 2018, we expect net cash flows from operating activities, together with cash available under our committed line of credit agreements, to provide adequate resources to fund capital expenditures, dividends, and other contractual commitments. 2018 and Forward Operating Cash Flows Due to federal income tax law changes, we expect our operating cash flows will be negatively impacted going forward primarily due to the loss of the bonus depreciation tax deduction and from the timing of the return of excess deferred taxes to customers. As a result, we may need to raise additional capital. Limitations on Issuances of Preferred Stock and First Mortgage Bonds We are restricted under our Restated Articles of Incorporation, as amended, as to the additional preferred stock we can issue. As of December 31, 2017, we could issue $1.3 billion of additional preferred stock at an assumed dividend rate of 6.0 percent. We are not planning to issue preferred stock. AVISTA CORPORATION Under the Avista Corp. and the AEL&P Mortgages and Deeds of Trust securing Avista Corp.'s and AEL&P's first mortgage bonds (including Secured Medium-Term Notes), respectively, each entity may issue additional first mortgage bonds in an aggregate principal amount equal to the sum of: • 66-2/3 percent of the cost or fair value (whichever is lower) of property additions of that entity which have not previously been made the basis of any application under that entity's Mortgage, or • an equal principal amount of retired first mortgage bonds of that entity which have not previously been made the basis of any application under that entity's Mortgage, or • deposit of cash. However, Avista Corp. and AEL&P may not individually issue any additional first mortgage bonds (with certain exceptions in the case of bonds issued on the basis of retired bonds) unless the particular entity issuing the bonds has “net earnings” (as defined in the respective Mortgages) for any period of 12 consecutive calendar months out of the preceding 18 calendar months that were at least twice the annual interest requirements on that entity's mortgage securities at the time outstanding, including the first mortgage bonds to be issued, and on all indebtedness of prior rank. As of December 31, 2017, property additions and retired bonds would have allowed, and the net earnings test would not have prohibited, the issuance of $1.3 billion in aggregate principal amount of additional first mortgage bonds at Avista Corp. and $24.1 million at AEL&P. We believe that we have adequate capacity to issue first mortgage bonds to meet our financing needs over the next several years. Capital Expenditures We are making capital investments in generation, transmission and distribution systems to preserve and enhance service reliability for our customers and replace aging infrastructure. The following table summarizes our actual and expected capital expenditures as of and for the year ended December 31, 2017 (in thousands): (1) Actual annual capital expenditures per the Consolidated Statement of Cash Flows may differ from our expected annual accrual-basis capital expenditures due to the timing of cash payments, the capital expenditure amounts accrued in accounts payable at the end of each period and the inclusion of AFUDC in our expected amounts, but excluded from the cash flow amounts. AVISTA CORPORATION The following graph shows Avista Utilities' capital budget for 2018: For 2018, we changed our method of capital expenditure planning and tracking from breaking expenditures down by functional area (i.e. generation, transmission, distribution, information technology) to the primary investment reason behind our capital expenditure decisions. This tracking better aligns with how capital expenditure decisions are made and how they are submitted for regulatory recovery to the various state commissions. These estimates of capital expenditures are subject to continuing review and adjustment. Actual capital expenditures may vary from our estimates due to factors such as changes in business conditions, construction schedules and environmental requirements. Off-Balance Sheet Arrangements As of December 31, 2017, we had $34.4 million in letters of credit outstanding under our $400.0 million committed line of credit, compared to $34.4 million as of December 31, 2016. Pension Plan We contributed $22.0 million to the pension plan in 2017. We expect to contribute a total of $110.0 million to the pension plan in the period 2018 through 2022, with an annual contribution of $22.0 million over that period. The final determination of pension plan contributions for future periods is subject to multiple variables, most of which are beyond our control, including changes to the fair value of pension plan assets, changes in actuarial assumptions (in particular the discount rate used in determining the benefit obligation), or changes in federal legislation. We may change our pension plan contributions in the future depending on changes to any variables, including those listed above. See "Note 10 of the Notes to Consolidated Financial Statements" for additional information regarding the pension plan. Credit Ratings Our access to capital markets and our cost of capital are directly affected by our credit ratings. In addition, many of our contracts for the purchase and sale of energy commodities contain terms dependent upon our credit ratings. See “Enterprise Risk Management - Credit Risk Liquidity Considerations” and “Note 6 of the Notes to Consolidated Financial Statements.” AVISTA CORPORATION The following table summarizes our credit ratings as of February 20, 2018: Standard & Poor’s (1) Moody’s (2) Corporate/Issuer rating BBB Baa1 Senior secured debt A- A2 Senior unsecured debt BBB Baa1 (1) Standard & Poor’s lowest “investment grade” credit rating is BBB-. (2) Moody’s lowest “investment grade” credit rating is Baa3. A security rating is not a recommendation to buy, sell or hold securities. Each security rating is subject to revision or withdrawal at any time by the assigning rating organization. Each security rating agency has its own methodology for assigning ratings, and, accordingly, each rating should be considered in the context of the applicable methodology, independent of all other ratings. The rating agencies provide ratings at the request of Avista Corp. and charge fees for their services. On December 22, 2017, the TCJA was signed into law. Although it is unclear when or how capital markets, credit rating agencies, the FERC or state public utility commissions may respond to this legislation, we expect that certain financial metrics used by credit rating agencies to evaluate the Company will be negatively impacted as a result of the TCJA. Also, we expect that our future cash flows from operations will be negatively impacted going forward. Further, there may be other material adverse effects resulting from the legislation that we have not yet identified. This has resulted in Moody's placing our credit ratings on negative outlook and could result in Moody's taking further negative action or other credit rating agencies taking similar action. These actions by the credit rating agencies may make it more difficult and costly for us to issue future debt securities and could increase borrowing costs under our credit facilities. See "Executive Level Summary" and "Note 11 of the Notes to Consolidated Financial Statements" for additional information regarding the TCJA and its impacts to Avista Corp. Dividends On February 2, 2018, Avista Corp.’s Board of Directors declared a quarterly dividend of $0.3725 per share on the Company’s common stock. This was an increase of $0.0150 per share, or 4.2 percent from the previous quarterly dividend of $0.3575 per share. See "Item 5. Market for Registrant’s Common Equity, Related Stockholder Matters and Issuer Purchases of Equity Securities" for a detailed discussion of our dividend policy and the factors which could limit the payment of dividends. Contractual Obligations The following table provides a summary of our future contractual obligations as of December 31, 2017 (dollars in millions): AVISTA CORPORATION (1) Represents our estimate of interest payments on long-term debt, which is calculated based on the assumption that all debt is outstanding until maturity. Interest on variable rate debt is calculated using the rate in effect at December 31, 2017. (2) Energy purchase contracts were entered into as part of the obligation to serve our retail electric and natural gas customers’ energy requirements. As a result, costs are generally recovered either through base retail rates or adjustments to retail rates as part of the power and natural gas cost deferral and recovery mechanisms. (3) Includes the interest component of the lease obligation. (4) Represents operational agreements, settlements and other contractual obligations for our generation, transmission and distribution facilities. These costs are generally recovered through base retail rates. (5) Includes information service contracts which are recorded to other operating expenses in the Consolidated Statements of Income. (6) Represents our estimated cash contributions to pension plans and other postretirement benefit plans through 2022. We cannot reasonably estimate pension plan contributions beyond 2022 at this time and have excluded them from the table above. (7) Represents the net mark-to-market fair value of outstanding unsettled interest rate swap derivatives as of December 31, 2017. Negative values in the table above represent contractual amounts that are owed to Avista Corp. by the counterparties. The values in the table above will change each period depending on fluctuations in market interest rates and could become either assets or liabilities. Also, the amounts in the table above are not reflective of cash collateral of $35.0 million and letters of credit of $5.0 million that are already posted with counterparties against the outstanding interest rate swap derivatives. (8) Primarily relates to long-term debt and capital lease maturities and the related interest. AEL&P contractual commitments also include contractually required capital project funding and operating and maintenance costs associated with the Snettisham hydroelectric project. These costs are generally recovered through base retail rates. (9) Primarily relates to operating lease commitments, venture fund commitments, and a commitment to fund a limited liability company in exchange for equity ownership, made by a subsidiary of Avista Capital. Also, there is a long-term debt maturity and the related interest associated with AERC. The above contractual obligations do not include income tax payments. Also, asset retirement obligations are not included above and payments associated with these have historically been less than $1 million per year. There are approximately $17.5 million remaining asset retirement obligations as of December 31, 2017. In addition to the contractual obligations disclosed above, we will incur additional operating costs and capital expenditures in future periods for which we are not contractually obligated as part of our normal business operations. Competition Our utility electric and natural gas distribution business has historically been recognized as a natural monopoly. In each regulatory jurisdiction, our rates for retail electric and natural gas services (other than specially negotiated retail rates for industrial or large commercial customers, which are subject to regulatory review and approval) are generally determined on a “cost of service” basis. Rates are designed to provide, after recovery of allowable operating expenses and capital investments, an opportunity for us to earn a reasonable return on investment as allowed by our regulators. In retail markets, we compete with various rural electric cooperatives and public utility districts in and adjacent to our service territories in the provision of service to new electric customers. Alternative energy technologies, including customer-sited solar, wind or geothermal generation, or energy storage may also compete with us for sales to existing customers. While the risk is currently small in our service territory given the small numbers of customers utilizing these technologies, advances in power generation, energy efficiency, energy storage and other alternative energy technologies could lead to more wide-spread usage of these technologies, thereby reducing customer demand for the energy supplied by us. This reduction in usage and demand would reduce our revenue and negatively impact our financial condition including possibly leading to our inability to fully recover our investments in generation, transmission and distribution assets. Similarly, our natural gas distribution operations compete with other energy sources including heating oil, propane and other fuels. Certain natural gas customers could bypass our natural gas system, reducing both revenues and recovery of fixed costs. To reduce the potential for such bypass, we price natural gas services, including transportation contracts, competitively and have varying degrees of flexibility to price transportation and delivery rates by means of individual contracts. These individual contracts are subject to state regulatory review and approval. We have long-term transportation contracts with several of our largest industrial customers under which the customer acquires its own commodity while using our infrastructure for delivery. Such contracts reduce the risk of these customers bypassing our system in the foreseeable future and minimizes the impact on our earnings. AVISTA CORPORATION Also, non-utility businesses are developing new technologies and services to help energy consumers manage energy in new ways that may improve productivity and could alter demand for the energy we sell. In wholesale markets, competition for available electric supply is influenced by the: • localized and system-wide demand for energy, • type, capacity, location and availability of generation resources, and • variety and circumstances of market participants. These wholesale markets are regulated by the FERC, which requires electric utilities to: • transmit power and energy to or for wholesale purchasers and sellers, • enlarge or construct additional transmission capacity for the purpose of providing these services, and • transparently price and offer transmission services without favor to any party, including the merchant functions of the utility. Participants in the wholesale energy markets include: • other utilities, • federal power marketing agencies, • energy marketing and trading companies, • independent power producers, • financial institutions, and • commodity brokers. Economic Conditions and Utility Load Growth The general economic data, on both national and local levels, contained in this section is based, in part, on independent government and industry publications, reports by market research firms or other independent sources. While we believe that these publications and other sources are reliable, we have not independently verified such data and can make no representation as to its accuracy. Avista Utilities We track multiple economic indicators affecting the three largest metropolitan statistical areas in our Avista Utilities service area: Spokane, Washington, Coeur d'Alene, Idaho, and Medford, Oregon.The key indicators are employment change and unemployment rates. On an annual basis, 2017 showed positive job growth and lower unemployment rates in all three metropolitan areas. However, the unemployment rates in Spokane and Medford are still slightly above the national average. Key leading indicators such as initial unemployment claims and residential building permits, signal continued growth over the next 12 months. Therefore, in 2018, we expect economic growth in our service area to be slightly stronger than the U.S. as a whole. Nonfarm employment (seasonally adjusted) in our eastern Washington, northern Idaho, and southwestern Oregon metropolitan service areas exhibited moderate growth between 2016 and 2017. In Spokane, Washington employment growth was 2.1 percent with gains in all major sectors except financial services. Employment increased by 1.7 percent in Coeur d'Alene, Idaho, reflecting gains in all major sectors except trade, transportation, and utilities; information; leisure and hospitality; and other services. In Medford, Oregon, employment growth was 2.3 percent, with gains in all major sectors except mining and logging; other services; and government. U.S. nonfarm sector jobs grew by 1.5 percent over the same period. Seasonally adjusted average unemployment rates went down in 2017 from the year earlier in Spokane, Coeur d'Alene, and Medford. In Spokane the average rate was 6.6 percent in 2016 and declined to 5.5 percent in 2017; in Coeur d'Alene the average rate went from 4.8 percent to 3.9 percent; and in Medford the average rate declined from 5.8 percent to 4.6 percent. The U.S. rate declined from 4.9 percent to 4.3 percent over the same period. Alaska Electric Light and Power Company Our AEL&P service area is centered in Juneau. Although Juneau is Alaska’s state capital, it is not a metropolitan statistical area. This means breadth and frequency of economic data is more limited. Therefore, the dates of Juneau's economic data may significantly lag the period of this filing. AVISTA CORPORATION The Quarterly Census of Employment and Wages for Juneau shows employment declined 1.8 percent between the first half of 2016 and second half of 2017. The employment decline was centered in government; construction; trade, transportation, and utilities; financial activities; and professional and business services; leisure and hospitality; and education and health services. Government (including active duty military personnel) accounts for approximately 37 percent of total employment. Between 2016 and 2017, the non-seasonally adjusted unemployment rate increased from 4.4 percent to 4.6 percent. Forecasted Customer and Load Growth Based on our forecast for 2018 through 2021 for Avista Utilities' service area, we expect annual electric customer growth to average 1.1 percent, within a forecast range of 0.7 percent to 1.5 percent. We expect annual natural gas customer growth to average 1.5 percent, within a forecast range of 1 percent to 2 percent. We anticipate retail electric load growth to average 0.5 percent, within a forecast range of 0.2 percent and 0.8 percent. We expect natural gas load growth to average 1.3 percent, within a forecast range of 0.8 percent and 1.8 percent. The forecast ranges reflect (1) the inherent uncertainty associated with the economic assumptions on which forecasts are based and (2) the historic variability of natural gas customer and load growth. In AEL&P's service area, we expect residential customer growth near 0 percent (no residential customer growth) for 2018 through 2021. We also expect no significant growth in commercial and government customers over the same period. We anticipate average annual total load growth will be in a narrow range around 0.3 percent, with residential load growth averaging 0.6 percent, commercial growth near 0 percent (no load growth); and government growth near 0 percent. The forward-looking statements set forth above regarding retail load growth are based, in part, upon purchased economic forecasts and publicly available population and demographic studies. The expectations regarding retail load growth are also based upon various assumptions, including: • assumptions relating to weather and economic and competitive conditions, • internal analysis of company-specific data, such as energy consumption patterns, • internal business plans, • an assumption that we will incur no material loss of retail customers due to self-generation or retail wheeling, and • an assumption that demand for electricity and natural gas as a fuel for mobility will for now be immaterial. Changes in actual experience can vary significantly from our projections. See also "Competition" above for a discussion of competitive factors that could affect our results of operations in the future. Environmental Issues and Contingencies We are subject to environmental regulation by federal, state and local authorities. The generation, transmission, distribution, service and storage facilities in which we have ownership interests are designed and operated in compliance with applicable environmental laws. Furthermore, we conduct periodic reviews and audits of pertinent facilities and operations to ensure compliance and to respond to or anticipate emerging environmental issues. The Company's Board of Directors has established a committee to oversee environmental issues. We monitor legislative and regulatory developments at all levels of government for environmental issues, particularly those with the potential to impact the operation and productivity of our generating plants and other assets. Environmental laws and regulations may: • increase the operating costs of generating plants; • increase the lead time and capital costs for the construction of new generating plants; • require modification of our existing generating plants; • require existing generating plant operations to be curtailed or shut down; • reduce the amount of energy available from our generating plants; • restrict the types of generating plants that can be built or contracted with; • require construction of specific types of generation plants at higher cost; and • increase costs of distributing natural gas. AVISTA CORPORATION Compliance with environmental laws and regulations could result in increases to capital expenditures and operating expenses. We intend to seek recovery of any such costs through the ratemaking process. Clean Air Act (CAA) The CAA creates a number of requirements for our thermal generating plants. The Colstrip Generating Station, Kettle Falls Generating Station and Rathdrum Combustion Turbine all require CAA Title V operating permits. The Boulder Park Generating Station, Northeast Combustion Turbine and a number of other operations require minor source permits or simple source registration permits. We have secured these permits and operate to meet their requirements. These requirements can change over time as the CAA or applicable implementing regulations are amended and new permits are issued. We actively monitor legislative, regulatory and other program developments of the CAA that may impact our facilities. Hazardous Air Pollutants (HAPs) The EPA regulates hazardous air pollutants from a published list of industrial sources referred to as "source categories" which must meet control technology requirements if they emit one or more of the pollutants in significant quantities. In 2012, the EPA finalized the Mercury Air Toxic Standards (MATS) for the coal and oil-fired source category. At the time of issuance in 2012, we examined the existing emission control systems of Colstrip Units 3 & 4, the only units in which we are a minority owner, and concluded that the existing emission control systems should be sufficient to meet mercury limits. For the remaining portion of the rule that utilized Particulate Matter as a surrogate for air toxics (including metals and acid gases), the Colstrip owners continue to review stack testing data and expect that no additional emission control systems will be needed for Units 3 & 4 MATS compliance. Regional Haze Program The EPA set a national goal of eliminating man-made visibility degradation in Class I areas by the year 2064. States are expected to take actions to make “reasonable progress” through 10-year plans. In the case where a State opts out of implementing the Regional Haze program, the EPA may act directly. In September 2012, the EPA finalized the Regional Haze federal implementation plan (FIP) for Montana; however, in May 2015, the Ninth circuit remanded the FIP back to the EPA. Colstrip Units 3 & 4 are not currently affected in the FIP, but are being evaluated in the 5-year Reasonable Progress Report submitted by the Montana Department of Environmental Quality (MDEQ) in August 2017. We do not anticipate any material impacts on Units 3 & 4 as a result of this report. Coal Ash Management/Disposal In 2015, the EPA issued a final rule regarding coal combustion residuals (CCRs), also termed coal combustion byproducts or coal ash. Colstrip, of which we are a 15 percent owner of Units 3 & 4, produces this byproduct. The rule establishes technical requirements for CCR landfills and surface impoundments under Subtitle D of the Resource Conservation and Recovery Act, the nation's primary law for regulating solid waste. We, in conjunction with the other owners, developed a multi-year compliance plan to strategically address the new CCR requirements and existing state obligations while maintaining operational stability. Based on available information from the Colstrip operator, we review and update our asset retirement obligation (ARO) periodically. See "Note 9 of the Notes to Consolidated Financial Statements" for additional information regarding AROs. In addition to an increase to our ARO, it is expected that there will be significant compliance costs at Colstrip in the future, both operating and capital costs, due to a series of incremental infrastructure improvements which are separate from the ARO. We cannot reasonably estimate the future compliance costs; however, we will update our ARO and compliance cost estimates as data becomes available. The actual asset retirement costs and future compliance costs related to the CCR rule requirements may vary substantially from the estimates used to record the ARO due to uncertainty about the compliance strategies that will be used and the nature of available data used to estimate costs, such as the quantity of coal ash present at certain sites and the volume of fill that will be needed to cap and cover certain impoundments. We will coordinate with the plant operators and continue to gather additional data in future periods to make decisions about compliance strategies and the timing of closure activities. As additional information becomes available, we will update the ARO and future nonretirement compliance costs for these changes in estimates, which could be material. We expect to seek recovery of increased costs related to complying with the CCR rule through customer rates. Climate Change Concerns about long-term global climate changes could have a significant effect on our business. Some companies have been subject to shareholder resolutions requiring climate-change specific planning or actions, which could increase costs. Our operations could also be affected by changes in laws and regulations intended to mitigate the risk of, or alter global climate AVISTA CORPORATION changes, including restrictions on the operation of our power generation resources and obligations imposed on the sale of natural gas. Changing temperatures and precipitation, including snowpack conditions, affect the availability and timing of streamflows, which impact hydroelectric generation. Extreme weather events could increase service interruptions, outages and maintenance costs. Changing temperatures could also increase or decrease customer demand. Our Climate Policy Council (an interdisciplinary team of management and other employees): • facilitates internal and external communications regarding climate change issues, • analyzes policy effects, anticipates opportunities and evaluates strategies for Avista Corp., and • develops recommendations on climate related policy positions and action plans. Climate Change - Federal Regulatory Actions The EPA released the final rules for the Clean Power Plan (Final CPP) and the Carbon Pollution Standards (Final CPS) in August 2015. The Final CPP and the Final CPS are both intended to reduce the carbon dioxide (CO2) emissions from certain coal-fired and natural gas electric generating units (EGUs). These rules were published in the Federal Register in October 2015 and were immediately challenged via lawsuits by other parties. The Final CPP was promulgated pursuant to Section 111(d) of the CAA and applies to CO2 emissions from existing EGUs. The Final CPP is intended to reduce national CO2 emissions by approximately 32 percent below 2005 levels by 2030. The Final CPS rule was issued pursuant to Section 111(b) of the CAA and applies to the emissions of new, modified and reconstructed EGUs. The two rules are the first rules ever adopted by the U.S. federal government to comprehensively control and reduce CO2 emissions from the power sector. The EPA also issued a proposed Federal Implementation Plan (Proposed FIP) for the Final CPP. The Final FIP that the EPA adopts could be imposed on states by the EPA, should a state decide not to develop its own plan. The Final CPP establishes individual state emission reduction goals based upon the assumed potential for (1) heat rate improvements at coal-fired units, (2) increased utilization of natural gas-fired combined cycle plants, and (3) increased utilization of low or zero carbon emitting generation resources. As expressed in the final rule, states had until September 2016 to submit state compliance plans, with a potential for two-year extensions. A stay granted by the U.S. Supreme Court, and described below, pushed this date out pending the results of the case. Avista Corp. owns two EGUs that are subject to the Final CPP: its portion (15 percent of Units 3 & 4) of Colstrip in Montana and Coyote Springs 2 in Oregon. States may adopt rate-based or mass-based plans, and may choose to focus compliance on specific EGUs or adopt broader measures to reduce carbon emissions from this sector. The states in which Avista Utilities generates or delivers electricity, Washington, Idaho, Montana and Oregon, are at differing stages of evaluating options for developing state plans, which will define compliance approaches and obligations. Alaska was exempted in the Final CPP. The EPA may consider rulemaking in the future for Alaska and Hawaii, both states which lack regional grid connections. In a separate but related rulemaking, the EPA finalized CO2 new source performance standards (NSPS) for new, modified and reconstructed fossil fuel-fired EGUs under the CAA section 111(b). These EGUs fall into the same two categories of sources regulated by the Final CPP: steam generating units (also known as “utility boilers and IGCC units”), which primarily burn coal, and stationary combustion turbines, which primarily burn natural gas. Greenhouse gas (GHG) emission standards could result in significant compliance costs. Such standards could also preclude us from developing, operating or contracting with certain types of generating plants. Additionally, the Climate Action Plan requirements related to preparing the U.S. for the impacts of climate change could affect us and others in the industry as transmission system modifications to improve resiliency may be needed in order to meet those requirements. The promulgated and proposed GHG rulemakings mentioned above have been legally challenged in multiple venues. On February 9, 2016, the U.S. Supreme Court granted a request for stay, halting implementation of the Final CPP. On March 28, 2017, the Department of Justice filed a motion with the U.S. Court of Appeals for the District of Columbia Circuit (D.C. Circuit) requesting that the Court hold the cases challenging the Final CPP in abeyance while the EPA reviews the final rules applicable to existing, as well as to new, modified, and reconstructed electric generating units pursuant to an Executive Order issued by President Trump. The Executive Order also instructed the EPA to review the Final CPP rule. On April 28, 2017 the D.C. Circuit issued orders to hold the litigation regarding the Clean Air Act §111(d) Clean Power Plan and the §111(b) New Source Performance Standards for power plants in abeyance for a period of 60 days with status reports due from the EPA every 30 days. On October 16, 2017, the EPA gave notice of proposed rule-making to repeal the Final CPP. On December 28, 2017, the EPA published an Advanced Notice of Proposed Rulemaking seeking comments on the potential for a Final CPP replacement rule. Comment periods on both notices remain open. Given these ongoing developments, we cannot fully predict the outcome or estimate the extent to which our facilities may be impacted by these AVISTA CORPORATION regulations at this time. We intend to seek recovery of costs related to compliance with these requirements through the ratemaking process. Climate Change - State Legislation and State Regulatory Activities The states of Washington and Oregon have adopted non-binding targets to reduce GHG emissions. Both states enacted their targets with an expectation of reaching the targets through a combination of renewable energy standards, and assorted “complementary policies,” but no specific reductions are mandated. Washington and Oregon apply a GHG emissions performance standard (EPS) to electric generation facilities used to serve retail loads in their jurisdictions, whether the facilities are located within those respective states or elsewhere. The EPS prevents utilities from constructing or purchasing generation facilities, or entering into power purchase agreements of five years or longer duration to purchase energy produced by plants that, in any case, have emission levels higher than 1,100 pounds of GHG per MWh. The Washington State Department of Commerce initiated a process to adopt a lower emissions performance standard in 2012, and is in the process of updating the standard, which is currently set at 970 pounds of GHG per MWh. We are engaging in the next process to revise the EPS, which began in 2017 and should conclude in 2018. In addition, citizens, local governments and states, particularly in Oregon and Washington, actively bring forth climate-related proposals that could impact our business and operations. We monitor and engage such activities as appropriate, and intend to seek recovery of costs related to new requirements resulting from such activities through the ratemaking process. Washington Energy Independence Act (EIA) The EIA in Washington requires electric utilities with over 25,000 customers to acquire qualified renewable energy resources and/or renewable energy credits equal to 15 percent of the utility's total retail load in Washington in 2020. I-937 also requires these utilities to meet biennial energy conservation targets beginning in 2012. The renewable energy standard increased from three percent in 2012 to nine percent in 2016 and will increase to 15 percent in 2020. Failure to comply with renewable energy and efficiency standards could result in penalties of $50 per MWh or greater assessed against a utility for each MWh it is deficient in meeting a standard. We have met, and will continue to meet, the requirements of the EIA through a variety of renewable energy generating means, including, but not limited to, some combination of hydro upgrades, wind, biomass and renewable energy credits. In 2012, the EIA was amended in such a way that our Kettle Falls GS and certain other biomass energy facilities, which commenced operation before March 31, 1999, are considered resources that may be used to meet the renewable energy standards. Clean Air Rule In September 2016, the Washington State Department of Ecology (Ecology) adopted the Clean Air Rule (CAR) to cap and reduce GHG emissions across the State of Washington in pursuit of the State’s GHG goals, which were enacted in 2008 by the Washington State Legislature. The CAR applies to sources of annual GHG emissions in excess of 100,000 tons for the first compliance period of 2017 through 2019; this threshold incrementally decreases to 70,000 metric tons beginning in 2035. The rule affects stationary sources and transportation fuel suppliers, as well as natural gas distribution companies. Ecology has identified approximately 30 entities that would be regulated under the CAR. Parties covered by the regulation must reduce emissions by 1.7 percent annually until 2035. Compliance can be demonstrated by achieving emission reductions and/or surrendering Emission Reduction Units (ERU), which are generated by parties that achieve reductions greater than required by the rule. ERUs can also take the form of renewable energy credits from renewable resources located in Washington, carbon emission offsets, and allowances acquired from an organized cap and trade market, such as that operating in California. In addition to the CAR's applicability to our burning of fuel as an electric utility, the CAR applies to us as a natural gas distribution company, for the emissions associated with the use of the natural gas we provide our customers who are not already covered under the regulation. In September 2016, Avista Corp., Cascade Natural Gas Corp., NW Natural and Puget Sound Energy (PSE) (collectively, Petitioners) jointly filed an action in the U.S. District Court for the Eastern District of Washington challenging Ecology’s promulgated CAR. The four companies also filed litigation in Thurston County Superior Court. The case in the U.S. District Court has been tolled while the state court case proceeds. On December 15, 2017, the Thurston County Superior Court issued a ruling invalidating the CAR. Motions are pending in front of the Court and it is unknown if the Court’s ruling will be appealed. We cannot fully predict the outcome of these matters at this time, but plan to seek recovery of costs related to compliance with surviving requirements through the ratemaking process. AVISTA CORPORATION Colstrip 3 & 4 Considerations In February 2014, the WUTC issued a letter finding that PSE’s 2013 Electric IRP meets the requirements of the Revised Code of Washington and the Washington Administrative Code. The letter does not constitute approval of any aspect of the plan. In its letter, however, the WUTC expressed concern regarding the continued operation of the Colstrip plant as a resource to serve retail customers. Although the WUTC recognized that the results of the analyses presented by PSE “differed significantly between [Colstrip] Units 1 & 2 and Units 3 & 4,” the WUTC did not limit its concerns solely to Colstrip Units 1 & 2. The WUTC recommended that PSE “consult with WUTC staff to consider a Colstrip Proceeding to determine the prudency of new investment in Colstrip before it is made or, alternatively, a closure or partial-closure plan.” As part of the Sierra Club litigation that was settled in 2016, Units 1 & 2 are scheduled to close by July 2022. In 2017, the WUTC issued an Order in PSE’s general rate case accelerating PSE’s depreciation of Units 3 & 4 to 2027 from 2044 and 2045, respectively, directing PSE to contribute $10 million from a combination of sources to a community transition fund to mitigate social and economic impacts from the closure of Colstrip, and encouraging PSE to engage stakeholders in a dialogue about utilizing surplus capacity on the Colstrip transmission system. As a 15 percent owner of Colstrip Units 3 & 4, we cannot estimate the effect of such proceeding, should it occur, on the future ownership, operation and operating costs of our share of Colstrip Units 3 & 4. Our remaining investment in Colstrip Units 3 & 4 as of December 31, 2017 was $124.4 million. In Oregon, legislation was enacted in 2016 which requires Portland General Electric and PacifiCorp to remove coal-fired generation from their Oregon rate base by 2030. This legislation does not directly relate to Avista Corp. because Avista Corp. is not an electric utility in Oregon. However, because these two utilities, along with Avista Corp., hold minority interests in Colstrip, the legislation could indirectly impact Avista Corp., though specific impacts cannot be identified at this time. While the legislation requires Portland General Electric and PacifiCorp to eliminate Colstrip from their rates, they would be permitted to sell the output of their shares of Colstrip into the wholesale market or, as is the case with PacifiCorp, reallocate the plant to other states. We cannot predict the eventual outcome of actions arising from this legislation at this time or estimate the effect thereof on Avista Corp.; however, we will continue to seek recovery, through the ratemaking process, of all operating and capitalized costs related to our generation assets. Threatened and Endangered Species and Wildlife A number of species of fish in the Northwest are listed as threatened or endangered under the Federal Endangered Species Act (ESA). Efforts to protect these and other species have not significantly impacted generation levels at our hydroelectric facilities, nor operations of our thermal plants or electrical distribution and transmission system. We are implementing fish protection measures at our hydroelectric project on the Clark Fork River under a 45-year FERC operating license for Cabinet Gorge and Noxon Rapids (issued March 2001) that incorporates a comprehensive settlement agreement. The restoration of native salmonid fish, including bull trout, is a key part of the agreement. The result is a collaborative native salmonid restoration program with the U.S. Fish and Wildlife Service, Native American tribes and the states of Idaho and Montana on the lower Clark Fork River, consistent with requirements of the FERC license. The U.S. Fish & Wildlife Service issued an updated Critical Habitat Designation for bull trout in 2010 that includes the lower Clark Fork River, as well as portions of the Coeur d'Alene basin within our Spokane River Project area, and issued a final Bull Trout Recovery Plan under the ESA. Issues related to these activities are expected to be resolved through the ongoing collaborative effort of our Clark Fork and Spokane River FERC licenses. See “Fish Passage at Cabinet Gorge and Noxon Rapids” in “Note 19 of the Notes to Consolidated Financial Statements” for further information. Various statutory authorities, including the Migratory Bird Treaty Act, have established penalties for the unauthorized take of migratory birds. Because we operate facilities that can pose risks to a variety of such birds, we have developed and follow an avian protection plan. We are also aware of other threatened and endangered species and issues related to them that could be impacted by our operations and we make every effort to comply with all laws and regulations relating to these threatened and endangered species. We expect costs associated with these compliance efforts to be recovered through the ratemaking process. Other For other environmental issues and other contingencies see “Note 19 of the Notes to Consolidated Financial Statements.” Enterprise Risk Management The material risks to our businesses are discussed in "Item 1A. Risk Factors," "Forward-Looking Statements," as well as "Environmental Issues and Contingencies." The following discussion focuses on our mitigation processes and procedures to address these risks. AVISTA CORPORATION We consider the management of these risks an integral part of managing our core businesses and a key element of our approach to corporate governance. Risk management includes identifying and measuring various forms of risk that may affect the Company. We have an enterprise risk management process for managing risks throughout our organization. Our Board of Directors and its Committees take an active role in the oversight of risk affecting the Company. Our risk management department facilitates the collection of risk information across the Company, providing senior management with a consolidated view of the Company’s major risks and risk mitigation measures. Each area identifies risks and implements the related mitigation measures. The enterprise risk process supports management in identifying, assessing, quantifying, managing and mitigating the risks. Despite all risk mitigation measures, however, risks are not eliminated. Our primary identified categories of risk exposure are: • Financial • Compliance • Utility regulatory • Technology • Energy commodity • Strategic • Operational • External Mandates Financial Risk Financial risk is any risk that could have a direct material impact on the financial performance or financial viability of the Company. Broadly, financial risks involve variation of earnings and liquidity. Underlying risks include, but are not limited to, those described in "Item 1A. Risk Factors." We mitigate financial risk in a variety of ways including through oversight from the Finance Committee of our Board of Directors and from senior management. Our Regulatory department is also critical in risk mitigation as they have regular communications with state commission regulators and staff and they monitor and develop rate strategies for the Company. Rate strategies, such as decoupling, help mitigate the impacts of revenue fluctuations due to weather, conservation or the economy. We also have a Treasury department that monitors our daily cash position and future cash flow needs, as well as monitoring market conditions to determine the appropriate course of action for capital financing and/or hedging strategies. Weather Risk To partially mitigate the risk of financial underperformance due to weather-related factors, we developed decoupling rate mechanisms that were approved by the Washington, Idaho and Oregon commissions. Decoupling mechanisms are designed to break the link between a utility's revenues and consumers' energy usage and instead provide revenue based on the number of customers, thus mitigating a large portion of the risk associated with lower customer loads. See "Regulatory Matters" for further discussion of our decoupling mechanisms. Access to Capital Markets Our capital requirements rely to a significant degree on regular access to capital markets. We actively engage with rating agencies, banks, investors and state public utility commissions to understand and address the factors that support access to capital markets on reasonable terms. We manage our capital structure to maintain a financial risk profile that we believe these parties will deem prudent. We forecast cash requirements to determine liquidity needs, including sources and variability of cash flows that may arise from our spending plans or from external forces, such as changes in energy prices or interest rates. Our financial and operating forecasts consider various metrics that affect credit ratings. Our regulatory strategies include working with state public utility commissions and filing for rate changes as appropriate to meet financial performance expectations. Interest Rate Risk Uncertainty about future interest rates causes risk related to a portion of our existing debt, our future borrowing requirements, and our pension and other post-retirement benefit obligations. We manage debt interest rate exposure by limiting our variable rate debt to a percentage of total capitalization of the Company. We hedge a portion of our interest rate risk on forecasted debt issuances with financial derivative instruments, which may include interest rate swaps and U.S. Treasury lock agreements. The Finance Committee of our Board of Directors periodically reviews and discusses interest rate risk management processes and the steps management has undertaken to control interest rate risk. Our RMC also reviews our interest rate risk management plan. Additionally, interest rate risk is managed by monitoring market conditions when timing the issuance of long-term debt and optional debt redemptions and establishing fixed rate long-term debt with varying maturities. Our interest rate swap derivatives are considered economic hedges against the future forecasted interest rate payments of our long-term debt. Interest rates on our long-term debt are generally set based on underlying U.S. Treasury rates plus credit AVISTA CORPORATION spreads, which are based on our credit ratings and prevailing market prices for debt. The interest rate swap derivatives hedge against changes in the U.S. Treasury rates but do not hedge the credit spread. Even though we work to manage our exposure to interest rate risk by locking in certain long-term interest rates through interest rate swap derivatives, if market interest rates decrease below the interest rates we have locked in, this will result in a liability related to our interest rate swap derivatives, which can be significant. However, through our regulatory accounting practices similar to our energy commodity derivatives, any interim mark-to-market gains or losses are offset by regulatory assets and liabilities. Upon settlement of interest rate swap derivatives, the regulatory asset or liability is amortized as a component of interest expense over the term of the associated debt. See "Regulatory Matters - Washington General Rate Cases" for a discussion of the recommendation by the WUTC Staff to deny the recovery of costs incurred in the settlement of certain interest rate swaps and the financial impact of such a denial. Depending on the outcome of this proceeding, we could determine to not manage interest rate risk through swap transactions in the future. The following table summarizes our interest rate swap derivatives outstanding as of December 31, 2017 and December 31, 2016 (dollars in thousands): (1) There are offsetting regulatory assets and liabilities for these items on the Consolidated Balance Sheets in accordance with regulatory accounting practices. (2) The balance as of December 31, 2017 and December 31, 2016 reflects the offsetting of $35.0 million and $34.9 million, respectively, of cash collateral against the net derivative positions where a legal right of offset exists. We estimate that a 10-basis-point increase in forward LIBOR interest rates as of December 31, 2017 would decrease the interest rate swap derivative net liability by $9.7 million, while a 10-basis-point decrease would increase the interest rate swap derivative net liability by $10.0 million. We estimated that a 10-basis-point increase in forward LIBOR interest rates as of December 31, 2016 would have decreased the interest rate swap derivative net liability by $10.4 million, while a 10-basis-point decrease would increase the interest rate swap derivative net liability by $10.7 million. The interest rate on $51.5 million of long-term debt to affiliated trusts is adjusted quarterly, reflecting current market rates. Amounts borrowed under our committed line of credit agreements have variable interest rates. The following table shows our long-term debt (including current portion) and related weighted-average interest rates, by expected maturity dates as of December 31, 2017 (dollars in thousands): (1) These balances include the fixed rate long-term debt of Avista Corp., AEL&P and AERC. AVISTA CORPORATION Our pension plan is exposed to interest rate risk because the value of pension obligations and other post-retirement obligations vary directly with changes in the discount rates, which are derived from end-of-year market interest rates. In addition, the value of pension investments and potential income on pension investments is partially affected by interest rates because a portion of pension investments are in fixed income securities. The Finance Committee of the Board of Directors approves investment policies, objectives and strategies that seek an appropriate return for the pension plan and it reviews and approves changes to the investment and funding policies. We manage interest rate risk associated with our pension and other post-retirement benefit plans by investing a targeted amount of pension plan assets in fixed income investments that have maturities with similar profiles to future projected benefit obligations. See "Note 10 of the Notes to Consolidated Financial Statements" for further discussion of our investment policy associated with the pension assets. Credit Risk Counterparty Non-Performance Risk Counterparty non-performance risk relates to potential losses that we would incur as a result of non-performance of contractual obligations by counterparties to deliver energy or make financial settlements. Changes in market prices may dramatically alter the size of credit risk with counterparties, even when we establish conservative credit limits. Should a counterparty fail to perform, we may be required to honor the underlying commitment or to replace existing contracts with contracts at then-current market prices. We enter into bilateral transactions with various counterparties. We also trade energy and related derivative instruments through clearinghouse exchanges. We seek to mitigate credit risk by: • transacting through clearinghouse exchanges, • entering into bilateral contracts that specify credit terms and protections against default, • applying credit limits and duration criteria to existing and prospective counterparties, • actively monitoring current credit exposures, • asserting our collateral rights with counterparties, and • carrying out transaction settlements timely and effectively. The extent of transactions conducted through exchanges has increased, as many market participants have shown a preference toward exchange trading and have reduced bilateral transactions. We actively monitor the collateral required by such exchanges to effectively manage our capital requirements. Counterparties’ credit exposure to us is dynamic in normal markets and may change significantly in more volatile markets. The amount of potential default risk to us from each counterparty depends on the extent of forward contracts, unsettled transactions, interest rates and market prices. There is a risk that we do not obtain sufficient additional collateral from counterparties that are unable or unwilling to provide it. Credit Risk Liquidity Considerations To address the impact on our operations of energy market price volatility, our hedging practices for electricity (including fuel for generation) and natural gas extend beyond the current operating year. Executing this extended hedging program may increase credit risk and demands for collateral. Our credit risk management process is designed to mitigate such credit risks through limit setting, contract protections and counterparty diversification, among other practices. Credit risk affects demands on our capital. We are subject to limits and credit terms that counterparties may assert to allow us to enter into transactions with them and maintain acceptable credit exposures. Many of our counterparties allow unsecured credit at limits prescribed by agreements or their discretion. Capital requirements for certain transaction types involve a combination of initial margin and market value margins without any unsecured credit threshold. Counterparties may seek assurances of performance from us in the form of letters of credit, prepayment or cash deposits. Credit exposure can change significantly in periods of commodity price and interest rate volatility. As a result, sudden and significant demands may be made against our credit facilities and cash. We actively monitor the exposure to possible collateral calls and take steps to minimize capital requirements. AVISTA CORPORATION As of December 31, 2017, we had cash deposited as collateral of $39.5 million and letters of credit of $23.0 million outstanding related to our energy derivative contracts. Price movements and/or a downgrade in our credit ratings could impact further the amount of collateral required. See “Credit Ratings” for further information. For example, in addition to limiting our ability to conduct transactions, if our credit ratings were lowered to below “investment grade” based on our positions outstanding at December 31, 2017, we would potentially be required to post additional collateral of up to $2.6 million. This amount is different from the amount disclosed in “Note 6 of the Notes to Consolidated Financial Statements” because, while this analysis includes contracts that are not considered derivatives in addition to the contracts considered in Note 6, this analysis also takes into account contractual threshold limits that are not considered in Note 6. Without contractual threshold limits, we would potentially be required to post additional collateral of $4.6 million. Under the terms of interest rate swap derivatives that we enter into periodically, we may be required to post cash or letters of credit as collateral depending on fluctuations in the fair value of the instrument. As of December 31, 2017, we had interest rate swap agreements outstanding with a notional amount totaling $450.0 million and we had deposited cash in the amount of $35.0 million and letters of credit of $5.0 million as collateral for these interest rate swap derivatives. If our credit ratings were lowered to below “investment grade” based on our interest rate swap derivatives outstanding at December 31, 2017, we would have to post $18.8 million of additional collateral. Foreign Currency Risk A significant portion of our utility natural gas supply (including fuel for electric generation) is obtained from Canadian sources. Most of those transactions are executed in U.S. dollars, which avoids foreign currency risk. A portion of our short-term natural gas transactions and long-term Canadian transportation contracts are committed based on Canadian currency prices. The short-term natural gas transactions are typically settled within sixty days with U.S. dollars. We economically hedge a portion of the foreign currency risk by purchasing Canadian currency exchange contracts when such commodity transactions are initiated. This risk has not had a material effect on our financial condition, results of operations or cash flows and these differences in cost related to currency fluctuations are included with natural gas supply costs for ratemaking. Further information for derivatives and fair values is disclosed at “Note 6 of the Notes to Consolidated Financial Statements” and “Note 16 of the Notes to Consolidated Financial Statements.” Utility Regulatory Risk Because we are primarily a regulated utility, we face the risk that regulators may not grant rates that provide timely or sufficient recovery of our costs or allow a reasonable rate of return for our shareholders. This includes costs associated with our investment in rate base, as well as commodity costs and other operating and financing expenses. We mitigate regulatory risk through oversight from our Board of Directors and from senior management. We have a separate regulatory group which communicates with commission regulators and staff regarding the Company’s business plans and concerns. The regulatory group also considers the regulator’s priorities and rate policies and makes recommendations to senior management on regulatory strategy for the Company. See “Regulatory Matters” for further discussion of regulatory matters affecting our Company. Energy Commodity Risk Energy commodity risks are associated with fulfilling our obligation to serve customers, managing variability of energy facilities, rights and obligations and fulfilling the terms of our energy commodity agreements with counterparties. These risks include, among other things, those described in "Item 1A. Risk Factors." We mitigate energy commodity risk primarily through our energy resources risk policy, which includes oversight from the RMC and oversight from the Audit Committee and the Environmental, Technology and Operations Committee of our Board of Directors. In conjunction with the oversight committees, our management team develops hedging strategies, detailed resource procurement plans, resource optimization strategies and long-term integrated resource planning to mitigate some of the risk associated with energy commodities. The various plans and strategies are monitored daily and developed with quantitative methods. Our energy resources risk policy includes our wholesale energy markets credit policy and control procedures to manage energy commodity price and credit risks. Nonetheless, adverse changes in commodity prices, generating capacity, customer loads, regulation and other factors may result in losses of earnings, cash flows and/or fair values. We measure the volume of monthly, quarterly and annual energy imbalances between projected power loads and resources. The measurement process is based on expected loads at fixed prices (including those subject to retail rates) and expected resources to the extent that costs are essentially fixed by virtue of known fuel supply costs or projected hydroelectric conditions. To the extent that expected costs are not fixed, either because of volume mismatches between loads and resources or because fuel cost AVISTA CORPORATION is not locked in through fixed price contracts or derivative instruments, our risk policy guides the process to manage this open forward position over a period of time. Normal operations result in seasonal mismatches between power loads and available resources. We are able to vary the operation of generating resources to match parts of intra-hour, hourly, daily and weekly load fluctuations. We use the wholesale power markets, including the natural gas market as it relates to power generation fuel, to sell projected resource surpluses and obtain resources when deficits are projected. We buy and sell fuel for thermal generation facilities based on comparative power market prices and marginal costs of fueling and operating available generating facilities and the relative economics of substitute market purchases for generating plant operation. To address the impact on our operations of energy market price volatility, our hedging practices for electricity (including fuel for generation) and natural gas extend beyond the current operating year. Executing this extended hedging program may increase our credit risks. Our credit risk management process is designed to mitigate such credit risks through limit setting, contract protections and counterparty diversification, among other practices. Our projected retail natural gas loads and resources are regularly reviewed by operating management and the RMC. To manage the impacts of volatile natural gas prices, we seek to procure natural gas through a diversified mix of spot market purchases and forward fixed price purchases from various supply basins and time periods. We have an active hedging program that extends into future years with the goal of reducing price volatility in our natural gas supply costs. We use natural gas storage capacity to support high demand periods and to procure natural gas when price spreads are favorable. Securing prices throughout the year and even into subsequent years mitigates potential adverse impacts of significant purchase requirements in a volatile price environment. The following table presents energy commodity derivative fair values as a net asset or (liability) as of December 31, 2017 that are expected to settle in each respective year (dollars in thousands): The following table presents energy commodity derivative fair values as a net asset or (liability) as of December 31, 2016 that were expected to settle in each respective year (dollars in thousands): (1) Physical transactions represent commodity transactions where we will take or make delivery of either electricity or natural gas; financial transactions represent derivative instruments with delivery of cash in the amount of the benefit or cost but with no physical delivery of the commodity, such as futures, swap derivatives, options, or forward contracts. The above electric and natural gas derivative contracts will be included in either power supply costs or natural gas supply costs during the period they are delivered and will be included in the various deferral and recovery mechanisms (ERM, PCA, and PGAs), or in the general rate case process, and are expected to eventually be collected through retail rates from customers. See "Item 1. Business - Electric Operations," "Item 1. Business - Natural Gas Operations," and "Item 1A. Risk Factors" for additional discussion of the risks associated with Energy Commodities. AVISTA CORPORATION Operational Risk Operational risk involves potential disruption, losses, or excess costs arising from external events or inadequate or failed internal processes, people and systems. Our operations are subject to operational and event risks that include, but are not limited to, those described in "Item 1A. Risk Factors." To manage operational and event risks, we maintain emergency operating plans, business continuity and disaster recovery plans, maintain insurance coverage against some, but not all, potential losses and seek to negotiate indemnification arrangements with contractors for certain event risks. In addition, we design and follow detailed vegetation management and asset management inspection plans, which help mitigate wildfire and storm event risks, as well as identify utility assets which may be failing and in need of repair or replacement. We also have an Emergency Operating Center, which is a team of employees that plan for and train to deal with potential emergencies or unplanned outages at our facilities, resulting from natural disasters or other events. To prevent unauthorized access to our facilities, we have both physical and cyber security in place. To address the risk related to fuel cost, availability and delivery restraints, we have an energy resources risk policy, which includes our wholesale energy markets credit policy and control procedures to manage energy commodity price and credit risks. Development of the energy resources risk policy includes planning for sufficient capacity to meet our customer and wholesale energy delivery obligations. See further discussion of the energy resources risk policy above. Oversight of the operational risk management process is performed by the Environmental, Technology and Operations Committee of our Board of Directors and from senior management with input from each operating department. Compliance Risk Compliance risk is the potential consequences of legal or regulatory sanctions or penalties arising from the failure of the Company to comply with requirements of applicable laws, rules and regulations. We have extensive compliance obligations. Our primary compliance risks and obligations include, among others, those described in "Item 1A. Risk Factors." We mitigate compliance risk through oversight from the Environmental, Technology and Operations Committee and the Audit Committee of our Board of Directors and from senior management, including our Chief Compliance Officer. We also have separate Regulatory and Environmental Compliance departments that monitor legislation, regulatory orders and actions to determine the overall potential impact to our Company and develop strategies for complying with the various rules and regulations. We also engage outside attorneys and consultants, when necessary, to help ensure compliance with laws and regulations. See "Item 1. Business, Regulatory Issues" through "Item 1. Business, Reliability Standards" and “Environmental Issues and Contingencies” for further discussion of compliance issues that impact our Company. Technology Risk Our primary technology risks are described in "Item 1A. Risk Factors." We mitigate technology risk through trainings and exercises at all levels of the Company. The Environmental, Technology and Operations Committee of our Board of Directors along with senior management are regularly briefed on security policy, programs and incidents. Annual cyber and physical training and testing of employees are included in our enterprise security program. Our enterprise business continuity program facilitates business impact analysis of core functions for development of emergency operating plans, and coordinates annual testing and training exercises. Technology governance is led by senior management, which includes new technology strategy, risk planning and major project planning and approval. The technology project management office and enterprise capital planning group provide project cost, timeline and schedule oversight. In addition, there are independent third party audits of our critical infrastructure security program and our business risk security controls. We have a Technology department dedicated to securing, maintaining, evaluating and developing our information technology systems. There are regular training sessions for the technology and security team. This group also evaluates the Company's technology for obsolescence and makes recommendations for upgrading or replacing systems as necessary. Additionally, this group monitors for intrusion and security events that may include a data breach or attack on our operations. Strategic Risk Strategic risk relates to the potential impacts resulting from incorrect assumptions about external and internal factors, inappropriate business plans, ineffective business strategy execution, or the failure to respond in a timely manner to changes in AVISTA CORPORATION the regulatory, macroeconomic or competitive environments. Our primary strategic risks include, among others, those described in "Item 1A. Risk Factors." We mitigate strategic risk through detailed oversight from the Board of Directors and from senior management. We also have a Chief Strategy Officer that leads strategic initiatives, to search for and evaluate opportunities for the Company and makes recommendations to senior management. We not only focus on whether opportunities are financially viable, but also consider whether these opportunities fall within our core policies and our core business strategies. We mitigate our reputational risk primarily through a focus on adherence to our core policies, including our Code of Conduct, maintaining an appropriate Company culture and tone at the top, and through communication and engagement of our external stakeholders. External Mandates Risk External mandate risk involves forces outside the Company, which may include significant changes in customer expectations, disruptive technologies that result in obsolescence of our business model and government action that could impact the Company. See "Environmental Issues and Contingencies" and "Forward-Looking Statements" for a discussion of or reference to our external mandates risks. We mitigate external mandate risk through detailed oversight from the Environmental, Technology and Operations Committee of our Board of Directors and from senior management. We have a Climate Council which meets internally to assess the potential impacts of climate policy to our business and to identify strategies to plan for change. We also have employees dedicated to actively engage and monitor federal, state and local government positions and legislative actions that may affect us or our customers. To prevent the threat of municipalization, we work to build strong relationships with the communities we serve through, among other things: • communication and involvement with local business leaders and community organizations, • providing customers with a multitude of limited income initiatives, including energy fairs, senior outreach and low income workshops, mobile outreach strategy and a Low Income Rate Assistance Plan, • tailoring our internal company initiatives to focus on choices for our customers, to increase their overall satisfaction with the Company, and • engaging in the legislative process in a manner that fosters the interests of our customers and the communities we serve.

<s>[INST] As of December 31, 2017, we have two reportable business segments, Avista Utilities and AEL&P. We also have other businesses which do not represent a reportable business segment and are conducted by various direct and indirect subsidiaries of Avista Corp. See "Part I, Item 1. Business Company Overview" for further discussion of our business segments. The following table presents net income (loss) attributable to Avista Corp. shareholders for each of our business segments (and the other businesses) for the year ended December 31 (dollars in thousands): Executive Level Summary Overall Results Net income attributable to Avista Corp. shareholders was $115.9 million for 2017, a decrease from $137.2 million for 2016. The decrease in earnings was due to a decrease in earnings at Avista Utilities and an increase in losses at our other businesses. These were partially offset by an increase in earnings at AEL&P for 2017. Avista Utilities' earnings decreased for 2017 primarily due to costs related to the pending acquisition by Hydro One (see further discussion at "Pending Acquisition by Hydro One" below), which are not being passed through to customers. Further, since a significant portion of these acquisition costs are not deductible for income tax purposes, earnings reflect the full amount of such costs. Excluding acquisition costs, there was a slight increase in other operating expenses, primarily due to an increase in generation and distribution maintenance costs and transmission operating costs. In addition, there were increases in depreciation and amortization and interest expense. Our 2016 requests for general rate increases in Washington were denied. See further discussion at "2016 Washington General Rate Cases" below and "Regulatory Matters" for additional discussion surrounding these requests and all of our other general rate cases. In addition to the increases in costs described above, there was an increase in income tax expense during 2017, primarily due to recent changes in the federal income tax law, which is discussed at "Federal Income Tax Law Changes" below. The increase in costs was partially offset by an increase in gross margin (operating revenues less resource costs) as a result of general rate AVISTA CORPORATION increases in Idaho and Oregon, customer growth and lower electric resource costs. See "Results of Operations Overall NonGAAP Financial Measures" for further discussion of gross margin. AEL&P earnings increased for 2017 resulting from an increase in revenue due to a general rate increase, higher electric loads and a slight increase in residential and commercial customers. During 2017, there was a customer refund charge related to a settlement agreement in AEL&P's electric general rate case which partially offset the increased revenues. There was also an increase in operating expenses for 2017 and a decrease in AFUDC and capitalized interest due to the construction of an additional backup generation plant completed in 2016. The increase in losses at our other businesses for 2017 was primarily related to an increase in income tax expense resulting from the new federal income tax law. There were also renovation expenses and increased compliance costs at one of our subsidiaries as well as impairment charges associated with two of our equity investments. More detailed explanations of the fluctuations are provided in the results of operations and business segment discussions (Avista Utilities, AEL&P, and the other businesses). 2016 Washington General Rate Cases In December 2016, the WUTC issued an order related to our Washington electric and natural gas general rate cases that were originally filed in February 2016. The WUTC order denied the Company's proposed electric and natural gas rate increase requests totaling $43.0 million. Accordingly, our electric and natural gas retail rates remained unchanged in Washington State for 2017. As a result of the above WUTC decision, for 2017 we expected to earn below our authorized return on equity (ROE) and we expected to experience earnings contraction of $0.20 to $0.30 per diluted share as compared to 2016 actual results. However, our actual 2017 earnings were not as negatively affected as we anticipated primarily due to lower resource [/INST] Positive. </s>

AVISTA CORP

2019-02-20

2018-12-31

ITEM 7. MANAGEMENT'S DISCUSSION AND ANALYSIS OF FINANCIAL CONDITION AND RESULTS OF OPERATIONS Business Segments As of December 31, 2018, we have two reportable business segments, Avista Utilities and AEL&P. We also have other businesses which do not represent a reportable business segment and are conducted by various direct and indirect subsidiaries of Avista Corp. See "Part I, Item 1. Business - Company Overview" for further discussion of our business segments. The following table presents net income (loss) attributable to Avista Corp. shareholders for each of our business segments (and the other businesses) for the year ended December 31 (dollars in thousands): AVISTA CORPORATION Executive Level Summary Overall Results Net income attributable to Avista Corp. shareholders was $136.4 million for 2018, an increase from $115.9 million for 2017. The increase in earnings was due to an increase in earnings at Avista Utilities and a decrease in losses at our other businesses, partially offset by a decrease in earnings at AEL&P. Avista Utilities' earnings increased for 2018 primarily due to a decrease in acquisition costs relating to the terminated acquisition by Hydro One and the positive impact of general rate increases and customer growth. These factors were partially offset by increased distribution and generation operating and maintenance costs, outside service costs (other operating expenses), depreciation and amortization, and interest expense. AEL&P earnings decreased for 2018, primarily due to an increase in depreciation and amortization and other miscellaneous expenses as well as a decrease in sales volumes to residential and commercial customers primarily during the fourth quarter of 2018. Losses at our other businesses decreased during 2018 as 2017 included a one-time tax expense in the fourth quarter from revaluing deferred taxes to the new tax rate of 21 percent as a result of federal income tax law changes. There was also a gain in 2018 from one of our equity investments. These were partially offset by increased expenses associated with a renovation project in 2018, impairment losses and an increase in losses on certain of our subsidiary investments. More detailed explanations of the fluctuations are provided in the results of operations and business segment discussions (Avista Utilities, AEL&P, and the other businesses). General Rate Cases and Regulatory Lag Due in part to the regulatory proceedings for the now terminated acquisition of the Company by Hydro One (see below), we elected not to file any general rate cases during 2018 to allow the commissions to focus on the merger proceedings. While we received a base rate increase effective January 1, 2019 in Idaho, which was related to a rate plan approved by the IPUC in 2017, we have not received base rate relief in Oregon since November 1, 2017, and have not received base rate relief in Washington since May 1, 2018. During 2017 and 2018, we continued to invest in our utility infrastructure to maintain and enhance our system; however, only limited portions of these costs are reflected in our current rates to customers. As such, we expect to experience regulatory lag during the period 2019 through 2021 due to the delay in general rate case filings and our continued investment in utility infrastructure. We plan to file general rate cases in Washington, Idaho and Oregon during the first half of 2019 with requested effective dates in early 2020 to begin remedying the regulatory lag. Going forward, we will continue to strive to reduce the regulatory timing lag and more closely align our earned returns with those authorized by 2022. This will require adequate and timely rate relief in our jurisdictions. Termination of the Proposed Acquisition by Hydro One On July 19, 2017, Avista Corp. entered into a Merger Agreement that provided for Avista Corp. to become an indirect, wholly-owned subsidiary of Hydro One, subject to the satisfaction or waiver of specified closing conditions, including approval by regulatory agencies. On January 23, 2019, Avista Corp., Hydro One and certain subsidiaries thereof, entered into a termination agreement (Termination Agreement) indicating their mutual agreement to terminate the Merger Agreement, effective immediately. Pursuant to the terms of the Merger Agreement and the Termination Agreement, Hydro One paid Avista Corp. a $103 million termination fee on January 24, 2019. The termination fee will be used for reimbursing our transaction costs incurred from 2017 to 2019. These costs, including income taxes, total approximately $51 million. The balance of the termination fee will be used for general corporate purposes and reduces our need for external financing. For further information, see "Notes 20 and 24 of the Notes to Consolidated Financial Statements.” Federal Income Tax Law Changes On December 22, 2017, the TCJA was signed into law, with most provisions of the new law effective on January 1, 2018. As a result of the TCJA and its reduction of the corporate income tax rate from 35 percent to 21 percent (among many other changes in the law), we recorded a regulatory liability associated with the revaluing of our deferred income tax assets and liabilities to the new corporate tax rate. The regulatory liability for plant-related excess deferred income taxes will be returned to customers through their future rates. The regulatory liability for non-plant excess deferred taxes will be returned to customers as prescribed by proposed settlement agreements in Washington, Idaho and Oregon discussed at "Regulatory Matters." The return of excess deferred income taxes does not impact our net income. Because most of the provisions of the TCJA were effective as of January 1, 2018 but customers' rates included a 35 percent corporate tax rate built in from prior general rate cases, we began accruing for a refund to customers for the change in federal AVISTA CORPORATION income tax expense beginning January 1, 2018 forward. For Washington and Idaho, this accrual was recorded until all benefits prior to a permanent rate change were properly captured through the deferral process. Refunds have begun for Washington and Idaho customers through tariffs or other regulatory mechanisms or proceedings. For Oregon, we will continue to defer these benefits until reflected in a future regulatory proceeding as approved by the OPUC. The primary impact to us from the TCJA is the loss of the bonus depreciation tax deduction, which results in less depreciation as a current tax deduction, which increases our taxable income and results in us having to pay taxes earlier than we had projected under the old tax laws. This negative impact to cash flows has impacted certain financial metrics used by credit rating agencies to evaluate the Company. The negative impact to our financial metrics contributed to Moody's downgrading our credit rating in 2018. Moody's also cited uncertainty with respect to regulatory outcomes in Washington as a contributing factor for the downgrade. Any further actions by credit ratings agencies may make it more difficult and costly for us to issue future debt securities and could increase borrowing costs under our credit facilities. See "Credit Ratings" for additional discussion. See "Regulatory Matters" and "Note 11 of the Notes to Consolidated Financial Statements" for additional information regarding the TCJA and its specific impacts to our financial statements. Regulatory Matters General Rate Cases We regularly review the need for electric and natural gas rate changes in each state in which we provide service. We will continue to file for rate adjustments to: • seek recovery of operating costs and capital investments, and • seek the opportunity to earn reasonable returns as allowed by regulators. With regards to the timing and plans for future filings, the assessment of our need for rate relief and the development of rate case plans takes into consideration short-term and long-term needs, as well as specific factors that can affect the timing of rate filings. Such factors include, but are not limited to, in-service dates of major capital investments and the timing of changes in major revenue and expense items. Avista Utilities Washington General Rate Cases and Other Proceedings 2015 General Rate Cases In January 2016 we received an order which was reaffirmed by the WUTC in February 2016 that concluded our electric and natural gas general rate cases that were originally filed with the WUTC in February 2015. New electric and natural gas rates were effective on January 11, 2016. The WUTC-approved rates were designed to provide a 1.6 percent, or $8.1 million decrease in electric base revenue, and a 7.4 percent, or $10.8 million increase in natural gas base revenue. The WUTC also approved an ROR of 7.29 percent, with a common equity ratio of 48.5 percent and a 9.5 percent ROE. In March 2016, the Public Counsel Unit of the Washington State Office of the Attorney General filed in Thurston County Superior Court a Petition for Judicial Review of the WUTC's orders that concluded our 2015 electric and natural gas general rate cases. In April 2016, this matter was certified for review directly by the Court of Appeals, an intermediate appellate court in the State of Washington. On August 7, 2018, the Court of Appeals issued an Opinion which concluded that the WUTC's use of an attrition allowance to calculate Avista Corp.'s rate base violated Washington law. The Court struck all portions of the attrition allowance attributable to Avista Corp.’s rate base and reversed and remanded the case for the WUTC to recalculate Avista Corp.’s rates without including an attrition allowance in the calculation of rate base. The total attrition allowance approved by the WUTC was $35.2 million, with $28.3 million related to electric and $6.9 million related to natural gas. The Company cannot predict the outcome of this matter at this time and cannot estimate how much, if any, of the attrition allowance may be removed from the general rate cases. The regulatory process to address this matter has not yet been established by the WUTC. See "Note 20 of the Notes to Consolidated Financial Statements" for further discussion of this matter. 2016 General Rate Cases In December 2016, the WUTC issued an order related to our Washington electric and natural gas general rate cases that were originally filed with the WUTC in February 2016. The WUTC order denied the Company's proposed electric and natural gas AVISTA CORPORATION rate increase requests of $38.6 million and $4.4 million, respectively. Accordingly, our electric and natural gas retail rates remained unchanged in Washington State following the order. The primary reason given by the WUTC in reaching its conclusion was that, in our request, we did not follow an “appropriate methodology” to show the existence of attrition, as between historical data and current and projected data. In support of its decision, the WUTC stated that we did not demonstrate that our current revenue was insufficient for covering costs and providing the opportunity to earn a reasonable return during the 2017 rate period. The WUTC also stated that we did not demonstrate that our capital expenditures and increased operating costs are both necessary and immediate. We did not appeal the WUTC's decision to the courts and instead focused on new general rate cases. 2017 General Rate Cases On April 26, 2018, the WUTC issued a final order in our electric and natural gas general rate cases that were originally filed on May 26, 2017. In the order, the WUTC approved new electric rates, effective on May 1, 2018, that increased base rates by 2.2 percent (designed to increase electric revenues by $10.8 million). The net increase in electric base rates was made up of an increase in our base revenue requirement of $23.2 million, an increase of $14.5 million in power supply costs and a decrease of $26.9 million for the impacts of the TCJA, which reflects the federal income tax rate change from 35 percent to 21 percent and the amortization of the regulatory liability for plant excess deferred income taxes that was recorded as of December 31, 2017. While the WUTC authorized an increase in the ERM baseline to reflect increased power supply costs, it directed the parties to examine the functionality and rationale of the Company's power cost modeling and adjust the baseline only in extraordinary circumstances if necessary to more closely match the baseline to actual conditions. For natural gas, the WUTC approved new natural gas base rates, effective on May 1, 2018, that decreased base rates by 2.4 percent (designed to decrease natural gas revenues by $2.1 million). The net decrease in natural gas base rates was made up of an increase in base revenues of $3.4 million that was offset by a decrease of $5.5 million for the impacts from the TCJA, which reflects the federal income tax rate change and the amortization of the regulatory liability for plant-related excess deferred income taxes that was recorded as of December 31, 2017. In addition to the above, the WUTC also ordered, effective June 1, 2018, a one-year temporary reduction of $7.9 million in our revenue requirements for electric and $3.2 million for natural gas, reflecting reductions for the return of tax benefits associated with the non-plant excess deferred income taxes and the customer refund liability that was established in 2018 related to the change in federal income tax expense for the period January 1, 2018 to April 30, 2018. The new rates are based on a ROR of 7.50 percent with a common equity ratio of 48.5 percent and a 9.5 percent ROE. In our original filings, we requested three-year rate plans for electric and natural gas; however, in the final order the WUTC only provided for new rates effective on May 1, 2018. In testimony filed in our 2017 general rate case, the WUTC Staff recommended the exclusion of our 2016 settlement costs of interest rate swaps from the cost of capital calculation. In the final order, the WUTC disagreed with WUTC Staff and did not disallow the settlement costs of our interest rate swaps. However, the WUTC did recommend that we make changes to our interest rate risk hedging policy to be more risk responsive. We are evaluating and making changes to our policy to meet the WUTC recommendations. TCJA Proceedings In February 2019, we filed an all-party settlement agreement with the WUTC related to the electric tax benefits that were set aside for Colstrip in the 2017 general rate case order. In the settlement agreement, the parties agreed to utilize $10.9 million of the electric tax benefits to offset costs associated with accelerating the depreciation of Colstrip Units 3 & 4, to reflect a remaining useful life of those units through December 31, 2027. The settlement agreement is subject to WUTC approval. Although the parties to the settlement agreement have agreed to the acceleration of depreciation of Colstrip Units 3 & 4, the settlement does not reflect any agreement with respect to the ultimate closure of Colstrip Units 3 & 4, since that decision would have to be made in conjunction with the other owners of Colstrip. 2019 General Rate Cases We expect to file electric and natural gas general rate cases with the WUTC in the first half of 2019. AVISTA CORPORATION Idaho General Rate Cases and Other Proceedings 2016 General Rate Cases In December 2016, the IPUC approved a settlement agreement between us and other parties, concluding our electric general rate case originally filed in May 2016. New rates were effective on January 1, 2017. We did not file a natural gas general rate case in 2016. The settlement agreement increased annual electric base rates by 2.6 percent (designed to increase annual electric revenues by $6.3 million). The settlement was based on a ROR of 7.58 percent with a common equity ratio of 50 percent and a 9.5 percent ROE. 2017 General Rate Cases On December 28, 2017, the IPUC approved a settlement agreement between us and other parties to our electric and natural gas general rate cases. New rates were effective on January 1, 2018 and January 1, 2019. The settlement agreement is a two-year rate plan and has the following electric and natural gas base rate changes each year, which are designed to result in the following increases in annual revenues (dollars in millions): The settlement agreement is based on a ROR of 7.61 percent with a common equity ratio of 50.0 percent and a 9.5 percent ROE. As a part of the two-year rate plan the Company will not file a new general rate case for a new rate plan to be effective prior to January 1, 2020. TCJA Proceedings On May 31, 2018, the IPUC approved the all-party settlement agreement related to the income tax benefits associated with the TCJA. Effective June 1, 2018, through separate tariff schedules, until such time as these changes can be reflected in base rates within the next general rate case, current customer rates were reduced to reflect the reduction of the federal income tax rate to 21 percent, and the amortization of the regulatory liability for plant-related excess deferred income taxes. This reduction reduces annual electric rates by $13.7 million (or 5.3 percent reduction to base rates) and natural gas rates by $2.6 million (or 6.1 percent reduction to base rates). In February 2019, we filed an all-party settlement agreement with the IPUC related to the electric tax benefits that were set aside for Colstrip in the 2017 general rate case order. In the settlement agreement, the parties agreed to utilize approximately $6.4 million of the electric tax benefits to offset costs associated with accelerating the depreciation of Colstrip Units 3 & 4, to reflect a remaining useful life of those units through December 31, 2027. The remaining tax benefits of approximately $5.8 million will be returned to customers through a temporary rate reduction over a period of one year beginning on April 1, 2019. The tax benefits being utilized are related to non-plant excess deferred income taxes, and the customer refund liability that was established in 2018 related to the change in federal income tax expense for the period January 1, 2018 to May 31, 2018. The settlement agreement is subject to IPUC approval. 2019 General Rate Cases We expect to file electric and natural gas general rate cases with the IPUC in the second quarter of 2019. AVISTA CORPORATION Oregon General Rate Cases and Other Proceedings 2016 General Rate Case In September 2017, the OPUC approved a settlement agreement between us and other parties to our natural gas general rate case that was filed with the OPUC in November 2016, which resolved all issues in the case. The OPUC approved rates designed to increase annual base revenues by 5.9 percent or $3.5 million. A rate adjustment of $2.6 million became effective October 1, 2017, and a second adjustment of $0.9 million became effective on November 1, 2017 to cover specific capital projects identified in the settlement agreement, which were completed in October. In addition, in the settlement agreement, we agreed to non-recovery of certain utility plant expenditures, which resulted in a write-off of $0.8 million in the second quarter of 2017. The settlement agreement reflects a 7.35 percent ROR with a common equity ratio of 50 percent and a 9.4 percent ROE. TCJA Proceedings In February 2019, the OPUC approved the deferral amount of $3.8 million related to 2018 income tax benefits associated with the TCJA. The 2018 deferred benefits are expected to be returned to customers through a temporary rate reduction over a period of one year beginning March 1, 2019. We requested to continue the deferral of the TCJA benefits during 2019 for later return to customers, until such time as these changes can be reflected in base rates. 2019 General Rate Case We expect to file a natural gas general rate case with the OPUC in the first quarter of 2019. AMI Project In March 2016, the WUTC granted our Petition for an Accounting Order to defer and include in a regulatory asset the undepreciated value of our existing Washington electric meters for the opportunity for later recovery. This accounting treatment is related to our plans to replace approximately 253,000 of our existing electric meters with new two-way digital meters and the related software and support services through our AMI project in Washington State. As of December 31, 2018, the estimated future undepreciated value for the existing electric meters is $20.6 million. In September 2017, the WUTC also approved our request to defer the undepreciated net book value of existing natural gas encoder receiver transmitters (ERT) (consistent with the accounting treatment we obtained on our existing electric meters) that will be retired as part of the AMI project. As of December 31, 2018, the estimated future undepreciated value for the existing natural gas ERTs is $3.7 million. Replacement of the electric meters and natural gas ERTs began during the second half of 2018. In September 2017, the WUTC approved a Petition to defer the depreciation expense associated with the AMI project, along with a carrying charge, and to seek recovery of the deferral and carrying charge in a future general rate case. Cost savings, such as reduced meter reading costs, will occur during the implementation period which will offset a portion of the AMI costs not being deferred. In May 2017, we filed Petitions with the IPUC and the OPUC requesting a depreciable life of 12.5 years for the meter data management system (MDM) related to the AMI project and both the IPUC and the OPUC approved the depreciable life. In addition, in connection with the 2017 Idaho electric general rate case (discussed above), the settling parties agreed to cost recovery of Idaho's share of the MDM system, effective January 1, 2019. In connection with the approval of the Oregon general rate case settlement (discussed above), the OPUC approved cost recovery of Oregon's share of the MDM system, effective November 1, 2017. Alaska Electric Light and Power Company Alaska General Rate Case In November 2017, the RCA approved an all-party settlement agreement related to AEL&P's electric general rate case, which was originally filed in September 2016. The settlement agreement is designed to increase base electric revenue by 3.86 percent or $1.3 million, making permanent the interim rate increase approved by the RCA in 2016. The agreement reflects an 8.91 percent ROR with a common equity ratio of 58.18 percent and an 11.95 percent ROE. TCJA Proceedings The RCA approved a settlement agreement between AEL&P and the Attorney General filed on June 15, 2018 (Order 3). Per Order 3, effective August 1, 2018, AEL&P reduced firm customer base rates by 6.7 percent ($2.4 million annually), to reflect income tax expense reductions associated with the TCJA. The RCA also approved AEL&P's proposal to refund to customers a one-time credit equal to the 6.7 percent rate reduction for bills between January 1 and July 31, 2018. AEL&P completed all one- AVISTA CORPORATION time credits during the third quarter of 2018. The impact of the TCJA on AEL&P’s deferred income taxes will be addressed in AEL&P’s next general rate case, due to be filed by August 30, 2021. Avista Utilities Purchased Gas Adjustments PGAs are designed to pass through changes in natural gas costs to Avista Utilities' customers with no change in utility margin (operating revenues less resource costs) or net income. In Oregon, we absorb (cost or benefit) 10 percent of the difference between actual and projected natural gas costs included in retail rates for supply that is not hedged. Total net deferred natural gas costs among all jurisdictions were a liability of $40.7 million as of December 31, 2018 and a liability of $37.5 million as of December 31, 2017. These deferred natural gas costs balances represent amounts due to customers. The following PGAs went into effect in our various jurisdictions during 2016 through 2018: (1) Due to declining wholesale natural gas prices that have occurred since the 2017 PGAs were filed and went into effect, we filed, and the respective commissions approved, out of cycle PGAs to reduce customer rates and pass through expected lower costs during the winter heating months, rather than waiting until the next regular PGA cycle. Power Cost Deferrals and Recovery Mechanisms Deferred power supply costs are recorded as a deferred charge or liability on the Consolidated Balance Sheets for future prudence review and recovery or rebate through retail rates. The power supply costs deferred include certain differences between actual net power supply costs incurred by Avista Utilities and the costs included in base retail rates. This difference in net power supply costs primarily results from changes in: • short-term wholesale market prices and sales and purchase volumes, • the level, availability and optimization of hydroelectric generation, • the level and availability of thermal generation (including changes in fuel prices), • retail loads, and • sales of surplus transmission capacity. The ERM is an accounting method used to track certain differences between Avista Utilities' actual power supply costs, net of wholesale sales and sales of fuel, and the amount included in base retail rates for our Washington customers. Total net deferred power costs under the ERM were a liability of $34.4 million as of December 31, 2018 and a liability $23.7 million as of December 31, 2017. These deferred power cost balances represent amounts due to customers. Pursuant to WUTC requirements, should the cumulative deferral balance exceed $30 million in the rebate or surcharge direction, we must make a filing with the WUTC to adjust customer rates to either return the balance to customers or recover the balance from customers. AVISTA CORPORATION Under the ERM, Avista Utilities absorbs the cost or receives the benefit from the initial amount of power supply costs in excess of or below the level in retail rates, which is referred to as the deadband. The annual (calendar year) deadband amount is $4.0 million. The following is a summary of the ERM: Under the ERM, Avista Utilities makes an annual filing on or before April 1 of each year to provide the opportunity for the WUTC staff and other interested parties to review the prudence of and audit the ERM deferred power cost transactions for the prior calendar year. The 2019 filing will also contain a proposed rate adjustment or refund, effective July 1, 2019, due to the cumulative rebate balance exceeding $30 million. Avista Utilities has a PCA mechanism in Idaho that allows us to modify electric rates on October 1 of each year with IPUC approval. Under the PCA mechanism, we defer 90 percent of the difference between certain actual net power supply expenses and the amount included in base retail rates for our Idaho customers. The October 1 rate adjustments recover or rebate power supply costs deferred during the preceding July-June twelve-month period. Total net power supply costs deferred under the PCA mechanism were a liability of $7.6 million as of December 31, 2018 and a liability of $6.1 million as of December 31, 2017. These deferred power cost balances represent amounts due to customers. Decoupling and Earnings Sharing Mechanisms Decoupling (also known as a FCA in Idaho) is a mechanism designed to sever the link between a utility's revenues and consumers' energy usage. In each of our jurisdictions, Avista Utilities' electric and natural gas revenues are adjusted so as to be based on the number of customers in certain customer rate classes and assumed "normal" kilowatt hour and therm sales, rather than being based on actual kilowatt hour and therm sales. The difference between revenues based on the number of customers and "normal" sales and revenues based on actual usage is deferred and either surcharged or rebated to customers beginning in the following year. Only residential and certain commercial customer classes are included in our decoupling mechanisms. Washington Decoupling and Earnings Sharing In Washington, the WUTC approved our decoupling mechanisms for electric and natural gas for a five-year period beginning January 1, 2015. In February 2019, the WUTC approved an all-party agreement that extends the life of the mechanisms through the end of our next general rate case, or April 1, 2020, whichever comes first. In that general rate case we will seek to either make permanent or extend the mechanisms for an additional multi-year term. Electric and natural gas decoupling surcharge rate adjustments to customers are limited to a 3 percent increase on an annual basis, with any remaining surcharge balance carried forward for recovery in a future period. There is no limit on the level of rebate rate adjustments. The decoupling mechanisms each include an after-the-fact earnings test. At the end of each calendar year, separate electric and natural gas earnings calculations are made for the calendar year just ended. These earnings tests reflect actual decoupled revenues, normalized power supply costs and other normalizing adjustments. If we earn more than our authorized ROR in Washington, 50 percent of excess earnings are rebated to customers through adjustments to existing decoupling surcharge or rebate balances. Idaho FCA Mechanism In Idaho, the IPUC approved the implementation of FCAs for electric and natural gas (similar in operation and effect to the Washington decoupling mechanisms) for an initial term of three years, beginning January 1, 2016. During the first quarter of 2018, the FCA in Idaho was extended for a one-year term through December 31, 2019. We expect to seek an extension of the FCAs in our next general rate case, expected in the second quarter of 2019. Oregon Decoupling Mechanism In February 2016, the OPUC approved the implementation of a decoupling mechanism for natural gas, similar to the Washington and Idaho mechanisms described above. The decoupling mechanism became effective on March 1, 2016. There will be an opportunity for interested parties to review the mechanism and recommend changes, if any, by September 2019. In AVISTA CORPORATION Oregon, an earnings review is conducted on an annual basis. In the annual earnings review, if we earn more than 100 basis points above our allowed return on equity, one-third of the earnings above the 100 basis points would be deferred and later rebated to customers. Cumulative Decoupling and Earnings Sharing Balances Total net cumulative decoupling deferrals among all jurisdictions were regulatory assets of $13.9 million as of December 31, 2018 and $16.5 million as of December 31, 2017. These decoupling assets represent amounts due from customers. Total net earnings sharing balances among all jurisdictions were regulatory liabilities of $1.5 million as of December 31, 2018 and $5.8 million as of December 31, 2017. These earnings sharing liabilities represent amounts due to customers. See "Results of Operations - Avista Utilities" for further discussion of the amounts recorded to operating revenues in 2016 through 2018 related to the decoupling and earnings sharing mechanisms. Results of Operations - Overall The following provides an overview of changes in our Consolidated Statements of Income. More detailed explanations are provided, particularly for operating revenues and operating expenses, in the business segment discussions (Avista Utilities, AEL&P and the other businesses) that follow this section. The balances included below for utility operations reconcile to the Consolidated Statements of Income. 2018 compared to 2017 The following graph shows the total change in net income attributable to Avista Corp. shareholders for 2017 to 2018, as well as the various factors that caused such change (dollars in millions): Utility revenues decreased at both Avista Utilities and AEL&P. Avista Utilities' revenues decreased primarily due to lower retail electric and natural gas sales volumes (due to warmer weather in the heating season and cooler weather in the cooling season) and accruals for refunds to customers and decreases to retail rates related to federal income tax law changes. As our customers' rates had the 35 percent corporate tax rate built in from prior general rate cases through May 1, 2018 in Washington and June 1, 2018 in Idaho, we deferred the impact of the change beginning January 1, 2018. Effective May 1, 2018 in Washington and June 1, 2018 in Idaho, base rates reflect the lower 21 percent corporate tax. Base rates in Oregon continue to have the 35 percent corporate tax rate built in and we are deferring the impact. There was no impact on our net income, as there was a corresponding decrease in income tax expense. Avista Utilities' decrease in revenues was partially offset by an increase in revenue from general rate increases in Washington, Idaho and Oregon, customer growth and decoupling. AEL&P's revenues decreased due to a decrease in retail rates associated with the federal income tax law change and the adoption of ASU No. 2014-09 effective January 1, 2018, which changed the presentation of AEL&P's utility-related taxes collected from customers from a gross basis to a net basis. The adoption of ASU No. 2014-09 decreased AEL&P's revenues and taxes other than income taxes by $2.3 million, but had no impact on net income. See "Notes 2 and 4 of the Notes to Consolidated Financial Statements" for further information on the adoption of this ASU. Utility resource costs decreased at both Avista Utilities and AEL&P. The decrease at Avista Utilities was primarily due to a decrease in natural gas purchased (due to a decrease in prices and volumes). The decrease at AEL&P was due to a decrease in AVISTA CORPORATION deferred power supply expenses. Utility operating expenses increased primarily from an increase at Avista Utilities as a result of an increase in generation and distribution operating and maintenance costs and outside service costs. The increase was partially offset by a decrease in pension costs. The acquisition costs are related to the now terminated acquisition by Hydro One. These costs decreased because 2018 consisted primarily of employee time incurred directly related to the transaction, whereas 2017 included financial advisers' fees, legal fees, consulting fees and employee time. None of these transaction costs are being passed through to customers. Utility depreciation and amortization increased due to additions to utility plant. Income taxes decreased due to federal income tax law changes, which reduced the corporate tax rate from 35 percent to 21 percent. Our effective tax rate was 16.0 percent for 2018 compared to 41.7 percent for 2017. In addition to the enacted tax rate decrease, the amortization of plant excess deferred income taxes also decreased our effective tax rate. See "Note 11 of the Notes to Consolidated Financial Statements" for further details and a reconciliation of our effective tax rate. The increase in other was primarily related to an increase in interest expense due to additional debt being outstanding during 2018 as compared to 2017. Also, there were impairment losses on investments and net losses from our equity method investments (which were partially offset by a gain from one of our equity method investments). In addition, we had increased expenses at one of our subsidiaries associated with the insolvency of the general contractor on a renovation project. The general contractor's insolvency resulted in the recording of a liability to various subcontractors. 2017 compared to 2016 The following graph shows the total change in net income attributable to Avista Corp. shareholders for 2016 to 2017, as well as the various factors that caused such change (dollars in millions): Utility revenues increased due to an increase at AEL&P, partially offset by a decrease at Avista Utilities. AEL&P's revenues increased primarily due to a general rate increase and higher retail heating loads due to weather that was cooler than the prior year. There was also a slight increase in the number of customers at AEL&P. Avista Utilities' revenues decreased primarily due to a decrease in electric and natural gas wholesale revenues and revenues from sales of fuel, mostly offset by an increase in electric and natural gas retail revenues. Retail revenues increased due to an increase in volumes and an electric general rate increase in Idaho and a natural gas general rate increase in Oregon. The higher retail sales volumes resulted from increased heating loads during the heating season, increased electric cooling loads during the summer and due to customer growth. The increased utility revenues were partially offset by decoupling rebates during 2017 due to weather that fluctuated from normal. This compares to decoupling surcharges during 2016. Utility resource costs decreased due to a decrease at Avista Utilities. Avista Utilities' electric resource costs decreased primarily due to a decrease in purchased power (from lower wholesale prices) and a decrease in fuel for generation (due in part to increased hydroelectric generation). Natural gas resource costs decreased due to a decrease in natural gas purchased resulting from lower wholesale sales volumes. Utility operating expenses increased due to an increase at Avista Utilities and a slight increase at AEL&P. The increase at Avista AVISTA CORPORATION Utilities' was the result of an increase in generation and distribution maintenance costs and transmission operating costs. There was also a write-off in Oregon of utility plant associated with a general rate case settlement. The increased costs were partially offset by decreases in pension, other postretirement benefit and medical expenses. The acquisition costs related to the now terminated acquisition by Hydro One and consist primarily of consulting, banking fees, legal fees and employee time and are not being passed through to customers. Utility depreciation and amortization increased due to additions to utility plant. Income tax expense increased primarily due to the enactment of the TCJA in December 2017, which resulted in a non-cash charge to income tax expense of $10.2 million during 2017 from revaluing our deferred income tax assets and liabilities based on the new federal tax rate. This was partially offset by the effect of a decrease in income before income taxes. Our effective tax rate was 41.7 percent for 2017 and 36.3 percent for 2016. The effective tax rate increased due to federal income tax law changes and due to acquisition costs. The acquisition costs reduced income before income taxes, but a significant portion of these costs were not deductible for tax purposes and thus did not reduce income tax expense. However, now that the transaction has been terminated, we expect to file amended tax returns as more of the transaction costs are deductible. See "Note 11 of the Notes to Consolidated Financial Statements" for a reconciliation of our effective income tax rate. Other was primarily related to an increase in interest expense, due to additional debt being outstanding during 2017 as compared to 2016 and partially due to an increase in the overall interest rate. There was also an increase in utility taxes other than income taxes primarily due to revenue-related taxes, which resulted from an increase in electric and natural gas retail revenue. Lastly, there were impairments recorded during 2017 on two of our equity investments. Non-GAAP Financial Measures The following discussion for Avista Utilities includes two financial measures that are considered “non-GAAP financial measures,” electric utility margin and natural gas utility margin. In the AEL&P section, we include a discussion of utility margin, which is also a non-GAAP financial measure. Generally, a non-GAAP financial measure is a numerical measure of a company's financial performance, financial position or cash flows that excludes (or includes) amounts that are included (excluded) in the most directly comparable measure calculated and presented in accordance with GAAP. Electric utility margin is electric operating revenues less electric resource costs, while natural gas utility margin is natural gas operating revenues less natural gas resource costs. The most directly comparable GAAP financial measure to electric and natural gas utility margin is utility operating revenues as presented in "Note 22 of the Notes to Consolidated Financial Statements." The presentation of electric utility margin and natural gas utility margin is intended to enhance understanding of our operating performance. We use these measures internally and believe they provide useful information to investors in their analysis of how changes in loads (due to weather, economic or other conditions), rates, supply costs and other factors impact our results of operations. Changes in loads, as well as power and natural gas supply costs, are generally deferred and recovered from customers through regulatory accounting mechanisms. Accordingly, the analysis of utility margin generally excludes most of the change in revenue resulting from these regulatory mechanisms. We present electric and natural gas utility margin separately below for Avista Utilities since each business has different cost sources, cost recovery mechanisms and jurisdictions, so we believe that separate analysis is beneficial. These measures are not intended to replace utility operating revenues as determined in accordance with GAAP as an indicator of operating performance. Reconciliations of operating revenues to utility margin are set forth below. AVISTA CORPORATION Results of Operations - Avista Utilities 2018 compared to 2017 Utility Operating Revenues The following graphs present Avista Utilities' electric operating revenues and megawatt-hour (MWh) sales for the years ended December 31 (dollars in millions and MWhs in thousands): (1) This balance includes public street and highway lighting, which is considered part of retail electric revenues, and deferrals/amortizations to customers related to federal income tax law changes. AVISTA CORPORATION The following table presents the current year deferrals and the amortization of prior year decoupling balances that are reflected in utility electric operating revenues for the years ended December 31 (dollars in thousands): (a) Positive amounts are increases in decoupling revenue in the current year and will be surcharged to customers in future years. Negative numbers are decreases in decoupling revenue in the current year and will be rebated to customers in future years. (b) Positive amounts are increases in decoupling revenue in the current year and are related to the amortization of rebate balances that resulted in prior years and are being refunded to customers (causing a corresponding decrease in retail revenue from customers) in the current year. Negative numbers are decreases in decoupling revenue in the current year and are related to the amortization of surcharge balances that resulted in prior years and are being surcharged to customers (causing a corresponding increase in retail revenue from customers) in the current year. Total electric revenues decreased $9.9 million for 2018 as compared to 2017, primarily reflecting the following: • an $11.1 million decrease in retail electric revenues due to a decrease in total MWhs sold (decreased revenues $30.2 million), partially offset by an increase in revenue per MWh (increased revenues $19.1 million). ◦ The decrease in total retail MWhs sold was the result of weather that was warmer than the prior year during the heating season (which decreased electric heating loads) and cooler than the prior year during the cooling season (which decreased electric cooling loads), partially offset by customer growth. Compared to 2017, residential electric use per customer decreased 7 percent and commercial use per customer decreased 3 percent. Heating degree days in Spokane were 7 percent below normal and 9 percent below 2017. Cooling degree days in Spokane were 5 percent below normal and 30 percent below the prior year. ◦ The increase in revenue per MWh was primarily due to general rate increases in Idaho (effective January 1, 2018) and Washington (effective May 1, 2018), as well as an increase in decoupling surcharge rates. This was partially offset by rate decreases associated with the lower corporate tax rate. • a $3.5 million increase in wholesale electric revenues due to an increase in sales volumes (increased revenues $17.6 million), partially offset by a decrease in sales prices (decreased revenues $14.1 million). The fluctuation in volumes and prices was primarily the result of our optimization activities. • a $2.7 million decrease in sales of fuel due to a decrease in sales of natural gas fuel as part of thermal generation resource optimization activities. For 2018, $30.6 million of these sales were made to our natural gas operations and are included as intracompany revenues and resource costs. For 2017, $35.3 million of these sales were made to our natural gas operations. • a $13.1 million increase in electric revenue due to decoupling. Weather was warmer than normal during the heating season and cooler than normal during the cooling season in 2018, which resulted in decoupling surcharges. • a $9.9 million decrease in electric revenue due to net deferrals for refunds to customers related to the federal income tax law changes (included in other revenue in the graph above) that lowered the corporate tax rate from 35 percent to 21 percent. As our customers' rates had the 35 percent corporate tax rate built in from prior general rate cases through May 1, 2018 in Washington and June 1, 2018 in Idaho, we deferred the impact of the change beginning January 1, 2018. Effective May 1, 2018 in Washington and June 1, 2018 in Idaho, base rates reflect the lower 21 percent corporate tax. • a $2.4 million decrease in transmission revenue (included in other revenue in the graph above). AVISTA CORPORATION The following graphs present Avista Utilities' natural gas operating revenues and therms delivered for the years ended December 31 (dollars in millions and therms in thousands): (1) This balance includes interruptible and industrial revenues, which are considered part of retail natural gas revenues, and deferrals/amortizations to customers related to federal income tax law changes. The following table presents the current year deferrals and the amortization of prior year decoupling balances that are reflected in natural gas operating revenues for the years ended December 31 (dollars in thousands): AVISTA CORPORATION (a) Positive amounts are increases in decoupling revenue in the current year and will be surcharged to customers in future years. Negative numbers are decreases in decoupling revenue in the current year and will be rebated to customers in future years. (b) Positive amounts are increases in decoupling revenue in the current year and are related to the amortization of rebate balances that resulted in prior years and are being refunded to customers (causing a corresponding decrease in retail revenue from customers) in the current year. Negative numbers are decreases in decoupling revenue in the current year and are related to the amortization of surcharge balances that resulted in prior years and are being surcharged to customers (causing a corresponding increase in retail revenue from customers) in the current year. Total natural gas revenues decreased $43.9 million for 2018 as compared to 2017, primarily reflecting the following: • a $41.6 million decrease in retail natural gas revenues due to a decrease in volumes (decreased revenues $18.9 million) and lower retail rates (decreased revenues $22.7 million). ◦ We sold less retail natural gas in 2018 as compared to 2017 primarily due to warmer weather during the heating season, partially offset by customer growth. Compared to 2017, residential use per customer decreased 8 percent and commercial use per customer decreased 7 percent. Heating degree days in Spokane were 7 percent below normal for 2018, and 9 percent below 2017. Heating degree days in Medford were 3 percent below normal for 2018, and 2 percent below 2017. ◦ Lower retail rates were due to PGAs and rate decreases associated with the lower corporate tax rate, partially offset by general rate increases in Washington, Oregon and Idaho. • a $5.6 million decrease in wholesale natural gas revenues due to a decrease in volumes (decreased revenues $11.2 million), partially offset by an increase in prices (increased revenues $5.6 million). In 2018, $44.7 million of these sales were made to our electric generation operations and are included as intracompany revenues and resource costs. In 2017, $49.3 million of these sales were made to our electric generation operations. Differences between revenues and costs from sales of resources in excess of retail load requirements and from resource optimization are accounted for through the PGA mechanisms. • a $7.4 million increase in natural gas revenue due to decoupling. Weather was warmer than normal during the heating season in 2018, which resulted in decoupling surcharges. • a $5.5 million decrease in natural gas revenue due to net deferrals for refunds to customers related to the federal income tax law changes (included in other revenue in the graph above) that lowered the corporate tax rate from 35 percent to 21 percent. As our customers' rates had the 35 percent corporate tax rate built in from prior general rate cases through May 1, 2018 in Washington and June 1, 2018 in Idaho, we deferred the impact of the change beginning January 1, 2018. Effective May 1, 2018 in Washington and June 1, 2018 in Idaho, base rates reflect the lower 21 percent corporate tax. Base rates in Oregon continue to have the 35 percent corporate tax rate built in and we are deferring the impact. The following table presents Avista Utilities' average number of electric and natural gas retail customers for the years ended December 31: AVISTA CORPORATION Utility Resource Costs The following graphs present Avista Utilities' resource costs for the years ended December 31 (dollars in millions): Total electric resource costs in the graph above include intracompany resource costs of $44.7 million and $49.3 million for 2018 and 2017, respectively. Total natural gas resource costs in the graph above include intracompany resource costs of $30.6 million and $35.3 million for 2018 and 2017, respectively. Total electric resource costs increased $3.8 million for 2018 as compared to 2017 primarily due to the following: • a $6.0 million increase in power purchased due to an increase in the volume of power purchases (increased costs $10.8 million), partially offset by a decrease in wholesale prices (decreased costs $4.8 million). The fluctuation in volumes and prices was primarily the result of our optimization activities. • a $6.5 million decrease in fuel for generation primarily due to a decrease in fuel prices. We also had a decrease in thermal generation at Colstrip and Coyote Springs 2 due to outages; however, this was offset by an increase in thermal AVISTA CORPORATION generation at the Lancaster Plant. • an $8.8 million decrease in other fuel costs. • a $5.3 million increase from amortizations and deferrals of power costs (included in other resource costs in the graph above). This change was primarily the result of lower net power supply costs. • a $7.8 million increase in other regulatory amortizations (included in other resource costs in the graph above). Total natural gas resource costs decreased $39.1 million for 2018 as compared to 2017 primarily reflecting the following: • a $31.8 million decrease in natural gas purchased due to a decrease in total therms purchased (decreased costs $16.1 million) and a decrease in the price of natural gas (decreased costs $15.7 million). • a $4.7 million decrease from amortizations and deferrals of natural gas costs (included in other resource costs in the graph above). • a $2.6 million decrease in other regulatory amortizations (included in other resource costs in the graph above). Utility Margin The following table reconciles Avista Utilities' operating revenues, as presented in "Note 22 of the Notes to Consolidated Financial Statements" to the Non-GAAP financial measure utility margin for the years ended December 31 (dollars in millions): Electric utility margin decreased $13.6 million and natural gas utility margin decreased $4.8 million. The primary reason for the decrease in both electric and natural gas utility margin was federal income tax law changes that lowered the corporate tax rate from 35 percent to 21 percent. As our customers' rates continued to have the 35 percent corporate tax rate built in from prior general rate cases, we deferred the impact of the change beginning January 1, 2018. Effective May 1, 2018 in Washington and June 1, 2018 in Idaho, base rates reflect the lower 21 percent corporate tax. As such, we are no longer deferring the tax rate change in these jurisdictions. There is no impact to our net income as there was a corresponding decrease in income tax expense. Electric utility margin was positively impacted during 2018 by general rate increases in Idaho (effective January 1, 2018) and Washington (effective May 1, 2018), as well as customer growth. For 2018, we recognized a pre-tax benefit of $6.1 million under the ERM in Washington compared to a benefit of $4.6 million for 2017. Natural gas utility margin was positively impacted by general rate increases in Oregon (effective October 1 and November 1, 2017), Idaho (effective January 1, 2018) and Washington (effective May 1, 2018), as well as customer growth. Intracompany revenues and resource costs represent purchases and sales of natural gas between our natural gas distribution operations and our electric generation operations (as fuel for our generation plants). These transactions are eliminated in the presentation of total results for Avista Utilities and in the consolidated financial statements but are included in the separate results for electric and natural gas presented above. AVISTA CORPORATION 2017 compared to 2016 Utility Operating Revenues The following graphs present Avista Utilities' electric operating revenues and megawatt-hour (MWh) sales for the years ended December 31 (dollars in millions and MWhs in thousands): (1) This balance includes public street and highway lighting, which is considered part of retail electric revenues and it also includes revenues and rebates from decoupling. AVISTA CORPORATION The following table presents the current year deferrals and the amortization of prior year decoupling balances that are reflected in utility electric operating revenues for the years ended December 31 (dollars in thousands): (a) Positive amounts are increases in decoupling revenue in the current year and will be surcharged to customers in future years. Negative numbers are decreases in decoupling revenue in the current year and will be rebated to customers in future years. (b) Positive amounts are increases in decoupling revenue in the current year and are related to the amortization of rebate balances that resulted in prior years and are being refunded to customers (causing a corresponding decrease in retail revenue from customers) in the current year. Negative numbers are decreases in decoupling revenue in the current year and are related to the amortization of surcharge balances that resulted in prior years and are being surcharged to customers (causing a corresponding increase in retail revenue from customers) in the current year. Total electric revenues decreased $16.6 million for 2017 as compared to 2016, primarily reflecting the following: • a $52.0 million increase in retail electric revenues due to an increase in total MWhs sold (increased revenues $36.6 million) and an increase in revenue per MWh (increased revenues $15.4 million). ◦ The increase in total retail MWhs sold was the result of weather that was cooler than the prior year during the heating season (which increased electric heating loads) and warmer than the prior year during the cooling season (which increased electric cooling loads), as well as customer growth. Compared to 2016, residential electric use per customer increased 8 percent and commercial use per customer did not change materially. Heating degree days in Spokane were 3 percent above normal and 17 percent above 2016. Cooling degree days in Spokane were 40 percent above normal and 57 percent above the prior year. ◦ The increase in revenue per MWh was primarily due to a general rate increase in Idaho and a greater portion of retail revenues from residential customers in 2017. • a $30.6 million decrease in wholesale electric revenues due to a decrease in sales prices (decreased revenues $27.3 million) and a decrease in sales volumes (decreased revenues $3.3 million). The fluctuation in volumes and prices was primarily the result of our optimization activities. • a $13.4 million decrease in sales of fuel due to a decrease in sales of natural gas fuel as part of thermal generation resource optimization activities. For 2017, $35.3 million of these sales were made to our natural gas operations and are included as intracompany revenues and resource costs. For 2016, $44.0 million of these sales were made to our natural gas operations. • a $25.6 million decrease in electric revenue due to decoupling. Weather was cooler than normal during the heating season and warmer than normal during the cooling season in 2017, which resulted in decoupling rebates for 2017. Weather was warmer than normal during the heating season in 2016, which resulted in significant decoupling surcharges. Decoupling mechanisms are not affected by fluctuations in weather compared to prior year; rather, they are only affected by weather fluctuations as compared to normal weather. AVISTA CORPORATION The following graphs present Avista Utilities' natural gas operating revenues and therms delivered for the years ended December 31 (dollars in millions and therms in thousands): (1) This balance includes interruptible and industrial revenues, which are considered part of retail natural gas revenues and it also includes revenues and rebates from decoupling. The following table presents the current year deferrals and the amortization of prior year decoupling balances that are reflected in natural gas operating revenues for the years ended December 31 (dollars in thousands): AVISTA CORPORATION (a) Positive amounts are increases in decoupling revenue in the current year and will be surcharged to customers in future years. Negative numbers are decreases in decoupling revenue in the current year and will be rebated to customers in future years. (b) Positive amounts are increases in decoupling revenue in the current year and are related to the amortization of rebate balances that resulted in prior years and are being refunded to customers (causing a corresponding decrease in retail revenue from customers) in the current year. Negative numbers are decreases in decoupling revenue in the current year and are related to the amortization of surcharge balances that resulted in prior years and are being surcharged to customers (causing a corresponding increase in retail revenue from customers) in the current year. Total natural gas revenues increased $3.8 million for 2017 as compared to 2016, primarily reflecting the following: • a $36.3 million increase in retail natural gas revenues due to an increase in volumes (increased revenues $51.2 million), partially offset by lower retail rates (decreased revenues $14.9 million). ◦ We sold more retail natural gas in 2017 as compared to 2016 primarily due to cooler weather in the first and fourth quarters, as well as customer growth. Compared to 2016, residential use per customer increased 16 percent and commercial use per customer increased 17 percent. Heating degree days in Spokane were 3 percent above normal for 2017, and 17 percent above 2016. Heating degree days in Medford were 1 percent below normal for 2017, and 17 percent above 2016. ◦ Lower retail rates were due to PGAs, partially offset by a general rate increase in Oregon. • a $10.7 million decrease in wholesale natural gas revenues due to a decrease in volumes (decreased revenues $36.4 million), partially offset by an increase in prices (increased revenues $25.7 million). In 2017, $49.3 million of these sales were made to our electric generation operations and are included as intracompany revenues and resource costs. In 2016, $51.2 million of these sales were made to our electric generation operations. Differences between revenues and costs from sales of resources in excess of retail load requirements and from resource optimization are accounted for through the PGA mechanisms. • a $23.7 million decrease in natural gas revenue due to decoupling. Weather was overall cooler than normal during the heating season in 2017, which resulted in decoupling rebates. Weather was warmer than normal during the heating season in 2016, which resulted in decoupling surcharges. Decoupling mechanisms are not impacted by fluctuations in weather compared to prior year; rather, they are only impacted by weather fluctuations as compared to normal weather. The following table presents Avista Utilities' average number of electric and natural gas retail customers for the years ended December 31: AVISTA CORPORATION Utility Resource Costs The following graphs present Avista Utilities' resource costs for the years ended December 31 (dollars in millions): Total electric resource costs in the graph above include intracompany resource costs of $49.3 million and $51.2 million for 2017 and 2016, respectively. Total natural gas resource costs in the graph above include intracompany resource costs of $35.3 million and $44.0 million for 2017 and 2016, respectively. Total electric resource costs decreased $29.3 million for 2017 as compared to 2016 primarily reflecting the following: • a $17.1 million decrease in power purchased due to a decrease in wholesale prices (decreased costs $22.5 million), partially offset by an increase in the volume of power purchases (increased costs $5.4 million). The fluctuation in volumes and prices was primarily the result of our optimization activities. • a $10.2 million decrease in fuel for generation primarily due to a decrease in thermal generation (due in part to increased hydroelectric generation) as well as a decrease in fuel prices. AVISTA CORPORATION • a $6.0 million decrease in other fuel costs. • a $1.5 million increase from amortizations and deferrals of power costs (included in other resource costs in the graph above). • a $0.5 million decrease in other electric resource costs (included in other resource costs in the graph above). • a $3.0 million increase in other regulatory amortizations (included in other resource costs in the graph above). Total natural gas resource costs decreased $9.4 million for 2017 as compared to 2016 primarily reflecting the following: • a $5.4 million decrease in natural gas purchased due to a decrease in total therms purchased (decreased costs $22.1 million), partially offset by an increase in the price of natural gas (increased costs $16.7 million). Total therms purchased decreased due to a decrease in wholesale sales, partially offset by an increase in retail sales. • a $6.6 million decrease from amortizations and deferrals of natural gas costs (included in other resource costs in the graph above). • a $2.6 million increase in other regulatory amortizations (included in other resource costs in the graph above). Utility Margin The following table reconciles Avista Utilities' operating revenues, as presented in "Note 22 of the Notes to Consolidated Financial Statements" to the Non-GAAP financial measure utility margin for the years ended December 31 (dollars in millions): Electric utility margin increased $12.8 million and natural gas utility margin increased $13.1 million. The increase in electric utility margin was primarily due to a general rate increase in Idaho, customer growth, increases in loads not subject to decoupling and lower resource costs. For 2017, we recognized a pre-tax benefit of $4.6 million under the ERM in Washington compared to a pre-tax benefit of $5.1 million for 2016. The increase in natural gas utility margin was primarily due to a general rate increase in Oregon, customer growth and increases in loads not subject to decoupling. Intracompany revenues and resource costs represent purchases and sales of natural gas between our natural gas distribution operations and our electric generation operations (as fuel for our generation plants). These transactions are eliminated in the presentation of total results for Avista Utilities and in the consolidated financial statements but are included in the separate results for electric and natural gas presented above. Results of Operations - Alaska Electric Light and Power Company 2018 compared to 2017 Net income for AEL&P was $8.3 million for the year ended December 31, 2018, compared to $9.1 million for 2017. The following table presents AEL&P's operating revenues, resource costs and resulting utility margin for the years ended December 31 (dollars in millions): AVISTA CORPORATION Electric revenues decreased for 2018 primarily due to the accrual for refunds to customers related to the federal income tax law changes that lowered the corporate tax rate from 35 percent to 21 percent. AEL&P recorded a customer refund liability of $1.7 million related to this tax law change, which was returned to customers during 2018. Effective August 1, 2018, retail rates to customers were reduced to reflect the lower corporate tax rate. For the full year of 2018 there was no impact to net income as there was a corresponding decrease in income tax expense. In addition to the above, there was a decrease in sales volumes to residential and commercial customers, primarily during the fourth quarter when winter rates are in effect. Effective January 1, 2018, due to the adoption of ASU No. 2014-09 (revenue recognition standard), AEL&P no longer records utility-related taxes collected from customers on a gross basis in revenue and taxes other than income taxes. These taxes are currently recorded on a net basis within revenue. This change in accounting reduced 2018 revenue, utility margin and taxes other than income taxes by $2.3 million for 2018 as compared to 2017 with no impact to net income. For operating expenses, there was a slight decrease in other operating expenses for 2018 primarily due to a decrease in generation maintenance and supplies expense, partially offset by an increase in transmission and distribution maintenance expenses. 2017 compared to 2016 Net income for AEL&P was $9.1 million for the year ended December 31, 2017, compared to $8.0 million for 2016. The following table presents AEL&P's operating revenues, resource costs and resulting utility margin for the years ended December 31 (dollars in millions): In 2017, there was an increase in utility margin which was primarily related to a general rate increase, effective in November 2016, and increases in electric heating loads due to weather that was cooler than the prior year. There were also slight increases in residential and commercial customers. This was partially offset by an increase in resource costs primarily due to purchased power and the general rate case settlement. An increase in resource costs of $1.0 million related to a settlement agreement for AEL&P's 2016 electric general rate case was included in utility margin for 2017. The increase in utility margin was partially offset by an increase in operating expenses and a decrease in equity-related AFUDC due to the construction of an additional back-up generation plant completed in 2016. Operating expenses increased primarily due to supplies expense for the new back-up generation plant, which went into service in the fourth quarter of 2016. Results of Operations - Other Businesses 2018 compared to 2017 The net loss from these operations was $6.7 million for 2018 compared to a net loss of $7.9 million for 2017. Losses at our other businesses decreased during 2018 as 2017 included a one-time tax expense in the fourth quarter from revaluing deferred taxes to the new tax rate of 21 percent as a result of federal income tax law changes. We also had a gain during 2018 from one of our equity investments. This was partially offset by increased expenses at one of our subsidiaries associated with the insolvency of the general contractor on a renovation project. The general contractor's insolvency resulted in the recording of a liability to various subcontractors. There were also impairment losses and an increase in equity method losses on our other investments. 2017 compared to 2016 The net loss from these operations was $7.9 million for 2017 compared to a net loss of $3.2 million for 2016. Net losses for 2017 were partially related to federal income tax law changes, which resulted in the revaluing of net deferred income tax assets to reflect the reduction in the corporate income tax rate from 35 percent to 21 percent, causing an increase in income tax expense. Also, there were renovation expenses and increased compliance costs at one of our subsidiaries, the recognition of our portion of net losses from our equity investments, corporate costs (including costs associated with exploring strategic opportunities) and impairment charges associated with two of our equity investments. AVISTA CORPORATION Accounting Standards to be Adopted in 2019 At this time, we are not expecting the adoption of accounting standards to have a material impact on our financial condition, results of operations and cash flows in 2019. While not expected to have a material impact, we do expect the adoption of the ASU No. 2016-02 “Leases (Topic 842)" effective January 1, 2019 to result in a right of use asset and lease liability of between $65.0 million and $75.0 million, not including the Snettisham finance lease (formerly a capital lease) of $57.2 million, which is already included on the Consolidated Balance Sheet as of December 31, 2018. For information on accounting standards adopted in 2018 and accounting standards expected to be adopted in future periods, see “Note 2 of the Notes to Consolidated Financial Statements.” Critical Accounting Policies and Estimates The preparation of our consolidated financial statements in conformity with GAAP requires us to make estimates and assumptions that affect amounts reported in the consolidated financial statements. Changes in these estimates and assumptions are considered reasonably possible and may have a material effect on our consolidated financial statements and thus actual results could differ from the amounts reported and disclosed herein. The following accounting policies represent those that our management believes are particularly important to the consolidated financial statements and require the use of estimates and assumptions: • Regulatory accounting, which requires that certain costs and/or obligations be reflected as deferred charges on our Consolidated Balance Sheets and are not reflected in our Consolidated Statements of Income until the period during which matching revenues are recognized. We also have decoupling revenue deferrals. As opposed to cost deferrals which are not recognized in the Consolidated Statements of Income until they are included in rates, decoupling revenue is recognized in the Consolidated Statements of Income during the period in which it occurs (i.e. during the period of revenue shortfall or excess due to fluctuations in customer usage), subject to certain limitations, and a regulatory asset/liability is established which will be surcharged or rebated to customers in future periods. GAAP requires that for any alternative revenue program, like decoupling, the revenue must be expected to be collected from customers within 24 months of the deferral to qualify for recognition in the current period. Any amounts included in the Company's decoupling program that are not expected to be collected from customers within 24 months are not recorded in the financial statements until the period in which revenue recognition criteria are met. This could ultimately result in more decoupling revenue being collected from customers over the life of the decoupling program than what is deferred and recognized in the current period financial statements. We make estimates regarding the amount of revenue that will be collected within 24 months of deferral. We also make the assumption that there are regulatory precedents for many of our regulatory items and that we will be allowed recovery of these costs via retail rates in future periods. If we were no longer allowed to apply regulatory accounting or no longer allowed recovery of these costs, we could be required to recognize significant write-offs of regulatory assets and liabilities in the Consolidated Statements of Income. See "Notes 1 and 21 of the Notes to Consolidated Financial Statements" for further discussion of our regulatory accounting policy and mechanisms. • Interest rate swap derivative asset and liability accounting, where we estimate the fair value of outstanding interest rate swap derivatives, and U.S. Treasury lock agreements and offset the derivative asset or liability with a regulatory asset or liability. This is similar to the treatment of energy commodity derivatives described above. Upon settlement of interest rate swap derivatives, the regulatory asset or liability is amortized as a component of interest expense over the term of the associated debt. We record an offset of interest rate swap derivative assets and liabilities with regulatory assets and liabilities, based on the prior practice of the commissions to provide recovery through the ratemaking process. If we concluded that recovery of interest rate swap related payments were no longer probable, we may be required to derecognize the related regulatory assets and liabilities and we could be required to recognize significant changes in fair value or settlements of these interest rate swap derivatives on a regular basis in the Consolidated Statements of Income, which could lead to significant fluctuations in net income. • Pension Plans and Other Postretirement Benefit Plans, discussed in further detail below. • Contingencies, related to unresolved regulatory, legal and tax issues for which there is inherent uncertainty for the ultimate outcome of the respective matter. We accrue a loss contingency if it is probable that an asset is impaired or a liability has been incurred and the amount of the loss or impairment can be reasonably estimated. We also disclose losses that do not meet these conditions for accrual, if there is a reasonable possibility that a potential loss may be incurred. For all material contingencies, we have made a judgment as to the probability of a loss occurring and as to whether or not the amount of the loss can be reasonably estimated. If the loss recognition criteria are met, liabilities AVISTA CORPORATION are accrued or assets are reduced. However, no assurance can be given to the ultimate outcome of any particular contingency. See "Notes 1 and 20 of the Notes to Consolidated Financial Statements" for further discussion of our commitments and contingencies. Pension Plans and Other Postretirement Benefit Plans - Avista Utilities We have a defined benefit pension plan covering substantially all regular full-time employees at Avista Utilities that were hired prior to January 1, 2014. For substantially all regular non-union full-time employees at Avista Utilities who were hired on or after January 1, 2014, a defined contribution 401(k) plan replaced the defined benefit pension plan. The Finance Committee of the Board of Directors approves investment policies, objectives and strategies that seek an appropriate return for the pension plan and it reviews and approves changes to the investment and funding policies. We have contracted with an independent investment consultant who is responsible for monitoring the individual investment managers. The investment managers’ performance and related individual fund performance is reviewed at least quarterly by an internal benefits committee and by the Finance Committee to monitor compliance with our established investment policy objectives and strategies. Our pension plan assets are invested in debt securities and mutual funds, trusts and partnerships that hold marketable debt and equity securities, real estate and absolute return funds. In seeking to obtain a return that aligns with the funded status of the pension plan, the investment consultant recommends allocation percentages by asset classes. These recommendations are reviewed by the internal benefits committee, which then recommends their adoption by the Finance Committee. The Finance Committee has established target investment allocation percentages by asset classes and also investment ranges for each asset class. The target investment allocation percentages are typically the midpoint of the established range. See “Note 10 of the Notes to Consolidated Financial Statements” for the target investment allocation percentages. We also have a Supplemental Executive Retirement Plan (SERP) that provides additional pension benefits to certain executive officers and others whose benefits under the pension plan are reduced due to the application of Section 415 of the Internal Revenue Code of 1986 and the deferral of salary under deferred compensation plans. Pension costs (including the SERP) were $22.8 million for 2018, $26.5 million for 2017 and $26.8 million for 2016. Of our pension costs (excluding the SERP), approximately 60 percent are expensed and 40 percent are capitalized consistent with labor charges. The costs related to the SERP are expensed. Our costs for the pension plan are determined in part by actuarial formulas that are dependent upon numerous factors resulting from actual plan experience and assumptions of future experience. Pension costs are affected by among other things: • employee demographics (including age, compensation and length of service by employees), • the amount of cash contributions we make to the pension plan, • the actual return on pension plan assets, • expected return on pension plan assets, • discount rate used in determining the projected benefit obligation and pension costs, • assumed rate of increase in employee compensation, • life expectancy of participants and other beneficiaries, and • expected method of payment (lump sum or annuity) of pension benefits. Any changes in pension plan obligations associated with these factors may not be immediately recognized as pension costs in our Consolidated Statement of Income, but we generally recognize the change in future years over the remaining average service period of pension plan participants. As such, our costs recorded in any period may not reflect the actual level of cash benefits provided to pension plan participants. We revise the key assumption of the discount rate each year. In selecting a discount rate, we consider yield rates at the end of the year for highly rated corporate bond portfolios with cash flows from interest and maturities similar to that of the expected payout of pension benefits. The expected long-term rate of return on plan assets is reset or confirmed annually based on past performance and economic forecasts for the types of investments held by our plan. AVISTA CORPORATION The following chart reflects the assumptions used each year for the pension discount rate (exclusive of the SERP), the expected long-term return on plan assets and the actual return on plan assets and their impacts to the pension plan associated with the change in assumption (dollars in millions): (a) The SERP has no plan assets. The plan assets in this disclosure are for the pension plan only. The following chart reflects the sensitivities associated with a change in certain actuarial assumptions by the indicated percentage (dollars in millions): * Changes in the expected return on plan assets would not affect our projected benefit obligation. We provide certain health care and life insurance benefits for substantially all of our retired employees. We accrue the estimated cost of postretirement benefit obligations during the years that employees provide service. Assumed health care cost trend rates have a significant effect on the amounts reported for our postretirement plans. A one-percentage-point increase in the assumed health care cost trend rate for each year would increase our accumulated postretirement benefit obligation as of December 31, 2018 by $8.1 million and the service and interest cost by $0.6 million. A one-percentage-point decrease in the assumed health care cost trend rate for each year would decrease our accumulated postretirement benefit obligation as of December 31, 2018 by $6.4 million and the service and interest cost by $0.5 million. Liquidity and Capital Resources Overall Liquidity Avista Corp.'s consolidated operating cash flows are primarily derived from the operations of Avista Utilities. The primary source of operating cash flows for Avista Utilities is revenues from sales of electricity and natural gas. Significant uses of cash flows from Avista Utilities include the purchase of power, fuel and natural gas, and payment of other operating expenses, taxes and interest, with any excess being available for other corporate uses such as capital expenditures and dividends. We design operating and capital budgets to control operating costs and to direct capital expenditures to choices that support immediate and long-term strategies, particularly for our regulated utility operations. In addition to operating expenses, we have continuing commitments for capital expenditures for construction and improvement of utility facilities. Our annual net cash flows from operating activities usually do not fully support the amount required for annual utility capital expenditures. As such, from time-to-time, we need to access long-term capital markets in order to fund these needs as well as fund maturing debt. See further discussion at “Capital Resources.” We periodically file for rate adjustments for recovery of operating costs and capital investments and to seek the opportunity to earn reasonable returns as allowed by regulators. Avista Utilities has regulatory mechanisms in place that provide for the deferral and recovery of the majority of power and natural gas supply costs. However, when power and natural gas costs exceed the levels currently recovered from retail AVISTA CORPORATION customers, net cash flows are negatively affected. Factors that could cause purchased power and natural gas costs to exceed the levels currently recovered from our customers include, but are not limited to, higher prices in wholesale markets when we buy energy or an increased need to purchase power in the wholesale markets, and a lack of regulatory approval for higher authorized net power supply costs through general rate case decisions. Factors beyond our control that could result in an increased need to purchase power in the wholesale markets include, but are not limited to: • increases in demand (due to either weather or customer growth), • low availability of streamflows for hydroelectric generation, • unplanned outages at generating facilities, and • failure of third parties to deliver on energy or capacity contracts. In addition to the above, Avista Utilities enters into derivative instruments to hedge our exposure to certain risks, including fluctuations in commodity market prices, foreign exchange rates and interest rates (for purposes of issuing long-term debt in the future). These derivative instruments often require collateral (in the form of cash or letters of credit) or other credit enhancements, or reductions or terminations of a portion of the contract through cash settlement, in the event of a downgrade in the Company's credit ratings or changes in market prices. In periods of price volatility, the level of exposure can change significantly. As a result, sudden and significant demands may be made against the Company's credit facilities and cash. See “Enterprise Risk Management - Demands for Collateral” below. We monitor the potential liquidity impacts of changes to energy commodity prices and other increased operating costs for our utility operations. We believe that we have adequate liquidity to meet such potential needs through our committed lines of credit. As of December 31, 2018, we had $199.5 million of available liquidity under the Avista Corp. committed line of credit and $25.0 million under the AEL&P committed line of credit. With our $400.0 million credit facility that expires in April 2021 and AEL&P's $25.0 million credit facility that expires in November 2019, we believe that we have adequate liquidity to meet our needs for the next 12 months. Review of Consolidated Cash Flow Statement Overall 2018 compared to 2017 Consolidated Operating Activities Net cash provided by operating activities was $361.9 million for 2018 compared to $410.3 million for 2017. The decrease in net cash provided by operating activities was primarily the result of the enactment of the TCJA, which caused a decrease in deferred income taxes due to the loss of the bonus depreciation tax deduction. In addition, this also impacted income taxes receivable as we are now in a payable position for federal income taxes whereas in prior years we were in receivable positions. See "Note 11 of the Notes to Consolidated Financial Statements" for further discussion of the TCJA. In addition, the settlement of interest rate swaps decreased operating cash flows as we paid a net amount of $26.6 million during 2018 compared to $8.8 million paid during 2017. The decreases above, were partially offset by an increase in net income from $115.9 million in 2017 to $136.6 million in 2018 and a decrease in collateral required for derivative instruments in 2018 compared to 2017. Consolidated Investing Activities Net cash used in investing activities was $440.4 million for 2018, an increase compared to $434.1 million for 2017. During 2018, we paid $424.4 million for utility capital expenditures, compared to $412.3 million for 2017. In addition, during 2018, our subsidiaries invested net cash of $13.7 million for notes receivable to third parties, equity investments and property investments, compared to $15.5 million in 2017. Consolidated Financing Activities Net cash provided by financing activities was $77.0 million for 2018 compared to $31.5 million for 2017. The increase in financing cash flows was primarily the result of an increase in short-term borrowings. During 2018 because we issued an insignificant amount of common stock due to the now terminated Hydro One transaction, we had to increase short-term borrowings to finance capital expenditures and for other corporate purposes. During 2017 we issued common stock for these purposes. Our net long-term debt (maturities and issuances) in both 2018 and 2017 increased by approximately $90 million. AVISTA CORPORATION The increases above were partially offset by an increase in cash dividends paid to $98.0 million (or $1.49 per share) for 2018 compared to $92.5 million (or $1.43 per share) for 2017. 2017 compared to 2016 Consolidated Operating Activities Net cash provided by operating activities was $410.3 million for 2017 compared to $358.3 million for 2016. The increase in net cash provided by operating activities was due in part to income tax refund claims in 2017 related to 2014 and 2015 tax years to utilize net operating losses and investment tax credits. We received an income tax refund of approximately $41.7 million during the fourth quarter of 2017 compared to an increase in income tax receivables of $33.9 million in 2016. In addition, during 2017 our net payments for the settlement of outstanding interest rate swaps decreased by $45.1 million, from $54.0 million in 2016 to $8.8 million for 2017. The increases above were partially offset by an increase in pension contributions from $12.0 million in 2016 to $22.0 million in 2017 and an increase in collateral posted for derivative instruments of $22.4 million in 2017, compared to a decrease in collateral posted of $10.7 million in 2016. The increase in collateral posted during 2017 was due to a decrease in the fair value of energy commodity derivatives which required additional collateral. In addition, most of our energy commodity derivatives are transacted on clearinghouse exchanges, which require initial margin collateral and additional cash collateral when derivatives are in liability positions. Consolidated Investing Activities Net cash used in investing activities was $434.1 million for 2017, an increase compared to $432.5 million for 2016. During 2017, we paid $412.3 million for utility capital expenditures, compared to $406.6 million for 2016. In addition, during 2017, our subsidiaries disbursed net cash of $15.5 million for notes receivable to third parties, equity investments and property investments, compared to $18.2 million in 2016. Consolidated Financing Activities Net cash provided by financing activities was $31.5 million for 2017 compared to $72.2 million for 2016. In 2017 we had the following significant transactions: • issuance and sale of $90.0 million of Avista Corp. first mortgage bonds in December 2017, the proceeds of which were used to pay down a portion of our committed line of credit, • payment of $3.3 million for the maturity of long-term debt, • increase in cash dividends paid to $92.5 million (or $1.43 per share) for 2017 from $87.2 million (or $1.37 per share) for 2016, • $15.0 million net decrease in the balance of our committed line of credit, and • issuance of $56.4 million of common stock (net of issuance costs). In 2016 we had the following significant transactions: • borrowing of $70.0 million pursuant to a term loan agreement in August, which was used to repay a portion of the $90.0 million in first mortgage bonds that matured in August 2016, • issuance and sale of $175.0 million of Avista Corp. first mortgage bonds in December 2016, the proceeds of which were used to repay the $70.0 million term loan, with the remainder being used to pay down a portion of our committed line of credit, • payment of $163.2 million for the maturity of long-term debt (including the $70.0 million term loan), • cash dividends paid of $87.2 million (or $1.37 per share), • $15.0 million net increase in the balance of our committed line of credit, and • issuance of $67.0 million of common stock (net of issuance costs). AVISTA CORPORATION Capital Resources Capital Structure Our consolidated capital structure, including the current portion of long-term debt and capital leases, and short-term borrowings, and excluding noncontrolling interests, consisted of the following as of December 31, 2018 and 2017 (dollars in thousands): Our shareholders’ equity increased $43.4 million during 2018 primarily due to net income, partially offset by dividends. We need to finance capital expenditures and acquire additional funds for operations from time to time. The cash requirements needed to service our indebtedness, both short-term and long-term, reduce the amount of cash flow available to fund capital expenditures, purchased power, fuel and natural gas costs, dividends and other requirements. Committed Lines of Credit Avista Corp. has a committed line of credit with various financial institutions in the total amount of $400.0 million that expires in April 2021. As of December 31, 2018, there was $199.5 million of available liquidity under this line of credit. The Avista Corp. credit facility contains customary covenants and default provisions, including a covenant which does not permit our ratio of “consolidated total debt” to “consolidated total capitalization” to be greater than 65 percent at any time. As of December 31, 2018, we were in compliance with this covenant with a ratio of 54.3 percent. AEL&P has a $25.0 million committed line of credit that expires in November 2019. As of December 31, 2018, there were no borrowings or letters of credit outstanding under this committed line of credit. The AEL&P credit facility contains customary covenants and default provisions including a covenant which does not permit the ratio of “consolidated total debt at AEL&P” to “consolidated total capitalization at AEL&P,” (including the impact of the Snettisham obligation) to be greater than 67.5 percent at any time. As of December 31, 2018, AEL&P was in compliance with this covenant with a ratio of 53.7 percent. Balances outstanding and interest rates of borrowings (excluding letters of credit) under Avista Corp.'s committed line of credit were as follows as of and for the year ended December 31 (dollars in thousands): As of December 31, 2018, Avista Corp. and its subsidiaries were in compliance with all of the covenants of their financing agreements, and none of Avista Corp.'s subsidiaries constituted a “significant subsidiary” as defined in Avista Corp.'s committed line of credit. Long-Term Debt Borrowings In May 2018, we issued and sold $375.0 million of 4.35 percent first mortgage bonds due in 2048 through a public offering. The total net proceeds from the sale of the bonds were used to repay maturing long-term debt of $272.5 million, repay the outstanding balance under our $400.0 million committed line of credit and for other general corporate purposes. In connection with the issuance and sale of the first mortgage bonds, we cash-settled fourteen interest rate swap derivatives (notional AVISTA CORPORATION aggregate amount of $275.0 million) and paid a net amount of $26.6 million. The effective interest rate of the first mortgage bonds is 4.87 percent, including the effects of the settled interest rate swap derivatives and issuance costs. Equity Issuances We have four separate sales agency agreements under which the sales agents may offer and sell new shares of our common stock from time to time. No shares were issued under these agreements during 2018. These agreements provide for the offering of a maximum of 3.8 million shares, of which approximately 1.1 million remain unissued as of December 31, 2018. Subject to the satisfaction of customary conditions (including any required regulatory approvals), the Company has the right to increase the maximum number of shares that may be offered under these agreements. 2019 Liquidity Expectations In January 2019, we received a $103 million termination fee from Hydro One in connection with the termination of the proposed acquisition. The termination fee will be used for reimbursing our transaction costs incurred from 2017 to 2019. These costs, including income taxes, total approximately $51 million. The balance of the termination fee will be used for general corporate purposes and reduces our need for external financing. After consideration of the net termination fee received from Hydro One, during 2019, we expect to issue approximately $165.0 million of long-term debt and up to $50.0 million of equity in order to refinance maturing long-term debt, fund planned capital expenditures and maintain an appropriate capital structure. After considering the expected issuances of long-term debt and equity during 2019, we expect net cash flows from operating activities, together with cash available under our committed line of credit agreements, to provide adequate resources to fund capital expenditures, dividends, and other contractual commitments. Limitations on Issuances of Preferred Stock and First Mortgage Bonds We are restricted under our Restated Articles of Incorporation, as amended, as to the additional preferred stock we can issue. As of December 31, 2018, we could issue $1.2 billion of additional preferred stock at an assumed dividend rate of 7.4 percent. We are not planning to issue preferred stock. Under the Avista Corp. and the AEL&P Mortgages and Deeds of Trust securing Avista Corp.'s and AEL&P's first mortgage bonds (including Secured Medium-Term Notes), respectively, each entity may issue additional first mortgage bonds in an aggregate principal amount equal to the sum of: • 66-2/3 percent of the cost or fair value (whichever is lower) of property additions of that entity which have not previously been made the basis of any application under that entity's Mortgage, or • an equal principal amount of retired first mortgage bonds of that entity which have not previously been made the basis of any application under that entity's Mortgage, or • deposit of cash. However, Avista Corp. and AEL&P may not individually issue any additional first mortgage bonds (with certain exceptions in the case of bonds issued on the basis of retired bonds) unless the particular entity issuing the bonds has “net earnings” (as defined in the respective Mortgages) for any period of 12 consecutive calendar months out of the preceding 18 calendar months that were at least twice the annual interest requirements on that entity's mortgage securities at the time outstanding, including the first mortgage bonds to be issued, and on all indebtedness of prior rank. As of December 31, 2018, property additions and retired bonds would have allowed, and the net earnings test would not have prohibited, the issuance of $1.2 billion in aggregate principal amount of additional first mortgage bonds at Avista Corp. and $27.0 million at AEL&P. We believe that we have adequate capacity to issue first mortgage bonds to meet our financing needs over the next several years. AVISTA CORPORATION Utility Capital Expenditures We are making capital investments at our utilities to enhance service and system reliability for our customers and replace aging infrastructure. The following table summarizes our actual and expected capital expenditures as of and for the year ended December 31, 2018 (in thousands): The following graph shows Avista Utilities' capital budget for 2019: These estimates of capital expenditures are subject to continuing review and adjustment. Actual expenditures may vary from our estimates due to factors such as changes in business conditions, construction schedules and environmental requirements. AVISTA CORPORATION Non-Regulated Investments and Capital Expenditures We are making investments and capital expenditures at our other businesses including those related to economic development projects in our service territory that will demonstrate the latest energy and environmental building innovations and house several local college degree programs. In addition, we are making investments in emerging technology companies and venture capital funds. The following table summarizes our actual and expected investments and capital expenditures at our other businesses as of and for the year ended December 31, 2018 (in thousands): These estimates of investments and capital expenditures are subject to continuing review and adjustment. Actual expenditures may vary from our estimates due to factors such as changes in business conditions or strategic plans. Off-Balance Sheet Arrangements As of December 31, 2018, we had $10.5 million in letters of credit outstanding under our $400.0 million committed line of credit, compared to $34.4 million as of December 31, 2017. Pension Plan We contributed $22.0 million to the pension plan in 2018. We expect to contribute a total of $110.0 million to the pension plan in the period 2019 through 2023, with an annual contribution of $22.0 million over that period. The final determination of pension plan contributions for future periods is subject to multiple variables, most of which are beyond our control, including changes to the fair value of pension plan assets, changes in actuarial assumptions (in particular the discount rate used in determining the benefit obligation), or changes in federal legislation. We may change our pension plan contributions in the future depending on changes to any variables, including those listed above. See "Note 10 of the Notes to Consolidated Financial Statements" for additional information regarding the pension plan. Credit Ratings Our access to capital markets and our cost of capital are directly affected by our credit ratings. In addition, many of our contracts for the purchase and sale of energy commodities contain terms dependent upon our credit ratings. See “Enterprise Risk Management - Credit Risk Liquidity Considerations” and “Note 6 of the Notes to Consolidated Financial Statements.” The following table summarizes our credit ratings as of February 19, 2019: Standard & Poor’s (1) Moody’s (2) Corporate/Issuer rating BBB Baa2 Senior secured debt A- A3 Senior unsecured debt BBB Baa2 (1) Standard & Poor’s lowest “investment grade” credit rating is BBB-. (2) Moody’s lowest “investment grade” credit rating is Baa3. A security rating is not a recommendation to buy, sell or hold securities. Each security rating is subject to revision or withdrawal at any time by the assigning rating organization. Each security rating agency has its own methodology for assigning ratings, and, accordingly, each rating should be considered in the context of the applicable methodology, independent of all other ratings. The rating agencies provide ratings at the request of Avista Corp. and charge fees for their services. AVISTA CORPORATION On December 20, 2018, Moody's downgraded our issuer rating from Baa1 to Baa2 and our senior secured and first mortgage bond ratings from A2 to A3. Moody's made these downgrades because of the impacts of the TCJA, which results in less operating cash flow from deferred income taxes due to the loss of bonus depreciation and lower tax rates. Moody's also expressed less predictability with regulatory outcomes in Washington as a contributing factor for the downgrade. See "Executive Level Summary" and "Note 11 of the Notes to Consolidated Financial Statements" for additional information regarding the TCJA and its impacts to Avista Corp. Dividends See "Item 5. Market for Registrant’s Common Equity, Related Stockholder Matters and Issuer Purchases of Equity Securities" for a detailed discussion of our dividend policy and the factors which could limit the payment of dividends. Contractual Obligations The following table provides a summary of our future contractual obligations as of December 31, 2018 (dollars in millions): (1) Represents our estimate of interest payments on long-term debt, which is calculated based on the assumption that all debt is outstanding until maturity. Interest on variable rate debt is calculated using the rate in effect at December 31, 2018. (2) Energy purchase contracts were entered into as part of the obligation to serve our retail electric and natural gas customers’ energy requirements. As a result, costs are generally recovered either through base retail rates or adjustments to retail rates as part of the power and natural gas cost deferral and recovery mechanisms. (3) Includes payments of $4.0 million annually for an operating lease, which has historically been included as a generation facility contractual commitment (number 4 below). The operating lease expires in 2047. (4) Represents operational agreements, settlements and other contractual obligations for our generation, transmission and distribution facilities. These costs are generally recovered through base retail rates. (5) Includes information service contracts which are recorded to other operating expenses in the Consolidated Statements of Income. (6) Represents our estimated cash contributions to pension plans and other postretirement benefit plans through 2023. We cannot reasonably estimate pension plan contributions beyond 2023 at this time and have excluded them from the table above. (7) Represents the net mark-to-market fair value of outstanding unsettled interest rate swap derivatives as of December 31, 2018. Negative values in the table above represent contractual amounts that are owed to Avista Corp. by the counterparties. The values in the table above will change each period depending on fluctuations in market interest rates and could become either assets or liabilities. Also, the amounts in the table above are not reflective of cash collateral of $0.5 million that is already posted with counterparties against the outstanding interest rate swap derivatives. (8) Primarily relates to long-term debt and capital lease maturities and the related interest. AEL&P contractual commitments also include contractually required capital project funding and operating and maintenance costs associated with the Snettisham hydroelectric project. These costs are generally recovered through base retail rates. AVISTA CORPORATION (9) Primarily relates to operating lease commitments, venture fund commitments, and a commitment to fund a limited liability company in exchange for equity ownership, made by a subsidiary of Avista Capital. Also, there is a long-term debt maturity and the related interest associated with AERC. The above contractual obligations do not include income tax payments. Also, asset retirement obligations are not included above and payments associated with these have historically been less than $1 million per year. There are approximately $18.3 million remaining asset retirement obligations as of December 31, 2018. In addition to the contractual obligations disclosed above, we will incur additional operating costs and capital expenditures in future periods for which we are not contractually obligated as part of our normal business operations. Competition Our utility electric and natural gas distribution business has historically been recognized as a natural monopoly. In each regulatory jurisdiction, our rates for retail electric and natural gas services (other than specially negotiated retail rates for industrial or large commercial customers, which are subject to regulatory review and approval) are generally determined on a “cost of service” basis. Rates are designed to provide, after recovery of allowable operating expenses and capital investments, an opportunity for us to earn a reasonable return on investment as allowed by our regulators. In retail markets, we compete with various rural electric cooperatives and public utility districts in and adjacent to our service territories in the provision of service to new electric customers. Alternative energy technologies, including customer-sited solar, wind or geothermal generation, or energy storage may also compete with us for sales to existing customers. While the risk is currently small in our service territory given the small numbers of customers utilizing these technologies, advances in power generation, energy efficiency, energy storage and other alternative energy technologies could lead to more wide-spread usage of these technologies, thereby reducing customer demand for the energy supplied by us. This reduction in usage and demand would reduce our revenue and negatively impact our financial condition including possibly leading to our inability to fully recover our investments in generation, transmission and distribution assets. Similarly, our natural gas distribution operations compete with other energy sources including heating oil, propane and other fuels. Certain natural gas customers could bypass our natural gas system, reducing both revenues and recovery of fixed costs. To reduce the potential for such bypass, we price natural gas services, including transportation contracts, competitively and have varying degrees of flexibility to price transportation and delivery rates by means of individual contracts. These individual contracts are subject to state regulatory review and approval. We have long-term transportation contracts with several of our largest industrial customers under which the customer acquires its own commodity while using our infrastructure for delivery. Such contracts reduce the risk of these customers bypassing our system in the foreseeable future and minimizes the impact on our earnings. Also, non-utility businesses are developing new technologies and services to help energy consumers manage energy in new ways that may improve productivity and could alter demand for the energy we sell. In wholesale markets, competition for available electric supply is influenced by the: • localized and system-wide demand for energy, • type, capacity, location and availability of generation resources, and • variety and circumstances of market participants. These wholesale markets are regulated by the FERC, which requires electric utilities to: • transmit power and energy to or for wholesale purchasers and sellers, • enlarge or construct additional transmission capacity for the purpose of providing these services, and • transparently price and offer transmission services without favor to any party, including the merchant functions of the utility. Participants in the wholesale energy markets include: • other utilities, • federal power marketing agencies, • energy marketing and trading companies, • independent power producers, AVISTA CORPORATION • financial institutions, and • commodity brokers. Economic Conditions and Utility Load Growth The general economic data, on both national and local levels, contained in this section is based, in part, on independent government and industry publications, reports by market research firms or other independent sources. While we believe that these publications and other sources are reliable, we have not independently verified such data and can make no representation as to its accuracy. Avista Utilities We track multiple economic indicators affecting the three largest metropolitan statistical areas in our Avista Utilities service area: Spokane, Washington, Coeur d'Alene, Idaho, and Medford, Oregon. The key indicators are employment change and unemployment rates. On an annual basis, 2018 showed positive job growth and lower unemployment rates in all three metropolitan areas. However, the unemployment rates in Spokane and Medford are still slightly above the national average. Key leading indicators such as initial unemployment claims and residential building permits, signal continued growth over the next 12 months. Therefore, in 2019, we expect economic growth in our service area to be slightly stronger than the U.S. as a whole. Nonfarm employment (seasonally adjusted) in our eastern Washington, northern Idaho, and southwestern Oregon metropolitan service areas exhibited moderate growth between 2017 and 2018. In Spokane, Washington employment growth was 2.3 percent with gains in all major sectors except financial activities. Employment increased by 3.2 percent in Coeur d'Alene, Idaho, reflecting gains in all major sectors except manufacturing; information; and government. In Medford, Oregon, employment growth was 2.8 percent, with gains in all major sectors except trade, transportation, and utilities and government. U.S. nonfarm sector jobs grew by 1.6 percent over the same period. Seasonally adjusted average unemployment rates went down in 2018 from the year earlier in Spokane, Coeur d'Alene, and Medford. In Spokane the average rate was 5.6 percent in 2017 and declined to 5.5 percent in 2018; in Coeur d'Alene the average rate declined from 3.8 percent to 3.4 percent; and in Medford the average rate declined from 4.8 percent to 4.7 percent. The U.S. rate declined from 4.4 percent to 3.9 percent over the same period. Alaska Electric Light and Power Company Our AEL&P service area is centered in Juneau. Although Juneau is Alaska’s state capital, it is not a metropolitan statistical area. This means breadth and frequency of economic data is more limited. Therefore, the dates of Juneau's economic data may significantly lag the period of this filing. The Quarterly Census of Employment and Wages for Juneau shows employment declined 0.4 percent between the first half of 2017 and first half of 2018. The employment decline was centered in government; construction; manufacturing; information; financial activities; and professional and business services; education and health services. Government (including active duty military personnel) accounts for approximately 37 percent of total employment. Between 2018 and 2019, the non-seasonally adjusted unemployment rate decreased from 4.7 percent to 4.5 percent. Forecasted Customer and Load Growth Based on our forecast for 2019 through 2022 for Avista Utilities' service area, we expect annual electric customer growth to average 1 percent, within a forecast range of 0.6 percent to 1.4 percent. We expect annual natural gas customer growth to average 1.4 percent, within a forecast range of 0.8 percent to 2 percent. We anticipate retail electric load growth to average 0.5 percent, within a forecast range of 0.2 percent and 0.8 percent. We expect natural gas load growth to average 1.1 percent, within a forecast range of 0.6 percent and 1.6 percent. The forecast ranges reflect (1) the inherent uncertainty associated with the economic assumptions on which forecasts are based and (2) the historic variability of natural gas customer and load growth. In AEL&P's service area, we expect no significant growth in residential, commercial and government customers for the period 2019 through 2022. We anticipate average annual total load growth will be in a narrow range around 0.3 percent, with residential load growth averaging 0.6 percent and commercial and government growth near 0 percent. The forward-looking statements set forth above regarding retail load growth are based, in part, upon purchased economic forecasts and publicly available population and demographic studies. The expectations regarding retail load growth are also based upon various assumptions, including: • assumptions relating to weather and economic and competitive conditions, • internal analysis of company-specific data, such as energy consumption patterns, AVISTA CORPORATION • internal business plans, • an assumption that we will incur no material loss of retail customers due to self-generation or retail wheeling, and • an assumption that demand for electricity and natural gas as a fuel for mobility will for now be immaterial. Changes in actual experience can vary significantly from our projections. See also "Competition" above for a discussion of competitive factors that could affect our results of operations in the future. Environmental Issues and Contingencies We are subject to environmental regulation by federal, state and local authorities. The generation, transmission, distribution, service and storage facilities in which we have ownership interests are designed and operated in compliance with applicable environmental laws. Furthermore, we conduct periodic reviews and audits of pertinent facilities and operations to ensure compliance and to respond to or anticipate emerging environmental issues. The Company's Board of Directors has established a committee to oversee environmental issues. We monitor legislative and regulatory developments at all levels of government for environmental issues, particularly those with the potential to impact the operation and productivity of our generating plants and other assets. Environmental laws and regulations may: • increase the operating costs of generating plants; • increase the lead time and capital costs for the construction of new generating plants; • require modification of our existing generating plants; • require existing generating plant operations to be curtailed or shut down; • reduce the amount of energy available from our generating plants; • restrict the types of generating plants that can be built or contracted with; • require construction of specific types of generation plants at higher cost; and • increase costs of distributing natural gas. Compliance with environmental laws and regulations could result in increases to capital expenditures and operating expenses. We intend to seek recovery of any such costs through the ratemaking process. Clean Air Act (CAA) The CAA creates a number of requirements for our thermal generating plants. Colstrip, Kettle Falls GS and Rathdrum CT all require CAA Title V operating permits. The Boulder Park GS, Northeast CT and a number of other operations require minor source permits or simple source registration permits. We have secured these permits and operate to meet their requirements. These requirements can change over time as the CAA or applicable implementing regulations are amended and new permits are issued. We actively monitor legislative, regulatory and other program developments of the CAA that may impact our facilities. Hazardous Air Pollutants (HAPs) On April 16, 2016, the Mercury Air Toxic Standards (MATS), an EPA rule for coal and oil-fired sources, became effective for all Colstrip units. Colstrip performs compliance assurance stack testing on a quarterly basis to meet the MATS site-wide limitation for Particulate Matter (PM) emissions (0.03 lbs./MMBtu). The Montana Department of Environmental Quality (MDEQ) was notified of a PM emission deviation by Talen, the plant operator, on June 28, 2018 for the testing performed on June 21, 2018. As a result, Unit 3 was immediately removed from service. Similarly, Unit 4 was removed from service on June 29, 2018. Talen proposed, and the MDEQ acknowledged, that limited operation of Units 3 & 4 for the evaluation of a corrective action and/or data gathering related to potential corrective action was a prudent approach to solving the issue. An extensive inspection was conducted including: the coal supply, coal mills, boiler, combustion, ductwork, air preheater, scrubbers, and the stack. Talen implemented cleaning, adjustments, troubleshooting, testing, and other corrective actions. As a part of the corrective action, new flow balancing plates were installed in all Unit 3 & 4 scrubber vessels to further enhance PM removal efficiency. AVISTA CORPORATION PM testing in September 2018 on Units 3 & 4 demonstrated compliance with the MATS. Both of these compliance tests were witnessed by the MDEQ. With the passing of the PM testing with MATS compliance, Talen returned both Units 3 & 4 to service in September 2018. Due to the June 2018 failure to meet the MATS standard, Colstrip Units 3 & 4 are now subject to potential MDEQ enforcement action. The extent of this action remains under investigation. Due to the complicated nature of the compliance calculation and the various factors that MDEQ may consider, we are unable to anticipate the extent of the impending enforcement action at this time. In December 2018, the EPA proposed to revise earlier findings and make a new determination that is not “appropriate and necessary” to regulate hazardous air pollutants from power plants. The EPA proposes this conclusion based on new cost/benefit analysis. The EPA is taking comments on this proposal, which contains additional measures, for 60 days from publication. Because Colstrip has already implemented applicable MATS control measures, it is unclear what, if any, impact the EPA’s most recent proposal will have. Coal Ash Management/Disposal In 2015, the EPA issued a final rule regarding coal combustion residuals (CCRs), also termed coal combustion byproducts or coal ash. The CCR rule has been the subject of ongoing litigation. In August 2018, the D.C. Circuit struck down provisions of the rule. Colstrip, of which we are a 15 percent owner of Units 3 & 4, produces this byproduct. The rule includes technical requirements for CCR landfills and surface impoundments under Subtitle D of the Resource Conservation and Recovery Act, the nation's primary law for regulating solid waste. The Colstrip owners developed a multi-year compliance plan to address the CCR requirements and existing state obligations (expressed largely through a 2012 Administrative Order on Consent). These requirements continue despite the 2018 federal court ruling. Based on available information from Talen, the Colstrip operator, we review and update our asset retirement obligation (ARO) periodically. See "Note 9 of the Notes to Consolidated Financial Statements" for additional information regarding AROs. In addition, under a 2012 Administrative Order on Consent, the owners of Colstrip are required to provide financial assurance, primarily in the form of surety bonds, to secure each owner’s pro rata share of various anticipated closure and remediation obligations. The amount of financial assurance required of each owner may, like the ARO, vary substantially due to the uncertainty and evolving nature of anticipated closure and remediation activities, and as those activities are completed over time. In addition to an increase to our ARO, it is expected that there will be significant compliance costs at Colstrip in the future, both operating and capital costs, due to a series of incremental infrastructure improvements which are separate from the ARO. We cannot reasonably estimate the future compliance costs; however, we will update our ARO and compliance cost estimates as data becomes available. The actual asset retirement costs and future compliance costs related to the CCR rule requirements may vary substantially from the estimates used to record the ARO due to uncertainty about the compliance strategies that will be used and the nature of available data used to estimate costs, such as the quantity of coal ash present at certain sites and the volume of fill that will be needed to cap and cover certain impoundments. We will coordinate with the plant operator and continue to gather additional data in future periods to make decisions about compliance strategies and the timing of closure activities. As additional information becomes available, we will update the ARO and future nonretirement compliance costs for these changes in estimates, which could be material. We expect to seek recovery of increased costs related to complying with the CCR rule and related requirements through the ratemaking process. Climate Change Concerns about long-term global climate changes could have a significant effect on our business. Some companies have been subject to shareholder resolutions requiring climate-change specific planning or actions, which could increase costs. Our operations could also be affected by changes in laws and regulations intended to mitigate the risk of, or alter global climate changes, including restrictions on the operation of our power generation resources and obligations imposed on the sale of natural gas. Changing temperatures and precipitation, including snowpack conditions, affect the availability and timing of streamflows, which impact hydroelectric generation. Extreme weather events could increase fire risks, service interruptions, outages and maintenance costs. Changing temperatures could also increase or decrease customer demand. Our Climate Policy Council (an interdisciplinary team of management and other employees): • facilitates internal and external communications regarding climate change issues, • analyzes policy effects, anticipates opportunities and evaluates strategies for Avista Corp., and AVISTA CORPORATION • develops recommendations on climate related policy positions and action plans. Climate Change - Federal Regulatory Actions The EPA released the final rules for the Clean Power Plan (CPP) and the Carbon Pollution Standards (CPS) in August 2015. The CPP and the CPS were both intended to reduce the carbon dioxide (CO2) emissions from certain coal-fired and natural gas electric generating units (EGUs). These rules were published in the Federal Register in October 2015. The CPP was promulgated pursuant to Section 111(d) of the CAA and applied to CO2 emissions from existing EGUs. The CPP was intended to reduce national CO2 emissions by approximately 32 percent below 2005 levels by 2030. The CPS rule was issued pursuant to Section 111(b) of the CAA and applied to the emissions of new, modified and reconstructed EGUs. The promulgated and proposed rulemakings mentioned above were legally challenged in multiple venues. On October 16, 2017, the EPA gave notice of proposed rule-making to repeal the Final CPP. On December 28, 2017, the EPA published an Advanced Notice of Proposed Rulemaking seeking comments on the potential for a CPP replacement rule. On August 31, 2018 the EPA issued a proposed replacement rule to the CPP, called the Affordable Clean Energy (ACE) rule. ACE proposes heat rate improvements as the best system of emissions reduction. The proposed rule also includes implementation guidelines for CAA section 111(d) as well as revisions to the New Source Review program. The public comment period for the rule ended October 30, 2018. GHG emission standards could result in significant compliance costs. Such standards could also preclude us from developing, operating or contracting with certain types of generating plants, as well as increase the cost of wholesale electricity. Given these ongoing developments, we cannot at this time predict the outcome or estimate the extent to which our facilities may be impacted by the proposed ACE rule. We intend to seek recovery of costs related to compliance with these requirements through the ratemaking process. Climate Change - State Legislation and State Regulatory Activities The states of Washington and Oregon have adopted non-binding targets to reduce GHG emissions. Both states enacted their targets with an expectation of reaching the targets through a combination of renewable energy standards, and assorted “complementary policies,” but no specific reductions are mandated. The Governors and Legislatures of both states began drafting climate-related proposals in late 2018, ahead of the 2019 legislative sessions. While we are unable to predict any outcome of these efforts, we are engaged with key parties in these policy deliberations. Washington and Oregon apply a GHG emissions performance standard (EPS) to electric generation facilities used to serve retail loads in their jurisdictions, whether the facilities are located within those respective states or elsewhere. The EPS prevents utilities from constructing or purchasing generation facilities, or entering into power purchase agreements of five years or longer duration to purchase energy produced by plants that, in any case, have emission levels higher than 1,100 pounds of GHG per MWh. The Washington State Department of Commerce reviews the standard every five years. In September 2018, it adopted a new standard of 925 pounds of GHG per MWh. We intend to seek recovery of costs related to ongoing and new requirements through the ratemaking process. Washington Energy Independence Act (EIA) The EIA in Washington requires electric utilities with over 25,000 customers to acquire qualified renewable energy resources and/or renewable energy credits equal to 15 percent of the utility's total retail load in Washington in 2020. The EIA also requires these utilities to meet biennial energy conservation targets beginning in 2012. The renewable energy standard increased from three percent in 2012 to nine percent in 2016 and will increase to 15 percent in 2020. Failure to comply with renewable energy and efficiency standards could result in penalties of $50 per MWh or greater assessed against a utility for each MWh it is deficient in meeting a standard. We have met, and will continue to meet, the requirements of the EIA through a variety of renewable energy generating means, including, but not limited to, some combination of hydro upgrades, wind, biomass and renewable energy credits. Clean Air Rule In September 2016, Ecology adopted the Clean Air Rule (CAR) to cap and reduce GHG emissions across the State of Washington in pursuit of the State’s GHG goals, which were enacted in 2008 by the Washington State Legislature. The CAR applies to sources of annual GHG emissions in excess of 100,000 tons for the first compliance period of 2017 through 2019; this threshold incrementally decreases to 70,000 metric tons beginning in 2035. The rule affects stationary sources and transportation fuel suppliers, as well as natural gas distribution companies. Ecology has identified approximately 30 entities that would be regulated under the CAR. Parties covered by the regulation must reduce emissions by 1.7 percent annually until 2035. Compliance can be demonstrated by achieving emission AVISTA CORPORATION reductions and/or surrendering Emission Reduction Units (ERU), which are generated by parties that achieve reductions greater than required by the rule. ERUs can also take the form of renewable energy credits from renewable resources located in Washington, carbon emission offsets, and allowances acquired from an organized cap and trade market, such as that operating in California. In addition to the CAR's applicability to our burning of fuel as an electric utility, the CAR applies to us as a natural gas distribution company, for the emissions associated with the use of the natural gas we provide our customers who are not already covered under the regulation. In September 2016, Avista Corp., Cascade Natural Gas Corp., NW Natural and Puget Sound Energy (PSE) (collectively, Petitioners) jointly filed an action in the U.S. District Court for the Eastern District of Washington challenging Ecology’s promulgated CAR. The four companies also filed litigation in Thurston County Superior Court. The case in the U.S. District Court has been tolled while the state court case proceeds. On December 15, 2017, the Thurston County Superior Court issued a ruling invalidating the CAR. On April 27, 2018, the Superior Court entered its order invalidating the CAR. Ecology has since appealed the ruling, and the Washington State Supreme Court has accepted review. The matter remains pending before the Washington Supreme Court; consequently, we cannot predict the outcome of these matters at this time, but plan to seek recovery of costs related to compliance with surviving requirements through the ratemaking process. Colstrip Units 3 & 4 Considerations In February 2014, the WUTC issued a letter finding that PSE’s 2013 Electric IRP meets the requirements of the Revised Code of Washington and the Washington Administrative Code. The letter does not constitute approval of any aspect of the plan. In its letter, however, the WUTC expressed concern regarding the continued operation of Colstrip as a resource to serve retail customers. Although the WUTC recognized that the results of the analyses presented by PSE “differed significantly between [Colstrip] Units 1 & 2 and Units 3 & 4,” the WUTC did not limit its concerns solely to Colstrip Units 1 & 2. The WUTC recommended that PSE “consult with WUTC staff to consider a Colstrip Proceeding to determine the prudency of new investment in Colstrip before it is made or, alternatively, a closure or partial-closure plan.” As part of the Sierra Club litigation that was settled in 2016, Colstrip Units 1 & 2 are scheduled to close by July 2022. In 2017, the WUTC issued an Order in PSE’s general rate case accelerating PSE’s depreciation of Colstrip Units 3 & 4 to 2027 from 2044 and 2045, respectively, directing PSE to contribute $10 million from a combination of sources to a community transition fund to mitigate social and economic impacts from the closure of Colstrip, and encouraging PSE to engage stakeholders in a dialogue about utilizing surplus capacity on the Colstrip transmission system. As a 15 percent owner of Colstrip Units 3 & 4, we cannot estimate the effect of such proceeding, should it occur, on the future ownership, operation and operating costs of our share of Colstrip Units 3 & 4. Our remaining investment in Colstrip Units 3 & 4 as of December 31, 2018 was $122.4 million. In Oregon, legislation was enacted in 2016 which requires Portland General Electric and PacifiCorp to remove coal-fired generation from their Oregon rate base by 2030. This legislation does not directly relate to Avista Corp. because Avista Corp. is not an electric utility in Oregon. However, because these two utilities, along with Avista Corp., hold minority interests in Colstrip, the legislation could indirectly impact Avista Corp., though specific impacts cannot be identified at this time. While the legislation requires Portland General Electric and PacifiCorp to eliminate Colstrip from their rates, they would be permitted to sell the output of their shares of Colstrip into the wholesale market or, as is the case with PacifiCorp, reallocate Colstrip to other states. We cannot predict the eventual outcome of actions arising from this legislation at this time or estimate the effect thereof on Avista Corp.; however, we will continue to seek recovery, through the ratemaking process, of all operating and capitalized costs related to our generation assets. Threatened and Endangered Species and Wildlife A number of species of fish in the Northwest are listed as threatened or endangered under the Federal Endangered Species Act (ESA). Efforts to protect these and other species have not significantly impacted generation levels at our hydroelectric facilities, nor operations of our thermal plants or electrical distribution and transmission system. We are implementing fish protection measures at our hydroelectric project on the Clark Fork River under a 45-year FERC operating license for Cabinet Gorge and Noxon Rapids (issued March 2001) that incorporates a comprehensive settlement agreement. The restoration of native salmonid fish, including bull trout, is a key part of the agreement. The result is a collaborative native salmonid restoration program with the U.S. Fish and Wildlife Service, Native American tribes and the states of Idaho and Montana on the lower Clark Fork River, consistent with requirements of the FERC license. The U.S. Fish & Wildlife Service issued an updated Critical Habitat Designation for bull trout in 2010 that includes the lower Clark Fork River, as well as portions of the Coeur d'Alene basin within our Spokane River Project area, and issued a final Bull Trout Recovery Plan under the ESA. Issues related to these activities are expected to be resolved through the ongoing collaborative effort of our Clark Fork and Spokane River FERC licenses. AVISTA CORPORATION Various statutory authorities, including the Migratory Bird Treaty Act, have established penalties for the unauthorized take of migratory birds. Because we operate facilities that can pose risks to a variety of such birds, we have developed and follow an avian protection plan. We are also aware of other threatened and endangered species and issues related to them that could be impacted by our operations and we make every effort to comply with all laws and regulations relating to these threatened and endangered species. We expect costs associated with these compliance efforts to be recovered through the ratemaking process. Other For other environmental issues and other contingencies see “Note 20 of the Notes to Consolidated Financial Statements.” Enterprise Risk Management The material risks to our businesses are discussed in "Item 1A. Risk Factors," "Forward-Looking Statements," as well as "Environmental Issues and Contingencies." The following discussion focuses on our mitigation processes and procedures to address these risks. We consider the management of these risks an integral part of managing our core businesses and a key element of our approach to corporate governance. Risk management includes identifying and measuring various forms of risk that may affect the Company. We have an enterprise risk management process for managing risks throughout our organization. Our Board of Directors and its Committees take an active role in the oversight of risk affecting the Company. Our risk management department facilitates the collection of risk information across the Company, providing senior management with a consolidated view of the Company’s major risks and risk mitigation measures. Each area identifies risks and implements the related mitigation measures. The enterprise risk process supports management in identifying, assessing, quantifying, managing and mitigating the risks. Despite all risk mitigation measures, however, risks are not eliminated. Our primary identified categories of risk exposure are: • Financial • Compliance • Utility regulatory • Cyber and Technology • Energy commodity • Strategic • Operational • External Mandates Financial Risk Financial risk is any risk that could have a direct material impact on the financial performance or financial viability of the Company. Broadly, financial risks involve variation of earnings and liquidity. Underlying risks include, but are not limited to, those described in "Item 1A. Risk Factors." Our Regulatory department is critical in mitigation of financial risk as they have regular communications with state commission regulators and staff and they monitor and develop rate strategies for the Company. Rate strategies, such as decoupling, help mitigate the impacts of revenue fluctuations due to weather, conservation or the economy. We also have a Treasury department that monitors our daily cash position and future cash flow needs, as well as monitoring market conditions to determine the appropriate course of action for capital financing and/or hedging strategies. Oversight of our financial risk mitigation strategies is performed by senior management and the Finance Committee of our Board of Directors. Weather Risk To partially mitigate the risk of financial underperformance due to weather-related factors, we developed decoupling rate mechanisms that were approved by the Washington, Idaho and Oregon commissions. Decoupling mechanisms are designed to break the link between a utility's revenues and consumers' energy usage and instead provide revenue based on the number of customers, thus mitigating a large portion of the risk associated with lower customer loads. See "Regulatory Matters" for further discussion of our decoupling mechanisms. Access to Capital Markets Our capital requirements rely to a significant degree on regular access to capital markets. We actively engage with rating agencies, banks, investors and state public utility commissions to understand and address the factors that support access to capital markets on reasonable terms. We manage our capital structure to maintain a financial risk profile that we believe these parties will deem prudent. We forecast cash requirements to determine liquidity needs, including sources and variability of cash AVISTA CORPORATION flows that may arise from our spending plans or from external forces, such as changes in energy prices or interest rates. Our financial and operating forecasts consider various metrics that affect credit ratings. Our regulatory strategies include working with state public utility commissions and filing for rate changes as appropriate to meet financial performance expectations. Interest Rate Risk Uncertainty about future interest rates causes risk related to a portion of our existing debt, our future borrowing requirements, and our pension and other post-retirement benefit obligations. We manage debt interest rate exposure by limiting our variable rate debt to a percentage of total capitalization of the Company. We hedge a portion of our interest rate risk on forecasted debt issuances with financial derivative instruments, which may include interest rate swaps and U.S. Treasury lock agreements. The Finance Committee of our Board of Directors periodically reviews and discusses interest rate risk management processes and the steps management has undertaken to control interest rate risk. Our RMC also reviews our interest rate risk management plan. Additionally, interest rate risk is managed by monitoring market conditions when timing the issuance of long-term debt and optional debt redemptions and establishing fixed rate long-term debt with varying maturities. Our interest rate swap derivatives are considered economic hedges against the future forecasted interest rate payments of our long-term debt. Interest rates on our long-term debt are generally set based on underlying U.S. Treasury rates plus credit spreads, which are based on our credit ratings and prevailing market prices for debt. The interest rate swap derivatives hedge against changes in the U.S. Treasury rates but do not hedge the credit spread. Even though we work to manage our exposure to interest rate risk by locking in certain long-term interest rates through interest rate swap derivatives, if market interest rates decrease below the interest rates we have locked in, this will result in a liability related to our interest rate swap derivatives, which can be significant. However, through our regulatory accounting practices similar to our energy commodity derivatives, any interim mark-to-market gains or losses are offset by regulatory assets and liabilities. Upon settlement of interest rate swap derivatives, the cash payments made or received are recorded as a regulatory asset or liability and are subsequently amortized as a component of interest expense over the life of the associated debt. The settled interest rate swap derivatives are also included as a part of Avista Corp.'s cost of debt calculation for ratemaking purposes. The following table summarizes our interest rate swap derivatives outstanding as of December 31, 2018 and December 31, 2017 (dollars in thousands): (1) There are offsetting regulatory assets and liabilities for these items on the Consolidated Balance Sheets in accordance with regulatory accounting practices. (2) The balance as of December 31, 2018 and December 31, 2017 reflects the offsetting of $0.5 million and $35.0 million, respectively, of cash collateral against the net derivative positions where a legal right of offset exists. We estimate that a 10-basis-point increase in forward LIBOR interest rates as of December 31, 2018 would increase the interest rate swap derivative net asset by $4.3 million, while a 10-basis-point decrease would decrease the interest rate swap derivative net asset by $4.4 million. We estimated that a 10-basis-point increase in forward LIBOR interest rates as of December 31, 2017 would have decreased the interest rate swap derivative net liability by $9.7 million, while a 10-basis-point decrease would increase the interest rate swap derivative net liability by $10.0 million. The interest rate on $51.5 million of long-term debt to affiliated trusts is adjusted quarterly, reflecting current market rates. Amounts borrowed under our committed line of credit agreements have variable interest rates. AVISTA CORPORATION The following table shows our long-term debt (including current portion) and related weighted-average interest rates, by expected maturity dates as of December 31, 2018 (dollars in thousands): (1) These balances include the fixed rate long-term debt of Avista Corp., AEL&P and AERC. Our pension plan is exposed to interest rate risk because the value of pension obligations and other post-retirement obligations vary directly with changes in the discount rates, which are derived from end-of-year market interest rates. In addition, the value of pension investments and potential income on pension investments is partially affected by interest rates because a portion of pension investments are in fixed income securities. Oversight of our pension plan investment strategies is performed by the Finance Committee of the Board of Directors, which approves investment and funding policies, objectives and strategies that seek an appropriate return for the pension plan. We manage interest rate risk associated with our pension and other post-retirement benefit plans by investing a targeted amount of pension plan assets in fixed income investments that have maturities with similar profiles to future projected benefit obligations. See "Note 10 of the Notes to Consolidated Financial Statements" for further discussion of our investment policy associated with the pension assets. Credit Risk Counterparty Non-Performance Risk Counterparty non-performance risk relates to potential losses that we would incur as a result of non-performance of contractual obligations by counterparties to deliver energy or make financial settlements. Changes in market prices may dramatically alter the size of credit risk with counterparties, even when we establish conservative credit limits. Should a counterparty fail to perform, we may be required to honor the underlying commitment or to replace existing contracts with contracts at then-current market prices. We enter into bilateral transactions with various counterparties. We also trade energy and related derivative instruments through clearinghouse exchanges. We seek to mitigate credit risk by: • transacting through clearinghouse exchanges, • entering into bilateral contracts that specify credit terms and protections against default, • applying credit limits and duration criteria to existing and prospective counterparties, • actively monitoring current credit exposures, • asserting our collateral rights with counterparties, and • carrying out transaction settlements timely and effectively. The extent of transactions conducted through exchanges has increased, as many market participants have shown a preference toward exchange trading and have reduced bilateral transactions. We actively monitor the collateral required by such exchanges to effectively manage our capital requirements. Counterparties’ credit exposure to us is dynamic in normal markets and may change significantly in more volatile markets. The amount of potential default risk to us from each counterparty depends on the extent of forward contracts, unsettled transactions, interest rates and market prices. There is a risk that we do not obtain sufficient additional collateral from counterparties that are unable or unwilling to provide it. AVISTA CORPORATION Credit Risk Liquidity Considerations To address the impact on our operations of energy market price volatility, our hedging practices for electricity (including fuel for generation) and natural gas extend beyond the current operating year. Executing this extended hedging program may increase credit risk and demands for collateral. Our credit risk management process is designed to mitigate such credit risks through limit setting, contract protections and counterparty diversification, among other practices. Credit risk affects demands on our capital. We are subject to limits and credit terms that counterparties may assert to allow us to enter into transactions with them and maintain acceptable credit exposures. Many of our counterparties allow unsecured credit at limits prescribed by agreements or their discretion. Capital requirements for certain transaction types involve a combination of initial margin and market value margins without any unsecured credit threshold. Counterparties may seek assurances of performance from us in the form of letters of credit, prepayment or cash deposits. Credit exposure can change significantly in periods of commodity price and interest rate volatility. As a result, sudden and significant demands may be made against our credit facilities and cash. We actively monitor the exposure to possible collateral calls and take steps to minimize capital requirements. As of December 31, 2018, we had cash deposited as collateral of $78.0 million and letters of credit of $6.5 million outstanding related to our energy derivative contracts. Price movements and/or a downgrade in our credit ratings could impact further the amount of collateral required. See “Credit Ratings” for further information. For example, in addition to limiting our ability to conduct transactions, if our credit ratings were lowered to below “investment grade” based on our positions outstanding at December 31, 2018, we would potentially be required to post additional collateral of up to $3.5 million. This amount is different from the amount disclosed in “Note 6 of the Notes to Consolidated Financial Statements” because, while this analysis includes contracts that are not considered derivatives in addition to the contracts considered in Note 6, this analysis also takes into account contractual threshold limits that are not considered in Note 6. Without contractual threshold limits, we would potentially be required to post additional collateral of $5.2 million. Under the terms of interest rate swap derivatives that we enter into periodically, we may be required to post cash or letters of credit as collateral depending on fluctuations in the fair value of the instrument. As of December 31, 2018, we had interest rate swap agreements outstanding with a notional amount totaling $235.0 million and we had deposited cash in the amount of $0.5 million as collateral for these interest rate swap derivatives. If our credit ratings were lowered to below “investment grade” based on our interest rate swap derivatives outstanding at December 31, 2018, we would have to post $2.9 million of additional collateral. Foreign Currency Risk A significant portion of our utility natural gas supply (including fuel for electric generation) is obtained from Canadian sources. Most of those transactions are executed in U.S. dollars, which avoids foreign currency risk. A portion of our short-term natural gas transactions and long-term Canadian transportation contracts are committed based on Canadian currency prices. The short-term natural gas transactions are typically settled within sixty days with U.S. dollars. We hedge a portion of the foreign currency risk by purchasing Canadian currency exchange derivatives when such commodity transactions are initiated. This risk has not had a material effect on our financial condition, results of operations or cash flows and these differences in cost related to currency fluctuations are included with natural gas supply costs for ratemaking. Further information for derivatives and fair values is disclosed at “Note 6 of the Notes to Consolidated Financial Statements” and “Note 16 of the Notes to Consolidated Financial Statements.” Utility Regulatory Risk Because we are primarily a regulated utility, we face the risk that regulators may not grant rates that provide timely or sufficient recovery of our costs or allow a reasonable rate of return for our shareholders. This includes costs associated with our investment in rate base, as well as commodity costs and other operating and financing expenses. Regulatory risk is mitigated through a separate regulatory group which communicates with commission regulators and staff regarding the Company’s business plans and concerns. The regulatory group also considers the regulator’s priorities and rate policies and makes recommendations to senior management on regulatory strategy for the Company. Oversight of our regulatory strategies and policies is performed by senior management and our Board of Directors. See “Regulatory Matters” for further discussion of regulatory matters affecting our Company. AVISTA CORPORATION Energy Commodity Risk Energy commodity risks are associated with fulfilling our obligation to serve customers, managing variability of energy facilities, rights and obligations and fulfilling the terms of our energy commodity agreements with counterparties. These risks include, among other things, those described in "Item 1A. Risk Factors." We mitigate energy commodity risk primarily through our energy resources risk policy, which includes oversight from the RMC and oversight from the Audit Committee and the Environmental, Technology and Operations Committee of our Board of Directors. In conjunction with the oversight committees, our management team develops hedging strategies, detailed resource procurement plans, resource optimization strategies and long-term integrated resource planning to mitigate some of the risk associated with energy commodities. The various plans and strategies are monitored daily and developed with quantitative methods. Our energy resources risk policy includes our wholesale energy markets credit policy and control procedures to manage energy commodity price and credit risks. Nonetheless, adverse changes in commodity prices, generating capacity, customer loads, regulation and other factors may result in losses of earnings, cash flows and/or fair values. We measure the volume of monthly, quarterly and annual energy imbalances between projected power loads and resources. The measurement process is based on expected loads at fixed prices (including those subject to retail rates) and expected resources to the extent that costs are essentially fixed by virtue of known fuel supply costs or projected hydroelectric conditions. To the extent that expected costs are not fixed, either because of volume mismatches between loads and resources or because fuel cost is not locked in through fixed price contracts or derivative instruments, our risk policy guides the process to manage this open forward position over a period of time. Normal operations result in seasonal mismatches between power loads and available resources. We are able to vary the operation of generating resources to match parts of intra-hour, hourly, daily and weekly load fluctuations. We use the wholesale power markets, including the natural gas market as it relates to power generation fuel, to sell projected resource surpluses and obtain resources when deficits are projected. We buy and sell fuel for thermal generation facilities based on comparative power market prices and marginal costs of fueling and operating available generating facilities and the relative economics of substitute market purchases for generating plant operation. To address the impact on our operations of energy market price volatility, our hedging practices for electricity (including fuel for generation) and natural gas extend beyond the current operating year. Executing this extended hedging program may increase our credit risks. Our credit risk management process is designed to mitigate such credit risks through limit setting, contract protections and counterparty diversification, among other practices. Our projected retail natural gas loads and resources are regularly reviewed by operating management and the RMC. To manage the impacts of volatile natural gas prices, we seek to procure natural gas through a diversified mix of spot market purchases and forward fixed price purchases from various supply basins and time periods. We have an active hedging program that extends into future years with the goal of reducing price volatility in our natural gas supply costs. We use natural gas storage capacity to support high demand periods and to procure natural gas when price spreads are favorable. Securing prices throughout the year and even into subsequent years mitigates potential adverse impacts of significant purchase requirements in a volatile price environment. The following table presents energy commodity derivative fair values as a net asset or (liability) as of December 31, 2018 that are expected to settle in each respective year (dollars in thousands): AVISTA CORPORATION The following table presents energy commodity derivative fair values as a net asset or (liability) as of December 31, 2017 that were expected to settle in each respective year (dollars in thousands): (1) Physical transactions represent commodity transactions where we will take or make delivery of either electricity or natural gas; financial transactions represent derivative instruments with delivery of cash in the amount of the benefit or cost but with no physical delivery of the commodity, such as futures, swap derivatives, options, or forward contracts. The above electric and natural gas derivative contracts will be included in either power supply costs or natural gas supply costs during the period they are delivered and will be included in the various deferral and recovery mechanisms (ERM, PCA, and PGAs), or in the general rate case process, and are expected to eventually be collected through retail rates from customers. See "Item 1. Business - Electric Operations," "Item 1. Business - Natural Gas Operations," and "Item 1A. Risk Factors" for additional discussion of the risks associated with Energy Commodities. Operational Risk Operational risk involves potential disruption, losses, or excess costs arising from external events or inadequate or failed internal processes, people and systems. Our operations are subject to operational and event risks that include, but are not limited to, those described in "Item 1A. Risk Factors." To manage operational and event risks, we maintain emergency operating plans, business continuity and disaster recovery plans, maintain insurance coverage against some, but not all, potential losses and seek to negotiate indemnification arrangements with contractors for certain event risks. In addition, we design and follow detailed vegetation management and asset management inspection plans, which help mitigate wildfire and storm event risks, as well as identify utility assets which may be failing and in need of repair or replacement. We also have an Emergency Operating Center, which is a team of employees that plan for and train to deal with potential emergencies or unplanned outages at our facilities, resulting from natural disasters or other events. To prevent unauthorized access to our facilities, we have both physical and cyber security in place. To address the risk related to fuel cost, availability and delivery restraints, we have an energy resources risk policy, which includes our wholesale energy markets credit policy and control procedures to manage energy commodity price and credit risks. Development of the energy resources risk policy includes planning for sufficient capacity to meet our customer and wholesale energy delivery obligations. See further discussion of the energy resources risk policy above. Oversight of the operational risk management process is performed by the Environmental, Technology and Operations Committee of our Board of Directors and from senior management with input from each operating department. Compliance Risk Compliance risk is the potential consequences of legal or regulatory sanctions or penalties arising from the failure of the Company to comply with requirements of applicable laws, rules and regulations. We have extensive compliance obligations. Our primary compliance risks and obligations include, among others, those described in "Item 1A. Risk Factors." Compliance risk is mitigated through separate Regulatory and Environmental Compliance departments that monitor legislation, regulatory orders and actions to determine the overall potential impact to our Company and develop strategies for complying with the various rules and regulations. We also engage outside attorneys and consultants, when necessary, to help ensure compliance with laws and regulations. Oversight of our compliance risk strategy is performed by senior management, including our Chief Compliance Officer, and the Environmental, Technology and Operations Committee and the Audit Committee of our Board of Directors. See "Item 1. Business, Regulatory Issues" through "Item 1. Business, Reliability Standards" and “Environmental Issues and Contingencies” for further discussion of compliance issues that impact our Company. AVISTA CORPORATION Cyber and Technology Risk Our primary cyber and technology risks are described in "Item 1A. Risk Factors." We mitigate cyber and technology risk through trainings and exercises at all levels of the Company. The Environmental, Technology and Operations Committee of our Board of Directors along with senior management are regularly briefed on security policy, programs and incidents. Annual cyber and physical training and testing of employees are included in our enterprise security program. Our enterprise business continuity program facilitates business impact analysis of core functions for development of emergency operating plans, and coordinates annual testing and training exercises. Technology governance is led by senior management, which includes new technology strategy, risk planning and major project planning and approval. The technology project management office and enterprise capital planning group provide project cost, timeline and schedule oversight. In addition, there are independent third party audits of our critical infrastructure security program and our business risk security controls. We have a Technology department dedicated to securing, maintaining, evaluating and developing our information technology systems. There are regular training sessions for the technology and security team. This group also evaluates the Company's technology for obsolescence and makes recommendations for upgrading or replacing systems as necessary. Additionally, this group monitors for intrusion and security events that may include a data breach or attack on our operations. Strategic Risk Strategic risk relates to the potential impacts resulting from incorrect assumptions about external and internal factors, inappropriate business plans, ineffective business strategy execution, or the failure to respond in a timely manner to changes in the regulatory, macroeconomic or competitive environments. Our primary strategic risks include, among others, those described in "Item 1A. Risk Factors." Oversight of our strategic risk is performed by the Board of Directors and senior management. We have a Chief Strategy Officer that leads strategic initiatives, to search for and evaluate opportunities for the Company and makes recommendations to senior management. We not only focus on whether opportunities are financially viable, but also consider whether these opportunities fall within our core policies and our core business strategies. We mitigate our reputational risk primarily through a focus on adherence to our core policies, including our Code of Conduct, maintaining an appropriate Company culture and tone at the top, and through communication and engagement of our external stakeholders. External Mandates Risk External mandate risk involves forces outside the Company, which may include significant changes in customer expectations, disruptive technologies that result in obsolescence of our business model and government action that could impact the Company. See "Environmental Issues and Contingencies" and "Forward-Looking Statements" for a discussion of or reference to our external mandates risks. Oversight of our external mandate risk mitigation strategies is performed by the Environmental, Technology and Operations Committee of our Board of Directors and senior management. We have a Climate Council which meets internally to assess the potential impacts of climate policy to our business and to identify strategies to plan for change. We also have employees dedicated to actively engage and monitor federal, state and local government positions and legislative actions that may affect us or our customers. To prevent the threat of municipalization, we work to build strong relationships with the communities we serve through, among other things: • communication and involvement with local business leaders and community organizations, • providing customers with a multitude of limited income initiatives, including energy fairs, senior outreach and low income workshops, mobile outreach strategy and a Low Income Rate Assistance Plan, • tailoring our internal company initiatives to focus on choices for our customers, to increase their overall satisfaction with the Company, and • engaging in the legislative process in a manner that fosters the interests of our customers and the communities we serve.

<s>[INST] As of December 31, 2018, we have two reportable business segments, Avista Utilities and AEL&P. We also have other businesses which do not represent a reportable business segment and are conducted by various direct and indirect subsidiaries of Avista Corp. See "Part I, Item 1. Business Company Overview" for further discussion of our business segments. The following table presents net income (loss) attributable to Avista Corp. shareholders for each of our business segments (and the other businesses) for the year ended December 31 (dollars in thousands): AVISTA CORPORATION Executive Level Summary Overall Results Net income attributable to Avista Corp. shareholders was $136.4 million for 2018, an increase from $115.9 million for 2017. The increase in earnings was due to an increase in earnings at Avista Utilities and a decrease in losses at our other businesses, partially offset by a decrease in earnings at AEL&P. Avista Utilities' earnings increased for 2018 primarily due to a decrease in acquisition costs relating to the terminated acquisition by Hydro One and the positive impact of general rate increases and customer growth. These factors were partially offset by increased distribution and generation operating and maintenance costs, outside service costs (other operating expenses), depreciation and amortization, and interest expense. AEL&P earnings decreased for 2018, primarily due to an increase in depreciation and amortization and other miscellaneous expenses as well as a decrease in sales volumes to residential and commercial customers primarily during the fourth quarter of 2018. Losses at our other businesses decreased during 2018 as 2017 included a onetime tax expense in the fourth quarter from revaluing deferred taxes to the new tax rate of 21 percent as a result of federal income tax law changes. There was also a gain in 2018 from one of our equity investments. These were partially offset by increased expenses associated with a renovation project in 2018, impairment losses and an increase in losses on certain of our subsidiary investments. More detailed explanations of the fluctuations are provided in the results of operations and business segment discussions (Avista Utilities, AEL&P, and the other businesses). General Rate Cases and Regulatory Lag Due in part to the regulatory proceedings for the now terminated acquisition of the Company by Hydro One (see below), we elected not to file any general rate cases during 2018 to allow the commissions to focus on the merger proceedings. While we received a base rate increase effective January 1, 2019 in Idaho, which was related to a rate plan approved by the IPUC in 2017, we have not received base rate relief in Oregon since November 1, 2017, and have not received base rate relief in Washington since May 1, 2018. During 2017 and 2018, we continued to invest in our utility infrastructure to maintain and enhance our system; however, only limited portions of these costs are reflected in our current rates to customers. As such, we expect to experience regulatory lag during the period 2019 through 2021 due to the delay in general rate case filings and our continued investment in utility infrastructure. We plan to file general rate cases in Washington, Idaho and Oregon during the first half of 2019 with requested effective dates in early 2020 to begin remedying the regulatory lag. Going forward, we will continue to strive to reduce the regulatory timing lag and more closely align our earned returns with those authorized by 2022. This will require adequate and timely rate relief in our jurisdictions. Termination of the Proposed Acquisition by Hydro One On July 19, 2017, Avista Corp. entered into a Merger Agreement that provided for Avista Corp. to become an indirect, whollyowned subsidiary of Hydro One, subject to the satisfaction or waiver of specified closing conditions, including approval by regulatory agencies. On January 23, 2019, Avista Corp., Hydro One and certain subsidiaries thereof, entered into a term [/INST] Positive. </s>

AVISTA CORP

2020-02-26

2019-12-31

ITEM 7. MANAGEMENT'S DISCUSSION AND ANALYSIS OF FINANCIAL CONDITION AND RESULTS OF OPERATIONS This section of this Annual Report on Form 10-K generally discusses 2019 and 2018 financial statement items and year-to-year comparisons between 2019 and 2018. Discussion of 2017 financial statement items and year-to-year comparisons between 2018 and 2017 that are not included in this Form 10-K can be found in "Management's Discussion and Analysis of Financial Conditions and Results of Operations" in Part II, Item 7 of the Company's Annual Report on Form 10-K for the year ended December 31, 2018. Business Segments As of December 31, 2019, we have two reportable business segments, Avista Utilities and AEL&P. We also have other businesses which do not represent a reportable business segment and are conducted by various direct and indirect subsidiaries of Avista Corp. See "Part I, Item 1. Business - Company Overview" for further discussion of our business segments. AVISTA CORPORATION The following table presents net income (loss) attributable to Avista Corp. shareholders for each of our business segments (and the other businesses) for the year ended December 31 (dollars in thousands): Executive Level Summary Overall Results Net income attributable to Avista Corp. shareholders was $197.0 million for 2019, an increase from $136.4 million for 2018. Avista Utilities' net income increased due to the receipt of a $103 million termination fee from Hydro One (see "Note 24 of the Notes to Consolidated Financial Statements"), as well as the positive impact of general rate increases and customer growth. These increases were partially offset by final transaction costs for the Hydro One transaction, taxes associated with the termination fee, increased transmission and distribution operating and maintenance costs, a $7 million donation to the Avista Foundation to support the local community (other operating expenses) and increased depreciation and amortization. AEL&P net income decreased primarily due to a decrease in operating revenues. The increase in net income at our other businesses was primarily due to the sale of METALfx and net investment gains from our other investments. More detailed explanations of the fluctuations are provided in the results of operations and business segment discussions (Avista Utilities, AEL&P, and the other businesses). General Rate Cases and Regulatory Lag We experienced regulatory lag during 2019 and we expect this to continue through the end of 2021 due to our continued investment in utility infrastructure and because we did not file general rate cases during 2018 due to the terminated Hydro One transaction. In April 2019, we filed general rates cases in Washington (partial settlement agreement in November 2019, refer to "Regulatory Matters"). We completed an electric only general rate case in Idaho, with new rates effective on December 1, 2019 and we also filed a natural gas general rate case in Oregon in March (with new rates effective on January 15, 2020). We expect these cases to provide rate relief in 2020 and start reducing the regulatory lag that we have been experiencing. Going forward, we will continue to strive to reduce the regulatory timing lag and more closely align our earned returns with those authorized by 2022. This will require adequate and timely rate relief in our jurisdictions. See "Regulatory Matters" for additional discussion of the 2019 general rate cases. Regulatory Matters General Rate Cases We regularly review the need for electric and natural gas rate changes in each state in which we provide service. We will continue to file for rate adjustments to: • seek recovery of operating costs and capital investments, and • seek the opportunity to earn reasonable returns as allowed by regulators. With regards to the timing and plans for future filings, the assessment of our need for rate relief and the development of rate case plans takes into consideration short-term and long-term needs, as well as specific factors that can affect the timing of rate filings. Such factors include, but are not limited to, in-service dates of major capital investments and the timing of changes in major revenue and expense items. Avista Utilities Washington General Rate Cases and Other Proceedings 2015 General Rate Cases In January 2016 we received an order which was reaffirmed by the WUTC in February 2016 that concluded our electric and natural gas general rate cases that were originally filed with the WUTC in February 2015. New electric and natural gas rates were effective on January 11, 2016. AVISTA CORPORATION In March 2016, the Public Counsel Unit of the Washington State Office of the Attorney General (Public Counsel) filed in Thurston County Superior Court a Petition for Judicial Review of the WUTC's orders that concluded our 2015 electric and natural gas general rate cases. In April 2016, this matter was certified for review directly by the Court of Appeals, an intermediate appellate court in the State of Washington. On August 7, 2018, the Court of Appeals issued an Opinion which concluded that the WUTC's use of an attrition allowance to calculate Avista Corp.'s rate base violated Washington law. The Court struck all portions of the attrition allowance attributable to Avista Corp.’s rate base and reversed and remanded the case for the WUTC to recalculate Avista Corp.’s rates without including an attrition allowance in the calculation of rate base. On April 17, 2019, the Thurston County Superior Court issued a Remand Order, granting a Joint Motion of Avista Corp., Public Counsel and the WUTC to remand the case back to the WUTC. On June 20, 2019, we filed testimony with the WUTC in the remand case. In our testimony we asserted that the potential amount to return to customers is limited to revenues collected on the basis of rates approved in the 2015 general rate cases, and we also asserted that no refund is due to customers. Subsequent to our filing, other parties in the case filed testimony and based on the testimonies filed (including our testimony), we believe the range is $3.6 million to $77.0 million as a refund to customers. While we do not agree as a legal matter with the positions of the other parties to the case, as a practical matter we believe it is probable that ultimately we will refund some amount to customers. As such, as of December 31, 2019 we have recorded a refund liability of $3.6 million, which represents the low-end of the range, as we cannot predict an outcome of this case. See "Note 21 of the Notes to Consolidated Financial Statements" for further discussion of this matter. 2017 General Rate Cases On April 26, 2018, the WUTC issued a final order in our electric and natural gas general rate cases that were originally filed on May 26, 2017. In the order, the WUTC approved new electric rates, effective on May 1, 2018, that increased base rates by 2.2 percent (designed to increase electric revenues by $10.8 million). The net increase in electric base rates was made up of an increase in our base revenue requirement of $23.2 million, an increase of $14.5 million in power supply costs and a decrease of $26.9 million for the impacts of the TCJA, which reflects the federal income tax rate change from 35 percent to 21 percent and the amortization of the regulatory liability for plant excess deferred income taxes that was recorded as of December 31, 2017. While the WUTC authorized an increase in the ERM baseline to reflect increased power supply costs, it directed the parties to examine the functionality and rationale of the Company's power cost modeling and adjust the baseline only in extraordinary circumstances if necessary to more closely match the baseline to actual conditions. For natural gas, the WUTC approved new natural gas base rates, effective on May 1, 2018, that decreased base rates by 2.4 percent (designed to decrease natural gas revenues by $2.1 million). The net decrease in natural gas base rates was made up of an increase in base revenues of $3.4 million that was offset by a decrease of $5.5 million for the impacts from the TCJA, which reflects the federal income tax rate change and the amortization of the regulatory liability for plant-related excess deferred income taxes that was recorded as of December 31, 2017. In addition to the above, the WUTC also ordered, effective June 1, 2018, a one-year temporary reduction of $7.9 million in our revenue requirements for electric and $3.2 million for natural gas, reflecting reductions for the return of tax benefits associated with the non-plant excess deferred income taxes and the customer refund liability that was established in 2018 related to the change in federal income tax expense for the period January 1, 2018 to April 30, 2018. The new rates are based on a ROR of 7.50 percent with a common equity ratio of 48.5 percent and a 9.5 percent ROE. In our original filings, we requested three-year rate plans for electric and natural gas; however, in the final order the WUTC only provided for new rates effective on May 1, 2018. TCJA Proceedings In February 2019, we filed an all-party settlement agreement with the WUTC related to the electric tax benefits associated with the TCJA that were set aside for Colstrip in the 2017 general rate case order (effective May 1, 2018). In the settlement agreement, the parties agreed to utilize $10.9 million of the electric tax benefits to offset costs associated with accelerating the depreciation of Colstrip Units 3 & 4, to reflect a remaining useful life of those units through December 31, 2027. That portion of the settlement agreement was denied. The WUTC has indicated that it will review the TCJA and Colstrip in our 2019 general rate case (discussed below). 2019 General Rate Cases On November 21, 2019, we reached a partial settlement agreement on our electric and natural gas general rate cases, which has been submitted to the WUTC for its consideration. If approved, new rates would take effect April 1, 2020. A second year rate increase was not agreed to in the partial settlement agreement, as was contemplated in our original general rate case filings. AVISTA CORPORATION The partial settlement agreement includes, among other things, agreement among all parties on the electric revenue increase and cost of capital as well as electric and natural gas rate spread and rate design. All parties, with the exception of the Public Counsel, agree on the natural gas base rate increase. The partial settlement agreement also includes agreement among all parties to accelerate the depreciation of Colstrip Units 3 & 4, to reflect a remaining useful life of those units through December 31, 2025. The other remaining issues to be resolved in the case include the ERM-contested issues and the extension of the electric and natural gas decoupling mechanisms. See "Decoupling and Earnings Sharing Mechanisms" section below. As it relates to ERM-contested issues, the primary issue is related to the cost of replacement power incurred in July and August 2018 due to a forced outage at Colstrip Units 3 & 4. That outage occurred due to the plant exceeding certain air quality standards. In testimony filed by WUTC Staff and Public Counsel on January 10, 2020, the parties recommend the WUTC disallow $3.3 million in replacement power costs. Avista Corp. filed testimony on January 23, 2020, and provided support for no disallowance, but if the WUTC believes a disallowance is appropriate, the level of disallowance would be $2.4 million. The parties have agreed that the final ERM rebate determined by the WUTC, after it resolves the remaining ERM contested issues, should be returned to customers over a two-year period. The ERM rebate is approximately $37.0 to $38.0 million with interest. The proposed rates under the partial settlement agreement are designed to increase annual base electric revenues by $28.5 million, or 5.7 percent, and annual natural gas base revenues by $8.0 million, or 8.5 percent, effective April 1, 2020. The partial settlement revenue increases are based on a 9.4 percent ROE with a common equity ratio of 48.5 percent and a rate of return ROR of 7.21 percent. In addition to Avista Corp., the parties to the electric and natural gas rate cases include the Staff of the WUTC, the Public Counsel, the Alliance of Western Energy Consumers, the NW Energy Coalition, The Energy Project, and Sierra Club. The recommendation to the Commission by the parties to approve the partial settlement is not binding on the WUTC itself. We originally filed our general rates cases on April 30, 2019, which were two-year rate plans, and requested the following electric and natural gas base rate changes each year, which were designed to result in the following increases in annual revenues (dollars in millions): Our original requests were based on a proposed ROR of 7.52 percent with a common equity ratio of 50 percent and a 9.9 percent ROE. The WUTC has up to 11 months to review our request and issue a decision. 2020 General Rate Cases We expect to file electric and natural gas general rate cases with the WUTC in the second or third quarter of 2020. Idaho General Rate Cases and Other Proceedings 2017 General Rate Cases On December 28, 2017, the IPUC approved a settlement agreement between us and other parties to our electric and natural gas general rate cases. New rates were effective on January 1, 2018 and January 1, 2019. The settlement agreement was a two-year rate plan and had the following electric and natural gas base rate changes each year, which were designed to result in the following increases in annual revenues (dollars in millions): AVISTA CORPORATION The settlement agreement was based on a ROR of 7.61 percent with a common equity ratio of 50.0 percent and a 9.5 percent ROE. TCJA Proceedings On May 31, 2018, the IPUC approved an all-party settlement agreement related to the income tax benefits associated with the TCJA. Effective June 1, 2018, current customer rates were reduced to reflect the reduction of the federal income tax rate to 21 percent, and the amortization of the regulatory liability for plant-related excess deferred income taxes. This reduction reduces annual electric rates by $13.7 million (or 5.3 percent reduction to base rates) and natural gas rates by $2.6 million (or 6.1 percent reduction to base rates). In March 2019, the IPUC approved an all-party settlement agreement related to the electric tax benefits that were set aside for Colstrip in the 2017 general rate case order. In the approved settlement agreement, the parties agreed to utilize approximately $6.4 million ($5.1 million when tax-effected) of the electric tax benefits to offset costs associated with accelerating the depreciation of Colstrip Units 3 & 4, to reflect a remaining useful life of those units through December 31, 2027. The remaining tax benefits of approximately $5.8 million will be returned to customers through a temporary rate reduction over a period of one year beginning on April 1, 2019. The tax benefits being utilized are related to non-plant excess deferred income taxes, and the customer refund liability that was established in 2018 related to the change in federal income tax expense for the period January 1, 2018 to May 31, 2018. 2019 General Rate Case On October 11, 2019, Avista Corp. and all parties to our electric general rate case reached a settlement agreement that was approved by the IPUC. New rates went into effect on December 1, 2019. The rates that went into effect are designed to decrease annual base electric revenues by $7.2 million (or 2.8 percent), effective December 1, 2019. The settlement revenue decreases are based on a 9.5 percent ROE with a common equity ratio of 50 percent and a rate of return ROR on rate base of 7.35 percent, which is a continuation of current levels. This outcome is in line with our expectations. The primary element of the difference in the agreed upon base revenues in the settlement agreement from our original request is that the settlement includes the continued recovery of costs for our wind generation power purchase agreements, which will include Palouse Wind and Rattlesnake Flat, through the PCA mechanism rather than through base rates. Our original request included an increase of annual electric base revenues of $5.3 million or 2.1 percent, effective January 1, 2020. The electric request was based on a proposed ROR on rate base of 7.55 percent with a common equity ratio of 50 percent and a 9.9 percent ROE, as well as the inclusion of wind power purchase costs in base rates rather than receiving recovery through the PCA. 2020 General Rate Cases We expect to file electric and natural gas general rate cases with the IPUC in the second half of 2020. Oregon General Rate Cases and Other Proceedings 2019 General Rate Case On October 9, 2019, the OPUC approved the all-party settlement agreements filed in the third quarter of 2019. New rates went into effect on January 15, 2020. OPUC approved rates that are designed to increase annual natural gas billed revenues by $3.6 million, or 4.2 percent. The OPUC’s decision reflects a ROR on rate base of 7.24 percent, with a common equity ratio of 50 percent and a 9.4 percent ROE, both of which represent a continuation of existing authorized levels. In addition, the approved settlement agreements included agreement among the parties to a future independent review of our interest rate hedging practices, with any recommendations based on the results and findings in the final report to be applicable only on a prospective basis and do not apply to any prior interest rate hedging activity. TCJA Proceedings In February 2019, the OPUC approved the deferral amount of $3.8 million related to 2018 income tax benefits associated with the TCJA. The 2018 deferred benefits will be returned to customers through a temporary rate reduction over a period of one year beginning March 1, 2019. We continued the deferral of the TCJA benefits during 2019 for later return to customers, until such time as these changes can be reflected in base rates. AVISTA CORPORATION Petition for Judicial Review of the Deferral of Capital Projects In February 2019 and October 2018, the OPUC issued orders which concluded that, contrary to the OPUC's past practice, Oregon statutes that authorize the deferral of expense for later recovery from customers do not authorize the OPUC to allow deferrals of any costs related to capital investments (utility plant). In April 2019, Avista Corp. and other petitioners filed a Petition for Judicial Review with the Oregon Court of Appeals seeking review of the above OPUC orders. The Company cannot predict the outcome of this matter at this time, including whether or not any decision of the court would have retroactive effect. 2020 General Rate Case We expect to file a natural gas general rate case with the OPUC in the first quarter of 2020. AMI Project In March 2016, the WUTC granted our Petition for an Accounting Order to defer and include in a regulatory asset the undepreciated value of our existing Washington electric meters for the opportunity for later recovery. This accounting treatment is related to our plans to replace our existing electric meters with new two-way digital meters and the related software and support services through our AMI project in Washington State. As of December 31, 2019, the estimated future undepreciated value for the existing electric meters was $21.2 million. In September 2017, the WUTC also approved our request to defer the undepreciated net book value of existing natural gas encoder receiver transmitters (ERT) (consistent with the accounting treatment we obtained on our existing electric meters) that will be retired as part of the AMI project. As of December 31, 2019, the estimated future undepreciated value for the existing natural gas ERTs was $4.4 million. Replacement of the electric meters and natural gas ERTs began during the second half of 2018 and is ongoing. In September 2017, the WUTC approved a Petition to defer the depreciation expense associated with the AMI project, along with a carrying charge, and to seek recovery of the deferral and carrying charge in a future general rate case. Cost savings, such as reduced meter reading costs, will occur during the implementation period, and will offset a portion of the AMI costs not being deferred. In May 2017, we filed Petitions with the IPUC and the OPUC requesting a depreciable life of 12.5 years for the meter data management system (MDM) related to the AMI project. Both the IPUC and the OPUC approved our request. In addition, in connection with the 2017 Idaho electric general rate case (discussed above), the settling parties agreed to cost recovery of Idaho's share of the MDM system, effective January 1, 2019. In connection with the approval of the Oregon general rate case settlement in 2017, the OPUC approved cost recovery of Oregon's share of the MDM system, effective November 1, 2017. Alaska Electric Light and Power Company Alaska General Rate Case In November 2017, the RCA approved an all-party settlement agreement related to AEL&P's electric general rate case, which was originally filed in September 2016. The settlement agreement was designed to increase base electric revenue by 3.86 percent or $1.3 million, making permanent the interim rate increase approved by the RCA in 2016. The agreement reflects an 8.91 percent ROR with a common equity ratio of 58.18 percent and an 11.95 percent ROE. TCJA Proceedings The RCA approved a settlement agreement between AEL&P and the Attorney General filed on June 15, 2018 (Order 3). Per Order 3, effective August 1, 2018, AEL&P reduced firm customer base rates by 6.7 percent ($2.4 million annually), to reflect income tax expense reductions associated with the TCJA. The RCA also approved AEL&P's proposal to refund to customers a one-time credit equal to the 6.7 percent rate reduction for bills between January 1 and July 31, 2018. AEL&P completed all one-time credits during the third quarter of 2018. The impact of the TCJA on AEL&P’s deferred income taxes will be addressed in AEL&P’s next general rate case, due to be filed by August 30, 2021. Avista Utilities Purchased Gas Adjustments PGAs are designed to pass through changes in natural gas costs to Avista Utilities' customers with no change in utility margin (operating revenues less resource costs) or net income. In Oregon, we absorb (cost or benefit) 10 percent of the difference between actual and projected natural gas costs included in base retail rates for supply that is not hedged. Total net deferred natural gas costs among all jurisdictions were a net liability of $3.2 million as of December 31, 2019 and a liability of $40.7 million as of December 31, 2018. These deferred natural gas cost balances represent amounts due to customers. AVISTA CORPORATION The following PGAs went into effect in our various jurisdictions during 2018 through 2019: (1) Due to declining wholesale natural gas prices that occurred since the 2017 PGAs were filed and went into effect, we filed, and the respective commissions approved, out of cycle PGAs to reduce customer rates and pass through expected lower costs during the winter heating months, rather than waiting until the next scheduled PGA. Power Cost Deferrals and Recovery Mechanisms Deferred power supply costs are recorded as a deferred charge or liability on the Consolidated Balance Sheets for future prudence review and recovery or rebate through retail rates. The power supply costs deferred include certain differences between actual net power supply costs incurred by Avista Utilities and the costs included in base retail rates. These differences primarily result from changes in: • short-term wholesale market prices and sales and purchase volumes, • the level, availability and optimization of hydroelectric generation, • the level and availability of thermal generation (including changes in fuel prices), • retail loads, and • sales of surplus transmission capacity. For our Washington customers, the ERM is an accounting method used to track certain differences between Avista Utilities' actual power supply costs, net of wholesale sales and sales of fuel, and the amount included in base retail rates. Total net deferred power costs under the ERM were a liability of $37.0 million as of December 31, 2019 and a liability $34.4 million as of December 31, 2018. These deferred power cost balances represent amounts due to customers. Pursuant to WUTC requirements, should the cumulative deferral balance exceed $30 million in the rebate or surcharge direction, we must make a filing with the WUTC to adjust customer rates to either return the balance to customers or recover the balance from customers. Under the ERM, Avista Utilities absorbs the cost or receives the benefit from the initial amount of power supply costs in excess of or below the level in retail rates, which is referred to as the deadband. The annual (calendar year) deadband amount is $4.0 million. The following is a summary of the ERM: Under the ERM, Avista Utilities makes an annual filing on or before April 1 of each year to provide the opportunity for the WUTC staff and other interested parties to review the prudence of and audit the ERM deferred power cost transactions for the prior calendar year. AVISTA CORPORATION The cumulative rebate balance exceeds $30 million and as a result, our 2019 filing contained a proposed rate refund, effective July 1, 2019 over a three-year period. During the second quarter of 2019 we filed a motion to consolidate this ERM filing with our 2019 Washington general rate case (which was filed on April 30, 2019). In our motion, we requested that the WUTC withhold the refund associated with the ERM for use in the 2019 general rate case rather than passing it back to customers over the three-year period that was proposed in the ERM filing. Our motion was approved by the WUTC and the ERM refund was consolidated with the 2019 Washington general rate case. However, in late 2019, the WUTC Staff granted a motion to remove the ERM from the 2019 general rate case and it is now being considered in a separate docket. In the 2019 Washington general rate case proposed settlement, new authorized power supply rates were not agreed to as it relates to the ERM, and as such, our authorized power supply rates are still based on a 2017 test year. We are currently participating in workshops with the WUTC to determine an appropriate methodology for updating the authorized power supply rates prospectively. New authorized rates will not be determined until the completion of the workshops sometime in 2020. Avista Utilities has a PCA mechanism in Idaho that allows us to modify electric rates on October 1 of each year with IPUC approval. Under the PCA mechanism, we defer 90 percent of the difference between certain actual net power supply expenses and the amount included in base retail rates for our Idaho customers. The October 1 rate adjustments recover or rebate power supply costs deferred during the preceding July-June twelve-month period. Total net power supply costs deferred under the PCA mechanism were an asset of $0.3 million as of December 31, 2019 and a liability of $7.6 million as of December 31, 2018. Deferred power cost assets represent amounts due from customers and liabilities represent amounts due to customers. Decoupling and Earnings Sharing Mechanisms Decoupling (also known as a FCA in Idaho) is a mechanism designed to sever the link between a utility's revenues and consumers' energy usage. In each of our jurisdictions, Avista Utilities' electric and natural gas revenues are adjusted so as to be based on the number of customers in certain customer rate classes and assumed "normal" kilowatt hour and therm sales, rather than being based on actual kilowatt hour and therm sales. The difference between revenues based on the number of customers and "normal" sales and revenues based on actual usage is deferred and either surcharged or rebated to customers beginning in the following year. Only residential and certain commercial customer classes are included in our decoupling mechanisms. Washington Decoupling and Earnings Sharing In Washington, the WUTC approved our decoupling mechanisms for electric and natural gas for a five-year period beginning January 1, 2015. In February 2019, the WUTC approved an all-party agreement that extends the life of the mechanisms through the end of our next general rate case, or April 1, 2020, whichever comes first. In our 2019 Washington general rate cases we have requested an extension of the mechanisms for an additional five-year term. The extension is contested by Public Counsel. Electric and natural gas decoupling surcharge rate adjustments to customers are limited to a 3 percent increase on an annual basis, with any remaining surcharge balance carried forward for recovery in a future period. There is no limit on the level of rebate rate adjustments. The decoupling mechanisms each include an after-the-fact earnings test. At the end of each calendar year, separate electric and natural gas earnings calculations are made for the calendar year just ended. These earnings tests reflect actual decoupled revenues, normalized power supply costs and other normalizing adjustments. If we earn more than our authorized ROR in Washington, 50 percent of excess earnings are rebated to customers through adjustments to existing decoupling surcharge or rebate balances. Idaho FCA Mechanism In Idaho, the IPUC approved the implementation of FCAs for electric and natural gas (similar in operation and effect to the Washington decoupling mechanisms) for an initial term of three years, beginning January 1, 2016. During the first quarter of 2018, the FCA in Idaho was extended for a one-year term through December 31, 2019. On December 13, 2019, the IPUC approved an extension of the FCAs through March 31, 2025. Oregon Decoupling Mechanism In February 2016, the OPUC approved the implementation of a decoupling mechanism for natural gas, similar to the Washington and Idaho mechanisms described above. The decoupling mechanism became effective on March 1, 2016. There was an opportunity for interested parties to review the mechanism and recommend changes, if any, by September 2019. Changes related to deferral interest rates were recommended by the parties in our 2019 general rate case and were implemented effective January 15, 2020. In Oregon, an earnings review is conducted on an annual basis. In the annual earnings review, if we earn more than 100 basis points above our allowed return on equity, one-third of the earnings above the 100 basis points would be deferred and later rebated to customers. AVISTA CORPORATION Cumulative Decoupling and Earnings Sharing Balances Total net cumulative decoupling deferrals among all jurisdictions were regulatory assets of $24.3 million as of December 31, 2019 and $13.9 million as of December 31, 2018. These decoupling assets represent amounts due from customers. Total net earnings sharing balances among all jurisdictions were regulatory liabilities of $0.7 million as of December 31, 2019 and $1.5 million as of December 31, 2018. These earnings sharing liabilities represent amounts due to customers. See "Results of Operations - Avista Utilities" for further discussion of the amounts recorded to operating revenues in 2018 and 2019 related to the decoupling and earnings sharing mechanisms. Results of Operations - Overall The following provides an overview of changes in our Consolidated Statements of Income. More detailed explanations are provided, particularly for operating revenues and operating expenses, in the business segment discussions (Avista Utilities, AEL&P and the other businesses) that follow this section. The balances included below for utility operations reconcile to the Consolidated Statements of Income. 2019 compared to 2018 The following graph shows the total change in net income attributable to Avista Corp. shareholders for 2019 to 2018, as well as the various factors that caused such change (dollars in millions): Utility revenues decreased at both Avista Utilities and AEL&P. Avista Utilities' revenues decreased primarily from a decrease in decoupling rates and PGA rates, which are included in rates billed to retail customers as well as a provision for customer rate refunds related to the 2015 Washington general rate cases. These decreases were partially offset by general rate increases and customer growth. AEL&P's revenues decreased from a reduction in sales volumes due to weather that was warmer than normal and warmer than the prior year. Non-utility revenues decreased due to the sale of METALfx, which occurred in April 2019. See "Note 25 of the Notes to Consolidated Financial Statements" for further discussion. Utility resource costs decreased at both Avista Utilities and AEL&P. While there was a decrease in gross resource costs at Avista Utilities, there was an increase in power purchase prices and thermal fuel costs. The decrease at AEL&P was due to a decrease in deferred power supply expenses, as well as the adoption of the new lease standard on January 1, 2019, which resulted in the reclassification of Snettisham power purchase costs from resource costs to depreciation and amortization and interest expense in 2019. See "Notes 2 and 5 of the Notes to Consolidated Financial Statements" for further information regarding the adoption of the new lease standard. The increase in utility operating expenses was due to an increase at Avista Utilities primarily related to increases in generation and distribution operating and maintenance costs, as well as a $7 million donation to the Avista Foundation to support the local AVISTA CORPORATION community, and increases in pensions and other benefits. The merger transaction costs are related to the terminated acquisition by Hydro One. These costs increased for 2019 because they included financial advisers' fees, legal fees, consulting fees and employee time, whereas 2018 costs consisted primarily of employee time incurred directly related to the transaction. None of the acquisition costs are being passed through to customers. Utility depreciation and amortization increased due to additions to utility plant and amortization of the Snettisham finance lease, which was reclassed from utility resource costs to depreciation and amortization, effective January 1, 2019. See "Notes 2 and 5 of the Notes to Consolidated Financial Statements" for further information regarding the Snettisham lease and the adoption of the new lease standard. Also, a March 2019 settlement in Idaho allowed us to utilize approximately $6.4 million ($5.1 million when tax-effected) of the electric tax benefits to offset costs associated with accelerating the depreciation of Colstrip Units 3 & 4 to reflect a remaining useful life of those units through December 31, 2027. This amount was recorded as a one-time charge to depreciation expense in the second quarter of 2019, with an offsetting amount included in income tax expense. Merger termination fee relates to the amount received from the terminated acquisition by Hydro One. See "Note 24 of the Notes to Consolidated Financial Statements" for further information. Income taxes increased primarily due to increased income. This was partially offset by the Idaho settlement related to the accelerated depreciation of Colstrip Units 3 & 4 discussed above and by our effective tax rate decreasing to 13.8 percent for 2019 compared to 16.0 percent for 2018. The increase in other was primarily related to a decrease in non-utility other operating expenses due to the sale of METALfx during the second quarter of 2019 and also due to lower property taxes. Non-GAAP Financial Measures The following discussion for Avista Utilities includes two financial measures that are considered “non-GAAP financial measures,” electric utility margin and natural gas utility margin. In the AEL&P section, we include a discussion of utility margin, which is also a non-GAAP financial measure. Generally, a non-GAAP financial measure is a numerical measure of a company's financial performance, financial position or cash flows that excludes (or includes) amounts that are included (excluded) in the most directly comparable measure calculated and presented in accordance with GAAP. Electric utility margin is electric operating revenues less electric resource costs, while natural gas utility margin is natural gas operating revenues less natural gas resource costs. The most directly comparable GAAP financial measure to electric and natural gas utility margin is utility operating revenues as presented in "Note 23 of the Notes to Consolidated Financial Statements." The presentation of electric utility margin and natural gas utility margin is intended to enhance understanding of our operating performance. We use these measures internally and believe they provide useful information to investors in their analysis of how changes in loads (due to weather, economic or other conditions), rates, supply costs and other factors impact our results of operations. Changes in loads, as well as power and natural gas supply costs, are generally deferred and recovered from customers through regulatory accounting mechanisms. Accordingly, the analysis of utility margin generally excludes most of the change in revenue resulting from these regulatory mechanisms. We present electric and natural gas utility margin separately below for Avista Utilities since each business has different cost sources, cost recovery mechanisms and jurisdictions, so we believe that separate analysis is beneficial. These measures are not intended to replace utility operating revenues as determined in accordance with GAAP as an indicator of operating performance. Reconciliations of operating revenues to utility margin are set forth below. AVISTA CORPORATION Results of Operations - Avista Utilities 2019 compared to 2018 Utility Operating Revenues The following graphs present Avista Utilities' electric operating revenues and megawatt-hour (MWh) sales for the years ended December 31 (dollars in millions and MWhs in thousands): (1) This balance includes public street and highway lighting, which is considered part of retail electric revenues, and deferrals/amortizations to customers related to federal income tax law changes. AVISTA CORPORATION The following table presents the current year deferrals and the amortization of prior year decoupling balances that are reflected in utility electric operating revenues for the years ended December 31 (dollars in thousands): (a) Positive amounts are increases in decoupling revenue in the current year and will be surcharged to customers in future years. Negative amounts are decreases in decoupling revenue in the current year and will be rebated to customers in future years. (b) Negative amounts are decreases in decoupling revenue in the current year and are related to the amortization of surcharge balances that resulted in prior years and are being surcharged to customers (causing a corresponding increase in retail revenue from customers) in the current year. Positive amounts are increases in decoupling revenue in the current year and are related to the amortization of rebate balances that resulted in prior years and are being refunded to customers (causing a corresponding decrease in retail revenue from customers) in the current year. Total electric revenues decreased $8.5 million for 2019 as compared to 2018, primarily reflecting the following: • a $0.7 million decrease in retail electric revenues due to a decrease in revenue per MWh (decreased revenues $7.3 million), partially offset by an increase in total MWhs sold (increased revenues $6.6 million). ◦ The decrease in revenue per MWh was primarily due to a decrease in decoupling rates (as our decoupling surcharges were larger in prior years, which resulted in higher surcharge rates in 2018 as compared to rebates in 2019) and decreases associated with the lower corporate tax rate. There was also a general rate decrease in Idaho (effective December 1, 2019). These decreases were partially offset by general rate increases in Washington (effective May 1, 2018) and Idaho (effective January 1, 2019). ◦ The increase in total retail MWhs sold was the result of weather that was cooler than the prior year during the first and fourth quarter heating seasons (which increased electric heating loads), and residential and commercial customer growth. Compared to 2018, residential electric use per customer increased 2 percent and commercial use per customer was consistent between years. Heating degree days in Spokane were 3 percent above normal and 11 percent above 2018. Cooling degree days in Spokane were 8 percent below normal and 6 percent below the prior year. • an $11.8 million decrease in wholesale electric revenues due to a decrease in sales volumes (decreased revenues $22.2 million), partially offset by an increase in sales prices (increased revenues $10.4 million). The fluctuation in volumes and prices was primarily the result of our optimization activities. • a $14.2 million decrease in sales of fuel due to a decrease in sales of natural gas fuel as part of thermal generation resource optimization activities. For 2019, $48.0 million of these sales were made to our natural gas operations and are included as intracompany revenues and resource costs. For 2018, $30.6 million of these sales were made to our natural gas operations. • a $3.8 million increase in electric revenue due to decoupling and was primarily the result of lower amortizations of prior year decoupling surcharge balances. • a $14.3 million increase in other electric revenues primarily related to federal income tax law changes that lowered the corporate tax rate from 35 percent to 21 percent. During the first quarter of 2018, our customers' rates had the 35 percent corporate tax rate built in from prior general rate cases and we were collecting this amount through retail revenues. At the same time, we were deferring the difference between the 35 percent and the 21 percent through other revenues. Effective May 1, 2018 in Washington and June 1, 2018 in Idaho, base rates reflect the lower 21 percent corporate tax. At that time, we began returning the deferred amounts to customers through other revenue. The tax amounts included in other revenue was partially offset by the accrual for customer refunds associated with the 2015 Washington general rate case. AVISTA CORPORATION The following graphs present Avista Utilities' natural gas operating revenues and therms delivered for the years ended December 31 (dollars in millions and therms in thousands): (1) This balance includes interruptible and industrial revenues, which are considered part of retail natural gas revenues, and deferrals/amortizations to customers related to federal income tax law changes. The following table presents the current year deferrals and the amortization of prior year decoupling balances that are reflected in natural gas operating revenues for the years ended December 31 (dollars in thousands): AVISTA CORPORATION (a) Positive amounts are increases in decoupling revenue in the current year and will be surcharged to customers in future years. Negative amounts are decreases in decoupling revenue in the current year and will be rebated to customers in future years. (b) Positive amounts are increases in decoupling revenue in the current year and are related to the amortization of rebate balances that resulted in prior years and are being refunded to customers (causing a corresponding decrease in retail revenue from customers) in the current year. Negative amounts are decreases in decoupling revenue in the current year and are related to the amortization of surcharge balances that resulted in prior years and are being surcharged to customers (causing a corresponding increase in retail revenue from customers) in the current year. Total natural gas revenues increased $16.5 million for 2019 as compared to 2018, primarily reflecting the following: • a $5.4 million increase in retail natural gas revenues due to an increase in volumes (increased revenues $32.3 million), partially offset by lower retail rates (decreased revenues $26.9 million). ◦ Retail natural gas sales increased in 2019 as compared to 2018 due to cooler weather during the heating season, and residential and commercial customer growth. Compared to 2018, residential use per customer increased 9 percent and commercial use per customer increased 12 percent. Heating degree days in Spokane were 3 percent above normal for 2019, and 11 percent above 2018. Heating degree days in Medford were 3 percent above normal for 2019, and 7 percent above 2018. ◦ Lower retail rates were due to PGAs and rate decreases associated with the lower corporate tax rate and decoupling rate decreases (as our decoupling surcharges were larger in prior years, which resulted in higher surcharge rates in 2018 as compared to rebates in 2019), partially offset by general rate increases in Washington (effective May 1, 2018) and Idaho (effective January 1, 2019). • a $2.1 million decrease in wholesale natural gas revenues due to a decrease in prices (decreased revenues $21.9 million), partially offset by an increase in volumes (increased revenues $19.8 million). In 2019, $65.4 million of these sales were made to our electric generation operations and are included as intracompany revenues and resource costs. In 2018, $44.7 million of these sales were made to our electric generation operations. Differences between revenues and costs from sales of resources in excess of retail load requirements and from resource optimization are accounted for through the PGA mechanisms. • a $4.9 million increase in natural gas revenue due to decoupling primarily related to amortizations of prior year decoupling balances. • an $8.8 million increase in other natural gas revenues primarily related to federal income tax law changes that lowered the corporate tax rate from 35 percent to 21 percent. During the first quarter of 2018, our customers' rates had the 35 percent corporate tax rate built in from prior general rate cases and we were collecting this amount through retail revenues. At the same time, we were deferring the difference between the 35 percent and the 21 percent through other revenues. Effective May 1, 2018 in Washington and June 1, 2018 in Idaho, base rates reflect the lower 21 percent corporate tax. At that time, we began returning the deferred amounts to customers through other revenue. The following table presents Avista Utilities' average number of electric and natural gas retail customers for the years ended December 31: AVISTA CORPORATION Utility Resource Costs The following graphs present Avista Utilities' resource costs for the years ended December 31 (dollars in millions): Total electric resource costs in the graph above include intracompany resource costs of $65.4 million and $44.7 million for 2019 and 2018, respectively. Total electric resource costs decreased $17.8 million for 2019 as compared to 2018 primarily due to the following: • a $2.0 million decrease in power purchased due to a decrease in the volume of power purchases (decreased costs $26.8 million), partially offset by an increase in wholesale prices (increased costs $24.8 million). The fluctuation in volumes and prices was primarily the result of our optimization activities. • an $11.1 million increase in fuel for generation primarily due to an increase in thermal generation resulting from lower hydroelectric generation, as well as an increase in natural gas fuel prices. • a $7.2 million decrease in other fuel costs. • a $19.6 million decrease from amortizations and deferrals of power costs (included in other resource costs in the graph above). This change was primarily the result of higher net power supply costs. • a $1.8 million decrease in other regulatory amortizations (included in other resource costs in the graph above). AVISTA CORPORATION Total natural gas resource costs in the graph above include intracompany resource costs of $48.0 million and $30.6 million for 2019 and 2018, respectively. Total natural gas resource costs increased $13.2 million for 2019 as compared to 2018 primarily reflecting the following: • a $48.2 million increase in natural gas purchased due to an increase in total therms purchased (increased costs $34.7 million) and an increase in the price of natural gas (increased costs $13.5 million). • a $38.6 million decrease from amortizations and deferrals of natural gas costs (included in other resource costs in the graph above). • a $3.5 million increase in other regulatory amortizations (included in other resource costs in the graph above). Utility Margin The following table reconciles Avista Utilities' operating revenues, as presented in "Note 23 of the Notes to Consolidated Financial Statements" to the Non-GAAP financial measure utility margin for the years ended December 31 (dollars in millions): Electric utility margin increased $9.3 million and natural gas utility margin increased $3.4 million. Electric utility margin was positively impacted during 2019 by general rate increases in Idaho (effective January 1, 2019) and Washington (effective May 1, 2018), as well as customer growth. This was partially offset by a general rate decrease in Idaho (effective December 1, 2019) and higher net power supply costs for 2019 as compared to 2018 due to higher than authorized power purchase prices, higher thermal fuel costs and lower hydroelectric generation. For 2019, we recognized a pre-tax benefit of $4.4 million under the ERM in Washington compared to a benefit of $6.1 million for 2018. In addition, electric utility margin was negatively affected by the accrual for customer refunds of $3.6 million related to the 2015 Washington general rate case. Natural gas utility margin was positively affected by general rate increases in Washington (effective May 1, 2018) and Idaho (effective January 1, 2019), and customer growth. Intracompany revenues and resource costs represent purchases and sales of natural gas between our natural gas distribution operations and our electric generation operations (as fuel for our generation plants). These transactions are eliminated in the AVISTA CORPORATION presentation of total results for Avista Utilities and in the consolidated financial statements but are included in the separate results for electric and natural gas presented above. Results of Operations - Alaska Electric Light and Power Company 2019 compared to 2018 Net income for AEL&P was $7.5 million for the year ended December 31, 2019, compared to $8.3 million for 2018. The following table presents AEL&P's operating revenues, resource costs and resulting utility margin for the years ended December 31 (dollars in millions): Electric revenues decreased for 2019 primarily due to lower sales volumes to residential and commercial customers for 2019 as compared to 2018. This resulted from weather that was warmer than normal and warmer than the prior year, as well as lower hydroelectric generation, which prevented AEL&P from making sales to an interruptible customer (discussed further below). Resource costs decreased from the prior year due to the adoption of the new lease standard on January 1, 2019, which resulted in the reclassification of Snettisham power purchase costs from resource costs to depreciation and amortization and interest expense in 2019. See "Note 2 and 5 of the Notes to Consolidated Financial Statements" for further information regarding the adoption of the new lease standard. In addition, AEL&P had low hydroelectric generation during 2019, which limited energy provided to their interruptible customers. A portion of the sales to interruptible customers is used to reduce the overall cost of power to AEL&P's firm customers. When interruptible sales are below a certain threshold, AEL&P recognizes a regulatory asset and records a reduction to deferred power supply costs (resource costs) to reflect a future billable amount to its firm customers when the cost of power rates are reset. Results of Operations - Other Businesses 2019 compared to 2018 The net income from these operations was $5.5 million for 2019 compared to a net loss of $6.7 million for 2018. In 2019, we had net investment gains associated with our equity investments compared to net investment losses during 2018. During the second quarter of 2019, we sold METALfx, which resulted in a net gain after-tax of approximately $3.3 million. See "Note 25 of the Notes to Consolidated Financial Statements" for further discussion of the sale of METALfx. Accounting Standards to be Adopted in 2020 At this time, we are not expecting the adoption of accounting standards to have a material impact on our financial condition, results of operations and cash flows in 2020. For information on accounting standards adopted in 2019 and accounting standards expected to be adopted in future periods, see “Note 2 of the Notes to Consolidated Financial Statements.” Critical Accounting Policies and Estimates The preparation of our consolidated financial statements in conformity with GAAP requires us to make estimates and assumptions that affect amounts reported in the consolidated financial statements. Changes in these estimates and assumptions are considered reasonably possible and may have a material effect on our consolidated financial statements and thus actual results could differ from the amounts reported and disclosed herein. The following accounting policies represent those that our management believes are particularly important to the consolidated financial statements and require the use of estimates and assumptions: • Regulatory accounting, in accordance with Financial Accounting Standards Board Accounting Standards Codification Topic 980, Regulated Operations, among other things, requires that costs and/or obligations that are probable of recovery through rates charged to our customers, but are not yet reflected in rates, not be reflected in our Consolidated Statements of Income until the period in which they are reflected in rates and matching revenues are recognized. Meanwhile, these costs and/or obligations are deferred and reflected on our Consolidated Balance Sheets as regulatory assets or liabilities. The provisions of the accounting guidance may result in recognition of revenues and expenses in time periods that are different than non-rate-regulated enterprises. In addition, regulatory accounting requires that decoupling revenue, unlike deferred costs, be recognized in the Consolidated Statements of Income during the period in which it occurs (i.e. during the period of revenue shortfall or excess due to fluctuations in customer usage), subject AVISTA CORPORATION to certain limitations, and a regulatory asset or liability is established which will be surcharged or rebated to customers in future periods. GAAP requires that for any alternative revenue program, like decoupling, the revenue must be expected to be collected from customers within 24 months of the deferral to qualify for recognition in the current period. Accordingly, we make estimates of the amount of this revenue that will be collected within 24 months. Any amounts included in the Company's decoupling program that are not expected to be collected from customers within 24 months are not recorded in the financial statements until the period in which revenue recognition criteria are met. Finally, with respect to all of our regulatory assets, we review regulatory precedents and, based on those precedents, we make the assumption that we will be allowed recovery of these costs via retail rates in future periods. If we were no longer allowed to apply regulatory accounting or no longer allowed recovery of these costs, we could be required to recognize significant write-offs of regulatory assets and liabilities in the Consolidated Statements of Income. See "Notes 1 and 22 of the Notes to Consolidated Financial Statements" for further discussion of our regulatory accounting policy and mechanisms. • Interest rate swap derivative asset and liability accounting, where we estimate the fair value of outstanding interest rate swap derivatives and offset the derivative asset or liability with a regulatory asset or liability. Upon settlement of interest rate swap derivatives, the regulatory asset or liability is amortized as a component of interest expense over the term of the associated debt. We record this offset because, based on the prior practice of the regulatory commissions, we assume that we will be allowed recovery through the ratemaking process. If we concluded that recovery of interest rate swap related payments were no longer probable, we would be required to derecognize the related regulatory assets and liabilities and we could be required to recognize significant changes in fair value or settlements of these interest rate swap derivatives on a regular basis in the Consolidated Statements of Income, which could lead to significant fluctuations in net income. • Pension Plans and Other Postretirement Benefit Plans, discussed in further detail below. • Contingencies, related to unresolved regulatory, legal and tax issues as to which there is inherent uncertainty for the ultimate outcome of the respective matter. We accrue a loss contingency if it is probable that an asset is impaired or a liability has been incurred and the amount of the loss or impairment can be reasonably estimated. We also disclose losses that do not meet these conditions for accrual, if there is a reasonable possibility that a potential loss may be incurred. For all material contingencies, we have made a judgment as to the probability of a loss occurring and as to whether or not the amount of the loss can be reasonably estimated. However, no assurance can be given as to the ultimate outcome of any particular contingency. See "Notes 1 and 21 of the Notes to Consolidated Financial Statements" for further discussion of our commitments and contingencies. Pension Plans and Other Postretirement Benefit Plans - Avista Utilities We have a defined benefit pension plan covering substantially all regular full-time employees at Avista Utilities that were hired prior to January 1, 2014. For substantially all regular non-union full-time employees at Avista Utilities who were hired on or after January 1, 2014, a defined contribution 401(k) plan replaced the defined benefit pension plan. Union employees hired on or after January 1, 2014 are still covered under the defined benefit pension plan. The Finance Committee of the Board of Directors approves investment policies, objectives and strategies that seek an appropriate return for the pension plan and it reviews and approves changes to the investment and funding policies. We have contracted with an independent investment consultant who is responsible for monitoring the individual investment managers. The investment managers’ performance and related individual fund performance is reviewed at least quarterly by an internal benefits committee and by the Finance Committee to monitor compliance with our established investment policy objectives and strategies. Our pension plan assets are invested in debt securities and mutual funds, trusts and partnerships that hold marketable debt and equity securities, real estate and absolute return funds. In seeking to obtain a return that aligns with the funded status of the pension plan, the investment consultant recommends allocation percentages by asset classes. These recommendations are reviewed by the internal benefits committee, which then recommends their adoption by the Finance Committee. The Finance Committee has established target investment allocation percentages by asset classes and also investment ranges for each asset class. The target investment allocation percentages are typically the midpoint of the established range. See “Note 10 of the Notes to Consolidated Financial Statements” for the target investment allocation percentages. We also have a Supplemental Executive Retirement Plan (SERP) that provides additional pension benefits to certain executive officers and others whose benefits under the pension plan are reduced due to the application of Section 415 of the Internal Revenue Code of 1986 and the deferral of salary under deferred compensation plans. AVISTA CORPORATION Pension costs (including the SERP) were $26.9 million for 2019, $22.8 million for 2018 and $26.5 million for 2017. Of our pension costs (excluding the SERP), approximately 60 percent are expensed and 40 percent are capitalized consistent with labor charges. The costs related to the SERP are expensed. Our costs for the pension plan are determined in part by actuarial formulas that are dependent upon numerous factors resulting from actual plan experience and assumptions of future experience. Pension costs are affected by among other things: • employee demographics (including age, compensation and length of service by employees), • the amount of cash contributions we make to the pension plan, • the actual return on pension plan assets, • expected return on pension plan assets, • discount rate used in determining the projected benefit obligation and pension costs, • assumed rate of increase in employee compensation, • life expectancy of participants and other beneficiaries, and • expected method of payment (lump sum or annuity) of pension benefits. In accordance with accounting standards, changes in pension plan obligations associated with these factors may not be immediately recognized as pension costs in our Consolidated Statement of Income, but we generally recognize the change in future years over the remaining average service period of pension plan participants. As such, our costs recorded in any period may not reflect the actual level of cash benefits provided to pension plan participants. We revise the key assumption of the discount rate each year. In selecting a discount rate, we consider yield rates at the end of the year for highly rated corporate bond portfolios with cash flows from interest and maturities similar to that of the expected payout of pension benefits. The expected long-term rate of return on plan assets is reset or confirmed annually based on past performance and economic forecasts for the types of investments held by our plan. The following chart reflects the assumptions used each year for the pension discount rate (exclusive of the SERP), the expected long-term return on plan assets and the actual return on plan assets and their impacts to the pension plan associated with the change in assumption (dollars in millions): (a) The SERP has no plan assets. The plan assets in this disclosure are for the pension plan only. The following chart reflects the sensitivities associated with a change in certain actuarial assumptions by the indicated percentage (dollars in millions): AVISTA CORPORATION * Changes in the expected return on plan assets would not affect our projected benefit obligation. We provide certain health care and life insurance benefits for substantially all of our retired employees. We accrue the estimated cost of postretirement benefit obligations during the years that employees provide service. Assumed health care cost trend rates have a significant effect on the amounts reported for our postretirement plans. A one-percentage-point increase in the assumed health care cost trend rate for each year would increase our accumulated postretirement benefit obligation as of December 31, 2019 by $13.9 million and the service and interest cost by $0.8 million. A one-percentage-point decrease in the assumed health care cost trend rate for each year would decrease our accumulated postretirement benefit obligation as of December 31, 2019 by $10.7 million and the service and interest cost by $0.6 million. Liquidity and Capital Resources Overall Liquidity Avista Corp.'s consolidated operating cash flows are primarily derived from the operations of Avista Utilities. The primary source of operating cash flows for Avista Utilities is revenues from sales of electricity and natural gas. Significant uses of cash flows from Avista Utilities include the purchase of power, fuel and natural gas, and payment of other operating expenses, taxes and interest, with any excess being available for other corporate uses such as capital expenditures and dividends. We design operating and capital budgets to control operating costs and to direct capital expenditures to choices that support immediate and long-term strategies, particularly for our regulated utility operations. In addition to operating expenses, we have continuing commitments for capital expenditures for construction and improvement of utility facilities. Our annual net cash flows from operating activities usually do not fully support the amount required for annual utility capital expenditures. As such, from time-to-time, we need to access long-term capital markets in order to fund these needs as well as fund maturing debt. See further discussion at “Capital Resources.” We periodically file for rate adjustments for recovery of operating costs and capital investments and to seek the opportunity to earn reasonable returns as allowed by regulators. Avista Utilities has regulatory mechanisms in place that provide for the deferral and recovery of the majority of power and natural gas supply costs. However, when power and natural gas costs exceed the levels currently recovered from retail customers, net cash flows are negatively affected. Factors that could cause purchased power and natural gas costs to exceed the levels currently recovered from our customers include, but are not limited to, higher prices in wholesale markets when we buy energy or an increased need to purchase power in the wholesale markets, and a lack of regulatory approval for higher authorized net power supply costs through general rate case decisions. Factors beyond our control that could result in an increased need to purchase power in the wholesale markets include, but are not limited to: • increases in demand (due to either weather or customer growth), • lower streamflows for hydroelectric generation, • unplanned outages at generating facilities, and • failure of third parties to deliver on energy or capacity contracts. In addition to the above, Avista Utilities enters into derivative instruments to hedge our exposure to certain risks, including fluctuations in commodity market prices, foreign exchange rates and interest rates (for purposes of issuing long-term debt in the future). These derivative instruments often require collateral (in the form of cash or letters of credit) or other credit enhancements, or reductions or terminations of a portion of the contract through cash settlement, in the event of a downgrade in the Company's credit ratings or changes in market prices. In periods of price volatility, the level of exposure can change significantly. As a result, sudden and significant demands may be made against the Company's credit facilities and cash. See “Enterprise Risk Management - Credit Risk Liquidity Considerations” below. AVISTA CORPORATION We monitor the potential liquidity impacts of changes to energy commodity prices and other increased operating costs for our utility operations. We believe that we have adequate liquidity to meet such potential needs through our committed lines of credit. As of December 31, 2019, we had $196.2 million of available liquidity under the Avista Corp. committed line of credit and $21.5 million under the AEL&P committed line of credit. With our $400.0 million credit facility that expires in April 2021 and AEL&P's $25.0 million credit facility that expires in November 2024, we believe that we have adequate liquidity to meet our needs for the next 12 months. Review of Consolidated Cash Flow Statement 2019 compared to 2018 Consolidated Operating Activities Net cash provided by operating activities was $398.2 million for 2019 compared to $361.9 million for 2018. The increase in net cash provided by operations was primarily the result of increased net income that included the receipt of the $103.0 million merger termination fee from Hydro One that is reflected in net income for 2019. The termination fee was used for reimbursing our transaction costs incurred from 2017 to 2019, which totaled approximately $51.0 million, including income taxes. The balance of the termination fee was used for general corporate purposes and reduced our need for external financing. Our total transaction costs were $19.7 million (pre-tax) for 2019 and we also incurred approximately $15.7 million in taxes in 2019 (net of $1.8 million in tax benefits recaptured from 2017 and 2018). For further information, see "Notes 21 and 24 of the Notes to Consolidated Financial Statements.” In addition, the settlement of interest rate swaps increased operating cash flows as we paid a net amount of $13.3 million during 2019 compared to $26.6 million paid during 2018. Also, collateral posted for derivative instruments decreased by $64.0 million in 2019 compared to an increase of $4.1 million due to fluctuations in market prices of our outstanding energy commodity derivatives. The increases above, were partially offset by power and natural gas deferrals which increased during 2019 due to higher natural gas prices during the year (which decreased cash flows by $45.9 million) as compared to an increase to operating cash flows of $10.3 million in 2018. Consolidated Investing Activities Net cash used in investing activities was $445.5 million for 2019, an increase compared to $440.4 million for 2018. During 2019, we paid $442.5 million for utility capital expenditures, compared to $424.4 million for 2018. The increase in utility capital expenditures was partially offset by $16.5 million of proceeds related to the sale of METALfx. For further information, see "Note 25 of the Notes to Consolidated Financial Statements." Consolidated Financing Activities Net cash provided by financing activities was $42.5 million for 2019 compared to $77.0 million for 2018. The decrease in financing cash flows was primarily the result of changes in short-term borrowings. In 2018, because we issued an insignificant amount of common stock due to the now terminated Hydro One transaction, we had to increase short-term borrowings to finance capital expenditures and for other corporate purposes. The decrease in short-term borrowings was partially offset by the net issuance of $64.6 million of common stock. AVISTA CORPORATION Capital Resources Capital Structure Our consolidated capital structure, including the current portion of long-term debt and short-term borrowings, and excluding noncontrolling interests, consisted of the following as of December 31, 2019 and 2018 (dollars in thousands): (1) Effective, January 1, 2019, we adopted ASC 842 which resulted in the reclassification of the Snettisham lease from long-term debt, to lease liabilities in 2019. The Snettisham lease amount is included here for this calculation. In addition, other operating leases were recorded on the Consolidated Balance Sheet as of January 1, 2019 and are included here for this calculation. See "Note 5 of the Notes to Consolidated Financial Statements" for further discussion and for the amounts recorded in 2019. Our shareholders’ equity increased $166.1 million during 2019 primarily due to net income and the issuance of common stock, partially offset by dividends. We need to finance capital expenditures and acquire additional funds for operations from time to time. The cash requirements needed to service our indebtedness, both short-term and long-term, reduce the amount of cash flow available to fund capital expenditures, purchased power, fuel and natural gas costs, dividends and other requirements. Committed Lines of Credit Avista Corp. has a committed line of credit with various financial institutions in the total amount of $400.0 million that expires in April 2021. As of December 31, 2019, there was $196.2 million of available liquidity under this line of credit. We expect to renew or replace this committed line of credit during 2020. The Avista Corp. credit facility contains customary covenants and default provisions, including a covenant which does not permit our ratio of “consolidated total debt” to “consolidated total capitalization” to be greater than 65 percent at any time. As of December 31, 2019, we were in compliance with this covenant with a ratio of 53.8 percent. Balances outstanding and interest rates of borrowings (excluding letters of credit) under Avista Corp.'s committed line of credit were as follows as of and for the year ended December 31 (dollars in thousands): In November of 2019, AEL&P renewed its $25.0 million committed line of credit with a new expiration date in November 2024. As of December 31, 2019, there was $21.5 million of available liquidity under this line of credit. The AEL&P credit facility contains customary covenants and default provisions including a covenant which does not permit the ratio of “consolidated total debt at AEL&P” to “consolidated total capitalization at AEL&P,” (including the impact of the Snettisham obligation) to be greater than 67.5 percent at any time. As of December 31, 2019, AEL&P was in compliance with this covenant with a ratio of 54.6 percent. As of December 31, 2019, Avista Corp. and its subsidiaries were in compliance with all of the covenants of their financing agreements, and none of Avista Corp.'s subsidiaries constituted a “significant subsidiary” as defined in Avista Corp.'s committed line of credit. AVISTA CORPORATION Long-Term Debt In November 2019, we issued and sold $180.0 million of 3.43 percent first mortgage bonds due in 2049 pursuant to a bond purchase agreement with institutional investors in the private placement market. The total net proceeds from the sale of the bonds were used to repay maturing long-term debt of $90.0 million, repay a portion of the outstanding balance under our $400.0 million committed line of credit and for other general corporate purposes. In connection with the issuance and sale of the first mortgage bonds, we cash-settled six interest rate swap derivatives (notional aggregate amount of $70.0 million) and paid a net amount of $13.3 million. The effective interest rate of the first mortgage bonds is 3.89 percent, including the effects of the settled interest rate swap derivatives and issuance costs. Equity Issuances We issued equity in 2019 for total net proceeds of $64.6 million. Most of these issuances came through our four separate sales agency agreements under which the sales agents may offer and sell new shares of our common stock from time to time. These agreements provide for the offering of a maximum of 4.6 million shares, of which approximately 3.2 million remain unissued as of December 31, 2019. In 2019, 1.4 million shares were issued under these agreements resulting in total net proceeds of $63.6 million. Subject to the satisfaction of customary conditions (including any required regulatory approvals), we have the right to increase the maximum number of shares that may be offered under these agreements. These agreements expire on February 29, 2020. We expect to negotiate and enter into new sales agency agreements in the second quarter of 2020. Hydro One Termination Fee In January 2019, we received a $103 million termination fee from Hydro One in connection with the termination of the proposed acquisition. The termination fee, after income taxes, was used for reimbursing our transaction costs incurred from 2017 to 2019. These costs and income taxes totaled approximately $51 million. The balance of the termination fee was used for general corporate purposes and reduced our need for external financing. 2020 Liquidity Expectations During 2020, we expect to issue approximately $160.0 million of long-term debt and up to $60.0 million of equity in order to refinance maturing long-term debt, fund planned capital expenditures and maintain an appropriate capital structure. After considering the expected issuances of long-term debt and equity during 2020, we expect net cash flows from operating activities, together with cash available under our committed line of credit agreements, to provide adequate resources to fund capital expenditures, dividends, and other contractual commitments. Limitations on Issuances of Preferred Stock and First Mortgage Bonds We are restricted under our Restated Articles of Incorporation, as amended, as to the additional preferred stock we can issue. As of December 31, 2019, we could issue $2.8 billion of additional preferred stock at an assumed dividend rate of 4.8 percent. We are not planning to issue preferred stock. Under the Avista Corp. and the AEL&P Mortgages and Deeds of Trust securing Avista Corp.'s and AEL&P's first mortgage bonds (including Secured Medium-Term Notes), respectively, each entity may issue additional first mortgage bonds in an aggregate principal amount equal to the sum of: • 66-2/3 percent of the cost or fair value (whichever is lower) of property additions of that entity which have not previously been made the basis of any application under that entity's Mortgage, or • an equal principal amount of retired first mortgage bonds of that entity which have not previously been made the basis of any application under that entity's Mortgage, or • deposit of cash. However, Avista Corp. and AEL&P may not individually issue any additional first mortgage bonds (with certain exceptions in the case of bonds issued on the basis of retired bonds) unless the particular entity issuing the bonds has “net earnings” (as defined in the respective Mortgages) for any period of 12 consecutive calendar months out of the preceding 18 calendar months that were at least twice the annual interest requirements on that entity's mortgage securities at the time outstanding, including the first mortgage bonds to be issued, and on all indebtedness of prior rank. As of December 31, 2019, property additions and retired bonds would have allowed, and the net earnings test would not have prohibited, the issuance of $1.5 billion in aggregate principal amount of additional first mortgage bonds at Avista Corp. and $30.4 million at AEL&P. We believe that we have adequate capacity to issue first mortgage bonds to meet our financing needs over the next several years. AVISTA CORPORATION Utility Capital Expenditures We are making capital investments at our utilities to enhance service and system reliability for our customers and replace aging infrastructure. The following table summarizes our actual and expected capital expenditures as of and for the year ended December 31, 2019 (in thousands): The following graph shows Avista Utilities' capital budget for 2020: These estimates of capital expenditures are subject to continuing review and adjustment. Actual expenditures may vary from our estimates due to factors such as changes in business conditions, construction schedules and environmental requirements. AVISTA CORPORATION Non-Regulated Investments and Capital Expenditures We are making investments and capital expenditures at our other businesses including those related to economic development projects in our service territory that will demonstrate the latest energy and environmental building innovations and house several local college degree programs. In addition, we are making investments in emerging technology companies and venture capital funds. The following table summarizes our actual and expected investments and capital expenditures at our other businesses as of and for the year ended December 31, 2019 (in thousands): These estimates of investments and capital expenditures are subject to continuing review and adjustment. Actual expenditures may vary from our estimates due to factors such as changes in business conditions or strategic plans. Off-Balance Sheet Arrangements As of December 31, 2019, we had $21.5 million in letters of credit outstanding under our $400.0 million committed line of credit, compared to $10.5 million as of December 31, 2018. Pension Plan We contributed $22.0 million to the pension plan in 2019. We expect to contribute a total of $110.0 million to the pension plan in the period 2020 through 2024, with an annual contribution of $22.0 million over that period. The final determination of pension plan contributions for future periods is subject to multiple variables, most of which are beyond our control, including changes to the fair value of pension plan assets, changes in actuarial assumptions (in particular the discount rate used in determining the benefit obligation), or changes in federal legislation. We may change our pension plan contributions in the future depending on changes to any variables, including those listed above. See "Note 11 of the Notes to Consolidated Financial Statements" for additional information regarding the pension plan. Credit Ratings Our access to capital markets and our cost of capital are directly affected by our credit ratings. In addition, many of our contracts for the purchase and sale of energy commodities contain terms dependent upon our credit ratings. See “Enterprise Risk Management - Credit Risk Liquidity Considerations” and “Note 7 of the Notes to Consolidated Financial Statements.” The following table summarizes our credit ratings as of February 25, 2020: Standard & Poor’s (1) Moody’s (2) Corporate/Issuer rating BBB Baa2 Senior secured debt A- A3 Senior unsecured debt BBB Baa2 (1) Standard & Poor’s lowest “investment grade” credit rating is BBB-. (2) Moody’s lowest “investment grade” credit rating is Baa3. A security rating is not a recommendation to buy, sell or hold securities. Each security rating is subject to revision or withdrawal at any time by the assigning rating organization. Each security rating agency has its own methodology for assigning ratings, and, accordingly, each rating should be considered in the context of the applicable methodology, independent of all other ratings. The rating agencies provide ratings at the request of Avista Corp. and charge fees for their services. AVISTA CORPORATION On December 20, 2018, Moody's downgraded our issuer rating from Baa1 to Baa2 and our senior secured and first mortgage bond ratings from A2 to A3. Moody's made these downgrades because of the impacts of the TCJA, which results in less operating cash flow from deferred income taxes due to the loss of bonus depreciation and lower tax rates. Moody's also expressed less predictability with regulatory outcomes in Washington as a contributing factor for the downgrade. See "Note 12 of the Notes to Consolidated Financial Statements" for additional information regarding the TCJA and its impacts to Avista Corp. Dividends See "Item 5. Market for Registrant’s Common Equity, Related Stockholder Matters and Issuer Purchases of Equity Securities" for a detailed discussion of our dividend policy and the factors which could limit the payment of dividends. Contractual Obligations The following table provides a summary of our future contractual obligations as of December 31, 2019 (dollars in millions): (1) Represents our estimate of interest payments on long-term debt, which is calculated based on the assumption that all debt is outstanding until maturity. Interest on variable rate debt is calculated using the rate in effect at December 31, 2019. (2) Energy purchase contracts were entered into as part of the obligation to serve our retail electric and natural gas customers’ energy requirements. As a result, costs are generally recovered either through base retail rates or adjustments to retail rates as part of the power and natural gas cost deferral and recovery mechanisms. (3) Primarily relates to an operating lease with the State of Montana for about $4.0 million annually and expires in 2046. See "Note 5 of the Notes to Consolidated Financial Statements" for further discussion of this and our other leases. (4) Represents operating agreements, settlements and other contractual obligations for our generation, transmission and distribution facilities. These costs are generally recovered through base retail rates. (5) Includes information service contracts which are recorded to other operating expenses in the Consolidated Statements of Income. (6) Represents our estimated cash contributions to pension plans and other postretirement benefit plans through 2024. We have only included pension and other postretirement funding through 2029 as we cannot reasonable estimate the amounts beyond that time period. This is consistent with the time period presented in "Note 11 of the Notes to Consolidated Financial Statements." This amount is above our contractually obligated amount. (7) Represents the net mark-to-market fair value of outstanding unsettled interest rate swap derivatives as of December 31, 2019. The values in the table above will change each period depending on fluctuations in market interest rates and could become either assets or liabilities. Also, the amounts in the table above are not reflective of cash collateral of $6.8 million that is already posted with counterparties against the outstanding interest rate swap derivatives. (8) Primarily relates to long-term debt and finance lease maturities and the related interest. AEL&P contractual commitments also include contractually required capital project funding and operating and maintenance costs associated with the Snettisham hydroelectric project. These costs are generally recovered through base retail rates. AVISTA CORPORATION (9) Primarily relates to venture fund commitments, and a commitment to fund a limited liability company in exchange for equity ownership, made by a subsidiary of Avista Capital. Also, there is a long-term debt maturity and the related interest associated with AERC. The above contractual obligations do not include income tax payments. Also, asset retirement obligations are not included above and payments associated with these have historically been less than $1 million per year. There are approximately $20.3 million remaining asset retirement obligations as of December 31, 2019. In addition to the contractual obligations disclosed above, we will incur additional operating costs and capital expenditures in future periods for which we are not contractually obligated as part of our normal business operations. Competition Our utility electric and natural gas distribution business has historically been recognized as a natural monopoly. In each regulatory jurisdiction, our rates for retail electric and natural gas services (other than specially negotiated retail rates for industrial or large commercial customers, which are subject to regulatory review and approval) are generally determined on a “cost of service” basis. Rates are designed to provide, after recovery of allowable operating expenses and capital investments, an opportunity for us to earn a reasonable return on investment as allowed by our regulators. In retail markets, we compete with various rural electric cooperatives and public utility districts in and adjacent to our service territories in the provision of service to new electric customers. Alternative energy technologies, including customer-sited solar, wind or geothermal generation, or energy storage may also compete with us for sales to existing customers. Advances in power generation, energy efficiency, energy storage and other alternative energy technologies could lead to more wide-spread usage of these technologies, thereby reducing customer demand for the energy supplied by us. This reduction in usage and demand would reduce our revenue and negatively impact our financial condition including possibly leading to our inability to fully recover our investments in generation, transmission and distribution assets. Similarly, our natural gas distribution operations compete with other energy sources including heating oil, propane and other fuels. Certain natural gas customers could bypass our natural gas system, reducing both revenues and recovery of fixed costs. To reduce the potential for such bypass, we price natural gas services, including transportation contracts, competitively and have varying degrees of flexibility to price transportation and delivery rates by means of individual contracts. These individual contracts are subject to state regulatory review and approval. We have long-term transportation contracts with several of our largest industrial customers under which the customer acquires its own commodity while using our infrastructure for delivery. Such contracts reduce the risk of these customers bypassing our system in the foreseeable future and minimizes the impact on our earnings. Also, non-utility businesses are developing new technologies and services to help energy consumers manage energy in new ways that may improve productivity and could alter demand for the energy we sell. In wholesale markets, competition for available electric supply is influenced by the: • localized and system-wide demand for energy, • type, capacity, location and availability of generation resources, and • variety and circumstances of market participants. These wholesale markets are regulated by the FERC, which requires electric utilities to: • transmit power and energy to or for wholesale purchasers and sellers, • enlarge or construct additional transmission capacity for the purpose of providing these services, and • transparently price and offer transmission services without favor to any party, including the merchant functions of the utility. Participants in the wholesale energy markets include: • other utilities, • federal power marketing agencies, • energy marketing and trading companies, • independent power producers, • financial institutions, and AVISTA CORPORATION • commodity brokers. Economic Conditions and Utility Load Growth The general economic data, on both national and local levels, contained in this section is based, in part, on independent government and industry publications, reports by market research firms or other independent sources. While we believe that these publications and other sources are reliable, we have not independently verified such data and can make no representation as to its accuracy. Avista Utilities We track multiple economic indicators affecting the three largest metropolitan statistical areas in our Avista Utilities service area: Spokane, Washington, Coeur d'Alene, Idaho, and Medford, Oregon. The key indicators are employment change and unemployment rates. On an annual basis, 2019 showed positive job growth with mixed changes in the unemployment rates in all three metropolitan areas. However, the unemployment rates in Spokane and Medford are still above the national average. Other leading indicators, such as initial unemployment claims and residential building permits, signal continued growth over the next 12 months. Considering all relevant indicators, we expect economic growth in our service area in 2020 to be in-line with the U.S. as a whole. Nonfarm employment (seasonally adjusted) in our eastern Washington, northern Idaho, and southwestern Oregon metropolitan service areas exhibited moderate growth in 2019. In Spokane, Washington employment growth was 1.9 percent with gains in all major sectors except trade, transportation, and utilities. Employment increased by 2.5 percent in Coeur d'Alene, Idaho, reflecting gains in all major sectors except; information; financial services; and government. In Medford, Oregon, employment growth was 0.8 percent, with gains in all major sectors except mining, logging, and construction; financial activities; professional and business services; and leisure and hospitality. U.S. nonfarm sector jobs grew by 1.6 percent over the same period. Changes in the unemployment rate in 2019 were mixed. In Spokane the average rate was 5.4 percent in 2018 and increased to 5.6 percent in 2019; in Coeur d'Alene the average rate stayed at 3.5 in 2018 and 2019; and in Medford the average rate declined from 4.8 percent to 4.5 percent. The U.S. unemployment rate declined from 3.9 percent to 3.7 percent in 2019. Alaska Electric Light and Power Company Our AEL&P service area is centered in Juneau. Although Juneau is Alaska’s state capital, it is not a metropolitan statistical area. This means breadth and frequency of economic data is more limited. Therefore, the dates of Juneau's economic data may significantly lag the period of this filing. The Quarterly Census of Employment and Wages for Juneau shows employment increased 1.1 percent between the first half of 2018 and first half of 2019. The employment increase was centered in natural resources and mining; manufacturing; trade, transportation, and utilities; financial activities; and professional and business services; education and health services. Government (including active duty military personnel) accounts for approximately 37 percent of total employment. Between 2018 and 2019, the unemployment rate increased from 4.4 percent to 4.6 percent. Forecasted Customer and Load Growth Based on our forecast for 2019 through 2023 for Avista Utilities' service area, we expect annual electric customer growth to average 1.1 percent, within a forecast range of 0.7 percent to 1.5 percent. We expect annual natural gas customer growth to average 1.6 percent, within a forecast range of 1 percent to 2.2 percent. We anticipate retail electric load growth to average 0.5 percent, within a forecast range of 0.2 percent and 0.8 percent. We expect natural gas load growth to average 1.1 percent, within a forecast range of 0.6 percent and 1.6 percent. The forecast ranges reflect (1) the inherent uncertainty associated with the economic assumptions on which forecasts are based and (2) the historic variability of natural gas customer and load growth. In AEL&P's service area, we expect no significant growth in residential, commercial and government customers for the period 2019 through 2023. We anticipate average annual total load growth will be in a narrow range around 0.3 percent, with residential load growth averaging 0.6 percent and commercial and government growth near 0 percent. The forward-looking statements set forth above regarding retail load growth are based, in part, upon purchased economic forecasts and publicly available population and demographic studies. The expectations regarding retail load growth are also based upon various assumptions, including: • assumptions relating to weather and economic and competitive conditions, • internal analysis of company-specific data, such as energy consumption patterns, • internal business plans, AVISTA CORPORATION • an assumption that we will incur no material loss of retail customers due to self-generation or retail wheeling, and • an assumption that demand for electricity and natural gas as a fuel for mobility will for now be immaterial. Changes in actual experience can vary significantly from our projections. See also "Competition" above for a discussion of competitive factors that could affect our results of operations in the future. Environmental Issues and Contingencies We are subject to environmental regulation by federal, state and local authorities. The generation, transmission, distribution, service and storage facilities in which we have ownership interests are subject to environmental laws relating to site conditions, air emissions, wastewater and stormwater discharges, waste handling, and other similar activities. We conduct periodic reviews and audits of pertinent facilities and operations to enhance compliance and to respond to or anticipate emerging environmental issues. The Company's Board of Directors has established a committee to oversee environmental issues and to assess and manage environmental risk. We monitor legislative and regulatory developments at different levels of government for environmental issues, particularly those with the potential to impact the operation and productivity of our generating plants and other assets. Environmental laws and regulations may restrict or impact our business activities in many ways, including, but not limited to: • increase the operating costs of generating plants; • increase the lead time and capital costs for the construction of new generating plants; • require modification of our existing generating plants; • require existing generating plant operations to be curtailed or shut down; • reduce the amount of energy available from our generating plants; • restrict the types of generating plants that can be built or contracted with; • require construction of specific types of generation plants at higher cost; and • increase costs of distributing, or limit our ability to distribute, electricity and/or natural gas. Compliance with environmental laws and regulations could result in increases to capital expenditures and operating expenses. We intend to seek recovery of any such costs through the ratemaking process. Clean Energy Commitment In April 2019, we announced a goal to serve our customers with 100 percent clean electricity by 2045 and to have a carbon-neutral supply of electricity by the end of 2027. To help achieve our goals and add to our clean electricity portfolio, in the last three years, we have implemented three renewable energy projects on behalf of our customers: the Community Solar project (0.4 MW) in Spokane Valley, Washington (owned by Avista Corp.), the Solar Select project (28 MW) in Lind, Washington (PPA), and the Rattlesnake Flat Wind project (144 MW) in Adams County, Washington (PPA). To achieve our clean energy goals, we expect that energy storage and other technologies, which are either not currently available or are not cost-effective under a lowest reasonable cost regulatory standard, will advance such that it will allow us to meet our goals while also maintaining reliability and affordability for our customers. If the required technology is not available or not affordable in the future, we may not meet our predetermined goals in the timeframe we have forecasted. Meeting our clean energy goals may also require accommodation from economic regulatory agencies insofar as the Company may need to acquire emission offsets to meet its goals. Climate Change Legal and policy changes responding to concerns about long-term global climate changes, and the potential impacts of such changes, could have a significant effect on our business. Our operations could be affected by changes in laws and regulations intended to mitigate the risk of, or alter, global climate changes, including restrictions on the operation of our power generation resources and obligations or limitations imposed on the sale of natural gas. Changing temperatures and precipitation, including snowpack conditions, affect the availability and timing of streamflows, which impact hydroelectric generation. Extreme weather events could increase fire risks, service interruptions, outages and maintenance costs. Changing temperatures could also increase or decrease customer demand. AVISTA CORPORATION Our Clean Energy Council is an interdisciplinary team of management and other employees of the Company which regularly meets to discuss, assess and manage potential risks associated with long-term global climate change. Among other things, the Clean Energy Council: • facilitates internal and external communications regarding climate change and related issues, • analyzes policy effects, anticipates opportunities and evaluates strategies for the Company, • develops recommendations on climate-related policy positions and action plans, and • provides direction and oversight with respect to the Company’s clean energy goals. In addition to the Clean Energy Council, issues concerning climate-related risk and the Company’s clean energy goals are reviewed and regularly discussed by the Board of Directors. The Board’s Environmental, Technology and Operations Committee regularly reviews and discusses environmental and climate related risks, and advises the full Board on any critical or emerging risks and/or related policies. Likewise, the Audit Committee provides oversight of climate-related disclosures in the Company’s financial statements. Federal Regulatory Actions The EPA released the final version of the Affordable Clean Energy (ACE) rule, the replacement for the Clean Power Plan (CPP), in June 2019. EPA’s final rule does not contain any final action on the proposed modifications to the new source review (NSR) program that would provide coal-fired power plants more latitude to make efficiency improvements without triggering pre-construction permit requirements. The final ACE rule combines three distinct EPA actions. First, EPA finalizes the repeal of the CPP. Second, the EPA finalizes the ACE rule, which comprises EPA’s determination of the Best System of Emissions Reduction (BSER) for existing coal-fired power plants and establishment of the procedures that will govern States’ promulgation of standards of performance for existing electric utility generating units within their borders. EPA sets the final BSER as heat rate efficiency improvements based on a range of “candidate technologies” that can be applied to a plant's operating units and requires that each State determine which apply to each coal-fired unit based on consideration of remaining useful plant life. Lastly, the EPA finalizes a number of changes to the implementing regulations for the timing of State plans for current and future Section 111(d) rulemakings. These regulatory actions have been challenged in federal court. With respect to the Colstrip Generation Station, the Montana Department of Environmental Protection (MDEQ) would initiate the BSER evaluation process. We cannot reasonably predict the timing or outcome of MDEQ’s efforts, or estimate the extent to which Colstrip may be impacted at this time. Washington Legislation and Regulatory Actions Energy Independence Act (EIA) The EIA in Washington requires electric utilities with over 25,000 customers to acquire qualified renewable energy resources and/or renewable energy credits equal to 15 percent of the utility's total retail load in Washington in 2020. The EIA also requires these utilities to meet biennial energy conservation targets. The renewable energy standard increased from three percent in 2012 to nine percent in 2016 and to 15 percent in 2020. Failure to comply with renewable energy and efficiency standards could result in penalties of $50 per MWh or greater assessed against a utility for each MWh it is deficient in meeting a standard. We meet the requirements of the EIA through a variety of renewable energy generating means, including, but not limited to, some combination of qualifying hydroelectric upgrades, wind, biomass and renewable energy credits. Clean Air Rule In September 2016, Ecology adopted the Clean Air Rule (CAR) to cap and reduce greenhouse gas (GHG) emissions across the State of Washington in pursuit of the State’s GHG goals, which were enacted in 2008 by the Washington State Legislature. The CAR applies to sources of annual GHG emissions in excess of 100,000 tons for the first compliance period of 2017 through 2019; this threshold incrementally decreases to 70,000 metric tons beginning in 2035. The rule affects stationary sources and transportation fuel suppliers, as well as natural gas distribution companies. Ecology originally identified approximately 30 entities that would be regulated under the CAR. Parties covered by the regulation will be required to reduce emissions by 1.7 percent annually until 2035. Compliance can be demonstrated by achieving emission reductions and/or surrendering Emission Reduction Units (ERU), which are generated by parties that achieve reductions greater than required by the rule. Allowable ERUs can also take the form of renewable energy credits from renewable resources located in Washington, carbon emission offsets, and allowances AVISTA CORPORATION acquired from an organized cap and trade market, such as the one operating in California. In addition to the CAR's applicability to our burning of fuel as an electric utility, the CAR would apply to us as a natural gas distribution company, for the emissions associated with the use of the natural gas we provide our customers who are not already covered under the regulation. In September 2016, Avista Corp., Cascade Natural Gas Corp., NW Natural and Puget Sound Energy (PSE) (collectively, Petitioners) jointly filed an action in the U.S. District Court for the Eastern District of Washington challenging Ecology’s promulgated CAR. The four companies also filed litigation in Thurston County Superior Court. The case in the U.S. District Court has been stayed while the state court case proceeded. On December 15, 2017, the Thurston County Superior Court issued a ruling invalidating the CAR. Ecology subsequently appealed the ruling, and the Washington State Supreme Court accepted review. On January 16, 2020, the Washington State Supreme Court issued a decision holding that the CAR was invalid as to non-emitters, such as natural gas distributors, but could be enforced against direct emitters, such as natural gas generation plants. The Court has remanded the matter to Thurston County Superior Court, where claims previously raised before, but not addressed by, that court may be revised with respect to, among other issues, alleged procedural infirmities. At this time, we are evaluating the potential impact of the surviving portion of the rule, if any, to our generation facilities, should their emissions exceed the rule’s compliance threshold. The rule is not intended to apply to the Kettle Falls Generating Station. We plan to seek recovery of any costs related to compliance with the surviving portion of the CAR through the ratemaking process. Clean Energy Transformation Act In 2019, the Washington State Legislature passed the Clean Energy Transformation Act (CETA), which requires Washington utilities to no longer allocate coal-fired resources to Washington retail customers by the end of 2025, and to achieve carbon neutrality by 2030 while meeting a minimum 80 percent of load through delivery of renewable or non-emitting resources to customers. The law has direct, specific impacts on Colstrip. The legislation sets-forth alternative compliance measures that can be pursued by an electric utility to offset emissions from fossil fuel generation. The CETA also requires utilities to meet 100 percent of load with renewable and non-emitting resources by 2045, although no penalties for failing to meet that standard were established. Our hydroelectric and biomass generation facilities are considered resources that can be used to comply with the CETA’s clean energy standards. CETA also effectuated changes to laws governing the WUTC to acknowledge that it has the discretion to employ flexible regulatory mechanisms, which may be used to address issues associated with regulatory lag. The law requires additional rulemaking by several Washington agencies for its measures to be enacted, which have not been issued to date. We intend to seek recovery of any costs associated with the clean energy legislation through the regulatory process. Washington Policy Statement In conjunction with the CETA, on January 31, 2020, the WUTC issued a policy statement concerning the treatment of used and useful plant in the context of rate filings, including in multi-year rate plans. This guidance should prove helpful in future filings. The policy statement intends to achieve four goals: •ensure general consistency with longstanding ratemaking practices, principles, and standards; •maintain flexibility in ratemaking; •avoid overly prescriptive guidance; and •support steamlined processes. Emissions Performance Standard Washington also applies a GHG emissions performance standard to electric generation facilities used to serve retail loads in their jurisdictions, whether the facilities are located within its state or elsewhere. The emissions performance standard prevents utilities from constructing or purchasing generation facilities, or entering into power purchase agreements of five years or longer duration to purchase energy produced by plants that, in any case, have emission levels higher than 1,100 pounds of GHG per MWh. The Washington State Department of Commerce reviews the standard every five years. In September 2018, it adopted a new standard of 925 pounds of GHG per MWh. We intend to seek recovery of costs related to ongoing and new requirements through the ratemaking process. GHG Reduction Targets The State of Washington has adopted non-binding targets to reduce GHG emissions. The State enacted its targets with an expectation of reaching the targets through a combination of renewable energy standards, eventual carbon pricing mechanisms, such as cap and trade regulation or a carbon tax, and assorted “complementary policies.” However, no AVISTA CORPORATION specific reductions are mandated as yet. The State’s targets, originally enacted in 2008, have been the evaluated by state institutions against the aims of the Paris Climate Accord of 2016, which include limiting the increase in the global average temperatures to at least below 2 degrees Celsius above pre-industrial levels and pursuing efforts to restrict the temperature increase to 1.5 degrees Celsius above pre-industrial levels. We cannot reasonably predict how the state legislature may revise the State's targets in the future. We intend to seek recovery of any new costs associated with these reduction targets, or any new reduction targets, through the regulatory process. Oregon Legislation and Regulatory Actions GHG Reduction Targets The State of Oregon has adopted non-binding targets to reduce GHG emissions. The State enacted its targets with an expectation of reaching the targets through a combination of renewable energy standards, eventual carbon pricing mechanisms, such as cap and trade regulation or a carbon tax, and assorted “complementary policies.” However, no specific reductions are mandated as yet. The State’s targets have been the evaluated by state institutions against the aims of the Paris Climate Accord of 2016, which include limiting the increase in the global average temperatures to at least below 2 degrees Celsius above pre-industrial levels and pursuing efforts to restrict the temperature increase to 1.5 degrees Celsius above pre-industrial levels. We cannot reasonably predict how the state legislature may revise the State's targets in the future. We intend to seek recovery of any new costs associated with these reduction targets, or any new reduction targets, through the regulatory process. Emissions Performance Standard Like Washington, Oregon applies a GHG emissions performance standard to electric generation facilities, requiring that any new baseload natural gas plant, non-base load natural gas plant, and non-generating facility reduce its net carbon dioxide emissions 17% below the most efficient combustion-turbine plant in the United States. The Oregon Energy Facility Siting Council issues rules periodically to update the standard, as more efficient power plants are built in other states. The standard can be met by any combination of efficiency, cogeneration, and offsets from carbon dioxide mitigation measures. We intend to seek recovery of costs related to ongoing and new requirements through the ratemaking process. Clean Electricity and Coal Transition Act In Oregon, legislation was enacted in 2016 which requires Portland General Electric and PacifiCorp to remove coal-fired generation from their Oregon rate base by 2030. This legislation does not directly relate to Avista Corp. because Avista Corp. is not an electric utility in Oregon. However, because these two utilities, along with Avista Corp., hold minority interests in Colstrip, the legislation could indirectly impact Avista Corp., though specific impacts cannot be reasonably predicted at this time. While the legislation requires Portland General Electric and PacifiCorp to eliminate Colstrip from their rates, they would be permitted to sell the output of their shares of Colstrip into the wholesale market or, as is the case with PacifiCorp, reallocate generation from Colstrip to other states. We cannot predict the eventual outcome of actions arising from this legislation at this time or estimate the effect thereof on Avista Corp.; however, we intend to continue to seek recovery, through the ratemaking process, of all operating and capitalized costs related to our generation assets. Colstrip-Specific Issues Depreciation of Colstrip Assets Colstrip Units 1 & 2, which we have no ownership in, were scheduled to close by 2022, but were closed in January 2020. We are still evaluating these closures for any financial impact applicable to us as joint owners of Units 3 & 4. We have received an order from the IPUC allowing us to accelerate the depreciation of our 15 percent ownership interest in Colstrip Units 3 & 4 to 2027. Similarly, in our 2019 Washington general rate case proposed settlement, the parties have agreed to accelerate the depreciation of our 15 percent ownership in Colstrip Units 3 & 4 to December 31, 2025. The proposed settlement in Washington is subject to WUTC approval. Our remaining investment in Colstrip Units 3 & 4 as of December 31, 2019 was $119.2 million. Hazardous Air Pollutants (HAPs) In April 2016, the Mercury Air Toxic Standards (MATS), an EPA rule for coal-and oil-fired sources, became effective for all Colstrip units. Colstrip has already implemented applicable MATS control measures to comply with the MATS rule, and continues to monitor potential changes in the rule to determine additional compliance obligations, if any. Colstrip performs compliance assurance stack testing on a quarterly basis to meet the MATS site-wide limitation for Particulate Matter (PM) emissions (0.03 lbs./MMBtu). In June 2018, the Montana Department of Environmental Quality (MDEQ) was AVISTA CORPORATION notified of a PM emission deviation by Talen, the plant operator, for the testing performed on June 21, 2018. As a result, Unit 3 was promptly removed from service. For similar reasons, Unit 4 was removed from service on June 29, 2018. Talen proposed, and the MDEQ acknowledged, that limited operation of Units 3 & 4 for the evaluation of a corrective action and/or data gathering related to potential corrective action was a prudent approach to solving the issue. An extensive inspection was conducted including: the coal supply, coal mills, boiler, combustion, ductwork, air preheater, scrubbers, and the stack. Talen implemented cleaning, adjustments, troubleshooting, testing, and other corrective actions. As a part of the corrective action, new flow balancing plates were installed in all Unit 3 & 4 scrubber vessels to further enhance PM removal efficiency. PM testing in September 2018 on Units 3 & 4 demonstrated compliance with the MATS. Both of these compliance tests were witnessed by the MDEQ. With the passing of the PM testing with MATS compliance, Talen, the Colstrip Operator returned both Units 3 & 4 to service in September 2018. Due to the June 2018 failure to meet the MATS standard, Colstrip Units 3 & 4 were subject to potential MDEQ enforcement action. In lieu of such an action, in December 2019, Talen and MDEQ entered a Stipulated Consent Decree providing for a cash penalty, partially offset by an agreement by Talen to fund specified Supplemental Environmental Projects, as well as additional monitoring activities. The total amount of the cash penalty allocable to Avista is not material. However, PacifiCorp, PSE, and Avista Corp. are all engaged in a consolidated proceeding before the WUTC to determine the recoverability of replacement power costs incurred during the period that Units 3 & 4 were out of service. These proceedings are discussed in Note 21 of the Notes to Consolidated Financial Statements. Coal Ash Management/Disposal In 2015, the EPA issued a final rule regarding coal combustion residuals (CCRs), also termed coal combustion byproducts or coal ash. The CCR rule has been the subject of ongoing litigation. In August 2018, the D.C. Circuit struck down provisions of the rule. Colstrip, of which we are a 15 percent owner of Units 3 & 4, produces this byproduct. On December 2, 2019, a proposed revision to the rule was published in the Federal Register to address the D.C. Circuit's decision. The rule includes technical requirements for CCR landfills and surface impoundments under Subtitle D of the Resource Conservation and Recovery Act, the nation's primary law for regulating solid waste. The Colstrip owners developed a multi-year compliance plan to address the CCR requirements and existing state obligations (expressed largely through a 2012 Administrative Order on Consent). These requirements continue despite the 2018 federal court ruling. Based on available information from Talen, we review and update our asset retirement obligations (AROs) periodically. See "Note 10 of the Notes to Consolidated Financial Statements" for additional information regarding AROs. In addition, under a 2012 Administrative Order on Consent with MDEQ, the owners of Colstrip are required to provide financial assurance, primarily in the form of surety bonds, to secure each owner’s pro rata share of various anticipated closure and remediation obligations. The amount of financial assurance required of each owner may, like the AROs, vary substantially due to the uncertainty and evolving nature of anticipated closure and remediation activities, and as those activities are completed over time. In addition to an increase to our AROs, it is expected that there will be significant compliance costs at Colstrip in the future. That will impact both operating and capital costs, due to a series of incremental infrastructure improvements which are separate from the AROs. We cannot reasonably estimate the future compliance costs; however, we will update our AROs and compliance cost estimates as appropriate. The actual asset retirement costs and future compliance costs related to the CCR rule requirements may vary substantially from the estimates used to record the AROs due to uncertainty about the compliance strategies that will be used and the nature of available data used to estimate costs, such as the quantity of coal ash present at certain sites and the volume of fill that will be needed to cap and cover certain impoundments. We intend to coordinate with the plant operator and continue to gather additional data in future periods to make decisions about compliance strategies and the timing of closure activities. As additional information becomes available, we intend to update the AROs and future nonretirement compliance costs for these changes in estimates, which could be material. We expect to seek recovery of increased costs related to complying with the CCR rule and related requirements through the ratemaking process. Colstrip Coal Contract Colstrip, which is operated by Talen Montana, is supplied with fuel from adjacent coal reserves under coal supply and transportation agreements. The contract for coal supply extended through 2019. Several of the co-owners of Colstrip, including the Company, have since negotiated an extension to the coal contract that runs through December 31, 2025. In January 2020, the Staff of the WUTC submitted a Petition to Initiate Joint Investigation to the Commission to investigate the contract. In their petition, the WUTC Staff is proposing one proceeding involving the three joint owners of Colstrip AVISTA CORPORATION Units 3 & 4 and the focus of their proposed investigation is to review the overall prudency of the new contract and any production tax credits associated with the contract. PSE Sale of Colstrip Unit 4 On December 10, 2019, PSE announced that it had entered into an agreement to sell its share of Colstrip Unit 4 to NorthWestern Energy, along with certain related transmission rights and assets. On February 20, 2020, PSE filed its application with the WUTC for an order authorizing the sale of all its interests in Colstrip Unit 4.The transaction is subject to approval from both the MPSC and the WUTC, as well as a right of first refusal held by the Co-Owners of Colstrip Units 3 & 4. If the transaction is successfully completed, PSE would continue to own an interest in Colstrip Unit 3 and would purchase energy generated by Colstrip Unit 4 from NorthWestern Energy until 2025. As a 15 percent owner in Colstrip Units 3 & 4, we are still evaluating the proposed transaction and what actions, if any, we might take. We cannot reasonably estimate the effect of the transaction, should it occur, on the future ownership, operation and operating costs of our share of Colstrip Units 3 & 4. Clean Air Act (CAA) The CAA creates a number of requirements for our thermal generating plants. Colstrip, Kettle Falls GS, Coyote Springs and Rathdrum CT all require CAA Title V operating permits. The Boulder Park GS, Northeast CT and a number of other operations require minor source permits or simple source registration permits. We have secured these permits and certify our compliance with Title V permits on an annual basis. These requirements can change over time as the CAA or applicable implementing regulations are amended and new permits are issued. We actively monitor legislative, regulatory and other program developments of the CAA that may impact our facilities. Threatened and Endangered Species and Wildlife A number of species of fish in the Northwest are listed as threatened or endangered under the Federal Endangered Species Act (ESA). Efforts to protect these and other species have not significantly impacted generation levels at our hydroelectric facilities, nor operations of our thermal plants or electrical distribution and transmission system. We are implementing fish protection measures at our hydroelectric project on the Clark Fork River under a 45-year FERC operating license for Cabinet Gorge and Noxon Rapids (issued March 2001) that incorporates a comprehensive settlement agreement. The restoration of native salmonid fish, including bull trout, is a key part of the agreement. The result is a collaborative native salmonid restoration program with the U.S. Fish and Wildlife Service, Native American tribes and the states of Idaho and Montana on the lower Clark Fork River, consistent with requirements of the FERC license. The U.S. Fish & Wildlife Service issued an updated Critical Habitat Designation for bull trout in 2010 that includes the lower Clark Fork River, as well as portions of the Coeur d'Alene basin within our Spokane River Project area, and issued a final Bull Trout Recovery Plan under the ESA. Issues related to these activities are expected to be resolved through the ongoing collaborative effort of our Clark Fork and Spokane River FERC licenses. Various statutory authorities, including the Migratory Bird Treaty Act, have established penalties for the unauthorized take of migratory birds. Because we operate facilities that can pose risks to a variety of such birds, we have developed and follow an avian protection plan. We are also aware of other threatened and endangered species and issues related to them that could be impacted by our operations and we make every effort to comply with all laws and regulations relating to these threatened and endangered species. We expect costs associated with these compliance efforts to be recovered through the ratemaking process. Cabinet Gorge Total Dissolved Gas Abatement Plan Dissolved atmospheric gas levels (referred to as "Total Dissolved Gas" or "TDG") in the Clark Fork River exceed state of Idaho and federal water quality numeric standards downstream of Cabinet Gorge particularly during periods when excess river flows must be diverted over the spillway. Under the terms of the Clark Fork Settlement Agreement as incorporated in Avista Corp.’s FERC license for the Clark Fork Project, Avista Corp. works in consultation with agencies, tribes and other stakeholders to address this issue through structural modifications to the spillgates, monitoring and analysis. The Company intends to continue to work with stakeholders to determine the degree to which TDG abatement reduces future mitigation obligations. The Company has sought, and intends to continue to seek recovery, through the ratemaking process, of all operating and capitalized costs related to this issue. Other For other environmental issues and other contingencies see “Note 21 of the Notes to Consolidated Financial Statements.” AVISTA CORPORATION Enterprise Risk Management The material risks to our businesses are discussed in "Item 1A. Risk Factors," "Forward-Looking Statements," as well as "Environmental Issues and Contingencies." The following discussion focuses on our mitigation processes and procedures to address these risks. We consider the management of these risks an integral part of managing our core businesses and a key element of our approach to corporate governance. Risk management includes identifying and measuring various forms of risk that may affect the Company. We have an enterprise risk management process for managing risks throughout our organization. Our Board of Directors and its Committees take an active role in the oversight of risk affecting the Company. Our risk management department facilitates the collection of risk information across the Company, providing senior management with a consolidated view of the Company’s major risks and risk mitigation measures. Each area identifies risks and implements the related mitigation measures. The enterprise risk process supports management in identifying, assessing, quantifying, managing and mitigating the risks. Despite all risk mitigation measures, however, risks are not eliminated. Our primary identified categories of risk exposure are: • Utility regulatory • External mandates • Operational • Financial • Cyber and Technology • Energy commodity • Strategic • Compliance Our primary categories of risks are described in "Item 1A. Risk Factors." Utility Regulatory Risk Regulatory risk is mitigated through a separate regulatory group which communicates with commission regulators and staff regarding the Company’s business plans and concerns. The regulatory group also considers the regulator’s priorities and rate policies and makes recommendations to senior management on regulatory strategy for the Company. Oversight of our regulatory strategies and policies is performed by senior management and our Board of Directors. See “Regulatory Matters” for further discussion of regulatory matters affecting our Company. Operational Risk To manage operational and event risks, we maintain emergency operating plans, business continuity and disaster recovery plans, maintain insurance coverage against some, but not all, potential losses and seek to negotiate indemnification arrangements with contractors for certain event risks. In addition, we design and follow detailed vegetation management and asset management inspection plans, which help mitigate wildfire and storm event risks, as well as identify utility assets which may be failing and in need of repair or replacement. We also have an Emergency Operating Center, which is a team of employees that plan for and train to deal with potential emergencies or unplanned outages at our facilities, resulting from natural disasters or other events. To prevent unauthorized access to our facilities, we have both physical and cyber security in place. To address the risk related to fuel cost, availability and delivery restraints, we have an energy resources risk policy, which includes our wholesale energy markets credit policy and control procedures to manage energy commodity price and credit risks. Development of the energy resources risk policy includes planning for sufficient capacity to meet our customer and wholesale energy delivery obligations. See further discussion of the energy resources risk policy below. Oversight of the operational risk management process is performed by the Environmental, Technology and Operations Committee of our Board of Directors and from senior management with input from each operating department. Cyber and Technology Risk We mitigate cyber and technology risk through trainings and exercises at all levels of the Company. The Environmental, Technology and Operations Committee of our Board of Directors along with senior management are regularly briefed on security policy, programs and incidents. Annual cyber and physical training and testing of employees are included in our enterprise security program. Our enterprise business continuity program facilitates business impact analysis of core functions for development of emergency operating plans, and coordinates annual testing and training exercises. Technology governance is led by senior management, which includes new technology strategy, risk planning and major project planning and approval. The technology project management office and enterprise capital planning group provide project cost, AVISTA CORPORATION timeline and schedule oversight. In addition, there are independent third party audits of our critical infrastructure security program and our business risk security controls. We have a Technology department dedicated to securing, maintaining, evaluating and developing our information technology systems. There are regular training sessions for the technology and security team. This group also evaluates the Company's technology for obsolescence and makes recommendations for upgrading or replacing systems as necessary. Additionally, this group monitors for intrusion and security events that may include a data breach or attack on our operations. Strategic Risk Oversight of our strategic risk is performed by the Board of Directors and senior management. We have a Chief Strategy Officer who leads strategic initiatives, to search for and evaluate opportunities for the Company and makes recommendations to senior management. We not only focus on whether opportunities are financially viable, but also consider whether these opportunities fall within our core policies and our core business strategies. We mitigate our reputational risk primarily through a focus on adherence to our core policies, including our Code of Conduct, maintaining an appropriate Company culture and tone at the top, and through communication and engagement of our external stakeholders. External Mandates Risk Oversight of our external mandate risk mitigation strategies is performed by the Environmental, Technology and Operations Committee of our Board of Directors and senior management. We have a Clean Energy Council which meets internally to assess the potential impacts of climate policy to our business and to identify strategies to plan for change. We also have employees dedicated to actively engage and monitor federal, state and local government positions and legislative actions that may affect us or our customers. To prevent the threat of municipalization, we work to build strong relationships with the communities we serve through, among other things: • communication and involvement with local business leaders and community organizations, • providing customers with a multitude of limited income initiatives, including energy fairs, senior outreach and low income workshops, mobile outreach strategy and a Low Income Rate Assistance Plan, • tailoring our internal company initiatives to focus on choices for our customers, to increase their overall satisfaction with the Company, and • engaging in the legislative process in a manner that fosters the interests of our customers and the communities we serve. Financial Risk Our Regulatory department is critical in mitigation of financial risk as they have regular communications with state commission regulators and staff and they monitor and develop rate strategies for the Company. Rate strategies, such as decoupling, help mitigate the impacts of revenue fluctuations due to weather, conservation or the economy. We also have a Treasury department that monitors our daily cash position and future cash flow needs, as well as monitoring market conditions to determine the appropriate course of action for capital financing and/or hedging strategies. Oversight of our financial risk mitigation strategies is performed by senior management and the Finance Committee of our Board of Directors. Weather Risk To partially mitigate the risk of financial under-performance due to weather-related factors, we developed decoupling rate mechanisms that were approved by the Washington, Idaho and Oregon commissions. Decoupling mechanisms are designed to break the link between a utility's revenues and consumers' energy usage and instead provide revenue based on the number of customers, thus mitigating a large portion of the risk associated with lower customer loads. See "Regulatory Matters" for further discussion of our decoupling mechanisms. Access to Capital Markets Our capital requirements rely to a significant degree on regular access to capital markets. We actively engage with rating agencies, banks, investors and state public utility commissions to understand and address the factors that support access to capital markets on reasonable terms. We manage our capital structure to maintain a financial risk profile that we believe these parties will deem prudent. We forecast cash requirements to determine liquidity needs, including sources and variability of cash flows that may arise from our spending plans or from external forces, such as changes in energy prices or interest rates. Our financial and operating forecasts consider various metrics that affect credit ratings. Our regulatory strategies include working with state public utility commissions and filing for rate changes as appropriate to meet financial performance expectations. AVISTA CORPORATION Interest Rate Risk Uncertainty about future interest rates causes risk related to a portion of our existing debt, our future borrowing requirements, and our pension and other post-retirement benefit obligations. We manage debt interest rate exposure by limiting our variable rate debt to a percentage of total capitalization of the Company. We hedge a portion of our interest rate risk on forecasted debt issuances with financial derivative instruments. The Finance Committee of our Board of Directors periodically reviews and discusses interest rate risk management processes and the steps management has undertaken to control interest rate risk. Our RMC also reviews our interest rate risk management plan. Additionally, interest rate risk is managed by monitoring market conditions when timing the issuance of long-term debt and optional debt redemptions and establishing fixed rate long-term debt with varying maturities. Our interest rate swap derivatives are considered economic hedges against the future forecasted interest rate payments of our long-term debt. Interest rates on our long-term debt are generally set based on underlying U.S. Treasury rates plus credit spreads, which are based on our credit ratings and prevailing market prices for debt. The interest rate swap derivatives hedge against changes in the U.S. Treasury rates but do not hedge the credit spread. Even though we work to manage our exposure to interest rate risk by locking in certain long-term interest rates through interest rate swap derivatives, if market interest rates decrease below the interest rates we have locked in, this will result in a liability related to our interest rate swap derivatives, which can be significant. However, through our regulatory accounting practices similar to our energy commodity derivatives, any interim mark-to-market gains or losses are offset by regulatory assets and liabilities. Upon settlement of interest rate swap derivatives, the cash payments made or received are recorded as a regulatory asset or liability and are subsequently amortized as a component of interest expense over the life of the associated debt. The settled interest rate swap derivatives are also included as a part of Avista Corp.'s cost of debt calculation for ratemaking purposes. The following table summarizes our interest rate swap derivatives outstanding as of December 31, 2019 and December 31, 2018 (dollars in thousands): (1) There are offsetting regulatory assets and liabilities for these items on the Consolidated Balance Sheets in accordance with regulatory accounting practices. (2) The balance as of December 31, 2019 and December 31, 2018 reflects the offsetting of $6.8 million and $0.5 million, respectively, of cash collateral against the net derivative positions where a legal right of offset exists. We estimate that a 10-basis-point increase in forward LIBOR interest rates as of December 31, 2019 would increase the interest rate swap derivative net liability by $5.1 million, while a 10-basis-point decrease would decrease the interest rate swap derivative net liability by $5.4 million. We estimated that a 10-basis-point increase in forward LIBOR interest rates as of December 31, 2018 would have increased the interest rate swap derivative net liability by $4.3 million, while a 10-basis-point decrease would decrease the interest rate swap derivative net liability by $4.4 million. The interest rate on $51.5 million of long-term debt to affiliated trusts is adjusted quarterly, reflecting current market rates. Amounts borrowed under our committed line of credit agreements have variable interest rates. AVISTA CORPORATION The following table shows our long-term debt (including current portion) and related weighted-average interest rates, by expected maturity dates as of December 31, 2019 (dollars in thousands): (1) These balances include the fixed rate long-term debt of Avista Corp., AEL&P and AERC. Our pension plan is exposed to interest rate risk because the value of pension obligations and other post-retirement obligations varies directly with changes in the discount rates, which are derived from end-of-year market interest rates. In addition, the value of pension investments and potential income on pension investments is partially affected by interest rates because a portion of pension investments are in fixed income securities. Oversight of our pension plan investment strategies is performed by the Finance Committee of the Board of Directors, which approves investment and funding policies, objectives and strategies that seek an appropriate return for the pension plan. We manage interest rate risk associated with our pension and other post-retirement benefit plans by investing a targeted amount of pension plan assets in fixed income investments that have maturities with similar profiles to future projected benefit obligations. See "Note 11 of the Notes to Consolidated Financial Statements" for further discussion of our investment policy associated with the pension assets. Credit Risk Counterparty Non-Performance Risk Counterparty non-performance risk relates to potential losses that we would incur as a result of non-performance of contractual obligations by counterparties to deliver energy or make financial settlements. Changes in market prices may dramatically alter the size of credit risk with counterparties, even when we establish conservative credit limits. Should a counterparty fail to perform, we may be required to honor the underlying commitment or to replace existing contracts with contracts at then-current market prices. We enter into bilateral transactions with various counterparties. We also trade energy and related derivative instruments through clearinghouse exchanges. We seek to mitigate credit risk by: • transacting through clearinghouse exchanges, • entering into bilateral contracts that specify credit terms and protections against default, • applying credit limits and duration criteria to existing and prospective counterparties, • actively monitoring current credit exposures, • asserting our collateral rights with counterparties, and • carrying out transaction settlements timely and effectively. The extent of transactions conducted through exchanges has increased, as many market participants have shown a preference toward exchange trading and have reduced bilateral transactions. We actively monitor the collateral required by such exchanges to effectively manage our capital requirements. Counterparties’ credit exposure to us is dynamic in normal markets and may change significantly in more volatile markets. The amount of potential default risk to us from each counterparty depends on the extent of forward contracts, unsettled transactions, interest rates and market prices. There is a risk that we do not obtain sufficient additional collateral from counterparties that are unable or unwilling to provide it. AVISTA CORPORATION Credit Risk Liquidity Considerations To address the impact on our operations of energy market price volatility, our hedging practices for electricity (including fuel for generation) and natural gas extend beyond the current operating year. Executing this extended hedging program may increase credit risk and demands for collateral. Our credit risk management process is designed to mitigate such credit risks through limit setting, contract protections and counterparty diversification, among other practices. Credit risk affects demands on our capital. We are subject to limits and credit terms that counterparties may assert to allow us to enter into transactions with them and maintain acceptable credit exposures. Many of our counterparties allow unsecured credit at limits prescribed by agreements or their discretion. Capital requirements for certain transaction types involve a combination of initial margin and market value margins without any unsecured credit threshold. Counterparties may seek assurances of performance from us in the form of letters of credit, prepayment or cash deposits. Credit exposure can change significantly in periods of commodity price and interest rate volatility. As a result, sudden and significant demands may be made against our credit facilities and cash. We actively monitor the exposure to possible collateral calls and take steps to minimize capital requirements. As of December 31, 2019, we had cash deposited as collateral of $7.8 million and letters of credit of $17.4 million outstanding related to our energy derivative contracts. Price movements and/or a downgrade in our credit ratings could impact further the amount of collateral required. See “Credit Ratings” for further information. For example, in addition to limiting our ability to conduct transactions, if our credit ratings were lowered to below “investment grade” based on our positions outstanding at December 31, 2019 (including contracts that are considered derivatives and those that are considered non-derivatives), we would potentially be required to post the following additional collateral (in thousands): Under the terms of interest rate swap derivatives that we enter into periodically, we may be required to post cash or letters of credit as collateral depending on fluctuations in the fair value of the instrument. As of December 31, 2019, we had interest rate swap agreements outstanding with a notional amount totaling $215.0 million and we had deposited cash in the amount of $6.8 million as collateral for these interest rate swap derivatives. If our credit ratings were lowered to below “investment grade” based on our interest rate swap derivatives outstanding at December 31, 2019, we would potentially be required to post the following additional collateral (in thousands): Foreign Currency Risk A significant portion of our utility natural gas supply (including fuel for electric generation) is obtained from Canadian sources. Most of those transactions are executed in U.S. dollars, which avoids foreign currency risk. A portion of our short-term natural gas transactions and long-term Canadian transportation contracts are committed based on Canadian currency prices. The short-term natural gas transactions are typically settled within sixty days with U.S. dollars. We hedge a portion of the foreign currency risk by purchasing Canadian currency exchange derivatives when such commodity transactions are initiated. This risk has not had a material effect on our financial condition, results of operations or cash flows and these differences in cost related to currency fluctuations are included with natural gas supply costs for ratemaking. Further information for derivatives and fair values is disclosed at “Note 7 of the Notes to Consolidated Financial Statements” and “Note 17 of the Notes to Consolidated Financial Statements.” Energy Commodity Risk We mitigate energy commodity risk primarily through our energy resources risk policy, which includes oversight from the RMC and oversight from the Audit Committee and the Environmental, Technology and Operations Committee of our Board of Directors. In conjunction with the oversight committees, our management team develops hedging strategies, detailed resource procurement plans, resource optimization strategies and long-term integrated resource planning to mitigate some of the risk AVISTA CORPORATION associated with energy commodities. The various plans and strategies are monitored daily and developed with quantitative methods. Our energy resources risk policy includes our wholesale energy markets credit policy and control procedures to manage energy commodity price and credit risks. Nonetheless, adverse changes in commodity prices, generating capacity, customer loads, regulation and other factors may result in losses of earnings, cash flows and/or fair values. We measure the volume of monthly, quarterly and annual energy imbalances between projected power loads and resources. The measurement process is based on expected loads at fixed prices (including those subject to retail rates) and expected resources to the extent that costs are essentially fixed by virtue of known fuel supply costs or projected hydroelectric conditions. To the extent that expected costs are not fixed, either because of volume mismatches between loads and resources or because fuel cost is not locked in through fixed price contracts or derivative instruments, our risk policy guides the process to manage this open forward position over a period of time. Normal operations result in seasonal mismatches between power loads and available resources. We are able to vary the operation of generating resources to match parts of intra-hour, hourly, daily and weekly load fluctuations. We use the wholesale power markets, including the natural gas market as it relates to power generation fuel, to sell projected resource surpluses and obtain resources when deficits are projected. We buy and sell fuel for thermal generation facilities based on comparative power market prices and marginal costs of fueling and operating available generating facilities and the relative economics of substitute market purchases for generating plant operation. To address the impact on our operations of energy market price volatility, our hedging practices for electricity (including fuel for generation) and natural gas extend beyond the current operating year. Executing this extended hedging program may increase our credit risks. Our credit risk management process is designed to mitigate such credit risks through limit setting, contract protections and counterparty diversification, among other practices. Our projected retail natural gas loads and resources are regularly reviewed by operating management and the RMC. To manage the impacts of volatile natural gas prices, we seek to procure natural gas through a diversified mix of spot market purchases and forward fixed price purchases from various supply basins and time periods. We have an active hedging program that extends into future years with the goal of reducing price volatility in our natural gas supply costs. We use natural gas storage capacity to support high demand periods and to procure natural gas when price spreads are favorable. Securing prices throughout the year and even into subsequent years mitigates potential adverse impacts of significant purchase requirements in a volatile price environment. The following table presents energy commodity derivative fair values as a net asset or (liability) as of December 31, 2019 that are expected to settle in each respective year (dollars in thousands). There are no expected deliveries of energy commodity derivatives after 2022: The following table presents energy commodity derivative fair values as a net asset or (liability) as of December 31, 2018 that were expected to settle in each respective year (dollars in thousands). There were no expected deliveries of energy commodity derivatives after 2021: (1) Physical transactions represent commodity transactions where we will take or make delivery of either electricity or natural gas; financial transactions represent derivative instruments with delivery of cash in the amount of the benefit or cost but with no physical delivery of the commodity, such as futures, swap derivatives, options, or forward contracts. AVISTA CORPORATION The above electric and natural gas derivative contracts will be included in either power supply costs or natural gas supply costs during the period they are delivered and will be included in the various deferral and recovery mechanisms (ERM, PCA, and PGAs), or in the general rate case process, and are expected to eventually be collected through retail rates from customers. See "Item 1. Business - Electric Operations" and "Item 1. Business - Natural Gas Operations," for additional discussion of the risks associated with Energy Commodities. Compliance Risk Compliance risk is mitigated through separate Regulatory and Environmental Compliance departments that monitor legislation, regulatory orders and actions to determine the overall potential impact to our Company and develop strategies for complying with the various rules and regulations. We also engage outside attorneys and consultants, when necessary, to help ensure compliance with laws and regulations. Oversight of our compliance risk strategy is performed by senior management, including our Chief Compliance Officer, and the Environmental, Technology and Operations Committee and the Audit Committee of our Board of Directors. See "Item 1. Business, Regulatory Issues" through "Item 1. Business, Reliability Standards" and “Environmental Issues and Contingencies” for further discussion of compliance issues that impact our Company.

<s>[INST] Business Segments As of December 31, 2019, we have two reportable business segments, Avista Utilities and AEL&P. We also have other businesses which do not represent a reportable business segment and are conducted by various direct and indirect subsidiaries of Avista Corp. See "Part I, Item 1. Business Company Overview" for further discussion of our business segments. AVISTA CORPORATION The following table presents net income (loss) attributable to Avista Corp. shareholders for each of our business segments (and the other businesses) for the year ended December 31 (dollars in thousands): Executive Level Summary Overall Results Net income attributable to Avista Corp. shareholders was $197.0 million for 2019, an increase from $136.4 million for 2018. Avista Utilities' net income increased due to the receipt of a $103 million termination fee from Hydro One (see "Note 24 of the Notes to Consolidated Financial Statements"), as well as the positive impact of general rate increases and customer growth. These increases were partially offset by final transaction costs for the Hydro One transaction, taxes associated with the termination fee, increased transmission and distribution operating and maintenance costs, a $7 million donation to the Avista Foundation to support the local community (other operating expenses) and increased depreciation and amortization. AEL&P net income decreased primarily due to a decrease in operating revenues. The increase in net income at our other businesses was primarily due to the sale of METALfx and net investment gains from our other investments. More detailed explanations of the fluctuations are provided in the results of operations and business segment discussions (Avista Utilities, AEL&P, and the other businesses). General Rate Cases and Regulatory Lag We experienced regulatory lag during 2019 and we expect this to continue through the end of 2021 due to our continued investment in utility infrastructure and because we did not file general rate cases during 2018 due to the terminated Hydro One transaction. In April 2019, we filed general rates cases in Washington (partial settlement agreement in November 2019, refer to "Regulatory Matters"). We completed an electric only general rate case in Idaho, with new rates effective on December 1, 2019 and we also filed a natural gas general rate case in Oregon in March (with new rates effective on January 15, 2020). We expect these cases to provide rate relief in 2020 and start reducing the regulatory lag that we have been experiencing. Going forward, we will continue to strive to reduce the regulatory timing lag and more closely align our earned returns with those authorized by 2022. This will require adequate and timely rate relief in our jurisdictions. See "Regulatory Matters" for additional discussion of the 2019 general rate cases. Regulatory Matters General Rate Cases We regularly review the need for electric and natural gas rate changes in each state in which we provide service. We will continue to file for rate adjustments to: seek recovery of operating costs and capital investments, and seek the opportunity to earn reasonable returns as allowed by regulators. With regards to the timing and plans for future filings, the assessment of our need for rate relief and the development of rate case plans takes into consideration shortterm and longterm needs, as well as specific factors that can affect the timing of rate filings. Such factors include, but are not limited to, inservice dates of major capital investments and the timing of changes in major revenue and expense items. Avista Utilities Washington General Rate Cases and Other Proceedings 2015 General Rate Cases In January 2016 we received an order which was reaffirmed by the WUTC in February 2016 that concluded our electric and natural gas general rate cases that were originally filed with the WUTC in February 2015. New electric and natural gas rates were effective on January 11, 2016. AVISTA CORPORATION In March 2016, the Public Counsel Unit of the Washington State Office of the Attorney General (Public Counsel) filed in Thurston County Superior Court a [/INST] Positive. </s>

PEOPLES BANCORP INC

2015-02-26

2014-12-31

ITEM 7. MANAGEMENT’S DISCUSSION AND ANALYSIS OF FINANCIAL CONDITION AND RESULTS OF OPERATIONS Forward-Looking Statements Certain statements in this Form 10-K, which are not historical fact, are forward-looking statements within the meaning of Section 27A of the Securities Act , Section 21E of the Exchange Act, and the Private Securities Litigation Reform Act of 1995. Words such as “anticipate”, “estimates”, “may”, “feels”, “expects”, “believes”, “plans”, “will”, “would”, “should”, “could” and similar expressions are intended to identify these forward-looking statements but are not the exclusive means of identifying such statements. Forward-looking statements are subject to risks and uncertainties that may cause actual results to differ materially. Factors that might cause such a difference include, but are not limited to: (1) the success, impact, and timing of the implementation of Peoples' business strategies, including the successful integration of recently completed acquisitions and the expansion of consumer lending activity; (2) Peoples' ability to integrate the Midwest Bancshares, Inc. ("Midwest"), Ohio Heritage Bancorp, Inc. ("Ohio Heritage") and North Akron Savings Bank ("North Akron") acquisitions and any future acquisitions, including the pending merger of NB&T into Peoples, may be unsuccessful, or may be more difficult, time-consuming or costly than expected; (3) the ability of Peoples and NB&T to obtain their respective shareholders' approval of the merger may be unsuccessful; (4) Peoples may issue equity securities in connection with future acquisitions, which could cause ownership and economic dilution to Peoples' current shareholders; (5) local, regional, national and international economic conditions and the impact they may have on Peoples and its customers, and Peoples' assessment of the impact, which may be different than anticipated; (6) competitive pressures among financial institutions or from non-financial institutions may increase significantly, including product and pricing pressures, third-party relationships and revenues, and Peoples' ability to attract, develop and retain qualified professionals; (7) changes in the interest rate environment due to economic conditions and/or the fiscal policies of the U.S. government and Federal Reserve Board, which may adversely impact interest rates, interest margins and interest rate sensitivity; (8) changes in prepayment speeds, loan originations, levels of non-performing assets, delinquent loans and charge-offs, which may be less favorable than expected and adversely impact the amount of interest income generated; (9) adverse changes in the economic conditions and/or activities, including, but not limited to, impacts from the implementation of the Budget Control Act of 2011 and the American Taxpayer Relief Act of 2012, as well as continued economic uncertainty in the U.S., the European Union, and other areas, which could decrease sales volumes and increase loan delinquencies and defaults; (10) legislative or regulatory changes or actions, including in particular the Dodd-Frank Wall Street Reform and Consumer Protection Act of 2010 and the regulations promulgated and to be promulgated thereunder by the Office of the Comptroller of the Currency, the Federal Reserve Board and the Consumer Financial Protection Bureau, which may subject Peoples, its subsidiaries, or one or more acquired companies to a variety of new and more stringent legal and regulatory requirements which adversely affect their respective businesses; (11) deterioration in the credit quality of Peoples' loan portfolio, which may adversely impact the provision for loan losses; (12) changes in accounting standards, policies, estimates or procedures which may adversely affect Peoples' reported financial condition or results of operations; (13) Peoples' assumptions and estimates used in applying critical accounting policies, which may prove unreliable, inaccurate or not predictive of actual results; (14) adverse changes in the conditions and trends in the financial markets, including political developments, which may adversely affect the fair value of securities within Peoples' investment portfolio, the interest rate sensitivity of Peoples' consolidated balance sheet, and the income generated by Peoples' trust and investment activities; (15) Peoples' ability to receive dividends from its subsidiaries; (16) Peoples' ability to maintain required capital levels and adequate sources of funding and liquidity; (17) the impact of new minimum capital thresholds established as a part of the implementation of Basel III; (18) the impact of larger or similar sized financial institutions encountering problems, which may adversely affect the banking industry and/or Peoples' business generation and retention, funding and liquidity; (19) the costs and effects of regulatory and legal developments, including the outcome of potential regulatory or other governmental inquiries and legal proceedings and results of regulatory examinations; (20) Peoples' ability to secure confidential information through the use of computer systems and telecommunications networks, including those of Peoples' third-party vendors and other service providers, may prove inadequate, which could adversely affect customer confidence in Peoples and/or result in Peoples incurring a financial loss; (21) the overall adequacy of Peoples' risk management program; (22) the impact on Peoples' businesses, as well as on the risks described above, of various domestic or international military or terrorist activities or conflicts; and (23) other risk factors relating to the banking, insurance and investments industry or Peoples as detailed from time to time in Peoples’ reports filed with the SEC, including those risk factors included in the disclosure under "ITEM 1A. RISK FACTORS" of this Form 10-K. All forward-looking statements speak only as of the filing date of this Form 10-K and are expressly qualified in their entirety by the cautionary statements. Although management believes the expectations in these forward-looking statements are based on reasonable assumptions within the bounds of management’s knowledge of Peoples’ business and operations, it is possible that actual results may differ materially from these projections. Additionally, Peoples undertakes no obligation to update these forward-looking statements to reflect events or circumstances after the filing date of this Form 10-K or to reflect the occurrence of unanticipated events except as may be required by applicable legal requirements. Copies of documents filed with the SEC are available free of charge at the SEC’s website at www.sec.gov and/or from Peoples' website - www.peoplesbancorp.com under the "Investor Relations" section. The following discussion and analysis of Peoples' Consolidated Financial Statements is presented to provide insight into management's assessment of the financial results and condition for the periods presented. This discussion and analysis should be read in conjunction with the audited Consolidated Financial Statements and Notes thereto, as well as the ratios and statistics, contained elsewhere in this Form 10-K. Summary of Significant Transactions and Events The following is a summary of transactions or events that have impacted or are expected by management to impact Peoples’ results of operations or financial condition: ◦ At the close of business on October 24, 2014, Peoples completed the acquisition of North Akron and its full service offices in Akron, Cuyahoga Falls, Munroe and Norton, Ohio. Under the terms of the merger agreement, Peoples paid $7,655 of consideration per share of North Akron common stock, or $20.1 million, of which 80% was paid in Peoples' common shares and the remaining 20% in cash. The acquisition added $111.5 million of loans and $108.1 million of deposits at the acquisition date, after purchase accounting adjustments. ◦ On August 7, 2014, Peoples announced the completion of the sale of 1,847,826 common shares at $23.00 per share to institutional investors through a private placement (the "Private Equity Issuance"). Peoples received net proceeds of $40.2 million from the sale, and intends to use the proceeds, in part, to fund the cash consideration for the NB&T acquisition. ◦ On August 4, 2014, Peoples entered into the NB&T Agreement. The NB&T Agreement calls for NB&T to merge into Peoples and for NB&T's wholly-owned subsidiary, The National Bank and Trust Company, which operates 22 full-service branches in southwest Ohio, to merge into Peoples Bank. Under the terms of the NB&T Agreement, shareholders of NB&T will receive 0.9319 of Peoples' common shares and $7.75 in cash for each share of NB&T. The NB&T transaction is expected to be completed during the first quarter of 2015, pending adoption of the NB&T Agreement by the shareholders of both NB&T and Peoples, the satisfaction of various closing conditions, including the accuracy of the representations and warranties of each party (subject to certain exceptions), the performance in all material respects by each party of its obligations under the NB&T Agreement, and other conditions customary for transactions of this type. ◦ At the close of business on August 22, 2014, Peoples completed the acquisition of Ohio Heritage and its six full service offices in Coshocton, Newark, Heath, Mount Vernon and New Philadelphia, Ohio. Under the terms of the merger agreement, Peoples paid $110.00 of consideration per share of Ohio Heritage common stock, or $37.7 million, of which 85% was paid in Peoples' common shares and the remaining 15% in cash. The acquisition added $175.8 million of loans and $174.9 million of deposits at the acquisition date, after purchase accounting adjustments. ◦ At the close of business on May 30, 2014, Peoples completed the acquisition of Midwest and its full service offices in Wellston and Jackson, Ohio. Under the terms of the merger agreement, Peoples paid $65.50 of consideration per share of Midwest common stock, or $12.6 million, of which 50% was paid in cash and the remaining 50% in Peoples' common shares. The acquisition added $58.7 million of loans and $77.9 million of deposits at the acquisition date, after purchase accounting adjustments. ◦ In 2014, Peoples incurred $5.1 million of acquisition-related expenses, compared to $1.5 million in 2013 and $641,000 in 2012, which were primarily fees for legal costs, other professional services, deconversion costs and write-offs associated with assets acquired. ◦ During 2013, Peoples took steps to reduce its investment in bank-owned life insurance ("BOLI") contracts and redeploy the funds in order to enhance long-term shareholder return. Peoples received proceeds of $43.1 million during 2013 as a result of the liquidation of BOLI contracts, while the remaining cash surrender value of approximately $6.6 million was recorded as a receivable at December 31, 2013. Peoples received the remaining cash surrender value in the first quarter of 2014, in accordance with the terms of the BOLI policies (collectively, the "BOLI Surrender"). The BOLI Surrender caused Peoples to incur a $2.2 million federal income tax liability in 2013 for the gain associated with the policies surrendered. ◦ Peoples periodically has taken actions to reduce interest rate exposure within the investment portfolio and the entire balance sheet, which have included the sale of low-yielding investment securities and repayment of high-cost borrowings. These actions included the sale of $68.8 million of investment securities, primarily low or volatile yielding residential mortgage-backed securities, during the first quarter of 2013. Some of the proceeds from these investment sales were reinvested in securities during the first quarter with the remaining reinvested early in the second quarter of 2013. ◦ As described in Note 11 of the Notes to the Consolidated Financial Statements, Peoples incurred settlement charges of $1.4 million during 2014 due to the aggregate amount of lump-sum distributions to participants in Peoples' defined benefit pension plan exceeding the threshold for recognizing such charges during the period. Settlement charges of $270,000 and $835,000 were recognized during 2013 and 2012, respectively. ◦ On September 17, 2012, Peoples introduced its new brand as part of a company-wide brand revitalization. The brand is Peoples' promise, which is a guarantee of satisfaction and quality. Peoples incurred costs throughout 2013 associated with the brand revitalization, including marketing due to advertisements, and depreciation expense for new assets related to the $5 million branch renovation project. ◦ Peoples' net interest income and net interest margin are impacted by changes in market interest rates based upon actions taken by the Federal Reserve Board either directly or through its Open Market Committee. These actions include changing the target Federal Funds Rate (the interest rate at which banks lend money to each other), Discount Rate (the interest rate charged to banks for money borrowed from the Federal Reserve Bank) and longer-term market interest rates (primarily U.S. Treasury securities). Longer-term market interest rates also are affected by the demand for U.S. Treasury securities. The resulting changes in the yield curve slope have a direct impact on reinvestment rates for Peoples' earning assets. ◦ The Federal Reserve Board has maintained its target Federal Funds Rate at a historically low level of 0% to 0.25% since December 2008 and has maintained the Discount Rate at 0.75% since December 2010. The Federal Reserve Board has indicated the possibility that these short-term rates could start to be raised as early as 2015. ◦ From late 2008 until year-end 2014, the Federal Reserve Board took various actions to lower longer-term market interest rates as a means of stimulating the economy - a policy commonly referred to as “quantitative easing”. These actions included the buying and selling of mortgage-backed and other debt securities through its open market operations. In December 2013, the Federal Reserve Board announced plans to taper its quantitative easing efforts. As a result, the slope of the U.S. Treasury yield curve has fluctuated significantly. Substantial flattening occurred in late 2008, in mid-2010 and early third quarter of 2011 through 2012, while moderate steepening occurred in the second half of 2009, late 2010 and mid-2013. The curve has remained relatively steep since mid-2013, primarily as a reaction to the Federal Reserve Board's announcement of a reduction in monthly asset purchases and generally improving economic conditions. The curve flattened gradually throughout 2014, primarily in response to the slowing global economy, geopolitical uncertainty and lower yields on sovereign debt throughout the world. The impact of these transactions, where material, is discussed in the applicable sections of this Management’s Discussion and Analysis of Financial Condition and Results of Operations. Critical Accounting Policies The accounting and reporting policies of Peoples conform to US GAAP and to general practices within the financial services industry. A summary of significant accounting policies is contained in Note 1 of the Notes to the Consolidated Financial Statements. While all of these policies are important to understanding the Consolidated Financial Statements, certain accounting policies require management to exercise judgment and make estimates or assumptions that affect the amounts reported in the Consolidated Financial Statements and accompanying Notes. These estimates and assumptions are based on information available as of the date of the Consolidated Financial Statements; accordingly, as this information changes, the Consolidated Financial Statements could reflect different estimates or assumptions. Management has identified the accounting policies described below as those that, due to the judgments, estimates and assumptions inherent in the policies, are critical to an understanding of Peoples' Consolidated Financial Statements and Management's Discussion and Analysis of Financial Condition and Results of Operations. Income Recognition Interest income on loans and investment securities is recognized by methods that result in level rates of return on principal amounts outstanding, including yield adjustments resulting from the amortization of loan costs and premiums on investment securities and accretion of loan fees and discounts on investment securities. Since mortgage-backed securities comprise a sizable portion of Peoples' investment portfolio, a significant increase in principal payments on those securities could impact interest income due to the corresponding acceleration of premium amortization or discount accretion. Peoples discontinues the accrual of interest on a loan when conditions cause management to believe collection of all or any portion of the loan's contractual interest is doubtful. Such conditions may include the borrower being 90 days or more past due on any contractual payments or current information regarding the borrower's financial condition and repayment ability. All unpaid accrued interest deemed uncollectable is reversed, which would reduce Peoples' net interest income. Interest received on nonaccrual loans is included in income only if principal recovery is reasonably assured. Allowance for Loan Losses In general, determining the amount of the allowance for loan losses requires significant judgment and the use of estimates by management. Peoples maintains an allowance for loan losses based on a quarterly analysis of the loan portfolio and estimation of the losses that are probable of occurrence within the loan portfolio. This formal analysis determines an appropriate level and allocation of the allowance for loan losses among loan types and the resulting recovery of or provision for loan losses by considering factors affecting losses, including specific losses, levels and trends in impaired and nonperforming loans; historical loan loss experience; current national and local economic conditions; volume; growth and composition of the portfolio, regulatory guidance and other relevant factors. Management continually monitors the loan portfolio through Peoples Bank's Credit Administration Department and Loan Loss Committee to evaluate the appropriateness of the allowance. The recovery or provision could increase or decrease each quarter based upon the results of management's formal analysis. The amount of the allowance for loan losses for the various loan types represents management's estimate of probable losses from existing loans. Management evaluates lending relationships deemed to be impaired on an individual basis and makes specific allocations of the allowance for loan losses for each relationship based on discounted cash flows using the loan's initial effective interest rate or the fair value of the collateral for certain collateral dependent loans. For all other loans, management evaluates pools of homogeneous loans (such as residential mortgage loans, and direct and indirect consumer loans) and makes general allocations for each loan pool based upon historical loss experience. While allocations are made to specific loans and pools of loans, the allowance is available for all loan losses. The evaluation of individual impaired loans requires management to make estimates of the amounts and timing of future cash flows on impaired loans, which consist primarily of loans placed on nonaccrual status, restructured or internally classified as substandard or doubtful. These reviews are based upon specific quantitative and qualitative criteria, including the size of the loan, the loan cash flow characteristics, loan quality ratings, value of collateral, repayment ability of borrowers, and historical experience factors. Allowances for homogeneous loans are evaluated based upon historical loss experience, adjusted for qualitative risk factors, such as trends in losses and delinquencies, growth of loans in particular markets, and known changes in economic conditions in each lending market. As part of the process of identifying the pools of homogenous loans, management takes into account any concentrations of risk within any portfolio segment, including any significant industrial concentrations. Consistent with the evaluation of allowances for homogenous loans, the allowance relating to the Overdraft Privilege program is based upon management's monthly analysis of accounts in the program. This analysis considers factors that could affect losses on existing accounts, including historical loss experience and length of overdraft. There can be no assurance the allowance for loan losses will be adequate to cover all losses, but management believes the allowance for loan losses at December 31, 2014 was adequate to provide for probable losses from existing loans based on information currently available. While management uses available information to estimate losses, the ultimate collectability of a substantial portion of the loan portfolio, and the need for future additions to the allowance, will be based on changes in economic conditions and other relevant factors. As such, adverse changes in economic activity could reduce currently estimated cash flows for both commercial and individual borrowers, which would likely cause Peoples to experience increases in problem assets, delinquencies and losses on loans in the future. Investment Securities Peoples' investment portfolio accounted for 27.8% of total assets at December 31, 2014, of which approximately 89% of the securities were classified as available-for-sale. Correspondingly, Peoples carries these securities at fair value on its Consolidated Balance Sheets, with any unrealized gain or loss recorded in stockholders' equity as a component of accumulated other comprehensive income or loss. As a result, both the investment and equity sections of Peoples' Consolidated Balance Sheet are sensitive to changes in the overall market value of the investment portfolio, due to changes in market interest rates, investor confidence and other factors affecting market values. While temporary changes in the fair value of available-for-sale securities are not recognized in earnings, Peoples is required to evaluate all investment securities with an unrealized loss on a quarterly basis to identify potential other-than-temporary impairment (“OTTI”) losses. This analysis requires management to consider various factors that involve judgment and estimation, including the duration and magnitude of the decline in value, the financial condition of the issuer or pool of issuers, and the structure of the security. Under current US GAAP, an OTTI loss is recognized in earnings only when (1) Peoples intends to sell the debt security; (2) it is more likely than not that Peoples will be required to sell the debt security before recovery of its amortized cost basis; or (3) Peoples does not expect to recover the entire amortized cost basis of the debt security. In situations where Peoples intends to sell, or when it is more likely than not that Peoples will be required to sell the debt security, the entire OTTI loss must be recognized in earnings. In all other situations, only the portion of the OTTI losses representing the credit loss must be recognized in earnings, with the remaining portion being recognized in stockholders' equity as a component of accumulated other comprehensive income or loss, net of deferred taxes. Peoples has not recognized an impairment loss in 2014, 2013 or 2012. Management performed its quarterly analysis of the investment securities with an unrealized loss at December 31, 2014, and concluded no individual securities were other-than-temporarily impaired. Goodwill and Other Intangible Assets During 2014 and in prior years, Peoples recorded goodwill and other intangible assets as a result of acquisitions accounted for under the purchase method of accounting. Under the purchase method, Peoples is required to allocate the cost of an acquired company to the assets acquired, including identified intangible assets, and liabilities assumed based on their estimated fair values at the date of acquisition. Goodwill represents the excess cost over the fair value of net assets acquired and is not amortized but is tested for impairment when indicators of impairment exist, or at least annually. Peoples' other intangible assets consist of customer relationship intangible assets, including core deposit intangibles, representing the present value of future net income to be earned from acquired customer relationships with definite useful lives, which are required to be amortized over their estimated useful lives. The value of recorded goodwill is supported ultimately by revenue that is driven by the volume of business transacted and Peoples' ability to provide quality, cost-effective services in a competitive market place. A decline in earnings as a result of a lack of growth or the inability to deliver cost-effective services over sustained periods can lead to impairment of goodwill that could adversely impact earnings in future periods. Potential goodwill impairment exists when the fair value of the reporting unit (as defined by US GAAP) is less than its carrying value. An impairment loss is recognized in earnings only when the carrying amount of goodwill is less than its implied fair value. Peoples performs its required annual impairment test as of June 30 each year. The goodwill impairment test consists of a two step process that includes (1) determining if potential goodwill impairment exists and (2) measuring the impairment loss, if any. At June 30, 2014, management's analysis concluded that the estimated fair value of Peoples' single reporting unit exceeded its carrying value. The analysis also included an assessment of events and circumstances considering several key factors such as economic and local market conditions, overall financial performance, changes in management or key personnel, and share price. Peoples is required to perform interim tests for goodwill impairment in subsequent quarters if events occur or circumstances change that indicate potential goodwill impairment exists, such as adverse changes to Peoples' business or a significant decline in Peoples' market capitalization. At December 31, 2014, Peoples' market capitalization was more than its book value, which management considered to be evidence that goodwill was not impaired. Peoples records servicing rights (“SRs”) in connection with its mortgage banking and small business lending activities, which are intangible assets representing the right to service loans sold to third-party investors. These intangible assets are recorded initially at fair value and subsequently amortized over the estimated life of the loans sold. SRs are stratified based on their predominant risk characteristics and assessed for impairment at the strata level at each reporting date based on their fair value. At December 31, 2014, management concluded no portion of the recorded SRs was impaired since the fair value equaled or exceeded the carrying value. However, future events, such as a significant increase in prepayment speeds, could result in a fair value that is less than the carrying amount, which would require the recognition of an impairment loss in earnings. Income Taxes Income taxes are recorded based on the liability method of accounting, which includes the recognition of deferred tax assets and liabilities for the temporary differences between carrying amounts and tax bases of assets and liabilities, computed using enacted tax rates. In general, Peoples records deferred tax assets when the event giving rise to the tax benefit has been recognized in the Consolidated Financial Statements. A valuation allowance is recognized to reduce any deferred tax asset that, based upon available information, it is more-likely-than-not all, or any portion, of the deferred tax asset will not be realized. Assessing the need for, and amount of, a valuation allowance for deferred tax assets requires significant judgment and analysis of evidence regarding realization of the deferred tax assets. In most cases, the realization of deferred tax assets is dependent upon Peoples generating a sufficient level of taxable income in future periods, which can be difficult to predict. Peoples' largest deferred tax assets involve differences related to Peoples' allowance for loan losses and accrued employee benefits. Given the nature of Peoples' deferred tax assets, management determined no valuation allowances were needed at either December 31, 2014 or 2013. The calculation of tax liabilities is complex and requires the use of estimates and judgment since it involves the application of complex tax laws that are subject to different interpretations by Peoples and the various tax authorities. These interpretations are subject to challenge by the tax authorities upon audit or to reinterpretation based on management's ongoing assessment of facts and evolving case law. From time-to-time and in the ordinary course of business, Peoples is involved in inquiries and reviews by tax authorities that normally require management to provide supplemental information to support certain tax positions taken by Peoples in its tax returns. Uncertain tax positions are initially recognized in the Consolidated Financial Statements when it is more likely than not the position will be sustained upon examination by the tax authorities. Such tax positions are initially and subsequently measured as the largest amount of tax benefit that is greater than 50% likely of being realized upon ultimate settlement with the tax authority assuming full knowledge of the position and all relevant facts. The amount of unrecognized tax benefits was immaterial at both December 31, 2014 and 2013. Management believes it has taken appropriate positions on its tax returns, although the ultimate outcome of any tax review cannot be predicted with certainty. Consequently, no assurance can be given that the final outcome of these matters will not be different than what is reflected in the current and historical financial statements. Fair Value Measurements As a financial services company, the carrying value of certain financial assets and liabilities is impacted by the application of fair value measurements, either directly or indirectly. In certain cases, an asset or liability is measured and reported at fair value on a recurring basis, such as available-for-sale investment securities. In other cases, management must rely on estimates or judgments to determine if an asset or liability not measured at fair value warrants an impairment write- down or whether a valuation reserve should be established. Given the inherent volatility, the use of fair value measurements may have a significant impact on the carrying value of assets or liabilities, or result in material changes to the consolidated financial statements, from period to period. Detailed information regarding fair value measurements can be found in Note 2 of the Notes to the Consolidated Financial Statements. The following is a summary of those assets and liabilities that may be affected by fair value measurements, as well as a brief description of the current accounting practices and valuation methodologies employed by Peoples: Available-for-Sale Investment Securities Investment securities classified as available-for-sale are measured and reported at fair value on a recurring basis. For most securities, the fair value is based upon quoted market prices (Level 1) or determined by pricing models that consider observable market data (Level 2). For structured investment securities, the fair value often must be based upon unobservable market data, such as non-binding broker quotes and discounted cash flow analysis or similar models, due to the absence of an active market for these securities (Level 3). As a result, management's determination of fair value for these securities is highly dependent on subjective or complex judgments, estimates and assumptions, which could change materially between periods. Management occasionally uses information from independent third-party consultants in its determination of the fair value of more complex structured investment securities. At December 31, 2014, all of Peoples' available-for-sale investment securities were measured using observable market data. At December 31, 2014, the majority of the investment securities with Level 2 fair values were determined using information provided by third-party pricing services. Management reviews the valuation methodology and quality controls utilized by the pricing services in management's overall assessment of the reasonableness of the fair values provided. To the extent available, management utilizes an independent third-party pricing source to assist in its assessment of the values provided by its primary pricing services. Management reviews the fair values provided by these third parties on a monthly basis and challenges prices when it believes a discrepancy in pricing exists. Based on Peoples' past experience, these challenges more-often-than-not result in the third party adjusting its valuation of the security. Impaired loans For loans considered impaired, the amount of impairment loss recognized is determined based on a discounted cash flow analysis or the fair value of the underlying collateral if repayment is expected solely from the sale of the collateral. Management typically relies on the fair value of the underlying collateral due to the significant uncertainty surrounding the borrower's ability to make future payments. The vast majority of the collateral securing impaired loans is real estate, although the collateral may also include accounts receivable and equipment, inventory or similar personal property. The fair value of the collateral used by management represents the estimated proceeds to be received from the sale of the collateral, less costs incurred during the sale, based upon observable market data or market value data provided by independent, licensed or certified appraisers. Goodwill The process of evaluating goodwill for impairment involves highly subjective or complex judgments, estimates and assumptions regarding the fair value of Peoples' reporting unit and, in some cases, goodwill itself. As a result, changes to these judgments, estimates and assumptions in future periods could result in materially different results. Peoples currently possesses a single reporting unit for goodwill impairment testing. While quoted market prices exist for Peoples' common shares since they are publicly traded, these market prices do not necessarily reflect the value associated with gaining control of an entity. Thus, management takes into account all appropriate fair value measurements in determining the estimated fair value of the reporting unit. The measurement of any actual impairment loss requires management to calculate the implied fair value of goodwill by deducting the fair value of all tangible and separately identifiable intangible net assets (including unrecognized intangible assets) from the fair value of the reporting unit. The fair value of net tangible assets is calculated using the methodologies described in Note 2 of the Notes to the Consolidated Financial Statements. Customer relationship intangibles are the only separately identifiable intangible assets included in the calculation of the implied fair value of goodwill. The amount of these intangibles represents the present value of the future earnings stream attributable to the deposit relationships. Servicing Rights SRs are carried at the lower of amortized cost or market value, and, therefore, can be subject to fair value measurements on a nonrecurring basis. SRs do not trade in an active market with readily observable prices. Thus, management determines fair value based upon a valuation model that calculates the present value of estimated future net servicing income provided by an independent third-party consultant. This valuation model is affected by various input factors, such as servicing costs, expected prepayment speeds and discount rates, which are subject to change between reporting periods. As a result, significant changes to these factors could result in a material change to the calculated fair value of SRs. EXECUTIVE SUMMARY Net income for the year ended December 31, 2014 was $16.7 million, compared to $17.6 million in 2013 and $20.4 million in 2012, representing earnings per diluted common share of $1.35, $1.63 and $1.92, respectively. The decrease in earnings during 2014 was primarily driven by acquisition-related costs of $5.1 million and pension settlement charges of $1.4 million. Earnings in 2013 were impacted by additional operating costs associated with various strategic investments to grow revenue and a lower recovery of loan losses. In 2014, Peoples had a provision for loan losses of $0.3 million due to its checking account overdrafts program, while asset quality trends remained favorable and recoveries exceeded charge-offs. Peoples recorded recoveries of loan losses of $4.4 million for 2013 and $4.7 million for 2012. Peoples recorded net recoveries of $0.5 million for 2014, compared to net recoveries of $3.7 million for 2013 and net charge-offs of $1.2 million for 2012. These recoveries or provisions represented amounts needed, in management's opinion, to maintain the appropriateness of the allowance for loan losses. Net interest income grew 25% to $69.5 million in 2014 compared to $55.4 million in 2013, mostly due to higher loan balances in connection with recent acquisitions and organic loan growth. Net interest margin was 3.45% in 2014, higher than the 3.23% in 2013 and 3.36% in 2012. The increase in 2014 was due to accretion income from acquisitions completed, loan growth, change in asset mix and a reduction in funding costs. Accretion income from acquisitions added approximately 12 basis points to net interest margin in 2014 compared to 4 basis points in 2013. The decrease in net interest margin during 2013 was largely a result of the low interest rate environment, which put downward pressure on asset yields. Total non-interest income, which excludes gains and losses on investment securities, asset disposals and other transactions, increased 8% in 2014 compared to 2013. During 2014, insurance income grew 11%, or $1.4 million, trust and investment income increased 8%, or $0.6 million, and electronic banking income was up 8%, or $0.5 million. The key driver of the increase in insurance income was additional performance-based commissions received due to the improved quality of the book of business and increased production with the insurance carriers. Mortgage banking income has slowed as refinancing activity has declined, leading to a reduction of $0.5 million in 2014 and $1.1 million in 2013. Total non-interest income was up 6% in 2013 compared to 2012, as insurance income and trust and investment income grew 24% and 16%, respectively. Total other expense increased 25%, or $16.7 million, for the year ended December 31, 2014, as a result of acquisition-related costs, higher salaries and employee benefits due to additional employees and increased electronic banking expense. Acquisition-related expenses included in other expenses during 2014 were $4.8 million compared to $1.4 million in 2013 and $569,000 in 2012. Also during 2014, the Board of Directors granted a one-time stock award of unrestricted common shares to all full-time and part-time employees who did not already participate in the equity plans, which resulted in expense of $298,000. In 2013, salaries and employee benefits increased due to a higher number of employees primarily because of acquisitions. At December 31, 2014, total assets were up 25% to $2.57 billion versus $2.06 billion at year-end 2013, with the acquisitions completed during 2014 adding approximately $464 million, and the remaining increase primarily due to loan growth. Portfolio loan balances grew $424.7 million during 2014, due to acquired loans and 12% organic growth. The allowance for loan losses increased $0.8 million to $17.9 million, or 1.48% of originated loans, net of deferred fees and costs, compared to $17.1 million and 1.58% at December 31, 2013. Total investment securities grew to $713.7 million, or 27.8% of total assets at December 31, 2014, compared to $680.5 million, or 33.0% of total assets at the prior year-end. Total liabilities were $2.23 billion at December 31, 2014, up $390.1 million since December 31, 2013. Contributing to this increase were acquired interest-bearing deposits of approximately $326.3 million and organic non-interest-bearing deposit growth of $77.8 million. Non-interest-bearing deposits comprised 23.0% of total retail deposits at December 31, 2014, versus 26.8% at year-end 2013. At December 31, 2014, total borrowed funds were $267.4 million, up $31.9 million compared to the prior year-end, as Peoples acquired and restructured long-term advances from the Ohio Heritage transaction. At December 31, 2014, total stockholders' equity was $340.1 million, up $118.6 million from December 31, 2013. Stockholders' equity represented common shares issued in connection with 2014 acquisitions was $54.4 million, and the Private Equity Issuance of common shares added $40.2 million. Peoples' regulatory capital ratios remained significantly higher than "well capitalized" minimums. Peoples' Tier 1 Common Capital ratio increased to 14.32% at December 31, 2014, versus 12.42% at December 31, 2013, while the Total Capital ratio was 15.48% versus 13.78% at December 31, 2013. In addition, Peoples' tangible common equity to tangible assets ratio was 9.39% and tangible book value per share was $15.57 at December 31, 2014, versus 7.26% and $13.57 at December 31, 2013, respectively. RESULTS OF OPERATIONS Interest Income and Expense Peoples earns interest income on loans and investments and incurs interest expense on interest-bearing deposits and borrowed funds. Net interest income, the amount by which interest income exceeds interest expense, remains Peoples' largest source of revenue. The amount of net interest income earned by Peoples is affected by various factors, including changes in market interest rates due to the Federal Reserve Board's monetary policy, the level and degree of pricing competition for both loans and deposits in Peoples' markets, and the amount and composition of Peoples' earning assets and interest-bearing liabilities. Peoples monitors net interest income performance and manages its balance sheet composition through regular ALCO meetings. The asset-liability management process employed by the ALCO is intended to mitigate the impact of future interest rate changes on Peoples' net interest income and earnings. However, the frequency and/or magnitude of changes in market interest rates are difficult to predict, and may have a greater impact on net interest income than adjustments management is able to make. The following table details Peoples’ average balance sheets for the years ended December 31: (1) Average balances are based on carrying value. (2) Interest income and yields are presented on a fully tax-equivalent basis using a 35% federal statutory tax rate. (3) Average balances include nonaccrual and impaired loans. Interest income includes interest earned on nonaccrual loans prior to the loans being placed on nonaccrual status. Loan fees included in interest income were immaterial for all periods presented. (4) Loans held for sale are included in the average loan balance listed. Related interest income on loans originated for sale prior to the loan being sold is included in loan interest income. The following table provides an analysis of the changes in fully tax-equivalent (“FTE”) net interest income: (1) The change in interest due to both rate and volume has been allocated to rate and volume changes in proportion to the relationship of the dollar amounts of the changes in each. (2) Presented on a fully tax-equivalent basis. As part of the analysis of net interest income, management converts tax-exempt income earned on obligations of states and political subdivisions to the pre-tax equivalent of taxable income using an effective tax rate of 35%. Management believes the resulting FTE net interest income allows for a more meaningful comparison of tax-exempt income and yields to their taxable equivalents. Net interest margin, which is calculated by dividing FTE net interest income by average interest- earning assets, serves as an important measurement of the net revenue stream generated by the volume, mix and pricing of earning assets and interest-bearing liabilities. The following table details the calculation of FTE net interest income for the years ended December 31: During 2014, Peoples recognized normal accretion income, net of amortization expense, from acquisitions of $2.6 million during 2014, which added approximately 12 basis points to net interest margin, compared to $0.7 million and 4 basis points, respectively, in 2013. Also during 2014, additional interest income from prepayment fees and interest recovered on nonaccrual loans was $240,000 compared to $976,000 in 2013 and $467,000 in 2012. The primary driver of the increase in net interest income during 2014 was a result of higher loan balances in connection with organic growth and acquired loans. The yield on investment securities stabilized in 2014 as long-term interest rates remained relatively steady for the majority of the year. As a result, principal prepayments from mortgage-backed securities stabilized compared to prior years, resulting in less yield compression and volatility. However, in 2013, investments yields had declined as the impact of lower reinvestment rates was magnified by a higher level of principal prepayments within mortgage-backed securities. During 2014, the average monthly principal cash flow received by Peoples from its investment portfolio was approximately $6.0 million, compared to a monthly average of approximately $8.0 million in 2013 and $11.9 million in 2012. Funding costs declined during 2014 and 2013 as Peoples executed its strategy of replacing higher-cost funding with low-cost deposits. Compared to 2013, funding costs during 2014 have decreased 14 basis points and increases in balances of low-cost deposits have provided funding for loan growth. Funding costs decreased during 2012 due to the extinguishment of $35.0 million of higher-cost wholesale borrowings in the first quarter of 2012 and the maturity of special higher-cost retail CDs. Peoples also redeemed trust preferred securities during 2012 and realized an annual interest expense savings of $1.1 million in 2013. Detailed information regarding changes in the Consolidated Balance Sheets can be found under appropriate captions of the “FINANCIAL CONDITION” section of this discussion. Additional information regarding Peoples' interest rate risk and the potential impact of interest rate changes on Peoples' results of operations and financial condition can be found later in this discussion under the caption “Interest Rate Sensitivity and Liquidity”. Provision for (Recovery of) Loan Losses The following table details Peoples’ provision for, or recovery of, loan losses recognized for the years ended December 31: The provision for, or recovery of, loan losses represents the amount needed to maintain the appropriateness of the allowance for loan losses based on management’s formal quarterly analysis of the loan portfolio and procedural methodology that estimates the amount of probable credit losses. This process considers various factors that affect losses, such as changes in Peoples’ loan quality, historical loss experience and current economic conditions. The provision for loan losses recorded in 2014 was driven by checking account overdrafts, while the impact of increases in criticized assets was mitigated by $1.8 million of recoveries on three loans that were previously charged-off. The recoveries of loan losses recorded during 2013 and 2012 were driven mostly by recoveries on commercial real estate loans that had previously incurred charge-offs. Additional information regarding changes in the allowance for loan losses and loan credit quality can be found later in this discussion under the caption “Allowance for Loan Losses”. Net Other Losses The following table details the other losses for the years ended December 31 recognized by Peoples: Net losses on bank premises and equipment during 2014 included $380,000 of asset write-offs associated with acquisition-related activity. Also during 2014, Peoples recognized a gain on debt extinguishment from a restructuring of acquired FHLB advances, and a loss on OREO from the sale of a residential property that was held. Net losses on bank premises and equipment incurred in 2013 included $248,000 of asset write-offs associated with the Ohio Commerce Bank ("Ohio Commerce") acquisition. The loss on debt extinguishment in 2012 included $3.1 million for the prepayment of $35 million of wholesale borrowings and $1.0 million for the redemption of trust preferred securities. Net losses on bank premises and equipment during 2012 were due to asset write-offs associated with the Sistersville Bancorp, Inc. acquisition. Non-Interest Income Peoples generates non-interest income, which excludes gains and losses on investments and other assets, from five primary sources: insurance sales revenues, deposit account service charges, trust and investment activities, electronic banking (“e-banking”), and mortgage banking. Peoples continues to focus on revenue growth from non-interest income sources in order to maintain a diversified revenue stream through greater reliance on fee-based revenues. As a result, total non-interest income accounted for 36.6% of Peoples' total revenues in 2014, compared to 40.2% in 2013 and 39.1% in 2012. The decline in Peoples' total non-interest income as a percent of total revenue during 2014 was primarily due to increased net interest income from recent acquisitions. Insurance income comprised the largest portion of Peoples' non-interest income. The following table details Peoples’ insurance income for the years ended December 31: During 2014 and 2013, increases in life and health insurance commissions were the result of acquisitions completed during the second quarter of 2013. Performance-based commissions were a key driver in the overall increase in insurance income and are typically recorded annually in the first quarter and are based on a combination of factors, such as loss experience of insurance policies sold, production volumes, and overall financial performance of the individual insurance carriers. Compared to 2012, the growth in property and casualty insurance commissions was a result of successful integration of acquisitions during 2013, a higher rate of referrals between lines of business and higher premiums throughout the industry. Service charges and other fees on deposit accounts, which are based on the recovery of costs associated with services provided, comprised a significant portion of Peoples' non-interest income. The following table details Peoples' deposit account service charges for the years ended December 31: The amount of deposit account service charges, particularly fees for overdrafts and non-sufficient funds, is largely dependent on the timing and volume of customer activity. Peoples typically experiences a lower volume of overdraft and non-sufficient funds fees annually in the first quarter attributable to customers receiving income tax refunds, while volumes generally increase in the fourth quarter in connection with the holiday shopping season. Management periodically evaluates its cost recovery fees to ensure they are reasonable based on operational costs and similar to fees charged in Peoples' markets by competitors. Increases in account maintenance fees in 2014, compared to 2013, were the result of higher fees received on commercial accounts and rewards checking accounts. Peoples' fiduciary and brokerage revenues continue to be based primarily upon the value of assets under management. The following table details Peoples’ trust and investment income for the years ended December 31: The following table details Peoples’ managed assets at year-end December 31: During 2014 and 2013, fiduciary income increased primarily due to higher managed asset account balances and retirement benefits plan income due to the addition of new plans. In recent years, Peoples has added experienced financial advisors in previously underserved market areas, and generated new business and revenue related to retirement plans for which it manages the assets and provides services. The U.S. financial markets continued to experience a general increase during 2014, which also contributed to the increase in managed assets. Peoples' e-banking services include ATM and debit cards, direct deposit services, internet and mobile banking, and serve as alternative delivery channels to traditional sales offices for providing services to clients. During 2014, electronic banking income grew $451,000, or 7% compared to 2013, due to a continued increase in the volume of debit card transactions. In 2014, Peoples' customers used their debit cards to complete $467 million of transactions, versus $416 million in 2013 and $391 million in 2012. Mortgage banking income is comprised mostly of net gains from the origination and sale of long-term, fixed-rate real estate loans in the secondary market. As a result, the amount of income recognized by Peoples is largely dependent on customer demand and long-term interest rates for residential real estate loans offered in the secondary market. Mortgage banking income decreased 30% in 2014 and 39% in 2013 due to slowed refinancing activity. In 2014, Peoples sold approximately $48.8 million of loans to the secondary market compared to $73.2 million in 2013 and $129.4 million in 2012. Non-Interest Expense Salaries and employee benefit costs remain Peoples’ largest non-interest expense, accounting for over half of total non-interest expense. The following table details Peoples’ salaries and employee benefit costs for the years ended December 31: Base salaries and wages increased in both 2014 and 2013 due to completed acquisitions, additional operational staff and the addition of new sales talent in several markets, which significantly impacted the number of full-time equivalent employees. Peoples' sales-based and incentive compensation is tied to corporate incentive plans and commission from sales production. This area has grown over recent years in conjunction with the increased commission-based revenue and improved financial performance. Peoples' employee benefit costs increased 62% compared to 2013 primarily due to pension settlement charges of $1.4 million incurred in 2014, compared to $270,000 in 2013 and $835,000 in 2012. Effective March 1, 2011, Peoples froze the accrual of pension benefits, and since then, settlement charges have been largely based on the timing of retirements of individuals and their election of lump-sum distributions. Under US GAAP, Peoples is required to recognize a settlement gain or loss when the aggregate amount of lump-sum distributions to participants equals or exceeds the sum of the service and interest cost components of the net periodic pension cost. The amount of settlement gain or loss recognized is the pro rata amount of the unrealized gain or loss existing immediately prior to the settlement. Management anticipates continued pension settlement charges in future years as individuals retire and elect lump-sum distributions from the plan. During 2014, employee benefit costs also increased $994,000 from higher employee medical benefit plan expenses, which are tied to claims activity, compared to a reduction in 2013 from 2012. Stock-based compensation is generally recognized over the vesting period, typically ranging from 6 months to 3 years. For all awards, expense is initially only recognized for the portion of awards that is expected to vest, and at the vesting date, an adjustment is made to recognize the entire expense for vested awards and reverse expense for non-vested awards. The majority of Peoples' stock-based compensation expense is attributable to annual equity-based incentive awards to employees, which are awarded in the first quarter and based upon Peoples achieving certain performance goals during the prior year. During 2014, Peoples granted restricted shares to non-employee directors, officers and key employees with performance-based vesting periods and time-based vesting periods. Stock-based compensation expense in 2014 included $1,048,000 of expense related to these awards, $298,000 related to a one-time stock award of unrestricted common shares to all full-time and part-time employees who did not already participate in the equity plan, while the remaining expense recognized was for grants awarded in previous years. As it is probable that all outstanding performance-based vesting conditions will be satisfied, Peoples recorded the pro-rata expense for all outstanding performance-based awards in 2014, as required by US GAAP. Additional information regarding Peoples' stock-based compensation plans and awards can be found in Note 16 of the Notes to the Consolidated Financial Statements. Deferred personnel costs represent the portion of current period salaries and employee benefit costs considered to be direct loan origination costs. These costs are capitalized and recognized over the life of the loan as a yield adjustment to interest income. As a result, the amount of deferred personnel costs for each year corresponds directly with the level of new loan originations. Additional information regarding Peoples' loan activity can be found later in this discussion under the caption “Loans”. Peoples’ net occupancy and equipment expense for the years ended December 31 was comprised of the following: During 2014, Peoples acquired several new offices which resulted in higher depreciation, repairs and maintenance costs and property taxes, utilities and other costs. In addition, Peoples opened several new branch locations, completed the renovation of its branch network that began in 2013 and finished a rebranding project in late 2012. Management continues to monitor capital expenditures and explore opportunities to enhance Peoples' operating efficiency. Professional fees expense represents the cost of accounting, legal and other third-party professional services utilized by Peoples, and increased 34% during 2014. Professional fees incurred as a result of acquisition-related activities were $2.0 million in 2014, compared to $448,000 and $300,000 in 2013 and 2012, respectively. Peoples' e-banking expense, which is comprised of bankcard, internet and mobile banking costs, increased in 2014 and 2013 due to customers completing a higher volume of transactions using their debit cards, Peoples' internet banking service and increased debit card compromises at certain large retail companies. These factors also produced a greater increase in the corresponding e-banking revenues over the same periods. In 2014, marketing expense, which includes advertising, donation and other public relations costs, was relatively flat compared to 2013. Marketing expense decreased in 2013 due to the higher expenses in 2012 recognized in connection with the rebranding efforts. Peoples contributed $300,000 in 2014, $200,000 in 2013 and $400,000 in 2012 to Peoples Bancorp Foundation Inc. Peoples formed this private foundation in 2004 to make charitable contributions to organizations within Peoples' primary market area. Future contributions to Peoples Bancorp Foundation Inc. will be evaluated on a quarterly basis, with the determination of the amount of any contribution based largely on the perceived level of need within the communities Peoples serves. Peoples is subject to state franchise taxes, which are based largely on Peoples Bank's equity at year-end, in the states where Peoples Bank has a physical presence. Franchise taxes increased during 2013 due to an increase in equity from the overall improvement in earnings. Peoples regularly evaluates the capital position of its direct and indirect subsidiaries from both a cost and leverage perspective. Ultimately, management seeks to optimize Peoples' consolidated capital position through allocation of capital, which is intended to enhance profitability and shareholder value. Peoples' intangible asset amortization expense is driven by acquisition-related activity, and increased 77% in 2014 and 59% in 2013. Management expects this amount to increase significantly in 2015 as it continues to complete acquisitions and recognizes a full year of amortization for acquisitions completed during 2014. Data processing and software costs include software support, maintenance and depreciation expense. These costs increased during 2014 due to the recent acquisitions and new software projects completed, and were relatively flat in 2013 compared to 2012. Peoples' FDIC insurance costs increased during 2014 as a result of recent acquisitions. These costs stabilized during 2013 and 2012, after new regulations required by the Dodd-Frank Act became effective during 2011. Additional information regarding Peoples' FDIC insurance assessments may be found in "ITEM 1 - BUSINESS" of this Form 10-K in the section captioned "Supervision and Regulation". Peoples' efficiency ratio, calculated as non-interest expense less amortization of other intangible assets divided by FTE net interest income plus non-interest income, was 75.37% for 2014, compared to 71.90% for 2013 and 69.55% for 2012. The increases in 2014 and 2013 were largely a result of one-time costs for acquisitions plus higher salaries and employee benefit costs. Income Tax Expense A key driver of the amount of income tax expense or benefit recognized by Peoples each year is the amount of pre-tax income derived from tax-exempt sources. Additionally, Peoples receives tax benefits from its investments in tax credit funds, which reduce Peoples' effective tax rate. A reconciliation of Peoples' recorded income tax expense/benefit and effective tax rate to the statutory tax rate can be found in Note 12 of the Notes to the Consolidated Financial Statements. Pre-Provision Net Revenue Pre-provision net revenue ("PPNR") has become a key financial measure used by federal bank regulatory agencies when assessing the capital adequacy of financial institutions. PPNR is defined as net interest income plus non-interest income minus non-interest expense and therefore, excludes the provision for (recovery of) loan losses and all gains and losses included in earnings. As a result, PPNR represents the earnings capacity that can be either retained in order to build capital or used to absorb unexpected losses and preserve existing capital. The following table provides a reconciliation of this non-GAAP financial measure to the amounts reported in Peoples' consolidated financial statements for the periods presented: During 2014, PPNR declined due to higher average assets resulting from recent acquisitions and organic growth, coupled with additional costs from acquisition-related activities. FINANCIAL CONDITION Cash and Cash Equivalents Peoples considers cash and cash equivalents to consist of Federal Funds sold, cash and balances due from banks, interest-bearing balances in other institutions and other short-term investments that are readily liquid. The amount of cash and cash equivalents fluctuates on a daily basis due to customer activity and Peoples' liquidity needs. At December 31, 2014, excess cash reserves at the Federal Reserve Bank were $12.4 million, compared to $14.2 million at December 31, 2013. The amount of excess cash reserves maintained is dependent upon Peoples' daily liquidity position, which is driven primarily by changes in deposit and loan balances. In 2014, Peoples' total cash and cash equivalents decreased $7.6 million, as cash provided by Peoples' operating activities of $31.5 million was mostly offset by cash used by investing activities of $9.7 million and financing activities of $14.2 million. Cash provided by activities in available-for-sale securities and business combinations of $44.7 million, and $17.1 million, respectively, partially funded loan growth of $76.1 million. Within Peoples' financing activities, the decreases in interest-bearing deposits and short-term borrowings of $56.1 million were tempered by an increase in non-interest bearing deposits of $18.4 million and $40.2 million in proceeds from issuance of common shares. In 2013, Peoples' total cash and cash equivalents decreased $8.7 million, as cash provided by Peoples' operating and financing activities of $40.5 million and $30.8 million, respectively, were more than offset by the $80.0 million of cash used by investing activities. Investing activities used $109.6 million to fund loan growth, while the BOLI Surrender provided cash of $43.1 million. Within Peoples' financing activities, the increase in short-term borrowings of $65.8 million was the result of loan growth, and decreases in deposit balances of $22.4 million, excluding the impact of acquired deposits. Further information regarding the management of Peoples' liquidity position can be found later in this discussion under “Interest Rate Sensitivity and Liquidity.” Investment Securities The following table provides information regarding Peoples’ investment portfolio at December 31: At December 31, 2014, Peoples' investment securities were approximately 27.8% of total assets compared to 33.0% at December 31, 2013, as Peoples continued to focus on reducing the relative size of the investment portfolio. During 2014, Peoples acquired and retained approximately $11.9 million of available-for-sale investment securities, while the remaining acquired securities were sold. The additional increases in the available-for-sale investment securities in 2014 were due to purchases outpacing sales, calls and maturities. In 2013, and throughout 2012, Peoples designated certain securities as "held-to-maturity" at the time of their purchase, as management made the determination Peoples would hold these securities until maturity and concluded Peoples had the ability to do so. Recently, Peoples has maintained the size of the held-to-maturity securities portfolio, for which the unrealized gain or loss does not directly impact stockholders' equity, in contrast to the impact from the available-for-sale securities portfolio. Peoples has taken actions within the investment portfolio in an effort to reduce interest rate exposure, resulting in sales during 2013 of several residential mortgage-backed securities and commercial mortgage-backed securities. Peoples' investment in residential and commercial mortgage-backed securities largely consists of securities either guaranteed by the U.S. government or issued by U.S. government sponsored agencies, such as Fannie Mae and Freddie Mac. The remaining portions of Peoples' mortgage-backed securities consist of securities issued by other entities, including other financial institutions, which are not guaranteed by the U.S. government. The amount of these “non-agency” securities included in the residential and commercial mortgage-backed securities totals above was as follows at December 31: Management continues to reinvest the principal runoff from the non-agency securities in U.S agency investments, which has accounted for the continued decline in the fair value of these securities. At December 31, 2014, Peoples' non-agency portfolio consisted entirely of first lien residential mortgages, with nearly all of the underlying loans in these securities originated prior to 2004 and possessing fixed interest rates. Management continues to monitor the non-agency portfolio closely for leading indicators of increasing stress and will continue to be proactive in taking actions to mitigate such risk when necessary. Additional information regarding Peoples' investment portfolio can be found in Note 3 of the Notes to the Consolidated Financial Statements. Loans The following table provides information regarding outstanding loan balances at December 31: (a) Includes all loans acquired in 2012 and thereafter. During 2014, total originated loans grew 12%, or $126.5 million, largely due to growth in commercial real estate, commercial and industrial and consumer loan balances. At December 31, 2014, loans acquired from Midwest, Ohio Heritage and North Akron were approximately $52.5 million, $166.6 million and $108.8 million, respectively. During 2013, total originated loans increased 13%, while acquired loans grew $84.5 million due to the Ohio Commerce acquisition. Also during 2013, Peoples retained a larger percentage of residential mortgage loans originated than in prior years which caused the increase in residential real estate loans. Beginning in 2013, Peoples placed greater emphasis on its consumer lending business, which primarily consists of automobile loans obtained directly or indirectly through automobile dealerships. Peoples added additional sales talent within this business line and established better relationships with dealers, resulting in substantially higher loan balances compared to prior years. The following table details the maturities of Peoples' commercial and construction loans at December 31, 2014: Loan Concentration Peoples categorizes its commercial loans according to standard industry classifications and monitors for concentrations in a single industry or multiple industries that could be impacted by changes in economic conditions in a similar manner. Loans secured by commercial real estate, including commercial construction loans, continue to comprise the largest portion of Peoples' loan portfolio. The following table provides information regarding the largest concentrations of commercial real estate loans within the loan portfolio at December 31, 2014: Peoples' commercial lending activities continue to focus on lending opportunities inside its primary and secondary market areas within Ohio, West Virginia and Kentucky. In all other states, the aggregate outstanding balances of commercial loans in each state were less than $4.0 million at both December 31, 2014 and December 31, 2013. Allowance for Loan Losses The amount of the allowance for loan losses at the end of each period represents management's estimate of probable losses from existing loans based upon its formal quarterly analysis of the loan portfolio described in the “Critical Accounting Policies” section of this discussion. While this process involves allocations being made to specific loans and pools of loans, the entire allowance is available for all losses incurred within the loan portfolio. The following details management's allocation of the allowance for loan losses at December 31: The reduction in the allowance for loan losses allocated to commercial real estate during 2014 was driven by net recoveries in recent years reducing the historical loss rates. Increases in the commercial and industrial, residential real estate, home equity lines of credit and consumer categories of the allowance for loan losses were driven by net charge-off activity and increases in balances of the respective loan portfolios. The significant allocations to commercial loans reflect the higher credit risk associated with these types of lending and the size of these loan categories in relationship to the entire loan portfolio. During 2014, Peoples experienced an increase of $15.7 million in criticized loans, which are those classified as watch, substandard or doubtful. Peoples received principal paydowns of $20.6 million in 2014, and upgraded $33.7 million in loans based upon the financial condition of the borrowers. Net charge-offs continued to remain at or below Peoples' long-term historical rate. The allowance allocated to the residential real estate and consumer loan categories was based upon Peoples' allowance methodology for homogeneous pools of loans. The fluctuations in these allocations have been directionally consistent with the changes in loan quality, loss experience and loan balances in these categories. The following table summarizes the changes in the allowance for loan losses for the years ended December 31: During 2014, Peoples recorded recoveries of $1.5 million on two previously charged-off commercial real estate loans. Peoples' net charge-offs continue to remain well below the long-term historical average of 0.30% to 0.50%. Peoples focuses on sound underwriting and prudent risk management to maintain this lower level of charge-offs. The following table details Peoples’ nonperforming assets at December 31: At December 31, 2014, loans 90+ days past due and accruing included $2.3 million of loans that were acquired that had evidence of credit quality deterioration since origination and for which interest income was being recognized on a level-yield method over the life of the loan. The majority of Peoples' nonaccrual commercial real estate loans continued to consist of non-owner occupied commercial properties and real estate development projects. In general, management believes repayment of these loans is dependent on the sale of the underlying collateral. As such, the carrying values of these loans are ultimately supported by management's estimate of the net proceeds Peoples would receive upon the sale of the collateral. These estimates are based in part on market values provided by independent, licensed or certified appraisers periodically, but no less frequently than annually. Given the volatility in commercial real estate values, management continues to monitor changes in real estate values from quarter-to-quarter and updates its estimates as needed based on observable changes in market prices and/or updated appraisals for similar properties. The significant decreases in nonaccrual commercial real estate loans during recent years was a result of the addition of a special assets group and their efforts in collecting and recovering payments on delinquent commercial loans. The increase in nonaccrual commercial and industrial loans during 2014 was driven by a single $1.2 million relationship placed on nonaccrual during the fourth quarter of 2014. Interest income on loans classified as nonaccrual and renegotiated at each year-end that would have been recorded under the original terms of the loans was $0.5 million for 2014, $0.2 million for 2013 and $0.5 million for 2012. No portion of the amounts was recorded during 2014, 2013 or 2012, consistent with the income recognition policy described in the “Critical Accounting Policies” section of this discussion. Overall, management believes the allowance for loan losses was adequate at December 31, 2014, based on all significant information currently available. Still, there can be no assurance that the allowance for loan losses will be adequate to cover future losses or that the amount of nonperforming loans will remain at current levels, especially considering the current economic uncertainty that exists and the concentration of commercial loans in Peoples’ loan portfolio. Deposits The following table details Peoples’ deposit balances at December 31: At December 31, 2014, the Midwest, Ohio Heritage and North Akron acquisitions added approximately $105.0 million of certificates of deposits (“CDs”), $165.1 million of money market deposit accounts, $2.1 million of governmental deposit accounts, $53.1 million of savings accounts, $1.0 million of interest-bearing demand accounts and $5.5 million of non-interest-bearing deposits. In 2014, Peoples continued to maintain its deposit strategy of growing low-cost core deposits, such as checking and savings accounts, and reducing its reliance on higher-cost, non-core deposits, such as CDs and brokered deposits. This strategy has included more selective pricing of long-term CDs, governmental/public fund deposits and similar non-core deposits, as well as not renewing maturing brokered deposits. As a result, organic balances in CDs and money market deposit accounts declined 10% and 38%, respectively, in 2014. Governmental deposit accounts experienced 20% organic growth as higher balances were maintained in several city and county deposit accounts. Also during 2014, interest-bearing demand accounts increased due to higher balances held by individual accounts. Non-interest-bearing deposits continued to grow in 2014, due largely to a mix of higher balances in both commercial and consumer deposit balances. During 2014, organic non-interest-bearing deposit balances increased $77.8 million, or 19%. Peoples' governmental deposit accounts represent savings and interest-bearing transaction accounts from state and local governmental entities. These funds are subject to periodic fluctuations based on the timing of tax collections and subsequent expenditures or disbursements. Peoples normally experiences an increase in balances annually during the first quarter corresponding with tax collections, with declines normally in the second half of each year corresponding with expenditures by the governmental entities. While these balances have increased since 2008, Peoples continues to emphasize growth of low-cost deposits that do not require Peoples to pledge assets as collateral, which is required in the case of governmental deposit accounts. The maturities of retail CDs with total balances of $250,000 or more at December 31 were as follows: Borrowed Funds The following table details Peoples’ short-term and long-term borrowings at December 31: Peoples' short-term FHLB advances generally consist of overnight borrowings being maintained in connection with the management of Peoples' daily liquidity position. During 2014, Peoples reduced its usage of short-term FHLB advances due to the increase in deposit balances. Peoples' retail repurchase agreements consist of overnight agreements with commercial customers and serve as a cash management tool. The increase in the long-term borrowings during 2014 was primarily due to Peoples acquiring and restructuring long-term FHLB advances from Ohio Heritage. During 2012, Peoples entered into a loan agreement that was subsequently amended in 2014 (as amended, "Amended Loan Agreement"), and Peoples is subject to certain covenants imposed by this Amended Loan Agreement. At December 31, 2014, Peoples was in compliance with the applicable material covenants. Additional information regarding Peoples' borrowed funds can be found in Notes 8 and 9 of the Notes to the Consolidated Financial Statements. Capital/Stockholders’ Equity During 2014, Peoples' total stockholders' equity increased primarily due to $54.4 million of common equity issued in connection with acquisitions completed during the year and the Private Equity Issuance of common shares which added $40.2 million in common equity. Also contributing to the increase were an excess of earnings over dividends declared, and a recovery in the market value of available-for-sale investment securities. Regulatory capital ratios continued to fluctuate due to recent acquisitions. At December 31, 2014, capital levels for both Peoples and Peoples Bank remained substantially higher than the minimum amounts needed to be considered "well capitalized" under banking regulations. These higher capital levels reflect Peoples' desire to maintain strong capital positions to provide greater flexibility to grow the company. The following table details Peoples' actual risk-based capital levels and corresponding ratios at December 31: In addition to traditional capital measurements, management uses tangible capital measures to evaluate the adequacy of Peoples' stockholders' equity. Such ratios represent non-GAAP financial information since their calculation removes the impact of intangible assets acquired through acquisitions on the Consolidated Balance Sheets. Management believes this information is useful to investors since it facilitates the comparison of Peoples' operating performance, financial condition and trends to peers, especially those without a similar level of intangible assets to that of Peoples. Further, intangible assets generally are difficult to convert into cash, especially during a financial crisis, and could decrease substantially in value should there be deterioration in the overall franchise value. As a result, tangible common equity represents a conservative measure of the capacity for a company to incur losses but remain solvent. The following table reconciles the calculation of these non-GAAP financial measures to amounts reported in Peoples' Consolidated Financial Statements at December 31: During 2014, Peoples' tangible common equity to tangible assets ratio increased significantly due to recent acquisitions, in which common shares represented a portion of the consideration, and the Private Equity Issuance. The reduction in 2013 was due to the impact of assets acquired in the Ohio Commerce acquisition, which was funded solely by cash consideration, as well as reductions in the fair value of the available-for-sale investment securities. Future Outlook Peoples was successful with many of the goals set for 2014, including organic loan growth and four acquisition announcements. Organic loan growth exceeded expectations throughout 2014 and was the driving force behind improvements in Peoples' asset mix, expanding net interest margin, and robust revenue growth. Three of the four acquisitions announced during 2014 were completed during the year, with the fourth, NB&T, to be closed in March 2015. Upon completion of NB&T, Peoples will exceed $3.2 billion in assets with 81 branch locations throughout the states of Ohio, West Virginia and Kentucky. The growth in organic loans and through acquisitions has made Peoples a stronger, more profitable company. Other key accomplishments included improved revenue generation from Peoples' wealth management and insurance operations, restored asset quality, and net demand deposit account growth. For 2015, Peoples will build off the momentum that was gained in 2014. Key strategic priorities will include generating positive operating leverage, maintaining superior asset quality, and remaining prudent with the use of capital. Overall, Peoples' key strategic objectives are to be a steady, dependable performer for its shareholders and take advantage of market expansion opportunities. Peoples' long-term strategic goals include generating results in the top quartile of performance relative to Peoples' defined peer group and providing returns for its shareholders superior to those of its peers, regardless of operating conditions. Revenue growth for 2014 was slightly better than expense growth, excluding one-time costs. Management believes Peoples is positioned to grow revenue faster than expenses in 2015 and is confident this goal will be achieved. The primary focus continues to be on growing revenue, rather than decreasing expenses. For 2015, net interest margin is expected to remain stable in the low 3.50's. Loan growth will again be the key driver in stabilizing asset yields, along with a continuation of the change in the asset mix. Peoples' efficiency ratio is expected to be below 65%, excluding one-time costs, in the second half of 2015. With the closing of NB&T in March, Peoples expects to have all related cost savings fully phased-in during the second quarter of 2015. Peoples has the capacity to be a much bigger company. Its experienced management team, along with its scalable systems, has the ability to drive meaningful revenue growth. Thus, Peoples’ long-term goal is to widen the revenue and expense growth gap in future years, which should cause Peoples’ efficiency ratio to improve by 1% to 2% each year. A major asset for Peoples is its strong fee-based businesses, such as insurance and wealth management. In 2014, Peoples' fee revenue comprised 37% of its total revenue, down from 40% in 2013. Peoples has capabilities that many banks in its market area lack, including some of the largest national banks, which include robust retirement plan services and comprehensive insurance products. Thus, management considers Peoples to have a competitive advantage that directly enhances revenue growth potential. For 2015, management will continue to strive for a diversified revenue stream that consists of 35% to 40% fee-based revenue to total revenue. The achievement of this goal will be driven by continued solid growth in insurance and investment income, and Peoples continually seeking acquisitions opportunities of insurance and wealth management companies. Even with a more diversified revenue stream than most community banks, net interest income remains a major source of revenue for Peoples. Thus, Peoples' ability to grow revenue in 2015 will be impacted by the amount of net interest income generated. The current outlook is mixed as to whether the Federal Reserve Board will hold short-term interest rates at their historically low levels throughout all of 2015, or if there will be increases in the later half of 2015. Long-term rates could increase but remain more volatile than prior years. Changes in long-term rates would affect reinvestment rates within the loan and investment portfolios. Should the yield curve flatten, Peoples would have limited opportunities to offset the impact on asset yields with a similar reduction in funding costs. Thus, Peoples' ability to produce meaningful loan growth remains the key driver for improving net interest income and margin in 2015. Management would expect both net interest income and margin to benefit from any meaningful increase in market interest rates based upon the current interest rate risk profile. However, it remains inherently difficult to predict and manage the future trend of Peoples' net interest income and margin due to the uncertainty surrounding the timing and magnitude of future interest rate changes, as well as the impact of competition for loans and deposits. While the primary focus is on revenue growth, management intends to remain disciplined with operating expenses. For 2015, total non-interest expense will increase due to a full year’s impact of the 2014 acquisitions. Outside these items, management will be working to limit increases in other expense areas. However, Peoples continues to have limited control over some expenses, such as employee medical and pension costs. Peoples continues to be more exposed to pension settlement charges given the frozen status of its defined benefit plan. The recognition of settlement charges is largely dependent upon the timing of distributions, the amount of pension benefit earned by the retirees, and whether the individuals elect a lump sum distribution. For 2015, management does not anticipate to incur the volume of settlement charges incurred in 2014. This expectation is based on normal retirement activity within the plan, but assumes all potential distributions are lump sum payouts. A key to Peoples’ 2015 revenue growth goal is achieving meaningful loan growth. Management believes period-end loan balances could increase by 7% to 9% in 2015, which assumes commercial loan growth of 8% to 10% and consumer loan growth of 3% to 5%. Within Peoples' commercial lending activity, the primary emphasis continues to be on non-mortgage commercial lending opportunities and capitalizing on growth opportunities provided by the acquisitions completed and to be completed in early 2015. As a result, commercial and industrial loan balances should increase at a greater rate than commercial real estate loan balances. Consumer lending activity is continuing to build and will remain a larger contributor to overall loan growth. Peoples' strategy is to reduce the size of the investment portfolio to 25% of its total assets by year end 2015. Consistent with this goal, management plans to use the cash flow generated by Peoples’ significant investment in mortgage-backed securities to fund new loan production. This action would temper the overall growth in total earning assets in 2014. Management could adjust the size or composition of the investment portfolio in response to other factors, such as changes in liquidity needs and interest rate conditions. In 2015, Peoples' funding strategy continues to emphasize growth of core deposits, such as checking and savings accounts, rather than higher-cost deposits. Thus, CD balances could maintain the declining trend experienced in recent years. Given the expected increase in earning assets, borrowed funds would increase in 2015 to the extent earning asset growth is more than deposit growth. Should this occur, management would evaluate using longer-term borrowings to match the duration of the assets being funded to minimize the long-term interest rate risk. Peoples remains committed to sound underwriting and prudent risk management. Management believes this credit discipline will benefit Peoples during future economic downturns. The long-term goal is to maintain key metrics in the top-quartile of Peoples' peer group regardless of economic conditions. Net charge-off trends are expected to normalize in 2015 as the prospects of large recoveries diminish. Management anticipates Peoples' net charge-off rate for 2015 to be near the low end of its long-term historical range of 0.20% to 0.30% of average loans. For 2015, management intends to remain prudent with the level of Peoples' allowance for loan losses. Given the expectation of net-charge offs for 2015, and the continued focus on consumer lending, management does not expect the level to drop much below its current level of 1.48% of total originated loans during 2015. However, the level will continue to be based upon management's quarterly assessment of the losses inherent in the loan portfolio, and the amount of any provision for loan losses should be driven mostly by a combination of the net charge-off rate and loan growth. Peoples will continue to explore market expansion opportunities in or near its current market areas during 2015. Management's primary focus will be on increasing market share within existing markets, while taking advantage of potential growth opportunities within its insurance and wealth management lines of business. Management believes Peoples' capital position remains strong enough to support an active merger and acquisition strategy, and expansion of Peoples' core financial service businesses of banking, insurance and wealth management. Consequently, management continues to explore acquisition opportunities in these activities. In evaluating acquisition opportunities, management will balance the potential for earnings accretion with maintaining adequate capital levels, which could result in Peoples' common stock being the predominate form of consideration and/or the need for Peoples to raise capital. Conversations with potential strategic partners are occurring on a regular basis. The evaluation of any potential opportunity will favor a transaction that complements Peoples' core competencies and strategic intent, with a lesser emphasis being placed on geographic location or size. Additionally, Peoples remains committed to maintaining a diversified revenue stream. Peoples’ management team is prepared to act quickly should a potential opportunity arise, but will remain disciplined with its approach. All transactions must be accretive by no later than the second year in order to satisfy Peoples' goal of improving shareholder return. Management is optimistic regarding Peoples’ ability to complete additional acquisitions in 2015. Management has built a culture where it is paramount that the associates take care of customers and take care of each other. Management is committed to profitable growth of the company and building long-term shareholder value. This will require management to remain focused on four key areas: responsible risk management; extraordinary client experience; profitable revenue growth; and maintaining a superior workforce. Success will be achieved through disciplined execution of strategies and providing extraordinary service to Peoples' clients and communities. Interest Rate Sensitivity and Liquidity While Peoples is exposed to various business risks, the risks relating to interest rate sensitivity and liquidity are major risks that can materially impact future results of operations and financial condition due to their complexity and dynamic nature. The objective of Peoples' asset/liability management (“ALM”) function is to measure and manage these risks in order to optimize net interest income within the constraints of prudent capital adequacy, liquidity and safety. This objective requires Peoples to focus on interest rate risk exposure and adequate liquidity through its management of the mix of assets and liabilities, their related cash flows and the rates earned and paid on those assets and liabilities. Ultimately, the ALM function is intended to guide management in the acquisition and disposition of earning assets and selection of appropriate funding sources. Interest Rate Risk Interest rate risk (“IRR”) is one of the most significant risks arising in the normal course of business of financial services companies like Peoples. IRR is the potential for economic loss due to future interest rate changes that can impact the earnings stream as well as market values of financial assets and liabilities. Peoples' exposure to IRR is due primarily to differences in the maturity or repricing of earning assets and interest-bearing liabilities. In addition, other factors, such as prepayments of loans and investment securities or early withdrawal of deposits, can affect Peoples' exposure to IRR and increase interest costs or reduce revenue streams. Peoples has assigned overall management of IRR to the ALCO, which has established an IRR management policy that sets minimum requirements and guidelines for monitoring and managing the level of IRR. The objective of Peoples' IRR policy is to assist the ALCO in its evaluation of the impact of changing interest rate conditions on earnings and economic value of equity, as well as assist with the implementation of strategies intended to reduce Peoples' IRR. The management of IRR involves either maintaining or changing the level of risk exposure by changing the repricing and maturity characteristics of the cash flows for specific assets or liabilities. Additional oversight of Peoples' IRR is provided by the Asset Liability Management and Investment Committee of Peoples Bank's Board of Directors. This committee also reviews and approves Peoples' IRR management policy at least annually. The ALCO uses various methods to assess and monitor the current level of Peoples' IRR and the impact of potential strategies or other changes. However, the ALCO predominantly relies on simulation modeling in its overall management of IRR since it is a dynamic measure. Simulation modeling also estimates the impact of potential changes in interest rates and balance sheet structures on future earnings and projected economic value of equity. The modeling process starts with a base case simulation using the current balance sheet and current interest rates held constant for the next twenty-four months. Alternate scenarios are prepared which simulate the impact of increasing and decreasing market interest rates, assuming parallel yield curve shifts. Comparisons produced from the simulation data, showing the changes in net interest income from the base interest rate scenario, illustrate the risks associated with the current balance sheet structure. Additional simulations, when deemed appropriate or necessary, are prepared using different interest rate scenarios from those used with the base case simulation and/or possible changes in balance sheet composition. The additional simulations include non-parallel shifts in interest rates whereby the direction and/or magnitude of change of short-term interest rates is different than the changes applied to longer-term interest rates. Comparisons showing the earnings and economic value of equity variance from the base case are provided to the ALCO for review and discussion. The ALCO has established limits on changes in the twelve-month net interest income forecast and the economic value of equity from the base case. The ALCO may establish risk tolerances for other parallel and non-parallel rate movements, as deemed necessary. The following table details the current policy limits used to manage the level of Peoples' IRR: The following table shows the estimated changes in net interest income and the economic value of equity based upon a standard, parallel shock analysis (dollars in thousands): This table uses a standard, parallel shock analysis for assessing the IRR to net interest income and the economic value of equity. A parallel shock means all points on the yield curve (one year, two year, three year, etc.) are directionally changed the same amount of basis points. For example, 100 basis points are equal to 1%. While management regularly assesses the impact of both increasing and decreasing interest rates, the table above only reflects the impact of upward shocks due to the fact a downward parallel shock of 100 basis points or more is not possible given that most short-term rates are currently less than 1%. Although a parallel shock table can give insight into the current direction and magnitude of IRR inherent in the balance sheet, interest rates do not always move in a complete parallel manner during interest rate cycles. These nonparallel movements in interest rates, commonly called yield curve steepening or flattening movements, tend to occur during the beginning and end of an interest rate cycle, with differences in the timing, direction and magnitude of changes in short-term and long-term interest rates. Thus, any benefit that could occur as a result of the Federal Reserve Board increasing short-term interest rates in future quarters could be offset by an inverse movement in long-term interest rates. As a result, management conducts more advanced interest rate shock scenarios to gain a better understanding of Peoples' exposure to nonparallel rate shifts. At December 31, 2014, Peoples' Consolidated Balance Sheet remained positioned for a rising interest rate environment, as illustrated by the potential increase in net interest income shown in the above table. During 2014, Peoples became less sensitive to rising interest rates (as measured by the expected percentage change in economic value of equity) due to several factors. The largest factors impacting Peoples' interest rate sensitivity were an overall reduction in the duration of assets, changes in expected prepayment speeds in the investment portfolio and the three bank acquisitions completed during 2014. Liquidity In addition to IRR management, another major objective of the ALCO is to maintain a sufficient level of liquidity. The ALCO defines liquidity as the ability to meet anticipated and unanticipated operating cash needs, loan demand and deposit withdrawals, without incurring a sustained negative impact on profitability. A primary source of liquidity for Peoples is retail deposits. Liquidity is also provided by cash generated from earning assets such as maturities, calls, and principal and interest payments from loans and investment securities. Peoples also uses various wholesale funding sources to supplement funding from customer deposits. These external sources provide Peoples with the ability to obtain large quantities of funds in a relatively short time period in the event of sudden unanticipated cash needs. However, an over-utilization of external funding sources can expose Peoples to greater liquidity risk as these external sources may not be accessible during times of market stress. Additionally, Peoples may be exposed to the risk associated with providing excess collateral to external funding providers, commonly referred to as counterparty risk. As a result, the ALCO's liquidity management policy sets limits on the net liquidity position and the concentration of non-core funding sources, both wholesale funding and brokered deposits. In addition to external sources of funding, Peoples considers certain types of deposits to be less stable or "volatile funding". These deposits include special money market products, large CDs and public funds. Peoples has established volatility factors for these various deposit products, and the liquidity management policy establishes a limit on the total level of volatile funding. Additionally, Peoples measures the maturities of external sources of funding for periods of 1 month, 3 months, 6 months and 12 months and has established policy limits for the amounts maturing in each of these periods. The purpose of these limits is to minimize exposure to what is commonly termed as rollover risk. An additional strategy used by Peoples in the management of liquidity risk is maintaining a targeted level of liquid assets. These are assets that can be converted into cash in a relatively short period of time. Management defines liquid assets as unencumbered cash, including cash on deposit at the Federal Reserve Bank and the market value of U.S. government and agency securities that are not pledged. Excluded from this definition are pledged securities, non- government and agency securities, municipal securities and loans. Management has established a minimum level of liquid assets in the liquidity management policy, which is expressed as a percentage of loans and unfunded loan commitments. Peoples also has established a policy limit around the level of liquefiable assets, also expressed as a percentage of loans and unfunded loan commitments. Liquefiable assets are defined as liquid assets plus the market value of unpledged securities not included in the liquid asset measurement. An essential element in the management of liquidity risk is a forecast of the sources and uses of anticipated cash flows. On a monthly basis, Peoples forecasts sources and uses of cash for the next twelve months. To assist in the management of liquidity, management has established a liquidity coverage ratio, which is defined as the total sources of cash divided by the total uses of cash. A ratio of greater than 1.0 times indicates that forecasted sources of cash are adequate to fund forecasted uses of cash. The liquidity management policy establishes a minimum limit of 1.0 times. As of December 31, 2014, Peoples had a ratio of 1.80 times, which was within policy limits. Peoples also forecasts secondary or contingent sources of cash, and this includes external sources of funding and liquid assets. These sources of cash would be required if and when the forecasted liquidity coverage ratio dropped below the policy limit of 1.0 times. An additional liquidity measurement used by management includes the total forecasted sources of cash and the contingent sources of cash divided by the forecasted uses of cash. Management has established a minimum ratio of 3.0 times for this liquidity management policy limit. As of December 31, 2014, Peoples had a ratio of 7.38 times, which was within policy limits. Disruptions in the sources and uses of cash can occur which can drastically alter the actual cash flows and negatively impact Peoples' ability to access internal and external sources of cash. Such disruptions might occur due to increased withdrawals of deposits, increases in the funding required for loan commitments, a decrease in the ability to access external funding sources and other forces that would increase the need for funding and limit Peoples' ability to access needed funds. As a result, Peoples maintains a liquidity contingency funding plan ("LCFP") that considers various degrees of disruptions and develops action plans around these scenarios. Peoples' LCFP identifies scenarios where funding disruptions might occur and creates scenarios of varying degrees of severity. The disruptions considered include an increase in funding of unfunded loan commitments, unanticipated withdrawals of deposits, decreases in the renewal of maturing CDs and reductions in cash earnings. Additionally, the LCFP creates stress scenarios where access to external funding sources, or contingency funding, is suddenly limited which includes a significant increase in the margin requirements where securities or loans are pledged, limited access to funding from other banks and limited access to funding from the FHLB and the Federal Reserve Bank. Peoples' LCFP scenarios include a base scenario, a mild stress scenario, a moderate stress scenario and a severe stress scenario. Each of these is defined as to the severity and action plans are developed around each. Liquidity management also requires the monitoring of risk indicators that may alert the ALCO to a developing liquidity situation or crisis. Early detection of stress scenarios allows Peoples to take actions to help mitigate the impact to Peoples Bank's business operations. The LCFP contains various indicators, termed key risk indicators ("KRI's") that are monitored on a monthly basis, at a minimum. The KRI's include both internal and external indicators and include loan delinquency levels, classified and watch list loan levels, non-performing loans to loans and to total assets, the loan to deposit ratio, the level of net non-core funding dependence, the level of contingency funding sources, the liquidity coverage ratio, changes in regulatory capital levels, forecasted operating loss and negative media concerning Peoples, irrational competitor pricing that persists and an increase in rates for external funding sources. The LCFP establishes levels that define each of these KRI's under base, mild, moderate and severe scenarios. The LCFP is reviewed and updated on at least an annual basis by the ALCO and the Asset Liability Management and Investment Committee of Peoples Bank's Board of Directors. Additionally, testing of the LCFP is required on an annual basis. Various stress scenarios and the related actions are simulated according to the LCFP. The results are reviewed and discussed and changes or revisions are made to the LCFP accordingly. Additionally, every two years, the LCFP is subjected to a third-party review for effectiveness and regulatory compliance. Overall, management believes the current balance of cash and cash equivalents, and anticipated cash flows from the investment portfolio, along with the availability of other funding sources, will allow Peoples to meet anticipated cash obligations, as well as special needs and off-balance sheet commitments. Off-Balance Sheet Activities and Contractual Obligations Peoples routinely engages in activities that involve, to varying degrees, elements of risk that are not reflected in whole or in part in the Consolidated Financial Statements. These activities are part of Peoples' normal course of business and include traditional off-balance sheet credit-related financial instruments, interest rate contracts and commitments to make additional capital contributions in low-income housing tax credit investments. The following is a summary of Peoples’ significant off-balance sheet activities and contractual obligations. Detailed information regarding these activities and obligations can be found in the Notes to the Consolidated Financial Statements as follows: Traditional off-balance sheet credit-related financial instruments are primarily commitments to extend credit and standby letters of credit. These activities are necessary to meet the financing needs of customers and could require Peoples to make cash payments to third parties in the event certain specified future events occur. The contractual amounts represent the extent of Peoples’ exposure in these off-balance sheet activities. However, since certain off-balance sheet commitments, particularly standby letters of credit, are expected to expire or only partially be used, the total amount of commitments does not necessarily represent future cash requirements. Peoples continues to lease certain facilities and equipment under noncancellable operating leases with terms providing for fixed monthly payments over periods generally ranging from two to ten years. Several of Peoples’ leased facilities are inside retail shopping centers or office buildings and, as a result, are not available for purchase. Management believes these leased facilities increase Peoples’ visibility within its markets and afford sales associates additional access to current and potential clients. For certain acquisitions, often those involving insurance businesses and wealth management books of businesses, a portion of the consideration is contingent upon revenue metrics being achieved. US GAAP requires that the amounts be recorded upon acquisition based on the best estimate of the future amounts to be paid at the time of acquisition. Any subsequent adjustment to the estimate is recorded in earnings. Based on the acquisitions completed to date, management does not expect contingent consideration to have a material impact on Peoples' future performance. The following table details the aggregate amount of future payments Peoples is required to make under certain contractual obligations as of December 31, 2014: Management does not anticipate Peoples’ current off-balance sheet activities will have a material impact on its future results of operations and financial condition based on historical experience and recent trends. Effects of Inflation on Financial Statements Substantially all of Peoples’ assets relate to banking and are monetary in nature. As a result, inflation does not impact Peoples to the same degree as companies in capital-intensive industries in a replacement cost environment. During a period of rising prices, a net monetary asset position results in a loss in purchasing power and conversely a net monetary liability position results in an increase in purchasing power. The opposite would be true during a period of decreasing prices. In the banking industry, monetary assets typically exceed monetary liabilities. The current monetary policy targeting low levels of inflation has resulted in relatively stable price levels. Therefore, inflation has had little impact on Peoples’ net assets.

<s>[INST] Certain statements in this Form 10K, which are not historical fact, are forwardlooking statements within the meaning of Section 27A of the Securities Act , Section 21E of the Exchange Act, and the Private Securities Litigation Reform Act of 1995. Words such as “anticipate”, “estimates”, “may”, “feels”, “expects”, “believes”, “plans”, “will”, “would”, “should”, “could” and similar expressions are intended to identify these forwardlooking statements but are not the exclusive means of identifying such statements. Forwardlooking statements are subject to risks and uncertainties that may cause actual results to differ materially. Factors that might cause such a difference include, but are not limited to: (1) the success, impact, and timing of the implementation of Peoples' business strategies, including the successful integration of recently completed acquisitions and the expansion of consumer lending activity; (2) Peoples' ability to integrate the Midwest Bancshares, Inc. ("Midwest"), Ohio Heritage Bancorp, Inc. ("Ohio Heritage") and North Akron Savings Bank ("North Akron") acquisitions and any future acquisitions, including the pending merger of NB&T into Peoples, may be unsuccessful, or may be more difficult, timeconsuming or costly than expected; (3) the ability of Peoples and NB&T to obtain their respective shareholders' approval of the merger may be unsuccessful; (4) Peoples may issue equity securities in connection with future acquisitions, which could cause ownership and economic dilution to Peoples' current shareholders; (5) local, regional, national and international economic conditions and the impact they may have on Peoples and its customers, and Peoples' assessment of the impact, which may be different than anticipated; (6) competitive pressures among financial institutions or from nonfinancial institutions may increase significantly, including product and pricing pressures, thirdparty relationships and revenues, and Peoples' ability to attract, develop and retain qualified professionals; (7) changes in the interest rate environment due to economic conditions and/or the fiscal policies of the U.S. government and Federal Reserve Board, which may adversely impact interest rates, interest margins and interest rate sensitivity; (8) changes in prepayment speeds, loan originations, levels of nonperforming assets, delinquent loans and chargeoffs, which may be less favorable than expected and adversely impact the amount of interest income generated; (9) adverse changes in the economic conditions and/or activities, including, but not limited to, impacts from the implementation of the Budget Control Act of 2011 and the American Taxpayer Relief Act of 2012, as well as continued economic uncertainty in the U.S., the European Union, and other areas, which could decrease sales volumes and increase loan delinquencies and defaults; (10) legislative or regulatory changes or actions, including in particular the DoddFrank Wall Street Reform and Consumer Protection Act of 2010 and the regulations promulgated and to be promulgated thereunder by the Office of the Comptroller of the Currency, the Federal Reserve Board and the Consumer Financial Protection Bureau, which may subject Peoples, its subsidiaries, or one or more acquired companies to a variety of new and more stringent legal and regulatory requirements which adversely affect their respective businesses; (11) deterioration in the credit quality of Peoples' loan portfolio, which may adversely impact the provision for loan losses; (12) changes in accounting standards, policies, estimates or procedures which may adversely affect Peoples' reported financial condition or results of operations; (13) Peoples' assumptions and estimates used in applying critical accounting policies, which may prove unreliable, inaccurate or not predictive of actual results; (14) adverse changes in the conditions and trends in the financial markets, including political developments, which may adversely affect the fair value of securities within Peoples' investment portfolio, the interest rate sensitivity of Peoples' consolidated balance sheet, and the income generated by Peoples' trust and investment activities; (15) [/INST] Positive. </s>

PEOPLES BANCORP INC

2016-02-26

2015-12-31

ITEM 7. MANAGEMENT’S DISCUSSION AND ANALYSIS OF FINANCIAL CONDITION AND RESULTS OF OPERATIONS Forward-Looking Statements Certain statements in this Form 10-K, which are not historical fact, are forward-looking statements within the meaning of Section 27A of the Securities Act , Section 21E of the Exchange Act, and the Private Securities Litigation Reform Act of 1995. Words such as “anticipate”, “estimates”, “may”, “feels”, “expects”, “believes”, “plans”, “will”, “would”, “should”, “could” and similar expressions are intended to identify these forward-looking statements but are not the exclusive means of identifying such statements. Forward-looking statements are subject to risks and uncertainties that may cause actual results to differ materially. Factors that might cause such a difference include, but are not limited to: (1) the success, impact, and timing of the implementation of Peoples' business strategies, including the successful integration of recently completed acquisitions and the expansion of consumer lending activity; (2) Peoples' ability to integrate the NB&T acquisition and any future acquisitions may be unsuccessful, or may be more difficult, time-consuming or costly than expected; (3) Peoples may issue equity securities in connection with future acquisitions, which could cause ownership and economic dilution to Peoples' current shareholders; (4) local, regional, national and international economic conditions and the impact they may have on Peoples, its customers and its counterparties, and Peoples' assessment of the impact, which may be different than anticipated; (5) competitive pressures among financial institutions or from non-financial institutions may increase significantly, including product and pricing pressures, third-party relationships and revenues, and Peoples' ability to attract, develop and retain qualified professionals; (6) changes in the interest rate environment due to economic conditions and/or the fiscal policies of the U.S. government and Federal Reserve Board, which may adversely impact interest rates, interest margins and interest rate sensitivity; (7) changes in prepayment speeds, loan originations, levels of non-performing assets, delinquent loans and charge-offs, which may be less favorable than expected and adversely impact the amount of interest income generated; (8) adverse changes in economic conditions and/or activities, including, but not limited to, continued economic uncertainty in the U.S., the European Union, Asia, and other areas, which could decrease sales volumes and increase loan delinquencies and defaults; (9) legislative or regulatory changes or actions, promulgated and to be promulgated thereunder by the State of Ohio, the Federal Deposit Insurance Corporation, the OCC, the Federal Reserve Board and the CFPB, which may subject Peoples, its subsidiaries, or one or more acquired companies to a variety of new and more stringent legal and regulatory requirements which adversely affect their respective businesses, including in particular the rules and regulations promulgated and to be promulgated under the Dodd-Frank Act; (10) deterioration in the credit quality of Peoples' loan portfolio, which may adversely impact the provision for loan losses; (11) changes in accounting standards, policies, estimates or procedures which may adversely affect Peoples' reported financial condition or results of operations; (12) Peoples' assumptions and estimates used in applying critical accounting policies, which may prove unreliable, inaccurate or not predictive of actual results; (13) adverse changes in the conditions and trends in the financial markets, including political developments, which may adversely affect the fair value of securities within Peoples' investment portfolio, the interest rate sensitivity of Peoples' consolidated balance sheet, and the income generated by Peoples' trust and investment activities; (14) Peoples' ability to receive dividends from its subsidiaries; (15) Peoples' ability to maintain required capital levels and adequate sources of funding and liquidity; (16) the impact of new minimum capital thresholds established as a part of the implementation of Basel III; (17) the impact of larger or similar sized financial institutions encountering problems, which may adversely affect the banking industry and/or Peoples' business generation and retention, funding and liquidity; (18) the costs and effects of regulatory and legal developments, including the outcome of potential regulatory or other governmental inquiries and legal proceedings and results of regulatory examinations; (19) Peoples' ability to secure confidential information through the use of computer systems and telecommunications networks, including those of Peoples' third-party vendors and other service providers, may prove inadequate, which could adversely affect customer confidence in Peoples and/or result in Peoples incurring a financial loss; (20) the overall adequacy of Peoples' risk management program; (21) the impact on Peoples' businesses, as well as on the risks described above, of various domestic or international military or terrorist activities or conflicts; and (22) other risk factors relating to the banking industry or Peoples as detailed from time to time in Peoples' reports filed with the SEC, including those risk factors included in the disclosures under the heading "ITEM 1A. RISK FACTORS" of this Form 10-K. All forward-looking statements speak only as of the filing date of this Form 10-K and are expressly qualified in their entirety by the cautionary statements. Although management believes the expectations in these forward-looking statements are based on reasonable assumptions within the bounds of management’s knowledge of Peoples’ business and operations, it is possible that actual results may differ materially from these projections. Additionally, Peoples undertakes no obligation to update these forward-looking statements to reflect events or circumstances after the filing date of this Form 10-K or to reflect the occurrence of unanticipated events except as may be required by applicable legal requirements. Copies of documents filed with the SEC are available free of charge at the SEC’s website at www.sec.gov and/or from Peoples' website - www.peoplesbancorp.com under the "Investor Relations" section. The following discussion and analysis of Peoples' Consolidated Financial Statements is presented to provide insight into management's assessment of the financial results and condition for the periods presented. This discussion and analysis should be read in conjunction with the audited Consolidated Financial Statements and Notes thereto, as well as the ratios and statistics, contained elsewhere in this Form 10-K. Summary of Significant Transactions and Events The following is a summary of transactions or events that have impacted or are expected by management to impact Peoples’ results of operations or financial condition: ◦ On January 6, 2016, Peoples Bank acquired a small financial advisory book of business in Marietta, Ohio for cash consideration of $0.5 million. This acquisition did not materially impact Peoples' financial position, results of operations or cash flows. ◦ During 2015, Peoples recorded aggregate charge-offs of $13.1 million on a single impaired commercial loan relationship consisting of four impaired loans. As of December 31, 2015, Peoples net recorded investment with respect to these loans was zero. ◦ On December 30, 2015, Peoples announced that Peoples Bank, National Association, the banking subsidiary of Peoples, converted from a national banking association into an Ohio state-chartered bank which is a member of the Federal Reserve System. As a result of the charter conversion, the legal name of Peoples' banking subsidiary was changed to "Peoples Bank" and the converted bank will continue to operate under the trade name and federally registered service mark "Peoples Bank." Additionally, Peoples' banking subsidiary will see a reduction in the annual cost associated with regulatory examination fees commencing in 2016. ◦ On November 3, 2015, Peoples announced that its Board of Directors approved and adopted a share repurchase program authorizing Peoples to purchase, from time to time, up to an aggregate of $20 million of its outstanding common shares. As of February 24, 2016, Peoples had repurchased an aggregate of 253,870 common shares with a total cost of $4.5 million, although none of these common shares was purchased in 2015. ◦ On July 24, 2015, Peoples repaid the principal balance of the $12.0 million term loan then outstanding under the Amended Loan Agreement described in Note 9 of the Notes to the Consolidated Financial Statements. There were no early termination fees associated with the repayment. The revolving credit loan commitment available under the Amended Loan Agreement remains outstanding. ◦ On July 21, 2015, Peoples Insurance acquired an insurance agency and related customer accounts in the Lebanon, Ohio area for total cash consideration of $0.9 million, and recorded $0.5 million of customer relationship intangibles and $0.4 million of goodwill. ◦ At the close of business on March 6, 2015, Peoples completed the acquisition of NB&T Financial Group, Inc. ("NB&T"). Under the terms of the merger agreement, Peoples paid $7.75 in cash and 0.9319 in Peoples' common shares for each of the 3,442,329 outstanding NB&T common shares for a total consideration of $102.7 million. NB&T merged into Peoples and NB&T's wholly-owned subsidiary, The National Bank and Trust Company, which operated 22 full-service branches in southwest Ohio, merged into Peoples Bank. The acquisition added $384.6 million of loans and $629.5 million of deposits at the acquisition date, after acquisition accounting adjustments. ◦ At the close of business on October 24, 2014, Peoples completed the acquisition of North Akron Savings Bank ("North Akron") and its 4 full-service offices in Akron, Cuyahoga Falls, Munroe and Norton, Ohio. Under the terms of the merger agreement, Peoples paid $7.655 of consideration per share of North Akron common stock, or $20.1 million, of which 80% was paid in Peoples' common shares and the remaining 20% in cash. The acquisition added $111.5 million of loans and $108.1 million of deposits at the acquisition date, after acquisition accounting adjustments. ◦ At the close of business on August 22, 2014, Peoples completed the acquisition of Ohio Heritage Bancorp, Inc. ("Ohio Heritage") and the 6 full-service offices of its subsidiary, Ohio Heritage Bank, in Coshocton, Newark, Heath, Mount Vernon and New Philadelphia, Ohio. Under the terms of the merger agreement, Peoples paid $110.00 of consideration per share of Ohio Heritage common stock, or $37.7 million, of which 85% was paid in Peoples' common shares and the remaining 15% in cash. The acquisition added $175.8 million of loans and $174.9 million of deposits at the acquisition date, after acquisition accounting adjustments. ◦ On August 7, 2014, Peoples announced the completion of the sale of 1,847,826 common shares at $23.00 per share to institutional investors through a private placement (the "Private Equity Issuance"). Peoples received net proceeds of $40.2 million from the sale, and used the proceeds, in part, to fund the cash consideration for the NB&T acquisition. ◦ At the close of business on May 30, 2014, Peoples completed the acquisition of Midwest Bancshares, Inc. ("Midwest") and the 2 full-service offices of its subsidiary, First National Bank of Wellston, in Wellston and Jackson, Ohio. Under the terms of the merger agreement, Peoples paid $65.50 of consideration per share of Midwest common stock, or $12.6 million, of which 50% was paid in cash and the remaining 50% in Peoples' common shares. The acquisition added $58.7 million of loans and $77.9 million of deposits at the acquisition date, after acquisition accounting adjustments. ◦ In 2015, Peoples incurred an aggregate of $11.3 million of acquisition-related expenses, compared to $5.1 million in 2014 and $1.5 million in 2013, which were primarily severance costs, fees for legal services and other professional services, deconversion costs and write-offs associated with assets acquired. ◦ During 2013, Peoples took steps to reduce its investment in bank-owned life insurance ("BOLI") contracts and redeploy the funds in order to enhance long-term shareholder return. Peoples received proceeds of $43.1 million during 2013 as a result of the liquidation of BOLI contracts, while the remaining cash surrender value of approximately $6.6 million was recorded as a receivable at December 31, 2013. Peoples received the remaining cash surrender value in the first quarter of 2014, in accordance with the terms of the BOLI contracts (collectively, the "BOLI Surrender"). The BOLI Surrender caused Peoples to incur a $2.2 million federal income tax liability in 2013 for the gain associated with the BOLI contracts surrendered. ◦ Peoples periodically has taken actions to reduce interest rate exposure within the investment portfolio and the entire balance sheet, which have included the sale of low-yielding investment securities and repayment of high-cost borrowings. These actions included the sale of $68.8 million of investment securities, primarily low or volatile yielding residential mortgage-backed securities, during the first quarter of 2013. Some of the proceeds from these investment sales were reinvested in securities during the first quarter with the remaining reinvested early in the second quarter of 2013. ◦ As described in Note 11 of the Notes to the Consolidated Financial Statements, Peoples incurred settlement charges of $459,000 during 2015 due to the aggregate amount of lump-sum distributions to participants in Peoples' defined benefit pension plan exceeding the threshold for recognizing such charges during the period. Settlement charges of $1.4 million and $270,000 were recognized during 2014 and 2013, respectively. ◦ On September 17, 2012, Peoples introduced its new brand as part of a company-wide brand revitalization. The brand is Peoples' promise, which is a guarantee of satisfaction and quality. Peoples incurred costs throughout 2013 associated with the brand revitalization, including marketing due to advertisements, and depreciation expense for new assets related to the $5 million branch renovation project. In 2014, Peoples acquired Midwest, Ohio Heritage and North Akron and in 2015 acquired NB&T and has continued the consistent company-wide brand revitalization in the newly-acquired facilities. ◦ Peoples' net interest income and net interest margin are impacted by changes in market interest rates based upon actions taken by the Federal Reserve Board either directly or through its Open Market Committee. These actions include changing the target Federal Funds Rate (the interest rate at which banks lend money to each other), Discount Rate (the interest rate charged to banks for money borrowed from the Federal Reserve Bank) and longer-term market interest rates (primarily U.S. Treasury securities). Longer-term market interest rates also are affected by the demand for U.S. Treasury securities. The resulting changes in the yield curve slope have a direct impact on reinvestment rates for Peoples' earning assets. ◦ In December 2015, the Federal Reserve Board raised short-term rates, including the Federal Funds Rate and the Discount Rate, 0.25%, to a range of 0.25% to 0.50% for the Federal Funds Rate and 1.00% for the Discount Rate. The Federal Reserve Board had previously maintained its target Federal Funds Rate at a historically low level of 0% to 0.25% since December 2008 and had maintained the Discount Rate at 0.75% since December 2010. The Federal Reserve Board has indicated the possibility that these short-term rates could again be raised in 2016. ◦ The Federal Reserve ended its program of quantitative easing in the fourth quarter of 2014. Much speculation occurred throughout 2015 as to when the Federal Reserve would begin to raise short-term interest rates. The yield on the 10-year Treasury note began the year with a significant rally, falling from 2.17% to 1.64% during the month of January. The yield peaked half way through 2015 at 2.49%. It fell below 2% again in October and traded in a range between 2.13% and 2.34% during the last two months of the year. Overall, the Treasury yield curve steepened throughout the year with the 30-year bond yield ending 2015 roughly 25 basis points higher than at the beginning of the year. The impact of these transactions, where material, is discussed in the applicable sections of this Management’s Discussion and Analysis of Financial Condition and Results of Operations. Critical Accounting Policies The accounting and reporting policies of Peoples conform to US GAAP and to general practices within the financial services industry. A summary of significant accounting policies is contained in Note 1 of the Notes to the Consolidated Financial Statements. While all of these policies are important to understanding the Consolidated Financial Statements, certain accounting policies require management to exercise judgment and make estimates or assumptions that affect the amounts reported in the Consolidated Financial Statements and accompanying Notes. These estimates and assumptions are based on information available as of the date of the Consolidated Financial Statements; accordingly, as this information changes, the Consolidated Financial Statements could reflect different estimates or assumptions. Management has identified the accounting policies described below as those that, due to the judgments, estimates and assumptions inherent in the policies, are critical to an understanding of Peoples' Consolidated Financial Statements and Management's Discussion and Analysis of Financial Condition and Results of Operations. Income Recognition Interest income on loans and investment securities is recognized by methods that result in level rates of return on principal amounts outstanding, including yield adjustments resulting from the amortization of loan costs and premiums on investment securities and accretion of loan fees and discounts on investment securities. Since mortgage-backed securities comprise a sizable portion of Peoples' investment portfolio, a significant increase in principal payments on those securities could impact interest income due to the corresponding acceleration of premium amortization or discount accretion. Peoples discontinues the accrual of interest on a loan when conditions cause management to believe collection of all or any portion of the loan's contractual interest is doubtful. Such conditions may include the borrower being 90 days or more past due on any contractual payments or current information regarding the borrower's financial condition and repayment ability. All unpaid accrued interest deemed uncollectable is reversed, which would reduce Peoples' net interest income. Interest received on nonaccrual loans is included in income only if principal recovery is reasonably assured. Allowance for Loan Losses In general, determining the amount of the allowance for loan losses requires significant judgment and the use of estimates by management. Peoples maintains an allowance for loan losses based on a quarterly analysis of the loan portfolio and estimation of the losses that are probable of occurrence within the loan portfolio. This formal analysis determines an appropriate level and allocation of the allowance for loan losses among loan types and the resulting recovery of or provision for loan losses by considering factors affecting losses, including specific losses, levels and trends in impaired and nonperforming loans; historical loan loss experience; current national and local economic conditions; volume; growth and composition of the portfolio; regulatory guidance and other relevant factors. Management continually monitors the loan portfolio through Peoples Bank's Credit Administration Department and Loan Loss Committee to evaluate the appropriateness of the allowance. The recovery or provision could increase or decrease each quarter based upon the results of management's formal analysis. The amount of the allowance for loan losses for the various loan types represents management's estimate of probable losses from existing loans. Management evaluates lending relationships deemed to be impaired on an individual basis and makes specific allocations of the allowance for loan losses for each relationship based on discounted cash flows using the loan's initial effective interest rate or the fair value of the collateral for certain collateral dependent loans. For all other loans, management evaluates pools of homogeneous loans (such as residential mortgage loans, and direct and indirect consumer loans) and makes general allocations for each loan pool based upon historical loss experience. While allocations are made to specific loans and pools of loans, the allowance is available for all loan losses. The evaluation of individual impaired loans requires management to make estimates of the amounts and timing of future cash flows on impaired loans, which consist primarily of loans placed on nonaccrual status, restructured or internally classified as substandard or doubtful. These reviews are based upon specific quantitative and qualitative criteria, including the size of the loan, the loan cash flow characteristics, loan quality ratings, value of collateral, repayment ability of the borrower, and historical experience factors. Allowances for homogeneous loans are evaluated based upon historical loss experience, adjusted for qualitative risk factors, such as trends in losses and delinquencies, growth of loans in particular markets, and known changes in economic conditions in each lending market. As part of the process of identifying the pools of homogenous loans, management takes into account any concentrations of risk within any portfolio segment, including any significant industrial concentrations. Consistent with the evaluation of allowances for homogenous loans, the allowance relating to the Overdraft Privilege program is based upon management's monthly analysis of accounts in the program. This analysis considers factors that could affect losses on existing accounts, including historical loss experience and length of overdraft. There can be no assurance the allowance for loan losses will be adequate to cover all losses, but management believes the allowance for loan losses at December 31, 2015 was adequate to provide for probable losses from existing loans based on information currently available. While management uses available information to estimate losses, the ultimate collectability of a substantial portion of the loan portfolio, and the need for future additions to the allowance, will be based on changes in economic conditions and other relevant factors. As such, adverse changes in economic activity could reduce currently estimated cash flows for both commercial and individual borrowers, which would likely cause Peoples to experience increases in problem assets, delinquencies and losses on loans in the future. Investment Securities Peoples' investment portfolio accounted for 26.7% and 27.8% of total assets at December 31, 2015, and December 31, 2014 respectively, of which approximately 90% of the securities were classified as available-for-sale. Correspondingly, Peoples carries these securities at fair value on its Consolidated Balance Sheets, with any unrealized gain or loss recorded in stockholders' equity as a component of accumulated other comprehensive income or loss. As a result, Peoples' Consolidated Balance Sheet may be sensitive to changes in the overall market value of the investment portfolio, due to changes in market interest rates, investor confidence and other factors affecting market values. While temporary changes in the fair value of available-for-sale securities are not recognized in earnings, Peoples is required to evaluate all investment securities with an unrealized loss on a quarterly basis to identify potential other-than-temporary impairment (“OTTI”) losses. This analysis requires management to consider various factors that involve judgment and estimation, including the duration and magnitude of the decline in value, the financial condition of the issuer or pool of issuers, and the structure of the security. Under current US GAAP, an OTTI loss is recognized in earnings only when (1) Peoples intends to sell the debt security; (2) it is more likely than not that Peoples will be required to sell the debt security before recovery of its amortized cost basis; or (3) Peoples does not expect to recover the entire amortized cost basis of the debt security. In situations where Peoples intends to sell, or when it is more likely than not that Peoples will be required to sell the debt security, the entire OTTI loss must be recognized in earnings. In all other situations, only the portion of the OTTI losses representing the credit loss must be recognized in earnings, with the remaining portion being recognized in stockholders' equity as a component of accumulated other comprehensive income or loss, net of deferred taxes. Management performed its quarterly analysis of the investment securities with an unrealized loss at December 31, 2015, and concluded no individual securities were other-than-temporarily impaired. Peoples has not recognized an impairment loss in 2015, 2014 or 2013. Goodwill and Other Intangible Assets During 2015 and in prior years, Peoples recorded goodwill and other intangible assets as a result of acquisitions accounted for under the acquisition method of accounting. Under the acquisition method, Peoples is required to allocate the cost of an acquired company to the assets acquired, including identified intangible assets, and liabilities assumed based on their estimated fair values at the date of acquisition. Goodwill represents the excess cost over the fair value of net assets acquired and is not amortized but is tested for impairment when indicators of impairment exist, or at least annually. Peoples' other intangible assets consist of customer relationship intangible assets, including core deposit intangibles, representing the present value of future net income to be earned from acquired customer relationships with definite useful lives, which are required to be amortized over their estimated useful lives. The value of recorded goodwill is supported ultimately by revenue that is driven by the volume of business transacted and Peoples' ability to provide quality, cost-effective services in a competitive market place. A decline in earnings as a result of a lack of growth or the inability to deliver cost-effective services over sustained periods can lead to impairment of goodwill that could adversely impact earnings in future periods. Potential goodwill impairment exists when the fair value of the reporting unit (as defined by US GAAP) is less than its carrying value. An impairment loss is recognized in earnings only when the carrying amount of goodwill is less than its implied fair value. The process of evaluating goodwill for impairment involves highly subjective or complex judgments, estimates and assumptions regarding the fair value of Peoples' reporting unit and, in some cases, goodwill itself. As a result, changes to these judgments, estimates and assumptions in future periods could result in materially different results. Peoples currently possesses a single reporting unit for goodwill impairment testing. While quoted market prices exist for Peoples' common shares since they are publicly traded, these market prices do not necessarily reflect the value associated with gaining control of an entity. Thus, management takes into account all appropriate fair value measurements in determining the estimated fair value of the reporting unit. The measurement of any actual impairment loss requires management to calculate the implied fair value of goodwill by deducting the fair value of all tangible and separately identifiable intangible net assets (including unrecognized intangible assets) from the fair value of the reporting unit. The fair value of net tangible assets is calculated using the methodologies described in Note 2 of the Notes to the Consolidated Financial Statements. Peoples performs its required annual impairment test as of June 30 each year. The goodwill impairment test consists of a two-step process that includes (1) determining if potential goodwill impairment exists and (2) measuring the impairment loss, if any. At June 30, 2015, management's analysis concluded that the estimated fair value of Peoples' single reporting unit exceeded its carrying value. The analysis also included an assessment of events and circumstances considering several key factors such as economic and local market conditions, overall financial performance, changes in management or key personnel, and share price. Peoples is required to perform interim tests for goodwill impairment in subsequent quarters if events occur or circumstances change that indicate potential goodwill impairment exists, such as adverse changes to Peoples' business or a significant decline in Peoples' market capitalization. At December 31, 2015, Peoples completed the interim test for goodwill, and due to potential indicators continued the analysis related to the first step of the goodwill impairment test. Peoples utilized the income approach and market approach analysis in determining that the fair value of the reporting unit exceeded the carrying amount and that the goodwill of the reporting unit was not considered impaired. Therefore, Peoples did not complete the second step of the goodwill impairment test. For further information regarding goodwill, refer to Note 6 of the Notes to the Consolidated Financial Statements. Peoples records servicing rights (“SRs”) in connection with its mortgage banking and small business lending activities, which are intangible assets representing the right to service loans sold to third-party investors. These intangible assets are recorded initially at fair value and subsequently amortized over the estimated life of the loans sold. SRs are stratified based on their predominant risk characteristics and assessed for impairment at the strata level at each reporting date based on their fair value. At December 31, 2015, management concluded no portion of the recorded SRs was impaired since the fair value equaled or exceeded the carrying value. However, future events, such as a significant increase in prepayment speeds, could result in a fair value that is less than the carrying amount, which would require the recognition of an impairment loss in earnings. Income Taxes Income taxes are recorded based on the liability method of accounting, which includes the recognition of deferred tax assets and liabilities for the temporary differences between carrying amounts and tax bases of assets and liabilities, computed using enacted tax rates. In general, Peoples records deferred tax assets when the event giving rise to the tax benefit has been recognized in the Consolidated Financial Statements. A valuation allowance is recognized to reduce any deferred tax asset that, based upon available information, it is more-likely-than-not all, or any portion, of the deferred tax asset will not be realized. Assessing the need for, and amount of, a valuation allowance for deferred tax assets requires significant judgment and analysis of evidence regarding realization of the deferred tax assets. In most cases, the realization of deferred tax assets is dependent upon Peoples generating a sufficient level of taxable income in future periods, which can be difficult to predict. Peoples' largest deferred tax assets involve differences related to Peoples' allowance for loan losses and accrued employee benefits. At December 31, 2015, management determined a valuation allowance would be recorded against the deferred tax assets associated with its investment in a partnership investment. No other valuation allowances were needed at either December 31, 2015 or 2014. The calculation of tax liabilities is complex and requires the use of estimates and judgment since it involves the application of complex tax laws that are subject to different interpretations by Peoples and the various tax authorities. Peoples' interpretations are subject to challenge by the tax authorities upon audit or to reinterpretation based on management's ongoing assessment of facts and evolving case law. From time-to-time and in the ordinary course of business, Peoples is involved in inquiries and reviews by tax authorities that normally require management to provide supplemental information to support certain tax positions taken by Peoples in its tax returns. Uncertain tax positions are initially recognized in the Consolidated Financial Statements when it is more likely than not the position will be sustained upon examination by the tax authorities. Such tax positions are initially and subsequently measured as the largest amount of tax benefit that is greater than 50% likely of being realized upon ultimate settlement with the tax authority assuming full knowledge of the position and all relevant facts. The amount of unrecognized tax benefits was immaterial at both December 31, 2015 and 2014. Management believes it has taken appropriate positions on its tax returns, although the ultimate outcome of any tax review cannot be predicted with certainty. Consequently, no assurance can be given that the final outcome of these matters will not be different than what is reflected in the current and historical financial statements. Fair Value Measurements As a financial services company, the carrying value of certain financial assets and liabilities is impacted by the application of fair value measurements, either directly or indirectly. In certain cases, an asset or liability is measured and reported at fair value on a recurring basis, such as available-for-sale investment securities. In other cases, management must rely on estimates or judgments to determine if an asset or liability not measured at fair value warrants an impairment write-down or whether a valuation reserve should be established. Given the inherent volatility, the use of fair value measurements may have a significant impact on the carrying value of assets or liabilities, or result in material changes to the consolidated financial statements, from period to period. Detailed information regarding fair value measurements can be found in Note 2 of the Notes to the Consolidated Financial Statements. The following is a summary of those assets and liabilities that may be affected by fair value measurements, as well as a brief description of the current accounting practices and valuation methodologies employed by Peoples: Available-for-Sale Investment Securities Investment securities classified as available-for-sale are measured and reported at fair value on a recurring basis. For most securities, the fair value is based upon quoted market prices (Level 1) or determined by pricing models that consider observable market data (Level 2). For structured investment securities, the fair value often must be based upon unobservable market data, such as non-binding broker quotes and discounted cash flow analysis or similar models, due to the absence of an active market for these securities (Level 3). As a result, management's determination of fair value for these securities is highly dependent on subjective or complex judgments, estimates and assumptions, which could change materially between periods. Management occasionally uses information from independent third-party consultants in its determination of the fair value of more complex structured investment securities. At December 31, 2015, all of Peoples' available-for-sale investment securities were measured using observable market data. At December 31, 2015, the majority of the investment securities with Level 2 fair values were determined using information provided by third-party pricing services. Management reviews the valuation methodology and quality controls utilized by the pricing services in management's overall assessment of the reasonableness of the fair values provided. To the extent available, management utilizes an independent third-party pricing source to assist in its assessment of the values provided by its primary pricing services. Management reviews the fair values provided by these third parties on a quarterly basis and challenges prices when it believes a discrepancy in pricing exists. Based on Peoples' past experience, no discrepancies have been noted related to current pricing and values. Impaired loans For loans considered impaired, the amount of impairment loss recognized is determined based on a discounted cash flow analysis or the fair value of the underlying collateral if repayment is expected solely from the sale of the collateral. Management typically relies on the fair value of the underlying collateral due to the significant uncertainty surrounding the borrower's ability to make future payments. The vast majority of the collateral securing impaired loans is real estate, although the collateral may also include accounts receivable and equipment, inventory or similar personal property. The fair value of the collateral used by management represents the estimated proceeds to be received from the sale of the collateral, less costs incurred during the sale, based upon observable market data or market value data provided by independent, licensed or certified appraisers. Servicing Rights SRs are carried at the lower of amortized cost or market value, and, therefore, can be subject to fair value measurements on a nonrecurring basis. SRs do not trade in an active market with readily observable prices. Thus, management determines fair value based upon a valuation model that calculates the present value of estimated future net servicing income provided by an independent third-party consultant. This valuation model is affected by various input factors, such as servicing costs, expected prepayment speeds and discount rates, which are subject to change between reporting periods. As a result, significant changes to these factors could result in a material change to the calculated fair value of SRs. To determine the fair value of its servicing rights (“SRs”) each reporting quarter, Peoples provides information representing loan information accompanied by escrow amounts to a third-party valuation firm. The third-party then evaluates the possible impairment of SRs as described below. Loans are evaluated on a discounted earnings basis to determine the present value of future earnings that Peoples expects to realize from the portfolio. Earnings are projected from a variety of sources including loan service fees, net interest earned on escrow balances, miscellaneous income and costs to service the loans. The present value of future earnings is the estimated fair value, calculated using consensus assumptions that a third-party purchaser would utilize in evaluating a potential acquisition of the SRs. Events that may significantly affect the estimates used are changes in interest rates and the related impact on mortgage loan prepayment speeds, and the payment performance of the underlying loans. Peoples believes this methodology provides a reasonable estimate. Mortgage loan prepayment estimates were determined through the application of the current dealer projected prepayment rates by product type and interest rate as published by Bloomberg, L.P. as of January 4, 2016, and adjusted for historical prepayment factors based on state, type of servicing, year of origination, and pass through coupon. The adjustable rate mortgage loan prepayment estimates were determined through the application of market trading assumptions as of January 4, 2016, and adjusted for historical prepayment factors based on state, type of servicing, year of origination, and pass through coupon. These earnings are used to calculate the approximate cash flow that could be received from the servicing portfolio. Valuation results are provided quarterly to Peoples. At that time, Peoples reviews the information and SRs are marked to the lower of amortized cost or fair value for the current quarter. EXECUTIVE SUMMARY Net income for the year ended December 31, 2015 was $10.9 million, compared to $16.7 million in 2014 and $17.6 million in 2013, representing earnings per diluted common share of $0.61, $1.35 and $1.63, respectively. The decrease in earnings during 2015 was primarily driven by provision for loan losses of $14.1 million coupled with $11.3 million of acquisition-related costs. The decrease in 2014 from 2013 was primarily driven by acquisition-related costs of $5.1 million and pension settlement charges of $1.4 million. Earnings in 2013 were impacted by additional operating costs associated with various strategic investments to grow revenue and a lower recovery of loan losses. In 2015, Peoples had a provision for loan losses of $14.1 million related primarily to the charge-off of one large commercial loan relationship coupled with loan growth and downward trends in criticized loans. Peoples recorded net charge-offs of $15.2 million for 2015, compared to net recoveries of $0.5 million and $3.7 million, respectively, for 2014 and 2013, respectively. The provision for or recovery of loan losses represented amounts needed, in management's opinion, to maintain the appropriate level of the allowance for loan losses. Year-over-year income and expense was largely effected by the acquisitions completed in 2014 and 2015. In 2014, Peoples acquired Midwest on May 30, Ohio Heritage on August 22, and North Akron on October 24, and in 2015, Peoples acquired NB&T on March 6. Due to the timing of the acquisitions, 2015 included a full year impact of the 2014 acquisitions compared to only a partial impact in 2014. In 2015, NB&T income and expenses were included beginning on March 6, 2015. Net interest income grew 40% to $97.6 million in 2015 compared to $69.5 million in 2014 and $55.4 million in 2013, mostly due to higher loan balances in connection with the recent acquisitions, coupled with organic loan growth. Net interest margin was 3.53% in 2015, higher than the 3.45% in 2014 and 3.23% in 2013. The increase in 2015 was due to accretion income from the completed acquisitions, organic loan growth, change in asset mix and a reduction in funding costs. Accretion income from acquisitions added approximately 17 basis points to net interest margin in 2015 compared to 13 basis points in 2014 and 4 basis points in 2013. The increase in net interest margin in 2014 was mostly due to higher loan balances in connection with acquisitions and organic loan growth. The decrease in net interest margin during 2013 was largely a result of the low interest rate environment, which put downward pressure on asset yields. Total non-interest income, which excludes gains and losses on investment securities, asset disposals and other transactions, increased 18% in 2015 compared to 2014 and increased 8% comparing 2014 to 2013. During 2015, electronic banking income grew 35%, or $2.3 million, trust and investment income increased 25%, or $1.9 million, service charges on deposit accounts grew 18%, or $1.7 million and bank owned life insurance income increased $0.5 million. The noted increases reflected a full year of income from the 2014 acquisitions and approximately nine months of income related to the NB&T acquisition. Total other expense increased 35%, or $30.1 million, for the year ended December 31, 2015, due largely to a full year of expenses related to the 2014 acquisitions and approximately nine months of expenses related to the NB&T acquisition. The NB&T acquisition added 22 additional branches which increased net occupancy and equipment, higher salaries and employee benefits, due to additional employees, increased intangible asset amortization and increased electronic banking expense. Acquisition-related expenses included in other expenses during 2015 were $10.7 million, compared to $4.8 million in 2014 and $1.4 million in 2013. At December 31, 2015, total assets were up 27%, or $691.2 million to $3.26 billion versus $2.57 billion at year-end 2014. The increase was primarily related to the acquisition of $710.5 million in assets during 2015. Excluding the impact of the loans acquired in the NB&T acquisition, loan balances grew 7% or $451.6 million for the year. The allowance for loan losses decreased $1.1 million to $16.8 million, or 1.19% of originated loans, net of deferred fees and costs, compared to $17.9 million and 1.48% at December 31, 2014. Total investment securities grew to $868.8 million, or 26.7% of total assets at December 31, 2015, compared to $713.7 million, or 27.8% of total assets at the prior year-end. Total liabilities were $2.84 billion at December 31, 2015, up $611.5 million since December 31, 2014. Contributing to this increase were acquired deposits of approximately $629.5 million. Non-interest-bearing deposits comprised 28.7% of total retail deposits at December 31, 2015, versus 26.0% at year-end 2014. At December 31, 2015, total borrowed funds were $274.1 million, up $6.7 million compared to the prior year-end, as Peoples assumed $6.6 million from the NB&T acquisition. At December 31, 2015, total stockholders' equity was $419.8 million, up $79.7 million from December 31, 2014. The increase in common stock within total stockholders' equity was primarily due to the common shares issued in connection with 2015 acquisition of NB&T which had a value of $76.0 million. Peoples' regulatory capital ratios remained significantly higher than "well capitalized" minimums. Peoples' Tier 1 Capital ratio decreased to 13.68% at December 31, 2015, versus 14.32% at December 31, 2014, while the Total Capital ratio was 14.55% versus 15.48% at December 31, 2014. In addition, Peoples' tangible equity to tangible assets ratio was 8.69% and tangible book value per share was $14.68 at December 31, 2015, versus 9.39% and $15.57 at December 31, 2014, respectively. Additional information regarding capital requirements can be found in Note 15 of the Notes to the Consolidated Financial Statements. RESULTS OF OPERATIONS Interest Income and Expense Peoples earns interest income on loans and investments and incurs interest expense on interest-bearing deposits and borrowed funds. Net interest income, the amount by which interest income exceeds interest expense, remains Peoples' largest source of revenue. The amount of net interest income earned by Peoples is affected by various factors, including changes in market interest rates due to the Federal Reserve Board's monetary policy, the level and degree of pricing competition for both loans and deposits in Peoples' markets, and the amount and composition of Peoples' earning assets and interest-bearing liabilities. Peoples monitors net interest income performance and manages its balance sheet composition through regular ALCO meetings. The asset-liability management process employed by the ALCO is intended to mitigate the impact of future interest rate changes on Peoples' net interest income and earnings. However, the frequency and/or magnitude of changes in market interest rates are difficult to predict, and may have a greater impact on net interest income than adjustments management is able to make. The following table details Peoples’ average balance sheets for the years ended December 31: (1) Average balances are based on carrying value. (2) Interest income and yields are presented on a fully tax-equivalent basis using a 35% federal statutory tax rate. (3) Average balances include nonaccrual and impaired loans. Interest income includes interest earned on nonaccrual loans prior to the loans being placed on nonaccrual status. Loan fees included in interest income were immaterial for all periods presented. (4) Loans held for sale are included in the average loan balance listed. Related interest income on loans originated for sale prior to the loan being sold is included in loan interest income. The following table provides an analysis of the changes in fully tax-equivalent (“FTE”) net interest income: (1) The change in interest due to both rate and volume has been allocated to rate and volume changes in proportion to the relationship of the dollar amounts of the changes in each. (2) Interest income and yields are presented on a fully tax-equivalent basis using a 35% federal statutory tax rate. As part of the analysis of net interest income, management converts tax-exempt income earned on obligations of states and political subdivisions to the pre-tax equivalent of taxable income using an effective tax rate of 35%. Management believes the resulting FTE net interest income allows for a more meaningful comparison of tax-exempt income and yields to their taxable equivalents. Net interest margin, which is calculated by dividing FTE net interest income by average interest- earning assets, serves as an important measurement of the net revenue stream generated by the volume, mix and pricing of earning assets and interest-bearing liabilities. The following table details the calculation of FTE net interest income for the years ended December 31: During 2015, Peoples recognized accretion income, net of amortization expense, from acquisitions of $4.8 million, which added approximately 17 basis points to net interest margin, compared to $2.6 million and 13 basis points, and $0.7 million and 4 basis points in 2014 and 2013, respectively. Also during 2015, additional interest income from prepayment fees and interest recovered on nonaccrual loans was $591,000 compared to $240,000 in 2014 and $976,000 in 2013. The primary driver of the increase in net interest income during 2015 was the higher loan balances resulting from organic growth and acquired loans. The yield on investment securities decreased in 2015 as interest rates fell and prepayment speeds on mortgage-backed securities increased. The increase in prepayment speeds was due primarily to greater mortgage refinancing activity driven by lower interest rates. This resulted in higher monthly principal cashflows in the investment portfolio. In 2015, the average monthly principal cashflow was approximately $10.1 million compared to $6.0 million in 2014 and $8.0 million in 2013. Funding costs have declined since 2013 as Peoples executed a strategy of replacing higher-cost funding with low-cost deposits. In 2015, funding costs decreased 18 basis points, compared to15 basis points in 2014 and 27 basis points in 2013. Additional improvement was due to deploying excess cash on the balance sheet by buying securities in the investment portfolio and paying off a $12.0 million term loan. The continued increase in the balance of low-cost deposits has provided funding for loan growth during these periods. Detailed information regarding changes in the Consolidated Balance Sheets can be found under appropriate captions of the “FINANCIAL CONDITION” section of this discussion. Additional information regarding Peoples' interest rate risk and the potential impact of interest rate changes on Peoples' results of operations and financial condition can be found later in this discussion under the caption “Interest Rate Sensitivity and Liquidity”. Provision for (Recovery of) Loan Losses The following table details Peoples’ provision for (or recovery of) loan losses recognized for the years ended December 31: The provision for (or recovery of) loan losses represents the amount needed to maintain the appropriate level of the allowance for loan losses based on management’s formal quarterly analysis of the loan portfolio and procedural methodology that estimates the amount of probable credit losses. This process considers various factors that affect losses, such as changes in Peoples’ loan quality, historical loss experience and current economic conditions. The provision for loan losses recorded in 2015 was primarily due to the charge-off of one large commercial loan relationship coupled with organic loan growth and downward trends in criticized loans. The provision for loan losses recorded in 2014 was driven by checking account overdrafts, while the impact of increases in criticized loans was mitigated by $1.8 million of recoveries on three loans that were previously charged off. The recovery of loan losses recorded during 2013 was driven mostly by recoveries on commercial real estate loans that had previously incurred charge-offs. Additional information regarding changes in the allowance for loan losses and loan credit quality can be found later in this discussion under the caption “Allowance for Loan Losses”. Net Loss on Asset Disposals and Other Transactions The following table details the other (losses) gains for the years ended December 31 recognized by Peoples: The net loss on OREO during 2015 was due mainly to the sale of six OREO properties and the write-down of four OREO properties during the period. During the first quarter of 2015, Peoples recognized a loss on debt extinguishment from the prepayment of several FHLB advances. Net losses on bank premises and equipment during 2015, 2014 and 2013 included $575,000, $380,000 and $248,000, respectively, of asset write-offs associated with acquisition-related activity. The remaining net loss on bank premises and equipment in 2015 was attributable to the write-off of obsolete fixed assets and the write-down of closed office locations that were for sale. Peoples recognized a gain on debt extinguishment from a restructuring of acquired FHLB advances in 2014. Non-Interest Income Peoples generates non-interest income, which excludes gains and losses on investments and other assets, from five primary sources: insurance sales revenues, deposit account service charges, trust and investment activities, electronic banking (“e-banking”), and mortgage banking. Peoples continues to focus on revenue growth from non-interest income sources in order to maintain a diversified revenue stream through greater reliance on fee-based revenues. As a result, total non-interest income accounted for 32.7% of Peoples' total revenues in 2015, compared to 36.6% in 2014 and 40.2% in 2013. The decline in Peoples' total non-interest income as a percent of total revenue during 2015 and 2014 was primarily due to increased net interest income from recent acquisitions. Insurance income comprised the largest portion of Peoples' non-interest income. The following table details Peoples’ insurance income for the years ended December 31: Continued increases in life and health insurance commissions over the past three years were the result of acquisitions and increased business. Performance-based commissions are typically recorded annually in the first quarter and are based on a combination of factors, such as loss experience of insurance policies sold, production volumes, and overall financial performance of the individual insurance carriers. Service charges and other fees on deposit accounts, which are based on the recovery of costs associated with services provided, comprised a significant portion of Peoples' non-interest income. The following table details Peoples' deposit account service charges for the years ended December 31: The amount of deposit account service charges, particularly fees for overdrafts and non-sufficient funds, is largely dependent on the timing and volume of customer activity. Peoples typically experiences a lower volume of overdraft and non-sufficient funds fees annually in the first quarter attributable to customers receiving income tax refunds, while volumes generally increase in the fourth quarter in connection with the holiday shopping season. Management periodically evaluates its cost recovery fees to ensure they are reasonable based on operational costs and similar to fees charged in Peoples' markets by competitors. The yearly increases in account maintenance fees were the result of higher fees received on commercial accounts and rewards checking accounts. Peoples' fiduciary and brokerage revenues continue to be based primarily upon the value of assets under management. The following table details Peoples’ trust and investment income for the years ended December 31: The following table details Peoples’ managed assets at year-end December 31: During 2015, the increase in fiduciary and brokerage revenues and managed assets was impacted by the acquisition of NB&T. Additionally, during 2015, 2014 and 2013, fiduciary income increased primarily due to higher managed asset account balances and retirement benefits plan income due to the addition of new plans. The U.S. financial markets also have an impact on managed assets. In recent years, Peoples has added experienced financial advisors in previously underserved market areas, and generated new business and revenue related to retirement plans for which it manages the assets and provides services. Peoples' e-banking services include ATM and debit cards, direct deposit services, internet and mobile banking, and serve as alternative delivery channels to traditional sales offices for providing services to clients. During 2015, electronic banking income grew $2.3 million, or 35% compared to 2014, due to acquisitions and a continued increase in the volume of debit card transactions. In 2015, Peoples' customers used their debit cards to complete $591 million of transactions, versus $467 million in 2014 and $416 million in 2013. Mortgage banking income is comprised mostly of net gains from the origination and sale of long-term, fixed-rate real estate loans in the secondary market. As a result, the amount of income recognized by Peoples is largely dependent on customer demand and long-term interest rates for residential real estate loans offered in the secondary market. Mortgage banking income increased 6% in 2015 due to acquisitions and additional market areas, while decreasing 30% in 2014 due to slowed refinancing activity. In 2015, Peoples sold approximately $56.0 million of loans to the secondary market compared to $48.8 million in 2014 and $73.2 million in 2013. Non-Interest Expense Year-over-year expenses were largely effected by the acquisitions completed in 2014 and 2015. Salaries and employee benefit costs remain Peoples’ largest non-interest expense, accounting for over half of the total non-interest expense. The following table details Peoples’ salaries and employee benefit costs for the years ended December 31: Base salaries and wages, employee benefits, payroll taxes and other employment costs increased in 2015, 2014 and 2013 due to completed acquisitions, additional operational staff and the addition of new sales talent in several markets, which significantly impacted the number of full-time equivalent employees. Peoples' sales-based and incentive compensation is tied to corporate incentive plans and commission from sales production. Sales-based and incentive compensation decreased in 2015, due primarily to corporate goals and incentives not being attained. The increase in employee benefits as a result of acquisitions was partially offset by a decrease in pension settlement charges which were $0.5 million, $1.4 million and $0.3 million in 2015, 2014 and 2013, respectively. Effective March 1, 2011, Peoples froze the accrual of pension benefits, and since then, settlement charges have been largely based on the timing of retirements of plan participants and their election of lump-sum distributions. Under US GAAP, Peoples is required to recognize a settlement gain or loss when the aggregate amount of lump-sum distributions to participants equals or exceeds the sum of the service and interest cost components of the net periodic pension cost. The amount of settlement gain or loss recognized is the pro rata amount of the unrealized gain or loss existing immediately prior to the settlement. Management anticipates continued pension settlement charges in future years as plan participants retire and elect lump-sum distributions from the plan. Stock-based compensation is generally recognized over the vesting period, typically ranging from 6 months to 3 years. For all awards, expense is initially only recognized for the portion of awards that is expected to vest, and at the vesting date, an adjustment is made to recognize the entire expense for vested awards and reverse expense for non-vested awards. The majority of Peoples' stock-based compensation expense is attributable to annual equity-based incentive awards to employees, which are awarded in the first quarter and based upon Peoples achieving certain performance goals during the prior year. During 2015, Peoples granted restricted shares to non-employee directors, officers and key employees with performance-based vesting periods and time-based vesting periods. Stock-based compensation expense in 2015 was $1.8 million which included $792,000 of expense related to these awards, while the remaining expense recognized was for grants awarded in previous years. As it is probable that all outstanding performance-based vesting conditions will be satisfied, Peoples recorded the pro-rata expense for all outstanding performance-based awards in 2015, as required by US GAAP. Stock-based compensation expense in 2014 included $298,000 related to a one-time stock award of unrestricted common shares to all full-time and part-time employees who did not already participate in the equity plan. Additional information regarding Peoples' stock-based compensation plans and awards can be found in Note 16 of the Notes to the Consolidated Financial Statements. Deferred personnel costs represent the portion of current period salaries and employee benefit costs considered to be direct loan origination costs. These costs are capitalized and recognized over the life of the loan as a yield adjustment to interest income. As a result, the amount of deferred personnel costs for each year corresponds directly with the level of new loan originations. Additional information regarding Peoples' loan activity can be found later in this discussion under the caption “Loans”. Peoples’ net occupancy and equipment expense for the years ended December 31 was comprised of the following: During 2015, Peoples acquired 22 new offices which resulted in higher depreciation, repairs and maintenance costs, and property taxes, utilities and other costs. In addition, Peoples completed renovations allowing for expanded service areas and efficiencies of operations. During 2014, Peoples acquired 12 new offices which resulted in higher depreciation, repairs and maintenance costs, and property taxes, utilities and other costs. In addition, Peoples completed the renovation of its branch network that began in 2013 and began renovation on newly-acquired branches. Management continues to monitor capital expenditures and explore opportunities to enhance Peoples' operating efficiency. Professional fees expense represents the cost of accounting, legal and other third-party professional services utilized by Peoples, and increased 29% during 2015. The increase was primarily due to additional costs in relation to increased accounting guidance, yearly audits and executive search fees. Professional fees incurred as a result of acquisition-related activities were $1.7 million in 2015, compared to $2.0 million and $448,000 in 2014 and 2013, respectively. Peoples' e-banking expense, which is comprised of bankcard, internet and mobile banking costs, increased in 2015, 2014 and 2013 due to additional accounts related to acquisitions, customers completing a higher volume of transactions using their debit cards and Peoples' internet banking service. These factors also produced a greater increase in the corresponding e-banking revenues over the same periods. Additionally, part of the increased e-banking expense in 2014 was due to increased debit card compromises at certain large retail companies. In 2015, marketing expense, which includes advertising, donation and other public relations costs, increased $0.5 million due primarily to marketing associated with acquired branches and additional community donations in those markets. Marketing expense remained relatively flat in 2014 compared to 2013. Peoples contributed $350,000 in 2015, $300,000 in 2014 and $200,000 in 2013 to Peoples Bancorp Foundation Inc. Peoples formed this private foundation in 2004 to make charitable contributions to organizations within Peoples' primary market area. Future contributions to Peoples Bancorp Foundation Inc. will be evaluated on a quarterly basis, with the determination of the amount of any contribution based largely on the perceived level of need within the communities Peoples serves. Peoples is subject to state franchise taxes, which are based largely on Peoples Bank's equity at year-end, in the states where Peoples Bank has a physical presence. Franchise taxes increased during 2015 due to an increase in equity from the issuance of common shares related to acquisitions in 2014 and 2015. In Ohio, Peoples is subject to Ohio Financial Institution Tax ("FIT") which is a business privilege tax that is imposed on financial institutions organized for profit and doing business in Ohio. The FIT is based on the total equity capital in proportion to the taxpayer's gross receipts in Ohio. Peoples' intangible asset amortization expense is driven by acquisition-related activity, and increased to $4.1 million in 2015 compared to $1.4 million in 2014. The increase in 2015 relates to the completed NB&T acquisition in 2015 and recognition of a full year of amortization for acquisitions completed during 2014. Data processing and software expense includes software support, maintenance and depreciation expense. These costs increased during 2015 and 2014 due to the recent acquisitions and new software projects completed. Peoples' FDIC insurance costs increased during 2015 and 2014 as a result of recent acquisitions. Additional information regarding Peoples' FDIC insurance assessments may be found in "ITEM 1 - BUSINESS" of this Form 10-K in the section captioned "Supervision and Regulation". Peoples' efficiency ratio, calculated as non-interest expense less amortization of other intangible assets divided by FTE net interest income plus non-interest income, was 75.50% for 2015, compared to 75.37% for 2014 and 71.90% for 2013. The increases in 2015 and 2014 were largely a result of one-time costs for acquisitions plus higher salaries and employee benefit costs. Income Tax Expense A key driver of the amount of income tax expense or benefit recognized by Peoples each year is the amount of pre-tax income derived from tax-exempt sources. Additionally, Peoples receives tax benefits from its investments in tax credit funds, which reduce Peoples' effective tax rate. A reconciliation of Peoples' recorded income tax expense/benefit and effective tax rate to the statutory tax rate can be found in Note 12 of the Notes to the Consolidated Financial Statements. Pre-Provision Net Revenue Pre-provision net revenue ("PPNR") has become a key financial measure used by federal bank regulatory agencies when assessing the capital adequacy of financial institutions. PPNR is defined as net interest income plus non-interest income minus non-interest expense and, therefore, excludes the provision for (recovery of) loan losses and all gains and losses included in earnings. As a result, PPNR represents the earnings capacity that can be either retained in order to build capital or used to absorb unexpected losses and preserve existing capital. The following table provides a reconciliation of this non-GAAP financial measure to the amounts reported in Peoples' Consolidated Financial Statements for the periods presented: During 2015, PPNR was higher while the pre-provision net revenue to total average assets ratio decreased compared to previous years due largely to the increase in net revenue as a result of the completion of the NB&T acquisition and recognition of a full year of revenue for acquisitions completed during 2014 being offset by the increase of average assets which also was reflective of the NB&T acquisition. Efficiency Ratio The efficiency ratio is a key financial measure used to monitor performance. The efficiency ratio is calculated as total other expenses (less intangible amortization) as a percentage of fully tax-equivalent net interest income plus non-interest income. This measure is non-GAAP since it excludes intangible amortization and all gains and/or losses included in earnings, and uses fully tax-equivalent net interest income. The following table provides a reconciliation of this non-GAAP financial measure to the amounts reported in Peoples' consolidated financial statements for the periods presented: FINANCIAL CONDITION Cash and Cash Equivalents Peoples considers cash and cash equivalents to consist of federal funds sold, cash and balances due from banks, interest-bearing balances in other institutions and other short-term investments that are readily liquid. The amount of cash and cash equivalents fluctuates on a daily basis due to customer activity and Peoples' liquidity needs. At December 31, 2015, excess cash reserves at the Federal Reserve Bank were $8.7 million, compared to $12.4 million at December 31, 2014. The amount of excess cash reserves maintained is dependent upon Peoples' daily liquidity position, which is driven primarily by changes in deposit and loan balances. In 2015, Peoples' total cash and cash equivalents increased $9.7 million, as cash provided by Peoples' operating activities of $47.9 million was partially offset by cash used in financing activities of $37.1 million and investing activities of $1.1 million. Cash provided by investing activities from business combinations of $97.3 million was offset by activities in available-for-sale securities of $12.8 million and funded loan growth of $77.9 million. Within Peoples' financing activities, the decrease in interest-bearing deposits was tempered by an increase in non-interest bearing deposits of $99.3 million. The paydown of long-term borrowings of $72.4 million was substantially offset by an increase of $72.1 million in short term borrowings. In 2014, Peoples' total cash and cash equivalents increased $7.6 million, as cash provided by Peoples' operating activities of $31.5 million was mostly offset by cash used by investing activities of $14.2 million and financing activities of $9.7 million. Cash provided by activities in available-for-sale securities and business combinations of $44.7 million, and $17.1 million, respectively, partially funded loan growth of $76.1 million. Within Peoples' financing activities, the decreases in interest-bearing deposits and short-term borrowings of $56.1 million were tempered by an increase in non-interest bearing deposits of $18.4 million and $40.2 million in proceeds from issuance of common shares. Further information regarding the management of Peoples' liquidity position can be found later in this discussion under “Interest Rate Sensitivity and Liquidity.” Investment Securities The following table provides information regarding Peoples’ investment portfolio at December 31: At December 31, 2015, Peoples' investment securities were approximately 26.7% of total assets compared to 27.8% at December 31, 2014, as Peoples continued to focus on reducing the relative size of the investment portfolio. Peoples acquired $156.4 million of investment securities as part of the NB&T acquisition, with the remaining fluctuation due to purchases being more than offset by principal paydowns, sales, calls and maturities. In 2013, and throughout 2012, Peoples designated certain securities as "held-to-maturity" at the time of their purchase, as management made the determination Peoples would hold these securities until maturity and concluded Peoples had the ability to do so. Since then, Peoples has maintained the size of the held-to-maturity securities portfolio at approximately the same level. The unrealized gain or loss related to held-to-maturity securities does not directly impact stockholders' equity, in contrast to the impact from the available-for-sale securities portfolio. Peoples' investment in residential and commercial mortgage-backed securities largely consists of securities either guaranteed by the U.S. government or issued by U.S. government sponsored agencies, such as Fannie Mae and Freddie Mac. The remaining portions of Peoples' mortgage-backed securities consist of securities issued by other entities, including other financial institutions, which are not guaranteed by the U.S. government. The amount of these “non-agency” securities included in the residential and commercial mortgage-backed securities totals above was as follows at December 31: Management continues to reinvest the principal runoff from the non-agency securities in U.S agency investments, which has accounted for the continued decline in the fair value of these securities. At December 31, 2015, Peoples' non-agency portfolio consisted entirely of first lien residential mortgages, with nearly all of the underlying loans in these securities originated prior to 2004 and possessing fixed interest rates. Management continues to monitor the non-agency portfolio closely for leading indicators of increasing stress and will continue to be proactive in taking actions to mitigate such risk when necessary. Additional information regarding Peoples' investment portfolio can be found in Note 3 of the Notes to the Consolidated Financial Statements. Loans The following table provides information regarding outstanding loan balances at December 31: (a) Includes all loans acquired, and related loan discount recorded as part of acquisition accounting, in 2012 and thereafter. During 2015, total originated loans (excluding acquired loans) grew 17%, or $202.6 million, due to increases in all categories except deposit account overdrafts. Consumer loan balances, which consist mostly of loans to finance automobile purchases, have continued to increase in recent years due largely to Peoples placing greater emphasis on its consumer lending activity. The increase in total acquired loans in 2015 was due to the NB&T acquisition. At December 31, 2015, loans acquired from NB&T were approximately $333.8 million compared to $384.6 million at acquisition date. During 2014, total originated loans grew 12%, or $126.5 million, largely due to growth in commercial real estate, commercial and industrial and consumer loan balances. At December 31, 2014, loans acquired from Midwest, Ohio Heritage and North Akron were approximately $52.5 million, $166.6 million and $108.8 million, respectively. During 2013, total originated loans increased 13%, while acquired loans grew $84.5 million due to the Ohio Commerce Bank acquisition. Also during 2013, Peoples retained a larger percentage of residential mortgage loans originated than in prior years which caused the increase in residential real estate loans. During 2013, Peoples placed greater emphasis on its consumer lending business, which primarily consists of automobile loans obtained directly or indirectly through automobile dealerships. Peoples added additional sales talent within this business line and established better relationships with dealers, resulting in substantially higher loan balances compared to prior years. The following table details the maturities of Peoples' commercial real estate and commercial and industrial loans at December 31, 2015: Loan Concentration Peoples categorizes its commercial loans according to standard industry classifications and monitors for concentrations in a single industry or multiple industries that could be impacted by changes in economic conditions in a similar manner. Peoples' commercial lending activities continue to be spread over a diverse range of businesses from all sectors of the economy, with no single industry comprising over 10% of Peoples' total loan portfolio. Loans secured by commercial real estate, including commercial construction loans, continue to comprise the largest portion of Peoples' loan portfolio. The following table provides information regarding the largest concentrations of commercial real estate loans within the loan portfolio at December 31, 2015: Peoples' commercial lending activities continue to focus on lending opportunities inside its primary and secondary market areas within Ohio, West Virginia and Kentucky. In all other states, the aggregate outstanding balances of commercial loans in each state were less than $4.0 million at both December 31, 2015 and December 31, 2014. Allowance for Loan Losses The amount of the allowance for loan losses at the end of each period represents management's estimate of probable losses from existing loans based upon its formal quarterly analysis of the loan portfolio described in the “Critical Accounting Policies” section of this discussion. While this process involves allocations being made to specific loans and pools of loans, the entire allowance is available for all losses incurred within the loan portfolio. The following details management's allocation of the allowance for loan losses at December 31: The allowance for loan losses as a percent of originated loans decreased in 2015 from previous years as a result of the continuation of the reduction in historic loss rates over the past five years. Past years included historic periods dating closer to the recession which included larger charge-offs. Peoples also considers recent trends in criticized loans and loan growth associated with each loan portfolio, as well as qualitative factors that could negatively impact these trends, such as unemployment, rising interest rates, fragile real estate values, and plummeting oil and gas prices. Peoples believe the reserves remain appropriate to cover probable losses that exist in the current portfolio. The reductions in the allowance for loan losses allocated to commercial real estate during 2015 and 2014 were driven by net recoveries in recent years reducing the historical loss rates. Increases in the commercial and industrial, home equity lines of credit and consumer categories of the allowance for loan losses were driven by net charge-off activity, and increases in the balances of the respective loan portfolios. The decrease in the allowance for loan losses allocated to residential real estate during 2015 was due to a reduction in net charge-off activity in recent years. The significant allocations to commercial loans reflect the higher credit risk associated with these types of lending and the size of these loan categories in relationship to the entire loan portfolio. During 2015, Peoples experienced an increase of $56.8 million in criticized loans, which are those classified as watch, substandard or doubtful. Net charge-offs were elevated during 2015 as a result of the full charge-off of one large commercial loan relationship. The allowance allocated to the residential real estate and consumer loan categories was based upon Peoples' allowance methodology for homogeneous pools of loans. The fluctuations in these allocations have been directionally consistent with the changes in loan quality, loss experience and loan balances in these categories. The following table summarizes the changes in the allowance for loan losses for the years ended December 31: (a) Includes purchased credit impaired charge-off of $60,000 in 2015. (b) Includes purchased credit impaired charge-off of $3,000 in 2015. (c) Includes purchased credit impaired provision for loan losses of $303,000 in 2015. During 2015, Peoples recorded charge-offs related to one large commercial loan relationship in the aggregate amount of $13.1 million, or .67% of average total loans. Peoples also experienced higher net charge-offs in residential real estate and consumer loans due to higher balances from recent originated loan growth. The following table details Peoples’ nonperforming assets at December 31: At December 31, 2015, loans 90+ days past due and accruing included $2.3 million of acquired loans that were purchased credit impaired, as they had evidence of credit quality deterioration since origination. Interest income on those loans is recognized on a level-yield method over the life of the loan. The majority of Peoples' nonaccrual commercial real estate loans continued to consist of non-owner occupied commercial properties and real estate development projects. In general, management believes repayment of these loans is dependent on the sale of the underlying collateral. As such, the carrying values of these loans are ultimately supported by management's estimate of the net proceeds Peoples would receive upon the sale of the collateral. These estimates are based in part on market values provided by independent, licensed or certified appraisers periodically, but no less frequently than annually. Given the volatility in commercial real estate values, management continues to monitor changes in real estate values from quarter-to-quarter and updates its estimates as needed based on observable changes in market prices and/or updated appraisals for similar properties. The significant increases in nonaccrual commercial real estate loans during 2015 was a result of commercial real estate relationship in the skilled nursing sector being placed on nonaccrual status. The increase in nonaccrual commercial and industrial loans during 2014 was driven by a single $1.2 million relationship placed on nonaccrual. The significant decreases in nonaccrual status from 2011 to 2012 and 2013 was a result of the addition of a special assets group and their efforts in collecting and recovering payments on delinquent commercial loans. Interest income on loans classified as nonaccrual and renegotiated at each year-end that would have been recorded under the original terms of the loans was $0.4 million for 2015, $0.5 million for 2014 and $0.2 million for 2013. No portion of these amounts was recorded during 2015, 2014 or 2013, consistent with the income recognition policy described in the “Critical Accounting Policies” section of this discussion. Overall, management believes the allowance for loan losses was adequate at December 31, 2015, based on all significant information currently available. Still, there can be no assurance that the allowance for loan losses will be adequate to cover future losses or that the amount of nonperforming loans will remain at current levels, especially considering the current economic uncertainty that exists and the concentration of commercial loans in Peoples’ loan portfolio. Deposits The following table details Peoples’ deposit balances at December 31: The increase in governmental deposit accounts was due to fluctuations of balances held by state and local governmental entities and their cash flow needs. Peoples also maintained its deposit strategy of growing low-cost core deposits, such as checking and savings accounts, and reducing its reliance on higher-cost, non-core deposits, such as CDs and brokered deposits. These actions accounted for much of the changes in deposit balances. Some of the increase in deposit balances was due to the NB&T acquisition, which included non-interest bearing deposits of $177.2, retail CDs totaling $48.0 million, savings accounts of $88.3 million, money market deposit accounts of $64.6 million, governmental deposit accounts of $104.8 million, and interest-bearing demand accounts of $57.9 million at December 31, 2015. The increase in total deposits in 2014, included the Midwest, Ohio Heritage and North Akron acquisitions which added an aggregate of $5.5 million of non-interest-bearing deposits, $105.0 million of CDs, $53.1 million of savings accounts, $165.1 million of money market deposit accounts, $2.1 million of governmental deposit accounts and $1.0 million of interest-bearing demand accounts at December 31, 2014. Peoples' governmental deposit accounts represent savings and interest-bearing transaction accounts from state and local governmental entities. These funds are subject to periodic fluctuations based on the timing of tax collections and subsequent expenditures or disbursements. Peoples normally experiences an increase in balances annually during the first quarter corresponding with tax collections, with declines normally in the second half of each year corresponding with expenditures by the governmental entities. While these balances have increased since 2008, Peoples continues to emphasize growth of low-cost deposits that do not require Peoples to pledge assets as collateral, which is required in the case of governmental deposit accounts. The maturities of retail CDs with total balances of $250,000 or more at December 31 were as follows: Borrowed Funds The following table details Peoples’ short-term and long-term borrowings at December 31: Peoples' short-term FHLB advances generally consist of overnight borrowings being maintained in connection with the management of Peoples' daily liquidity position. During 2015, Peoples repaid approximately $52.1 million of long-term FHLB advances during 2015 and recorded a loss on debt extinguishment of $520,000. During 2015, Peoples increased its usage of short-term FHLB advances due to the decrease and pre-payment of long-term debt. During 2014, Peoples had reduced its usage of short-term FHLB advances due to acquiring long-term FHLB advances from Ohio Heritage. Peoples' retail repurchase agreements consist of overnight agreements with commercial customers and serve as a cash management tool. Additionally, in 2015, Peoples acquired subordinated debt in the NB&T acquisition. During 2012, Peoples entered into a loan agreement that was subsequently amended in 2014 (as amended, "Amended Loan Agreement"), and Peoples is subject to certain covenants imposed by this Amended Loan Agreement. At December 31, 2015, Peoples was in compliance with the applicable covenants. Additional information regarding Peoples' borrowed funds can be found in Note 8 and Note 9 of the Notes to the Consolidated Financial Statements. Capital/Stockholders’ Equity During 2015, Peoples' total stockholders' equity increased primarily due to $76.0 million of common equity issued in connection with the NB&T acquisition. Regulatory capital ratios continued to fluctuate due to recent acquisitions. At December 31, 2015, capital levels for both Peoples and Peoples Bank remained substantially higher than the minimum amounts needed to be considered "well capitalized" under banking regulations. These higher capital levels reflect Peoples' desire to maintain strong capital positions to provide greater flexibility to grow the Company. Also during the first quarter of 2015, Peoples adopted the new Basel III regulatory capital framework, as approved by the federal banking regulators. The adoption of this new framework modified the calculations and well capitalized thresholds of the current capital ratios and added the new Common Equity Tier 1 capital ratio. Additionally, under the new rules, in order to avoid limitations on capital distributions, including dividend payments, Peoples must hold a capital conservation buffer above the adequately capitalized Common Equity Tier 1 capital ratio. The capital conservation buffer is being phased in from 0.00% for 2015 to 2.50% by 2019. The following table details Peoples' actual risk-based capital levels and corresponding ratios at December 31: In addition to traditional capital measurements, management uses tangible capital measures to evaluate the adequacy of Peoples' stockholders' equity. Such ratios represent non-GAAP financial information since their calculation removes the impact of intangible assets acquired through acquisitions on the Consolidated Balance Sheets. Management believes this information is useful to investors since it facilitates the comparison of Peoples' operating performance, financial condition and trends to peers, especially those without a similar level of intangible assets to that of Peoples. Further, intangible assets generally are difficult to convert into cash, especially during a financial crisis, and could decrease substantially in value should there be deterioration in the overall franchise value. As a result, tangible equity represents a conservative measure of the capacity for a company to incur losses but remain solvent. The following table reconciles the calculation of these non-GAAP financial measures to amounts reported in Peoples' Consolidated Financial Statements at December 31: The decrease in tangible equity to tangible assets ratio at December 31, 2015 compared to December 31, 2014 was due to the impact of assets acquired in the NB&T acquisition as well as a reduction in retained earnings as most of the net income was paid to common shareholders as dividends. In 2014, Peoples' tangible equity to tangible assets ratio increased significantly due to recent acquisitions, in which common shares represented a portion of the consideration, and the Private Equity Issuance. The reduction in 2013 was due to the impact of assets acquired in the Ohio Commerce Bank acquisition, which was funded solely by cash consideration, as well as reductions in the fair value of the available-for-sale investment securities. Future Outlook In 2015, Peoples completed its largest bank acquisition to date, and incurred a large provision for loan losses attributable primarily to one large commercial relationship. The first half of 2015 was a challenge for Peoples as there was minimal loan growth and expenses were elevated, due in part to the acquisition costs incurred associated with the NB&T acquisition. During the second half of 2015, Peoples showed improvement as loan growth was strong and expenses were managed; however, these positives were largely overshadowed by the large provision for loan losses that was taken due to the one large commercial relationship. For 2016, Peoples will build off the momentum that was gained in the second half of 2015 related to loan growth and expense management. Key strategic priorities continue to include generating positive operating leverage, maintaining superior asset quality, and remaining prudent with the use of capital. Overall, Peoples' key strategic objectives are to be a steady, dependable performer for its shareholders and to take advantage of market expansion opportunities. Peoples' long-term strategic goals include generating results in the top quartile of performance relative to Peoples' peer group, as defined in the Proxy Statement, and providing returns for its shareholders superior to those of its peers, regardless of operating conditions. Net interest income remains a major source of revenue for Peoples. Thus, Peoples' ability to grow revenue in 2016 will be impacted by the amount of net interest income generated. The current outlook is mixed as to whether the Federal Reserve Board will continue to raise interest rates throughout 2016. Long-term rates could increase but remain more volatile than in prior years. Changes in long-term interest rates would affect reinvestment rates within the loan and investment portfolios. Should the yield curve flatten, Peoples would have limited opportunities to offset the impact on asset yields with a similar reduction in funding costs. Thus, Peoples' ability to produce meaningful loan growth remains the key driver for improving net interest income and margin in 2016. Net interest margin for 2016 is expected to remain stable in the low 3.50%'s given the interest rate environment. Loan growth will again be the key driver in stabilizing asset yields. The net accretion income impact on net interest margin is expected to be slightly less than that experienced in 2015. Management would expect both net interest income and margin to benefit from any meaningful increase in market interest rates based upon the current interest rate risk profile. However, it remains inherently difficult to predict and manage the future trend of Peoples' net interest income and margin due to the uncertainty surrounding the timing and magnitude of future interest rate changes, as well as the impact of competition for loans and deposits. Peoples continues to seek to maintain a diversified revenue stream though its strong fee-based businesses, such as insurance and wealth management. In 2015, Peoples' fee revenue comprised 33% of its total revenue, down from 37% in 2014 and 40% in 2013. The decline in recent years was due primarily to the four bank acquisitions completed during 2014 and 2015, only one of which had a wealth management practice, and only two relatively small insurance agencies were purchased during the same period of time. Peoples has capabilities that many banks in its market area lack, including some of the largest national banks, which include robust retirement plan services and comprehensive insurance products. Thus, management considers Peoples to have a competitive advantage that directly enhances revenue growth potential. For 2016, acquisition activity will be focused primarily on growing fee-based businesses as management continues to strive for a diversified revenue stream that consists of 35% to 40% fee-based revenue to total revenue. While the primary focus will be on revenue growth, management remains disciplined with operating expenses. In 2015, total non-interest expense included $10.7 million of one-time acquisition costs. For 2016, total non-interest expense will increase due to a full year’s impact of the NB&T acquisition. Normalizing for these items, management expects expense growth to be in the low single digits in 2016. However, Peoples continues to have limited control over some expenses, such as employee medical and pension costs. Peoples continues to be exposed to more pension settlement charges given the frozen status of its defined benefit plan. The recognition of settlement charges is largely dependent upon the timing of distributions, the amount of pension benefit earned by the retirees, and whether the individuals elect a lump-sum distribution. For 2016, management anticipates a comparable volume of settlement charges to that incurred in 2015. This expectation is based on normal retirement activity within the defined benefit plan, but assumes all potential distributions are lump sum payouts. Normalizing 2015 for a full year impact of the NB&T acquisition, and excluding the acquisition costs incurred in 2015, management expects 4% to 6% growth in total revenue in 2016, and the low-single digit percentage expense growth. As a result, Peoples' efficiency ratio is expected to be below 65% for 2016. A key to Peoples’ 2016 revenue growth goal is achieving meaningful loan growth. Management believes period-end loan balances could increase by 6% to 8% in 2016. Within Peoples' commercial lending activity, the primary emphasis continues to be on non-mortgage commercial lending opportunities and capitalizing on growth opportunities provided by the acquisitions completed. As a result, commercial and industrial loan balances should increase at a greater rate than commercial real estate loan balances. Consumer lending activity is continuing to strengthen and will remain a larger contributor to overall loan growth, primarily indirect lending. In 2015, Peoples invested $50 million of excess cash in the investment portfolio, resulting in the investment portfolio comprising 27% of total assets as of December 31, 2015. In 2016, the investment portfolio to anticipated to comprise between 25% and 27% of total assets. Management can use the cash flow generated by Peoples’ significant investment in mortgage-backed securities to fund new loan production. Peoples will continue to seek opportunities to execute a shift in the mix on the asset side of the balance sheet to reduce the relative size of the investment portfolio allowing Peoples to fund the expected loan growth. Management may adjust the size or composition of the investment portfolio in response to other factors, such as changes in liquidity needs and interest rate conditions. Peoples' funding strategy continues to emphasize growth of core deposits, such as checking and savings accounts, rather than higher-cost deposits. Thus, CD balances could maintain the declining trend experienced in recent years. Given the expected increase in earning assets, borrowed funds would increase in 2016 to the extent earning asset growth is more than deposit growth. Should this occur, management would evaluate using longer-term borrowings to match the duration of the assets being funded to minimize the long-term interest rate risk. Peoples remains committed to sound underwriting and prudent risk management. Management believes this credit discipline will benefit Peoples during future economic downturns. The long-term goal is to maintain key metrics in the top-quartile of Peoples' peer group regardless of economic conditions. Net charge-off trends are expected to normalize in 2016 as the prospects of large charge-offs and recoveries diminish. Management anticipates Peoples' provision for loan losses and the net charge-off rate for 2016 to normalize, with the net charge-off rate near the low end of its long-term historical range of 0.20% to 0.30% of average loans. For 2016, management intends to remain prudent with the level of Peoples' allowance for loan losses. However, the level will continue to be based upon management's quarterly assessment of the losses inherent in the loan portfolio, and the amount of any provision for loan losses should be driven mostly by a combination of the net charge-off rate and loan growth. Peoples' capital position remains strong. Given the excess capital position and the anticipated pause in bank acquisitions, Peoples will continue to look for ways to effectively manage its capital. Late in 2015, Peoples approved a share repurchase program of up to $20 million. Given the activity in the stock market in early 2016, specifically as it related to the price of Peoples' common shares, purchases were executed under the program in January and February, totaling $4.5 million. Peoples will continue to evaluate additional purchase opportunities throughout 2016. Management has built a culture where it is paramount that the associates take care of customers and take care of each other. Management is committed to profitable growth of the company and building long-term shareholder value. This will require management to remain focused on four key areas: responsible risk management; extraordinary client experience; profitable revenue growth; and maintaining a superior workforce. Success will be achieved through disciplined execution of strategies and providing extraordinary service to Peoples' clients and communities. Interest Rate Sensitivity and Liquidity While Peoples is exposed to various business risks, the risks relating to interest rate sensitivity and liquidity are major risks that can materially impact future results of operations and financial condition due to their complexity and dynamic nature. The objective of Peoples' asset/liability management (“ALM”) function is to measure and manage these risks in order to optimize net interest income within the constraints of prudent capital adequacy, liquidity and safety. This objective requires Peoples to focus on interest rate risk exposure and adequate liquidity through its management of the mix of assets and liabilities, their related cash flows and the rates earned and paid on those assets and liabilities. Ultimately, the ALM function is intended to guide management in the acquisition and disposition of earning assets and selection of appropriate funding sources. Interest Rate Risk Interest rate risk (“IRR”) is one of the most significant risks arising in the normal course of business of financial services companies like Peoples. IRR is the potential for economic loss due to future interest rate changes that can impact the earnings stream as well as market values of financial assets and liabilities. Peoples' exposure to IRR is due primarily to differences in the maturity or repricing of earning assets and interest-bearing liabilities. In addition, other factors, such as prepayments of loans and investment securities or early withdrawal of deposits, can affect Peoples' exposure to IRR and increase interest costs or reduce revenue streams. Peoples has assigned overall management of IRR to the ALCO, which has established an IRR management policy that sets minimum requirements and guidelines for monitoring and managing the level of IRR. The objective of Peoples' IRR policy is to assist the ALCO in its evaluation of the impact of changing interest rate conditions on earnings and economic value of equity, as well as assist with the implementation of strategies intended to reduce Peoples' IRR. The management of IRR involves either maintaining or changing the level of risk exposure by changing the repricing and maturity characteristics of the cash flows for specific assets or liabilities. Additional oversight of Peoples' IRR is provided by the Asset Liability Management and Investment Committee of Peoples Bank's Board of Directors. This committee also reviews and approves Peoples' IRR management policy at least annually. The ALCO uses various methods to assess and monitor the current level of Peoples' IRR and the impact of potential strategies or other changes. However, the ALCO predominantly relies on simulation modeling in its overall management of IRR since it is a dynamic measure. Simulation modeling also estimates the impact of potential changes in interest rates and balance sheet structures on future earnings and projected economic value of equity. The modeling process starts with a base case simulation using the current balance sheet and current interest rates held constant for the next twenty-four months. Alternate scenarios are prepared which simulate the impact of increasing and decreasing market interest rates, assuming parallel yield curve shifts. Comparisons produced from the simulation data, showing the changes in net interest income from the base interest rate scenario, illustrate the risks associated with the current balance sheet structure. Additional simulations, when deemed appropriate or necessary, are prepared using different interest rate scenarios from those used with the base case simulation and/or possible changes in balance sheet composition. The additional simulations include non-parallel shifts in interest rates whereby the direction and/or magnitude of change of short-term interest rates is different than the changes applied to longer-term interest rates. Comparisons showing the earnings and economic value of equity variance from the base case are provided to the ALCO for review and discussion. The ALCO has established limits on changes in the twelve-month net interest income forecast and the economic value of equity from the base case. The ALCO may establish risk tolerances for other parallel and non-parallel rate movements, as deemed necessary. The following table details the current policy limits used to manage the level of Peoples' IRR: The following table shows the estimated changes in net interest income and the economic value of equity based upon a standard, parallel shock analysis (dollars in thousands): This table uses a standard, parallel shock analysis for assessing the IRR to net interest income and the economic value of equity. A parallel shock means all points on the yield curve (one year, two year, three year, etc.) are directionally changed the same amount of basis points. For example, 100 basis points equals 1%. While management regularly assesses the impact of both increasing and decreasing interest rates, the table above only reflects the impact of upward shocks due to the fact a downward parallel shock of 100 basis points or more is not possible given that most short-term rates are currently less than 1%. Although a parallel shock table can give insight into the current direction and magnitude of IRR inherent in the balance sheet, interest rates do not usually move in a complete parallel manner during interest rate cycles. These nonparallel movements in interest rates, commonly called yield curve steepening or flattening movements, tend to occur during the beginning and end of an interest rate cycle, with differences in the timing, direction and magnitude of changes in short-term and long-term interest rates. Thus, any benefit that could occur as a result of the Federal Reserve Board increasing short-term interest rates in future quarters could be offset by an inverse movement in long-term interest rates. As a result, management conducts more advanced interest rate shock scenarios to gain a better understanding of Peoples' exposure to nonparallel rate shifts. At December 31, 2015, Peoples' Consolidated Balance Sheet remained positioned for a rising interest rate environment, as illustrated by the potential increase in net interest income shown in the above table. During 2015, Peoples became slightly sensitive to rising interest rates (as measured by the expected percentage change in economic value of equity) due to several factors. The largest factors impacting Peoples' interest rate sensitivity were the NB&T acquisition in March and the deployment of excess cash in the balance sheet post-acquisition. Liquidity In addition to IRR management, another major objective of the ALCO is to maintain sufficient levels of liquidity. The ALCO defines liquidity as the ability to meet anticipated and unanticipated operating cash needs, loan demand and deposit withdrawals without incurring a sustained negative impact on profitability. A primary source of liquidity for Peoples is retail deposits. Liquidity is also provided by cash generated from earning assets such as maturities, calls, and principal and interest payments from loans and investment securities. Peoples also uses various wholesale funding sources to supplement funding from customer deposits. These external sources provide Peoples with the ability to obtain large quantities of funds in a relatively short time period in the event of sudden unanticipated cash needs. However, an over-utilization of external funding sources can expose Peoples to greater liquidity risk as these external sources may not be accessible during times of market stress. Additionally, Peoples may be exposed to the risk associated with providing excess collateral to external funding providers, commonly referred to as counterparty risk. As a result, the ALCO's liquidity management policy sets limits on the net liquidity position and the concentration of non-core funding sources, both wholesale funding and brokered deposits. In addition to external sources of funding, Peoples considers certain types of deposits to be less stable or "volatile funding". These deposits include special money market products, large CDs and public funds. Peoples has established volatility factors for these various deposit products, and the liquidity management policy establishes a limit on the total level of volatile funding. Additionally, Peoples measures the maturities of external sources of funding for periods of 1 month, 3 months, 6 months and 12 months and has established policy limits for the amounts maturing in each of these periods. The purpose of these limits is to minimize exposure to what is commonly termed rollover risk. An additional strategy used by Peoples in the management of liquidity risk is maintaining a targeted level of liquid assets. These are assets that can be converted into cash in a relatively short period of time. Management defines liquid assets as unencumbered cash (including cash on deposit at the Federal Reserve Bank), and the market value of U.S. government and agency securities that are not pledged. Excluded from this definition are pledged securities, non-government and agency securities, municipal securities and loans. Management has established a minimum level of liquid assets in the liquidity management policy, which is expressed as a percentage of loans and unfunded loan commitments. Peoples also has established a policy limit around the level of liquefiable assets also expressed as a percentage of loans and unfunded loan commitments. Liquefiable assets are defined as liquid assets plus the market value of unpledged securities not included in the liquid asset measurement. An essential element in the management of liquidity risk is a forecast of the sources and uses of anticipated cash flows. On a monthly basis, Peoples forecasts sources and uses of cash for the next twelve months. To assist in the management of liquidity, management has established a liquidity coverage ratio, which is defined as the total sources of cash divided by the total uses of cash. A ratio of greater than 1.0 times indicates that forecasted sources of cash are adequate to fund forecasted uses of cash. The liquidity management policy establishes a minimum limit of 1.0 times. As of December 31, 2015, Peoples had a ratio of 1.8 times, which was within policy limits. Peoples also forecasts secondary or contingent sources of cash, and this includes external sources of funding and liquid assets. These sources of cash would be required if and when the forecasted liquidity coverage ratio dropped below the policy limit of 1.0 times. An additional liquidity measurement used by management includes the total forecasted sources of cash and the contingent sources of cash divided by the forecasted uses of cash. Management has established a minimum ratio of 3.0 times for this liquidity management policy limit. As of December 31, 2015, Peoples had a ratio of 7.4 times, which was within policy limits. Disruptions in the sources and uses of cash can occur which can drastically alter the actual cash flows and negatively impact Peoples' ability to access internal and external sources of cash. Such disruptions might occur due to increased withdrawals of deposits, increases in the funding required for loan commitments, a decrease in the ability to access external funding sources and other forces that would increase the need for funding and limit Peoples' ability to access needed funds. As a result, Peoples maintains a liquidity contingency funding plan ("LCFP") that considers various degrees of disruptions and develops action plans around these scenarios. Peoples' LCFP identifies scenarios where funding disruptions might occur and creates scenarios of varying degrees of severity. The disruptions considered include an increase in funding of unfunded loan commitments, unanticipated withdrawals of deposits, decreases in the renewal of maturing CDs and reductions in cash earnings. Additionally, the LCFP creates stress scenarios where access to external funding sources, or contingency funding, is suddenly limited which includes a significant increase in the margin requirements where securities or loans are pledged, limited access to funding from other banks and limited access to funding from the FHLB and the Federal Reserve Bank. Peoples' LCFP scenarios include a base scenario, a mild stress scenario, a moderate stress scenario and a severe stress scenario. Each of these is defined as to the severity, and action plans are developed around each. Liquidity management also requires the monitoring of risk indicators that may alert the ALCO to a developing liquidity situation or crisis. Early detection of stress scenarios allows Peoples to take actions to help mitigate the impact to Peoples Bank's business operations. The LCFP contains various indicators, termed key risk indicators ("KRI's") that are monitored on a monthly basis, at a minimum. The KRI's include both internal and external indicators and include loan delinquency levels, classified and watch list loan levels, non-performing loans to loans and to total assets, the loan to deposit ratio, the level of net non-core funding dependence, the level of contingency funding sources, the liquidity coverage ratio, changes in regulatory capital levels, forecasted operating loss and negative media concerning Peoples, irrational competitor pricing that persists and an increase in rates for external funding sources. The LCFP establishes levels that define each of these KRI's under base, mild, moderate and severe scenarios. The LCFP is reviewed and updated at least on an annual basis by the ALCO and the Asset Liability Management and Investment Committee of Peoples Bank's Board of Directors. Additionally, testing of the LCFP is required on an annual basis. Various stress scenarios and the related actions are simulated according to the LCFP. The results are reviewed and discussed, and changes or revisions are made to the LCFP accordingly. Additionally, every two years, the LCFP is subjected to a third-party review for effectiveness and regulatory compliance. Overall, management believes the current balance of cash and cash equivalents, and anticipated cash flows from the investment portfolio, along with the availability of other funding sources, will allow Peoples to meet anticipated cash obligations, as well as special needs and off-balance sheet commitments. Off-Balance Sheet Activities and Contractual Obligations Peoples routinely engages in activities that involve, to varying degrees, elements of risk that are not reflected in whole or in part in the Consolidated Financial Statements. These activities are part of Peoples' normal course of business and include traditional off-balance sheet credit-related financial instruments, interest rate contracts and commitments to make additional capital contributions in low-income housing tax credit investments. The following is a summary of Peoples’ significant off-balance sheet activities and contractual obligations. Detailed information regarding these activities and obligations can be found in the Notes to the Consolidated Financial Statements as follows: Traditional off-balance sheet credit-related financial instruments are primarily commitments to extend credit and standby letters of credit. These activities are necessary to meet the financing needs of customers and could require Peoples to make cash payments to third parties in the event certain specified future events occur. The contractual amounts represent the extent of Peoples’ exposure in these off-balance sheet activities. However, since certain off-balance sheet commitments, particularly standby letters of credit, are expected to expire or only partially be used, the total amount of commitments does not necessarily represent future cash requirements. Peoples continues to lease certain facilities and equipment under noncancellable operating leases with terms providing for fixed monthly payments over periods generally ranging from two to ten years. Several of Peoples’ leased facilities are inside retail shopping centers or office buildings and, as a result, are not available for purchase. Management believes these leased facilities increase Peoples’ visibility within its markets and afford sales associates additional access to current and potential clients. For certain acquisitions, often those involving insurance businesses and wealth management books of business, a portion of the consideration is contingent upon revenue metrics being achieved. US GAAP requires that the amounts be recorded upon acquisition based on the best estimate of the future amounts to be paid at the time of acquisition. Any subsequent adjustment to the estimate is recorded in earnings. Based on the acquisitions completed to date, management does not expect contingent consideration to have a material impact on Peoples' future performance. The following table details the aggregate amount of future payments Peoples is required to make under certain contractual obligations as of December 31, 2015: Management does not anticipate Peoples’ current off-balance sheet activities will have a material impact on its future results of operations and financial condition based on historical experience and recent trends. Effects of Inflation on Financial Statements Substantially all of Peoples’ assets relate to banking and are monetary in nature. As a result, inflation does not impact Peoples to the same degree as companies in capital-intensive industries in a replacement cost environment. During a period of rising prices, a net monetary asset position results in a loss in purchasing power and conversely a net monetary liability position results in an increase in purchasing power. The opposite would be true during a period of decreasing prices. In the banking industry, monetary assets typically exceed monetary liabilities. The current monetary policy targeting low levels of inflation has resulted in relatively stable price levels. Therefore, inflation has had little impact on Peoples’ net assets.

<s>[INST] Certain statements in this Form 10K, which are not historical fact, are forwardlooking statements within the meaning of Section 27A of the Securities Act , Section 21E of the Exchange Act, and the Private Securities Litigation Reform Act of 1995. Words such as “anticipate”, “estimates”, “may”, “feels”, “expects”, “believes”, “plans”, “will”, “would”, “should”, “could” and similar expressions are intended to identify these forwardlooking statements but are not the exclusive means of identifying such statements. Forwardlooking statements are subject to risks and uncertainties that may cause actual results to differ materially. Factors that might cause such a difference include, but are not limited to: (1) the success, impact, and timing of the implementation of Peoples' business strategies, including the successful integration of recently completed acquisitions and the expansion of consumer lending activity; (2) Peoples' ability to integrate the NB&T acquisition and any future acquisitions may be unsuccessful, or may be more difficult, timeconsuming or costly than expected; (3) Peoples may issue equity securities in connection with future acquisitions, which could cause ownership and economic dilution to Peoples' current shareholders; (4) local, regional, national and international economic conditions and the impact they may have on Peoples, its customers and its counterparties, and Peoples' assessment of the impact, which may be different than anticipated; (5) competitive pressures among financial institutions or from nonfinancial institutions may increase significantly, including product and pricing pressures, thirdparty relationships and revenues, and Peoples' ability to attract, develop and retain qualified professionals; (6) changes in the interest rate environment due to economic conditions and/or the fiscal policies of the U.S. government and Federal Reserve Board, which may adversely impact interest rates, interest margins and interest rate sensitivity; (7) changes in prepayment speeds, loan originations, levels of nonperforming assets, delinquent loans and chargeoffs, which may be less favorable than expected and adversely impact the amount of interest income generated; (8) adverse changes in economic conditions and/or activities, including, but not limited to, continued economic uncertainty in the U.S., the European Union, Asia, and other areas, which could decrease sales volumes and increase loan delinquencies and defaults; (9) legislative or regulatory changes or actions, promulgated and to be promulgated thereunder by the State of Ohio, the Federal Deposit Insurance Corporation, the OCC, the Federal Reserve Board and the CFPB, which may subject Peoples, its subsidiaries, or one or more acquired companies to a variety of new and more stringent legal and regulatory requirements which adversely affect their respective businesses, including in particular the rules and regulations promulgated and to be promulgated under the DoddFrank Act; (10) deterioration in the credit quality of Peoples' loan portfolio, which may adversely impact the provision for loan losses; (11) changes in accounting standards, policies, estimates or procedures which may adversely affect Peoples' reported financial condition or results of operations; (12) Peoples' assumptions and estimates used in applying critical accounting policies, which may prove unreliable, inaccurate or not predictive of actual results; (13) adverse changes in the conditions and trends in the financial markets, including political developments, which may adversely affect the fair value of securities within Peoples' investment portfolio, the interest rate sensitivity of Peoples' consolidated balance sheet, and the income generated by Peoples' trust and investment activities; (14) Peoples' ability to receive dividends from its subsidiaries; (15) Peoples' ability to maintain required capital levels and adequate sources of funding and liquidity; (16) the impact of new minimum capital thresholds established as a part of the implementation of Basel III; (17) the impact of larger or similar sized financial institutions encountering problems, which may adversely affect the banking industry and/or Peoples' business generation and retention, funding and liquidity; [/INST] Positive. </s>

PEOPLES BANCORP INC

2017-02-27

2016-12-31

ITEM 7. MANAGEMENT’S DISCUSSION AND ANALYSIS OF FINANCIAL CONDITION AND RESULTS OF OPERATIONS Forward-Looking Statements Certain statements in this Form 10-K, which are not historical fact, are forward-looking statements within the meaning of Section 27A of the Securities Act , Section 21E of the Exchange Act, and the Private Securities Litigation Reform Act of 1995. Words such as “anticipate”, “estimates”, “may”, “feels”, “expects”, “believes”, “plans”, “will”, “would”, “should”, “could” and similar expressions are intended to identify these forward-looking statements but are not the exclusive means of identifying such statements. Forward-looking statements are subject to risks and uncertainties that may cause actual results to differ materially. Factors that might cause such a difference include, but are not limited to: (1) Peoples' ability to leverage the system conversion (including the related core operating systems, data systems and products) without complications or difficulties that may otherwise result in the loss of customers, operational problems or one-time costs currently not anticipated to arise in connection with such conversion; (2) the success, impact, and timing of the implementation of Peoples' business strategies, including the successful integration of acquisitions and the expansion of consumer lending activity; (3) Peoples' ability to integrate future acquisitions which may be unsuccessful, or may be more difficult, time-consuming or costly than expected; (4) Peoples may issue equity securities in connection with future acquisitions, which could cause ownership and economic dilution to Peoples' current shareholders; (5) local, regional, national and international economic conditions and the impact they may have on Peoples, its customers and its counterparties, and Peoples' assessment of the impact, which may be different than anticipated; (6) competitive pressures among financial institutions or from non-financial institutions may increase significantly, including product and pricing pressures, changes to third-party relationships and revenues, and Peoples' ability to attract, develop and retain qualified professionals; (7) changes in the interest rate environment due to economic conditions and/or the fiscal policies of the U.S. government and Federal Reserve Board, which may adversely impact interest rates, interest margins, loan demand and interest rate sensitivity; (8) changes in prepayment speeds, loan originations, levels of non-performing assets, delinquent loans and charge-offs, which may be less favorable than expected and adversely impact the amount of interest income generated; (9) adverse changes in economic conditions and/or activities, including, but not limited to, continued economic uncertainty in the U.S., the European Union (including the uncertainty created by the June 23, 2016 referendum by British voters to exit the European Union), Asia, and other areas, which could decrease sales volumes and increase loan delinquencies and defaults; (10) uncertainty regarding the nature, timing and effect of legislative or regulatory changes or actions, promulgated and to be promulgated by governmental and regulatory agencies including the ODFI, the FDIC, the OCC, the Federal Reserve Board and the CFPB, which may subject Peoples, its subsidiaries, or one or more acquired companies to a variety of new and more stringent legal and regulatory requirements which adversely affect their respective businesses, including in particular the rules and regulations promulgated and to be promulgated under the Dodd-Frank Wall Street Reform and Consumer Protection Act of 2010, and the Basel III regulatory capital reform; (11) deterioration in the credit quality of Peoples' loan portfolio, which may adversely impact the provision for loan losses; (12) changes in accounting standards, policies, estimates or procedures which may adversely affect Peoples' reported financial condition or results of operations; (13) Peoples' assumptions and estimates used in applying critical accounting policies, which may prove unreliable, inaccurate or not predictive of actual results; (14) adverse changes in the conditions and trends in the financial markets, including political developments, which may adversely affect the fair value of securities within Peoples' investment portfolio, the interest rate sensitivity of Peoples' consolidated balance sheet, and the income generated by Peoples' trust and investment activities; (15) Peoples' ability to receive dividends from its subsidiaries; (16) Peoples' ability to maintain required capital levels and adequate sources of funding and liquidity; (17) the impact of new minimum capital thresholds established as a part of the implementation of Basel III; (18) the impact of larger or similar sized financial institutions encountering problems, which may adversely affect the banking industry and/or Peoples' business generation and retention, funding and liquidity; (19) the costs and effects of regulatory and legal developments, including the outcome of potential regulatory or other governmental inquiries and legal proceedings and results of regulatory examinations; (20) Peoples' ability to secure confidential information through the use of computer systems and telecommunications networks, including those of Peoples' third-party vendors and other service providers, may prove inadequate, which could adversely affect customer confidence in Peoples and/or result in Peoples incurring a financial loss; (21) changes in consumer spending, borrowing and saving habits, whether due to changes in business and economic conditions, legislative or regulatory initiatives, or other factors, which may be different than anticipated; (22) the overall adequacy of Peoples' risk management program; (23) the impact on Peoples' businesses, as well as on the risks described above, of various domestic or international military or terrorist activities or conflicts; (24) significant changes in the tax laws, which may adversely affect the fair values of net deferred tax assets and obligations of states and political subdivisions held in Peoples' investment securities portfolio; and (25) other risk factors relating to the banking industry or Peoples as detailed from time to time in Peoples' reports filed with the SEC, including those risk factors included in the disclosures under the heading "ITEM 1A. RISK FACTORS" of this Form 10-K. All forward-looking statements speak only as of the filing date of this Form 10-K and are expressly qualified in their entirety by the cautionary statements. Although management believes the expectations in these forward-looking statements are based on reasonable assumptions within the bounds of management’s knowledge of Peoples’ business and operations, it is possible that actual results may differ materially from these projections. Additionally, Peoples undertakes no obligation to update these forward-looking statements to reflect events or circumstances after the filing date of this Form 10-K or to reflect the occurrence of unanticipated events except as may be required by applicable legal requirements. Copies of documents filed with the SEC are available free of charge at the SEC’s website at www.sec.gov and/or from Peoples' website - www.peoplesbancorp.com under the "Investor Relations" section. The following discussion and analysis of Peoples' Consolidated Financial Statements is presented to provide insight into management's assessment of the financial position and results of operations for the periods presented. This discussion and analysis should be read in conjunction with the audited Consolidated Financial Statements and Notes thereto, as well as the ratios and statistics, contained elsewhere in this Form 10-K. Summary of Significant Transactions and Events The following is a summary of transactions or events that have impacted or are expected by management to impact Peoples’ results of operations or financial condition: ◦ On January 31, 2017, Peoples Insurance acquired a third-party insurance administration company with annual net revenue of $0.4 million. This acquisition did not materially impact Peoples' financial position, results of operations or cash flows. ◦ On November 7, 2016, Peoples converted its core banking system (including the related operating systems, data systems and products). The conversion resulted in a pre-tax combined revenue and expense impact of $1.3 million, or $0.05 in earnings per diluted share, for the full year. Deposit account service charges were impacted by the system conversion as Peoples granted waivers of $85,000 related to account services charges in the month of the conversion. The remainder of the $1.3 million was recorded in various expense categories, primarily in other non-interest expense, professional fees, and salaries and employee benefit costs. ◦ In 2016, Peoples closed three Ohio branches that were located in Owensville, Marietta and The Plains. Additional branches to close in 2017 include two Ohio offices located in Belpre and Wilmington, and two West Virginia offices located in Huntington and Point Pleasant. These four branches will remain open through March 31, 2017. ◦ Peoples continually evaluates the overall balance sheet position given the interest rate environment. During 2016, Peoples executed transactions to take advantage of the low interest rates, which included: ▪ Peoples restructured $20.0 million of FHLB long-term advance borrowings that had a weighted-average rate of 2.97%, resulting in a $700,000 loss. Peoples replaced these borrowings with a long-term FHLB advance, which has an interest rate of 2.17% and matures in 2026. ▪ Peoples borrowed an additional $35.0 million of long-term FHLB amortizing advances, which had interest rates ranging from 1.08% to 1.40%, and mature between 2019 and 2031. ▪ Peoples entered into five forward starting interest rate swaps to obtain short-term borrowings at fixed rates, with interest rates ranging from 1.49% to 1.83%, which become effective in 2018 and mature between 2022 and 2026. These swaps locked in funding rates for $40.0 million in FHLB advances that mature in 2018, which have interest rates ranging from 3.57% to 3.92%. ◦ On June 8, 2016, Peoples purchased an additional $35.0 million in bank owned life insurance ("BOLI"). ◦ During the second quarter of 2016, Peoples sold $28.9 million of available-for-sale securities with a weighted average yield of 2.14%, for a gain of $767,000. ◦ Effective March 2, 2016, Peoples terminated the loan agreement with U.S. Bank National Association dated as of December 18, 2012, as amended (the "U.S. Bank Loan Agreement"). As of the termination date, Peoples had no outstanding borrowings under the U.S. Bank Loan Agreement. Peoples paid an immaterial non-usage fee in connection with the termination of the U.S. Bank Loan Agreement. ◦ On March 4, 2016, Peoples entered into a Credit Agreement (the "RJB Credit Agreement") with Raymond James Bank, N.A. ("Raymond James Bank"), which provides Peoples with a revolving line of credit in the maximum aggregate principal amount of $15 million, for the purpose of: (i) to the extent that any amounts remained outstanding, paying off the then outstanding $15 million revolving line of credit to Peoples pursuant to the U.S. Bank Loan Agreement; (ii) making acquisitions; (iii) making stock repurchases; (iv) working capital needs; and (v) other general corporate purposes. On March 4, 2016, Peoples paid upfront fees for the establishment of a revolving line of credit agreement of $70,600, representing 0.47% of the loan commitment under the RJB Credit Agreement. ◦ On January 6, 2016, Peoples Bank acquired a small financial advisory book of business in Marietta, Ohio for cash consideration of $0.5 million. This acquisition did not materially impact Peoples' financial position, results of operations or cash flows. ◦ During 2015, Peoples recorded aggregate charge-offs of $13.1 million on a single, impaired commercial loan relationship consisting of four impaired loans. As of December 31, 2015, Peoples net recorded investment with respect to these loans was zero. ◦ On December 30, 2015, Peoples announced that Peoples Bank, National Association, the banking subsidiary of Peoples, converted from a national banking association into an Ohio state-chartered bank which is a member of the Federal Reserve System. As a result of the charter conversion, the legal name of Peoples' banking subsidiary was changed to "Peoples Bank" and the converted bank operates under the trade name and federally registered service mark "Peoples Bank." Additionally, Peoples' banking subsidiary saw a reduction in the annual cost associated with regulatory examination fees commencing in 2016. ◦ On November 3, 2015, Peoples announced that its Board of Directors approved and adopted a share repurchase program authorizing Peoples to purchase, from time to time, up to an aggregate of $20 million of its outstanding common shares. As of December 31, 2016, Peoples had repurchased an aggregate of 279,770 common shares with a total cost of $5.0 million. All of these common shares were purchased in the first half of 2016 with none being purchased in 2015. ◦ On July 24, 2015, Peoples repaid the principal balance of the $12.0 million term loan then outstanding under the U.S. Bank Loan Agreement. There were no early termination fees associated with the repayment. The revolving credit loan commitment available under the U.S. Bank Loan Agreement remained outstanding until the termination of the U.S. Bank Loan Agreement effective March 2, 2016, as described above. ◦ On July 21, 2015, Peoples Insurance acquired an insurance agency and related customer accounts in the Lebanon, Ohio area for total cash consideration of $0.9 million, and recorded $0.5 million of customer relationship intangibles and $0.4 million of goodwill. ◦ In December 2016, the Federal Reserve Board raised short-term rates, including the Federal Funds Rate and the Discount Rate by 0.25%, to a range of 0.50% to 0.75% for the Federal Funds Rate and to 1.25% for the Discount Rate. The Federal Reserve Board had previously maintained its target Federal Funds Rate at a level of 0.25% to 0.50% since December 2015 and had maintained the Discount Rate at 1.00% since December 2015. The Federal Reserve Board has indicated the possibility that these short-term rates could again be raised in 2017. The impact of these transactions, where material, is discussed in the applicable sections of this Management’s Discussion and Analysis of Financial Condition and Results of Operations. Critical Accounting Policies The accounting and reporting policies of Peoples conform to US GAAP and to general practices within the financial services industry. A summary of significant accounting policies is contained in Note 1 of the Notes to the Consolidated Financial Statements. While all of these policies are important to understanding the Consolidated Financial Statements, certain accounting policies require management to exercise judgment and make estimates or assumptions that affect the amounts reported in the Consolidated Financial Statements and accompanying Notes. These estimates and assumptions are based on information available as of the date of the Consolidated Financial Statements; accordingly, as this information changes, the Consolidated Financial Statements could reflect different estimates or assumptions. Management has identified the accounting policies described below as those that, due to the judgments, estimates and assumptions inherent in the policies, are critical to an understanding of Peoples' Consolidated Financial Statements and Management's Discussion and Analysis of Financial Condition and Results of Operations. Interest Income Recognition Interest income on loans and investment securities is recognized by methods that result in level rates of return on principal amounts outstanding, including yield adjustments resulting from the amortization of loan costs and premiums on investment securities and accretion of loan fees and discounts on investment securities. Since mortgage-backed securities comprise a sizable portion of Peoples' investment portfolio, a significant increase in principal payments on those securities could impact interest income due to the corresponding acceleration of premium amortization or discount accretion. Peoples discontinues the accrual of interest on a loan when conditions cause management to believe collection of all or any portion of the loan's contractual interest is doubtful. Such conditions may include the borrower being 90 days or more past due on any contractual payments or current information regarding the borrower's financial condition and repayment ability. All unpaid accrued interest deemed uncollectable is reversed, which would reduce Peoples' net interest income. Interest received on nonaccrual loans is included in income only if principal recovery is reasonably assured. Allowance for Loan Losses In general, determining the amount of the allowance for loan losses requires significant judgment and the use of estimates by management. Peoples maintains an allowance for loan losses based on a quarterly analysis of the loan portfolio and estimation of the losses that are probable of occurrence within the loan portfolio. This formal analysis determines an appropriate level and allocation of the allowance for loan losses among loan types and the resulting recovery of or provision for loan losses by considering factors affecting losses, including specific losses, levels and trends in impaired and nonperforming loans; historical loan loss experience; current national and local economic conditions; volume; growth and composition of the portfolio; regulatory guidance and other relevant factors. Management continually monitors the loan portfolio through Peoples Bank's Credit Administration Department and Loan Loss Committee to evaluate the appropriateness of the allowance. The recovery or provision could increase or decrease each quarter based upon the results of management's formal analysis. The amount of the allowance for loan losses for the various loan types represents management's estimate of probable losses from existing loans. Management evaluates lending relationships deemed to be impaired on an individual basis and makes specific allocations of the allowance for loan losses for each relationship based on discounted cash flows using the loan's initial effective interest rate or the fair value of the collateral for certain collateral dependent loans. For all other loans, management evaluates pools of homogeneous loans (such as residential mortgage loans, and direct and indirect consumer loans) and makes general allocations for each loan pool based upon historical loss experience. While allocations are made to specific loans and pools of loans, the allowance is available for all loan losses. The evaluation of individual impaired loans requires management to make estimates of the amounts and timing of future cash flows on impaired loans, which consist primarily of loans placed on nonaccrual status, restructured or internally classified as substandard or doubtful. These reviews are based upon specific quantitative and qualitative criteria, including the size of the loan, the loan cash flow characteristics, the loan quality ratings, the value of collateral, the repayment ability of the borrower, and historical experience factors. Allowances for homogeneous loans are evaluated based upon historical loss experience, adjusted for qualitative risk factors, such as trends in losses and delinquencies, growth of loans in particular markets, and known changes in economic conditions in each lending market. As part of the process of identifying the pools of homogenous loans, management takes into account any concentrations of risk within any portfolio segment, including any significant industrial concentrations. Consistent with the evaluation of allowances for homogenous loans, the allowance relating to the Overdraft Privilege program is based upon management's monthly analysis of accounts in the program. This analysis considers factors that could affect losses on existing accounts, including historical loss experience and length of overdraft. There can be no assurance that the allowance for loan losses will be adequate to cover all losses, but management believes the allowance for loan losses at December 31, 2016 was adequate to provide for probable losses from existing loans based on information currently available. While management uses available information to estimate losses, the ultimate collectability of a substantial portion of the loan portfolio, and the need for future additions to the allowance, will be based on changes in economic conditions and other relevant factors. As such, adverse changes in economic activity could reduce currently estimated cash flows for both commercial and individual borrowers, which would likely cause Peoples to experience increases in problem assets, delinquencies and losses on loans in the future. Investment Securities Peoples' investment portfolio accounted for 25.0% and 26.7% of total assets at December 31, 2016, and December 31, 2015 respectively, of which approximately 90% of the securities were classified as available-for-sale. Correspondingly, Peoples carries these securities at fair value on its Consolidated Balance Sheets, with any unrealized gain or loss recorded in stockholders' equity as a component of accumulated other comprehensive income or loss. As a result, Peoples' Consolidated Balance Sheet may be sensitive to changes in the overall market value of the investment portfolio, due to changes in market interest rates, investor confidence and other factors affecting market values. While temporary changes in the fair value of available-for-sale securities are not recognized in earnings, Peoples is required to evaluate all investment securities with an unrealized loss on a quarterly basis to identify potential other-than-temporary impairment (“OTTI”) losses. This analysis requires management to consider various factors that involve judgment and estimation, including the duration and magnitude of the decline in value, the financial condition of the issuer or pool of issuers, and the structure of the security. Under current US GAAP, an OTTI loss is recognized in earnings only when (1) Peoples intends to sell the investment security; (2) it is more likely than not that Peoples will be required to sell the investment security before recovery of its amortized cost basis; or (3) Peoples does not expect to recover the entire amortized cost basis of the investment security. In situations where Peoples intends to sell, or when it is more likely than not that Peoples will be required to sell the investment security, the entire OTTI loss must be recognized in earnings. In all other situations, only the portion of the OTTI losses representing the credit loss must be recognized in earnings, with the remaining portion being recognized in stockholders' equity as a component of accumulated other comprehensive income or loss, net of deferred taxes. Management performed its quarterly analysis of the investment securities with an unrealized loss at December 31, 2016, and concluded no individual securities were other-than-temporarily impaired. Peoples has not recognized an impairment loss in 2016, 2015 or 2014. Goodwill and Other Intangible Assets Prior to 2016, Peoples performed its annual goodwill impairment test as of June 30. During 2016, Peoples changed its method in applying the accounting principle and completed the annual goodwill impairment test as of October 1, and will do so annually on that date hereafter. This voluntary change was considered preferable by Peoples as it aligns the goodwill impairment testing with the preparation of the underlying data used in the annual test, including financial and strategic information that is prepared late in the year. This change was not intended to delay, accelerate or avoid any impairment charges. This change was not applied retrospectively as it was impracticable to do so because retrospective application would have required application of significant estimates and assumptions with the use of hindsight. Accordingly the change was applied prospectively. Peoples records goodwill and other intangible assets as a result of acquisitions accounted for under the acquisition method of accounting. Under the acquisition method, Peoples is required to allocate the consideration paid for an acquired company to the assets acquired, including identified intangible assets, and liabilities assumed based on their estimated fair values at the date of acquisition. Goodwill represents the excess cost over the fair value of net assets acquired and is not amortized but is tested for impairment when indicators of impairment exist, or at least annually. Peoples' other intangible assets consist of customer relationship intangible assets, including core deposit intangibles, representing the present value of future net income to be earned from acquired customer relationships with definite useful lives, which are required to be amortized over their estimated useful lives. The value of recorded goodwill is supported ultimately by revenue that is driven by the volume of business transacted and Peoples' ability to provide quality, cost-effective services in a competitive market place. A decline in earnings as a result of a lack of growth or the inability to deliver cost-effective services over sustained periods can lead to impairment of goodwill that could adversely impact earnings in future periods. Potential goodwill impairment exists when the fair value of the reporting unit (as defined by US GAAP) is less than its carrying value. An impairment loss is recognized in earnings only when the carrying amount of goodwill is less than its implied fair value. The process of evaluating goodwill for impairment involves highly subjective or complex judgments, estimates and assumptions regarding the fair value of Peoples' reporting unit and, in some cases, goodwill itself. As a result, changes to these judgments, estimates and assumptions in future periods could result in materially different results. Peoples currently possesses a single reporting unit for goodwill impairment testing. While quoted market prices exist for Peoples' common shares since they are publicly traded, these market prices do not necessarily reflect the value associated with gaining control of an entity. Thus, management takes into account all appropriate fair value measurements in determining the estimated fair value of the reporting unit. The measurement of any actual impairment loss requires management to calculate the implied fair value of goodwill by deducting the fair value of all tangible and separately identifiable intangible net assets (including unrecognized intangible assets) from the fair value of the reporting unit. The fair value of net tangible assets is calculated using the methodologies described in Note 2 of the Notes to the Consolidated Financial Statements. Peoples performs its required annual impairment test as of October 1st each year, beginning in 2016. Peoples first assesses qualitative factors to determine whether it is more likely than not that the fair value of the reporting unit is less than its carrying amount, including goodwill. In this evaluation, Peoples assesses relevant events and circumstances, which may include macroeconomic conditions, industry and market conditions, cost factors, overall financial performance, events specific to Peoples, significant changes in the reporting unit, or a sustained decrease in stock price. If Peoples determines that it is more likely than not that the fair value of the reporting unit is greater than its carrying amount, then performing the two-step impairment test is unnecessary. However, if there are indicators of impairment, Peoples must complete a two-step process that includes (1) determining if potential goodwill impairment exists and (2) measuring the impairment loss, if any. At October 1, 2016, management's qualitative analysis concluded that the estimated fair value of Peoples' single reporting unit exceeded its carrying value. Peoples is required to perform interim tests for goodwill impairment in subsequent quarters if events occur or circumstances change that indicate potential goodwill impairment exists, such as adverse changes to Peoples' business or a significant decline in Peoples' market capitalization. For further information regarding goodwill, refer to Note 6 of the Notes to the Consolidated Financial Statements. Peoples records servicing rights (“SRs”) in connection with its mortgage banking and small business lending activities, which are intangible assets representing the right to service loans sold to third-party investors. These intangible assets are recorded initially at fair value and subsequently amortized over the estimated life of the loans sold. SRs are stratified based on their predominant risk characteristics and assessed for impairment at the strata level at each reporting date based on their fair value. At December 31, 2016, management concluded no portion of the recorded SRs was impaired since the fair value equaled or exceeded the carrying value. However, future events, such as a significant increase in prepayment speeds, could result in a fair value that is less than the carrying amount, which would require the recognition of an impairment loss in earnings. Income Taxes Income taxes are recorded based on the liability method of accounting, which includes the recognition of deferred tax assets and liabilities for the temporary differences between carrying amounts and tax bases of assets and liabilities, computed using enacted tax rates. In general, Peoples records deferred tax assets when the event giving rise to the tax benefit has been recognized in the Consolidated Financial Statements. A valuation allowance is recognized to reduce any deferred tax asset when, based upon available information, it is more-likely-than-not all, or any portion, of the deferred tax asset will not be realized. Assessing the need for, and amount of, a valuation allowance for deferred tax assets requires significant judgment and analysis of evidence regarding realization of the deferred tax assets. In most cases, the realization of deferred tax assets is dependent upon Peoples generating a sufficient level of taxable income in future periods, which can be difficult to predict. Peoples' largest deferred tax assets involve differences related to Peoples' allowance for loan losses and accrued employee benefits. At December 31, 2016 and December 31, 2015, management determined a valuation allowance would be recorded against the deferred tax assets associated with its investment in a partnership investment. No other valuation allowances were recorded at either December 31, 2016 or 2015. The calculation of tax liabilities is complex and requires the use of estimates and judgment since it involves the application of complex tax laws that are subject to different interpretations by Peoples and the various tax authorities. Peoples' interpretations are subject to challenge by the tax authorities upon audit or to reinterpretation based on management's ongoing assessment of facts and evolving case law. From time-to-time and in the ordinary course of business, Peoples is involved in inquiries and reviews by tax authorities that normally require management to provide supplemental information to support certain tax positions taken by Peoples in its tax returns. Uncertain tax positions are initially recognized in the Consolidated Financial Statements when it is more likely than not the position will be sustained upon examination by the tax authorities. Such tax positions are initially and subsequently measured as the largest amount of tax benefit that is greater than 50% likely of being realized upon ultimate settlement with the tax authority assuming full knowledge of the position and all relevant facts. The amount of unrecognized tax benefits was immaterial at both December 31, 2016 and 2015. Management believes it has taken appropriate positions on its tax returns, although the ultimate outcome of any tax review cannot be predicted with certainty. Consequently, no assurance can be given that the final outcome of these matters will not be different than what is reflected in the current and historical financial statements. Fair Value Measurements As a financial services company, the carrying value of certain financial assets and liabilities is impacted by the application of fair value measurements, either directly or indirectly. In certain cases, an asset or liability is measured and reported at fair value on a recurring basis, such as available-for-sale investment securities. In other cases, management must rely on estimates or judgments to determine if an asset or liability not measured at fair value warrants an impairment write-down or whether a valuation reserve should be established. Given the inherent volatility, the use of fair value measurements may have a significant impact on the carrying value of assets or liabilities, or result in material changes to the consolidated financial statements, from period to period. Detailed information regarding fair value measurements can be found in Note 2 of the Notes to the Consolidated Financial Statements. The following is a summary of those assets and liabilities that may be affected by fair value measurements, as well as a brief description of the current accounting practices and valuation methodologies employed by Peoples: Available-for-Sale Investment Securities Investment securities classified as available-for-sale are measured and reported at fair value on a recurring basis. For most securities, the fair value is based upon quoted market prices (Level 1) or determined by pricing models that consider observable market data (Level 2). For structured investment securities, the fair value often must be based upon unobservable market data, such as non-binding broker quotes and discounted cash flow analysis or similar models, due to the absence of an active market for these securities (Level 3). As a result, management's determination of fair value for these securities is highly dependent on subjective or complex judgments, estimates and assumptions, which could change materially between periods. Management occasionally uses information from independent third-party consultants in its determination of the fair value of more complex structured investment securities. At December 31, 2016, all of Peoples' available-for-sale investment securities were measured using observable market data. At December 31, 2016, the majority of the investment securities with Level 2 fair values were determined using information provided by third-party pricing services. Management reviews the valuation methodology and quality controls utilized by the pricing services in management's overall assessment of the reasonableness of the fair values provided. To the extent available, management utilizes an independent third-party pricing source to assist in its assessment of the values provided by its primary pricing services. Management reviews the fair values provided by these third parties on a quarterly basis and challenges prices when it believes a discrepancy in pricing exists. Based on Peoples' past experience, no discrepancies were noted related to current pricing and values. Impaired loans For loans considered impaired, the amount of impairment loss recognized is determined based on a discounted cash flow analysis or the fair value of the underlying collateral if repayment is expected solely from the sale of the collateral. Management typically relies on the fair value of the underlying collateral due to the significant uncertainty surrounding the borrower's ability to make future payments. The vast majority of the collateral securing impaired loans is real estate, although the collateral may also include accounts receivable and equipment, inventory or similar personal property. The fair value of the collateral used by management represents the estimated proceeds to be received from the sale of the collateral, less costs incurred during the sale, based upon observable market data or market value data provided by independent, licensed or certified appraisers. Servicing Rights SRs are carried at the lower of amortized cost or market value, and, therefore, can be subject to fair value measurements on a nonrecurring basis. SRs do not trade in an active market with readily observable prices. Thus, management determines fair value based upon a valuation model that calculates the present value of estimated future net servicing income provided by an independent third-party consultant. This valuation model is affected by various input factors, such as servicing costs, expected prepayment speeds and discount rates, which are subject to change between reporting periods. As a result, significant changes to these factors could result in a material change to the calculated fair value of SRs. To determine the fair value of its SRs each reporting quarter, Peoples provides information representing loan information accompanied by escrow amounts to a third-party valuation firm. The third-party valuation firm then evaluates the possible impairment of SRs as described below. Loans are evaluated on a discounted earnings basis to determine the present value of future earnings that Peoples expects to realize from the portfolio. Earnings are projected from a variety of sources including loan service fees, net interest earned on escrow balances, miscellaneous income and costs to service the loans. The present value of future earnings is the estimated fair value, calculated using consensus assumptions that a third-party purchaser would utilize in evaluating a potential acquisition of the SRs. Events that may significantly affect the estimates used are changes in interest rates and the related impact on mortgage loan prepayment speeds, and the payment performance of the underlying loans. Peoples believes this methodology provides a reasonable estimate. Mortgage loan prepayment estimates were determined through the application of the current dealer projected prepayment rates by product type and interest rate as published by Bloomberg, L.P. as of January 3, 2017, and adjusted for historical prepayment factors based on state, type of servicing, year of origination, and pass through coupon. The adjustable rate mortgage loan prepayment estimates were determined through the application of market trading assumptions as of January 3, 2017, and adjusted for historical prepayment factors based on state, type of servicing, year of origination, and pass through coupon. These earnings are used to calculate the approximate cash flow that could be received from the servicing portfolio. Valuation results are provided quarterly to Peoples. At that time, Peoples reviews the information and SRs are marked to the lower of amortized cost or fair value for the current quarter. Cash flow hedges Cash flow hedges are carried at fair value on Peoples' Consolidated Balance Sheets. Cash flow hedges do not trade in an active market with readily observable prices. Management determines the fair value of cash flow hedges based on third-party pricing, which is driven by changes in market interest rates. As of December 31, 2016, the fair value of the cash flow hedges, based on market interest rates, resulted in an asset of $1.8 million. EXECUTIVE SUMMARY Net income for the year ended December 31, 2016 was $31.2 million, compared to $10.9 million in 2015 and $16.7 million in 2014, representing earnings per diluted common share of $1.71, $0.61 and $1.35, respectively. The increase in earnings during 2016 was driven by a decrease in the provision for loan losses of $10.6 million, primarily due to the control of credit quality and associated credit costs. In 2016, earnings also benefited from a decrease in acquisition-related charges of $10.7 million compared to 2015, which was partially offset by costs related to the conversion of Peoples' core banking system of $1.3 million. The increase in the provision for loan losses and acquisition-related charges in 2015 were the primary reasons for the decrease in net income for the year ended December 31, 2015 compared to 2014. In 2016, Peoples had a provision for loan losses of $3.5 million, a decrease of $10.6 million compared to the $14.1 million that was recorded in 2015. The decrease in 2016 from 2015 was primarily related to Peoples recording net charge-offs of $1.9 million compared to $15.2 million for 2016 and 2015, respectively. The charge-off in 2015 was primarily due to the charge-off of one large commercial loan relationship. The provision for loan losses represented amounts needed, in management's opinion, to maintain the appropriate level of the allowance for loan losses. Net interest income grew 7% to $104.9 million in 2016 mostly due to higher loan balances. In 2015, net interest income grew 40% to $97.6 million, primarily due to acquisitions. Net interest margin was 3.54% in 2016, higher than the 3.53% in 2015 and 3.45% in 2014. Accretion income from acquisitions added approximately 11 basis points to net interest margin in 2016 compared to 17 basis points in 2015 and 13 basis points in 2014. The increase in net interest margin in 2015 compared to 2014 was mostly due to higher loan balances in connection with acquisitions and organic loan growth. Total non-interest income, which excludes gains and losses on investment securities, asset disposals and other transactions, increased 8% in 2016 compared to 2015 and 18% in 2015 compared to 2014. The increase in 2016 compared to 2015 was due to increases in electronic banking income, trust and investment income, bank owned life insurance income and commercial loan swap fee income, with a portion of the growth attributable to the NB&T acquisition. The increase in electronic banking income was the result of the increased usage of debit cards by more customers. The increase in trust and investment income was due largely to growth in assets under management and the full year effect of NB&T operations. The increase in bank owned life insurance income was the result of the additional $35.0 million of bank owned life insurance policies that were purchased late in the second quarter of 2016. Commercial loan swap fee income is dependent upon customers' preference for fixed versus variable interest rate loans, and the ability of the customers seeking the swap product to satisfy the financially sophisticated criteria to be eligible, which leads to variability in this income stream. Total non-interest income increased 18% in 2015 and was primarily due to increases in trust and investment income, deposit account service charges and electronic banking income. The noted increases reflected a full year of income from the 2014 acquisitions and approximately nine months of income related to the NB&T acquisition. Total other expense decreased 7%, or $8.2 million, for the year ended December 31, 2016, due largely to acquisition-related expenses of $10.7 million in 2015, partially offset by a full-year effect of operating expenses associated with the NB&T acquisition, and increased sales-based and incentive compensation earned under the corporate incentive plan. At December 31, 2016, total assets were up 5%, or $173.4 million, to $3.43 billion versus $3.26 billion at year-end 2015. The increase was primarily related to an increase of 7% in loan growth coupled with the additional $35.0 million of bank owned life insurance policies that were purchased late in the second quarter of 2016. The allowance for loan losses increased $1.7 million to $18.4 million, or 1.08% of originated loans, net of deferred fees and costs, compared to $16.8 million and 1.19% at December 31, 2015. Total liabilities were $3.00 billion at December 31, 2016, up $157.9 million since December 31, 2015. At December 31, 2016, total borrowed funds were $450.8 million, up $176.7 million compared to the prior year-end, which was largely used to fund loan growth. Non-interest-bearing deposits were up $16.5 million, or 2%, and comprised 29% of total deposits at December 31, 2016, versus 28% at year-end 2015. At December 31, 2016, total stockholders' equity was $435.3 million, up $15.5 million from December 31, 2015. The increase was primarily due to the increase in retained earnings as the $31.2 million of earnings in 2016 was only partially offset by dividends of $11.7 million. Peoples' regulatory capital ratios remained significantly higher than "well capitalized" minimums. Peoples' Tier 1 Capital ratio decreased to 13.21% at December 31, 2016, versus 13.67% at December 31, 2015, while the Total Capital ratio was 14.11% versus 14.54% at December 31, 2015. In addition, Peoples' book value per share was $23.92 at December 31, 2016. Peoples' tangible book value per share was $15.89 at December 31, 2016, and its tangible equity to tangible assets ratio was 8.80%, versus $14.68 and 9.39% at December 31, 2015, respectively. Additional information regarding capital requirements can be found in Note 15 of the Notes to the Consolidated Financial Statements. RESULTS OF OPERATIONS Interest Income and Expense Peoples earns interest income on loans and investments and incurs interest expense on interest-bearing deposits and borrowed funds. Net interest income, the amount by which interest income exceeds interest expense, remains Peoples' largest source of revenue. The amount of net interest income earned by Peoples is affected by various factors, including changes in market interest rates due to the Federal Reserve Board's monetary policy, the level and degree of pricing competition for both loans and deposits in Peoples' markets, and the amount and composition of Peoples' earning assets and interest-bearing liabilities. Peoples monitors net interest income performance and manages its balance sheet composition through regular ALCO meetings. The asset-liability management process employed by the ALCO is intended to mitigate the impact of future interest rate changes on Peoples' net interest income and earnings. However, the frequency and/or magnitude of changes in market interest rates are difficult to predict, and may have a greater impact on net interest income than adjustments management is able to make. The following table details Peoples’ average balance sheets for the years ended December 31: (1) Average balances are based on carrying value. (2) Interest income and yields are presented on a fully tax-equivalent basis using a 35% federal statutory tax rate. (3) Average balances include nonaccrual and impaired loans. Interest income includes interest earned and received on nonaccrual loans prior to the loans being placed on nonaccrual status. Loan fees included in interest income were immaterial for all periods presented. (4) Loans held for sale are included in the average loan balance listed. Related interest income on loans originated for sale prior to the loan being sold is included in loan interest income. The following table provides an analysis of the changes in fully tax-equivalent (“FTE”) net interest income: (1) The change in interest due to both rate and volume has been allocated to rate and volume changes in proportion to the relationship of the dollar amounts of the changes in each. (2) Interest income and yields are presented on a fully tax-equivalent basis using a 35% federal statutory tax rate. As part of the analysis of net interest income, management converts tax-exempt income earned on obligations of states and political subdivisions to the pre-tax equivalent of taxable income using an effective tax rate of 35%. Management believes the resulting FTE net interest income allows for a more meaningful comparison of tax-exempt income and yields to their taxable equivalents. Net interest margin, which is calculated by dividing FTE net interest income by average interest- earning assets, serves as an important measurement of the net revenue stream generated by the volume, mix and pricing of earning assets and interest-bearing liabilities. The following table details the calculation of FTE net interest income for the years ended December 31: The comparison of the income statement and average balance sheet results between the full year of 2015 and the full year of 2016 was affected by the NB&T acquisition, which closed March 6, 2015. During 2016, Peoples recognized accretion income, net of amortization expense, from acquisitions of $3.5 million, which added approximately 11 basis points to net interest margin, compared to $4.8 million and 17 basis points and $2.6 million and 13 basis points in 2015 and 2014, respectively. Also during 2016, additional interest income from prepayment fees and interest recovered on nonaccrual loans was $964,000 compared to $591,000 in 2015 and $240,000 in 2014. The primary driver of the increase in net interest income during 2015 was the higher loan balances resulting from organic growth and acquired loans. The yield on investment securities decreased in 2016 as interest rates fell and prepayment speeds on mortgage-backed securities increased. The increase in prepayment speeds was due primarily to greater mortgage refinancing activity driven by lower interest rates. This resulted in higher monthly principal cashflows in the investment portfolio. In 2016, the average monthly principal cashflow was approximately $10.6 million compared to $10.1 million in 2015 and $6.0 million in 2014. Funding costs have declined since 2013 as Peoples has continued to execute a strategy of replacing higher-cost funding with low-cost deposits. In 2016, funding costs decreased 3 basis points, compared to 18 basis points in 2015 and 15 basis points in 2014. In 2015, the improvement included deploying excess cash on the balance sheet by buying securities in the investment portfolio and paying off a $12.0 million term loan. Detailed information regarding changes in the Consolidated Balance Sheets can be found under appropriate captions of the “FINANCIAL CONDITION” section of this discussion. Additional information regarding Peoples' interest rate risk and the potential impact of interest rate changes on Peoples' results of operations and financial condition can be found later in this discussion under the caption “Interest Rate Sensitivity and Liquidity”. Provision for Loan Losses The following table details Peoples’ provision for loan losses recognized for the years ended December 31: The provision for loan losses represents the amount needed to maintain the appropriate level of the allowance for loan losses based on management’s formal quarterly analysis of the loan portfolio and procedural methodology that estimates the amount of probable credit losses. This process considers various factors that affect losses, such as changes in Peoples’ loan quality, historical loss experience and current economic conditions. The provision for loan losses recorded in 2016 was primarily due to loan growth and stable asset quality trends. The provision for loan losses recorded in 2015 was primarily due to the charge-off of one large commercial loan relationship, coupled with organic loan growth and increases in criticized loans. The provision for loan losses recorded in 2014 was driven by checking account overdrafts, while the impact of increases in criticized loans was mitigated by $1.8 million of recoveries on three loans that were previously charged-off. Additional information regarding changes in the allowance for loan losses and loan credit quality can be found later in this discussion under the caption “Allowance for Loan Losses”. Net Loss on Asset Disposals and Other Transactions The following table details the other (losses) gains for the years ended December 31 recognized by Peoples: The net loss on debt extinguishment in 2016 was due to the prepayment of $20.0 million of long-term FHLB advances. The net loss on bank premises and equipment during 2016 was due mainly to the closing of a leased office and related disposal of leasehold improvements. The net loss on other assets during 2016 was related to the write-down of an investment made in an asset that had a corresponding tax benefit to Peoples. The net loss on OREO during 2015 was due mainly to the sale of six OREO properties and the write-down of four OREO properties during the period. During the first quarter of 2015, Peoples recognized a loss on debt extinguishment from the prepayment of several FHLB advances. The losses on bank premises and equipment in 2015 and 2014 of $575,000, and $380,000, respectively, were associated with acquisition-related activity. The remaining net loss on bank premises and equipment in 2015 was attributable to the write-off of obsolete fixed assets and the write-down of closed office locations that were for sale. Peoples recognized a gain on debt extinguishment from a restructuring of acquired FHLB advances in 2014. Non-Interest Income Peoples generates non-interest income, which excludes gains and losses on investments and other assets, from four primary sources: insurance sales revenues; deposit account service charges; trust and investment activities; and electronic banking (“e-banking”). Peoples continues to focus on revenue growth from non-interest income sources in order to maintain a diversified revenue stream through greater reliance on fee-based revenues. As a result, total non-interest income accounted for 32.8% of Peoples' total revenues in 2016 compared to 32.7% in 2015 and 36.6% in 2014. The decline in Peoples' total non-interest income as a percent of total revenue during 2015 from 2014 was primarily due to increased net interest income from recent acquisitions and organic growth. Insurance income comprised the largest portion of Peoples' non-interest income. The following table details Peoples’ insurance income for the years ended December 31: Insurance income in 2016 was relatively flat compared to 2015 due to a soft commercial insurance market, resulting in reduced commercial insurance premiums. Performance-based commissions are typically recorded annually in the first quarter and are based on a combination of factors, such as loss experience of insurance policies sold, production volumes, and overall financial performance of the individual insurance carriers. Service charges and other fees on deposit accounts, which are based on the recovery of costs associated with services provided, comprised a significant portion of Peoples' non-interest income. The following table details Peoples' deposit account service charges for the years ended December 31: The amount of deposit account service charges, particularly fees for overdrafts and non-sufficient funds, is largely dependent on the timing and volume of customer activity. Management periodically evaluates its cost recovery fees to ensure they are reasonable based on operational costs and similar to fees charged in Peoples' markets by competitors. The yearly increases in account maintenance fees were the result of higher fees received on commercial accounts and checking accounts. Peoples' fiduciary and brokerage revenues continue to be based primarily upon the value of assets under management. The following table details Peoples’ trust and investment income for the years ended December 31: The following table details Peoples’ managed assets at year-end December 31: During 2016, the increase in fiduciary and brokerage revenues was primarily due to the increase in average managed assets which included a full year of the impact related to the acquisition of NB&T, coupled with a fee increase implemented during 2016. Additionally, during 2015 and 2014, fiduciary income increased primarily due to higher managed asset account balances and retirement benefits plan income due to the addition of new plans. The U.S. financial markets also have an impact on managed assets. In recent years, Peoples has added experienced financial advisors in previously underserved market areas, and generated new business and revenue related to retirement plans for which it manages the assets and provides services. Peoples' e-banking services include ATM and debit cards, direct deposit services, internet and mobile banking, and serve as alternative delivery channels to traditional sales offices for providing services to clients. During 2016, electronic banking income grew $1.4 million, or 16%, compared to 2015. During 2015, electronic banking income increased $2.3 million, or 35%, compared to 2014. The increase in electronic banking income in 2016 was the result of the increased usage of debit cards by more customers. The increase in 2015 was due to acquisitions and an increase in the volume of debit card transactions. In 2016, Peoples' customers used their debit cards to complete $728 million of transactions, versus $591 million in 2015 and $467 million in 2014. During 2016, bank owned life insurance income increased to $1.4 million, compared to $598,000 million in 2015. The increase in bank owned life insurance income was the result of the additional $35.0 million of bank owned life insurance policies that were purchased late in the second quarter of 2016. Mortgage banking income is comprised mostly of net gains from the origination and sale of long-term, fixed-rate real estate loans in the secondary market. As a result, the amount of income recognized by Peoples is largely dependent on customer demand and long-term interest rates for residential real estate loans offered in the secondary market. Mortgage banking income decreased 1% in 2016, while increasing 6% in 2015 due to refinancing activity. In 2016, Peoples sold approximately $67.1 million of loans to the secondary market compared to $56.0 million in 2015 and $48.8 million in 2014. Non-Interest Expense Salaries and employee benefit costs remain Peoples’ largest non-interest expense, accounting for over half of the total non-interest expense. The following table details Peoples’ salaries and employee benefit costs for the years ended December 31: Base salaries and wages, employee benefits, and payroll taxes and other employment costs decreased in 2016, primarily due to severance payments of $4.3 million related to the NB&T acquisition in 2015, which were offset partially by yearly merit increases and costs associated with the system conversion. The increase in 2015 from 2014 was due to completed acquisitions, additional operational staff and the addition of new sales talent in several markets, which significantly impacted the number of full-time equivalent employees. Peoples' sales-based and incentive compensation is tied to corporate incentive plans and commission from sales production. Sales-based and incentive compensation increased in 2016, due primarily to corporate goals and incentives being attained. Peoples' sales-based and incentive compensation plans are designed to grow core earnings while managing risk, and do not encourage unnecessary and excessive risk-taking that could threaten the value of Peoples. The sales-based and incentive compensation plans reward employees for appropriate behaviors and include provisions for inappropriate practices with respect to Peoples and its customers. The decrease in employee benefits in 2016 was partially due to no pension settlement charges in 2016, compared to $0.5 million and $1.4 million in 2015 and 2014, respectively. Effective March 1, 2011, Peoples froze the accrual of pension benefits, and since then, settlement charges have been largely based on the timing of retirements of plan participants and their election of lump-sum distributions. Under US GAAP, Peoples is required to recognize a settlement gain or loss when the aggregate amount of lump-sum distributions to participants equals or exceeds the sum of the service and interest cost components of the net periodic pension cost. The amount of settlement gain or loss recognized is the pro rata amount of the unrealized gain or loss existing immediately prior to the settlement. Management anticipates continued pension settlement charges in future years as plan participants retire and elect lump-sum distributions from the plan. Stock-based compensation is generally recognized over the vesting period, typically ranging from 6 months to 3 years. For all awards, expense is initially only recognized for the portion of awards that is expected to vest, and at the vesting date, an adjustment is made to recognize the entire expense for vested awards and reverse expense for non-vested awards. The majority of Peoples' stock-based compensation expense is attributable to annual equity-based incentive awards to employees, which are awarded in the first quarter and based upon Peoples achieving certain performance goals during the prior year. During 2016, Peoples granted restricted shares to officers and key employees with performance-based vesting periods and time-based vesting periods. Stock-based compensation expense recorded in 2016 related to the awards granted in 2016, for 2015 performance, was $209,000, compared to $792,000 recorded in 2015 related to awards granted for 2014 performance. The decrease in expense in 2016 compared to 2015 was primarily due to the difference in Peoples' results between the years which resulted in fewer awards granted and expensed. The remaining expense was recognized for grants awarded in previous years. As it is probable that all outstanding performance-based vesting conditions will be satisfied, Peoples recorded the pro-rata expense for all outstanding performance-based awards in 2016, as required by US GAAP. Stock-based compensation expense in 2014 included $298,000 related to a one-time stock award of unrestricted common shares to all full-time and part-time employees who did not already participate in the equity plan. Additional information regarding Peoples' stock-based compensation plans and awards can be found in Note 16 of the Notes to the Consolidated Financial Statements. Deferred personnel costs represent the portion of current period salaries and employee benefit costs considered to be direct loan origination costs. These costs are capitalized and recognized over the life of the loan as a yield adjustment to interest income. As a result, the amount of deferred personnel costs for each year corresponds directly with the level of new loan originations. Additional information regarding Peoples' loan activity can be found later in this discussion under the caption “Loans”. Peoples’ net occupancy and equipment expense for the years ended December 31 was comprised of the following: During 2016, depreciation increased as a full year of depreciation was recognized on the acquired NB&T offices, and office renovations that were completed in 2015. Repairs and maintenance costs, coupled with property taxes, utilities and other costs, declined during 2016, compared to 2015, as expenses recognized on the acquired offices decreased. Management continues to monitor capital expenditures and explore opportunities to enhance Peoples' operating efficiency. During 2015, Peoples acquired 22 offices which resulted in higher depreciation, repairs and maintenance costs, and property taxes, utilities and other costs compared to 2014. In addition, in 2015, Peoples completed renovations on the 22 acquired offices and several operations areas to accommodate recent growth. Peoples' e-banking expense, which is comprised of bankcard, internet and mobile banking costs, increased in 2016, 2015 and 2014 due to the addition of accounts related to acquisitions, customers completing a higher volume of transactions using their debit cards and Peoples' internet banking service. These factors also produced a greater increase in the corresponding e-banking revenues over the same periods. Peoples' intangible asset amortization expense is driven by acquisition-related activity. Amortization expense was $4.0 million in 2016, compared to $4.1 million and $1.4 million in 2015 and 2014, respectively. The increase in 2015 related to the completed NB&T acquisition in 2015 and recognition of a full year of amortization for acquisitions completed during 2014. Data processing and software expense includes software support, maintenance and depreciation expense. These costs increased during 2016 due to increased software support. The increase from 2014 to 2015 was due to the recent acquisitions and new software projects completed. Peoples is subject to state franchise taxes, which are based largely on Peoples Bank's equity at year-end, in the states where Peoples Bank has a physical presence. Franchise taxes increased during 2016 due to an increase in equity and revenues. In 2015, the increase was from the issuance of common shares related to acquisitions in 2014 and 2015. Peoples is subject to Ohio Financial Institution Tax ("FIT") which is a business privilege tax that is imposed on financial institutions organized for profit and doing business in Ohio. The FIT is based on the total equity capital in proportion to the taxpayer's gross receipts in Ohio. Peoples' FDIC insurance costs decreased in 2016 as a result of the FDIC Insurance Fund’s reserve ratio reaching 1.15% effective June 30. The increases during 2015 and 2014 were the result of recent acquisitions. Additional information regarding Peoples' FDIC insurance assessments may be found in "ITEM 1 - BUSINESS" of this Form 10-K in the section captioned "Supervision and Regulation". In 2016, marketing expense, which includes advertising, donation and other public relations costs, decreased $1.2 million. The marketing expense in 2015 and 2014 was higher due to the timing of acquisitions and the additional marketing associated with acquired branches and additional community donations in those markets. Peoples contributed $225,000 in 2016, $350,000 in 2015 and $300,000 in 2014 to Peoples Bank Foundation, Inc. Peoples formed this private foundation in 2004 to make charitable contributions to organizations within Peoples' primary market area. Future contributions to Peoples Bank Foundation, Inc. will be evaluated on a quarterly basis, with the determination of the amount of any contribution based largely on the perceived level of need within the communities Peoples serves. Other non-interest expense decreased $5.1 million in 2016 compared to 2015. The decrease was primarily driven by $3.7 million of acquisition-related expenses incurred in other expenses during 2015, which was partially offset by $0.7 million of system conversion costs. The acquisition-related expenses incurred in 2015 was the primary increase compared to 2014. Peoples' efficiency ratio, calculated as total other expenses less amortization of other intangible assets divided by FTE net interest income plus non-interest income, was 65.13% for 2016, compared to 75.50% for 2015 and 75.37% for 2014. The increases in 2015 and 2014 were largely the result of one-time costs for acquisitions plus higher salaries and employee benefit costs. For the full year of 2016, the efficiency ratio, when adjusted for non-core items, was 64.3% compared to 67.5% in 2015. The decrease in the adjusted efficiency ratio in 2016 compared to 2015 was due primarily to 8% revenue growth between 2016 and 2015. Income Tax Expense A key driver of the amount of income tax expense or benefit recognized by Peoples each year is the amount of pre-tax income. Additionally, Peoples receives tax benefits from its investments in tax credit funds, which reduce Peoples' effective tax rate. A reconciliation of Peoples' recorded income tax expense/benefit and effective tax rate to the statutory tax rate can be found in Note 12 of the Notes to the Consolidated Financial Statements. Pre-Provision Net Revenue Pre-provision net revenue ("PPNR") has become a key financial measure used by federal bank regulatory agencies when assessing the capital adequacy of financial institutions. PPNR is defined as net interest income plus non-interest income minus total other expenses and, therefore, excludes the provision for (recovery of) loan losses and all gains and losses included in earnings. As a result, PPNR represents the earnings capacity that can be either retained in order to build capital or used to absorb unexpected losses and preserve existing capital. The following table provides a reconciliation of this non-GAAP financial measure to the amounts of income before income taxes reported in Peoples' Consolidated Financial Statements for the periods presented: During 2016, PPNR and the pre-provision net revenue to total average assets ratio increased compared to previous years due largely to the increase in revenue as a result of increased net interest income growth coupled with a decrease in non-interest expenses. The increase in the PPNR in 2015 was primarily due to the completion of the NB&T acquisition and recognition of a full year of revenue for acquisitions completed during 2014 with the decrease in the pre-provision net revenue to total average assets ratio reflecting the increase in PPNR being offset by the increase of average assets, which also was reflective of the NB&T acquisition. Core Non-Interest Income and Expense Core non-interest income and expense are financial measures used to evaluate Peoples' recurring revenue and expense streams. These measures are non-GAAP since they exclude the impact of system conversion revenue and costs, acquisition-related costs, pension settlement charges, search firm fees and legal settlement charges. The following tables provide reconciliations of these non-GAAP measures to the amounts reported in Peoples' Consolidated Financial Statements for the periods presented: Efficiency Ratio The efficiency ratio is a key financial measure used to monitor performance. The efficiency ratio is calculated as total other expenses (less amortization of other intangible assets) as a percentage of fully tax-equivalent net interest income plus non-interest income. This measure is non-GAAP since it excludes amortization of other intangible assets and all gains and/or losses included in earnings, and uses fully tax-equivalent net interest income. The following table provides a reconciliation of this non-GAAP financial measure to the amounts reported in Peoples' Consolidated Financial Statements for the periods presented: FINANCIAL CONDITION Cash and Cash Equivalents Peoples considers cash and cash equivalents to consist of federal funds sold, cash and balances due from banks, interest-bearing balances in other institutions and other short-term investments that are readily liquid. The amount of cash and cash equivalents fluctuates on a daily basis due to customer activity and Peoples' liquidity needs. At December 31, 2016, excess cash reserves at the Federal Reserve Bank were $4.4 million, compared to $8.7 million at December 31, 2015. The amount of excess cash reserves maintained is dependent upon Peoples' daily liquidity position, which is driven primarily by changes in deposit and loan balances. In 2016, Peoples' total cash and cash equivalents decreased $5.0 million, as $198.4 million of cash was used in investing activities which were offset partially by operating activities of $60.3 million and $133.1 million of financing activities. Cash used in investing activities was primarily due to funded loan growth of $149.0 million. The loan growth was partially funded by the increase of Peoples' financing activities of short and long-term borrowings of $175.9 million, and the increase in operating activities of $31.2 million of net income. In 2015, Peoples' total cash and cash equivalents increased $9.7 million, as cash provided by Peoples' operating activities of $47.9 million was partially offset by cash used in financing activities of $37.1 million and investing activities of $1.1 million. Cash provided by investing activities from business combinations of $97.3 million was offset by activities in available-for-sale securities of $12.8 million and funded loan growth of $77.9 million. Within Peoples' financing activities, the decrease in interest-bearing deposits of $125.4 million was tempered by an increase in non-interest bearing deposits of $99.3 million. The paydown of long-term borrowings of $72.4 million was substantially offset by an increase of $72.1 million in short-term borrowings. Further information regarding the management of Peoples' liquidity position can be found later in this discussion under “Interest Rate Sensitivity and Liquidity.” Investment Securities The following table provides information regarding Peoples’ investment portfolio at December 31: At December 31, 2016, Peoples' investment securities were approximately 25.0% of total assets compared to 26.7% at December 31, 2015. The decline in available-for-sale investment securities during 2016, compared to 2015, was due to principal paydowns and declines in market values outpacing the reinvestment of cash into the portfolio. In 2015, Peoples acquired $156.4 million of investment securities as part of the NB&T acquisition, with the remaining fluctuation due to purchases being more than offset by principal paydowns, sales, calls and maturities. In 2014, Peoples acquired $69.7 million of available-for-sale investment securities, and retained approximately $11.9 million, with the remainder being sold. In 2013 and 2012, Peoples designated certain securities as "held-to-maturity" at the time of their purchase, as management made the determination Peoples would hold these securities until maturity and concluded Peoples had the ability to do so. The unrealized gain or loss related to held-to-maturity securities does not directly impact total stockholders' equity, in contrast to the impact from the available-for-sale securities portfolio. Peoples' investment in residential and commercial mortgage-backed securities largely consists of securities either guaranteed by the U.S. government or issued by U.S. government sponsored agencies, such as Fannie Mae and Freddie Mac. The remaining portions of Peoples' mortgage-backed securities consist of securities issued by other entities, including other financial institutions, which are not guaranteed by the U.S. government. The amount of these “non-agency” securities included in the residential mortgage-backed securities totals above was as follows at December 31: Management continues to reinvest the principal runoff from the non-agency securities in U.S. agency investments, which has accounted for the continued decline in the fair value of these securities. At December 31, 2016, Peoples' non-agency portfolio consisted entirely of first lien residential mortgages, with nearly all of the underlying loans in these securities originated prior to 2004 and possessing fixed interest rates. Management continues to monitor the non-agency portfolio closely for leading indicators of increasing stress and will continue to be proactive in taking actions to mitigate such risk when necessary. Additional information regarding Peoples' investment portfolio can be found in Note 3 of the Notes to the Consolidated Financial Statements. Loans The following table provides information regarding outstanding loan balances at December 31: (a) Includes all loans acquired, and related loan discount recorded as part of acquisition accounting, in 2012 and thereafter. During 2016, total loans grew 7%, or $152.5 million, with growth of 8% in commercial loan balances and 7% in consumer loan balances. Indirect lending experienced the largest growth across all loan categories for the year, increasing by $85.7 million, or 51%. Commercial and industrial loan growth was $70.6 million, or 20%, for the year. During 2015, total originated loans (excluding acquired loans) grew 17%, or $202.6 million, due to increases in all categories except deposit account overdrafts. Consumer loan balances, which consist mostly of loans to finance automobile purchases, have continued to increase in recent years due largely to Peoples placing greater emphasis on its consumer lending activity. The increase in total acquired loans in 2015 was due to the NB&T acquisition. At December 31, 2015, loans acquired from NB&T were approximately $333.8 million compared to $384.6 million at acquisition date. During 2014, total originated loans grew 12%, or $126.5 million, largely due to growth in commercial real estate, commercial and industrial and consumer loan balances. At December 31, 2014, loans acquired from the Midwest, Ohio Heritage and North Akron acquisitions were approximately $52.5 million, $166.6 million and $108.8 million, respectively. During 2013, total originated loans increased 13%, while acquired loans grew $84.5 million due to the Ohio Commerce Bank acquisition. Also during 2013, Peoples retained a larger percentage of residential mortgage loans originated than in prior years which caused the increase in residential real estate loans. The following table details the maturities of Peoples' commercial real estate and commercial and industrial loans at December 31, 2016: Loan Concentration Peoples categorizes its commercial loans according to standard industry classifications and monitors for concentrations in a single industry or multiple industries that could be impacted by changes in economic conditions in a similar manner. Peoples' commercial lending activities continue to be spread over a diverse range of businesses from all sectors of the economy, with no single industry comprising over 10% of Peoples' total loan portfolio. Loans secured by commercial real estate, including commercial construction loans, continue to comprise the largest portion of Peoples' loan portfolio. The following table provides information regarding the largest concentrations of commercial real estate loans within the loan portfolio at December 31, 2016: Peoples' commercial lending activities continue to focus on lending opportunities inside its primary and secondary market areas within Ohio, West Virginia and Kentucky. In all other states, the aggregate outstanding balances of commercial loans in each state were less than $4.0 million at both December 31, 2016 and December 31, 2015. Allowance for Loan Losses The amount of the allowance for loan losses at the end of each period represents management's estimate of probable losses from existing loans based upon its formal quarterly analysis of the loan portfolio described in the “Critical Accounting Policies” section of this discussion. While this process involves allocations being made to specific loans and pools of loans, the entire allowance is available for all losses incurred within the loan portfolio. The following details management's allocation of the allowance for loan losses at December 31: The allowance for loan losses as a percent of originated loans decreased in 2016 from previous years as a result of the continuation of the reduction in historic loss rates, coupled with the current stable credit quality trends. Past years included historic periods dating closer to the recession which included larger charge-offs. Peoples also considers recent trends in criticized loans and loan growth associated with each loan portfolio, as well as qualitative factors that could negatively impact these trends, such as unemployment, rising interest rates, fragile real estate values, and fluctuating oil and gas prices. Peoples believes the reserves remain appropriate to cover probable losses that exist in the current portfolio. The allowance for loan losses allocated to the residential real estate and consumer loan categories was based upon Peoples' allowance methodology for homogeneous pools of loans. The fluctuations in these allocations have been directionally consistent with the changes in loan quality, loss experience and loan balances in these categories. The increase in the allowance for loan losses for consumer loans has been mostly driven by loan growth in indirect lending in recent periods. The increase of 9% in the allowance for loan losses related to total commercial loans in 2016 was in relation to the commercial loan balance growth of 8%. The reductions in the allowance for loan losses allocated to commercial real estate during 2015 and 2014 were driven by net recoveries in recent years reducing the historical loss rates. During 2015, increases in the commercial and industrial, home equity lines of credit and consumer categories of the allowance for loan losses were driven by net charge-off activity, and increases in the balances of the respective loan portfolios. The significant allocations to commercial loans reflect the higher credit risk associated with these types of lending and the size of these loan categories in relationship to the entire loan portfolio. Criticized loans, which are those classified as watch, substandard or doubtful, decreased by $23.0 million during 2016, compared to an increase of $47.6 million in 2015. Net charge-offs were elevated during 2015 as a result of the full charge-off of one large commercial loan relationship. The following table summarizes the changes in the allowance for loan losses for the years ended December 31: (a) Includes purchase credit impaired loan charge-offs of $44,000 in 2016 and $60,000 in 2015. (b) Includes purchase credit impaired loan charge-offs of $23,000 in 2016 and $3,000 in 2015. (c) Includes purchase credit impaired loan provision for loan losses of $66,000 in 2016 and $303,000 in 2015. During 2016, net charge-offs were nominal at 0.09% of average total loans and were positively impacted by a $1.0 million recovery of a prior period commercial real estate charge-off. Gross charge-offs totaled $5.2 million in 2016, and were largely associated with the consumer loan portfolio. In 2015, Peoples recorded charge-offs related to one large commercial loan relationship in the aggregate amount of $13.1 million, or .67% of average total loans. Peoples also experienced higher net charge-offs in residential real estate and consumer loans due to higher balances from recent originated loan growth. The following table details Peoples’ nonperforming assets at December 31: (a) Includes loans categorized as watch, substandard or doubtful. (b) Includes loans categorized as substandard or doubtful. Nonperforming loans increased in 2016, largely due to the increase in nonaccrual loans, which was partially offset by a decrease in loans 90+ days past due and accruing. The increase in nonaccrual loans was driven by several relatively smaller relationships that were placed on nonaccrual status during 2016. At December 31, 2015, loans 90+ days past due and accruing included $2.3 million of acquired loans that were purchase credit impaired loans, as they had evidence of credit quality deterioration since acquisition. Interest income on these loans is recognized on a level-yield method over the life of the loan. The majority of Peoples' nonaccrual commercial real estate loans continued to consist of non-owner occupied commercial properties and real estate development projects. In general, management believes repayment of these loans is dependent on the sale of the underlying collateral. As such, the carrying values of these loans are ultimately supported by management's estimate of the net proceeds Peoples would receive upon the sale of the collateral. These estimates are based in part on market values provided by independent, licensed or certified appraisers periodically, but no less frequently than annually. Given the volatility in commercial real estate values, management continues to monitor changes in real estate values from quarter-to-quarter and updates its estimates as needed based on observable changes in market prices and/or updated appraisals for similar properties. The significant increase in nonaccrual commercial real estate loans during 2016 was a result of three commercial loans moving to nonaccrual status, while the increase in 2015 was a result of one commercial real estate relationship in the skilled nursing sector being placed on nonaccrual status. The increase in nonaccrual commercial and industrial loans during 2014 was driven by a single $1.2 million relationship placed on nonaccrual. The significant decreases in nonaccrual status from 2012 and 2013 was a result of the addition of a special assets group and their efforts in collecting and recovering payments on delinquent commercial loans. Interest income on loans classified as nonaccrual and renegotiated at each year-end that would have been recorded under the original terms of the loans was $1.9 million for 2016, $2.1 million for 2015 and $1.4 million for 2014. No portion of these amounts was recorded during 2016, 2015 or 2014, consistent with the income recognition policy described in the “Critical Accounting Policies” section of this discussion. Overall, management believes the allowance for loan losses was adequate at December 31, 2016, based on all significant information currently available. Still, there can be no assurance that the allowance for loan losses will be adequate to cover future losses or that the amount of nonperforming loans will remain at current levels, especially considering the current economic uncertainty that exists and the concentration of commercial loans in Peoples’ loan portfolio. Deposits The following table details Peoples’ deposit balances at December 31: In 2016, deposits decreased primarily due to decreases in retail and brokered certificates of deposits ("CDs") and governmental deposit accounts. Peoples continued its deposit strategy of growing low-cost core deposits, such as checking and savings accounts, and reducing its reliance on higher-cost, non-core deposits, such as CDs and brokered deposits. These actions accounted for much of the changes in deposit balances over the last year. In 2015, the increase in deposits included increases in governmental deposit accounts which were due to fluctuations of balances held by state and local governmental entities and their cash flow needs. Peoples also maintained its deposit strategy of growing low-cost core deposits, such as checking and savings accounts, and reducing its reliance on higher-cost, non-core deposits, such as CDs and brokered deposits. These actions accounted for a portion of the changes in deposit balances. Some of the increase in deposit balances was due to the NB&T acquisition, which included non-interest bearing deposits of $177.2 million, retail CDs totaling $48.0 million, savings accounts of $88.3 million, money market deposit accounts of $64.6 million, governmental deposit accounts of $104.8 million, and interest-bearing demand accounts of $57.9 million at December 31, 2015. The increase in total deposits in 2014, included the Midwest, Ohio Heritage and North Akron acquisitions which added an aggregate of $5.5 million of non-interest-bearing deposits, $105.0 million of CDs, $53.1 million of savings accounts, $165.1 million of money market deposit accounts, $2.1 million of governmental deposit accounts and $1.0 million of interest-bearing demand accounts at December 31, 2014. Peoples' governmental deposit accounts represent savings and interest-bearing transaction accounts from state and local governmental entities. In 2016, governmental deposit accounts decreased due primarily to the loss of one relationship. Additionally, these funds are subject to periodic fluctuations based on the timing of tax collections and subsequent expenditures or disbursements. Peoples normally experiences an increase in balances annually during the first quarter corresponding with tax collections, with declines normally in the second half of each year corresponding with expenditures by the governmental entities. Peoples continues to emphasize growth of low-cost deposits that do not require Peoples to pledge assets as collateral, which is required in the case of governmental deposit accounts. The maturities of retail CDs with total balances of $100,000 or more at December 31 were as follows: Borrowed Funds The following table details Peoples’ short-term and long-term borrowings at December 31: Peoples' short-term FHLB advances generally consist of overnight borrowings being maintained in connection with the management of Peoples' daily liquidity position. Peoples continually evaluates the overall balance sheet position given the interest rate environment. During 2016, Peoples executed transactions to take advantage of the low interest rates, which included: ▪ Peoples restructured $20.0 million of long-term FHLB advances that had a weighted-average rate of 2.97%, resulting in a $700,000 loss. Peoples replaced these borrowings with a long-term FHLB advance, which has an interest rate of 2.17% and matures in 2026. ▪ Peoples borrowed an additional $35.0 million of long-term FHLB amortizing advances, which had interest rates ranging from 1.08% to 1.40%, and mature between 2019 and 2031. ▪ Peoples entered into five forward starting interest rate swaps to obtain short-term borrowings at fixed rates, with interest rates ranging from 1.49% to 1.83%, which become effective in 2018 and mature between 2022 and 2026. These swaps locked in funding rates for $40.0 million in FHLB advances that mature in 2018, which have interest rates ranging from 3.57% to 3.92%. Peoples repaid approximately $52.1 million of long-term FHLB advances during 2015 and recorded a loss on debt extinguishment of $520,000. Peoples increased its usage of short-term FHLB advances due to the decrease and pre-payment of long-term FHLB advances. During 2014, Peoples had reduced its usage of short-term FHLB advances due to acquiring long-term FHLB advances from Ohio Heritage. Peoples' retail repurchase agreements consist of overnight agreements with commercial customers and serve as a cash management tool. Additionally, in 2015, Peoples acquired subordinated debt in the NB&T acquisition. On March 4, 2016, Peoples entered into the RJB Credit Agreement, with Raymond James Bank, which provides Peoples with a revolving line of credit in the maximum aggregate principal amount of $15 million (the "RJB Loan Commitment"). Peoples is subject to certain covenants imposed by the RJB Credit Agreement and was in compliance as of December 31, 2016. Additional information regarding Peoples' borrowed funds can be found in Note 8 and Note 9 of the Notes to the Consolidated Financial Statements. Capital/Stockholders’ Equity During 2016, Peoples' total stockholders' equity increased due to higher retained earnings, which were offset slightly by the repurchase of 279,770 treasury shares and the slight decline in the market value of investments. At December 31, 2016, capital levels for both Peoples and Peoples Bank remained substantially higher than the minimum amounts needed to be considered "well capitalized" under banking regulations. These higher capital levels reflect Peoples' desire to maintain a strong capital position. During the first quarter of 2015, Peoples adopted the new Basel III regulatory capital framework, as approved by the federal banking agencies. The adoption of this new framework modified the calculations and well capitalized thresholds of the existing risk-based capital ratios and added the Common Equity Tier 1 risk-based capital ratio. Additionally, under the new rules, in order to avoid limitations on dividends, equity repurchases and compensation, Peoples must exceed the three minimum required ratios by at least the capital conservation buffer. The capital conservation buffer is being phased in from 0.625% beginning January 1, 2016 to 2.50% by January 1, 2019, and applies to the Common Equity Tier 1 ("CET1") ratio, tier 1 capital ratio and total risk-based capital ratio. At December 31, 2016, Peoples' had a capital buffer of 6.11% compared to 2.50% for the fully phased-in capital conservation buffer required by January 1, 2019. As such, Peoples exceeded the minimum ratios including the capital conservation buffer at December 31, 2016. In 2015, Peoples' total stockholders' equity increased primarily due to $76.0 million of common equity issued in connection with the NB&T acquisition. The following table details Peoples' actual risk-based capital levels and corresponding ratios at December 31: In addition to traditional capital measurements, management uses tangible capital measures to evaluate the adequacy of Peoples' stockholders' equity. Such ratios represent non-GAAP financial information since their calculation removes the impact on the Consolidated Balance Sheets of intangible assets acquired through acquisitions. Management believes this information is useful to investors since it facilitates the comparison of Peoples' operating performance, financial condition and trends to peers, especially those without a similar level of intangible assets to that of Peoples. Further, intangible assets generally are difficult to convert into cash, especially during a financial crisis, and could decrease substantially in value should there be deterioration in the overall franchise value. As a result, tangible equity represents a conservative measure of the capacity for Peoples to incur losses but remain solvent. The following table reconciles the calculation of these non-GAAP financial measures to amounts reported in Peoples' Consolidated Financial Statements at December 31: The increase in tangible equity for 2016, and tangible equity to tangible assets ratio, compared to 2015, was due mainly to the increase in retained earnings, offset slightly by the repurchase of 279,770 treasury shares and the decline in the market value of investment securities. In 2015, the decrease in the tangible equity to tangible assets ratio compared to the ratio in 2014 was due to the impact of assets acquired in the NB&T acquisition as well as a reduction in retained earnings as most of the net income was paid to common shareholders as dividends. Future Outlook Peoples achieved success in several major areas in 2016, which included generating quality loan growth, increasing net interest margin, effectively managing credit costs, growing fee income and successfully controlling expenses. Success in these areas resulted in positive operating leverage for the year, an efficiency ratio below 65% and record net income for Peoples. The achievements of 2016 were all done while executing a system conversion of Peoples' core banking systems, which was a time consuming endeavor but one that was critical to the future success of Peoples. For 2017, Peoples expects to leverage the new core banking systems and build off the momentum that was gained in 2016 related to loan growth, fee income growth and expense management. Key strategic priorities continue to include generating positive operating leverage, maintaining superior asset quality, and remaining prudent with the use of capital. Overall, Peoples' key strategic objectives are to be a steady, dependable performer for its shareholders and to take advantage of market expansion opportunities. Peoples' long-term strategic goals include generating results in the top quartile of performance relative to Peoples' peer group, as defined in Peoples' Proxy Statement, and providing returns for its shareholders superior to those of its peers, regardless of operating conditions. In 2016, net interest income made up 67% of Peoples' revenue, and therefore, remained a major source of revenue. Thus, Peoples' ability to grow revenue in 2017 will be impacted by the amount of net interest income generated. The Federal Reserve Board is expected to raise interest rates throughout 2017. Long-term rates could increase but remain more volatile than in prior years. Changes in long-term interest rates would affect reinvestment rates within the loan and investment portfolios. Should the yield curve flatten, Peoples would have limited opportunities to offset the impact on asset yields with a similar reduction in funding costs. Thus, Peoples' ability to produce meaningful loan growth remains the key driver for improving net interest income and margin in 2017. Net interest margin for 2017 is expected to be in the range of 3.45% and 3.50% given the interest rate environment. Loan growth will again be the key driver in stabilizing asset yields. The net accretion income impact on net interest margin is expected to be slightly less than that experienced in 2016. Management would expect both net interest income and margin to benefit from any meaningful increase in market interest rates based upon the current interest rate risk profile. However, it remains inherently difficult to predict and manage the future trend of Peoples' net interest income and margin due to the uncertainty surrounding the timing and magnitude of future interest rate changes, as well as the impact of competition for loans and deposits. Peoples seeks to maintain a diversified revenue stream though its strong fee-based businesses, such as insurance and wealth management. However, in 2016, Peoples' fee revenue comprised 33% of its total revenue, consistent with 2015 but down from the high of 40% in 2013. The decline in recent years was due primarily to the bank acquisitions completed since 2013, only one of which had a wealth management practice. In addition, only two relatively small insurance agencies and one small financial advisory book of business were purchased during the same period of time. Peoples has capabilities that many banks in its market area lack, including some of the largest national banks, which include robust retirement plan services and comprehensive insurance products. Thus, management considers Peoples to have a competitive advantage that directly enhances revenue growth potential. For 2017, management expects fee-based revenue growth of between 4% and 6%. While the primary focus will be on revenue growth, management remains disciplined with operating expenses. Peoples continues to have limited control over some expenses, such as employee medical and pension costs. Peoples continues to be exposed to more pension settlement charges given the frozen status of its defined benefit plan. The recognition of settlement charges is largely dependent upon the timing of distributions, the amount of pension benefit earned by the retirees, and whether the individuals elect a lump-sum distribution. For 2017, management anticipates a higher volume of settlement charges to that incurred in 2016, during which time there were no settlement charges. This expectation is based on normal retirement activity within the defined benefit plan, but assumes all potential distributions are lump-sum payouts. For total expenses, management expects growth in the low single digits. Management expects 4% to 6% growth in total revenue in 2017, and low-single digit percentage expense growth, which would result in positive operating leverage. Peoples' efficiency ratio is expected to be between 62% and 64% for 2017. The expected revenue growth goal for 2017 is largely dependent upon achieving meaningful loan growth. Management believes period-end loan balances could increase by 5% to 7% in 2017. Within Peoples' commercial lending activity, the primary emphasis continues to be on non-mortgage commercial lending opportunities and capitalizing on growth opportunities provided by the acquisitions completed. Consumer lending activity grew significantly during 2016 and is expected to remain a large contributor to overall loan growth in 2017, primarily indirect lending. At December 31, 2016, the investment portfolio comprised 25% of total assets. In 2017, the investment portfolio is anticipated to continue to comprise approximately 25% of total assets. Management can use the cash flow generated by Peoples’ significant investment in mortgage-backed securities to fund new loan production. Peoples will continue to seek opportunities to execute a shift in the mix on the asset side of the balance sheet to reduce the relative size of the investment portfolio. Management may adjust the size or composition of the investment portfolio in response to other factors, such as changes in liquidity needs and interest rate conditions. Peoples' funding strategy continues to emphasize growth of core deposits, such as checking and savings accounts, rather than higher-cost deposits. Thus, CD balances could continue the declining trend experienced in recent years. Given the expected increase in earning assets, borrowed funds are expected to increase in 2017 to the extent earning asset growth is more than deposit growth. Should this occur, management would evaluate using longer-term borrowings to match the duration of the assets being funded to minimize the long-term interest rate risk. Peoples remains committed to sound underwriting and prudent risk management. Management believes this credit discipline will benefit Peoples during any future economic downturns. The long-term goal is to maintain key metrics in the top-quartile of Peoples' peer group regardless of economic conditions. Net charge-off trends are expected to normalize in 2017 as the prospects of large charge-offs and recoveries diminish. Management anticipates Peoples' provision for loan losses and the net charge-off rate for 2017 will normalize, with the net charge-off rate near the low end of its long-term historical range of 0.20% to 0.30% of average loans. For 2017, management intends to remain prudent with the level of Peoples' allowance for loan losses. However, the level will continue to be based upon management's quarterly assessment of the losses inherent in the loan portfolio, and the amount of any provision for loan losses should be driven mostly by a combination of the net charge-off rate and loan growth. Peoples' capital position remains strong. Given the excess capital position and the increase in Peoples' stock price, Peoples will continue to look for ways to effectively manage its capital, including, but not limited to, bank acquisitions and dividends. Late in 2015, Peoples approved a share repurchase program of up to $20 million, under which Peoples purchased $5.0 million in 2016. Given the activity in the stock market in late 2016 and early 2017, specifically as it related to the price of Peoples' common shares, Peoples' appetite to repurchase common shares has diminished. However, given that there is a share repurchase program still in place, with capacity of $15.0 million remaining, Peoples will continue to evaluate additional purchase opportunities throughout 2017. Management has built a culture where it is paramount that the associates take care of customers and take care of each other. Management is committed to profitable growth of the company and building long-term shareholder value. This will require management to remain focused on four key areas: responsible risk management; extraordinary client experience; profitable revenue growth; and maintaining a superior workforce. Success will be achieved through disciplined execution of strategies and providing extraordinary service to Peoples' clients and communities. Interest Rate Sensitivity and Liquidity While Peoples is exposed to various business risks, the risks relating to interest rate sensitivity and liquidity are major risks that can materially impact future results of operations and financial condition due to their complexity and dynamic nature. The objective of Peoples' asset/liability management (“ALM”) function is to measure and manage these risks in order to optimize net interest income within the constraints of prudent capital adequacy, liquidity and safety. This objective requires Peoples to focus on interest rate risk exposure and adequate liquidity through its management of the mix of assets and liabilities, their related cash flows and the rates earned and paid on those assets and liabilities. Ultimately, the ALM function is intended to guide management in the acquisition and disposition of earning assets and selection of appropriate funding sources. Interest Rate Risk Interest rate risk (“IRR”) is one of the most significant risks arising in the normal course of business of financial services companies like Peoples. IRR is the potential for economic loss due to future interest rate changes that can impact the earnings stream as well as market values of financial assets and liabilities. Peoples' exposure to IRR is due primarily to differences in the maturity or repricing of earning assets and interest-bearing liabilities. In addition, other factors, such as prepayments of loans and investment securities or early withdrawal of deposits, can affect Peoples' exposure to IRR and increase interest costs or reduce revenue streams. Peoples has assigned overall management of IRR to the ALCO, which has established an IRR management policy that sets minimum requirements and guidelines for monitoring and managing the level of IRR. The objective of Peoples' IRR policy is to assist the ALCO in its evaluation of the impact of changing interest rate conditions on earnings and economic value of equity, as well as assist with the implementation of strategies intended to reduce Peoples' IRR. The management of IRR involves either maintaining or changing the level of risk exposure by changing the repricing and maturity characteristics of the cash flows for specific assets or liabilities. Additional oversight of Peoples' IRR is provided by the Board of Directors of Peoples Bank, who reviews and approves Peoples' IRR management policy at least annually. The ALCO uses various methods to assess and monitor the current level of Peoples' IRR and the impact of potential strategies or other changes. However, the ALCO predominantly relies on simulation modeling in its overall management of IRR since it is a dynamic measure. Simulation modeling also estimates the impact of potential changes in interest rates and balance sheet structures on future earnings and projected economic value of equity. The modeling process starts with a base case simulation using the current balance sheet and current interest rates held constant for the next twenty-four months. Alternate scenarios are prepared which simulate the impact of increasing and decreasing market interest rates, assuming parallel yield curve shifts. Comparisons produced from the simulation data, showing the changes in net interest income from the base interest rate scenario, illustrate the risks associated with the current balance sheet structure. Additional simulations, when deemed appropriate or necessary, are prepared using different interest rate scenarios from those used with the base case simulation and/or possible changes in balance sheet composition. The additional simulations include non-parallel shifts in interest rates whereby the direction and/or magnitude of change of short-term interest rates is different than the changes applied to longer-term interest rates. Comparisons showing the earnings and economic value of equity variance from the base case are provided to the ALCO for review and discussion. The ALCO has established limits on changes in the twelve-month net interest income forecast and the economic value of equity from the base case. The ALCO may establish risk tolerances for other parallel and non-parallel rate movements, as deemed necessary. The following table details the current policy limits used to manage the level of Peoples' IRR: The following table shows the estimated changes in net interest income and the economic value of equity based upon a standard, parallel shock analysis (dollars in thousands): This table uses a standard, parallel shock analysis for assessing the IRR to net interest income and the economic value of equity. A parallel shock means all points on the yield curve (one year, two year, three year, etc.) are directionally changed the same amount of basis points. For example, 100 basis points equals 1%. While management regularly assesses the impact of both increasing and decreasing interest rates, the table above only reflects the impact of upward shocks due to the fact a downward parallel shock of 100 basis points or more is not possible given that most short-term rates are currently less than 1%. Although a parallel shock table can give insight into the current direction and magnitude of IRR inherent in the balance sheet, interest rates do not usually move in a complete parallel manner during interest rate cycles. These nonparallel movements in interest rates, commonly called yield curve steepening or flattening movements, tend to occur during the beginning and end of an interest rate cycle, with differences in the timing, direction and magnitude of changes in short-term and long-term interest rates. Thus, any benefit that could occur as a result of the Federal Reserve Board increasing short-term interest rates in future quarters could be offset by an inverse movement in long-term interest rates. As a result, management conducts more advanced interest rate shock scenarios to gain a better understanding of Peoples' exposure to nonparallel rate shifts. During 2016, Peoples' Consolidated Balance Sheet remained positioned for a relatively neutral interest rate environment as illustrated by the overall small changes in net interest income shown in the above table. The largest factors affecting Peoples' interest rate sensitivity were the amount of cash on the balance sheet and the asset/liability mix in the balance sheet. This positioning was appropriate given the Federal Reserve Board's stated goal of potentially raising interest rates at a slow and measured pace. In fact, the Federal funds rate was raised only one time in 2016 by 25 basis points in December. An asset/liability model, used to produce the analysis above, requires assumptions to be made such as prepayment rates on interest-earning assets and repricing impact on non-maturity deposits. These business assumptions are based on business plans, economic and market trends, and available industry data. Management believes that its methodology for developing such assumptions is reasonable; however, there can be no assurance that modeled results will be achieved. Liquidity In addition to IRR management, another major objective of the ALCO is to maintain sufficient levels of liquidity. The ALCO defines liquidity as the ability to meet anticipated and unanticipated operating cash needs, loan demand and deposit withdrawals without incurring a sustained negative impact on profitability. A primary source of liquidity for Peoples is retail deposits. Liquidity is also provided by cash generated from earning assets such as maturities, calls, and principal and interest payments from loans and investment securities. Peoples also uses various wholesale funding sources to supplement funding from customer deposits. These external sources provide Peoples with the ability to obtain large quantities of funds in a relatively short time period in the event of sudden unanticipated cash needs. However, an over-utilization of external funding sources can expose Peoples to greater liquidity risk as these external sources may not be accessible during times of market stress. Additionally, Peoples may be exposed to the risk associated with providing excess collateral to external funding providers, commonly referred to as counterparty risk. As a result, the ALCO's liquidity management policy sets limits on the net liquidity position and the concentration of non-core funding sources, both wholesale funding and brokered deposits. In addition to external sources of funding, Peoples considers certain types of deposits to be less stable or "volatile funding". These deposits include special money market products, large CDs and public funds. Peoples has established volatility factors for these various deposit products, and the liquidity management policy establishes a limit on the total level of volatile funding. Additionally, Peoples measures the maturities of external sources of funding for periods of 1 month, 3 months, 6 months and 12 months and has established policy limits for the amounts maturing in each of these periods. The purpose of these limits is to minimize exposure to what is commonly termed rollover risk. An additional strategy used by Peoples in the management of liquidity risk is maintaining a targeted level of liquid assets. These are assets that can be converted into cash in a relatively short period of time. Management defines liquid assets as unencumbered cash (including cash on deposit at the Federal Reserve Bank), and the market value of U.S. government and agency securities that are not pledged. Excluded from this definition are pledged securities, non-government and agency securities, municipal securities and loans. Management has established a minimum level of liquid assets in the liquidity management policy, which is expressed as a percentage of loans and unfunded loan commitments. Peoples also has established a policy limit around the level of liquefiable assets also expressed as a percentage of loans and unfunded loan commitments. Liquefiable assets are defined as liquid assets plus the market value of unpledged securities not included in the liquid asset measurement. Peoples remained within these two parameters throughout the year. An essential element in the management of liquidity risk is a forecast of the sources and uses of anticipated cash flows. On a monthly basis, Peoples forecasts sources and uses of cash for the next twelve months. To assist in the management of liquidity, management has established a liquidity coverage ratio, which is defined as the total sources of cash divided by the total uses of cash. A ratio of greater than 1.0 times indicates that forecasted sources of cash are adequate to fund forecasted uses of cash. The liquidity management policy establishes a minimum limit of 1.0 times. As of December 31, 2016, Peoples had a ratio of 1.8 times, which was within policy limits. Peoples also forecasts secondary or contingent sources of cash, and this includes external sources of funding and liquid assets. These sources of cash would be required if and when the forecasted liquidity coverage ratio dropped below the policy limit of 1.0 times. An additional liquidity measurement used by management includes the total forecasted sources of cash and the contingent sources of cash divided by the forecasted uses of cash. Management has established a minimum ratio of 3.0 times for this liquidity management policy limit. As of December 31, 2016, Peoples had a ratio of 7.4 times, which was within policy limits. Disruptions in the sources and uses of cash can occur which can drastically alter the actual cash flows and negatively impact Peoples' ability to access internal and external sources of cash. Such disruptions might occur due to increased withdrawals of deposits, increases in the funding required for loan commitments, a decrease in the ability to access external funding sources and other forces that would increase the need for funding and limit Peoples' ability to access needed funds. As a result, Peoples maintains a liquidity contingency funding plan ("LCFP") that considers various degrees of disruptions and develops action plans around these scenarios. Peoples' LCFP identifies scenarios where funding disruptions might occur and creates scenarios of varying degrees of severity. The disruptions considered include an increase in funding of unfunded loan commitments, unanticipated withdrawals of deposits, decreases in the renewal of maturing CDs and reductions in cash earnings. Additionally, the LCFP creates stress scenarios where access to external funding sources, or contingency funding, is suddenly limited which includes a significant increase in the margin requirements where securities or loans are pledged, limited access to funding from other banks and limited access to funding from the FHLB and the Federal Reserve Bank. Peoples' LCFP scenarios include a base scenario, a mild stress scenario, a moderate stress scenario and a severe stress scenario. Each of these is defined as to the severity, and action plans are developed around each. Liquidity management also requires the monitoring of risk indicators that may alert the ALCO to a developing liquidity situation or crisis. Early detection of stress scenarios allows Peoples to take actions to help mitigate the impact to Peoples Bank's business operations. The LCFP contains various indicators, termed key risk indicators ("KRI's") that are monitored on a monthly basis, at a minimum. The KRI's include both internal and external indicators and include loan delinquency levels, classified and watch list loan levels, non-performing loans to loans and to total assets, the loan to deposit ratio, the level of net non-core funding dependence, the level of contingency funding sources, the liquidity coverage ratio, changes in regulatory capital levels, forecasted operating loss and negative media concerning Peoples, irrational competitor pricing that persists and an increase in rates for external funding sources. The LCFP establishes levels that define each of these KRI's under base, mild, moderate and severe scenarios. The LCFP is reviewed and updated at least on an annual basis by the ALCO and Peoples Bank's Board of Directors. Additionally, testing of the LCFP is required on an annual basis. Various stress scenarios and the related actions are simulated according to the LCFP. The results are reviewed and discussed, and changes or revisions are made to the LCFP accordingly. Additionally, every two years, the LCFP is subjected to a third-party review for effectiveness and regulatory compliance. Overall, management believes the current balance of cash and cash equivalents, and anticipated cash flows from the investment portfolio, along with the availability of other funding sources, will allow Peoples to meet anticipated cash obligations, as well as special needs and off-balance sheet commitments. Off-Balance Sheet Activities and Contractual Obligations Peoples routinely engages in activities that involve, to varying degrees, elements of risk that are not reflected in whole or in part in the Consolidated Financial Statements. These activities are part of Peoples' normal course of business and include traditional off-balance sheet credit-related financial instruments, interest rate contracts and commitments to make additional capital contributions in low-income housing tax credit investments. The following is a summary of Peoples’ significant off-balance sheet activities and contractual obligations. Detailed information regarding these activities and obligations can be found in the Notes to the Consolidated Financial Statements as follows: Traditional off-balance sheet credit-related financial instruments are primarily commitments to extend credit and standby letters of credit. These activities are necessary to meet the financing needs of customers and could require Peoples to make cash payments to third parties in the event certain specified future events occur. The contractual amounts represent the extent of Peoples’ exposure in these off-balance sheet activities. However, since certain off-balance sheet commitments, particularly standby letters of credit, are expected to expire or only partially be used, the total amount of commitments does not necessarily represent future cash requirements. Peoples continues to lease certain facilities and equipment under noncancellable operating leases with terms providing for fixed monthly payments over periods generally ranging from two to ten years. Several of Peoples’ leased facilities are inside retail shopping centers or office buildings and, as a result, are not available for purchase. Management believes these leased facilities increase Peoples’ visibility within its markets and afford sales associates additional access to current and potential clients. For certain acquisitions, often those involving insurance businesses and wealth management books of business, a portion of the consideration is contingent upon revenue metrics being achieved. US GAAP requires that the amounts be recorded upon acquisition based on the best estimate of the future amounts to be paid at the time of acquisition. Any subsequent adjustment to the estimate is recorded in earnings. Based on the acquisitions completed to date, management does not expect contingent consideration to have a material impact on Peoples' future performance. The following table details the aggregate amount of future payments Peoples is required to make under certain contractual obligations as of December 31, 2016: (a) Amounts reflect solely the minimum required principal payments. (b) Amounts assume projected revenue metrics are achieved. Management does not anticipate that Peoples’ current off-balance sheet activities will have a material impact on its future results of operations and financial condition based on historical experience and recent trends. Effects of Inflation on Financial Statements Substantially all of Peoples’ assets relate to banking and are monetary in nature. As a result, inflation does not impact Peoples to the same degree as companies in capital-intensive industries in a replacement cost environment. During a period of rising prices, a net monetary asset position results in a loss in purchasing power and conversely a net monetary liability position results in an increase in purchasing power. The opposite would be true during a period of decreasing prices. In the banking industry, monetary assets typically exceed monetary liabilities. The current monetary policy targeting low levels of inflation has resulted in relatively stable price levels. Therefore, inflation has had little impact on Peoples’ net assets.

<s>[INST] Certain statements in this Form 10K, which are not historical fact, are forwardlooking statements within the meaning of Section 27A of the Securities Act , Section 21E of the Exchange Act, and the Private Securities Litigation Reform Act of 1995. Words such as “anticipate”, “estimates”, “may”, “feels”, “expects”, “believes”, “plans”, “will”, “would”, “should”, “could” and similar expressions are intended to identify these forwardlooking statements but are not the exclusive means of identifying such statements. Forwardlooking statements are subject to risks and uncertainties that may cause actual results to differ materially. Factors that might cause such a difference include, but are not limited to: (1) Peoples' ability to leverage the system conversion (including the related core operating systems, data systems and products) without complications or difficulties that may otherwise result in the loss of customers, operational problems or onetime costs currently not anticipated to arise in connection with such conversion; (2) the success, impact, and timing of the implementation of Peoples' business strategies, including the successful integration of acquisitions and the expansion of consumer lending activity; (3) Peoples' ability to integrate future acquisitions which may be unsuccessful, or may be more difficult, timeconsuming or costly than expected; (4) Peoples may issue equity securities in connection with future acquisitions, which could cause ownership and economic dilution to Peoples' current shareholders; (5) local, regional, national and international economic conditions and the impact they may have on Peoples, its customers and its counterparties, and Peoples' assessment of the impact, which may be different than anticipated; (6) competitive pressures among financial institutions or from nonfinancial institutions may increase significantly, including product and pricing pressures, changes to thirdparty relationships and revenues, and Peoples' ability to attract, develop and retain qualified professionals; (7) changes in the interest rate environment due to economic conditions and/or the fiscal policies of the U.S. government and Federal Reserve Board, which may adversely impact interest rates, interest margins, loan demand and interest rate sensitivity; (8) changes in prepayment speeds, loan originations, levels of nonperforming assets, delinquent loans and chargeoffs, which may be less favorable than expected and adversely impact the amount of interest income generated; (9) adverse changes in economic conditions and/or activities, including, but not limited to, continued economic uncertainty in the U.S., the European Union (including the uncertainty created by the June 23, 2016 referendum by British voters to exit the European Union), Asia, and other areas, which could decrease sales volumes and increase loan delinquencies and defaults; (10) uncertainty regarding the nature, timing and effect of legislative or regulatory changes or actions, promulgated and to be promulgated by governmental and regulatory agencies including the ODFI, the FDIC, the OCC, the Federal Reserve Board and the CFPB, which may subject Peoples, its subsidiaries, or one or more acquired companies to a variety of new and more stringent legal and regulatory requirements which adversely affect their respective businesses, including in particular the rules and regulations promulgated and to be promulgated under the DoddFrank Wall Street Reform and Consumer Protection Act of 2010, and the Basel III regulatory capital reform; (11) deterioration in the credit quality of Peoples' loan portfolio, which may adversely impact the provision for loan losses; (12) changes in accounting standards, policies, estimates or procedures which may adversely affect Peoples' reported financial condition or results of operations; (13) Peoples' assumptions and estimates used in applying critical accounting policies, which may prove unreliable, inaccurate or not predictive of actual results; (14) adverse changes in the conditions and trends in the financial markets, including political developments, which may adversely affect the fair value of securities within Peoples' investment portfolio, the interest rate sensitivity of Peoples' consolidated balance sheet, and the income generated by Peoples' trust and investment activities; [/INST] Negative. </s>

PEOPLES BANCORP INC

2018-02-27

2017-12-31

ITEM 7 MANAGEMENT’S DISCUSSION AND ANALYSIS OF FINANCIAL CONDITION AND RESULTS OF OPERATIONS Forward-Looking Statements Certain statements in this Form 10-K, which are not historical fact, are forward-looking statements within the meaning of Section 27A of the Securities Act , Section 21E of the Exchange Act, and the Private Securities Litigation Reform Act of 1995. Words such as “anticipate,” “estimate,” “may,” “feel,” “expect,” “believe,” “plan,” “will,” “would,” “should,” “could” and similar expressions are intended to identify these forward-looking statements but are not the exclusive means of identifying such statements. Forward-looking statements are subject to risks and uncertainties that may cause actual results to differ materially. Factors that might cause such a difference include, but are not limited to: (1) the success, impact, and timing of the implementation of Peoples' business strategies, including the successful integration of acquisitions and the expansion of consumer lending activity; (2) Peoples' ability to integrate any future acquisitions, including the pending merger with ASB, which may be unsuccessful, or may be more difficult, time-consuming or costly than expected; (3) Peoples' ability to obtain regulatory approvals of the proposed merger of Peoples with ASB on the proposed terms and schedule, and approval of the merger by the shareholders of ASB on March 9, 2018 may be unsuccessful; (4) competitive pressures among financial institutions or from non-financial institutions which may increase significantly, including product and pricing pressures, changes to third-party relationships and revenues, and Peoples' ability to attract, develop and retain qualified professionals; (5) changes in the interest rate environment due to economic conditions and/or the fiscal policies of the United States ("U.S.") government and the Board of Governors of the Federal Reserve System (the "Federal Reserve Board"), which may adversely impact interest rates, interest margins, loan demand and interest rate sensitivity; (6) uncertainty regarding the nature, timing and effect of legislative or regulatory changes or actions, promulgated and to be promulgated by governmental and regulatory agencies in the State of Ohio, the Federal Deposit Insurance Corporation, the Federal Reserve Board and the Consumer Financial Protection Bureau, which may subject Peoples, its subsidiaries, or one or more acquired companies to a variety of new and more stringent legal and regulatory requirements which adversely affect their respective businesses, including in particular the rules and regulations promulgated and to be promulgated under the Dodd-Frank Wall Street Reform and Consumer Protection Act of 2010, and the Basel III regulatory capital reform; (7) changes in policy and other regulatory and legal developments accompanying the current presidential administration, including the recently-enacted Tax Cuts and Jobs Act, and uncertainty or speculation pending the enactment of such changes; (8) uncertainties in Peoples' preliminary review of, and additional analysis of, the Tax Cuts and Jobs Act; (9) local, regional, national and international economic conditions and the impact these conditions may have on Peoples, its customers and its counterparties, and Peoples' assessment of the impact, which may be different than anticipated; (10) Peoples may issue equity securities in connection with future acquisitions, which could cause ownership and economic dilution to Peoples' current shareholders; (11) changes in prepayment speeds, loan originations, levels of nonperforming assets, delinquent loans and charge-offs, which may be less favorable than expected and adversely impact the amount of interest income generated; (12) adverse changes in the economic conditions and/or activities, including, but not limited to, continued economic uncertainty in the U.S., the European Union (including uncertainty surrounding the actions to be taken to implement the referendum by British voters to exit the European Union), Asia and other areas, which could decrease sales volumes, add volatility to the global stock markets and increase loan delinquencies and defaults; (13) deterioration in the credit quality of Peoples' loan portfolio, which may adversely impact the provision for loan losses; (14) changes in accounting standards, policies, estimates or procedures which may adversely affect Peoples' reported financial condition or results of operations; (15) Peoples' assumptions and estimates used in applying critical accounting policies, which may prove unreliable, inaccurate or not predictive of actual results; (16) adverse changes in the conditions and trends in the financial markets, including political developments, which may adversely affect the fair value of securities within Peoples' investment portfolio, the interest rate sensitivity of Peoples' consolidated balance sheet, and the income generated by Peoples' trust and investment activities; (17) Peoples' ability to receive dividends from its subsidiaries; (18) Peoples' ability to maintain required capital levels and adequate sources of funding and liquidity; (19) the impact of minimum capital thresholds established as a part of the implementation of Basel III; (20) the impact of larger or similar-sized financial institutions encountering problems, which may adversely affect the banking industry and/or Peoples' business generation and retention, funding and liquidity; (21) the costs and effects of regulatory and legal developments, including the outcome of potential regulatory or other governmental inquiries and legal proceedings and results of regulatory examinations; (22) Peoples' ability to secure confidential information through the use of computer systems and telecommunications networks, including those of Peoples' third-party vendors and other service providers, may prove inadequate, which could adversely affect customer confidence in Peoples and/or result in Peoples incurring a financial loss; (23) Peoples' reliance on, and the potential failure of, a number of third party vendors to perform as expected, including its primary core banking system provider; (24) ability to anticipate and respond to technological changes which can impact Peoples' ability to respond to customer needs and meet competitive demands; (25) changes in consumer spending, borrowing and saving habits, whether due to the newly-enacted tax legislation, changes in business and economic conditions, legislative or regulatory initiatives, or other factors, which may be different than anticipated; (26) the overall adequacy of Peoples' risk management program; (27) the impact on Peoples' businesses, as well as on the risks described above, of various domestic or international widespread natural or other disasters, pandemics, cyber attacks, civil unrest, military or terrorist activities or international conflicts; (28) significant changes in the tax laws, which may adversely affect the fair values of deferred tax assets and obligations of states and political subdivisions held in Peoples' investment securities portfolio; and (29) other risk factors relating to the banking industry or Peoples as detailed from time to time in Peoples' reports filed with the SEC, including those risk factors included in the disclosures under the heading "ITEM 1A RISK FACTORS" of this Form 10-K. All forward-looking statements speak only as of the filing date of this Form 10-K and are expressly qualified in their entirety by the cautionary statements. Although management believes the expectations in these forward-looking statements are based on reasonable assumptions within the bounds of management’s knowledge of Peoples’ business and operations, it is possible that actual results may differ materially from these projections. Additionally, Peoples undertakes no obligation to update these forward-looking statements to reflect events or circumstances after the filing date of this Form 10-K or to reflect the occurrence of unanticipated events except as may be required by applicable legal requirements. Copies of documents filed with the SEC are available free of charge at the SEC’s website at www.sec.gov and/or from Peoples' website - www.peoplesbancorp.com under the "Investor Relations" section. The following discussion and analysis of Peoples' Consolidated Financial Statements is presented to provide insight into management's assessment of the financial position and results of operations for the periods presented. This discussion and analysis should be read in conjunction with the audited Consolidated Financial Statements and Notes thereto, as well as the ratios and statistics, contained elsewhere in this Form 10-K. Summary of Significant Transactions and Events The following is a summary of transactions or events that have impacted or are expected by management to impact Peoples’ results of operations or financial condition: ◦ As of December 31, 2017, Peoples recorded a revaluation of its deferred tax assets and liabilities in light of the applicable provisions of the recently-enacted Tax Cuts and Jobs Act. Previously, Peoples had recognized its deferred tax assets and deferred tax liabilities at a federal income tax rate of 35%, and the new law required the use of a 21% federal income tax rate. As a result, Peoples wrote down its net deferred tax assets by $0.9 million, which had a direct impact on income tax expense recorded during 2017. ◦ During 2017, Peoples sold $5.0 million of available-for-sale equity securities, resulting in a gain of $3.0 million. The sales were not a normal occurrence for Peoples' business. Beginning in 2018, fluctuations in the market value of equity investment securities will be recognized on the income statement. Peoples' remaining positions in equity investment securities could pose some volatility in future quarters, depending on their respective market values at the end of future reporting periods. ◦ During 2017, Peoples closed six full-service bank branches, four located in Ohio, and two located in West Virginia. Peoples continues to evaluate its bank branch network in an effort to optimize efficiency. In 2016, Peoples closed three Ohio branches. ◦ During 2017, Peoples recorded non-core expense items of $341,000 in acquisition-related costs and $242,000 in pension settlement costs, compared to no acquisition-related costs or pension settlement costs being recorded in 2016. ◦ During 2017, Peoples entered into two forward starting interest rate swaps to obtain fixed rate borrowings with interest rates of 2.47% and 2.53%, which become effective in January and April of 2018 and mature in 2025 and 2027. These swaps locked in funding rates for $20.0 million in repurchase agreements that mature in 2018 and have interest rates of 3.61% and 3.55%. ◦ On October 23, 2017, Peoples entered into a merger agreement with ASB that calls for ASB to merge into Peoples and for ASB’s wholly-owned subsidiary, American Savings Bank, fsb, which operates six branches located in southern Ohio and northern Kentucky, to merge into Peoples Bank. This transaction is expected to close during the second quarter of 2018, subject to the satisfaction of customary closing conditions, including regulatory approvals and the approval of the shareholders of ASB. As of December 31, 2017, ASB had approximately $288.3 million in total assets, which included approximately $247.2 million in net loans, and approximately $203.2 million in total deposits. Under the terms of the ASB agreement, shareholders of ASB can elect to receive either 0.592 common share of Peoples for each share of ASB common stock or $20.00 cash per share, with a limit of 15% of the merger consideration being paid in cash. ASB is soliciting proxies for use at its special meeting of shareholders to be held on March 9, 2018, to vote on the adoption and approval of the Merger Agreement. ◦ On October 2, 2017, Peoples Insurance acquired a property and casualty focused independent insurance agency for total cash consideration of $1.7 million, and recorded $1.1 million of customer relationship intangibles and $100,000 of fixed assets, resulting in $480,000 of goodwill. The acquisition did not materially impact Peoples' financial position, results of operations or cash flows. ◦ On January 31, 2017, Peoples Insurance acquired a third-party insurance administration company for total cash consideration of $450,000, and recorded $450,000 of customer relationship intangibles resulting in no goodwill. This acquisition did not materially impact Peoples' financial position, results of operations or cash flows. ◦ On November 7, 2016, Peoples converted to an upgraded core banking system (including the related operating systems, data systems and products). The conversion resulted in a pre-tax combined revenue and expense impact of $1.3 million, or $0.05 in earnings per diluted share, for the full year of 2016. Deposit account service charges were impacted by the system conversion as Peoples granted waivers of $85,000 related to account services charges in the month of the conversion. The remainder of the $1.3 million was recorded in various expense categories, primarily in other non-interest expense, professional fees, and salaries and employee benefit costs. ◦ During 2017, Peoples borrowed an additional $75.0 million of long-term FHLB non-amortizing advances, which have interest rates ranging from 1.20% to 2.03% and mature between 2018 and 2022. ◦ Peoples continually evaluates the overall balance sheet position given the interest rate environment. During 2016, Peoples executed transactions to take advantage of the low interest rates, which included: ▪ Peoples restructured $20.0 million of FHLB long-term advance borrowings that had a weighted-average rate of 2.97%, resulting in a $700,000 loss. Peoples replaced these borrowings with a long-term FHLB advance, which has an interest rate of 2.17% and matures in 2026. ▪ Peoples borrowed an additional $35.0 million of long-term FHLB amortizing advances, which had interest rates ranging from 1.08% to 1.40%, and mature between 2019 and 2031. ▪ Peoples entered into five forward starting interest rate swaps to obtain short-term borrowings at fixed rates, with interest rates ranging from 1.49% to 1.83%, which become effective in 2018 and mature between 2022 and 2026. These swaps locked in funding rates for $40.0 million in FHLB advances that mature in 2018, which have interest rates ranging from 3.57% to 3.92%. ◦ On June 8, 2016, Peoples purchased an additional $35.0 million in bank owned life insurance ("BOLI"). ◦ During the second quarter of 2016, Peoples sold $28.9 million of available-for-sale investment securities with a weighted average yield of 2.14%, for a gain of $767,000. ◦ Effective March 2, 2016, Peoples terminated the loan agreement with U.S. Bank National Association dated as of December 18, 2012, as amended (the "U.S. Bank Loan Agreement"). As of the termination date, Peoples had no outstanding borrowings under the U.S. Bank Loan Agreement. Peoples paid an immaterial non-usage fee in connection with the termination of the U.S. Bank Loan Agreement. ◦ On March 4, 2016, Peoples entered into a Credit Agreement (the "RJB Credit Agreement") with Raymond James Bank, N.A. ("Raymond James Bank"), which provides Peoples with a revolving line of credit in the maximum aggregate principal amount of $15 million, for the purpose of: (i) to the extent that any amounts remained outstanding, paying off the then outstanding $15 million revolving line of credit to Peoples pursuant to the U.S. Bank Loan Agreement; (ii) making acquisitions; (iii) making stock repurchases; (iv) working capital needs; and (v) other general corporate purposes. On March 4, 2016, Peoples paid upfront fees for the establishment of a revolving line of credit agreement of $70,600, representing 0.47% of the loan commitment under the RJB Credit Agreement. ◦ On January 6, 2016, Peoples Bank acquired a small financial advisory book of business in Marietta, Ohio for cash consideration of $0.5 million. This acquisition did not materially impact Peoples' financial position, results of operations or cash flows. ◦ Peoples' net interest income and net interest margin are impacted by changes in market interest rates based upon actions taken by the Federal Reserve Board (the "Fed"), either directly or through its Open Market Committee. These actions include changing its target Federal Funds Rate (the interest rate at which banks lend money to each other), Discount Rate (the interest rate charged to banks for money borrowed from a Federal Reserve Bank) and longer-term market interest rates (primarily through transactions in U.S. Treasury securities). Interest rates also are affected by investor demand for U.S. Treasury securities. The resulting changes in the yield curve slope have a direct impact on reinvestment rates for Peoples' earning assets. ◦ The Fed has raised the benchmark Federal Funds Target Rate by 25 basis points in each of December of 2016 and March, June and December of 2017. The Fed has also begun to reduce the size of its $4.5 trillion dollar balance sheet, which could result in higher interest rates as well. However, there was no indication that the Fed would alter its current posture of tightening monetary policy at future meetings. Peoples is closely monitoring interest rates, both foreign and domestic, and potential impacts of changes in interest rates to Peoples Bank’s operations. The impact of these transactions, where material, is discussed in the applicable sections of this Management’s Discussion and Analysis of Financial Condition and Results of Operations. Critical Accounting Policies The accounting and reporting policies of Peoples conform to US GAAP and to general practices within the financial services industry. A summary of significant accounting policies is contained in Note 1 of the Notes to the Consolidated Financial Statements. While all of these policies are important to understanding the Consolidated Financial Statements, certain accounting policies require management to exercise judgment and make estimates or assumptions that affect the amounts reported in the Consolidated Financial Statements and accompanying Notes. These estimates and assumptions are based on information available as of the date of the Consolidated Financial Statements; accordingly, as this information changes, the Consolidated Financial Statements could reflect different estimates or assumptions. Management has identified the accounting policies described below as those that, due to the judgments, estimates and assumptions inherent in the policies, are critical to an understanding of Peoples' Consolidated Financial Statements and Management's Discussion and Analysis of Financial Condition and Results of Operations. Revenue Recognition Peoples recognizes revenues as they are earned based on contractual terms, or as services are provided and collectability is reasonably assured. Peoples’ principal source of revenue is interest income, which is recognized on an accrual basis primarily according to formulas in written contracts, such as loan agreements or securities contracts. As of January 1, 2018, Accounting Standards Update ("ASU") 2014-09 - Revenue from Contracts with Customers (Topic 606) updates the guidance for revenue recognition as it relates to uncompleted contracts. For further information on this updated guidance, refer to Note 1 of the Notes to the Consolidated Financial Statements. Interest Income Recognition Interest income on loans and investment securities is recognized by methods that result in level rates of return on principal amounts outstanding, including yield adjustments resulting from the amortization of loan costs and premiums on investment securities and accretion of loan fees and discounts on investment securities. Since mortgage-backed securities comprise a sizable portion of Peoples' investment portfolio, a significant increase in principal payments on those securities could impact interest income due to the corresponding acceleration of premium amortization or discount accretion. Peoples discontinues the accrual of interest on a loan when conditions cause management to believe collection of all or any portion of the loan's contractual interest is doubtful. Such conditions may include the borrower being 90 days or more past due on any contractual payments or current information regarding the borrower's financial condition and repayment ability. All unpaid accrued interest deemed uncollectable is reversed, which would reduce Peoples' net interest income. Interest received on nonaccrual loans is included in income only if principal recovery is reasonably assured. Allowance for Loan Losses In general, determining the amount of the allowance for loan losses requires significant judgment and the use of estimates by management. Peoples maintains an allowance for loan losses based on a quarterly analysis of the loan portfolio and estimation of the losses that are probable of occurrence within the loan portfolio. This formal analysis determines an appropriate level and allocation of the allowance for loan losses among loan types and the resulting provision for or recovery of loan losses by considering factors affecting losses, including specific losses, levels and trends in impaired and nonperforming loans; historical loan loss experience; current national and local economic conditions; volume; growth and composition of the portfolio; regulatory guidance and other relevant factors. Management continually monitors the loan portfolio through Peoples Bank's Credit Administration Department and Loan Loss Committee to evaluate the appropriateness of the allowance. The provision or recovery could increase or decrease each quarter based upon the results of management's formal analysis. The amount of the allowance for loan losses for the various loan types represents management's estimate of probable losses from existing loans. Management evaluates lending relationships deemed to be impaired on an individual basis and makes specific allocations of the allowance for loan losses for each relationship based on discounted cash flows using the loan's initial effective interest rate or the fair value of the collateral for certain collateral dependent loans. For all other loans, management evaluates pools of homogeneous loans (such as residential mortgage loans, and direct and indirect consumer loans) and makes general allocations for each pool based upon historical loss experience, adjusted for qualitative factors. While allocations are made to specific loans and pools of loans, the allowance is available for all loan losses. The evaluation of individual impaired loans requires management to make estimates of the amounts and timing of future cash flows on impaired loans, which consist primarily of loans placed on nonaccrual status, restructured or internally classified as substandard or doubtful. These reviews are based upon specific quantitative and qualitative criteria, including the size of the loan, the loan cash flow characteristics, the loan quality ratings, the value of collateral, the repayment ability of the borrower, and historical experience factors. Allowances for homogeneous loans are evaluated based upon historical loss experience, adjusted for qualitative risk factors, such as trends in losses and delinquencies, growth of loans in particular markets, and known changes in economic conditions in each lending market. As part of the process of identifying the pools of homogenous loans, management takes into account any concentrations of risk within any portfolio segment, including any significant industrial concentrations. Consistent with the evaluation of allowances for homogenous loans, the allowance relating to the Overdraft Privilege program is based upon management's monthly analysis of accounts in the program. This analysis considers factors that could affect losses on existing accounts, including historical loss experience and length of overdraft. There can be no assurance that the allowance for loan losses will be adequate to cover all losses, but management believes the allowance for loan losses at December 31, 2017 was adequate to provide for probable losses from existing loans based on information currently available. While management uses available information to estimate losses, the ultimate collectability of a substantial portion of the loan portfolio, and the need for future additions to the allowance, will be based on changes in economic conditions and other relevant factors. As such, adverse changes in economic activity could reduce currently estimated cash flows for both commercial and individual borrowers, which would likely cause Peoples to experience increases in problem assets, delinquencies and losses on loans in the future. Investment Securities Peoples' investment portfolio accounted for 24.4% and 25.0% of total assets at December 31, 2017, and December 31, 2016, respectively, of which approximately 90.9% of the securities were classified as available-for-sale as of December 31, 2017. Correspondingly, Peoples carries these securities at fair value on its Consolidated Balance Sheets, with any unrealized gain or loss recorded in stockholders' equity as a component of accumulated other comprehensive income or loss. As a result, Peoples' Consolidated Balance Sheet may be sensitive to changes in the overall market value of the investment portfolio, due to changes in market interest rates, investor confidence and other factors affecting market values. Per ASU 2016-01, beginning in 2018, fluctuations in the market value of equity investment securities will be recognized in the income statement. Peoples' remaining positions in equity investment securities could pose some volatility in future quarters, depending on their respective market values at the end of future reporting periods. While temporary changes in the fair value of available-for-sale securities are not recognized in earnings, Peoples is required to evaluate all investment securities with an unrealized loss on a quarterly basis to identify potential other-than-temporary impairment (“OTTI”) losses. This analysis requires management to consider various factors that involve judgment and estimation, including the duration and magnitude of the decline in value, the financial condition of the issuer or pool of issuers, and the structure of the security. Under current US GAAP, an OTTI loss is recognized in earnings only when (1) Peoples intends to sell the investment security; (2) it is more likely than not that Peoples will be required to sell the investment security before recovery of its amortized cost basis; or (3) Peoples does not expect to recover the entire amortized cost basis of the investment security. In situations where Peoples intends to sell, or when it is more likely than not that Peoples will be required to sell the investment security, the entire OTTI loss must be recognized in earnings. In all other situations, only the portion of the OTTI losses representing the credit loss must be recognized in earnings, with the remaining portion being recognized in stockholders' equity as a component of accumulated other comprehensive income or loss, net of deferred taxes. Management performed its quarterly analysis of the investment securities with an unrealized loss at December 31, 2017, and concluded no individual securities were other-than-temporarily impaired. Peoples has not recognized an OTTI loss in 2017, 2016 or 2015. Goodwill and Other Intangible Assets Peoples records goodwill and other intangible assets as a result of acquisitions accounted for under the acquisition method of accounting. Under the acquisition method, Peoples is required to allocate the consideration paid for an acquired company to the assets acquired, including identified intangible assets, and liabilities assumed based on their estimated fair values at the date of acquisition. Goodwill represents the excess cost over the fair value of net assets acquired and is not amortized but is tested for impairment when indicators of impairment exist, and, in any case, at least annually. Peoples' other intangible assets consist of customer relationship intangible assets, including core deposit intangibles, representing the present value of future net income to be earned from acquired customer relationships with definite useful lives, which are required to be amortized over their estimated useful lives. The value of recorded goodwill is supported ultimately by revenue that is driven by the volume of business transacted and Peoples' ability to provide quality, cost-effective services in a competitive market place. A decline in earnings as a result of a lack of growth or the inability to deliver cost-effective services over sustained periods can lead to impairment of goodwill that could adversely impact earnings in future periods. Potential goodwill impairment exists when the fair value of the reporting unit (as defined by US GAAP) is less than its carrying value. An impairment loss is recognized in earnings only when the carrying amount of goodwill is less than its implied fair value. The process of evaluating goodwill for impairment involves highly subjective and complex judgments, estimates and assumptions regarding the fair value of Peoples' reporting unit and, in some cases, goodwill itself. As a result, changes to these judgments, estimates and assumptions in future periods could result in materially different results. Peoples currently maintains a single reporting unit for goodwill impairment testing. While quoted market prices exist for Peoples' common shares since they are publicly traded, these market prices do not necessarily reflect the value associated with gaining control of an entity. Thus, management takes into account all appropriate fair value measurements in determining the estimated fair value of the reporting unit. The measurement of any actual impairment loss requires management to calculate the implied fair value of goodwill by deducting the fair value of all tangible and separately identifiable intangible net assets (including unrecognized intangible assets) from the fair value of the reporting unit. The fair value of net tangible assets is calculated using the methodologies described in Note 2 of the Notes to the Consolidated Financial Statements. Peoples performs its required annual impairment test as of October 1st each year. Peoples first assesses qualitative factors to determine whether it is more likely than not that the fair value of the reporting unit is less than its carrying amount, including goodwill. In this evaluation, Peoples assesses relevant events and circumstances, which may include macroeconomic conditions, industry and market conditions, cost factors, overall financial performance, events specific to Peoples, significant changes in the reporting unit, or a sustained decrease in stock price. If Peoples determines that it is more likely than not that the fair value of the reporting unit is greater than its carrying amount, then performing the two-step impairment test is unnecessary. However, if there are indicators of impairment, Peoples must complete a two-step process that includes (1) determining if potential goodwill impairment exists and (2) measuring the impairment loss, if any. Under ASU 2017-04, step (2) of the current impairment test will be eliminated effective January 1, 2020. Under the amendment, the annual or interim goodwill impairment test will compare the fair value of a reporting unit with its carrying amount. An impairment charge would be recorded if the carrying amount exceeds the reporting unit’s fair value, but the loss recognized cannot exceed the total amount of goodwill allocated to that reporting unit. At October 1, 2017, management's qualitative analysis concluded that the estimated fair value of Peoples' single reporting unit exceeded its carrying value. Peoples is required to perform interim tests for goodwill impairment in subsequent quarters if events occur or circumstances change that indicate potential goodwill impairment exists, such as adverse changes to Peoples' business or a significant decline in Peoples' market capitalization. For further information regarding goodwill, refer to Note 6 of the Notes to the Consolidated Financial Statements. Peoples records servicing rights (“SRs”) in connection with its mortgage banking, small business and agricultural lending activities, which are intangible assets representing the right to service loans sold to third-party investors. These intangible assets are recorded initially at fair value and subsequently amortized over the estimated life of the loans sold. SRs are stratified based on their predominant risk characteristics and assessed for impairment at the strata level at each reporting date based on their fair value. At December 31, 2017, management concluded no portion of the recorded SRs was impaired since the fair value equaled or exceeded the carrying value. However, future events, such as a significant increase in prepayment speeds, could result in a fair value that is less than the carrying amount, which would require the recognition of an impairment loss in earnings. Income Taxes Income taxes are recorded based on the liability method of accounting, which includes the recognition of deferred tax assets and liabilities for the temporary differences between carrying amounts and tax bases of assets and liabilities, computed using enacted tax rates. In general, Peoples records deferred tax assets when the event giving rise to the tax benefit has been recognized in the Consolidated Financial Statements. A valuation allowance is recognized to reduce any deferred tax asset when, based upon available information, it is more-likely-than-not all, or any portion, of the deferred tax asset will not be realized. Assessing the need for, and amount of, a valuation allowance for deferred tax assets requires significant judgment and analysis of evidence regarding realization of the deferred tax assets. In most cases, the realization of deferred tax assets is dependent upon Peoples generating a sufficient level of taxable income in future periods, which can be difficult to predict. Peoples' largest deferred tax assets involve differences related to Peoples' allowance for loan losses and accrued employee benefits. Management determined a valuation allowance of $805,000 at December 31, 2017, and $1.3 million at December 31, 2016, to be recorded against the deferred tax assets associated with its investment in a partnership investment. The decrease in the valuation from the previous year was due to the recently-enacted Tax Cuts and Jobs Act which reduced the tax rate from 35% to 21%. No other valuation allowances were recorded at either December 31, 2017 or 2016. The calculation of tax liabilities is complex and requires the use of estimates and judgment since it involves the application of complex tax laws that are subject to different interpretations by Peoples and the various tax authorities. Peoples' interpretations are subject to challenge by the tax authorities upon audit or to reinterpretation based on management's ongoing assessment of facts and evolving case law. From time-to-time and in the ordinary course of business, Peoples is involved in inquiries and reviews by tax authorities that normally require management to provide supplemental information to support certain tax positions taken by Peoples in its tax returns. Uncertain tax positions are initially recognized in the Consolidated Financial Statements when it is more likely than not the position will be sustained upon examination by the tax authorities. Such tax positions are initially and subsequently measured as the largest amount of tax benefit that is greater than 50% likely of being realized upon ultimate settlement with the tax authority assuming full knowledge of the position and all relevant facts. The amount of unrecognized tax benefits was immaterial at both December 31, 2017 and 2016. Management believes it has taken appropriate positions on its tax returns, although the ultimate outcome of any tax review cannot be predicted with certainty. Consequently, no assurance can be given that the final outcome of these matters will not be different than what is reflected in the current and historical financial statements. Fair Value Measurements As a financial services company, the carrying value of certain financial assets and liabilities is impacted by the application of fair value measurements, either directly or indirectly. In certain cases, an asset or liability is measured and reported at fair value on a recurring basis, such as available-for-sale investment securities. In other cases, management must rely on estimates or judgments to determine if an asset or liability not measured at fair value warrants an impairment write-down or whether a valuation reserve should be established. Given the inherent volatility, the use of fair value measurements may have a significant impact on the carrying value of assets or liabilities, or result in material changes to the consolidated financial statements, from period to period. Detailed information regarding fair value measurements can be found in Note 2 of the Notes to the Consolidated Financial Statements. The following is a summary of those assets and liabilities that may be affected by fair value measurements, as well as a brief description of the current accounting practices and valuation methodologies employed by Peoples: Available-for-Sale Investment Securities Investment securities classified as available-for-sale are measured and reported at fair value on a recurring basis. For most securities, the fair value is based upon quoted market prices (Level 1) or determined by pricing models that consider observable market data (Level 2). For structured investment securities, the fair value often must be based upon unobservable market data, such as non-binding broker quotes and discounted cash flow analysis or similar models, due to the absence of an active market for these securities (Level 3). As a result, management's determination of fair value for these securities is highly dependent on subjective and complex judgments, estimates and assumptions, which could change materially between periods. Management occasionally uses information from independent third-party consultants in its determination of the fair value of more complex structured investment securities. At December 31, 2017, all of Peoples' available-for-sale investment securities were measured using observable market data. At December 31, 2017, the majority of the investment securities with Level 2 fair values were determined using information provided by third-party pricing services. Management reviews the valuation methodology and quality controls utilized by the pricing services in management's overall assessment of the reasonableness of the fair values provided. To the extent available, management utilizes an independent third-party pricing source to assist in its assessment of the values provided by its primary pricing services. Management reviews the fair values provided by these third parties on a quarterly basis and challenges prices when it believes a discrepancy in pricing exists. Based on Peoples' past experience, no discrepancies were noted related to current pricing and values. Impaired loans For loans considered impaired, the amount of impairment loss recognized is determined based on a discounted cash flow analysis or the fair value of the underlying collateral if repayment is expected solely from the sale of the collateral. Management typically relies on the fair value of the underlying collateral due to the significant uncertainty surrounding the borrower's ability to make future payments. The vast majority of the collateral securing impaired loans is real estate, although the collateral may also include accounts receivable and equipment, inventory or similar personal property. The fair value of the collateral used by management represents the estimated proceeds to be received from the sale of the collateral, less costs incurred during the sale, based upon observable market data or market value data provided by independent, licensed or certified appraisers. Servicing Rights SRs are carried at the lower of amortized cost or market value, and, therefore, can be subject to fair value measurements on a nonrecurring basis. SRs do not trade in an active market with readily observable prices. Thus, management determines fair value based upon a valuation model that calculates the present value of estimated future net servicing income provided by an independent third-party consultant. This valuation model is affected by various input factors, such as servicing costs, expected prepayment speeds and discount rates, which are subject to change between reporting periods. As a result, significant changes to these factors could result in a material change to the calculated fair value of SRs. To determine the fair value of its SRs each reporting quarter, Peoples provides loan information accompanied by escrow amounts to a third-party valuation firm. The third-party valuation firm then evaluates the possible impairment of SRs as described below. Loans are evaluated on a discounted earnings basis to determine the present value of future earnings that Peoples expects to realize from the portfolio. Earnings are projected from a variety of sources including loan service fees, net interest earned on escrow balances, miscellaneous income and costs to service the loans. The present value of future earnings is the estimated fair value, calculated using consensus assumptions that a third-party purchaser would utilize in evaluating a potential acquisition of the SRs. Events that may significantly affect the estimates used are changes in interest rates and the related impact on mortgage loan prepayment speeds, and the payment performance of the underlying loans. Peoples believes this methodology provides a reasonable estimate. Mortgage loan prepayment estimates were determined through the application of the current dealer projected prepayment rates by product type and interest rate as published by Bloomberg, L.P. as of January 3, 2018, and adjusted for historical prepayment factors based on state, type of servicing, year of origination, and pass through coupon. The adjustable rate mortgage loan prepayment estimates were determined through the application of market trading assumptions as of January 3, 2018, and adjusted for historical prepayment factors based on state, type of servicing, year of origination, and pass through coupon. These earnings are used to calculate the approximate cash flow that could be received from the servicing portfolio. Valuation results are provided quarterly to Peoples. At that time, Peoples reviews the information and SRs are marked to the lower of amortized cost or fair value for the current quarter. Cash flow hedges Cash flow hedges are carried at fair value on Peoples' Consolidated Balance Sheets. Cash flow hedges do not trade in an active market with readily observable prices. Management determines the fair value of cash flow hedges based on third-party pricing, which is driven by changes in market interest rates. As of December 31, 2017, the fair value of the cash flow hedges, based on market interest rates, resulted in an asset of $1.4 million. EXECUTIVE SUMMARY Net income for the year ended December 31, 2017 was $38.5 million, compared to $31.2 million in 2016 and $10.9 million in 2015, representing earnings per diluted common share of $2.10, $1.71 and $0.61, respectively. The increase in earnings during 2017 was driven by an increase of $8.5 million in net interest income, coupled with investment security gains of $3.0 million. These increases were partially offset by an $0.9 million write-down of net deferred tax assets in connection with the recently-enacted Tax Cuts and Jobs Act, $0.3 million of acquisition-related costs and $0.2 million of pension settlement charges. In 2016, earnings benefited from a $10.7 million decrease in acquisition-related costs and a $10.6 million decrease in provision for loan losses compared to 2015, which was partially offset by costs related to the conversion of Peoples' core banking system of $1.3 million. In 2017, Peoples recorded provision for loan losses of $3.8 million, an increase of $0.2 million compared to the $3.5 million that was recorded in 2016. The increase in 2017 from 2016 was driven primarily by loan growth. Peoples recorded net charge-offs of $3.4 million compared to $1.9 million for 2017 and 2016, respectively. The increase in net charge-offs during 2017 was primarily related to commercial real estate loans, indirect consumer loans and deposit account overdrafts. The provision for loan losses represented amounts needed, in management's opinion, to maintain the appropriate level of the allowance for loan losses. Net charge-offs as a percent of annualized average total loans were 0.15% during 2017, compared to 0.09% in 2016. Net interest income grew 8% to $113.4 million in 2017, and 7% to $104.9 million in 2016, mostly due to loan growth and the increase in current rates on variable interest rate loans. Net interest margin was 3.62% in 2017, an increase from 3.54% in 2016 and 3.53% in 2015. Accretion income, net of amortization expense, from acquisitions added approximately 10 basis points to net interest margin in 2017 compared to 11 basis points in 2016 and 17 basis points in 2015. In 2017, proceeds of $0.8 million received on an investment security that had been previously written down due to an other-than-temporary impairment, added 3 basis points to the net interest margin. The increase in net interest margin in 2017 compared to 2016 was mostly due to the increase in loan yields associated with increasing interest rates. Total non-interest income increased 9% in 2017 compared to 2016. The increase in 2017 compared to 2016 was primarily due to the gain on investment securities, coupled with increases in trust and investment income, mortgage banking income, and bank owned life insurance income. These increases were partially offset by a decrease in deposit account service charges. The increase in trust and investment income was due largely to the growth in the value of assets under administration and management. Mortgage banking income increased due to customer demand. The increase in bank owned life insurance income was the result of the additional $35.0 million of bank owned life insurance policies that were purchased late in the second quarter of 2016, for which a full year of income was recognized in 2017. Total non-interest income increased 10% in 2016 compared to 2015, and was due to increases in electronic banking income, trust and investment income, bank owned life insurance income and commercial loan swap fee income, with a portion of the growth attributable to the NB&T acquisition. The increase in electronic banking income was the result of the increased usage of debit cards by more customers. The increase in trust and investment income was due largely to growth in assets under administration and management, and the full year effect of the NB&T acquisition. The increase in bank owned life insurance income was the result of the additional $35.0 million of bank owned life insurance policies that were purchased late in the second quarter of 2016. Commercial loan swap fee income is dependent upon customers' preference for fixed versus variable interest rate loans, which leads to variability in this income stream. Total non-interest expense increased 1% during 2017, largely due to higher salaries and benefit costs, driven by increased incentive compensation which was tied to corporate performance for 2017. These increases were coupled with increased medical insurance costs and pension settlement charges recognized in 2017. These increases were partially offset by declines in professional fees, communications expense, amortization of other intangible assets and the $1.3 million of core banking system conversion costs that were incurred in 2016. In 2016, total non-interest expense decreased 7%, or $8.2 million, compared to 2015 due largely to no acquisition-related expenses recorded in 2016 compared to $10.7 million in 2015. The decrease was partially offset by the full-year effect of operating expenses associated with the NB&T acquisition, and increased salaries and employee benefits due to higher incentive compensation earned under the corporate incentive plan. At December 31, 2017, total assets were up 4%, or $149.3 million, to $3.58 billion versus $3.43 billion at year-end 2016. The increase was primarily related to an increase of 6% in loan balances. The allowance for loan losses increased slightly to $18.8 million, or 0.80% of total loans, net of deferred fees and costs, compared to $18.4 million and 0.83% at December 31, 2016. Total liabilities were $3.12 billion at December 31, 2017, up $126.0 million since December 31, 2016. At December 31, 2017, total borrowed funds were $353.5 million, down $97.3 million compared to the prior year-end. Total demand deposits increased $136.0 million, or 13%, and were 42% of total deposits at December 31, 2017 compared to 40% at December 31, 2016. Shifts in balances occurred between non-interest-bearing deposits and interest-bearing demand account balances as consumers were migrated to new products during the second half of 2017. This migration resulted in interest bearing demand deposits increasing $314.4 million, or 113%, and non-interest-bearing deposits decreasing $178.4 million, or 24% . Total certificates of deposit ("CDs") at December 31, 2017 increased $97.7 million, or 24%, compared to December 31, 2016. The increases in total deposits were used to reduce borrowings, and fund loan growth and investment purchases. At December 31, 2017, total stockholders' equity was $458.6 million, up 5%, or $23.3 million, from December 31, 2016. The increase was primarily due to 2017 earnings of $38.5 million, which were partially offset by dividends of $15.3 million and the reductions in the market value of investment securities. Peoples' regulatory capital ratios remained significantly higher than "well capitalized" minimums, and were positively impacted during 2017 from earnings exceeding dividends paid. Peoples' tier 1 capital ratio increased to 13.74% at December 31, 2017, versus 13.21% at December 31, 2016, while the total capital ratio was 14.62% versus 14.11% at December 31, 2016. The common equity tier 1 risk-based capital ratio was 13.45% at December 31, 2017 compared to 12.91% at December 31, 2016. In addition, Peoples' book value per share was $25.08 at December 31, 2017. Peoples' tangible book value per share was $17.17 at December 31, 2017, and its tangible equity to tangible assets ratio was 9.14%, versus $15.89 and 8.80% at December 31, 2016, respectively. Additional information regarding capital requirements can be found in Note 15 of the Notes to the Consolidated Financial Statements. RESULTS OF OPERATIONS Interest Income and Expense Peoples earns interest income on loans and investments and incurs interest expense on interest-bearing deposits and borrowed funds. Net interest income, the amount by which interest income exceeds interest expense, remains Peoples' largest source of revenue. The amount of net interest income earned by Peoples is affected by various factors, including changes in market interest rates due to the Federal Reserve Board's monetary policy, the level and degree of pricing competition for both loans and deposits in Peoples' markets, and the amount and composition of Peoples' earning assets and interest-bearing liabilities. Peoples monitors net interest income performance and manages its balance sheet composition through regular ALCO meetings. The asset-liability management process employed by the ALCO is intended to mitigate the impact of future interest rate changes on Peoples' net interest income and earnings. However, the frequency and/or magnitude of changes in market interest rates are difficult to predict, and may have a greater impact on net interest income than adjustments management is able to make. The following table details Peoples’ average balance sheets for the years ended December 31: (a) Average balances are based on carrying value. (b) Interest income and yields are presented on a fully tax-equivalent basis using a 35% federal tax rate. (c) Interest income and yield presented for 2017 include $0.8 million of proceeds on an investment security for which an other-than-temporary-impairment had previously been recorded. (d) Average balances include nonaccrual, impaired loans, and loans held for sale. Interest income includes interest earned and received on nonaccrual loans prior to the loans being placed on nonaccrual status. Loan fees included in interest income were immaterial for all periods presented. (e) Loans held for sale are included in the average loan balance listed. Related interest income on loans originated for sale prior to the loan being sold is included in loan interest income. The following table provides an analysis of the changes in fully tax-equivalent (“FTE”) net interest income: (1) The change in interest due to both rate and volume has been allocated to rate and volume changes in proportion to the relationship of the dollar amounts of the changes in each. (2) Interest income and yields are presented on a fully tax-equivalent basis using a 35% federal tax rate. As part of the analysis of net interest income, management converts tax-exempt income earned on obligations of states and political subdivisions to the pre-tax equivalent of taxable income using a federal income tax rate of 35%. Management believes the resulting FTE net interest income allows for a more meaningful comparison of tax-exempt income and yields to their taxable equivalents. Net interest margin, which is calculated by dividing FTE net interest income by average interest-earning assets, serves as an important measurement of the net revenue stream generated by the volume, mix and pricing of earning assets and interest-bearing liabilities. As of January 1, 2018, the Tax Cuts and Jobs Act was enacted and as a result, beginning on January 1, 2018, Peoples will use a federal income tax rate of 21%. The following table details the calculation of FTE net interest income for the years ended December 31: During 2017, Peoples recognized accretion income, net of amortization expense, from acquisitions of $3.1 million, which added approximately 10 basis points to net interest margin, compared to $3.5 million and 11 basis points in 2016, and $4.8 million and 17 basis points in 2015. During 2017, proceeds of $814,000 were received on an investment security that had been previously written down due to an other-than-temporary impairment, which added three basis points to the net interest margin. Additional interest income in 2017 from prepayment fees and interest recovered on nonaccrual loans was $826,000, compared to $964,000 in 2016 and $591,000 in 2015. The primary driver of the increase in net interest income during the past two years has been the higher loan balances resulting from organic growth. During 2017, net interest income also benefited from increases in interest rates. The comparison of the income statement and average balance sheet results between 2015 and 2016 was affected by the NB&T acquisition, which closed on March 6, 2015. Funding costs increased in 2017 as the Federal Reserve raised the benchmark Federal Funds Target Rate by 25 basis points in each of December of 2016 and March, June and December of 2017. These rate increases drove higher loan yields which outpaced increases in deposit and short-term funding costs in 2017. In 2016, funding costs decreased three basis points due to the deployment of excess cash on the balance sheet to interest bearing investment portfolio and paying off debt. Detailed information regarding changes in the Consolidated Balance Sheets can be found under appropriate captions of the “FINANCIAL CONDITION” section of this discussion. Additional information regarding Peoples' interest rate risk and the potential impact of interest rate changes on Peoples' results of operations and financial condition can be found later in this discussion under the caption “Interest Rate Sensitivity and Liquidity.” Provision for Loan Losses The following table details Peoples’ provision for loan losses recognized for the years ended December 31: The provision for loan losses represents the amount needed to maintain the appropriate level of the allowance for loan losses based on management’s formal quarterly analysis of the loan portfolio and procedural methodology that estimates the amount of probable credit losses. This process considers various factors that affect losses, such as changes in Peoples’ loan quality, historical loss experience and current economic conditions. The provision for loan losses recorded in 2017 and 2016 was driven by loan growth and stable asset quality trends. The provision for loan losses recorded in 2015 was primarily due to the charge-off of one large commercial loan relationship, coupled with organic loan growth and increases in criticized loans. Additional information regarding changes in the allowance for loan losses and loan credit quality can be found later in this discussion under the caption “Allowance for Loan Losses.” Net Loss on Asset Disposals and Other Transactions The following table details the net loss on asset disposals and other transactions for the years ended December 31 recognized by Peoples: The net gain on bank premises and equipment during 2017 was due to the sale of a previously closed branch which was offset partially by a loss on the sale of a parking lot that was no longer being utilized. The net loss on OREO was a result of the sale of two commercial properties during 2017. The net gain on other assets was primarily due to a net gain on repossessed assets. The net loss on debt extinguishment in 2016 was due to the prepayment of $20.0 million of long-term FHLB advances. The net loss on bank premises and equipment during 2016 was due mainly to the closing of a leased office and related disposal of leasehold improvements. The net loss on other assets during 2016 was related to the write-down of an investment made in an asset that had a corresponding tax benefit to Peoples. The net loss on OREO during 2015 was due mainly to the sale of six OREO properties and the write-down of four OREO properties during the period. During the first quarter of 2015, Peoples recognized a loss on debt extinguishment from the prepayment of several FHLB advances. The losses on bank premises and equipment in 2015 were primarily associated with acquisition-related activity. The remaining net loss on bank premises and equipment in 2015 was attributable to the write-off of obsolete fixed assets and the write-down of closed office locations that were for sale. Non-Interest Income Peoples generates non-interest income, excluding gains and losses on investments and other assets, from four primary sources: insurance income; deposit account service charges; trust and investment income; and electronic banking income (“e-banking”). Peoples continues to focus on revenue growth from non-interest income sources in order to maintain a diversified revenue stream through greater reliance on fee-based revenues. As a result, total non-interest income accounted for 31.7% of Peoples' total revenues in 2017 compared to 32.8% in 2016. The slight decline in Peoples' total non-interest income as a percent of total revenue during 2017 from 2016 was primarily due to increased net interest income resulting from loan growth. Insurance income comprised the largest portion of Peoples' non-interest income. The following table details Peoples’ insurance income for the years ended December 31: The majority of performance-based commissions typically are recorded annually in the first quarter and are based on a combination of factors, such as loss experience of insurance policies sold, production volumes, and overall financial performance of the individual insurance carriers. The increase in other fees and charges was due to the acquisition of a third-party insurance administration company that occurred in January 2017. Peoples' fiduciary and brokerage revenues continue to be based primarily upon the value of assets under administration and management. The following table details Peoples’ trust and investment income for the years ended December 31: The following table details Peoples’ assets under administration and management at year-end December 31: During 2017 and 2016, the increases in fiduciary and brokerage revenues were primarily due to the increase in assets under administration and management and retirement benefits plans, which includes the impact related to the acquisition of NB&T in 2015, coupled with a fee increase implemented during 2016. The U.S. financial markets have also had a positive impact on assets under administration and management. In recent years, Peoples has added experienced financial advisors in previously underserved market areas, and generated new business and revenue related to retirement plans for which it manages the assets and provides services. Deposit account service charges, which are based on the recovery of costs associated with services provided, comprised a significant portion of Peoples' non-interest income. The following table details Peoples' deposit account service charges for the years ended December 31: The amount of deposit account service charges, particularly fees for overdrafts and non-sufficient funds, is largely dependent on the timing and volume of customer activity. Management periodically evaluates its cost recovery fees to ensure they are reasonable based on operational costs and similar to fees charged in Peoples' markets by competitors. The yearly increases in account maintenance fees were the result of higher fees received on commercial and consumer checking accounts. The following table details the other items included within Peoples' total non-interest income for the years ended December 31: Peoples' e-banking services include ATM and debit cards, direct deposit services, internet and mobile banking, and remote deposit capture, and serve as alternative delivery channels to traditional sales offices for providing services to clients. The amount of e-banking is largely dependent on the timing and volume of customer activity. During 2017, e-banking income was essentially unchanged compared to 2016 and increased $1.4 million, or 16%, in 2016 compared to 2015. The increase in e-banking income in 2016 was the result of the increased usage of debit cards by more customers. In 2017, Peoples' customers used their debit cards to complete $729 million of transactions, versus $728 million in 2016 and $591 million in 2015. E-banking income during 2016 also benefited from the impact of additional customers and accounts related to the acquisition of NB&T. During 2017, bank owned life insurance income increased to $2.0 million, compared to $1.4 million in 2016. The increase in bank owned life insurance income was the result of the additional $35.0 million of bank owned life insurance policies that were purchased late in the second quarter of 2016, for which a full year was recognized in 2017. Mortgage banking income is comprised mostly of net gains from the origination and sale of long-term, fixed rate real estate loans in the secondary market, as well as servicing income for sold loans. As a result, the amount of income recognized by Peoples is largely dependent on customer demand and long-term interest rates for residential real estate loans offered in the secondary market. Mortgage banking income increased 43.6% in 2017, while decreasing 1% in 2016 due to customer demand and increased gain on sale of loans. In 2017, Peoples sold approximately $65.2 million of loans to the secondary market compared to $67.1 million in 2016 and $56.0 million in 2015. Non-Interest Expense Salaries and employee benefit costs remain Peoples’ largest non-interest expense, accounting for over half of the total non-interest expense. The following table details Peoples’ salaries and employee benefit costs for the years ended December 31: Sales-based and incentive compensation increased in 2017 largely due to higher incentive compensation, which was tied to corporate performance for 2017. Peoples' sales-based and incentive compensation plans are designed to grow core earnings while managing risk, and do not encourage unnecessary and excessive risk-taking that could threaten the value of Peoples. The sales-based and incentive compensation plans reward employees for appropriate behaviors and include provisions for inappropriate practices with respect to Peoples and its customers. Employee benefits also increased during 2017 from higher medical insurance costs and pension settlement charges recognized. The decrease in 2016 compared to 2015 was primarily due to severance payments of $4.3 million related to the NB&T acquisition in 2015, which were offset partially by yearly merit increases and costs associated with the core banking system conversion. The decrease in employee benefits in 2016 was partially due to no pension settlement charges being recognized in 2016, compared to $0.5 million in 2015. Effective March 1, 2011, Peoples froze the accrual of pension benefits, and since then, settlement charges have been largely based on the timing of retirements of plan participants and their election of lump-sum distributions. Under US GAAP, Peoples is required to recognize a settlement gain or loss when the aggregate amount of lump-sum distributions to participants equals or exceeds the sum of the service and interest cost components of the net periodic pension cost. The amount of settlement gain or loss recognized is the pro rata amount of the unrealized gain or loss existing immediately prior to the settlement. Management anticipates continued pension settlement charges in future years as plan participants retire and elect lump-sum distributions from the plan. Stock-based compensation is generally recognized over the vesting period, which can range from immediate vesting to three year vesting. For all awards, expense is initially only recognized for the portion of awards that is expected to vest, and at the vesting date, an adjustment is made to recognize the entire expense for vested awards and reverse expense for non-vested awards. The majority of Peoples' stock-based compensation expense is attributable to annual equity-based incentive awards to employees, which are awarded in the first quarter and based upon Peoples achieving certain performance goals during the prior year. During 2017, Peoples granted restricted common shares to officers and key employees with performance-based vesting periods and time-based vesting periods. Stock-based compensation expense recorded in 2017 related to the awards granted in 2017, for 2016 performance, was $993,000, compared to $209,000 recorded in 2016 related to awards granted for 2015 performance. The increase in expense in 2017 compared to 2016 was primarily due to the difference in Peoples' results between the years which resulted in more awards granted and expensed. The remaining expense was recognized for grants awarded in previous years. As it is probable that all outstanding performance-based vesting conditions will be satisfied, Peoples recorded the pro-rata expense for all outstanding performance-based awards in 2017, as required by US GAAP. Additional information regarding Peoples' stock-based compensation plans and awards can be found in Note 16 of the Notes to the Consolidated Financial Statements. Deferred personnel costs represent the portion of current period salaries and employee benefit costs considered to be direct loan origination costs. These costs are capitalized and recognized over the life of the loan as a yield adjustment to interest income. As a result, the amount of deferred personnel costs for each year corresponds directly with the level of new loan originations. Additional information regarding Peoples' loan activity can be found later in this discussion under the caption “Loans.” Peoples’ net occupancy and equipment expense for the years ended December 31 was comprised of the following: During 2017, depreciation decreased as assets became fully depreciated, branches were closed and new fixed asset purchases decreased. During 2016, depreciation increased as a full year of depreciation was recognized on the acquired NB&T offices, and office renovations that were completed in 2015. Repairs and maintenance costs, coupled with property taxes, utilities and other costs, declined during 2016, compared to 2015, as expenses recognized on the acquired offices decreased. Management continues to monitor capital expenditures and explore opportunities to enhance Peoples' operating efficiency. The following table details the other items included within Peoples' total non-interest expense for the years ended December 31: Peoples' e-banking expense, which is comprised of bankcard, internet and mobile banking costs, increased in 2016 and 2015 due to the addition of accounts related to acquisitions, customers completing a higher volume of transactions using their debit cards and Peoples' internet banking service. These factors also produced a greater increase in the corresponding e-banking revenues over the same periods. Data processing and software expense includes software support, maintenance and depreciation expense. These costs increased during 2017 due to the increase of software support and higher depreciation related to software and the core banking system conversion in late 2016, which provides additional customer services and capabilities. Peoples' amortization of other intangible assets is driven by acquisition-related activity. Amortization expense was $3.5 million in 2017, compared to $4.0 million and $4.1 million in 2016 and 2015, respectively. Peoples is subject to state franchise taxes, which are based largely on Peoples Bank's equity at year-end, in the states where Peoples Bank has a physical presence. Franchise taxes increased during 2017 and 2016 due to increases in equity and revenues. Peoples is subject to the Ohio Financial Institution Tax ("FIT") which is a business privilege tax that is imposed on financial institutions organized for profit and doing business in Ohio. The Ohio FIT is based on the total equity capital in proportion to the taxpayer's gross receipts in Ohio. Peoples' 2017 FDIC insurance costs decreased slightly from 2016 as assessment changes became effective July 1, 2016. The FDIC quarterly assessment rate is applied to average total assets less average tangible equity, and is based on leverage ratio, net income before taxes, nonperforming loans, OREO, loan mix and asset growth. Peoples experienced improvements in each of these categories during 2016 and 2017, leading to a reduction in the quarterly FDIC assessment rate, which offset increases in the expense that are attributable to the asset growth experienced during the last two years. Additional information regarding Peoples' FDIC insurance assessments may be found in "ITEM 1 BUSINESS" of this Form 10-K in the section captioned "Supervision and Regulation." The decrease in communication expense during 2017 compared to 2016 and 2015, resulted from the consolidation of traditional phone lines to a method of transmitting all voice traffic over the internet and the discontinuation of overlapping traditional phone line contracts that occurred during the transition. In 2017, marketing expense, which includes advertising, donation and other public relations costs, increased $120,000 from 2016. The increase was primarily due to increased donations to Peoples Bank Foundation, Inc. Peoples formed this private foundation in 2004 to make charitable contributions to organizations within Peoples' primary market area. Future contributions to Peoples Bank Foundation, Inc. will be evaluated on an annual basis, with the determination of the amount of any contribution based largely on the perceived level of need within the communities Peoples serves. Other non-interest expense decreased $181,000 in 2017 compared to 2016 and decreased $5.1 million in 2016 compared to 2015. During 2016, Peoples recorded $0.7 million of expense related to the core system conversion costs. Included in 2015 were $3.7 million of acquisition-related expenses. Income Tax Expense A key driver of the amount of income tax expense or benefit recognized by Peoples each year is the amount of pre-tax income. During the fourth quarter of 2017, income tax expense was impacted by the net deferred tax asset write-down as a result of recently-enacted Tax Cuts and Jobs Act. In addition to the expense recognized, Peoples receives tax benefits from municipal investments, bank owned life insurance and investments in tax credit funds, which reduce Peoples' effective tax rate. A reconciliation of Peoples' recorded income tax expense/benefit and effective tax rate to the statutory tax rate can be found in Note 12 of the Notes to the Consolidated Financial Statements. In 2017, Peoples recorded a tax benefit of $154,000 as the result of the adoption of ASU 2016-09, which became effective January 1, 2017. The tax benefit related to stock awards that settled or vested during the year, with the majority recorded in the first quarter of 2017. As of December 31, 2017, Peoples recorded a revaluation of its deferred tax assets and liabilities in light of the applicable provisions of the recently-enacted Tax Cuts and Jobs Act. Previously, Peoples had recognized its deferred tax assets and deferred tax liabilities at a federal income tax rate of 35%, and the new law required the use of a 21% federal income tax rate. As a result, Peoples wrote down its net deferred tax assets by $0.9 million, which had a direct impact on income tax expense recorded during 2017. Additionally, as of December 31, 2017, Peoples early adopted ASU 2018-02 Income Statement - Reporting Comprehensive Income (Topic 220): Reclassification of Certain Tax Effects from Accumulated Other Comprehensive Income and elected to reclassify from accumulated other comprehensive income to retained earnings the stranded income tax effects in accumulated other comprehensive loss resulting from the Tax Cuts and Jobs Act. Pre-Provision Net Revenue Pre-provision net revenue ("PPNR") has become a key financial measure used by federal bank regulatory agencies when assessing the capital adequacy of financial institutions. PPNR is defined as net interest income plus total fee-based income minus total non-interest expense and, therefore, excludes the provision for (recovery of) loan losses and all gains and/or losses included in earnings. As a result, PPNR represents the earnings capacity that can be either retained in order to build capital or used to absorb unexpected losses and preserve existing capital. The following table provides a reconciliation of this non-GAAP financial measure to the amounts of income before income taxes reported in Peoples' Consolidated Financial Statements for the periods presented: Peoples generated positive operating leverage for the full year of 2017, with 6% revenue growth outpacing expense growth of 1% compared to 2016. PPNR and the pre-provision net revenue to total average assets ratio increased compared to previous years due largely to the increase in revenue as a result of net interest income growth offset partially by a slight increase in total non-interest expenses. The increase in the PPNR in 2016 was primarily due to an increase in revenue as a result of net interest income growth coupled with a decrease in total non-interest expense. The increase in the PPNR in 2015 was primarily due to the completion of the NB&T acquisition and recognition of a full year of revenue for acquisitions completed during 2014, with the decrease in the pre-provision net revenue to total average assets ratio reflecting the increase in PPNR being offset by the increase of average assets, which also was reflective of the NB&T acquisition. Core Fee-Based Income and Expense Core fee-based income and core non-interest expense are financial measures used to evaluate Peoples' recurring revenue and expense streams. These measures are non-GAAP since they exclude the impact of all gains and/or losses, core banking system conversion revenue and costs, acquisition-related costs, pension settlement charges and other non-recurring expenses. The following tables provide reconciliations of these non-GAAP measures to the amounts reported in Peoples' Consolidated Financial Statements for the periods presented: Efficiency Ratio The efficiency ratio is a key financial measure used to monitor performance. The efficiency ratio is calculated as total non-interest expense (less amortization of other intangible assets) as a percentage of fully tax-equivalent net interest income plus total fee-based income, which excludes all gains and/or losses. This measure is non-GAAP since it excludes amortization of other intangible assets and all gains and/or losses included in earnings, and uses fully tax-equivalent net interest income. The following table provides a reconciliation of this non-GAAP financial measure to the amounts reported in Peoples' Consolidated Financial Statements for the periods presented: Peoples' efficiency ratio was 62.20% for 2017, compared to 65.13% for 2016 and 75.50% for 2015. During 2017, the decline in the efficiency ratio was driven by higher net interest income resulting from loan growth, increased fee-based income and controlled non-interest expenses. For the full year of 2017, the efficiency ratio, when adjusted for non-core items, was 61.85% compared to 64.30% in 2016. The continued decline in the adjusted efficiency ratio in recent years has been driven by acquisitions, coupled with the focus of growing revenues and controlling expenses. Managing expenses has been a major focus over the last two years, however, during this time Peoples has continued to make meaningful investments in its infrastructure and systems. FINANCIAL CONDITION Cash and Cash Equivalents Peoples considers cash and cash equivalents to consist of federal funds sold, cash and balances due from banks, interest-bearing balances in other institutions and other short-term investments that are readily liquid. The amount of cash and cash equivalents fluctuates on a daily basis due to customer activity and Peoples' liquidity needs. At December 31, 2017, excess cash reserves at the Federal Reserve Bank were $9.3 million, compared to $4.4 million at December 31, 2016. The amount of excess cash reserves maintained is dependent upon Peoples' daily liquidity position, which is driven primarily by changes in deposit and loan balances. In 2017, Peoples' total cash and cash equivalents increased $6.0 million, as cash provided by financing activities and operating activities of $107.9 million and $60.8 million, respectively, were partially offset by cash used of $162.7 million in investing activities. Cash used in investing activities was primarily due to funded loan growth of $130.4 million. The loan growth was partially funded by the increase of Peoples' financing activities of deposit growth of $220.6 million, which was offset by decreases of $97.5 million in short and long-term borrowings, and the increase in operating activities due to $38.5 million of net income. In 2016, Peoples' total cash and cash equivalents decreased $5.0 million, as $198.4 million of cash was used in investing activities, which was offset partially by operating activities of $60.3 million and $133.1 million of financing activities. Cash used in investing activities was primarily due to funded loan growth of $149.0 million. The loan growth was partially funded by the increase of Peoples' financing activities of short and long-term borrowings of $175.9 million, and the increase in operating activities due to $31.2 million of net income. Further information regarding the management of Peoples' liquidity position can be found later in this discussion under “Interest Rate Sensitivity and Liquidity.” Investment Securities The following table provides information regarding Peoples’ investment portfolio at December 31: At December 31, 2017, Peoples' investment securities were approximately 24.4% of total assets compared to 25.0% at December 31, 2016. Although Peoples' investment securities as a percentage of total assets declined during 2017, compared to 2016, the total investment portfolio increased largely due to purchases of residential mortgage-backed securities, which was partially offset by principal paydowns. In 2015, Peoples acquired $156.4 million of investment securities as part of the NB&T acquisition, with the remaining fluctuation due to purchases being more than offset by principal paydowns, sales, calls and maturities. In 2014, Peoples acquired $69.7 million of available-for-sale investment securities, and retained approximately $11.9 million, with the remainder being sold. Peoples designates certain securities as "held-to-maturity" at the time of their purchase if management determines Peoples would have the ability to hold certain purchased securities until maturity. The unrealized gain or loss related to held-to-maturity securities does not directly impact total stockholders' equity, in contrast to the impact from the available-for-sale securities portfolio. Peoples' investment in residential and commercial mortgage-backed securities largely consists of securities either guaranteed by the U.S. government or issued by U.S. government sponsored agencies, such as Fannie Mae and Freddie Mac. The remaining portions of Peoples' mortgage-backed securities consist of securities issued by other entities, including other financial institutions, which are not guaranteed by the U.S. government. The amount of these “non-agency” securities included in the residential mortgage-backed securities totals above was as follows at December 31: Management continues to reinvest the principal runoff from the non-agency securities in U.S. agency investments, which has accounted for the continued decline in the fair value of these securities. At December 31, 2017, Peoples' non-agency portfolio consisted entirely of first lien residential mortgages, with nearly all of the underlying loans in these securities originated prior to 2004 and possessing fixed interest rates. Management continues to monitor the non-agency portfolio closely for leading indicators of increasing stress and will continue to be proactive in taking actions to mitigate such risk when necessary. Additional information regarding Peoples' investment portfolio can be found in Note 3 of the Notes to the Consolidated Financial Statements. Loans The following table provides information regarding outstanding loan balances at December 31: (a)Includes all loans acquired, and related loan discount recorded as part of acquisition accounting, in 2012 and thereafter. (b)Not meaningful As of December 31, 2017, total loans grew 6%, or $132.2 million. The increase was primarily the result of commercial loan growth of $95.5 million, or 8%, which includes commercial real estate and commercial and industrial loan balances. Additionally, indirect consumer lending had growth of $87.9 million, or 35%, compared to December 31, 2016, and was partially offset by reductions in residential real estate loans. During 2016, total loans grew 7%, or $152.5 million, with growth of 8% in commercial loan balances and 7% in consumer loan balances. Indirect consumer lending experienced the largest growth across all loan categories for the year, increasing by $85.7 million, or 51%. Commercial and industrial loan growth was $70.6 million, or 20%, for the year. During 2015, total originated loans (excluding acquired loans) grew 17%, or $202.6 million, due to increases in all categories except deposit account overdrafts. Consumer loan balances, which consist mostly of loans to finance automobile purchases, have continued to increase in recent years due largely to Peoples placing greater emphasis on its consumer lending activity. The increase in total acquired loans in 2015 was due to the NB&T acquisition. The following table details the maturities of Peoples' commercial real estate and commercial and industrial loans at December 31, 2017: Loan Concentration Peoples categorizes its commercial loans according to standard industry classifications and monitors for concentrations in a single industry or multiple industries that could be impacted by changes in economic conditions in a similar manner. Peoples' commercial lending activities continue to be spread over a diverse range of businesses from all sectors of the economy, with no single industry comprising over 10% of Peoples' total loan portfolio. Loans secured by commercial real estate, including commercial construction loans, continue to comprise the largest portion of Peoples' loan portfolio. The following table provides information regarding the largest concentrations of commercial real estate loans within the loan portfolio at December 31, 2017: Peoples' commercial lending activities continue to focus on lending opportunities inside its primary and secondary market areas within Ohio, West Virginia and Kentucky. In all other states, the aggregate outstanding balances of commercial loans in each state were not material at either December 31, 2017 or December 31, 2016. Allowance for Loan Losses The amount of the allowance for loan losses at the end of each period represents management's estimate of probable losses from existing loans based upon its formal quarterly analysis of the loan portfolio described in the “Critical Accounting Policies” section of this discussion. While this process involves allocations being made to specific loans and pools of loans, the entire allowance is available for all losses incurred within the loan portfolio. The following details management's allocation of the allowance for loan losses at December 31: The allowance for loan losses as a percent of total loans decreased 3 basis points in 2017 compared to 2016 as a result of the reduction in delinquencies and stable credit quality trends. During 2017, the increase in allowance for loan losses related to consumer indirect loans was a result of loan growth in recent periods. Past years included historic periods dating closer to the recession which included larger charge-offs. Peoples also considers recent trends in criticized loans and loan growth associated with each loan portfolio, as well as qualitative factors that could negatively impact these trends, such as unemployment, rising interest rates, fragile real estate values, and fluctuating oil and gas prices. Peoples believes the reserves remain appropriate to cover probable losses that exist in the current portfolio. The allowance for loan losses allocated to the residential real estate and consumer loan categories was based upon Peoples' allowance methodology for homogeneous pools of loans. The fluctuations in these allocations have been directionally consistent with the changes in loan quality, loss experience and loan balances in these categories. The increase in the allowance for loan losses for consumer loans has been mostly driven by loan growth in indirect lending in recent periods. During 2016, the increase of 9% in the allowance for loan losses related to total commercial and consumer indirect balance growth. The reductions in the allowance for loan losses allocated to commercial real estate during 2015 and 2014 were driven by net recoveries in recent years reducing the historical loss rates. During 2015, increases in the commercial and industrial, home equity lines of credit and consumer categories of the allowance for loan losses were driven by net charge-off activity, and increases in the balances of the respective loan portfolios. The significant allocations to commercial loans reflect the higher credit risk associated with these types of lending and the size of these loan categories in relationship to the entire loan portfolio. The following table summarizes the changes in the allowance for loan losses for the years ended December 31: (a) Includes purchased credit impaired loan charge-offs of $0 in 2017, $44,000 in 2016 and $60,000 in 2015. (b) Includes purchased credit impaired loan charge-offs of $0 in 2017, $23,000 in 2016 and $3,000 in 2015. (c) Includes purchased credit impaired loan charge-offs of $7,000 in 2017, $23,000 in 2016 and $3,000 in 2015. (d) Includes purchased credit impaired loan provision for loan losses of $117,000 in 2017, $66,000 in 2016 and $303,000 in 2015. During 2017, net charge-offs were 0.15% of average total loans. The increase from 2016 was primarily related to a decline in recoveries of commercial loans and an increase in net charge-offs of consumer indirect loans due to higher balances from recent loan growth. During 2016, net charge-offs were nominal at 0.09% of average total loans and were positively impacted by a $1.0 million recovery of a prior period commercial real estate charge-off. Gross charge-offs totaled $5.2 million in 2016, and were largely associated with the growth in the consumer loan portfolio. In 2015, Peoples recorded charge-offs related to one large commercial loan relationship in the aggregate amount of $13.1 million. The following table details Peoples’ nonperforming assets at December 31: (a) Includes loans categorized as special mention, substandard or doubtful. (b) Includes loans categorized as substandard or doubtful. Nonperforming loans decreased in 2017, largely due to the decrease in nonaccrual loans, coupled with declines in loans 90+ days past due and accruing. The decrease in nonaccrual loans was driven by several commercial real estate relationships that were paid off in 2017. Nonperforming loans increased in 2016, largely due to the increase in nonaccrual loans, which was partially offset by a decrease in loans 90+ days past due and accruing. The increase in nonaccrual loans was driven by several relatively smaller relationships that were placed on nonaccrual status during 2016. At December 31, 2015, loans 90+ days past due and accruing included $2.3 million of acquired loans that were purchased credit impaired loans, as they had evidence of credit quality deterioration since acquisition. Interest income on these loans is recognized on a level-yield method over the life of the loan. The majority of Peoples' nonaccrual commercial real estate loans continued to consist of non-owner occupied commercial properties and real estate development projects. In general, management believes repayment of these loans is dependent on the sale of the underlying collateral. As such, the carrying values of these loans are ultimately supported by management's estimate of the net proceeds Peoples would receive upon the sale of the collateral. These estimates are based in part on market values provided by independent, licensed or certified appraisers periodically, but no less frequently than annually. Given the volatility in commercial real estate values, management continues to monitor changes in real estate values from quarter-to-quarter and updates its estimates as needed based on observable changes in market prices and/or updated appraisals for similar properties. The significant increase in nonaccrual commercial real estate loans during 2016 was a result of three commercial loans moving to nonaccrual status, while the increase in 2015 was a result of one commercial real estate relationship in the skilled nursing sector being placed on nonaccrual status. Interest income on loans classified as nonaccrual and renegotiated at each year-end that would have been recorded under the original terms of the loans was $2.6 million for 2017, $1.9 million for 2016 and $2.1 million for 2015. No portion of these amounts was recorded during 2017, 2016 or 2015, consistent with the income recognition policy described in the “Critical Accounting Policies” section of this discussion. Overall, management believes the allowance for loan losses was adequate at December 31, 2017, based on all significant information currently available. Still, there can be no assurance that the allowance for loan losses will be adequate to cover future losses or that the amount of nonperforming loans will remain at current levels, especially considering the current economic uncertainty that exists and the concentration of commercial loans in Peoples’ loan portfolio. Deposits The following table details Peoples’ deposit balances at December 31: The increase in total deposit balances compared to December 31, 2016 was primarily due to increases of $314.4 million in interest-bearing demand deposits and $120.8 million in brokered CDs, offset partially by a decrease of $178.4 million in non-interest-bearing demand deposits. Shifts in balances occurred between non-interest-bearing deposits and interest-bearing demand account balances as Peoples migrated consumers to new products during the second half of 2017. During this migration, customer accounts were evaluated based on certain characteristics, and some accounts that were traditionally non-interest-bearing deposits were converted to interest-bearing demand accounts as Peoples moves toward a relationship-based deposit product. The increase in brokered CDs in 2017 was the result of adding relatively shorter term funding on the balance sheet to secure fixed rate funding in a rising rate environment. In 2016, deposits decreased primarily due to decreases in retail and brokered CDs and governmental deposit accounts. Peoples continued its deposit strategy of growing low-cost core deposits, such as checking and savings accounts, and reducing its reliance on higher-cost, non-core deposits, such as CDs and brokered deposits, based on the rate environment that existed in 2016. These actions accounted for much of the changes in deposit balances in 2016 compared to 2015. Peoples' governmental deposit accounts represent savings and interest-bearing transaction accounts from state and local governmental entities. These funds are subject to periodic fluctuations based on the timing of tax collections and subsequent expenditures or disbursements. Peoples normally experiences an increase in balances annually during the first quarter corresponding with tax collections, with declines normally in the second half of each year corresponding with expenditures by the governmental entities. Peoples continues to emphasize growth of low-cost deposits that do not require Peoples to pledge assets as collateral, which is required in the case of governmental deposit accounts. In 2015 and 2014, the increases in deposits primarily related to the acquisitions of NB&T, Midwest, Ohio Heritage and North Akron. The maturities of retail CDs with total balances of $100,000 or more at December 31 were as follows: Borrowed Funds The following table details Peoples’ short-term and long-term borrowings at December 31: Peoples' short-term FHLB advances generally consist of overnight borrowings being maintained in connection with the management of Peoples' daily liquidity position. Peoples continually evaluates the overall balance sheet position. Given the current interest rate environment, Peoples added long-term FHLB advances in anticipation of a rising rate environment. During 2017, $40.0 million of long-term FHLB advances, with fixed rates ranging from 1.20% to 3.92%, were reclassified to short-term borrowings due to the advances maturing within one year. In 2017, short-term retail repurchase agreements increased due to the reclassification of repurchase agreements from long-term borrowings that mature within one year. During 2017, Peoples entered into two forward starting interest rate swaps to obtain fixed rate borrowings with interest rates of 2.47% and 2.53%, which become effective in January and April of 2018 and mature in 2025 and 2027. These swaps locked in funding rates for $20.0 million in repurchase agreements that mature in 2018 and have interest rates of 3.61% and 3.55%. During 2016, Peoples executed transactions to take advantage of the low interest rates, which included: ▪ Peoples restructured $20.0 million of long-term FHLB advances that had a weighted-average rate of 2.97%, resulting in a $700,000 loss. Peoples replaced these borrowings with a long-term FHLB advance, which has an interest rate of 2.17% and matures in 2026. ▪ Peoples borrowed an additional $35.0 million of long-term FHLB amortizing advances, which had interest rates ranging from 1.08% to 1.40%, and mature between 2019 and 2031. ▪ Peoples entered into five forward starting interest rate swaps to obtain short-term borrowings at fixed rates, with interest rates ranging from 1.49% to 1.83%, which become effective in 2018 and mature between 2022 and 2026. These swaps locked in funding rates for $40.0 million in FHLB advances that mature in 2018, which have interest rates ranging from 3.57% to 3.92%. Peoples repaid approximately $52.1 million of long-term FHLB advances during 2015 and recorded a loss on debt extinguishment of $520,000. Peoples increased its usage of short-term FHLB advances due to the decrease and pre-payment of long-term FHLB advances. On March 4, 2016, Peoples entered into the RJB Credit Agreement, with Raymond James Bank, which provides Peoples with a revolving line of credit in the maximum aggregate principal amount of $15 million (the "RJB Loan Commitment"). Peoples is subject to certain covenants imposed by the RJB Credit Agreement and was in compliance with all of these covenants as of December 31, 2017. Additional information regarding Peoples' borrowed funds can be found in Note 8 and Note 9 of the Notes to the Consolidated Financial Statements. Capital/Stockholders’ Equity During 2017, Peoples' total stockholders' equity increased due to higher net income offset slightly by dividends paid and declines in the market value of investments. At December 31, 2017, capital levels for both Peoples and Peoples Bank remained substantially higher than the minimum amounts needed to be considered "well capitalized" under banking regulations. These higher capital levels reflect Peoples' desire to maintain a strong capital position. During the first quarter of 2015, Peoples adopted the new Basel III regulatory capital framework, as approved by the federal banking agencies. The adoption of this new framework modified the calculations and well-capitalized thresholds of the existing risk-based capital ratios and added the Common Equity Tier 1 risk-based capital ratio. Additionally, under the new rules, in order to avoid limitations on dividends, equity repurchases and compensation, Peoples must exceed the three minimum required ratios by at least the capital conservation buffer. These three minimum required ratios are the common equity tier 1 capital ratio, tier 1 capital ratio and total risk-based capital ratio. The capital conservation buffer is being phased in from 0.625% beginning January 1, 2016 to 2.50% by January 1, 2019, and applies to the Common Equity Tier 1 ("CET1") ratio, tier 1 capital ratio and total risk-based capital ratio. Peoples' had a capital buffer of 6.62% at December 31, 2017 and 6.11% at December 31, 2016 compared to the fully phased-in capital conservation buffer of 2.50% required by January 1, 2019. As such, Peoples exceeded the minimum ratios including the capital conservation buffer at December 31, 2017. In 2016, Peoples' total stockholders' equity increased due to higher retained earnings offset slightly by the repurchase of 279,770 treasury shares and the slight decline in the market value of investments. In 2015, Peoples' total stockholders' equity increased primarily due to $76.0 million of common equity issued in connection with the NB&T acquisition. The following table details Peoples' actual risk-based capital levels and corresponding ratios at December 31: In addition to traditional capital measurements, management uses tangible capital measures to evaluate the adequacy of Peoples' stockholders' equity. Such ratios represent non-GAAP financial information since their calculation removes the impact on the Consolidated Balance Sheets of intangible assets acquired through acquisitions. Management believes this information is useful to investors since it facilitates the comparison of Peoples' operating performance, financial condition and trends to peers, especially those without a similar level of intangible assets to that of Peoples. Further, intangible assets generally are difficult to convert into cash, especially during a financial crisis, and could decrease substantially in value should there be deterioration in the overall franchise value. As a result, tangible equity represents a conservative measure of the capacity for Peoples to incur losses but remain solvent. The following table reconciles the calculation of these non-GAAP financial measures to amounts reported in Peoples' Consolidated Financial Statements at December 31: The 2017 increase in tangible equity and tangible assets ratio, compared to 2016, was due mainly to the increase in retained earnings, offset by the decline in the market value of investment securities. In 2016, the increase in tangible equity to tangible assets ratio, compared to 2015, was due mainly to the increase in retained earnings, offset slightly by the repurchase of 279,770 treasury shares and the decline in the market value of investment securities. In 2015, the decrease in the tangible equity to tangible assets ratio compared to the ratio in 2014 was due to the impact of assets acquired in the NB&T acquisition as well as a reduction in retained earnings as most of the net income was paid to common shareholders as dividends. Future Outlook During 2017, Peoples reported notable accomplishments in many areas, including generating quality loan growth, increasing net interest margin, effectively managing credit costs, growing fee income and successfully controlling expenses. Success in these areas resulted in positive operating leverage for the year, an efficiency ratio of 62.20% and record net income for Peoples. Additionally, Peoples announced the pending acquisition of ASB, which is expected to close in mid April 2018. The projections for 2018 that are included below exclude the anticipated benefits of the ASB acquisition. The ASB acquisition is expected to be accretive to earnings by approximately 6 to 7 cents in 2018 and 13 to 15 cents in 2019, excluding one-time acquisition costs. Peoples currently anticipates one-time acquisition costs of approximately $8.2 million in 2018. The majority of the one-time acquisition costs will be recognized during the second quarter of 2018. For 2018, Peoples expects to build on the success and momentum of 2017 related to loan growth, fee income growth and expense management. Key strategic priorities continue to include generating positive operating leverage, maintaining superior asset quality, and remaining prudent with the use of capital. Overall, Peoples' key strategic objectives are to be a steady, dependable performer for its shareholders and to take advantage of market expansion opportunities. Peoples' long-term strategic goals include generating results in the top quartile of performance relative to Peoples' peer group, as defined in Peoples' proxy statement for the 2018 Annual Meeting of Shareholders, and providing returns for its shareholders superior to those of its peers, regardless of operating conditions. Net interest income comprised 68% of Peoples' revenue for 2017, and therefore, remained a major source of revenue. Thus, Peoples' ability to grow revenue in 2018 will be impacted by the amount of net interest income generated. During 2017, Peoples benefited from the Federal Reserve Board's decision to raise interest rates, which they are expected to continue to do throughout 2018. Long-term rates could increase but remain more volatile than in prior years. Changes in long-term interest rates would affect reinvestment rates within the loan and investment portfolios. At December 31, 2017, Peoples' Consolidated Balance Sheet remained positioned for a rising rate environment, meaning that net interest income would increase to the extent interest rates increase. However, should the yield curve flatten, Peoples would have limited opportunities to offset the impact on asset yields with a similar reduction in funding costs. Thus, Peoples' ability to produce meaningful loan growth remains the key driver for improving net interest income and margin in 2018. For 2017, net interest margin was 3.62%. Net interest margin for 2018 is expected to be approximately 3.60%. Loan growth will again be the key driver in stabilizing asset yields. Management would expect both net interest income and margin to benefit from any meaningful increase in market interest rates based upon the current interest rate risk profile. However, it remains inherently difficult to predict and manage the future trend of Peoples' net interest income and margin due to the uncertainty surrounding the timing and magnitude of future interest rate changes, as well as the impact of competition for loans and deposits. Peoples has continually sought to maintain a diversified revenue stream through its strong fee-based businesses, such as insurance and wealth management. However, Peoples' fee revenue as a percent of total revenue has decreased slightly over the last few years. In 2015 and 2016, Peoples' fee revenue comprised 33% of its total revenue, and 32% in 2017. In 2013, Peoples' fee revenue comprised 40% of total revenue, which was the highest point. The decline in recent years has been due primarily to loan growth, coupled with the rising interest rates, and the bank acquisitions completed since 2013, only one of which had a wealth management practice. In addition, only four relatively small insurance agencies and one small financial advisory book of business were purchased during the same period of time. Peoples has capabilities that many banks in its market area lack, including some of the largest national banks, which include robust retirement plan services and comprehensive insurance products. Thus, management considers Peoples to have a competitive advantage that directly enhances revenue growth potential. Additionally impacting total non-interest income in 2018 will be the market volatility of equity investment securities, which had a fair value of $7.8 million at December 31, 2017, as the change in market value will be recognized in total non-interest income instead of accumulated other comprehensive loss. For 2018, management expects fee-based revenue growth of between 2% and 4%. While the primary focus will be on revenue growth, management remains disciplined with operating expenses. Management has deployed an expense management approach to control the annual growth in total non-interest expense. The management of the growth rate is partially achieved through having various areas within the organization attempt to "self-fund" investments, meaning that the areas must determine cost savings opportunities prior to making additional investments. Peoples continues to have limited control over some expenses, such as employee medical and pension costs. Peoples continues to be exposed to more pension settlement charges given the frozen status of its defined benefit plan. For 2018, management anticipates a slightly higher volume of settlement charges to that incurred in 2017. This expectation is based on normal retirement activity within the defined benefit plan, but assumes all potential distributions are lump-sum payouts. For total expenses, management expects growth of between 2% and 4%. Given the expected revenue and expense growth, Peoples anticipates generating positive operating leverage in 2018. Additionally, Peoples' efficiency ratio is expected to be between 61% and 63% for 2018. As previously mentioned, net interest income growth for 2018 is largely dependent upon achieving meaningful loan growth. Management believes period-end loan balances could increase by 5% to 7% in 2018. Within Peoples' commercial lending activity, the primary emphasis continues to be on non-mortgage commercial lending opportunities. Consumer lending activity grew significantly during 2017 and is expected to remain a large contributor to overall loan growth in 2018, primarily indirect lending. At December 31, 2017, the investment portfolio comprised 24% of total assets. In 2018, the investment portfolio is anticipated to decrease slightly. Management can use the cash flow generated by Peoples’ significant investment in mortgage-backed securities to fund new loan production. Peoples will continue to seek opportunities to execute a shift in the mix on the asset side of the balance sheet to reduce the relative size of the investment portfolio. Management may adjust the size or composition of the investment portfolio in response to other factors, such as changes in liquidity needs and interest rate conditions. Peoples' funding strategy continues to emphasize growth of core deposits, such as checking and savings accounts, rather than higher-cost deposits. Given the expected increase in earning assets, borrowed funds are expected to increase in 2018 to the extent earning asset growth is more than deposit growth. Similar to prior years, should this occur, management would evaluate using longer-term borrowings to match the duration of the assets being funded to minimize the long-term interest rate risk. Peoples remains committed to sound underwriting and prudent risk management. Management believes this credit discipline will benefit Peoples during any future economic downturns. The long-term goal is to maintain key metrics in the top-quartile of Peoples' peer group regardless of economic conditions. Net charge-off trends are expected to normalize in 2018 as the prospects of large charge-offs and recoveries diminish. Management anticipates Peoples' provision for loan losses and the net charge-off rate for 2018 will normalize, with the net charge-off rate within its long-term historical range of 0.20% to 0.30% of average loans. For 2018, management intends to remain prudent with the level of Peoples' allowance for loan losses. However, the level will continue to be based upon management's quarterly assessment of the losses inherent in the loan portfolio, and the amount of any provision for loan losses should be driven mostly by a combination of the net charge-off rate and loan growth. Peoples' capital position remains strong. Given the excess capital position and the increase in Peoples' common share price, Peoples will continue to look for ways to effectively manage its capital, including, but not limited to, bank acquisitions and dividends. In January 2018, Peoples announced a quarterly dividend of $0.26 per common share, which was an 18% increase. Late in 2015, Peoples approved a share repurchase program of up to $20 million, under which Peoples purchased $5.0 million in 2016. Given the activity in the stock market since late in 2016, specifically as it related to the price of Peoples' common shares, Peoples' appetite to repurchase common shares has diminished. However, given that there is a share repurchase program still in place, with capacity of $15.0 million remaining, Peoples will continue to evaluate additional purchase opportunities throughout 2018. Management has built a culture where it is paramount that the associates take care of customers and take care of each other. Management is committed to profitable growth of the company and building long-term shareholder value. This will require management to remain focused on four key areas: responsible risk management; extraordinary client experience; profitable revenue growth; and maintaining a superior workforce. Success will be achieved through disciplined execution of strategies and providing extraordinary service to Peoples' clients and communities. Interest Rate Sensitivity and Liquidity While Peoples is exposed to various business risks, the risks relating to interest rate sensitivity and liquidity are major risks that can materially impact future results of operations and financial condition due to their complexity and dynamic nature. The objective of Peoples' asset/liability management (“ALM”) function is to measure and manage these risks in order to optimize net interest income within the constraints of prudent capital adequacy, liquidity and safety. This objective requires Peoples to focus on interest rate risk exposure and adequate liquidity through its management of the mix of assets and liabilities, their related cash flows and the rates earned and paid on those assets and liabilities. Ultimately, the ALM function is intended to guide management in the acquisition and disposition of earning assets and selection of appropriate funding sources. Interest Rate Risk Interest rate risk (“IRR”) is one of the most significant risks arising in the normal course of business of financial services companies like Peoples. IRR is the potential for economic loss due to future interest rate changes that can impact the earnings stream as well as market values of financial assets and liabilities. Peoples' exposure to IRR is due primarily to differences in the maturity or repricing of earning assets and interest-bearing liabilities. In addition, other factors, such as prepayments of loans and investment securities or early withdrawal of deposits, can affect Peoples' exposure to IRR and increase interest costs or reduce revenue streams. Peoples has assigned overall management of IRR to the ALCO, which has established an IRR management policy that sets minimum requirements and guidelines for monitoring and managing the level of IRR. The objective of Peoples' IRR policy is to assist the ALCO in its evaluation of the impact of changing interest rate conditions on earnings and economic value of equity, as well as assist with the implementation of strategies intended to reduce Peoples' IRR. The management of IRR involves either maintaining or changing the level of risk exposure by changing the repricing and maturity characteristics of the cash flows for specific assets or liabilities. Additional oversight of Peoples' IRR is provided by the Board of Directors of Peoples Bank, who reviews and approves Peoples' IRR management policy at least annually. The ALCO uses various methods to assess and monitor the current level of Peoples' IRR and the impact of potential strategies or other changes. However, the ALCO predominantly relies on simulation modeling in its overall management of IRR since it is a dynamic measure. Simulation modeling also estimates the impact of potential changes in interest rates and balance sheet structures on future earnings and projected economic value of equity. The modeling process starts with a base case simulation using the current balance sheet and current interest rates held constant for the next twenty-four months. Alternate scenarios are prepared which simulate the impact of increasing and decreasing market interest rates, assuming parallel yield curve shifts. Comparisons produced from the simulation data, showing the changes in net interest income from the base interest rate scenario, illustrate the risks associated with the current balance sheet structure. Additional simulations, when deemed appropriate or necessary, are prepared using different interest rate scenarios from those used with the base case simulation and/or possible changes in balance sheet composition. The additional simulations include non-parallel shifts in interest rates whereby the direction and/or magnitude of change of short-term interest rates is different than the changes applied to longer-term interest rates. Comparisons showing the earnings and economic value of equity variance from the base case are provided to the ALCO for review and discussion. The ALCO has established limits on changes in the twelve-month net interest income forecast and the economic value of equity from the base case. The ALCO may establish risk tolerances for other parallel and non-parallel rate movements, as deemed necessary. The following table details the current policy limits used to manage the level of Peoples' IRR: The following table shows the estimated changes in net interest income and the economic value of equity based upon a standard, parallel shock analysis (dollars in thousands): This table uses a standard, parallel shock analysis for assessing the IRR to net interest income and the economic value of equity. A parallel shock means all points on the yield curve (one year, two year, three year, etc.) are directionally changed the same amount of basis points. Management regularly assesses the impact of both increasing and decreasing interest rates, the table above reflects the impact of upward shocks, and a downward parallel shock of 100 basis points. Downward shocks of 200 and 300 basis points are excluded from the table above as they are not probable given the current interest rate environment. Although a parallel shock table can give insight into the current direction and magnitude of IRR inherent in the balance sheet, interest rates do not usually move in a complete parallel manner during interest rate cycles. These nonparallel movements in interest rates, commonly called yield curve steepening or flattening movements, tend to occur during the beginning and end of an interest rate cycle, with differences in the timing, direction and magnitude of changes in short-term and long-term interest rates. Thus, any benefit that could occur as a result of the Federal Reserve Board increasing short-term interest rates in future quarters could be offset by an inverse movement in long-term interest rates. As a result, management conducts more advanced interest rate shock scenarios to gain a better understanding of Peoples' exposure to nonparallel rate shifts. During 2017, Peoples' Consolidated Balance Sheet remained positioned for a relatively neutral interest rate environment as illustrated by the overall small changes in net interest income shown in the above table. The largest factors affecting Peoples' interest rate sensitivity were the amount of cash on the balance sheet and the asset/liability mix in the balance sheet. This positioning was in light of the Federal Reserve Board's stated goal of potentially raising interest rates at a slow and measured pace. During 2017, the federal funds rate was raised three times totaling 75 basis points. An asset/liability model, used to produce the analysis above, requires assumptions to be made such as prepayment rates on interest-earning assets and repricing impact on non-maturity deposits. These business assumptions are based on business plans, economic and market trends, and available industry data. Management believes that its methodology for developing such assumptions is reasonable; however, there can be no assurance that modeled results will be achieved. Liquidity In addition to IRR management, another major objective of the ALCO is to maintain sufficient levels of liquidity. The ALCO defines liquidity as the ability to meet anticipated and unanticipated operating cash needs, loan demand and deposit withdrawals without incurring a sustained negative impact on profitability. A primary source of liquidity for Peoples is retail deposits. Liquidity is also provided by cash generated from earning assets such as maturities, calls, and principal and interest payments from loans and investment securities. Peoples also uses various wholesale funding sources to supplement funding from customer deposits. These external sources provide Peoples with the ability to obtain large quantities of funds in a relatively short time period in the event of sudden unanticipated cash needs. However, an over-utilization of external funding sources can expose Peoples to greater liquidity risk as these external sources may not be accessible during times of market stress. Additionally, Peoples may be exposed to the risk associated with providing excess collateral to external funding providers, commonly referred to as counterparty risk. As a result, the ALCO's liquidity management policy sets limits on the net liquidity position and the concentration of non-core funding sources, both wholesale funding and brokered deposits. In addition to external sources of funding, Peoples considers certain types of deposits to be less stable or "volatile funding". These deposits include special money market products, large CDs and public funds. Peoples has established volatility factors for these various deposit products, and the liquidity management policy establishes a limit on the total level of volatile funding. Additionally, Peoples measures the maturities of external sources of funding for periods of 1 month, 3 months, 6 months and 12 months and has established policy limits for the amounts maturing in each of these periods. The purpose of these limits is to minimize exposure to what is commonly termed rollover risk. An additional strategy used by Peoples in the management of liquidity risk is maintaining a targeted level of liquid assets. These are assets that can be converted into cash in a relatively short period of time. Management defines liquid assets as unencumbered cash (including cash on deposit at the Federal Reserve Bank), and the market value of U.S. government and agency securities that are not pledged. Excluded from this definition are pledged securities, non-government and agency securities, municipal securities and loans. Management has established a minimum level of liquid assets in the liquidity management policy, which is expressed as a percentage of loans and unfunded loan commitments. Peoples also has established a policy limit around the level of liquefiable assets also expressed as a percentage of loans and unfunded loan commitments. Liquefiable assets are defined as liquid assets plus the market value of unpledged securities not included in the liquid asset measurement. Peoples remained within these two parameters throughout the year. An essential element in the management of liquidity risk is a forecast of the sources and uses of anticipated cash flows. On a monthly basis, Peoples forecasts sources and uses of cash for the next twelve months. To assist in the management of liquidity, management has established a liquidity coverage ratio, which is defined as the total sources of cash divided by the total uses of cash. A ratio of greater than 1.0 times indicates that forecasted sources of cash are adequate to fund forecasted uses of cash. The liquidity management policy establishes a minimum limit of 1.0 times. As of December 31, 2017, Peoples had a ratio of 1.7 times, which was within policy limits. Peoples also forecasts secondary or contingent sources of cash, and this includes external sources of funding and liquid assets. These sources of cash would be required if and when the forecasted liquidity coverage ratio dropped below the policy limit of 1.0 times. An additional liquidity measurement used by management includes the total forecasted sources of cash and the contingent sources of cash divided by the forecasted uses of cash. Management has established a minimum ratio of 3.0 times for this liquidity management policy limit. As of December 31, 2017, Peoples had a ratio of 7.1 times, which was within policy limits. Disruptions in the sources and uses of cash can occur which can drastically alter the actual cash flows and negatively impact Peoples' ability to access internal and external sources of cash. Such disruptions might occur due to increased withdrawals of deposits, increases in the funding required for loan commitments, a decrease in the ability to access external funding sources and other forces that would increase the need for funding and limit Peoples' ability to access needed funds. As a result, Peoples maintains a liquidity contingency funding plan ("LCFP") that considers various degrees of disruptions and develops action plans around these scenarios. Peoples' LCFP identifies scenarios where funding disruptions might occur and creates scenarios of varying degrees of severity. The disruptions considered include an increase in funding of unfunded loan commitments, unanticipated withdrawals of deposits, decreases in the renewal of maturing CDs and reductions in cash earnings. Additionally, the LCFP creates stress scenarios where access to external funding sources, or contingency funding, is suddenly limited which includes a significant increase in the margin requirements where securities or loans are pledged, limited access to funding from other banks and limited access to funding from the FHLB and the Federal Reserve Bank. Peoples' LCFP scenarios include a base scenario, a mild stress scenario, a moderate stress scenario and a severe stress scenario. Each of these is defined as to the severity, and action plans are developed around each. Liquidity management also requires the monitoring of risk indicators that may alert the ALCO to a developing liquidity situation or crisis. Early detection of stress scenarios allows Peoples to take actions to help mitigate the impact to Peoples Bank's business operations. The LCFP contains various indicators, termed key risk indicators ("KRI's") that are monitored on a monthly basis, at a minimum. The KRI's include both internal and external indicators and include loan delinquency levels, classified and special mention list loan levels, non-performing loans to loans and to total assets, the loan to deposit ratio, the level of net non-core funding dependence, the level of contingency funding sources, the liquidity coverage ratio, changes in regulatory capital levels, forecasted operating loss and negative media concerning Peoples, irrational competitor pricing that persists and an increase in rates for external funding sources. The LCFP establishes levels that define each of these KRI's under base, mild, moderate and severe scenarios. The LCFP is reviewed and updated at least on an annual basis by the ALCO and Peoples Bank's Board of Directors. Additionally, testing of the LCFP is required on an annual basis. Various stress scenarios and the related actions are simulated according to the LCFP. The results are reviewed and discussed, and changes or revisions are made to the LCFP accordingly. Additionally, every two years, the LCFP is subjected to a third-party review for effectiveness and regulatory compliance. Overall, management believes the current balance of cash and cash equivalents, and anticipated cash flows from the investment portfolio, along with the availability of other funding sources, will allow Peoples to meet anticipated cash obligations, as well as special needs and off-balance sheet commitments. Off-Balance Sheet Activities and Contractual Obligations Peoples routinely engages in activities that involve, to varying degrees, elements of risk that are not reflected in whole or in part in the Consolidated Financial Statements. These activities are part of Peoples' normal course of business and include traditional off-balance sheet credit-related financial instruments, interest rate contracts and commitments to make additional capital contributions in low-income housing tax credit investments. The following is a summary of Peoples’ significant off-balance sheet activities and contractual obligations. Detailed information regarding these activities and obligations can be found in the Notes to the Consolidated Financial Statements as follows: Traditional off-balance sheet credit-related financial instruments are primarily commitments to extend credit and standby letters of credit. These activities are necessary to meet the financing needs of customers and could require Peoples to make cash payments to third parties in the event certain specified future events occur. The contractual amounts represent the extent of Peoples’ exposure in these off-balance sheet activities. However, since certain off-balance sheet commitments, particularly standby letters of credit, are expected to expire or only partially be used, the total amount of commitments does not necessarily represent future cash requirements. Peoples continues to lease certain facilities and equipment under noncancellable operating leases with terms providing for fixed monthly payments over periods generally ranging from two to ten years. Several of Peoples’ leased facilities are inside retail shopping centers or office buildings and, as a result, are not available for purchase. Management believes these leased facilities increase Peoples’ visibility within its markets and afford sales associates additional access to current and potential clients. For certain acquisitions, often those involving insurance businesses and wealth management books of business, a portion of the consideration is contingent upon revenue metrics being achieved. US GAAP requires that the amounts be recorded upon acquisition based on the best estimate of the future amounts to be paid at the time of acquisition. Any subsequent adjustment to the estimate is recorded in earnings. Based on the acquisitions completed to date, management does not expect contingent consideration to have a material impact on Peoples' future performance. The following table details the aggregate amount of future payments Peoples is required to make under certain contractual obligations as of December 31, 2017: (a) Amounts reflect solely the minimum required principal payments. (b) Amounts assume projected revenue metrics are achieved. Management does not anticipate that Peoples’ current off-balance sheet activities will have a material impact on its future results of operations and financial condition based on historical experience and recent trends. Effects of Inflation on Financial Statements Substantially all of Peoples’ assets relate to banking and are monetary in nature. As a result, inflation does not impact Peoples to the same degree as companies in capital-intensive industries in a replacement cost environment. During a period of rising prices, a net monetary asset position results in a loss in purchasing power and conversely a net monetary liability position results in an increase in purchasing power. The opposite would be true during a period of decreasing prices. In the banking industry, monetary assets typically exceed monetary liabilities. The current monetary policy targeting low levels of inflation has resulted in relatively stable price levels. Therefore, inflation has had little impact on Peoples’ net assets.

<s>[INST] Certain statements in this Form 10K, which are not historical fact, are forwardlooking statements within the meaning of Section 27A of the Securities Act , Section 21E of the Exchange Act, and the Private Securities Litigation Reform Act of 1995. Words such as “anticipate,” “estimate,” “may,” “feel,” “expect,” “believe,” “plan,” “will,” “would,” “should,” “could” and similar expressions are intended to identify these forwardlooking statements but are not the exclusive means of identifying such statements. Forwardlooking statements are subject to risks and uncertainties that may cause actual results to differ materially. Factors that might cause such a difference include, but are not limited to: (1) the success, impact, and timing of the implementation of Peoples' business strategies, including the successful integration of acquisitions and the expansion of consumer lending activity; (2) Peoples' ability to integrate any future acquisitions, including the pending merger with ASB, which may be unsuccessful, or may be more difficult, timeconsuming or costly than expected; (3) Peoples' ability to obtain regulatory approvals of the proposed merger of Peoples with ASB on the proposed terms and schedule, and approval of the merger by the shareholders of ASB on March 9, 2018 may be unsuccessful; (4) competitive pressures among financial institutions or from nonfinancial institutions which may increase significantly, including product and pricing pressures, changes to thirdparty relationships and revenues, and Peoples' ability to attract, develop and retain qualified professionals; (5) changes in the interest rate environment due to economic conditions and/or the fiscal policies of the United States ("U.S.") government and the Board of Governors of the Federal Reserve System (the "Federal Reserve Board"), which may adversely impact interest rates, interest margins, loan demand and interest rate sensitivity; (6) uncertainty regarding the nature, timing and effect of legislative or regulatory changes or actions, promulgated and to be promulgated by governmental and regulatory agencies in the State of Ohio, the Federal Deposit Insurance Corporation, the Federal Reserve Board and the Consumer Financial Protection Bureau, which may subject Peoples, its subsidiaries, or one or more acquired companies to a variety of new and more stringent legal and regulatory requirements which adversely affect their respective businesses, including in particular the rules and regulations promulgated and to be promulgated under the DoddFrank Wall Street Reform and Consumer Protection Act of 2010, and the Basel III regulatory capital reform; (7) changes in policy and other regulatory and legal developments accompanying the current presidential administration, including the recentlyenacted Tax Cuts and Jobs Act, and uncertainty or speculation pending the enactment of such changes; (8) uncertainties in Peoples' preliminary review of, and additional analysis of, the Tax Cuts and Jobs Act; (9) local, regional, national and international economic conditions and the impact these conditions may have on Peoples, its customers and its counterparties, and Peoples' assessment of the impact, which may be different than anticipated; (10) Peoples may issue equity securities in connection with future acquisitions, which could cause ownership and economic dilution to Peoples' current shareholders; (11) changes in prepayment speeds, loan originations, levels of nonperforming assets, delinquent loans and chargeoffs, which may be less favorable than expected and adversely impact the amount of interest income generated; (12) adverse changes in the economic conditions and/or activities, including, but not limited to, continued economic uncertainty in the U.S., the European Union (including uncertainty surrounding the actions to be taken to implement the referendum by British voters to exit the European Union), Asia and other areas, which could decrease sales volumes, add volatility to the global stock markets and increase loan delinquencies and defaults; (13) deterioration in the credit quality of Peoples' loan portfolio, which may adversely impact the provision for loan losses; (14) changes in accounting standards, policies, estimates or procedures which may adversely affect Pe [/INST] Positive. </s>

PEOPLES BANCORP INC

2019-03-01

2018-12-31

ITEM 7 MANAGEMENT’S DISCUSSION AND ANALYSIS OF FINANCIAL CONDITION AND RESULTS OF OPERATIONS Forward-Looking Statements Certain statements in this Form 10-K, which are not historical fact, are forward-looking statements within the meaning of Section 27A of the Securities Act , Section 21E of the Exchange Act, and the Private Securities Litigation Reform Act of 1995. Words such as "anticipate," "estimate," "may," "feel," "expect," "believe," "plan," "will," "would," "should," "could," "project," "goal," "target," "potential," "seek," "intend," and similar expressions are intended to identify these forward-looking statements but are not the exclusive means of identifying such statements. Forward-looking statements are subject to risks and uncertainties that may cause actual results to differ materially. Factors that might cause such a difference include, but are not limited to: (1) the success, impact, and timing of the implementation of Peoples' business strategies, including the successful integration of the acquisition of ASB and the expansion of consumer lending activity; (2) Peoples' ability to integrate future acquisitions, including the pending merger with First Prestonsburg, may be unsuccessful, or may be more difficult, time-consuming or costly than expected, and expected cost savings, synergies and other financial benefits may not be realized or take longer than anticipated; (3) Peoples' ability to obtain regulatory approvals of the proposed merger of Peoples with First Prestonsburg on the proposed terms and schedule, may be unsuccessful; (4) competitive pressures among financial institutions, or from non-financial institutions, which may increase significantly, including product and pricing pressures, changes to third-party relationships and revenues, and Peoples' ability to attract, develop and retain qualified professionals; (5) changes in the interest rate environment due to economic conditions and/or the fiscal policies of the U.S. government and the Federal Reserve Board, which may adversely impact interest rates, interest margins, loan demand and interest rate sensitivity; (6) uncertainty regarding the nature, timing, cost, and effect of legislative or regulatory changes or actions, promulgated and to be promulgated by governmental and regulatory agencies in the State of Ohio, the FDIC, the Federal Reserve Board and the CFPB, which may subject Peoples, its subsidiaries, or one or more acquired companies to a variety of new and more stringent legal and regulatory requirements which adversely affect their respective businesses, including in particular the rules and regulations promulgated and to be promulgated under the Dodd-Frank Act, and the Basel III regulatory capital reform; (7) the effects of easing restrictions on participants in the financial services industry; (8) local, regional, national and international economic conditions (including the impact of tariffs, a U.S. withdrawal from or significant renegotiation of trade agreements, trade wars and other changes in trade regulations) and the impact these conditions may have on Peoples, its customers and its counterparties, and Peoples' assessment of the impact, which may be different than anticipated; (9) the existence or exacerbation of general geopolitical instability and uncertainty; (10) changes in policy and other regulatory and legal developments, including the Tax Cuts and Jobs Act, and uncertainty or speculation pending the enactment of such changes; (11) Peoples may issue equity securities in connection with future acquisitions, including the pending merger with First Prestonsburg if consummated, which could cause ownership and economic dilution to Peoples' current shareholders; (12) changes in prepayment speeds, loan originations, levels of nonperforming assets, delinquent loans and charge-offs, which may be less favorable than expected and adversely impact the amount of interest income generated; (13) adverse changes in the economic conditions and/or activities, including, but not limited to, potential or imposed tariffs, continued economic uncertainty in the U.S., the European Union (including the uncertainty surrounding the actions to be taken to implement the referendum by British voters to exit the European Union), Asia, and other areas, which could decrease sales volumes, add volatility to the global stock markets, and increase loan delinquencies and defaults; (14) slowing or reversal of the current U.S. economic expansion; (15) deterioration in the credit quality of Peoples' loan portfolio, which may adversely impact the provision for loan losses; (16) changes in accounting standards, policies, estimates or procedures, which may adversely affect Peoples' reported financial condition or results of operations; (17) Peoples' assumptions and estimates used in applying critical accounting policies, which may prove unreliable, inaccurate or not predictive of actual results; (18) the discontinuation of LIBOR and other reference rates may result in increased expenses and litigation, and adversely impact the effectiveness of hedging strategies; (19) adverse changes in the conditions and trends in the financial markets, including political developments, which may adversely affect the fair value of securities within Peoples' investment portfolio, the interest rate sensitivity of Peoples' consolidated balance sheet, and the income generated by Peoples' trust and investment activities; (20) Peoples' ability to receive dividends from its subsidiaries; (21) Peoples' ability to maintain required capital levels and adequate sources of funding and liquidity; (22) the impact of minimum capital thresholds established as a part of the implementation of Basel III; (23) the impact of larger or similar-sized financial institutions encountering problems, which may adversely affect the banking industry and/or Peoples' business generation and retention, funding and liquidity; (24) the costs and effects of new federal and state laws, and other regulatory and legal developments, including the outcome of potential regulatory or other governmental inquiries and legal proceedings and results of regulatory examinations; (25) Peoples' ability to secure confidential information through the use of computer systems and telecommunications networks, including those of Peoples' third-party vendors and other service providers, which may prove inadequate, and could adversely affect customer confidence in Peoples and/or result in Peoples incurring a financial loss; (26) Peoples' reliance on, and the potential failure of, a number of third-party vendors to perform as expected, including its primary core banking system provider; (27) Peoples' ability to anticipate and respond to technological changes which can impact Peoples' ability to respond to customer needs and meet competitive demands; (28) operational issues stemming from and/or capital spending necessitated by the potential need to adapt to industry changes in information technology systems on which Peoples and its subsidiaries are highly dependent; (29) changes in consumer spending, borrowing and saving habits, whether due to tax reform legislation, changes in business and economic conditions, legislative or regulatory initiatives, or other factors, which may be different than anticipated; (30) the adequacy of Peoples' risk management program in the event of changes in market, economic, operational, asset/liability repricing, liquidity, credit and interest rate risks associated with Peoples' business; (31) the impact on Peoples' businesses, as well as on the risks described above, of various domestic or international widespread natural or other disasters, pandemics, cyber attacks, civil unrest, military or terrorist activities or international conflicts; (32) significant changes in the tax laws, which may adversely affect the fair values of deferred tax assets and liabilities, and obligations of states and political subdivisions held in Peoples' investment securities portfolio; (33) Peoples' continued ability to grow deposits; and (34) other risk factors relating to the banking industry or Peoples as detailed from time to time in Peoples' reports filed with the SEC, including those risk factors included in the disclosures under the heading "ITEM 1A. RISK FACTORS" of this Form 10-K. All forward-looking statements speak only as of the filing date of this Form 10-K and are expressly qualified in their entirety by the cautionary statements. Although management believes the expectations in these forward-looking statements are based on reasonable assumptions within the bounds of management’s knowledge of Peoples’ business and operations, it is possible that actual results may differ materially from these projections. Additionally, Peoples undertakes no obligation to update these forward-looking statements to reflect events or circumstances after the filing date of this Form 10-K or to reflect the occurrence of unanticipated events except as may be required by applicable legal requirements. Copies of documents filed with the SEC are available free of charge at the SEC’s website at www.sec.gov and/or from Peoples' website - www.peoplesbancorp.com under the "Investor Relations" section. The following discussion and analysis of Peoples' Consolidated Financial Statements is presented to provide insight into management's assessment of the financial position and results of operations for the periods presented. This discussion and analysis should be read in conjunction with the audited Consolidated Financial Statements and Notes thereto, as well as the ratios and statistics, contained elsewhere in this Form 10-K. Summary of Significant Transactions and Events The following is a summary of transactions or events that have impacted or are expected by management to impact Peoples’ results of operations or financial condition: ◦ On October 29, 2018, Peoples entered into a merger agreement with First Prestonsburg, which calls for First Prestonsburg to merge into Peoples. First Prestonsburg is the parent company of First Commonwealth, which operates nine full-service branches located in eastern Kentucky. Following the merger of First Prestonsburg into Peoples, First Commonwealth will merge into Peoples Bank. This transaction is expected to close during the second quarter of 2019, subject to the satisfaction of customary closing conditions. Refer to Note 19 Acquisitions of the Notes to the Consolidated Financial Statements for additional information. ◦ At the close of business on April 13, 2018, Peoples closed the acquisition of ASB. ASB merged into Peoples, and ASB's wholly-owned subsidiary, American Savings Bank, fsb, which operated seven full-service bank branches and two loan production offices in southern Ohio and eastern Kentucky, merged into Peoples Bank. Under the terms of the merger agreement, Peoples paid total consideration of $41.5 million. The acquisition added $239.2 million of loans, net of deferred fees and costs, and loans held for sale in the aggregate, and $198.6 million of total deposits at the acquisition date, after acquisition accounting adjustments. Peoples also recorded $2.6 million of other intangible assets and $18.1 million of goodwill. Refer to Note 19 Acquisitions of the Notes to the Consolidated Financial Statements for additional information. ◦ Multiple items impacted Peoples' income tax expense during 2018 and 2017, primarily as a result of the Tax Cuts and Jobs Act, which lowered the statutory federal corporate income tax rate to 21% as of January 1, 2018, from a previous rate of 35%. ▪ Beginning on January 1, 2018, Peoples began recognizing income tax expense at the 21% statutory federal corporate income tax rate, which resulted in lower income tax expense for 2018, compared to the 35% statutory federal corporate income tax rate for 2017. ▪ During the fourth quarter of 2018, Peoples finalized the remeasurement of its net deferred tax assets and liabilities at the new statutory federal corporate income tax rate of 21%, which resulted in a reduction to income tax expense of $0.7 million in 2018. The final adjustment was mainly due to Peoples' contribution of $3.2 million to Peoples' defined benefit pension plan during 2018. ▪ During 2018, Peoples released a valuation allowance which reduced income tax expense by $0.8 million. The valuation allowance was related to a historical tax credit that Peoples had invested in during 2015. Peoples sold $6.7 million of equity investment securities in the second quarter of 2018, which resulted in a capital gain for tax purposes. This capital gain was large enough to offset an anticipated future capital loss, which is expected to be recognized due to the structure of the historical tax credit investment, resulting in the release of the valuation allowance. ▪ During the fourth quarter of 2017, as a result of its initial remeasurement at the new statutory federal corporate income tax rate, Peoples' wrote down its net deferred tax assets by $0.9 million. ◦ During 2018, Peoples incurred $7.5 million of acquisition-related costs, which included $203,000 of losses recorded in net loss on asset disposals and other transactions, and $7.3 million in total non-interest expense. The acquisition-related costs incurred in 2018 were primarily related to fees associated with early termination of contracts, severance costs and write-offs associated with assets acquired. During 2017, Peoples incurred $341,000 in acquisition-related costs, which was all recorded in total non-interest expense. The acquisition costs in 2017 and 2018 were primarily related to the ASB acquisition. ◦ During 2018, Peoples incurred $267,000 in pension settlement costs due to the aggregate amount of lump-sum distributions to participants in Peoples' defined benefit pension plan exceeding the threshold for recognizing such charges during the period. Settlement costs of $242,000 were recognized during 2017. ◦ On July 31, 2018, Peoples entered into $50.0 million of interest rate swaps, which will mature between 2021 and 2028, with interest rates ranging from 2.92% to 3.00%. Additionally, the three interest rate swaps acquired with the ASB acquisition matured in July of 2018. On January 27, 2017, Peoples entered into $20.0 million of forward starting interest rate swaps, which became effective in January and April of 2018 and mature between 2025 and 2027, with interest rates ranging from 2.47% to 2.53%. During 2016, Peoples entered into five forward starting interest rate swaps, with a $40 million notional value, to obtain short-term borrowings at fixed rates, with interest rates ranging from 1.49% to 1.83%, which became effective in 2018 and mature between 2022 and 2026. These swaps locked in funding rates for $40.0 million, in notional value, in FHLB advances that matured in 2018, which had interest rates ranging from 3.57% to 3.92%. For additional information regarding Peoples' interest rate swaps, refer to Note 14 Derivative Financial Instruments of the Notes to the Consolidated Financial Statements. ◦ During 2018, Peoples provided notification that it will be closing two full-service bank branches located in West Virginia, which are currently leased. The lease terms for these locations expire in 2019 and will not be renewed. Additionally, Peoples closed one insurance office located in Ohio when the lease for the location expired at the end of January 2019. During 2017, Peoples closed six full-service bank branches, four located in Ohio, and two located in West Virginia. Peoples continues to evaluate its bank branch network in an effort to optimize efficiency. ◦ On January 1, 2018, Peoples adopted ASU 2016-01, resulting in the reclassification of $7.8 million of equity investment securities from available-for-sale investment securities to other investment securities and the reclassification of $5.0 million in net unrealized gains on equity investment securities from accumulated other comprehensive loss to retained earnings. ASU 2016-01 also requires changes in the fair value of the equity investment securities to be recorded in non-interest income instead of other comprehensive income, which resulted in $207,000 of gains recorded in other non-interest income during 2018. During 2017, Peoples reduced its position in certain equity investment securities. This action was taken as a result of the high appreciation in the market value of these securities. The sales completed resulted in a net gain on investment securities of $3.0 million in 2017. As of December 31, 2018, Peoples had substantially reduced its equity investment securities portfolio. ◦ During 2017, Peoples borrowed an additional $75.0 million of long-term FHLB non-amortizing advances, which have interest rates ranging from 1.20% to 2.03% and mature between 2018 and 2022, of which $10.0 million matured during 2018. Peoples borrowed no additional long-term FHLB non-amortizing advances during 2018. ◦ On October 2, 2017, Peoples Insurance acquired a property and casualty focused independent insurance agency with annual net revenue of $0.8 million located in the Cleveland, Ohio area for total cash consideration of $1.7 million, and recorded $1.1 million of customer relationship intangibles, and $100,000 of fixed assets, resulting in $480,000 of goodwill. ◦ On January 31, 2017, Peoples Insurance acquired a third-party insurance administration company located in Piketon, Ohio for total cash consideration of $0.5 million, and recorded $0.5 million of customer relationship intangibles. ◦ On November 7, 2016, Peoples converted to an upgraded core banking system (including the related operating systems, data systems and products). The conversion resulted in a negative impact to pre-tax income of $1.3 million, or $0.05 in earnings per diluted share, for the full year of 2016, which included lost revenue and additional total non-interest expenses. Deposit account service charges were impacted by the system conversion as Peoples granted waivers of $85,000 related to account services charges in the month of the conversion. The remainder of the $1.3 million was recorded in various expense categories, primarily in other non-interest expense, professional fees, and salaries and employee benefit costs. ◦ The Federal Reserve Board began tightening monetary policy in December 2015 by raising the benchmark Federal Funds Target Rate. Since then, the rate has increased several times from a range of 0.25% to 0.50% to its current range of 2.25% to 2.50%. The recent pace of rate increases is expected to be slower in 2019, with perhaps no increases in 2019. The Federal Reserve Board began reducing the size of its $4.5 trillion balance sheet in the fourth quarter of 2017. However, in February 2019, they indicated that they could pause the unwinding of the balance sheet. If they continue to reduce the size of the balance sheet, it could result in higher interest rates. Peoples is closely monitoring interest rates, both foreign and domestic; and potential impacts of changes in interest rates to Peoples' operations. These rate increases drove higher loan and investment security yields as well as increases in deposit and wholesale funding costs. The impact of these transactions, where material, is discussed in the applicable sections of this Management’s Discussion and Analysis of Financial Condition and Results of Operations. Critical Accounting Policies The accounting and reporting policies of Peoples conform to US GAAP and to general practices within the financial services industry. A summary of significant accounting policies is contained in Note 1 Summary of Significant Accounting Policies of the Notes to the Consolidated Financial Statements. While all of these policies are important to understanding the Consolidated Financial Statements, certain accounting policies require management to exercise judgment and make estimates or assumptions that affect the amounts reported in the Consolidated Financial Statements and accompanying Notes. These estimates and assumptions are based on information available as of the date of the Consolidated Financial Statements; accordingly, as this information changes, the Consolidated Financial Statements could reflect different estimates or assumptions. Management has identified the accounting policies described below as those that, due to the judgments, estimates and assumptions inherent in the policies, are critical to an understanding of Peoples' Consolidated Financial Statements and Management's Discussion and Analysis of Financial Condition and Results of Operations. Allowance for Loan Losses In general, determining the amount of the allowance for loan losses requires significant judgment and the use of estimates by management. Peoples maintains an allowance for loan losses based on a quarterly analysis of the loan portfolio and estimation of the losses that are probable of occurrence within the loan portfolio. This formal analysis determines an appropriate level and allocation of the allowance for loan losses among loan types and the resulting provision for or recovery of loan losses by considering factors affecting losses, including specific losses, levels and trends in impaired and nonperforming loans; historical loan loss experience; current national and local economic conditions; volume; growth and composition of the portfolio; regulatory guidance and other relevant factors. Management continually monitors the loan portfolio through Peoples Bank's Credit Administration Department and Loan Loss Committee to evaluate the appropriateness of the allowance. The provision or recovery could increase or decrease each quarter based upon the results of management's formal analysis. The amount of the allowance for loan losses for the various loan types represents management's estimate of probable losses from existing loans. Management evaluates lending relationships deemed to be impaired on an individual basis and makes specific allocations of the allowance for loan losses for each relationship based on discounted cash flows using the loan's initial effective interest rate or the fair value of the collateral for certain collateral dependent loans. For all other loans, management evaluates pools of homogeneous loans (such as residential mortgage loans, and direct and indirect consumer loans) and makes general allocations for each pool based upon historical loss experience, adjusted for qualitative factors. While allocations are made to specific loans and pools of loans, the allowance is available for all loan losses. The evaluation of individual impaired loans requires management to make estimates of the amounts and timing of future cash flows on impaired loans, which consist primarily of loans placed on nonaccrual status, restructured or internally classified as substandard or doubtful. These reviews are based upon specific quantitative and qualitative criteria, including the size of the loan, the loan cash flow characteristics, the loan quality ratings, the value of collateral, the repayment ability of the borrower, and historical experience factors. Allowances for homogeneous loans are evaluated based upon historical loss experience, adjusted for qualitative risk factors, such as trends in losses and delinquencies, growth of loans in particular markets, and known changes in economic conditions in each lending market. As part of the process of identifying the pools of homogenous loans, management takes into account any concentrations of risk within any portfolio segment, including any significant industrial concentrations. Consistent with the evaluation of allowances for homogenous loans, the allowance relating to the Overdraft Privilege program is based upon management's monthly analysis of accounts in the program. This analysis considers factors that could affect losses on existing accounts, including historical loss experience and length of overdraft. There can be no assurance that the allowance for loan losses will be adequate to cover all losses, but management believes the allowance for loan losses at December 31, 2018 was adequate to provide for probable losses from existing loans based on information currently available. While management uses available information to estimate losses, the ultimate collectability of a substantial portion of the loan portfolio, and the need for future additions to the allowance, will be based on changes in economic conditions and other relevant factors. As such, adverse changes in economic activity could reduce currently estimated cash flows for both commercial and individual borrowers, which would likely cause Peoples to experience increases in problem assets, delinquencies and losses on loans in the future. Peoples also evaluates unfunded commitments for construction loans, floor plan lines of credit, home equity lines of credit, other credit lines and letters of credit on a quarterly basis. The calculation of the reserve for unfunded commitments utilizes the same look back period as the allowance for loan losses, and is based on the reported losses on unfunded commitments during this look back period. This annualized loss rate is then applied to the probable drawn amount of the pooled unfunded commitments to determine the required reserve. Peoples also evaluates classified credit exposures with unfunded commitments individually to determine if a loss is both probable and reasonably estimable. Business Combinations Peoples utilizes the acquisition method of accounting for business combinations. As of the acquisition date, Peoples records the acquired company's net assets at fair value. The determination of fair value as of the acquisition date requires management to consider various factors that involve judgment and estimation, including the application of discount rates, attrition rates, future estimates of interest rates, as well as many other assumptions. These assumptions can have a material impact on the estimated fair value, and as a result, the goodwill recorded in a business combination. Goodwill Peoples records goodwill as a result of acquisitions accounted for under the acquisition method of accounting. Under the acquisition method, Peoples is required to allocate the consideration paid for an acquired company to the assets acquired, including identified intangible assets, and liabilities assumed based on their estimated fair values at the date of acquisition. Goodwill represents the excess cost over the fair value of net assets acquired and is not amortized but is tested for impairment when indicators of impairment exist, and, in any case, at least annually. The value of recorded goodwill is supported by revenue that is driven by the volume of business transacted and Peoples' ability to provide quality, cost-effective services in a competitive market place. A decline in earnings as a result of a lack of growth or the inability to deliver cost-effective services over sustained periods can lead to impairment of goodwill that could adversely impact earnings in future periods. Potential goodwill impairment exists when the fair value of the reporting unit (as defined by US GAAP) is less than its carrying value. An impairment loss is recognized in earnings only when the carrying amount of goodwill is less than its implied fair value. The process of evaluating goodwill for impairment involves highly subjective and complex judgments, estimates and assumptions regarding the fair value of Peoples' reporting unit and, in some cases, goodwill itself. As a result, changes to these judgments, estimates and assumptions in future periods could result in materially different results. Peoples currently maintains a single reporting unit for goodwill impairment testing. While quoted market prices exist for Peoples' common shares since they are publicly traded, these market prices do not necessarily reflect the value associated with gaining control of an entity. Thus, management takes into account all appropriate fair value measurements in determining the estimated fair value of the reporting unit. The measurement of any actual impairment loss requires management to calculate the implied fair value of goodwill by deducting the fair value of all tangible and separately identifiable intangible assets (including unrecognized intangible assets), net of accumulated amortization, from the fair value of the reporting unit. The fair value of net tangible assets is calculated using the methodologies described in Note 2 Fair Value of Financial Instruments of the Notes to the Consolidated Financial Statements. Peoples performs its required annual impairment test as of October 1st each year. Peoples first assesses qualitative factors to determine whether it is more likely than not that the fair value of the reporting unit is less than its carrying amount, including goodwill. In this evaluation, Peoples assesses relevant events and circumstances, which may include macroeconomic conditions, industry and market conditions, cost factors, overall financial performance, events specific to Peoples, significant changes in the reporting unit, or a sustained decrease in stock price. If Peoples determines that it is more likely than not that the fair value of the reporting unit is greater than its carrying amount, then performing the two-step impairment test is unnecessary. However, if there are indicators of impairment, Peoples must complete a two-step process that includes (1) determining if potential goodwill impairment exists and (2) measuring the impairment loss, if any. At October 1, 2018, management's qualitative analysis concluded that the estimated fair value of Peoples' single reporting unit exceeded its carrying value. Peoples is required to perform interim tests for goodwill impairment in subsequent quarters if events occur or circumstances change that indicate potential goodwill impairment exists, such as adverse changes to Peoples' business or a significant decline in Peoples' market capitalization. For further information regarding goodwill, refer to Note 6 Goodwill and Other Intangible Assets of the Notes to the Consolidated Financial Statements. Income Taxes Income taxes are recorded based on the liability method of accounting, which includes the recognition of deferred tax assets and liabilities for the temporary differences between carrying amounts and tax bases of assets and liabilities, computed using enacted tax rates. In general, Peoples records deferred tax assets when the event giving rise to the tax benefit has been recognized in the Consolidated Financial Statements. A valuation allowance is recognized to reduce any deferred tax asset when, based upon available information, it is more-likely-than-not all, or any portion, of the deferred tax asset will not be realized. Assessing the need for, and amount of, a valuation allowance for deferred tax assets requires significant judgment and analysis of evidence regarding realization of the deferred tax assets. In most cases, the realization of deferred tax assets is dependent upon Peoples generating a sufficient level of taxable income in future periods, which can be difficult to predict. Peoples' largest deferred tax assets involve differences related to Peoples' allowance for loan losses, available-for-sale securities, and accrued employee benefits. Management determined a valuation allowance of $805,000 at December 31, 2017, to be recorded against the deferred tax assets associated with its investment in a partnership investment. In 2018, Peoples released the valuation allowance, which reduced income tax expense by $805,000. Peoples sold $6.7 million of equity investment securities in the second quarter of 2018, which resulted in a capital gain for tax purposes. This capital gain was large enough to offset an anticipated future capital loss, which is expected to be recognized due to the structure of the historical tax credit investment, resulting in the release of the valuation allowance. No other valuation allowances were recorded at December 31, 2018. The calculation of tax liabilities is complex and requires the use of estimates and judgment since it involves the application of complex tax laws that are subject to different interpretations by Peoples and the various tax authorities. Peoples' interpretations are subject to challenge by the tax authorities upon audit or to reinterpretation based on management's ongoing assessment of facts and evolving case law. From time-to-time and in the ordinary course of business, Peoples is involved in inquiries and reviews by tax authorities that normally require management to provide supplemental information to support certain tax positions taken by Peoples in its tax returns. Uncertain tax positions are initially recognized in the Consolidated Financial Statements when it is more likely than not the position will be sustained upon examination by the tax authorities. Such tax positions are initially and subsequently measured as the largest amount of tax benefit that is greater than 50% likely of being realized upon ultimate settlement with the tax authority assuming full knowledge of the position and all relevant facts. The amount of unrecognized tax benefits was immaterial at both December 31, 2018 and 2017. Management believes it has taken appropriate positions on its tax returns, although the ultimate outcome of any tax review cannot be predicted with certainty. Consequently, no assurance can be given that the final outcome of these matters will not be different than what is reflected in the current and historical financial statements. Fair Value Measurements As a financial services company, the carrying value of certain financial assets and liabilities is impacted by the application of fair value measurements, either directly or indirectly. In certain cases, an asset or liability is measured and reported at fair value on a recurring basis, such as available-for-sale investment securities. In other cases, management must rely on estimates or judgments to determine if an asset or liability not measured at fair value warrants an impairment write-down or whether a valuation reserve should be established. Given the inherent volatility, the use of fair value measurements may have a significant impact on the carrying value of assets or liabilities, or result in material changes to the consolidated financial statements, from period to period. Detailed information regarding fair value measurements can be found in Note 2 Fair Value of Financial Instruments of the Notes to the Consolidated Financial Statements. EXECUTIVE SUMMARY Net income for the year ended December 31, 2018 was $46.3 million, compared to $38.5 million in 2017 and $31.2 million in 2016, representing earnings per diluted common share of $2.41, $2.10 and $1.71, respectively. The growth during 2018 was driven by increases of $16.2 million in net interest income and $1.2 million in non-interest income, coupled with a $10.0 million decline in income tax expense. These benefits were partially offset by a $7.1 million increase in acquisition-related costs, coupled with the ongoing costs of the ASB acquisition. The increase in earnings during 2017 was driven by higher net interest income, which grew by $8.5 million, along with investment security gains of $3.0 million. These increases were partially offset by a $0.9 million write-down of net deferred tax assets in connection with the Tax Cuts and Jobs Act. Net interest income was $129.6 million in 2018, an increase of 14%, compared to $113.4 million in 2017, which was up 8% compared to 2016. The growth during 2018 was mostly due to originated loan growth and the acquisition of ASB. Growth during 2017 was primarily due to originated loan growth. During both years, higher yields on investment securities and loans were tempered by an increase in deposit and borrowing costs. Net interest margin was 3.71% in 2018, an increase from 3.62% in 2017 and 3.54% in 2016. Accretion income, net of amortization expense, from acquisitions added approximately 6 basis points to net interest margin in 2018, compared to 10 basis points in 2017 and 11 basis points in 2016. In 2018, proceeds of $0.9 million were received on an investment security that, in prior years, had been written-down due to an other-than-temporary impairment, which added 3 basis points to the net interest margin, compared to $0.8 million, and 3 basis points, during 2017. Similar proceeds were not received in 2016. In 2018, Peoples recorded provision for loan losses of $5.4 million, an increase of $1.7 million compared to the $3.8 million that was recorded in 2017 and higher than the $3.5 million recorded for 2016. The increase in 2018 from 2017 was driven primarily by loan growth and an increase in net charge-offs of $638,000. Net charge-offs in 2018 included $827,000 related to one acquired commercial loan relationship. The provision for loan losses represented amounts needed, in management's opinion, to maintain the appropriate level of the allowance for loan losses. Peoples recorded net charge-offs of $4.0 million during 2018, compared to $3.4 million for 2017 and $1.9 million for 2016. Net charge-offs as a percent of average total loans were 0.15% during 2018 and 2017, and 0.09% for 2016. Total non-interest income increased $1.2 million, or 2%, in 2018 compared to 2017. The increase was led by higher income from mortgage banking, electronic banking, trust and investments, and insurance. Mortgage banking income increased because of the benefits of the mortgage origination operations acquired from ASB. In addition, other non-interest income grew during 2018 as a result of higher income related to Small Business Administration ("SBA") loans, coupled with the change in fair value of equity investment securities during 2018. The majority of these equity investment securities were liquidated during 2018, and the fair value change in future periods should be minimal. Total non-interest income increased 9% in 2017 compared to 2016, and was primarily due to the gain on investment securities, coupled with increases in trust and investment, mortgage banking, and bank owned life insurance income. These increases were partially offset by a decrease in deposit account service charges. The increase in trust and investment income was due largely to the growth in the value of assets under administration and management. Mortgage banking income increased due to customer demand. The increase in bank owned life insurance income was the result of the additional $35.0 million of bank owned life insurance policies that were purchased late in the second quarter of 2016, for which a full year of income was recognized in 2017. Total non-interest expense increased 17% during 2018, driven by the increase in acquisition-related expenses of $6.9 million compared to 2017. Also contributing to the changes were higher salaries and employee benefits costs. These costs grew $9.0 million and were the result of a combination of the one-time expenses associated with the ASB acquisition and the resulting increase in number of retained employees from the acquisition. Also contributing to the change were higher sales-based and incentive compensation, and merit increases. Merit increases included the implementation of a $15 per hour minimum wage standard established during 2018, which is expected to be fully implemented by January 1, 2020. In 2017, total non-interest expense increased 1%, or $1.1 million, compared to 2016, largely due to higher salaries and benefit costs. The increase in salaries and benefit costs was driven by increased incentive compensation that was tied to corporate performance for 2017, coupled with higher medical insurance costs and pension settlement charges recognized in 2017. These increases were partially offset by declines in professional fees, communications expense, amortization of other intangible assets and the nonrecurring $1.3 million in core banking system conversion costs that were incurred in 2016. Income tax expense was $8.7 million in 2018 compared to $18.7 million in 2017. The reduction in income tax expense compared to 2017 was largely a result of the Tax Cuts and Jobs Act, which lowered the federal corporate income tax rate from 35% to 21%, combined with the release of a tax valuation allowance of $0.8 million and the final impact related to the statutory federal corporate income tax rate change of $0.7 million during 2018. Income tax expense increased $4.6 million, or 33%, in 2017 compared to 2016, largely due to the increase in pre-tax income in the comparison and the remeasurement of net deferred tax assets as of December 31, 2017. At December 31, 2018, total assets were up 11%, or $409.8 million, to $3.99 billion versus $3.58 billion at year-end 2017. The increase was primarily related to the acquisition of ASB and $213.7 million of originated loan growth. The allowance for loan losses increased slightly to $20.2 million, or 0.74% of total loans, net of deferred fees and costs, compared to $18.8 million and 0.80%, respectively, at December 31, 2017. Total liabilities were $3.47 billion at December 31, 2018, up $348.2 million since December 31, 2017. At December 31, 2018, total deposits increased $225.1 million to $2.96 billion, compared to the prior year-end. Total demand deposits increased $32.2 million, or 3%, and were 40% of total deposits at December 31, 2018 compared to 42% of total deposits at December 31, 2017. The growth in deposits in 2018 compared to the prior year-end was primarily due to acquired ASB deposit balances of $198.6 million. An increase in total borrowed funds of $112.3 million to $465.8 million at December 31, 2018, compared to $353.5 million at December 31, 2017, also contributed to the change in total liabilities. At December 31, 2018, total stockholders' equity was $520.1 million, up 13%, or $61.5 million, from December 31, 2017. The increase was primarily due to earnings of $46.3 million during 2018, the issuance of $40.9 million of common stock related to the acquisition of ASB, and equity-based compensation. Dividends of $21.6 million paid to shareholders and reductions in the market value of investment securities, partially offset these increases. Peoples exceeded the capital required by the Federal Reserve Board to be deemed "well capitalized." Regulatory capital was impacted by the ASB acquisition during 2018, which created increases in capital and risk-weighted assets. Peoples' tier 1 capital ratio increased to 13.87% at December 31, 2018, versus 13.55% at December 31, 2017, while the total capital ratio was 14.60% at December 31, 2018, versus 14.43% at December 31, 2017. The common equity tier 1 risk-based capital ratio was 13.61% at December 31, 2018 compared to 13.26% at December 31, 2017. Peoples' book value and tangible book value per share were $26.59 and $18.30, respectively, at December 31, 2018, compared to $25.08 and $17.17, respectively, at December 31, 2017. Additional information regarding capital requirements can be found in Note 16 Regulatory Matters of the Notes to the Consolidated Financial Statements. RESULTS OF OPERATIONS Interest Income and Expense Peoples earns interest income on loans and investments, and incurs interest expense on interest-bearing deposits and borrowed funds. Net interest income, the amount by which interest income exceeds interest expense, remains Peoples' largest source of revenue. The amount of net interest income earned by Peoples is affected by various factors, including changes in market interest rates due to the Federal Reserve Board's monetary policy, the level and degree of pricing competition for both loans and deposits in Peoples' markets, and the amount and composition of Peoples' earning assets and interest-bearing liabilities. Peoples monitors net interest income performance and manages its balance sheet composition through regular ALCO meetings. The asset-liability management process employed by the ALCO is intended to mitigate the impact of future interest rate changes on Peoples' net interest income and earnings. However, the frequency and/or magnitude of changes in market interest rates are difficult to predict, and may have a greater impact on net interest income than adjustments management is able to make. As part of the analysis of net interest income, management converts tax-exempt income earned on obligations of states and political subdivisions to the pre-tax equivalent of taxable income using a statutory federal corporate income tax rate of 21% for 2018, as a result of the Tax Cuts and Jobs Act, and 35% for 2017 and 2016. Management believes the resulting fully tax-equivalent ("FTE") net interest income allows for a more meaningful comparison of tax-exempt income and yields to their taxable equivalents. Net interest margin, which is calculated by dividing FTE net interest income by average interest-earning assets, serves as an important measurement of the net revenue stream generated by the volume, mix and pricing of earning assets and interest-bearing liabilities. The following table details the calculation of FTE net interest income for the years ended December 31: The following table details Peoples’ average balance sheets, with corresponding income/expense and yield/cost, for the years ended December 31: (a) Average balances are based on carrying value. (b) Interest income and yields are presented on a fully tax-equivalent basis using a 21% statutory federal corporate income tax rate for 2018 and a 35% statutory federal corporate income tax rate for 2017 and 2016. (c) Interest income and yield presented for 2018 and 2017 includes $0.9 million and $0.8 million, respectively, of proceeds on an investment security for which an other-than-temporary-impairment had been recorded in previous years. (d) Average balances include nonaccrual, impaired loans, and loans held for sale. Interest income includes interest earned and received on nonaccrual loans prior to the loans being placed on nonaccrual status. Loan fees included in interest income were immaterial for all periods presented. (e) Loans held for sale are included in the average loan balance listed. Related interest income on loans originated for sale prior to the loan being sold is included in loan interest income. The following table provides an analysis of the changes in FTE net interest income: (a) The change in interest due to both rate and volume has been allocated to rate and volume changes in proportion to the relationship of the dollar amounts of the changes in each. (b) Interest income and yields are presented on a fully tax-equivalent basis using a 21% statutory federal corporate income tax rate for 2018 and a 35% statutory federal corporate income tax rate for 2017 and 2016. During 2018, Peoples recognized accretion income, net of amortization expense, from acquisitions of $2.2 million, which added approximately 6 basis points to net interest margin, compared to $3.1 million and 10 basis points in 2017, and $3.5 million and 11 basis points in 2016. During 2018, proceeds of $894,000 were received on an investment security that had been, in previous years, written-down due to an other-than-temporary impairment, which added 3 basis points to the net interest margin, compared to $814,000, and 3 basis points, in 2017. No such amount was recorded in 2016. Additional interest income in 2018 from prepayment fees and interest recovered on nonaccrual loans was $420,000, compared to $826,000 in 2017 and $964,000 in 2016. The primary driver of the increase in net interest income during the past two years has been the higher loan balances resulting from organic growth and the ASB acquisition in 2018. During 2018 and 2017, net interest income also benefited from increases in interest rates. Funding costs increased in 2018 and 2017 as the Federal Reserve Board raised the benchmark Federal Funds Target Rate by 25 basis points in each of December of 2016, and March, June and December of 2017, as well as March, June, September, and December of 2018. These rate increases drove higher loan and investment security yields, which outpaced increases in deposit and wholesale funding costs in 2018 and 2017. Detailed information regarding changes in the Consolidated Balance Sheets can be found under appropriate captions of the "FINANCIAL CONDITION" section of this discussion. Additional information regarding Peoples' interest rate risk and the potential impact of interest rate changes on Peoples' results of operations and financial condition can be found later in this discussion under the caption "Interest Rate Sensitivity and Liquidity." Provision for Loan Losses The following table details Peoples’ provision for loan losses recognized for the years ended December 31: The provision for loan losses represents the amount needed to maintain the appropriate level of the allowance for loan losses based on management’s formal quarterly analysis of the loan portfolio and procedural methodology that estimates the amount of probable credit losses. This process considers various factors that affect losses, such as changes in Peoples’ loan quality, historical loss experience, current economic conditions, and other environmental factors such as changes in real estate market conditions, unemployment, and the economic impact of tariffs. The provision for loan losses recorded in 2018 was primarily due to continued loan growth and net charge-offs of $2.0 million related to consumer indirect lending, coupled with charge-offs of $827,000 related to one acquired commercial loan relationship. The provision for loan losses recorded in 2017 and 2016 was driven by loan growth and stable asset quality trends. Additional information regarding changes in the allowance for loan losses and loan credit quality can be found later in this discussion under the caption "Allowance for Loan Losses." Net Gains (Losses) Included in Total Non-Interest Income The following table details Peoples’ net gains and losses, recognized in total non-interest income, for the years ended December 31: During 2017, Peoples reduced its position in certain equity investment securities, which resulted in net gains on investment securities of $3.0 million. The following table details the net loss on asset disposals and other transactions for the years ended December 31 recognized by Peoples: The net loss on other assets during 2018 was primarily due to the disposal of $190,000 of ASB fixed assets acquired coupled with $198,000 of market value write-downs related to closed offices that were held for sale. The net loss on other transactions during 2018 was due to the write-down of a limited partnership investment. During 2017, the net loss on OREO was a result of the sale of two commercial properties. The net gain on other assets during 2017 was due to the sale of a previously closed branch, which was offset partially by a loss on the sale of a parking lot that was no longer being utilized. The net loss on debt extinguishment in 2016 was mainly due to the prepayment of $20.0 million of long-term FHLB advances. The net loss on other transactions during 2016 was related to the write-down of an investment made in an asset that had a corresponding tax benefit to Peoples. The net loss on other assets during 2016 was due mainly to the closing of a leased office and related disposal of leasehold improvements. Total Non-Interest Income Excluding Net Gains and Losses Peoples generates total non-interest income excluding net gains and losses from four primary sources: insurance income; trust and investment income; electronic banking income ("e-banking"); and deposit account service charges. Peoples continues to focus on revenue growth from non-interest income sources in order to maintain a diversified revenue stream through greater reliance on total non-interest income excluding net gains and losses. As a result, total non-interest income excluding net gains and losses accounted for 30.6% of Peoples' total revenues (defined as net interest income plus total non-interest income excluding net gains and losses) in 2018, compared to 31.7% in 2017 and 32.8% in 2016. The slight decline in Peoples' total non-interest income excluding net gains and losses as a percent of total revenue during 2018 from 2017 was primarily due to increased net interest income due to originated loan growth and the acquisition of ASB, as well as interest rate increases. The decline in the ratio in 2017 compared to 2016 was primarily due to increased net interest income resulting from loan growth and higher interest rates. Insurance income comprised the largest portion of Peoples' non-interest income. The following table details Peoples’ insurance income for the years ended December 31: The majority of performance-based commissions typically are recorded annually in the first quarter and are based on a combination of factors, such as loss experience of insurance policies sold, production volumes and overall financial performance of the individual insurance carriers. The increase in life and health insurance commissions was primarily due to timing of revenue recognition attributable to the implementation of ASU 2014-09. The increase in other fees and charges during 2017 was due to the acquisition of a third-party insurance administration company that occurred in January 2017. Peoples' fiduciary and brokerage revenues continue to be based primarily upon the value of assets under administration and management. The following table details Peoples’ trust and investment income for the years ended December 31: The following table details Peoples’ assets under administration and management at year-end December 31: During 2018, the increases in fiduciary and brokerage revenues were due to a combination of growth of new business, primarily in fee-based accounts, and growth in retirement benefit plans. In recent years, Peoples has added experienced financial advisors in previously underserved market areas, and generated new business and revenue related to retirement plans for which it manages the assets and provides services. Average assets under administration and management during 2018 increased compared to 2017 due primarily to new assets under administration and management, coupled with an increase in the market value of accounts. The U.S. financial markets shifted downward at the end of 2018, resulting in the decline in end-of-period assets under administration and management at December 31, 2018 compared to December 31, 2017. During 2017, the increase in fiduciary and brokerage revenues was primarily due to the increase in assets under administration and management, which were positively impacted by the U.S. financial markets, and retirement benefits plans. E-banking income increased $1.1 million to $11.5 million in 2018, compared to $10.4 million in both 2017 and 2016. Peoples' e-banking services include ATM and debit cards, direct deposit services, internet and mobile banking, and remote deposit capture, and serve as alternative delivery channels to traditional sales offices for providing services to clients. Revenue is derived largely from ATM and debit cards, as other services are mainly provided at no charge to the customers. The amount of e-banking income is largely dependent on the timing and volume of customer activity. The increase in e-banking income in 2018 was the result of the increased usage of debit cards by more customers, which includes the impact of additional customers and accounts related to the acquisition of ASB. In 2018, Peoples' customers used their debit cards to complete $801 million of transactions, versus $729 million in 2017 and $728 million in 2016. Deposit account service charges, which are based on the recovery of costs associated with services provided, comprised a significant portion of Peoples' non-interest income. The following table details Peoples' deposit account service charges for the years ended December 31: The amount of deposit account service charges, particularly fees for overdrafts and non-sufficient funds, is largely dependent on the timing and volume of customer activity. Management periodically evaluates its cost recovery fees to ensure they are reasonable based on operational costs and similar to fees charged in Peoples' markets by competitors. The slight decline in overdraft and non-sufficient funds fees between 2018 and 2017 was partially due to changes made to the calculation of fees to be more in line with industry practices. The increase in account maintenance fees in 2018, compared to 2017, was largely due to implementation of new consumer checking products that occurred near the end of 2017. Other fees and charges declined in 2018, compared to 2017, mainly due to changes made in the calculation of personalized check fees. The increase between 2017 and 2016 in account maintenance fees was the result of higher fees received on commercial and consumer checking accounts. The following table details the other items included within Peoples' total non-interest income for the years ended December 31: (a) As of January 1, 2018, Peoples adopted ASU 2016-01, resulting in a gain in income of $207,000 for 2018. Mortgage banking income is comprised mostly of net gains from the origination and sale of long-term, fixed rate real estate loans in the secondary market, as well as servicing income for sold loans. As a result, the amount of income recognized by Peoples is largely dependent on customer demand and long-term interest rates for residential real estate loans offered in the secondary market. Mortgage banking income increased 78.0% in 2018, largely due to gains on sale of real estate loans originated by the mortgage origination operation acquired as part of the ASB acquisition, and increased 43.6% in 2017, due to customer demand. In 2018, Peoples sold approximately $66.3 million of loans to the secondary market with servicing retained and sold approximately $56.4 million in loans with servicing released. Peoples sold $65.2 million of loans to the secondary market with servicing retained during 2017 and $67.1 million in 2016. Bank owned life insurance income was essentially flat during 2018 compared to 2017. Peoples purchased no additional bank owned life insurance policies during 2018 and 2017; however, $4.8 million was acquired in the ASB acquisition. During 2017, bank owned life insurance income increased to $2.0 million, compared to $1.4 million in 2016. The increase in bank owned life insurance income was the result of the additional $35.0 million of bank owned life insurance policies that were purchased in the second quarter of 2016, for which a full year was recognized in 2017. Commercial loan swap fee income is largely dependent on the timing and volume of customer activity. During 2018, an increase in the number of individual transactions was more than offset by a decline in the average size of each transaction, resulting in lower commercial loan swap fee income in 2018, compared to 2017. The increase in other non-interest income in 2018 compared to 2017 was primarily due to an increase of $318,000 in the income related to the sale of SBA loans. During 2018, other non-interest income also included $207,000 recorded in connection with the implementation of a new accounting standard, which modified how the change in the fair value of equity investment securities was recorded effective January 1, 2018. Total Non-Interest Expense Salaries and employee benefit costs remain Peoples’ largest non-interest expense, accounting for over half of the total non-interest expense. The following table details Peoples’ salaries and employee benefit costs for the years ended December 31: Base salaries and wages in 2018 included $2.2 million of one-time expenses associated with the acquisition of ASB. The ongoing retention of ASB employees also contributed to the increase in base salaries and wages, and in the number of employees in 2018 compared to 2017. Merit increases also contributed to the increase in base salaries and wages during 2018, which included the implementation of a $15 per hour minimum wage throughout the company, which was announced in early 2018 and will be fully implemented by January 1, 2020. Sales-based and incentive compensation increased in 2018 and 2017 largely due to higher incentive compensation related to the mortgage banking income growth, coupled with improvement in corporate performance for 2018. Peoples' sales-based and incentive compensation plans are designed to grow core earnings while managing risk, and do not encourage unnecessary and excessive risk-taking that could threaten the value of Peoples. The sales-based and incentive compensation plans reward employees for appropriate behaviors and include provisions for inappropriate practices with respect to Peoples and its customers, including clawbacks for executives. During 2018, employee benefit costs were relatively flat compared to 2017. Employee benefit costs increased during 2017 compared to 2016 from higher medical insurance costs and pension settlement charges recognized. Settlement charges are largely based on the timing of retirements of plan participants and their election of lump-sum distributions. A pension settlement charge is recognized when the aggregate amount of lump-sum distributions to participants in Peoples' defined benefit pension plan exceeds threshold for recognizing such charges during the period. Management anticipates continued pension settlement charges in future years as plan participants retire and elect lump-sum distributions from the pension plan. Stock-based compensation is generally recognized over the vesting period, which can range from immediate vesting to three-year vesting, for the portion of awards that are expected to vest, and at the vesting date, an adjustment is made to recognize the entire expense for vested awards and reverse expense for non-vested awards. The majority of Peoples' stock-based compensation is attributable to annual equity-based incentive awards to employees, which are awarded in the first quarter and based upon Peoples achieving certain performance goals during the prior year. During the years presented in the table above, Peoples granted restricted common shares to officers and key employees with performance-based vesting periods and time-based vesting periods, generally with a three-year vesting. The increase in stock-based compensation during the three years presented in the table above correlates to Peoples' improved performance during recent years. The increase in 2018, compared to 2017, was also impacted by the Board of Directors granting 12,144 unrestricted common shares to full-time and part-time employees who did not already participate in the Peoples Bancorp Inc. Third Amended and Restated 2006 Equity Plan, which resulted in stock-based compensation of $416,000. Additional information regarding Peoples' stock-based compensation plans and awards can be found in Note 17 Stock-Based Compensation of the Notes to the Consolidated Financial Statements. Deferred personnel costs represent the portion of current period salaries and employee benefit costs considered to be direct loan origination costs. These costs are capitalized and recognized over the life of the loan as a yield adjustment in interest income. As a result, the amount of deferred personnel costs for each year corresponds directly with the level of new loan originations. Higher loan originations in 2018 compared to 2017 drove the increase in deferred personnel costs during 2018. Additional information regarding Peoples' loan activity can be found later in this discussion under the caption "Loans." Payroll taxes and other employee costs increased during 2018 as a result of higher base salaries and wages, sales-based and incentive compensation, and employee benefits compared to 2017. Peoples’ net occupancy and equipment expense for the years ended December 31 was comprised of the following: Net occupancy and equipment expense increased during 2018 primarily due to the increased maintenance costs, property taxes, utilities and other costs related to the addition of seven full-service bank branches and two loan production offices from the ASB acquisition and ongoing increased operating costs associated with the expanded footprint. Increases in depreciation expense related to the additional branches were partially offset by the full-year impact of the closure of six full-service branches during 2017. During 2017, depreciation expense decreased as assets became fully depreciated, branches were closed and new fixed asset purchases decreased. Management continues to monitor capital expenditures and explore opportunities to enhance Peoples' operating efficiency. The following table details the other items included within Peoples' total non-interest expense for the years ended December 31: Professional fees increased in 2018 compared to 2017 due to higher consulting expenses and an increase of $785,000 in acquisition-related expenses (investment banking and legal fees). Peoples' e-banking expense is comprised of costs associated with debit and ATM cards, as well as internet and mobile banking costs. The increase in 2018 and 2017 was due to customers completing a higher volume of transactions using their debit cards, and Peoples' internet and mobile banking service. Also contributing to the increase in 2018 was the addition of accounts related to the ASB acquisition. These factors also produced a greater increase in the corresponding e-banking revenues over the same period. Data processing and software expense includes software support, maintenance and depreciation expense. These costs increased during 2018 due to the implementation of enhanced functionalities for Peoples' core banking system, including making certain mobile banking tools available to customers, growth in the number of accounts, implementation of customer relationship profitability and a new floor plan system implemented at the end of 2017. The increase during 2017 was due to the increase of software support and higher depreciation related to software and the core banking system conversion in late 2016, which provides additional customer services and capabilities. Peoples' amortization of other intangible assets is driven by acquisition-related activity. Amortization of other intangible assets declined during 2018 and 2017 as a result of the amortization schedules related to core deposit and customer relationship intangible assets arising from acquisitions. The decline during 2018 was partially offset by additional amortization related to the acquisition of ASB. Peoples is subject to state franchise taxes, which are based largely on Peoples' equity at year-end, in the states where Peoples has a physical presence. Franchise tax expense also includes the Ohio Financial Institution Tax ("FIT"), which is a business privilege tax that is imposed on financial institutions organized for profit and doing business in Ohio. The Ohio FIT is based on the total equity capital in proportion to the taxpayer's gross receipts in Ohio. Expenses related to state franchise taxes, which includes Ohio FIT, increased in 2018 due to additional equity from the issuance of common shares related to the acquisition of ASB and from operating results. In 2018, marketing expense, which includes advertising, donations and other public relations costs, increased $248,000 from 2017. The increase during 2018 includes $119,000 of one-time acquisition-related expenses and additional marketing campaigns in the new market areas. During 2017, marketing expense increased primarily due to higher donations to Peoples Bank Foundation, Inc. Peoples formed this private foundation in 2004 to make charitable contributions to organizations within Peoples' primary market area. Future contributions to Peoples Bank Foundation, Inc. will be evaluated on an annual basis, with the determination of the amount of any contribution based largely on the perceived level of need within the communities Peoples serves. The FDIC quarterly assessment rate is applied to average total assets less average tangible equity, and is based on the leverage ratio, net income before taxes, nonperforming loans as a percent of total assets, OREO, loan mix and asset growth. Peoples experienced improvements in each of these categories during 2017 and 2018, leading to a reduction in the quarterly FDIC assessment rate, which offset increases in the expense that are attributable to the asset growth experienced during the last two years. Peoples' 2017 FDIC insurance expense also decreased slightly from 2016 as assessment changes became effective July 1, 2016. Additional information regarding Peoples' FDIC insurance assessments may be found in "ITEM 1 BUSINESS" of this Form 10-K in the section captioned "Supervision and Regulation." Foreclosed real estate and other loan expenses increased during 2018 due to higher real estate loan expense and collection expenses. The higher real estate loan expense was due to additional mortgage processing associated with the acquired origination group from the ASB acquisition. The increase in collection expenses was related to the growth in indirect consumer lending. The decrease in communication expense during 2018 was attributable to the re-negotiation of contracts with vendors. The decrease in 2017 compared to 2016 resulted from the consolidation of traditional phone lines to a method of transmitting all voice traffic over the internet and the discontinuation of overlapping traditional phone line contracts that occurred during the transition. Other non-interest expense increased $5.2 million in 2018 compared to 2017, and decreased $181,000 in 2017 compared to 2016. The increase during 2018 was driven by $3.6 million of one-time acquisition-related expenses in 2018 compared to $14,000 in 2017. The 2018 acquisition-related expenses related mainly to contract termination fees and other costs related to the system conversion. The remaining increase in 2018 compared to 2017 was made up of various other small items. During 2016, Peoples recorded $0.7 million of expense related to the core system conversion costs. Income Tax Expense A key driver for the amount of income tax expense or benefit recognized by Peoples each year is the amount of pre-tax income. In addition to the expense recognized, Peoples receives tax benefits from tax-exempt investments and loans, bank owned life insurance, stock awards that settled or vested during the year, and investments in tax credit funds, which reduce Peoples' effective tax rate. A reconciliation of Peoples' recorded income tax expense/benefit and effective tax rate to the statutory tax rate can be found in Note 12 Income Taxes of the Notes to the Consolidated Financial Statements. On January 1, 2018, the Tax Cuts and Jobs Act lowered the statutory federal corporate income tax rate from 35% to 21%, and was the primary cause of the decline in Peoples' income tax expense for 2018 compared to 2017. The difference of 14% in the statutory federal corporate income tax rate between 2018 and 2017, applied to the income before income taxes for 2018, equates to a $7.7 million reduction in income tax expense. During the fourth quarter of 2018, the final remeasurement of deferred tax assets and deferred tax liabilities at the new statutory federal corporate income tax rate of 21%, down from 35%, resulted in a reduction to income tax expense of $0.7 million. During the fourth quarter of 2017, as a result of its initial remeasurement of deferred tax assets and deferred tax liabilities at the new statutory federal corporate income tax rate, Peoples wrote down its net deferred tax assets by $0.9 million, which had a direct impact on income tax expense recorded during 2017. Additionally, as of December 31, 2017, Peoples early adopted ASU 2018-02 Income Statement - Reporting Comprehensive Income (Topic 220): Reclassification of Certain Tax Effects from Accumulated Other Comprehensive Income and elected to reclassify, from accumulated other comprehensive income to retained earnings, the stranded income tax effects in accumulated other comprehensive loss resulting from the Tax Cuts and Jobs Act. In 2018, Peoples released a valuation allowance, which reduced income tax expense by $0.8 million. The valuation allowance was related to a historic tax credit that Peoples had invested in during 2015. Peoples sold $6.7 million of equity investment securities in 2018, which resulted in a capital gain for tax purposes. This capital gain was large enough to offset an anticipated future capital loss, which is expected to be recognized due to the structure of the historic tax credit investment, resulting in the release of the valuation allowance. Peoples recorded a tax benefit of $332,000 in 2018 and a tax benefit of $154,000 in 2017, as the result of the adoption of ASU 2016-09, which became effective January 1, 2017. The tax benefit related to stock awards that settled or vested during the year, with the majority recorded in the first quarter of each year. Pre-Provision Net Revenue (non-US GAAP) Pre-provision net revenue ("PPNR") has become a key financial measure used by federal bank regulatory agencies when assessing the capital adequacy of financial institutions. PPNR is defined as net interest income plus total non-interest income (excluding all gains and losses) minus total non-interest expense and, therefore, excludes the provision for (recovery of) loan losses and all gains and/or losses included in earnings. As a result, PPNR represents the earnings capacity that can be either retained in order to build capital or used to absorb unexpected losses and preserve existing capital. The following table provides a reconciliation of this non-US GAAP financial measure to the amounts of income before income taxes reported in Peoples' Consolidated Financial Statements for the periods presented: During 2018, PPNR was higher while the pre-provision net revenue to total average assets ratio declined compared to 2017. The growth of average assets during the year, which was partially attributable to the ASB acquisition, outpaced the increase in PPNR, which was diminished by $7.3 million of acquisition-related expenses. The increase in PPNR in 2017 was due to the increase in revenue as a result of net interest income growth offset partially by a slight increase in total non-interest expenses. The increase in the PPNR in 2016 was primarily due to an increase in revenue as a result of net interest income growth coupled with a decrease in total non-interest expense. The increase in the PPNR in 2015 was primarily due to the completion of the NB&T acquisition and recognition of a full year of revenue for acquisitions completed during 2014. The decrease in the pre-provision net revenue to total average assets ratio for 2015 compared to 2014 reflected the increase of average assets, which also was reflective of the NB&T acquisition, offsetting the increase in PPNR, which was diminished by acquisition-related expenses of $10.7 million. Core Non-Interest Income and Expense (non-US GAAP) Core non-interest income and core non-interest expense are financial measures used to evaluate Peoples' recurring revenue and expense streams. These measures are non-US GAAP since they exclude the impact of all gains and/or losses, core banking system conversion revenue and expenses, acquisition-related expenses, pension settlement charges and other non-recurring expenses. The following tables provide reconciliations of these non-US GAAP measures to the amounts reported in Peoples' Consolidated Financial Statements for the periods presented: Efficiency Ratio (non-US GAAP) The efficiency ratio is a key financial measure used to monitor performance. The efficiency ratio is calculated as total non-interest expense (less amortization of other intangible assets) as a percentage of fully tax-equivalent net interest income plus total non-interest income excluding net gains and losses. This measure is non-US GAAP since it excludes amortization of other intangible assets and all gains and/or losses included in earnings, and uses fully tax-equivalent net interest income. The following table provides a reconciliation of this non-US GAAP financial measure to the amounts reported in Peoples' Consolidated Financial Statements for the periods presented: (a) Based on a 21% statutory federal corporate income tax rate for 2018 and a 35% statutory federal corporate income tax rate for 2017 and prior periods. The increase in the efficiency ratio between 2018 and 2017 was driven by acquisition-related expenses of $7.3 million in 2018, compared to $341,000 in 2017. The continued decline in the efficiency ratio adjusted for non-core items in recent years has been driven by acquisitions, coupled with the focus of growing revenues at a higher rate than expenses on a percentage basis. Managing expenses has been a major focus over the last three years, however, during this time Peoples has continued to make meaningful investments in its infrastructure and systems. Return on Average Assets Adjusted for Non-Core Items (non-US GAAP) In addition to return on average assets, management uses return on average assets adjusted for non-core items to monitor performance. The return on average assets ratio adjusted for non-core items represents a non-US GAAP financial measure since it excludes the release of the deferred tax asset valuation allowance, the impact of the Tax Cuts and Jobs Act on the remeasurement of deferred tax assets and deferred tax liabilities, and the after-tax impact of all gains and losses, core banking system conversion revenue and expenses, acquisition-related expenses, pension settlement charges, and other non-recurring expenses in earnings. The following table provides a reconciliation of this non-US GAAP financial measure to the amounts reported in Peoples' Consolidated Financial Statements for the periods presented: (a) Based on a 21% statutory federal corporate income tax rate for 2018 and a 35% statutory federal corporate income tax rate for 2017 and prior periods. Return on Average Tangible Equity (non-US GAAP) The return on average tangible equity ratio is a key financial measure used to monitor performance. The return on tangible equity is calculated as net income (less after-tax impact of amortization of other intangible assets) divided by tangible equity. This measure is non-US GAAP since it excludes amortization of other intangible assets from earnings and the impact of goodwill and other intangible assets acquired through acquisitions on total stockholders' equity. (a) Based on a 21% statutory federal corporate income tax rate for 2018 and a 35% statutory federal corporate income tax rate for 2017 and prior periods. The return on average stockholders' equity and average tangible equity ratios increased in 2018 compared to 2017, reflecting the increase in net income which outpaced the increases in average stockholders' equity and average tangible equity. Average stockholders' equity and average tangible equity increased due mainly to net income and the ASB acquisition, partially offset by dividends declared. FINANCIAL CONDITION Cash and Cash Equivalents Peoples considers cash and cash equivalents to consist of federal funds sold, cash and balances due from banks, interest-bearing balances in other institutions and other short-term investments that are readily liquid. The amount of cash and cash equivalents fluctuates on a daily basis due to customer activity and Peoples' liquidity needs. At December 31, 2018, excess cash reserves at the FRB were $11.2 million, compared to $9.3 million at December 31, 2017. The amount of excess cash reserves maintained is dependent upon Peoples' daily liquidity position, which is driven primarily by changes in deposit and loan balances. In 2018, Peoples' total cash and cash equivalents increased $5.4 million, as cash provided by operating and financing activities of $75.2 million and $60.3 million, respectively, were partially offset by cash used of $130.2 million in investing activities. Cash used in investing activities was primarily due to funded loan growth of $134.1 million. Loan growth was partially funded by the increase of Peoples' financing activities of short-term borrowings of $61.9 million and deposit growth, excluding deposits acquired from the ASB acquisition, of $25.8 million. The increase in operating activities was due primarily to $46.3 million of net income. In 2017, Peoples' total cash and cash equivalents increased $6.0 million, as cash provided by financing and operating activities of $107.7 million and $61.0 million, respectively, were partially offset by cash used of $162.7 million in investing activities. Cash used in investing activities was primarily due to funded loan growth of $130.4 million. The loan growth was partially funded by deposit growth of $220.6 million, which was offset by decreases of $97.5 million in short and long-term borrowings. The increase in operating activities was due primarily to $38.5 million of net income. Further information regarding the management of Peoples' liquidity position can be found later in this discussion under "Interest Rate Sensitivity and Liquidity." Investment Securities The following table provides information regarding Peoples’ investment portfolio at December 31: (a) As of January 1, 2018, Peoples adopted ASU 2016-01, resulting in the reclassification of equity investment securities from available-for-sale investment securities to other investment securities. At December 31, 2018, $277,000 of equity investment securities were included in other investment securities compared to $7.8 million of equity investment securities included in available-for-sale investment securities at December 31, 2017. At December 31, 2018, Peoples' investment securities were approximately 21.8% of total assets, compared to 24.4% at December 31, 2017. During 2018, Peoples acquired, in the ASB acquisition, investment securities totaling approximately $18.8 million and subsequently sold approximately $14.6 million of acquired available-for-sale investment securities. Proceeds from security sales were used to reduce overnight borrowing at FHLB. Investment securities increased at December 31, 2017 from December 31, 2016 due to purchases of residential mortgage-backed securities that were partially offset by principal paydowns during that year. In 2015, Peoples acquired $156.4 million of investment securities as part of the NB&T acquisition, with the remaining fluctuation due to purchases being more than offset by principal paydowns, sales, calls and maturities. Peoples designates certain securities as "held-to-maturity" at the time of their purchase if management determines Peoples would have the intent and ability to hold certain purchased securities until maturity. The unrealized gain or loss related to held-to-maturity investment securities does not directly impact total stockholders' equity, in contrast to the impact from the available-for-sale investment securities portfolio. Peoples' investment in residential and commercial mortgage-backed securities largely consists of securities either guaranteed by the U.S. government or issued by U.S. government sponsored agencies, such as Fannie Mae and Freddie Mac. The remaining portions of Peoples' mortgage-backed securities consist of securities issued by other entities, including other financial institutions, which are not guaranteed by the U.S. government. The amount of these "non-agency" securities included in the residential mortgage-backed securities totals above was as follows at December 31: Management continues to reinvest the principal runoff from the non-agency securities in U.S. agency investments, which accounted for the continued decline in these securities. At December 31, 2018, Peoples' non-agency portfolio consisted entirely of first lien residential mortgages, with nearly all of the underlying loans in these securities originated prior to 2004 and possessing fixed interest rates. Management continues to monitor the non-agency portfolio closely for leading indicators of increasing stress and will continue to be proactive in taking actions to mitigate such risk when necessary. Additional information regarding Peoples' investment portfolio can be found in Note 3 Investment Securities of the Notes to the Consolidated Financial Statements. Loans The following table provides information regarding outstanding loan balances at December 31: (a) Includes all loans acquired, and related loan discount recorded as part of acquisition accounting, in 2014 and thereafter. Loans that were acquired and subsequently re-underwritten are reported as originated upon execution of such credit actions (for example, renewals and increases in lines of credit). (b) NM = not meaningful. As of December 31, 2018, total loans grew 16%, or $371.6 million, compared to December 31, 2017. Total originated loans (excluding acquired loans) grew 11%, or $213.7 million, during 2018. Originated loan growth was led by an increase in commercial and industrial loans of $92.2 million, or 21%, and indirect consumer lending growth of $66.8 million, or 20%. Total acquired loans grew $157.9 million during 2018, which included $208.9 million related to the ASB acquisition as of December 31, 2018, partially offset by the continued decline of the loan balances acquired in previous acquisitions. Balances in loan accounts acquired from ASB as of December 31, 2018 included $116.5 million in residential real estate loans, $49.6 million in commercial real estate loans, $24.5 million in home equity lines of credit, $9.5 million in commercial and industrial loans, $7.0 million in construction loans, and $1.8 million in consumer loans. During 2017, total loans grew 6%, or $132.2 million. The increase was primarily the result of commercial loan growth of $95.5 million, or 8%, which includes commercial real estate and commercial and industrial loan balances. Additionally, continued emphasis on growing indirect consumer lending led to growth of $87.9 million, or 35%, compared to December 31, 2016, and was partially offset by reductions in residential real estate loans. During 2016, total loans grew 7%, or $152.5 million, with growth of 8% in commercial loan balances and 7% in consumer loan balances. Continuing the trend of 2015, indirect consumer lending experienced the largest growth across all loan categories for the year, increasing by $85.7 million, or 51%. Commercial and industrial loan growth was $70.6 million, or 20%, for the year. During 2015, total loans grew 28%, or $451.5 million. Total originated loans (excluding acquired loans) grew 17%, or $202.6 million, due to increases in all categories except deposit account overdrafts. The increase in total acquired loans in 2015 was due to the NB&T acquisition. The following table details the maturities of Peoples' commercial real estate and commercial and industrial loans at December 31, 2018: Loan Concentration Peoples categorizes its commercial loans according to standard industry classifications and monitors for concentrations in a single industry or multiple industries that could be impacted by changes in economic conditions in a similar manner. Peoples' commercial lending activities continue to be spread over a diverse range of businesses from all sectors of the economy, with no single industry comprising over 10% of Peoples' total loan portfolio. Loans secured by commercial real estate, including commercial construction loans, continue to comprise the largest portion of Peoples' loan portfolio. The following table provides information regarding the largest concentrations of commercial real estate loans within the loan portfolio at December 31, 2018: (a) All other outstanding balances are less than 2% of the total loan portfolio. (a) All other outstanding balances are less than 2% of the total loan portfolio. Peoples' commercial lending activities continue to focus on lending opportunities inside its primary and secondary market areas within Ohio, West Virginia and Kentucky. In all other states, the aggregate outstanding balances of commercial loans in each state were not material at either December 31, 2018 or December 31, 2017. Additional information regarding Peoples' loan portfolio can be found in Note 4 Loans of the Notes to the Consolidated Financial Statements. Allowance for Loan Losses The amount of the allowance for loan losses at the end of each period represents management's estimate of probable losses from existing loans based upon its formal quarterly analysis of the loan portfolio described in the "Critical Accounting Policies" section of this discussion. While this process involves allocations being made to specific loans and pools of loans, the entire allowance is available for all losses incurred within the loan portfolio. The following details management's allocation of the allowance for loan losses at December 31: The allowance for loan losses as a percent of total loans decreased 6 basis points in 2018 compared to 2017 as a result of relatively stable asset quality metrics and trends, and the loans acquired in the ASB acquisition. In accordance with US GAAP, at the acquisition date, acquired loans are recorded at fair value with no associated allowance for loan losses. At December 31, 2018, the ratio included total acquired loans, from the ASB acquisition and previous acquisitions, of $572.7 million and an allowance for acquired loan losses of $0.5 million. During 2018, the increase in allowance for loan losses was primarily related to continued loan growth in most of the originated loan portfolios. The continued decline in the allowance for loan losses as a percent of total loans, net of deferred fees and costs, relates to the historic lookback period and the recession-era charge-offs no longer being included in the calculation. Peoples also considers recent trends in criticized loans and loan growth associated with each loan portfolio, as well as qualitative factors that could negatively impact these trends, such as unemployment, rising interest rates, changes in real estate market conditions, fluctuating oil and gas prices, and the economic impact of tariffs. Peoples believes the reserves remain appropriate to cover probable losses that exist in the current portfolio. The allowance for loan losses allocated to the residential real estate and consumer loan categories was based upon Peoples' allowance methodology for homogeneous pools of loans. The fluctuations in these allocations have been directionally consistent with the changes in loan quality, loss experience and loan balances in these categories. The increase in the allowance for loan losses for consumer loans has been mostly driven by loan growth in indirect lending in recent periods. During 2017, the increase in allowance for loan losses related primarily to growth in consumer indirect loan balances. During 2016, the increase of 9% in the allowance for loan losses related to total commercial and consumer indirect balance growth. The reductions in the allowance for loan losses allocated to commercial real estate during 2015 and 2014 were driven by net recoveries in then recent years reducing the historical loss rates. During 2015, increases in the commercial and industrial, home equity lines of credit and consumer categories of the allowance for loan losses were driven by net charge-off activity, and increases in the balances of the respective loan portfolios. The allowance for loan losses as a percent of total loans declined during 2015 compared to 2014 as a result of the reduction in historic loss rates, and the NB&T acquisition, as the loans acquired from NB&T were recorded at a preliminary fair value, in accordance with US GAAP, and no allowance for loan loss related to these loans has been recorded based on an analysis of the loans as of December 31, 2015. The significant allocations to commercial loans reflect the higher credit risk associated with these types of lending and the size of these loan categories in relationship to the entire loan portfolio. The following table summarizes the changes in the allowance for loan losses for the years ended December 31: (a) Includes purchased credit impaired loan charge-offs of $0 in 2018, $0 in 2017, $44,000 in 2016, $60,000 in 2015 and $0 in 2014. (b) Includes purchased credit impaired loan charge-offs of $2,000 in 2018, $0 in 2017, $23,000 in 2016, $3,000 in 2015 and $0 in 2014. (c) Includes purchased credit impaired loan charge-offs of $0 in 2018, $7,000 in 2017, $23,000 in 2016, $3,000 in 2015, and $0 in 2014. (d) Includes purchased credit impaired loan provision for loan losses of $0 in 2018, $117,000 in 2017, $66,000 in 2016, $303,000 in 2015 and $0 in 2014. (e) Includes nonimpaired loan provision for loan losses of $383,000 in 2018 and $0 in 2017, 2016, 2015 and 2014. Net charge-offs for 2018 increased $638,000 compared to 2017; however, net charge-offs as a percent of average total loans was unchanged at 0.15%. Net charge-offs in 2018 included $827,000 related to one acquired commercial loan relationship. Indirect consumer lending has provided significant growth in recent periods, resulting in the growth in the allowance for loan losses and net charge-offs within that category. The increase in net charge-offs from 2016 to 2017 was primarily related to a decline in recoveries of commercial loans and an increase in net charge-offs of consumer indirect loans due to higher balances from recent loan growth. During 2016, net charge-offs were nominal at 0.09% of average total loans and were positively impacted by a $1.0 million recovery of a prior period commercial real estate loan charge-off. Gross charge-offs totaled $5.2 million in 2016, and were largely associated with the growth in the consumer loan portfolio. In 2015, Peoples recorded charge-offs related to one large commercial loan relationship in the aggregate amount of $13.1 million, or 0.67% of average total loans. The following table details Peoples’ nonperforming assets at December 31: (a) Includes loans categorized as special mention, substandard or doubtful. (b) Includes loans categorized as substandard or doubtful. (c) Data presented as of the end of the period indicated. (d) Nonperforming loans include loans 90+ days past due and accruing, troubled debt restructured loans and nonaccrual loans. Nonperforming assets include nonperforming loans and OREO. The increase in loans 90+ days past due and accruing during 2018 was driven primarily by one commercial loan, which was in the process of renewal at December 31, 2018. During 2018, the growth in nonaccrual loans was driven primarily by one commercial loan that was over 90 days past due. Nonperforming loans decreased in 2017, largely due to the decrease in nonaccrual loans, coupled with declines in loans 90+ days past due and accruing. The decrease in nonaccrual loans was driven by several commercial real estate relationships that were paid off in 2017. Nonperforming loans increased in 2016, largely due to the increase in nonaccrual loans, which was partially offset by a decrease in loans 90+ days past due and accruing. The increase in nonaccrual loans was driven by several relatively smaller relationships that were placed on nonaccrual status during 2016. The significant increase in nonaccrual commercial real estate loans during 2016 was a result of three commercial loans moving to nonaccrual status. At December 31, 2015, loans 90+ days past due and accruing included $2.3 million of acquired loans that were purchased credit impaired loans, as they had evidence of credit quality deterioration since acquisition. Interest income on purchase credit impaired loans is recognized on a level-yield method over the life of the loan. The increase in nonaccrual commercial real estate loans during 2015 was a result of one commercial real estate relationship in the skilled nursing sector being placed on nonaccrual status. The majority of Peoples' nonaccrual commercial real estate loans continued to consist of non-owner occupied commercial properties and real estate development projects. In general, management believes repayment of these loans is dependent on the sale of the underlying collateral. As such, the carrying values of these loans are ultimately supported by management's estimate of the net proceeds Peoples would receive upon the sale of the collateral. These estimates are based in part on market values provided by independent, licensed or certified appraisers periodically, but no less frequently than annually. Given the volatility in commercial real estate values, management continues to monitor changes in real estate values from quarter-to-quarter and updates its estimates as needed based on observable changes in market prices and/or updated appraisals for similar properties. Peoples discontinues the accrual of interest on a loan when conditions cause management to believe collection of all or any portion of the loan's contractual interest is doubtful. Such conditions may include the borrower being 90 days or more past due on any contractual payments or current information regarding the borrower's financial condition and repayment ability. All unpaid accrued interest deemed uncollectable is reversed, which would reduce Peoples' net interest income. Interest received on nonaccrual loans is included in income only if principal recovery is reasonably assured. Interest income on loans classified as nonaccrual and renegotiated at each year-end that would have been recorded under the original terms of the loans was $1.3 million for 2018, $2.6 million for 2017 and $1.9 million for 2016. No portion of these amounts were recorded during 2018, 2017 or 2016. Overall, management believes the allowance for loan losses was appropriate at December 31, 2018, based on all significant information currently available. Still, there can be no assurance that the allowance for loan losses will be adequate to cover future losses or that the amount of nonperforming loans will remain at current levels, especially considering economic uncertainties that exist and the concentration of commercial loans in Peoples’ loan portfolio. Additional information regarding Peoples' allowance for loan losses can be found in Note 4 Loans of the Notes to the Consolidated Financial Statements. Deposits The following table details Peoples’ deposit balances at December 31: (a) The sum of amounts presented are considered total demand deposits. The increase of $225.1 million, or 8%, in total deposits between December 31, 2018 and December 31, 2017 was largely due to $198.6 million of balances in deposit accounts acquired from ASB on April 13, 2018, coupled with higher one-way buy CDARS deposits, which are included in brokered CD balances. As of December 31, 2018, the acquired deposit accounts from ASB contributed $22.7 million of non-interest-bearing deposits, $27.6 million of interest-bearing demand accounts, $18.7 million of savings accounts, $36.7 million of retail CDs and $29.3 million of money market deposit accounts. The increase in total deposit balances at December 31, 2017 compared to December 31, 2016 was primarily due to increases of $314.4 million in interest-bearing demand deposits and $120.8 million in brokered CDs, offset partially by a decrease of $178.4 million in non-interest-bearing demand deposits. Shifts in balances occurred between non-interest-bearing deposits and interest-bearing demand account balances as Peoples migrated consumers to new products during the second half of 2017. During this migration, customer accounts were evaluated based on certain characteristics, and some accounts that were traditionally non-interest-bearing deposits were converted to interest-bearing demand accounts as Peoples moved to a relationship-based deposit product. The increase in brokered CDs in 2017 was the result of adding relatively shorter term funding on the balance sheet to secure fixed rate funding in a rising rate environment. At December 31, 2016, total deposits decreased compared to December 31, 2015, primarily due to decreases in retail and brokered CDs, and governmental deposit accounts. Peoples continued its deposit strategy of growing low-cost core deposits, such as checking and savings accounts, and reducing its reliance on higher-cost, non-core deposits, such as CDs and brokered deposits, based on the rate environment that existed in 2016. These actions accounted for much of the changes in deposit balances in 2016 compared to 2015. In 2015, the increases in deposits primarily related to the acquisition of NB&T. Peoples' governmental deposit accounts represent savings and interest-bearing transaction accounts from state and local governmental entities. These funds are subject to periodic fluctuations based on the timing of tax collections and subsequent expenditures or disbursements. Peoples normally experiences an increase in balances annually during the first and third quarter, corresponding with tax collections, with declines normally in the second and fourth quarter of each year, corresponding with expenditures by the governmental entities. Peoples continues to emphasize growth of low-cost deposits that do not require Peoples to pledge assets as collateral, which is required in the case of governmental deposit accounts. The maturities of retail CDs with total balances of $100,000 or more at December 31 were as follows: Additional information regarding Peoples' deposits can be found in Note 7 Deposits of the Notes to the Consolidated Financial Statements. Borrowed Funds The following table details Peoples’ short-term and long-term borrowings at December 31: (a) Unamortized debt issuance costs are related to the costs associated with the Credit Agreement with Raymond James Bank, N.A. which was a short-term obligation as of December 31, 2018. Peoples' short-term FHLB advances generally consist of overnight borrowings maintained in connection with the management of Peoples' daily liquidity position. Borrowed funds, in total, which includes overnight borrowings, are mainly a function of loan growth and changes in total deposit balances. Over the recent periods, Peoples has locked in longer term funding when rates were deemed favorable because interest rates were projected to increase in future periods. FHLB 90-day advances are used to fund interest rate swaps and are expected to be extended every 90 days through the maturity dates of the swaps. As of December 31, 2018, Peoples had twelve effective interest rate swaps, for an aggregate notional value of $110.0 million. Additionally, long-term FHLB advances declined $30 million due to the reclassification to short-term borrowings as the maturity of the borrowing was less than one year. During 2017, $50.6 million of long-term FHLB advances were reclassified to short-term borrowings due to the advances maturing within one year. Of these reclassified borrowings, $30.6 million remained as of December 31, 2017. Short-term retail repurchase agreements and other increased due to the reclassification of repurchase agreements from long-term borrowings, as they mature within one year. During 2016, Peoples restructured $20.0 million of long-term FHLB advances resulting in a $700,000 loss. Peoples replaced these borrowings with a long-term FHLB advance which matures in 2026. Peoples also borrowed an additional $35.0 million of long-term FHLB amortizing advances which mature between 2019 and 2031. Peoples repaid approximately $52.1 million of long-term FHLB advances during 2015 and recorded a loss on debt extinguishment of $520,000. Due to the interest rate environment in 2015, Peoples increased its usage of FHLB overnight borrowings due to the reduction in long-term FHLB advances. On March 4, 2016, Peoples entered into the RJB Credit Agreement with Raymond James Bank, which has a three-year term and provides Peoples with a revolving line of credit in the maximum aggregate principal amount of $15 million. Peoples is subject to certain covenants imposed by the RJB Credit Agreement and was in compliance with all of these covenants as of December 31, 2018. The RJB Credit Agreement matures on March 3, 2019. Peoples is in the process of renewing this facility and expects that it will be renewed prior to its expiration. Additional information regarding Peoples' borrowed funds can be found in Note 8 Short-Term Borrowings and Note 9 Long-Term Borrowings of the Notes to the Consolidated Financial Statements. Capital/Stockholders’ Equity During 2018, Peoples' total stockholders' equity increased $61.5 million, or 13%, mainly due to $40.9 million of common shares issued in connection with the acquisition of ASB. Also contributing to the increase in total stockholders' equity was net income of $46.3 million, which was offset by dividends paid of $21.6 million, and declines in the market value of available-for-sale investment securities. At December 31, 2018, capital levels for both Peoples and Peoples Bank remained substantially higher than the minimum amounts needed to be considered "well capitalized" under banking regulations. These higher capital levels reflect Peoples' desire to maintain a strong capital position. During the first quarter of 2015, Peoples adopted the new Basel III regulatory capital framework, as approved by the federal banking agencies. The adoption of this new framework modified the calculations and well-capitalized thresholds of the existing risk-based capital ratios and added the common equity tier 1 capital ratio. Additionally, under the new rules, in order to avoid limitations on dividends, equity repurchases and compensation, Peoples must exceed the three minimum required ratios by at least the capital conservation buffer. These three minimum required ratios are the common equity tier 1 capital ratio, tier 1 risk-based capital ratio and total risk-based capital ratio. The capital conservation buffer was phased in from 0.625% beginning January 1, 2016 to 2.50% on January 1, 2019. Peoples had a capital conservation buffer of 6.60% at December 31, 2018, 6.43% at December 31, 2017, and 6.11% at December 31, 2016, compared to the fully phased in capital conservation buffer of 2.50% required at January 1, 2019. As such, Peoples exceeded the minimum ratios, including the capital conservation buffer, at December 31, 2018. In 2017, Peoples' total stockholders' equity increased due to higher retained earnings offset slightly by declines in the market value of investments. In 2016, Peoples' total stockholders' equity increased due to higher retained earnings, offset slightly by the repurchase 279,770, or $5.0 million, of treasury shares and the slight decline in the market value of investments. In 2015, Peoples' total stockholders' equity increased primarily due to $76.0 million of common equity issued in connection with the NB&T acquisition. The following table details Peoples' actual risk-based capital levels and corresponding ratios at December 31: In addition to traditional capital measurements, management uses tangible capital measures to evaluate the adequacy of Peoples' total stockholders' equity. Such ratios represent non-US GAAP financial information since their calculation removes the impact on the Consolidated Balance Sheets of goodwill and other intangible assets acquired through acquisitions. Management believes this information is useful to investors since it facilitates the comparison of Peoples' operating performance, financial condition and trends to peers, especially those without a similar level of intangible assets to that of Peoples. Further, intangible assets generally are difficult to convert into cash, especially during a financial crisis, and could decrease substantially in value should there be deterioration in the overall franchise value. As a result, tangible equity represents a conservative measure of the capacity for Peoples to incur losses but remain solvent. The following table reconciles the calculation of these non-US GAAP financial measures to amounts reported in Peoples' Consolidated Financial Statements at December 31: The increase in the tangible equity and tangible assets ratio for 2018, 2017, and 2016 was the result of higher retained earnings, partially offset by the decline in the market value of available-for-sale investment securities. Also contributing to the increase in 2018 was the common shares issued in connection with the ASB acquisition. The increase in 2016 was partially offset by the repurchase of 279,770 treasury shares. In 2015, the decrease in the tangible equity to tangible assets ratio compared to the ratio in 2014 was due to the impact of assets acquired in the NB&T acquisition, as well as a reduction in retained earnings as most of the net income was paid to common shareholders as dividends. Future Outlook Peoples achieved success in several areas during 2018, including the acquisition of ASB, and the announcement of the First Prestonsburg acquisition that is expected to close in April 2019. With respect to the balance sheet, loan growth was 16% when comparing period-end balances for December 31, 2018 to December 31, 2017, which included $208.9 million of period-end loans at December 31, 2018 from the ASB acquisition. Deposit balances grew 8% between December 31, 2018 and December 31, 2017, with total stockholders’ equity increasing 13%. Cash dividends paid during 2018 were $1.12 per share, with the amount for 2017 being $0.84 per share, an increase of 33%. Peoples’ book value per share and tangible book value per share both increased, 6.0% and 6.6%, respectively, when compared to December 31, 2017. As it relates to the income statement, underlying results were muted by elevated expenses due to the acquisition-related costs incurred associated with the ASB acquisition, and also, but to a lesser extent, by the announcement of the First Prestonsburg acquisition. Net interest income increased 14%, with net interest margin expanding 9 basis points between 2018 and 2017. The efficiency ratio was 65.33% for 2018, compared to 62.20% for 2017, but when adjusted for non-core items, improved to 61.32% and 61.85%, respectively. As noted above, Peoples announced the pending acquisition of First Prestonsburg, which is expected to close in April 2019. The projections for 2019 that are included below exclude the anticipated benefits and acquisition-related costs of the First Prestonsburg acquisition. Peoples currently anticipates one-time acquisition-related costs of approximately $8.5 million to $9.0 million in 2019. The majority of the one-time acquisition costs will be recognized during the second quarter of 2019. Peoples expects to carry the momentum from 2018 into 2019 related to loan growth, fee income growth and expense management. Key strategic priorities continue to include generating positive operating leverage, maintaining superior asset quality, and remaining prudent with the use of capital. Overall, Peoples' key strategic objectives are to be a steady, dependable performer for its shareholders and to take advantage of market expansion opportunities. Peoples' long-term strategic goals include generating results in the top quartile of performance relative to Peoples' peer group, as defined in Peoples' proxy statement for the 2019 Annual Meeting of Shareholders, and providing returns for its shareholders superior to those of its peers, regardless of market conditions. Net interest income comprised 69% of Peoples' revenue for 2018, and therefore, remained a major source of revenue. Thus, Peoples' ability to grow revenue in 2019 will be impacted by the amount of net interest income generated. During 2018, Peoples benefited from the Federal Reserve Board's decision to raise interest rates, however, there is uncertainty regarding potential increases in 2019. Long-term rates could increase but remain more volatile than in prior years. Changes in long-term interest rates would affect reinvestment rates within the loan and investment portfolios. At December 31, 2018, Peoples' Consolidated Balance Sheet remained positioned for a rising rate environment, meaning that net interest income would increase to the extent interest rates increase. However, should the yield curve flatten, Peoples would have limited opportunities to offset the impact on asset yields with a similar reduction in funding costs. Thus, Peoples' ability to produce meaningful loan growth and the ability to attract and retain deposits remains the key driver for improving net interest income and margin in 2019. For 2018, net interest margin was 3.71%. Net interest margin for 2019 is expected to be around 3.75%. Loan growth will again be the key driver in stabilizing asset yields. Management would expect both net interest income and margin to benefit from any meaningful increase in market interest rates based upon the current interest rate risk profile. However, it remains inherently difficult to predict and manage the future trend of Peoples' net interest income and margin due to the uncertainty surrounding the timing and magnitude of future interest rate changes, as well as the impact of competition for loans and deposits. Peoples has continually sought to maintain a diversified revenue stream through its strong fee-based businesses, such as insurance and wealth management. However, Peoples' total non-interest income excluding net gains and losses as a percent of total revenue has decreased over the last few years. In 2015 and 2016, Peoples' total non-interest income excluding net gains and losses comprised 33% of total revenue, compared to 32% in 2017 and 31% in 2018. In 2013, Peoples' total non-interest income excluding net gains and losses comprised 40% of total revenue, which was the highest point in the most recent five years. The decline in recent years has been due primarily to loan growth, coupled with the rising interest rates, and the bank acquisitions completed since 2013, only one of which had a wealth management practice. In addition, only four relatively small insurance agencies and one small financial advisory book of business were purchased during the same period of time. Peoples has capabilities that many banks in its market area lack, including some of the largest national banks, which include robust retirement plan services and comprehensive insurance products. Thus, management considers Peoples to have a competitive advantage that directly enhances revenue growth potential. For 2019, management expects growth of between 7% and 9% in total non-interest income excluding net gains and losses. While the primary focus will be on revenue growth, management remains disciplined with operating expenses. Management has deployed an expense management approach to control the annual growth in total non-interest expense. Management continues to stress the importance of generating positive operating leverage, which is having the growth rate of revenue exceed the growth rate of expenses, on a percentage basis, year-over-year. The management of the expense growth rate is partially achieved through having various areas within the organization attempt to "self-fund" investments, meaning that the areas must determine cost savings opportunities prior to making additional investments. Peoples continues to have limited control over some expenses, such as employee medical and pension costs. Peoples continues to be exposed to more pension settlement charges given the frozen status of its defined benefit plan. For 2019, management anticipates a slightly higher volume of settlement charges compared to 2018. This expectation is based on normal retirement activity within the defined benefit plan, but assumes all potential distributions are lump-sum payouts. Management expects total non-interest expense growth for 2019 to be in the mid-single digits. Given the expected revenue and expense growth, Peoples anticipates generating positive operating leverage in 2019. Additionally, Peoples' efficiency ratio is expected to be between 59% and 61% for 2019. During 2018, there were some unusual items that were recorded as benefits to income tax expense. No such items are expected in 2019, and management expects the effective tax rate to be between 19.0% and 19.5%. As previously mentioned, net interest income growth for 2019 is largely dependent upon achieving meaningful loan growth. Management expects period-end loan balances to increase by 6% to 8% in 2019. However, management anticipates a slow start to the year as it relates to loan growth due to the expectation of an abnormally high level of loan payoffs in the first quarter of 2019, and therefore, minimal growth. Within Peoples' commercial lending activity, the primary emphasis continues to be on non-mortgage commercial lending opportunities. Consumer lending activity grew significantly during 2017 and 2018, and is expected to remain a large contributor to overall loan growth in 2019, primarily in indirect lending. At December 31, 2018, the investment portfolio comprised 22% of total assets. In 2019, the investment portfolio is anticipated to decrease slightly. Management can use the cash flow generated by Peoples’ significant investment in mortgage-backed securities to fund new loan production. Peoples will continue to seek opportunities to execute a shift in the mix on the asset side of the balance sheet to reduce the relative size of the investment portfolio. Management may adjust the size or composition of the investment portfolio in response to other factors, such as changes in liquidity needs and interest rate conditions. Peoples' funding strategy continues to emphasize growth of core deposits, such as checking and savings accounts, rather than higher-cost deposits. Given the interest rate environment, the value of core deposits has increased and will be a greater focus of Peoples in 2019. Additionally, based on the expected increase in earning assets, borrowed funds are expected to increase in 2019 to the extent earning asset growth is more than deposit growth. Similar to prior years, should this occur, management would evaluate using longer-term borrowings to match the duration of the assets being funded to minimize the long-term interest rate risk. Peoples remains committed to sound underwriting and prudent risk management. Management believes this credit discipline will benefit Peoples during any future economic downturns. The long-term goal is to maintain key metrics in the top-quartile of Peoples' peer group regardless of economic conditions. The prospects of large charge-offs and recoveries are believed to have diminished. Management anticipates Peoples' provision for loan losses and the net charge-off rate for 2019 will normalize, with the net charge-off rate closer to its long-term historical range of 0.20% to 0.30% of average loans. For 2019, management intends to remain prudent with the level of Peoples' allowance for loan losses. However, the level will continue to be based upon management's quarterly assessment of the losses inherent in the loan portfolio, and the amount of any provision for loan losses should be driven mostly by a combination of the net charge-off rate and loan growth. Peoples' capital position remains strong. Given the excess capital position and the increase in Peoples' common share price, Peoples will continue to look for ways to effectively manage its capital, including, but not limited to, bank acquisitions and dividends. As previously noted, cash dividends paid between 2018 and 2017 increased 33%, and management will continue to evaluate the cash dividend. Late in 2015, Peoples approved a common share repurchase program of up to $20 million, under which Peoples purchased $5.0 million in 2016. Given the pending acquisition with First Prestonsburg, Peoples had been unable to repurchase common shares. However, given that there is a common share repurchase program still in place, with capacity of $15.0 million remaining, Peoples will continue to evaluate additional purchase opportunities throughout 2019. Management has built a culture where it is paramount that the associates take care of customers and take care of each other. Management is committed to profitable growth of the company and building long-term shareholder value. This will require management to remain focused on four key areas: responsible risk management; extraordinary client experience; profitable revenue growth; and maintaining a superior workforce. Success will be achieved through disciplined execution of strategies and providing extraordinary service to Peoples' clients and communities. Interest Rate Sensitivity and Liquidity While Peoples is exposed to various business risks, the risks relating to interest rate sensitivity and liquidity are major risks that can materially impact future results of operations and financial condition due to their complexity and dynamic nature. The objective of Peoples' asset-liability management function is to measure and manage these risks in order to optimize net interest income within the constraints of prudent capital adequacy, liquidity and safety. This objective requires Peoples to focus on interest rate risk exposure and adequate liquidity through its management of the mix of assets and liabilities, their related cash flows and the rates earned and paid on those assets and liabilities. Ultimately, the asset-liability management function is intended to guide management in the acquisition and disposition of earning assets and selection of appropriate funding sources. Interest Rate Risk Interest rate risk ("IRR") is one of the most significant risks arising in the normal course of business of financial services companies like Peoples. IRR is the potential for economic loss due to future interest rate changes that can impact the earnings stream, as well as market values, of financial assets and liabilities. Peoples' exposure to IRR is due primarily to differences in the maturity or repricing of earning assets and interest-bearing liabilities. In addition, other factors, such as prepayments of loans and investment securities, or early withdrawal of deposits, can affect Peoples' exposure to IRR and increase interest costs or reduce revenue streams. Peoples has assigned overall management of IRR to the ALCO, which has established an IRR management policy that sets minimum requirements and guidelines for monitoring and managing the level of IRR. The objective of Peoples' IRR management policy is to assist the ALCO in its evaluation of the impact of changing interest rate conditions on earnings and economic value of equity, as well as assist with the implementation of strategies intended to reduce Peoples' IRR. The management of IRR involves either maintaining or changing the level of risk exposure by changing the repricing and maturity characteristics of the cash flows for specific assets or liabilities. Additional oversight of Peoples' IRR is provided by the Board of Directors of Peoples Bank, who reviews and approves Peoples' IRR management policy at least annually. The ALCO uses various methods to assess and monitor the current level of Peoples' IRR and the impact of potential strategies or other changes. However, the ALCO predominantly relies on simulation modeling in its overall management of IRR since it is a dynamic measure. Simulation modeling also estimates the impact of potential changes in interest rates and balance sheet structures on future earnings and projected economic value of equity. The methods used by ALCO to assess IRR remain largely unchanged from those disclosed at December 31, 2017. However, during the third quarter of 2018, Peoples began using new software for modeling the balance sheet and income statement, which offers increased capabilities and functionality better suited for Peoples given the growth of the company. The modeling process starts with a base case simulation using the current balance sheet and current interest rates held constant for the next twenty-four months. Alternate scenarios are prepared which simulate the impact of increasing and decreasing market interest rates, assuming parallel yield curve shifts. Comparisons produced from the simulation data, showing the changes in net interest income from the base interest rate scenario, illustrate the risks associated with the current balance sheet structure. Additional simulations, when deemed appropriate or necessary, are prepared using different interest rate scenarios from those used with the base case simulation and/or possible changes in balance sheet composition. The additional simulations include non-parallel shifts in interest rates whereby the direction and/or magnitude of change of short-term interest rates is different from the changes applied to longer-term interest rates. Comparisons showing the net interest income and economic value of equity variances from the base case are provided to the ALCO for review and discussion. The ALCO has established limits on changes in the twelve-month net interest income forecast and the economic value of equity from the base case. The ALCO may establish risk tolerances for other parallel and non-parallel rate movements, as deemed necessary. The following table details the current policy limits used to manage the level of Peoples' IRR: The following table shows the estimated changes in net interest income and the economic value of equity based upon a standard, parallel shock analysis with balances held constant (dollars in thousands): (a) NM = not meaningful. This table uses a standard, parallel shock analysis for assessing the IRR to net interest income and the economic value of equity. A parallel shock means all points on the yield curve (one year, two year, three year, etc.) are directionally changed the same amount of basis points. Management regularly assesses the impact of both increasing and decreasing interest rates, the table above reflects the impact of upward parallel shocks, and a downward parallel shock of 100 and 200 basis points. Downward parallel shocks of 300 basis points are excluded from the table above, as they are not probable given the current interest rate environment. As of December 31, 2017, downward parallel shocks of 200 basis points were excluded from the table above, as they were not probable given the interest rate environment at that time. At December 31, 2018, the weighted average rate on Peoples' non maturity deposits was roughly 28 basis points. In the event of a parallel downward shift of 200 basis points, the expense on Peoples' non maturity deposits would reach a floor at zero, unable to experience the full benefit of falling rates. This floor at zero is consistent with an assumption of non-negative deposit rates. On the asset side of the balance sheet, a significant majority of the floating rate loans (primarily tied to prime and LIBOR) would be impacted by the downward 200 basis point shock. Estimated changes in net interest income and economic value of equity are partially driven by assumptions regarding the rate at which non-maturity deposits will reprice given a move in short-term interest rates. Peoples takes a historically conservative approach when determining what repricing rates (deposit betas) are used in modeling interest rate risk. These assumptions are monitored closely by Peoples and are updated at least annually. The actual deposit betas experienced recently by Peoples in the repricing of non-maturity deposits are lower than those used in Peoples’ current interest rate risk modeling. Peoples has benefited from this trend in the current interest rate and competitor environment as it has provided for growth in Peoples’ net interest income. However, in recent months, Peoples has experienced more pressure on margin expansion and rate competition in its markets. Peoples also considers the interest rate risk impact of a bull flattener scenario in addition to analyzing the impact of parallel yield curve shifts. The bull flattener scenario is a yield curve shift in which long-term rates decline while short-term rates remain stable. The degree to which long-term rates fall and which maturities along the yield curve are affected is subjective. The bull flattener scenario provides an estimate of interest rate risk which may be more realistic in unusual interest rate environments. At December 31, 2018, the U.S. Treasury and LIBOR swap curves were relatively flat compared to historical norms, and some inversion was present for maturities less than five years. Given the shape of market yield curves at December 31, 2018, consideration of the bull flattener scenario yields insights which were not captured by parallel shifts. The key insight presented by the bull flattener scenario highlights the risk to net interest income when long term yields fall while short-term rates remain constant. In such a scenario, Peoples’ funding costs, which are correlated with short-term rates, remain constant, while asset yields correlated with long-term rates decline. During 2018, Peoples' Consolidated Balance Sheet was positioned to benefit from rising interest rates in terms of potential impact on net interest income. The table illustrates this point as changes to net interest income increase in the rising rate scenarios. The increase in asset sensitivity from December 31, 2017 was largely attributable to the 90-day advances Peoples entered into to fund the interest rate swaps, effectively reducing the interest rate sensitivity of the liabilities on the balance sheet. However, there was a slight reduction of asset sensitivity as a result of the ASB acquisition. While parallel interest rate shock scenarios are useful in accessing the level of IRR inherent in the balance sheet, interest rates typically move in a nonparallel manner with differences in the timing, direction and magnitude of changes in short-term and long-term interest rates. Thus, any benefit that might occur as a result of the Federal Reserve Board increasing short-term interest rates in the future could be offset by an inverse movement in long-term rates. The table also illustrates a significant reduction in long-term interest rate risk as is evidenced by the drop in the negative impact of rising interest rates on economic value of equity. The reduction is largely attributable to the increased functionality of the new interest rate risk model employed by Peoples during 2018, primarily the ability to apply enhanced pre-payment estimates on loans. Peoples has entered into interest rate swaps as part of its interest rate risk management strategy. These interest rate swaps are designated as cash flow hedges and involve the receipt of variable rate amounts from a counterparty in exchange for Peoples making fixed payments. As of December 31, 2018, Peoples had twelve interest rate swap contracts, with an aggregate notional value of $110.0 million. Additional information regarding Peoples' interest rate swaps can be found in Note 14 Derivative Financial Instruments of the Notes to the Consolidated Financial Statements. An asset/liability model, used to produce the analysis above, requires assumptions to be made such as prepayment rates on interest-earning assets and repricing impact on non-maturity deposits. These business assumptions are based on business plans, economic and market trends, and available industry data. Management believes that its methodology for developing such assumptions is reasonable; however, there can be no assurance that modeled results will be achieved. Liquidity In addition to IRR management, another major objective of the ALCO is to maintain sufficient levels of liquidity. The ALCO defines liquidity as the ability to meet anticipated and unanticipated operating cash needs, loan demand and deposit withdrawals without incurring a sustained negative impact on profitability. A primary source of liquidity for Peoples is deposits. Liquidity is also provided by cash generated from earning assets such as maturities, calls, and principal and interest payments from loans and investment securities. Peoples also uses various wholesale funding sources to supplement funding from customer deposits. These external sources provide Peoples with the ability to obtain large quantities of funds in a relatively short time period in the event of sudden unanticipated cash needs. However, an over-utilization of external funding sources can expose Peoples to greater liquidity risk, as these external sources may not be accessible during times of market stress. Additionally, Peoples may be exposed to the risk associated with providing excess collateral to external funding providers, commonly referred to as counterparty risk. As a result, the ALCO's liquidity management policy sets limits on the net liquidity position and the concentration of non-core funding sources, which includes wholesale funding and brokered deposits. In addition to external sources of funding, Peoples considers certain types of deposits to be less stable or "volatile funding." These deposits include special money market products, large CDs and public funds. Peoples has established volatility factors for these various deposit products, and the liquidity management policy establishes a limit on the total level of volatile funding. Additionally, Peoples measures the maturities of external sources of funding for periods of one month, three months, six months and twelve months, and has established policy limits for the amounts maturing in each of these periods. The purpose of these limits is to minimize exposure to what is commonly termed rollover risk. An additional strategy used by Peoples in the management of liquidity risk is maintaining a targeted level of liquid assets. These are assets that can be converted into cash in a relatively short period of time. Management defines liquid assets as unencumbered cash (including cash on deposit at the FRB), and the market value of U.S. government and agency securities that are not pledged. Excluded from this definition are pledged securities, non-government and agency securities, municipal securities and loans. Management has established a minimum level of liquid assets in the liquidity management policy, which is expressed as a percentage of total loans and unfunded loan commitments. Peoples also has established a policy limit around the level of liquefiable assets also expressed as a percentage of total loans and unfunded loan commitments. Liquefiable assets are defined as liquid assets plus the market value of unpledged securities not included in the liquid asset measurement. Peoples remained within these two parameters throughout 2018. An essential element in the management of liquidity risk is a forecast of the sources and uses of anticipated cash flows. On a monthly basis, Peoples forecasts sources and uses of cash for the next twelve months. To assist in the management of liquidity, management has established a liquidity coverage ratio, which is defined as the total sources of cash divided by the total uses of cash. A ratio of greater than 1.0 times indicates that forecasted sources of cash are adequate to fund forecasted uses of cash. The liquidity management policy establishes a minimum limit of 1.0 times. As of December 31, 2018, Peoples had a ratio of 1.5 times, which was within policy limits. Peoples also forecasts secondary or contingent sources of cash, and this includes external sources of funding and liquid assets. These sources of cash would be required if and when the forecasted liquidity coverage ratio dropped below the policy limit of 1.0 times. An additional liquidity measurement used by management includes the total forecasted sources of cash and the contingent sources of cash divided by the forecasted uses of cash. Management has established a minimum ratio of 3.0 times for this liquidity management policy limit. As of December 31, 2018, Peoples had a ratio of 3.8 times, which was within policy limits. Disruptions in the sources and uses of cash can occur which can drastically alter the actual cash flows and negatively impact Peoples' ability to access internal and external sources of cash. Such disruptions might occur due to increased withdrawals of deposits, increases in the funding required for loan commitments, a decrease in the ability to access external funding sources and other factors that would increase the need for funding and limit Peoples' ability to access needed funds. As a result, Peoples maintains a liquidity contingency funding plan ("LCFP") that considers various degrees of disruptions and develops action plans around these scenarios. Peoples' LCFP identifies scenarios where funding disruptions might occur and creates scenarios of varying degrees of severity. The disruptions considered include an increase in funding of unfunded loan commitments, unanticipated withdrawals of deposits, decreases in the renewal of maturing CDs and reductions in cash earnings. Additionally, the LCFP creates stress scenarios where access to external funding sources, or contingency funding, is suddenly limited, which includes a significant increase in the margin requirements where securities or loans are pledged, limited access to funding from other banks and limited access to funding from the FHLB and the FRB. Peoples' LCFP scenarios include a base scenario, a mild stress scenario, a moderate stress scenario and a severe stress scenario. Each of these is defined as to the severity, and action plans are developed around each. Liquidity management also requires the monitoring of risk indicators that may alert the ALCO to a developing liquidity situation or crisis. Early detection of stress scenarios allows Peoples to take actions to help mitigate the impact to Peoples Bank's business operations. The LCFP contains various indicators, termed key risk indicators ("KRI's") that are monitored on a monthly basis, at a minimum. The KRI's include both internal and external indicators and include loan delinquency levels, criticized and classified loan levels, non-performing loans to loans and to total assets, the total loan to total deposit ratio, the level of net non-core funding dependence, the level of contingency funding sources, the liquidity coverage ratio, changes in regulatory capital levels, forecasted operating loss and negative media concerning Peoples, irrational competitor pricing that persists, and an increase in rates for external funding sources. The LCFP establishes levels that define each of these KRI's under base, mild, moderate and severe scenarios. The LCFP is reviewed and updated at least on an annual basis by the ALCO and Peoples Bank's Board of Directors. Additionally, testing of the LCFP is required on an annual basis. Various stress scenarios and the related actions are simulated according to the LCFP. The results are reviewed and discussed, and changes or revisions are made to the LCFP accordingly. Additionally, every two years, the LCFP is subjected to a third-party review for effectiveness and regulatory compliance. Overall, management believes the current balance of cash and cash equivalents, and anticipated cash flows from the investment portfolio, along with the availability of other funding sources, will allow Peoples to meet anticipated cash obligations, as well as special needs and off-balance sheet commitments. Off-Balance Sheet Activities and Contractual Obligations Peoples routinely engages in activities that involve, to varying degrees, elements of risk that are not reflected in whole or in part in the Consolidated Financial Statements. These activities are part of Peoples' normal course of business and include traditional off-balance sheet credit-related financial instruments, interest rate contracts and commitments to make additional capital contributions in low-income housing tax credit investments. The following is a summary of Peoples’ significant off-balance sheet activities and contractual obligations. Detailed information regarding these activities and obligations can be found in the Notes to the Consolidated Financial Statements as follows: Traditional off-balance sheet credit-related financial instruments are primarily commitments to extend credit and standby letters of credit. These activities are necessary to meet the financing needs of customers and could require Peoples to make cash payments to third parties in the event certain specified future events occur. The contractual amounts represent the extent of Peoples’ exposure in these off-balance sheet activities. However, since certain off-balance sheet commitments, particularly standby letters of credit, are expected to expire or only partially be used, the total amount of commitments does not necessarily represent future cash requirements. Peoples continues to lease certain facilities and equipment under noncancellable operating leases with terms providing for fixed monthly payments over periods generally ranging from two to ten years. Several of Peoples’ leased facilities are inside retail shopping centers or office buildings and, as a result, are not available for purchase. Management believes these leased facilities increase Peoples’ visibility within its markets and afford sales associates additional access to current and potential clients. For certain acquisitions, often those involving insurance businesses and wealth management books of business, a portion of the consideration is contingent upon revenue metrics being achieved. US GAAP requires that the amounts be recorded upon acquisition based on the best estimate of the future amounts to be paid at the time of acquisition. Any subsequent adjustment to the estimate is recorded in earnings. Based on the acquisitions completed to date, management does not expect contingent consideration to have a material impact on Peoples' future performance. The following table details the aggregate amount of future payments Peoples is required to make under certain contractual obligations as of December 31, 2018: (a) Amounts reflect solely the minimum required principal payments. (b) Amounts assume projected revenue metrics are achieved. Management does not anticipate that Peoples’ current off-balance sheet activities will have a material impact on its future results of operations and financial condition based on historical experience and recent trends. Effects of Inflation on Financial Statements Substantially all of Peoples’ assets relate to banking and are monetary in nature. As a result, inflation does not impact Peoples to the same degree as companies in capital-intensive industries in a replacement cost environment. During a period of rising prices, a net monetary asset position results in a loss in purchasing power and conversely a net monetary liability position results in an increase in purchasing power. The opposite would be true during a period of decreasing prices. In the banking industry, monetary assets typically exceed monetary liabilities. The current monetary policy targeting low levels of inflation has resulted in relatively stable price levels. Therefore, inflation has had little impact on Peoples’ net assets.

<s>[INST] Certain statements in this Form 10K, which are not historical fact, are forwardlooking statements within the meaning of Section 27A of the Securities Act , Section 21E of the Exchange Act, and the Private Securities Litigation Reform Act of 1995. Words such as "anticipate," "estimate," "may," "feel," "expect," "believe," "plan," "will," "would," "should," "could," "project," "goal," "target," "potential," "seek," "intend," and similar expressions are intended to identify these forwardlooking statements but are not the exclusive means of identifying such statements. Forwardlooking statements are subject to risks and uncertainties that may cause actual results to differ materially. Factors that might cause such a difference include, but are not limited to: (1) the success, impact, and timing of the implementation of Peoples' business strategies, including the successful integration of the acquisition of ASB and the expansion of consumer lending activity; (2) Peoples' ability to integrate future acquisitions, including the pending merger with First Prestonsburg, may be unsuccessful, or may be more difficult, timeconsuming or costly than expected, and expected cost savings, synergies and other financial benefits may not be realized or take longer than anticipated; (3) Peoples' ability to obtain regulatory approvals of the proposed merger of Peoples with First Prestonsburg on the proposed terms and schedule, may be unsuccessful; (4) competitive pressures among financial institutions, or from nonfinancial institutions, which may increase significantly, including product and pricing pressures, changes to thirdparty relationships and revenues, and Peoples' ability to attract, develop and retain qualified professionals; (5) changes in the interest rate environment due to economic conditions and/or the fiscal policies of the U.S. government and the Federal Reserve Board, which may adversely impact interest rates, interest margins, loan demand and interest rate sensitivity; (6) uncertainty regarding the nature, timing, cost, and effect of legislative or regulatory changes or actions, promulgated and to be promulgated by governmental and regulatory agencies in the State of Ohio, the FDIC, the Federal Reserve Board and the CFPB, which may subject Peoples, its subsidiaries, or one or more acquired companies to a variety of new and more stringent legal and regulatory requirements which adversely affect their respective businesses, including in particular the rules and regulations promulgated and to be promulgated under the DoddFrank Act, and the Basel III regulatory capital reform; (7) the effects of easing restrictions on participants in the financial services industry; (8) local, regional, national and international economic conditions (including the impact of tariffs, a U.S. withdrawal from or significant renegotiation of trade agreements, trade wars and other changes in trade regulations) and the impact these conditions may have on Peoples, its customers and its counterparties, and Peoples' assessment of the impact, which may be different than anticipated; (9) the existence or exacerbation of general geopolitical instability and uncertainty; (10) changes in policy and other regulatory and legal developments, including the Tax Cuts and Jobs Act, and uncertainty or speculation pending the enactment of such changes; (11) Peoples may issue equity securities in connection with future acquisitions, including the pending merger with First Prestonsburg if consummated, which could cause ownership and economic dilution to Peoples' current shareholders; (12) changes in prepayment speeds, loan originations, levels of nonperforming assets, delinquent loans and chargeoffs, which may be less favorable than expected and adversely impact the amount of interest income generated; (13) adverse changes in the economic conditions and/or activities, including, but not limited to, potential or imposed tariffs, continued economic uncertainty in the U.S., the European Union (including the uncertainty surrounding the actions to be taken to implement the referendum by British voters to exit the European Union), Asia, and other areas, which could decrease sales volumes, add volatility to the global stock markets, and increase loan delinquencies and defaults; (14) [/INST] Negative. </s>

PEOPLES BANCORP INC

2020-03-03

2019-12-31

ITEM 7 MANAGEMENT’S DISCUSSION AND ANALYSIS OF FINANCIAL CONDITION AND RESULTS OF OPERATIONS Forward-Looking Statements Certain statements made in this Form 10-K, which are not historical fact, are forward-looking statements within the meaning of Section 27A of the Securities Act , Section 21E of the Exchange Act, and the Private Securities Litigation Reform Act of 1995. Words such as "anticipate," "estimate," "may," "feel," "expect," "believe," "plan," "will," "will likely," "would," "should," "could," "project," "goal," "target," "potential," "seek," "intend," and similar expressions are intended to identify these forward-looking statements but are not the exclusive means of identifying such statements. Forward-looking statements are subject to risks and uncertainties that may cause actual results to differ materially. Factors that might cause such a difference include, but are not limited to: (1) the success, impact, and timing of the implementation of Peoples' business strategies and its ability to manage strategic initiatives, including the successful integration of the business of First Prestonsburg and the expansion of consumer lending activity; (2) risks and uncertainties associated with Peoples' entry into new geographic markets and risks resulting from Peoples' inexperience in these new geographic markets; (3) Peoples' ability to identify, acquire, or integrate suitable strategic acquisitions, which may be unsuccessful, or may be more difficult, time-consuming or costly than expected; (4) competitive pressures among financial institutions, or from non-financial institutions, which may increase significantly, including product and pricing pressures, which can in turn impact Peoples' credit spreads, changes to third-party relationships and revenues, changes in the manner of providing services, customer acquisition and retention pressures, and Peoples' ability to attract, develop and retain qualified professionals; (5) changes in the interest rate environment due to economic conditions and/or the fiscal policies of the U.S. government and the Board of Governors of the Federal Reserve System (the "Federal Reserve Board"), which may adversely impact interest rates, interest margins, loan demand and interest rate sensitivity; (6) uncertainty regarding the nature, timing, cost, and effect of legislative or regulatory changes or actions, or deposit insurance premium levels, promulgated and to be promulgated by governmental and regulatory agencies in the State of Ohio, the Federal Deposit Insurance Corporation, the Federal Reserve Board and the Consumer Financial Protection Bureau, which may subject Peoples, its subsidiaries, or one or more acquired companies to a variety of new and more stringent legal and regulatory requirements which adversely affect their respective businesses, including in particular the rules and regulations promulgated and to be promulgated under the Dodd-Frank Wall Street Reform and Consumer Protection Act of 2010, and the Basel III regulatory capital reform; (7) the effects of easing restrictions on participants in the financial services industry; (8) local, regional, national and international economic conditions (including the impact of potential or imposed tariffs, a U.S. withdrawal from or significant renegotiation of trade agreements, trade wars and other changes in trade regulations, and the relationship of the U.S. and its global trading partners) and the impact these conditions may have on Peoples, its customers and its counterparties, and Peoples' assessment of the impact, which may be different than anticipated; (9) the existence or exacerbation of general geopolitical instability and uncertainty; (10) changes in policy and other regulatory and legal developments, and uncertainty or speculation pending the enactment of such changes; (11) Peoples may issue equity securities in connection with future acquisitions, which could cause ownership and economic dilution to Peoples' current shareholders; (12) changes in prepayment speeds, loan originations, levels of nonperforming assets, delinquent loans, charge-offs, and customer creditworthiness generally, which may be less favorable than expected and adversely impact the amount of interest income generated; (13) adverse changes in economic conditions and/or activities, including, but not limited to, slowing or reversal of the current U.S. economic expansion, continued economic uncertainty in the U.S., the European Union (including the uncertainty surrounding the actions to be taken to implement the exit of Great Britain from the European Union), Asia, and other areas, which could decrease sales volumes, add volatility to the global stock markets, and increase loan delinquencies and defaults; (14) deterioration in the credit quality of Peoples' loan portfolio, which may adversely impact the provision for loan losses; (15) Peoples may have more credit risk and higher credit losses to the extent there are loan concentrations by location or industry of borrowers or collateral; (16) changes in accounting standards, policies, estimates or procedures, including the extent to which the new current expected credit loss accounting standard issued by the Financial Accounting Standards Board in June 2016 and effective for Peoples as of January 1, 2020, which will require banks to record, at the time of origination, credit losses expected throughout the life of the asset portfolio on loans and held-to-maturity securities, as opposed to the current practice of recording losses when it is probable that a loss event has occurred, may adversely affect Peoples' reported financial condition or results of operations; (17) Peoples' assumptions and estimates used in applying critical accounting policies, and modeling, which may prove unreliable, inaccurate or not predictive of actual results; (18) the discontinuation of London Inter-Bank Offered Rate and other reference rates may result in increased expenses and litigation, and adversely impact the effectiveness of hedging strategies; (19) adverse changes in the conditions and trends in the financial markets, including political developments, which may adversely affect the fair value of securities within Peoples' investment portfolio, the interest rate sensitivity of Peoples' consolidated balance sheet, and the income generated by Peoples' trust and investment activities; (20) the volatility from quarter to quarter of mortgage banking income, whether due to interest rates, demand, the fair value of mortgage loans, or other factors; (21) Peoples' ability to receive dividends from its subsidiaries; (22) Peoples' ability to maintain required capital levels and adequate sources of funding and liquidity; (23) the impact of larger or similar-sized financial institutions encountering problems, which may adversely affect the banking industry and/or Peoples' business generation and retention, funding and liquidity; (24) Peoples' ability to secure confidential information and deliver products and services through the use of computer systems and telecommunications networks, including those of Peoples' third-party vendors and other service providers, which may prove inadequate, and could adversely affect customer confidence in Peoples and/or result in Peoples incurring a financial loss; (25) Peoples' ability to anticipate and respond to technological changes, and Peoples' reliance on, and the potential failure of, a number of third-party vendors to perform as expected, including Peoples' primary core banking system provider, which can impact Peoples' ability to respond to customer needs and meet competitive demands; (26) operational issues stemming from and/or capital spending necessitated by the potential need to adapt to industry changes in information technology systems on which Peoples and its subsidiaries are highly dependent; (27) changes in consumer spending, borrowing and saving habits, whether due to changes in retail distribution strategies, consumer preferences and behavior, changes in business and economic conditions, legislative or regulatory initiatives, or other factors, which may be different than anticipated; (28) the adequacy of Peoples' internal controls and risk management program in the event of changes in strategic, reputational, market, economic, operational, cybersecurity, compliance, legal, asset/liability repricing, liquidity, credit and interest rate risks associated with Peoples' business; (29) the impact on Peoples' businesses, personnel, facilities, or systems, of losses related to acts of fraud, theft, or violence; (30) the impact on Peoples' businesses, as well as on the risks described above, of various domestic or international widespread natural or other disasters, pandemics, cybersecurity attacks, system failures, civil unrest, military or terrorist activities or international conflicts; (31) the impact on Peoples' businesses and operating results of any costs associated with obtaining rights in intellectual property claimed by others and adequately protecting Peoples' intellectual property; (32) Peoples' continued ability to grow deposits; and (33) other risk factors relating to the banking industry or Peoples as detailed from time to time in Peoples' reports filed with the SEC, including those risk factors included in the disclosures under the heading "ITEM 1A RISK FACTORS" of this Form 10-K. All forward-looking statements speak only as of the filing date of this Form 10-K and are expressly qualified in their entirety by the cautionary statements. Although management believes the expectations in these forward-looking statements are based on reasonable assumptions within the bounds of management’s knowledge of Peoples’ business and operations, it is possible that actual results may differ materially from these projections. Additionally, Peoples undertakes no obligation to update these forward-looking statements to reflect events or circumstances after the filing date of this Form 10-K or to reflect the occurrence of unanticipated events except as may be required by applicable legal requirements. Copies of documents filed with the SEC are available free of charge at the SEC’s website at www.sec.gov and/or from Peoples' website - www.peoplesbancorp.com under the "Investor Relations" section. The following discussion and analysis of Peoples' Consolidated Financial Statements is presented to provide insight into management's assessment of the financial position and results of operations for the periods presented. This discussion and analysis should be read in conjunction with the audited Consolidated Financial Statements and Notes thereto, as well as the ratios and statistics, contained elsewhere in this Form 10-K. Summary of Significant Transactions and Events The following is a summary of transactions or events that have impacted or are expected by management to impact Peoples’ results of operations or financial condition: ◦On February 28, 2020, Peoples announced that on February 27, 2020, Peoples' Board of Directors authorized a share repurchase program authorizing Peoples to purchase up to an aggregate of $40 million of its outstanding common shares. This program replaced the share repurchase program authorizing Peoples to purchase up to an aggregate of $20 million of its outstanding common shares, which Peoples' Board of Directors had authorized on November 3, 2015 and which was terminated on February 27, 2020. ◦On January 1, 2020, Peoples Insurance acquired a property and casualty-focused independent insurance agency for a purchase price amount equal to $866,000. ◦During 2019, Peoples repurchased 26,427 of its common shares through its share repurchase program for a total of $805,000. ◦During 2019, Peoples recognized $482,000 in bank owned life insurance ("BOLI") income related to tax-free death benefits that exceeded the cash surrender value of the insurance policies. ◦During 2019, Peoples recognized two credits to its FDIC insurance expense related to two of its quarterly assessments as a result of the deposit insurance fund reaching its target threshold for smaller banks to recognize a credit to their insurance expense. ◦During each of 2019 and 2018, Peoples incurred $7.5 million of acquisition-related costs. During 2019, acquisition-related costs included $243,000 of losses recorded in net loss on asset disposals and other transactions, and $7.3 million in total non-interest expense. During 2018, acquisition-related costs included $203,000 of losses recorded in net loss on asset disposals and other transactions, and $7.3 million in total non-interest expense. During 2017, Peoples incurred $341,000 in acquisition-related costs, which was all recorded in total non-interest expense. The acquisition-related costs in 2019 were primarily related to the First Prestonsburg acquisition, and in 2018 and 2017 were primarily related to the ASB acquisition. The acquisition-related costs in 2019 and 2018 consisted mainly of fees associated with early termination of contracts, severance costs and write-offs associated with assets acquired. ◦During 2019, Peoples entered into five interest rate swaps with a notional value in the aggregate of $50.0 million, which became effective immediately and will mature between 2023 and 2029, with interest rates ranging from 1.44% to 1.91%. On July 31, 2018, Peoples entered into $50.0 million of interest rate swaps with an aggregate notional value of $50.0 million, which will mature between 2021 and 2028, with interest rates ranging from 2.92% to 3.00%. Additionally, the three interest rate swaps acquired with the ASB acquisition matured in July of 2018. On January 27, 2017, Peoples entered into two forward starting interest rate swaps with an aggregate notional value of $20.0 million, which became effective in January and April of 2018 and mature between 2025 and 2027, with interest rates ranging from 2.47% to 2.53%. For additional information regarding Peoples' interest rate swaps, refer to "Note 14 Derivative Financial Instruments" of the Notes to the Consolidated Financial Statements. ◦During 2019, Peoples closed one full-service bank branch located in Kentucky, and two full-service bank branches located in West Virginia and one insurance office located in Ohio when the respective leases for those West Virginia and Ohio locations expired. Additionally, Peoples closed one full-service bank branch located in West Virginia when the lease for the location expired in January 2020. Most employees at the closed locations filled open positions at other branches or offices. Peoples closed no locations during 2018. During 2017, Peoples closed six full-service bank branches, four located in Ohio, and two located in West Virginia. Peoples continues to evaluate its bank branch network in an effort to optimize efficiency. ◦On August 22, 2019, Peoples Risk Management, Inc., a wholly-owned subsidiary of Peoples, was formed. Peoples Risk Management, Inc. is a Nevada-chartered captive insurance company which insures against certain risks unique to the operations of Peoples and for which insurance may not be currently available or economically feasible. Peoples Risk Management, Inc. pools resources with several other similar insurance company subsidiaries of financial institutions to help minimize the risk allocable to each participating insurer. ◦On April 22, 2019, Peoples Bank signed an agreement to open a Federal Funds liquidity facility with Canadian Imperial Bank of Commerce, which either party may cancel at any time. The $20.0 million facility increases Peoples Bank's contingent liquidity funding and will serve to help manage Peoples Bank's daily liquidity needs. As of December 31, 2019, Peoples Bank had not borrowed under the agreement. ◦At the close of business on April 12, 2019, Peoples completed the merger with First Prestonsburg. First Prestonsburg merged into Peoples and First Prestonsburg's wholly-owned subsidiary, The First Commonwealth Bank of Prestonsburg, Inc., which operated nine full-service bank branches in central and eastern Kentucky, merged into Peoples Bank. First Prestonsburg shareholders received total merger consideration of $43.7 million, of which $11.3 million was in the form of a special cash dividend paid by First Prestonsburg to its shareholders prior to the merger with the remainder being paid in the form of an aggregate of 1,005,478 Peoples common shares by Peoples. The merger added $129.4 million of total loans and $257.2 million of total deposits at the acquisition date, after preliminary fair value adjustments. Peoples also recorded $4.2 million of other intangible assets and $15.2 million of goodwill. Refer to "Note 19 Acquisitions" of the Notes to the Consolidated Financial Statements for additional information. ◦On April 3, 2019, Peoples entered into a Loan Agreement (the “U.S. Bank Loan Agreement”) with U.S. Bank National Association. The U.S. Bank Loan Agreement has a one-year term and provides Peoples with a revolving line of credit in the maximum aggregate principal amount of $20.0 million that may be used: (i) for working capital purposes; (ii) to finance dividends or other distributions (other than stock dividends and stock splits) on or in respect of Peoples’ capital stock and redemptions, repurchases or other acquisitions of any of Peoples’ capital stock permitted under the U.S. Bank Loan Agreement and (iii) to finance acquisitions permitted under the U.S. Bank Loan Agreement. ◦During 2019, Peoples recognized a $1.8 million recovery on a previously charged-off commercial loan. ◦During 2019, Peoples sold its restricted Class B Visa stock, which had been held at a carrying cost and fair value of zero due to the litigation liability associated with the stock, resulting in a gain of $787,000 recorded in other non-interest income. ◦Multiple items impacted Peoples' income tax expense during 2018 and 2017, primarily as a result of the Tax Cuts and Jobs Act (the "TCJ Act"), which lowered the statutory federal corporate income tax rate to 21% as of January 1, 2018, from a previous rate of 35%. ▪Beginning on January 1, 2018, Peoples began recognizing lower income tax expense due to the lower 21% statutory federal corporate income tax rate. ▪During the fourth quarter of 2018, Peoples finalized the remeasurement of its net deferred tax assets and liabilities at the new statutory federal corporate income tax rate of 21%, which resulted in a reduction to income tax expense of $0.7 million in 2018. The final adjustment was mainly due to Peoples' contribution of $3.2 million to Peoples' defined benefit pension plan during 2018. ▪During 2018, Peoples released a valuation allowance which reduced income tax expense by $0.8 million. The valuation allowance was related to a historical tax credit that Peoples had invested in during 2015. Peoples sold $6.7 million of equity investment securities in the second quarter of 2018, which resulted in a capital gain for tax purposes. This capital gain was large enough to offset an anticipated future capital loss, which is expected to be recognized due to the structure of the historical tax credit investment, resulting in the release of the valuation allowance. ▪During the fourth quarter of 2017, as a result of its initial remeasurement at the new statutory federal corporate income tax rate, Peoples' wrote down its net deferred tax assets by $0.9 million. ◦During 2018, Peoples incurred $267,000 in pension settlement costs due to the aggregate amount of lump-sum distributions to participants in Peoples' defined benefit pension plan exceeding the threshold for recognizing such charges during the period. Pension settlement costs of $242,000 were recognized during 2017. There were no pension settlement costs in 2019. ◦At the close of business on April 13, 2018, Peoples completed the merger with ASB. ASB merged into Peoples, and ASB's wholly-owned subsidiary, American Savings Bank, fsb, which operated seven full-service bank branches and two loan production offices in southern Ohio and eastern Kentucky, merged into Peoples Bank. Under the terms of the merger agreement, Peoples paid total merger consideration of $41.5 million. The merger added an aggregate of $239.2 million of total loans and loans held for sale, and $198.6 million of total deposits at the acquisition date, after acquisition accounting adjustments. Peoples also recorded $2.6 million of other intangible assets and $18.1 million of goodwill. ◦On January 1, 2018, Peoples adopted ASU 2016-01, resulting in the reclassification of $7.8 million of equity investment securities from available-for-sale investment securities to other investment securities and the reclassification of $5.0 million in net unrealized gains on equity investment securities from accumulated other comprehensive loss to retained earnings. ASU 2016-01 also requires changes in the fair value of the equity investment securities to be recorded in non-interest income instead of other comprehensive income, which resulted in $207,000 of gains recorded in other non-interest income during 2018. During 2017, Peoples reduced its position in certain equity investment securities. This action was taken as a result of the high appreciation in the market value of these securities. The sales completed resulted in a net gain on investment securities of $3.0 million in 2017. As of December 31, 2019 and December 31, 2018, Peoples had equity investment securities of $321,000 and $277,000, respectively. ◦The Federal Reserve Board lowered the benchmark Federal Funds Target Rate a total of 75 basis points during the third and fourth quarter of 2019. At that time, the Federal Open Market Committee signaled they would likely be on hold with monetary policy throughout 2020. However, the global public health concerns of early 2020 have altered the interest rate environment. Chairman Powell has indicated that if market conditions warrant rate cuts, actions would be taken. As of March 2, 2020, it remains unclear on how the public health concerns will materialize and the ultimate number of rate cuts that may occur, if any. The impact of these transactions, where material, is discussed in the applicable sections of this Management’s Discussion and Analysis of Financial Condition and Results of Operations. Pending Accounting Pronouncements The FASB issued new accounting guidance with respect to credit losses in ASU 2016-13, which became effective for Peoples on January 1, 2020. This guidance replaces the current "incurred loss" model for recognizing credit losses with an "expected loss" model, referred to as the CECL model. The measurement of expected credit losses is to be based on information about past events, including historical experience, current conditions, and reasonable and supportable forecasts that affect the collectability of the reported amount. This measurement will take place at the time the financial asset is first added to the balance sheet and periodically thereafter. This differs significantly from the "incurred loss" model required under historic US GAAP, which delays recognition until it is probable a loss has been incurred. Accordingly, Peoples expects that the adoption of the CECL model will materially affect how the allowance for loan losses is determined and could require significant increases to the allowance for credit losses. Moreover, the CECL model may create more volatility in the level of Peoples' allowance for credit losses and credit loss experience. If required to materially increase the level of allowance for credit losses for any reason, such increase could adversely affect Peoples' business, financial condition and results of operations. The CECL standard is to become effective for interim and annual reporting periods beginning after December 15, 2019 (effective January 1, 2020 for Peoples). Peoples has a committee that meets regularly to monitor progress and oversee the project. Peoples has implemented a third-party software solution, and utilized the tool to run test calculations throughout 2019 in anticipation of the full implementation at the beginning of 2020. Peoples has engaged consultants to assist with the completion of certain aspects of the project plan. Peoples is in the process of finalizing its model validation, and is currently refining the economic forecasting process, documenting accounting policies, reviewing business processes, critically reviewing model output and executing internal control framework. Peoples completed a test run of its process, inclusive of the model, at the end of each of the third and fourth quarter of 2019. Peoples expects to recognize a one-time cumulative-effect adjustment to the allowance for credit losses, and related tax effect, as of the beginning of the first reporting period in which the new standard is effective, consistent with regulatory expectations set forth in interagency guidance issued at the end of 2016. The cumulative-effect adjustment will be based on the change in the allowance for credit losses for modeled results for outstanding loans, individually evaluated loans, qualitative factors, investment securities and the unfunded commitment liability. The impact of the implementation for purchased credit deteriorated loans will be contemplated separately from the one-time cumulative-effect adjustment. Peoples is in the process of determining the magnitude of any such one-time cumulative-effect adjustment and of the overall impact of the new standard on Peoples' financial condition and results of operations. Peoples anticipates finalizing processes and recording the transition adjustment during the first quarter of 2020. There is a three-year phase-in option for regulatory capital effects of the one-time cumulative-effect adjustment; however, Peoples does not currently anticipate opting for the phase-in based upon preliminary projections, but could change its position once closer to finalizing the implementation process. In addition, this updated guidance also changes the process for analyzing available-for-sale investment securities for impairment. Currently, Peoples evaluates the available-for-sale investment securities portfolio for other-than-temporary impairment on a quarterly basis. Under the new guidance, this process will change to determine what portion, if any, of the unrealized loss on available-for-sale investment securities is considered to be driven by a credit loss. If it is determined that market price deterioration in the available-for-sale investment securities is credit-related, and likely to be permanent, an allowance for credit losses will be established for the credit loss portion of the unrealized loss. Peoples is finalizing the processes and other assumptions related to the CECL model, including validations and determining the implementation impact as of January 1, 2020. Peoples has preliminary projections based on the current status of the CECL model, which are subject to change based on continued finalization of procedures and execution of internal control framework. Peoples' projections include the potential impact of changes related to outstanding loans, individually evaluated loans, preliminary qualitative factors, investment securities and purchased credit deteriorated assets. Based upon the preliminary projections, Peoples estimates the following: (a) The estimated allowance for credit losses includes outstanding loans, individually evaluated loans, preliminary qualitative factors and investment securities. (b) The estimated allowance for purchased credit deteriorated loans includes the gross up of loan balances for the transition adjustment to establish the allowance for credit losses. (c) The estimated unfunded commitment liability includes the impact of off-balance credit exposures consisting of unfunded commitments available under financing receivables, standby letters of credit and financial guarantees. (d) The estimated range of the cumulative-effect adjustment as a reduction to retained earnings reflects the impact of the transition to the CECL model, net of tax, and excludes the gross up of loan balances for the purchased credit deteriorated loan transition adjustment. The estimates provided above are subject to change based upon the completion of all aspects of the implementation process by Peoples, and may differ from actual implementation results that will be reported in Peoples' Quarterly Report on Form 10-Q for the quarterly period ended March 31, 2020. Critical Accounting Policies The accounting and reporting policies of Peoples conform to US GAAP and to general practices within the financial services industry. A summary of significant accounting policies is contained in "Note 1 Summary of Significant Accounting Policies" of the Notes to the Consolidated Financial Statements. While all of these policies are important to understanding the Consolidated Financial Statements, certain accounting policies require management to exercise judgment and make estimates or assumptions that affect the amounts reported in the Consolidated Financial Statements and accompanying Notes. These estimates and assumptions are based on information available as of the date of the Consolidated Financial Statements; accordingly, as this information changes, the Consolidated Financial Statements could reflect different estimates or assumptions. Management has identified four accounting policies as those that, due to the judgments, estimates and assumptions inherent in the policies, are critical to an understanding of Peoples' Consolidated Financial Statements and Management's Discussion and Analysis of Financial Condition and Results of Operations. The four accounting policies identified were the allowance for loan losses, business combinations, goodwill, and income taxes. These four accounting policies are described in further detail below. Allowance for Loan Losses In general, determining the amount of the allowance for loan losses requires significant judgment and the use of estimates by management. Peoples maintains an allowance for loan losses based on a quarterly analysis of the loan portfolio and estimation of the losses that are probable of occurrence within the loan portfolio. This formal analysis determines an appropriate level and allocation of the allowance for loan losses among loan types and the resulting provision for or recovery of loan losses by considering factors affecting losses, including specific losses, levels and trends in impaired and nonperforming loans; historical loan loss experience; current national and local economic conditions; volume; growth and composition of the portfolio; regulatory guidance and other relevant factors. Management continually monitors the loan portfolio through Peoples Bank's Credit Administration Department and Loan Loss Committee to evaluate the appropriateness of the allowance. The provision for or recovery of loan losses could increase or decrease each quarter based upon the results of management's formal analysis. The amount of the allowance for loan losses for the various loan types represents management's estimate of probable losses from existing loans. Management evaluates lending relationships deemed to be impaired on an individual basis and makes specific allocations of the allowance for loan losses for each relationship based on discounted cash flows using the loan's initial effective interest rate or the fair value of the collateral for certain collateral dependent loans. For all other loans, management evaluates pools of homogeneous loans (such as residential mortgage loans, and direct and indirect consumer loans) and makes general allocations for each pool based upon historical loss experience, adjusted for qualitative factors. While allocations are made to specific loans and pools of loans, the allowance is available for all loan losses. The evaluation of individual impaired loans requires management to make estimates of the amounts and timing of future cash flows on the impaired loans, which consist primarily of loans placed on nonaccrual status, restructured loans or loans internally classified as substandard or doubtful. These reviews are based upon specific quantitative and qualitative criteria, including the size of the loan, the loan cash flow characteristics, the loan quality ratings, the value of associated collateral, the repayment ability of the borrower, and historical experience factors. Allowances for homogeneous loans are evaluated based upon historical loss experience, adjusted for qualitative risk factors, such as trends in losses and delinquencies, growth of loans in particular markets, and known changes in economic conditions in each lending market. As part of the process of identifying the pools of homogenous loans, management takes into account any concentrations of risk within any portfolio segment, including any significant industrial concentrations. Consistent with the evaluation of allowances for homogenous loans, the allowance relating to the Overdraft Privilege program is based upon management's monthly analysis of accounts in the program. This analysis considers factors that could affect losses on existing accounts, including historical loss experience and the length of each overdraft. There can be no assurance that the allowance for loan losses will be adequate to cover all losses, but management believes the allowance for loan losses at December 31, 2019 was adequate to provide for probable losses from existing loans based on information currently available. While management uses available information to estimate losses, the ultimate collectability of a substantial portion of the loan portfolio, and the need for future additions to the allowance, will be based on changes in economic conditions and other relevant factors. As such, adverse changes in economic activity could reduce currently estimated cash flows for both commercial and individual borrowers, which would likely cause Peoples to experience increases in problem assets, delinquencies and losses on loans in the future. Peoples also evaluates unfunded commitments for construction loans, floor plan lines of credit, home equity lines of credit, other credit lines and letters of credit on a quarterly basis. The calculation of the reserve for unfunded commitments utilizes the same look back period as the allowance for loan losses, and is based on the reported losses on unfunded commitments during this look back period. This annualized loss rate is then applied to the probable drawn amount of the pooled unfunded commitments to determine the required reserve. Peoples also evaluates classified credit exposures with unfunded commitments individually to determine if a loss is both probable and reasonably estimable. ASU 2016-13 became effective for Peoples beginning January 1, 2020, and replaces the current "incurred loss" model for recognizing credit losses with an "expected loss" model, referred to as the CECL model. This differs significantly from the "incurred loss" model required under historic US GAAP, which delays recognition until it is probable a loss has been incurred. Business Combinations Peoples utilizes the acquisition method of accounting for business combinations. As of the acquisition date, Peoples records the acquired company's net assets at fair value. The determination of fair value as of the acquisition date requires management to consider various factors that involve judgment and estimation, including the application of discount rates, attrition rates, future estimates of interest rates, as well as many other assumptions. These assumptions can have a material impact on the estimated fair value, and as a result, the goodwill recorded in a business combination. Goodwill Peoples records goodwill as a result of acquisitions accounted for under the acquisition method of accounting. Under the acquisition method, Peoples is required to allocate the consideration paid for an acquired company to the assets acquired, including identified intangible assets, and liabilities assumed based on their estimated fair values at the date of acquisition. Goodwill represents the excess cost over the fair value of net assets acquired and is not amortized but is tested for impairment when indicators of impairment exist, and, in any case, at least annually. The value of recorded goodwill is supported by revenue that is driven by the volume of business transacted and Peoples' ability to provide quality, cost-effective services in a competitive market place. A decline in earnings as a result of a lack of growth or the inability to deliver cost-effective services over sustained periods can lead to impairment of goodwill that could adversely impact earnings in future periods. Goodwill impairment exists when the carrying value of the reporting unit (as defined by US GAAP) exceeds its carrying value and an impairment loss is recognized in earnings in an amount equal to that excess, limited to the total amount of goodwill allocated to the reporting unit. The process of evaluating goodwill for impairment involves highly subjective and complex judgments, estimates and assumptions regarding the fair value of Peoples' reporting unit and, in some cases, goodwill itself. As a result, changes to these judgments, estimates and assumptions in future periods could result in materially different results. Peoples currently maintains a single reporting unit for goodwill impairment testing. While quoted market prices exist for Peoples' common shares since they are publicly traded, these market prices do not necessarily reflect the value associated with gaining control of an entity. Thus, management takes into account all appropriate fair value measurements in determining the estimated fair value of the reporting unit. Peoples elected to early adopt Accounting Standards Update (ASU) 2017-04 as of January 1, 2019. The amendments in this ASU simplify how an entity is required to test goodwill for impairment by eliminating the requirement to calculate the implied fair value of goodwill to measure a goodwill impairment charge. Instead, entities will record an impairment charge based on the excess of a reporting unit’s carrying amount over its fair value. Peoples performs its required annual impairment test as of October 1st each year. Peoples first assesses qualitative factors to determine whether it is more likely than not that the fair value of the reporting unit is less than its carrying amount, including goodwill. In this evaluation, Peoples assesses relevant events and circumstances, which may include macroeconomic conditions, industry and market conditions, cost factors, overall financial performance, events specific to Peoples, significant changes in the reporting unit, or a sustained decrease in stock price. If Peoples determines that it is more likely than not that the fair value of the reporting unit is greater than its carrying amount, then performing the quantitative impairment test is unnecessary. However, Peoples has the option to complete the quantitative impairment test to corroborate the findings of its qualitative analysis. If Peoples determines that it is more likely than not that the fair value of a reporting unit is less than its carrying amount, Peoples must complete the quantitative impairment test. At October 1, 2019, management's qualitative analysis concluded that the estimated fair value of Peoples' single reporting unit exceeded its carrying value. Thus, a quantitative assessment was not required to be performed; however, management opted to perform a quantitative assessment using the market capitalization approach, which also determined the fair value of the reporting unit exceeded its carrying value. Peoples is required to perform interim tests for goodwill impairment in subsequent quarters if events occur or circumstances change that indicate potential goodwill impairment exists, such as adverse changes to Peoples' business or a significant decline in Peoples' market capitalization. For further information regarding goodwill, refer to "Note 6 Goodwill and Other Intangible Assets" of the Notes to the Consolidated Financial Statements. Income Taxes Income taxes are recorded based on the liability method of accounting, which includes the recognition of deferred tax assets and liabilities for the temporary differences between carrying amounts and tax bases of assets and liabilities, computed using enacted tax rates. In general, Peoples records deferred tax assets when the event giving rise to the tax benefit has been recognized in the Consolidated Financial Statements. A valuation allowance is recognized to reduce any deferred tax asset when, based upon available information, it is more-likely-than-not all, or any portion, of the deferred tax asset will not be realized. Assessing the need for, and amount of, a valuation allowance for deferred tax assets requires significant judgment and analysis of evidence regarding realization of the deferred tax assets. In most cases, the realization of deferred tax assets is dependent upon Peoples generating a sufficient level of taxable income in future periods, which can be difficult to predict. Peoples' largest deferred tax assets involve differences related to Peoples' allowance for loan losses, available-for-sale securities, and accrued employee benefits. Management determined a valuation allowance of $805,000 at December 31, 2017, to be recorded against the deferred tax assets associated with its investment in a partnership investment. In 2018, Peoples released the valuation allowance, which reduced income tax expense by $805,000. Peoples sold $6.7 million of equity investment securities in the second quarter of 2018, which resulted in a capital gain for tax purposes. This capital gain was large enough to offset an anticipated future capital loss, which is expected to be recognized due to the structure of the historical tax credit investment, resulting in the release of the valuation allowance. There were no valuation allowances recorded at December 31, 2019. The calculation of tax liabilities is complex and requires the use of estimates and judgment since it involves the application of complex tax laws that are subject to different interpretations by Peoples and the various tax authorities. Peoples' interpretations are subject to challenge by the tax authorities upon audit or to reinterpretation based on management's ongoing assessment of facts and evolving case law. From time-to-time and in the ordinary course of business, Peoples is involved in inquiries and reviews by tax authorities that normally require management to provide supplemental information to support certain tax positions taken by Peoples in its tax returns. Uncertain tax positions are initially recognized in the Consolidated Financial Statements when it is more likely than not the position will be sustained upon examination by the tax authorities. Such tax positions are initially and subsequently measured as the largest amount of tax benefit that is greater than 50% likely of being realized upon ultimate settlement with the tax authority assuming full knowledge of the position and all relevant facts. The amount of unrecognized tax benefits was immaterial at both December 31, 2019 and 2018. Management believes it has taken appropriate positions on its tax returns, although the ultimate outcome of any tax review cannot be predicted with certainty. Consequently, no assurance can be given that the final outcome of these matters will not be different than what is reflected in the current and historical financial statements. Fair Value Measurements As a financial services company, the carrying value of certain financial assets and liabilities is impacted by the application of fair value measurements, either directly or indirectly. In certain cases, an asset or liability is measured and reported at fair value on a recurring basis, such as available-for-sale investment securities. In other cases, management must rely on estimates or judgments to determine if an asset or liability not measured at fair value warrants an impairment write-down or whether a valuation reserve should be established. Given the inherent volatility, the use of fair value measurements may have a significant impact on the carrying value of assets or liabilities, or result in material changes to the consolidated financial statements, from period to period. Detailed information regarding fair value measurements can be found in "Note 2 Fair Value of Financial Instruments" of the Notes to the Consolidated Financial Statements. EXECUTIVE SUMMARY Net income for the year ended December 31, 2019 was $53.7 million, compared to $46.3 million in 2018 and $38.5 million in 2017, representing earnings per diluted common share of $2.63, $2.41 and $2.10, respectively. The growth during 2019 was driven by increases of $11.2 million in net interest income and $7.5 million in non-interest income. These benefits were partially offset by an $11.3 million increase in non-interest expenses, which were impacted by the ongoing operating costs of the First Prestonsburg acquisition. The growth during 2018 was driven by increases of $16.2 million in net interest income and $1.2 million in non-interest income, coupled with a $10.0 million decline in income tax expense. These benefits were partially offset by a $7.1 million increase in acquisition-related costs, primarily related to the ASB acquisition. Net interest income was $140.8 million in 2019, an increase of 9%, compared to $129.6 million in 2018, which had been up 14% compared to $113.4 million in 2017. The growth during 2019 was driven by loan growth, which was positively impacted by the First Prestonsburg and ASB acquisitions, and higher loan yields. The increase in interest income on loans outpaced the increase in interest expense from deposits, which was up primarily due to higher rates paid on deposits, combined with additional interest expense related to deposits from the recent acquisitions. The growth during 2018 was mostly due to originated loan growth and the impact of the acquisition of ASB. During 2018, higher yields on investment securities and loans were tempered by an increase in deposit and borrowing costs. Net interest margin was 3.69% in 2019, compared to 3.71% in 2018 and 3.62% in 2017. The decline in net interest margin compared to 2018 was driven by the overall increase in rates on deposits and borrowings, combined with lower yields on investment securities, given accelerated premium amortization in the latter half of the year. Accretion income, net of amortization expense, from acquisitions added approximately 12 basis points to net interest margin in 2019, compared to six basis points in 2018 and 10 basis points in 2017. In 2018, proceeds of $0.9 million were received on an investment security that, in prior years, had been written-down due to an other-than-temporary impairment, which added three basis points to the net interest margin, compared to $0.8 million, and three basis points, during 2017. Similar proceeds were not received in 2019. In 2019, Peoples recorded a provision for loan losses of $2.5 million, a decrease of $2.9 million compared to the $5.4 million that was recorded in 2018 and down from the $3.8 million recorded for 2017. The lower provision for loans losses for 2019 compared to 2018 was due to lower net charge-offs, which included a recovery of $1.8 million recorded on a previously charged-off commercial loan, and less loan growth compared to 2018. Net charge-offs in 2018 included a charge-off of $827,000 related to one acquired commercial loan relationship. The increase in the provision for loan losses for 2018 compared to 2017 was driven primarily by loan growth and an increase in net charge-offs of $638,000. Peoples recorded net charge-offs of $1.1 million during 2019, compared to $4.0 million for 2018 and $3.4 million for 2017. Net charge-offs as a percent of average total loans were 0.04% during 2019, and 0.15% during each of 2018 and 2017. Total non-interest income increased $7.5 million, or 13%, in 2019 compared to 2018. The increase was led by higher income from electronic banking, deposit account service charges, commercial loan swap fees and mortgage banking. Electronic banking income increased as the result of increased debit card usage, which was positively impacted by the cardholders added in the First Prestonsburg and ASB acquisitions. Income from deposit account service charges was up primarily due to the additional accounts from the acquisitions, coupled with changes in deposit fees. Commercial loan swap fees more than tripled and mortgage banking income was higher mainly due to an increase in customer demand as a result of interest rate declines in the latter half of the year. Realized and unrealized gains on equity investment securities increased $624,000 compared to 2018, driven by $787,000 of income related to the sale of restricted Class B Visa stock during 2019. Additionally, BOLI income during 2019 included $482,000 of tax-free death benefits that exceeded the cash surrender value of the policies. Total non-interest income increased 2%, in 2018 compared to 2017. The increase was led by higher income from mortgage banking, electronic banking, trust and investments, and insurance. Mortgage banking income increased because of the benefits of the mortgage origination operations acquired from ASB. In addition, other non-interest income grew during 2018 as a result of higher income related to Small Business Administration ("SBA") loans, coupled with the change in fair value of equity investment securities during 2018. The majority of these equity investment securities were liquidated during 2018. Total non-interest expense increased 9% during 2019, driven by higher salaries and employee benefits costs, net occupancy and equipment expense, electronic banking expense, and data processing and software expense, partially offset by declines in FDIC insurance expense and professional fees. Salaries and employee benefit costs were up primarily due to higher base salaries, which were impacted by merit increases, including continued movement towards a $15 per hour minimum wage throughout Peoples' organization, and the employees added from the acquisitions in 2019 and 2018. Net occupancy and equipment expenses increased primarily due to the added facilities obtained in the acquisitions. Peoples' investments in technology, coupled with higher transaction volume, resulted in increases in data processing and software expense and electronic banking expense. FDIC insurance expense declined due to credits against assessments received during the year. Professional fees were down mostly due to the impact of legal expenses and consulting work performed during 2018, which was not duplicated in 2019. Acquisition-related expenses were $7.3 million during both 2019 and 2018. In 2018, total non-interest expense increased 17%, driven by the increase in acquisition-related expenses of $6.9 million, compared to 2017. Also contributing to the changes were higher salaries and employee benefits costs. These costs grew $9.0 million and were the result of a combination of the one-time expenses associated with the ASB acquisition and the resulting increase in number of retained employees from the acquisition. Also contributing to the change were higher sales-based and incentive compensation, merit increases, and the continued movement towards a $15 per hour minimum wage throughout Peoples' organization. Income tax expense in 2019 was $11.7 million compared to $8.7 million in 2018, and $18.7 million in 2017. The increase in income tax expense from 2018 to 2019 was primarily due to higher pre-tax income. The decline in 2018 compared to 2017 was largely a result of the TCJ Act, which lowered the federal corporate income tax rate from 35% to 21%. During 2019, income tax expense included a tax benefit of $508,000 related to non-taxable BOLI income. Income tax expense for 2018 included the release of a tax valuation allowance of $805,000 (which had been recorded at December 31, 2017 against certain deferred assets) and a reduction to income tax expense of $705,000 as a result of the final impact related to the statutory federal corporate income tax rate change from the TCJ Act. During 2017, income tax expense included a write down of $879,000 of net deferred tax assets as a result of the initial remeasurement at the new statutory federal corporate income tax rate from the TCJ Act. At December 31, 2019, total assets were up 9%, or $362.7 million, to $4.35 billion versus $3.99 billion at year-end 2018. The increase was primarily related to the acquisition of First Prestonsburg and $117.8 million of originated loan growth. The allowance for loan losses increased slightly to $21.6 million or 0.75% of total loans, net of deferred fees and costs, compared to $20.2 million and 0.74%, respectively, at December 31, 2018. Total liabilities were $3.76 billion at December 31, 2019, up $288.5 million since December 31, 2018. At December 31, 2019, total deposits increased $335.9 million to $3.29 billion compared to the prior year-end. Total demand deposits increased $125.3 million, or 11%, and were unchanged at 40% of total deposits at both December 31, 2019 and December 31, 2018. The growth in deposits in 2019 compared to the prior year-end was primarily due to acquired First Prestonsburg deposit balances of $257.2 million. The increase in total deposits was partially offset by a decline in total borrowed funds of $65.7 million to $400.1 million at December 31, 2019, compared to $465.8 million at December 31, 2018. At December 31, 2019, total stockholders' equity was $594.4 million, up 14%, or $74.3 million, from December 31, 2018. The increase was primarily due to earnings of $53.7 million during 2019, the issuance of $32.4 million of common shares related to the acquisition of First Prestonsburg, and an increase in the market value of investment securities. Dividends of $26.9 million paid to shareholders, partially offset these increases. Additionally, Peoples repurchased 26,427 of its common shares for a total of $805,000 during 2019. Peoples exceeded the capital required by the Federal Reserve Board to be deemed "well capitalized." Regulatory capital was positively impacted by the First Prestonsburg acquisition during 2019, which created increases in capital and risk-weighted assets. Peoples' tier 1 capital ratio increased to 14.84% at December 31, 2019, versus 13.92% at December 31, 2018, while the total capital ratio was 15.58% at December 31, 2019, versus 14.65% at December 31, 2018. The common equity tier 1 risk-based capital ratio was 14.59% at December 31, 2019 compared to 13.66% at December 31, 2018. Peoples' book value and tangible book value per share were $28.72 and $20.14, respectively, at December 31, 2019, compared to $26.59 and $18.30, respectively, at December 31, 2018. Additional information regarding capital requirements can be found in "Note 16 Regulatory Matters" of the Notes to the Consolidated Financial Statements. RESULTS OF OPERATIONS Net Interest Income Peoples earns interest income on loans and investments, and incurs interest expense on interest-bearing deposits and borrowed funds. Net interest income, the amount by which interest income exceeds interest expense, remains Peoples' largest source of revenue and was 68% of total revenue during 2019. The amount of net interest income earned by Peoples is affected by various factors, including changes in market interest rates due to the Federal Reserve Board's monetary policy, the level and degree of pricing competition for both loans and deposits in Peoples' markets, and the amount and composition of Peoples' earning assets and interest-bearing liabilities. Peoples monitors net interest income performance and manages its balance sheet composition through regular ALCO meetings. The asset-liability management process employed by the ALCO is intended to mitigate the impact of future interest rate changes on Peoples' net interest income and earnings. However, the frequency and/or magnitude of changes in market interest rates are difficult to predict, and may have a greater impact on net interest income than adjustments management is able to make. As part of the analysis of net interest income, management converts tax-exempt income earned on obligations of states and political subdivisions to the pre-tax equivalent of taxable income using a statutory federal corporate income tax rate of 21% for 2019 and 2018 and 35% for 2017. Management believes the resulting fully tax-equivalent ("FTE") net interest income allows for a more meaningful comparison of tax-exempt income and yields to their taxable equivalents. Net interest margin, which is calculated by dividing FTE net interest income by average interest-earning assets, serves as an important measurement of the net revenue stream generated by the volume, mix and pricing of earning assets and interest-bearing liabilities. The following table details the calculation of FTE net interest income for the years ended December 31: The following table details Peoples’ average balance sheets, with corresponding income/expense and yield/cost, for the years ended December 31: (a) Average balances are based on carrying value. (b) Interest income and yields are presented on an FTE basis using a 21% statutory federal corporate income tax rate for 2019 and 2018 and a 35% statutory federal corporate income tax rate for 2017. (c) Interest income and yield presented for 2018 and 2017 includes $0.9 million and $0.8 million, respectively, of proceeds on an investment security for which an other-than-temporary-impairment had been recorded in previous years. (d) Average balances include nonaccrual, impaired loans, and loans held for sale. Interest income includes interest earned and received on nonaccrual loans prior to the loans being placed on nonaccrual status. Loan fees included in interest income were immaterial for all periods presented. (e) Loans held for sale are included in the average loan balance listed. Related interest income on loans originated for sale prior to the loan being sold is included in loan interest income. The following table provides an analysis of the changes in FTE net interest income: (a)The change in interest due to both rate and volume has been allocated to rate and volume changes in proportion to the relationship of the dollar amounts of the changes in each. (b)Interest income and yields are presented on a FTE basis using a 21% statutory federal corporate income tax rate for 2019 and 2018 and a 35% statutory federal corporate income tax rate for 2017. During 2019, Peoples recognized accretion income, net of amortization expense, from acquisitions of $4.9 million, which added approximately 12 basis points to net interest margin, compared to $2.2 million and six basis points in 2018, and $3.1 million and 10 basis points in 2017. During 2018, proceeds of $894,000 were received on an investment security that had been, in previous years, written-down due to an other-than-temporary impairment, which added three basis points to the net interest margin, compared to $814,000, and three basis points, in 2017. No such amount was recorded in 2019. Additional interest income in 2019 from prepayment fees and interest recovered on nonaccrual loans was $564,000, compared to $420,000 in 2018 and $826,000 in 2017. The primary driver of the increase in net interest income during the past two years has been the higher interest income on loans due to a combination of loan growth, which was boosted by the acquisitions of ASB in 2018 and First Prestonsburg in 2019, and higher yields on loans. During 2019, net interest income was constrained by an unusual amount of loan payoffs and decreases in interest rates during the latter half of 2019. Yields on investment securities declined in 2019 as the Federal Reserve Board lowered the benchmark Federal Funds Target Rate by 25 basis points in each of July, September and October of 2019 resulting in essence a parallel shift downward of the yield curve by year-end 2019. The decline in net interest margin compared to 2018 was driven by the overall increase in rates paid on deposits and borrowings, combined with lower yields on investment securities, given accelerated premium amortization. During 2018, net interest income also benefited from increases in interest rates. Funding costs increased in 2018 as the Federal Reserve Board raised the benchmark Federal Funds Target Rate by 25 basis points in each of March, June and December of 2017, as well as in each of March, June, September, and December of 2018. These rate increases drove higher loan and investment security yields, which outpaced increases in deposit and wholesale funding costs in 2018. Detailed information regarding changes in the Consolidated Balance Sheets can be found under appropriate captions of the "FINANCIAL CONDITION" section of this discussion. Additional information regarding Peoples' interest rate risk and the potential impact of interest rate changes on Peoples' results of operations and financial condition can be found later in this discussion under the caption "Interest Rate Sensitivity and Liquidity." Provision for Loan Losses The following table details Peoples’ provision for loan losses recognized for the years ended December 31: The provision for loan losses represents the amount needed to maintain the appropriate level of the allowance for loan losses based on management’s formal quarterly analysis of the loan portfolio and procedural methodology that estimates the amount of probable credit losses. This process considers various factors that affect losses, such as changes in Peoples’ loan quality, historical loss experience, current economic conditions, and other environmental factors such as changes in real estate market conditions, unemployment, and the economic impact of tariffs. The lower provision for loans losses for 2019 compared to 2018 was due to lower charge-offs and less loan growth compared to 2018. Net charge-offs in 2019 were $1.1 million and included a recovery of $1.8 million recorded on a previously charged-off commercial loan. The provision for loan losses recorded in 2018 was primarily due to continued loan growth and net charge-offs of $2.0 million related to consumer indirect lending, coupled with charge-offs of $827,000 related to one acquired commercial loan relationship. The provision for loan losses recorded in 2017 was driven by loan growth and stable asset quality trends. Additional information regarding changes in the allowance for loan losses and loan credit quality can be found later in this discussion under the caption "Allowance for Loan Losses." Net Gains (Losses) Included in Total Non-Interest Income Net gains (losses) include gains and losses on investment securities, asset disposals and other transactions, which are recognized in total non-interest income. The following table details the net gains (losses) for the years ended December 31 recognized by Peoples: The net loss on asset disposals and other transactions during 2019 was driven by net losses on repossessed assets of $320,000, the write-offs of fixed assets acquired from First Prestonsburg of $243,000 and market value write-downs related to closed offices that were held for sale. The net loss on other assets during 2018 was primarily due to the disposal of $190,000 of ASB fixed assets acquired coupled with $198,000 of market value write-downs related to closed offices that were held for sale. The net loss on other transactions during 2018 was due to the write-down of a limited partnership investment. During 2017, the net loss on OREO was a result of the sale of two commercial properties. The net gain on other assets during 2017 was due to the sale of a previously closed branch, which was offset partially by a loss on the sale of a parking lot that was no longer being utilized. Total Non-Interest Income, Excluding Net Gains and Losses Peoples generates total non-interest income excluding net gains and losses from four primary sources: insurance income; electronic banking income ("e-banking"); trust and investment income; and deposit account service charges. Peoples continues to focus on revenue growth from non-interest income sources in order to maintain a diversified revenue stream through greater reliance on total non-interest income excluding net gains and losses. As a result, total non-interest income excluding net gains and losses accounted for 31.5% of Peoples' total revenues (defined as net interest income plus total non-interest income excluding net gains and losses) in 2019, compared to 30.6% in 2018 and 31.7% in 2017. The increase in Peoples' total non-interest income excluding net gains and losses as a percent of total revenue during 2019 from 2018 was due to increases in nearly all non-interest income categories, combined with the recent interest rate environment and an unusual amount of loan payoffs constraining net interest income in the latter half of 2019. The slight decline in the ratio in 2018 compared to 2017 was primarily due to increased net interest income due to originated loan growth and the acquisition of ASB, as well as interest rate increases. Insurance income comprised the largest portion of Peoples' non-interest income. The following table details Peoples’ insurance income for the years ended December 31: (a) As of January 1, 2018, Peoples adopted ASU 2014-09 and began recording deferred income related to insurance commissions. The majority of performance-based commissions typically are recorded annually in the first quarter and are based on a combination of factors, such as loss experience of insurance policies sold, production volumes and overall financial performance of the individual insurance carriers. The increase in life and health insurance commissions during 2018 compared to 2017 was primarily due to timing of revenue recognition attributable to the implementation of ASU 2014-09. The following table shows Peoples' e-banking income for the years ended December 31: Peoples' e-banking services include ATM and debit cards, direct deposit services, Internet and mobile banking, and remote deposit capture, and serve as alternative delivery channels to traditional sales offices for providing services to clients. Revenue is derived largely from ATM and debit cards, as other services are mainly provided at no charge to the customers. The amount of e-banking income is largely dependent on the timing and volume of customer activity. The increases in e-banking income in 2019 and 2018 were the result of the increased volume of customers and usage of debit cards, which includes the impact of additional customers and accounts added in the acquisition of First Prestonsburg in 2019 and of ASB in 2018. In 2019, Peoples' customers used their debit cards to complete $913.7 million of transactions, versus $801.2 million in 2018 and $729.0 million in 2017. Peoples' fiduciary and brokerage revenues continue to be based primarily upon the value of assets under administration and management. The following table details Peoples’ trust and investment income for the years ended December 31: The following table details Peoples’ assets under administration and management at year-end December 31: During 2019, the increases in fiduciary and brokerage revenues were due to a combination of an increase in the market value of accounts during the latter part of 2019 and new assets under administration and management. Average assets under administration and management during 2019 were impacted by the lower balance at the beginning of 2019 as a result of the downward shift in U.S. financial markets at the end of 2018 and in early 2019. Income from employee benefit plans in 2019 has increased compared to 2018 due to the continued growth in administration of 401(k) plans for businesses. In recent years, Peoples has added experienced financial advisors in previously underserved market areas, and generated new business and revenue related to retirement plans for which it manages the assets and provides services. During 2018, the increases in fiduciary and brokerage revenues were due to a combination of growth of new business, primarily in fee-based accounts, and growth in retirement benefit plans. Average assets under administration and management during 2018 increased compared to 2017 due primarily to new assets under administration and management, coupled with an increase in the market value of accounts. The U.S. financial markets shifted downward at the end of 2018, resulting in the decline in end-of-period assets under administration and management at December 31, 2018 compared to December 31, 2017. Deposit account service charges, which are based on the costs associated with services provided, comprised a significant portion of Peoples' non-interest income. The following table details Peoples' deposit account service charges for the years ended December 31: The amount of deposit account service charges, particularly fees for overdrafts and non-sufficient funds, is largely dependent on the timing and volume of customer activity. Management periodically evaluates its fees to ensure they are reasonable based on operational costs and similar to fees charged in Peoples' markets by competitors. Income from deposit account service charges increased in 2019 compared to 2018 primarily due to the First Prestonsburg and ASB acquisitions, coupled with changes in fee schedules. Peoples implemented a new deposit account fee schedule in March 2019, and it is anticipated that the higher deposit fees associated with the new fee schedule will diminish somewhat over time. The slight decline in overdraft and non-sufficient funds fees between 2018 and 2017 was partially due to changes made to the calculation of fees to be more in line with industry practices. The increase in account maintenance fees in 2018, compared to 2017, was largely due to implementation of new consumer checking products that occurred near the end of 2017. Other fees and charges declined in 2018, compared to 2017, mainly due to changes made in the calculation of personalized check fees. The following table details the other items included within Peoples' total non-interest income for the years ended December 31: (a) As of January 1, 2018, Peoples adopted ASU 2016-01, resulting in a gain in income of $831,000 for 2019 and $207,000 for 2018. Mortgage banking income is comprised mostly of net gains from the origination and sale of long-term, fixed rate real estate loans in the secondary market, as well as servicing income for sold loans. As a result, the amount of income recognized by Peoples is largely dependent on customer demand and long-term interest rates for residential real estate loans offered in the secondary market. Mortgage banking income increased in 2019, compared to 2018, due to higher customer demand, which was driven by the decline in mortgage interest rates during second half of 2019. Mortgage banking income increased in 2018, largely due to gains on sale of real estate loans originated by the mortgage origination operation acquired as part of the ASB acquisition. In 2019, Peoples sold approximately $98.2 million of loans to the secondary market with servicing retained and sold approximately $55.4 million in loans with servicing released, compared to approximately $66.3 million and $56.4 million, respectively, in 2018. Peoples sold $65.2 million of loans to the secondary market with servicing retained during 2017. The volume of sales has a direct impact on the amount of mortgage banking income. BOLI income in 2019 increased compared to 2018 due to the recognition of $482,000 of tax-free death benefits that exceeded the cash surrender value of the insurance policies. BOLI income was essentially flat during 2018 compared to 2017. Peoples purchased no additional BOLI policies during 2019, 2018 and 2017; however, $4.8 million in BOLI policies were acquired during 2018 in the ASB acquisition. Commercial loan swap fees are largely dependent on the timing and volume of customer activity. Commercial loan swap fees in 2019 more than tripled compared to 2018, driven by an increase in customer demand as a result of the interest rate declines in the latter half of 2019. During 2018, an increase in the number of individual transactions was more than offset by a decline in the average size of each transaction, resulting in lower commercial loan swap fees in 2018, compared to 2017. In 2019, other non-interest income included an increase in realized and unrealized gains on equity investment securities of $624,000 compared to 2018, driven by $787,000 of income related to the sale of restricted Class B Visa stock during 2019. Other non-interest income in 2019 also included a decline in SBA income of $559,000, or 80%, compared to 2018 as a result of lower volume of loan originations and sales. The increase in other non-interest income in 2018 compared to 2017 was primarily due to an increase of $318,000 in the income related to the sale of SBA loans. During 2018, other non-interest income also included $207,000 recorded in connection with the implementation of a new accounting standard, which modified how the change in the fair value of equity investment securities was recorded beginning on January 1, 2018. Total Non-Interest Expense Salaries and employee benefit costs remain Peoples’ largest non-interest expense, accounting for over half of the total non-interest expense. The following table details Peoples’ salaries and employee benefit costs for the years ended December 31: Base salaries and wages in both 2019 and 2018 included $2.2 million of one-time expenses associated with acquisitions. In all comparisons, base salaries and wages were impacted by merit increases, as well as continued movement towards a $15 per hour minimum wage throughout Peoples' organization. The $15 per hour minimum wage was phased in beginning in 2018 and was largely implemented as of January 1, 2020. For First Prestonsburg locations acquired during 2019, the $15 per hour minimum wage is expected to be implemented by January 1, 2021. Base salaries and wages were also impacted by the addition of employees, primarily as a result of the First Prestonsburg acquisition in 2019 and the ASB acquisition in 2018. Sales-based and incentive compensation increased in 2019 and 2018 largely due to higher incentive compensation related to the mortgage banking income growth, coupled with improvement in corporate performance for 2018. Peoples' sales-based and incentive compensation plans are designed to grow core earnings while managing risk, and do not encourage unnecessary and excessive risk-taking that could threaten the value of Peoples. The sales-based and incentive compensation plans reward employees for appropriate behaviors and include provisions addressing inappropriate practices with respect to Peoples and its customers, including clawbacks for executives. The increase in employee benefits in 2019 compared to 2018 was impacted by the First Prestonsburg and ASB acquisitions, and included an increase in medical insurance costs of $1.8 million due primarily to higher medical claims, which was impacted by an increase in the number of participants in the insurance plan. During 2018, employee benefit costs were relatively flat compared to 2017. Stock-based compensation is generally recognized over the vesting period, which generally ranges from immediate vesting to vesting at the end of three years, and an adjustment is made at the vesting date to reverse expense for non-vested awards. The majority of Peoples' stock-based compensation is attributable to annual equity-based incentive awards to employees, which are awarded in the first quarter and based upon Peoples achieving certain performance goals during the prior year. During the years presented in the table above, Peoples granted restricted common shares to officers and key employees with performance-based vesting periods and time-based vesting periods, generally with a three-year cliff vesting. The increase in stock-based compensation during the three years presented in the table above correlates to Peoples' improved performance during recent years. The increase in 2019 compared to 2018 was also driven by higher expense related to stock grants made to retirement eligible grantees. Stock grants to retirement eligible grantees are expensed either immediately or over a shorter period than the vesting period. The increase in 2018, compared to 2017, was also impacted by Peoples' Board of Directors granting an aggregate of 12,144 unrestricted common shares to full-time and part-time employees who did not already participate in the Peoples Bancorp Inc. Third Amended and Restated 2006 Equity Plan, which resulted in stock-based compensation of $416,000. Additional information regarding Peoples' stock-based compensation plans and awards can be found in "Note 17 Stock-Based Compensation" of the Notes to the Consolidated Financial Statements. Deferred personnel costs represent the portion of current period salaries and employee benefit costs considered to be direct loan origination costs. These costs are capitalized and recognized over the life of the loan as a yield adjustment in interest income. As a result, the amount of deferred personnel costs for each year corresponds directly with the level of new loan originations. Higher loan originations in 2019 compared to 2018 and in 2018 compared to 2017 drove the increase in deferred personnel costs during 2019 and 2018. Additional information regarding Peoples' loan activity can be found later in this discussion under the caption "Loans." Payroll taxes and other employee costs increased during 2019 and 2018 as a result of higher base salaries and wages, sales-based and incentive compensation, and employee benefits. Peoples’ net occupancy and equipment expense for the years ended December 31 was comprised of the following: Net occupancy and equipment expense increased during 2019 primarily due to the increased maintenance costs, property taxes, utilities and other costs related to the addition of nine full-service bank branches from the First Prestonsburg acquisition; a full year of expenses related to the additional locations from the ASB acquisitions in 2018; and ongoing increased operating costs associated with the expanded footprint. These increases were partially offset by a reduction in ATM repairs and maintenance costs resulting from a new vendor servicing agreement. During 2018, net occupancy and equipment expense increased primarily due to costs related to the addition of seven full-service bank branches and two loan production offices from the ASB acquisition, partially offset by the full-year impact of the closure of six full-service branches during 2017. The following table details the other items included within Peoples' total non-interest expense for the years ended December 31: Peoples' e-banking expense is comprised of costs associated with debit and ATM cards, as well as Internet and mobile banking costs. The increases in 2019 and 2018 were due to customers completing a higher volume of transactions using their debit cards, and Peoples' Internet and mobile banking service. Also contributing to the increase was the addition of accounts related to the acquisitions of First Prestonsburg in 2019 and ASB in 2018, as well as the annual increase in the cost of each unit of service in internet and mobile banking. The increased volume of customers and usage of debit cards also produced a greater increase in the corresponding e-banking revenues over the same period. Professional fees were down compared to 2018, mainly due to lower legal expenses and consulting work performed during 2018, which was not duplicated in 2019, combined with a decline in acquisition-related expenses of $481,000 compared to 2018. Professional fees were higher in 2018 compared to 2017 due to higher consulting expenses and an increase of $785,000 in acquisition-related expenses (investment banking and legal fees). Data processing and software expense includes software support, maintenance and depreciation expense. The increase in these costs during 2019 was driven by systems and software upgrades and overall growth, which included: the implementation of enhanced functionalities for Peoples' core banking system, including making certain mobile banking tools available to customers; increases in customer accounts and customer usage of mobile and online banking tools; software upgrades; and additional network capacity and security features. During 2018, these costs increased due to the implementation of enhanced functionalities for Peoples' core banking system, including making certain mobile banking tools available to customers, growth in the number of accounts, implementation of customer relationship profitability and a new floor plan system implemented at the end of 2017. Peoples' amortization of other intangible assets is driven by acquisition-related activity. Amortization of other intangible assets increased slightly during 2019 as a result of additional amortization related to the acquisition of First Prestonsburg. During 2018, amortization of other intangible assets declined as a result of the amortization schedules related to core deposit and customer relationship intangible assets arising from acquisitions, partially offset by additional amortization related to the acquisition of ASB. Peoples is subject to state franchise taxes, which are based largely on Peoples' equity at year-end, in the states where Peoples has a physical presence. Expenses related to state franchise taxes increased in 2019 primarily due to additional taxes paid in Kentucky as a result of the First Prestonsburg acquisition in 2019. Franchise tax expense also includes the Ohio Financial Institution Tax ("FIT"), which is a business privilege tax that is imposed on financial institutions organized for profit and doing business in Ohio. The Ohio FIT is based on the total equity capital in proportion to the taxpayer's gross receipts in Ohio. Expenses related to state franchise taxes, which includes Ohio FIT, increased in 2018 due to additional equity from the issuance of common shares related to the acquisition of ASB in 2018, and from operating results. Marketing expense, which includes advertising, donations and other public relations costs, included one-time acquisition-related expenses of $162,000 in 2019, compared to $119,000 in 2018 and none in 2017. Marketing expense was higher during 2019 due to overall increases in spending on brand awareness, donations to Peoples Bank Foundation, Inc., and product marketing campaigns. Peoples Bank Foundation, Inc. was formed by Peoples in 2004 as a private foundation to make charitable contributions to organizations within Peoples' primary market area. The increases in marketing expense were also impacted by Peoples' expanded footprint due to the First Prestonsburg acquisition in 2019 and the ASB acquisition in 2018. Peoples' FDIC insurance expense declined in 2019 due to two credits received related to its quarterly assessments as a result of the deposit insurance fund reaching its target threshold for smaller banks (banks with total consolidated assets of less than $10 billion) to recognize a credit to their insurance expense. Peoples cannot reasonably anticipate any future recognition of credits, as the deposit insurance fund is analyzed on a quarterly basis, and is the premise for receiving credits. The FDIC quarterly assessment rate is applied to average total assets less average tangible equity, and is based on the leverage ratio, net income before taxes, nonperforming loans as a percent of total assets, OREO, loan mix and asset growth. Peoples experienced improvements in each of these categories during 2018, leading to a reduction in the quarterly FDIC assessment rate in 2018, which offset increases in the expense that are attributable to the asset growth experienced during 2018. Additional information regarding Peoples' FDIC insurance assessments may be found in "ITEM 1 BUSINESS" of this Form 10-K in the section captioned "Supervision and Regulation." Foreclosed real estate and other loan expenses increased during 2019 due to higher real estate loan expense, which was driven by the mortgage banking demand due to interest rate declines in the latter half of 2019. Foreclosed real estate and other loan expenses increased during 2018 due to higher real estate loan expense and collection expenses. The higher real estate loan expense was due to additional mortgage processing associated with the origination group acquired in the ASB acquisition. The increase in collection expenses was related to the growth in indirect consumer lending. The decrease in communication expense during 2019 and 2018 was attributable to the re-negotiation of contracts with vendors, as well as the elimination of analog circuits that have been replaced with newer more efficient technology. Other non-interest expense increased $140,000 in 2019 compared to 2018, and increased $5.2 million in 2018 compared to 2017. The increases during 2019 and 2018 compared to 2017 were driven by $3.9 million of one-time acquisition-related expenses in 2019 compared to $3.6 million in 2018 and $14,000 in 2017. The 2019 and 2018 acquisition-related expenses related mainly to contract termination fees and other costs related to the system conversion. Income Tax Expense A key driver for the amount of income tax expense or benefit recognized by Peoples each year is the amount of pre-tax income. In addition to the expense recognized, Peoples receives tax benefits from tax-exempt investments and loans, BOLI, stock awards that settled or vested during the year, and investments in tax credit funds, which reduce Peoples' effective tax rate. A reconciliation of Peoples' recorded income tax expense/benefit and effective tax rate to the statutory tax rate can be found in "Note 12 Income Taxes" of the Notes to the Consolidated Financial Statements. For the full year of 2019, income tax expense totaled $11.7 million, compared to $8.7 million in 2018, and $18.7 million in 2017, and the effective tax rate for 2019 was 17.8%, compared to 15.9% for 2018, and 32.7% for 2017. The increase in income tax expense in 2019 compared to 2018 was primarily due to higher pre-tax income. The decline in income tax expense in 2018 compared to 2017 was primarily a result of the TCJ Act, which lowered the statutory federal corporate income tax rate from 35% to 21%, effective January 1, 2018. The 14% reduction in the statutory federal corporate income tax rate applied to the income before income taxes for 2018 equated to a $7.7 million reduction in income tax expense. During 2019, income tax expense and the effective tax rate were positively impacted by a tax benefit of $508,000 related to non-taxable BOLI income. In 2018, Peoples released a valuation allowance, which reduced income tax expense by $805,000. The valuation allowance was related to a historic tax credit that Peoples had invested in during 2015. Peoples sold $6.7 million of equity investment securities in 2018, which resulted in a capital gain for tax purposes. This capital gain was large enough to offset an anticipated future capital loss which is expected to be recognized due to the structure of the historic tax credit investment, resulting in the release of the valuation allowance. During 2018, the final remeasurement of deferred tax assets and deferred tax liabilities at the new statutory federal corporate income tax rate from the TCJ Act resulted in a reduction to income tax expense of $705,000. The initial remeasurement at the new statutory federal corporate income tax rate resulted in write-down of $897,000 of Peoples' net deferred tax assets, which increased income tax expense recorded during 2017. Additionally, as of December 31, 2017, Peoples early adopted ASU 2018-02 Income Statement - Reporting Comprehensive Income (Topic 220): Reclassification of Certain Tax Effects from Accumulated Other Comprehensive Income and elected to reclassify, from accumulated other comprehensive income to retained earnings, the stranded income tax effects in accumulated other comprehensive loss resulting from the TCJ Act. Peoples also recorded tax benefits of $195,000 in 2019, $332,000 in 2018, and $154,000 in 2017 related to stock awards that settled or vested during the year, with the majority recorded in the first quarter of each year. Pre-Provision Net Revenue (non-US GAAP) Pre-provision net revenue ("PPNR") has become a key financial measure used by federal banking regulatory agencies when assessing the capital adequacy of financial institutions. PPNR is defined as net interest income plus total non-interest income (excluding all gains and losses) minus total non-interest expense and, therefore, excludes the provision for (recovery of) loan losses and all gains and/or losses included in earnings. As a result, PPNR represents the earnings capacity that can be either retained in order to build capital or used to absorb unexpected losses and preserve existing capital. The following table provides a reconciliation of this non-US GAAP financial measure to the amounts of income before income taxes reported in Peoples' Consolidated Financial Statements for the periods presented: The continued increase in PPNR in recent years has been driven by acquisitions, coupled with the focus of growing revenues at a higher rate than expenses on a percentage basis. The ratio of PPNR to total average assets for 2018 declined compared to 2017 due to $7.3 million of acquisition-related expenses during 2018, mitigating the increase in PPNR, combined with the growth of average assets during the year, which was partially attributable to the ASB acquisition. The increase in the PPNR in 2016 was boosted by a decrease in total non-interest expense, given that 2015 included $10.7 million of acquisition-related expenses. Core Non-Interest Income and Expense (non-US GAAP) Core non-interest income and core non-interest expense are financial measures used to evaluate Peoples' recurring revenue and expense streams. These measures are non-US GAAP since they exclude the impact of all gains and/or losses, core banking system conversion revenue and expenses, acquisition-related expenses, pension settlement charges, severance expenses, and other non-recurring expenses. The following tables provide reconciliations of these non-US GAAP measures to the amounts of total non-interest income and total non-interest expense reported in Peoples' Consolidated Financial Statements for the periods presented: Efficiency Ratio (non-US GAAP) The efficiency ratio is a key financial measure used to monitor performance. The efficiency ratio is calculated as total non-interest expense (less amortization of other intangible assets) as a percentage of FTE net interest income plus total non-interest income excluding net gains and losses. This measure is non-US GAAP since it excludes amortization of other intangible assets and all gains and/or losses included in earnings, and uses FTE net interest income. The following table provides a reconciliation of this non-US GAAP financial measure to the amounts of total non-interest income and total non-interest expense reported in Peoples' Consolidated Financial Statements for the periods presented: (a) Based on a 21% statutory federal corporate income tax rate for 2019 and 2018 and a 35% statutory federal corporate income tax rate for 2017 and prior years. The continued decline in the efficiency ratio adjusted for non-core items in recent years has been driven by acquisitions, coupled with the focus of growing revenues at a higher rate than expenses on a percentage basis. Furthermore, managing expenses has been a major focus over the last four years; however, during this time Peoples has continued to make meaningful investments in its infrastructure and systems. The increase in the efficiency ratio between 2018 and 2017 was driven by acquisition-related expenses of $7.3 million in 2018, compared to $341,000 in 2017. Return on Average Assets Adjusted for Non-Core Items (non-US GAAP) In addition to return on average assets, management uses return on average assets adjusted for non-core items to monitor performance. The return on average assets ratio adjusted for non-core items represents a non-US GAAP financial measure since it excludes the release of the deferred tax asset valuation allowance, the impact of the TCJ Act on the remeasurement of deferred tax assets and deferred tax liabilities, and the after-tax impact of all gains and losses, core banking system conversion revenue and expenses, acquisition-related expenses, pension settlement charges, severance expenses, and other non-recurring expenses in earnings. The following table provides a reconciliation of this non-US GAAP financial measure to the amount of net income reported in Peoples' Consolidated Financial Statements for the periods presented: (a) Based on a 21% statutory federal corporate income tax rate for 2019 and 2018 and a 35% statutory federal corporate income tax rate for 2017 and prior years. The increases in return on average assets and return on average assets adjusted for non-core items over the last four years has been driven by the acquisitions in 2019, 2018, and 2015, coupled with the focus of growing revenues at a higher rate than expenses on a percentage basis. Managing expenses has been a major focus over the last four years; however, during this time Peoples has continued to make meaningful investments in its infrastructure and systems. The return on average assets and return on average assets adjusted for non-core items in 2015 was impacted by an issue with a single credit that resulted in a provision for loan losses of $14.1 million. The ratios in 2019 and 2018 were also positively impacted by the lower statutory federal corporate income tax rate. Return on Average Tangible Equity (non-US GAAP) The return on average tangible equity ratio is a key financial measure used to monitor performance. The return on tangible equity is calculated as net income (less after-tax impact of amortization of other intangible assets) divided by tangible equity. This measure is non-US GAAP since it excludes amortization of other intangible assets from earnings and the impact of goodwill and other intangible assets acquired through acquisitions on total stockholders' equity. (a) Based on a 21% statutory federal corporate income tax rate for 2019 and 2018 and a 35% statutory federal corporate income tax rate for 2017 and prior periods. The decline in return on average tangible equity ratio in 2019 compared to 2018, was impacted by the First Prestonsburg acquisition, which increased capital. The return on average stockholders' equity and average tangible equity ratios increased in 2018 compared to 2017, reflecting the increase in net income which outpaced the increases in average stockholders' equity and average tangible equity. Average stockholders' equity and average tangible equity increased due mainly to net income and the ASB acquisition, partially offset by dividends declared. FINANCIAL CONDITION Cash and Cash Equivalents Peoples considers cash and cash equivalents to consist of federal funds sold, cash and balances due from banks, interest-bearing balances in other institutions and other short-term investments that are readily liquid. The amount of cash and cash equivalents fluctuates on a daily basis due to customer activity and Peoples' liquidity needs. At December 31, 2019, excess cash reserves at the FRB of Cleveland were $15.6 million, compared to $11.2 million at December 31, 2018. The amount of excess cash reserves maintained is dependent upon Peoples' daily liquidity position, which is driven primarily by changes in deposit and loan balances. In 2019, Peoples' total cash and cash equivalents increased $37.6 million, as cash provided by operating activities and investing activities of $67.2 million and $1.1 million, respectively, were partially offset by cash used in financing activities of $30.6 million. Cash used in financing activities was primarily due to a reduction in short-term borrowings of $76.9 million and dividends paid of $25.9 million, partially offset by the growth in deposit balances of $77.7 million. The increase in cash provided by operating activities was due primarily to $53.7 million of net income. In 2018, Peoples' total cash and cash equivalents increased $5.4 million, as cash provided by operating activities and financing activities of $75.2 million and $60.3 million, respectively, were largely offset by cash used in investing activities of $130.2 million. Cash used in investing activities was primarily due to funded loan growth of $134.1 million. Loan growth was partially funded by the increase within Peoples' financing activities of short-term borrowings of $61.9 million and deposit growth, excluding deposits acquired from the ASB acquisition, of $25.8 million. The increase in cash provided by operating activities was due primarily to $46.3 million of net income. Further information regarding the management of Peoples' liquidity position can be found later in this discussion under "Interest Rate Sensitivity and Liquidity." Investment Securities The following table provides information regarding Peoples’ investment portfolio at December 31: (a) As of January 1, 2018, Peoples adopted ASU 2016-01, resulting in the reclassification of equity investment securities from available-for-sale investment securities to other investment securities. At December 31, 2018, $277,000 of equity investment securities were included in other investment securities compared to $7.8 million of equity investment securities included in available-for-sale investment securities at December 31, 2017. At December 31, 2019, Peoples' investment securities represented approximately 23.2% of total assets, compared to 21.8% at December 31, 2018. During 2019, Peoples acquired, in the First Prestonsburg acquisition, investment securities totaling $139.7 million and subsequently sold $65.1 million of acquired available-for-sale investment securities. In April and May of 2019, $53.7 million of the proceeds were reinvested. Additionally, the fair value of investment securities increased, driven by overall declines in market interest rates during the latter half of 2019. During 2018, Peoples acquired, in the ASB acquisition, investment securities totaling $18.8 million and subsequently sold $14.6 million of acquired available-for-sale investment securities. Proceeds from the sale of investment securities were used to reduce overnight borrowing at the FHLB of Cincinnati. Investment securities increased at December 31, 2017 from December 31, 2016 due to purchases of residential mortgage-backed securities that were partially offset by principal paydowns during that year. Peoples designates certain securities as "held-to-maturity" at the time of their purchase if management determines Peoples would have the intent and ability to hold the purchased securities until maturity. The unrealized gain or loss related to held-to-maturity investment securities does not directly impact total stockholders' equity, in contrast to the impact from the available-for-sale investment securities portfolio. Additional information regarding Peoples' investment portfolio can be found in "Note 3 Investment Securities" of the Notes to the Consolidated Financial Statements. Loans The following table provides information regarding outstanding loan balances at or for the year ended December 31: a.Includes all loans acquired, and related loan discount recorded as part of acquisition accounting, in 2012 and thereafter. Loans that were acquired and subsequently re-underwritten are reported as originated upon execution of such credit actions (for example, renewals and increases in lines of credit). b.NM = not meaningful. As of December 31, 2019, total loans had grown 5%, or $144.7 million, compared to December 31, 2018. Loan originations during 2019 were higher than in the prior year; however, significantly higher loan payoffs experienced in the commercial loan portfolios during 2019 minimized the impact of the increased production on loan balances compared to December 31, 2018. Total originated loans (excluding acquired loans) grew 5%, or $117.8 million, during 2019. Originated loan growth was led by an increase in commercial and industrial loans of $92.0 million, or 17%. Total acquired loans grew $26.9 million during 2019, which included $109.9 million related to the First Prestonsburg acquisition as of December 31, 2019, partially offset by the continued decline of the loan balances acquired in previous acquisitions. Balances in loan accounts acquired from First Prestonsburg as of December 31, 2019 included $50.7 million in residential real estate loans, $33.6 million in commercial real estate loans, $13.3 million in commercial and industrial loans, $5.9 million in home equity lines of credit, $4.5 million in consumer, direct loans, and $1.9 million in constructions loans. During 2018, total loans grew 16%, or $371.6 million. Total originated loans (excluding acquired loans) grew 11%, or $213.7 million, due to increases in all categories except residential real estate and deposit account overdrafts. The increase in total acquired loans during 2018 was due to the ASB acquisition, partially offset by the decline of the loan balances acquired in previous acquisitions. During 2017, total loans grew 6%, or $132.2 million. The increase was primarily the result of commercial loan growth of $95.5 million, or 8%, which includes commercial real estate, and commercial and industrial loan balances. Additionally, continued emphasis on growing indirect consumer lending led to growth of $87.9 million, or 35%, compared to December 31, 2016, and was partially offset by reductions in residential real estate loans. During 2016, total loans grew 7%, or $152.5 million, with growth of 8% in commercial loan balances and 7% in consumer loan balances. Continuing the trend of 2015, indirect consumer lending experienced the largest growth across all loan categories for the year, increasing by $85.7 million, or 51%. Commercial and industrial loan growth was $70.6 million, or 20%, for the 2016 year. The following table details the maturities of Peoples' commercial real estate and commercial and industrial loans at December 31, 2019: Loan Concentration Peoples categorizes its commercial loans according to standard industry classifications and monitors for concentrations in a single industry or multiple industries that could be impacted by changes in economic conditions in a similar manner. Peoples' commercial lending activities continue to be spread over a diverse range of businesses from all sectors of the economy, with no single industry comprising over 10% of Peoples' total loan portfolio. Loans secured by commercial real estate, including commercial construction loans, continue to comprise the largest portion of Peoples' loan portfolio. The following table provides information regarding the largest concentrations of commercial real estate loans within the loan portfolio at December 31, 2019: (a)All other outstanding balances are less than 2% of the total loan portfolio. (a)All other outstanding balances are less than 2% of the total loan portfolio. Peoples' commercial lending activities continue to focus on lending opportunities inside its primary and secondary market areas within Ohio, Kentucky and West Virginia. In all other states, the aggregate outstanding balances of commercial loans in each state were not material at either December 31, 2019 or December 31, 2018. Additional information regarding Peoples' loan portfolio can be found in "Note 4 Loans" of the Notes to the Consolidated Financial Statements. Allowance for Loan Losses The amount of the allowance for loan losses at the end of each period represents management's estimate of probable losses from existing loans based upon its formal quarterly analysis of the loan portfolio described in the "Critical Accounting Policies" section of this discussion. While this process involves allocations being made to specific loans and pools of loans, the entire allowance is available for all losses incurred within the loan portfolio. The following details management's allocation of the allowance for loan losses at December 31: During 2019, the increase in allowance for loan losses was primarily related to continued loan growth in most of the originated loan portfolios. The allowance for loan losses as a percent of total loans was relatively flat in 2019 compared to 2018 as a result of relatively stable asset quality metrics and trends, combined with loan growth during 2019. The ratio includes all acquired loans, from both First Prestonsburg and previous acquisitions, of $599.7 million and allowance for acquired loan losses of $729,000 at December 31, 2019. In accordance with US GAAP, at the acquisition date, acquired loans are recorded at fair value with no associated allowance for loan losses. Peoples considers recent trends in criticized loans and loan growth associated with each loan portfolio, as well as qualitative factors that could negatively impact these trends, such as unemployment, rising interest rates, changes in real estate market conditions, fluctuating oil and gas prices, and the economic impact of tariffs. Peoples believes the reserves remain appropriate to cover probable losses that exist in the current portfolio. During 2018, the increase in allowance for loan losses was primarily related to continued loan growth in most of the originated loan portfolios. The allowance for loan losses as a percent of total loans decreased six basis points in 2018 compared to 2017 as a result of relatively stable asset quality metrics and trends, and the loans acquired in the ASB acquisition. During 2017, the increase in allowance for loan losses related primarily to growth in consumer indirect loan balances. During 2016, the increase of 9% in the allowance for loan losses related to total commercial and consumer indirect balance growth. The allowance for loan losses allocated to the residential real estate and consumer loan categories was based upon Peoples' allowance methodology for homogeneous pools of loans. The fluctuations in these allocations have been directionally consistent with the changes in loan quality, loss experience and loan balances in these categories. The increase in the allowance for loan losses for consumer loans has been mostly driven by loan growth in indirect lending in recent periods. The significant allocations to commercial loans reflect the higher credit risk associated with these types of lending and the size of these loan categories in relationship to the entire loan portfolio. The following table summarizes the changes in the allowance for loan losses for the years ended December 31: (a) Includes purchased credit impaired loan charge-offs of $0 in 2019, $0 in 2018, $0 in 2017, $44,000 in 2016, and $60,000 in 2015. (b) Includes nonimpaired loan charge-offs of $2,000 in 2019 and $0 in 2018, 2017, 2016 and 2015. (c) Includes purchased credit impaired loan charge-offs of $0 in 2019, $2,000 in 2018, $0 in 2017, $23,000 in 2016, and $3,000 in 2015. (d) Includes purchased credit impaired loan charge-offs of $0 in 2019, $0 in 2018, $7,000 in 2017, $23,000 in 2016, and $3,000 in 2015. (e) Includes purchased credit impaired loan provision for loan losses of $19,000 in 2019, $0 in 2018, $117,000 in 2017, $66,000 in 2016, and $303,000 in 2015. (f) Includes nonimpaired loan provision for loan losses of $215,000 in 2019, $383,000 in 2018 and $0 in 2017, 2016, and 2015. (g) Each with "--%" not meaningful. Net charge-offs for 2019 were $1.1 million, or 0.04% of average total loans, down $2.9 million compared to $4.0 million, or 0.15% of average total loans, for 2018. Net charge-offs in 2019 included a recovery of $1.8 million, or 0.06% of average total loans, recorded with respect to a previously charged-off commercial loan, while 2018 included a charge-off of $827,000 on one acquired commercial loan relationship. Net charge-offs for 2018 increased $638,000 compared to 2017, driven by a charge-off of $827,000 related to one acquired commercial loan relationship. Indirect consumer lending provided significant growth during 2018, resulting in the growth in the allowance for loan losses and net charge-offs within that category. The increase in net charge-offs from 2016 to 2017 was primarily related to a decline in recoveries of commercial loans and an increase in net charge-offs of consumer indirect loans due to higher balances from recent loan growth. During 2016, net charge-offs were nominal at 0.09% of average total loans and were positively impacted by a $1.0 million recovery of a prior period commercial real estate loan charge-off. Gross charge-offs totaled $5.2 million in 2016, and were largely associated with the growth in the consumer loan portfolio. In 2015, Peoples recorded charge-offs related to one large commercial loan relationship in the aggregate amount of $13.1 million, or 0.67% of average total loans. The following table details Peoples’ nonperforming assets at December 31: (a) Includes loans categorized as special mention, substandard or doubtful. (b) Includes loans categorized as substandard or doubtful. (c) Data presented as of the end of the year indicated. (d) Nonperforming loans include loans 90+ days past due and accruing, troubled debt restructured loans and nonaccrual loans. Nonperforming assets include nonperforming loans and OREO. The increase in nonperforming assets during 2019, was partially due to acquired loans from First Prestonsburg, which comprised $1.9 million of nonperforming assets at December 31, 2019, with the remainder due to smaller relationships that have become 90+ days past due and are still accruing. Classified loans, which are those categorized as substandard or doubtful, increased $22.3 million, or 51%, during 2019, due to the combination of acquired First Prestonsburg loans, coupled with downgrades of three other commercial loan relationships totaling $15.2 million during 2019. Criticized loans, which are those categorized as special mention, substandard or doubtful, declined $17.4 million, or 15%, compared to December 31, 2018, due to upgrades of several loans and paydowns during 2019. The increase in loans 90+ days past due and accruing during 2018 was driven primarily by one commercial loan, which was in the process of renewal at December 31, 2018. During 2018, the growth in nonaccrual loans was driven primarily by one commercial loan that was over 90 days past due. Nonperforming loans decreased in 2017, largely due to the decrease in nonaccrual loans, coupled with a decline in loans 90+ days past due and accruing. The decrease in nonaccrual loans was driven by several commercial real estate relationships that were paid off in 2017. Nonperforming loans increased in 2016, largely due to the increase in nonaccrual loans, which was partially offset by a decrease in loans 90+ days past due and accruing. The increase in nonaccrual loans was driven by several relatively smaller relationships that were placed on nonaccrual status during 2016. The significant increase in nonaccrual commercial real estate loans during 2016 was a result of three commercial loans moving to nonaccrual status. The majority of Peoples' nonaccrual commercial real estate loans consists primarily of owner occupied commercial properties. In general, management believes repayment of these loans is dependent on the sale of the underlying collateral. As such, the carrying values of these loans are ultimately supported by management's estimate of the net proceeds Peoples would receive upon the sale of the collateral. These estimates are based in part on market values provided by independent, licensed or certified appraisers periodically, but no less frequently than annually. Given the volatility in commercial real estate values, management continues to monitor changes in real estate values from quarter-to-quarter and updates its estimates as needed based on observable changes in market prices and/or updated appraisals for similar properties. Peoples discontinues the accrual of interest on a loan when conditions cause management to believe collection of all or any portion of the loan's contractual interest is doubtful. Such conditions may include the borrower being 90 days or more past due on any contractual payments or updated information regarding the borrower's financial condition and repayment ability. All unpaid accrued interest deemed uncollectable is reversed, which would reduce Peoples' net interest income. Interest received on nonaccrual loans is included in income only if principal recovery is reasonably assured. Interest income on loans classified as nonaccrual and renegotiated at each year-end that would have been recorded under the original terms of the loans was $1.4 million for 2019, $1.3 million for 2018 and $2.6 million for 2017. No portion of these amounts were recorded during 2019, 2018 or 2017. Overall, management believes the allowance for loan losses was appropriate at December 31, 2019, based on all significant information currently available. Still, there can be no assurance that the allowance for loan losses will be adequate to cover future losses or that the amount of nonperforming loans will remain at current levels, especially considering economic uncertainties that currently exist and the concentration of commercial loans in Peoples’ loan portfolio. Additional information regarding Peoples' allowance for loan losses can be found in "Note 4 Loans" of the Notes to the Consolidated Financial Statements. Deposits The following table details Peoples’ deposit balances at December 31: (a) The sum of amounts presented are considered total demand deposits. At December 31, 2019, the period-end deposit increase of $335.9 million, or 11%, compared to December 31, 2018, was primarily driven by the deposits acquired in the First Prestonsburg acquisition, which totaled $194.2 million at December 31, 2019. During 2019, Peoples issued $50.0 million of 90-day brokered CDs to fund five $10.0 million interest rate swaps with a notional value in the aggregate of $50.0 million. The swaps will pay a fixed rate of interest while receiving three-month LIBOR, which offsets the rate on the brokered CDs. The brokered CDs are expected to be extended every 90 days through the maturity dates of the swaps. The increase in total deposits between December 31, 2018 and December 31, 2017 was largely due to $198.6 million of balances in deposit accounts acquired from ASB on April 13, 2018, coupled with higher one-way buy CDARS deposits, which are included in brokered CD balances. The increase in total deposit balances at December 31, 2017 compared to December 31, 2016 was primarily due to increases of $314.4 million in interest-bearing demand deposits and $120.8 million in brokered CDs, partially offset by a decrease of $178.4 million in non-interest-bearing demand deposits. Shifts in balances occurred between non-interest-bearing deposits and interest-bearing demand account balances as Peoples migrated consumers to new products during the second half of 2017. During this migration, customer accounts were evaluated based on certain characteristics, and some accounts that were traditionally non-interest-bearing deposits were converted to interest-bearing demand accounts as Peoples moved to a relationship-based deposit product. The increase in brokered CDs in 2017 was the result of adding relatively shorter term funding on the balance sheet to secure fixed rate funding in a rising rate environment. At December 31, 2016, total deposits decreased compared to December 31, 2015, primarily due to decreases in retail and brokered CDs, and governmental deposit accounts. Peoples executed a deposit strategy of growing low-cost core deposits, such as checking and savings accounts, and reducing its reliance on higher-cost, non-core deposits, such as CDs and brokered deposits, based on the rate environment that existed in 2016. These actions accounted for much of the changes in deposit balances in 2016 compared to 2015. Peoples' governmental deposit accounts represent savings and interest-bearing transaction accounts from state and local governmental entities. These funds are subject to periodic fluctuations based on the timing of tax collections and subsequent expenditures or disbursements. Peoples normally experiences an increase in balances annually during the first and third quarter, corresponding with tax collections, with declines normally in the second and fourth quarter of each year, corresponding with expenditures by the governmental entities. Peoples continues to emphasize growth of low-cost deposits that do not require Peoples to pledge assets as collateral, which is required in the case of governmental deposit accounts. The maturities of retail CDs with total balances of $100,000 or more at December 31 were as follows: Additional information regarding Peoples' deposits can be found in "Note 7 Deposits" of the Notes to the Consolidated Financial Statements. Borrowed Funds The following table details Peoples’ short-term and long-term borrowings at December 31: (a) Unamortized debt issuance costs are related to the costs associated with the Credit Agreement with Raymond James Bank, N.A. which Peoples terminated as of April 3, 2019. Peoples' short-term FHLB advances generally consist of overnight borrowings maintained in connection with the management of Peoples' daily liquidity position. Total borrowed funds, which include overnight borrowings, are mainly a function of loan growth and changes in total deposit balances. As of December 31, 2019, Peoples had seventeen effective interest rate swaps, with an aggregate notional value of $160.0 million, $110.0 million of which were funded by FHLB 90-day advances, which are expected to be extended every 90 days through the maturity dates of the swaps. The remaining $50.0 million of interest rate swaps were funded by 90-day brokered CDs, which are also expected to be extended every 90 days through the maturity dates of the swaps. Peoples continually evaluates the overall balance sheet position given the interest rate environment. Long-term FHLB advances declined by $26.7 million due to the reclassification to short-term borrowings as the time to maturity of these advances had become less than one year. During 2018, Peoples entered into twelve effective interest rate swaps with an aggregate notional value of $110.0 million, all of which were funded by FHLB 90-day advances. Long-term FHLB advances declined by $30 million due to the reclassification to short-term borrowings as the time to maturity of these advances had become less than one year. During 2017, $50.6 million of long-term FHLB advances were reclassified to short-term borrowings due to the time to maturity of these advances becoming less than one year. Of these reclassified borrowings, $30.6 million remained as of December 31, 2017. Short-term retail repurchase agreements increased due to the reclassification of these repurchase agreements from long-term borrowings, as the time to maturity had become less than one year. During 2016, Peoples restructured $20.0 million of long-term FHLB advances resulting in a $700,000 loss. Peoples replaced these borrowings with a long-term FHLB advance which matures in 2026. Peoples also borrowed an additional $35.0 million of long-term FHLB amortizing advances, of which $10.0 million matured during 2019 and the remaining advances mature between 2020 and 2031. Effective April 3, 2019, Peoples terminated the Credit Agreement, dated as of March 4, 2016 between Peoples, as Borrower, and Raymond James Bank, N.A., as Lender (the "RJB Credit Agreement"), which provided for a revolving line of credit in the maximum aggregate principal amount of $15.0 million. On April 3, 2019, Peoples entered into a Loan Agreement (the “U.S. Bank Loan Agreement”) with U.S. Bank National Association. The U.S. Bank Loan Agreement has a one-year term and provides Peoples with a revolving line of credit in the maximum aggregate principal amount of $20.0 million. Additional information regarding Peoples' borrowed funds can be found in "Note 8 Short-Term Borrowings" and "Note 9 Long-Term Borrowings" of the Notes to the Consolidated Financial Statements. Capital/Stockholders’ Equity During 2019, Peoples' total stockholders' equity increased $74.3 million, or 14%, mainly due to net income of $53.7 million, $32.4 million of common shares issued in connection with the acquisition of First Prestonsburg, and an increase in the market value of available-for-sale investment securities, partially offset by dividends paid of $26.9 million. At December 31, 2019, capital levels for both Peoples and Peoples Bank remained substantially higher than the minimum amounts needed to be considered "well capitalized" under banking regulations. These higher capital levels reflect Peoples' desire to maintain a strong capital position. During 2018, Peoples' total stockholders' equity increased compared to 2017 mainly due to $40.9 million of common shares issued in connection with the acquisition of ASB. Also contributing to the increase in total stockholders' equity was net income of $46.3 million, partially offset by dividends paid of $21.6 million and declines in the market value of available-for-sale investment securities. In 2017, Peoples' total stockholders' equity increased compared to 2016 due to higher retained earnings offset slightly by declines in the market value of available-for-sale investment securities. In 2016, Peoples' total stockholders' equity increased compared to 2015 due to higher retained earnings, offset slightly by the repurchase of 279,770, or $5.0 million, of common shares to be held in treasury and the slight decline in the market value of available-for-sale investment securities. During the first quarter of 2015, Peoples adopted the new Basel III regulatory capital framework, as approved by the federal banking agencies. The adoption of this new framework modified the calculations and well-capitalized thresholds of the existing risk-based capital ratios and added the common equity tier 1 capital ratio. Additionally, under the new rules, in order to avoid limitations on dividends, equity repurchases and compensation, Peoples must exceed the three minimum required ratios by at least the capital conservation buffer. These three minimum required ratios are the common equity tier 1 capital ratio, tier 1 risk-based capital ratio and total risk-based capital ratio. The capital conservation buffer was phased in from 0.625% beginning January 1, 2016 to 2.50% on January 1, 2019. Peoples had a capital conservation buffer of 7.58% at December 31, 2019, 6.65% at December 31, 2018, 6.43% at December 31, 2017, and 6.11% at December 31, 2016, compared to the fully phased in capital conservation buffer of 2.50% required at January 1, 2019. As such, Peoples exceeded the minimum ratios, including the capital conservation buffer, at December 31, 2019. The following table details Peoples' actual risk-based capital levels and corresponding ratios at December 31: In addition to traditional capital measurements, management uses tangible capital measures to evaluate the adequacy of Peoples' total stockholders' equity. Such financial measures represent non-US GAAP financial information since they exclude the impact of goodwill and other intangible assets acquired through acquisitions on the Consolidated Balance Sheets. Peoples' management believes this information is useful to investors since it facilitates the comparison of Peoples' operating performance, financial condition and trends to peers, especially those without a level of intangible assets similar to that of Peoples. Further, intangible assets generally are difficult to convert into cash, especially during a financial crisis, and could decrease substantially in value should there be deterioration in the overall franchise value. As a result, tangible equity represents a conservative measure of the capacity for Peoples to incur losses but remain solvent. The following table reconciles the calculation of these non-US GAAP financial measures to amounts reported in Peoples' Consolidated Financial Statements at December 31: The increase in the tangible equity to tangible assets ratio for 2019 was the result of higher retained earnings, combined with common shares issued in connection with the First Prestonsburg acquisition and an increase in the market value of available-for-sale investment securities. The increase in the tangible equity to tangible assets ratio for each of 2018, 2017 and 2016 was the result of higher retained earnings, partially offset by the decline in the market value of available-for-sale investment securities. Also contributing to the increase in 2018 was the issuance of common shares in connection with the ASB acquisition. The increase in 2016 was also partially offset by the repurchase of 279,770 common shares to be held in treasury. Future Outlook Peoples improved in many aspects during 2019. The most notable growth was a 16% increase in net income, with a 9% increase in diluted earnings per share compared to 2018. Peoples generated positive operating leverage, on an adjusted for non-core items basis, for the fourth consecutive year. The acquisition of First Prestonsburg was successfully completed during the second quarter of 2019, garnering additional growth and potential in the Kentucky markets. The efficiency ratio improved to 64.74% for 2019, compared to 65.33% for 2018, and improved 23 basis points on an adjusted for non-core items basis. In addition, non-interest income, excluding net gains and losses, grew to 32% of total revenue, compared to 31% in 2018. Peoples also reduced its loan-to-deposit ratio to 87% at December 31, 2019, compared to 92% at December 31, 2018. Net interest income was challenged in the latter half of 2019, as the interest rate environment changed significantly from market expectations earlier in the year. For 2020, Peoples anticipated a stabilization in interest rates, however, given recent activity in early 2020, mainly related to global public health concerns, there has been an inversion of the interest rate yield curve. Peoples has worked diligently to control deposit costs, reducing deposit interest rates in late 2019, which will provide a source of strength with respect to its net interest income and net interest margin. Peoples will continue to monitor deposit interest rates, and will look to lower costs wherever possible. Net interest margin continues to be aided by accretion income, which is net of amortization expense, related to the prior acquisitions. Although it is expected that this will decline over time, there should continue to be a positive impact from the acquisitions. Peoples will continue to focus on quality loan growth, which could also help stabilize net interest margin. For 2020, Peoples expects net interest margin to be between 3.50% and 3.65%. However, should the yield curve remain inverted for an extended period, or interest rates remain low or decrease further, Peoples would experience downward pressure to its net interest margin. Non-interest income, excluding gains and losses, for 2020 is expected to grow in the mid-single digits compared to 2019. While there were several positives in 2019 impacting non-interest income, such as growth in commercial loan swap fees and bank-owned life insurance income, these involved transactional fees that cannot be assumed to continue. The growth in deposit account service charges was largely due to fee structure changes in 2019, and that growth should level off as Peoples moves into 2020. Due to global public health concerns in early 2020, equity market valuations have declined. Should this trend continue, Peoples may see a decline in fee income line items, such as trust and investments income. Peoples will continue to look to make meaningful investments in its infrastructure and technology. During 2019, Peoples made investments, including the addition of faster person-to-person payment processing capabilities and a new mobile application for insurance and 401(k) clients, the introduction of a mobile-friendly website and work to refresh its ATM network. In addition, clients are now able to apply for a mortgage loan using their smart phones. One of the go-to market propositions that Peoples is able to offer its clients is the same mobile capabilities as those offered by the larger institutions. Total non-interest expense growth is expected to be in the low single digits compared to 2019, when adjusted for non-core items. Peoples continually reviews its expenses and works to control costs at a reasonable level. Peoples places high importance on generating positive operating leverage and improving the efficiency ratio. While some costs are controllable, expenses related to medical insurance costs and pension costs are hard to predict. Peoples benefited from reduced FDIC insurance expense during 2019, but cannot reasonably anticipate any future recognition of credits, as these are determined on a quarterly basis by the FDIC. In late 2019, Peoples made some strategic changes, which should benefit non-interest expense into 2020. The efficiency ratio is expected to be between 60% and 62% for 2020. For Peoples, the largest change in 2020 will likely be the implementation of ASU 2016-13. The CECL model inherently involves a number of uncertainties, and will be subject to movement based on future economic assumptions. While Peoples is in the process of implementing the processes and procedures related to this updated guidance, the sensitivity of the models used can be impacted by loan growth, and the type of loan growth, as well as many changes outside of the control of Peoples. Therefore, Peoples will place higher importance on other metrics for reporting, such as PPNR. Peoples will continue to remain prudent with its underwriting and lending practices; however, the uncertainty around the ongoing calculations of the models underlying CECL could provide for some volatility in Peoples' allowance for credit losses, and related credit loss expense going forward. As a result of the recent interest rate environment, Peoples will continue to analyze its balance sheet mix in an effort to mitigate exposure to risk. As such, Peoples will review its investment portfolio and adjust it accordingly to mitigate exposures related to interest rates, while continuing to fulfill liquidity needs. The investment portfolio in recent periods has reduced in size relative to total assets, and may continue to do so, depending on future loan growth opportunities. Loan payoffs during 2019 were higher than normal, and Peoples cannot be reasonably certain that this higher than normal level of loan payoffs will decline in 2020, but believes that excluding the same level of payoffs, loan growth should continue to be respectable in 2020. Peoples expects that point-to-point loan growth will be between 5% to 7%, compared to 2019. Peoples remains diligent in following the underwriting standards it has put into practice, and will not sacrifice loan quality for growth. While the allowance for credit losses is hard to predict going forward, Peoples does not believe that the historically-low charge-off levels throughout the industry, and being experienced by Peoples, is sustainable. Peoples expects the net charge-off rate for 2020 will be closer to its long-term historical range of 0.20% to 0.30% of average loans. Deposit growth was 11% compared to December 31, 2018, and was primarily driven by the large deposit base acquired from First Prestonsburg. Peoples' funding strategy is focused on growth of lower-cost core deposits, which exclude CDs. Because of the interest rate environment going into 2020, the value of core deposits has declined. Peoples will look to closely monitor and reduce deposit costs where possible during the year, in an effort to control funding costs, due to the lower loan growth experienced during 2019. Peoples remains dedicated to maintaining strong capital levels. During 2019, Peoples used a variety of methods to deploy excess capital, such as the increased shareholder dividends and stock repurchases. Peoples will continue to monitor its capital levels and find opportunities to effectively manage its capital, including increased shareholder dividends. As previously noted, Peoples completed the acquisition of an independent insurance agency in January of 2020, located near Portsmouth, Ohio. This acquisition will complement the locations added from the ASB acquisition, adding additional services for those clients within the area, as well as cultivating banking relationships with the new insurance clients. During 2020, Peoples will continue to analyze its branch footprint. Peoples monitors profitability and activity within its markets to determine the most effective and meaningful branch structure. Of the utmost importance for Peoples is providing solid and consistent results for its shareholders. Peoples' long-term strategic goals include generating results in the top quartile of performance relative to Peoples' peer group, as defined in Peoples' proxy statement for the 2020 Annual Meeting of Shareholders, and providing returns for its shareholders superior to those of this peer group, regardless of market conditions. Peoples is defined by the associates who embody the principles it holds in high regard. Peoples does not believe in selling clients services to make a profit. Instead, it works to cultivate a relationship of trust. Peoples also focuses on giving back to the communities in which it operates, including through monetary donations, and encouraging associates to volunteer. Peoples not only strives to generate revenue, but to be the helping hand to those in need. For more information regarding risks and uncertainties that could impact the projections described, please refer to "ITEM 1A RISK FACTORS" of this Form 10-K. Interest Rate Sensitivity and Liquidity While Peoples is exposed to various business risks, the risks relating to interest rate sensitivity and liquidity are major risks that can materially impact future results of operations and financial condition due to their complexity and dynamic nature. The objective of Peoples' asset-liability management function is to measure and manage these risks in order to optimize net interest income within the constraints of prudent capital adequacy, liquidity and safety. This objective requires Peoples to focus on interest rate risk exposure and adequate liquidity through its management of the mix of assets and liabilities, their related cash flows and the rates earned and paid on those assets and liabilities. Ultimately, the asset-liability management function is intended to guide management in the acquisition and disposition of earning assets and selection of appropriate funding sources. Interest Rate Risk Interest rate risk ("IRR") is one of the most significant risks arising in the normal course of business of financial services companies like Peoples. IRR is the potential for economic loss due to future interest rate changes that can impact the earnings stream, as well as market values, of financial assets and liabilities. Peoples' exposure to IRR is due primarily to differences in the maturity or repricing of earning assets and interest-bearing liabilities. In addition, other factors, such as prepayments of loans and investment securities, or early withdrawal of deposits, can affect Peoples' exposure to IRR and increase interest costs or reduce revenue streams. Peoples has assigned overall management of IRR to the ALCO, which has established an IRR management policy that sets minimum requirements and guidelines for monitoring and managing the level of IRR. The objective of Peoples' IRR management policy is to assist the ALCO in its evaluation of the impact of changing interest rate conditions on earnings and the economic value of equity, as well as assist with the implementation of strategies intended to reduce Peoples' IRR. The management of IRR involves either maintaining or changing the level of risk exposure by changing the repricing and maturity characteristics of the cash flows for specific assets or liabilities. Additional oversight of Peoples' IRR is provided by the Board of Directors of Peoples Bank, who reviews and approves Peoples' IRR management policy at least annually. The ALCO uses various methods to assess and monitor the current level of Peoples' IRR and the impact of potential strategies or other changes. However, the ALCO predominantly relies on simulation modeling in its overall management of IRR since it is a dynamic measure. Simulation modeling also estimates the impact of potential changes in interest rates and balance sheet structures on future earnings and projected economic value of equity. The methods used by ALCO to assess IRR remain largely unchanged from those disclosed at December 31, 2018. The modeling process starts with a base case simulation using the current balance sheet and current interest rates held constant for the next twenty-four months. Alternate scenarios are prepared which simulate the impact of increasing and decreasing market interest rates, assuming parallel yield curve shifts. Comparisons produced from the simulation data, showing the changes in net interest income from the base interest rate scenario, illustrate the risks associated with the current balance sheet structure. Additional simulations, when deemed appropriate or necessary, are prepared using different interest rate scenarios from those used with the base case simulation and/or possible changes in balance sheet composition. The additional simulations include non-parallel shifts in interest rates whereby the direction and/or magnitude of changes in short-term interest rates is different from the changes applied to longer-term interest rates. Comparisons showing the net interest income and economic value of equity variances from the base case are provided to the ALCO for review and discussion. The ALCO has established limits on changes in the twelve-month net interest income forecast and the economic value of equity from the base case. The ALCO may establish risk tolerances for other parallel and non-parallel rate movements, as deemed necessary. The following table details the current policy limits used to manage the level of Peoples' IRR: The following table shows the estimated changes in net interest income and the economic value of equity based upon a standard, parallel shock analysis with balances held constant (dollars in thousands): This table uses a standard, parallel shock analysis for assessing the IRR to net interest income and the economic value of equity. A parallel shock means all points on the yield curve (one year, two year, three year, etc.) are directionally changed the same amount of basis points. Management regularly assesses the impact of both increasing and decreasing interest rates. The table above shows the impact of upward parallel shocks and a downward parallel shock of 100 basis points. Downward parallel shocks of 300 and 200 basis points are excluded from the table as they are not probable given the current interest rate environment. For the full year 2019, the weighted average rate on Peoples' non-maturity deposits was roughly 30 basis points. In the event of a parallel downward shift of 100 basis points, the expense on Peoples' non-maturity deposits would reach a floor at zero, unable to experience the full benefit of falling rates. This floor at zero is consistent with an assumption of non-negative deposit rates. On the asset side of the balance sheet, a significant majority of the floating rate loans (primarily tied to LIBOR and prime) would be impacted by the downward 100 basis point shock. Estimated changes in net interest income and economic value of equity are partially driven by assumptions regarding the rate at which non-maturity deposits will reprice given a move in short-term interest rates. Peoples takes a historically conservative approach when determining what repricing rates (deposit betas) are used in modeling interest rate risk. These assumptions are monitored closely by Peoples and are reviewed at least semi-annually. As of December 31, 2019, the actual deposit betas experienced by Peoples in the repricing of non-maturity deposits were lower than those used in Peoples’ interest rate risk modeling. While parallel interest rate shock scenarios are useful in assessing the level of IRR inherent in the balance sheet, interest rates typically move in a nonparallel manner with differences in the timing, direction and magnitude of changes in short-term and long-term interest rates. Thus, any benefit that might occur as a result of the Federal Reserve Board increasing short-term interest rates in the future could be offset by an inverse movement in long-term rates, and vice versa. For this reason, Peoples considers other interest rate scenarios in addition to analyzing the impact of parallel yield curve shifts. These include various flattening and steepening scenarios in which short-term and long-term rates move in different directions with varying magnitude. Peoples believes these scenarios to be more reflective of how interest rates change versus the severe parallel rate shocks described above. Given the shape of market yield curves at December 31, 2019, consideration of the bull flattener scenario provides insights which were not captured by parallel shifts. The key insight presented by the bull flattener scenario highlights the risk to net interest income when long-term rates fall while short-term rates remain constant. In such a scenario, Peoples’ deposit costs, which are correlated with short-term rates, remain constant while asset yields, which are correlated with long-term rates, fall. Asset yields being reduced through increased premium amortization of investment securities and lower rates on re-investment would not be offset by reductions in deposit or funding costs, resulting in a decreased amount of net interest income. During 2019, Peoples' Consolidated Balance Sheet was positioned to benefit from rising interest rates in terms of the potential impact on net interest income. The table illustrates this point as changes to net interest income increase in the rising rate scenarios. While the heavy concentration of floating rate loans remains the largest contributor to the level of asset sensitivity, the increase in asset sensitivity from December 31, 2018 was largely attributable to greater forecasted impacts of interest rate movements on the amount of premium amortization in the investment portfolio. The table also illustrates a significant reduction in long-term interest rate risk as is evidenced by the drop in the negative impact of rising interest rates on economic value of equity. The reduction is largely attributable to increased forecasted base case investment portfolio pre-payments, which shortens the effective duration of assets. While interest rates typically move in a nonparallel manner, interest rate movements that occurred over the course of 2019 were in essence parallel downward shifts. As interest rates were rising in 2018 and the early part of 2019, Peoples benefited from having deposit betas which were lower than those assumed in IRR modeling. In that environment, Peoples asset yields increased at a much faster rate than deposit costs. In the latter part of 2019, however, the Federal Reserve Board cut interest rates three times which was compounded by a downward shift in the yield curve. Peoples net interest income was negatively impacted by this as asset yields repriced lower, which happened at a faster rate than deposit costs. Should the yield curve flatten or invert in the future, Peoples will be negatively impacted as the spread between asset yields and liability costs will be further diminished. In early 2020, markets were impacted by global public health concerns. This has resulted in a significant drop in longer-term interest rates and, recently, has resulted in an inverted yield curve. As a result, yields on treasury securities have dropped to historically low levels. The duration of the inversion is unknown. If the yield curve remains inverted for an extended period of time, or interest rates remain low or decrease further, it could have a significant impact on Peoples' net interest margin and net interest income. Peoples has entered into interest rate swaps as part of its interest rate risk management strategy. These interest rate swaps are designated as cash flow hedges and involve the receipt of variable rate amounts from a counterparty in exchange for Peoples making fixed payments. As of December 31, 2019, Peoples had seventeen interest rate swap contracts, with an aggregate notional value of $160.0 million. Additional information regarding Peoples' interest rate swaps can be found in "Note 14 Derivative Financial Instruments" of the Notes to the Consolidated Financial Statements. An asset/liability model used to produce the analysis above requires assumptions to be made such as prepayment rates on interest-earning assets and repricing impact on non-maturity deposits. These business assumptions are based on business plans, economic and market trends, and available industry data. Management believes that its methodology for developing such assumptions is reasonable; however, there can be no assurance that modeled results will be achieved. Liquidity In addition to IRR management, another major objective of the ALCO is to ensure sufficient levels of liquidity are maintained. The ALCO defines liquidity as the ability to meet anticipated and unanticipated operating cash needs, loan demand and deposit withdrawals without incurring a sustained negative impact on profitability. A primary source of liquidity for Peoples is deposits. Liquidity is also provided by cash generated from earning assets such as maturities, calls, and principal and interest payments from loans and investment securities. Peoples also uses various wholesale funding sources to supplement funding from customer deposits. These external sources provide Peoples with the ability to obtain large quantities of funds in a relatively short time period in the event of sudden unanticipated cash needs. However, an over-utilization of external funding sources can expose Peoples to greater liquidity risk, as these external sources may not be accessible during times of market stress. Additionally, Peoples may be exposed to the risk associated with providing excess collateral to external funding providers, commonly referred to as counterparty risk. As a result, the ALCO's liquidity management policy sets limits on the net liquidity position and the concentration of non-core funding sources, which includes wholesale funding and brokered deposits. In addition to external sources of funding, Peoples considers certain types of deposits to be less stable or "volatile funding." These deposits include special money market products, large CDs and public funds. Peoples has established volatility factors for these various deposit products, and the liquidity management policy establishes a limit on the total level of volatile funding. Additionally, Peoples measures the maturities of external sources of funding for periods of one month, three months, six months and twelve months, and has established policy limits for the amounts maturing in each of these periods. The purpose of these limits is to minimize exposure to what is commonly termed rollover risk. An additional strategy used by Peoples in the management of liquidity risk is maintaining a targeted level of liquid assets. These are assets that can be converted into cash in a relatively short period of time. Management defines liquid assets as unencumbered cash (including cash on deposit at the FRB of Cleveland), and the market value of U.S. government and agency securities that are not pledged. Excluded from this definition are pledged securities, non-government securities, non-agency securities, municipal securities and loans. Management has established a minimum level of liquid assets in the liquidity management policy, which is expressed as a percentage of total loans and unfunded loan commitments. Peoples has also established a policy limit around the level of liquefiable assets expressed as a percentage of total loans and unfunded loan commitments. Liquefiable assets are defined as liquid assets plus the market value of unpledged securities not included in the liquid asset measurement. Peoples remained within these two parameters throughout 2019. An essential element in the management of liquidity risk is a forecast of the sources and uses of anticipated cash flows. On a monthly basis, Peoples forecasts sources and uses of cash for the next twelve months. To assist in the management of liquidity, management has established a liquidity coverage ratio, which is defined as the total sources of cash divided by the total uses of cash. A ratio of greater than 1.0 times indicates that forecasted sources of cash are adequate to fund forecasted uses of cash. The liquidity management policy establishes a minimum limit of 1.0 times. As of December 31, 2019, Peoples had a ratio of 3.1 times, which was within policy limits. Peoples also forecasts secondary or contingent sources of cash, and this includes external sources of funding and liquid assets. These sources of cash would be required if and when the forecasted liquidity coverage ratio dropped below the policy limit of 1.0 times. An additional liquidity measurement used by management includes the total forecasted sources of cash and the contingent sources of cash divided by the forecasted uses of cash. Management has established a minimum ratio of 3.0 times for this liquidity management policy limit. As of December 31, 2019, Peoples had a ratio of 5.8 times, which was within policy limits. Disruptions in the sources and uses of cash can occur which can drastically alter the actual cash flows and negatively impact Peoples' ability to access internal and external sources of cash. Such disruptions might occur due to increased withdrawals of deposits, increases in the funding required for loan commitments, a decrease in the ability to access external funding sources and other factors that would increase the need for funding and limit Peoples' ability to access needed funds. As a result, Peoples maintains a liquidity contingency funding plan ("LCFP") that considers various degrees of disruptions and develops action plans around these scenarios. Peoples' LCFP identifies scenarios where funding disruptions might occur and creates scenarios of varying degrees of severity. The disruptions considered include an increase in funding of unfunded loan commitments, unanticipated withdrawals of deposits, decreases in the renewal of maturing CDs and reductions in cash earnings. Additionally, the LCFP creates stress scenarios where access to external funding sources, or contingency funding, is suddenly limited, which includes a significant increase in the margin requirements where securities or loans are pledged, limited access to funding from other banks and limited access to funding from the FHLB of Cincinnati and the FRB of Cleveland. Peoples' LCFP scenarios include a base scenario, a mild stress scenario, a moderate stress scenario and a severe stress scenario. Each of these is defined as to the related severity and action plans are developed around each. Liquidity management also requires the monitoring of risk indicators that may alert the ALCO to a developing liquidity situation or crisis. Early detection of stress scenarios allows Peoples to take actions to help mitigate the impact to Peoples Bank's business operations. The LCFP contains various indicators, termed key risk indicators ("KRIs") that are monitored on a monthly basis, at a minimum. The KRIs include both internal and external indicators and include loan delinquency levels, criticized and classified loan levels, non-performing loans to loans and to total assets, the total loan to total deposit ratio, the level of net non-core funding dependence, the level of contingency funding sources, the liquidity coverage ratio, changes in regulatory capital levels, forecasted operating loss and negative media concerning Peoples, irrational competitor pricing that persists, and an increase in rates for external funding sources. The LCFP establishes levels that define each of these KRIs under base, mild, moderate and severe scenarios. The LCFP is reviewed and updated at least on an annual basis by the ALCO and Peoples Bank's Board of Directors. Additionally, testing of the LCFP is required on an annual basis. Various stress scenarios and the related actions are simulated according to the LCFP. The results are reviewed and discussed, and changes or revisions are made to the LCFP accordingly. Additionally, every two years, the LCFP is subjected to a third-party review for effectiveness and regulatory compliance. Overall, management believes the current balance of cash and cash equivalents, and anticipated cash flows from the investment portfolio, along with the availability of other funding sources, will allow Peoples to meet anticipated cash obligations, as well as special needs and off-balance sheet commitments. Off-Balance Sheet Activities and Contractual Obligations Peoples routinely engages in activities that involve, to varying degrees, elements of risk that are not reflected in whole or in part in the Consolidated Financial Statements. These activities are part of Peoples' normal course of business and include traditional off-balance sheet credit-related financial instruments, interest rate contracts and commitments to make additional capital contributions in low-income housing tax credit investments. The following is a summary of Peoples’ significant off-balance sheet activities and contractual obligations. Detailed information regarding these activities and obligations can be found in the Notes to the Consolidated Financial Statements as follows: Traditional off-balance sheet credit-related financial instruments are primarily commitments to extend credit and standby letters of credit. These activities are necessary to meet the financing needs of customers and could require Peoples to make cash payments to third parties in the event certain specified future events occur. The contractual amounts represent the extent of Peoples’ exposure in these off-balance sheet activities. However, since certain off-balance sheet commitments, particularly standby letters of credit, are expected to expire or be only partially used, the total amount of commitments does not necessarily represent future cash requirements. Peoples continues to lease certain facilities and equipment under noncancellable operating leases with terms providing for fixed monthly payments over periods generally ranging from two to thirty years. Several of Peoples’ leased facilities are inside retail shopping centers or office buildings and, as a result, are not available for purchase. Management believes these leased facilities increase Peoples’ visibility within its markets and afford sales associates additional access to current and potential clients. For certain acquisitions, often those involving insurance businesses and wealth management books of business, a portion of the consideration is contingent upon revenue metrics being achieved. US GAAP requires that the amounts be recorded upon acquisition based on the best estimate of the future amounts to be paid at the time of acquisition. Any subsequent adjustment to the estimate is recorded in earnings. Based on the acquisitions completed to date, management does not expect contingent consideration to have a material impact on Peoples' future performance. The following table details the aggregate amount of future payments Peoples is required to make under certain contractual obligations as of December 31, 2019: (a) Amounts reflect solely the minimum required principal payments. (b) Amounts assume projected revenue metrics are achieved. Management does not anticipate that Peoples’ current off-balance sheet activities will have a material impact on its future results of operations and financial condition based on historical experience and recent trends. Effects of Inflation on Financial Statements Substantially all of Peoples’ assets relate to banking and are monetary in nature. As a result, inflation does not impact Peoples to the same degree as companies in capital-intensive industries in a replacement cost environment. During a period of rising prices, a net monetary asset position results in a loss in purchasing power and conversely a net monetary liability position results in an increase in purchasing power. The opposite would be true during a period of decreasing prices. In the banking industry, monetary assets typically exceed monetary liabilities. The current monetary policy targeting low levels of inflation has resulted in relatively stable price levels. Therefore, inflation has had little impact on Peoples’ net assets.

<s>[INST] Certain statements made in this Form 10K, which are not historical fact, are forwardlooking statements within the meaning of Section 27A of the Securities Act , Section 21E of the Exchange Act, and the Private Securities Litigation Reform Act of 1995. Words such as "anticipate," "estimate," "may," "feel," "expect," "believe," "plan," "will," "will likely," "would," "should," "could," "project," "goal," "target," "potential," "seek," "intend," and similar expressions are intended to identify these forwardlooking statements but are not the exclusive means of identifying such statements. Forwardlooking statements are subject to risks and uncertainties that may cause actual results to differ materially. Factors that might cause such a difference include, but are not limited to: (1) the success, impact, and timing of the implementation of Peoples' business strategies and its ability to manage strategic initiatives, including the successful integration of the business of First Prestonsburg and the expansion of consumer lending activity; (2) risks and uncertainties associated with Peoples' entry into new geographic markets and risks resulting from Peoples' inexperience in these new geographic markets; (3) Peoples' ability to identify, acquire, or integrate suitable strategic acquisitions, which may be unsuccessful, or may be more difficult, timeconsuming or costly than expected; (4) competitive pressures among financial institutions, or from nonfinancial institutions, which may increase significantly, including product and pricing pressures, which can in turn impact Peoples' credit spreads, changes to thirdparty relationships and revenues, changes in the manner of providing services, customer acquisition and retention pressures, and Peoples' ability to attract, develop and retain qualified professionals; (5) changes in the interest rate environment due to economic conditions and/or the fiscal policies of the U.S. government and the Board of Governors of the Federal Reserve System (the "Federal Reserve Board"), which may adversely impact interest rates, interest margins, loan demand and interest rate sensitivity; (6) uncertainty regarding the nature, timing, cost, and effect of legislative or regulatory changes or actions, or deposit insurance premium levels, promulgated and to be promulgated by governmental and regulatory agencies in the State of Ohio, the Federal Deposit Insurance Corporation, the Federal Reserve Board and the Consumer Financial Protection Bureau, which may subject Peoples, its subsidiaries, or one or more acquired companies to a variety of new and more stringent legal and regulatory requirements which adversely affect their respective businesses, including in particular the rules and regulations promulgated and to be promulgated under the DoddFrank Wall Street Reform and Consumer Protection Act of 2010, and the Basel III regulatory capital reform; (7) the effects of easing restrictions on participants in the financial services industry; (8) local, regional, national and international economic conditions (including the impact of potential or imposed tariffs, a U.S. withdrawal from or significant renegotiation of trade agreements, trade wars and other changes in trade regulations, and the relationship of the U.S. and its global trading partners) and the impact these conditions may have on Peoples, its customers and its counterparties, and Peoples' assessment of the impact, which may be different than anticipated; (9) the existence or exacerbation of general geopolitical instability and uncertainty; (10) changes in policy and other regulatory and legal developments, and uncertainty or speculation pending the enactment of such changes; (11) Peoples may issue equity securities in connection with future acquisitions, which could cause ownership and economic dilution to Peoples' current shareholders; (12) changes in prepayment speeds, loan originations, levels of nonperforming assets, delinquent loans, chargeoffs, and customer creditworthiness generally, which may be less favorable than expected and adversely impact the amount of interest income generated; (13) adverse changes in economic conditions and/or activities, including, but not limited to, slowing or reversal of the current U.S. economic expansion, continued economic uncertainty in the U.S., the European Union (including [/INST] Negative. </s>

INGLES MARKETS INC

2015-12-10

2015-09-26

Item 7. MANAGEMENT’S DISCUSSION AND ANALYSIS OF FINANCIAL CONDITION AND RESULTS OF OPERATIONS Overview Ingles, a leading supermarket chain in the Southeast United States, operates 201 supermarkets in Georgia (71), North Carolina (71), South Carolina (36), Tennessee (20), Virginia (2) and Alabama (1). The Company locates its supermarkets primarily in suburban areas, small towns and rural communities. Ingles supermarkets offer customers a wide variety of nationally advertised food products, including grocery, meat and dairy products, produce, frozen foods and other perishables and non-food products. Non-food products include fuel centers, pharmacies, health and beauty care products and general merchandise, as well as quality private label items. In addition, the Company focuses on selling high-growth, high-margin products to its customers through the development of certified organic products, bakery departments and prepared foods including delicatessen sections. As of September 26, 2015, the Company operated 97 in-store pharmacies and 88 fuel centers. Ingles also operates a fluid dairy and earns shopping center rentals. The fluid dairy sells approximately 27% of its products to the retail grocery segment and approximately 73% of its products to third parties. Real estate ownership is an important component of the Company’s operations, providing both operational and economic benefit. Critical Accounting Policies Critical accounting policies are those accounting policies that management believes are important to the portrayal of Ingles’ financial condition and results of operations, and require management’s most difficult, subjective or complex judgments, often as a result of the need to make estimates about the effect of matters that are inherently uncertain. Estimates are based on historical experience and other factors believed to be reasonable under the circumstances, the results of which form the basis for making judgments about the carrying values of assets and liabilities that are not readily apparent from other sources. Management estimates, by their nature, involve judgments regarding future uncertainties, and actual results may therefore differ materially from these estimates. Self-Insurance The Company is self-insured for workers’ compensation, general liability, and group medical and dental benefits. Risks and uncertainties are associated with self-insurance; however, the Company has limited its exposure by maintaining excess liability coverage of $750,000 per occurrence for workers’ compensation, $500,000 for general liability, and $325,000 per covered person for medical care benefits for a policy year. Self-insurance liabilities are established based on claims filed and estimates of claims incurred but not reported. The estimates are based on data provided by the respective claims administrators which is then applied to appropriate actuarial methods. These estimates can fluctuate if historical trends are not predictive of the future. The majority of the Company’s properties are self-insured for casualty losses and business interruption; however, liability coverage is maintained. The Company’s self-insurance reserves totaled $36.3 million and $29.9 million for employee group insurance, workers’ compensation insurance and general liability insurance at September 26, 2015 and September 27, 2014, respectively. The September 26, 2015 amount is inclusive of $4.9 of expected self-insurance recoveries from excess cost insurance or other sources that are recorded as a receivable at September 26, 2015. Asset Impairments The Company accounts for the impairment of long-lived assets in accordance with Financial Accounting Standards Board Accounting Standards Codification (“FASB ASC”) Topic 360. Asset groups are primarily comprised of our individual store and shopping center properties. For assets to be held and used, the Company tests for impairment using undiscounted cash flows and calculates the amount of impairment using discounted cash flows. For assets held for sale, impairment is recognized based on the excess of remaining book value over expected recovery value. The recovery value is the fair value as determined by independent quotes or expected sales prices developed by internal associates, net of costs to sell. Estimates of future cash flows and expected sales prices are judgments based upon the Company’s experience and knowledge of local operations and cash flows that are projected for several years into the future. These estimates can fluctuate significantly due to changes in real estate market conditions, the economic environment, capital spending decisions and inflation. The Company monitors the carrying value of long-lived assets for potential impairment each quarter based on whether any indicators of impairment have occurred. Vendor Allowances The Company receives funds for a variety of merchandising activities from the many vendors whose products the Company buys for resale in its stores. These incentives and allowances are primarily comprised of volume or purchase based incentives, advertising allowances, slotting fees, and promotional discounts. The purpose of these incentives and allowances is generally to help defray the costs incurred by the Company for stocking, advertising, promoting and selling the vendor’s products. These allowances generally relate to short term arrangements with vendors, often relating to a period of a month or less, and are negotiated on a purchase-by-purchase or transaction-by-transaction basis. Whenever possible, vendor discounts and allowances that relate to buying and merchandising activities are recorded as a component of item cost in inventory and recognized in merchandise costs when the item is sold. Due to system constraints and the nature of certain allowances, it is sometimes not practicable to apply allowances to the item cost of inventory. In those instances, the allowances are applied as a reduction of merchandise costs using a rational and systematic methodology, which results in the recognition of these incentives when the inventory related to the vendor consideration received is sold. Vendor allowances applied as a reduction of merchandise costs totaled $115.8 million, $126.7 million and $121.9 million for the fiscal years ended September 26, 2015, September 27, 2014 and September 28, 2013, respectively. Vendor advertising allowances that represent a reimbursement of specific identifiable incremental costs of advertising the vendor’s specific products are recorded as a reduction to the related expense in the period that the related expense is incurred. Vendor advertising allowances recorded as a reduction of advertising expense totaled $14.3 million, $14.8 million, and $14.5 million for the fiscal years ended September 26, 2015, September 27, 2014 and September 28, 2013, respectively. If vendor advertising allowances were substantially reduced or eliminated, the Company would likely consider other methods of advertising as well as the volume and frequency of the Company’s product advertising, which could increase or decrease the Company’s expenditures. Similarly, the Company is not able to assess the impact of vendor advertising allowances on creating additional revenue, as such allowances do not directly generate revenue for the Company’s stores. Results of Operations Ingles operates on a 52- or 53-week fiscal year ending on the last Saturday in September. The consolidated statements of income for the fiscal years ended September 26, 2015, September 27, 2014 and September 28, 2013, each consisted of 52 weeks of operations, respectively. Comparable store sales are defined as sales by grocery stores in operation for five full fiscal quarters. The Company has an ongoing renovation and expansion plan to modernize the appearance and layout of its existing stores. Sales from replacement stores, major remodels and the addition of fuel stations to existing stores are included in the comparable store sales calculation from the date of completion of the replacement, remodel or addition. A replacement store is a new store that is opened to replace an existing nearby store that is closed. A major remodel entails substantial remodeling of an existing store and may include additional retail square footage. For the fiscal years ended September 26, 2015 and September 27, 2014 comparable store sales include 199 and 200 stores, respectively. Weighted average retail square footage added to comparable stores due to replacement and remodeled stores was insignificant for the fiscal years ended September 26, 2015 and September 27, 2014, respectively. The following table sets forth, for the periods indicated, selected financial information as a percentage of net sales. Fiscal Year Ended September 26, 2015 Compared to the Fiscal Year Ended September 27, 2014 The Company achieved record non-gasoline sales for the fiscal year ended September 26, 2015. Comparable store non-gasoline sales also increased. Retail gasoline and fluid dairy gallons sold both increased, but decreases in per gallon costs resulted in lower total dollar sales. Net income for the fiscal year ended September 26, 2015 was $59.4 million, an increase of 15.4% over net income of $51.4 million for the fiscal year ended September 27, 2014. Fiscal 2015 net income is the highest in the Company’s 51 year history. Net Sales. Net sales for the fiscal year ended September 26, 2015 totaled $3.78 billion, compared with $3.84 billion for the fiscal year ended September 27, 2014. Comparable store sales excluding gasoline increased 2.1%. The number of customer transactions (excluding gasoline) increased 0.2%, while the average transaction size (excluding gasoline) increased 2.6%. Comparing fiscal 2015 with fiscal 2014, gasoline gallons sold increased, per gallon prices were down 27.9% and gasoline gross profit was significantly higher. Sales by product category for the fiscal years ended September 26, 2015 and September 27, 2014, respectively, were as follows: The grocery category includes grocery, dairy and frozen foods. The non-foods category includes alcoholic beverages, tobacco, pharmacy, health and video. The perishables category includes meat, produce, deli and bakery. Changes in retail grocery sales for the fiscal year ended September 26, 2015 are summarized as follows (in thousands): During fiscal 2015 and 2014, the Company devoted the majority of its grocery segment capital expenditures to improvements in the configuration and appearance of a number of its stores. These improvements along with effective promotions and cost competitiveness drove increased sales in fiscal 2015. The Ingles Advantage Savings and Rewards Card (the “Ingles Advantage Card”) also contributes to the increase in net sales and comparable store sales. Information obtained from holders of the Ingles Advantage Card assists the Company in optimizing product offerings and promotions specific to customer shopping patterns. The Company expects non-gasoline sales will be higher in the 2016 fiscal year compared with fiscal 2015. The Company anticipates adding one or more new stores in fiscal 2016 and expects to benefit from recent interior improvements to a number of existing stores. Fiscal 2016 sales growth will also be influenced by market fluctuations in the per gallon price of gasoline and milk, changes in commodity food prices and general economic conditions. Gross Profit. Gross profit for the year ended September 26, 2015 increased $48.1 million, or 5.7%, to $893.3 million compared with $845.2 million for the year ended September 27, 2014. As a percentage of sales, gross profit totaled 23.6% for the year ended September 26, 2015 and 22.0% for the year ended September 27, 2014. The increase in grocery segment gross profit dollars was primarily due to the higher sales volume. Grocery segment gross profit as a percentage of total sales (excluding gasoline) increased 64 basis points in fiscal 2015 compared with fiscal 2014. The gross margin increase was broad based across most products, except for gasoline. The mix of grocery sales in favor of higher margin products also has a positive impact on gross profit and gross margin. In addition to the direct product cost, the cost of goods sold line item for the grocery segment includes inbound freight charges and the costs related to the Company’s distribution network. Operating and Administrative Expenses. Operating and administrative expenses increased $33.7 million, or 4.7%, to $756.3 million for the year ended September 26, 2015, from $722.6 million for the year ended September 27, 2014. As a percentage of sales, operating and administrative expenses were 20.0% for the fiscal year ended September 26, 2015 and 18.8% for the fiscal year ended September 27, 2014. Excluding gasoline, which does not have significant direct operating expenses, the ratio of operating expenses to sales was 22.9% for fiscal 2015 compared with 22.3% for fiscal 2014. A breakdown of the major increases in operating and administrative expenses is as follows: Salaries and wages increased due to the addition of labor hours required for the increased sales volume, including new stores opened during fiscal 2015 and 2014. Insurance expense increased due to unfavorable claims experience under the Company’s self-insurance programs and due to higher medical insurance costs under recent regulatory requirements. Depreciation and amortization increased as a result of the Company’s capital expenditures programs, including smaller remodeling projects that contain capital assets with shorter useful lives-compared with real restate. Repair and maintenance expenses increased due to increases in the amount and complexity of equipment in the Company’s stores to support new products offered, increase energy efficiency and to improve the customer shopping experience. Taxes and licenses increased due to increases in the value of the Company’s real estate and for additional fees paid to municipalities to conduct business and offer certain products. Gain from Sale or Disposal of Assets. Gain from sale or disposal of assets totaled $2.2 million for fiscal 2015 compared with gains of $0.8 million for fiscal 2014. During fiscal 2015, the Company sold outparcels and wrote off buildings demolished in advance of rebuilding new store buildings in a future period. None of these transactions were individually significant. Other Income, Net. Other income, net totaled $2.3 million and $3.0 million for the fiscal years ended September 26, 2015 and September 27, 2014, respectively. Other income consists primarily of sales of waste paper and packaging. Interest Expense. Interest expense increased $0.4 million for the year ended September 26, 2015 to $47.0 million from $46.6 million for the year ended September 27, 2014. Total debt was $895.3 million at the end of fiscal 2015 compared with $937.3 million at the end of fiscal 2014. Income Taxes. Income tax expense as a percentage of pre-tax income was 37.2% for the 2015 fiscal year compared with 35.5% for the 2014 fiscal year. The increase in the effective tax rate is primarily attributable to certain discrete items which are not expected to recur in future periods. Net Income. Net income totaled $59.4 million for the fiscal year ended September 26, 2015 compared with net income of $51.4 million for the fiscal year ended September 27, 2014. Basic and diluted earnings per share for Class A Common Stock were $3.02 and $2.93, respectively, for the fiscal year ended September 26, 2015 compared with $2.36 and $2.28, respectively, for the fiscal year ended September 27, 2014. Basic and diluted earnings per share for Class B Common Stock were each $2.74 for the fiscal year ended September 26, 2015 compared with $2.14 of basic and diluted earnings per share for the fiscal year ended September 27, 2014. Fiscal Year Ended September 27, 2014 Compared to the Fiscal Year Ended September 28, 2013 The Company achieved record sales for the 50th consecutive year for the fiscal year ended September 27, 2014. Total and comparable store sales increased, both with and without the inclusion of gasoline sales. Net income for the fiscal year ended September 27, 2014 was $51.4 million, compared with $20.8 million for the fiscal year ended September 28, 2013. In fiscal year 2013, the Company incurred $43.1 million of pre-tax debt extinguishment costs in conjunction with significant refinancing transactions that resulted in lower financing costs in fiscal 2014. 2014 pre-tax income increased 15.0% after adding back debt extinguishment costs to 2013 pre-tax income. Net Sales. Net sales for the fiscal year ended September 27, 2014 increased 2.6% to $3.84 billion, compared with $3.74 billion for the fiscal year ended September 28, 2013. Comparable store sales increased 1.9%, including gasoline and 0.9% excluding gasoline. The number of customer transactions (excluding gasoline) decreased 0.2%, while the average transaction size (excluding gasoline) increased 1.3%. Comparing fiscal 2014 with fiscal 2013, gasoline gallons sold increased, per gallon prices were slightly lower and gasoline gross profit was lower. Sales by product category for the fiscal years ended September 27, 2014 and September 28, 2013, respectively, were as follows: The grocery category includes grocery, dairy and frozen foods. The non-foods category includes alcoholic beverages, tobacco, pharmacy, health and video. The perishables category includes meat, produce, deli and bakery. Changes in retail grocery sales for the fiscal year ended September 27, 2014 are summarized as follows (in thousands): During fiscal 2013 and 2014, the Company devoted the majority of its grocery segment capital expenditures to improvements in the configuration and appearance of a number of its stores. These improvements along with effective promotions and cost competitiveness drove increased sales in fiscal 2014. The Ingles Advantage Savings and Rewards Card (the “Ingles Advantage Card”) also contributes to the increase in net sales and comparable store sales. Information obtained from holders of the Ingles Advantage Card assists the Company in optimizing product offerings and promotions specific to customer shopping patterns. Net sales to outside parties for the Company’s milk processing subsidiary increased 10.7% in fiscal 2014 compared with fiscal 2013. The price of raw milk increased during fiscal 2014, but case volumes sold decreased as a result of industry consolidation and overall decreased milk consumption. Gross Profit. Gross profit for the year ended September 27, 2014 increased $17.4 million, or 2.1%, to $845.2 million compared with $827.8 million for the year ended September 28, 2013. As a percentage of sales, gross profit totaled 22.0% for the year ended September 27, 2014 and 22.2% for the year ended September 28, 2013. The increase in grocery segment gross profit dollars was primarily due to the higher sales volume. Grocery segment gross profit as a percentage of total sales (excluding gasoline) increased 36 basis points in fiscal 2014 compared with fiscal 2013. The gross margin increase was broad based across most products, except for gasoline. The mix of grocery sales in favor of higher margin products also has a positive impact on gross profit and gross margin. Gross profit for the Company’s milk processing subsidiary for the year ended September 27, 2014 increased 3.2% compared with the year ended September 28, 2013. Gross profit as a percentage of sales was 10.3% for fiscal 2014 compared with 10.7% for fiscal 2013. In addition to the direct product cost, the cost of goods sold line item for the grocery segment includes inbound freight charges and the costs related to the Company’s distribution network. The milk processing segment is a manufacturing process; therefore, the costs mentioned above as well as purchasing and receiving costs, production costs, inspection costs, warehousing costs, internal transfer costs, and other costs of distribution incurred by the milk processing segment are included in the cost of sales line item, while these items are included in operating and administrative expenses for the grocery segment. Operating and Administrative Expenses. Operating and administrative expenses increased $16.1 million, or 2.3%, to $722.6 million for the year ended September 27, 2014, from $706.5 million for the year ended September 28, 2013. As a percentage of sales, operating and administrative expenses were 18.8% for the fiscal year ended September 27, 2014 and 18.9% for the fiscal year ended September 28, 2013. Excluding gasoline, which does not have significant direct operating expenses, the ratio of operating expenses to sales was 22.3% for fiscal 2014 compared with 22.1% for fiscal 2013. A breakdown of the major increases (decreases) in operating and administrative expenses is as follows: Salaries and wages increased due to the addition of labor hours required for the increased sales volume, including new stores opened during fiscal 2014 and 2013. Bank charges increased due to higher fees charged for debit and credit card transactions, and a higher volume of such transactions in the Company’s stores and fuel centers. Utilities and fuel increased as a result of increased internal freight activity and the transition of additional store space to perishable items. Depreciation and amortization increased as a result of the Company’s capital expenditures for smaller remodeling projects that contain capital assets with shorter useful lives-compared with real restate. Insurance expense decreased due to favorable claims experience under the Company’s self-insurance programs. Gain from Sale or Disposal of Assets. Gain from sale or disposal of assets totaled $0.8 million for fiscal 2014 compared with gains of $4.3 million for fiscal 2013. During fiscal 2013, the Company sold a former store property for $7.5 million and recognized a pre-tax gain of $3.9 million. There were no other significant sale or disposal transactions during fiscal 2014 or 2013. Other Income, Net. Other income, net totaled $3.0 million and $2.9 million for the fiscal years ended September 27, 2014 and September 28, 2013, respectively. Other income consists primarily of sales of waste paper and packaging. Interest Expense. Interest expense decreased $12.5 million for the year ended September 27, 2014 to $46.6 million from $59.1 million for the year ended September 28, 2013. Total debt was $937.3 million at the end of fiscal 2014 compared with $912.5 million at the end of fiscal 2013. Interest expense decreased due to the refinancing of existing debt at lower rates during the third quarter of fiscal 2013. Loss on Early Extinguishment of Debt. In connection with the fiscal 2013 early payoff of the $575.0 million senior notes due 2017, the Company paid $27.8 million in debt extinguishment costs and expensed $15.3 million of unamortized loan costs. Income Taxes. Income tax expense as a percentage of pre-tax income was 35.5% for the 2014 fiscal year compared with 20.8% for the 2013 fiscal year. The increase in the effective tax rate is primarily attributable to tax credits in fiscal 2013 representing a greater percentage of pre-tax income. Net Income. Net income totaled $51.4 million for the fiscal year ended September 27, 2014 compared with net income of $20.8 million for the fiscal year ended September 28, 2013. Basic and diluted earnings per share for Class A Common Stock were $2.36 and $2.28, respectively, for the fiscal year ended September 27, 2014 compared with $0.89 and $0.87, respectively, for the fiscal year ended September 28, 2013. Basic and diluted earnings per share for Class B Common Stock were each $2.14 for the fiscal year ended September 27, 2014 compared with $0.85 of basic and diluted earnings per share for the fiscal year ended September 28, 2013. Liquidity and Capital Resources The Company believes that a key to its ability to continue to increase sales and develop a loyal customer base is providing conveniently located, clean and modern stores which provide customers with good service and an increasingly diverse selection of competitively priced products. As such, the Company has invested and will continue to invest significant amounts of capital toward the modernization of its store base. The Company’s modernization program includes the opening of new stores, the completion of major remodels and expansion of selected existing stores, and the relocation of selected existing stores to larger, more convenient locations. The Company also believes that the new warehouse and distribution facility completed during fiscal 2012 has lowered its overall distribution costs and improved product availability in its stores. Capital expenditures totaled $104.1 million and $108.3 million for fiscal 2015 and 2014, respectively. Major capital expenditures include the following: (including those added at new or replacement stores) Capital expenditures also included upgrading and replacing store equipment, technology investments, capital expenditures related to the Company’s distribution operation and its milk processing plant, and expenditures for stores to open in subsequent fiscal years. During fiscal 2015, the Company closed two stores and plans to rebuild larger stores on the same land site as the demolished stores. Also during fiscal 2015, the Company purchased three locations where it was operating a leased store. Ingles’ capital expenditure plans for fiscal 2016 include investments of approximately $100 to $140 million. The majority of the Company’s fiscal 2016 capital expenditures will be dedicated to continued improvement of its store base and will include construction of two or more new/remodeled stores. Fiscal 2016 capital expenditures will also include investments in stores expected to open in fiscal 2017 as well as technology improvements, upgrading and replacing existing store equipment and warehouse and transportation equipment and improvements to the Company’s milk processing plant. The Company expects that its net annual capital expenditures will be in the range of approximately $100 to $160 million going forward in order to maintain a modern store base. Planned expenditures for any given future fiscal year will be affected by the availability of financing, which can affect both the number of projects pursued at any given time and the cost of those projects. The number of projects may also fluctuate due to the varying costs of the types of projects pursued including new stores and major remodel/expansions. The Company makes decisions on the allocation of capital expenditure dollars based on many factors including the competitive environment, other Company capital initiatives and its financial condition. In general, the Company finances its capital expenditures to the extent possible from cash on hand and cash flow from operations. Additional financing sources for capital expenditures include borrowings under the $175 million of committed line of credit, other borrowings that could be collateralized by unencumbered real property and equipment with a net book value of approximately $952 million, and the public debt or equity markets. The Company has used each of these to finance past capital expenditures and expects to have them available in the future. The Company does not generally enter into commitments for capital expenditures other than on a store-by-store basis at the time it begins construction on a new store or begins a major or minor remodeling project. Construction commitments at September 26, 2015 totaled $15.9 million. Liquidity The Company generated $153.5 million of cash from operations in fiscal 2015 compared with $154.3 million for fiscal 2014. Increased net income and noncash depreciation were offset by increased working capital requirements. Cash used by investing activities for fiscal 2015 totaled $99.7 million compared with $107.9 million for fiscal 2014. The Company’s most significant investing activity is capital expenditures. Comparing fiscal year 2015 with fiscal year 2014, capital expenditures were slightly lower and proceeds from asset sales were higher. During fiscal 2015, the Company’s net financing activities of $54.9 million consisted primarily of dividends and a reduction of total debt. During fiscal 2014, the Company’s net financing activities used $54.7 million primarily for stock repurchases and regular dividends, funded primarily with borrowings under its line of credit (the “Line”). In June 2013, the Company issued $700.0 million aggregate principal amount of senior notes due in 2023 (the “Notes”). The Notes bear an interest rate of 5.75% per annum and were issued at par. Note proceeds were used to repay $575.0 million aggregate principal amount of senior notes maturing in 2017, $52.0 million of indebtedness outstanding under the Company’s line of credit, and pay costs related to the offering of the Notes. Remaining Note proceeds were used for general corporate purposes, including capital expenditures. The Company’s effective interest rate on senior notes borrowings decreased from 9.50% to 5.75%. In connection with the offering of the Notes, the Company extended the maturity date of its $175.0 million line of credit from December 29, 2015 to June 12, 2018 and modified certain interest rate options and covenants. At September 26, 2015, the Company had $0.5 million borrowing outstanding under the Line. The Line provides the Company with various interest rate options based on the prime rate, the Federal Funds Rate, or the London Interbank Offering Rate. The Line allows the Company to issue up to $30.0 million in unused letters of credit, of which $10.5 million of unused letters of credit were issued at September 26, 2015. The Company is not required to maintain compensating balances in connection with the Line. On December 29, 2010, the Company completed the funding of $99.7 million of Recovery Zone Facility Bonds (the “Bonds”) for: (A) acquisition, construction and equipping of an approximately 830,000 square foot new warehouse and distribution center located in Buncombe County, North Carolina (the “Project”), and (B) the payment of certain expenses incurred in connection with the issuance of the Bonds. The final maturity date of the Bonds is January 1, 2036. Under a Continuing Covenant and Collateral Agency Agreement (the “Covenant Agreement”) between certain financial institutions and the Company, the financial institutions would hold the Bonds until January 2, 2018, subject to certain events. Mandatory redemption of the Bonds by the Company in the annual amount of $4,530,000 began on January 1, 2014. In connection with the offering of the Notes, the Company extended the maturity date of the Covenant Agreement from January 2, 2018 to June 30, 2021 and modified certain interest rate options and covenants. The Company may redeem the Bonds without penalty or premium at any time prior to June 30, 2021. The Company’s long-term debt agreements generally have cross-default provisions which could result in the acceleration of payments due under the Company’s line of credit, Bond and Notes indenture in the event of default under any one instrument. The Notes, the Bonds and the line of credit contain provisions that under certain circumstances would permit lending institutions to terminate or withdraw their respective extensions of credit to the Company. Included among the triggering factors permitting the termination or withdrawal of the line of credit to the Company are certain events of default, including both monetary and non-monetary defaults, the initiation of bankruptcy or insolvency proceedings, and the failure of the Company to meet certain financial covenants designated in its respective loan documents. As of September 26, 2015, the Company was in compliance with these covenants by a significant margin. Under the most restrictive of these covenants, the Company would be able to incur approximately $397 million of additional borrowings (including borrowings under the line of credit) as of September 26, 2015. The Company’s principal sources of liquidity are expected to be cash flow from operations, borrowings under the Line and long-term financing. The Company believes, based on its current results of operations and financial condition, that its financial resources, including cash balances, the existing Line, short- and long-term financing expected to be available to it and internally generated funds, will be sufficient to meet planned capital expenditures and working capital requirements for the foreseeable future, including any debt service requirements of additional borrowings. However, there can be no assurance that any such sources of financing will be available to the Company on acceptable terms, or at all. It is possible that, in the future, the Company’s results of operations and financial condition will be different from that described in this report based on a number of intangible factors. These factors may include, among others, increased competition, changing regional and national economic conditions, adverse climatic conditions affecting food production and delivery and changing demographics as well as the additional factors discussed above and elsewhere under “Item 1A. Risk Factors.” It is also possible, for such reasons, that the results of operations from the new, expanded, remodeled and/or replacement stores will not meet or exceed the results of operations from existing stores that are described in this report. Contractual Obligations and Commercial Commitments The Company has assumed various financial obligations and commitments in the normal course of its operations and financing activities. Financial obligations are considered to represent known future cash payments that the Company is required to make under existing contractual arrangements, such as debt and lease arrangements. The following table represents the scheduled maturities of the Company’s long-term contractual obligations as of September 26, 2015: Payment Due by Period (1) Scheduled interest on floating rate debt calculated using rates in effect on September 26, 2015. Amounts available to the Company under commercial commitments as of September 26, 2015, were as follows: Amount of Commitment Expiration per Period Off Balance Sheet Arrangements The Company is not a party to any off-balance sheet arrangements that have, or are reasonably likely to have, a current or future material effect on the Company’s financial condition, revenues, expenses, results of operations, liquidity, capital expenditures or capital resources. Quarterly Cash Dividends Since December 27, 1993, the Company has paid regular quarterly cash dividends of $0.165 per share on its Class A Common Stock and $0.15 per share on its Class B Common Stock for an annual rate of $0.66 and $0.60 per share, respectively. Because of increased tax rates on dividends that went into effect in January 2013, the Company paid in December 2012 a special dividend equal to $0.66 cents per each Class A share and $0.60 cents per each Class B share. The Company also accelerated the payment of the regular quarterly January 2013 dividend into December 2012. Both dividends were declared on December 7, 2012, payable on December 31, 2012 to shareholders of record on December 21, 2012. The Company expects to continue paying regular cash dividends on a quarterly basis. However, the Board of Directors periodically reconsiders the declaration of dividends. The Company pays these dividends at the discretion of the Board of Directors and the continuation of these payments, the amount of such dividends, and the form in which the dividends are paid (cash or stock) depends upon the results of operations, the financial condition of the Company and other factors which the Board of Directors deems relevant. Long-term debt and line of credit agreements contain various restrictive covenants requiring, among other things, minimum levels of net worth and maintenance of certain financial ratios. These covenants have the effect of restricting certain types of transactions, including the payment of cash dividends generally and in excess of current quarterly per share amounts. Further, the Company is prevented from declaring dividends at any time that it is in default under the indenture governing the Notes. Impact of Inflation The following table from the United States Bureau of Labor Statistics lists annualized changes in the Consumer Price Index that could have an effect on the Company’s operations. One of the Company’s significant costs is labor, which increases with general inflation. Inflation or deflation in energy costs affects both the Company’s gasoline sales and distribution expenses. New Accounting Pronouncements For new accounting pronouncements, see Note 1 to the Consolidated Financial Statements included in this Annual Report on Form 10-K. Outlook and Trends in the Company’s Markets The Company has improved the interior layout and product offerings in a significant number of stores over the past three fiscal years. Economic conditions have improved to the point that the Company has accelerated the increase and improvement of its total retail square footage. The Company continually assesses and modifies its business model to meet the changing needs and expectations of its customers. In connection with this review, the Company assesses the trends present in the markets in which it competes. Generally, it is difficult to predict whether a trend will continue for a period of time and it is possible that new trends will develop which will affect an existing trend. The Company believes that the following trends are likely to continue for at least the next fiscal year: · The supermarket industry will remain highly competitive and will be characterized by industry consolidation, fragmented food retail platforms, and continued competition from super centers and other non-supermarket operators. · Uncertain economic conditions will continue to affect customer behavior. Economic conditions may affect purchasing patterns with regard to meal replacement items, private label purchases, promotions and product variety. · The Company and its customers will continue to become more environmentally aware, evidenced by the Company’s increased recycled waste paper and pallets and customers’ increased usage of reusable shopping bags. · Volatile petroleum costs will impact utility and distribution costs, plastic supplies cost and may change customer shopping and dining behavior. · Retail gasoline costs and retail prices will continue to be volatile, affecting the Company’s gasoline sales and gross margin. The Company plans to continue to focus on balancing sales growth and gross margin maintenance (excluding the effect of gasoline sales), and will carefully monitor its product mix and customer trends.

<s>[INST] Ingles, a leading supermarket chain in the Southeast United States, operates 201 supermarkets in Georgia (71), North Carolina (71), South Carolina (36), Tennessee (20), Virginia (2) and Alabama (1). The Company locates its supermarkets primarily in suburban areas, small towns and rural communities. Ingles supermarkets offer customers a wide variety of nationally advertised food products, including grocery, meat and dairy products, produce, frozen foods and other perishables and nonfood products. Nonfood products include fuel centers, pharmacies, health and beauty care products and general merchandise, as well as quality private label items. In addition, the Company focuses on selling highgrowth, highmargin products to its customers through the development of certified organic products, bakery departments and prepared foods including delicatessen sections. As of September 26, 2015, the Company operated 97 instore pharmacies and 88 fuel centers. Ingles also operates a fluid dairy and earns shopping center rentals. The fluid dairy sells approximately 27% of its products to the retail grocery segment and approximately 73% of its products to third parties. Real estate ownership is an important component of the Company’s operations, providing both operational and economic benefit. Critical Accounting Policies Critical accounting policies are those accounting policies that management believes are important to the portrayal of Ingles’ financial condition and results of operations, and require management’s most difficult, subjective or complex judgments, often as a result of the need to make estimates about the effect of matters that are inherently uncertain. Estimates are based on historical experience and other factors believed to be reasonable under the circumstances, the results of which form the basis for making judgments about the carrying values of assets and liabilities that are not readily apparent from other sources. Management estimates, by their nature, involve judgments regarding future uncertainties, and actual results may therefore differ materially from these estimates. SelfInsurance The Company is selfinsured for workers’ compensation, general liability, and group medical and dental benefits. Risks and uncertainties are associated with selfinsurance; however, the Company has limited its exposure by maintaining excess liability coverage of $750,000 per occurrence for workers’ compensation, $500,000 for general liability, and $325,000 per covered person for medical care benefits for a policy year. Selfinsurance liabilities are established based on claims filed and estimates of claims incurred but not reported. The estimates are based on data provided by the respective claims administrators which is then applied to appropriate actuarial methods. These estimates can fluctuate if historical trends are not predictive of the future. The majority of the Company’s properties are selfinsured for casualty losses and business interruption; however, liability coverage is maintained. The Company’s selfinsurance reserves totaled $36.3 million and $29.9 million for employee group insurance, workers’ compensation insurance and general liability insurance at September 26, 2015 and September 27, 2014, respectively. The September 26, 2015 amount is inclusive of $4.9 of expected selfinsurance recoveries from excess cost insurance or other sources that are recorded as a receivable at September 26, 2015. Asset Impairments The Company accounts for the impairment of longlived assets in accordance with Financial Accounting Standards Board Accounting Standards Codification (“FASB ASC”) Topic 360. Asset groups are primarily comprised of our individual store and shopping center properties. For assets to be held and used, the Company tests for impairment using undiscounted cash flows and calculates the amount of impairment using discounted cash flows. For assets held for sale, impairment is recognized based on the excess of remaining book value over expected recovery value. The recovery value is the fair value as determined by independent quotes or expected sales prices developed by internal associates, net of costs to sell. Estimates of future cash flows and expected sales prices are judgments based upon the Company’s experience and knowledge of local operations and cash flows that are projected for several years into the future. [/INST] Negative. </s>

INGLES MARKETS INC

2016-12-16

2016-09-24

Item 7. MANAGEMENT’S DISCUSSION AND ANALYSIS OF FINANCIAL CONDITION AND RESULTS OF OPERATIONS Overview Ingles, a leading supermarket chain in the Southeast United States, operates 201 supermarkets in Georgia (71), North Carolina (70), South Carolina (36), Tennessee (21), Virginia (2) and Alabama (1). The Company locates its supermarkets primarily in suburban areas, small towns and rural communities. Ingles supermarkets offer customers a wide variety of nationally advertised food products, including grocery, meat and dairy products, produce, frozen foods and other perishables and non-food products. Non-food products include fuel centers, pharmacies, health and beauty care products and general merchandise. The Company offers quality private label items in most of its departments. In addition, the Company focuses on selling high-growth, high-margin products to its customers through the development of certified organic products, bakery departments and prepared foods including delicatessen sections. As of September 24, 2016, the Company operated 99 in-store pharmacies and 93 fuel centers. Ingles also operates a fluid dairy and earns shopping center rentals. The fluid dairy sells approximately 25% of its products to the retail grocery segment and approximately 75% of its products to third parties. Real estate ownership is an important component of the Company’s operations, providing both operational and economic benefit.  Critical Accounting Policies Critical accounting policies are those accounting policies that management believes are important to the portrayal of Ingles’ financial condition and results of operations, and require management’s most difficult, subjective or complex judgments, often as a result of the need to make estimates about the effect of matters that are inherently uncertain. Estimates are based on historical experience and other factors believed to be reasonable under the circumstances, the results of which form the basis for making judgments about the carrying values of assets and liabilities that are not readily apparent from other sources. Management estimates, by their nature, involve judgments regarding future uncertainties, and actual results may therefore differ materially from these estimates. Self-Insurance The Company is self-insured for workers’ compensation, general liability, and group medical and dental benefits. Risks and uncertainties are associated with self-insurance; however, the Company has limited its exposure by maintaining excess liability coverage of $750,000 per occurrence for workers’ compensation, $500,000 for general liability, and $325,000 per covered person for medical care benefits for a policy year. Self-insurance liabilities are established based on claims filed and estimates of claims incurred but not reported. The estimates are based on data provided by the respective claims administrators which is then applied to appropriate actuarial methods. These estimates can fluctuate if historical trends are not predictive of the future. The majority of the Company’s properties are self-insured for casualty losses and business interruption; however, liability coverage is maintained. The Company’s self-insurance reserves totaled $35.9 million and $36.3 million for employee group insurance, workers’ compensation insurance and general liability insurance at September 24, 2016 and September 26, 2015, respectively. These amounts are inclusive of expected recoveries from excess cost insurance or other sources that are recorded as receivables of $4.8 million and $4.9 million at September 24, 2016 and September 26, 2015, respectively.  Asset Impairments The Company accounts for the impairment of long-lived assets in accordance with Financial Accounting Standards Board Accounting Standards Codification (“FASB ASC”) Topic 360. Asset groups are primarily comprised of our individual store and shopping center properties. For assets to be held and used, the Company tests for impairment using undiscounted cash flows and calculates the amount of impairment using discounted cash flows. For assets held for sale, impairment is recognized based on the excess of remaining book value over expected recovery value. The recovery value is the fair value as determined by independent quotes or expected sales prices developed by internal associates, net of costs to sell. Estimates of future cash flows and expected sales prices are judgments based upon the Company’s experience and knowledge of local operations and cash flows that are projected for several years into the future. These estimates can fluctuate significantly due to changes in real estate market conditions, the economic environment, capital spending decisions and inflation. The Company monitors the carrying value of long-lived assets for potential impairment each quarter based on whether any indicators of impairment have occurred. Vendor Allowances The Company receives funds for a variety of merchandising activities from the many vendors whose products the Company buys for resale in its stores. These incentives and allowances are primarily comprised of volume or purchase based incentives, advertising allowances, slotting fees, and promotional discounts. The purpose of these incentives and allowances is generally to help defray the costs incurred by the Company for stocking, advertising, promoting and selling the vendor’s products. These allowances generally relate to short term arrangements with vendors, often relating to a period of a month or less, and are negotiated on a purchase-by-purchase or transaction-by-transaction basis. Whenever possible, vendor discounts and allowances that relate to buying and merchandising activities are recorded as a component of item cost in inventory and recognized in merchandise costs when the item is sold. Due to system constraints and the nature of certain allowances, it is sometimes not practicable to apply allowances to the item cost of inventory. In those instances, the allowances are applied as a reduction of merchandise costs using a rational and systematic methodology, which results in the recognition of these incentives when the inventory related to the vendor consideration received is sold. Vendor allowances applied as a reduction of merchandise costs totaled $115.8 million, $115.8 million and $126.7 million for the fiscal years ended September 24, 2016, September 26, 2015 and September 27, 2014, respectively. Vendor advertising allowances that represent a reimbursement of specific identifiable incremental costs of advertising the vendor’s specific products are recorded as a reduction to the related expense in the period that the related expense is incurred. Vendor advertising allowances recorded as a reduction of advertising expense totaled $13.5 million, $14.3 million, and $14.8 million for the fiscal years ended September 24, 2016, September 26, 2015 and September 27, 2014, respectively.  If vendor advertising allowances were substantially reduced or eliminated, the Company would likely consider other methods of advertising as well as the volume and frequency of the Company’s product advertising, which could increase or decrease the Company’s expenditures.  Similarly, the Company is not able to assess the impact of vendor advertising allowances on creating additional revenue, as such allowances do not directly generate revenue for the Company’s stores.  Results of Operations Ingles operates on a 52- or 53-week fiscal year ending on the last Saturday in September. The consolidated statements of income for the fiscal years ended September 24, 2016, September 26, 2015 and September 27, 2014, each consisted of 52 weeks of operations, respectively.  Comparable store sales are defined as sales by grocery stores in operation for five full fiscal quarters. The Company has an ongoing renovation and expansion plan to modernize the appearance and layout of its existing stores. Sales from replacement stores, major remodels and the addition of fuel stations to existing stores are included in the comparable store sales calculation from the date of completion of the replacement, remodel or addition. A replacement store is a new store that is opened to replace an existing nearby store that is closed. A major remodel entails substantial remodeling of an existing store and may include additional retail square footage. For the fiscal years ended September 24, 2016 and September 26, 2015 comparable store sales include 199 stores each. Weighted average retail square footage added to comparable stores due to replacement and remodeled stores was insignificant for the fiscal years ended September 24, 2016 and September 26, 2015, respectively.  The following table sets forth, for the periods indicated, selected financial information as a percentage of net sales.   Fiscal Year Ended September 24, 2016 Compared to the Fiscal Year Ended September 26, 2015 Net income for the fiscal year ended September 24, 2016 was $54.2 million, a decrease of 8.7% over net income of $59.4 million for the fiscal year ended September 26, 2015. Increased sales and gross profit were offset by larger increases in operating expenses. Personnel expenses increased due to a tightening labor market and expanded product offerings that carried a comparatively larger labor cost component. Expansion and modernization of the Company’s store base accelerated in 2016, which also impacted labor and equipment costs. Net Sales. Net sales for the fiscal year ended September 24, 2016 totaled $3.79 billion, compared with $3.78 billion for the fiscal year ended September 26, 2015. Comparable store sales excluding gasoline increased 2.0%. The number of customer transactions (excluding gasoline) increased 1.5%, while the average transaction size (excluding gasoline) increased 1.1%. Comparing fiscal 2016 with fiscal 2015, gasoline gallons sold increased, per gallon prices were down 13% and gasoline gross profit was slightly lower.  Sales by product category for the fiscal years ended September 24, 2016 and September 26, 2015, respectively, were as follows:    The grocery category includes grocery, dairy and frozen foods. The non-foods category includes alcoholic beverages, tobacco, pharmacy, health and video. The perishables category includes meat, produce, deli and bakery.  Changes in retail grocery sales for the fiscal year ended September 24, 2016 are summarized as follows (in thousands):   During fiscal 2016 and 2015, the Company devoted the majority of its grocery segment capital expenditures to improvements in the configuration and appearance of a number of its stores. These improvements along with effective promotions and cost competitiveness drove increased sales in fiscal 2016. The Ingles Advantage Savings and Rewards Card (the “Ingles Advantage Card”) also contributes to the increase in net sales and comparable store sales. Information obtained from holders of the Ingles Advantage Card assists the Company in optimizing product offerings and promotions specific to customer shopping patterns. The Company expects non-gasoline sales will be higher in the 2017 fiscal year compared with fiscal 2016. The Company anticipates adding one or more new stores in fiscal 2017 and expects to benefit from recent interior improvements to a number of existing stores. Fiscal 2017 sales growth will also be influenced by market fluctuations in the per gallon price of gasoline and milk, changes in commodity food prices and general economic conditions.  Gross Profit. Gross profit for the year ended September 24, 2016 increased $31.1 million, or 3.5%, to $924.4 million compared with $893.3 million for the year ended September 26, 2015. As a percentage of sales, gross profit totaled 24.4% for the year ended September 24, 2016 and 23.6% for the year ended September 26, 2015.  The increase in grocery segment gross profit dollars was primarily due to the higher sales volume. Grocery segment gross profit as a percentage of total sales (excluding gasoline) increased 16 basis points in fiscal 2016 compared with fiscal 2015. The gross margin increase was broad based across most products, except for gasoline. The mix of grocery sales in favor of higher margin products also has a positive impact on gross profit and gross margin. In addition to the direct product cost, the cost of goods sold line item for the grocery segment includes inbound freight charges and the costs related to the Company’s distribution network. Operating and Administrative Expenses. Operating and administrative expenses increased $38.3 million, or 5.1%, to $794.6 million for the year ended September 24, 2016, from $756.3 million for the year ended September 26, 2015. As a percentage of sales, operating and administrative expenses were 21.0% for the fiscal year ended September 24, 2016 and 20.0% for the fiscal year ended September 26, 2015. Excluding gasoline, which does not have significant direct operating expenses, the ratio of operating expenses to sales was 23.5% for fiscal 2016 compared with 22.9% for fiscal 2015. A breakdown of the major increases in operating and administrative expenses is as follows:   Salaries and wages increased due to the addition of labor hours required for the increased sales volume and changes to the sales mix. In general the labor market in the Company’s market area has become more competitive.  Repair and maintenance expenses increased due to increases in the amount and complexity of equipment in the Company’s stores to support new products offered, increase energy efficiency and to improve the customer shopping experience.  Bank charges have increased as more sales transactions are being settled with debit and credit cards, and the per transaction card costs have increased.  Depreciation and amortization increased as a result of the Company’s capital expenditures programs, including smaller remodeling projects that contain capital assets with shorter useful lives-compared with real restate.  Taxes and licenses increased due to increases in the value of the Company’s real estate and for additional fees paid to municipalities to conduct business and offer certain products.  Loss or gain from Sale or Disposal of Assets. Loss from sale or disposal of assets totaled $1.2 million for fiscal 2016 compared with gains of $2.2 million for fiscal 2015. During fiscal 2016, the Company demolished certain buildings for redevelopment into larger and improved store or tenant space. During fiscal 2015, the Company sold outparcels and wrote off buildings demolished in advance of rebuilding new store buildings in a future period. None of these transactions were individually significant. Other Income, Net. Other income, net totaled $2.4 million and $2.3 million for the fiscal years ended September 24, 2016 and September 26, 2015, respectively. Other income consists primarily of sales of waste paper and packaging. Interest Expense. Interest expense decreased $0.7 million for the year ended September 24, 2016 to $46.3 million from $47.0 million for the year ended September 26, 2015. Total debt was $876.5 million at the end of fiscal 2016 compared with $886.1 million at the end of fiscal 2015.  Income Taxes. Income tax expense as a percentage of pre-tax income was 36.0% for the 2016 fiscal year compared with 37.2% for the 2015 fiscal year. The decrease in the effective tax rate is primarily attributable to certain fiscal year 2015 discrete items which are not expected to recur in future periods. Net Income. Net income totaled $54.2 million for the fiscal year ended September 24, 2016 compared with net income of $59.4 million for the fiscal year ended September 26, 2015. Basic and diluted earnings per share for Class A Common Stock were $2.75 and $2.68, respectively, for the fiscal year ended September 24, 2016 compared with $3.02 and $2.93, respectively, for the fiscal year ended September 26, 2015. Basic and diluted earnings per share for Class B Common Stock were each $2.50 for the fiscal year ended September 24, 2016 compared with $2.74 of basic and diluted earnings per share for the fiscal year ended September 26, 2015.  Fiscal Year Ended September 26, 2015 Compared to the Fiscal Year Ended September 27, 2014 The Company achieved record non-gasoline sales for the fiscal year ended September 26, 2015. Comparable store non-gasoline sales also increased. Retail gasoline and fluid dairy gallons sold both increased, but decreases in per gallon costs resulted in lower total dollar sales.  Net income for the fiscal year ended September 26, 2015 was $59.4 million, an increase of 15.4% over net income of $51.4 million for the fiscal year ended September 27, 2014. Fiscal 2015 net income is the highest in the Company’s 51 year history. Net Sales. Net sales for the fiscal year ended September 26, 2015 totaled $3.78 billion, compared with $3.84 billion for the fiscal year ended September 27, 2014. Comparable store sales excluding gasoline increased 2.1%. The number of customer transactions (excluding gasoline) increased 0.2%, while the average transaction size (excluding gasoline) increased 2.6%. Comparing fiscal 2015 with fiscal 2014, gasoline gallons sold increased, per gallon prices were down 27.9% and gasoline gross profit was significantly higher.  Sales by product category for the fiscal years ended September 26, 2015 and September 27, 2014, respectively, were as follows:    The grocery category includes grocery, dairy and frozen foods. The non-foods category includes alcoholic beverages, tobacco, pharmacy, health and video. The perishables category includes meat, produce, deli and bakery.  Changes in retail grocery sales for the fiscal year ended September 26, 2015 are summarized as follows (in thousands):   During fiscal 2015 and 2014, the Company devoted the majority of its grocery segment capital expenditures to improvements in the configuration and appearance of a number of its stores. These improvements along with effective promotions and cost competitiveness drove increased non-gas sales in fiscal 2015. The Ingles Advantage Savings and Rewards Card (the “Ingles Advantage Card”) also contributed to the increase in net sales and comparable store sales. Information obtained from holders of the Ingles Advantage Card assists the Company in optimizing product offerings and promotions specific to customer shopping patterns. The Company expects non-gasoline sales will be higher in the 2016 fiscal year compared with fiscal 2015. The Company anticipates adding one or more new stores in fiscal 2016 and expects to benefit from recent interior improvements to a number of existing stores. Fiscal 2016 sales growth will also be influenced by market fluctuations in the per gallon price of gasoline and milk, changes in commodity food prices and general economic conditions.  Gross Profit. Gross profit for the year ended September 26, 2015 increased $48.1 million, or 5.7%, to $893.3 million compared with $845.2 million for the year ended September 27, 2014. As a percentage of sales, gross profit totaled 23.6% for the year ended September 26, 2015 and 22.0% for the year ended September 27, 2014.  The increase in grocery segment gross profit dollars was primarily due to the higher sales volume. Grocery segment gross profit as a percentage of total sales (excluding gasoline) increased 18 basis points in fiscal 2015 compared with fiscal 2014. The gross margin increase was broad based across most products, except for gasoline. The mix of grocery sales in favor of higher margin products also has a positive impact on gross profit and gross margin. In addition to the direct product cost, the cost of goods sold line item for the grocery segment includes inbound freight charges and the costs related to the Company’s distribution network. Operating and Administrative Expenses. Operating and administrative expenses increased $33.7 million, or 4.7%, to $756.3 million for the year ended September 26, 2015, from $722.6 million for the year ended September 27, 2014. As a percentage of sales, operating and administrative expenses were 20.0% for the fiscal year ended September 26, 2015 and 18.8% for the fiscal year ended September 27, 2014. Excluding gasoline, which does not have significant direct operating expenses, the ratio of operating expenses to sales was 22.9% for fiscal 2015 compared with 22.3% for fiscal 2014. A breakdown of the major increases in operating and administrative expenses is as follows:    Salaries and wages increased due to the addition of labor hours required for the increased sales volume, including new stores opened during fiscal 2015 and 2014.  Insurance expense increased due to unfavorable claims experience under the Company’s self-insurance programs and due to higher medical insurance costs under recent regulatory requirements.  Depreciation and amortization increased as a result of the Company’s capital expenditures programs, including smaller remodeling projects that contain capital assets with shorter useful lives-compared with real restate.  Repair and maintenance expenses increased due to increases in the amount and complexity of equipment in the Company’s stores to support new products offered, increase energy efficiency and to improve the customer shopping experience.  Taxes and licenses increased due to increases in the value of the Company’s real estate and for additional fees paid to municipalities to conduct business and offer certain products.  Gain from Sale or Disposal of Assets. Gain from sale or disposal of assets totaled $2.2 million for fiscal 2015 compared with gains of $0.8 million for fiscal 2014. During fiscal 2015, the Company sold outparcels and wrote off buildings demolished in advance of rebuilding new store buildings in a future period. None of these transactions were individually significant. Other Income, Net. Other income, net totaled $2.3 million and $3.0 million for the fiscal years ended September 26, 2015 and September 27, 2014, respectively. Other income consists primarily of sales of waste paper and packaging. Interest Expense. Interest expense increased $0.4 million for the year ended September 26, 2015 to $47.0 million from $46.6 million for the year ended September 27, 2014. Total debt was $886.1 million at the end of fiscal 2015 compared with $926.7 million at the end of fiscal 2014.  Income Taxes. Income tax expense as a percentage of pre-tax income was 37.2% for the 2015 fiscal year compared with 35.5% for the 2014 fiscal year. The increase in the effective tax rate is primarily attributable to certain discrete items which are not expected to recur in future periods. Net Income. Net income totaled $59.4 million for the fiscal year ended September 26, 2015 compared with net income of $51.4 million for the fiscal year ended September 27, 2014. Basic and diluted earnings per share for Class A Common Stock were $3.02 and $2.93, respectively, for the fiscal year ended September 26, 2015 compared with $2.36 and $2.28, respectively, for the fiscal year ended September 27, 2014. Basic and diluted earnings per share for Class B Common Stock were each $2.74 for the fiscal year ended September 26, 2015 compared with $2.14 of basic and diluted earnings per share for the fiscal year ended September 27, 2014. Liquidity and Capital Resources  The Company believes that a key to its ability to continue to increase sales and develop a loyal customer base is providing conveniently located, clean and modern stores which provide customers with good service and an increasingly diverse selection of competitively priced products. As such, the Company has invested and will continue to invest significant amounts of capital toward the modernization of its store base. The Company’s modernization program includes the opening of new stores, the completion of major remodels and expansion of selected existing stores, and the relocation of selected existing stores to larger, more convenient locations. The Company also believes that the new warehouse and distribution facility completed during fiscal 2012 has lowered its overall distribution costs and improved product availability in its stores.  Capital expenditures totaled $137.6 million and $104.1 million for fiscal 2016 and 2015, respectively. Major capital expenditures include the following:   (including those added at new or replacement stores)  Capital expenditures also included upgrading and replacing store equipment, technology investments, capital expenditures related to the Company’s distribution operation and its milk processing plant, and expenditures for stores to open in subsequent fiscal years. In addition to the activity in the table above, during fiscal 2016, the Company significantly expanded two existing stores. Just after the end of the fiscal year, the Company opened a rebuilt store on the same land site as a previously demolished store building. Ingles’ capital expenditure plans for fiscal 2017 include investments of approximately $100 to $140 million. The majority of the Company’s fiscal 2017 capital expenditures will be dedicated to continued improvement of its store base and will include construction of one or more new/remodeled stores. Fiscal 2017 capital expenditures will also include investments in stores expected to open in fiscal 2018 as well as technology improvements, upgrading and replacing existing store equipment and warehouse and transportation equipment and improvements to the Company’s milk processing plant. The Company expects that its net annual capital expenditures will be in the range of approximately $100 to $160 million going forward in order to maintain a modern store base. Planned expenditures for any given future fiscal year will be affected by the availability of financing, which can affect both the number of projects pursued at any given time and the cost of those projects. The number of projects may also fluctuate due to the varying costs of the types of projects pursued including new stores and major remodel/expansions. The Company makes decisions on the allocation of capital expenditure dollars based on many factors including the competitive environment, other Company capital initiatives and its financial condition.  In general, the Company finances its capital expenditures to the extent possible from cash on hand and cash flow from operations. Additional financing sources for capital expenditures include borrowings under the $175 million of committed line of credit, other borrowings that could be collateralized by unencumbered real property and equipment with a net book value of approximately $999 million, and the public debt or equity markets. The Company has used each of these to finance past capital expenditures and expects to have them available in the future. The Company does not generally enter into commitments for capital expenditures other than on a store-by-store basis at the time it begins construction on a new store or begins a major or minor remodeling project. Construction commitments at September 24, 2016 totaled $10.9 million. Liquidity The Company generated $159.0 million of cash from operations in fiscal 2016 compared with $153.5 million for fiscal 2015. Net income was lower in fiscal 2016 compared with fiscal 2015 but non-cash depreciation and deferred taxes were higher, resulting in an increase in net cash from operations. Cash used by investing activities for fiscal 2016 totaled $136.9 million compared with $99.7 million for fiscal 2015. The Company’s most significant investing activity is capital expenditures. Comparing fiscal year 2016 with fiscal year 2015, capital expenditures were higher and proceeds from asset sales were lower.  During fiscal 2016, the Company’s net financing activities of $24.0 million consisted primarily of dividends and debt reduction. During fiscal 2015, the Company’s net financing activities of $54.9 million consisted primarily of dividends and a reduction of total debt.  In June 2013, the Company issued $700.0 million aggregate principal amount of senior notes due in 2023 (the “Notes”). The Notes bear an interest rate of 5.75% per annum and were issued at par.  The Company has a $175.0 million line of credit (the “Line”) that matures in June 2018. The Line provides the Company with various interest rate options based on the prime rate, the Federal Funds Rate, or the London Interbank Offering Rate. The Line allows the Company to issue up to $30.0 million in unused letters of credit, of which $9.4 million of unused letters of credit were issued at September 24, 2016. The Company is not required to maintain compensating balances in connection with the Line. At September 24, 2016, the Company had no borrowing outstanding under the Line.  On December 29, 2010, the Company completed the funding of $99.7 million of Recovery Zone Facility Bonds (the “Bonds”) for construction and equipping of an approximately 830,000 square foot new warehouse and distribution center located in Buncombe County, North Carolina (the “Project”). The final maturity date of the Bonds is January 1, 2036.  Under a Continuing Covenant and Collateral Agency Agreement (the “Covenant Agreement”) between certain financial institutions and the Company, the financial institutions would hold the Bonds until January 2, 2018, subject to certain events. Mandatory redemption of the Bonds by the Company in the annual amount of $4,530,000 began on January 1, 2014. In connection with the offering of the Notes, the Company extended the maturity date of the Covenant Agreement from January 2, 2018 to June 30, 2021 and modified certain interest rate options and covenants. The Company may redeem the Bonds without penalty or premium at any time prior to June 30, 2021.  The Company’s long-term debt agreements generally have cross-default provisions which could result in the acceleration of payments due under the Company’s Line, Bond and Notes indenture in the event of default under any one instrument.  The Notes, the Bonds and the Line contain provisions that under certain circumstances would permit lending institutions to terminate or withdraw their respective extensions of credit to the Company. Included among the triggering factors permitting the termination or withdrawal of the Line to the Company are certain events of default, including both monetary and non-monetary defaults, the initiation of bankruptcy or insolvency proceedings, and the failure of the Company to meet certain financial covenants designated in its respective loan documents. As of September 24, 2016, the Company was in compliance with these covenants by a significant margin. Under the most restrictive of these covenants, the Company would be able to incur approximately $384 million of additional borrowings (including borrowings under the Line) as of September 24, 2016.  The Company’s principal sources of liquidity are expected to be cash flow from operations, borrowings under the Line and long-term financing. The Company believes, based on its current results of operations and financial condition, that its financial resources, including cash balances, the existing Line, short- and long-term financing expected to be available to it and internally generated funds, will be sufficient to meet planned capital expenditures and working capital requirements for the foreseeable future, including any debt service requirements of additional borrowings. However, there can be no assurance that any such sources of financing will be available to the Company on acceptable terms, or at all. It is possible that, in the future, the Company’s results of operations and financial condition will be different from that described in this report based on a number of intangible factors. These factors may include, among others, increased competition, changing regional and national economic conditions, adverse climatic conditions affecting food production and delivery and changing demographics as well as the additional factors discussed above and elsewhere under “Item 1A. Risk Factors.” It is also possible, for such reasons, that the results of operations from the new, expanded, remodeled and/or replacement stores will not meet or exceed the results of operations from existing stores that are described in this report. Contractual Obligations and Commercial Commitments The Company has assumed various financial obligations and commitments in the normal course of its operations and financing activities. Financial obligations are considered to represent known future cash payments that the Company is required to make under existing contractual arrangements, such as debt and lease arrangements. The following table represents the scheduled maturities of the Company’s long-term contractual obligations as of September 24, 2016:  Payment Due by Period   (1) Scheduled interest on floating rate debt calculated using rates in effect on September 24, 2016.  Amounts available to the Company under commercial commitments as of September 24, 2016, were as follows: Amount of Commitment Expiration per Period  Off Balance Sheet Arrangements The Company is not a party to any off-balance sheet arrangements that have, or are reasonably likely to have, a current or future material effect on the Company’s financial condition, revenues, expenses, results of operations, liquidity, capital expenditures or capital resources. Quarterly Cash Dividends Since December 27, 1993, the Company has paid regular quarterly cash dividends of $0.165 per share on its Class A Common Stock and $0.15 per share on its Class B Common Stock for an annual rate of $0.66 and $0.60 per share, respectively.  The Company expects to continue paying regular cash dividends on a quarterly basis. However, the Board of Directors periodically reconsiders the declaration of dividends. The Company pays these dividends at the discretion of the Board of Directors and the continuation of these payments, the amount of such dividends, and the form in which the dividends are paid (cash or stock) depends upon the results of operations, the financial condition of the Company and other factors which the Board of Directors deems relevant.  Long-term debt and line of credit agreements contain various restrictive covenants requiring, among other things, minimum levels of net worth and maintenance of certain financial ratios. These covenants have the effect of restricting certain types of transactions, including the payment of cash dividends generally and in excess of current quarterly per share amounts. Further, the Company is prevented from declaring dividends at any time that it is in default under the indenture governing the Notes. Impact of Inflation The following table from the United States Bureau of Labor Statistics lists annualized changes in the Consumer Price Index that could have an effect on the Company’s operations. One of the Company’s significant costs is labor, which increases with general inflation. Inflation or deflation in energy costs affects both the Company’s gasoline sales and distribution expenses.   New Accounting Pronouncements For new accounting pronouncements, see Note 1 to the Consolidated Financial Statements included in this Annual Report on Form 10-K.  Outlook and Trends in the Company’s Markets  The Company has improved the interior layout and product offerings in a significant number of stores over the past three fiscal years. Economic conditions have improved to the point that the Company has accelerated the increase and improvement of its total retail square footage.  The Company continually assesses and modifies its business model to meet the changing needs and expectations of its customers. In connection with this review, the Company assesses the trends present in the markets in which it competes. Generally, it is difficult to predict whether a trend will continue for a period of time and it is possible that new trends will develop which will affect an existing trend. The Company believes that the following trends are likely to continue for at least the next fiscal year:  · The supermarket industry will remain highly competitive and will be characterized by industry consolidation, fragmented food retail platforms, and continued competition from super centers and other non-supermarket operators.  · Economic conditions will continue to affect customer behavior. Economic conditions may affect purchasing patterns with regard to meal replacement items, private label purchases, promotions and product variety.  · The Company and its customers will continue to become more environmentally aware, evidenced by the Company’s increased recycled waste paper and pallets and customers’ increased usage of reusable shopping bags.  · Volatile petroleum costs will impact utility and distribution costs, plastic supplies cost and may change customer shopping and dining behavior.  · Retail gasoline costs and retail prices will continue to be volatile, affecting the Company’s gasoline sales and gross margin.  The Company plans to continue to focus on balancing sales growth and gross margin maintenance (excluding the effect of gasoline sales), and will carefully monitor its product mix and customer trends. 

<s>[INST] Ingles, a leading supermarket chain in the Southeast United States, operates 201 supermarkets in Georgia (71), North Carolina (70), South Carolina (36), Tennessee (21), Virginia (2) and Alabama (1). The Company locates its supermarkets primarily in suburban areas, small towns and rural communities. Ingles supermarkets offer customers a wide variety of nationally advertised food products, including grocery, meat and dairy products, produce, frozen foods and other perishables and nonfood products. Nonfood products include fuel centers, pharmacies, health and beauty care products and general merchandise. The Company offers quality private label items in most of its departments. In addition, the Company focuses on selling highgrowth, highmargin products to its customers through the development of certified organic products, bakery departments and prepared foods including delicatessen sections. As of September 24, 2016, the Company operated 99 instore pharmacies and 93 fuel centers. Ingles also operates a fluid dairy and earns shopping center rentals. The fluid dairy sells approximately 25% of its products to the retail grocery segment and approximately 75% of its products to third parties. Real estate ownership is an important component of the Company’s operations, providing both operational and economic benefit.  Critical Accounting Policies Critical accounting policies are those accounting policies that management believes are important to the portrayal of Ingles’ financial condition and results of operations, and require management’s most difficult, subjective or complex judgments, often as a result of the need to make estimates about the effect of matters that are inherently uncertain. Estimates are based on historical experience and other factors believed to be reasonable under the circumstances, the results of which form the basis for making judgments about the carrying values of assets and liabilities that are not readily apparent from other sources. Management estimates, by their nature, involve judgments regarding future uncertainties, and actual results may therefore differ materially from these estimates. SelfInsurance The Company is selfinsured for workers’ compensation, general liability, and group medical and dental benefits. Risks and uncertainties are associated with selfinsurance; however, the Company has limited its exposure by maintaining excess liability coverage of $750,000 per occurrence for workers’ compensation, $500,000 for general liability, and $325,000 per covered person for medical care benefits for a policy year. Selfinsurance liabilities are established based on claims filed and estimates of claims incurred but not reported. The estimates are based on data provided by the respective claims administrators which is then applied to appropriate actuarial methods. These estimates can fluctuate if historical trends are not predictive of the future. The majority of the Company’s properties are selfinsured for casualty losses and business interruption; however, liability coverage is maintained. The Company’s selfinsurance reserves totaled $35.9 million and $36.3 million for employee group insurance, workers’ compensation insurance and general liability insurance at September 24, 2016 and September 26, 2015, respectively. These amounts are inclusive of expected recoveries from excess cost insurance or other sources that are recorded as receivables of $4.8 million and $4.9 million at September 24, 2016 and September 26, 2015, respectively.  Asset Impairments The Company accounts for the impairment of longlived assets in accordance with Financial Accounting Standards Board Accounting Standards Codification (“FASB ASC”) Topic 360. Asset groups are primarily comprised of our individual store and shopping center properties. For assets to be held and used, the Company tests for impairment using undiscounted cash flows and calculates the amount of impairment using discounted cash flows. For assets held for sale, impairment is recognized based on the excess of remaining book value over expected recovery value. The recovery value is the fair value as determined by independent quotes or expected sales prices developed by internal associates, net of costs to sell. Estimates of future cash flows and expected sales prices are judgments based upon the Company’s experience and knowledge of local operations and cash flows that are [/INST] Positive. </s>

INGLES MARKETS INC

2017-12-06

2017-09-30

Item 7. MANAGEMENT’S DISCUSSION AND ANALYSIS OF FINANCIAL CONDITION AND RESULTS OF OPERATIONS Overview Ingles, a leading supermarket chain in the Southeast United States, operates 199 supermarkets in Georgia (70), North Carolina (70), South Carolina (36), Tennessee (21), Virginia (1) and Alabama (1). The Company locates its supermarkets primarily in suburban areas, small towns and rural communities. Ingles supermarkets offer customers a wide variety of nationally advertised food products, including grocery, meat and dairy products, produce, frozen foods and other perishables and non-food products. Non-food products include fuel centers, pharmacies, health and beauty care products and general merchandise. The Company offers quality private label items in most of its departments. In addition, the Company focuses on selling high-growth, high-margin products to its customers through the development of certified organic products, bakery departments and prepared foods including delicatessen sections. As of September 30, 2017, the Company operated 103 in-store pharmacies and 97 fuel centers. Ingles also operates a fluid dairy and earns shopping center rentals. The fluid dairy sells approximately 26% of its products to the retail grocery segment and approximately 74% of its products to third parties. Real estate ownership is an important component of the Company’s operations, providing both operational and economic benefit.  Critical Accounting Policies Critical accounting policies are those accounting policies that management believes are important to the portrayal of Ingles’ financial condition and results of operations, and require management’s most difficult, subjective or complex judgments, often as a result of the need to make estimates about the effect of matters that are inherently uncertain. Estimates are based on historical experience and other factors believed to be reasonable under the circumstances, the results of which form the basis for making judgments about the carrying values of assets and liabilities that are not readily apparent from other sources. Management estimates, by their nature, involve judgments regarding future uncertainties, and actual results may therefore differ materially from these estimates. Self-Insurance The Company is self-insured for workers’ compensation, general liability, and group medical and dental benefits. Risks and uncertainties are associated with self-insurance; however, the Company has limited its exposure by maintaining excess liability coverage of $750,000 per occurrence for workers’ compensation, $500,000 for general liability, and $450,000 per covered person for medical care benefits for a policy year. Self-insurance liabilities are established based on claims filed and estimates of claims incurred but not reported. The estimates are based on data provided by the respective claims administrators which is then applied to appropriate actuarial methods. These estimates can fluctuate if historical trends are not predictive of the future. The majority of the Company’s properties are self-insured for casualty losses and business interruption; however, liability coverage is maintained. The Company’s self-insurance reserves totaled $35.5 million and $35.9 million for employee group insurance, workers’ compensation insurance and general liability insurance at September 30, 2017 and September 24, 2016, respectively. These amounts are inclusive of expected recoveries from excess cost insurance or other sources that are recorded as receivables of $4.8 million both at September 30, 2017 and September 24, 2016.  Asset Impairments The Company accounts for the impairment of long-lived assets in accordance with Financial Accounting Standards Board Accounting Standards Codification (“FASB ASC”) Topic 360. Asset groups are primarily comprised of our individual store and shopping center properties. For assets to be held and used, the Company tests for impairment using undiscounted cash flows and calculates the amount of impairment using discounted cash flows. For assets held for sale, impairment is recognized based on the excess of remaining book value over expected recovery value. The recovery value is the fair value as determined by independent quotes or expected sales prices developed by internal associates, net of costs to sell. Estimates of future cash flows and expected sales prices are judgments based upon the Company’s experience and knowledge of local operations and cash flows that are projected for several years into the future. These estimates can fluctuate significantly due to changes in real estate market conditions, the economic environment, capital spending decisions and inflation. The Company monitors the carrying value of long-lived assets for potential impairment each quarter based on whether any indicators of impairment have occurred. Vendor Allowances The Company receives funds for a variety of merchandising activities from the many vendors whose products the Company buys for resale in its stores. These incentives and allowances are primarily comprised of volume or purchase based incentives, advertising allowances, slotting fees, and promotional discounts. The purpose of these incentives and allowances is generally to help defray the costs incurred by the Company for stocking, advertising, promoting and selling the vendor’s products. These allowances generally relate to short term arrangements with vendors, often relating to a period of a month or less, and are negotiated on a purchase-by-purchase or transaction-by-transaction basis. Whenever possible, vendor discounts and allowances that relate to buying and merchandising activities are recorded as a reduction of item cost in inventory and recognized in merchandise costs when the item is sold. Due to system constraints and the nature of certain allowances, it is sometimes not practicable to apply allowances to the item cost of inventory. In those instances, the allowances are applied as a reduction of merchandise costs using a rational and systematic methodology, which results in the recognition of these incentives when the inventory related to the vendor consideration received is sold. Vendor allowances applied as a reduction of merchandise costs totaled $116.6 million, $115.8 million and $115.8 million for the fiscal years ended September 30, 2017, September 24, 2016 and September 26, 2015, respectively. Vendor advertising allowances that represent a reimbursement of specific identifiable incremental costs of advertising the vendor’s specific products are recorded as a reduction to the related expense in the period that the related expense is incurred. Vendor advertising allowances recorded as a reduction of advertising expense totaled $13.8 million, $13.5 million, and $14.3 million for the fiscal years ended September 30, 2017, September 24, 2016 and September 26, 2015, respectively.  If vendor advertising allowances were substantially reduced or eliminated, the Company would likely consider other methods of advertising as well as the volume and frequency of the Company’s product advertising, which could increase or decrease the Company’s expenditures.  Similarly, the Company is not able to assess the impact of vendor advertising allowances on creating additional revenue, as such allowances do not directly generate revenue for the Company’s stores.  Results of Operations Ingles operates on a 52- or 53-week fiscal year ending on the last Saturday in September. The consolidated statements of income for the fiscal year ended September 30, 2017 consisted of 53 weeks of operations. The consolidated statements of income for the fiscal years ended, September 24, 2016 and September 26, 2015, each consisted of 52 weeks of operations.  Comparable store sales are defined as sales by grocery stores in operation for five full fiscal quarters. The Company has an ongoing renovation and expansion plan to modernize the appearance and layout of its existing stores. Sales from replacement stores, major remodels and the addition of fuel stations to existing stores are included in the comparable store sales calculation from the date of completion of the replacement, remodel or addition. A replacement store is a new store that is opened to replace an existing nearby store that is closed. A major remodel entails substantial remodeling of an existing store and may include additional retail square footage. For the fiscal years ended September 30, 2017 and September 24, 2016 comparable store sales include 197 and 199 stores, respectively. Weighted average retail square footage added to comparable stores due to replacement and remodeled stores was approximately 36,000 for the fiscal year ended September 30, 2017 and insignificant for the fiscal year ended September 24, 2016.  The following table sets forth, for the periods indicated, selected financial information as a percentage of net sales.    Fiscal Year Ended September 30, 2017 Compared to the Fiscal Year Ended September 24, 2016 Net income for the fiscal year ended September 30, 2017 was $53.9 million, compared with net income of $54.2 million for the fiscal year ended September 24, 2016. Comparisons of fiscal year 2017 to fiscal year 2016 are affected by the difference in the number of weeks in each year. Fiscal year 2017 contained 53 weeks while fiscal year 2016 consisted of 52 weeks. Fiscal year 2017 sales increased even after consideration of the additional week, but non-gasoline gross margin decreased slightly.  Labor continued to tighten in the Company’s market area in fiscal 2017, which contributed to increased operating expenses in total and as a percent of sales. During fiscal 2017 the Company’s capital expenditures for expansion and modernization of its store base continued to be higher than most of the previous few years, a trend that was begun in fiscal year 2016. This expansion also has an impact on ongoing operating costs for labor and equipment service. Net Sales. Net sales for the fiscal year ended September 30, 2017 totaled $4.00 billion, compared with $3.79 billion for the fiscal year ended September 24, 2016. In fiscal years with 53 weeks, such as fiscal 2017, management analyzes comparable store sales for the 53 weeks of the year with the corresponding 53 calendar weeks of the previous year. On this basis, retail comparable sales excluding gasoline increased 1.5% during fiscal 2017 compared with 2016 on a 53-week basis. The number of transactions (excluding gasoline) increased 0.8% while the average transaction size (excluding gasoline) increased by 1.1%. Comparing fiscal 2017 with 2016 on a 53-week basis, gasoline gallons increased 4.5% and per gallon gasoline prices increased 11.6%.  Sales by product category for the fiscal years ended September 30, 2017 and September 24, 2016, respectively, were as follows:    The grocery category includes grocery, dairy and frozen foods. The non-foods category includes alcoholic beverages, tobacco, pharmacy, health and video. The perishables category includes meat, produce, deli and bakery.  Changes in retail grocery sales for the fiscal year ended September 30, 2017 are summarized as follows (in thousands):   In addition to capital improvements to the store base, increased fiscal 2017 sales resulted from the introduction of new products, product presentation within the stores, effective promotions and cost competitiveness. The Ingles Advantage Savings and Rewards Card (the “Ingles Advantage Card”) also contributes to the increase in net sales and comparable store sales. Information obtained from holders of the Ingles Advantage Card assists the Company in optimizing product offerings and promotions specific to customer shopping patterns. The Company expects non-gasoline sales will be higher in the 2018 fiscal year compared with fiscal 2017. The Company anticipates adding one or more new stores in fiscal 2018 and expects to benefit from recent interior improvements to a number of existing stores, and the addition of fuel centers. Fiscal 2018 sales growth will also be influenced by market fluctuations in the per gallon price of gasoline and milk, changes in commodity food prices, general economic conditions and changing customer preferences for purchasing items sold by the Company.  Gross Profit. Gross profit for the fiscal year ended September 30, 2017 increased $39.2 million, or 4.2%, to $963.6 million compared with $924.4 million for the fiscal year ended September 24, 2016. As a percentage of sales, gross profit totaled 24.1% for the fiscal year ended September 30, 2017 and 24.4% for the fiscal year ended September 24, 2016.  The increase in grocery segment gross profit dollars was primarily due to the higher sales volume and the impact of the 53rd week in fiscal 2017. Grocery segment gross profit as a percentage of total sales (excluding gasoline) decreased 8 basis points in fiscal 2017 compared with fiscal 2016. The gross margin decrease was primarily due to competitive factors, which offset a favorable change in the mix of products sold. In addition to the direct product cost, the cost of goods sold line item for the grocery segment includes inbound freight charges and the costs related to the Company’s distribution network. Operating and Administrative Expenses. Operating and administrative expenses increased $42.5 million, or 5.4%, to $837.1 million for the fiscal year ended September 30, 2017, from $794.6 million for the fiscal year ended September 24, 2016. As a percentage of sales, operating and administrative expenses were 20.9% for both fiscal years 2017 and 2016. Excluding gasoline, which does not have significant direct operating expenses, the ratio of operating expenses to sales was 23.8% for fiscal 2017 compared with 23.5% for fiscal 2016. A breakdown of the major increases in operating and administrative expenses is as follows:    Salaries and wages increased due to the addition of labor hours required for the increased sales volume and changes to the sales mix. In general the labor market in the Company’s market area has become more competitive.  Depreciation and amortization increased as a result of the Company’s capital expenditures programs, including smaller remodeling projects that contain capital assets with shorter useful lives-compared with real restate.  Repair and maintenance expenses increased due to increases in the amount and complexity of equipment in the Company’s stores to support new products offered, increase energy efficiency and to improve the customer shopping experience.  Bank charges have increased as more sales transactions are being settled with debit and credit cards, and the per transaction card costs have increased.  Taxes and licenses increased due to increases in the value of the Company’s real estate and for additional fees paid to municipalities to conduct business and offer certain products.  Loss or gain from Sale or Disposal of Assets. Gains from sale or disposal of assets totaled $1.5 million for fiscal 2017 compared with losses of $1.2 million for fiscal 2016. There were no individually significant gains during fiscal 2017. During fiscal 2016, the Company demolished certain buildings for redevelopment into larger and improved store or tenant space. None of these transactions were individually significant. Other Income, Net. Other income, net totaled $3.8 million and $2.4 million for the fiscal years ended September 30, 2017 and September 24, 2016, respectively. Other income consists primarily of sales of waste paper and packaging. Interest Expense. Interest expense increased $1.1 million for the fiscal year ended September 30, 2017 to $47.4 million from $46.3 million for the fiscal year ended September 24, 2016. Total debt was $877.9 million at the end of fiscal 2017 compared with $876.5 million at the end of fiscal 2016. Market interest rates increased during fiscal 2017, which affected interest expense on the Company’s floating rate debt. During the latter part of fiscal 2017, the Company renegotiated or refinanced some of its debt at lower base rates and more favorable terms.  Income Taxes. Income tax expense as a percentage of pre-tax income was 36.1% for the 2017 fiscal year compared with 36.0% for the 2016 fiscal year. There were no significant changes in major components of tax expense between fiscal years 2017 and 2016. Cash income taxes paid by the Company increased in fiscal 2017 compared with fiscal 2016 due to the reversal of taxes deferred in prior years. Net Income. Net income totaled $53.9 million for the fiscal year ended September 30, 2017 compared with net income of $54.2 million for the fiscal year ended September 24, 2016. Basic and diluted earnings per share for Class A Common Stock were $2.74 and $2.66, respectively, for the fiscal year ended September 30, 2017 compared with $2.75 and $2.68, respectively, for the fiscal year ended September 24, 2016. Basic and diluted earnings per share for Class B Common Stock were each $2.49 for the fiscal year ended September 30, 2017 compared with $2.50 of basic and diluted earnings per share for the fiscal year ended September 24, 2016.  Fiscal Year Ended September 24, 2016 Compared to the Fiscal Year Ended September 26, 2015 Net income for the fiscal year ended September 24, 2016 was $54.2 million, a decrease of 8.7% over net income of $59.4 million for the fiscal year ended September 26, 2015. Increased sales and gross profit were offset by larger increases in operating expenses. Personnel expenses increased due to a tightening labor market and expanded product offerings that carried a comparatively larger labor cost component. Expansion and modernization of the Company’s store base accelerated in 2016, which also impacted labor and equipment costs. Net Sales. Net sales for the fiscal year ended September 24, 2016 totaled $3.79 billion, compared with $3.78 billion for the fiscal year ended September 26, 2015. Comparable store sales excluding gasoline increased 2.0%. The number of customer transactions (excluding gasoline) increased 1.5%, while the average transaction size (excluding gasoline) increased 1.1%. Comparing fiscal 2016 with fiscal 2015, gasoline gallons sold increased, per gallon prices were down 13% and gasoline gross profit was slightly lower.  Sales by product category for the fiscal years ended September 24, 2016 and September 26, 2015, respectively, were as follows:    The grocery category includes grocery, dairy and frozen foods. The non-foods category includes alcoholic beverages, tobacco, pharmacy, health and video. The perishables category includes meat, produce, deli and bakery.  Changes in retail grocery sales for the fiscal year ended September 24, 2016 are summarized as follows (in thousands):   During fiscal 2016 and 2015, the Company devoted the majority of its grocery segment capital expenditures to improvements in the configuration and appearance of a number of its stores. These improvements along with effective promotions and cost competitiveness drove increased sales in fiscal 2016. The Ingles Advantage Savings and Rewards Card (the “Ingles Advantage Card”) also contributes to the increase in net sales and comparable store sales. Information obtained from holders of the Ingles Advantage Card assists the Company in optimizing product offerings and promotions specific to customer shopping patterns. The Company expects non-gasoline sales will be higher in the 2017 fiscal year compared with fiscal 2016. The Company anticipates adding one or more new stores in fiscal 2017 and expects to benefit from recent interior improvements to a number of existing stores. Fiscal 2017 sales growth will also be influenced by market fluctuations in the per gallon price of gasoline and milk, changes in commodity food prices and general economic conditions.  Gross Profit. Gross profit for the year ended September 24, 2016 increased $31.1 million, or 3.5%, to $924.4 million compared with $893.3 million for the year ended September 26, 2015. As a percentage of sales, gross profit totaled 24.4% for the year ended September 24, 2016 and 23.6% for the year ended September 26, 2015.  The increase in grocery segment gross profit dollars was primarily due to the higher sales volume. Grocery segment gross profit as a percentage of total sales (excluding gasoline) increased 16 basis points in fiscal 2016 compared with fiscal 2015. The gross margin increase was broad based across most products, except for gasoline. The mix of grocery sales in favor of higher margin products also has a positive impact on gross profit and gross margin. In addition to the direct product cost, the cost of goods sold line item for the grocery segment includes inbound freight charges and the costs related to the Company’s distribution network. Operating and Administrative Expenses. Operating and administrative expenses increased $38.3 million, or 5.1%, to $794.6 million for the year ended September 24, 2016, from $756.3 million for the year ended September 26, 2015. As a percentage of sales, operating and administrative expenses were 21.0% for the fiscal year ended September 24, 2016 and 20.0% for the fiscal year ended September 26, 2015. Excluding gasoline, which does not have significant direct operating expenses, the ratio of operating expenses to sales was 23.5% for fiscal 2016 compared with 22.9% for fiscal 2015. A breakdown of the major increases in operating and administrative expenses is as follows:    Salaries and wages increased due to the addition of labor hours required for the increased sales volume and changes to the sales mix. In general the labor market in the Company’s market area has become more competitive.  Repair and maintenance expenses increased due to increases in the amount and complexity of equipment in the Company’s stores to support new products offered, increase energy efficiency and to improve the customer shopping experience.  Bank charges have increased as more sales transactions are being settled with debit and credit cards, and the per transaction card costs have increased.  Depreciation and amortization increased as a result of the Company’s capital expenditures programs, including smaller remodeling projects that contain capital assets with shorter useful lives-compared with real restate.  Taxes and licenses increased due to increases in the value of the Company’s real estate and for additional fees paid to municipalities to conduct business and offer certain products.  Loss or gain from Sale or Disposal of Assets. Loss from sale or disposal of assets totaled $1.2 million for fiscal 2016 compared with gains of $2.2 million for fiscal 2015. During fiscal 2016, the Company demolished certain buildings for redevelopment into larger and improved store or tenant space. During fiscal 2015, the Company sold outparcels and wrote off buildings demolished in advance of rebuilding new store buildings in a future period. None of these transactions were individually significant. Other Income, Net. Other income, net totaled $2.4 million and $2.3 million for the fiscal years ended September 24, 2016 and September 26, 2015, respectively. Other income consists primarily of sales of waste paper and packaging. Interest Expense. Interest expense decreased $0.7 million for the year ended September 24, 2016 to $46.3 million from $47.0 million for the year ended September 26, 2015. Total debt was $876.5 million at the end of fiscal 2016 compared with $886.1 million at the end of fiscal 2015.  Income Taxes. Income tax expense as a percentage of pre-tax income was 36.0% for the 2016 fiscal year compared with 37.2% for the 2015 fiscal year. The decrease in the effective tax rate is primarily attributable to certain fiscal year 2015 discrete items which are not expected to recur in future periods. Net Income. Net income totaled $54.2 million for the fiscal year ended September 24, 2016 compared with net income of $59.4 million for the fiscal year ended September 26, 2015. Basic and diluted earnings per share for Class A Common Stock were $2.75 and $2.68, respectively, for the fiscal year ended September 24, 2016 compared with $3.02 and $2.93, respectively, for the fiscal year ended September 26, 2015. Basic and diluted earnings per share for Class B Common Stock were each $2.50 for the fiscal year ended September 24, 2016 compared with $2.74 of basic and diluted earnings per share for the fiscal year ended September 26, 2015. Liquidity and Capital Resources  The Company believes that a key to its ability to continue to increase sales and develop a loyal customer base is providing conveniently located, clean and modern stores which provide customers with good service and an increasingly diverse selection of competitively priced products. As such, the Company has invested and will continue to invest significant amounts of capital toward the modernization of its store base. The Company’s modernization program includes the opening of new stores, the completion of major remodels and expansion of selected existing stores, and the relocation of selected existing stores to larger, more convenient locations. The Company also believes that the warehouse and distribution facility completed during fiscal 2012 has lowered its overall distribution costs and improved product availability in its stores.  Capital expenditures totaled $127.7 million and $137.6 million for fiscal 2017 and 2016, respectively. Major capital expenditures include the following:    (including those added at new or replacement stores)  Capital expenditures also included upgrading and replacing store equipment, technology investments, capital expenditures related to the Company’s distribution operation and its milk processing plant, and expenditures for stores to open in subsequent fiscal years. Ingles’ capital expenditure plans for fiscal 2018 include investments of approximately $100 to $140 million. The majority of the Company’s fiscal 2018 capital expenditures will be dedicated to continued improvement of its store base and will include construction of one or more new/remodeled stores. Fiscal 2018 capital expenditures will also include investments in stores expected to open in fiscal 2019 as well as technology improvements, upgrading and replacing existing store equipment and warehouse and transportation equipment and improvements to the Company’s milk processing plant. The Company expects that its net annual capital expenditures will be in the range of approximately $100 to $160 million going forward in order to maintain a modern store base. Planned expenditures for any given future fiscal year will be affected by the availability of financing, which can affect both the number of projects pursued at any given time and the cost of those projects. The number of projects may also fluctuate due to the varying costs of the types of projects pursued including new stores and major remodel/expansions. The Company makes decisions on the allocation of capital expenditure dollars based on many factors including the competitive environment, other Company capital initiatives and its financial condition.  In general, the Company finances its capital expenditures to the extent possible from cash on hand and cash flow from operations. Additional financing sources for capital expenditures include borrowings under the $175 million of committed line of credit, other borrowings that could be collateralized by unencumbered real property and equipment with a net book value of approximately $1.04 billion, and the public debt or equity markets. The Company has used each of these to finance past capital expenditures and expects to have them available in the future. The Company does not generally enter into commitments for capital expenditures other than on a store-by-store basis at the time it begins construction on a new store or begins a major or minor remodeling project. Construction commitments at September 30, 2017 totaled $12.2 million. Liquidity The Company generated $156.3 million of cash from operations in fiscal 2017 compared with $159.0 million for fiscal 2016. The primary reasons for the slight decrease were changes in net working capital. Cash used by investing activities for fiscal 2017 totaled $125.4 million compared with $136.9 million for fiscal 2016. The Company’s most significant investing activity is capital expenditures. Comparing fiscal year 2017 with fiscal year 2016, capital expenditures were lower and proceeds from asset sales were higher.  During fiscal 2017, the Company’s net financing activities of $12.7 million consisted primarily of dividends. During fiscal 2016, the Company’s net financing activities of $24.0 million consisted primarily of dividends and debt reduction.  In June 2013, the Company issued $700.0 million aggregate principal amount of senior notes due in 2023 (the “Notes”). The Notes bear an interest rate of 5.75% per annum and were issued at par.  The Company has a $175.0 million line of credit (the “Line”) that matures in September 2022. During fiscal 2017, the Line was renewed and the maturity date extended from June 2018 to September 2022. The Line provides the Company with various interest rate options based on the prime rate, the Federal Funds Rate, or the London Interbank Offering Rate. The Line allows the Company to issue up to $20.0 million in unused letters of credit, of which $9.5 million of unused letters of credit were issued at September 30, 2017. The Company is not required to maintain compensating balances in connection with the Line. At September 30, 2017, the Company had no borrowing outstanding under the Line.  On December 29, 2010, the Company completed the funding of $99.7 million of Recovery Zone Facility Bonds (the “Bonds”) for construction and equipping of an approximately 830,000 square foot new warehouse and distribution center located in Buncombe County, North Carolina (the “Project”). The final maturity date of the Bonds is January 1, 2036.  Under a Continuing Covenant and Collateral Agency Agreement (the “Covenant Agreement”) between certain financial institutions and the Company, the financial institutions would hold the Bonds until June 2021, subject to certain events. Mandatory redemption of the Bonds by the Company in the annual amount of $4,530,000 began on January 1, 2014. The Company may redeem the Bonds without penalty or premium at any time prior to June 30, 2021.  During fiscal 2017, the Company refinanced approximately $60 million secured borrowing obligations that were scheduled to mature in fiscal years 2018-2020 with obligations maturing in fiscal 2027.  The Company’s long-term debt agreements generally have cross-default provisions which could result in the acceleration of payments due under the Company’s Line, Bond and Notes indenture in the event of default under any one instrument.  The Notes, the Bonds and the Line contain provisions that under certain circumstances would permit lending institutions to terminate or withdraw their respective extensions of credit to the Company. Included among the triggering factors permitting the termination or withdrawal of the Line to the Company are certain events of default, including both monetary and non-monetary defaults, the initiation of bankruptcy or insolvency proceedings, and the failure of the Company to meet certain financial covenants designated in its respective loan documents. As of September 30, 2017, the Company was in compliance with these covenants by a significant margin. Under the most restrictive of these covenants, the Company would be able to incur approximately $426 million of additional borrowings (including borrowings under the Line) as of September 30, 2017.  The Company’s principal sources of liquidity are expected to be cash flow from operations, borrowings under the Line and long-term financing. The Company believes, based on its current results of operations and financial condition, that its financial resources, including cash balances, the existing Line, short- and long-term financing expected to be available to it and internally generated funds, will be sufficient to meet planned capital expenditures and working capital requirements for the foreseeable future, including any debt service requirements of additional borrowings. However, there can be no assurance that any such sources of financing will be available to the Company on acceptable terms, or at all. It is possible that, in the future, the Company’s results of operations and financial condition will be different from that described in this report based on a number of intangible factors. These factors may include, among others, increased competition, changing regional and national economic conditions, adverse climatic conditions affecting food production and delivery and changing demographics as well as the additional factors discussed above and elsewhere under “Item 1A. Risk Factors.” It is also possible, for such reasons, that the results of operations from the new, expanded, remodeled and/or replacement stores will not meet or exceed the results of operations from existing stores that are described in this report. Contractual Obligations and Commercial Commitments The Company has assumed various financial obligations and commitments in the normal course of its operations and financing activities. Financial obligations are considered to represent known future cash payments that the Company is required to make under existing contractual arrangements, such as debt and lease arrangements. The following table represents the scheduled maturities of the Company’s long-term contractual obligations as of September 30, 2017:  Payment Due by Period   (1) Scheduled interest on floating rate debt calculated using rates in effect on September 30, 2017.  The Company has entered supply contracts to provide approximately 70% of the fuel sold in its fuel centers. Pricing is based on certain market indices at the time of purchase. The suppliers can modify or terminate the contracts if the Company does not meet certain minimum monthly purchase requirements.  Amounts available to the Company under commercial commitments as of September 30, 2017, were as follows: Amount of Commitment Expiration per Period   Off Balance Sheet Arrangements The Company is not a party to any off-balance sheet arrangements that have, or are reasonably likely to have, a current or future material effect on the Company’s financial condition, revenues, expenses, results of operations, liquidity, capital expenditures or capital resources. Quarterly Cash Dividends Since December 27, 1993, the Company has paid regular quarterly cash dividends of $0.165 per share on its Class A Common Stock and $0.15 per share on its Class B Common Stock for an annual rate of $0.66 and $0.60 per share, respectively.  The Company expects to continue paying regular cash dividends on a quarterly basis. However, the Board of Directors periodically reconsiders the declaration of dividends. The Company pays these dividends at the discretion of the Board of Directors and the continuation of these payments, the amount of such dividends, and the form in which the dividends are paid (cash or stock) depends upon the results of operations, the financial condition of the Company and other factors which the Board of Directors deems relevant.  Long-term debt and line of credit agreements contain various restrictive covenants requiring, among other things, minimum levels of net worth and maintenance of certain financial ratios. These covenants have the effect of restricting certain types of transactions, including the payment of cash dividends generally and in excess of current quarterly per share amounts. Further, the Company is prevented from declaring dividends at any time that it is in default under the indenture governing the Notes. Impact of Inflation The following table from the United States Bureau of Labor Statistics lists annualized changes in the Consumer Price Index that could have an effect on the Company’s operations. One of the Company’s significant costs is labor, which increases with general inflation. Inflation or deflation in energy costs affects both the Company’s gasoline sales and distribution expenses.    New Accounting Pronouncements For new accounting pronouncements, see Note 1 to the Consolidated Financial Statements included in this Annual Report on Form 10-K.  Outlook and Trends in the Company’s Markets  The Company has improved the interior layout and product offerings in a significant number of stores over the past three fiscal years. Economic conditions have improved to the point that the Company has accelerated the increase and improvement of its total retail square footage.  The Company continually assesses and modifies its business model to meet the changing needs and expectations of its customers. In connection with this review, the Company assesses the trends present in the markets in which it competes. Generally, it is difficult to predict whether a trend will continue for a period of time and it is possible that new trends will develop which will affect an existing trend. The Company believes that the following trends are likely to continue for at least the next fiscal year:  · The supermarket industry will remain highly competitive and will be characterized by industry consolidation, fragmented food retail platforms, and continued competition from super centers and other non-supermarket operators.  · Traditional supermarket products will be acquired by customers in new and diverse ways, including online ordering, home delivery and pre-picked for customer pickup.  · Economic conditions will continue to affect customer behavior. Economic conditions may affect purchasing patterns with regard to meal replacement items, private label purchases, promotions and product variety.  · The Company and its customers will continue to become more environmentally aware, evidenced by the Company’s increased recycled waste paper and pallets and customers’ increased usage of reusable shopping bags.  · Volatile petroleum costs will impact utility and distribution costs, plastic supplies cost and may change customer shopping and dining behavior.  · Retail gasoline costs and retail prices will continue to be volatile, affecting the Company’s gasoline sales and gross margin.  The Company plans to continue to focus on balancing sales growth and gross margin maintenance (excluding the effect of gasoline sales), and will carefully monitor its product mix and customer trends. 

<s>[INST] Ingles, a leading supermarket chain in the Southeast United States, operates 199 supermarkets in Georgia (70), North Carolina (70), South Carolina (36), Tennessee (21), Virginia (1) and Alabama (1). The Company locates its supermarkets primarily in suburban areas, small towns and rural communities. Ingles supermarkets offer customers a wide variety of nationally advertised food products, including grocery, meat and dairy products, produce, frozen foods and other perishables and nonfood products. Nonfood products include fuel centers, pharmacies, health and beauty care products and general merchandise. The Company offers quality private label items in most of its departments. In addition, the Company focuses on selling highgrowth, highmargin products to its customers through the development of certified organic products, bakery departments and prepared foods including delicatessen sections. As of September 30, 2017, the Company operated 103 instore pharmacies and 97 fuel centers. Ingles also operates a fluid dairy and earns shopping center rentals. The fluid dairy sells approximately 26% of its products to the retail grocery segment and approximately 74% of its products to third parties. Real estate ownership is an important component of the Company’s operations, providing both operational and economic benefit.  Critical Accounting Policies Critical accounting policies are those accounting policies that management believes are important to the portrayal of Ingles’ financial condition and results of operations, and require management’s most difficult, subjective or complex judgments, often as a result of the need to make estimates about the effect of matters that are inherently uncertain. Estimates are based on historical experience and other factors believed to be reasonable under the circumstances, the results of which form the basis for making judgments about the carrying values of assets and liabilities that are not readily apparent from other sources. Management estimates, by their nature, involve judgments regarding future uncertainties, and actual results may therefore differ materially from these estimates. SelfInsurance The Company is selfinsured for workers’ compensation, general liability, and group medical and dental benefits. Risks and uncertainties are associated with selfinsurance; however, the Company has limited its exposure by maintaining excess liability coverage of $750,000 per occurrence for workers’ compensation, $500,000 for general liability, and $450,000 per covered person for medical care benefits for a policy year. Selfinsurance liabilities are established based on claims filed and estimates of claims incurred but not reported. The estimates are based on data provided by the respective claims administrators which is then applied to appropriate actuarial methods. These estimates can fluctuate if historical trends are not predictive of the future. The majority of the Company’s properties are selfinsured for casualty losses and business interruption; however, liability coverage is maintained. The Company’s selfinsurance reserves totaled $35.5 million and $35.9 million for employee group insurance, workers’ compensation insurance and general liability insurance at September 30, 2017 and September 24, 2016, respectively. These amounts are inclusive of expected recoveries from excess cost insurance or other sources that are recorded as receivables of $4.8 million both at September 30, 2017 and September 24, 2016.  Asset Impairments The Company accounts for the impairment of longlived assets in accordance with Financial Accounting Standards Board Accounting Standards Codification (“FASB ASC”) Topic 360. Asset groups are primarily comprised of our individual store and shopping center properties. For assets to be held and used, the Company tests for impairment using undiscounted cash flows and calculates the amount of impairment using discounted cash flows. For assets held for sale, impairment is recognized based on the excess of remaining book value over expected recovery value. The recovery value is the fair value as determined by independent quotes or expected sales prices developed by internal associates, net of costs to sell. Estimates of future cash flows and expected sales prices are judgments based upon the Company’s experience and knowledge of local operations and cash flows [/INST] Positive. </s>

INGLES MARKETS INC

2018-12-07

2018-09-29

Item 7. MANAGEMENT’S DISCUSSION AND ANALYSIS OF FINANCIAL CONDITION AND RESULTS OF OPERATIONS Overview Ingles, a leading supermarket chain in the Southeast United States, operates 200 supermarkets in North Carolina (72), Georgia (69), South Carolina (36), Tennessee (21), Virginia (1) and Alabama (1). The Company locates its supermarkets primarily in suburban areas, small towns and neighborhood shopping centers. Ingles supermarkets offer customers a wide variety of nationally advertised food products, including grocery, meat and dairy products, produce, frozen foods and other perishables and non-food products. Non-food products include fuel centers, pharmacies, health and beauty care products and general merchandise. The Company offers quality private label items in most of its departments. In addition, the Company focuses on selling high-growth, high-margin products to its customers through the development of certified organic products, bakery departments and prepared foods including delicatessen sections. As of September 29, 2018, the Company operated 108 in-store pharmacies and 102 fuel centers. Ingles also operates a fluid dairy and earns shopping center rentals. The fluid dairy sells approximately 27% of its products to the retail grocery segment and approximately 73% of its products to third parties. Real estate ownership is an important component of the Company’s operations, providing both operational and economic benefit.  Critical Accounting Policies Critical accounting policies are those accounting policies that management believes are important to the portrayal of Ingles’ financial condition and results of operations, and require management’s most difficult, subjective or complex judgments, often as a result of the need to make estimates about the effect of matters that are inherently uncertain. Estimates are based on historical experience and other factors believed to be reasonable under the circumstances, the results of which form the basis for making judgments about the carrying values of assets and liabilities that are not readily apparent from other sources. Management estimates, by their nature, involve judgments regarding future uncertainties, and actual results may therefore differ materially from these estimates. Self-Insurance The Company is self-insured for workers’ compensation, general liability, and group medical and dental benefits. Risks and uncertainties are associated with self-insurance; however, the Company has limited its exposure by maintaining excess liability coverage of $750,000 per occurrence for workers’ compensation, $500,000 for general liability, and $450,000 per covered person for medical care benefits for a policy year. Self-insurance liabilities are established based on claims filed and estimates of claims incurred but not reported. The estimates are based on data provided by the respective claims administrators which is then applied to appropriate actuarial methods. These estimates can fluctuate if historical trends are not predictive of the future. The majority of the Company’s properties are self-insured for casualty losses and business interruption; however, liability coverage is maintained. The Company’s self-insurance reserves totaled $34.7 million and $35.5 million for employee group insurance, workers’ compensation insurance and general liability insurance at September 29, 2018 and September 30, 2017, respectively. These amounts are inclusive of expected recoveries from excess cost insurance or other sources that are recorded as receivables of $4.6 million at September 29, 2018 and $4.8 million at September 30, 2017.  Asset Impairments The Company accounts for the impairment of long-lived assets in accordance with Financial Accounting Standards Board Accounting Standards Codification (“FASB ASC”) Topic 360. Asset groups are primarily comprised of our individual store and shopping center properties. For assets to be held and used, the Company tests for impairment using undiscounted cash flows and calculates the amount of impairment using discounted cash flows. For assets held for sale, impairment is recognized based on the excess of remaining book value over expected recovery value. The recovery value is the fair value as determined by independent quotes or expected sales prices developed by internal associates, net of costs to sell. Estimates of future cash flows and expected sales prices are judgments based upon the Company’s experience and knowledge of local operations and cash flows that are projected for several years into the future. These estimates can fluctuate significantly due to changes in real estate market conditions, the economic environment, capital spending decisions and inflation. The Company monitors the carrying value of long-lived assets for potential impairment each quarter based on whether any indicators of impairment have occurred. Vendor Allowances The Company receives funds for a variety of merchandising activities from the many vendors whose products the Company buys for resale in its stores. These incentives and allowances are primarily comprised of volume or purchase based incentives, advertising allowances, slotting fees, and promotional discounts. The purpose of these incentives and allowances is generally to help defray the costs incurred by the Company for stocking, advertising, promoting and selling the vendor’s products. These allowances generally relate to short term arrangements with vendors, often relating to a period of a month or less, and are negotiated on a purchase-by-purchase or transaction-by-transaction basis. Whenever possible, vendor discounts and allowances that relate to buying and merchandising activities are recorded as a reduction of item cost in inventory and recognized in merchandise costs when the item is sold. Due to system constraints and the nature of certain allowances, it is sometimes not practicable to apply allowances to the item cost of inventory. In those instances, the allowances are applied as a reduction of merchandise costs using a rational and systematic methodology, which results in the recognition of these incentives when the inventory related to the vendor consideration received is sold. Vendor allowances applied as a reduction of merchandise costs totaled $116.5 million, $116.6 million and $115.8 million for the fiscal years ended September 29, 2018, September 30, 2017 and September 24, 2016, respectively. Vendor advertising allowances that represent a reimbursement of specific identifiable incremental costs of advertising the vendor’s specific products are recorded as a reduction to the related expense in the period that the related expense is incurred. Vendor advertising allowances recorded as a reduction of advertising expense totaled $14.1 million, $13.8 million, and $13.5 million for the fiscal years ended September 29, 2018, September 30, 2017 and September 24, 2016, respectively.  If vendor advertising allowances were substantially reduced or eliminated, the Company would likely consider other methods of advertising as well as the volume and frequency of the Company’s product advertising, which could increase or decrease the Company’s expenditures.  Similarly, the Company is not able to assess the impact of vendor advertising allowances on creating additional revenue, as such allowances do not directly generate revenue for the Company’s stores.  Results of Operations Ingles operates on a 52- or 53-week fiscal year ending on the last Saturday in September. The consolidated statements of income for the fiscal years ended September 29, 2018, September 30, 2017 and September 24, 2016, consisted of 52, 53 and 52 weeks of operations, respectively.  Comparable store sales are defined as sales by grocery stores in operation for five full fiscal quarters. The Company has an ongoing renovation and expansion plan to modernize the appearance and layout of its existing stores. Sales from replacement stores, major remodels and the addition of fuel stations to existing stores are included in the comparable store sales calculation from the date of completion of the replacement, remodel or addition. A replacement store is a new store that is opened to replace an existing nearby store that is closed. A major remodel entails substantial remodeling of an existing store and may include additional retail square footage. For the fiscal years ended September 29, 2018 and September 30, 2017 comparable store sales include 196 and 197 stores, respectively. Weighted average retail square footage added to comparable stores due to replacement and remodeled stores was approximately 86,000 for the fiscal year ended September 29, 2018 and 36,000 for the fiscal year ended September 30, 2017.  The following table sets forth, for the periods indicated, selected financial information as a percentage of net sales.    Fiscal Year Ended September 29, 2018 Compared to the Fiscal Year Ended September 30, 2017 There are two significant occurrences that will affect many of the comparisons between the fiscal years ended September 29, 2018 and September 30, 2017. First, fiscal year 2017 was a 53 week year, resulting generally in higher sales, operating expenses and operating income compared with the 52 weeks in fiscal year 2018. In addition, changes to Federal tax laws and the Company’s adoption of a different tax calculation method resulted in significant deferred tax benefits totaling $37.3 million in fiscal year 2018. The Company will cite these factors wherever they are relevant to the comparison of its results of operations for fiscal years 2018 with those of fiscal year 2017.  Net income for the fiscal year ended September 29, 2018 was $97.4 million, compared with net income of $53.9 million for the fiscal year ended September 30, 2017, primarily due to the positive impact of the fiscal year 2018 deferred tax benefits. Pretax income was $80.3 million for fiscal year 2018, compared with pretax income of $84.3 million for fiscal year 2017, a decrease primarily attributable to fiscal year 2017’s extra week.  Sales and gross margin increased in the retail segment, including increases in gasoline margins. Expenses increased primarily as a result of continued tight labor conditions in the Company’s market area. Fluid dairy income decreased due to decreased overall milk demand, and real estate income increased as the Company added tenants in existing shopping centers and in acquired shopping centers where the Company had previously leased a store.  Net Sales. Net sales for the fiscal year ended September 29, 2018 totaled $4.09 billion, compared with $4.00 billion for the fiscal year ended September 30, 2017. Management analyzes comparable store sales for the 52 weeks of fiscal year 2018 with the corresponding 52 calendar weeks of fiscal year 2017. On this basis, retail comparable sales excluding gasoline increased 2.0% during fiscal 2018 compared with 2017. The number of transactions (excluding gasoline) increased 0.3% while the average transaction size (excluding gasoline) increased by 2.2%. Comparing fiscal 2018 with 2017 on a 52-week basis, gasoline gallons increased 2.3% and per gallon gasoline prices increased 19.1%.  Sales by product category for the fiscal years ended September 29, 2018 and September 30, 2017, respectively, were as follows:    The grocery category includes grocery, dairy and frozen foods. The non-foods category includes alcoholic beverages, tobacco, pharmacy, health and video. The perishables category includes meat, produce, deli and bakery.  Changes in retail grocery sales for the fiscal year ended September 29, 2018 are summarized as follows (in thousands):   Increased fiscal 2018 sales resulted from new and replacement store buildings, the introduction of new products and product presentation, especially in higher margin products, effective promotions and cost competitiveness. The Company increased its use of The Ingles Advantage Savings and Rewards Card (the “Ingles Advantage Card”) to increase net sales and comparable store sales through enhanced loyalty programs and special offers. Information obtained from holders of the Ingles Advantage Card also assists the Company in optimizing product offerings and promotions specific to customer shopping patterns. The Company expects non-gasoline sales will be higher in the 2019 fiscal year compared with fiscal 2018. The Company anticipates adding new stores in fiscal 2019, expects to continue remodeling a significant number of existing stores, and plans to add more fuel stations and pharmacies. Fiscal 2019 sales growth will also be influenced by market fluctuations in the per gallon price of gasoline and milk, changes in commodity food prices, general labor- and distribution-influenced economic conditions and changing customer preferences for purchasing items sold by the Company.  Gross Profit. Gross profit for the 52 week fiscal year ended September 29, 2018 increased $16.6 million, or 1.7%, to $980.2 million compared with $963.6 million for the 53 week fiscal year ended September 30, 2017. As a percentage of sales, gross profit totaled 24.0% for the fiscal year ended September 29, 2018 and 24.1% for the fiscal year ended September 30, 2017.  Grocery segment gross profit as a percentage of total sales (excluding gasoline) increased 31 basis points in fiscal 2018 compared with fiscal 2017. The gross margin increase was primarily due to a favorable change in the mix of products sold, offset by a slightly lower dollar gross margin on gasoline sales. In addition to the direct product cost, the cost of goods sold line item for the grocery segment includes inbound freight charges and the costs related to the Company’s distribution network. Operating and Administrative Expenses. Operating and administrative expenses increased $19.0 million, or 2.3%, to $856.1 million for the 52 week fiscal year ended September 29, 2018, from $837.1 million for the 53 week fiscal year ended September 30, 2017. As a percentage of sales, operating and administrative expenses were 20.9% for both fiscal years 2018 and 2017. Excluding gasoline, which does not have significant direct operating expenses, the ratio of operating expenses to sales was 24.3% for fiscal 2018 compared with 23.8% for fiscal 2017. A breakdown of the major increases in operating and administrative expenses is as follows. Dollar increases are for the 52 weeks of fiscal year 2018 compared with the 53 weeks of fiscal year 2017. On an equivalent week basis, the dollar increases would have been higher.    Salaries and wages increased due to the addition of labor hours required for the increased sales volume and changes to the sales mix. In general the labor market in the Company’s market area has become more competitive.  Insurance expenses increased due to higher claims experienced under its self-insurance programs and increased market costs, including cost of the Affordable Care Act.  Depreciation and amortization increased as a result of the Company’s capital expenditures programs, including smaller remodeling projects that contain capital assets with shorter useful lives-compared with real restate.  Utilities and fuel increased due to increases in market energy costs and due to increases in store and shopping center square feet.  Bank charges have increased as more sales transactions are being settled with debit and credit cards, and the per transaction card costs have increased.  Gain from Sale or Disposal of Assets. Gains from sale or disposal of assets totaled $0.7 million for fiscal 2018 compared with gains of $1.5 million for fiscal 2017. There were no individually significant transactions during either fiscal year. Other Income, Net. Other income, net totaled $3.1 million and $3.8 million for the fiscal years ended September 29, 2018 and September 30, 2017, respectively. Other income consists primarily of sales of waste paper and packaging. Interest Expense. Interest expense was relatively unchanged at $47.6 million for the fiscal year ended September 29, 2018 and $47.4 million for the fiscal year ended September 30, 2017. Total debt was $865.6 million at the end of fiscal 2018 compared with $877.9 million at the end of fiscal 2017. Market interest rates increased during fiscal years 2017 and 2018, which affected interest expense on the Company’s floating rate debt. During late fiscal year 2017 and early fiscal year 2018, the Company renegotiated or refinanced some of its debt at lower base rates and entered into an interest rate swap to fix the interest on certain debt. These actions as well as a reduction in total debt reduced the impact of rising market interest rates.  Income Taxes. In December 2017, the Tax Cuts and Jobs Act (the “Tax Act”) became law. Among other things, the Tax Act reduced the federal corporate tax rate from 35% to 21% and allowed for full depreciation expensing of qualified property when placed in service.  As a result of the decrease in the effective tax rate, the Company recorded a decrease in its net deferred tax liabilities of $26.7 million, with a corresponding reduction to deferred income tax expense. During fiscal year 2018, the Company adopted a tax depreciation calculation method change that resulted in the accelerated deduction of certain property-related expenditures. As a result of this change and the aforementioned change in the federal corporate tax rate, the Company recorded an additional decrease in its net deferred tax liabilities of $10.6 million, with a corresponding reduction to deferred income tax expense.  Without the $37.3 million tax expense reductions, the Company’s effective tax rate would have been 25.2% for the fiscal year ended September 29, 2018 compared with 36.1% for the fiscal year ended September 30, 2017. This decrease is attributable to the aforementioned reduction in the federal corporate tax rate. Net Income. Net income totaled $97.4 million for the fiscal year ended September 29, 2018 compared with net income of $53.9 million for the fiscal year ended September 30, 2017. Basic and diluted earnings per share for Class A Common Stock were $4.94 and $4.81, respectively, for the fiscal year ended September 29, 2018 compared with $2.74 and $2.66, respectively, for the fiscal year ended September 30, 2017. Basic and diluted earnings per share for Class B Common Stock were each $4.49 for the fiscal year ended September 29, 2018 compared with $2.49 of basic and diluted earnings per share for the fiscal year ended September 30, 2017.  Fiscal Year Ended September 30, 2017 Compared to the Fiscal Year Ended September 24, 2016 Net income for the fiscal year ended September 30, 2017 was $53.9 million, compared with net income of $54.2 million for the fiscal year ended September 24, 2016. Comparisons of fiscal year 2017 to fiscal year 2016 are affected by the difference in the number of weeks in each year. Fiscal year 2017 contained 53 weeks while fiscal year 2016 consisted of 52 weeks. Fiscal year 2017 sales increased even after consideration of the additional week, but non-gasoline gross margin decreased slightly.  Labor continued to tighten in the Company’s market area in fiscal 2017, which contributed to increased operating expenses in total and as a percent of sales. During fiscal 2017 the Company’s capital expenditures for expansion and modernization of its store base continued to be higher than most of the previous few years, a trend that was begun in fiscal year 2016. This expansion also has an impact on ongoing operating costs for labor and equipment service. Net Sales. Net sales for the fiscal year ended September 30, 2017 totaled $4.00 billion, compared with $3.79 billion for the fiscal year ended September 24, 2016. In fiscal years with 53 weeks, such as fiscal 2017, management analyzes comparable store sales for the 53 weeks of the year with the corresponding 53 calendar weeks of the previous year. On this basis, retail comparable sales excluding gasoline increased 1.5% during fiscal 2017 compared with 2016 on a 53-week basis. The number of transactions (excluding gasoline) increased 0.8% while the average transaction size (excluding gasoline) increased by 1.1%. Comparing fiscal 2017 with 2016 on a 53-week basis, gasoline gallons increased 4.5% and per gallon gasoline prices increased 11.6%.  Sales by product category for the fiscal years ended September 30, 2017 and September 24, 2016, respectively, were as follows:    The grocery category includes grocery, dairy and frozen foods. The non-foods category includes alcoholic beverages, tobacco, pharmacy, and health/beauty/cosmetic products. The perishables category includes meat, produce, deli and bakery.  Changes in retail grocery sales for the fiscal year ended September 30, 2017 are summarized as follows (in thousands):   In addition to capital improvements to the store base, increased fiscal 2017 sales resulted from the introduction of new products, product presentation within the stores, effective promotions and cost competitiveness. The Ingles Advantage Savings and Rewards Card (the “Ingles Advantage Card”) also contributes to the increase in net sales and comparable store sales. Information obtained from holders of the Ingles Advantage Card assists the Company in optimizing product offerings and promotions specific to customer shopping patterns. Gross Profit. Gross profit for the fiscal year ended September 30, 2017 increased $39.2 million, or 4.2%, to $963.6 million compared with $924.4 million for the fiscal year ended September 24, 2016. As a percentage of sales, gross profit totaled 24.1% for the fiscal year ended September 30, 2017 and 24.4% for the fiscal year ended September 24, 2016.  The increase in grocery segment gross profit dollars was primarily due to the higher sales volume and the impact of the 53rd week in fiscal 2017. Grocery segment gross profit as a percentage of total sales (excluding gasoline) decreased 8 basis points in fiscal 2017 compared with fiscal 2016. The gross margin decrease was primarily due to competitive factors, which offset a favorable change in the mix of products sold. In addition to the direct product cost, the cost of goods sold line item for the grocery segment includes inbound freight charges and the costs related to the Company’s distribution network. Operating and Administrative Expenses. Operating and administrative expenses increased $42.5 million, or 5.4%, to $837.1 million for the fiscal year ended September 30, 2017, from $794.6 million for the fiscal year ended September 24, 2016. As a percentage of sales, operating and administrative expenses were 20.9% for fiscal year 2017 and 21.0% for fiscal year 2016. Excluding gasoline, which does not have significant direct operating expenses, the ratio of operating expenses to sales was 23.8% for fiscal 2017 compared with 23.5% for fiscal 2016. A breakdown of the major increases in operating and administrative expenses is as follows:    Salaries and wages increased due to the addition of labor hours required for the increased sales volume and changes to the sales mix. In general the labor market in the Company’s market area has become more competitive.  Depreciation and amortization increased as a result of the Company’s capital expenditures programs, including smaller remodeling projects that contain capital assets with shorter useful lives-compared with real restate.  Repair and maintenance expenses increased due to increases in the amount and complexity of equipment in the Company’s stores to support new products offered, increase energy efficiency and to improve the customer shopping experience.  Bank charges have increased as more sales transactions are being settled with debit and credit cards, and the per transaction card costs have increased.  Taxes and licenses increased due to increases in the value of the Company’s real estate and for additional fees paid to municipalities to conduct business and offer certain products.  Loss or gain from Sale or Disposal of Assets. Gains from sale or disposal of assets totaled $1.5 million for fiscal 2017 compared with losses of $1.2 million for fiscal 2016. There were no individually significant gains during fiscal 2017. During fiscal 2016, the Company demolished certain buildings for redevelopment into larger and improved store or tenant space. None of these transactions were individually significant. Other Income, Net. Other income, net totaled $3.8 million and $2.4 million for the fiscal years ended September 30, 2017 and September 24, 2016, respectively. Other income consists primarily of sales of waste paper and packaging. Interest Expense. Interest expense increased $1.1 million for the fiscal year ended September 30, 2017 to $47.4 million from $46.3 million for the fiscal year ended September 24, 2016. Total debt was $877.9 million at the end of fiscal 2017 compared with $876.5 million at the end of fiscal 2016. Market interest rates increased during fiscal 2017, which affected interest expense on the Company’s floating rate debt. During the latter part of fiscal 2017, the Company renegotiated or refinanced some of its debt at lower base rates and more favorable terms.  Income Taxes. Income tax expense as a percentage of pre-tax income was 36.1% for the 2017 fiscal year compared with 36.0% for the 2016 fiscal year. There were no significant changes in major components of tax expense between fiscal years 2017 and 2016. Cash income taxes paid by the Company increased in fiscal 2017 compared with fiscal 2016 due to the reversal of taxes deferred in prior years. Net Income. Net income totaled $53.9 million for the fiscal year ended September 30, 2017 compared with net income of $54.2 million for the fiscal year ended September 24, 2016. Basic and diluted earnings per share for Class A Common Stock were $2.74 and $2.66, respectively, for the fiscal year ended September 30, 2017 compared with $2.75 and $2.68, respectively, for the fiscal year ended September 24, 2016. Basic and diluted earnings per share for Class B Common Stock were each $2.49 for the fiscal year ended September 30, 2017 compared with $2.50 of basic and diluted earnings per share for the fiscal year ended September 24, 2016.  Liquidity and Capital Resources  Capital Expenditures  The Company believes that a key to its ability to continue to increase sales and develop a loyal customer base is providing conveniently located, clean and modern stores which provide customers with good service and an increasingly diverse selection of competitively priced products. As such, the Company has invested and will continue to invest significant amounts of capital toward the modernization of its store base. The Company’s modernization program includes the opening of new stores, the completion of major remodels and expansion of selected existing stores, and the relocation of selected existing stores to larger, more convenient locations. The Company also believes that the warehouse and distribution facility completed during fiscal 2012 has lowered its overall distribution costs and improved product availability in its stores.  Capital expenditures totaled $150.5 million and $127.7 million for fiscal 2018 and 2017, respectively. Major capital expenditures include the following:    (including those added at new or replacement stores)  During fiscal year 2018, the Company purchased three shopping centers which contained Ingles stores that had been leased from third party landlords.  Capital expenditures also included upgrading and replacing store equipment, technology investments, capital expenditures related to the Company’s distribution operation and its milk processing plant, and expenditures for stores to open in subsequent fiscal years. Ingles’ capital expenditure plans for fiscal 2019 include investments of approximately $120 to $160 million. The majority of the Company’s fiscal 2019 capital expenditures will be dedicated to continued improvement of its store base and will include construction of one or more new/remodeled stores. Fiscal 2019 capital expenditures will also include investments in stores expected to open in fiscal 2020 as well as technology improvements, upgrading and replacing existing store equipment and warehouse and transportation equipment and improvements to the Company’s milk processing plant. The Company will also consider land acquisitions for future development and the purchase of shopping centers where the Company operates leased stores. The Company expects that its net annual capital expenditures will be in the range of approximately $100 to $160 million going forward in order to maintain a modern store base. Planned expenditures for any given future fiscal year will be affected by the availability of financing, which can affect both the number of projects pursued at any given time and the cost of those projects. The number of projects may also fluctuate due to the varying costs of the types of projects pursued including new stores and major remodel/expansions. The Company makes decisions on the allocation of capital expenditure dollars based on many factors including the competitive environment, other Company capital initiatives and its financial condition.  In general, the Company finances its capital expenditures to the extent possible from cash on hand and cash flow from operations. Additional financing sources for capital expenditures include borrowings under the $175 million of committed line of credit, other borrowings that could be collateralized by unencumbered real property and equipment with a net book value of approximately $1.10 billion, and the public debt or equity markets. The Company has used each of these to finance past capital expenditures and expects to have them available in the future. The Company does not generally enter into commitments for capital expenditures other than on a store-by-store basis at the time it begins construction on a new store or begins a major or minor remodeling project. Construction commitments at September 29, 2018 totaled $12.6 million. Liquidity The Company generated $161.2 million of cash from operations in fiscal 2018 compared with $156.3 million for fiscal 2017. Net income increased substantially, but much of the increase is from income tax benefits that will be received as cash in future periods. Cash used by investing activities for fiscal 2018 totaled $148.1 million compared with $125.4 million for fiscal 2017. The Company’s most significant investing activity is capital expenditures. Comparing fiscal year 2018 with fiscal year 2017, the Company invested a greater amount in new buildings and shopping center purchases.  During fiscal 2018, the Company’s net financing activities of $26.5 million consisted primarily of Dividends and debt repayment. During fiscal 2017, the Company’s net financing activities of $12.7 million consisted primarily of dividends.  In June 2013, the Company issued $700.0 million aggregate principal amount of senior notes due in 2023 (the “Notes”). The Notes bear an interest rate of 5.75% per annum and were issued at par.  The Company has a $175.0 million line of credit (the “Line”) that matures in September 2022. The Line provides the Company with various interest rate options based on the prime rate, the Federal Funds Rate, or the London Interbank Offering Rate. The Line allows the Company to issue up to $20.0 million in unused letters of credit, of which $9.4 million of unused letters of credit were issued at September 29, 2018. The Company is not required to maintain compensating balances in connection with the Line. At September 29, 2018, the Company had no borrowing outstanding under the Line.  On December 29, 2010, the Company completed the funding of $99.7 million of Recovery Zone Facility Bonds (the “Bonds”) for construction and equipping of an approximately 830,000 square foot new warehouse and distribution center located in Buncombe County, North Carolina (the “Project”). The final maturity date of the Bonds is January 1, 2036.  Under a Continuing Covenant and Collateral Agency Agreement (the “Covenant Agreement”) between certain financial institutions and the Company, the financial institutions would hold the Bonds until June 2021, subject to certain events. Mandatory redemption of the Bonds by the Company in the annual amount of $4,530,000 began on January 1, 2014. During fiscal year 2018, the Covenant Agreement was amended to change certain terms and to extend the maturity to September 2026. The Company may redeem the Bonds without penalty or premium at any time prior to September 26, 2026.  On December 19, 2017, the Company entered into an interest rate swap agreement for a notional amount of $58.5 million at a fixed rate of 3.92%. Under this agreement, the Company pays monthly the fixed rate of 3.92% and receives the one-month LIBOR plus 1.65%. The interest rate swap effectively hedges $60 million of floating rate debt closed by the Company in September 2017. Both the floating rate debt and the interest rate swap have monthly principal amortization of $0.5 million and mature October 1, 2027. The fair market value of the interest rate swap is measured quarterly, with adjustments, if significant, recorded in other comprehensive income. The fair market value of the interest rate swap at September 29, 2018 was not significant.  The Company’s long-term debt agreements generally have cross-default provisions which could result in the acceleration of payments due under the Company’s Line, Bond and Notes indenture in the event of default under any one instrument.  The Notes, the Bonds and the Line contain provisions that under certain circumstances would permit lending institutions to terminate or withdraw their respective extensions of credit to the Company. Included among the triggering factors permitting the termination or withdrawal of the Line to the Company are certain events of default, including both monetary and non-monetary defaults, the initiation of bankruptcy or insolvency proceedings, and the failure of the Company to meet certain financial covenants designated in its respective loan documents. As of September 29, 2018, the Company was in compliance with these covenants by a significant margin. Under the most restrictive of these covenants, the Company would be able to incur approximately $416 million of additional borrowings (including borrowings under the Line) as of September 29, 2018.  The Company’s principal sources of liquidity are expected to be cash flow from operations, borrowings under the Line and long-term financing. The Company believes, based on its current results of operations and financial condition, that its financial resources, including cash balances, the existing Line, short- and long-term financing expected to be available to it and internally generated funds, will be sufficient to meet planned capital expenditures and working capital requirements for the foreseeable future, including any debt service requirements of additional borrowings. However, there can be no assurance that any such sources of financing will be available to the Company on acceptable terms, or at all. It is possible that, in the future, the Company’s results of operations and financial condition will be different from that described in this report based on a number of intangible factors. These factors may include, among others, increased competition, changing regional and national economic conditions, adverse climatic conditions affecting food production and delivery and changing demographics as well as the additional factors discussed above and elsewhere under “Item 1A. Risk Factors.” It is also possible, for such reasons, that the results of operations from the new, expanded, remodeled and/or replacement stores will not meet or exceed the results of operations from existing stores that are described in this report. Contractual Obligations and Commercial Commitments The Company has assumed various financial obligations and commitments in the normal course of its operations and financing activities. Financial obligations are considered to represent known future cash payments that the Company is required to make under existing contractual arrangements, such as debt and lease arrangements. The following table represents the scheduled maturities of the Company’s long-term contractual obligations as of September 29, 2018:  Payment Due by Period   (1) Scheduled interest on floating rate debt calculated using rates in effect on September 29, 2018.  (2) Operating lease obligations in the above table do not include common area maintenance, insurance, utility and tax payments for which the Company is obligated under certain operating leases. These amounts are not significant compared with the operating lease payments listed in the above table.  The Company has entered supply contracts to provide approximately 70% of the fuel sold in its fuel centers. Pricing is based on certain market indices at the time of purchase. The suppliers can modify or terminate the contracts if the Company does not meet certain minimum monthly purchase requirements.  Amounts available to the Company under commercial commitments as of September 29, 2018, were as follows: Amount of Commitment Expiration per Period   Off Balance Sheet Arrangements The Company is not a party to any off-balance sheet arrangements that have, or are reasonably likely to have, a current or future material effect on the Company’s financial condition, revenues, expenses, results of operations, liquidity, capital expenditures or capital resources. Quarterly Cash Dividends Since December 27, 1993, the Company has paid regular quarterly cash dividends of $0.165 per share on its Class A Common Stock and $0.15 per share on its Class B Common Stock for an annual rate of $0.66 and $0.60 per share, respectively.  The Company expects to continue paying regular cash dividends on a quarterly basis. However, the Board of Directors periodically reconsiders the declaration of dividends. The Company pays these dividends at the discretion of the Board of Directors and the continuation of these payments, the amount of such dividends, and the form in which the dividends are paid (cash or stock) depends upon the results of operations, the financial condition of the Company and other factors which the Board of Directors deems relevant.  Long-term debt and line of credit agreements contain various restrictive covenants requiring, among other things, minimum levels of net worth and maintenance of certain financial ratios. These covenants have the effect of restricting certain types of transactions, including the payment of cash dividends generally and in excess of current quarterly per share amounts. Further, the Company is prevented from declaring dividends at any time that it is in default under the indenture governing the Notes. Impact of Inflation The following table from the United States Bureau of Labor Statistics lists annualized changes in the Consumer Price Index that could have an effect on the Company’s operations. One of the Company’s significant costs is labor, which increases with general inflation. Inflation or deflation in energy costs affects the Company’s gasoline sales, distribution expenses and plastic supply costs.    New Accounting Pronouncements For new accounting pronouncements, see Note 1 to the Consolidated Financial Statements included in this Annual Report on Form 10-K.  Outlook and Trends in the Company’s Markets  The Company has improved the interior layout and product offerings in a significant number of stores over the past three fiscal years. Economic conditions have improved to the point that the Company has accelerated the increase and improvement of its total retail square footage.  The Company continually assesses and modifies its business model to meet the changing needs and expectations of its customers. In connection with this review, the Company assesses the trends present in the markets in which it competes. Generally, it is difficult to predict whether a trend will continue for a period of time and it is possible that new trends will develop which will affect an existing trend. The Company believes that the following trends are likely to continue for at least the next fiscal year:  · The supermarket industry will remain highly competitive and will be characterized by industry consolidation, fragmented food retail platforms, and continued competition from super centers and other non-supermarket operators.  · Traditional supermarket products will be acquired by customers in new and diverse ways, including online ordering, home delivery and pre-picked for customer pickup.  · Economic conditions will continue to affect customer behavior. Economic conditions may affect purchasing patterns with regard to meal replacement items, private label purchases, promotions and product variety.  · The Company and its customers will continue to become more environmentally aware, evidenced by the Company’s increased recycled waste paper and pallets and customers’ increased usage of reusable shopping bags.  · Volatile petroleum costs will impact utility and distribution costs, plastic supplies cost and may change customer shopping and dining behavior.  · Retail gasoline costs and retail prices will continue to be volatile, affecting the Company’s gasoline sales and gross margin.  The Company plans to continue to focus on balancing sales growth and gross margin maintenance (excluding the effect of gasoline sales), and will carefully monitor its product mix and customer trends. 

<s>[INST] Ingles, a leading supermarket chain in the Southeast United States, operates 200 supermarkets in North Carolina (72), Georgia (69), South Carolina (36), Tennessee (21), Virginia (1) and Alabama (1). The Company locates its supermarkets primarily in suburban areas, small towns and neighborhood shopping centers. Ingles supermarkets offer customers a wide variety of nationally advertised food products, including grocery, meat and dairy products, produce, frozen foods and other perishables and nonfood products. Nonfood products include fuel centers, pharmacies, health and beauty care products and general merchandise. The Company offers quality private label items in most of its departments. In addition, the Company focuses on selling highgrowth, highmargin products to its customers through the development of certified organic products, bakery departments and prepared foods including delicatessen sections. As of September 29, 2018, the Company operated 108 instore pharmacies and 102 fuel centers. Ingles also operates a fluid dairy and earns shopping center rentals. The fluid dairy sells approximately 27% of its products to the retail grocery segment and approximately 73% of its products to third parties. Real estate ownership is an important component of the Company’s operations, providing both operational and economic benefit.  Critical Accounting Policies Critical accounting policies are those accounting policies that management believes are important to the portrayal of Ingles’ financial condition and results of operations, and require management’s most difficult, subjective or complex judgments, often as a result of the need to make estimates about the effect of matters that are inherently uncertain. Estimates are based on historical experience and other factors believed to be reasonable under the circumstances, the results of which form the basis for making judgments about the carrying values of assets and liabilities that are not readily apparent from other sources. Management estimates, by their nature, involve judgments regarding future uncertainties, and actual results may therefore differ materially from these estimates. SelfInsurance The Company is selfinsured for workers’ compensation, general liability, and group medical and dental benefits. Risks and uncertainties are associated with selfinsurance; however, the Company has limited its exposure by maintaining excess liability coverage of $750,000 per occurrence for workers’ compensation, $500,000 for general liability, and $450,000 per covered person for medical care benefits for a policy year. Selfinsurance liabilities are established based on claims filed and estimates of claims incurred but not reported. The estimates are based on data provided by the respective claims administrators which is then applied to appropriate actuarial methods. These estimates can fluctuate if historical trends are not predictive of the future. The majority of the Company’s properties are selfinsured for casualty losses and business interruption; however, liability coverage is maintained. The Company’s selfinsurance reserves totaled $34.7 million and $35.5 million for employee group insurance, workers’ compensation insurance and general liability insurance at September 29, 2018 and September 30, 2017, respectively. These amounts are inclusive of expected recoveries from excess cost insurance or other sources that are recorded as receivables of $4.6 million at September 29, 2018 and $4.8 million at September 30, 2017.  Asset Impairments The Company accounts for the impairment of longlived assets in accordance with Financial Accounting Standards Board Accounting Standards Codification (“FASB ASC”) Topic 360. Asset groups are primarily comprised of our individual store and shopping center properties. For assets to be held and used, the Company tests for impairment using undiscounted cash flows and calculates the amount of impairment using discounted cash flows. For assets held for sale, impairment is recognized based on the excess of remaining book value over expected recovery value. The recovery value is the fair value as determined by independent quotes or expected sales prices developed by internal associates, net of costs to sell. Estimates of future cash flows and expected sales prices are judgments based upon the Company’s experience [/INST] Positive. </s>

INGLES MARKETS INC

2019-12-10

2019-09-28

Item 7. MANAGEMENT’S DISCUSSION AND ANALYSIS OF FINANCIAL CONDITION AND RESULTS OF OPERATIONS  Overview  Ingles, a leading supermarket chain in the Southeast United States, operates 198 supermarkets in North Carolina (73), Georgia (66), South Carolina (36), Tennessee (21), Virginia (1) and Alabama (1). The Company locates its supermarkets primarily in suburban areas, small towns and neighborhood shopping centers. Ingles supermarkets offer customers a wide variety of nationally advertised food products, including grocery, meat and dairy products, produce, frozen foods and other perishables and non-food products. Non-food products include fuel centers, pharmacies, health and beauty care products and general merchandise. The Company offers quality private label items in most of its departments. In addition, the Company focuses on selling high-growth, high-margin products to its customers through the development of certified organic products, bakery departments and prepared foods including delicatessen sections. As of September 28, 2019, the Company operated 108 in-store pharmacies and 104 fuel centers. Ingles also operates a fluid dairy and earns shopping center rentals.  Critical Accounting Policies  Critical accounting policies are those accounting policies that management believes are important to the portrayal of Ingles’ financial condition and results of operations, and require management’s most difficult, subjective or complex judgments, often as a result of the need to make estimates about the effect of matters that are inherently uncertain. Estimates are based on historical experience and other factors believed to be reasonable under the circumstances, the results of which form the basis for making judgments about the carrying values of assets and liabilities that are not readily apparent from other sources. Management estimates, by their nature, involve judgments regarding future uncertainties, and actual results may therefore differ materially from these estimates.  Self-Insurance  The Company is self-insured for workers’ compensation, general liability, and group medical and dental benefits. Risks and uncertainties are associated with self-insurance; however, the Company has limited its exposure by maintaining excess liability coverage of $1,000,000 per occurrence for workers’ compensation, $500,000 for general liability, and $450,000 per covered person for medical care benefits for a policy year. Effective October 1, 2019 the excess liability limit was increased to $1,000,000 for general liability. Self-insurance liabilities are established based on claims filed and estimates of claims incurred but not reported. The estimates are based on data provided by the respective claims administrators which is then applied to appropriate actuarial methods. These estimates can fluctuate if historical trends are not predictive of the future. The majority of the Company’s properties are self-insured for casualty losses and business interruption; however, liability coverage is maintained. The Company’s self-insurance reserves totaled $31.0 million and $34.7 million for employee group insurance, workers’ compensation insurance and general liability insurance at September 28, 2019 and September 29, 2018, respectively. These amounts are inclusive of expected recoveries from excess cost insurance or other sources that are recorded as receivables of $3.6 million at September 28, 2019 and $4.6 million at September 29, 2018.  Asset Impairments  The Company accounts for the impairment of long-lived assets in accordance with Financial Accounting Standards Board Accounting Standards Codification (“FASB ASC”) Topic 360. Asset groups are primarily comprised of our individual store and shopping center properties. For assets to be held and used, the Company tests for impairment using undiscounted cash flows and calculates the amount of impairment using discounted cash flows. For assets held for sale, impairment is recognized based on the excess of remaining book value over expected recovery value. The recovery value is the fair value as determined by independent quotes or expected sales prices developed by internal associates, net of costs to sell. Estimates of future cash flows and expected sales prices are judgments based upon the Company’s experience and knowledge of local operations and cash flows that are projected for several years into the future. These estimates can fluctuate significantly due to changes in real estate market conditions, the economic environment, capital spending decisions and inflation. The Company monitors the carrying value of long-lived assets for potential impairment each quarter based on whether any indicators of impairment have occurred.  Vendor Allowances  The Company receives funds for a variety of merchandising activities from the many vendors whose products the Company buys for resale in its stores. These incentives and allowances are primarily comprised of volume or purchase based incentives, advertising allowances, slotting fees, and promotional discounts. The purpose of these incentives and allowances is generally to help defray the costs incurred by the Company for stocking, advertising, promoting and selling the vendor’s products. These allowances generally relate to short term arrangements with vendors, often relating to a period of a month or less, and are negotiated on a purchase-by-purchase or transaction-by-transaction basis. Whenever possible, vendor discounts and allowances that relate to buying and merchandising activities are recorded as a reduction of item cost in inventory and recognized in merchandise costs when the item is sold. Due to system constraints and the nature of certain allowances, it is sometimes not practicable to apply allowances to the item cost of inventory. In those instances, the allowances are applied as a reduction of merchandise costs using a rational and systematic methodology, which results in the recognition of these incentives when the inventory related to the vendor consideration received is sold. Vendor allowances applied as a reduction of merchandise costs totaled $111.7 million, $116.5 million and $116.6 million for the fiscal years ended September 28, 2019, September 29, 2018 and September 30, 2017, respectively. Vendor advertising allowances that represent a reimbursement of specific identifiable incremental costs of advertising the vendor’s specific products are recorded as a reduction to the related expense in the period that the related expense is incurred. Vendor advertising allowances recorded as a reduction of advertising expense totaled $13.8 million, $14.1 million, and $13.8 million for the fiscal years ended September 28, 2019, September 29, 2018 and September 30, 2017, respectively.  If vendor advertising allowances were substantially reduced or eliminated, the Company would likely consider other methods of advertising as well as the volume and frequency of the Company’s product advertising, which could increase or decrease the Company’s expenditures.  Similarly, the Company is not able to assess the impact of vendor advertising allowances on creating additional revenue; as such allowances do not directly generate revenue for the Company’s stores.  Results of Operations  Ingles operates on a 52- or 53-week fiscal year ending on the last Saturday in September. The consolidated statements of income for the fiscal years ended September 28, 2019, September 29, 2018 and September 30, 2017, consisted of 52, 52 and 53 weeks of operations, respectively.  Comparable store sales are defined as sales by grocery stores in operation for five full fiscal quarters. The Company has an ongoing renovation and expansion plan to modernize the appearance and layout of its existing stores. Sales from replacement stores, major remodels and the addition of fuel stations to existing stores are included in the comparable store sales calculation from the date of completion of the replacement, remodel or addition. A replacement store is a new store that is opened to replace an existing nearby store that is closed. A major remodel entails substantial remodeling of an existing store and may include additional retail square footage. For the fiscal years ended September 28, 2019 and September 29, 2018 comparable store sales each included 196 stores. Weighted average retail square footage added to comparable stores due to replacement and remodeled stores was approximately 300 for the fiscal year ended September 28, 2019 and 86,000 for the fiscal year ended September 29, 2018.  The following table sets forth, for the periods indicated, selected financial information as a percentage of net sales.     Fiscal Year Ended September 28, 2019 Compared to the Fiscal Year Ended September 29, 2018  The Company’s fiscal year 2019 performance was strong, with increases in sales and gross margin driving increased pre-tax income. Last year, in fiscal year 2018, income tax credits totaling $37.3 million resulted in higher net income when compared with the current fiscal year ended September 28, 2019.  Net income for the fiscal year ended September 28, 2019 was $81.6 million, compared with net income of $97.4 million for the fiscal year ended September 29, 2018, primarily due to the positive impact of the fiscal year 2018 deferred tax benefits. Pretax income was $106.6 million for fiscal year 2019, an increase of 32.7% compared with pretax income of $80.3 million for fiscal year 2018.  Sales and gross margin increased in the retail segment, including increases in gasoline gross profit. Expenses increased primarily as a result of continued tight labor conditions in the Company’s market area. Fluid dairy income was level over the comparative fiscal years, and real estate income increased as the Company added tenants in existing shopping centers and in acquired shopping centers where the Company had previously leased a store.  Net Sales. Net sales for the fiscal year ended September 28, 2019 totaled $4.20 billion, compared with $4.09 billion for the fiscal year ended September 29, 2018.  Retail comparable sales excluding gasoline increased 3.9% during fiscal 2019 compared with 2018. The number of transactions (excluding gasoline) increased 0.9% while the average transaction size (excluding gasoline) increased by 2.8%. Comparing fiscal 2019 with 2018, gasoline gallons sold decreased 0.5% and per gallon gasoline prices decreased 3.5%.  Sales by product category for the fiscal years ended September 28, 2019 and September 29, 2018, respectively, were as follows:    The grocery category includes grocery, dairy and frozen foods. The non-foods category includes alcoholic beverages, tobacco, pharmacy, and health/beauty/cosmetic products. The perishables category includes meat, produce, deli and bakery.  Changes in retail grocery sales for the fiscal year ended September 28, 2019 are summarized as follows (in thousands):    Increased fiscal 2019 sales resulted from new and replacement store buildings, the introduction of new products and product presentation, especially in higher margin products, effective promotions and cost competitiveness. General economic conditions were favorable in the Company’s market area. The Company increased its use of The Ingles Advantage Savings and Rewards Card (the “Ingles Advantage Card”) to increase net sales and comparable store sales through enhanced loyalty programs and special offers. Information obtained from holders of the Ingles Advantage Card also assists the Company in optimizing product offerings and promotions specific to customer shopping patterns.  The Company expects non-gasoline sales will be higher in the 2020 fiscal year compared with fiscal 2019. The Company anticipates adding new stores in fiscal 2020, expects to continue remodeling a significant number of existing stores, and plans to add more fuel stations and pharmacies. Fiscal 2020 sales growth will also likely be influenced by market fluctuations in the per gallon price of gasoline and milk, changes in commodity food prices, general labor- and distribution-influenced economic conditions and changing customer preferences for purchasing items sold by the Company.  Gross Profit. Gross profit for the fiscal year ended September 28, 2019 increased $41.8 million, or 4.3%, to $1.02 billion compared with $980.2 million for the fiscal year ended September 29, 2018. As a percentage of sales, gross profit totaled 24.3% for the fiscal year ended September 28, 2019 and 24.0% for the fiscal year ended September 29, 2018. Gasoline gross profit increased $13.1 million for fiscal year 2019 compared with 2018.  Grocery segment gross profit as a percentage of total sales (excluding gasoline) decreased 19 basis points in fiscal 2019 compared with fiscal 2018. The gross margin decrease was primarily due to market factors that adversely affected certain product lines.  In addition to the direct product cost, the cost of goods sold line item for the grocery segment includes inbound freight charges and the costs related to the Company’s distribution network.  Operating and Administrative Expenses. Operating and administrative expenses increased $17.8 million, or 2.1%, to $873.9 million for the fiscal year ended September 28, 2019, from $856.1 million for the fiscal year ended September 29, 2018. As a percentage of sales, operating and administrative expenses were 20.8% and 20.9% for fiscal years 2019 and 2018, respectively. Excluding gasoline, which does not have significant direct operating expenses, the ratio of operating expenses to sales was 23.9% for fiscal 2019 compared with 24.3% for fiscal 2018. Fiscal year 2019 sales growth resulted in operating expense leverage.  A breakdown of the major increases in operating and administrative expenses is as follows.   Salaries and wages increased due to the addition of labor hours required for the increased sales volume and changes to the sales mix. In general, the labor market in the Company’s market area has become more competitive.  Repairs and maintenance increased due to a higher level of maintenance required on more sophisticated equipment and updated lighting in our stores, and also due to a higher level of building maintenance.  Bank charges have increased as more sales transactions are being settled with debit and credit cards, and the per transaction card costs have increased.  Advertising and promotion expenses decreased as a result of more efficient usage of digital, broadcast, and print advertising programs.  Insurance expenses decreased due to lower claims experienced under its self-insurance programs.  Gain from Sale or Disposal of Assets. During the current fiscal year, the Company recognized a $3.2 million gain on the sale of a former store property. There were no other significant sale/disposal transactions in either fiscal year 2019 or 2018.  Other Income, Net. Other income, net totaled $1.8 million and $3.1 million for the fiscal years ended September 28, 2019 and September 29, 2018, respectively. Other income consists primarily of sales of waste paper and packaging.  Interest Expense. Interest expense was relatively unchanged at $47.4 million for the fiscal year ended September 28, 2019 and $47.6 million for the fiscal year ended September 29, 2018. Total debt was $852.2 million at the end of fiscal 2019 compared with $865.6 million at the end of fiscal 2018. The Company had lower line of credit usage during the current fiscal year, and interest rates have been relatively stable.  Income Taxes. Income tax expense totaled $25.0 million for fiscal year 2019, an effective tax rate of 23.5%. This compares with an income tax benefit totaling $17.0 million for fiscal year 2018.  In December 2017, the Tax Cuts and Jobs Act (the “Tax Act”) became law. Among other things, the Tax Act reduced the federal corporate tax rate from 35% to 21% and allowed for full depreciation expensing of qualified property when placed in service.  For the fiscal years ended September 28, 2019 and September 29, 2018 the Company has a blended federal corporate tax rate of 21.0% and 24.5%, respectively, based on the effective date of the tax rate reduction. As a result of the decrease in the federal rate, the Company recorded in fiscal year 2018 a decrease in its net deferred tax liabilities of $26.7 million, with a corresponding reduction to deferred income tax expense.  Also during fiscal year 2018 the Company adopted a tax calculation method change that resulted in the accelerated deduction of certain property-related expenditures. As a result of this change and the change in the federal statutory tax rate, the Company recorded a decrease in its net deferred tax liabilities of $10.6 million, with a corresponding reduction to deferred income tax expense.  Without the $37.3 million tax expense reductions, the Company’s effective tax rate would have been 25.2% for the fiscal year ended September 29, 2018.  Net Income. Net income totaled $81.6 million for the fiscal year ended September 28, 2019 compared with net income of $97.4 million for the fiscal year ended September 29, 2018. Basic and diluted earnings per share for Class A Common Stock were $4.14 and $4.03, respectively, for the fiscal year ended September 28, 2019 compared with $4.94 and $4.81, respectively, for the fiscal year ended September 29, 2018. Basic and diluted earnings per share for Class B Common Stock were each $3.76 for the fiscal year ended September 28, 2019 compared with $4.49 of basic and diluted earnings per share for the fiscal year ended September 29, 2018.  Fiscal Year Ended September 29, 2018 Compared to the Fiscal Year Ended September 30, 2017  There are two significant occurrences that will affect many of the comparisons between the fiscal years ended September 29, 2018 and September 30, 2017. First, fiscal year 2017 was a 53 week year, resulting generally in higher sales, operating expenses and operating income compared with the 52 weeks in fiscal year 2018. In addition, changes to Federal tax laws and the Company’s adoption of a different tax calculation method resulted in significant deferred tax benefits totaling $37.3 million in fiscal year 2018. The Company will cite these factors wherever they are relevant to the comparison of its results of operations for fiscal years 2018 with those of fiscal year 2017.  Net income for the fiscal year ended September 29, 2018 was $97.4 million, compared with net income of $53.9 million for the fiscal year ended September 30, 2017, primarily due to the positive impact of the fiscal year 2018 deferred tax benefits. Pretax income was $80.3 million for fiscal year 2018, compared with pretax income of $84.3 million for fiscal year 2017, a decrease primarily attributable to fiscal year 2017’s extra week.  Sales and gross margin increased in the retail segment, including increases in gasoline margins. Expenses increased primarily as a result of continued tight labor conditions in the Company’s market area. Fluid dairy income decreased due to decreased overall milk demand, and real estate income increased as the Company added tenants in existing shopping centers and in acquired shopping centers where the Company had previously leased a store.  Net Sales. Net sales for the fiscal year ended September 29, 2018 totaled $4.09 billion, compared with $4.00 billion for the fiscal year ended September 30, 2017.  Management analyzes comparable store sales for the 52 weeks of fiscal year 2018 with the corresponding 52 calendar weeks of fiscal year 2017. On this basis, retail comparable sales excluding gasoline increased 2.0% during fiscal 2018 compared with 2017. The number of transactions (excluding gasoline) increased 0.3% while the average transaction size (excluding gasoline) increased by 2.2%. Comparing fiscal 2018 with 2017 on a 52-week basis, gasoline gallons increased 2.3% and per gallon gasoline prices increased 19.1%.  Sales by product category for the fiscal years ended September 29, 2018 and September 30, 2017, respectively, were as follows:    The grocery category includes grocery, dairy and frozen foods. The non-foods category includes alcoholic beverages, tobacco, pharmacy, and health/beauty/cosmetic products. The perishables category includes meat, produce, deli and bakery.  Changes in retail grocery sales for the fiscal year ended September 29, 2018 are summarized as follows (in thousands):    Increased fiscal 2018 sales resulted from new and replacement store buildings, the introduction of new products and product presentation, especially in higher margin products, effective promotions and cost competitiveness. The Company increased its use of The Ingles Advantage Savings and Rewards Card (the “Ingles Advantage Card”) to increase net sales and comparable store sales through enhanced loyalty programs and special offers. Information obtained from holders of the Ingles Advantage Card also assists the Company in optimizing product offerings and promotions specific to customer shopping patterns.  Gross Profit. Gross profit for the 52 week fiscal year ended September 29, 2018 increased $16.6 million, or 1.7%, to $980.2 million compared with $963.6 million for the 53 week fiscal year ended September 30, 2017. As a percentage of sales, gross profit totaled 24.0% for the fiscal year ended September 29, 2018 and 24.1% for the fiscal year ended September 30, 2017.  Grocery segment gross profit as a percentage of total sales (excluding gasoline) increased 31 basis points in fiscal 2018 compared with fiscal 2017. The gross margin increase was primarily due to a favorable change in the mix of products sold, offset by a slightly lower dollar gross margin on gasoline sales.  In addition to the direct product cost, the cost of goods sold line item for the grocery segment includes inbound freight charges and the costs related to the Company’s distribution network.  Operating and Administrative Expenses. Operating and administrative expenses increased $19.0 million, or 2.3%, to $856.1 million for the 52 week fiscal year ended September 29, 2018, from $837.1 million for the 53 week fiscal year ended September 30, 2017. As a percentage of sales, operating and administrative expenses were 20.9% for both fiscal years 2018 and 2017. Excluding gasoline, which does not have significant direct operating expenses, the ratio of operating expenses to sales was 24.3% for fiscal 2018 compared with 23.8% for fiscal 2017.  A breakdown of the major increases in operating and administrative expenses is as follows. Dollar increases are for the 52 weeks of fiscal year 2018 compared with the 53 weeks of fiscal year 2017. On an equivalent week basis, the dollar increases would have been higher.   Salaries and wages increased due to the addition of labor hours required for the increased sales volume and changes to the sales mix. In general the labor market in the Company’s market area has become more competitive.  Insurance expenses increased due to higher claims experienced under its self-insurance programs and increased market costs, including cost of the Affordable Care Act.  Depreciation and amortization increased as a result of the Company’s capital expenditures programs, including smaller remodeling projects that contain capital assets with shorter useful lives-compared with real restate.  Utilities and fuel increased due to increases in market energy costs and due to increases in store and shopping center square feet.  Bank charges have increased as more sales transactions are being settled with debit and credit cards, and the per transaction card costs have increased.  Gain from Sale or Disposal of Assets. Gains from sale or disposal of assets totaled $0.7 million for fiscal 2018 compared with gains of $1.5 million for fiscal 2017. There were no individually significant transactions during either fiscal year. Other Income, Net. Other income, net totaled $3.1 million and $3.8 million for the fiscal years ended September 29, 2018 and September 30, 2017, respectively. Other income consists primarily of sales of waste paper and packaging.  Interest Expense. Interest expense was relatively unchanged at $47.6 million for the fiscal year ended September 29, 2018 and $47.4 million for the fiscal year ended September 30, 2017. Total debt was $865.6 million at the end of fiscal 2018 compared with $877.9 million at the end of fiscal 2017. Market interest rates increased during fiscal years 2017 and 2018, which affected interest expense on the Company’s floating rate debt. During late fiscal year 2017 and early fiscal year 2018, the Company renegotiated or refinanced some of its debt at lower base rates and entered into an interest rate swap to fix the interest on certain debt. These actions as well as a reduction in total debt reduced the impact of rising market interest rates.  Income Taxes. In December 2017, the Tax Cuts and Jobs Act (the “Tax Act”) became law. Among other things, the Tax Act reduced the federal corporate tax rate from 35% to 21% and allowed for full depreciation expensing of qualified property when placed in service.  As a result of the decrease in the effective tax rate, the Company recorded a decrease in its net deferred tax liabilities of $26.7 million, with a corresponding reduction to deferred income tax expense. During fiscal year 2018, the Company adopted a tax depreciation calculation method change that resulted in the accelerated deduction of certain property-related expenditures. As a result of this change and the aforementioned change in the federal corporate tax rate, the Company recorded an additional decrease in its net deferred tax liabilities of $10.6 million, with a corresponding reduction to deferred income tax expense.  Without the $37.3 million tax expense reductions, the Company’s effective tax rate would have been 25.2% for the fiscal year ended September 29, 2018 compared with 36.1% for the fiscal year ended September 30, 2017. This decrease is attributable to the aforementioned reduction in the federal corporate tax rate.  Net Income. Net income totaled $97.4 million for the fiscal year ended September 29, 2018 compared with net income of $53.9 million for the fiscal year ended September 30, 2017. Basic and diluted earnings per share for Class A Common Stock were $4.94 and $4.81, respectively, for the fiscal year ended September 29, 2018 compared with $2.74 and $2.66, respectively, for the fiscal year ended September 30, 2017. Basic and diluted earnings per share for Class B Common Stock were each $4.49 for the fiscal year ended September 29, 2018 compared with $2.49 of basic and diluted earnings per share for the fiscal year ended September 30, 2017.  Liquidity and Capital Resources  Capital Expenditures  The Company believes that a key to its ability to continue to increase sales and develop a loyal customer base is providing conveniently located, clean and modern stores which provide customers with good service and an increasingly diverse selection of competitively priced products. As such, the Company has invested and will continue to invest significant amounts of capital toward the modernization of its store base. The Company’s modernization program includes the opening of new stores, the completion of major remodels and expansion of selected existing stores, and the relocation of selected existing stores to larger, more convenient locations.  Capital expenditures totaled $161.8 million and $150.5 million for fiscal 2019 and 2018, respectively. Major capital expenditures include the following:    (including those added at new or replacement stores)   During fiscal years 2019 and 2018, the Company purchased a total of four shopping centers which contained Ingles stores that had been leased from third-party landlords.  Capital expenditures also included upgrading and replacing store equipment, technology investments, capital expenditures related to the Company’s distribution operation and its milk processing plant, and expenditures for stores to open in subsequent fiscal years.  Ingles’ capital expenditure plans for fiscal 2020 include investments of approximately $120 to $160 million. The majority of the Company’s fiscal 2020 capital expenditures will be dedicated to continued improvement of its store base and will include construction of one or more new/remodeled stores. Fiscal 2020 capital expenditures will also include investments in stores expected to open in fiscal 2021, as well as technology improvements, upgrading and replacing existing store equipment and warehouse and transportation equipment and improvements to the Company’s milk processing plant. The Company will also consider land acquisitions for future store development.  The Company expects that its net annual capital expenditures will be in the range of approximately $100 to $160 million going forward in order to maintain a modern store base. Planned expenditures for any given future fiscal year will be affected by the availability of financing, which can affect both the number of projects pursued at any given time and the cost of those projects. The number of projects may also fluctuate due to the varying costs of the types of projects pursued including new stores, major store remodels/expansions, and build-out of tenant space under the long-term leases. The Company makes decisions on the allocation of capital expenditure dollars based on many factors including the competitive environment, other Company capital initiatives and its financial condition.  In general, the Company finances its capital expenditures to the extent possible from cash on hand and cash flow from operations. Additional financing sources for capital expenditures include borrowings under the $175 million of committed line of credit, other borrowings that could be collateralized by unencumbered real property and equipment with a net book value of approximately $1.15 billion, and the public debt or equity markets. The Company has used each of these to finance past capital expenditures and expects to have them available in the future.  The Company does not generally enter into commitments for capital expenditures other than on a store-by-store basis at the time it begins construction on a new store or begins a major or minor remodeling project. Construction commitments at September 28, 2019 totaled $6.6 million.  Liquidity  The Company generated $211.5 million of cash from operations in fiscal 2019 compared with $161.2 million for fiscal 2018. The increase is primarily due to higher pre-tax income and cash provided by income tax refunds collected in fiscal year 2019.  Cash used by investing activities for fiscal 2019 totaled $152.8 million compared with $148.1 million for fiscal 2018. The Company’s most significant investing activity is capital expenditures.  The Company’s net financing activities totaled $27.1 million and $26.5 million for fiscal years 2019 and 2018, respectively. Financing activities primarily consisted of dividends and debt repayment.  In June 2013, the Company issued $700.0 million aggregate principal amount of senior notes due in 2023 (the “Notes”). The Notes bear an interest rate of 5.75% per annum and were issued at par.  The Company has a $175.0 million line of credit (the “Line”) that matures in September 2022. The Line provides the Company with various interest rate options based on the prime rate, the Federal Funds Rate, or the London Interbank Offering Rate. The Line allows the Company to issue up to $20.0 million in unused letters of credit, of which $9.0 million of unused letters of credit were issued at September 28, 2019. The Company is not required to maintain compensating balances in connection with the Line. At September 28, 2019, the Company had no borrowing outstanding under the Line.  In December 2010, the Company completed the funding of $99.7 million of Recovery Zone Facility Bonds (the “Bonds”) for construction and equipping of an approximately 830,000 square foot new warehouse and distribution center located in Buncombe County, North Carolina (the “Project”). The final maturity date of the Bonds is January 1, 2036.  Under a Continuing Covenant and Collateral Agency Agreement (the “Covenant Agreement”) between certain financial institutions and the Company, the financial institutions would hold the Bonds until September 2026, subject to certain events. Mandatory redemption of the Bonds by the Company in the annual amount of $4,530,000 began on January 1, 2014. The Company may redeem the Bonds without penalty or premium at any time prior to September 2026.  The Company has an interest rate swap agreement for a current notional amount of $48.5 million at a fixed rate of 3.92%. Under this agreement, the Company pays monthly the fixed rate of 3.92% and receives the one-month LIBOR plus 1.65%. The interest rate swap effectively hedges floating rate debt in the same amount as the current notional amount of the interest rate swap. Both the floating rate debt and the interest rate swap have monthly principal amortization of $0.5 million and mature October 1, 2027. The fair market value of the interest rate swap is measured quarterly with adjustments recorded in other comprehensive income.  The Company’s long-term debt agreements generally have cross-default provisions which could result in the acceleration of payments due under the Company’s Line, Bond and Notes indenture in the event of default under any one instrument.  The Notes, the Bonds and the Line contain provisions that under certain circumstances would permit lending institutions to terminate or withdraw their respective extensions of credit to the Company. Included among the triggering factors permitting the termination or withdrawal of the Line to the Company are certain events of default, including both monetary and non-monetary defaults, the initiation of bankruptcy or insolvency proceedings, and the failure of the Company to meet certain financial covenants designated in its respective loan documents. As of September 28, 2019, the Company was in compliance with these covenants by a significant margin. Under the most restrictive of these covenants, the Company would be able to incur approximately $595 million of additional borrowings (including borrowings under the Line) as of September 28, 2019.  The Company’s principal sources of liquidity are expected to be cash flow from operations, borrowings under the Line and long-term financing. The Company believes, based on its current results of operations and financial condition, that its financial resources, including cash balances, the existing Line, short- and long-term financing expected to be available to it and internally generated funds, will be sufficient to meet planned capital expenditures and working capital requirements for the foreseeable future, including any debt service requirements of additional borrowings. However, there can be no assurance that any such sources of financing will be available to the Company on acceptable terms, or at all.  It is possible that, in the future, the Company’s results of operations and financial condition will be different from that described in this report based on a number of intangible factors. These factors may include, among others, increased competition, changing regional and national economic conditions, adverse climatic conditions affecting food production and delivery and changing demographics as well as the additional factors discussed above and elsewhere under “Item 1A. Risk Factors.” It is also possible, for such reasons, that the results of operations from the new, expanded, remodeled and/or replacement stores will not meet or exceed the results of operations from existing stores that are described in this report.  Contractual Obligations and Commercial Commitments  The Company has assumed various financial obligations and commitments in the normal course of its operations and financing activities. Financial obligations are considered to represent known future cash payments that the Company is required to make under existing contractual arrangements, such as debt and lease arrangements. The following table represents the scheduled maturities of the Company’s long-term contractual obligations as of September 28, 2019:  Payment Due by Period    (1) Scheduled interest on floating rate debt calculated using rates in effect on September 28, 2019. (2) Operating lease obligations in the above table do not include common area maintenance, insurance, utility and tax payments for which the Company is obligated under certain operating leases. These amounts are not significant compared with the operating lease payments listed in the above table.  The Company has entered supply contracts to provide approximately 82% of the fuel sold in its fuel centers. Pricing is based on certain market indices at the time of purchase. The suppliers can modify or terminate the contracts if the Company does not meet certain minimum monthly purchase requirements.  The Company is self-insured for workers’ compensation, general liability, and group medical and dental benefits. The Company’s self-insurance reserves totaled $31.0 million at September 28, 2019 and $34.7 million at September 29, 2018. Self-insurance liabilities are based on estimates and actuarial assumptions and can fluctuate in both amount and in timing of cash settlement if historical trends are not predictive of the future. For this reason they are not included in the above table.  The Company has a nonqualified investment plan to provide retirement benefits to certain of the Company’s management employees who are otherwise subject to limited participation in the 401(k) feature of the Company’s Investment/Profit Sharing Plan. The liability to plan participants totaled $16.4 million at September 28, 2019 and $15.0 million at September 29, 2018. The settlement of this obligation is dependent upon participant elections to withdraw funds, which cannot be predicted. For this reason they are not included in the above table.  Amounts available to the Company under commercial commitments as of September 28, 2019, were as follows:  Amount of Commitment Expiration per Period    Off Balance Sheet Arrangements  The Company is not a party to any off-balance sheet arrangements that have, or are reasonably likely to have, a current or future material effect on the Company’s financial condition, revenues, expenses, results of operations, liquidity, capital expenditures or capital resources.  Quarterly Cash Dividends  Since December 27, 1993, the Company has paid regular quarterly cash dividends of $0.165 per share on its Class A Common Stock and $0.15 per share on its Class B Common Stock for an annual rate of $0.66 and $0.60 per share, respectively.  The Company expects to continue paying regular cash dividends on a quarterly basis. However, the Board of Directors periodically reconsiders the declaration of dividends. The Company pays these dividends at the discretion of the Board of Directors and the continuation of these payments, the amount of such dividends, and the form in which the dividends are paid (cash or stock) depends upon the results of operations, the financial condition of the Company and other factors which the Board of Directors deems relevant.  Long-term debt and line of credit agreements contain various restrictive covenants requiring, among other things, minimum levels of net worth and maintenance of certain financial ratios. These covenants have the effect of restricting certain types of transactions, including the payment of cash dividends generally and in excess of current quarterly per share amounts. Further, the Company is prevented from declaring dividends at any time that it is in default under the indenture governing the Notes.  Impact of Inflation  The following table from the United States Bureau of Labor Statistics lists annualized changes in the Consumer Price Index that could have an effect on the Company’s operations. One of the Company’s significant costs is labor, which increases with general inflation. Inflation or deflation in energy costs affects the Company’s gasoline sales, distribution expenses and plastic supply costs.     New Accounting Pronouncements  For new accounting pronouncements, see Note 1 to the Consolidated Financial Statements included in this Annual Report on Form 10-K.  Outlook and Trends in the Company’s Markets  The Company has improved the interior layout and product offerings in a significant number of stores over the past few fiscal years. Economic conditions have remained favorable and the Company continues to increase and improve its total retail square footage.  The Company continually assesses and modifies its business model to meet the changing needs and expectations of its customers. In connection with this review, the Company assesses the trends present in the markets in which it competes. Generally, it is difficult to predict whether a trend will continue for a period of time and it is possible that new trends will develop which will affect an existing trend. The Company believes that the following trends are likely to continue for at least the next fiscal year: · The supermarket industry will remain highly competitive and will be characterized by industry consolidation, fragmented food retail platforms, and continued competition from super centers and other non-supermarket operators. · Traditional supermarket products will be acquired by customers in new and diverse ways, including online ordering, home delivery and pre-picked for customer pickup. · Economic conditions will continue to affect customer behavior. Economic conditions may affect purchasing patterns with regard to meal replacement items, private label purchases, promotions and product variety. · The Company and its customers will continue to become more environmentally aware, evidenced by the Company’s increased recycled waste paper and pallets and customers’ increased usage of reusable shopping bags. · Volatile petroleum costs will impact utility and distribution costs, plastic supplies cost and may change customer shopping and dining behavior. · Retail gasoline costs and retail prices will continue to be volatile, affecting the Company’s gasoline sales and gross margin.  The Company plans to continue to focus on balancing sales growth and gross margin maintenance (excluding the effect of gasoline sales) and will carefully monitor its product mix and customer trends.

<s>[INST] Overview  Ingles, a leading supermarket chain in the Southeast United States, operates 198 supermarkets in North Carolina (73), Georgia (66), South Carolina (36), Tennessee (21), Virginia (1) and Alabama (1). The Company locates its supermarkets primarily in suburban areas, small towns and neighborhood shopping centers. Ingles supermarkets offer customers a wide variety of nationally advertised food products, including grocery, meat and dairy products, produce, frozen foods and other perishables and nonfood products. Nonfood products include fuel centers, pharmacies, health and beauty care products and general merchandise. The Company offers quality private label items in most of its departments. In addition, the Company focuses on selling highgrowth, highmargin products to its customers through the development of certified organic products, bakery departments and prepared foods including delicatessen sections. As of September 28, 2019, the Company operated 108 instore pharmacies and 104 fuel centers. Ingles also operates a fluid dairy and earns shopping center rentals.  Critical Accounting Policies  Critical accounting policies are those accounting policies that management believes are important to the portrayal of Ingles’ financial condition and results of operations, and require management’s most difficult, subjective or complex judgments, often as a result of the need to make estimates about the effect of matters that are inherently uncertain. Estimates are based on historical experience and other factors believed to be reasonable under the circumstances, the results of which form the basis for making judgments about the carrying values of assets and liabilities that are not readily apparent from other sources. Management estimates, by their nature, involve judgments regarding future uncertainties, and actual results may therefore differ materially from these estimates.  SelfInsurance  The Company is selfinsured for workers’ compensation, general liability, and group medical and dental benefits. Risks and uncertainties are associated with selfinsurance; however, the Company has limited its exposure by maintaining excess liability coverage of $1,000,000 per occurrence for workers’ compensation, $500,000 for general liability, and $450,000 per covered person for medical care benefits for a policy year. Effective October 1, 2019 the excess liability limit was increased to $1,000,000 for general liability. Selfinsurance liabilities are established based on claims filed and estimates of claims incurred but not reported. The estimates are based on data provided by the respective claims administrators which is then applied to appropriate actuarial methods. These estimates can fluctuate if historical trends are not predictive of the future. The majority of the Company’s properties are selfinsured for casualty losses and business interruption; however, liability coverage is maintained. The Company’s selfinsurance reserves totaled $31.0 million and $34.7 million for employee group insurance, workers’ compensation insurance and general liability insurance at September 28, 2019 and September 29, 2018, respectively. These amounts are inclusive of expected recoveries from excess cost insurance or other sources that are recorded as receivables of $3.6 million at September 28, 2019 and $4.6 million at September 29, 2018.  Asset Impairments  The Company accounts for the impairment of longlived assets in accordance with Financial Accounting Standards Board Accounting Standards Codification (“FASB ASC”) Topic 360. Asset groups are primarily comprised of our individual store and shopping center properties. For assets to be held and used, the Company tests for impairment using undiscounted cash flows and calculates the amount of impairment using discounted cash flows. For assets held for sale, impairment is recognized based on the excess of remaining book value over expected recovery value. The recovery value is the fair value as determined by independent quotes or expected sales prices developed by internal associates, net of costs to sell. Estimates of future cash flows and expected sales prices are judgments based upon the Company’s experience and knowledge of local operations and cash flows that are projected for several years into [/INST] Positive. </s>

BP PRUDHOE BAY ROYALTY TRUST

2015-03-04

2014-12-31

ITEM 7. TRUSTEE’S DISCUSSION AND ANALYSIS OF FINANCIAL CONDITION AND RESULTS OF OPERATIONS Liquidity and Capital Resources The Trust is a passive entity. The Trustee’s activities are limited to collecting and distributing the revenues from the Royalty Interest and paying liabilities and expenses of the Trust. Generally, the Trust has no source of liquidity and no capital resources other than the revenue attributable to the Royalty Interest that it receives from time to time. See the discussion under “THE ROYALTY INTEREST” in Item 1 for a description of the calculation of the Per Barrel Royalty, and the discussion under “THE PRUDHOE BAY UNIT AND FIELD - Reserve Estimates” in Item 1 for information concerning the estimated future net revenues of the Trust. However, the Trust Agreement gives the Trustee power to borrow, establish a cash reserve, or dispose of all or part of the Trust property under limited circumstances. See the discussion under “THE TRUST - Sales of Royalty Interest; Borrowings and Reserves” in Item 1. Since 1999, the Trustee has maintained a $1,000,000 cash reserve to provide liquidity to the Trust during any future periods in which the Trust does not receive a distribution. The Trustee will draw funds from the cash reserve account during any quarter in which the quarterly distribution received by the Trust does not exceed the liabilities and expenses of the Trust, and will replenish the reserve from future quarterly distributions, if any. The Trustee anticipates that it will keep this cash reserve program in place until termination of the Trust. Amounts set aside for the cash reserve are invested by the Trustee in U.S. government or agency securities secured by the full faith and credit of the United States. Interest income received by the Trust from the investment of the reserve fund is added to the distributions received from BP Alaska and paid to the Unit holders on each Quarterly Record Date. Annual decreases in Trust corpus and total assets are the result of amortization of the Royalty Interest. See Notes 2 and 3 of Notes to Financial Statements in Item 8. Results of Operations Relatively modest changes in oil prices significantly affect the Trust’s revenues and results of operations. Crude oil prices are subject to significant changes in response to fluctuations in the domestic and world supply and demand and other market conditions as well as the world political situation as it affects OPEC and other producing countries. The effect of changing economic conditions on the demand and supply for energy throughout the world and future prices of oil cannot be accurately projected. Royalty revenues are generally received on the Quarterly Record Date (generally the fifteenth day of the month) following the end of the calendar quarter in which the related Royalty Production occurred. The Trustee, to the extent possible, pays all expenses of the Trust for each quarter on the Quarterly Record Date on which the revenues for the quarter are received. For the statement of cash earnings and distributions, revenues and Trust expenses are recorded on a cash basis and, as a result, distributions to Unit holders in each calendar year ending December 31 are attributable to BP Alaska’s operations during the twelve-month period ended on the preceding September 30. When BP Alaska’s average net production of oil and condensate per quarter from the 1989 Working Interests exceeds 90,000 barrels a day, the principal factors affecting the Trust’s revenues and distributions to Unit holders are changes in WTI Prices, scheduled annual increases in Chargeable Costs, changes in the Consumer Price Index and changes in Production Taxes. However, it is likely that the Trust’s revenues in future periods also will be affected by increases and decreases in production from the 1989 Working Interests. BP Alaska’s net production of oil and condensate allocated to the Trust from proved reserves was less than 90,000 barrels per day on an annual basis during 2012, 2013 and 2014. The Trustee has been advised that BP Alaska expects that average net production allocated to the Trust from the proved reserves will be less than 90,000 barrels a day on an annual basis in future years. BP Alaska estimates Royalty Production from the 1989 Working Interests for purposes of calculating quarterly royalty payments to the Trust because complete actual field production data for the preceding calendar quarter generally is not available by the Quarterly Record Date. To the extent that average net production from the 1989 Working Interests is below 90,000 barrels per day, calculation by BP Alaska of actual Royalty Production data may result in revisions of prior Royalty Production estimates. Revisions by BP Alaska of its Royalty Production calculations may result in quarterly royalty payments by BP Alaska which reflect adjustments for overpayments or underpayments of royalties with respect to prior quarters. Such adjustments, if material, may adversely affect certain Unit holders who buy or sell Units between the Quarterly Record Dates for the Quarterly Distributions affected. See Note 8 of Notes to Financial Statements in Item 8. Because the annual statement of cash earnings and distributions of the Trust is prepared on a modified cash basis, royalty revenues for the calendar year do not include the amounts of underpayments or overpayments affecting payments received during the fourth quarter of the year. During the years 2013 and 2014 and the period of 2015 up to the date of this report, WTI Prices have been above the level necessary for the Trust to receive a Per Barrel Royalty. Whether the Trust will be entitled to future distributions during the remainder of 2015 will depend on WTI Prices prevailing during the remainder of the year. 2014 compared to 2013 As explained in Note 2 of Notes to Financial Statements below, the financial statements of the Trust are prepared on a modified cash basis and differ from financial statements prepared in accordance with generally accepted accounting principles in that (a) revenues are recorded when received (generally within 15 days of the end of the preceding quarter) and distributions to Trust Unit holders are recorded when paid and (b) Trust expenses are recorded on an accrual basis. As a consequence, Trust royalty revenues for the fiscal year are based on Royalty Production during the twelve months ended September 30 of the fiscal year. Average WTI prices during the twelve months ended September 30, 2014, a period that ended prior to the steep decline in crude oil prices that accelerated during the fourth quarter of 2014, increased compared to the preceding twelve-month period. WTI prices during this period fluctuated in a relatively narrow range during the period between an average price of $100.66 during October 2013 and $93.09 during September 2014, with a high average price of $105.34 during June 2014 and the low average price of $93.09 during the last month of the period in September 2014. The increase in the Consumer Price Index used to calculate the Cost Adjustment Factor, as well as the scheduled increase in Chargeable Costs from $16.80 in calendar 2013 to $16.90 in calendar 2014, resulted in the increase in Adjusted Chargeable Costs during the twelve month ended September 30, 2014. The increase in the average Per Barrel Royalty resulted from the decrease in Production Taxes during the first three quarters of 2014 as a result of the changes to the Alaska Production Statutes by the Act, which took effect January 1, 2014. In addition to the effects of the Act, the modest decline in the production levels from the 1989 Working Interest for the twelve-month period also contributed to the decrease in Production Taxes. The decline in average net production from the 1089 Working Interests between the two periods reflects a combination of (1) naturally declining production from the Prudhoe Bay field and (2) variance in the impacts of planned and unplanned downtime during the two reporting periods. The increase in the average Per Barrel Royalty that resulted from the decrease in Production Taxes during the first three quarters of 2014 as a result of the changes to the Alaska Production Statutes by the Act had a corresponding effect on royalty revenues, cash earnings and cash distributions for the twelve months ended December 31, 2014. The decrease in administrative expenses reflects timing differences in accruals of expenses for supplies and services. 2013 compared to 2012 Average WTI prices during the twelve months ended September 30, 2013 remained virtually unchanged overall compared to the preceding twelve-month period, despite fluctuating between an average price of $89.52 during October 2012 and an average price of $106.31 during September 2013, with a high average price of $106.55 during August 2013 and a low average price of $86.69 during November 2012. The increase in the Consumer Price Index used to calculate the Cost Adjustment Factor, as well as the scheduled increase in Chargeable Costs from $16.70 in calendar 2012 to $16.80 in calendar 2013, resulted in the increase in Adjusted Chargeable Costs during the twelve months ended September 30, 2013. The decrease in Production Taxes during the twelve-month period was primarily due to the modest decline in the production levels from the 1989 Working Interest for the twelve-month period. The decline in production levels during this period resulted primarily from two TAPS-related planned maintenance events and two planned Greater Prudhoe Bay field facility turnarounds during the second and third quarters of 2013. The decline in the production levels from the 1989 Working Interest due to the two TAPS-related planned maintenance events and the two facility turnarounds at the Greater Prudhoe Bay field during the second and third quarters of 2013 had a corresponding effect on royalty revenues, cash earnings and cash distributions for the twelve months ended December 31, 2013. The increase in administrative expenses reflects certain increases in the overall costs of supplies and services and timing differences in accruals of expenses.

<s>[INST] The Trust is a passive entity. The Trustee’s activities are limited to collecting and distributing the revenues from the Royalty Interest and paying liabilities and expenses of the Trust. Generally, the Trust has no source of liquidity and no capital resources other than the revenue attributable to the Royalty Interest that it receives from time to time. See the discussion under “THE ROYALTY INTEREST” in Item 1 for a description of the calculation of the Per Barrel Royalty, and the discussion under “THE PRUDHOE BAY UNIT AND FIELD Reserve Estimates” in Item 1 for information concerning the estimated future net revenues of the Trust. However, the Trust Agreement gives the Trustee power to borrow, establish a cash reserve, or dispose of all or part of the Trust property under limited circumstances. See the discussion under “THE TRUST Sales of Royalty Interest; Borrowings and Reserves” in Item 1. Since 1999, the Trustee has maintained a $1,000,000 cash reserve to provide liquidity to the Trust during any future periods in which the Trust does not receive a distribution. The Trustee will draw funds from the cash reserve account during any quarter in which the quarterly distribution received by the Trust does not exceed the liabilities and expenses of the Trust, and will replenish the reserve from future quarterly distributions, if any. The Trustee anticipates that it will keep this cash reserve program in place until termination of the Trust. Amounts set aside for the cash reserve are invested by the Trustee in U.S. government or agency securities secured by the full faith and credit of the United States. Interest income received by the Trust from the investment of the reserve fund is added to the distributions received from BP Alaska and paid to the Unit holders on each Quarterly Record Date. Annual decreases in Trust corpus and total assets are the result of amortization of the Royalty Interest. See Notes 2 and 3 of Notes to Financial Statements in Item 8. Results of Operations Relatively modest changes in oil prices significantly affect the Trust’s revenues and results of operations. Crude oil prices are subject to significant changes in response to fluctuations in the domestic and world supply and demand and other market conditions as well as the world political situation as it affects OPEC and other producing countries. The effect of changing economic conditions on the demand and supply for energy throughout the world and future prices of oil cannot be accurately projected. Royalty revenues are generally received on the Quarterly Record Date (generally the fifteenth day of the month) following the end of the calendar quarter in which the related Royalty Production occurred. The Trustee, to the extent possible, pays all expenses of the Trust for each quarter on the Quarterly Record Date on which the revenues for the quarter are received. For the statement of cash earnings and distributions, revenues and Trust expenses are recorded on a cash basis and, as a result, distributions to Unit holders in each calendar year ending December 31 are attributable to BP Alaska’s operations during the twelvemonth period ended on the preceding September 30. When BP Alaska’s average net production of oil and condensate per quarter from the 1989 Working Interests exceeds 90,000 barrels a day, the principal factors affecting the Trust’s revenues and distributions to Unit holders are changes in WTI Prices, scheduled annual increases in Chargeable Costs, changes in the Consumer Price Index and changes in Production Taxes. However, it is likely that the Trust’s revenues in future periods also will be affected by increases and decreases in production from the 1989 Working Interests. BP Alaska’s net production of oil and condensate allocated to the Trust from proved reserves was less than 90,000 barrels per day on an annual basis during 2012, 2013 and 2014. The Trustee has been advised that BP Alaska expects that average net production allocated to the Trust from the proved reserves will be less than 90,000 barrels a day on an annual basis in future years. BP Alaska estimates Royalty Production from the 1989 Working Interests for purposes of calculating quarterly royalty payments to the Trust because complete actual field production data for the preceding calendar quarter generally is not [/INST] Negative. </s>

BP PRUDHOE BAY ROYALTY TRUST

2016-02-29

2015-12-31

ITEM 7. TRUSTEE’S DISCUSSION AND ANALYSIS OF FINANCIAL CONDITION AND RESULTS OF OPERATIONS Liquidity and Capital Resources The Trust is a passive entity. The Trustee’s activities are limited to collecting and distributing the revenues from the Royalty Interest and paying liabilities and expenses of the Trust. Generally, the Trust has no source of liquidity and no capital resources other than the revenue attributable to the Royalty Interest that it receives from time to time. See the discussion under “THE ROYALTY INTEREST” in Item 1 for a description of the calculation of the Per Barrel Royalty, and the discussion under “THE PRUDHOE BAY UNIT AND FIELD - Reserve Estimates” in Item 1 for information concerning the estimated future net revenues of the Trust. However, the Trust Agreement gives the Trustee power to borrow, establish a cash reserve, or dispose of all or part of the Trust property under limited circumstances. See the discussion under “THE TRUST - Sales of Royalty Interest; Borrowings and Reserves” in Item 1. Since 1999, the Trustee has maintained a $1,000,000 cash reserve to provide liquidity to the Trust during any future periods in which the Trust does not receive a distribution. The Trustee will draw funds from the cash reserve account during any quarter in which the quarterly distribution received by the Trust does not exceed the liabilities and expenses of the Trust, and will replenish the reserve from future quarterly distributions, if any. The Trustee anticipates that it will keep this cash reserve program in place until termination of the Trust. Amounts set aside for the cash reserve are invested by the Trustee in U.S. government or agency securities secured by the full faith and credit of the United States. Interest income received by the Trust from the investment of the reserve fund is added to the distributions received from BP Alaska and paid to the Unit holders on each Quarterly Record Date. Results of Operations Relatively modest changes in oil prices significantly affect the Trust’s revenues and results of operations. Crude oil prices are subject to significant changes in response to fluctuations in the domestic and world supply and demand and other market conditions as well as the world political situation as it affects OPEC and other producing countries. The effect of changing economic conditions on the demand and supply for energy throughout the world and future prices of oil cannot be accurately projected. Royalty revenues are generally received on the Quarterly Record Date (generally the fifteenth day of the month) following the end of the calendar quarter in which the related Royalty Production occurred. The Trustee, to the extent possible, pays all expenses of the Trust for each quarter on the Quarterly Record Date on which the revenues for the quarter are received. For the statement of cash earnings and distributions, revenues and Trust expenses are recorded on a cash basis and, as a result, distributions to Unit holders in each calendar year ending December 31 are attributable to BP Alaska’s operations during the twelve-month period ended on the preceding September 30. When BP Alaska’s average net production of oil and condensate per quarter from the 1989 Working Interests exceeds 90,000 barrels a day, the principal factors affecting the Trust’s revenues and distributions to Unit holders are changes in WTI Prices, scheduled annual increases in Chargeable Costs, changes in the Consumer Price Index and changes in Production Taxes. However, it is likely that the Trust’s revenues in future periods also will be affected by increases and decreases in production from the 1989 Working Interests. BP Alaska’s net production of oil and condensate allocated to the Trust from proved reserves was less than 90,000 barrels per day on an annual basis during 2013, 2014 and 2015. The Trustee has been advised that BP Alaska expects that average net production allocated to the Trust from the proved reserves will be less than 90,000 barrels a day on an annual basis in future years. BP Alaska estimates Royalty Production from the 1989 Working Interests for purposes of calculating quarterly royalty payments to the Trust because complete actual field production data for the preceding calendar quarter generally is not available by the Quarterly Record Date. To the extent that average net production from the 1989 Working Interests is below 90,000 barrels per day, calculation by BP Alaska of actual Royalty Production data may result in revisions of prior Royalty Production estimates. Revisions by BP Alaska of its Royalty Production calculations may result in quarterly royalty payments by BP Alaska which reflect adjustments for overpayments or underpayments of royalties with respect to prior quarters. Such adjustments, if material, may adversely affect certain Unit holders who buy or sell Units between the Quarterly Record Dates for the Quarterly Distributions affected. See Note 8 of Notes to Financial Statements in Item 8. Because the annual statement of cash earnings and distributions of the Trust is prepared on a modified cash basis, royalty revenues for the calendar year do not include the amounts of underpayments or overpayments affecting payments received during the fourth quarter of the year. During the years 2014 and 2015 and the period of 2016 up to the date of this report, WTI Prices have been above the level necessary for the Trust to receive a Per Barrel Royalty. Whether the Trust will be entitled to future distributions during the remainder of 2016 will depend on WTI Prices prevailing during the remainder of the year. As discussed above in Item 1A “RISK FACTORS”, it is anticipated that global oil prices could remain low for a significant period. As also discussed above in Item 1A “RISK FACTORS”, on January 1, 2016, the “break-even” WTI price (the price at which all taxes and prescribed deductions are equal to the WTI price) for the Trust to receive a positive Per Barrel Royalty with respect to a particular day’s production was $32.25. From the beginning of the first quarter of 2016 through February 22, 2016, the WTI crude oil spot price has fluctuated between a high of $36.76 per barrel on January 4, 2016 and a low of $26.21 per barrel on February 11, 2016. The WTI crude oil spot price on February 22, 2016 was $31.48 per barrel. The quarterly royalty payment by BP Alaska to the Trust is the sum of the individual revenues attributed to the Trust as calculated each day during the quarter. Any single calculation of a calendar day will not reflect the value of the dividend paid to the Trust for the quarter, nor will it reflect the estimated future value of the Trust. However, if the current low oil price environment continues for a protracted period, as anticipated, quarterly royalty payments during that period can be expected to be significantly lower than royalty payments for recent periods, and could in fact be zero. 2015 compared to 2014 As explained in Note 2 of Notes to Financial Statements below, the financial statements of the Trust are prepared on a modified cash basis and differ from financial statements prepared in accordance with generally accepted accounting principles in that (a) revenues are recorded when received (generally within 15 days of the end of the preceding quarter) and distributions to Trust Unit holders are recorded when paid and (b) Trust expenses are recorded on an accrual basis. As a consequence, Trust royalty revenues for the fiscal year are based on Royalty Production during the twelve months ended September 30 of the fiscal year. Average WTI prices during the twelve months ended September 30, 2015 declined steeply compared to the preceding twelve-month period. Although the average WTI price for the second quarter of 2015 actually rose nearly 20% compared to the average WTI price for the first quarter of 2015, WTI prices during this period declined overall from an average high price of $84.47 during October 2014 to an average price of $45.43 during the last month of the period in September 2015. The lowest average monthly price for the period was $43.19 in August 2015. The increase in the Consumer Price Index used to calculate the Cost Adjustment Factor, as well as the scheduled increase in Chargeable Costs from $16.90 in calendar 2014 to $17.00 in calendar 2015, resulted in the modest increase in Adjusted Chargeable Costs during the twelve month ended September 30, 2015. The decrease in the average Per Barrel Royalty for the period resulted primarily from the decline in WTI prices. This decline was partially offset by the decline in Production Taxes. The decline in WTI prices resulted in Production Taxes for the second and third quarters of 2015 being calculated on the basis of the minimum tax under the Act and the 2014 Letter Agreement. See Note 5 of Notes to Financial Statements in Item 8 below. The increase in the average net production from the 1989 Working Interests between the two periods reflects the BP Operating unit reaching the cumulative condensate limit of 1,175,000,000 barrels in the second quarter of 2014. Once the cumulative condensate limit was reached, the production associated with condensate became subject to the Oil Rim Initial Participating Area royalty interest of 50.6848339% instead of the Gas Cap Participating Area Royalty Interest of 13.8398950%. Ongoing development activity and projects also contributed to this increase by partially offsetting the naturally declining production rate from the Prudhoe Bay field and variance in the impacts of planned and unplanned downtime during the two reporting periods. The period-to-period decreases in royalty revenues, cash earnings and cash distributions are due to the significantly lower average WTI Prices that prevailed during 2015 compared to 2014. The decreases in royalty revenues, cash earnings and cash distributions were offset somewhat by the increase in royalty interest received by the Trust as a result of the cumulative condensate limit being reached at the end of the second quarter of 2014 and the decrease in Production Taxes. The increase in administrative expenses reflects higher overall costs of supplies and services and timing differences in accruals of expenses. 2014 compared to 2013 Average WTI prices during the twelve months ended September 30, 2014, a period that ended prior to the steep decline in crude oil prices that accelerated during the fourth quarter of 2014, increased compared to the preceding twelve-month period. WTI prices during this period fluctuated in a relatively narrow range during the period between an average price of $100.66 during October 2013 and $93.09 during September 2014, with a high average price of $105.34 during June 2014 and the low average price of $93.09 during the last month of the period in September 2014. The increase in the Consumer Price Index used to calculate the Cost Adjustment Factor, as well as the scheduled increase in Chargeable Costs from $16.80 in calendar 2013 to $16.90 in calendar 2014, resulted in the increase in Adjusted Chargeable Costs during the twelve month ended September 30, 2014. The increase in the average Per Barrel Royalty resulted from the decrease in Production Taxes during the first three quarters of 2014 as a result of the changes to the Alaska Production Statutes by the Act, which took effect January 1, 2014. In addition to the effects of the Act, the modest decline in the production levels from the 1989 Working Interest for the twelve-month period also contributed to the decrease in Production Taxes. The decline in average net production from the 1989 Working Interests between the two periods reflects a combination of (1) naturally declining production from the Prudhoe Bay field and (2) variance in the impacts of planned and unplanned downtime during the two reporting periods. The increase in the average Per Barrel Royalty that resulted from the decrease in Production Taxes during the first three quarters of 2014 as a result of the changes to the Alaska Production Statutes by the Act had a corresponding effect on royalty revenues, cash earnings and cash distributions for the twelve months ended December 31, 2014. The decrease in administrative expenses reflects timing differences in accruals of expenses for supplies and services.

<s>[INST] The Trust is a passive entity. The Trustee’s activities are limited to collecting and distributing the revenues from the Royalty Interest and paying liabilities and expenses of the Trust. Generally, the Trust has no source of liquidity and no capital resources other than the revenue attributable to the Royalty Interest that it receives from time to time. See the discussion under “THE ROYALTY INTEREST” in Item 1 for a description of the calculation of the Per Barrel Royalty, and the discussion under “THE PRUDHOE BAY UNIT AND FIELD Reserve Estimates” in Item 1 for information concerning the estimated future net revenues of the Trust. However, the Trust Agreement gives the Trustee power to borrow, establish a cash reserve, or dispose of all or part of the Trust property under limited circumstances. See the discussion under “THE TRUST Sales of Royalty Interest; Borrowings and Reserves” in Item 1. Since 1999, the Trustee has maintained a $1,000,000 cash reserve to provide liquidity to the Trust during any future periods in which the Trust does not receive a distribution. The Trustee will draw funds from the cash reserve account during any quarter in which the quarterly distribution received by the Trust does not exceed the liabilities and expenses of the Trust, and will replenish the reserve from future quarterly distributions, if any. The Trustee anticipates that it will keep this cash reserve program in place until termination of the Trust. Amounts set aside for the cash reserve are invested by the Trustee in U.S. government or agency securities secured by the full faith and credit of the United States. Interest income received by the Trust from the investment of the reserve fund is added to the distributions received from BP Alaska and paid to the Unit holders on each Quarterly Record Date. Results of Operations Relatively modest changes in oil prices significantly affect the Trust’s revenues and results of operations. Crude oil prices are subject to significant changes in response to fluctuations in the domestic and world supply and demand and other market conditions as well as the world political situation as it affects OPEC and other producing countries. The effect of changing economic conditions on the demand and supply for energy throughout the world and future prices of oil cannot be accurately projected. Royalty revenues are generally received on the Quarterly Record Date (generally the fifteenth day of the month) following the end of the calendar quarter in which the related Royalty Production occurred. The Trustee, to the extent possible, pays all expenses of the Trust for each quarter on the Quarterly Record Date on which the revenues for the quarter are received. For the statement of cash earnings and distributions, revenues and Trust expenses are recorded on a cash basis and, as a result, distributions to Unit holders in each calendar year ending December 31 are attributable to BP Alaska’s operations during the twelvemonth period ended on the preceding September 30. When BP Alaska’s average net production of oil and condensate per quarter from the 1989 Working Interests exceeds 90,000 barrels a day, the principal factors affecting the Trust’s revenues and distributions to Unit holders are changes in WTI Prices, scheduled annual increases in Chargeable Costs, changes in the Consumer Price Index and changes in Production Taxes. However, it is likely that the Trust’s revenues in future periods also will be affected by increases and decreases in production from the 1989 Working Interests. BP Alaska’s net production of oil and condensate allocated to the Trust from proved reserves was less than 90,000 barrels per day on an annual basis during 2013, 2014 and 2015. The Trustee has been advised that BP Alaska expects that average net production allocated to the Trust from the proved reserves will be less than 90,000 barrels a day on an annual basis in future years. BP Alaska estimates Royalty Production from the 1989 Working Interests for purposes of calculating quarterly royalty payments to the Trust because complete actual field production data for the preceding calendar quarter generally is not available by the Quarterly Record Date. To the extent that average net production from the 1989 Working Interests is below 90,000 barrels per day, calculation by BP Alaska [/INST] Negative. </s>

BP PRUDHOE BAY ROYALTY TRUST

2017-03-01

2016-12-31

ITEM 7. TRUSTEE’S DISCUSSION AND ANALYSIS OF FINANCIAL CONDITION AND RESULTS OF OPERATIONS Liquidity and Capital Resources The Trust is a passive entity. The Trustee’s activities are limited to collecting and distributing the revenues from the Royalty Interest and paying liabilities and expenses of the Trust. Generally, the Trust has no source of liquidity and no capital resources other than the revenue attributable to the Royalty Interest that it receives from time to time. See the discussion under “THE ROYALTY INTEREST” in Item 1 for a description of the calculation of the Per Barrel Royalty, and the discussion under “THE PRUDHOE BAY UNIT AND FIELD - Reserve Estimates” in Item 1 for information concerning the estimated future net revenues of the Trust. However, the Trust Agreement gives the Trustee power to borrow, establish a cash reserve, or dispose of all or part of the Trust property under limited circumstances. See the discussion under “THE TRUST - Sales of Royalty Interest; Borrowings and Reserves” in Item 1. Since 1999, the Trustee has maintained a $1,000,000 cash reserve to provide liquidity to the Trust during any future periods in which the Trust does not receive a distribution. The Trustee will draw funds from the cash reserve account during any quarter in which the quarterly distribution received by the Trust does not exceed the liabilities and expenses of the Trust, and will replenish the reserve from future quarterly distributions, if any. The Trustee anticipates that it will keep this cash reserve program in place until termination of the Trust. Amounts set aside for the cash reserve are invested by the Trustee in U.S. government or agency securities secured by the full faith and credit of the United States. Interest income received by the Trust from the investment of the reserve fund is added to the distributions received from BP Alaska and paid to the Unit holders on each Quarterly Record Date. Results of Operations Relatively modest changes in oil prices significantly affect the Trust’s revenues and results of operations. Crude oil prices are subject to significant changes in response to fluctuations in the domestic and world supply and demand and other market conditions as well as the world political situation as it affects OPEC and other producing countries. The effect of changing economic conditions on the demand and supply for energy throughout the world and future prices of oil cannot be accurately projected. Royalty revenues are generally received on the Quarterly Record Date (generally the fifteenth day of the month) following the end of the calendar quarter in which the related Royalty Production occurred. The Trustee, to the extent possible, pays all expenses of the Trust for each quarter on the Quarterly Record Date on which the revenues for the quarter are received. For the statement of cash earnings and distributions, revenues and Trust expenses are recorded on a cash basis and, as a result, distributions to Unit holders in each calendar year ending December 31 are attributable to BP Alaska’s operations during the twelve-month period ended on the preceding September 30. When BP Alaska’s average net production of oil and condensate per quarter from the 1989 Working Interests exceeds 90,000 barrels a day, the principal factors affecting the Trust’s revenues and distributions to Unit holders are changes in WTI Prices, scheduled annual increases in Chargeable Costs, changes in the Consumer Price Index and changes in Production Taxes. However, it is likely that the Trust’s revenues in future periods also will be affected by increases and decreases in production from the 1989 Working Interests. BP Alaska’s net production of oil and condensate allocated to the Trust from proved reserves was less than 90,000 barrels per day on an annual basis during 2014, 2015 and 2016. The Trustee has been advised that BP Alaska expects that average net production allocated to the Trust from the proved reserves will be less than 90,000 barrels a day on an annual basis in future years. BP Alaska estimates Royalty Production from the 1989 Working Interests for purposes of calculating quarterly royalty payments to the Trust because complete actual field production data for the preceding calendar quarter generally is not available by the Quarterly Record Date. To the extent that average net production from the 1989 Working Interests is below 90,000 barrels per day, calculation by BP Alaska of actual Royalty Production data may result in revisions of prior Royalty Production estimates. Revisions by BP Alaska of its Royalty Production calculations may result in quarterly royalty payments by BP Alaska which reflect adjustments for overpayments or underpayments of royalties with respect to prior quarters. Such adjustments, if material, may adversely affect certain Unit holders who buy or sell Units between the Quarterly Record Dates for the Quarterly Distributions affected. See Note 8 of Notes to Financial Statements in Item 8. Because the annual statement of cash earnings and distributions of the Trust is prepared on a modified cash basis, royalty revenues for the calendar year do not include the amounts of underpayments or overpayments affecting payments received during the fourth quarter of the year. During the years 2015 and 2016 and the period of 2017 up to the date of this report, WTI Prices have been above the level necessary for the Trust to receive a Per Barrel Royalty. Whether the Trust will be entitled to future distributions during the remainder of 2017 will depend on WTI Prices prevailing during the remainder of the year. As discussed above in Item 1A “RISK FACTORS”, it is anticipated that global oil prices could remain low for a significant period. As also discussed above in Item 1A “RISK FACTORS”, on January 1, 2017, the “break-even” WTI price (the price at which all taxes and prescribed deductions are equal to the WTI price) for the Trust to receive a positive Per Barrel Royalty with respect to a particular day’s production was $32.99. From the beginning of the first quarter of 2017 through February 22, 2017, the WTI crude oil spot price has fluctuated between a high of $54.06 per barrel on February 21, 2017 and a low of $50.82 per barrel on January 10, 2017. The WTI crude oil spot price on February 22, 2016 was $53.59 per barrel. The quarterly royalty payment by BP Alaska to the Trust is the sum of the individual revenues attributed to the Trust as calculated each day during the quarter. Any single calculation of a calendar day will not reflect the value of the dividend paid to the Trust for the quarter, nor will it reflect the estimated future value of the Trust. However, if a low oil price environment should occur for a protracted period, quarterly royalty payments could decline significantly, and could in fact be zero. 2016 compared to 2015 As explained in Note 2 of Notes to Financial Statements below, the financial statements of the Trust are prepared on a modified cash basis and differ from financial statements prepared in accordance with generally accepted accounting principles in that (a) revenues are recorded when received (generally within 15 days of the end of the preceding quarter) and distributions to Trust Unit holders are recorded when paid and (b) Trust expenses are recorded on an accrual basis. As a consequence, Trust royalty revenues for the fiscal year are based on Royalty Production during the twelve months ended September 30 of the fiscal year. Average WTI prices during the twelve months ended September 30, 2016 declined significantly compared to the preceding twelve-month period. Nevertheless, because WTI prices began to rise after reaching lows early in the first quarter of 2016, the decline in WTI price for the period was substantially less than it was for the prior period, as indicated in the chart below. WTI prices during this period ranged from an average high price of $46.22 during October 2015 to an average price of $45.18 during the last month of the period in September 2016. The lowest average monthly price for the period was $30.32 in February 2016. The increase in the Consumer Price Index used to calculate the Cost Adjustment Factor, as well as the scheduled increase in Chargeable Costs from $17.00 in calendar 2015 to $17.10 in calendar 2016, resulted in the modest increase in Adjusted Chargeable Costs during the twelve month ended September 30, 2016. The decrease in the average Per Barrel Royalty for the period resulted primarily from the decline in WTI prices. This decline was partially offset by the decline in Production Taxes. The decline in WTI prices resulted in Production Taxes for the fourth quarter of 2015 and the first three quarters of 2016 being calculated on the basis of the minimum tax under the Act and the 2014 Letter Agreement. See Note 5 of Notes to Financial Statements in Item 8 below. The increase in the average net production from the 1989 Working Interests between the two periods was due to ongoing development activity and projects, which partially offset the naturally declining production rate from the Prudhoe Bay field and variance in the impacts of planned and unplanned downtime during the two reporting periods. The period-to-period decreases in royalty revenues, cash earnings and cash distributions are due to the significantly lower average WTI Prices that prevailed during 2016 compared to 2015. The decrease in administrative expenses reflects lower overall costs of supplies and services and timing differences in accruals of expenses. 2015 compared to 2014 Average WTI prices during the twelve months ended September 30, 2015 declined significantly compared to the preceding twelve-month period. Although the average WTI price for the second quarter of 2015 actually rose nearly 20% compared to the average WTI price for the first quarter of 2015, WTI prices during this period declined overall from an average high price of $84.47 during October 2014 to an average price of $45.43 during the last month of the period in September 2015. The lowest average monthly price for the period was $43.19 in August 2015. The increase in the Consumer Price Index used to calculate the Cost Adjustment Factor, as well as the scheduled increase in Chargeable Costs from $16.90 in calendar 2014 to $17.00 in calendar 2015, resulted in the modest increase in Adjusted Chargeable Costs during the twelve month ended September 30, 2015. The decrease in the average Per Barrel Royalty for the period resulted primarily from the decline in WTI prices. This decline was partially offset by the decline in Production Taxes. The decline in WTI prices resulted in Production Taxes for the second and third quarters of 2015 being calculated on the basis of the minimum tax under the Act and the 2014 Letter Agreement. See Note 5 of Notes to Financial Statements in Item 8 below. The increase in the average net production from the 1989 Working Interests between the two periods reflects the BP Operating unit reaching the cumulative condensate limit of 1,175,000,000 barrels in the second quarter of 2014. Once the cumulative condensate limit was reached, the production associated with condensate became subject to the Oil Rim Initial Participating Area royalty interest of 50.6848339% instead of the Gas Cap Participating Area Royalty Interest of 13.8398950%. Ongoing development activity and projects also contributed to this increase by partially offsetting the naturally declining production rate from the Prudhoe Bay field and variance in the impacts of planned and unplanned downtime during the two reporting periods. The period-to-period decreases in royalty revenues, cash earnings and cash distributions are due to the significantly lower average WTI Prices that prevailed during 2015 compared to 2014. The decreases in royalty revenues, cash earnings and cash distributions were offset somewhat by the increase in royalty interest received by the Trust as a result of the cumulative condensate limit being reached at the end of the second quarter of 2014 and the decrease in Production Taxes. The increase in administrative expenses reflects higher overall costs of supplies and services and timing differences in accruals of expenses.

<s>[INST] The Trust is a passive entity. The Trustee’s activities are limited to collecting and distributing the revenues from the Royalty Interest and paying liabilities and expenses of the Trust. Generally, the Trust has no source of liquidity and no capital resources other than the revenue attributable to the Royalty Interest that it receives from time to time. See the discussion under “THE ROYALTY INTEREST” in Item 1 for a description of the calculation of the Per Barrel Royalty, and the discussion under “THE PRUDHOE BAY UNIT AND FIELD Reserve Estimates” in Item 1 for information concerning the estimated future net revenues of the Trust. However, the Trust Agreement gives the Trustee power to borrow, establish a cash reserve, or dispose of all or part of the Trust property under limited circumstances. See the discussion under “THE TRUST Sales of Royalty Interest; Borrowings and Reserves” in Item 1. Since 1999, the Trustee has maintained a $1,000,000 cash reserve to provide liquidity to the Trust during any future periods in which the Trust does not receive a distribution. The Trustee will draw funds from the cash reserve account during any quarter in which the quarterly distribution received by the Trust does not exceed the liabilities and expenses of the Trust, and will replenish the reserve from future quarterly distributions, if any. The Trustee anticipates that it will keep this cash reserve program in place until termination of the Trust. Amounts set aside for the cash reserve are invested by the Trustee in U.S. government or agency securities secured by the full faith and credit of the United States. Interest income received by the Trust from the investment of the reserve fund is added to the distributions received from BP Alaska and paid to the Unit holders on each Quarterly Record Date. Results of Operations Relatively modest changes in oil prices significantly affect the Trust’s revenues and results of operations. Crude oil prices are subject to significant changes in response to fluctuations in the domestic and world supply and demand and other market conditions as well as the world political situation as it affects OPEC and other producing countries. The effect of changing economic conditions on the demand and supply for energy throughout the world and future prices of oil cannot be accurately projected. Royalty revenues are generally received on the Quarterly Record Date (generally the fifteenth day of the month) following the end of the calendar quarter in which the related Royalty Production occurred. The Trustee, to the extent possible, pays all expenses of the Trust for each quarter on the Quarterly Record Date on which the revenues for the quarter are received. For the statement of cash earnings and distributions, revenues and Trust expenses are recorded on a cash basis and, as a result, distributions to Unit holders in each calendar year ending December 31 are attributable to BP Alaska’s operations during the twelvemonth period ended on the preceding September 30. When BP Alaska’s average net production of oil and condensate per quarter from the 1989 Working Interests exceeds 90,000 barrels a day, the principal factors affecting the Trust’s revenues and distributions to Unit holders are changes in WTI Prices, scheduled annual increases in Chargeable Costs, changes in the Consumer Price Index and changes in Production Taxes. However, it is likely that the Trust’s revenues in future periods also will be affected by increases and decreases in production from the 1989 Working Interests. BP Alaska’s net production of oil and condensate allocated to the Trust from proved reserves was less than 90,000 barrels per day on an annual basis during 2014, 2015 and 2016. The Trustee has been advised that BP Alaska expects that average net production allocated to the Trust from the proved reserves will be less than 90,000 barrels a day on an annual basis in future years. BP Alaska estimates Royalty Production from the 1989 Working Interests for purposes of calculating quarterly royalty payments to the Trust because complete actual field production data for the preceding calendar quarter generally is not available by the Quarterly Record Date. To the extent that average net production from the 1989 Working Interests is below 90,000 barrels per day, calculation by BP Alaska [/INST] Negative. </s>

BP PRUDHOE BAY ROYALTY TRUST

2018-03-01

2017-12-31

ITEM 7. TRUSTEE’S DISCUSSION AND ANALYSIS OF FINANCIAL CONDITION AND RESULTS OF OPERATIONS Liquidity and Capital Resources The Trust is a passive entity. The Trustee’s activities are limited to collecting and distributing the revenues from the Royalty Interest and paying liabilities and expenses of the Trust. Generally, the Trust has no source of liquidity and no capital resources other than the revenue attributable to the Royalty Interest that it receives from time to time. See the discussion under “THE ROYALTY INTEREST” in Item 1 for a description of the calculation of the Per Barrel Royalty, and the discussion under “THE PRUDHOE BAY UNIT AND FIELD - Reserve Estimates” in Item 1 for information concerning the estimated future net revenues of the Trust. However, the Trust Agreement gives the Trustee power to borrow, establish a cash reserve, or dispose of all or part of the Trust property under limited circumstances. See the discussion under “THE TRUST - Sales of Royalty Interest; Borrowings and Reserves” in Item 1. Since 1999, the Trustee has maintained a $1,000,000 cash reserve to provide liquidity to the Trust during any future periods in which the Trust does not receive a distribution. The Trustee will draw funds from the cash reserve account during any quarter in which the quarterly distribution received by the Trust does not exceed the liabilities and expenses of the Trust, and will replenish the reserve from future quarterly distributions, if any. The Trustee anticipates that it will keep this cash reserve program in place until termination of the Trust. Amounts set aside for the cash reserve are invested by the Trustee in U.S. government or agency securities secured by the full faith and credit of the United States, or mutual funds investing in such securities. Interest income received by the Trust from the investment of the reserve fund is added to the distributions received from BP Alaska and paid to the Unit holders on each Quarterly Record Date. Results of Operations Relatively modest changes in oil prices significantly affect the Trust’s revenues and results of operations. Crude oil prices are subject to significant changes in response to fluctuations in the domestic and world supply and demand and other market conditions as well as the world political situation as it affects OPEC and other producing countries. The effect of changing economic conditions on the demand and supply for energy throughout the world and future prices of oil cannot be accurately projected. Royalty revenues are generally received on the Quarterly Record Date (generally the fifteenth day of the month) following the end of the calendar quarter in which the related Royalty Production occurred. The Trustee, to the extent possible, pays all expenses of the Trust for each quarter on the Quarterly Record Date on which the revenues for the quarter are received. For the statement of cash earnings and distributions, revenues and Trust expenses are recorded on a cash basis and, as a result, distributions to Unit holders in each calendar year ending December 31 are attributable to BP Alaska’s operations during the twelve-month period ended on the preceding September 30. When BP Alaska’s average net production of oil and condensate per quarter from the 1989 Working Interests exceeds 90,000 barrels a day, the principal factors affecting the Trust’s revenues and distributions to Unit holders are changes in WTI Prices, scheduled annual increases in Chargeable Costs, changes in the Consumer Price Index and changes in Production Taxes. However, it is likely that the Trust’s revenues in future periods also will be affected by increases and decreases in production from the 1989 Working Interests. BP Alaska’s net production of oil and condensate allocated to the Trust from proved reserves was less than 90,000 barrels per day on an annual basis during 2015, 2016 and 2017. The Trustee has been advised that BP Alaska expects that average net production allocated to the Trust from the proved reserves will be less than 90,000 barrels a day on an annual basis in future years. BP Alaska estimates Royalty Production from the 1989 Working Interests for purposes of calculating quarterly royalty payments to the Trust because complete actual field production data for the preceding calendar quarter generally is not available by the Quarterly Record Date. To the extent that average net production from the 1989 Working Interests is below 90,000 barrels per day, calculation by BP Alaska of actual Royalty Production data may result in revisions of prior Royalty Production estimates. Revisions by BP Alaska of its Royalty Production calculations may result in quarterly royalty payments by BP Alaska which reflect adjustments for overpayments or underpayments of royalties with respect to prior quarters. Such adjustments, if material, may adversely affect certain Unit holders who buy or sell Units between the Quarterly Record Dates for the Quarterly Distributions affected. See Note 8 of Notes to Financial Statements in Item 8. Because the annual statement of cash earnings and distributions of the Trust is prepared on a modified cash basis, royalty revenues for the calendar year do not include the amounts of underpayments or overpayments affecting payments received during the fourth quarter of the year. During the years 2016 and 2017 and the period of 2018 up to the date of this report, WTI Prices have been above the level necessary for the Trust to receive a Per Barrel Royalty. Whether the Trust will be entitled to future distributions during the remainder of 2018 will depend on WTI Prices prevailing during the remainder of the year. As discussed above in Item 1A “RISK FACTORS”, it is possible that global oil prices could remain at current or lower levels for a significant period. As also discussed above in Item 1A “RISK FACTORS”, on January 1, 2018, the “break-even” WTI price (the price at which all taxes and prescribed deductions are equal to the WTI price) for the Trust to receive a positive Per Barrel Royalty with respect to a particular day’s production was $39.26. From the beginning of the first quarter of 2018 through February 20, 2018, the WTI crude oil spot price fluctuated between a high of $66.14 per barrel on January 26, 2018 and a low of $59.19 per barrel on February 13, 2018. The WTI crude oil spot price on February 20, 2018 was $61.90 per barrel. The quarterly royalty payment by BP Alaska to the Trust is the sum of the individual revenues attributed to the Trust as calculated each day during the quarter. Any single calculation of a calendar day will not reflect the value of the dividend paid to the Trust for the quarter, nor will it reflect the estimated future value of the Trust. However, if a low oil price environment should occur for a protracted period, quarterly royalty payments could decline significantly, and could in fact be zero. 2017 compared to 2016 As explained in Note 2 of Notes to Financial Statements below, the financial statements of the Trust are prepared on a modified cash basis and differ from financial statements prepared in accordance with generally accepted accounting principles in that (a) revenues are recorded when received (generally within 15 days of the end of the preceding quarter) and distributions to Trust Unit holders are recorded when paid and (b) Trust expenses are recorded on an accrual basis. As a consequence, Trust royalty revenues for the fiscal year are based on Royalty Production during the twelve months ended September 30 of the fiscal year. Average WTI prices during the twelve months ended September 30, 2017 increased significantly compared to the preceding twelve-month period. WTI prices during this period ranged from an average high price of $53.47 during February 2017 to an average price of $49.82 during the last month of the period in September 2017. The lowest average monthly price for the period was $45.18 in June 2017. The increase in the Consumer Price Index used to calculate the Cost Adjustment Factor, as well as the scheduled increase in Chargeable Costs from $17.10 in calendar 2016 to $17.20 in calendar 2017, resulted in the modest increase in Adjusted Chargeable Costs during the twelve month ended September 30, 2017. The increase in the average Per Barrel Royalty for the period resulted primarily from the rise in WTI prices. This increase was partially offset by the increase in Production Taxes. Although the 22.6 percent increase in Production Taxes resulted from the increase in WTI price between the two periods, Production Taxes remained historically low for the twelve months ended September 30, 2017 because, as with each quarter since the second quarter of 2015, Production Taxes for each quarter during the period were calculated on the basis of the minimum tax under the Act and the 2014 Letter Agreement. See Note 5 of Notes to Financial Statements in Item 8 below. The decrease in the average net production from the 1989 Working Interests between the two periods was due to the naturally declining production rate from the Prudhoe Bay field and variance in the impacts of planned and unplanned downtime during the two reporting periods. The period-to-period increases in royalty revenues, cash earnings and cash distributions are due to the significantly higher average WTI Prices that prevailed during 2017 compared to 2016. The decrease in administrative expenses reflects lower overall costs of supplies and services and timing differences in accruals of expenses. 2016 compared to 2015 Average WTI prices during the twelve months ended September 30, 2016 declined significantly compared to the preceding twelve-month period. Nevertheless, because WTI prices began to rise after reaching lows early in the first quarter of 2016, the decline in WTI price for the period was substantially less than it was for the prior period, as indicated in the chart below. WTI prices during this period ranged from an average high price of $46.22 during October 2015 to an average price of $45.18 during the last month of the period in September 2016. The lowest average monthly price for the period was $30.32 in February 2016. The increase in the Consumer Price Index used to calculate the Cost Adjustment Factor, as well as the scheduled increase in Chargeable Costs from $17.00 in calendar 2015 to $17.10 in calendar 2016, resulted in the modest increase in Adjusted Chargeable Costs during the twelve month ended September 30, 2016. The decrease in the average Per Barrel Royalty for the period resulted primarily from the decline in WTI prices. This decline was partially offset by the decline in Production Taxes. The decline in WTI prices resulted in Production Taxes for the fourth quarter of 2015 and the first three quarters of 2016 being calculated on the basis of the minimum tax under the Act and the 2014 Letter Agreement. See Note 5 of Notes to Financial Statements in Item 8 below. The increase in the average net production from the 1989 Working Interests between the two periods was due to ongoing development activity and projects, which partially offset the naturally declining production rate from the Prudhoe Bay field and variance in the impacts of planned and unplanned downtime during the two reporting periods. The period-to-period decreases in royalty revenues, cash earnings and cash distributions are due to the significantly lower average WTI Prices that prevailed during 2016 compared to 2015. The decrease in administrative expenses reflects lower overall costs of supplies and services and timing differences in accruals of expenses.

<s>[INST] The Trust is a passive entity. The Trustee’s activities are limited to collecting and distributing the revenues from the Royalty Interest and paying liabilities and expenses of the Trust. Generally, the Trust has no source of liquidity and no capital resources other than the revenue attributable to the Royalty Interest that it receives from time to time. See the discussion under “THE ROYALTY INTEREST” in Item 1 for a description of the calculation of the Per Barrel Royalty, and the discussion under “THE PRUDHOE BAY UNIT AND FIELD Reserve Estimates” in Item 1 for information concerning the estimated future net revenues of the Trust. However, the Trust Agreement gives the Trustee power to borrow, establish a cash reserve, or dispose of all or part of the Trust property under limited circumstances. See the discussion under “THE TRUST Sales of Royalty Interest; Borrowings and Reserves” in Item 1. Since 1999, the Trustee has maintained a $1,000,000 cash reserve to provide liquidity to the Trust during any future periods in which the Trust does not receive a distribution. The Trustee will draw funds from the cash reserve account during any quarter in which the quarterly distribution received by the Trust does not exceed the liabilities and expenses of the Trust, and will replenish the reserve from future quarterly distributions, if any. The Trustee anticipates that it will keep this cash reserve program in place until termination of the Trust. Amounts set aside for the cash reserve are invested by the Trustee in U.S. government or agency securities secured by the full faith and credit of the United States, or mutual funds investing in such securities. Interest income received by the Trust from the investment of the reserve fund is added to the distributions received from BP Alaska and paid to the Unit holders on each Quarterly Record Date. Results of Operations Relatively modest changes in oil prices significantly affect the Trust’s revenues and results of operations. Crude oil prices are subject to significant changes in response to fluctuations in the domestic and world supply and demand and other market conditions as well as the world political situation as it affects OPEC and other producing countries. The effect of changing economic conditions on the demand and supply for energy throughout the world and future prices of oil cannot be accurately projected. Royalty revenues are generally received on the Quarterly Record Date (generally the fifteenth day of the month) following the end of the calendar quarter in which the related Royalty Production occurred. The Trustee, to the extent possible, pays all expenses of the Trust for each quarter on the Quarterly Record Date on which the revenues for the quarter are received. For the statement of cash earnings and distributions, revenues and Trust expenses are recorded on a cash basis and, as a result, distributions to Unit holders in each calendar year ending December 31 are attributable to BP Alaska’s operations during the twelvemonth period ended on the preceding September 30. When BP Alaska’s average net production of oil and condensate per quarter from the 1989 Working Interests exceeds 90,000 barrels a day, the principal factors affecting the Trust’s revenues and distributions to Unit holders are changes in WTI Prices, scheduled annual increases in Chargeable Costs, changes in the Consumer Price Index and changes in Production Taxes. However, it is likely that the Trust’s revenues in future periods also will be affected by increases and decreases in production from the 1989 Working Interests. BP Alaska’s net production of oil and condensate allocated to the Trust from proved reserves was less than 90,000 barrels per day on an annual basis during 2015, 2016 and 2017. The Trustee has been advised that BP Alaska expects that average net production allocated to the Trust from the proved reserves will be less than 90,000 barrels a day on an annual basis in future years. BP Alaska estimates Royalty Production from the 1989 Working Interests for purposes of calculating quarterly royalty payments to the Trust because complete actual field production data for the preceding calendar quarter generally is not available by the Quarterly Record Date. To the extent that average net production from the 1989 Working Interests is below 90,000 [/INST] Negative. </s>

BP PRUDHOE BAY ROYALTY TRUST

2019-03-01

2018-12-31

ITEM 7. TRUSTEE’S DISCUSSION AND ANALYSIS OF FINANCIAL CONDITION AND RESULTS OF OPERATIONS Liquidity and Capital Resources The Trust is a passive entity. The Trustee’s activities are limited to collecting and distributing the revenues from the Royalty Interest and paying liabilities and expenses of the Trust. Generally, the Trust has no source of liquidity and no capital resources other than the revenue attributable to the Royalty Interest that it receives from time to time. See the discussion under “THE ROYALTY INTEREST” in Item 1 for a description of the calculation of the Per Barrel Royalty, and the discussion under “THE PRUDHOE BAY UNIT AND FIELD - Reserve Estimates” in Item 1 for information concerning the estimated future net revenues of the Trust. However, the Trust Agreement gives the Trustee power to borrow, establish a cash reserve, or dispose of all or part of the Trust property under limited circumstances. See the discussion under “THE TRUST - Sales of Royalty Interest; Borrowings and Reserves” in Item 1. Since 1999, the Trustee has maintained a $1,000,000 cash reserve to provide liquidity to the Trust during any future periods in which the Trust does not receive a distribution. As noted above under “THE TRUST - Sales of Royalty Interest; Borrowings and Reserves”, on December 19, 2018, the Trust issued a press release to announce that the Trustee had determined to gradually increase the Trustee’s existing cash reserve for the payment of future expenses and liabilities of the Trust, as permitted by the Trust Agreement. Commencing with the distribution to Unit holders payable in April, 2019, the Trustee intends to withhold the greater of $33,750 or 0.17% of the funds otherwise available for distribution each quarter to gradually increase existing cash reserves by a total of approximately $270,000. The Trustee may increase or decrease the targeted amount at any time, and may increase or decrease the rate at which it is withholding funds to build the cash reserve at any time, without advance notice to the Unit holders. Cash held in reserve will be invested as required by the Trust Agreement. Any cash reserved in excess of the amount necessary to pay or provide for the payment of future known, anticipated or contingent expenses or liabilities eventually will be distributed to Unit holders, together with interest earned on the funds. The Trustee will draw funds from the cash reserve account during any quarter in which the quarterly distribution received by the Trust does not exceed the liabilities and expenses of the Trust, and will replenish the reserve from future quarterly distributions, if any. The Trustee anticipates that it will keep this cash reserve program in place until termination of the Trust. Amounts set aside for the cash reserve are invested by the Trustee in U.S. government or agency securities secured by the full faith and credit of the United States, or mutual funds investing in such securities. Interest income received by the Trust from the investment of the reserve fund is added to the distributions received from BP Alaska and paid to the Unit holders on each Quarterly Record Date. Results of Operations Relatively modest changes in oil prices significantly affect the Trust’s revenues and results of operations. Crude oil prices are subject to significant changes in response to fluctuations in the domestic and world supply and demand and other market conditions as well as the world political situation as it affects OPEC and other producing countries. The effect of changing economic conditions on the demand and supply for energy throughout the world and future prices of oil cannot be accurately projected. Royalty revenues are generally received on the Quarterly Record Date (generally the fifteenth day of the month) following the end of the calendar quarter in which the related Royalty Production occurred. The Trustee, to the extent possible, pays all expenses of the Trust for each quarter on the Quarterly Record Date on which the revenues for the quarter are received. For the statement of cash earnings and distributions, revenues and Trust expenses are recorded on a cash basis and, as a result, distributions to Unit holders in each calendar year ending December 31 are attributable to BP Alaska’s operations during the twelve-month period ended on the preceding September 30. When BP Alaska’s average net production of oil and condensate per quarter from the 1989 Working Interests exceeds 90,000 barrels a day, the principal factors affecting the Trust’s revenues and distributions to Unit holders are changes in WTI Prices, scheduled annual increases in Chargeable Costs, changes in the Consumer Price Index and changes in Production Taxes. However, it is likely that the Trust’s revenues in future periods also will be affected by increases and decreases in production from the 1989 Working Interests. BP Alaska’s net production of oil and condensate allocated to the Trust from proved reserves was less than 90,000 barrels per day on an annual basis during 2016, 2017 and 2018. The Trustee has been advised that BP Alaska expects that average net production allocated to the Trust from the proved reserves will be less than 90,000 barrels a day on an annual basis in future years. BP Alaska estimates Royalty Production from the 1989 Working Interests for purposes of calculating quarterly royalty payments to the Trust because complete actual field production data for the preceding calendar quarter generally is not available by the Quarterly Record Date. To the extent that average net production from the 1989 Working Interests is below 90,000 barrels per day, calculation by BP Alaska of actual Royalty Production data may result in revisions of prior Royalty Production estimates. Revisions by BP Alaska of its Royalty Production calculations may result in quarterly royalty payments by BP Alaska which reflect adjustments for overpayments or underpayments of royalties with respect to prior quarters. Such adjustments, if material, may adversely affect certain Unit holders who buy or sell Units between the Quarterly Record Dates for the Quarterly Distributions affected. See Note 8 of Notes to Financial Statements in Item 8. Because the annual statement of cash earnings and distributions of the Trust is prepared on a modified cash basis, royalty revenues for the calendar year do not include the amounts of underpayments or overpayments affecting payments received during the fourth quarter of the year. During the years 2017 and 2018 and the period of 2019 up to the date of this report, WTI Prices have been above the level necessary for the Trust to receive a Per Barrel Royalty. Whether the Trust will be entitled to future distributions during the remainder of 2019 will depend on WTI Prices prevailing during the remainder of the year. As discussed above in Item 1A “RISK FACTORS”, it is possible that global oil prices could remain at current or lower levels for a significant period. As also discussed above in Item 1A “RISK FACTORS”, on January 1, 2019, the “break-even” WTI price (the price at which all taxes and prescribed deductions are equal to the WTI price) for the Trust to receive a positive Per Barrel Royalty with respect to a particular day’s production was $47.69. From the beginning of the first quarter of 2019 through February 20, 2019, the WTI crude oil spot price fluctuated between a high of $57.11 per barrel on February 20, 2019 and a low of $46.31 per barrel on January 2, 2019. The WTI crude oil spot price on February 21, 2019 was $56.84 per barrel. The quarterly royalty payment by BP Alaska to the Trust is the sum of the individual revenues attributed to the Trust as calculated each day during the quarter. Any single calculation of a calendar day will not reflect the value of the dividend paid to the Trust for the quarter, nor will it reflect the estimated future value of the Trust. However, if a low oil price environment should occur for a protracted period, quarterly royalty payments could decline significantly, and could in fact be zero. 2018 compared to 2017 As explained in Note 2 of Notes to Financial Statements below, the financial statements of the Trust are prepared on a modified cash basis and differ from financial statements prepared in accordance with generally accepted accounting principles in that (a) revenues are recorded when received (generally within 15 days of the end of the preceding quarter) and distributions to Trust Unit holders are recorded when paid and (b) Trust expenses are recorded on an accrual basis. As a consequence, Trust royalty revenues for the fiscal year are based on Royalty Production during the twelve months ended September 30 of the fiscal year. Average WTI prices during the twelve months ended September 30, 2018 increased significantly compared to the preceding twelve-month period. Average monthly WTI prices during this period ranged from a low of $51.56 during the first month of the period in October 2017 to a high of $70.84 during July 2018. The increase in the Consumer Price Index used to calculate the Cost Adjustment Factor, as well as the scheduled increase in Chargeable Costs from $17.20 in calendar 2017 to $20.00 in calendar 2018, resulted in the increase in Adjusted Chargeable Costs during the twelve month ended September 30, 2018. The increase in the average Per Barrel Royalty for the period resulted primarily from the rise in WTI prices. This increase was partially offset by the increase in Production Taxes. Although the nearly 40 percent increase in Production Taxes resulted from the increase in WTI price between the two periods, Production Taxes remained historically low for the twelve months ended September 30, 2018 because Production Taxes for the first three quarters during the period were calculated on the basis of the minimum tax under the Act and the 2014 Letter Agreement. See Note 5 of Notes to Financial Statements in Item 8 below. The decrease in the average net production from the 1989 Working Interests between the two periods was due to the naturally declining production rate from the Prudhoe Bay field and variance in the impacts of planned and unplanned downtime during the two reporting periods. The period-to-period increases in royalty revenues, cash earnings and cash distributions are due to the significantly higher average WTI Prices that prevailed during 2018 compared to 2017. The decrease in administrative expenses reflects lower overall costs of supplies and services and timing differences in accruals of expenses. The decrease in the Trust corpus reflects the increase in accrued expenses for the period. 2017 compared to 2016 Average WTI prices during the twelve months ended September 30, 2017 increased significantly compared to the preceding twelve-month period. WTI prices during this period ranged from an average high price of $53.47 during February 2017 to an average price of $49.82 during the last month of the period in September 2017. The lowest average monthly price for the period was $45.18 in June 2017. The increase in the Consumer Price Index used to calculate the Cost Adjustment Factor, as well as the scheduled increase in Chargeable Costs from $17.10 in calendar 2016 to $17.20 in calendar 2017, resulted in the modest increase in Adjusted Chargeable Costs during the twelve month ended September 30, 2017. The increase in the average Per Barrel Royalty for the period resulted primarily from the rise in WTI prices. This increase was partially offset by the increase in Production Taxes. Although the 22.6 percent increase in Production Taxes resulted from the increase in WTI price between the two periods, Production Taxes remained historically low for the twelve months ended September 30, 2017 because, as with each quarter since the second quarter of 2015, Production Taxes for each quarter during the period were calculated on the basis of the minimum tax under the Act and the 2014 Letter Agreement. See Note 5 of Notes to Financial Statements in Item 8 below. The decrease in the average net production from the 1989 Working Interests between the two periods was due to the naturally declining production rate from the Prudhoe Bay field and variance in the impacts of planned and unplanned downtime during the two reporting periods. The period-to-period increases in royalty revenues, cash earnings and cash distributions are due to the significantly higher average WTI Prices that prevailed during 2017 compared to 2016. The decrease in administrative expenses reflects lower overall costs of supplies and services and timing differences in accruals of expenses.

<s>[INST] The Trust is a passive entity. The Trustee’s activities are limited to collecting and distributing the revenues from the Royalty Interest and paying liabilities and expenses of the Trust. Generally, the Trust has no source of liquidity and no capital resources other than the revenue attributable to the Royalty Interest that it receives from time to time. See the discussion under “THE ROYALTY INTEREST” in Item 1 for a description of the calculation of the Per Barrel Royalty, and the discussion under “THE PRUDHOE BAY UNIT AND FIELD Reserve Estimates” in Item 1 for information concerning the estimated future net revenues of the Trust. However, the Trust Agreement gives the Trustee power to borrow, establish a cash reserve, or dispose of all or part of the Trust property under limited circumstances. See the discussion under “THE TRUST Sales of Royalty Interest; Borrowings and Reserves” in Item 1. Since 1999, the Trustee has maintained a $1,000,000 cash reserve to provide liquidity to the Trust during any future periods in which the Trust does not receive a distribution. As noted above under “THE TRUST Sales of Royalty Interest; Borrowings and Reserves”, on December 19, 2018, the Trust issued a press release to announce that the Trustee had determined to gradually increase the Trustee’s existing cash reserve for the payment of future expenses and liabilities of the Trust, as permitted by the Trust Agreement. Commencing with the distribution to Unit holders payable in April, 2019, the Trustee intends to withhold the greater of $33,750 or 0.17% of the funds otherwise available for distribution each quarter to gradually increase existing cash reserves by a total of approximately $270,000. The Trustee may increase or decrease the targeted amount at any time, and may increase or decrease the rate at which it is withholding funds to build the cash reserve at any time, without advance notice to the Unit holders. Cash held in reserve will be invested as required by the Trust Agreement. Any cash reserved in excess of the amount necessary to pay or provide for the payment of future known, anticipated or contingent expenses or liabilities eventually will be distributed to Unit holders, together with interest earned on the funds. The Trustee will draw funds from the cash reserve account during any quarter in which the quarterly distribution received by the Trust does not exceed the liabilities and expenses of the Trust, and will replenish the reserve from future quarterly distributions, if any. The Trustee anticipates that it will keep this cash reserve program in place until termination of the Trust. Amounts set aside for the cash reserve are invested by the Trustee in U.S. government or agency securities secured by the full faith and credit of the United States, or mutual funds investing in such securities. Interest income received by the Trust from the investment of the reserve fund is added to the distributions received from BP Alaska and paid to the Unit holders on each Quarterly Record Date. Results of Operations Relatively modest changes in oil prices significantly affect the Trust’s revenues and results of operations. Crude oil prices are subject to significant changes in response to fluctuations in the domestic and world supply and demand and other market conditions as well as the world political situation as it affects OPEC and other producing countries. The effect of changing economic conditions on the demand and supply for energy throughout the world and future prices of oil cannot be accurately projected. Royalty revenues are generally received on the Quarterly Record Date (generally the fifteenth day of the month) following the end of the calendar quarter in which the related Royalty Production occurred. The Trustee, to the extent possible, pays all expenses of the Trust for each quarter on the Quarterly Record Date on which the revenues for the quarter are received. For the statement of cash earnings and distributions, revenues and Trust expenses are recorded on a cash basis and, as a result, distributions to Unit holders in each calendar year ending December 31 are attributable to BP Alaska’s operations during the twelvemonth period ended on the preceding September 30. When BP Alaska’s average net production of oil and condensate per quarter from the 1989 Working Interests exceeds 90,000 barrels a [/INST] Negative. </s>

BP PRUDHOE BAY ROYALTY TRUST

2020-03-02

2019-12-31

ITEM 7. TRUSTEE’S DISCUSSION AND ANALYSIS OF FINANCIAL CONDITION AND RESULTS OF OPERATIONS Liquidity and Capital Resources The Trust is a passive entity. The Trustee’s activities are limited to collecting and distributing the revenues from the Royalty Interest and paying liabilities and expenses of the Trust. Generally, the Trust has no source of liquidity and no capital resources other than the revenue attributable to the Royalty Interest that it receives from time to time. See the discussion under “THE ROYALTY INTEREST” in Item 1 for a description of the calculation of the Per Barrel Royalty, and the discussion under “THE PRUDHOE BAY UNIT AND FIELD - Reserve Estimates” in Item 1 for information concerning the estimated future net revenues of the Trust. However, the Trust Agreement gives the Trustee power to borrow, establish a cash reserve, or dispose of all or part of the Trust property under limited circumstances. See the discussion under “THE TRUST - Sales of Royalty Interest; Borrowings and Reserves” in Item 1. Since 1999, the Trustee has maintained a $1,000,000 cash reserve to provide liquidity to the Trust during any future periods in which the Trust does not receive a distribution. As noted above under “THE TRUST - Sales of Royalty Interest; Borrowings and Reserves”, on December 19, 2018, the Trust issued a press release to announce that the Trustee had determined to gradually increase the Trustee’s existing cash reserve for the payment of future expenses and liabilities of the Trust, as permitted by the Trust Agreement. Commencing with the distribution to Unit holders payable in April, 2019, the Trustee began withholding the greater of $33,750 or 0.17% of the funds otherwise available for distribution each quarter to gradually increase existing cash reserves by a total of approximately $270,000. The Trustee may increase or decrease the targeted amount at any time, and may increase or decrease the rate at which it is withholding funds to build the cash reserve at any time, without advance notice to the Unit holders. Cash held in reserve will be invested as required by the Trust Agreement. Any cash reserved in excess of the amount necessary to pay or provide for the payment of future known, anticipated or contingent expenses or liabilities eventually will be distributed to Unit holders, together with interest earned on the funds. The Trustee will draw funds from the cash reserve account during any quarter in which the quarterly distribution received by the Trust does not exceed the liabilities and expenses of the Trust, and will replenish the reserve from future quarterly distributions, if any. The Trustee anticipates that it will keep this cash reserve program in place until termination of the Trust. The Trust believes current cash reserves are sufficient to pay approximately one year’s current and expected liabilities of the Trust, given that, if the current WTI pricing environment continues through 2020, the Trust may not receive royalty payments during the remaining quarters of 2020. Amounts set aside for the cash reserve are invested by the Trustee in U.S. government or agency securities secured by the full faith and credit of the United States, or mutual funds investing in such securities. Results of Operations Relatively modest changes in oil prices significantly affect the Trust’s revenues and results of operations. Crude oil prices are subject to significant changes in response to fluctuations in the domestic and world supply and demand and other market conditions as well as the world political situation as it affects OPEC and other producing countries. The effect of changing economic conditions on the demand and supply for energy throughout the world and future prices of oil cannot be accurately projected. Royalty revenues are generally received on the Quarterly Record Date (generally the fifteenth day of the month) following the end of the calendar quarter in which the related Royalty Production occurred. The Trustee, to the extent possible, pays all expenses of the Trust for each quarter on the Quarterly Record Date on which the revenues for the quarter are received. For the statement of cash earnings and distributions, revenues and Trust expenses are recorded on a cash basis and, as a result, distributions to Unit holders in each calendar year ending December 31 are attributable to BP Alaska’s operations during the twelve-month period ended on the preceding September 30. When BP Alaska’s average net production of oil and condensate per quarter from the 1989 Working Interests exceeds 90,000 barrels a day, the principal factors affecting the Trust’s revenues and distributions to Unit holders are changes in WTI Prices, scheduled annual increases in Chargeable Costs, changes in the Consumer Price Index and changes in Production Taxes. However, it is likely that the Trust’s revenues in future periods also will be affected by increases and decreases in production from the 1989 Working Interests. BP Alaska’s net production of oil and condensate allocated to the Trust from proved reserves was less than 90,000 barrels per day on an annual basis during 2017, 2018 and 2019. The Trustee has been advised that BP Alaska expects that average net production allocated to the Trust from the proved reserves will be less than 90,000 barrels a day on an annual basis in future years. BP Alaska estimates Royalty Production from the 1989 Working Interests for purposes of calculating quarterly royalty payments to the Trust because complete actual field production data for the preceding calendar quarter generally is not available by the Quarterly Record Date. To the extent that average net production from the 1989 Working Interests is below 90,000 barrels per day, calculation by BP Alaska of actual Royalty Production data may result in revisions of prior Royalty Production estimates. Revisions by BP Alaska of its Royalty Production calculations may result in quarterly royalty payments by BP Alaska which reflect adjustments for overpayments or underpayments of royalties with respect to prior quarters. Such adjustments, if material, may adversely affect certain Unit holders who buy or sell Units between the Quarterly Record Dates for the Quarterly Distributions affected. See Note 8 of Notes to Financial Statements in Item 8. Because the annual statement of cash earnings and distributions of the Trust is prepared on a modified cash basis, royalty revenues for the calendar year do not include the amounts of underpayments or overpayments affecting payments received during the fourth quarter of the year. During the years 2018 and 2019, WTI Prices have been above the level necessary for the Trust to receive a Per Barrel Royalty. Whether the Trust will be entitled to future distributions during the remainder of 2020 will depend on WTI Prices prevailing during the remainder of the year. As discussed above in Item 1A “RISK FACTORS”, it is possible that global oil prices could remain at current or lower levels for a significant period. As also discussed above in Item 1A “RISK FACTORS”, on January 1, 2020, the “break-even” WTI price (the price at which all taxes and prescribed deductions are equal to the WTI price) for the Trust to receive a positive Per Barrel Royalty with respect to a particular day’s production was $54.34. From the beginning of the first quarter of 2020 through February 27, 2020, the WTI crude oil spot price fluctuated between a high of $63.27 per barrel on January 6, 2020 and a low of $47.09 per barrel on February 27, 2020. The quarterly royalty payment by BP Alaska to the Trust is the sum of the individual revenues attributed to the Trust as calculated each day during the quarter. Any single calculation of a calendar day will not reflect the value of the dividend paid to the Trust for the quarter, nor will it reflect the estimated future value of the Trust. However, if a low oil price environment should occur for a protracted period, quarterly royalty payments could decline significantly, and could in fact be zero. 2019 compared to As explained in Note 2 of Notes to Financial Statements below, the financial statements of the Trust are prepared on a modified cash basis and differ from financial statements prepared in accordance with generally accepted accounting principles in that (a) revenues are recorded when received (generally within 15 days of the end of the preceding quarter) and distributions to Trust Unit holders are recorded when paid and (b) Trust expenses are recorded on an accrual basis. As a consequence, Trust royalty revenues for the fiscal year are based on Royalty Production during the twelve months ended September 30 of the fiscal year. Average WTI prices during the twelve months ended September 30, 2019 decreased by approximately 10 percent compared to the preceding twelve-month period. Average monthly WTI prices during this period ranged from a high of $70.72 during the first month of the period in October 2018 to a low of $48.82 at the end of December 2018. The increase in the Consumer Price Index used to calculate the Cost Adjustment Factor, as well as the scheduled increase in Chargeable Costs from $20.00 in calendar 2018 to $23.75 in calendar 2019, resulted in the 20 percent increase in Adjusted Chargeable Costs during the twelve months ended September 30, 2019. The decrease in the average Per Barrel Royalty for the period resulted primarily from the decrease in WTI prices and the increase in Adjusted Chargeable Costs. This decrease was modestly offset by the decline in Production Taxes, which remained historically low for the twelve months ended September 30, 2019 because Production Taxes during the period were calculated on the basis of the minimum tax under the Act and the 2014 Letter Agreement. See Note 5 of Notes to Financial Statements in Item 8 below. The decrease in the average net production from the 1989 Working Interests between the two periods was due to the naturally declining production rate from the Prudhoe Bay field and variance in the impacts of planned and unplanned downtime during the two reporting periods. The period-to-period decreases in royalty revenues, cash earnings and cash distributions are due to the substantial decline in the average Per Barrel Royalty as a result of the lower average WTI Price, the increase in Adjusted Chargeable Costs and the decline in average net production that prevailed during 2019 compared to 2018. The decrease in administrative expenses reflects lower overall costs of supplies and services and timing differences in accruals of expenses. The increase in the Trust corpus reflects the decrease in accrued expenses for the period. 2018 compared to 2017 Average WTI prices during the twelve months ended September 30, 2018 increased significantly compared to the preceding twelve-month period. Average monthly WTI prices during this period ranged from a low of $51.58 during the first month of the period in October 2017 to a high of $70.92 during July 2018. The increase in the Consumer Price Index used to calculate the Cost Adjustment Factor, as well as the scheduled increase in Chargeable Costs from $17.20 in calendar 2017 to $20.00 in calendar 2018, resulted in the increase in Adjusted Chargeable Costs during the twelve month ended September 30, 2018. The increase in the average Per Barrel Royalty for the period resulted primarily from the rise in WTI prices. This increase was partially offset by the increase in Production Taxes. Although the nearly 40 percent increase in Production Taxes resulted from the increase in WTI price between the two periods, Production Taxes remained historically low for the twelve months ended September 30, 2018 because Production Taxes for the first three quarters during the period were calculated on the basis of the minimum tax under the Act and the 2014 Letter Agreement. See Note 5 of Notes to Financial Statements in Item 8 below. The decrease in the average net production from the 1989 Working Interests between the two periods was due to the naturally declining production rate from the Prudhoe Bay field and variance in the impacts of planned and unplanned downtime during the two reporting periods. The period-to-period increases in royalty revenues, cash earnings and cash distributions are due to the significantly higher average WTI Prices that prevailed during 2018 compared to 2017. The decrease in administrative expenses reflects lower overall costs of supplies and services and timing differences in accruals of expenses. The decrease in the Trust corpus reflects the increase in accrued expenses for the period.

<s>[INST] The Trust is a passive entity. The Trustee’s activities are limited to collecting and distributing the revenues from the Royalty Interest and paying liabilities and expenses of the Trust. Generally, the Trust has no source of liquidity and no capital resources other than the revenue attributable to the Royalty Interest that it receives from time to time. See the discussion under “THE ROYALTY INTEREST” in Item 1 for a description of the calculation of the Per Barrel Royalty, and the discussion under “THE PRUDHOE BAY UNIT AND FIELD Reserve Estimates” in Item 1 for information concerning the estimated future net revenues of the Trust. However, the Trust Agreement gives the Trustee power to borrow, establish a cash reserve, or dispose of all or part of the Trust property under limited circumstances. See the discussion under “THE TRUST Sales of Royalty Interest; Borrowings and Reserves” in Item 1. Since 1999, the Trustee has maintained a $1,000,000 cash reserve to provide liquidity to the Trust during any future periods in which the Trust does not receive a distribution. As noted above under “THE TRUST Sales of Royalty Interest; Borrowings and Reserves”, on December 19, 2018, the Trust issued a press release to announce that the Trustee had determined to gradually increase the Trustee’s existing cash reserve for the payment of future expenses and liabilities of the Trust, as permitted by the Trust Agreement. Commencing with the distribution to Unit holders payable in April, 2019, the Trustee began withholding the greater of $33,750 or 0.17% of the funds otherwise available for distribution each quarter to gradually increase existing cash reserves by a total of approximately $270,000. The Trustee may increase or decrease the targeted amount at any time, and may increase or decrease the rate at which it is withholding funds to build the cash reserve at any time, without advance notice to the Unit holders. Cash held in reserve will be invested as required by the Trust Agreement. Any cash reserved in excess of the amount necessary to pay or provide for the payment of future known, anticipated or contingent expenses or liabilities eventually will be distributed to Unit holders, together with interest earned on the funds. The Trustee will draw funds from the cash reserve account during any quarter in which the quarterly distribution received by the Trust does not exceed the liabilities and expenses of the Trust, and will replenish the reserve from future quarterly distributions, if any. The Trustee anticipates that it will keep this cash reserve program in place until termination of the Trust. The Trust believes current cash reserves are sufficient to pay approximately one year’s current and expected liabilities of the Trust, given that, if the current WTI pricing environment continues through 2020, the Trust may not receive royalty payments during the remaining quarters of 2020. Amounts set aside for the cash reserve are invested by the Trustee in U.S. government or agency securities secured by the full faith and credit of the United States, or mutual funds investing in such securities. Results of Operations Relatively modest changes in oil prices significantly affect the Trust’s revenues and results of operations. Crude oil prices are subject to significant changes in response to fluctuations in the domestic and world supply and demand and other market conditions as well as the world political situation as it affects OPEC and other producing countries. The effect of changing economic conditions on the demand and supply for energy throughout the world and future prices of oil cannot be accurately projected. Royalty revenues are generally received on the Quarterly Record Date (generally the fifteenth day of the month) following the end of the calendar quarter in which the related Royalty Production occurred. The Trustee, to the extent possible, pays all expenses of the Trust for each quarter on the Quarterly Record Date on which the revenues for the quarter are received. For the statement of cash earnings and distributions, revenues and Trust expenses are recorded on a cash basis and, as a result, distributions to Unit holders in each calendar year ending December 31 are attributable to BP Alaska’s operations during the twelvemonth period ended on the preceding September 30. When BP Alaska’s average net production of oil and condens [/INST] Negative. </s>

STANDARD MOTOR PRODUCTS INC

2015-02-27

2014-12-31

ITEM 7. MANAGEMENT’S DISCUSSION AND ANALYSIS OF FINANCIAL CONDITION AND RESULTS OF OPERATIONS The following discussion should be read in conjunction with our consolidated financial statements and the notes thereto. This discussion summarizes the significant factors affecting our results of operations and the financial condition of our business during each of the fiscal years in the three-year period ended December 31, 2014. Overview We are a leading independent manufacturer and distributor of replacement parts for motor vehicles in the automotive aftermarket industry, with an increasing focus on heavy duty, industrial equipment and the original equipment service market. We are organized into two major operating segments, each of which focuses on specific lines of replacement parts. Our Engine Management Segment manufactures and remanufactures ignition and emission parts, ignition wires, battery cables, fuel system parts and sensors for vehicle systems. Our Temperature Control Segment manufactures and remanufactures air conditioning compressors, air conditioning and heating parts, engine cooling system parts, power window accessories, and windshield washer system parts. We sell our products primarily to warehouse distributors, large retail chains, original equipment manufacturers and original equipment service part operations in the United States, Canada, Latin America, and Europe. Our customers consist of many of the leading warehouse distributors and auto parts retail chains, such as NAPA Auto Parts (National Automotive Parts Association, Inc.), Advance Auto Parts, Inc./CARQUEST Auto Parts, AutoZone, Inc., O’Reilly Automotive, Inc., Canadian Tire Corporation Limited and The Pep Boys Manny, Moe & Jack, as well as national program distribution groups, such as Auto Value and All Pro/Bumper to Bumper (Aftermarket Auto Parts Alliance, Inc.), Automotive Distribution Network LLC, The National Pronto Association (“Pronto”), Federated Auto Parts Distributors, Inc. (“Federated”), Pronto and Federated’s newly formed organization, the Automotive Parts Services Group or The Group, and specialty market distributors. We distribute parts under our own brand names, such as Standard®, BWD®, Intermotor®, GP Sorensen®, TechSmart®, Tech Expert®, OEM®, LockSmart®, Select®, Four Seasons®, Factory Air®, EVERCO®, ACi®, Imperial®, COMPRESSORWORKS®, TORQFLO® and Hayden® and through co-labels and private labels, such as CARQUEST® BWD®, CARQUEST® Intermotor®, Duralast®, Duralast Gold®, Import Direct®, Master Pro®, Murray®, NAPA®, NAPA® Echlin®, Mileage Plus®, NAPA Proformer™, NAPA Temp Products™, Cold Power® and NAPA® Belden®. Business Strategy Our goal is to grow revenues and earnings and deliver returns in excess of our cost of capital by providing high quality original equipment and replacement products to the engine management and temperature control markets. The key elements of our strategy are as follows: · Maintain Our Strong Competitive Position in the Engine Management and Temperature Control Businesses. We are one of the leading independent manufacturers and distributors serving North America and other geographic areas in our core businesses of Engine Management and Temperature Control. We believe that our success is attributable to our emphasis on product quality, the breadth and depth of our product lines for both domestic and import vehicles, and our reputation for outstanding customer service. To maintain our strong competitive position in our markets, we remain committed to the following: · providing our customers with broad lines of high quality engine management and temperature control products, supported by the highest level of customer service and reliability; · continuing to maximize our production, supply chain and distribution efficiencies; Index · continuing to improve our cost position through increased global sourcing and increased manufacturing in low cost regions; and · focusing on our engineering development efforts including a focus on bringing more product manufacturing in house. · Provide Superior Customer Service, Product Availability and Technical Support. Our goal is to increase sales to existing and new customers by leveraging our skills in rapidly filling orders, maintaining high levels of product availability, providing insightful customer category management, and providing technical support in a cost-effective manner. In addition, our category management and technically skilled sales force professionals provide product selection, assortment and application support to our customers. · Expand Our Product Lines. We intend to increase our sales by continuing to develop internally, or through potential acquisitions, the range of Engine Management and Temperature Control products that we offer to our customers. We are committed to investing the resources necessary to maintain and expand our technical capability to manufacture multiple product lines that incorporate the latest technologies. · Broaden Our Customer Base. Our goal is to increase our customer base by (a) continuing to leverage our manufacturing capabilities to secure additional original equipment business globally with automotive, industrial, marine, military and heavy duty vehicle and equipment manufacturers and their service part operations as well as our existing customer base including traditional warehouse distributors, large retailers, other manufacturers and export customers, and (b) supporting the service part operations of vehicle and equipment manufacturers with value added services and product support for the life of the part. · Improve Operating Efficiency and Cost Position. Our management places significant emphasis on improving our financial performance by achieving operating efficiencies and improving asset utilization, while maintaining product quality and high customer order fill rates. We intend to continue to improve our operating efficiency and cost position by: · increasing cost-effective vertical integration in key product lines through internal development; · focusing on integrated supply chain management, customer collaborations and vendor managed inventory initiatives; · evaluating additional opportunities to relocate manufacturing to our low-cost, off-shore plants; · maintaining and improving our cost effectiveness and competitive responsiveness to better serve our customer base, including sourcing certain materials and products from low cost regions such as those in Asia without compromising product quality; · enhancing company-wide programs geared toward manufacturing and distribution efficiency; and · focusing on company-wide overhead and operating expense cost reduction programs. · Cash Utilization. We intend to apply any excess cash flow from operations and the management of working capital primarily to reduce our outstanding indebtedness, pay dividends to our shareholders, repurchase shares of our common stock, expand our product lines and grow revenues through potential acquisitions. The Automotive Aftermarket The automotive aftermarket industry is comprised of a large number of diverse manufacturers varying in product specialization and size. In addition to manufacturing, aftermarket companies allocate resources towards an efficient distribution process and product engineering in order to maintain the flexibility and responsiveness on which their customers depend. Aftermarket manufacturers must be efficient producers of small lot sizes and do not have to provide systems engineering support. Aftermarket manufacturers also must distribute, with rapid turnaround times, products for a full range of vehicles on the road. The primary customers of the automotive aftermarket manufacturers are national and regional warehouse distributors, large retail chains, automotive repair chains and the dealer service networks of original equipment manufacturers (“OEMs”). Index The automotive aftermarket industry differs substantially from the OEM supply business. Unlike the OEM supply business that primarily follows trends in new car production, the automotive aftermarket industry’s performance primarily tends to follow different trends, such as: · growth in number of vehicles on the road; · increase in average vehicle age; · change in total miles driven per year; · new and modified environmental regulations, including fuel-efficiency standards; · increase in pricing of new cars; · economic and financial market conditions; · new car quality and related warranties; · changes in automotive technologies; · change in vehicle scrap rates; and · change in average fuel prices. Traditionally, the parts manufacturers of OEMs and the independent manufacturers who supply the original equipment (“OE”) part applications have supplied a majority of the business to new car dealer networks. However, certain parts manufacturers have become more independent and are no longer affiliated with OEMs, which has provided, and may continue to provide, opportunities for us to supply replacement parts to the dealer service networks of the OEMs, both for warranty and out-of-warranty repairs. Seasonality. Historically, our operating results have fluctuated by quarter, with the greatest sales occurring in the second and third quarters of the year and revenues generally being recognized at the time of shipment. It is in these quarters that demand for our products is typically the highest, specifically in the Temperature Control Segment of our business. In addition to this seasonality, the demand for our Temperature Control products during the second and third quarters of the year may vary significantly with the summer weather and customer inventories. For example, a cool summer, as we experienced in both 2014 and 2013, may lessen the demand for our Temperature Control products, while a hot summer may increase such demand. As a result of this seasonality and variability in demand of our Temperature Control products, our working capital requirements typically peak near the end of the second quarter, as the inventory build-up of air conditioning products is converted to sales and payments on the receivables associated with such sales have yet to be received. During this period, our working capital requirements are typically funded by borrowing from our revolving credit facility. Inventory Management. We face inventory management issues as a result of warranty and overstock returns. Many of our products carry a warranty ranging from a 90-day limited warranty to a lifetime limited warranty, which generally covers defects in materials or workmanship and failure to meet industry published specifications and/or the result of installer error. In addition to warranty returns, we also permit our customers to return products to us within customer-specific limits (which are generally limited to a specified percentage of their annual purchases from us) in the event that they have overstocked their inventories. We accrue for overstock returns as a percentage of sales, after giving consideration to recent returns history. In order to better control warranty and overstock return levels, we have in place procedures for authorized warranty returns, including for warranty returns which result from installer error, placed restrictions on the amounts customers can return and instituted a program to better estimate potential future product returns. In addition, with respect to our air conditioning compressors, which are our most significant customer product warranty returns, we established procedures whereby a warranty will be voided if a customer does not provide acceptable proof that complete air conditioning system repair was performed. Index Discounts, Allowances, and Incentives. We offer a variety of usual customer discounts, allowances and incentives. First, we offer cash discounts for paying invoices in accordance with the specified discount terms of the invoice. Second, we offer pricing discounts based on volume purchased from us and participation in our cost reduction initiatives. These discounts are principally in the form of “off-invoice” discounts and are immediately deducted from sales at the time of sale. For those customers that choose to receive a payment on a quarterly basis instead of “off-invoice,” we accrue for such payments as the related sales are made and reduce sales accordingly. Finally, rebates and discounts are provided to customers as advertising and sales force allowances, and allowances for warranty and overstock returns are also provided. Management analyzes historical returns, current economic trends, and changes in customer demand when evaluating the adequacy of the sales returns and other allowances. Significant management judgments and estimates must be made and used in connection with establishing the sales returns and other allowances in any accounting period. We account for these discounts and allowances as a reduction to revenues, and record them when sales are recorded. Comparison of Fiscal Years 2014 and 2013 Sales. Consolidated net sales for 2014 were $980.4 million, a decrease of $3.3 million compared to $983.7 million in the same period of 2013. Consolidated net sales decreased in both our Engine Management and Temperature Control Segments as compared to 2013. The following table summarizes net sales and gross margins by segment for the years ended December 31, 2014 and 2013, respectively: Engine Management’s net sales decreased $2 million to $709.3 million for 2014. The year-over-year decrease in net sales resulted primarily from lower net sales in the OE/OES and export markets as compared to 2013, which more than offset the higher net sales in the retail, traditional and specialty markets. Temperature Control’s net sales decreased $3.5 million, or 1.3%, to $259.1 million for 2014. The year-over-year decrease in net sales at Temperature Control resulted from the lower results in the traditional and retail markets offset, in part, by the higher net sales in the OE/OES and specialty markets. Included in the 2014 net sales are incremental sales of $8.5 million from the business acquired in connection with our asset acquisition of Annex Manufacturing in April 2014. Excluding the incremental sales from the acquisition, Temperature Control’s net sales decreased $12 million compared to 2013. Demand for our Temperature Control products may vary significantly with summer weather conditions and customer inventories. Gross Margins. Gross margins, as a percentage of consolidated net sales, were flat at 29.5% when compared to 2013. Gross margins at Engine Management increased 0.3 percentage points from 30.7% to 31% while gross margins at Temperature Control decreased 0.5 percentage points from 22.1% to 21.6%. The gross margin percentage improvement in Engine Management compared to the prior year was primarily the result of improved global sourcing and manufacturing efficiencies, including the increase in manufacturing at our lower cost facilities. The gross margin percentage decline in Temperature Control compared to the prior year resulted primarily from lower production volumes to bring inventories in line with anticipated market demand. Index Selling, General and Administrative Expenses. Selling, general and administrative expenses (“SG&A”) decreased by $7.8 million to $193.5 million or 19.7% of consolidated net sales in 2014, as compared to $201.3 million or 20.5% of consolidated net sales in 2013. The decrease in SG&A expenses as compared to 2013 is principally due to lower employee benefit costs and savings from the integration of the CompressorWorks acquisition in April 2012. Litigation Charge. During 2014, we recorded a $10.6 million litigation charge in connection with a settlement agreement in a legal proceeding with a third party. The settlement amount was funded from cash on hand and available credit under our revolving credit facility. For additional information, see Note 19 of the notes to our financial statements. Restructuring and Integration Expenses. Restructuring and integration expenses decreased to $1.2 million in 2014 compared to $3.4 million in 2013. Components of our restructuring and integration accruals, by segment, were as follows (in thousands): During 2013, we offered a voluntary separation incentive program to certain eligible employees to reduce costs and improve our operating efficiency. Eligible employees, who accepted the program, received enhanced severance and other retiree benefit enhancements. In connection with the program, we recorded a charge of $1.8 million during the year ended December 31, 2013. Other Income, Net. Other income, net was $1.1 million in 2014 compared to $1 million for the year ended December 31, 2013. During 2014 and 2013, we recognized $1 million of deferred gain related to the sale-leaseback of our Long Island City, New York facility. Operating Income. Operating income decreased $1.6 million to $85.3 million in 2014, compared to $86.9 million in 2013. The year-over year decline in operating income reflects the impact of lower net sales and the $10.6 million litigation charge incurred in 2014 in connection with a settlement agreement in a legal proceeding with a third party, offset in part by lower SG&A and restructuring and integration expenses. Other Non-Operating Income (Expense), Net. Other non-operating expense, net was $2 million in 2014. During 2014, we recognized foreign currency exchange losses of $1.6 million and equity losses from our joint ventures of $0.8 million, which were offset by interest and dividend income of $0.3 million. Other non-operating income (expense), net during 2013 consisted of foreign currency losses of $0.1 million and equity losses from our joint ventures of $0.3 million, offset by interest and dividend income of $0.3 million. Interest Expense. Interest expense decreased by $0.3 million to $1.6 million in 2014 compared to interest expense of $1.9 million in 2013 as average interest rates declined year-over-year. The year-over-year decline in interest rates reflects the impact of the lower interest rates in our May 2013 amendment to our revolving credit facility. Income Tax Provision. The income tax provision for 2014 was $28.9 million at an effective tax rate of 35.3%, compared to $31.9 million at an effective tax rate of 37.6% in 2013. The lower year-over-year effective tax rate is the result of the change in the mix of pre-tax income from the U.S. to the lower foreign tax rate jurisdictions, the reversal of previously established reserves for uncertain tax positions as a result of the expiration of the statue of limitations and tax return adjustments relating to production deductions and research and development credits. Index Loss from Discontinued Operations, Net of Income Tax Benefit. Loss from discontinued operations, net of income tax, reflects information contained in the most recent actuarial studies performed as of August 31, 2014 and 2013, and other information available and considered by us, and legal expenses incurred associated with our asbestos-related liability. During 2014 and 2013, we recorded a loss of $9.9 million and $1.6 million, net of tax, from discontinued operations, respectively. The loss from discontinued operations for 2014 includes a $12.8 million pre-tax provision reflecting the impact of the results of the August 2014 actuarial study. No similar adjustment to our asbestos liability was made in 2013 as the difference between the low end of the range in the August 2013 actuarial study and our recorded liability was not material. As discussed more fully in Note 19 in the notes to our financial statements, we are responsible for certain future liabilities relating to alleged exposure to asbestos containing products. Comparison of Fiscal Years 2013 and 2012 Sales. Consolidated net sales for 2013 were $983.7 million, an increase of $34.8 million, or 3.7%, compared to $948.9 million in the same period of 2012. Consolidated net sales increased primarily due to higher sales in the retail, traditional and OE/OES markets of our Engine Management Segment as compared to 2012, which more than offset the lower sales achieved by our Temperature Control Segment. The following table summarizes net sales and gross margins by segment for the years ended December 31, 2013 and 2012, respectively: Engine Management’s net sales increased $46.1 million, or 6.9%, to $711.2 million for 2013. Year-over-year increases in net sales were achieved in the traditional, retail and OE/OES markets as compared to 2012. Temperature Control’s net sales decreased $6.3 million, or 2.3%, to $262.5 million for 2013. Included in the year end 2013 net sales were incremental sales of $16.6 million from our asset acquisition of CompressorWorks, Inc., acquired in April 2012. Excluding the incremental sales from the acquisition, Temperature Control’s net sales decreased $22.9 million compared to 2012. The year-over-year decline in net sales, excluding the acquisition, resulted primarily from the impact of a cool, wet spring and milder summer weather conditions in 2013 as compared to the same period in the prior year. Gross Margins. Gross margins, as a percentage of consolidated net sales, increased by 2.1 percentage points to 29.5% in 2013 from 27.4% in 2012. Gross margins at Engine Management increased 2.5 percentage points from 28.2% to 30.7% while gross margins at Temperature Control increased 0.3 percentage points from 21.8% to 22.1%. The gross margin percentage improvement in Engine Management compared to the prior year was primarily the result of increased volume, improved global sourcing and manufacturing efficiencies including the increase in manufacturing at our lower cost facilities. The gross margin percentage improvement in Temperature Control compared to the prior year was primarily the result of the increase in manufacturing at our lower cost facilities and the benefits achieved as a result of the integration of CompressorWorks product lines. Index Selling, General and Administrative Expenses. Selling, general and administrative expenses (“SG&A”) increased by $13.8 million to $201.3 million or 20.5% of consolidated net sales in 2013, as compared to $187.5 million or 19.8% of consolidated net sales in 2012. The increase in SG&A expenses was principally due to the incremental expenses from our asset acquisition of CompressorWorks, Inc., including amortization of intangible assets acquired, and the higher sales, marketing and distribution expenses associated with the increased sales volumes. Restructuring and Integration Expenses. Restructuring and integration expenses increased to $3.4 million in 2013 compared to $1.4 million in 2012. Components of our restructuring and integration accruals, by segment, were as follows (in thousands): During 2013, we offered a voluntary separation incentive program to certain eligible employees to reduce costs and improve our operating efficiency. Eligible employees, who accepted the program, received enhanced severance and other retiree benefit enhancements. In connection with the program, we recorded a charge of $1.8 million during the year ended December 31, 2013. Other Income, Net. Other income, net was $1 million in 2013 compared to $0.7 million for the year ended December 31, 2012. During 2013 and 2012, we recognized $1 million of deferred gain related to the sale-leaseback of our Long Island City, New York facility. In addition, other income, net in 2012 included a $0.2 million gain on the sale of land located in the U.K. and a $0.6 million loss on the disposal of certain machinery and equipment. Operating Income. Operating income was $86.9 million in 2013, compared to $71.4 million in 2012. The increase of $15.5 million was the result of higher year-over-year consolidated net sales and higher gross margins as a percentage of consolidated net sales offset, in part, by higher SG&A and restructuring and integration expenses. Other Non-Operating Income (Expense), Net. Other non-operating expense, net was $0.7 million for the year ended December 31, 2012 and included a fair market value adjustment for the option provided to the buyers of our European business in November 2009 to purchase 20% of our SMP Poland subsidiary. Interest Expense. Interest expense decreased by $0.9 million to $1.9 million in 2013 compared to interest expense of $2.8 million in 2012 as average outstanding borrowings and average interest rates declined year-over-year. The year-over-year decline in interest rates reflected the impact of the lower interest rates in our May 2013 amendment to our revolving credit facility. Income Tax Provision. The income tax provision for 2013 was $31.9 million at an effective tax rate of 37.6%, compared to $25 million at an effective tax rate of 36.8% in 2012. The effective tax rate in 2013 and 2012 was favorably impacted by $0.4 million and $0.8 million, respectively, related to certain foreign tax and research and development credits, and production deductions which were finalized during the year. For further information, see Note 16 of the notes to our financial statements. Loss from Discontinued Operations, Net of Income Tax Benefit. Loss from discontinued operations, net of income tax, reflects information contained in the most recent actuarial studies performed as of August 31, 2013 and 2012, other information available and considered by us, and legal expenses incurred associated with our asbestos-related liability. During each of 2013 and 2012, we recorded a loss of $1.6 million, net of tax, from discontinued operations. As discussed more fully in Note 19 in the notes to our consolidated financial statements, we are responsible for certain future liabilities relating to alleged exposure to asbestos containing products. Index Restructuring and Integration Costs The aggregated liabilities included in “sundry payables and accrued expenses” and “other accrued liabilities” in the consolidated balance sheet relating to the restructuring and integration activities as of and for the years ended December 31, 2014 and 2013, consisted of the following (in thousands): During 2013, we offered a voluntary separation incentive program to certain eligible employees to reduce costs and improve our operating efficiency. Eligible employees, who accepted the program, received enhanced severance and other retiree benefit enhancements. In connection with the program, we have recorded a charge of $1.8 million during the year ended December 31, 2013. Liabilities associated with the remaining restructuring and integration costs as of December 31, 2014 relate primarily to employee severance and other retiree benefit enhancements to be paid through 2018 and environmental clean-up costs at our Long Island City, New York location in connection with the closure of our manufacturing operations at the site. Liquidity and Capital Resources Operating Activities. During 2014, cash provided by operations was $47 million, compared to $57.6 million in 2013. Included in cash provided by operations during 2014 was a nonrecurring $10.6 million cash payment in connection with a settlement agreement in a legal proceeding with a third party. During 2014, (1) the decrease in accounts receivable was $1.8 million compared to the year-over-year increase in accounts receivable of $27.3 million in 2013; (2) the increase in inventory was $6.7 million compared to the year-over-year increase in inventory of $6.1 million in 2013; (3) the decrease in accounts payable was $4.3 million compared to the year-over-year increase in accounts payable of $12.5 million in 2013; and (4) the decrease in sundry payables and accrued expenses was $7.7 million compared to the year-over-year increase in sundry payables and accrued expenses of $8.7 million in 2013. We continue to actively manage our working capital to maximize our operating cash flow. During 2013, cash provided by operations was $57.6 million, compared to $93.6 million in 2012. The year-over-year decrease in cash provided by operations is primarily the result of year-over-year increases in accounts receivable, inventory, and prepaid expenses and other current assets partially offset by an increase in accounts payable balances. Accounts receivable balances increased during 2013 resulting in a $27.3 million cash usage as compared to a decrease in accounts receivable balances during 2012, providing $15.4 million of operating cash flow. The increase in inventory balances during 2013 resulted in a cash usage of $6.1 million as compared to a $1.6 million cash usage in 2012. Prepaid expenses and other current assets increased during 2013 resulting in a $4 million cash usage as compared to a $0.7 million cash usage in 2012. Accounts payable balances increased during 2013 providing $12.5 million of operating cash flow compared to an increase in 2012, providing $3.3 million of operating cash flow. The increase in accounts receivable balances reflects the impact of strong fourth quarter 2013 net sales compared net sales in the fourth quarter 2012. Index Investing Activities. Cash used in investing activities was $51.2 million in 2014, compared to $24.8 million in 2013 and $49.9 million in 2012. Investing activities in 2014 consist of (1) our acquisition of certain assets of Pensacola Fuel Injection Inc., our primary vendor for rebuilt diesel fuel injectors and other related diesel products, for $12.2 million; (2) our acquisition of a 50% interest in the joint venture with Gwo Yng Enterprise Co., Ltd., a China based manufacturer of air conditioning accumulators, filter driers, hose assemblies, and switches for the automotive aftermarket and OEM/OES markets for $14 million; (3) our acquisition of certain assets of Annex Manufacturing of Fort Worth, Texas, a distributor of a variety of temperature control products for the automotive aftermarket, for $11.5 million; and (4) capital expenditures of $13.9 million. Cash used in investing activities was $24.8 million in 2013. Cash used in investing activities in 2013 consisted primarily of (1) our acquisition of an approximate 25% minority interest in Orange Electronic Co. Ltd., our supplier of tire pressure monitoring systems located in Taiwan, for $6.3 million, (2) our acquisition of the original equipment business of Standard Motor Products Holdings Ltd., our former affiliate in the U.K., for $6.5 million, and (3) $11.4 million in capital expenditures. Cash used in investing activities was $49.9 million in 2012. Cash used in investing activities in 2012 included (1) a cash payment of $38.6 million related to the asset acquisition of CompressorWorks, Inc. and (2) capital expenditures of $11.8 million. Financing Activities. Cash provided by financing activities was $15.3 million in 2014, compared to cash used in financing activities of $39.3 million in 2013 and $42.8 million in 2012. Borrowings under our revolving credit facility in 2014, along with the cash provided by operations, were used to pay dividends and to fund acquisitions, business investments, capital expenditures, and the repurchase of 284,284 shares of our common stock for $10 million. Cash used in financing activities was $39.3 million in 2013. The excess cash provided by operations over cash used in investing activities in 2013 was used to (1) pay down borrowings under our revolving credit facility; (2) to fund the purchase of 209,973 shares of our common stock for $6.9 million; (3) to pay $1.3 million of debt issuance costs in connection with our May 2013 amendment to our restated credit agreement; and (4) pay dividends. Cash used in financing activities was $42.8 million in 2012. The excess cash provided by operations over cash used in investing activities in 2012 was used to pay down borrowings under our revolving credit facility, to fund the purchase of 380,777 shares of our common stock for $5 million, and pay dividends. Dividends of $11.9 million, $10.1 million and $8.2 million were paid in 2014, 2013 and 2012, respectively. Liquidity Our primary cash requirements include working capital, capital expenditures, regular quarterly dividends and principal and interest payments on indebtedness. Our primary sources of funds are ongoing net cash flows from operating activities and availability under our secured revolving credit facility (as detailed below). We have entered into the Third Amended and Restated Credit Agreement with General Electric Capital Corporation, as agent, and a syndicate of lenders for a secured revolving credit facility. The restated credit agreement (as amended) provides for a line of credit of up to $250 million (inclusive of the Canadian revolving credit facility described below) and expires in March 2018. Direct borrowings under the restated credit agreement bear interest at the LIBOR rate plus the applicable margin (as defined), or floating at the index rate plus the applicable margin, at our option. The interest rate may vary depending upon our borrowing availability. The restated credit agreement is guaranteed by certain of our subsidiaries and secured by certain of our assets. Index In February 2013, we amended the restated credit agreement to provide us with greater flexibility regarding the payment of cash dividends and stock repurchases. In May 2013, we further amended our restated credit agreement (1) to extend the maturity date of our credit facility to March 2018; (2) to increase the line of credit from $200 million to $250 million (inclusive of the Canadian revolving credit facility described below); (3) to reduce the margin added to the LIBOR rate to 1.50% - 2%; (4) to reduce the margin added to the index rate to 0.50% - 1%; (5) to reduce the unused fee to 0.25%; and (6) to provide us with greater flexibility regarding acquisitions, other permissible debt financing, cash held and capital expenditures, among other matters. Borrowings under the restated credit agreement are collateralized by substantially all of our assets, including accounts receivable, inventory and fixed assets, and those of certain of our subsidiaries. After taking into account outstanding borrowings under the restated credit agreement, there was an additional $127.3 million available for us to borrow pursuant to the formula at December 31, 2014. Outstanding borrowings under the restated credit agreement (inclusive of the Canadian revolving credit facility described below), which are classified as current liabilities, were $56.6 million and $21.4 million at December 31, 2014 and 2013, respectively. Borrowings under the restated credit agreement have been classified as current liabilities based upon the accounting rules and certain provisions in the agreement. At December 31, 2014, the weighted average interest rate on our restated credit agreement was 1.8%, which consisted of $53 million in direct borrowings at 1.7% and an index loan of $3.6 million at 3.8%. At December 31, 2013, the weighted average interest rate on our restated credit agreement was 2%, which consisted of $18 million in direct borrowings at 1.7% and an index loan of $3.4 million at 3.8%. During 2014 and 2013, our average daily index loan balance was $4.4 million and $4.1 million, respectively. At any time that our average borrowing availability is less than $25 million, the terms of our restated credit agreement provide for, among other provisions, a financial covenant requiring us, on a consolidated basis, to maintain specified levels of fixed charge coverage at the end of each fiscal quarter (rolling twelve months). As of December 31, 2014, we were not subject to these covenants. Availability under our restated credit agreement is based on a formula of eligible accounts receivable, eligible inventory and eligible fixed assets. Our restated credit agreement also permits dividends and distributions by us provided specific conditions are met. Our Canadian Credit Agreement with GE Canada Finance Holding Company, for itself and as agent for the lenders provides for a $10 million revolving credit facility. The Canadian $10 million line of credit is part of the $250 million available for borrowing under our restated credit agreement with General Electric Capital Corporation. In May 2013, we amended our Canadian Credit Agreement to extend the maturity date of the agreement to March 2018 and modify certain provisions, including interest rates, to parallel the revolving credit provisions of the restated credit agreement (described above). The amended credit agreement is guaranteed and secured by us and certain of our wholly-owned subsidiaries. Direct borrowings under the amended credit agreement bear interest at the same rate as our restated credit agreement with General Electric Capital Corporation. As of December 31, 2014, we have no outstanding borrowings under the Canadian Credit Agreement. In order to reduce our accounts receivable balances and improve our cash flow, we sell undivided interests in certain of our receivables to financial institutions. We enter these agreements at our discretion when we determine that the cost of factoring is less than the cost of servicing our receivables with existing debt. Under the terms of the agreements, we retain no rights or interest, have no obligations with respect to the sold receivables, and do not service the receivables after the sale. As such, these transactions are being accounted for as a sale. Pursuant to these agreements, we sold $690.3 million and $672.8 million of receivables for the years ended December 31, 2014 and 2013, respectively. A charge in the amount of $13.1 million, $13.9 million and $13.7 million related to the sale of receivables is included in selling, general and administrative expenses in our consolidated statements of operations for the years ended December 31, 2014, 2013 and 2012, respectively. If we do not enter into these arrangements or if any of the financial institutions with which we enter into these arrangements were to experience financial difficulties or otherwise terminate these arrangements, our financial condition, results of operations and cash flows could be materially and adversely affected by delays or failures to collect future trade accounts receivable. Index In May 2012, our Board of Directors authorized the purchase of up to $5 million of our common stock under a stock repurchase program. Under this program, during the years ended December 31, 2013 and 2012, we repurchased 30,601 shares and 312,527 shares, respectively, of our common stock at a total cost of $0.9 million and $4.1 million, respectively. No stock repurchases remain available under the 2012 program as the entire $5 million was utilized. In February 2013, our Board of Directors authorized the purchase of up to an additional $6 million of our common stock under a stock repurchase program. During the year ended December 31, 2013, we repurchased 179,372 shares of our common stock under this program at a total cost of $6 million. No stock repurchases remain available under the 2013 program as the entire $6 million was utilized. In February 2014, our Board of Directors authorized the purchase of up to an additional $10 million of our common stock under a stock repurchase program. During the year ended December 31, 2014, we repurchased 284,284 shares of our common stock under this program at a total cost of $10 million. No stock repurchases remain available under the 2014 program as the entire $10 million was utilized. In February 2015, our Board of Directors authorized the purchase of up to an additional $10 million of our common stock under a stock repurchase program. Stock will be purchased from time to time, in the open market or through private transactions, as market conditions warrant. We anticipate that our cash flow from operations, available cash and available borrowings under our revolving credit facility will be adequate to meet our future liquidity needs for at least the next twelve months. Significant assumptions underlie this belief, including, among other things, that there will be no material adverse developments in our business, liquidity or capital requirements. If material adverse developments were to occur in any of these areas, there can be no assurance that our business will generate sufficient cash flow from operations, or that future borrowings will be available to us under our revolving credit facility in amounts sufficient to enable us to pay the principal and interest on our indebtedness, or to fund our other liquidity needs. In addition, if we default on any of our indebtedness, or breach any financial covenant in our revolving credit facility, our business could be adversely affected. The following table summarizes our contractual commitments as of December 31, 2014 and expiration dates of commitments through 2023: (1) Indebtedness under our revolving credit facilities of $56.6 million as of December 31, 2014 is not included in the table above as it is reported as a current liability in our consolidated balance sheets. Critical Accounting Policies We have identified the policies below as critical to our business operations and the understanding of our results of operations. The impact and any associated risks related to these policies on our business operations is discussed throughout “Management’s Discussion and Analysis of Financial Condition and Results of Operations,” where such policies affect our reported and expected financial results. For a detailed discussion on the application of these and other accounting policies, see Note 1 of the notes to our consolidated financial statements. You should be aware that preparation of our consolidated annual and quarterly financial statements requires us to make estimates and assumptions that affect the reported amount of assets and liabilities, disclosure of contingent assets and liabilities at the date of our consolidated financial statements, and the reported amounts of revenue and expenses during the reporting periods. We can give no assurance that actual results will not differ from those estimates. Although we do not believe that there is a reasonable likelihood that there will be a material change in the future estimate or in the assumptions that we use in calculating the estimate, unforeseen changes in the industry, or business could materially impact the estimate and may have a material adverse effect on our business, financial condition and results of operations. Index Revenue Recognition. We derive our revenue primarily from sales of replacement parts for motor vehicles from both our Engine Management and Temperature Control Segments. We recognize revenues when products are shipped and title has been transferred to a customer, the sales price is fixed and determinable, and collection is reasonably assured. For some of our sales of remanufactured products, we also charge our customers a deposit for the return of a used core component which we can use in our future remanufacturing activities. Such deposit is not recognized as revenue but rather carried as a core liability. The liability is extinguished when a core is actually returned to us. We estimate and record provisions for cash discounts, quantity rebates, sales returns and warranties in the period the sale is recorded, based upon our prior experience and current trends. As described below, significant management judgments and estimates must be made and used in estimating sales returns and allowances relating to revenue recognized in any accounting period. Inventory Valuation. Inventories are valued at the lower of cost or market. Cost is determined on the first-in, first-out basis. Where appropriate, standard cost systems are utilized for purposes of determining cost; the standards are adjusted as necessary to ensure they approximate actual costs. Estimates of lower of cost or market value of inventory are determined based upon current economic conditions, historical sales quantities and patterns and, in some cases, the specific risk of loss on specifically identified inventories. We also evaluate inventories on a regular basis to identify inventory on hand that may be obsolete or in excess of current and future projected market demand. For inventory deemed to be obsolete, we provide a reserve on the full value of the inventory. Inventory that is in excess of current and projected use is reduced by an allowance to a level that approximates our estimate of future demand. Future projected demand requires management judgment and is based upon (a) our review of historical trends and (b) our estimate of projected customer specific buying patterns and trends in the industry and markets in which we do business. Using rolling twelve month historical information, we estimate future demand on a continuous basis. As such, the historical volatility of such estimates has been minimal. We utilize cores (used parts) in our remanufacturing processes for air conditioning compressors, diesel injectors, diesel pumps, and turbo chargers. The production of air conditioning compressors, diesel injectors, diesel pumps, and turbo chargers, involves the rebuilding of used cores, which we acquire either in outright purchases from used parts brokers or from returns pursuant to an exchange program with customers. Under such exchange programs, we reduce our inventory, through a charge to cost of sales, when we sell a finished good compressor, and put back to inventory the used core exchanged at standard cost through a credit to cost of sales when it is actually received from the customer. Sales Returns and Other Allowances and Allowance for Doubtful Accounts. We must make estimates of potential future product returns related to current period product revenue. We analyze historical returns, current economic trends, and changes in customer demand when evaluating the adequacy of the sales returns and other allowances. Significant judgments and estimates must be made and used in connection with establishing the sales returns and other allowances in any accounting period. At December 31, 2014, the allowance for sales returns was $30.6 million. Similarly, we must make estimates of the uncollectability of our accounts receivables. We specifically analyze accounts receivable and analyze historical bad debts, customer concentrations, customer credit-worthiness, current economic trends and changes in our customer payment terms when evaluating the adequacy of the allowance for doubtful accounts. At December 31, 2014, the allowance for doubtful accounts and for discounts was $6.4 million. Index New Customer Acquisition Costs. New customer acquisition costs refer to arrangements pursuant to which we incur change-over costs to induce a new customer to switch from a competitor’s brand. In addition, change-over costs include the costs related to removing the new customer’s inventory and replacing it with Standard Motor Products inventory commonly referred to as a stocklift. New customer acquisition costs are recorded as a reduction to revenue when incurred. Accounting for Income Taxes. As part of the process of preparing our consolidated financial statements, we are required to estimate our income taxes in each of the jurisdictions in which we operate. This process involves estimating our actual current tax expense together with assessing temporary differences resulting from differing treatment of items for tax and accounting purposes. These differences result in deferred tax assets and liabilities, which are included within our consolidated balance sheet. We must then assess the likelihood that our deferred tax assets will be recovered from future taxable income, and to the extent we believe that it is more likely than not that the deferred tax assets will not be recovered, we must establish a valuation allowance. To the extent we establish a valuation allowance or increase or decrease this allowance in a period, we must include an expense or recovery, respectively, within the tax provision in the statement of operations. We maintain valuation allowances when it is more likely than not that all or a portion of a deferred asset will not be realized. In determining whether a valuation allowance is warranted, we evaluate factors such as prior earnings history, expected future earnings, carryback and carryforward periods and tax strategies. We consider all positive and negative evidence to estimate if sufficient future taxable income will be generated to realize the deferred tax asset. We consider cumulative losses in recent years as well as the impact of one-time events in assessing our pre-tax earnings. Assumptions regarding future taxable income require significant judgment. Our assumptions are consistent with estimates and plans used to manage our business, which includes restructuring and integration initiatives that are expected to generate significant savings in future periods. The valuation allowance of $0.4 million as of December 31, 2014 is intended to provide for the uncertainty regarding the ultimate realization of our U.S. foreign tax credit carryovers, state investment tax credit carryovers and foreign net operating loss carryovers. The assessment of the adequacy of our valuation allowance is based on our estimates of taxable income in these jurisdictions and the period over which our deferred tax assets will be recoverable. Based on these considerations, we believe it is more likely than not that we will realize the benefit of the net deferred tax asset of $51.5 million as of December 31, 2014, which is net of the remaining valuation allowance. In the event that actual results differ from these estimates, or we adjust these estimates in future periods for current trends or expected changes in our estimating assumptions, we may need to modify the level of the valuation allowance which could materially impact our business, financial condition and results of operations. In accordance with generally accepted accounting practices, we recognize in our financial statements only those tax positions that meet the more-likely-than-not-recognition threshold. We establish tax reserves for uncertain tax positions that do not meet this threshold. As of December 31, 2014, we do not believe there is a need to establish a liability for uncertain tax positions. Penalties associated with income tax matters are included in the provision for income taxes in our consolidated statement of operations. Valuation of Long-Lived and Intangible Assets and Goodwill. At acquisition, we estimate and record the fair value of purchased intangible assets, which primarily consists of customer relationships, trademarks and trade names, patents and non-compete agreements. The fair values of these intangible assets are estimated based on our assessment. Goodwill is the excess of the purchase price over the fair value of identifiable net assets acquired in business combinations. Goodwill and certain other intangible assets having indefinite lives are not amortized to earnings, but instead are subject to periodic testing for impairment. Intangible assets determined to have definite lives are amortized over their remaining useful lives. Index We assess the impairment of long-lived assets, identifiable intangibles assets and goodwill whenever events or changes in circumstances indicate that the carrying value may not be recoverable. With respect to goodwill and identifiable intangible assets having indefinite lives, we test for impairment on an annual basis or in interim periods if an event occurs or circumstances change that may indicate the fair value is below its carrying amount. Factors we consider important, which could trigger an impairment review, include the following: (a) significant underperformance relative to expected historical or projected future operating results; (b) significant changes in the manner of our use of the acquired assets or the strategy for our overall business; and (c) significant negative industry or economic trends. We review the fair values using the discounted cash flows method and market multiples. When performing our evaluation of goodwill for impairment, if we conclude qualitatively that it is not more likely than not that the fair value of the reporting unit is less than its carrying amount, than the two-step impairment test is not required. If we are unable to reach this conclusion, then we would perform the two-step impairment test. Initially, the fair value of the reporting unit is compared to its carrying amount. To the extent the carrying amount of a reporting unit exceeds the fair value of the reporting unit; we are required to perform a second step, as this is an indication that the reporting unit goodwill may be impaired. In this step, we compare the implied fair value of the reporting unit goodwill with the carrying amount of the reporting unit goodwill and recognize a charge for impairment to the extent the carrying value exceeds the implied fair value. The implied fair value of goodwill is determined by allocating the fair value of the reporting unit to all of the assets (recognized and unrecognized) and liabilities of the reporting unit in a manner similar to a purchase price allocation. The residual fair value after this allocation is the implied fair value of the reporting unit goodwill. In addition, identifiable intangible assets having indefinite lives are reviewed for impairment on an annual basis using a methodology consistent with that used to evaluate goodwill. Intangible assets having definite lives and other long-lived assets are reviewed for impairment whenever events such as product discontinuance, plant closures, product dispositions or other changes in circumstances indicate that the carrying amount may not be recoverable. In reviewing for impairment, we compare the carrying value of such assets to the estimated undiscounted future cash flows expected from the use of the assets and their eventual disposition. When the estimated undiscounted future cash flows are less than their carrying amount, an impairment loss is recognized equal to the difference between the assets fair value and their carrying value. There are inherent assumptions and estimates used in developing future cash flows requiring our judgment in applying these assumptions and estimates to the analysis of identifiable intangibles and long-lived asset impairment including projecting revenues, interest rates, tax rates and the cost of capital. Many of the factors used in assessing fair value are outside our control and it is reasonably likely that assumptions and estimates will change in future periods. These changes can result in future impairments. In the event our planning assumptions were modified resulting in impairment to our assets, we would be required to include an expense in our statement of operations, which could materially impact our business, financial condition and results of operations. Retirement and Postretirement Medical Benefits. Each year, we calculate the costs of providing retiree benefits under the provisions of the Financial Accounting Standards Board (“FASB”) Accounting Standards Codification (“ASC”) 712, Nonretirement Postemployment Benefits, and FASB ASC 715, Retirement Benefits. The determination of defined benefit pension and postretirement plan obligations and their associated costs requires the use of actuarial computations to estimate participant plan benefits the employees will be entitled to. The key assumptions used in making these calculations are the eligibility criteria of participants and the discount rate used to value the future obligation. The discount rate reflects the yields available on high-quality, fixed-rate debt securities. Share-Based Compensation. The provisions of FASB ASC 718, Stock Compensation, require the measurement and recognition of compensation expense for all share-based payment awards made to employees and directors based on estimated fair values on the grant date using an option-pricing model. The value of the portion of the award that is ultimately expected to vest is recognized as expense on a straight-line basis over the requisite service periods in our condensed consolidated statement of operations. Forfeitures are estimated at the time of grant based on historical trends in order to estimate the amount of share-based awards that will ultimately vest. We monitor actual forfeitures for any subsequent adjustment to forfeiture rates. Index Environmental Reserves. We are subject to various U.S. Federal, state and local environmental laws and regulations and are involved in certain environmental remediation efforts. We estimate and accrue our liabilities resulting from such matters based upon a variety of factors including the assessments of environmental engineers and consultants who provide estimates of potential liabilities and remediation costs. Such estimates are not discounted to reflect the time value of money due to the uncertainty in estimating the timing of the expenditures, which may extend over several years. Potential recoveries from insurers or other third parties of environmental remediation liabilities are recognized independently from the recorded liability, and any asset related to the recovery will be recognized only when the realization of the claim for recovery is deemed probable. Asbestos Litigation. We are responsible for certain future liabilities relating to alleged exposure to asbestos-containing products. In accordance with our accounting policy, our most recent actuarial study as of August 31, 2014 estimated an undiscounted liability for settlement payments, excluding legal costs and any potential recovery from insurance carriers, ranging from $36.1 million to $55.4 million for the period through 2058. Based on the information contained in the actuarial study and all other available information considered by us, we have concluded that no amount within the range of settlement payments was more likely than any other and, therefore, in assessing our asbestos liability we compare the low end of the range to our recorded liability to determine if an adjustment is required. Based upon the results of the August 31, 2014 actuarial study, in September 2014 we increased our asbestos liability to $36.1 million, the low end of the range, and recorded an incremental pre-tax provision of $12.8 million in earnings (loss) from discontinued operations in the accompanying statement of operations. In addition, according to the updated study, legal costs, which are expensed as incurred and reported in earnings (loss) from discontinued operations, are estimated to range from $43 million to $76.4 million during the same period. We will continue to perform an annual actuarial analysis during the third quarter of each year for the foreseeable future. Based on this analysis and all other available information, we will continue to reassess the recorded liability and, if deemed necessary, record an adjustment to the reserve, which will be reflected as a loss or gain from discontinued operations. The aforementioned estimated settlement payments and legal costs do not reflect any coverage with insurance carriers for certain asbestos-related claims that we may obtain in the future. Other Loss Reserves. We have other loss exposures, for such matters as legal claims and legal proceedings. Establishing loss reserves for these matters requires estimates, judgment of risk exposure, and ultimate liability. We record provisions when the liability is considered probable and reasonably estimable. Significant judgment is required in both the determination of probability and the determination as to whether an exposure can be reasonably estimated. As additional information becomes available, we reassess our potential liability related to these matters. Such revisions of the potential liabilities could have a material adverse effect on our business, financial condition or results of operations. Recently Issued Accounting Pronouncements Discontinued Operations and Disclosures of Disposals of Components of an Entity In April 2014, the Financial Accounting Standards Board (“FASB”) issued Accounting Standards Update (“ASU”) 2014-08, Reporting Discontinued Operations and Disclosures of Disposals of Components of an Entity (“ASU 2014-08”), which changes the criteria for determining which disposals can be presented as discontinued operations and modifies related disclosure requirements. Under the new guidance, a discontinued operation is defined as a disposal of a component or group of components that is disposed of or is classified as held for sale and “represents a strategic shift that has (or will have) a major effect on an entity’s operations and financial results.” The new standard applies prospectively to new disposals and new classifications of disposal groups as held for sale after the effective date. The amendment is effective for annual reporting periods beginning after December 15, 2014, which for us is January 1, 2015, and interim periods within those annual periods. The adoption of this standard will not change the manner in which we currently present discontinued operations in our consolidated financial statements. Index Revenue from Contracts with Customers In May 2014, the FASB issued ASU 2014-09, Revenue from Contracts with Customers (“ASU 2014-09”), which outlines a single comprehensive model for entities to use in accounting for revenue arising from contracts with customers and supersedes most current revenue recognition guidance, including industry-specific guidance. Under the new guidance, “an entity recognizes revenue to depict the transfer of promised goods or services to customers in an amount that reflects the consideration to which the entity expects to be entitled in exchange for those goods or services.” The new standard provides entities the option of using either a full retrospective or a modified approach to adopt the guidance. The new standard is effective for annual reporting periods beginning after December 15, 2016, which for us is January 1, 2017, and interim periods within those annual periods. Early adoption is not permitted. We are currently evaluating the impact, if any, this new standard will have on our consolidated financial statements and have not yet determined the method of adoption. Disclosure of Uncertainties About an Entity’s Ability to Continue as a Going Concern In August 2014, the FASB issued ASU 2014-15, Disclosure of Uncertainties About an Entity’s Ability to Continue as a Going Concern (“ASU 2014-15”), which provides guidance on determining when and how to disclose going concern uncertainties in the consolidated financial statements. Under the new guidance, management would be required to perform interim and annual assessments of an entity’s ability to continue as a going concern within one year of the date the financial statements are issued. Certain disclosures must be provided if “conditions or events raise substantial doubt about an entity’s ability to continue as a going concern.” The new standard is effective for annual reporting periods ending after December 15, 2016, which for us is December 31, 2016, and interim periods thereafter. Early adoption is permitted. Upon adoption, although we do not anticipate that the new standard will have an impact on our disclosures, we will consider the new standard when conducting our interim and annual assessments of our ability to continue as a going concern. Income Statement - Extraordinary and Unusual Items In January 2015, the FASB issued ASU 2015-01, Income Statement - Extraordinary and Unusual Items, (“ASU 2015-01”), which removes the concept of extraordinary items from U.S. GAAP. Under the existing guidance, an entity is required to separately disclose extraordinary items, net of tax, in the income statement after income from continuing operations if an event or transaction is unusual and occurs infrequently. This separate, net-of-tax presentation will no longer be allowed. The existing requirement to separately disclose events or transactions that are unusual or occur infrequently on a pre-tax basis within continuing operations in the income statement has been retained. The new guidance requires similar separate presentation of items that are both unusual and infrequent. The new standard is effective for periods beginning after December 15, 2015, which for us is January 1, 2016. Early adoption is permitted, but only as of the beginning of the fiscal year of adoption. Upon adoption, we will present transactions that are both unusual and infrequent on a pre-tax basis within continuing operations in the income statement. Index

<s>[INST] Overview We are a leading independent manufacturer and distributor of replacement parts for motor vehicles in the automotive aftermarket industry, with an increasing focus on heavy duty, industrial equipment and the original equipment service market. We are organized into two major operating segments, each of which focuses on specific lines of replacement parts. Our Engine Management Segment manufactures and remanufactures ignition and emission parts, ignition wires, battery cables, fuel system parts and sensors for vehicle systems. Our Temperature Control Segment manufactures and remanufactures air conditioning compressors, air conditioning and heating parts, engine cooling system parts, power window accessories, and windshield washer system parts. We sell our products primarily to warehouse distributors, large retail chains, original equipment manufacturers and original equipment service part operations in the United States, Canada, Latin America, and Europe. Our customers consist of many of the leading warehouse distributors and auto parts retail chains, such as NAPA Auto Parts (National Automotive Parts Association, Inc.), Advance Auto Parts, Inc./CARQUEST Auto Parts, AutoZone, Inc., O’Reilly Automotive, Inc., Canadian Tire Corporation Limited and The Pep Boys Manny, Moe & Jack, as well as national program distribution groups, such as Auto Value and All Pro/Bumper to Bumper (Aftermarket Auto Parts Alliance, Inc.), Automotive Distribution Network LLC, The National Pronto Association (“Pronto”), Federated Auto Parts Distributors, Inc. (“Federated”), Pronto and Federated’s newly formed organization, the Automotive Parts Services Group or The Group, and specialty market distributors. We distribute parts under our own brand names, such as Standard®, BWD®, Intermotor®, GP Sorensen®, TechSmart®, Tech Expert®, OEM®, LockSmart®, Select®, Four Seasons®, Factory Air®, EVERCO®, ACi®, Imperial®, COMPRESSORWORKS®, TORQFLO® and Hayden® and through colabels and private labels, such as CARQUEST® BWD®, CARQUEST® Intermotor®, Duralast®, Duralast Gold®, Import Direct®, Master Pro®, Murray®, NAPA®, NAPA® Echlin®, Mileage Plus®, NAPA Proformer™, NAPA Temp Products™, Cold Power® and NAPA® Belden®. Business Strategy Our goal is to grow revenues and earnings and deliver returns in excess of our cost of capital by providing high quality original equipment and replacement products to the engine management and temperature control markets. The key elements of our strategy are as follows: · Maintain Our Strong Competitive Position in the Engine Management and Temperature Control Businesses. We are one of the leading independent manufacturers and distributors serving North America and other geographic areas in our core businesses of Engine Management and Temperature Control. We believe that our success is attributable to our emphasis on product quality, the breadth and depth of our product lines for both domestic and import vehicles, and our reputation for outstanding customer service. To maintain our strong competitive position in our markets, we remain committed to the following: · providing our customers with broad lines of high quality engine management and temperature control products, supported by the highest level of customer service and reliability; · continuing to maximize our production, supply chain and distribution efficiencies; Index · continuing to improve our cost position through increased global sourcing and increased manufacturing in low cost regions; and · focusing on our engineering development efforts including a focus on bringing more product manufacturing in house. · Provide Superior Customer Service, Product Availability and Technical Support. Our goal is to increase sales to existing and new customers by leveraging our skills in rapidly filling orders, maintaining high levels of product availability, providing insightful customer category management, and providing technical support in a costeffective manner. In addition, our category management and technically skilled sales force professionals provide product selection, assortment and application support to our customers. · Expand Our Product Lines. We intend to increase our sales by continuing to develop internally, or through potential acquisitions, the range of Engine Management and Temperature Control products that we offer to our customers. We are committed to investing the resources necessary to maintain and expand our technical capability to manufacture multiple product lines [/INST] Positive. </s>

STANDARD MOTOR PRODUCTS INC

2016-02-26

2015-12-31

ITEM 7. MANAGEMENT’S DISCUSSION AND ANALYSIS OF FINANCIAL CONDITION AND RESULTS OF OPERATIONS The following discussion should be read in conjunction with our consolidated financial statements and the notes thereto. This discussion summarizes the significant factors affecting our results of operations and the financial condition of our business during each of the fiscal years in the three-year period ended December 31, 2015. Overview We are a leading independent manufacturer and distributor of replacement parts for motor vehicles in the automotive aftermarket industry, with a complementary focus on heavy duty, industrial equipment and the original equipment service market. We are organized into two major operating segments, each of which focuses on specific lines of replacement parts. Our Engine Management Segment manufactures and remanufactures ignition and emission parts, ignition wires, battery cables, fuel system parts and sensors for vehicle systems. Our Temperature Control Segment manufactures and remanufactures air conditioning compressors, air conditioning and heating parts, engine cooling system parts, power window accessories, and windshield washer system parts. We sell our products primarily to warehouse distributors, large retail chains, original equipment manufacturers and original equipment service part operations in the United States, Canada, Latin America, and Europe. Our customers consist of many of the leading warehouse distributors and auto parts retail chains, such as NAPA Auto Parts (National Automotive Parts Association, Inc.), Advance Auto Parts, Inc./CARQUEST Auto Parts, AutoZone, Inc., O’Reilly Automotive, Inc., Canadian Tire Corporation Limited and The Pep Boys Manny, Moe & Jack, as well as national program distribution groups, such as Auto Value and All Pro/Bumper to Bumper (Aftermarket Auto Parts Alliance, Inc.), Automotive Distribution Network LLC, The National Pronto Association (“Pronto”), Federated Auto Parts Distributors, Inc. (“Federated”), Pronto and Federated’s newly formed organization, the Automotive Parts Services Group or The Group, and specialty market distributors. We distribute parts under our own brand names, such as Standard®, Blue Streak®, BWD®, Select®, Intermotor®, GP Sorensen®, TechSmart®, Tech Expert®, OEM®, LockSmart®, Four Seasons®, Factory Air®, EVERCO®, ACi®, Imperial®, COMPRESSORWORKS®, TORQFLO® and Hayden® and through co-labels and private labels, such as CARQUEST® BWD®, CARQUEST® Intermotor®, Duralast®, Duralast Gold®, Import Direct®, Master Pro®, Murray®, NAPA®, NAPA® Echlin®, NAPA Proformer™ Mileage Plus®, NAPA Temp Products™, Cold Power®, DriveworksTM, ToughOneTM and NAPA® Belden®. Business Strategy Our goal is to grow revenues and earnings and deliver returns in excess of our cost of capital by providing high quality original equipment and replacement products to the engine management and temperature control markets. The key elements of our strategy are as follows: · Maintain Our Strong Competitive Position in the Engine Management and Temperature Control Businesses. We are one of the leading independent manufacturers and distributors serving North America and other geographic areas in our core businesses of Engine Management and Temperature Control. We believe that our success is attributable to our emphasis on product quality, the breadth and depth of our product lines for both domestic and import vehicles, and our reputation for outstanding value-added services. To maintain our strong competitive position in our markets, we remain committed to the following: · providing our customers with broad lines of high quality engine management and temperature control products, supported by the highest level of value-added services; · continuing to maximize our production, supply chain and distribution efficiencies; Index · continuing to improve our cost position through increased global sourcing and increased manufacturing in low cost regions; and · focusing on our engineering development efforts including a focus on bringing more product manufacturing in house. · Provide Superior Value-Added Services, Product Availability and Technical Support. Our goal is to increase sales to existing and new customers by leveraging our skills in rapidly filling orders, maintaining high levels of product availability, providing insightful customer category management, and providing technical support in a cost-effective manner. In addition, our category management and technically skilled sales force professionals provide product selection, assortment and application support to our customers. · Expand Our Product Lines. We intend to increase our sales by continuing to develop internally, or through potential acquisitions, the range of Engine Management and Temperature Control products that we offer to our customers. We are committed to investing the resources necessary to maintain and expand our technical capability to manufacture multiple product lines that incorporate the latest technologies. · Broaden Our Customer Base. Our goal is to increase our customer base by (a) continuing to leverage our manufacturing capabilities to secure additional original equipment business globally with automotive, industrial, marine, military and heavy duty vehicle and equipment manufacturers and their service part operations as well as our existing customer base including traditional warehouse distributors, large retailers, other manufacturers and export customers, and (b) supporting the service part operations of vehicle and equipment manufacturers with value added services and product support for the life of the part. · Improve Operating Efficiency and Cost Position. Our management places significant emphasis on improving our financial performance by achieving operating efficiencies and improving asset utilization, while maintaining product quality and high customer order fill rates. We intend to continue to improve our operating efficiency and cost position by: · increasing cost-effective vertical integration in key product lines through internal development; · focusing on integrated supply chain management, customer collaboration and vendor managed inventory initiatives; · evaluating additional opportunities to relocate manufacturing to our low-cost plants located outside of the U.S.; · maintaining and improving our cost effectiveness and competitive responsiveness to better serve our customer base, including sourcing certain materials and products from low cost regions such as those in Asia without compromising product quality; · enhancing company-wide programs geared toward manufacturing and distribution efficiency; and · focusing on company-wide overhead and operating expense cost reduction programs. · Cash Utilization. We intend to apply any excess cash flow from operations and the management of working capital primarily to reduce our outstanding indebtedness, pay dividends to our shareholders, repurchase shares of our common stock, expand our product lines and grow revenues through potential acquisitions. The Automotive Aftermarket The automotive aftermarket industry is comprised of a large number of diverse manufacturers varying in product specialization and size. In addition to manufacturing, aftermarket companies allocate resources towards an efficient distribution process and product engineering in order to maintain the flexibility and responsiveness on which their customers depend. Aftermarket manufacturers must be efficient producers of small lot sizes and do not have to provide systems engineering support. Aftermarket manufacturers also must distribute, with rapid turnaround times, products for a full range of domestic and import vehicles on the road. The primary customers of the automotive aftermarket manufacturers are national and regional warehouse distributors, large retail chains, automotive repair chains and the dealer service networks of original equipment manufacturers (“OEMs”). Index The automotive aftermarket industry differs substantially from the OEM supply business. Unlike the OEM supply business that primarily follows trends in new car production, the automotive aftermarket industry’s performance primarily tends to follow different trends, such as: · growth in number of vehicles on the road; · increase in average vehicle age; · change in total miles driven per year; · new or modified environmental and vehicle safety regulations, including fuel-efficiency and emissions reduction standards; · increase in pricing of new cars; · economic and financial market conditions; · new car quality and related warranties; · changes in automotive technologies; · change in vehicle scrap rates; and · change in average fuel prices. Traditionally, the parts manufacturers of OEMs and the independent manufacturers who supply the original equipment (“OE”) part applications have supplied a majority of the business to new car dealer networks. However, certain parts manufacturers have become more independent and are no longer affiliated with OEMs, which has provided, and may continue to provide, opportunities for us to supply replacement parts to the dealer service networks of the OEMs, both for warranty and out-of-warranty repairs. Seasonality. Historically, our operating results have fluctuated by quarter, with the greatest sales occurring in the second and third quarters of the year and revenues generally being recognized at the time of shipment. It is in these quarters that demand for our products is typically the highest, specifically in the Temperature Control Segment of our business. In addition to this seasonality, the demand for our Temperature Control products during the second and third quarters of the year may vary significantly with the summer weather and customer inventories. For example, a cool summer, as we experienced in both 2014 and 2013, may lessen the demand for our Temperature Control products, while a warm summer, as we experienced in 2015, may increase such demand. As a result of this seasonality and variability in demand of our Temperature Control products, our working capital requirements typically peak near the end of the second quarter, as the inventory build-up of air conditioning products is converted to sales and payments on the receivables associated with such sales have yet to be received. During this period, our working capital requirements are typically funded by borrowing from our revolving credit facility. Inventory Management. We face inventory management issues as a result of warranty and overstock returns. Many of our products carry a warranty ranging from a 90-day limited warranty to a lifetime limited warranty, which generally covers defects in materials or workmanship and failure to meet industry published specifications and/or the result of installation error. In addition to warranty returns, we also permit our customers to return new, undamaged products to us within customer-specific limits (which are generally limited to a specified percentage of their annual purchases from us) in the event that they have overstocked their inventories. We accrue for overstock returns as a percentage of sales, after giving consideration to recent returns history. In order to better control warranty and overstock return levels, we have in place procedures for authorized warranty returns, including for warranty returns which result from installation error, placed restrictions on the amounts customers can return and instituted a program to better estimate potential future product returns. In addition, with respect to our air conditioning compressors, which are our most significant customer product warranty returns, we established procedures whereby a warranty will be voided if a customer does not provide acceptable proof that complete air conditioning system repair was performed. Index Discounts, Allowances, and Incentives. We offer a variety of usual customer discounts, allowances and incentives. First, we offer cash discounts for paying invoices in accordance with the specified discount terms of the invoice. Second, we offer pricing discounts based on volume purchased from us and participation in our cost reduction initiatives. These discounts are principally in the form of “off-invoice” discounts and are immediately deducted from sales at the time of sale. For those customers that choose to receive a payment on a quarterly basis instead of “off-invoice,” we accrue for such payments as the related sales are made and reduce sales accordingly. Finally, rebates and discounts are provided to customers as advertising and sales force allowances, and allowances for warranty and overstock returns are also provided. Management analyzes historical returns, current economic trends, and changes in customer demand when evaluating the adequacy of the sales returns and other allowances. Significant management judgments and estimates must be made and used in connection with establishing the sales returns and other allowances in any accounting period. We account for these discounts and allowances as a reduction to revenues, and record them when sales are recorded. Comparison of Fiscal Years 2015 and 2014 Sales. Consolidated net sales for 2015 were $972 million, a decrease of $8.4 million compared to $980.4 million in the same period of 2014. Consolidated net sales at our Engine Management Segment decreased year-over-year, which more than offset the increase in sales at our Temperature Control Segment. Had the same Canadian Dollar and Polish Zloty exchange rates applied in 2014 been used in 2015, net sales for 2015 would have been $8.2 million higher, or $980.2 million. The following table summarizes net sales and gross margins by segment for the years ended December 31, 2015 and 2014, respectively (in thousands): Engine Management’s net sales decreased $11.2 million, or 1.6%, to $698 million for 2015. Net sales in 2015 were negatively impacted by customer ordering patterns and diesel injector returns for quality inspection. Also contributing to the reduction in net sales was the negative impact of foreign currency exchange rates. Had the same Polish Zloty exchange rate applied in 2014 been used in 2015, net sales for 2015 would have been $1.5 million higher, or $699.5 million. Temperature Control’s net sales increased $5.4 million, or 2.1%, to $264.5 million for 2015. Included in the 2015 net sales are incremental sales of $4.7 million from our asset acquisition of Annex Manufacturing, acquired in April 2014. Excluding the incremental sales from the acquisition, Temperature Control’s net sales increased $0.7 million compared to 2014. The year-over-year increase in net sales at Temperature Control resulted from the impact of warmer summer conditions in 2015 as compared to the same period in 2014. Offsetting the increase in net sales at Temperature Control was the negative impact of foreign currency exchange rates. Had the same Canadian exchange rate applied in 2014 been used in 2015, net sales for 2015 would have been $1.1 million higher, or $265.6 million. Demand for our Temperature Control products may vary significantly with summer weather conditions and customer inventories. Index Gross Margins. Gross margins, as a percentage of consolidated net sales, decreased to 28.9% in 2015 compared to 29.5% in 2014. Gross margins at Engine Management decreased 0.6 percentage points from 31% to 30.4% while gross margins at Temperature Control increased 0.3 percentage points from 21.6% to 21.9%. The gross margin percentage decline in Engine Management compared to the prior year was primarily the result of costs incurred to improve our diesel manufacturing production processes and quality controls. The gross margin percentage increase in Temperature Control compared to the prior year reflects the impact of higher production volumes to meet the increase in customer demand due to warmer year-over-year summer weather conditions. Selling, General and Administrative Expenses. Selling, general and administrative expenses (“SG&A”) increased to $206.3 million, or 21.2% of consolidated net sales in 2015, as compared to $193.5 million or 19.7% of consolidated net sales in 2014. The $12.8 million increase in SG&A expenses as compared to 2014 reflects the impact of the net $3.5 million charge recorded in 2015 to reduce our outstanding accounts receivable balance from one of our customers that filed for bankruptcy in January 2016 to our estimated recovery amount, in addition to higher selling, marketing and distribution expenses, higher expenses related to the sale of receivables, and higher employee compensation and benefit costs including the reduction of postretirement prior service cost benefit amortization. Litigation Charge. During 2014, we recorded a $10.6 million litigation charge in connection with a settlement agreement in a legal proceeding with a third party. The settlement amount was paid in September 2014 and was funded from cash on hand and available credit under our revolving credit facility. For additional information, see Note 19 of the notes to our financial statements. Restructuring and Integration (Income) Expenses. Restructuring and integration income was $0.1 million in 2015 compared to restructuring and integration expenses of $1.2 million in 2014. Components of our restructuring and integration accruals, by segment, were as follows (in thousands): Other Income, Net. Other income, net was $1 million in 2015 compared to $1.1 million for the year ended December 31, 2014. During 2015 and 2014, we recognized $1 million of deferred gain related to the sale-leaseback of our Long Island City, New York facility. Operating Income. Operating income was $75.9 million in 2015, compared to $85.3 million in 2014. Included in operating income in 2014 was a $10.6 million charge in connection with a settlement agreement in a legal proceeding with a third party. Excluding the $10.6 million charge in 2014, operating income in 2014 was $95.9 million. The year-over year decline in operating income is the result of lower net sales, lower gross margins as a percentage of consolidated net sales and higher SG&A expenses. Other Non-Operating Income (Expense), Net. Other non-operating expense, net was $0.2 million in 2015, compared to other non-operating expense, net of $2 million in 2014. During 2015, we recognized foreign currency losses of $0.7 million, and upon entering into a new revolving credit agreement wrote-off $0.8 million of unamortized deferred financing costs associated with the prior revolving credit agreement. Offsetting these other non-operating expenses in 2015 were $1 million of equity income from our joint ventures, and interest, dividend income and other income of $0.2 million. Other non-operating expense, net during 2014 consisted of foreign currency losses of $1.6 million and equity losses from our joint ventures of $0.8 million, which were offset by interest and dividend income of $0.3 million. Index Interest Expense. Interest expense was essentially flat year-over year. Interest expense was $1.5 million in 2015 compared to $1.6 million in 2014. The lower average outstanding borrowings in 2015, when compared to 2014, were offset by slightly higher interest rates. Income Tax Provision. The income tax provision for 2015 was $26 million at an effective tax rate of 35.1%, compared to $28.9 million at an effective tax rate of 35.3% in 2014. The effective tax rate was essentially flat year-over-year. Loss from Discontinued Operations, Net of Income Tax Benefit. Loss from discontinued operations, net of income tax, reflects information contained in the most recent actuarial studies performed as of August 31, 2015 and 2014, and other information available and considered by us, and legal expenses incurred associated with our asbestos-related liability. During 2015 and 2014, we recorded a loss of $2.1 million and $9.9 million, net of tax, from discontinued operations, respectively. The loss from discontinued operations in 2014 includes a $12.8 million pre-tax provision reflecting the impact of the results of the August 2014 actuarial study. In 2015, the difference between the low end of the range in the August 2015 actuarial study and our recorded liability indicated a favorable pre-tax adjustment that was not material and, as such, was not recorded. As discussed more fully in Note 19 of the notes to our financial statements, we are responsible for certain future liabilities relating to alleged exposure to asbestos containing products. Comparison of Fiscal Years 2014 and 2013 Sales. Consolidated net sales for 2014 were $980.4 million, a decrease of $3.3 million compared to $983.7 million in the same period of 2013. Consolidated net sales decreased in both our Engine Management and Temperature Control Segments as compared to 2013. The following table summarizes net sales and gross margins by segment for the years ended December 31, 2014 and 2013, respectively (in thousands): Engine Management’s net sales decreased $2 million to $709.3 million for 2014. The year-over-year decrease in net sales resulted primarily from lower net sales in the OE/OES and export markets as compared to 2013, which more than offset the higher net sales in the retail, traditional and specialty markets. Temperature Control’s net sales decreased $3.5 million, or 1.3%, to $259.1 million for 2014. The year-over-year decrease in net sales at Temperature Control resulted from the lower results in the traditional and retail markets offset, in part, by the higher net sales in the OE/OES and specialty markets. Included in the 2014 net sales are incremental sales of $8.5 million from the business acquired in connection with our asset acquisition of Annex Manufacturing in April 2014. Excluding the incremental sales from the acquisition, Temperature Control’s net sales decreased $12 million compared to 2013. Demand for our Temperature Control products may vary significantly with summer weather conditions and customer inventories. Index Gross Margins. Gross margins, as a percentage of consolidated net sales, were flat at 29.5% when compared to 2013. Gross margins at Engine Management increased 0.3 percentage points from 30.7% to 31% while gross margins at Temperature Control decreased 0.5 percentage points from 22.1% to 21.6%. The gross margin percentage improvement in Engine Management compared to the prior year was primarily the result of improved global sourcing and manufacturing efficiencies, including the increase in manufacturing at our lower cost facilities. The gross margin percentage decline in Temperature Control compared to the prior year resulted primarily from lower production volumes to bring inventories in line with anticipated market demand. Selling, General and Administrative Expenses. Selling, general and administrative expenses (“SG&A”) decreased by $7.8 million to $193.5 million or 19.7% of consolidated net sales in 2014, as compared to $201.3 million or 20.5% of consolidated net sales in 2013. The decrease in SG&A expenses as compared to 2013 is principally due to lower employee benefit costs and savings from the integration of the CompressorWorks acquisition in April 2012. Litigation Charge. During 2014, we recorded a $10.6 million litigation charge in connection with a settlement agreement in a legal proceeding with a third party. The settlement amount was funded from cash on hand and available credit under our revolving credit facility. For additional information, see Note 19 of the notes to our financial statements. Restructuring and Integration Expenses. Restructuring and integration expenses decreased to $1.2 million in 2014 compared to $3.4 million in 2013. Components of our restructuring and integration accruals, by segment, were as follows (in thousands): During 2013, we offered a voluntary separation incentive program to certain eligible employees to reduce costs and improve our operating efficiency. Eligible employees, who accepted the program, received enhanced severance and other retiree benefit enhancements. In connection with the program, we recorded a charge of $1.8 million during the year ended December 31, 2013. Other Income, Net. Other income, net was $1.1 million in 2014 compared to $1 million for the year ended December 31, 2013. During 2014 and 2013, we recognized $1 million of deferred gain related to the sale-leaseback of our Long Island City, New York facility. Operating Income. Operating income decreased $1.6 million to $85.3 million in 2014, compared to $86.9 million in 2013. The year-over year decline in operating income reflects the impact of lower net sales and the $10.6 million litigation charge incurred in 2014 in connection with a settlement agreement in a legal proceeding with a third party, offset in part by lower SG&A and restructuring and integration expenses. Other Non-Operating Income (Expense), Net. Other non-operating expense, net was $2 million in 2014. During 2014, we recognized foreign currency exchange losses of $1.6 million and equity losses from our joint ventures of $0.8 million, which were offset by interest and dividend income of $0.3 million. Other non-operating income (expense), net during 2013 consisted of foreign currency losses of $0.1 million and equity losses from our joint ventures of $0.3 million, offset by interest and dividend income of $0.3 million. Interest Expense. Interest expense decreased by $0.3 million to $1.6 million in 2014 compared to interest expense of $1.9 million in 2013 as average interest rates declined year-over-year. The year-over-year decline in interest rates reflects the impact of the lower interest rates in our May 2013 amendment to our revolving credit facility. Index Income Tax Provision. The income tax provision for 2014 was $28.9 million at an effective tax rate of 35.3%, compared to $31.9 million at an effective tax rate of 37.6% in 2013. The lower year-over-year effective tax rate is the result of the change in the mix of pre-tax income from the U.S. to the lower foreign tax rate jurisdictions, the reversal of previously established reserves for uncertain tax positions as a result of the expiration of the statue of limitations and tax return adjustments relating to production deductions and research and development credits. Loss from Discontinued Operations, Net of Income Tax Benefit. Loss from discontinued operations, net of income tax, reflects information contained in the most recent actuarial studies performed as of August 31, 2014 and 2013, and other information available and considered by us, and legal expenses incurred associated with our asbestos-related liability. During 2014 and 2013, we recorded a loss of $9.9 million and $1.6 million, net of tax, from discontinued operations, respectively. The loss from discontinued operations for 2014 includes a $12.8 million pre-tax provision reflecting the impact of the results of the August 2014 actuarial study. No similar adjustment to our asbestos liability was made in 2013 as the difference between the low end of the range in the August 2013 actuarial study and our recorded liability was not material. As discussed more fully in Note 19 in the notes to our financial statements, we are responsible for certain future liabilities relating to alleged exposure to asbestos containing products. Restructuring and Integration (Income) Expenses The aggregated liabilities included in “sundry payables and accrued expenses” and “other accrued liabilities” in the consolidated balance sheet relating to the restructuring and integration activities as of and for the years ended December 31, 2015 and 2014, consisted of the following (in thousands): Liabilities associated with the remaining restructuring and integration costs as of December 31, 2015 relate primarily to employee severance and other retiree benefit enhancements to be paid through 2019 and environmental clean-up costs at our Long Island City, New York location in connection with the closure of our manufacturing operations at the site. Liquidity and Capital Resources Operating Activities. During 2015, cash provided by operations was $65.2 million, compared to $47 million in 2014. Included in cash provided by operations during 2014 was a nonrecurring $10.6 million cash payment in connection with a settlement agreement in a legal proceeding with a third party. During 2015, cash provided by operations was favorably impacted by (1) net earnings of $46 million compared to net earnings of $43 million in 2014; (2) the increase in accounts payable of $1.9 million compared to the year-over-year decrease in accounts payable of $4.3 million in 2014; and (3) the increase in sundry payables and accrued expenses of $1.9 million compared to the year-over-year decrease in sundry payables and accrued expenses of $7.7 million in 2014. Partially offsetting the favorable result in operating cash flow was (1) the increase in accounts receivable of $2 million compared to the year-over-year decrease in accounts receivable of $1.8 million in 2014; and (2) the increase in inventory of $12.5 million compared to the year-over-year increase in inventory of $6.7 million in 2014. We continue to actively manage our working capital to maximize our operating cash flow. Index During 2014, cash provided by operations was $47 million, compared to $57.6 million in 2013. Included in cash provided by operations during 2014 was a nonrecurring $10.6 million cash payment in connection with a settlement agreement in a legal proceeding with a third party. During 2014, cash provided by operations was unfavorably impacted by (1) net earnings of $43 million compared to net earnings of $51.5 million in 2013; (2) the increase in inventory of $6.7 million compared to the year-over-year increase in inventory of $6.1 million in 2013; (3) the decrease in accounts payable of $4.3 million compared to the year-over-year increase in accounts payable of $12.5 million in 2013; and (4) the decrease in sundry payables and accrued expenses of $7.7 million compared to the year-over-year increase in sundry payables and accrued expenses of $8.7 million in 2013. Partially offsetting the unfavorable result in operating cash flow was the decrease in accounts receivable of $1.8 million in 2014 compared to the year-over-year increase in accounts receivable of $27.3 million in 2013. Investing Activities. Cash used in investing activities was $18 million in 2015, compared to $51.2 million in 2014 and $24.8 million in 2013. Investing activities in 2015 consisted of capital expenditures of $18 million. Cash used in investing activities was $51.2 million in 2014. Investing activities in 2014 consisted of (1) our acquisition of certain assets of Pensacola Fuel Injection Inc., our primary vendor for rebuilt diesel fuel injectors and other related diesel products, for $12.2 million; (2) our acquisition of a 50% interest in the joint venture with Gwo Yng Enterprise Co., Ltd., a China based manufacturer of air conditioning accumulators, filter driers, hose assemblies, and switches for the automotive aftermarket and OEM/OES markets for $14 million; (3) our acquisition of certain assets of Annex Manufacturing of Fort Worth, Texas, a distributor of a variety of temperature control products for the automotive aftermarket, for $11.5 million; and (4) capital expenditures of $13.9 million. Cash used in investing activities was $24.8 million in 2013. Cash used in investing activities in 2013 consisted primarily of (1) our acquisition of an approximate 25% minority interest in Orange Electronic Co. Ltd., our supplier of tire pressure monitoring systems located in Taiwan, for $6.3 million, (2) our acquisition of the original equipment business of Standard Motor Products Holdings Ltd., our former affiliate in the U.K., for $6.5 million, and (3) $11.4 million in capital expenditures. Financing Activities. Cash used in financing activities was $41.2 million in 2015, compared to cash provided by financing activities of $15.3 million in 2014, and cash used in financing activities of $39.3 million in 2013. Cash provided by operating cash flow in 2015 was used to fund capital expenditures, pay dividends, repurchase company stock and reduce borrowings under our revolving credit facility. During 2015, we reduced borrowings under our revolving credit facilities by $9.1 million and repurchased 551,791 shares of our common stock for $19.6 million. Cash provided by financing activities was $15.3 million in 2014. Borrowings under our revolving credit facility in 2014, along with the cash provided by operations, were used to pay dividends and to fund acquisitions, business investments, capital expenditures, and the repurchase of 284,284 shares of our common stock for $10 million. Cash used in financing activities was $39.3 million in 2013. The excess cash provided by operations over cash used in investing activities in 2013 was used to (1) pay down borrowings under our revolving credit facility; (2) to fund the purchase of 209,973 shares of our common stock for $6.9 million; (3) to pay $1.3 million of debt issuance costs in connection with our May 2013 amendment to our restated credit agreement; and (4) pay dividends. Dividends of $13.7 million, $11.9 million and $10.1 million were paid in 2015, 2014 and 2013, respectively. Quarterly dividends were paid at a rate of $0.15 per share in 2015, $0.13 per share in 2014 and $0.11 per share in 2013. In January 2016, our Board of Directors voted to increase our quarterly dividend from $0.15 per share in 2015 to $0.17 per share in 2016. Index Liquidity Our primary cash requirements include working capital, capital expenditures, regular quarterly dividends and principal and interest payments on indebtedness. Our primary sources of funds are ongoing net cash flows from operating activities and availability under our secured revolving credit facility (as detailed below). In October 2015, we entered into a Credit Agreement with JPMorgan Chase Bank, N.A., as agent, and a syndicate of lenders for a senior secured revolving credit facility with a line of credit of up to $250 million (with an additional $50 million accordion feature) and a maturity date in October 2020. The new credit agreement replaces our prior credit facility with General Electric Capital Corporation, as agent, and the lenders therein. Direct borrowings under the new credit agreement bear interest at LIBOR plus a margin ranging from 1.25% to 1.75% based on our borrowing availability, or floating at the alternate base rate plus a margin ranging from 0.25% to 0.75% based on our borrowing availability, at our option. The credit agreement is guaranteed by certain of our subsidiaries and secured by certain of our assets. Borrowings under the new credit agreement are secured by substantially all of our assets, including accounts receivable, inventory and certain fixed assets, and those of certain of our subsidiaries. Availability under the credit agreement is based on a formula of eligible accounts receivable, eligible inventory, eligible equipment and eligible fixed assets. After taking into account outstanding borrowings under the credit agreement, there was an additional $128.5 million available for us to borrow pursuant to the formula at December 31, 2015. Outstanding borrowings under the credit agreements, which are classified as current liabilities, were $47.4 million and $56.6 million at December 31, 2015 and 2014, respectively. Borrowings under the restated credit agreement have been classified as current liabilities based upon the accounting rules and certain provisions in the agreement. At December 31, 2015, the weighted average interest rate on our credit agreement was 1.7%, which consisted of $44 million in direct borrowings at 1.6% and an alternative base rate loan of $3.4 million at 3.8%. At December 31, 2014, the weighted average interest rate under our prior credit facility with General Electric Capital Corporation was 1.8%, which consisted of $53 million in direct borrowings at 1.7% and an index loan of $3.6 million at 3.8%. During 2015, our average daily alternative base rate/index loan balance was $4.9 million and during 2014 our average daily index loan balance under our prior credit facility with General Electric Capital Corporation was $4.4 million. At any time that our borrowing availability is less than the greater of either (a) $25 million, or 10% of the commitments if fixed assets are not included in the borrowing base, or (b) $31.25 million, or 12.5% of the commitments if fixed assets are included in the borrowing base, the terms of the credit agreement provide for, among other provisions, a financial covenant requiring us, on a consolidated basis, to maintain a fixed charge coverage ratio of 1:1 at the end of each fiscal quarter (rolling four quarters). As of December 31, 2015, we were not subject to these covenants. The credit agreement permits us to pay cash dividends of $20 million and make stock repurchases of $20 million in any fiscal year subject to a minimum availability of $25 million. Provided specific conditions are met, the credit agreement also permits acquisitions, permissible debt financing, capital expenditures, and cash dividend payments and stock repurchases of greater than $20 million. The new credit agreement also replaces our Canadian Credit Agreement with GE Canada Finance Holding Company. The new agreement with JPMorgan Chase Bank, N.A. allows for a $10 million line of credit to Canada as part of the $250 million available for borrowing. In order to reduce our accounts receivable balances and improve our cash flow, we sell undivided interests in certain of our receivables to financial institutions. We enter these agreements at our discretion when we determine that the cost of factoring is less than the cost of servicing our receivables with existing debt. Under the terms of the agreements, we retain no rights or interest, have no obligations with respect to the sold receivables, and do not service the receivables after the sale. As such, these transactions are being accounted for as a sale. Index Pursuant to these agreements, we sold $693.6 million and $690.3 million of receivables for the years ended December 31, 2015 and 2014, respectively. A charge in the amount of $14.3 million, $13.1 million and $13.9 million related to the sale of receivables is included in selling, general and administrative expenses in our consolidated statements of operations for the years ended December 31, 2015, 2014 and 2013, respectively. If we do not enter into these arrangements or if any of the financial institutions with which we enter into these arrangements were to experience financial difficulties or otherwise terminate these arrangements, our financial condition, results of operations and cash flows could be materially and adversely affected by delays or failures to collect future trade accounts receivable. In January 2016, one of our customers filed a petition for bankruptcy. In connection with the bankruptcy filing, we evaluated our potential risk and exposure as related to our outstanding accounts receivable balance from the customer as of December 31, 2015, and estimated our anticipated recovery. As a result of our evaluation, we recorded a net $3.5 million pre-tax charge during the year ended December 31, 2015 to reduce our accounts receivable balance to our estimated recovery. The net $3.5 million pre-tax charge is included in selling, general and administrative expenses in our consolidated statement of operations. We will continue to monitor the circumstances surrounding the bankruptcy in determining whether additional provisions may be necessary. In May 2012, our Board of Directors authorized the purchase of up to $5 million of our common stock under a stock repurchase program. Under this program, during the years ended December 31, 2013 and 2012, we repurchased 30,601 shares and 312,527 shares, respectively, of our common stock at a total cost of $0.9 million and $4.1 million, respectively. No stock repurchases remain available under the 2012 program as the entire $5 million was utilized. In February 2013, our Board of Directors authorized the purchase of up to $6 million of our common stock under a stock repurchase program. During the year ended December 31, 2013, we repurchased 179,372 shares of our common stock under this program at a total cost of $6 million. No stock repurchases remain available under the 2013 program as the entire $6 million was utilized. In February 2014, our Board of Directors authorized the purchase of up to $10 million of our common stock under a stock repurchase program. During the year ended December 31, 2014, we repurchased 284,284 shares of our common stock under this program at a total cost of $10 million. No stock repurchases remain available under the 2014 program as the entire $10 million was utilized. In February 2015, our Board of Directors authorized the purchase of up to $10 million of our common stock under a stock repurchase program. In July 2015, our Board of Directors authorized the purchase of up to an additional $10 million of our common stock under another stock repurchase program. Under these programs, during the year ended December 31, 2015, we repurchased 551,791 shares of our common stock at a total cost of $19.6 million. As of December 31, 2015, there was approximately $0.4 million available for future stock repurchases under the programs. In January 2016, we repurchased an additional 10,135 shares of our common stock under the programs at a total cost of $0.4 million, thereby completing the 2015 Board of Directors authorizations. We anticipate that our cash flow from operations, available cash and available borrowings under our revolving credit facility will be adequate to meet our future liquidity needs for at least the next twelve months. Significant assumptions underlie this belief, including, among other things, that there will be no material adverse developments in our business, liquidity or capital requirements. If material adverse developments were to occur in any of these areas, there can be no assurance that our business will generate sufficient cash flow from operations, or that future borrowings will be available to us under our revolving credit facility in amounts sufficient to enable us to pay the principal and interest on our indebtedness, or to fund our other liquidity needs. In addition, if we default on any of our indebtedness, or breach any financial covenant in our revolving credit facility, our business could be adversely affected. Index The following table summarizes our contractual commitments as of December 31, 2015 and expiration dates of commitments through 2025(a): (a) Indebtedness under our revolving credit facilities of $47.4 million as of December 31, 2015 is not included in the table above as it is reported as a current liability in our consolidated balance sheets. Critical Accounting Policies We have identified the policies below as critical to our business operations and the understanding of our results of operations. The impact and any associated risks related to these policies on our business operations is discussed throughout “Management’s Discussion and Analysis of Financial Condition and Results of Operations,” where such policies affect our reported and expected financial results. For a detailed discussion on the application of these and other accounting policies, see Note 1 of the notes to our consolidated financial statements. You should be aware that preparation of our consolidated annual and quarterly financial statements requires us to make estimates and assumptions that affect the reported amount of assets and liabilities, disclosure of contingent assets and liabilities at the date of our consolidated financial statements, and the reported amounts of revenue and expenses during the reporting periods. We can give no assurance that actual results will not differ from those estimates. Although we do not believe that there is a reasonable likelihood that there will be a material change in the future estimate or in the assumptions that we use in calculating the estimate, unforeseen changes in the industry, or business could materially impact the estimate and may have a material adverse effect on our business, financial condition and results of operations. Revenue Recognition. We derive our revenue primarily from sales of replacement parts for motor vehicles from both our Engine Management and Temperature Control Segments. We recognize revenues when products are shipped and title has been transferred to a customer, the sales price is fixed and determinable, and collection is reasonably assured. For some of our sales of remanufactured products, we also charge our customers a deposit for the return of a used core component which we can use in our future remanufacturing activities. Such deposit is not recognized as revenue but rather carried as a core liability. The liability is extinguished when a core is actually returned to us. We estimate and record provisions for cash discounts, quantity rebates, sales returns and warranties in the period the sale is recorded, based upon our prior experience and current trends. As described below, significant management judgments and estimates must be made and used in estimating sales returns and allowances relating to revenue recognized in any accounting period. Inventory Valuation. Inventories are valued at the lower of cost or market. Cost is determined on the first-in, first-out basis. Where appropriate, standard cost systems are utilized for purposes of determining cost; the standards are adjusted as necessary to ensure they approximate actual costs. Estimates of lower of cost or market value of inventory are determined based upon current economic conditions, historical sales quantities and patterns and, in some cases, the specific risk of loss on specifically identified inventories. We also evaluate inventories on a regular basis to identify inventory on hand that may be obsolete or in excess of current and future projected market demand. For inventory deemed to be obsolete, we provide a reserve on the full value of the inventory. Inventory that is in excess of current and projected use is reduced by an allowance to a level that approximates our estimate of future demand. Future projected demand requires management judgment and is based upon (a) our review of historical trends and (b) our estimate of projected customer specific buying patterns and trends in the industry and markets in which we do business. Using rolling twelve month historical information, we estimate future demand on a continuous basis. As such, the historical volatility of such estimates has been minimal. Index We utilize cores (used parts) in our remanufacturing processes for air conditioning compressors, diesel injectors, diesel pumps, and turbo chargers. The production of air conditioning compressors, diesel injectors, diesel pumps, and turbo chargers, involves the rebuilding of used cores, which we acquire either in outright purchases from used parts brokers or from returns pursuant to an exchange program with customers. Under such exchange programs, we reduce our inventory, through a charge to cost of sales, when we sell a finished good compressor, and put back to inventory the used core exchanged at standard cost through a credit to cost of sales when it is actually received from the customer. Sales Returns and Other Allowances and Allowance for Doubtful Accounts. We must make estimates of potential future product returns related to current period product revenue. We analyze historical returns, current economic trends, and changes in customer demand when evaluating the adequacy of the sales returns and other allowances. Significant judgments and estimates must be made and used in connection with establishing the sales returns and other allowances in any accounting period. At December 31, 2015, the allowance for sales returns was $38.8 million. Similarly, we must make estimates of the uncollectability of our accounts receivables. We specifically analyze accounts receivable and analyze historical bad debts, customer concentrations, customer credit-worthiness, current economic trends and changes in our customer payment terms when evaluating the adequacy of the allowance for doubtful accounts. In January 2016, one of our customers filed a petition for bankruptcy. In connection with the bankruptcy filing, we evaluated our potential risk and exposure as related to our outstanding accounts receivable balance from the customer as of December 31, 2015, and estimated our anticipated recovery. As a result of our evaluation, we recorded a net $3.5 million pre-tax charge during the year ended December 31, 2015 to reduce our accounts receivable balance to our estimated recovery. We will continue to monitor the circumstances surrounding the bankruptcy in determining whether additional provisions may be necessary. At December 31, 2015, the allowance for doubtful accounts and for discounts was $4.2 million. New Customer Acquisition Costs. New customer acquisition costs refer to arrangements pursuant to which we incur change-over costs to induce a new customer to switch from a competitor’s brand. In addition, change-over costs include the costs related to removing the new customer’s inventory and replacing it with Standard Motor Products inventory commonly referred to as a stocklift. New customer acquisition costs are recorded as a reduction to revenue when incurred. Accounting for Income Taxes. As part of the process of preparing our consolidated financial statements, we are required to estimate our income taxes in each of the jurisdictions in which we operate. This process involves estimating our actual current tax expense together with assessing temporary differences resulting from differing treatment of items for tax and accounting purposes. These differences result in deferred tax assets and liabilities, which are included within our consolidated balance sheet. We must then assess the likelihood that our deferred tax assets will be recovered from future taxable income, and to the extent we believe that it is more likely than not that the deferred tax assets will not be recovered, we must establish a valuation allowance. To the extent we establish a valuation allowance or increase or decrease this allowance in a period, we must include an expense or recovery, respectively, within the tax provision in the statement of operations. We maintain valuation allowances when it is more likely than not that all or a portion of a deferred asset will not be realized. In determining whether a valuation allowance is warranted, we evaluate factors such as prior earnings history, expected future earnings, carryback and carryforward periods and tax strategies. We consider all positive and negative evidence to estimate if sufficient future taxable income will be generated to realize the deferred tax asset. We consider cumulative losses in recent years as well as the impact of one-time events in assessing our pre-tax earnings. Assumptions regarding future taxable income require significant judgment. Our assumptions are consistent with estimates and plans used to manage our business, which includes restructuring and integration initiatives that are expected to generate significant savings in future periods. Index The valuation allowance of $0.4 million as of December 31, 2015 is intended to provide for the uncertainty regarding the ultimate realization of our U.S. foreign tax credit carryovers and foreign net operating loss carryovers. The assessment of the adequacy of our valuation allowance is based on our estimates of taxable income in these jurisdictions and the period over which our deferred tax assets will be recoverable. Based on these considerations, we believe it is more likely than not that we will realize the benefit of the net deferred tax asset of $51.4 million as of December 31, 2015, which is net of the remaining valuation allowance. In the event that actual results differ from these estimates, or we adjust these estimates in future periods for current trends or expected changes in our estimating assumptions, we may need to modify the level of the valuation allowance which could materially impact our business, financial condition and results of operations. In accordance with generally accepted accounting practices, we recognize in our financial statements only those tax positions that meet the more-likely-than-not-recognition threshold. We establish tax reserves for uncertain tax positions that do not meet this threshold. As of December 31, 2015, we do not believe there is a need to establish a liability for uncertain tax positions. Penalties associated with income tax matters are included in the provision for income taxes in our consolidated statement of operations. Valuation of Long-Lived and Intangible Assets and Goodwill. At acquisition, we estimate and record the fair value of purchased intangible assets, which primarily consists of customer relationships, trademarks and trade names, patents and non-compete agreements. The fair values of these intangible assets are estimated based on our assessment. Goodwill is the excess of the purchase price over the fair value of identifiable net assets acquired in business combinations. Goodwill and certain other intangible assets having indefinite lives are not amortized to earnings, but instead are subject to periodic testing for impairment. Intangible assets determined to have definite lives are amortized over their remaining useful lives. We assess the impairment of long-lived assets, identifiable intangibles assets and goodwill whenever events or changes in circumstances indicate that the carrying value may not be recoverable. With respect to goodwill and identifiable intangible assets having indefinite lives, we test for impairment on an annual basis or in interim periods if an event occurs or circumstances change that may indicate the fair value is below its carrying amount. Factors we consider important, which could trigger an impairment review, include the following: (a) significant underperformance relative to expected historical or projected future operating results; (b) significant changes in the manner of our use of the acquired assets or the strategy for our overall business; and (c) significant negative industry or economic trends. We review the fair values using the discounted cash flows method and market multiples. When performing our evaluation of goodwill for impairment, if we conclude qualitatively that it is not more likely than not that the fair value of the reporting unit is less than its carrying amount, than the two-step impairment test is not required. If we are unable to reach this conclusion, then we would perform the two-step impairment test. Initially, the fair value of the reporting unit is compared to its carrying amount. To the extent the carrying amount of a reporting unit exceeds the fair value of the reporting unit; we are required to perform a second step, as this is an indication that the reporting unit goodwill may be impaired. In this step, we compare the implied fair value of the reporting unit goodwill with the carrying amount of the reporting unit goodwill and recognize a charge for impairment to the extent the carrying value exceeds the implied fair value. The implied fair value of goodwill is determined by allocating the fair value of the reporting unit to all of the assets (recognized and unrecognized) and liabilities of the reporting unit in a manner similar to a purchase price allocation. The residual fair value after this allocation is the implied fair value of the reporting unit goodwill. In addition, identifiable intangible assets having indefinite lives are reviewed for impairment on an annual basis using a methodology consistent with that used to evaluate goodwill. Index Intangible assets having definite lives and other long-lived assets are reviewed for impairment whenever events such as product discontinuance, plant closures, product dispositions or other changes in circumstances indicate that the carrying amount may not be recoverable. In reviewing for impairment, we compare the carrying value of such assets to the estimated undiscounted future cash flows expected from the use of the assets and their eventual disposition. When the estimated undiscounted future cash flows are less than their carrying amount, an impairment loss is recognized equal to the difference between the assets fair value and their carrying value. There are inherent assumptions and estimates used in developing future cash flows requiring our judgment in applying these assumptions and estimates to the analysis of identifiable intangibles and long-lived asset impairment including projecting revenues, interest rates, tax rates and the cost of capital. Many of the factors used in assessing fair value are outside our control and it is reasonably likely that assumptions and estimates will change in future periods. These changes can result in future impairments. In the event our planning assumptions were modified resulting in impairment to our assets, we would be required to include an expense in our statement of operations, which could materially impact our business, financial condition and results of operations. Retirement and Postretirement Medical Benefits. Each year, we calculate the costs of providing retiree benefits under the provisions of the Financial Accounting Standards Board (“FASB”) Accounting Standards Codification (“ASC”) 712, Nonretirement Postemployment Benefits, and FASB ASC 715, Retirement Benefits. The determination of defined benefit pension and postretirement plan obligations and their associated costs requires the use of actuarial computations to estimate participant plan benefits the employees will be entitled to. The key assumptions used in making these calculations are the eligibility criteria of participants and the discount rate used to value the future obligation. The discount rate reflects the yields available on high-quality, fixed-rate debt securities. Share-Based Compensation. The provisions of FASB ASC 718, Stock Compensation, require the measurement and recognition of compensation expense for all share-based payment awards made to employees and directors based on estimated fair values on the grant date. The value of the portion of the award that is ultimately expected to vest is recognized as expense on a straight-line basis over the requisite service periods in our condensed consolidated statement of operations. Forfeitures are estimated at the time of grant based on historical trends in order to estimate the amount of share-based awards that will ultimately vest. We monitor actual forfeitures for any subsequent adjustment to forfeiture rates. Environmental Reserves. We are subject to various U.S. Federal, state and local environmental laws and regulations and are involved in certain environmental remediation efforts. We estimate and accrue our liabilities resulting from such matters based upon a variety of factors including the assessments of environmental engineers and consultants who provide estimates of potential liabilities and remediation costs. Such estimates are not discounted to reflect the time value of money due to the uncertainty in estimating the timing of the expenditures, which may extend over several years. Potential recoveries from insurers or other third parties of environmental remediation liabilities are recognized independently from the recorded liability, and any asset related to the recovery will be recognized only when the realization of the claim for recovery is deemed probable. Asbestos Litigation. We are responsible for certain future liabilities relating to alleged exposure to asbestos-containing products. In accordance with our accounting policy, our most recent actuarial study as of August 31, 2015 estimated an undiscounted liability for settlement payments, excluding legal costs and any potential recovery from insurance carriers, ranging from $33.3 million to $51.1 million for the period through 2058. Based on the information contained in the actuarial study and all other available information considered by us, we have concluded that no amount within the range of settlement payments was more likely than any other and, therefore, in assessing our asbestos liability we compare the low end of the range to our recorded liability to determine if an adjustment is required. Based upon the results of the August 31, 2015 actuarial study, a favorable adjustment to the asbestos liability was not recorded in our consolidated financial statements as the difference between our recorded liability and the liability in the actuarial report at the low end of the range was not material. In addition, according to the updated study, future legal costs, which are expensed as incurred and reported in loss from discontinued operations in the accompanying statement of operations, are estimated to range from $40 million to $75.5 million for the period through 2058. We will continue to perform an annual actuarial analysis during the third quarter of each year for the foreseeable future. Based on this analysis and all other available information, we will continue to reassess the recorded liability and, if deemed necessary, record an adjustment to the reserve, which will be reflected as a loss or gain from discontinued operations. Index Other Loss Reserves. We have other loss exposures, for such matters as legal claims and legal proceedings. Establishing loss reserves for these matters requires estimates, judgment of risk exposure, and ultimate liability. We record provisions when the liability is considered probable and reasonably estimable. Significant judgment is required in both the determination of probability and the determination as to whether an exposure can be reasonably estimated. As additional information becomes available, we reassess our potential liability related to these matters. Such revisions of the potential liabilities could have a material adverse effect on our business, financial condition or results of operations. Recently Issued Accounting Pronouncements For a detailed discussion on recently issued accounting pronouncements and their impact on our consolidated financial statements, see Note 1, “Summary of Significant Accounting Policies” of the notes to our consolidated financial statements. Index

<s>[INST] Overview We are a leading independent manufacturer and distributor of replacement parts for motor vehicles in the automotive aftermarket industry, with a complementary focus on heavy duty, industrial equipment and the original equipment service market. We are organized into two major operating segments, each of which focuses on specific lines of replacement parts. Our Engine Management Segment manufactures and remanufactures ignition and emission parts, ignition wires, battery cables, fuel system parts and sensors for vehicle systems. Our Temperature Control Segment manufactures and remanufactures air conditioning compressors, air conditioning and heating parts, engine cooling system parts, power window accessories, and windshield washer system parts. We sell our products primarily to warehouse distributors, large retail chains, original equipment manufacturers and original equipment service part operations in the United States, Canada, Latin America, and Europe. Our customers consist of many of the leading warehouse distributors and auto parts retail chains, such as NAPA Auto Parts (National Automotive Parts Association, Inc.), Advance Auto Parts, Inc./CARQUEST Auto Parts, AutoZone, Inc., O’Reilly Automotive, Inc., Canadian Tire Corporation Limited and The Pep Boys Manny, Moe & Jack, as well as national program distribution groups, such as Auto Value and All Pro/Bumper to Bumper (Aftermarket Auto Parts Alliance, Inc.), Automotive Distribution Network LLC, The National Pronto Association (“Pronto”), Federated Auto Parts Distributors, Inc. (“Federated”), Pronto and Federated’s newly formed organization, the Automotive Parts Services Group or The Group, and specialty market distributors. We distribute parts under our own brand names, such as Standard®, Blue Streak®, BWD®, Select®, Intermotor®, GP Sorensen®, TechSmart®, Tech Expert®, OEM®, LockSmart®, Four Seasons®, Factory Air®, EVERCO®, ACi®, Imperial®, COMPRESSORWORKS®, TORQFLO® and Hayden® and through colabels and private labels, such as CARQUEST® BWD®, CARQUEST® Intermotor®, Duralast®, Duralast Gold®, Import Direct®, Master Pro®, Murray®, NAPA®, NAPA® Echlin®, NAPA Proformer™ Mileage Plus®, NAPA Temp Products™, Cold Power®, DriveworksTM, ToughOneTM and NAPA® Belden®. Business Strategy Our goal is to grow revenues and earnings and deliver returns in excess of our cost of capital by providing high quality original equipment and replacement products to the engine management and temperature control markets. The key elements of our strategy are as follows: · Maintain Our Strong Competitive Position in the Engine Management and Temperature Control Businesses. We are one of the leading independent manufacturers and distributors serving North America and other geographic areas in our core businesses of Engine Management and Temperature Control. We believe that our success is attributable to our emphasis on product quality, the breadth and depth of our product lines for both domestic and import vehicles, and our reputation for outstanding valueadded services. To maintain our strong competitive position in our markets, we remain committed to the following: · providing our customers with broad lines of high quality engine management and temperature control products, supported by the highest level of valueadded services; · continuing to maximize our production, supply chain and distribution efficiencies; Index · continuing to improve our cost position through increased global sourcing and increased manufacturing in low cost regions; and · focusing on our engineering development efforts including a focus on bringing more product manufacturing in house. · Provide Superior ValueAdded Services, Product Availability and Technical Support. Our goal is to increase sales to existing and new customers by leveraging our skills in rapidly filling orders, maintaining high levels of product availability, providing insightful customer category management, and providing technical support in a costeffective manner. In addition, our category management and technically skilled sales force professionals provide product selection, assortment and application support to our customers. · Expand Our Product Lines. We intend to increase our sales by continuing to develop internally, or through potential acquisitions, the range of Engine Management and Temperature Control products that we offer to our customers. We are committed to investing the resources [/INST] Negative. </s>

STANDARD MOTOR PRODUCTS INC

2017-02-21

2016-12-31

ITEM 7. MANAGEMENT’S DISCUSSION AND ANALYSIS OF FINANCIAL CONDITION AND RESULTS OF OPERATIONS The following discussion should be read in conjunction with our consolidated financial statements and the notes thereto. This discussion summarizes the significant factors affecting our results of operations and the financial condition of our business during each of the fiscal years in the three-year period ended December 31, 2016. Overview We are a leading independent manufacturer and distributor of replacement parts for motor vehicles in the automotive aftermarket industry, with a complementary focus on heavy duty, industrial equipment and the original equipment service market. We are organized into two major operating segments, each of which focuses on specific lines of replacement parts. Our Engine Management Segment manufactures and remanufactures ignition and emission parts, ignition wires, battery cables, fuel system parts and sensors for vehicle systems. Our Temperature Control Segment manufactures and remanufactures air conditioning compressors, air conditioning and heating parts, engine cooling system parts, power window accessories, and windshield washer system parts. We sell our products primarily to warehouse distributors, large retail chains, original equipment manufacturers and original equipment service part operations in the United States, Canada, Latin America, and Europe. Our customers consist of many of the leading warehouse distributors and auto parts retail chains, such as NAPA Auto Parts (National Automotive Parts Association, Inc.), Advance Auto Parts, Inc./CARQUEST Auto Parts, AutoZone, Inc., O’Reilly Automotive, Inc., Canadian Tire Corporation Limited and The Pep Boys Manny, Moe & Jack, as well as national program distribution groups, such as Auto Value and All Pro/Bumper to Bumper (Aftermarket Auto Parts Alliance, Inc.), Automotive Distribution Network LLC, The National Pronto Association (“Pronto”), Federated Auto Parts Distributors, Inc. (“Federated”), Pronto and Federated’s affiliate, the Automotive Parts Services Group or The Group, Auto Plus and specialty market distributors. We distribute parts under our own brand names, such as Standard®, Blue Streak®, BWD®, Select®, Intermotor®, GP Sorensen®, TechSmart®, Tech Expert®, OEM®, LockSmart®, Four Seasons®, EVERCO®, ACi®, COMPRESSORWORKS® and Hayden® and through co-labels and private labels, such as CARQUEST®, Duralast®, Duralast Gold®, Import Direct®, Master Pro®, Omni-Spark®, Ultima Select®, Murray®, NAPA®, NAPA® Echlin®, NAPA Proformer™ Mileage Plus®, NAPA Temp Products™, NAPA® Belden®, Cold Power®, DriveworksTM and ToughOneTM. Business Strategy Our goal is to grow revenues and earnings and deliver returns in excess of our cost of capital by being the best-in-class, full-line, full-service supplier of premium products to the engine management and temperature control markets. The key elements of our strategy are as follows: · Maintain Our Strong Competitive Position in the Engine Management and Temperature Control Businesses. We are one of the leading independent manufacturers and distributors serving North America and other geographic areas in our core businesses of Engine Management and Temperature Control. We believe that our success is attributable to our emphasis on product quality, the breadth and depth of our product lines for both domestic and import vehicles, and our reputation for outstanding value-added services. To maintain our strong competitive position in our markets, we remain committed to the following: · providing our customers with full-line coverage of high quality engine management and temperature control products, supported by the highest level of value-added services; · continuing to maximize our production, supply chain and distribution efficiencies; Index · continuing to improve our cost position through increased global sourcing and increased manufacturing at our low-cost plants; and · focusing on our engineering development efforts including a focus on bringing more product manufacturing in house. · Provide Superior Value-Added Services, Product Availability and Technical Support. Our goal is to increase sales to existing and new customers by leveraging our skills in rapidly filling orders, maintaining high levels of product availability, providing insightful customer category management, and providing technical support in a cost-effective manner. In addition, our category management and technically skilled sales force professionals provide product selection, assortment and application support to our customers. · Expand Our Product Lines. We intend to increase our sales by continuing to develop internally, or through potential acquisitions, the range of Engine Management and Temperature Control products that we offer to our customers. We are committed to investing the resources necessary to maintain and expand our technical capability to manufacture multiple product lines that incorporate the latest technologies. · Broaden Our Customer Base. Our goal is to increase our customer base by (a) continuing to leverage our manufacturing capabilities to secure additional original equipment business globally with automotive, industrial, marine, military and heavy duty vehicle and equipment manufacturers and their service part operations as well as our existing customer base including traditional warehouse distributors, large retailers, other manufacturers and export customers, and (b) supporting the service part operations of vehicle and equipment manufacturers with value added services and product support for the life of the part. · Improve Operating Efficiency and Cost Position. Our management places significant emphasis on improving our financial performance by achieving operating efficiencies and improving asset utilization, while maintaining product quality and high customer order fill rates. We intend to continue to improve our operating efficiency and cost position by: · increasing cost-effective vertical integration in key product lines through internal development; · focusing on integrated supply chain management, customer collaboration and vendor managed inventory initiatives; · evaluating additional opportunities to relocate manufacturing to our low-cost plants; · maintaining and improving our cost effectiveness and competitive responsiveness to better serve our customer base, including sourcing certain materials and products from low cost regions such as those in Asia without compromising product quality; · enhancing company-wide programs geared toward manufacturing and distribution efficiency; and · focusing on company-wide overhead and operating expense cost reduction programs. · Cash Utilization. We intend to apply any excess cash flow from operations and the management of working capital primarily to reduce our outstanding indebtedness, pay dividends to our shareholders, repurchase shares of our common stock, expand our product lines and grow revenues through potential acquisitions. The Automotive Aftermarket The automotive aftermarket industry is comprised of a large number of diverse manufacturers varying in product specialization and size. In addition to manufacturing, aftermarket companies allocate resources towards an efficient distribution process and product engineering in order to maintain the flexibility and responsiveness on which their customers depend. Aftermarket manufacturers must be efficient producers of small lot sizes and do not have to provide systems engineering support. Aftermarket manufacturers also must distribute, with rapid turnaround times, products for a full range of domestic and import vehicles on the road. The primary customers of the automotive aftermarket manufacturers are national and regional warehouse distributors, large retail chains, automotive repair chains and the dealer service networks of original equipment manufacturers (“OEMs”). Index The automotive aftermarket industry differs substantially from the OEM supply business. Unlike the OEM supply business that primarily follows trends in new car production, the automotive aftermarket industry’s performance primarily tends to follow different trends, such as: · growth in number of vehicles on the road; · increase in average vehicle age; · change in total miles driven per year; · new or modified environmental and vehicle safety regulations, including fuel-efficiency and emissions reduction standards; · increase in pricing of new cars; · economic and financial market conditions; · new car quality and related warranties; · changes in automotive technologies; · change in vehicle scrap rates; and · change in average fuel prices. Traditionally, the parts manufacturers of OEMs and the independent manufacturers who supply the original equipment (“OE”) part applications have supplied a majority of the business to new car dealer networks. However, certain parts manufacturers have become more independent and are no longer affiliated with OEMs, which has provided, and may continue to provide, opportunities for us to supply replacement parts to the dealer service networks of the OEMs, both for warranty and out-of-warranty repairs. Seasonality. Historically, our operating results have fluctuated by quarter, with the greatest sales occurring in the second and third quarters of the year and revenues generally being recognized at the time of shipment. It is in these quarters that demand for our products is typically the highest, specifically in the Temperature Control Segment of our business. In addition to this seasonality, the demand for our Temperature Control products during the second and third quarters of the year may vary significantly with the summer weather and customer inventories. For example, a cool summer, as we experienced in both 2014 and 2013, may lessen the demand for our Temperature Control products, while a warm summer, as we experienced in 2016, may increase such demand. As a result of this seasonality and variability in demand of our Temperature Control products, our working capital requirements typically peak near the end of the second quarter, as the inventory build-up of air conditioning products is converted to sales and payments on the receivables associated with such sales have yet to be received. During this period, our working capital requirements are typically funded by borrowing from our revolving credit facility. Inventory Management. We face inventory management issues as a result of warranty and overstock returns. Many of our products carry a warranty ranging from a 90-day limited warranty to a lifetime limited warranty, which generally covers defects in materials or workmanship and failure to meet industry published specifications and/or the result of installation error. In addition to warranty returns, we also permit our customers to return new, undamaged products to us within customer-specific limits (which are generally limited to a specified percentage of their annual purchases from us) in the event that they have overstocked their inventories. We accrue for overstock returns as a percentage of sales, after giving consideration to recent returns history. In order to better control warranty and overstock return levels, we have in place procedures for authorized warranty returns, including for warranty returns which result from installation error, placed restrictions on the amounts customers can return and instituted a program to better estimate potential future product returns. In addition, with respect to our air conditioning compressors, which are our most significant customer product warranty returns, we established procedures whereby a warranty will be voided if a customer does not provide acceptable proof that complete air conditioning system repair was performed. Index Discounts, Allowances, and Incentives. We offer a variety of usual customer discounts, allowances and incentives. First, we offer cash discounts for paying invoices in accordance with the specified discount terms of the invoice. Second, we offer pricing discounts based on volume purchased from us and participation in our cost reduction initiatives. These discounts are principally in the form of “off-invoice” discounts and are immediately deducted from sales at the time of sale. For those customers that choose to receive a payment on a quarterly basis instead of “off-invoice,” we accrue for such payments as the related sales are made and reduce sales accordingly. Finally, rebates and discounts are provided to customers as advertising and sales force allowances, and allowances for warranty and overstock returns are also provided. Management analyzes historical returns, current economic trends, and changes in customer demand when evaluating the adequacy of the sales returns and other allowances. Significant management judgments and estimates must be made and used in connection with establishing the sales returns and other allowances in any accounting period. We account for these discounts and allowances as a reduction to revenues, and record them when sales are recorded. Comparison of Fiscal Years 2016 and 2015 Sales. Consolidated net sales for 2016 were $1,058.5 million, an increase of $86.5 million compared to $972 million in the same period of 2015. Consolidated net sales increased due to the higher net sales achieved by both our Engine Management and Temperature Control Segments. The following table summarizes consolidated net sales by segment and by major product group within each segment for the years ended December 31, 2016 and 2015 (in thousands): Engine Management’s net sales increased $67.5 million, or 9.7%, to $765.5 million for the year ended December 31, 2016. Net sales in the ignition, emissions and fuel systems parts product group for the year ended December 31, 2016 were $616.5 million, an increase of $18.3 million, or 3.1%, compared to $598.2 million in the same period of 2015. Net sales in the wire and cable product group for the year ended December 31, 2016 were $149 million, an increase of $49.1 million, or 49.2%, compared to $99.9 million in the year ended December 31, 2015. In May 2016, we acquired the North American automotive ignition wire business of General Cable Corporation. Incremental net sales from the acquisition of $52.9 million were included in net sales of the wire and cable product group from the date of acquisition through December 31, 2016. Excluding the incremental sales from the acquisition, Engine Management net sales increased $14.6 million, or 2.1%, compared to the same period of 2015. Temperature Control’s net sales increased $19.3 million, or 7.3%, to $283.7 million for the year ended December 31, 2016. Net sales in the compressors product group for the year ended December 31, 2016 were $148.6 million, an increase of $20.7 million, or 16.2%, compared to $127.9 million in the same period of 2015. Net sales in the other climate control parts product group for the year ended December 31, 2016 were $135.1 million, a decrease of $1.5 million, or 1.1%, compared to $136.6 million in the year ended December 31, 2015. Demand for our Temperature Control products may vary significantly with summer weather conditions and customer inventories. Index Gross Margins. Gross margins, as a percentage of consolidated net sales, increased to 30.5% for 2016, compared to 28.9% for 2015. The following table summarizes gross margins by segment for the years ended December 31, 2016 and 2015, respectively (in thousands): Gross margins at Engine Management increased 0.9 percentage points from 30.4% to 31.3%, and gross margins at Temperature Control increased 3.7 percentage points from 21.9% to 25.6%. The gross margin percentage increase in Engine Management compared to the prior year was primarily the result of the year-over-year increase in production volume and the impact of one-time costs incurred in the prior year to improve our diesel manufacturing production processes. The gross margin percentage increase in Temperature Control compared to the prior year resulted primarily from year-over-year increased production volumes, and unabsorbed manufacturing overheads charged in the prior year results which negatively impacted 2015 gross margins. Selling, General and Administrative Expenses. SG&A expenses increased to $221.7 million, or 20.9% of consolidated net sales in 2016, as compared to $206.3 million, or 21.2% of consolidated net sales, in 2015. The $15.4 million increase in SG&A expenses as compared to 2015 is principally due to (1) higher selling and marketing costs, higher distribution expenses, and higher costs incurred in our accounts receivable factoring program, all associated with increased sales volumes; and (2) incremental expenses of $7.5 million from our acquisition of the North American automotive ignition wire business of General Cable Corporation, including amortization of intangible assets acquired. Restructuring and Integration Expenses (Income). Restructuring and integration expenses were $4 million in 2016 compared to restructuring and integration income of $0.1 million in 2015. The $4.1 million year-over-year increase in restructuring and integration expenses reflects primarily the impact of the plant rationalization program that commenced in February 2016 and the wire and cable relocation program announced in October 2016. Other Income, Net. Other income, net was $1.2 million in 2016 compared to $1 million in 2015. During 2016 and 2015, we recognized $1 million of deferred gain related to the sale-leaseback of our Long Island City, New York facility. Operating Income. Operating income was $98.1 million in 2016, compared to $75.9 million in 2015. The year-over-year increase in operating income of $22.2 million is the result of higher consolidated net sales and higher gross margins as a percentage of consolidated net sales offset, in part, by higher SG&A expenses and higher restructuring and integration expenses. Other Non-Operating Income, Net. Other non-operating income, net was $2.1 million in 2016, compared to other non-operating expense, net of $0.2 million in 2015. The year-over-year increase in other non-operating income, net resulted primarily from the increase in equity income from our joint ventures, the favorable impact of changes in foreign currency exchange rates and the year-over-year impact of the write-off in 2015 of $0.8 million of unamortized deferred finance costs associated with the refinancing of the prior revolving credit facility. Index Interest Expense. Interest expense was $1.6 million in 2016 compared to $1.5 million in 2015. The impact of the year-over-year increase in average outstanding borrowings during 2016 when compared to 2015 was partially offset by the slight decline in average interest rates on our revolving credit facility. The year-over-year increase in our average outstanding borrowings resulted primarily from our May 2016 acquisition of the North American automotive ignition wire business of General Cable Corporation for approximately $67.5 million which was funded by our revolving credit facility. Income Tax Provision. The income tax provision for 2016 was $36.2 million at an effective tax rate of 36.7%, compared to $26 million at an effective tax rate of 35.1% in 2015. The higher year-over-year effective tax rate is the result of a change in the mix of pre-tax income from lower foreign tax rate jurisdictions to the U.S., and the year-over-year increase in state and local effective tax rates. Loss from Discontinued Operations. Loss from discontinued operations, net of income tax, reflects information contained in the most recent actuarial studies performed as of August 31, 2016 and 2015, other information available and considered by us, and legal expenses associated with our asbestos-related liability. During 2016 and 2015, we recorded a loss of $2 million and $2.1 million, net of tax, from discontinued operations, respectively. Based upon the actuarial studies performed as of August 31, 2016 and 2015, a favorable adjustment to the asbestos liability was not recorded in our consolidated financial statements in each of 2016 and 2015 as the difference between the low end of the range in each of the actuarial studies and our recorded liability was not material. As discussed more fully in Note 19 of the notes to our financial statements, we are responsible for certain future liabilities relating to alleged exposure to asbestos containing products. Comparison of Fiscal Years 2015 and 2014 Sales. Consolidated net sales for 2015 were $972 million, a decrease of $8.4 million compared to $980.4 million in the same period of 2014. Consolidated net sales at our Engine Management Segment decreased year-over-year, which more than offset the increase in sales at our Temperature Control Segment. Had the same Canadian Dollar and Polish Zloty exchange rates applied in 2014 been used in 2015, net sales for 2015 would have been $8.2 million higher, or $980.2 million. The following table summarizes consolidated net sales by segment and by major product group within each segment for the years ended December 31, 2015 and 2014 (in thousands): Engine Management’s net sales decreased $11.2 million, or 1.6%, to $698 million for 2015. Net sales in the ignition, emissions and fuel systems parts product group for the year ended December 31, 2015 were $598.2 million, a decrease of $2.7 million, or 0.5%, compared to $600.9 million in the same period of 2014. Net sales in the wire and cable product group for the year ended December 31, 2015 were $99.9 million, a decrease of $8.5 million, or 7.8%, compared to $108.4 million in the year ended December 31, 2014. Net sales in 2015 were negatively impacted by customer ordering patterns and diesel injector returns for quality inspection. Also contributing to the reduction in net sales was the negative impact of foreign currency exchange rates. Had the same Polish Zloty exchange rate applied in 2014 been used in 2015, net sales for 2015 would have been $1.5 million higher, or $699.5 million. Index Temperature Control’s net sales increased $5.4 million, or 2.1%, to $264.5 million for 2015. Net sales in the compressors product group for the year ended December 31, 2015 were $127.9 million, an increase of $3.7 million, or 3%, compared to $124.2 million in the same period of 2014. Net sales in the other climate control parts product group for the year ended December 31, 2015 were $136.6 million, an increase of $1.8 million, or 1.3%, compared to $134.8 million in the year ended December 31, 2014. Included in the 2015 net sales are incremental sales of $4.7 million from our asset acquisition of Annex Manufacturing, acquired in April 2014. Excluding the incremental sales from the acquisition, Temperature Control’s net sales increased $0.7 million compared to 2014. The year-over-year increase in net sales at Temperature Control resulted from the impact of warmer summer conditions in 2015 as compared to the same period in 2014. Offsetting the increase in net sales at Temperature Control was the negative impact of foreign currency exchange rates. Had the same Canadian exchange rate applied in 2014 been used in 2015, net sales for 2015 would have been $1.1 million higher, or $265.6 million. Demand for our Temperature Control products may vary significantly with summer weather conditions and customer inventories. Gross Margins. Gross margins, as a percentage of consolidated net sales, decreased to 28.9% in 2015 compared to 29.5% in 2014. The following table summarizes net sales and gross margins by segment for the years ended December 31, 2015 and 2014, respectively (in thousands): Gross margins at Engine Management decreased 0.6 percentage points from 31% to 30.4% while gross margins at Temperature Control increased 0.3 percentage points from 21.6% to 21.9%. The gross margin percentage decline in Engine Management compared to the prior year was primarily the result of costs incurred to improve our diesel manufacturing production processes and quality controls. The gross margin percentage increase in Temperature Control compared to the prior year reflects the impact of higher production volumes to meet the increase in customer demand due to warmer year-over-year summer weather conditions. Selling, General and Administrative Expenses. Selling, general and administrative expenses (“SG&A”) increased to $206.3 million, or 21.2% of consolidated net sales in 2015, as compared to $193.5 million or 19.7% of consolidated net sales in 2014. The $12.8 million increase in SG&A expenses as compared to 2014 reflects the impact of the net $3.5 million charge recorded in 2015 to reduce our outstanding accounts receivable balance from one of our customers that filed for bankruptcy in January 2016 to our estimated recovery amount, in addition to higher selling, marketing and distribution expenses, higher expenses related to the sale of receivables, and higher employee compensation and benefit costs including the reduction of postretirement prior service cost benefit amortization. Index Litigation Charge. During 2014, we recorded a $10.6 million litigation charge in connection with a settlement agreement in a legal proceeding with a third party. The settlement amount was paid in September 2014 and was funded from cash on hand and available credit under our revolving credit facility. Restructuring and Integration Expenses (Income). Restructuring and integration income was $0.1 million in 2015 compared to restructuring and integration expenses of $1.2 million in 2014. The $1.3 million year-over-year decrease in restructuring and integration expenses reflects the reduction of expenses related to prior year programs. Other Income, Net. Other income, net was $1 million in 2015 compared to $1.1 million for the year ended December 31, 2014. During 2015 and 2014, we recognized $1 million of deferred gain related to the sale-leaseback of our Long Island City, New York facility. Operating Income. Operating income was $75.9 million in 2015, compared to $85.3 million in 2014. Included in operating income in 2014 was a $10.6 million charge in connection with a settlement agreement in a legal proceeding with a third party. Excluding the $10.6 million charge in 2014, operating income in 2014 was $95.9 million. The year-over-year decline in operating income is the result of lower net sales, lower gross margins as a percentage of consolidated net sales and higher SG&A expenses. Other Non-Operating Income (Expense), Net. Other non-operating expense, net was $0.2 million in 2015, compared to other non-operating expense, net of $2 million in 2014. During 2015, we recognized foreign currency losses of $0.7 million, and upon entering into a new revolving credit agreement wrote-off $0.8 million of unamortized deferred financing costs associated with the prior revolving credit agreement. Offsetting these other non-operating expenses in 2015 were $1 million of equity income from our joint ventures, and interest, dividend income and other income of $0.2 million. Other non-operating expense, net during 2014 consisted of foreign currency losses of $1.6 million and equity losses from our joint ventures of $0.8 million, which were offset by interest and dividend income of $0.3 million. Interest Expense. Interest expense was essentially flat year-over-year. Interest expense was $1.5 million in 2015 compared to $1.6 million in 2014. The lower average outstanding borrowings in 2015, when compared to 2014, were offset by slightly higher interest rates. Income Tax Provision. The income tax provision for 2015 was $26 million at an effective tax rate of 35.1%, compared to $28.9 million at an effective tax rate of 35.3% in 2014. The effective tax rate was essentially flat year-over-year. Loss from Discontinued Operations, Net of Income Tax Benefit. Loss from discontinued operations, net of income tax, reflects information contained in the most recent actuarial studies performed as of August 31, 2015 and 2014, and other information available and considered by us, and legal expenses incurred associated with our asbestos-related liability. During 2015 and 2014, we recorded a loss of $2.1 million and $9.9 million, net of tax, from discontinued operations, respectively. The loss from discontinued operations in 2014 includes a $12.8 million pre-tax provision reflecting the impact of the results of the August 2014 actuarial study. In 2015, the difference between the low end of the range in the August 2015 actuarial study and our recorded liability indicated a favorable pre-tax adjustment that was not material and, as such, was not recorded. As discussed more fully in Note 19 of the notes to our financial statements, we are responsible for certain future liabilities relating to alleged exposure to asbestos containing products. Index Restructuring and Integration Programs Plant Rationalization Program In February 2016, in connection with our ongoing efforts to improve operating efficiencies and reduce costs, we finalized our intention to implement a plant rationalization initiative. As part of the plant rationalization, we plan to relocate certain production activities from our Grapevine, Texas manufacturing facility to facilities in Greenville, South Carolina and Reynosa, Mexico, relocate certain service functions from Grapevine, Texas to our administrative offices in Lewisville, Texas, and close our Grapevine, Texas facility. In addition, certain production activities will be relocated from our Greenville, South Carolina manufacturing facility to our manufacturing facility in Bialystok, Poland. The following table summarizes the Plant Rationalization Program’s forecast and the amounts incurred through December 31, 2016: Wire and Cable Relocation In connection with our acquisition of the North American automotive ignition wire business of General Cable Corporation in May 2016, we expect to incur certain integration expenses, including costs to be incurred in connection with the consolidation of the General Cable Corporation Altoona, Pennsylvania distribution center into our existing wire distribution center in Edwardsville, Kansas and the relocation of certain machinery and equipment. In October 2016, we further announced our plan to relocate all production from the acquired Nogales, Mexico wire set assembly operation to our existing wire assembly facility in Reynosa, Mexico and to close the Nogales, Mexico plant. The following table summarizes the Wire and Cable Relocation Program’s forecast and the amounts incurred through December 31, 2016: Orlando Plant Rationalization Program In January 2017, in connection with our ongoing efforts to improve operating efficiencies and reduce costs, we finalized our intention to implement another plant rationalization initiative at our Orlando, Florida facility. As part of the plant rationalization, we plan to relocate production activities from our Orlando, Florida manufacturing facility to Independence, Kansas, and close our Orlando, Florida facility. One-time plan rationalization costs of approximately $3.7 million are expected to be incurred in 2017 and 2018 consisting of restructuring and integration expenses of approximately $3.1 million related to employee severance and relocation of certain machinery and equipment; and capital expenditures of approximately $0.6 million. Index For a detailed discussion on the restructuring and integration costs, see Note 3, “Restructuring and Integration Expense (Income),” of the notes to our consolidated financial statements. Liquidity and Capital Resources Operating Activities. During 2016, cash provided by operations was $97.8 million, compared to $65.2 million in 2015. During 2016, cash provided by operations was favorably impacted by (1) net earnings of $60.4 million compared to net earnings of $46 million in 2015; (2) the increase in accounts payable of $7.3 million compared to the year-over-year increase in accounts payable of $1.9 million in 2015; (3) the increase in sundry payables and accrued expenses of $21 million compared to the year-over-year increase in sundry payables and accrued expenses of $1.9 million in 2015; and (4) the decrease in prepaid expenses and other current assets of $3.5 million compared to the year-over-year decrease in prepaid expenses and other current assets of $0.4 million. Partially offsetting the favorable result in operating cash flow was (1) the increase in accounts receivable of $8.8 million compared to the year-over-year increase in accounts receivable of $2 million in 2015; and (2) the increase in inventory of $20.2 million compared to the year-over-year increase in inventory of $12.5 million in 2015. The higher year-over-year increase in sundry payables and accrued expenses in 2016 as compared to 2015 reflects higher employee compensation, and restructuring and integration accruals, which are expected to be paid in 2017. The higher year-over-year increase in inventories in 2016 as compared to 2015 is the result of “safety stock” built in connection with our restructuring and integration programs, while the comparative increase in accounts receivable is the result of the impact of our May 2016 acquisition of the North American automotive ignition wire business of General Cable Corporation. We continue to actively manage our working capital to maximize our operating cash flow. During 2015, cash provided by operations was $65.2 million, compared to $47 million in 2014. Included in cash provided by operations during 2014 was a nonrecurring $10.6 million cash payment in connection with a settlement agreement in a legal proceeding with a third party. During 2015, cash provided by operations was favorably impacted by (1) net earnings of $46 million compared to net earnings of $43 million in 2014; (2) the increase in accounts payable of $1.9 million compared to the year-over-year decrease in accounts payable of $4.3 million in 2014; and (3) the increase in sundry payables and accrued expenses of $1.9 million compared to the year-over-year decrease in sundry payables and accrued expenses of $7.7 million in 2014. Partially offsetting the favorable result in operating cash flow was (1) the increase in accounts receivable of $2 million compared to the year-over-year decrease in accounts receivable of $1.8 million in 2014; and (2) the increase in inventory of $12.5 million compared to the year-over-year increase in inventory of $6.7 million in 2014. Investing Activities. Cash used in investing activities was $88 million in 2016, compared to $18 million in 2015 and $51.2 million in 2014. Investing activities in 2016 consisted of (1) our acquisition of certain assets and the assumption of certain liabilities of General Cable Corporation’s automotive ignition wire business in North America as well as 100% of the equity interests of a General Cable subsidiary in Nogales, Mexico for $67.3 million, net of cash acquired and (2) capital expenditures of $20.9 million. Cash used in investing activities was $18 million in 2015 which consisted of capital expenditures of $18 million. Cash used in investing activities was $51.2 million in 2014. Investing activities in 2014 consisted of (1) our acquisition of certain assets of Pensacola Fuel Injection Inc., our primary vendor for rebuilt diesel fuel injectors and other related diesel products, for $12.2 million; (2) our acquisition of a 50% interest in the joint venture with Gwo Yng Enterprise Co., Ltd., a China based manufacturer of air conditioning accumulators, filter driers, hose assemblies, and switches for the automotive aftermarket and OEM/OES markets for $14 million; (3) our acquisition of certain assets of Annex Manufacturing of Fort Worth, Texas, a distributor of a variety of temperature control products for the automotive aftermarket, for $11.5 million; and (4) capital expenditures of $13.9 million. Index Financing Activities. Cash used in financing activities was $7.8 million in 2016, compared to cash used in financing activities of $41.2 million in 2015, and cash provided by financing activities of $15.3 million in 2014. During 2016, borrowings under our revolving credit facility, along with cash provided by operating activities, were used to fund the acquisition of the North American automotive ignition business of General Cable Corporation, purchase shares of our common stock, pay dividends and fund capital expenditures. During 2016, we increased borrowings under our revolving credit facility by $7.4 million and repurchased 10,135 shares of our common stock by $0.4 million. Cash used by finance activities was $41.2 million in 2015. Cash provided by operating cash flow in 2015 was used to fund capital expenditures, pay dividends, repurchase company stock and reduce borrowings under our revolving credit facility. During 2015, we reduced borrowings under our revolving credit facilities by $9.1 million and repurchased 551,791 shares of our common stock for $19.6 million. Cash provided by financing activities was $15.3 million in 2014. Borrowings under our revolving credit facility in 2014, along with the cash provided by operations, were used to pay dividends and to fund acquisitions, business investments, capital expenditures, and the repurchase of 284,284 shares of our common stock for $10 million. During 2014, we increased borrowings under our revolving credit facility by $35.2 million. Dividends of $15.4 million, $13.7 million and $11.9 million were paid in 2016, 2015 and 2014, respectively. Quarterly dividends were paid at a rate of $0.17 per share in 2016, $0.15 per share in 2015 and $0.13 per share in 2014. In January 2017, our Board of Directors voted to increase our quarterly dividend from $0.17 per share in 2016 to $0.19 per share in 2017. Liquidity Our primary cash requirements include working capital, capital expenditures, regular quarterly dividends, stock repurchases, principal and interest payments on indebtedness and acquisitions. Our primary sources of funds are ongoing net cash flows from operating activities and availability under our secured revolving credit facility (as detailed below). In October 2015, we entered into a Credit Agreement with JPMorgan Chase Bank, N.A., as agent, and a syndicate of lenders for a senior secured revolving credit facility with a line of credit of up to $250 million (with an additional $50 million accordion feature) and a maturity date in October 2020. The new credit agreement replaces our prior credit facility with General Electric Capital Corporation, as agent, and the lenders therein. Direct borrowings under the new credit agreement bear interest at LIBOR plus a margin ranging from 1.25% to 1.75% based on our borrowing availability, or floating at the alternate base rate plus a margin ranging from 0.25% to 0.75% based on our borrowing availability, at our option. The credit agreement is guaranteed by certain of our subsidiaries and secured by certain of our assets. Borrowings under the new credit agreement are secured by substantially all of our assets, including accounts receivable, inventory and certain fixed assets, and those of certain of our subsidiaries. Availability under the credit agreement is based on a formula of eligible accounts receivable, eligible inventory, eligible equipment and eligible fixed assets. After taking into account outstanding borrowings under the credit agreement, there was an additional $139.8 million available for us to borrow pursuant to the formula at December 31, 2016. Outstanding borrowings under the credit agreements, which are classified as current liabilities, were $54.8 million and $47.4 million at December 31, 2016 and 2015, respectively. Borrowings under the restated credit agreement have been classified as current liabilities based upon the accounting rules and certain provisions in the agreement. At December 31, 2016, the weighted average interest rate on our credit agreement was 2.3%, which consisted of $45 million in direct borrowings at 2% and an alternative base rate loan of $9.8 million at 4%. Index At December 31, 2015, the weighted average interest rate on our credit agreement was 1.7%, which consisted of $44 million in direct borrowings at 1.6% and an alternative base rate loan of $3.4 million at 3.8%. Our average daily alternative base rate/index loan balance was $2.6 million and $4.9 million during 2016 and 2015, respectively. At any time that our borrowing availability is less than the greater of either (a) $25 million, or 10% of the commitments if fixed assets are not included in the borrowing base, or (b) $31.25 million, or 12.5% of the commitments if fixed assets are included in the borrowing base, the terms of the credit agreement provide for, among other provisions, a financial covenant requiring us, on a consolidated basis, to maintain a fixed charge coverage ratio of 1:1 at the end of each fiscal quarter (rolling four quarters). As of December 31, 2016, we were not subject to these covenants. The credit agreement permits us to pay cash dividends of $20 million and make stock repurchases of $20 million in any fiscal year subject to a minimum availability of $25 million. Provided specific conditions are met, the credit agreement also permits acquisitions, permissible debt financing, capital expenditures, and cash dividend payments and stock repurchases of greater than $20 million. The new credit agreement also replaces our Canadian Credit Agreement with GE Canada Finance Holding Company. The new agreement with JPMorgan Chase Bank, N.A. allows for a $10 million line of credit to Canada as part of the $250 million available for borrowing. In order to reduce our accounts receivable balances and improve our cash flow, we sell undivided interests in certain of our receivables to financial institutions. We enter these agreements at our discretion when we determine that the cost of factoring is less than the cost of servicing our receivables with existing debt. Under the terms of the agreements, we retain no rights or interest, have no obligations with respect to the sold receivables, and do not service the receivables after the sale. As such, these transactions are being accounted for as a sale. Pursuant to these agreements, we sold $759.2 million and $693.6 million of receivables for the years ended December 31, 2016 and 2015, respectively. A charge in the amount of $19.3 million, $14.3 million and $13.1 million related to the sale of receivables is included in selling, general and administrative expenses in our consolidated statements of operations for the years ended December 31, 2016, 2015 and 2014, respectively. If we do not enter into these arrangements or if any of the financial institutions with which we enter into these arrangements were to experience financial difficulties or otherwise terminate these arrangements, our financial condition, results of operations and cash flows could be materially and adversely affected by delays or failures to collect future trade accounts receivable. In February 2014, our Board of Directors authorized the purchase of up to $10 million of our common stock under a stock repurchase program. During the year ended December 31, 2014, we repurchased 284,284 shares of our common stock under this program at a total cost of $10 million. No stock repurchases remain available under the 2014 program as the entire $10 million was utilized. In February 2015, our Board of Directors authorized the purchase of up to $10 million of our common stock under a stock repurchase program. In July 2015, our Board of Directors authorized the purchase of up to an additional $10 million of our common stock under another stock repurchase program. Under these programs, during the year ended December 31, 2015, we repurchased 551,791 shares of our common stock at a total cost of $19.6 million. As of December 31, 2015, there was approximately $0.4 million available for future stock repurchases under the programs. In January 2016, we repurchased an additional 10,135 shares of our common stock under the programs at a total cost of $0.4 million, thereby completing the 2015 Board of Directors authorizations. Our Board of Directors did not authorize a stock repurchase program in 2016. As of December 31, 2016, there was no shares available for future stock repurchases under the programs. In February 2017, our Board of Directors authorized the purchase of up to $20 million of our common stock under a new stock repurchase program. Index In February 2016, in connection with our ongoing efforts to improve operating efficiencies and reduce costs, we finalized our intention to implement a plant rationalization initiative. As part of the plant rationalization, we plan to relocate certain production activities from our Grapevine, Texas manufacturing facility to facilities in Greenville, South Carolina and Reynosa, Mexico, relocate certain service functions from Grapevine, Texas to our administrative offices in Lewisville, Texas, and close our Grapevine, Texas facility. In addition, certain production activities will be relocated from our Greenville, South Carolina manufacturing facility to our manufacturing facility in Bialystok, Poland. One-time plant rationalization costs of approximately $9 million are expected to be incurred in 2016 and 2017 consisting of restructuring and integration expenses of approximately $5 million related to employee severance and relocation of certain machinery and equipment; capital expenditures of approximately $2.6 million; and temporary incremental operating expenses of approximately $1.4 million. Substantially all of the one-time plant rationalization costs are expected to result in future cash expenditures and will be recognized throughout the program. As of December 31, 2016, cash expenditures of approximately $4 million have been made related to the program. We anticipate that the plant rationalization will be completed by the end of 2017. In connection with our acquisition of the North American automotive ignition wire business of General Cable Corporation in May 2016, we expect to incur certain integration expenses, including costs to be incurred in connection with the consolidation of the General Cable Corporation Altoona, Pennsylvania distribution center into our existing wire distribution center in Edwardsville, Kansas and the relocation of certain machinery and equipment. In October 2016, we further announced our plan to relocate all production from the acquired Nogales, Mexico wire set assembly operation to our existing wire assembly facility in Reynosa, Mexico and to close the Nogales, Mexico plant. Integration expenses expected to be incurred related to the closure of the Nogales, Mexico plant include employee severance and the relocation of certain machinery and equipment. Total integration expenses of $2.9 million are expected to be incurred related to the program. Substantially all of the integration expenses are expected to result in future cash expenditures. During the year ended December 31, 2016, integration expenses related to the program of $0.7 million were recognized. We anticipate that the wire and cable relocation program will be completed by the end of the first quarter of 2018. We anticipate that our cash flow from operations, available cash and available borrowings under our revolving credit facility will be adequate to meet our future liquidity needs for at least the next twelve months. Significant assumptions underlie this belief, including, among other things, that there will be no material adverse developments in our business, liquidity or capital requirements. If material adverse developments were to occur in any of these areas, there can be no assurance that our business will generate sufficient cash flow from operations, or that future borrowings will be available to us under our revolving credit facility in amounts sufficient to enable us to pay the principal and interest on our indebtedness, or to fund our other liquidity needs. In addition, if we default on any of our indebtedness, or breach any financial covenant in our revolving credit facility, our business could be adversely affected. The following table summarizes our contractual commitments as of December 31, 2016 and expiration dates of commitments through 2026(a) (b): (a) Indebtedness under our revolving credit facilities is not included in the table above as it is reported as a current liability in our consolidated balance sheets. As of December 31, 2016, amounts outstanding under our revolving credit facilities were $54.8 million. (b) We anticipate total aggregate severance payments of approximately $3.7 million to be recorded related to the plant rationalization program initiated in February 2016 and the wire and cable relocation program. Both programs are expected to be completed by the end of the first quarter of 2018. Index Critical Accounting Policies We have identified the policies below as critical to our business operations and the understanding of our results of operations. The impact and any associated risks related to these policies on our business operations is discussed throughout “Management’s Discussion and Analysis of Financial Condition and Results of Operations,” where such policies affect our reported and expected financial results. For a detailed discussion on the application of these and other accounting policies, see Note 1 of the notes to our consolidated financial statements. You should be aware that preparation of our consolidated annual and quarterly financial statements requires us to make estimates and assumptions that affect the reported amount of assets and liabilities, disclosure of contingent assets and liabilities at the date of our consolidated financial statements, and the reported amounts of revenue and expenses during the reporting periods. We can give no assurance that actual results will not differ from those estimates. Although we do not believe that there is a reasonable likelihood that there will be a material change in the future estimate or in the assumptions that we use in calculating the estimate, unforeseen changes in the industry, or business could materially impact the estimate and may have a material adverse effect on our business, financial condition and results of operations. Revenue Recognition. We derive our revenue primarily from sales of replacement parts for motor vehicles from both our Engine Management and Temperature Control Segments. We recognize revenues when products are shipped and title has been transferred to a customer, the sales price is fixed and determinable, and collection is reasonably assured. For certain of our sales of remanufactured products, we also charge our customers a deposit for the return of a used core component which we can use in our future remanufacturing activities. Such deposit is not recognized as revenue but rather carried as a core liability. The liability is extinguished when a core is actually returned to us. We estimate and record provisions for cash discounts, quantity rebates, sales returns and warranties in the period the sale is recorded, based upon our prior experience and current trends. As described below, significant management judgments and estimates must be made and used in estimating sales returns and allowances relating to revenue recognized in any accounting period. Inventory Valuation. Inventories are valued at the lower of cost or market. Cost is determined on the first-in, first-out basis. Where appropriate, standard cost systems are utilized for purposes of determining cost; the standards are adjusted as necessary to ensure they approximate actual costs. Estimates of lower of cost or market value of inventory are determined based upon current economic conditions, historical sales quantities and patterns and, in some cases, the specific risk of loss on specifically identified inventories. We also evaluate inventories on a regular basis to identify inventory on hand that may be obsolete or in excess of current and future projected market demand. For inventory deemed to be obsolete, we provide a reserve on the full value of the inventory. Inventory that is in excess of current and projected use is reduced by an allowance to a level that approximates our estimate of future demand. Future projected demand requires management judgment and is based upon (a) our review of historical trends and (b) our estimate of projected customer specific buying patterns and trends in the industry and markets in which we do business. Using rolling twelve month historical information, we estimate future demand on a continuous basis. As such, the historical volatility of such estimates has been minimal. We utilize cores (used parts) in our remanufacturing processes for air conditioning compressors, diesel injectors, diesel pumps, and turbo chargers. The production of air conditioning compressors, diesel injectors, diesel pumps, and turbo chargers, involves the rebuilding of used cores, which we acquire either in outright purchases from used parts brokers or from returns pursuant to an exchange program with customers. Under such exchange programs, we reduce our inventory, through a charge to cost of sales, when we sell a finished good compressor, and put back to inventory the used core exchanged at standard cost through a credit to cost of sales when it is actually received from the customer. Sales Returns and Other Allowances and Allowance for Doubtful Accounts. We must make estimates of potential future product returns related to current period product revenue. We analyze historical returns, current economic trends, and changes in customer demand when evaluating the adequacy of the sales returns and other allowances. Significant judgments and estimates must be made and used in connection with establishing the sales returns and other allowances in any accounting period. At December 31, 2016, the allowance for sales returns was $40.2 million. Index Similarly, we must make estimates of the uncollectability of our accounts receivables. We specifically analyze accounts receivable and analyze historical bad debts, customer concentrations, customer credit-worthiness, current economic trends and changes in our customer payment terms when evaluating the adequacy of the allowance for doubtful accounts. In January 2016, one of our customers filed a petition for bankruptcy. In connection with the bankruptcy filing, we evaluated our potential risk and exposure, and estimated our anticipated recovery as related to our outstanding accounts receivable balance from the customer. As a result of our evaluations, we recorded a net $3.5 million pre-tax charge during the year ended December 31, 2015, and an additional net $0.8 million pre-tax charge during the year ended December 31, 2016, which resulted in the write-off of our entire accounts receivable balance from the customer as of December 31, 2016. At December 31, 2016, the allowance for doubtful accounts and for discounts was $4.4 million. New Customer Acquisition Costs. New customer acquisition costs refer to arrangements pursuant to which we incur change-over costs to induce a new customer to switch from a competitor’s brand. In addition, change-over costs include the costs related to removing the new customer’s inventory and replacing it with Standard Motor Products inventory commonly referred to as a stocklift. New customer acquisition costs are recorded as a reduction to revenue when incurred. Accounting for Income Taxes. As part of the process of preparing our consolidated financial statements, we are required to estimate our income taxes in each of the jurisdictions in which we operate. This process involves estimating our actual current tax expense together with assessing temporary differences resulting from differing treatment of items for tax and accounting purposes. These differences result in deferred tax assets and liabilities, which are included within our consolidated balance sheet. We must then assess the likelihood that our deferred tax assets will be recovered from future taxable income, and to the extent we believe that it is more likely than not that the deferred tax assets will not be recovered, we must establish a valuation allowance. To the extent we establish a valuation allowance or increase or decrease this allowance in a period, we must include an expense or recovery, respectively, within the tax provision in the statement of operations. We maintain valuation allowances when it is more likely than not that all or a portion of a deferred asset will not be realized. In determining whether a valuation allowance is warranted, we evaluate factors such as prior earnings history, expected future earnings, carryback and carryforward periods and tax strategies. We consider all positive and negative evidence to estimate if sufficient future taxable income will be generated to realize the deferred tax asset. We consider cumulative losses in recent years as well as the impact of one-time events in assessing our pre-tax earnings. Assumptions regarding future taxable income require significant judgment. Our assumptions are consistent with estimates and plans used to manage our business, which includes restructuring and integration initiatives that are expected to generate significant savings in future periods. The valuation allowance of $0.5 million as of December 31, 2016 is intended to provide for the uncertainty regarding the ultimate realization of our U.S. foreign tax credit carryovers and foreign net operating loss carryovers. The assessment of the adequacy of our valuation allowance is based on our estimates of taxable income in these jurisdictions and the period over which our deferred tax assets will be recoverable. Based on these considerations, we believe it is more likely than not that we will realize the benefit of the net deferred tax asset of $51.1 million as of December 31, 2016, which is net of the remaining valuation allowance. In the event that actual results differ from these estimates, or we adjust these estimates in future periods for current trends or expected changes in our estimating assumptions, we may need to modify the level of the valuation allowance which could materially impact our business, financial condition and results of operations. In accordance with generally accepted accounting practices, we recognize in our financial statements only those tax positions that meet the more-likely-than-not recognition threshold. We establish tax reserves for uncertain tax positions that do not meet this threshold. As of December 31, 2016, we do not believe there is a need to establish a liability for uncertain tax positions. Penalties and interest associated with income tax matters are included in the provision for income taxes in our consolidated statement of operations. Index Valuation of Long-Lived and Intangible Assets and Goodwill. At acquisition, we estimate and record the fair value of purchased intangible assets, which primarily consists of customer relationships, trademarks and trade names, patents and non-compete agreements. The fair values of these intangible assets are estimated based on our assessment. Goodwill is the excess of the purchase price over the fair value of identifiable net assets acquired in business combinations. Goodwill and certain other intangible assets having indefinite lives are not amortized to earnings, but instead are subject to periodic testing for impairment. Intangible assets determined to have definite lives are amortized over their remaining useful lives. We assess the impairment of long-lived assets, identifiable intangibles assets and goodwill whenever events or changes in circumstances indicate that the carrying value may not be recoverable. With respect to goodwill and identifiable intangible assets having indefinite lives, we test for impairment on an annual basis or in interim periods if an event occurs or circumstances change that may indicate the fair value is below its carrying amount. Factors we consider important, which could trigger an impairment review, include the following: (a) significant underperformance relative to expected historical or projected future operating results; (b) significant changes in the manner of our use of the acquired assets or the strategy for our overall business; and (c) significant negative industry or economic trends. We review the fair values using the discounted cash flows method and market multiples. When performing our evaluation of goodwill for impairment, if we conclude qualitatively that it is not more likely than not that the fair value of the reporting unit is less than its carrying amount, than the two-step impairment test is not required. If we are unable to reach this conclusion, then we would perform the two-step impairment test. Initially, the fair value of the reporting unit is compared to its carrying amount. To the extent the carrying amount of a reporting unit exceeds the fair value of the reporting unit; we are required to perform a second step, as this is an indication that the reporting unit goodwill may be impaired. In this step, we compare the implied fair value of the reporting unit goodwill with the carrying amount of the reporting unit goodwill and recognize a charge for impairment to the extent the carrying value exceeds the implied fair value. The implied fair value of goodwill is determined by allocating the fair value of the reporting unit to all of the assets (recognized and unrecognized) and liabilities of the reporting unit in a manner similar to a purchase price allocation. The residual fair value after this allocation is the implied fair value of the reporting unit goodwill. In addition, identifiable intangible assets having indefinite lives are reviewed for impairment on an annual basis using a methodology consistent with that used to evaluate goodwill. Intangible assets having definite lives and other long-lived assets are reviewed for impairment whenever events such as product discontinuance, plant closures, product dispositions or other changes in circumstances indicate that the carrying amount may not be recoverable. In reviewing for impairment, we compare the carrying value of such assets to the estimated undiscounted future cash flows expected from the use of the assets and their eventual disposition. When the estimated undiscounted future cash flows are less than their carrying amount, an impairment loss is recognized equal to the difference between the assets fair value and their carrying value. There are inherent assumptions and estimates used in developing future cash flows requiring our judgment in applying these assumptions and estimates to the analysis of identifiable intangibles and long-lived asset impairment including projecting revenues, interest rates, tax rates and the cost of capital. Many of the factors used in assessing fair value are outside our control and it is reasonably likely that assumptions and estimates will change in future periods. These changes can result in future impairments. In the event our planning assumptions were modified resulting in impairment to our assets, we would be required to include an expense in our statement of operations, which could materially impact our business, financial condition and results of operations. Index Postretirement Medical Benefits. Each year, we calculate the costs of providing retiree benefits under the provisions of the Financial Accounting Standards Board (“FASB”) Accounting Standards Codification (“ASC”) 712, Nonretirement Postemployment Benefits. The determination of postretirement plan obligations and their associated costs requires the use of actuarial computations to estimate participant plan benefits the employees will be entitled to. The key assumptions used in making these calculations are the eligibility criteria of participants and the discount rate used to value the future obligation. The discount rate reflects the yields available on high-quality, fixed-rate debt securities. Share-Based Compensation. The provisions of FASB ASC 718, Stock Compensation, require the measurement and recognition of compensation expense for all share-based payment awards made to employees and directors based on estimated fair values on the grant date. The value of the portion of the award that is ultimately expected to vest is recognized as expense on a straight-line basis over the requisite service periods in our condensed consolidated statement of operations. Forfeitures are estimated at the time of grant based on historical trends in order to estimate the amount of share-based awards that will ultimately vest. We monitor actual forfeitures for any subsequent adjustment to forfeiture rates. Environmental Reserves. We are subject to various U.S. Federal, state and local environmental laws and regulations and are involved in certain environmental remediation efforts. We estimate and accrue our liabilities resulting from such matters based upon a variety of factors including the assessments of environmental engineers and consultants who provide estimates of potential liabilities and remediation costs. Such estimates are not discounted to reflect the time value of money due to the uncertainty in estimating the timing of the expenditures, which may extend over several years. Potential recoveries from insurers or other third parties of environmental remediation liabilities are recognized independently from the recorded liability, and any asset related to the recovery will be recognized only when the realization of the claim for recovery is deemed probable. Asbestos Litigation. We are responsible for certain future liabilities relating to alleged exposure to asbestos-containing products. In accordance with our accounting policy, our most recent actuarial study as of August 31, 2016 estimated an undiscounted liability for settlement payments, excluding legal costs and any potential recovery from insurance carriers, ranging from $31 million to $47.7 million for the period through 2059. Based on the information contained in the actuarial study and all other available information considered by us, we have concluded that no amount within the range of settlement payments was more likely than any other and, therefore, in assessing our asbestos liability we compare the low end of the range to our recorded liability to determine if an adjustment is required. Based upon the results of the August 31, 2016 actuarial study, a favorable adjustment to the asbestos liability was not recorded in our consolidated financial statements as the difference between our recorded liability and the liability in the actuarial report at the low end of the range was not material. In addition, according to the updated study, future legal costs, which are expensed as incurred and reported in loss from discontinued operations in the accompanying statement of operations, are estimated to range from $42.7 million to $78.6 million for the period through 2059. We will continue to perform an annual actuarial analysis during the third quarter of each year for the foreseeable future. Based on this analysis and all other available information, we will continue to reassess the recorded liability and, if deemed necessary, record an adjustment to the reserve, which will be reflected as a loss or gain from discontinued operations. Other Loss Reserves. We have other loss exposures, for such matters as legal claims and legal proceedings. Establishing loss reserves for these matters requires estimates, judgment of risk exposure, and ultimate liability. We record provisions when the liability is considered probable and reasonably estimable. Significant judgment is required in both the determination of probability and the determination as to whether an exposure can be reasonably estimated. As additional information becomes available, we reassess our potential liability related to these matters. Such revisions of the potential liabilities could have a material adverse effect on our business, financial condition or results of operations. Index Recently Issued Accounting Pronouncements For a detailed discussion on recently issued accounting pronouncements and their impact on our consolidated financial statements, see Note 1, “Summary of Significant Accounting Policies” of the notes to our consolidated financial statements.

<s>[INST] The following discussion should be read in conjunction with our consolidated financial statements and the notes thereto. This discussion summarizes the significant factors affecting our results of operations and the financial condition of our business during each of the fiscal years in the threeyear period ended December 31, 2016. Overview We are a leading independent manufacturer and distributor of replacement parts for motor vehicles in the automotive aftermarket industry, with a complementary focus on heavy duty, industrial equipment and the original equipment service market. We are organized into two major operating segments, each of which focuses on specific lines of replacement parts. Our Engine Management Segment manufactures and remanufactures ignition and emission parts, ignition wires, battery cables, fuel system parts and sensors for vehicle systems. Our Temperature Control Segment manufactures and remanufactures air conditioning compressors, air conditioning and heating parts, engine cooling system parts, power window accessories, and windshield washer system parts. We sell our products primarily to warehouse distributors, large retail chains, original equipment manufacturers and original equipment service part operations in the United States, Canada, Latin America, and Europe. Our customers consist of many of the leading warehouse distributors and auto parts retail chains, such as NAPA Auto Parts (National Automotive Parts Association, Inc.), Advance Auto Parts, Inc./CARQUEST Auto Parts, AutoZone, Inc., O’Reilly Automotive, Inc., Canadian Tire Corporation Limited and The Pep Boys Manny, Moe & Jack, as well as national program distribution groups, such as Auto Value and All Pro/Bumper to Bumper (Aftermarket Auto Parts Alliance, Inc.), Automotive Distribution Network LLC, The National Pronto Association (“Pronto”), Federated Auto Parts Distributors, Inc. (“Federated”), Pronto and Federated’s affiliate, the Automotive Parts Services Group or The Group, Auto Plus and specialty market distributors. We distribute parts under our own brand names, such as Standard®, Blue Streak®, BWD®, Select®, Intermotor®, GP Sorensen®, TechSmart®, Tech Expert®, OEM®, LockSmart®, Four Seasons®, EVERCO®, ACi®, COMPRESSORWORKS® and Hayden® and through colabels and private labels, such as CARQUEST®, Duralast®, Duralast Gold®, Import Direct®, Master Pro®, OmniSpark®, Ultima Select®, Murray®, NAPA®, NAPA® Echlin®, NAPA Proformer™ Mileage Plus®, NAPA Temp Products™, NAPA® Belden®, Cold Power®, DriveworksTM and ToughOneTM. Business Strategy Our goal is to grow revenues and earnings and deliver returns in excess of our cost of capital by being the bestinclass, fullline, fullservice supplier of premium products to the engine management and temperature control markets. The key elements of our strategy are as follows: · Maintain Our Strong Competitive Position in the Engine Management and Temperature Control Businesses. We are one of the leading independent manufacturers and distributors serving North America and other geographic areas in our core businesses of Engine Management and Temperature Control. We believe that our success is attributable to our emphasis on product quality, the breadth and depth of our product lines for both domestic and import vehicles, and our reputation for outstanding valueadded services. To maintain our strong competitive position in our markets, we remain committed to the following: · providing our customers with fullline coverage of high quality engine management and temperature control products, supported by the highest level of valueadded services; · continuing to maximize our production, supply chain and distribution efficiencies; Index · continuing to improve our cost position through increased global sourcing and increased manufacturing at our lowcost plants; and · focusing on our engineering development efforts including a focus on bringing more product manufacturing in house. · Provide Superior ValueAdded Services, Product Availability and Technical Support. Our goal is to increase sales to existing and new customers by leveraging our skills in rapidly filling orders, maintaining high levels of product availability, providing insightful customer category management, and providing technical support in a costeffective manner. In addition, our category management and technically [/INST] Positive. </s>

STANDARD MOTOR PRODUCTS INC

2018-02-22

2017-12-31

ITEM 7. MANAGEMENT’S DISCUSSION AND ANALYSIS OF FINANCIAL CONDITION AND RESULTS OF OPERATIONS The following discussion should be read in conjunction with our consolidated financial statements and the notes thereto. This discussion summarizes the significant factors affecting our results of operations and the financial condition of our business during each of the fiscal years in the three-year period ended December 31, 2017. Overview We are a leading independent manufacturer and distributor of replacement parts for motor vehicles in the automotive aftermarket industry, with a complementary focus on heavy duty, industrial equipment and the original equipment market. We are organized into two major operating segments, each of which focuses on specific lines of replacement parts. Our Engine Management Segment manufactures and remanufactures ignition and emission parts, ignition wires, battery cables, fuel system parts and sensors for vehicle systems. Our Temperature Control Segment manufactures and remanufactures air conditioning compressors, air conditioning and heating parts, engine cooling system parts, power window accessories, and windshield washer system parts. We sell our products primarily to large retail chains, warehouse distributors, original equipment manufacturers and original equipment service part operations in the United States, Canada, Latin America, and Europe. Our customers consist of many of the leading auto parts retail chains, such as NAPA Auto Parts (National Automotive Parts Association, Inc.), Advance Auto Parts, Inc./CARQUEST Auto Parts, AutoZone, Inc., O’Reilly Automotive, Inc., Canadian Tire Corporation Limited and The Pep Boys Manny, Moe & Jack, as well as national program distribution groups, such as Auto Value and All Pro/Bumper to Bumper (Aftermarket Auto Parts Alliance, Inc.), Automotive Distribution Network LLC, The National Pronto Association (“Pronto”), Federated Auto Parts Distributors, Inc. (“Federated”), Pronto and Federated’s affiliate, the Automotive Parts Services Group or The Group, Auto Plus and specialty market distributors. We distribute parts under our own brand names, such as Standard®, Blue Streak®, BWD®, Select®, Intermotor®, GP Sorensen®, TechSmart®, Tech Expert®, OEM®, LockSmart®, Four Seasons®, EVERCO®, ACi® and Hayden® and through co-labels and private labels, such as CARQUEST®, Duralast®, Duralast Gold®, Import Direct®, Master Pro®, Omni-Spark®, Ultima Select®, Murray®, NAPA®, NAPA® Echlin®, NAPA Proformer™ Mileage Plus®, NAPA Temp Products™, NAPA® Belden®, Cold Power®, DriveworksTM and ToughOneTM. Business Strategy Our goal is to grow revenues and earnings and deliver returns in excess of our cost of capital by being the best-in-class, full-line, full-service supplier of premium products to the engine management and temperature control markets. The key elements of our strategy are as follows: · Maintain Our Strong Competitive Position in the Engine Management and Temperature Control Businesses. We are a leading independent manufacturer and distributor serving North America and other geographic areas in our core businesses of Engine Management and Temperature Control. We believe that our success is attributable to our emphasis on product quality, the breadth and depth of our product lines for both domestic and import vehicles, and our reputation for outstanding value-added services. To maintain our strong competitive position in our markets, we remain committed to the following: · providing our customers with full-line coverage of high quality engine management and temperature control products, supported by the highest level of value-added services; · continuing to maximize our production, supply chain and distribution efficiencies; Index · continuing to improve our cost position through increased global sourcing, increased manufacturing at our low-cost plants, and strategic transactions with manufacturers in low-cost regions; and · focusing on our engineering development efforts including a focus on bringing more product manufacturing in house. · Provide Superior Value-Added Services, Product Availability and Technical Support. Our goal is to increase sales to existing and new customers by leveraging our skills in rapidly filling orders, maintaining high levels of product availability, offering a product portfolio that provides comprehensive coverage for all vehicle applications, providing insightful customer category management, and providing technical support in a cost-effective manner. In addition, our category management and technically skilled sales force professionals provide product selection, assortment and application support to our customers. · Expand Our Product Lines. We intend to increase our sales by continuing to develop internally, or through potential acquisitions, the range of Engine Management and Temperature Control products that we offer to our customers. We are committed to investing the resources necessary to maintain and expand our technical capability to manufacture multiple product lines that incorporate the latest technologies, including product lines relating to safety, advanced driver assistance and collision avoidance systems. · Broaden Our Customer Base. Our goal is to increase our customer base by (a) continuing to leverage our manufacturing capabilities to secure additional original equipment business globally with automotive, industrial, marine, military and heavy duty vehicle and equipment manufacturers and their service part operations as well as our existing customer base including traditional warehouse distributors, large retailers, other manufacturers and export customers, and (b) supporting the service part operations of vehicle and equipment manufacturers with value added services and product support for the life of the part. · Improve Operating Efficiency and Cost Position. Our management places significant emphasis on improving our financial performance by achieving operating efficiencies and improving asset utilization, while maintaining product quality and high customer order fill rates. We intend to continue to improve our operating efficiency and cost position by: · increasing cost-effective vertical integration in key product lines through internal development; · focusing on integrated supply chain management, customer collaboration and vendor managed inventory initiatives; · evaluating additional opportunities to relocate manufacturing to our low-cost plants; · maintaining and improving our cost effectiveness and competitive responsiveness to better serve our customer base, including sourcing certain materials and products from low cost regions such as those in Asia without compromising product quality; · enhancing company-wide programs geared toward manufacturing and distribution efficiency; and · focusing on company-wide overhead and operating expense cost reduction programs. · Cash Utilization. We intend to apply any excess cash flow from operations and the management of working capital primarily to reduce our outstanding indebtedness, pay dividends to our shareholders, repurchase shares of our common stock, expand our product lines and grow revenues through potential acquisitions. Index The Automotive Aftermarket The automotive aftermarket industry is comprised of a large number of diverse manufacturers varying in product specialization and size. In addition to manufacturing, aftermarket companies allocate resources towards an efficient distribution process and product engineering in order to maintain the flexibility and responsiveness on which their customers depend. Aftermarket manufacturers must be efficient producers of small lot sizes and do not have to provide systems engineering support. Aftermarket manufacturers also must distribute, with rapid turnaround times, products for a full range of domestic and import vehicles on the road. The primary customers of the automotive aftermarket manufacturers are large retail chains, national and regional warehouse distributors, automotive repair chains and the dealer service networks of original equipment manufacturers (“OEMs”). The automotive aftermarket industry differs substantially from the OEM supply business. Unlike the OEM supply business that primarily follows trends in new car production, the automotive aftermarket industry’s performance primarily tends to follow different trends, such as: · growth in number of vehicles on the road; · increase in average vehicle age; · change in total miles driven per year; · new or modified environmental and vehicle safety regulations, including fuel-efficiency and emissions reduction standards; · increase in pricing of new cars; · economic and financial market conditions; · new car quality and related warranties; · changes in automotive technologies; · change in vehicle scrap rates; and · change in average fuel prices. Traditionally, the parts manufacturers of OEMs and the independent manufacturers who supply the original equipment (“OE”) part applications have supplied a majority of the business to new car dealer networks. However, certain parts manufacturers have become more independent and are no longer affiliated with OEMs, which has provided, and may continue to provide, opportunities for us to supply replacement parts to the dealer service networks of the OEMs, both for warranty and out-of-warranty repairs. Seasonality. Historically, our operating results have fluctuated by quarter, with the greatest sales occurring in the second and third quarters of the year and revenues generally being recognized at the time of shipment. It is in these quarters that demand for our products is typically the highest, specifically in the Temperature Control Segment of our business. In addition to this seasonality, the demand for our Temperature Control products during the second and third quarters of the year may vary significantly with the summer weather and customer inventories. For example, a cool summer, as we experienced in 2017, may lessen the demand for our Temperature Control products, while a warm summer, as we experienced in 2016, may increase such demand. As a result of this seasonality and variability in demand of our Temperature Control products, our working capital requirements typically peak near the end of the second quarter, as the inventory build-up of air conditioning products is converted to sales and payments on the receivables associated with such sales have yet to be received. During this period, our working capital requirements are typically funded by borrowing from our revolving credit facility. Inventory Management. We face inventory management issues as a result of overstock returns. We also permit our customers to return new, undamaged products to us within customer-specific limits (which are generally limited to a specified percentage of their annual purchases from us) in the event that they have overstocked their inventories. In addition, the seasonality of our Temperature Control Segment requires that we increase our inventory during the winter season in preparation of the summer selling season and customers purchasing such inventory have the right to make returns. We accrue for overstock returns as a percentage of sales, after giving consideration to recent returns history. Index Discounts, Allowances, and Incentives. We offer a variety of usual customer discounts, allowances and incentives. First, we offer cash discounts for paying invoices in accordance with the specified discount terms of the invoice. Second, we offer pricing discounts based on volume purchased from us and participation in our cost reduction initiatives. These discounts are principally in the form of “off-invoice” discounts and are immediately deducted from sales at the time of sale. For those customers that choose to receive a payment on a quarterly basis instead of “off-invoice,” we accrue for such payments as the related sales are made and reduce sales accordingly. Finally, rebates and discounts are provided to customers as advertising and sales force allowances, and allowances for warranty and overstock returns are also provided. Management analyzes historical returns, current economic trends, and changes in customer demand when evaluating the adequacy of the sales returns and other allowances. Significant management judgments and estimates must be made and used in connection with establishing the sales returns and other allowances in any accounting period. We account for these discounts and allowances as a reduction to revenues, and record them when sales are recorded. Tax Cuts and Jobs Act In December 2017, the U.S. enacted the Tax Cuts and Jobs Act (the “Act”), which included a broad range of tax reform affecting businesses, including the reduction of the federal corporate tax rate from 35% to 21%, changes in the deductibility of certain business expenses, and the manner in which international operations are taxed in the U.S. Although the majority of the changes resulting from the Act are effective beginning in 2018, U.S. GAAP requires that certain impacts of the Act be recognized in the income tax provision in the period of enactment. In connection with the enactment of the Act, our income tax provision for the fourth quarter of 2017 included an increase of $17.5 million, reflecting an increase of $16.1 million for the remeasurement of our net deferred tax assets and an increase in tax of $1.4 million due to the deemed repatriation of earnings of our foreign subsidiaries. As related to the deemed repatriation of earnings of foreign subsidiaries, the Act includes a mandatory one-time tax on accumulated earnings of foreign subsidiaries. As a result, all previously unremitted earnings for which no U.S. deferred tax liability had been accrued are now subject to U.S. tax. In accordance with the guidelines provided in the Act, we have aggregated the estimated untaxed foreign earnings and profits, and utilized participating exemption deductions and available foreign tax credits in deriving the $1.4 million repatriation tax, which will be payable currently. Notwithstanding the U.S. taxation of these amounts, we intend to continue to invest most or all of these earnings indefinitely outside of the U.S., and do not expect to incur any significant additional taxes related to such amounts. Although we believe that the impact of the Act has been properly reflected in the fourth quarter of 2017, there may be further adjustments in the coming quarters as the relevant authorities provide further guidance on the impacts of the Act. Based upon our initial reviews, and assuming no further adjustments, we estimate that our effective tax rate for 2018 will be approximately 26%. Index Comparison of Fiscal Years 2017 and 2016 Sales. Consolidated net sales for 2017 were $1,116.1 million, an increase of $57.6 million, or 5.4%, compared to $1,058.5 million in the same period of 2016. Consolidated net sales increased due to the higher results achieved by our Engine Management Segment. The following table summarizes consolidated net sales by segment and by major product group within each segment for the years ended December 31, 2017 and 2016 (in thousands): Engine Management’s net sales increased $63.9 million, or 8.3%, to $829.4 million for the year ended December 31, 2017. Net sales in the ignition, emissions and fuel systems parts product group for the year ended December 31, 2017 were $657.3 million, an increase of $40.8 million, or 6.6%, compared to $616.5 million in the same period of 2016. Net sales in the wire and cable product group for the year ended December 31, 2017 were $172.1 million, an increase of $23.1 million, or 15.5%, compared to $149 million in the same period of 2016. In May 2016, we acquired the North American automotive ignition wire business of General Cable Corporation. Incremental net sales from the acquisition of $38.4 million were included in net sales of the wire and cable product group for the year ended December 31, 2017. Excluding the incremental sales from the acquisition, net sales in the wire and cable product group declined $15.3 million, or 10.3%, and Engine Management net sales increased $25.5 million, or 3.3%, compared to the year ended December 31, 2016, in line with our expectations of low single digit organic growth. Temperature Control’s net sales decreased $4.6 million, or 1.6%, to $279.1 million for the year ended December 31, 2017. Net sales in the compressors product group for the year ended December 31, 2017 were $148.4 million, a decrease of $0.2 million, or 0.2%, compared to $148.6 million in the same period of 2016. Net sales in the other climate control parts product group for the year ended December 31, 2017 were $130.8 million, a decrease of $4.4 million, or 3.2%, compared to $135.1 million for the year ended December 31, 2016. Temperature Control’s decrease in net sales for the year ended December 31, 2017 of 1.6% reflects the impact of a cool 2017 summer following a very warm 2016, and is slightly better than our customers’ reported year-to-date net sales decrease of 4%. Demand for our Temperature Control products may vary significantly with summer weather conditions and customer inventories. Index Gross Margins. Gross margins, as a percentage of consolidated net sales, decreased to 29.3% for 2017, compared to 30.5% for 2016. The following table summarizes gross margins by segment for the years ended December 31, 2017 and 2016, respectively (in thousands): (a) Segment net sales include intersegment sales in our Engine Management and Temperature Control segments. Compared to 2016, gross margins at Engine Management decreased 1.9 percentage points from 31.3% to 29.4%, and gross margins at Temperature Control increased 0.6 percentage points from 25.6% to 26.2%. The gross margin percentage decrease in Engine Management compared to the prior year reflects inefficiencies and redundant costs incurred during our various planned production moves. The gross margin percentage increase in Temperature Control compared to the prior year resulted primarily from transferring production manufacturing to our lower cost Reynosa, Mexico facility. Selling, General and Administrative Expenses. SG&A expenses increased to $223.6 million, or 20% of consolidated net sales in 2017, as compared to $221.7 million, or 20.9% of consolidated net sales in 2016. The $1.9 million increase in SG&A expenses as compared to 2016 is principally due to higher distribution expenses and higher costs incurred in our accounts receivable factoring program, both of which are associated with increased sales volumes offset, in part, by the benefits from our General Cable integration and lower incentive compensation expenses. Restructuring and Integration Expenses. Restructuring and integration expenses were $6.2 million in 2017 compared to restructuring and integration expenses of $4 million in 2016. The $2.2 million year-over-year increase in restructuring and integration expenses reflects the impact of the plant rationalization program that commenced in February 2016, the wire and cable relocation program announced in October 2016, and the Orlando plant rationalization program that commenced in January 2017. Other Income, Net. Other income, net was $1.3 million in 2017 compared to $1.2 million in 2016. During 2017 and 2016, we recognized $1 million of deferred gain related to the sale-leaseback of our Long Island City, New York facility. Operating Income. Operating income was $98.2 million in 2017, compared to $98.1 million in 2016. The year-over-year increase in operating income of $0.1 million reflects the impact of higher consolidated net sales offset, in part, by lower gross margins as a percentage of consolidated net sales, higher SG&A expenses and higher restructuring and integration expenses. Other Non-Operating Income, Net. Other non-operating income, net was $0.6 million in 2017, compared to other non-operating income, net of $2.1 million in 2016. Included in other non-operating income, net in 2017 is a noncash impairment charge of approximately $1.8 million related to our minority interest investment in Orange Electronics Co., Ltd. Interest Expense. Interest expense was $2.3 million in 2017 compared to $1.6 million in 2016. The year-over-year increase reflects the impact of higher year-over-year average interest rates on our revolving credit facility, and higher average outstanding borrowings during 2017 when compared to 2016. Index Income Tax Provision. The income tax provision for 2017 was $52.8 million at an effective tax rate of 54.8%, compared to $36.2 million at an effective tax rate of 36.7% in 2016. During 2017, we recorded an increase of $17.5 million to the income tax provision resulting from the remeasurement of our net deferred tax assets, and the tax on deemed repatriated earnings of our foreign subsidiaries as a result of the enactment of the Tax Cuts and Jobs Act. Excluding the impact of the Tax Cuts and Jobs Act, the income tax provision for 2017 was $35.3 million at an effective tax rate of 36.6%. Loss from Discontinued Operations. Loss from discontinued operations, net of income tax, reflects information contained in the most recent actuarial studies performed as of August 31, 2017 and 2016, other information available and considered by us, and legal expenses associated with our asbestos-related liability. During 2017 and 2016, we recorded a loss of $5.7 million and $2 million from discontinued operations, respectively. The loss from discontinued operations for 2017 includes a $6 million pre-tax provision reflecting the impact of the results of the August 2017 actuarial study. No adjustment was made in 2016 to our asbestos liability as the difference between the low end of the range in the August 2016 actuarial study and our recorded liability was not material. As discussed more fully in Note 19 in the notes to our consolidated financial statements, we are responsible for certain future liabilities relating to alleged exposure to asbestos containing products. Comparison of Fiscal Years 2016 and 2015 Sales. Consolidated net sales for 2016 were $1,058.5 million, an increase of $86.5 million compared to $972 million in the same period of 2015. Consolidated net sales increased due to the higher net sales achieved by both our Engine Management and Temperature Control Segments. The following table summarizes consolidated net sales by segment and by major product group within each segment for the years ended December 31, 2016 and 2015 (in thousands): Engine Management’s net sales increased $67.5 million, or 9.7%, to $765.5 million for the year ended December 31, 2016. Net sales in the ignition, emissions and fuel systems parts product group for the year ended December 31, 2016 were $616.5 million, an increase of $18.3 million, or 3.1%, compared to $598.2 million in the same period of 2015. Net sales in the wire and cable product group for the year ended December 31, 2016 were $149 million, an increase of $49.1 million, or 49.2%, compared to $99.9 million in the year ended December 31, 2015. In May 2016, we acquired the North American automotive ignition wire business of General Cable Corporation. Incremental net sales from the acquisition of $52.9 million were included in net sales of the wire and cable product group from the date of acquisition through December 31, 2016. Excluding the incremental sales from the acquisition, net sales in the wire and cable product group declined $3.8 million, or 3.8%, and Engine Management net sales increased $14.6 million, or 2.1%, compared to the same period of 2015. Index Temperature Control’s net sales increased $19.3 million, or 7.3%, to $283.7 million for the year ended December 31, 2016. Net sales in the compressors product group for the year ended December 31, 2016 were $148.6 million, an increase of $20.7 million, or 16.2%, compared to $127.9 million in the same period of 2015. Net sales in the other climate control parts product group for the year ended December 31, 2016 were $135.1 million, a decrease of $1.5 million, or 1.1%, compared to $136.6 million in the year ended December 31, 2015. Temperature Control’s increase in net sales for the year ended December 31, 2016 of 7.3% reflects the impact of the first warm summer in three years, and is slightly less than our customers’ reported year-to-date net sales increase of 9%. Demand for our Temperature Control products may vary significantly with summer weather conditions and customer inventories. Gross Margins. Gross margins, as a percentage of consolidated net sales, increased to 30.5% for 2016, compared to 28.9% for 2015. The following table summarizes gross margins by segment for the years ended December 31, 2016 and 2015, respectively (in thousands): Gross margins at Engine Management increased 0.9 percentage points from 30.4% to 31.3%, and gross margins at Temperature Control increased 3.7 percentage points from 21.9% to 25.6%. The gross margin percentage increase in Engine Management compared to the prior year was primarily the result of the year-over-year increase in production volume and the impact of one-time costs incurred in the prior year to improve our diesel manufacturing production processes. The gross margin percentage increase in Temperature Control compared to the prior year resulted primarily from year-over-year increased production volumes, and unabsorbed manufacturing overheads charged in the prior year results which negatively impacted 2015 gross margins. Selling, General and Administrative Expenses. SG&A expenses increased to $221.7 million, or 20.9% of consolidated net sales in 2016, as compared to $206.3 million, or 21.2% of consolidated net sales, in 2015. The $15.4 million increase in SG&A expenses as compared to 2015 is principally due to (1) higher selling and marketing costs, higher distribution expenses, and higher costs incurred in our accounts receivable factoring program, all associated with increased sales volumes; and (2) incremental expenses of $7.5 million from our acquisition of the North American automotive ignition wire business of General Cable Corporation, including amortization of intangible assets acquired. Restructuring and Integration Expenses (Income). Restructuring and integration expenses were $4 million in 2016 compared to restructuring and integration income of $0.1 million in 2015. The $4.1 million year-over-year increase in restructuring and integration expenses reflects primarily the impact of the plant rationalization program that commenced in February 2016 and the wire and cable relocation program announced in October 2016. Other Income, Net. Other income, net was $1.2 million in 2016 compared to $1 million in 2015. During 2016 and 2015, we recognized $1 million of deferred gain related to the sale-leaseback of our Long Island City, New York facility. Index Operating Income. Operating income was $98.1 million in 2016, compared to $75.9 million in 2015. The year-over-year increase in operating income of $22.2 million is the result of higher consolidated net sales and higher gross margins as a percentage of consolidated net sales offset, in part, by higher SG&A expenses and higher restructuring and integration expenses. Other Non-Operating Income, Net. Other non-operating income, net was $2.1 million in 2016, compared to other non-operating expense, net of $0.2 million in 2015. The year-over-year increase in other non-operating income, net resulted primarily from the increase in equity income from our joint ventures, the favorable impact of changes in foreign currency exchange rates and the year-over-year impact of the write-off in 2015 of $0.8 million of unamortized deferred finance costs associated with the refinancing of the prior revolving credit facility. Interest Expense. Interest expense was $1.6 million in 2016 compared to $1.5 million in 2015. The impact of the year-over-year increase in average outstanding borrowings during 2016 when compared to 2015 was partially offset by the slight decline in average interest rates on our revolving credit facility. The year-over-year increase in our average outstanding borrowings resulted primarily from our May 2016 acquisition of the North American automotive ignition wire business of General Cable Corporation for approximately $67.5 million which was funded by our revolving credit facility. Income Tax Provision. The income tax provision for 2016 was $36.2 million at an effective tax rate of 36.7%, compared to $26 million at an effective tax rate of 35.1% in 2015. The higher year-over-year effective tax rate is the result of a change in the mix of pre-tax income from lower foreign tax rate jurisdictions to the U.S., and the year-over-year increase in state and local effective tax rates. Loss from Discontinued Operations. Loss from discontinued operations, net of income tax, reflects information contained in the most recent actuarial studies performed as of August 31, 2016 and 2015, other information available and considered by us, and legal expenses associated with our asbestos-related liability. During 2016 and 2015, we recorded a loss of $2 million and $2.1 million, net of tax, from discontinued operations, respectively. Based upon the actuarial studies performed as of August 31, 2016 and 2015, a favorable adjustment to the asbestos liability was not recorded in our consolidated financial statements in each of 2016 and 2015 as the difference between the low end of the range in each of the actuarial studies and our recorded liability was not material. As discussed more fully in Note 19 of the notes to our financial statements, we are responsible for certain future liabilities relating to alleged exposure to asbestos containing products. Index Restructuring and Integration Programs Plant Rationalization Program In February 2016, in connection with our ongoing efforts to improve operating efficiencies and reduce costs, we finalized our intention to implement a plant rationalization initiative. As part of the plant rationalization, certain production activities will be relocated from our Grapevine, Texas manufacturing facility to facilities in Greenville, South Carolina and Reynosa, Mexico, certain service functions will be relocated from Grapevine, Texas to our administrative offices in Lewisville, Texas, and our Grapevine, Texas facility will be closed. As of December 31, 2017, all of our Grapevine, Texas production activities have been relocated to facilities in Greenville, South Carolina and Reynosa, Mexico. In addition, as part of the program, certain production activities were relocated from our Greenville, South Carolina manufacturing facility to our manufacturing facility in Bialystok, Poland. The following table summarizes the Plant Rationalization Program’s current forecast estimate through the end of the program, and the amounts incurred through December 31, 2017: Temporary incremental operating expense consists of labor and overhead inefficiencies during the program resulting from running duplicate facilities. Wire and Cable Relocation In connection with our acquisition of the North American automotive ignition wire business of General Cable Corporation in May 2016, we incurred certain integration expenses, including costs incurred in connection with the consolidation of the General Cable Corporation Altoona, Pennsylvania wire distribution center into our existing wire distribution center in Edwardsville, Kansas and the relocation of certain machinery and equipment. In October 2016, we further announced our plan to relocate all production from the acquired Nogales, Mexico wire set assembly operation to our existing wire assembly facility in Reynosa, Mexico and to close the Nogales, Mexico plant. The following table summarizes the Wire and Cable Relocation Program’s current forecast estimate through the end of the program, and the amounts incurred through December 31, 2017: Temporary incremental operating expense consists of labor and overhead inefficiencies during the program resulting from running duplicate facilities. Orlando Plant Rationalization Program In January 2017, to further our ongoing efforts to improve operating efficiencies and reduce costs, we finalized our intention to implement a plant rationalization initiative at our Orlando, Florida facility. As part of the plant rationalization, we will relocate production activities from our Orlando, Florida manufacturing facility to Independence, Kansas, and close our Orlando, Florida facility. In addition, certain production activities will be relocated from our Independence, Kansas manufacturing facility to our manufacturing facility in Reynosa, Mexico. The following table summarizes the Orlando Plant Rationalization Program’s current forecast estimate through the end of the program, and the amounts incurred through December 31, 2017: Temporary incremental operating expense consists of labor and overhead inefficiencies during the program resulting from running duplicate facilities. Index For a detailed discussion on the restructuring and integration costs, see Note 3, “Restructuring and Integration Expense (Income),” of the notes to our consolidated financial statements. Liquidity and Capital Resources Operating Activities. During 2017, cash provided by operations was $64.6 million, compared to $97.8 million in 2016. During 2017, the year-over-year decrease in operating cash flow is primarily the result of (1) lower net earnings, which was offset, in part, by the decrease in deferred tax assets as a result of the enactment of the Tax Cuts and Jobs Act; (2) the year-over-year decrease in accounts payable compared to the year-over-year increase in accounts payable in the same period of 2016; (3) the year-over-year decrease in sundry payables and accrued expenses compared to the year-over-year increase in sundry payables and accrued expenses in the same period of 2016; and (4) the year-over-year increase in prepaid expenses and other current assets compared to the year-over-year decrease in prepaid expenses and other current assets in the same period of 2016. Partially offsetting the unfavorable result in operating cash flow was (1) the smaller year-over-year increase in accounts receivable; and (2) the smaller year-over-year increase in inventories. Net earnings during 2017 were $38 million compared to $60.4 million in the same period of 2016. As a result of the enactment of the Tax Cuts and Jobs Act, included in net earnings in 2017 is a noncash increase in the provision for income taxes of $17.5 million, resulting from the remeasurement of our deferred tax assets of $16.1 million, and an increase in tax of $1.4 million due to the deemed repatriation of earnings of our foreign subsidiaries, which offset, in part, the year-over-year decline in net earnings. During the year ended December 31, 2017, (1) the year-over-year decrease in accounts payable was $7.2 million compared to the year-over-year increase in accounts payable of $7.3 million in 2016; (2) the year-over-year decrease in sundry payables and accrued expenses was $6 million compared to the year-over-year increase in sundry payables and accrued expenses of $21 million in 2016; (3) the year-over-year increase in prepaid expenses and other current assets was $4.9 million compared to the year-over-year decrease in prepaid expenses and other current assets of $3.5 million in 2016; (4) the year-over-year increase in receivables was $5.1 million compared to the year-over-year increase in receivables of $8.8 million in 2016; and (5) the year-over-year increase in inventories was $13.9 million compared to the year-over-year increase in inventories of $20.2 million in 2016. The decrease in sundry payables and accrued expenses reflects the impact of lower year-over-year incentive compensation expenses. We continue to actively manage our working capital to maximize our operating cash flow. During 2016, cash provided by operations was $97.8 million, compared to $65.2 million in 2015. During 2016, cash provided by operations was favorably impacted by (1) net earnings of $60.4 million compared to net earnings of $46 million in 2015; (2) the increase in accounts payable of $7.3 million compared to the year-over-year increase in accounts payable of $1.9 million in 2015; (3) the increase in sundry payables and accrued expenses of $21 million compared to the year-over-year increase in sundry payables and accrued expenses of $1.9 million in 2015; and (4) the decrease in prepaid expenses and other current assets of $3.5 million compared to the year-over-year decrease in prepaid expenses and other current assets of $0.4 million. Partially offsetting the favorable result in operating cash flow was (1) the increase in accounts receivable of $8.8 million compared to the year-over-year increase in accounts receivable of $2 million in 2015; and (2) the increase in inventory of $20.2 million compared to the year-over-year increase in inventory of $12.5 million in 2015. The higher year-over-year increase in sundry payables and accrued expenses in 2016 as compared to 2015 reflects higher employee compensation, and restructuring and integration accruals, which were paid in 2017. The higher year-over-year increase in inventories in 2016 as compared to 2015 is the result of “safety stock” built in connection with our restructuring and integration programs, while the comparative increase in accounts receivable is the result of the impact of our May 2016 acquisition of the North American automotive ignition wire business of General Cable Corporation. We continue to actively manage our working capital to maximize our operating cash flow. Investing Activities. Cash used in investing activities was $31.2 million in 2017, compared to $88 million in 2016 and $18 million in 2015. Investing activities in 2017 consisted of (1) the payment $6.8 million representing the first two contributions of the approximate $12.5 million for our acquisition of a 50% interest in a joint venture with Foshan Guangdong Automotive Air Conditioning Co., Ltd., a China-based manufacturer of air conditioning compressors for the automotive aftermarket and the Chinese OE market and (2) capital expenditures of $24.4 million. Index Cash used in investing activities was $88 million in 2016. Investing activities in 2016 consisted of (1) our acquisition of certain assets and the assumption of certain liabilities of General Cable Corporation’s automotive ignition wire business in North America as well as 100% of the equity interests of a General Cable subsidiary in Nogales, Mexico for $67.3 million, net of cash acquired and (2) capital expenditures of $20.9 million. Cash used in investing activities was $18 million in 2015 which consisted of capital expenditures of $18 million. Financing Activities. Cash used in financing activities was $35.9 million in 2017, compared to $7.8 million in 2016, and $41.2 million in 2015. During 2017, borrowings under our revolving credit facility and our Polish overdraft facility, along with cash provided by operating activities were used to fund the first two contributions of our acquisition of a 50% interest in a joint venture with Foshan Guangdong Automotive Air Conditioning Co., Ltd., purchase shares of our common stock, pay dividends and fund our capital expenditures. During 2017, we increased borrowings under our revolving credit facility by $2.2 million; borrowed $4.1 million under the Polish overdraft facility, net of payments under our capital lease obligations; and made cash payments of $24.4 million for the repurchase of our common stock. Cash used by finance activities was $7.8 million in 2016. Borrowings under our revolving credit facility, along with cash provided by operating activities, were used to fund the acquisition of the North American automotive ignition business of General Cable Corporation, purchase shares of our common stock, pay dividends and fund capital expenditures. During 2016, we increased borrowings under our revolving credit facility by $7.4 million and made cash payments of $0.4 million for the repurchase of our common stock. Cash used by finance activities was $41.2 million in 2015. Cash provided by operating cash flow in 2015 was used to fund capital expenditures, pay dividends, purchase shares of our common stock and reduce borrowings under our revolving credit facility. During 2015, we reduced borrowings under our revolving credit facilities by $9.1 million and made cash payments of $19.6 million for the repurchase of our common stock. Dividends of $17.3 million, $15.4 million and $13.7 million were paid in 2017, 2016 and 2015, respectively. Quarterly dividends were paid at a rate of $0.19 per share in 2017, $0.17 per share in 2016 and $0.15 per share in 2015. In February 2018, our Board of Directors voted to increase our quarterly dividend from $0.19 per share in 2017 to $0.21 per share in 2018. Liquidity Our primary cash requirements include working capital, capital expenditures, regular quarterly dividends, stock repurchases, principal and interest payments on indebtedness and acquisitions. Our primary sources of funds are ongoing net cash flows from operating activities and availability under our secured revolving credit facility (as detailed below). In October 2015, we entered into a Credit Agreement with JPMorgan Chase Bank, N.A., as agent, and a syndicate of lenders for a senior secured revolving credit facility with a line of credit of up to $250 million (with an additional $50 million accordion feature) and a maturity date in October 2020. The line of credit under the agreement also allows for a $10 million line of credit to Canada as part of the $250 million available for borrowing. Direct borrowings under the credit agreement bear interest at LIBOR plus a margin ranging from 1.25% to 1.75% based on our borrowing availability, or floating at the alternate base rate plus a margin ranging from 0.25% to 0.75% based on our borrowing availability, at our option. The credit agreement is guaranteed by certain of our subsidiaries and secured by certain of our assets. Borrowings under the credit agreement are secured by substantially all of our assets, including accounts receivable, inventory and certain fixed assets, and those of certain of our subsidiaries. Availability under the credit agreement is based on a formula of eligible accounts receivable, eligible inventory, eligible equipment and eligible fixed assets. After taking into account outstanding borrowings under the credit agreement, there was an additional $142.9 million available for us to borrow pursuant to the formula at December 31, 2017. Outstanding borrowings under the credit agreement, which are classified as current liabilities, were $57 million and $54.8 million at December 31, 2017 and 2016, respectively. Borrowings under the credit agreement have been classified as current liabilities based upon the accounting rules and certain provisions in the agreement. Index At December 31, 2017, the weighted average interest rate on our credit agreement was 2.7%, which consisted of $57 million in direct borrowings. At December 31, 2016, the weighted average interest rate on our credit agreement was 2.3%, which consisted of $45 million in direct borrowings at 2% and an alternative base rate loan of $9.8 million at 4%. Our average daily alternative base rate/index loan balance was $3.8 million and $2.6 million during 2017 and 2016, respectively. At any time that our borrowing availability is less than the greater of either (a) $25 million, or 10% of the commitments if fixed assets are not included in the borrowing base, or (b) $31.25 million, or 12.5% of the commitments if fixed assets are included in the borrowing base, the terms of the credit agreement provide for, among other provisions, a financial covenant requiring us, on a consolidated basis, to maintain a fixed charge coverage ratio of 1:1 at the end of each fiscal quarter (rolling four quarters). As of December 31, 2017, we were not subject to these covenants. The credit agreement permits us to pay cash dividends of $20 million and make stock repurchases of $20 million in any fiscal year subject to a minimum availability of $25 million. Provided specific conditions are met, the credit agreement also permits acquisitions, permissible debt financing, capital expenditures, and cash dividend payments and stock repurchases of greater than $20 million. In December 2017, our Polish subsidiary, SMP Poland sp.z.o.o., entered into an overdraft facility with HSBC Bank Polska S.A. (“HSBC Poland”) for Zloty 30 million (approximately $8.2 million). The facility expires on December 2018. Borrowings under the overdraft facility will bear interest at a rate equal to WIBOR + 0.75% and are guaranteed by Standard Motor Products, Inc., the ultimate parent company. At December 31, 2017, borrowings under the overdraft facility were Zloty 16.2 million (approximately $4.7 million). In order to reduce our accounts receivable balances and improve our cash flow, we sell undivided interests in certain of our receivables to financial institutions. We enter these agreements at our discretion when we determine that the cost of factoring is less than the cost of servicing our receivables with existing debt. Under the terms of the agreements, we retain no rights or interest, have no obligations with respect to the sold receivables, and do not service the receivables after the sale. As such, these transactions are being accounted for as a sale. Pursuant to these agreements, we sold $780.5 million and $759.2 million of receivables for the years ended December 31, 2017 and 2016, respectively. A charge in the amount of $22.6 million, $19.3 million and $14.3 million related to the sale of receivables is included in selling, general and administrative expenses in our consolidated statements of operations for the years ended December 31, 2017, 2016 and 2015, respectively. If we do not enter into these arrangements or if any of the financial institutions with which we enter into these arrangements were to experience financial difficulties or otherwise terminate these arrangements, our financial condition, results of operations and cash flows could be materially and adversely affected by delays or failures to collect future trade accounts receivable. In February 2015, our Board of Directors authorized the purchase of up to $10 million of our common stock under a stock repurchase program. In July 2015, our Board of Directors authorized the purchase of up to an additional $10 million of our common stock under another stock repurchase program. Under these programs, during the year ended December 31, 2015, we repurchased 551,791 shares of our common stock at a total cost of $19.6 million. As of December 31, 2015, there was approximately $0.4 million available for future stock repurchases under the programs. In January 2016, we repurchased an additional 10,135 shares of our common stock under the programs at a total cost of $0.4 million, thereby completing the 2015 Board of Directors authorizations. Our Board of Directors did not authorize a stock repurchase program in 2016. Index In February 2017, our Board of Directors authorized the purchase of up to $20 million of our common stock under a stock repurchase program. In November 2017, our Board of Directors authorized the purchase of up to an additional $10 million of our common stock under another stock repurchase program. Under these programs, during the year ended December 31, 2017, we repurchased 539,760 shares of our common stock at a total cost of $24.8 million. As of December 31, 2017, there was approximately $5.2 million available for future stock repurchases under the programs. During the period from January 1, 2018 through February 16, 2018, we repurchased an additional 35,756 shares of our common stock under the programs at a total cost of $1.7 million, thereby leaving approximately $3.5 million available for future stock purchases under the programs. In February 2016, in connection with our ongoing efforts to improve operating efficiencies and reduce costs, we finalized our intention to implement a plant rationalization initiative. As part of the plant rationalization, certain production activities will be relocated from our Grapevine, Texas manufacturing facility to facilities in Greenville, South Carolina and Reynosa, Mexico, certain service functions will be relocated from Grapevine, Texas to our administrative offices in Lewisville, Texas, and our Grapevine, Texas facility will be closed. As of December 31, 2017, all of our Grapevine, Texas production activities have been relocated to facilities in Greenville, South Carolina and Reynosa, Mexico. In addition, as part of the program, certain production activities were relocated from our Greenville, South Carolina manufacturing facility to our manufacturing facility in Bialystok, Poland. One-time plant rationalization costs of approximately $12.8 million are expected to be incurred, consisting of restructuring and integration expenses of approximately $5.8 million related to employee severance and relocation of certain machinery and equipment; capital expenditures of approximately $3.9 million; and temporary incremental operating expenses of approximately $3.1 million, which consists of labor and overhead inefficiencies during the program resulting from running duplicate facilities. Substantially all of the one-time plant rationalization costs have been incurred as of December 31, 2017, a portion of which will result in future cash expenditures. As of December 31, 2017, cash expenditures of approximately $11.1 million have been made related to the program. The plant rationalization program is substantially completed. In connection with our acquisition of the North American automotive ignition wire business of General Cable Corporation in May 2016, we incurred certain integration expenses, including costs incurred in connection with the consolidation of the General Cable Corporation Altoona, Pennsylvania wire distribution center into our existing wire distribution center in Edwardsville, Kansas and the relocation of certain machinery and equipment. In October 2016, we further announced our plan to relocate all production from the acquired Nogales, Mexico wire set assembly operation to our existing wire assembly facility in Reynosa, Mexico and to close the Nogales, Mexico plant. One-time plant rationalization costs related to the program of approximately $10.7 million are expected to be incurred, consisting of restructuring and integration expenses of approximately $4.1 million related to employee severance and relocation of certain machinery and equipment; capital expenditures of approximately $0.7 million; and temporary incremental operating expenses of approximately $5.9 million, which consists of labor and overhead inefficiencies during the program resulting from running duplicate facilities. Substantially all of the one-time rationalization costs are expected to result in future cash expenditures and will be recognized throughout the program. As of December 31, 2017, cash expenditures of approximately $6.9 million have been made related to the program. We anticipate that the wire and cable relocation program will be completed by the second half of 2018. In January 2017, to further our ongoing efforts to improve operating efficiencies and reduce costs, we finalized our intention to implement a plant rationalization initiative at our Orlando, Florida facility. As part of the plant rationalization, we will relocate production activities from our Orlando, Florida manufacturing facility to Independence, Kansas, and close our Orlando, Florida facility. In addition, certain production activities will be relocated from our Independence, Kansas manufacturing facility to our manufacturing facility in Reynosa, Mexico. One-time plant rationalization costs related to the program of approximately $4 million are expected to be incurred, consisting of restructuring and integration expenses of approximately $2.9 million related to employee severance and relocation of certain machinery and equipment; capital expenditures of approximately $0.8 million; and temporary incremental operating expenses of approximately $0.3 million, which consists of labor and overhead inefficiencies during the program resulting from running duplicate facilities. Substantially all of the one-time rationalization costs are expected to result in future cash expenditures and will be recognized throughout the program. As of December 31, 2017, cash expenditures of approximately $1.5 million have been made related to the program. We anticipate that the Orlando plant rationalization program will be completed by the second half of 2018. Index We anticipate that our cash flow from operations, available cash and available borrowings under our revolving credit facility will be adequate to meet our future liquidity needs for at least the next twelve months. Significant assumptions underlie this belief, including, among other things, that there will be no material adverse developments in our business, liquidity or capital requirements. If material adverse developments were to occur in any of these areas, there can be no assurance that our business will generate sufficient cash flow from operations, or that future borrowings will be available to us under our revolving credit facility in amounts sufficient to enable us to pay the principal and interest on our indebtedness, or to fund our other liquidity needs. In addition, if we default on any of our indebtedness, or breach any financial covenant in our revolving credit facility, our business could be adversely affected. The following table summarizes our contractual commitments as of December 31, 2017 and expiration dates of commitments through 2026(a) (b): (a) Indebtedness under our revolving credit facilities is not included in the table above as it is reported as a current liability in our consolidated balance sheets. As of December 31, 2017, amounts outstanding under our revolving credit facilities were $57 million. (b) We anticipate total aggregate future severance payments of approximately $2.9 million related to the plant rationalization program, the wire and cable relocation program and the Orlando plant rationalization program. All programs are expected to be completed by the second half of 2018. Critical Accounting Policies We have identified the policies below as critical to our business operations and the understanding of our results of operations. The impact and any associated risks related to these policies on our business operations is discussed throughout “Management’s Discussion and Analysis of Financial Condition and Results of Operations,” where such policies affect our reported and expected financial results. For a detailed discussion on the application of these and other accounting policies, see Note 1 of the notes to our consolidated financial statements. You should be aware that preparation of our consolidated annual and quarterly financial statements requires us to make estimates and assumptions that affect the reported amount of assets and liabilities, disclosure of contingent assets and liabilities at the date of our consolidated financial statements, and the reported amounts of revenue and expenses during the reporting periods. We can give no assurance that actual results will not differ from those estimates. Although we do not believe that there is a reasonable likelihood that there will be a material change in the future estimate or in the assumptions that we use in calculating the estimate, unforeseen changes in the industry, or business could materially impact the estimate and may have a material adverse effect on our business, financial condition and results of operations. Revenue Recognition. We derive our revenue primarily from sales of replacement parts for motor vehicles from both our Engine Management and Temperature Control Segments. We recognize revenues when products are shipped and title has been transferred to a customer, the sales price is fixed and determinable, and collection is reasonably assured. For certain of our sales of remanufactured products, we also charge our customers a deposit for the return of a used core component which we can use in our future remanufacturing activities. Such deposit is not recognized as revenue but rather carried as a core liability. The liability is extinguished when a core is actually returned to us. We estimate and record provisions for cash discounts, quantity rebates, sales returns and warranties in the period the sale is recorded, based upon our prior experience and current trends. As described below, significant management judgments and estimates must be made and used in estimating sales returns and allowances relating to revenue recognized in any accounting period. Index Inventory Valuation. Inventories are valued at the lower of cost and net realizable value. Cost is determined on the first-in, first-out basis. Where appropriate, standard cost systems are utilized for purposes of determining cost; the standards are adjusted as necessary to ensure they approximate actual costs. Estimates of lower of cost and net realizable value of inventory are determined by comparing the actual cost of the product to the estimated selling prices in the ordinary course of business less reasonably predictable costs of completion, disposal and transportation of the inventory. We also evaluate inventories on a regular basis to identify inventory on hand that may be obsolete or in excess of current and future projected market demand. For inventory deemed to be obsolete, we provide a reserve on the full value of the inventory. Inventory that is in excess of current and projected use is reduced by an allowance to a level that approximates our estimate of future demand. Future projected demand requires management judgment and is based upon (a) our review of historical trends and (b) our estimate of projected customer specific buying patterns and trends in the industry and markets in which we do business. Using rolling twelve month historical information, we estimate future demand on a continuous basis. As such, the historical volatility of such estimates has been minimal. We utilize cores (used parts) in our remanufacturing processes for air conditioning compressors, diesel injectors, and diesel pumps. The production of air conditioning compressors, diesel injectors, and diesel pumps involves the rebuilding of used cores, which we acquire either in outright purchases from used parts brokers or from returns pursuant to an exchange program with customers. Under such exchange programs, we reduce our inventory, through a charge to cost of sales, when we sell a finished good compressor, diesel injector, or diesel pump and put back to inventory the used core exchanged at standard cost through a credit to cost of sales when it is actually received from the customer. Sales Returns and Other Allowances and Allowance for Doubtful Accounts. We must make estimates of potential future product returns related to current period product revenue. We analyze historical returns, current economic trends, and changes in customer demand when evaluating the adequacy of the sales returns and other allowances. Significant judgments and estimates must be made and used in connection with establishing the sales returns and other allowances in any accounting period. At December 31, 2017, the allowance for sales returns was $35.9 million. Similarly, we must make estimates of the uncollectability of our accounts receivables. We specifically analyze accounts receivable and analyze historical bad debts, customer concentrations, customer credit-worthiness, current economic trends and changes in our customer payment terms when evaluating the adequacy of the allowance for doubtful accounts. At December 31, 2017, the allowance for doubtful accounts and for discounts was $5 million. New Customer Acquisition Costs. New customer acquisition costs refer to arrangements pursuant to which we incur change-over costs to induce a new customer to switch from a competitor’s brand. In addition, change-over costs include the costs related to removing the new customer’s inventory and replacing it with Standard Motor Products inventory commonly referred to as a stocklift. New customer acquisition costs are recorded as a reduction to revenue when incurred. Accounting for Income Taxes. As part of the process of preparing our consolidated financial statements, we are required to estimate our income taxes in each of the jurisdictions in which we operate. This process involves estimating our actual current tax expense together with assessing temporary differences resulting from differing treatment of items for tax and accounting purposes. These differences result in deferred tax assets and liabilities, which are included within our consolidated balance sheet. We must then assess the likelihood that our deferred tax assets will be recovered from future taxable income, and to the extent we believe that it is more likely than not that the deferred tax assets will not be recovered, we must establish a valuation allowance. To the extent we establish a valuation allowance or increase or decrease this allowance in a period, we must include an expense or recovery, respectively, within the tax provision in the statement of operations. Index We maintain valuation allowances when it is more likely than not that all or a portion of a deferred tax asset will not be realized. In determining whether a valuation allowance is warranted, we evaluate factors such as prior earnings history, expected future earnings, carryback and carryforward periods and tax strategies. We consider all positive and negative evidence to estimate if sufficient future taxable income will be generated to realize the deferred tax asset. We consider cumulative losses in recent years as well as the impact of one-time events in assessing our pre-tax earnings. Assumptions regarding future taxable income require significant judgment. Our assumptions are consistent with estimates and plans used to manage our business, which includes restructuring and integration initiatives that are expected to generate significant savings in future periods. The valuation allowance of $0.4 million as of December 31, 2017 is intended to provide for the uncertainty regarding the ultimate realization of our U.S. foreign tax credit carryovers and foreign net operating loss carryovers. The assessment of the adequacy of our valuation allowance is based on our estimates of taxable income in these jurisdictions and the period over which our deferred tax assets will be recoverable. Based on these considerations, we believe it is more likely than not that we will realize the benefit of the net deferred tax asset of $32.4 million as of December 31, 2017, which is net of the remaining valuation allowance. In the event that actual results differ from these estimates, or we adjust these estimates in future periods for current trends or expected changes in our estimating assumptions, we may need to modify the level of the valuation allowance which could materially impact our business, financial condition and results of operations. In accordance with generally accepted accounting practices, we recognize in our financial statements only those tax positions that meet the more-likely-than-not recognition threshold. We establish tax reserves for uncertain tax positions that do not meet this threshold. As of December 31, 2017, we do not believe there is a need to establish a liability for uncertain tax positions. Penalties and interest associated with income tax matters are included in the provision for income taxes in our consolidated statement of operations. In December 2017, the U.S. enacted the Tax Cuts and Jobs Act (“the Act”), which included a broad range of tax reform affecting businesses, including the reduction of the federal corporate tax rate from 35% to 21%, changes in the deductibility of certain business expenses, and the manner in which international operations are taxed in the U.S. For a discussion of the impact of the Act on our consolidated financial statements, see Note 16, “Income Taxes,” of the notes to our consolidated financial statements. Valuation of Long-Lived and Intangible Assets and Goodwill. At acquisition, we estimate and record the fair value of purchased intangible assets, which primarily consists of customer relationships, trademarks and trade names, patents and non-compete agreements. The fair values of these intangible assets are estimated based on our assessment. Goodwill is the excess of the purchase price over the fair value of identifiable net assets acquired in business combinations. Goodwill and certain other intangible assets having indefinite lives are not amortized to earnings, but instead are subject to periodic testing for impairment. Intangible assets determined to have definite lives are amortized over their remaining useful lives. We assess the impairment of long-lived assets, identifiable intangibles assets and goodwill whenever events or changes in circumstances indicate that the carrying value may not be recoverable. With respect to goodwill and identifiable intangible assets having indefinite lives, we test for impairment on an annual basis or in interim periods if an event occurs or circumstances change that may indicate the fair value is below its carrying amount. Factors we consider important, which could trigger an impairment review, include the following: (a) significant underperformance relative to expected historical or projected future operating results; (b) significant changes in the manner of our use of the acquired assets or the strategy for our overall business; and (c) significant negative industry or economic trends. We review the fair values using the discounted cash flows method and market multiples. Index When performing our evaluation of goodwill for impairment, if we conclude qualitatively that it is not more likely than not that the fair value of the reporting unit is less than its carrying amount, than the two-step impairment test is not required. If we are unable to reach this conclusion, then we would perform the two-step impairment test. Initially, the fair value of the reporting unit is compared to its carrying amount. To the extent the carrying amount of a reporting unit exceeds the fair value of the reporting unit; we are required to perform a second step, as this is an indication that the reporting unit goodwill may be impaired. In this step, we compare the implied fair value of the reporting unit goodwill with the carrying amount of the reporting unit goodwill and recognize a charge for impairment to the extent the carrying value exceeds the implied fair value. The implied fair value of goodwill is determined by allocating the fair value of the reporting unit to all of the assets (recognized and unrecognized) and liabilities of the reporting unit in a manner similar to a purchase price allocation. The residual fair value after this allocation is the implied fair value of the reporting unit goodwill. In addition, identifiable intangible assets having indefinite lives are reviewed for impairment on an annual basis using a methodology consistent with that used to evaluate goodwill. Intangible assets having definite lives and other long-lived assets are reviewed for impairment whenever events such as product discontinuance, plant closures, product dispositions or other changes in circumstances indicate that the carrying amount may not be recoverable. In reviewing for impairment, we compare the carrying value of such assets to the estimated undiscounted future cash flows expected from the use of the assets and their eventual disposition. When the estimated undiscounted future cash flows are less than their carrying amount, an impairment loss is recognized equal to the difference between the assets fair value and their carrying value. There are inherent assumptions and estimates used in developing future cash flows requiring our judgment in applying these assumptions and estimates to the analysis of identifiable intangibles and long-lived asset impairment including projecting revenues, interest rates, tax rates and the cost of capital. Many of the factors used in assessing fair value are outside our control and it is reasonably likely that assumptions and estimates will change in future periods. These changes can result in future impairments. In the event our planning assumptions were modified resulting in impairment to our assets, we would be required to include an expense in our statement of operations, which could materially impact our business, financial condition and results of operations. Postretirement Medical Benefits. Each year, we calculate the costs of providing retiree benefits under the provisions of the Financial Accounting Standards Board (“FASB”) Accounting Standards Codification (“ASC”) 712, Nonretirement Postemployment Benefits. The determination of postretirement plan obligations and their associated costs requires the use of actuarial computations to estimate participant plan benefits the employees will be entitled to. The key assumptions used in making these calculations are the eligibility criteria of participants and the discount rate used to value the future obligation. The discount rate reflects the yields available on high-quality, fixed-rate debt securities. Share-Based Compensation. The provisions of FASB ASC 718, Stock Compensation, require the measurement and recognition of compensation expense for all share-based payment awards made to employees and directors based on estimated fair values on the grant date. The value of the portion of the award that is ultimately expected to vest is recognized as expense on a straight-line basis over the requisite service periods in our condensed consolidated statement of operations. Forfeitures are estimated at the time of grant based on historical trends in order to estimate the amount of share-based awards that will ultimately vest. We monitor actual forfeitures for any subsequent adjustment to forfeiture rates. Environmental Reserves. We are subject to various U.S. Federal, state and local environmental laws and regulations and are involved in certain environmental remediation efforts. We estimate and accrue our liabilities resulting from such matters based upon a variety of factors including the assessments of environmental engineers and consultants who provide estimates of potential liabilities and remediation costs. Such estimates are not discounted to reflect the time value of money due to the uncertainty in estimating the timing of the expenditures, which may extend over several years. Potential recoveries from insurers or other third parties of environmental remediation liabilities are recognized independently from the recorded liability, and any asset related to the recovery will be recognized only when the realization of the claim for recovery is deemed probable. Index Asbestos Litigation. We are responsible for certain future liabilities relating to alleged exposure to asbestos-containing products. In accordance with our accounting policy, our most recent actuarial study as of August 31, 2017 estimated an undiscounted liability for settlement payments, excluding legal costs and any potential recovery from insurance carriers, ranging from $35.2 million to $54 million for the period through 2060. Based on the information contained in the actuarial study and all other available information considered by us, we have concluded that no amount within the range of settlement payments was more likely than any other and, therefore, in assessing our asbestos liability we compare the low end of the range to our recorded liability to determine if an adjustment is required. Based upon the results of the August 31, 2017 actuarial study, in September 2017 we increased our asbestos liability to $35.2 million, the low end of the range, and recorded an incremental pre-tax provision of $6 million in earnings (loss) from discontinued operations in the accompanying statement of operations. In addition, according to the updated study, future legal costs, which are expensed as incurred and reported in earnings (loss) from discontinued operations in the accompanying statement of operations, are estimated to range from $44.3 million to $79.6 million for the period through 2060. We will continue to perform an annual actuarial analysis during the third quarter of each year for the foreseeable future. Based on this analysis and all other available information, we will continue to reassess the recorded liability and, if deemed necessary, record an adjustment to the reserve, which will be reflected as a loss or gain from discontinued operations. Other Loss Reserves. We have other loss exposures, for such matters as legal claims and legal proceedings. Establishing loss reserves for these matters requires estimates, judgment of risk exposure, and ultimate liability. We record provisions when the liability is considered probable and reasonably estimable. Significant judgment is required in both the determination of probability and the determination as to whether an exposure can be reasonably estimated. As additional information becomes available, we reassess our potential liability related to these matters. Such revisions of the potential liabilities could have a material adverse effect on our business, financial condition or results of operations. Recently Issued Accounting Pronouncements For a detailed discussion on recently issued accounting pronouncements and their impact on our consolidated financial statements, see Note 1, “Summary of Significant Accounting Policies” of the notes to our consolidated financial statements. Index

<s>[INST] The following discussion should be read in conjunction with our consolidated financial statements and the notes thereto. This discussion summarizes the significant factors affecting our results of operations and the financial condition of our business during each of the fiscal years in the threeyear period ended December 31, 2017. Overview We are a leading independent manufacturer and distributor of replacement parts for motor vehicles in the automotive aftermarket industry, with a complementary focus on heavy duty, industrial equipment and the original equipment market. We are organized into two major operating segments, each of which focuses on specific lines of replacement parts. Our Engine Management Segment manufactures and remanufactures ignition and emission parts, ignition wires, battery cables, fuel system parts and sensors for vehicle systems. Our Temperature Control Segment manufactures and remanufactures air conditioning compressors, air conditioning and heating parts, engine cooling system parts, power window accessories, and windshield washer system parts. We sell our products primarily to large retail chains, warehouse distributors, original equipment manufacturers and original equipment service part operations in the United States, Canada, Latin America, and Europe. Our customers consist of many of the leading auto parts retail chains, such as NAPA Auto Parts (National Automotive Parts Association, Inc.), Advance Auto Parts, Inc./CARQUEST Auto Parts, AutoZone, Inc., O’Reilly Automotive, Inc., Canadian Tire Corporation Limited and The Pep Boys Manny, Moe & Jack, as well as national program distribution groups, such as Auto Value and All Pro/Bumper to Bumper (Aftermarket Auto Parts Alliance, Inc.), Automotive Distribution Network LLC, The National Pronto Association (“Pronto”), Federated Auto Parts Distributors, Inc. (“Federated”), Pronto and Federated’s affiliate, the Automotive Parts Services Group or The Group, Auto Plus and specialty market distributors. We distribute parts under our own brand names, such as Standard®, Blue Streak®, BWD®, Select®, Intermotor®, GP Sorensen®, TechSmart®, Tech Expert®, OEM®, LockSmart®, Four Seasons®, EVERCO®, ACi® and Hayden® and through colabels and private labels, such as CARQUEST®, Duralast®, Duralast Gold®, Import Direct®, Master Pro®, OmniSpark®, Ultima Select®, Murray®, NAPA®, NAPA® Echlin®, NAPA Proformer™ Mileage Plus®, NAPA Temp Products™, NAPA® Belden®, Cold Power®, DriveworksTM and ToughOneTM. Business Strategy Our goal is to grow revenues and earnings and deliver returns in excess of our cost of capital by being the bestinclass, fullline, fullservice supplier of premium products to the engine management and temperature control markets. The key elements of our strategy are as follows: · Maintain Our Strong Competitive Position in the Engine Management and Temperature Control Businesses. We are a leading independent manufacturer and distributor serving North America and other geographic areas in our core businesses of Engine Management and Temperature Control. We believe that our success is attributable to our emphasis on product quality, the breadth and depth of our product lines for both domestic and import vehicles, and our reputation for outstanding valueadded services. To maintain our strong competitive position in our markets, we remain committed to the following: · providing our customers with fullline coverage of high quality engine management and temperature control products, supported by the highest level of valueadded services; · continuing to maximize our production, supply chain and distribution efficiencies; Index · continuing to improve our cost position through increased global sourcing, increased manufacturing at our lowcost plants, and strategic transactions with manufacturers in lowcost regions; and · focusing on our engineering development efforts including a focus on bringing more product manufacturing in house. · Provide Superior ValueAdded Services, Product Availability and Technical Support. Our goal is to increase sales to existing and new customers by leveraging our skills in rapidly filling orders, maintaining high levels of product availability, offering a product portfolio that provides comprehensive coverage for all vehicle applications, providing insightful customer category management, and providing technical support in a costeffective manner [/INST] Negative. </s>

STANDARD MOTOR PRODUCTS, INC.

2019-02-20

2018-12-31

ITEM 7. MANAGEMENT’S DISCUSSION AND ANALYSIS OF FINANCIAL CONDITION AND RESULTS OF OPERATIONS The following discussion should be read in conjunction with our consolidated financial statements and the notes thereto. This discussion summarizes the significant factors affecting our results of operations and the financial condition of our business during each of the fiscal years in the three-year period ended December 31, 2018. Overview We are a leading independent manufacturer and distributor of premium replacement parts for the engine management and temperature control systems of motor vehicles in the automotive aftermarket industry with a complementary focus on heavy duty, industrial equipment and the original equipment market. We are organized into two operating segments. Each segment focuses on providing our customers with full-line coverage of premium engine management or temperature control products, and a full suite of complimentary services that are tailored to our customers’ business needs and driving end-user demand for our products. We sell our products primarily to automotive aftermarket retailers, program distribution groups, warehouse distributors, original equipment manufacturers and original equipment service part operations in the United States, Canada, Mexico, Europe, Asia and other Latin American countries. Our Business Strategy Our mission is to be the best-in-class, full-line, full-service supplier of premium engine management and temperature control products. The key elements of our strategy are as follows: · Maintain Our Strong Competitive Position in our Engine Management and Temperature Control Businesses. We are a leading independent manufacturer and distributor serving North America and other geographic areas in our core businesses of Engine Management and Temperature Control. We believe that our success is attributable to our emphasis on product quality, the breadth and depth of our product lines for both domestic and import vehicles, and our reputation for outstanding value-added services. To maintain our strong competitive position, we remain committed to the following: · providing our customers with full-line coverage of high quality engine management and temperature control products, supported by the highest level of value-added services; · continuing to maximize our production, supply chain and distribution efficiencies; · continuing to improve our cost position through increased global sourcing, increased manufacturing at our low-cost plants, and strategic transactions with manufacturers in low-cost regions; and · focusing on our engineering development efforts including a focus on bringing more product manufacturing in-house. · Provide Superior Value-Added Services and Product Availability. Our goal is to increase sales to existing and new customers by leveraging our skills in rapidly filling orders, maintaining high levels of product availability and offering a product portfolio that provides comprehensive coverage for all vehicle applications. In addition, our marketing support provides insightful customer category management, technical support and award-winning programs, and our technically skilled sales personnel provide our customers with product selection, assortment and application support, and technical training on diagnosing and repairing vehicles equipped with complex systems related to our products. Index · Expand Our Product Lines. We intend to increase our sales by continuing to develop internally, or through potential acquisitions, the range of engine management and temperature control products that we offer to our customers. We are committed to investing the resources necessary to maintain and expand our technical capability to manufacture product lines that incorporate the latest technologies, including product lines relating to safety, advanced driver assistance and collision avoidance systems. · Broaden Our Customer Base. Our goal is to increase our customer base by (a) leveraging our manufacturing capabilities to secure additional business globally with original equipment vehicle and equipment manufacturers and their service part operations, as well as our existing customer base of large retailers, program distribution groups, warehouse distributors, other manufacturers and export customers, and (b) supporting the service part operations of vehicle and equipment manufacturers with value-added services and product support for the life of the part. · Improve Operating Efficiency and Cost Position. Our management places significant emphasis on improving our financial performance by achieving operating efficiencies and improving asset utilization, while maintaining product quality and high customer order fill rates. We intend to continue to improve our operating efficiency and cost position by: · increasing cost-effective vertical integration in key product lines through internal development; · focusing on integrated supply chain management, customer collaboration and vendor managed inventory initiatives; · evaluating additional opportunities to relocate manufacturing to our low-cost plants; · maintaining and improving our cost effectiveness and competitive responsiveness to better serve our customer base, including sourcing certain materials and products from low cost regions such as those in Asia without compromising product quality; · enhancing company-wide programs geared toward manufacturing and distribution efficiency; and · focusing on company-wide overhead and operating expense cost reduction programs. · Cash Utilization. We intend to apply any excess cash flow from operations and the management of working capital primarily to reduce our outstanding indebtedness, pay dividends to our shareholders, expand our product lines by investing in new tooling and equipment, grow revenues through potential acquisitions and repurchase shares of our common stock. The Automotive Aftermarket The automotive aftermarket industry is comprised of a large number of diverse manufacturers varying in product specialization and size. In addition to manufacturing, aftermarket companies must allocate resources towards an efficient distribution process in order to maintain the flexibility and responsiveness on which their customers depend. Aftermarket manufacturers must be efficient producers of small lot sizes, and must distribute, with rapid turnaround times, products for nearly all domestic and import vehicles on the road today. Index The automotive aftermarket replacement parts business differs substantially from the OEM parts business. Unlike the OEM parts business that primarily follows trends in new car production, the automotive aftermarket replacement parts business primarily tends to follow different trends, such as: · the number of vehicles on the road; · the average age of vehicles on the road; and · the total number of miles driven per year. Seasonality. Historically, our operating results have fluctuated by quarter, with the greatest sales occurring in the second and third quarters of the year and revenues generally being recognized at the time of shipment. It is in these quarters that demand for our products is typically the highest, specifically in the Temperature Control Segment of our business. In addition to this seasonality, the demand for our Temperature Control products during the second and third quarters of the year may vary significantly with the summer weather and customer inventories. For example, a warm summer, as we experienced in 2018, may increase the demand for our temperature control products, while a mild summer, as we experienced in 2017, may lessen such demand. As a result of this seasonality and variability in demand of our Temperature Control products, our working capital requirements typically peak near the end of the second quarter, as the inventory build-up of air conditioning products is converted to sales and payments on the receivables associated with such sales have yet to be received. During this period, our working capital requirements are typically funded by borrowing from our revolving credit facility. Inventory Management. We face inventory management issues as a result of overstock returns. We permit our customers to return new, undamaged products to us within customer-specific limits (which are generally limited to a specified percentage of their annual purchases from us) in the event that they have overstocked their inventories. In addition, the seasonality of our Temperature Control Segment requires that we increase our inventory during the winter season in preparation of the summer selling season and customers purchasing such inventory have the right to make returns. We accrue for overstock returns as a percentage of sales after giving consideration to recent returns history. Discounts, Allowances, and Incentives. We offer a variety of usual customer discounts, allowances and incentives. First, we offer cash discounts for paying invoices in accordance with the specified discount terms of the invoice. Second, we offer pricing discounts based on volume purchased from us and participation in our cost reduction initiatives. These discounts are principally in the form of “off-invoice” discounts and are immediately deducted from sales at the time of sale. For those customers that choose to receive a payment on a quarterly basis instead of “off-invoice,” we accrue for such payments as the related sales are made and reduce sales accordingly. Finally, rebates and discounts are provided to customers as advertising and sales force allowances, and allowances for warranty and overstock returns are also provided. Management analyzes historical returns, current economic trends, and changes in customer demand when evaluating the adequacy of the sales returns and other allowances. Significant management judgments and estimates must be made and used in connection with establishing the sales returns and other allowances in any accounting period. We account for these discounts and allowances as a reduction to revenues, and record them when sales are recorded. Tax Cuts and Jobs Act In December 2017, the U.S. enacted the Tax Cuts and Jobs Act (the “Act”), which included a broad range of tax reform affecting businesses, including the reduction of the federal corporate tax rate from 35% to 21%, changes in the deductibility of certain business expenses, and the manner in which international operations are taxed in the U.S. Although the majority of the changes resulting from the Act are effective beginning in 2018, U.S. GAAP requires that certain impacts of the Act be recognized in the income tax provision in the period of enactment. In connection with the enactment of the Act, our income tax provision for 2017 included an increase of $17.5 million, reflecting an increase of $16.1 million for the remeasurement of our net deferred tax assets and an increase in tax of $1.4 million due to the deemed repatriation of earnings of our foreign subsidiaries. Index As related to the deemed repatriation of earnings of foreign subsidiaries, the Act includes a mandatory one-time tax on accumulated earnings of foreign subsidiaries. As a result, all previously unremitted earnings for which no U.S. deferred tax liability had been accrued are now subject to U.S. tax. In accordance with the guidelines provided in the Act, as of December 31, 2017 we have aggregated our estimated foreign earnings and profits, and utilized participating deductions and available foreign tax credits. The gross repatriation tax was $2.3 million, which was offset by $0.9 million of foreign tax credits for a net repatriation tax charge of $1.4 million. The net repatriation tax of $1.4 million was recorded in the fourth quarter of 2017. During 2018, we refined and updated our calculation of the gross repatriation tax to $2.7 million, which was paid to the U.S. Treasury. The difference in the refined and updated repatriation tax and what was previously recorded in 2017 was reflected in the 2018 tax provision. Notwithstanding the U.S. taxation of these amounts, we intend to continue to invest most or all of these earnings indefinitely outside of the U.S., and do not expect to incur any significant additional taxes related to such amounts. In addition, although we believe that the impact of the Act has been properly reflected in our financial statements, the Internal Revenue Service is continuing to issue new regulations for the various provisions of the Act and, therefore, amounts recorded are subject to change. See Note 19, “Income Taxes,” of the Notes to Consolidated Financial Statements in Item 8 of this Report for additional information. Impact of Changes in U.S. Trade Policy During 2018, changes in U.S. trade policy, particularly as it relates to China, as with much of our industry, have resulted in the assessment of increased tariffs on goods that we import into the United States. Although our operating results in 2018 have been slightly impacted by the timing of Chinese sourced products, we have taken, and continue to take, several actions to mitigate the impact of the increased tariffs, including but not limited to, price increases to our customers. We do not anticipate that the increased tariffs will have a significant impact on our future operating results. Although we are confident that we will be able to pass along the impact of the increased tariffs to our customers, there can be no assurances that we will be able to pass on the entire increased costs imposed by the tariffs. Index Comparison of Fiscal Years 2018 and 2017 Sales. Consolidated net sales for 2018 were $1,092 million, a decrease of $24.1 million, or 2.2%, compared to $1,116.1 million in the same period of 2017, with the majority of our net sales to customers located in the United States. Consolidated net sales decreased due to the lower results achieved by our Engine Management Segment. The following table summarizes consolidated net sales by segment and by major product group within each segment for the years ended December 31, 2018 and 2017 (in thousands): Engine Management’s net sales decreased $25.9 million, or 3.1%, to $803.5 million for the year ended December 31, 2018. Net sales in ignition, emission control, fuel and safety related system products for the year ended December 31, 2018 were $648.3 million, a decrease of $9 million, or 1.4%, compared to $657.3 million in the same period of 2017. Net sales in the wire and cable product group for the year ended December 31, 2018 were $155.2 million, a decrease of $16.9 million, or 9.8%, compared to $172.1 million in the same period of 2017. Engine Management’s decrease in net sales for the year ended December 31, 2018 compared to the same period in 2017 reflects the impact of large pipeline orders placed in the first half of 2017 by certain customers, who were in the process of increasing the breadth and depth of their inventories. In addition, Engine Management’s year-over-year decrease in net sales reflects the impact of the gradual decline in our wire and cable business, which is an older technology used on fewer cars, and due to the product lifecycle will continue to reduce overall Engine Management net sales. During the third and fourth quarters of 2018, as our customers experienced increases in Engine Management product sell-through, demand for our products in ignition, emission control, fuel and safety related system parts increased, resulting in an increase in Engine Management sales in the third and fourth quarters of 2018 compared to the same period of 2017. More significantly, our customers reported Engine Management POS up approximately 4% in both the 2018 fourth quarter and full year, in line with our long-term forecast. Temperature Control’s net sales were essentially flat for the year ended December 31, 2018 when compared to the same period in 2017. Net sales in the compressors product group were flat at $148.4 million for each of the years ended December 31, 2018 and 2017. Net sales in other climate control parts for the year ended December 31, 2018 were $130 million, a decrease of $0.8 million, or 0.6%, compared to $130.8 million for the year ended December 31, 2017. Temperature Control’s net sales in 2018 as compared to 2017 reflects the impact of a slow start to the 2018 season, resulting from a mild 2017 summer, higher than normal customer inventory levels going into 2018, and a cool early spring. As weather conditions began to turn warm in mid-May, customer orders strengthened in June and continued throughout the third and fourth quarters of 2018, resulting in strong third and fourth quarter 2018 Temperature Control net sales, as our customers reported Temperature Control POS sales increases in the 6% - 7% range. Demand for our Temperature Control products may vary significantly with summer weather conditions and customer inventory levels. Index Margins. Gross margins, as a percentage of consolidated net sales, decreased to 28.6% for 2018, compared to 29.3% for 2017. The following table summarizes gross margins by segment for the years ended December 31, 2018 and 2017, respectively (in thousands): (a) Segment net sales include intersegment sales in our Engine Management and Temperature Control segments. Compared to 2017, gross margins at Engine Management decreased 0.8 percentage points from 29.4% to 28.6%, and gross margins at Temperature Control decreased 0.9 percentage points from 26.2% to 25.3%. The gross margin percentage decrease in Engine Management compared to the prior year reflects the impact of product mix, inefficiencies and redundant costs incurred as a result of our various planned production moves, and the slight negative impact caused by the timing of tariffs incurred with Chinese sourced products in 2018. The gross margin percentage decrease in Temperature Control compared to the prior year reflects the impact of product mix, and the impact of unfavorable production variances carriedforward from the weak 2017 season. Selling, General and Administrative Expenses. SG&A expenses increased to $231.3 million, or 21.2% of consolidated net sales in 2018, as compared to $224.2 million, or 20.1% of consolidated net sales in 2017. The $7.1 million increase in SG&A expenses as compared to 2017 is principally due to higher distribution expenses at Temperature Control and higher expenses related to the sale of receivables, offset in part, by lower selling and marketing expenses. The higher than usual distribution expenses at Temperature Control were due to a combination of significant additional labor costs to keep up with the surge in sales in the third and fourth quarters of 2018, as well as start-up costs related to the installation of a new automation project in our distribution center. In 2019, we anticipate lower distribution costs in our Temperature Control segment as the new automation project is optimized. Restructuring and Integration Expenses. Restructuring and integration expenses were $4.5 million in 2018 compared to restructuring and integration expenses of $6.2 million in 2017. The $1.7 million year-over-year decrease in restructuring and integration expenses reflects the impact of lower expenses incurred in connection with the plant rationalization program that commenced in February 2017, the wire and cable relocation program announced in October 2017, and the Orlando plant rationalization program that commenced in January 2017, all of which were substantially completed as of December 31, 2018, and which more than offset the $1.3 million increase in environmental cleanup costs related to the remediation in connection with the prior closure of our manufacturing operations at our Long Island City, New York location. Other Income, Net. Other income, net was $4.3 million in 2018 compared to $1.3 million in 2017. The $3 million increase in other income, net as compared to 2017 is principally due to the $3.9 million gain on the December 2018 sale of our property located in Grapevine, Texas offset, in part, by the lower year-over-year deferred gain related to the sale-leaseback of our Long Island City, New York facility. During 2018 and 2017, we recognized $0.2 million and $1 million, respectively, of deferred gain related to the sale-leaseback of our Long Island City, New York facility. The recognition of the deferred gain related to the sale-leaseback of our Long Island City, New York facility ended in the first quarter of 2018 upon the termination of the initial 10-year lease term for the facility. Index Operating Income. Operating income was $81.3 million in 2018, compared to $97.5 million in 2017. The year-over-year decrease in operating income of $16.2 million is the result of the impact of lower consolidated net sales, lower gross margins as a percentage of consolidated net sales and higher SG&A expenses, which more than offset the impact of lower restructuring and integration expenses and higher other income, net. Other Non-Operating Income (Expense), Net. Other non-operating expense, net was $0.4 million in 2018, compared to other non-operating income, net of $1.3 million in 2017. Included in other non-operating income (expense), net in 2018 and 2017 are noncash impairment charges of approximately $1.7 million and $1.8 million, respectively, related to our minority interest investment in Orange Electronics Co., Ltd. Recognizing that the year-over-year impact of the noncash impairment charges is essentially flat, the year-over-year decline in other non-operating income (expense), net results principally from the unfavorable impact of changes in foreign currency exchange rates, and the year-over-year decline in the actuarial net gain related to our postretirement medical benefit plans. Our postretirement medical benefit plans to substantially all eligible U.S. and Canadian employees terminated on December 31, 2016. Interest Expense. Interest expense was $4 million in 2018 compared to $2.3 million in 2017. The year-over-year increase in interest expense reflects the impact of higher year-over-year average interest rates on our revolving credit facility, and higher average outstanding borrowings during 2018 when compared to 2017. Income Tax Provision. The income tax provision for 2018 was $20 million at an effective tax rate of 26%, compared to $52.8 million at an effective tax rate of 54.8% in 2017. The lower effective tax rate in 2018 compared to 2017 reflects the impact of the Tax Cuts and Jobs Act enacted in the U.S. in December 2017. The enactment of the Tax Cuts and Jobs Act impacted the year-over-year income tax provision and effective tax rate through (1) a reduction in the effective tax rate due to lowering of federal corporate tax rate from 35% to 21%, and (2) an increase in the 2017 income tax provision of $17.5 million resulting from the remeasurement of our deferred tax assets, and the tax on deemed repatriated earnings of our foreign subsidiaries. Excluding the impact of the Tax Cuts and Jobs Act, the income tax provision for 2017 was $35.3 million at an effective tax rate of 36.6%. Loss from Discontinued Operations. Loss from discontinued operations, net of income tax, reflects information contained in the most recent actuarial studies performed as of August 31, 2018 and revised to reflect events occurring through November 20, 2018, and as of August 31, 2017, other information available and considered by us, and legal expenses associated with our asbestos-related liability. During the years ended December 31, 2018 and 2017, we recorded a loss of $13.9 million and $5.7 million from discontinued operations, respectively. The loss from discontinued operations for 2018 and 2017 includes a $13.6 million and $6 million pre-tax provision, respectively, to increase our indemnity liability in line with the 2018 and 2017 actuarial studies. As discussed more fully in Note 23 in the notes to our consolidated financial statements, we are responsible for certain future liabilities relating to alleged exposure to asbestos containing products. Index Comparison of Fiscal Years 2017 and 2016 Sales. Consolidated net sales for 2017 were $1,116.1 million, an increase of $57.6 million, or 5.4%, compared to $1,058.5 million in the same period of 2016, with the majority of our net sales to customers located in the United States. Consolidated net sales increased due to the higher results achieved by our Engine Management Segment. The following table summarizes consolidated net sales by segment and by major product group within each segment for the years ended December 31, 2017 and 2016 (in thousands): Engine Management’s net sales increased $63.9 million, or 8.3%, to $829.4 million for the year ended December 31, 2017. Net sales in ignition, emission control, fuel and safety related system products for the year ended December 31, 2017 were $657.3 million, an increase of $40.8 million, or 6.6%, compared to $616.5 million in the same period of 2016. Net sales in the wire and cable product group for the year ended December 31, 2017 were $172.1 million, an increase of $23.1 million, or 15.5%, compared to $149 million in the same period of 2016. In May 2016, we acquired the North American automotive ignition wire business of General Cable Corporation. Incremental net sales from the acquisition of $38.4 million were included in net sales of the wire and cable product group for the year ended December 31, 2017. Excluding the incremental sales from the acquisition, net sales in the wire and cable product group declined $15.3 million, or 10.3%, and Engine Management net sales increased $25.5 million, or 3.3%, compared to the year ended December 31, 2016, in line with our expectations of low single digit organic growth. Temperature Control’s net sales decreased $4.6 million, or 1.6%, to $279.1 million for the year ended December 31, 2017. Net sales in the compressors product group for the year ended December 31, 2017 were $148.4 million, a decrease of $0.2 million, or 0.2%, compared to $148.6 million in the same period of 2016. Net sales in other climate control parts for the year ended December 31, 2017 were $130.8 million, a decrease of $4.4 million, or 3.2%, compared to $135.1 million for the year ended December 31, 2016. Temperature Control’s decrease in net sales for the year ended December 31, 2017 of 1.6% reflects the impact of a cool 2017 summer following a very warm 2016, and is slightly better than our customers’ reported year-to-date net sales decrease of 4%. Demand for our Temperature Control products may vary significantly with summer weather conditions and customer inventories. Index Gross Margins. Gross margins, as a percentage of consolidated net sales, decreased to 29.3% for 2017, compared to 30.5% for 2016. The following table summarizes gross margins by segment for the years ended December 31, 2017 and 2016, respectively (in thousands): (a) Segment net sales include intersegment sales in our Engine Management and Temperature Control segments. Compared to 2016, gross margins at Engine Management decreased 1.9 percentage points from 31.3% to 29.4%, and gross margins at Temperature Control increased 0.6 percentage points from 25.6% to 26.2%. The gross margin percentage decrease in Engine Management compared to the prior year reflects inefficiencies and redundant costs incurred during our various planned production moves. The gross margin percentage increase in Temperature Control compared to the prior year resulted primarily from transferring production manufacturing to our lower cost Reynosa, Mexico facility. Selling, General and Administrative Expenses. SG&A expenses increased to $224.2 million, or 20.1% of consolidated net sales in 2017, as compared to $220.9 million, or 20.9% of consolidated net sales in 2016. The $3.3 million increase in SG&A expenses as compared to 2016 is principally due to higher distribution expenses and higher costs incurred in our accounts receivable factoring program, both of which are associated with increased sales volumes offset, in part, by the benefits from our General Cable integration and lower incentive compensation expenses. Restructuring and Integration Expenses. Restructuring and integration expenses were $6.2 million in 2017 compared to restructuring and integration expenses of $4 million in 2016. The $2.2 million year-over-year increase in restructuring and integration expenses reflects the impact of the plant rationalization program that commenced in February 2016, the wire and cable relocation program announced in October 2016, and the Orlando plant rationalization program that commenced in January 2017. Other Income, Net. Other income, net was $1.3 million in 2017 compared to $1.2 million in 2016. During 2017 and 2016, we recognized $1 million of deferred gain related to the sale-leaseback of our Long Island City, New York facility. Operating Income. Operating income was $97.5 million in 2017, compared to $98.8 million in 2016. The year-over-year decrease in operating income of $1.3 million reflects the impact of lower gross margins as a percentage of consolidated net sales, higher SG&A expenses and higher restructuring and integration expenses, which more than offset the impact of higher consolidated net sales. Other Non-Operating Income, Net. Other non-operating income, net was $1.3 million in both 2017 and 2016. Included in other non-operating income, net in 2017 is a noncash impairment charge of approximately $1.8 million related to our minority interest investment in Orange Electronics Co., Ltd. Interest Expense. Interest expense was $2.3 million in 2017 compared to $1.6 million in 2016. The year-over-year increase reflects the impact of higher year-over-year average interest rates on our revolving credit facility, and higher average outstanding borrowings during 2017 when compared to 2016. Index Income Tax Provision. The income tax provision for 2017 was $52.8 million at an effective tax rate of 54.8%, compared to $36.2 million at an effective tax rate of 36.7% in 2016. During 2017, we recorded an increase of $17.5 million to the income tax provision resulting from the remeasurement of our net deferred tax assets, and the tax on deemed repatriated earnings of our foreign subsidiaries as a result of the enactment of the Tax Cuts and Jobs Act. Excluding the impact of the Tax Cuts and Jobs Act, the income tax provision for 2017 was $35.3 million at an effective tax rate of 36.6%. Loss from Discontinued Operations. Loss from discontinued operations, net of income tax, reflects information contained in the most recent actuarial studies performed as of August 31, 2017 and 2016, other information available and considered by us, and legal expenses associated with our asbestos-related liability. During 2017 and 2016, we recorded a loss of $5.7 million and $2 million from discontinued operations, respectively. The loss from discontinued operations for 2017 includes a $6 million pre-tax provision reflecting the impact of the results of the August 2017 actuarial study. No adjustment was made in 2016 to our asbestos liability as the difference between the low end of the range in the August 2016 actuarial study and our recorded liability was not material. As discussed more fully in Note 23 in the notes to our consolidated financial statements, we are responsible for certain future liabilities relating to alleged exposure to asbestos containing products. Restructuring and Integration Programs As of December 31, 2018, the plant rationalization program that commenced in February 2016, the wire and cable relocation program announced in October 2016, and the Orlando plant rationalization program that commenced in January 2017 are all substantially completed. For a detailed discussion on the restructuring and integration costs, see Note 5, “Restructuring and Integration Expense,” of the notes to our consolidated financial statements. Liquidity and Capital Resources Operating Activities. During 2018, cash provided by operating activities was $70.3 million compared to $64.6 million in 2017. The year-over-year increase in operating cash flow is primarily the result of higher net earnings, the year-over-year increase in accounts payable compared to the year-over-year decrease in accounts payable in 2017, the year-over-year increase in sundry payables and accrued expenses compared to the year-over-year decrease in sundry payables and accrued expenses in 2017, and the year-over-year decrease in prepaid expenses and other current assets compared to the year-over-year increase in prepaid expenses and other current assets in 2017 offset, in part, by the larger year-over-year increase in accounts receivable, and the larger year-over-year increase in inventories. Net earnings during 2018, were $43 million compared to $38 million in 2017. During 2018 (1) the increase in receivables was $13.7 million compared to the year-over-year increase in receivables of $5.1 million in 2017; (2) the increase in inventories was $30.2 million compared to the year-over-year increase in inventories of $13.9 million in 2017; (3) the decrease in prepaid expenses and other current assets was $4.9 million compared to the year-over-year increase in prepaid expenses and other current assets of $4.9 million in 2017; (4) the increase in accounts payable was $16.9 million compared to the year-over-year decrease in accounts payable of $7.2 million in 2017; and (5) the increase in sundry payables and accrued expenses was $8.4 million compared to the year-over-year decrease in sundry payables and accrued expenses of $6 million in 2017. We continue to actively manage our working capital to maximize our operating cash flow. During 2017, cash provided by operations was $64.6 million, compared to $97.8 million in 2016. During 2017, the year-over-year decrease in operating cash flow is primarily the result of (1) lower net earnings of $38 million compared to net earnings of $60.4 million in 2016, (2) the year-over-year decrease in accounts payable of $7.2 million compared to the year-over-year increase in accounts payable of $7.3 million in 2016; (3) the year-over-year decrease in sundry payables and accrued expenses of $6 million compared to the year-over-year increase in sundry payables and accrued expenses of $21 million in 2016; and (4) the year-over-year increase in prepaid expenses and other current assets of $4.9 million compared to the year-over-year decrease in prepaid expenses and other current assets of $3.5 million in 2016. Partially offsetting the unfavorable result in operating cash flow was (1) the year-over-year increase in receivables of $5.1 million compared to the year-over-year increase in receivables of $8.8 million in 2016; and (2) the year-over-year increase in inventories of $13.9 million compared to the year-over-year increase in inventories of $20.2 million in 2016. The year-over-year decline in net earnings included a noncash increase in the provision for income taxes of $17.5 million, resulting from the remeasurement of our deferred tax assets of $16.1 million, and an increase in tax of $1.4 million due to the deemed repatriation of earnings of our foreign subsidiaries as a result of the enactment of the Tax Cuts and Jobs Act; while the decrease in sundry payables and accrued expenses reflects the impact of lower year-over-year incentive compensation expenses. We continue to actively manage our working capital to maximize our operating cash flow. Index Investing Activities. Cash used in investing activities was $29.9 million in 2018, compared to $31.2 million in 2017 and $88 million in 2016. Investing activities in 2018 consisted of (1) the payment of the third and final contribution of $5.7 million for our November 2017 acquisition of a 50% interest in Foshan FGD SMP Automotive Compressor Co., Ltd., a China-based joint venture that manufactures air conditioning compressors for the automotive aftermarket and the Chinese OE market; (2) the payment of $4.2 million for our 15% increase in equity ownership in Foshan GWO YNG SMP Vehicle Climate Control & Cooling Products Co. Ltd., a China-based joint venture that manufactures air conditioner accumulators, filter driers, hose assemblies and switches for the automotive aftermarket and OEM/OES markets; and (3) capital expenditures of $20.1 million. Cash used in investing activities was $31.2 million in 2017. Investing activities in 2017 consisted of (1) the payment $6.8 million representing the first two contributions of the approximate $12.5 million for our acquisition of a 50% interest in Foshan FGD SMP Automotive Compressor Co., Ltd., a China-based joint venture that manufactures air conditioning compressors for the automotive aftermarket and the Chinese OE market and (2) capital expenditures of $24.4 million. Cash used in investing activities was $88 million in 2016. Investing activities in 2016 consisted of (1) our acquisition of certain assets and the assumption of certain liabilities of General Cable Corporation’s automotive ignition wire business in North America as well as 100% of the equity interests of a General Cable subsidiary in Nogales, Mexico for $67.3 million, net of cash acquired and (2) capital expenditures of $20.9 million. Financing Activities. Cash used in financing activities was $46.1 million in 2018, compared to $35.9 million in 2017, and $7.8 million in 2016. During 2018, cash provided by operating activities, along with borrowings under our Polish overdraft facility, net of payments under our capital lease obligations, were used to fund the third and final contribution of our acquisition of a 50% interest in Foshan FGD SMP Automotive Compressor Co., Ltd., fund the 15% increase in equity ownership in Foshan GWO YNG SMP Vehicle Climate Control & Cooling Products Co. Ltd., pay down borrowings under our revolving credit facility, purchase shares of our common stock, pay dividends and fund our capital expenditures. During 2018, we increased borrowings under the Polish overdraft facility, net of payments under our capital lease obligations of $1.1 million, paid down borrowings under our revolving credit facility of $13.3 million and made cash payments of $14.9 million for the repurchase of our common stock. Cash used by finance activities was $35.9 million in 2017. Borrowings under our revolving credit facility and our Polish overdraft facility, along with cash provided by operating activities were used to fund the first two contributions of our acquisition of a 50% interest in Foshan FGD SMP Automotive Compressor Co., Ltd., purchase shares of our common stock, pay dividends and fund our capital expenditures. During 2017, we increased borrowings under our revolving credit facility by $2.2 million; borrowed $4.1 million under the Polish overdraft facility, net of payments under our capital lease obligations; and made cash payments of $24.4 million for the repurchase of our common stock. Cash used by finance activities was $7.8 million in 2016. Borrowings under our revolving credit facility, along with cash provided by operating activities, were used to fund the acquisition of the North American automotive ignition business of General Cable Corporation, purchase shares of our common stock, pay dividends and fund capital expenditures. During 2016, we increased borrowings under our revolving credit facility by $7.4 million and made cash payments of $0.4 million for the repurchase of our common stock. Index Dividends of $18.9 million, $17.3 million and $15.4 million were paid in 2018, 2017 and 2016, respectively. Quarterly dividends were paid at a rate of $0.21 per share in 2018, $0.19 per share in 2017 and $0.17 per share in 2016. In February 2019, our Board of Directors voted to increase our quarterly dividend from $0.21 per share in 2018 to $0.23 per share in 2019. Liquidity Our primary cash requirements include working capital, capital expenditures, regular quarterly dividends, stock repurchases, principal and interest payments on indebtedness and acquisitions. Our primary sources of funds are ongoing net cash flows from operating activities and availability under our secured revolving credit facility (as detailed below). In December 2018, we amended our Credit Agreement with JPMorgan Chase Bank, N.A., as agent, and a syndicate of lenders. The amended credit agreement provides for a senior secured revolving credit facility with a line of credit of up to $250 million (with an additional $50 million accordion feature) and extends the maturity date to December 2023. The line of credit under the amended agreement also allows for a $10 million line of credit to Canada as part of the $250 million available for borrowing. Direct borrowings under the amended credit agreement bear interest at LIBOR plus a margin ranging from 1.25% to 1.75% based on our borrowing availability, or floating at the alternate base rate plus a margin ranging from 0.25% to 0.75% based on our borrowing availability, at our option. The amended credit agreement is guaranteed by certain of our subsidiaries and secured by certain of our assets. Borrowings under the amended credit agreement are secured by substantially all of our assets, including accounts receivable, inventory and certain fixed assets, and those of certain of our subsidiaries. Availability under the amended credit agreement is based on a formula of eligible accounts receivable, eligible drafts presented to the banks under our factoring agreements, eligible inventory, eligible equipment and eligible fixed assets. After taking into account outstanding borrowings under the amended credit agreement, there was an additional $203.1 million available for us to borrow pursuant to the formula at December 31, 2018. Outstanding borrowings under the credit agreement, which are classified as current liabilities, were $43.7 million and $57 million at December 31, 2018 and 2017, respectively. Borrowings under the credit agreement have been classified as current liabilities based upon the accounting rules and certain provisions in the agreement. At December 31, 2018, the weighted average interest rate on our amended credit agreement was 3.9%, which consisted of $40 million in direct borrowings at 3.4% and an alternative base rate loan of $3.7 million at 5.8%. At December 31, 2017, the weighted average interest rate on our credit agreement was 2.7%, which consisted of $57 million in direct borrowings. Our average daily alternative base rate loan balance was $1.8 million and $3.8 million during 2018 and 2017, respectively. At any time that our borrowing availability is less than the greater of either (a) $25 million, or 10% of the commitments if fixed assets are not included in the borrowing base, or (b) $31.25 million, or 12.5% of the commitments if fixed assets are included in the borrowing base, the terms of the amended credit agreement provide for, among other provisions, a financial covenant requiring us, on a consolidated basis, to maintain a fixed charge coverage ratio of 1:1 at the end of each fiscal quarter (rolling four quarters). As of December 31, 2018, we were not subject to these covenants. The amended credit agreement permits us to pay cash dividends of $20 million and make stock repurchases of $20 million in any fiscal year subject to a minimum availability of $25 million. Provided specific conditions are met, the amended credit agreement also permits acquisitions, permissible debt financing, capital expenditures, and cash dividend payments and stock repurchases of greater than $20 million. Our Polish subsidiary, SMP Poland sp. z.o.o., has entered into an overdraft facility with HSBC Bank Polska S.A. (“HSBC Poland”) for Zloty 30 million (approximately $8 million). The facility, as amended, expires on December 2019. Borrowings under the overdraft facility will bear interest at a rate equal to WIBOR + 0.75% and are guaranteed by Standard Motor Products, Inc., the ultimate parent company. At December 31, 2018 and 2017, borrowings under the overdraft facility were Zloty 19.9 million (approximately $5.3 million) and Zloty 16.2 million (approximately $4.7 million), respectively. Index In order to reduce our accounts receivable balances and improve our cash flow, we sell undivided interests in certain of our receivables to financial institutions. We enter these agreements at our discretion when we determine that the cost of factoring is less than the cost of servicing our receivables with existing debt. Under the terms of the agreements, we retain no rights or interest, have no obligations with respect to the sold receivables, and do not service the receivables after the sale. As such, these transactions are being accounted for as a sale. Pursuant to these agreements, we sold $720 million and $780.5 million of receivables for the years ended December 31, 2018 and 2017, respectively, which was reflected as a reduction of accounts receivable in the consolidated balance sheet at the time of sale. A charge in the amount of $24.4 million, $22.6 million and $19.3 million related to the sale of receivables is included in selling, general and administrative expenses in our consolidated statements of operations for the years ended December 31, 2018, 2017 and 2016, respectively. If we do not enter into these arrangements or if any of the financial institutions with which we enter into these arrangements were to experience financial difficulties or otherwise terminate these arrangements, our financial condition, results of operations and cash flows could be materially and adversely affected by delays or failures to collect future trade accounts receivable. During 2015, our Board of Directors authorized the purchase of up to $20 million of our common stock under stock repurchase programs. Under these programs, during the years ended December 31, 2015 and 2016, we repurchased 551,791 and 10,135 shares of our common stock, respectively, in the open market at a total cost of $19.6 million and $0.4 million, respectively, thereby completing the 2015 Board of Directors’ authorizations. Our Board of Directors did not authorize a stock repurchase program in 2016. During 2017, our Board of Directors authorized the purchase of up to $30 million of our common stock under stock repurchase programs. Under these programs, during the years ended December 31, 2017 and 2018, we repurchased 539,760 and 112,307 shares of our common stock, respectively, in the open market at a total cost of $24.8 million and $5.2 million, respectively, thereby completing the 2017 Board of Directors’ authorizations. In May 2018, our Board of Directors authorized the purchase of up to an additional $20 million of our common stock under a new stock repurchase program. Stock will be purchased from time to time, in the open market or through private transactions, as market conditions warrant. Under this program, during the year ended December 31, 2018, we repurchased 201,484 shares of our common stock at a total cost of $9.3 million. As of December 31, 2018, there was approximately $10.7 million available for future stock purchases under the program. During the period from January 1, 2019 through February 15, 2019, we have not repurchased any additional shares of our common stock under the program. We anticipate that our cash flow from operations, available cash and available borrowings under our revolving credit facility will be adequate to meet our future liquidity needs for at least the next twelve months. Significant assumptions underlie this belief, including, among other things, that there will be no material adverse developments in our business, liquidity or capital requirements. If material adverse developments were to occur in any of these areas, there can be no assurance that our business will generate sufficient cash flow from operations, or that future borrowings will be available to us under our revolving credit facility in amounts sufficient to enable us to pay the principal and interest on our indebtedness, or to fund our other liquidity needs. In addition, if we default on any of our indebtedness, or breach any financial covenant in our revolving credit facility, our business could be adversely affected. Index The following table summarizes our contractual commitments as of December 31, 2018 and expiration dates of commitments through 2028 (a) (b) (c): (a) Indebtedness under our revolving credit facilities is not included in the table above as it is reported as a current liability in our consolidated balance sheets. As of December 31, 2018, amounts outstanding under our revolving credit facilities were $43.7 million. (b) We anticipate total aggregate future severance payments of approximately $0.7 million related to the plant rationalization program and the Orlando plant rationalization program. All programs are substantially completed as of December 31, 2018. (c) Effective January 1, 2019, upon the adoption of ASU 2016-02, Leases, lease obligations will be recorded as a liability on our consolidated balance sheet. Critical Accounting Policies We have identified the policies below as critical to our business operations and the understanding of our results of operations. The impact and any associated risks related to these policies on our business operations is discussed throughout “Management’s Discussion and Analysis of Financial Condition and Results of Operations,” where such policies affect our reported and expected financial results. For a detailed discussion on the application of these and other accounting policies, see Note 1 of the notes to our consolidated financial statements. You should be aware that preparation of our consolidated annual and quarterly financial statements requires us to make estimates and assumptions that affect the reported amount of assets and liabilities, disclosure of contingent assets and liabilities at the date of our consolidated financial statements, and the reported amounts of revenue and expenses during the reporting periods. We can give no assurance that actual results will not differ from those estimates. Although we do not believe that there is a reasonable likelihood that there will be a material change in the future estimate or in the assumptions that we use in calculating the estimate, unforeseen changes in the industry, or business could materially impact the estimate and may have a material adverse effect on our business, financial condition and results of operations. Revenue Recognition. We derive our revenue primarily from sales of replacement parts for motor vehicles from both our Engine Management and Temperature Control Segments. We recognize revenues when our performance obligation has been satisfied and the control of products has been transferred to a customer which typically occurs upon shipment. Revenue is measured as the amount of consideration we expect to receive in exchange for the transfer of goods or providing services. The amount of consideration we receive and revenue we recognize depends on the marketing incentives, product warranty and overstock returns we offer to our customers. For certain of our sales of remanufactured products, we also charge our customers a deposit for the return of a used core component which we can use in our future remanufacturing activities. Such deposit is not recognized as revenue at the time of the sale but rather carried as a core liability. At the same time, we estimate the core expected to be returned from the customer and record the estimated return as unreturned customer inventory. The liability is extinguished when a core is actually returned to us, or at period end when we estimate and recognize revenue for the core deposits not expected to be returned. We estimate and record provisions for cash discounts, quantity rebates, sales returns and warranties in the period the sale is recorded, based upon our prior experience and current trends. Significant management judgments and estimates must be made and used in estimating sales returns and allowances relating to revenue recognized in any accounting period. Index Sales Returns and Other Allowances and Allowance for Doubtful Accounts. Many of our products carry a warranty ranging from a 90-day limited warranty to a lifetime limited warranty, which generally covers defects in materials or workmanship and failure to meet industry published specifications and/or the result of installation error. In addition to warranty returns, we also permit our customers to return new, undamaged products to us within customer-specific limits (which are generally limited to a specified percentage of their annual purchases from us) in the event that they have overstocked their inventories. At the time products are sold, we accrue a liability for product warranties and overstock returns as a percentage of sales based upon estimates established using historical information on the nature, frequency and average cost of the claim and the probability of the customer return. At the same time, we record an estimate of anticipated customer returns as unreturned customer inventory. Significant judgments and estimates must be made and used in connection with establishing the sales returns and other allowances in any accounting period. Revision to these estimates is made when necessary, based upon changes in these factors. We regularly study trends of such claims. At December 31, 2018, the allowance for sales returns was $57.4 million. Similarly, we must make estimates of the uncollectability of our accounts receivable. We specifically analyze accounts receivable and analyze historical bad debts, customer concentrations, customer credit-worthiness, current economic trends and changes in our customer payment terms when evaluating the adequacy of the allowance for doubtful accounts. At December 31, 2018, the allowance for doubtful accounts and for discounts was $5.7 million. New Customer Acquisition Costs. New customer acquisition costs refer to arrangements pursuant to which we incur change-over costs to induce a new customer to switch from a competitor’s brand. In addition, change-over costs include the costs related to removing the new customer’s inventory and replacing it with our inventory commonly referred to as a stocklift. New customer acquisition costs are recorded as a reduction to revenue when incurred. Inventory Valuation. Inventories are valued at the lower of cost and net realizable value. Cost is determined on the first-in, first-out basis. Where appropriate, standard cost systems are utilized for purposes of determining cost; the standards are adjusted as necessary to ensure they approximate actual costs. Estimates of lower of cost and net realizable value of inventory are determined by comparing the actual cost of the product to the estimated selling prices in the ordinary course of business less reasonably predictable costs of completion, disposal and transportation of the inventory. We also evaluate inventories on a regular basis to identify inventory on hand that may be obsolete or in excess of current and future projected market demand. For inventory deemed to be obsolete, we provide a reserve on the full value of the inventory. Inventory that is in excess of current and projected use is reduced by an allowance to a level that approximates our estimate of future demand. Future projected demand requires management judgment and is based upon (a) our review of historical trends and (b) our estimate of projected customer specific buying patterns and trends in the industry and markets in which we do business. Using rolling twelve month historical information, we estimate future demand on a continuous basis. As such, the historical volatility of such estimates has been minimal. We utilize cores (used parts) in our remanufacturing processes for air conditioning compressors, diesel injectors, and diesel pumps. The production of air conditioning compressors, diesel injectors, and diesel pumps involves the rebuilding of used cores, which we acquire either in outright purchases from used parts brokers or from returns pursuant to an exchange program with customers. Under such exchange programs, at the time of sale of air conditioning compressors, diesel injectors, and diesel pumps, we estimate the core expected to be returned from the customer and record the estimated return as unreturned customer inventory. In addition, many of our customers can return inventory to us based upon customer warranty and overstock arrangements within customer specific limits. At the time products are sold, we accrue a liability for product warranties and overstock returns and record as unreturned customer inventory our estimate of anticipated customer returns. Estimates are based upon historical information on the nature, frequency and probability of the customer return. Unreturned core, warranty and overstock customer inventory is recorded at standard cost. Revision to these estimates is made when necessary, based upon changes in these factors. We regularly study trends of such claims. Index Accounting for Income Taxes. As part of the process of preparing our consolidated financial statements, we are required to estimate our income taxes in each of the jurisdictions in which we operate. This process involves estimating our actual current tax expense together with assessing temporary differences resulting from differing treatment of items for tax and accounting purposes. These differences result in deferred tax assets and liabilities, which are included within our consolidated balance sheet. We must then assess the likelihood that our deferred tax assets will be recovered from future taxable income, and to the extent we believe that it is more likely than not that the deferred tax assets will not be recovered, we must establish a valuation allowance. To the extent we establish a valuation allowance or increase or decrease this allowance in a period, we must include an expense or recovery, respectively, within the tax provision in the statement of operations. We maintain valuation allowances when it is more likely than not that all or a portion of a deferred tax asset will not be realized. In determining whether a valuation allowance is warranted, we evaluate factors such as prior earnings history, expected future earnings, carryback and carryforward periods and tax strategies. We consider all positive and negative evidence to estimate if sufficient future taxable income will be generated to realize the deferred tax asset. We consider cumulative losses in recent years as well as the impact of one-time events in assessing our pre-tax earnings. Assumptions regarding future taxable income require significant judgment. Our assumptions are consistent with estimates and plans used to manage our business, which includes restructuring and integration initiatives that are expected to generate significant savings in future periods. The valuation allowance of $0.4 million as of December 31, 2018 is intended to provide for the uncertainty regarding the ultimate realization of our U.S. foreign tax credit carryovers and foreign net operating loss carryovers. The assessment of the adequacy of our valuation allowance is based on our estimates of taxable income in these jurisdictions and the period over which our deferred tax assets will be recoverable. Based on these considerations, we believe it is more likely than not that we will realize the benefit of the net deferred tax asset of $42.3 million as of December 31, 2018, which is net of the remaining valuation allowance. In the event that actual results differ from these estimates, or we adjust these estimates in future periods for current trends or expected changes in our estimating assumptions, we may need to modify the level of the valuation allowance which could materially impact our business, financial condition and results of operations. In accordance with generally accepted accounting practices, we recognize in our financial statements only those tax positions that meet the more-likely-than-not recognition threshold. We establish tax reserves for uncertain tax positions that do not meet this threshold. During the years ended December 31, 2018, 2017 and 2016, we did not establish a liability for uncertain tax positions. Penalties and interest associated with income tax matters are included in the provision for income taxes in our consolidated statement of operations. In December 2017, the U.S. enacted the Tax Cuts and Jobs Act (“the Act”), which included a broad range of tax reform affecting businesses, including the reduction of the federal corporate tax rate from 35% to 21%, changes in the deductibility of certain business expenses, and the manner in which international operations are taxed in the U.S. For a discussion of the impact of the Act on our consolidated financial statements, see Note 19, “Income Taxes,” of the notes to our consolidated financial statements. Valuation of Long-Lived and Intangible Assets and Goodwill. At acquisition, we estimate and record the fair value of purchased intangible assets, which primarily consists of customer relationships, trademarks and trade names, patents and non-compete agreements. The fair values of these intangible assets are estimated based on our assessment. Goodwill is the excess of the purchase price over the fair value of identifiable net assets acquired in business combinations. Goodwill and certain other intangible assets having indefinite lives are not amortized to earnings, but instead are subject to periodic testing for impairment. Intangible assets determined to have definite lives are amortized over their remaining useful lives. Index We assess the impairment of long-lived assets, identifiable intangibles assets and goodwill whenever events or changes in circumstances indicate that the carrying value may not be recoverable. With respect to goodwill and identifiable intangible assets having indefinite lives, we test for impairment on an annual basis or in interim periods if an event occurs or circumstances change that may indicate the fair value is below its carrying amount. Factors we consider important, which could trigger an impairment review, include the following: (a) significant underperformance relative to expected historical or projected future operating results; (b) significant changes in the manner of our use of the acquired assets or the strategy for our overall business; and (c) significant negative industry or economic trends. We review the fair values using the discounted cash flows method and market multiples. When performing our evaluation of goodwill for impairment, if we conclude qualitatively that it is not more likely than not that the fair value of the reporting unit is less than its carrying amount, than the two-step impairment test is not required. If we are unable to reach this conclusion, then we would perform the two-step impairment test. Initially, the fair value of the reporting unit is compared to its carrying amount. To the extent the carrying amount of a reporting unit exceeds the fair value of the reporting unit; we are required to perform a second step, as this is an indication that the reporting unit goodwill may be impaired. In this step, we compare the implied fair value of the reporting unit goodwill with the carrying amount of the reporting unit goodwill and recognize a charge for impairment to the extent the carrying value exceeds the implied fair value. The implied fair value of goodwill is determined by allocating the fair value of the reporting unit to all of the assets (recognized and unrecognized) and liabilities of the reporting unit in a manner similar to a purchase price allocation. The residual fair value after this allocation is the implied fair value of the reporting unit goodwill. In addition, identifiable intangible assets having indefinite lives are reviewed for impairment on an annual basis using a methodology similar with that used to evaluate goodwill. Intangible assets having definite lives and other long-lived assets are reviewed for impairment whenever events such as product discontinuance, plant closures, product dispositions or other changes in circumstances indicate that the carrying amount may not be recoverable. In reviewing for impairment, we compare the carrying value of such assets to the estimated undiscounted future cash flows expected from the use of the assets and their eventual disposition. When the estimated undiscounted future cash flows are less than their carrying amount, an impairment loss is recognized equal to the difference between the assets fair value and their carrying value. There are inherent assumptions and estimates used in developing future cash flows requiring our judgment in applying these assumptions and estimates to the analysis of identifiable intangibles and long-lived asset impairment including projecting revenues, interest rates, tax rates and the cost of capital. Many of the factors used in assessing fair value are outside our control and it is reasonably likely that assumptions and estimates will change in future periods. These changes can result in future impairments. In the event our planning assumptions were modified resulting in impairment to our assets, we would be required to include an expense in our statement of operations, which could materially impact our business, financial condition and results of operations. Share-Based Compensation. The provisions of FASB ASC 718, Stock Compensation, require the measurement and recognition of compensation expense for all share-based payment awards made to employees and directors based on estimated fair values on the grant date. The value of the portion of the award that is ultimately expected to vest is recognized as expense on a straight-line basis over the requisite service periods in our condensed consolidated statement of operations. Forfeitures are estimated at the time of grant based on historical trends in order to estimate the amount of share-based awards that will ultimately vest. We monitor actual forfeitures for any subsequent adjustment to forfeiture rates. Environmental Reserves. We are subject to various U.S. Federal, state and local environmental laws and regulations and are involved in certain environmental remediation efforts. We estimate and accrue our liabilities resulting from such matters based upon a variety of factors including the assessments of environmental engineers and consultants who provide estimates of potential liabilities and remediation costs. Such estimates are not discounted to reflect the time value of money due to the uncertainty in estimating the timing of the expenditures, which may extend over several years. Potential recoveries from insurers or other third parties of environmental remediation liabilities are recognized independently from the recorded liability, and any asset related to the recovery will be recognized only when the realization of the claim for recovery is deemed probable. Index Asbestos Litigation. In evaluating our potential asbestos-related liability, we use an actuarial study that is prepared by a leading actuarial firm with expertise in assessing asbestos-related liabilities. We evaluate the estimate of the range of undiscounted liability to determine which amount to accrue. Based on the information contained in the actuarial study and all other available information considered by us, we have concluded that no amount within the range was more likely than any other and, therefore, in assessing our asbestos liability we compare the low end of the range to our recorded liability to determine if an adjustment is required. Legal costs are expensed as incurred. We will continue to perform an annual actuarial analysis during the third quarter of each year for the foreseeable future, and whenever events or changes in circumstances indicate that additional provisions may be necessary. Based on the actuarial studies and all other available information, we will continue to reassess the recorded liability and, if deemed necessary, record an adjustment to the reserve, which will be reflected as a loss or gain from discontinued operations. See Note 23, “Commitments and Contingencies,” of the Notes to Consolidated Financial Statements in Item 8 of this Report for additional information. Other Loss Reserves. We have other loss exposures, for such matters as legal claims and legal proceedings. Establishing loss reserves for these matters requires estimates, judgment of risk exposure, and ultimate liability. We record provisions when the liability is considered probable and reasonably estimable. Significant judgment is required in both the determination of probability and the determination as to whether an exposure can be reasonably estimated. As additional information becomes available, we reassess our potential liability related to these matters. Such revisions of the potential liabilities could have a material adverse effect on our business, financial condition or results of operations. Recently Issued Accounting Pronouncements For a detailed discussion on recently issued accounting pronouncements and their impact on our consolidated financial statements, see Note 1, “Summary of Significant Accounting Policies” of the Notes to Consolidated Financial Statements in Item 8 of this Report. Index

<s>[INST] The following discussion should be read in conjunction with our consolidated financial statements and the notes thereto. This discussion summarizes the significant factors affecting our results of operations and the financial condition of our business during each of the fiscal years in the threeyear period ended December 31, 2018. Overview We are a leading independent manufacturer and distributor of premium replacement parts for the engine management and temperature control systems of motor vehicles in the automotive aftermarket industry with a complementary focus on heavy duty, industrial equipment and the original equipment market. We are organized into two operating segments. Each segment focuses on providing our customers with fullline coverage of premium engine management or temperature control products, and a full suite of complimentary services that are tailored to our customers’ business needs and driving enduser demand for our products. We sell our products primarily to automotive aftermarket retailers, program distribution groups, warehouse distributors, original equipment manufacturers and original equipment service part operations in the United States, Canada, Mexico, Europe, Asia and other Latin American countries. Our Business Strategy Our mission is to be the bestinclass, fullline, fullservice supplier of premium engine management and temperature control products. The key elements of our strategy are as follows: · Maintain Our Strong Competitive Position in our Engine Management and Temperature Control Businesses. We are a leading independent manufacturer and distributor serving North America and other geographic areas in our core businesses of Engine Management and Temperature Control. We believe that our success is attributable to our emphasis on product quality, the breadth and depth of our product lines for both domestic and import vehicles, and our reputation for outstanding valueadded services. To maintain our strong competitive position, we remain committed to the following: · providing our customers with fullline coverage of high quality engine management and temperature control products, supported by the highest level of valueadded services; · continuing to maximize our production, supply chain and distribution efficiencies; · continuing to improve our cost position through increased global sourcing, increased manufacturing at our lowcost plants, and strategic transactions with manufacturers in lowcost regions; and · focusing on our engineering development efforts including a focus on bringing more product manufacturing inhouse. · Provide Superior ValueAdded Services and Product Availability. Our goal is to increase sales to existing and new customers by leveraging our skills in rapidly filling orders, maintaining high levels of product availability and offering a product portfolio that provides comprehensive coverage for all vehicle applications. In addition, our marketing support provides insightful customer category management, technical support and awardwinning programs, and our technically skilled sales personnel provide our customers with product selection, assortment and application support, and technical training on diagnosing and repairing vehicles equipped with complex systems related to our products. Index · Expand Our Product Lines. We intend to increase our sales by continuing to develop internally, or through potential acquisitions, the range of engine management and temperature control products that we offer to our customers. We are committed to investing the resources necessary to maintain and expand our technical capability to manufacture product lines that incorporate the latest technologies, including product lines relating to safety, advanced driver assistance and collision avoidance systems. · Broaden Our Customer Base. Our goal is to increase our customer base by (a) leveraging our manufacturing capabilities to secure additional business globally with original equipment vehicle and equipment manufacturers and their service part operations, as well as our existing customer base of large retailers, program distribution groups, warehouse distributors, other manufacturers and export customers, and (b) supporting the service part operations of vehicle and equipment manufacturers with valueadded services and product support for the life of the part. · Improve Operating Efficiency and Cost Position. Our management places significant emphasis on improving our financial performance by achieving operating efficiencies and improving asset utilization, while maintaining product quality and high customer order fill rates. We intend to continue to improve our operating efficiency and cost position by: · increasing costeffective vertical integration in key product lines through internal development; · focusing on integrated supply chain management, customer collaboration and vendor managed inventory initiatives; · evaluating additional opportunities to relocate manufacturing to our lowcost plants; · maintaining and improving our cost effectiveness and competitive responsiveness to better serve our customer base, including sourcing certain materials and products from low cost regions such as [/INST] Positive. </s>

STANDARD MOTOR PRODUCTS, INC.

2020-02-20

2019-12-31

ITEM 7. MANAGEMENT’S DISCUSSION AND ANALYSIS OF FINANCIAL CONDITION AND RESULTS OF OPERATIONS The following discussion should be read in conjunction with our consolidated financial statements and the notes thereto. This discussion summarizes the significant factors affecting our results of operations and the financial condition of our business during each of the fiscal years in the three-year period ended December 31, 2019. Overview We are a leading independent manufacturer and distributor of premium replacement parts for the engine management and temperature control systems of motor vehicles in the automotive aftermarket industry with a complementary focus on the heavy duty, industrial equipment and original equipment markets. We are organized into two operating segments. Each segment focuses on providing our customers with full-line coverage of its products, and a full suite of complimentary services that are tailored to our customers’ business needs and driving end-user demand for our products. We sell our products primarily to automotive aftermarket retailers, program distribution groups, warehouse distributors, original equipment manufacturers and original equipment service part operations in the United States, Canada, Europe, Asia, Mexico and other Latin American countries. Our Business Strategy Our mission is to be the best full-line, full-service supplier of premium engine management and temperature control products. The key elements of our strategy are as follows: ● Maintain Our Strong Competitive Position in our Engine Management and Temperature Control Businesses. We are a leading independent manufacturer and distributor serving North America and other geographic areas in our core businesses of Engine Management and Temperature Control. We believe that our success is attributable to our emphasis on product quality, the breadth and depth of our product lines for both domestic and import vehicles, and our reputation for outstanding value-added services. To maintain our strong competitive position, we remain committed to the following: ● providing our customers with full-line coverage of high quality engine management and temperature control products, supported by the highest level of value-added services; ● continuing to maximize our production, supply chain and distribution efficiencies; ● continuing to improve our cost position through increased global sourcing, increased manufacturing at our low-cost plants, and strategic transactions with manufacturers in low-cost regions; and ● focusing on our engineering development efforts including a focus on bringing more product manufacturing in-house. ● Provide Superior Value-Added Services and Product Availability. Our goal is to increase sales to existing and new customers by leveraging our skills in rapidly filling orders, maintaining high levels of product availability and offering a product portfolio that provides comprehensive coverage for all vehicle applications. In addition, our marketing support provides insightful customer category management, technical support and award-winning programs, and our technically skilled sales personnel provide our customers with product selection, assortment and application support, and technical training on diagnosing and repairing vehicles equipped with complex systems related to our products. Index ● Expand Our Product Lines. We intend to increase our sales by continuing to develop internally, or through potential acquisitions, the range of engine management and temperature control products that we offer to our customers. We are committed to investing the resources necessary to maintain and expand our technical capability to manufacture product lines that incorporate the latest technologies, including product lines relating to safety, advanced driver assistance and collision avoidance systems. ● Broaden Our Customer Base. Our goal is to increase our customer base by (a) leveraging our manufacturing capabilities to secure additional business globally with original equipment vehicle and equipment manufacturers and their service part operations, as well as our existing customer base of large retailers, program distribution groups, warehouse distributors, other manufacturers and export customers, and (b) supporting the service part operations of vehicle and equipment manufacturers with value-added services and product support for the life of the part. ● Improve Operating Efficiency and Cost Position. Our management places significant emphasis on improving our financial performance by achieving operating efficiencies and improving asset utilization, while maintaining product quality and high customer order fill rates. We intend to continue to improve our operating efficiency and cost position by: ● increasing cost-effective vertical integration in key product lines through internal development; ● focusing on integrated supply chain management, customer collaboration and vendor managed inventory initiatives; ● evaluating additional opportunities to relocate manufacturing to our low-cost plants; ● maintaining and improving our cost effectiveness and competitive responsiveness to better serve our customer base, including sourcing certain materials and products from low cost regions such as those in Asia without compromising product quality; ● enhancing company-wide programs geared toward manufacturing and distribution efficiency; and ● focusing on company-wide overhead and operating expense cost reduction programs. ● Cash Utilization. We intend to apply any excess cash flow from operations and the management of working capital primarily to reduce our outstanding indebtedness, pay dividends to our shareholders, expand our product lines by investing in new tooling and equipment, grow revenues through potential acquisitions and repurchase shares of our common stock. The Automotive Aftermarket The automotive aftermarket industry is comprised of a large number of diverse manufacturers varying in product specialization and size. In addition to manufacturing, aftermarket companies must allocate resources towards an efficient distribution process in order to maintain the flexibility and responsiveness on which their customers depend. Aftermarket manufacturers must be efficient producers of small lot sizes, and must distribute, with rapid turnaround times, products for nearly all domestic and import vehicles on the road today. Index The automotive aftermarket replacement parts business differs substantially from the OEM parts business. Unlike the OEM parts business that primarily follows trends in new car production, the automotive aftermarket replacement parts business primarily tends to follow different trends, such as: ● the number of vehicles on the road; ● the average age of vehicles on the road; and ● the total number of miles driven per year. Seasonality. Historically, our operating results have fluctuated by quarter, with the greatest sales occurring in the second and third quarters of the year and revenues generally being recognized at the time of shipment. It is in these quarters that demand for our products is typically the highest, specifically in the Temperature Control Segment of our business. In addition to this seasonality, the demand for our Temperature Control products during the second and third quarters of the year may vary significantly with the summer weather and customer inventories. For example, a warm summer, as we experienced in 2018, may increase the demand for our temperature control products, while a mild summer, as we experienced in 2017, may lessen such demand. As a result of this seasonality and variability in demand of our Temperature Control products, our working capital requirements typically peak near the end of the second quarter, as the inventory build-up of air conditioning products is converted to sales and payments on the receivables associated with such sales have yet to be received. During this period, our working capital requirements are typically funded by borrowing from our revolving credit facility. Inventory Management. We face inventory management issues as a result of overstock returns. We permit our customers to return new, undamaged products to us within customer-specific limits (which are generally limited to a specified percentage of their annual purchases from us) in the event that they have overstocked their inventories. In addition, the seasonality of our Temperature Control Segment requires that we increase our inventory during the winter season in preparation of the summer selling season and customers purchasing such inventory have the right to make returns. We accrue for overstock returns as a percentage of sales after giving consideration to recent returns history. Discounts, Allowances, and Incentives. We offer a variety of usual customer discounts, allowances and incentives. First, we offer cash discounts for paying invoices in accordance with the specified discount terms of the invoice. Second, we offer pricing discounts based on volume purchased from us and participation in our cost reduction initiatives. These discounts are principally in the form of “off-invoice” discounts and are immediately deducted from sales at the time of sale. For those customers that choose to receive a payment on a quarterly basis instead of “off-invoice,” we accrue for such payments as the related sales are made and reduce sales accordingly. Finally, rebates and discounts are provided to customers as advertising and sales force allowances, and allowances for warranty and overstock returns are also provided. Management analyzes historical returns, current economic trends, and changes in customer demand when evaluating the adequacy of the sales returns and other allowances. Significant management judgments and estimates must be made and used in connection with establishing the sales returns and other allowances in any accounting period. We account for these discounts and allowances as a reduction to revenues, and record them when sales are recorded. Impact of Changes in U.S. Trade Policy Changes in U.S. trade policy, particularly as it relates to China, as with much of our industry, have resulted in the assessment of increased tariffs on goods that we import into the United States. Although our operating results in 2019 have been slightly impacted by the timing of Chinese sourced products, we have taken, and continue to take, several actions to mitigate the impact of the increased tariffs, including but not limited to, price increases to our customers. We do not anticipate that the increased tariffs will have a significant impact on our future operating results. Although we are confident that we will be able to pass along the impact of the increased tariffs to our customers, there can be no assurances that we will be able to pass on the entire increased costs imposed by the tariffs. Index Comparison of Results of Operations For Fiscal Years 2019 and 2018 Sales. Consolidated net sales for 2019 were $1,137.9 million, an increase of $45.8 million, or 4.2%, compared to $1,092.1 million in the same period of 2018, with the majority of our net sales to customers located in the United States. Consolidated net sales increased in our Engine Management Segment and were essentially flat year-over-year in our Temperature Control Segment. The following table summarizes consolidated net sales by segment and by major product group within each segment for the years ended December 31, 2019 and 2018 (in thousands): Engine Management’s net sales increased $45.7 million, or 5.7%, to $849.2 million for the year ended December 31, 2019. Net sales in ignition, emission control, fuel and safety related system products for the year ended December 31, 2019 were $706 million, an increase of $57.7 million, or 8.9%, compared to $648.3 million in the same period of 2018. Net sales in the wire and cable product group for the year ended December 31, 2019 were $143.2 million, a decrease of $12 million, or 7.7%, compared to $155.2 million in the same period of 2018. Engine Management’s increase in net sales for the year ended December 31, 2019 compared to the same period in 2018 primarily reflects the impact of incremental sales from our April 2019 acquisition of certain assets and liabilities of the Pollak business of Stoneridge, Inc., as well as pipeline orders from several customers, general price increases, tariff costs passed on to customers, and low single digit organic growth. Engine Management’s year-over-year increase in net sales was offset, in part, by the general decline in our wire and cable business due to its product lifecycle. Incremental sales from our acquisition of the Pollak business of $28.2 million were included in the net sales of the ignition, emission control, fuel and safety related system products market from the date of acquisition through December 31, 2019. Compared to the year ended December 31, 2018, excluding the incremental net sales from the acquisition, net sales in the ignition, emission control, fuel and safety related system products market increased $29.5 million, or 4.6%, and Engine Management net sales increased $17.5 million, or 2.2%. Temperature Control’s net sales of $278.4 million for the year ended December 31, 2019 were essentially flat when compared to the same period in 2018. Net sales in the compressors product group for the year ended December 31, 2019 were $160.5 million, an increase of $12.1 million, or 8.1%, compared to $148.4 million in the same period of 2018. Net sales in the other climate control parts group for the year ended December 31, 2019 were $117.9 million, a decrease of $12.1 million, or 9.3%, compared to $130 million for the year ended December 31, 2018. Temperature Control’s net sales for the year ending December 31, 2019 when compared to the same period in 2018, reflect the impact of (1) increased year-over-year net sales during the first six months of 2019 due to strong pre-season orders as customers rebuilt their inventory levels after a very strong 2018 selling season; (2) lower year-over-year net sales during the second half of 2019 as customer ordering patterns normalized in 2019 as compared to the same period in 2018, when customer orders strengthened in June and continued throughout the second half of 2018 after a slow start to the 2018 season; and (3) to a lesser extent incremental pricing for tariff costs passed on to customers. In addition, the decline in net sales in the other climate control parts product group results from the impact of the introduction of air conditioner repair kits, which are sold as a complete repair kit inclusive of the compressor and other climate control parts. These air conditioner repair kits are classified as sales under the compressor product group, resulting in a shift in reported sales from the other climate control parts product group into the compressor product group. Demand for our Temperature Control products may vary significantly with summer weather conditions and customer inventory levels. Index Margins. Gross margins, as a percentage of consolidated net sales, increased to 29.2% for 2019, compared to 28.6% for 2018. The following table summarizes gross margins by segment for the years ended December 31, 2019 and 2018, respectively (in thousands): (a) Segment net sales include intersegment sales in our Engine Management and Temperature Control segments. Compared to 2018, gross margins at Engine Management increased 1 percentage point from 28.6% to 29.6%, while gross margins at Temperature Control decreased 0.1 percentage point from 25.3% to 25.2%. The gross margin percentage increase in Engine Management compared to the prior year reflects our return to historical productivity in our Reynosa, Mexico wire plant after the lengthy integration of the General Cable wire business, a continued emphasis on cost reductions, as well as certain pricing actions, which more than offset the negative impact of tariff costs passed on to customers without any markup. The gross margin percentage decrease in Temperature Control compared to the prior year resulted primarily from the negative impact of tariffs passed on to customers without any markup. Selling, General and Administrative Expenses. Selling, general and administrative expenses (“SG&A”) increased to $234.7 million, or 20.6% of consolidated net sales in 2019, as compared to $231.3 million, or 21.2% of consolidated net sales in 2018. The $3.4 million increase in SG&A expenses as compared to 2018 reflects the impact of (1) incremental expenses of $4.3 million from our acquisition of certain assets and liabilities of the Pollak business of Stoneridge, Inc., including amortization of intangible assets acquired; and (2) higher selling and marketing expenses, and other general and administrative costs, which were offset by lower distribution expenses primarily at Temperature Control and lower costs incurred related to our accounts receivable supply chain financing arrangements. Higher than usual distribution expenses at Temperature Control in 2018 were due to a combination of significant additional labor costs to meet the surge in sales in the third and fourth quarters of 2018, as well as start-up costs related to the installation of a new automation project in our distribution center. The automation project has yielded significant savings in 2019 compared to 2018. Restructuring and Integration Expenses. Restructuring and integration expenses were $2.6 million in 2019 compared to restructuring and integration expenses of $4.5 million in 2018. Restructuring and integration expenses incurred in 2019 of $2.6 million consisted of $2.2 million of expenses related to relocation of certain inventory, machinery and equipment acquired in our April 2019 acquisition of the Pollak business of Stoneridge, Inc. to our existing facilities and the $0.4 million increase in environmental cleanup costs for the ongoing monitoring and remediation at our Long Island City, New York former manufacturing facility; while restructuring and integration expenses incurred in 2018 of $4.5 million consisted of $3.2 million of expenses related to the Plant Rationalization Program that commenced in February 2016, the Orlando Plant Rationalization Program that commenced in January 2017, and the wire and cable relocation program announced in October 2016, all of which were substantially completed as of December 31, 2018, and the $1.3 million increase in environmental cleanup costs for the ongoing monitoring and remediation in connection at our Long Island City, New York former manufacturing facility. Index Other Income (Expense), Net. Other expense, net was $5,000 in 2019 compared to other income, net of $4.3 million in 2018. During the year ended December 31, 2018, we recognized a $3.9 million gain on the sale of our property located in Grapevine, Texas, and a $0.2 million deferred gain related to the sale-leaseback of our Long Island City, New York facility. The recognition of the deferred gain related to the sale-leaseback of our Long Island City, New York facility ended in the first quarter of 2018 upon the termination of the initial 10-year lease term for the facility. Operating Income. Operating income was $94.5 million in 2019, compared to $81.3 million in 2018. The year-over-year increase in operating income of $13.2 million is the result of the impact of higher consolidated net sales, higher gross margins as a percentage of consolidated net sales, and lower restructuring and integration expenses offset, in part, by higher SG&A expenses and lower other income (expense), net. Other Non-Operating Income (Expense), Net. Other non-operating income, net was $2.6 million in 2019, compared to other non-operating expense, net of $0.4 million in 2018. Included in other non-operating expense, net in 2018 is a noncash impairment charge of approximately $1.7 million related to our minority interest investment in Orange Electronics Co., Ltd. Excluding the year-over-year impact of the noncash impairment charge, the year-over-year increase in other non-operating income (expense), net of $1.3 million resulted primarily from the increase in year-over-year equity income from our joint ventures offset, in part, by the unfavorable impact of changes in foreign currency exchange rates. Interest Expense. Interest expense was $5.3 million in 2019 compared to $4 million in 2018. The year-over-year increase in interest expense reflects the impact of both higher average outstanding borrowings during 2019 when compared to 2018, and the higher year-over-year average interest rates on our revolving credit facility. The higher year-over-year average outstanding borrowings during 2019 resulted primarily from the timing of the acquisition of the Pollak business of Stoneridge, Inc. Income Tax Provision. The income tax provision for 2019 was $22.7 million at an effective tax rate of 24.8%, compared to $20 million at an effective tax rate of 26% in 2018. The lower effective tax rate in 2019 compared to 2018 results primarily from a change in the mix of U.S. and foreign income. Loss from Discontinued Operations. Loss from discontinued operations, net of income tax, reflects information contained in the actuarial studies performed as of August 31, 2019, and as of August 31, 2018 (which was revised to reflect the events occurring through November 30, 2018), other information available and considered by us, and legal expenses and other costs associated with our asbestos-related liability. During the years ended December 31, 2019 and 2018, we recorded a net loss of $11.1 million and $13.9 million from discontinued operations, respectively. The loss from discontinued operations for the year ended December 31, 2019 and 2018 includes a $9.7 million and $13.6 million pre-tax provision, respectively, to increase our indemnity liability in line with the 2019 and 2018 actuarial studies; and legal expenses, before taxes, of $4.7 million and $5.1 million during 2019 and 2018, respectively. As discussed more fully in Note 22 “Commitments and Contingencies” in the notes to our consolidated financial statements, we are responsible for certain future liabilities relating to alleged exposure to asbestos containing products. Comparison of Results of Operations For Fiscal Years 2018 and 2017 For a detailed discussion on the comparison of fiscal year 2018 to fiscal year 2017, see Item 7 “Management’s Discussion and Analysis of Financial Condition and Results of Operations” in the Company’s Annual Report on Form 10-K for the fiscal year ended December 31, 2018. Index Restructuring and Integration Programs The Plant Rationalization Program that commenced in February 2016, the Wire and Cable Relocation Program announced in October 2016, and the Orlando Plant Rationalization Program that commenced in January 2017, were all substantially completed as of December 31, 2018. As a result of our April 2019 acquisition of the Pollak business of Stoneridge, Inc., we incurred $2.2 million of integration expenses related to the relocation of certain inventory, machinery, and equipment from Pollak’s distribution and manufacturing facilities to our existing facilities. The Pollak relocation was substantially completed as of December 31, 2019. For a detailed discussion on the restructuring and integration costs, see Note 5, “Restructuring and Integration Expense,” of the notes to our consolidated financial statements. Liquidity and Capital Resources Operating Activities. During 2019, cash provided by operating activities was $76.9 million compared to $70.3 million in 2018. The year-over-year increase in operating cash flow is primarily the result of the increase in net earnings, the year-over-year decrease in accounts receivable compared to the year-over-year increase in accounts receivable in 2018, and the smaller year-over-year increase in inventories, offset, in part, by the year-over-year increase in prepaid expenses and other current assets compared to the year-over-year decrease in prepaid expenses and other current assets in 2018, the year-over-year decrease in accounts payable compared to the year-over-year increase in accounts payable in 2018, and the year-over-year decrease in sundry payables and accrued expenses compared to the year-over-year increase in sundry payables and accrued expenses in 2018. Net earnings during 2019, were $57.9 million compared to $43 million in 2018. During 2019, (1) the decrease in accounts receivable was $17.9 million compared to the year-over-year increase in accounts receivable of $13.7 million in 2018; (2) the increase in inventories was $17.9 million compared to the year-over-year increase in inventories of $30.2 million in 2018; (3) the increase in prepaid expenses and other current assets was $8.3 million compared to the year-over-year decrease in prepaid expenses and other current assets of $4.9 million in 2018; (4) the decrease in accounts payable was $2 million compared to the year-over-year increase in accounts payable of $16.9 million in 2018; and (5) the decrease in sundry payables and accrued expenses was $18.1 million compared to the year-over-year increase in sundry payables and accrued expenses of $8.4 million in 2018. The cash impact of the changes in sundry payables and accrued expenses relates primarily to the timing of defective and overstock customer returns, and customer core returns used in our future remanufacturing activities. We continue to actively manage our working capital to maximize our operating cash flow. Investing Activities. Cash used in investing activities was $54.8 million in 2019 compared to $29.9 million in 2018. Investing activities in 2019 consisted of (1) net cash proceeds of $4.8 million received in January 2019 from the December 2018 sale of our property in Grapevine, Texas; (2) the payment of $38.4 million for our acquisition of certain assets and liabilities of the Pollak business of Stoneridge, Inc.; (3) the payment of $5.1 million for our acquisition of an approximate 29% minority interest in Jiangsu Che Yijia New Energy Technology Co., Ltd.; and (4) capital expenditures of $16.2 million. Investing activities in 2018 consisted of (1) the payment of the third and final contribution of $5.7 million for our November 2017 acquisition of a 50% interest in Foshan FGD SMP Automotive Compressor Co., Ltd., a China-based joint venture that manufactures air conditioning compressors for the automotive aftermarket and the Chinese OE market; (2) the payment of $4.2 million for our 15% increase in equity ownership in Foshan GWO YNG SMP Vehicle Climate Control & Cooling Products Co. Ltd., a China-based joint venture that manufactures air conditioner accumulators, filter driers, hose assemblies and switches for the automotive aftermarket and OEM/OES markets; and (3) capital expenditures of $20.1 million. Financing Activities. Cash used in financing activities was $23.4 million in 2019 compared to $46.1 million in 2018. During 2019, (1) we increased borrowings under our revolving credit facility by $8.8 million; (2) we made cash payments for the repurchase of shares of our common stock of $10.7 million; and (3) we paid dividends of $20.6 million. Borrowings under our revolving credit facility in 2019, along with cash provided by operating activities, were used to fund our investing activities, purchase shares of our common stock and pay dividends. Index Cash used by finance activities was $46.1 million in 2018. During 2018, (1) we increased our borrowings under the Polish overdraft facility, net of payments under our capital lease obligations of $1.1 million; (2) we paid down borrowings under our revolving credit facility of $13.3 million; (3) we made cash payments of $14.9 million for the repurchase of our common stock; and (4) we paid dividends of $18.9 million. Cash provided by operating activities, along with borrowings under our Polish overdraft facility, net of payments under our capital lease obligations, were used to fund our investing activities, pay down borrowings under our revolving credit facility, purchase shares of our common stock and pay dividends. Dividends of $20.6 million and $18.9 million were paid in 2019 and 2018, respectively. Quarterly dividends were paid at a rate of $0.23 per share in 2019 and $0.21 per share in 2018. In January 2020, our Board of Directors voted to increase our quarterly dividend from $0.23 per share in 2019 to $0.25 per share in 2020. Comparison of Liquidity and Capital Resources For Fiscal Years 2018 and 2017 For a detailed discussion of our Liquidity and Capital Resources comparison of fiscal year 2018 to fiscal year 2017, see Item 7 “Management’s Discussion and Analysis of Financial Condition and Results of Operations” in the Company’s Annual Report on Form 10-K for the fiscal year ended December 31, 2018. Liquidity Our primary cash requirements include working capital, capital expenditures, regular quarterly dividends, stock repurchases, principal and interest payments on indebtedness and acquisitions. Our primary sources of funds are ongoing net cash flows from operating activities and availability under our secured revolving credit facility (as detailed below). In December 2018, we amended our Credit Agreement with JPMorgan Chase Bank, N.A., as agent, and a syndicate of lenders. The amended credit agreement provides for a senior secured revolving credit facility with a line of credit of up to $250 million (with an additional $50 million accordion feature) and extends the maturity date to December 2023. The line of credit under the amended agreement also allows for a $10 million line of credit to Canada as part of the $250 million available for borrowing. Direct borrowings under the amended credit agreement bear interest at LIBOR plus a margin ranging from 1.25% to 1.75% based on our borrowing availability, or floating at the alternate base rate plus a margin ranging from 0.25% to 0.75% based on our borrowing availability, at our option. The amended credit agreement is guaranteed by certain of our subsidiaries and secured by certain of our assets. Borrowings under the amended credit agreement are secured by substantially all of our assets, including accounts receivable, inventory and certain fixed assets, and those of certain of our subsidiaries. Availability under the amended credit agreement is based on a formula of eligible accounts receivable, eligible drafts presented to the banks under our supply chain financing arrangements, eligible inventory, eligible equipment and eligible fixed assets. After taking into account outstanding borrowings under the amended credit agreement, there was an additional $194.3 million available for us to borrow pursuant to the formula at December 31, 2019. Outstanding borrowings under the credit agreement, which are classified as current liabilities, were $52.5 million and $43.7 million at December 31, 2019 and 2018, respectively; while letters of credit outstanding under the credit agreement were $3.1 million at both December 31, 2019 and 2018. Borrowings under the credit agreement have been classified as current liabilities based upon accounting rules and certain provisions in the agreement. At December 31, 2019, the weighted average interest rate on our amended credit agreement was 3.5%, which consisted of $40 million in direct borrowings at 2.3% and an alternative base rate loan of $12.5 million at 5%. At December 31, 2018, the weighted average interest rate on our amended credit agreement was 3.9%, which consisted of $40 million in direct borrowings at 3.4% and an alternative base rate loan of $3.7 million at 5.8%. Our average daily alternative base rate loan balance was $1.7 million and $1.8 million during 2019 and 2018, respectively. Index At any time that our borrowing availability is less than the greater of either (a) $25 million, or 10% of the commitments if fixed assets are not included in the borrowing base, or (b) $31.25 million, or 12.5% of the commitments if fixed assets are included in the borrowing base, the terms of the amended credit agreement provide for, among other provisions, a financial covenant requiring us, on a consolidated basis, to maintain a fixed charge coverage ratio of 1:1 at the end of each fiscal quarter (rolling four quarters). As of December 31, 2019, we were not subject to these covenants. The amended credit agreement permits us to pay cash dividends of $20 million and make stock repurchases of $20 million in any fiscal year subject to a minimum availability of $25 million. Provided specific conditions are met, the amended credit agreement also permits acquisitions, permissible debt financing, capital expenditures, and cash dividend payments and stock repurchases of greater than $20 million. Our Polish subsidiary, SMP Poland sp. z.o.o., has entered into an overdraft facility with HSBC France (Spolka Akcyjna) Oddzial w Polsce, formerly HSBC Bank Polska S.A., for Zloty 30 million (approximately $7.9 million). The facility, as amended, expires in December 2020. Borrowings under the overdraft facility will bear interest at a rate equal to WIBOR + 0.75% and are guaranteed by Standard Motor Products, Inc., the ultimate parent company. At December 31, 2019 and 2018, borrowings under the overdraft facility were Zloty 16.7 million (approximately $4.4 million) and Zloty 19.9 million (approximately $5.3 million), respectively. In order to reduce our accounts receivable balances and improve our cash flow, we are party to several supply chain financing arrangements, in which we may sell certain of our customers’ trade accounts receivable to such customers’ financial institutions. We sell our undivided interests in certain of these receivables at our discretion when we determine that the cost of these arrangements is less than the cost of servicing our receivables with existing debt. Under the terms of the agreements, we retain no rights or interest, have no obligations with respect to the sold receivables, and do not service the receivables after the sale. As such, these transactions are being accounted for as a sale. Pursuant to these agreements, we sold $719 million and $720 million of receivables for the years ended December 31, 2019 and 2018, respectively, which was reflected as a reduction of accounts receivable in the consolidated balance sheet at the time of sale. A charge in the amount of $22 million, $24.4 million and $22.6 million related to the sale of receivables is included in selling, general and administrative expenses in our consolidated statements of operations for the years ended December 31, 2019, 2018 and 2017, respectively. To the extent that these arrangements are terminated, our financial condition, results of operations, cash flows and liquidity could be adversely affected by extended payment terms, delays or failures in collecting trade accounts receivables. The utility of the supply chain financing arrangements also depends upon the LIBOR rate, as it is a component of the discount rate applicable to each arrangement. If the LIBOR rate increases significantly, we may be negatively impacted as we may not be able to pass these added costs on to our customers, which could have a material and adverse effect upon our financial condition, results of operations and cash flows. During 2017, our Board of Directors authorized the purchase of up to $30 million of our common stock under stock repurchase programs. Under these programs, during the years ended December 31, 2017 and 2018, we repurchased 539,760 and 112,307 shares of our common stock, respectively, in the open market at a total cost of $24.8 million and $5.2 million, respectively, thereby completing the 2017 Board of Directors’ authorizations. In May 2018, our Board of Directors authorized the purchase of up to an additional $20 million of our common stock under a new stock repurchase program. Under this program, during the year ended December 31, 2018 and 2019, we repurchased 201,484 and 221,748 shares of our common stock, respectively, at a total cost of $9.3 million and $10.7 million, respectively, thereby completing the 2018 Board of Directors authorization. We anticipate that our cash flow from operations, available cash and available borrowings under our revolving credit facility will be adequate to meet our future liquidity needs for at least the next twelve months. Significant assumptions underlie this belief, including, among other things, that there will be no material adverse developments in our business, liquidity or capital requirements. If material adverse developments were to occur in any of these areas, there can be no assurance that our business will generate sufficient cash flow from operations, or that future borrowings will be available to us under our revolving credit facility in amounts sufficient to enable us to pay the principal and interest on our indebtedness, or to fund our other liquidity needs. In addition, if we default on any of our indebtedness, or breach any financial covenant in our revolving credit facility, our business could be adversely affected. Index The following table summarizes our contractual commitments as of December 31, 2019 and expiration dates of commitments through 2028 (a) (b): (a) Indebtedness under our revolving credit facilities is not included in the table above as it is reported as a current liability in our consolidated balance sheets. As of December 31, 2019, amounts outstanding under our revolving credit facility was $52.5 million. (b) As of January 1, 2019 we adopted ASU 2016-02, Leases, which resulted in the recording of the lease obligations on our consolidated balance sheet. For information related to our adoption of ASU 2016-02, see Note 1 “Summary of Significant Accounting Policies” and Note 2 “Leases” of the notes to our consolidated financial statements. Critical Accounting Policies We have identified the policies below as critical to our business operations and the understanding of our results of operations. The impact and any associated risks related to these policies on our business operations is discussed throughout “Management’s Discussion and Analysis of Financial Condition and Results of Operations,” where such policies affect our reported and expected financial results. For a detailed discussion on the application of these and other accounting policies, see Note 1 of the notes to our consolidated financial statements. You should be aware that preparation of our consolidated annual and quarterly financial statements requires us to make estimates and assumptions that affect the reported amount of assets and liabilities, disclosure of contingent assets and liabilities at the date of our consolidated financial statements, and the reported amounts of revenue and expenses during the reporting periods. We can give no assurance that actual results will not differ from those estimates. Although we do not believe that there is a reasonable likelihood that there will be a material change in the future estimate or in the assumptions that we use in calculating the estimate, unforeseen changes in the industry, or business could materially impact the estimate and may have a material adverse effect on our business, financial condition and results of operations. Revenue Recognition. We derive our revenue primarily from sales of replacement parts for motor vehicles from both our Engine Management and Temperature Control Segments. We recognize revenues when our performance obligation has been satisfied and the control of products has been transferred to a customer which typically occurs upon shipment. Revenue is measured as the amount of consideration we expect to receive in exchange for the transfer of goods or providing services. The amount of consideration we receive and revenue we recognize depends on the marketing incentives, product warranty and overstock returns we offer to our customers. For certain of our sales of remanufactured products, we also charge our customers a deposit for the return of a used core component which we can use in our future remanufacturing activities. Such deposit is not recognized as revenue at the time of the sale but rather carried as a core liability. At the same time, we estimate the core expected to be returned from the customer and record the estimated return as unreturned customer inventory. The liability is extinguished when a core is actually returned to us, or at period end when we estimate and recognize revenue for the core deposits not expected to be returned. We estimate and record provisions for cash discounts, quantity rebates, sales returns and warranties in the period the sale is recorded, based upon our prior experience and current trends. Significant management judgments and estimates must be made and used in estimating sales returns and allowances relating to revenue recognized in any accounting period. Index Sales Returns and Other Allowances and Allowance for Doubtful Accounts. Many of our products carry a warranty ranging from a 90-day limited warranty to a lifetime limited warranty, which generally covers defects in materials or workmanship and failure to meet industry published specifications and/or the result of installation error. In addition to warranty returns, we also permit our customers to return new, undamaged products to us within customer-specific limits (which are generally limited to a specified percentage of their annual purchases from us) in the event that they have overstocked their inventories. At the time products are sold, we accrue a liability for product warranties and overstock returns as a percentage of sales based upon estimates established using historical information on the nature, frequency and average cost of the claim and the probability of the customer return. At the same time, we record an estimate of anticipated customer returns as unreturned customer inventory. Significant judgments and estimates must be made and used in connection with establishing the sales returns and other allowances in any accounting period. Revision to these estimates is made when necessary, based upon changes in these factors. We regularly study trends of such claims. At December 31, 2019 and 2018, the allowance for sales returns was $44.1 million and $57.4 million, respectively. Similarly, we must make estimates of the uncollectability of our accounts receivable. We specifically analyze accounts receivable and analyze historical bad debts, customer concentrations, customer credit-worthiness, current economic trends and changes in our customer payment terms when evaluating the adequacy of the allowance for doubtful accounts. At December 31, 2019, the allowance for doubtful accounts and for discounts was $5.2 million. New Customer Acquisition Costs. New customer acquisition costs refer to arrangements pursuant to which we incur change-over costs to induce a new customer to switch from a competitor’s brand. In addition, change-over costs include the costs related to removing the new customer’s inventory and replacing it with our inventory commonly referred to as a stocklift. New customer acquisition costs are recorded as a reduction to revenue when incurred. Inventory Valuation. Inventories are valued at the lower of cost and net realizable value. Cost is determined on the first-in, first-out basis. Where appropriate, standard cost systems are utilized for purposes of determining cost; the standards are adjusted as necessary to ensure they approximate actual costs. Estimates of lower of cost and net realizable value of inventory are determined by comparing the actual cost of the product to the estimated selling prices in the ordinary course of business less reasonably predictable costs of completion, disposal and transportation of the inventory. We also evaluate inventories on a regular basis to identify inventory on hand that may be obsolete or in excess of current and future projected market demand. For inventory deemed to be obsolete, we provide a reserve on the full value of the inventory. Inventory that is in excess of current and projected use is reduced by an allowance to a level that approximates our estimate of future demand. Future projected demand requires management judgment and is based upon (a) our review of historical trends and (b) our estimate of projected customer specific buying patterns and trends in the industry and markets in which we do business. Using rolling twelve month historical information, we estimate future demand on a continuous basis. As such, the historical volatility of such estimates has been minimal. We utilize cores (used parts) in our remanufacturing processes for air conditioning compressors, diesel injectors, and diesel pumps. The production of air conditioning compressors, diesel injectors, and diesel pumps involves the rebuilding of used cores, which we acquire either in outright purchases from used parts brokers or from returns pursuant to an exchange program with customers. Under such exchange programs, at the time of sale of air conditioning compressors, diesel injectors, and diesel pumps, we estimate the core expected to be returned from the customer and record the estimated return as unreturned customer inventory. In addition, many of our customers can return inventory to us based upon customer warranty and overstock arrangements within customer specific limits. At the time products are sold, we accrue a liability for product warranties and overstock returns and record as unreturned customer inventory our estimate of anticipated customer returns. Estimates are based upon historical information on the nature, frequency and probability of the customer return. Unreturned core, warranty and overstock customer inventory is recorded at standard cost. Revision to these estimates is made when necessary, based upon changes in these factors. We regularly study trends of such claims. Index Accounting for Income Taxes. As part of the process of preparing our consolidated financial statements, we are required to estimate our income taxes in each of the jurisdictions in which we operate. This process involves estimating our actual current tax expense together with assessing temporary differences resulting from differing treatment of items for tax and accounting purposes. These differences result in deferred tax assets and liabilities, which are included within our consolidated balance sheet. We must then assess the likelihood that our deferred tax assets will be recovered from future taxable income, and to the extent we believe that it is more likely than not that the deferred tax assets will not be recovered, we must establish a valuation allowance. To the extent we establish a valuation allowance or increase or decrease this allowance in a period, we must include an expense or recovery, respectively, within the tax provision in the statement of operations. We maintain valuation allowances when it is more likely than not that all or a portion of a deferred tax asset will not be realized. In determining whether a valuation allowance is warranted, we evaluate factors such as prior earnings history, expected future earnings, carryback and carryforward periods and tax strategies. We consider all positive and negative evidence to estimate if sufficient future taxable income will be generated to realize the deferred tax asset. We consider cumulative losses in recent years as well as the impact of one-time events in assessing our pre-tax earnings. Assumptions regarding future taxable income require significant judgment. Our assumptions are consistent with estimates and plans used to manage our business, which includes restructuring and integration initiatives that are expected to generate significant savings in future periods. The valuation allowance of $0.8 million as of December 31, 2019 is intended to provide for the uncertainty regarding the ultimate realization of our U.S. foreign tax credit carryovers and foreign net operating loss carryovers. The assessment of the adequacy of our valuation allowance is based on our estimates of taxable income in these jurisdictions and the period over which our deferred tax assets will be recoverable. Based on these considerations, we believe it is more likely than not that we will realize the benefit of the net deferred tax asset of $37.3 million as of December 31, 2019, which is net of the remaining valuation allowance. In the event that actual results differ from these estimates, or we adjust these estimates in future periods for current trends or expected changes in our estimating assumptions, we may need to modify the level of the valuation allowance which could materially impact our business, financial condition and results of operations. In accordance with generally accepted accounting practices, we recognize in our financial statements only those tax positions that meet the more-likely-than-not recognition threshold. We establish tax reserves for uncertain tax positions that do not meet this threshold. During the years ended December 31, 2019, 2018 and 2017, we did not establish a liability for uncertain tax positions. Penalties associated with income tax matters are included in the provision for income taxes in our consolidated statement of operations. Leases. We determine if an arrangement is a lease at inception. For operating leases, we include and report operating lease right-of-use (“ROU”) assets, sundry payables and accrued expenses, and noncurrent operating lease liabilities on our consolidated balance sheet for leases with a term longer than twelve months. Finance leases are reported on our consolidated balance sheets in property, plant and equipment, current portion of other debt, and long-term debt. Operating lease ROU assets and operating lease liabilities are recognized at the lease commencement date based on the present value of the total lease payments over the lease term. Our ROU assets represent the right to use an underlying leased asset over the existing lease term, and the corresponding lease liabilities represent our obligation to make lease payments arising from the lease agreement. As most of our leases do not provide for an implicit rate, we use our secured incremental borrowing rate based on the information available when determining the present value of our lease payments. Our lease terms may include options to terminate, or extend, our lease when it is reasonably certain that we will execute the option. Lease agreements may contain lease and non-lease components, which are generally accounted for separately. Operating lease expense is recognized on a straight-line basis over the lease term. Index Valuation of Long-Lived and Intangible Assets and Goodwill. At acquisition, we estimate and record the fair value of purchased intangible assets, which primarily consist of customer relationships, trademarks and trade names, patents and non-compete agreements. The fair values of these intangible assets are estimated based on our assessment. Goodwill is the excess of the purchase price over the fair value of identifiable net assets acquired in business combinations. Goodwill and certain other intangible assets having indefinite lives are not amortized to earnings, but instead are subject to periodic testing for impairment. Intangible assets determined to have definite lives are amortized over their remaining useful lives. We assess the impairment of long-lived assets, identifiable intangibles assets and goodwill whenever events or changes in circumstances indicate that the carrying value may not be recoverable. With respect to goodwill and identifiable intangible assets having indefinite lives, we test for impairment on an annual basis or in interim periods if an event occurs or circumstances change that may indicate the fair value is below its carrying amount. Factors we consider important, which could trigger an impairment review, include the following: (a) significant underperformance relative to expected historical or projected future operating results; (b) significant changes in the manner of our use of the acquired assets or the strategy for our overall business; and (c) significant negative industry or economic trends. We review the fair values using the discounted cash flows method and market multiples. When performing our evaluation of goodwill for impairment, if we conclude qualitatively that it is not more likely than not that the fair value of the reporting unit is less than its carrying amount, than the two-step impairment test is not required. If we are unable to reach this conclusion, then we would perform the two-step impairment test. Initially, the fair value of the reporting unit is compared to its carrying amount. To the extent the carrying amount of a reporting unit exceeds the fair value of the reporting unit; we are required to perform a second step, as this is an indication that the reporting unit goodwill may be impaired. In this step, we compare the implied fair value of the reporting unit goodwill with the carrying amount of the reporting unit goodwill and recognize a charge for impairment to the extent the carrying value exceeds the implied fair value. The implied fair value of goodwill is determined by allocating the fair value of the reporting unit to all of the assets (recognized and unrecognized) and liabilities of the reporting unit in a manner similar to a purchase price allocation. The residual fair value after this allocation is the implied fair value of the reporting unit goodwill. On January 1, 2020, we will adopt Accounting Standards Update (“ASU”) 2017-04, Simplifying the Test for Goodwill Impairment (“ASU 2017-04”). ASU 2017-04 removes the second step of the impairment test, which requires a hypothetical purchase price allocation to determine the implied fair value of the reporting unit goodwill. Instead, under ASU 2017-04, goodwill impairment is the amount by which a reporting unit’s carrying value exceeds its fair value, not to exceed the carrying amount of goodwill. ASU 2017-04 will be applied prospectively. Identifiable intangible assets having indefinite lives are reviewed for impairment on an annual basis using a methodology similar with that used to evaluate goodwill. Intangible assets having definite lives and other long-lived assets are reviewed for impairment whenever events such as product discontinuance, plant closures, product dispositions or other changes in circumstances indicate that the carrying amount may not be recoverable. In reviewing for impairment, we compare the carrying value of such assets to the estimated undiscounted future cash flows expected from the use of the assets and their eventual disposition. When the estimated undiscounted future cash flows are less than their carrying amount, an impairment loss is recognized equal to the difference between the assets fair value and their carrying value. There are inherent assumptions and estimates used in developing future cash flows requiring our judgment in applying these assumptions and estimates to the analysis of identifiable intangibles and long-lived asset impairment including projecting revenues, interest rates, tax rates and the cost of capital. Many of the factors used in assessing fair value are outside our control and it is reasonably likely that assumptions and estimates will change in future periods. These changes can result in future impairments. In the event our planning assumptions were modified resulting in impairment to our assets, we would be required to include an expense in our statement of operations, which could materially impact our business, financial condition and results of operations. Index Share-Based Compensation. The provisions of FASB ASC 718, Stock Compensation, require the measurement and recognition of compensation expense for all share-based payment awards made to employees and directors based on estimated fair values on the grant date. The value of the portion of the award that is ultimately expected to vest is recognized as expense on a straight-line basis over the requisite service periods in our condensed consolidated statement of operations. Forfeitures are estimated at the time of grant based on historical trends in order to estimate the amount of share-based awards that will ultimately vest. We monitor actual forfeitures for any subsequent adjustment to forfeiture rates. Environmental Reserves. We are subject to various U.S. Federal, state and local environmental laws and regulations and are involved in certain environmental remediation efforts. We estimate and accrue our liabilities resulting from such matters based upon a variety of factors including the assessments of environmental engineers and consultants who provide estimates of potential liabilities and remediation costs. Such estimates are not discounted to reflect the time value of money due to the uncertainty in estimating the timing of the expenditures, which may extend over several years. Potential recoveries from insurers or other third parties of environmental remediation liabilities are recognized independently from the recorded liability, and any asset related to the recovery will be recognized only when the realization of the claim for recovery is deemed probable. Asbestos Litigation. In evaluating our potential asbestos-related liability, we use an actuarial study that is prepared by a leading actuarial firm with expertise in assessing asbestos-related liabilities. We evaluate the estimate of the range of undiscounted liability to determine which amount to accrue. Based on the information contained in the actuarial study and all other available information considered by us, we have concluded that no amount within the range was more likely than any other and, therefore, in assessing our asbestos liability we compare the low end of the range to our recorded liability to determine if an adjustment is required. Legal costs are expensed as incurred. We will continue to perform an annual actuarial analysis during the third quarter of each year for the foreseeable future, and whenever events or changes in circumstances indicate that additional provisions may be necessary. Based on the actuarial studies and all other available information, we will continue to reassess the recorded liability and, if deemed necessary, record an adjustment to the reserve, which will be reflected as a loss or gain from discontinued operations. See Note 22, “Commitments and Contingencies,” of the Notes to Consolidated Financial Statements in Item 8 of this Report for additional information. Other Loss Reserves. We have other loss exposures, for such matters as legal claims and legal proceedings. Establishing loss reserves for these matters requires estimates, judgment of risk exposure, and ultimate liability. We record provisions when the liability is considered probable and reasonably estimable. Significant judgment is required in both the determination of probability and the determination as to whether an exposure can be reasonably estimated. As additional information becomes available, we reassess our potential liability related to these matters. Such revisions of the potential liabilities could have a material adverse effect on our business, financial condition or results of operations. Recently Issued Accounting Pronouncements For a detailed discussion on recently issued accounting pronouncements and their impact on our consolidated financial statements, see Note 1, “Summary of Significant Accounting Policies” of the Notes to Consolidated Financial Statements in Item 8 of this Report. Index

<s>[INST] Overview We are a leading independent manufacturer and distributor of premium replacement parts for the engine management and temperature control systems of motor vehicles in the automotive aftermarket industry with a complementary focus on the heavy duty, industrial equipment and original equipment markets. We are organized into two operating segments. Each segment focuses on providing our customers with fullline coverage of its products, and a full suite of complimentary services that are tailored to our customers’ business needs and driving enduser demand for our products. We sell our products primarily to automotive aftermarket retailers, program distribution groups, warehouse distributors, original equipment manufacturers and original equipment service part operations in the United States, Canada, Europe, Asia, Mexico and other Latin American countries. Our Business Strategy Our mission is to be the best fullline, fullservice supplier of premium engine management and temperature control products. The key elements of our strategy are as follows: Maintain Our Strong Competitive Position in our Engine Management and Temperature Control Businesses. We are a leading independent manufacturer and distributor serving North America and other geographic areas in our core businesses of Engine Management and Temperature Control. We believe that our success is attributable to our emphasis on product quality, the breadth and depth of our product lines for both domestic and import vehicles, and our reputation for outstanding valueadded services. To maintain our strong competitive position, we remain committed to the following: providing our customers with fullline coverage of high quality engine management and temperature control products, supported by the highest level of valueadded services; continuing to maximize our production, supply chain and distribution efficiencies; continuing to improve our cost position through increased global sourcing, increased manufacturing at our lowcost plants, and strategic transactions with manufacturers in lowcost regions; and focusing on our engineering development efforts including a focus on bringing more product manufacturing inhouse. Provide Superior ValueAdded Services and Product Availability. Our goal is to increase sales to existing and new customers by leveraging our skills in rapidly filling orders, maintaining high levels of product availability and offering a product portfolio that provides comprehensive coverage for all vehicle applications. In addition, our marketing support provides insightful customer category management, technical support and awardwinning programs, and our technically skilled sales personnel provide our customers with product selection, assortment and application support, and technical training on diagnosing and repairing vehicles equipped with complex systems related to our products. Index Expand Our Product Lines. We intend to increase our sales by continuing to develop internally, or through potential acquisitions, the range of engine management and temperature control products that we offer to our customers. We are committed to investing the resources necessary to maintain and expand our technical capability to manufacture product lines that incorporate the latest technologies, including product lines relating to safety, advanced driver assistance and collision avoidance systems. Broaden Our Customer Base. Our goal is to increase our customer base by (a) leveraging our manufacturing capabilities to secure additional business globally with original equipment vehicle and equipment manufacturers and their service part operations, as well as our existing customer base of large retailers, program distribution groups, warehouse distributors, other manufacturers and export customers, and (b) supporting the service part operations of vehicle and equipment manufacturers with valueadded services and product support for the life of the part. Improve Operating Efficiency and Cost Position. Our management places significant emphasis on improving our financial performance by achieving operating efficiencies and improving asset utilization, while maintaining product quality and high customer order fill rates. We intend to continue to improve our operating efficiency and cost position by: increasing costeffective vertical integration in key product lines through internal development; focusing on integrated supply chain management, customer collaboration and vendor managed inventory initiatives; evaluating additional opportunities to relocate manufacturing to our lowcost plants; maintaining and improving our cost effectiveness and competitive responsiveness to better serve our customer base, including sourcing certain materials and products from low cost regions such as those in Asia without compromising product quality; enhancing companywide programs geared toward manufacturing and distribution efficiency; and focusing on companywide overhead and operating expense cost reduction programs. Cash Utilization. We intend to apply any excess cash flow from operations and the management of working capital primarily to reduce our outstanding indebtedness, pay dividends to our shareholders, expand our product lines by investing in new tooling and equipment, grow revenues through potential acquisitions and [/INST] Negative. </s>

DANAHER CORP /DE/

2015-02-25

2014-12-31

ITEM 7. MANAGEMENT’S DISCUSSION AND ANALYSIS OF FINANCIAL CONDITION AND RESULTS OF OPERATIONS Management’s Discussion and Analysis of Financial Condition and Results of Operations (“MD&A”) is designed to provide a reader of Danaher’s financial statements with a narrative from the perspective of Company management. The Company’s MD&A is divided into five sections: • Overview • Results of Operations • Liquidity and Capital Resources • Critical Accounting Estimates • New Accounting Standards OVERVIEW General Please see “Item 1. Business - General” for a discussion of Danaher’s objectives and methodologies for delivering shareholder value. Danaher is a multinational corporation with global operations. During 2014, approximately 57% of Danaher’s sales were derived from customers outside the United States. As a diversified, global business, Danaher’s operations are affected by worldwide, regional and industry-specific economic and political factors. Danaher’s geographic and industry diversity, as well as the range of its products and services, typically help limit the impact of any one industry or the economy of any single country on the consolidated operating results. Given the broad range of products manufactured, software and services provided and geographies served, management does not use any indices other than general economic trends to predict the overall outlook for the Company. The Company’s individual businesses monitor key competitors and customers, including to the extent possible their sales, to gauge relative performance and the outlook for the future. As a result of the Company’s geographic and industry diversity, the Company faces a variety of opportunities and challenges, including rapid technological development (particularly with respect to computing, mobile connectivity, communications and digitization) in most of the Company’s served markets, the expansion and evolution of opportunities in high-growth markets, trends and costs associated with a global labor force, consolidation of the Company’s competitors and increasing regulation. The Company operates in a highly competitive business environment in most markets, and the Company’s long-term growth and profitability will depend in particular on its ability to expand its business in high-growth geographies and high-growth market segments, identify, consummate and integrate appropriate acquisitions, develop innovative and differentiated new products, services and software with higher gross profit margins, expand and improve the effectiveness of the Company’s sales force, continue to reduce costs and improve operating efficiency and quality, and effectively address the demands of an increasingly regulated environment. The Company is making significant investments, organically and through acquisitions, to address the rapid pace of technological change in its served markets and to globalize its manufacturing, research and development and customer-facing resources (particularly in high-growth markets) in order to be responsive to the Company’s customers throughout the world and improve the efficiency of the Company’s operations. Business Performance and Outlook While differences exist among the Company’s businesses, on an overall basis, demand for the Company’s products, software and services increased in 2014 compared to 2013 driving year-over-year sales growth from existing businesses. The Company’s continued investments in sales growth initiatives and the other business-specific factors discussed below also contributed to year-over-year sales growth. Geographically, year-over-year sales growth rates from existing businesses during 2014 were led primarily by the high-growth markets. Sales from existing businesses in high-growth markets grew at a mid-single digit rate in 2014 compared to 2013 and sales from high-growth markets represented approximately 26% of the Company's total sales in 2014. Sales from existing businesses in developed markets grew at a low-single digit rate in 2014 compared to 2013 and were driven by North America and Western Europe. The Company expects overall sales growth to continue but remains cautious about challenges due to macro-economic and geopolitical uncertainties and global uncertainties related to monetary and fiscal policies. While individual business results will vary, the Company expects sales from existing businesses to continue to grow on a year-over-year basis during 2015 at a level in line with the growth levels experienced in 2014. Restructuring Activities Consistent with the Company's approach of positioning itself to provide superior products and services to its customers in a cost efficient manner, in the second half of 2014 the Company initiated actions to improve productivity and reduce costs in its businesses. The actions, which were substantially completed by December 31, 2014, resulted in pre-tax charges of approximately $155 million, the majority of which was incurred in the fourth quarter of 2014. The charges, including both employee-related termination costs as well as other termination and exit costs, are expected to result in savings of approximately $125 million in 2015 compared to 2014 expense levels. In addition, the Company incurred $107 million of costs associated with restructuring activities in 2013 which resulted in savings of approximately $75 million in 2014 compared to 2013 expense levels. Acquisitions and Divestitures On December 11, 2014, the Company successfully completed its tender offer for the outstanding shares of common stock of Nobel Biocare Holding AG, acquiring 97% of the outstanding shares for an aggregate cash purchase price of approximately CHF 1.9 billion (approximately $1.9 billion based on exchange rates as of the date the shares of common stock were acquired) including debt assumed and net of cash acquired. Danaher is in the process of acquiring the remaining outstanding Nobel Biocare shares by means of a squeeze-out transaction, as permitted under Swiss law. Headquartered in Zurich, Switzerland, Nobel Biocare is a world leader in the field of innovative implant-based dental restorations with a portfolio of solutions that include dental implant systems, high-precision individualized prosthetics, biomaterials and digital diagnostics, treatment planning and guided surgery. Nobel Biocare had revenues of €567 million in 2013 (approximately $780 million based on exchange rates as of December 31, 2013), and is now part of the Company's Dental segment. The Company financed the acquisition of Nobel Biocare from available cash. In addition to the acquisition of Nobel Biocare, during 2014 the Company acquired sixteen businesses for total consideration of approximately $1.3 billion in cash, net of cash acquired. The businesses acquired complement existing units of the Test & Measurement, Environmental, Life Sciences & Diagnostics and Dental segments. The aggregate annual sales of these sixteen businesses at the time of their respective acquisitions, in each case based on the company’s revenues for its last completed fiscal year prior to the acquisition, were approximately $420 million. In the fourth quarter of 2014, Danaher entered into a definitive agreement with NetScout to combine the majority of the Company's Test & Measurement segment's communications business with NetScout (Danaher will retain the data communications cable installation business and the communication service provider (field and test tool systems) business of Fluke Networks and these will become part of the Test & Measurement segment’s instruments business following the closing of the transaction). The transaction will be structured as a distribution of the communications business to Danaher shareholders in either a spin-off transaction, a split-off transaction, or a combination split-off and spin-off, followed by a merger of the communications business with a subsidiary of NetScout for consideration of 62.5 million NetScout shares, subject to adjustment. Both the distribution and merger are expected to qualify as tax-free transactions to Danaher and its shareholders, except to the extent that cash is paid to Danaher stockholders in lieu of fractional shares. If Danaher elects a spin-off, all Danaher shareholders will participate pro-rata. If Danaher elects a split-off, Danaher will conduct an exchange offer pursuant to which its shareholders will elect whether to exchange Danaher shares for common units of the communications business. If the split-off exchange offer is not fully subscribed, the additional common units of the communications business held by Danaher will be distributed in a spin-off on a pro rata basis to Danaher shareholders. Danaher will determine which approach it will take prior to closing the transaction and no decision has been made at this time. At closing, depending on the number of shares of NetScout common stock outstanding, Danaher shareholders will receive approximately 60% of the common shares of NetScout stock outstanding following the combination. The transaction remains subject to approval by NetScout’s shareholders and the satisfaction of customary closing conditions, including regulatory approvals and the absence of a material adverse change with respect to either the communications business or NetScout. On December 24, 2014, NetScout received a request for additional information (“second request”) from the U.S. Department of Justice. The effect of the second request is to extend the waiting period imposed by the Hart-Scott-Rodino Antitrust Improvements Act until 30 days after both NetScout and Danaher have substantially complied with the request, unless that period is extended voluntarily by the parties or terminated sooner by the U.S. Department of Justice. Upon the closing of the transaction, the Company will classify the communications business as a discontinued operation in its historical financial statements. Sales of the communications business to be combined with NetScout represented 22% of the sales of the Test & Measurement segment for the year ended December 31, 2014. The transaction is expected to be completed in 2015. In August 2014, the Company completed the divestiture of its electric vehicle systems ("EVS")/hybrid product line for a sale price of $87 million in cash. This product line, which was part of the Industrial Technologies segment, had revenues of approximately $60 million in 2014 prior to the divestiture and approximately $100 million in each of 2013 and 2012. Operating results of the product line were not significant to segment or overall Company reported results in 2014. The Company recorded a pre-tax gain on the sale of the product line of $34 million ($26 million after-tax or $0.04 per diluted share) in its third quarter 2014 results. Subsequent to the sale, the Company has no continuing involvement in the EVS/hybrid product line. For a discussion of the Company’s 2013 and 2012 acquisition and divestiture activity, refer to “Liquidity and Capital Resources - Investing Activities”. Sale of Investments During 2014, the Company received cash proceeds of $167 million from the sale of certain marketable equity securities and recorded a pre-tax gain related to these sales of $123 million ($77 million after-tax or $0.11 per diluted share). RESULTS OF OPERATIONS Consolidated sales for the year ended December 31, 2014 increased 4.0% compared to 2013. Sales from existing businesses contributed 3.5% growth and sales from acquired businesses contributed 1.5% growth on a year-over-year basis. The impact of currency translation reduced reported sales by 1.0% as the U.S. dollar was, on average, stronger against other major currencies during 2014 as compared to exchange rate levels during 2013. Consolidated sales for the year ended December 31, 2013 increased 4.5% compared to 2012. Sales from existing businesses contributed 2.5% growth and sales from acquired businesses contributed 2.5% growth on a year-over-year basis. The impact of currency translation reduced reported sales by 0.5% as the U.S. dollar was, on average, stronger against other major currencies during 2013 as compared to exchange rate levels during 2012. In this report, references to sales from existing businesses refers to sales from continuing operations calculated according to generally accepted accounting principles in the United States (“GAAP”) but excluding (1) sales from acquired businesses and (2) the impact of currency translation. References to sales or operating profit attributable to acquisitions or acquired businesses refer to GAAP sales or operating profit, as applicable, from acquired businesses recorded prior to the first anniversary of the acquisition less the amount of sales attributable to certain divested product lines not considered discontinued operations. The portion of revenue attributable to currency translation is calculated as the difference between (a) the period-to-period change in revenue (excluding sales from acquired businesses) and (b) the period-to-period change in revenue (excluding sales from acquired businesses) after applying current period foreign exchange rates to the prior year period. Sales from existing businesses should be considered in addition to, and not as a replacement for or superior to, sales, and may not be comparable to similarly titled measures reported by other companies. Management believes that reporting the non-GAAP financial measure of sales from existing businesses provides useful information to investors by helping identify underlying growth trends in our business and facilitating easier comparisons of our revenue performance with our performance in prior and future periods and to our peers. The Company excludes the effect of currency translation from sales from existing businesses because currency translation is not under management’s control, is subject to volatility and can obscure underlying business trends, and excludes the effect of acquisitions and divestiture related items because the nature, size and number of acquisitions and divestitures can vary dramatically from period to period and between the Company and its peers and can also obscure underlying business trends and make comparisons of long-term performance difficult. References to sales volume refer to the impact of both price and unit sales. Operating profit margins were 17.2% for the year ended December 31, 2014 as compared to 17.1% in 2013. The following factors impacted year-over-year operating profit margin comparisons. 2014 vs. 2013 operating profit margin comparisons were favorably impacted by: • Higher 2014 sales volumes and incremental year-over-year cost savings associated with the restructuring actions and continuing productivity improvement initiatives taken in 2013 and 2014, net of incremental year-over-year costs associated with various product development, sales and marketing growth investments - 65 basis points • The fourth quarter 2013 impairment of intangible assets associated with a technology investment in the communications business - 15 basis points 2014 vs. 2013 operating profit margin comparisons were unfavorably impacted by: • Incremental year-over-year costs associated with restructuring actions and continuing productivity improvement initiatives - 25 basis points • The incremental net dilutive effect in 2014 of acquired businesses and acquisition related charges recorded in 2014 associated with the Nobel Biocare acquisition, including transaction costs deemed significant and fair value adjustments to acquired inventory, net of the positive effect of the product line disposition in the third quarter of 2014 - 45 basis points The Company deems acquisition-related transaction costs incurred in a given period to be significant (generally relating to the Company’s larger acquisitions) if it determines that such costs exceed the range of acquisition-related transaction costs typical for the Company in a given period. Operating profit margins were 17.1% for the year ended December 31, 2013 as compared to 17.3% in 2012. The following factors impacted year-over-year operating profit margin comparisons. 2013 vs. 2012 operating profit margin comparisons were favorably impacted by: • Higher 2013 sales volumes and incremental year-over-year cost savings associated with the restructuring actions and continuing productivity improvement initiatives taken in 2012 and 2013, net of incremental year-over-year costs associated with various product development, sales and marketing growth investments - 80 basis points 2013 vs. 2012 operating profit margin comparisons were unfavorably impacted by: • The incremental net dilutive effect in 2013 of acquired businesses - 40 basis points • The divestiture of the Apex joint venture in 2013. Prior to the sale, the Company had accounted for its investment in Apex under the equity method - 40 basis points • The fourth quarter 2013 impairment of intangible assets associated with a technology investment in the communications business - 15 basis points • A 2012 gain relating to the resolution of contingencies with respect to a prior disposition of assets - 5 basis points Business Segments Sales by business segment for the years ended December 31 are as follows ($ in millions): TEST & MEASUREMENT The Company’s Test & Measurement segment offerings help customers design cutting-edge innovations, keep their businesses up and running and safeguard their network operations. Danaher's instrument business offers test, measurement and monitoring products that are used in electronic design, manufacturing and advanced technology development, as well as for installation, service and maintenance of electrical, industrial, electronic and calibration applications. Danaher's communications business is a leading provider of products and solutions used in the design, deployment, monitoring and security of traditional, virtualized, mobile and cloud-based networks operated by communications service providers, hosting service providers, enterprises and government agencies worldwide. Customers for these products and services include manufacturers of electronic instruments; service, installation and maintenance professionals; manufacturers who design, develop, manufacture and deploy network equipment; and service providers who implement, maintain and manage communications networks and services. Also included in the Test & Measurement segment are the Company’s mobile tool and wheel service businesses. Test & Measurement Selected Financial Data Components of Sales Growth 2014 COMPARED TO 2013 Price increases in the segment contributed 0.5% to sales growth on a year-over-year basis during 2014 as compared to 2013 and are reflected as a component of the change in sales from existing businesses. On an overall basis, sales from existing businesses in the segment’s instruments, mobile tool and wheel service businesses grew during 2014 as compared to 2013. This growth was more than offset by year-over-year sales declines in the segment's communications businesses. Sales from existing businesses in the segment's instruments business grew at a low-single digit rate during 2014 as compared to 2013, due to increased year-over-year sales of electrical and calibration products, primarily from strong sales of new product offerings. Geographically, growth was led by increased demand in North America, China, and Western Europe. Sales from existing businesses in the segment's communications business declined at a low-double digit rate during 2014 as compared to 2013 as certain large North American network management solutions customers are in the process of migrating to next-generation communication network technology infrastructures, and as a result delayed capital spending on their networks. The communications business is actively working with these customers to support this transition, including by increasing research and development investments to bring to market solutions for these customers’ next generation technology requirements. This decline in North America was slightly offset by growth in Western Europe and the Middle East. In addition, in the segment’s network security product line sales from existing businesses grew year-over-year, led by North America and Western Europe. The Company expects year-over-year sales growth from existing businesses in the segment's communications businesses for the full-year ending December 31, 2015, but expects sales growth from existing businesses to remain negative on a year-over-year basis in the first quarter of 2015. As noted above, in the fourth quarter of 2014 Danaher entered into a definitive agreement with NetScout to combine Danaher’s communications business with NetScout. See Note 3 to the Consolidated Financial Statements for additional information related to this transaction. Operating profit margins declined 60 basis points during 2014 as compared to 2013. The following factors impacted year-over-year operating profit margin comparisons. 2014 vs. 2013 operating profit margin comparisons were favorably impacted by: • 2013 impact from the impairment of intangible assets associated with a technology investment in the communications business - 90 basis points 2014 vs. 2013 operating profit margin comparisons were unfavorably impacted by: • Lower sales volumes from existing businesses with respect to high margin communications sales as well as incremental year-over-year costs associated with various new product development, sales and marketing growth investments, net of incremental year-over-year cost savings associated with the restructuring actions and continuing productivity improvement initiatives taken in 2014 and 2013 - 30 basis points • Incremental year-over-year costs associated with restructuring actions and continuing productivity improvement initiatives - 60 basis points • The incremental net dilutive effect in 2014 of acquired businesses - 60 basis points 2013 COMPARED TO 2012 Price increases in the segment contributed 0.5% to sales growth on a year-over-year basis during 2013 as compared to 2012 and are reflected as a component of the change in sales from existing businesses. Sales in the segment's instrument business declined at a low-single digit rate during 2013 as compared to 2012, as lower demand for thermography, calibration and electronic test products more than offset modest increases in demand for industrial products. Decreased demand in the North American, European and Chinese end markets contributed to the decline in sales. However, the Company did see demand stabilize during the second half of 2013 as compared to the first half of 2013, particularly in Europe and North America. Sales in the segment's communications business grew at a mid-single digit rate during 2013 compared to 2012 with robust year-over-year increase in demand for network security and analysis solutions. Geographically, strong year-over-year demand in the North America and Latin America regions was somewhat offset by declines in demand in Asia. Operating profit margins declined 110 basis points during 2013 as compared to 2012. The favorable impacts of higher operating profit margin communication business products comprising a higher percentage of sales in 2013 compared to 2012 and lower year-over-year costs for restructuring and productivity improvement initiatives were offset by lower year-over-year instrument sales volumes and incremental year-over-year costs associated with various sales, marketing and product development growth investments. In addition, 2013 vs. 2012 operating profit margin comparisons were unfavorably impacted by: • The fourth quarter 2013 impairment of intangible assets associated with a technology investment in the communications business - 90 basis points • The incremental net dilutive effect in 2013 of acquired businesses - 20 basis points ENVIRONMENTAL The Company’s Environmental segment products and services help protect the global water supply, facilitate environmental stewardship, enhance the safety of personal data and improve business efficiencies. Danaher’s water quality business provides instrumentation and disinfection systems to help analyze, treat and manage the quality of ultra-pure, potable, waste, ground and ocean water in residential, commercial, industrial and natural resource applications. Danaher’s retail/commercial petroleum business is a leading worldwide provider of solutions and services focused on fuel dispensing, remote fuel management, point-of-sale and payment systems, environmental compliance, vehicle tracking and fleet management. Environmental Selected Financial Data Components of Sales Growth 2014 COMPARED TO 2013 Price increases in the segment contributed 0.5% to sales growth on a year-over-year basis during 2014 as compared with 2013 and are reflected as a component of the change in sales from existing businesses. Sales from existing businesses in the segment’s water quality business grew at a mid-single digit rate during 2014 as compared to 2013. Sales growth in the analytical instrumentation product line was led primarily by continued strong sales of instruments and related consumables and service in North America, China, Europe and Latin America. Sales in the business' chemical treatment solutions product line grew on a year-over-year basis due primarily to continued sales force investments in the U.S. market, and to a lesser extent, continued international expansion. Year-over-year sales in the business' ultraviolet water disinfection product line declined during 2014 due to continued weak demand in municipal end markets, primarily in North America and Western Europe. Sales from existing businesses in the segment's retail petroleum equipment business grew at a mid-single digit rate during 2014 as compared to 2013. Demand for the business' dispenser systems was particularly strong in North America and China during 2014. Continued strong demand for point-of-sale systems, service and vapor recovery products in most major geographies also contributed to year-over-year sales growth. The business expects growth to continue in 2015 as customers upgrade payment systems, primarily in the United States, to comply with upcoming enhanced security requirements based on the EMV global standard. Operating profit margins declined 110 basis points during 2014 as compared to 2013. The following factors impacted year-over-year operating profit margin comparisons. 2014 vs. 2013 operating profit margin comparisons were favorably impacted by: • Higher 2014 sales volumes and incremental year-over-year cost savings associated with the restructuring actions and continuing productivity improvement initiatives taken in 2014 and 2013, net of incremental year-over-year costs associated with various product development, sales and marketing growth investments - 35 basis points 2014 vs. 2013 operating profit margin comparisons were unfavorably impacted by: • Incremental year-over-year costs associated with restructuring actions and continuing productivity improvement initiatives - 50 basis points • The incremental net dilutive effect in 2014 of acquired businesses - 95 basis points Depreciation as a percentage of sales increased during 2014 as compared to 2013 primarily as a result of investments in assets leased to customers, largely in businesses acquired during the second half of 2013. The inclusion of a full year of depreciation expense in 2014 and continued investments in such assets drove the increase. Depreciation expense as a percentage of sales in the segment in 2015 is expected to be in line with 2014 levels. 2013 COMPARED TO 2012 Price increases in the segment contributed 1.0% to sales growth on a year-over-year basis during 2013 as compared with 2012 and are reflected as a component of the change in sales from existing businesses. Sales from existing businesses in the segment’s water quality business grew at a mid-single digit rate during 2013 as compared to 2012 primarily due to increased demand across most major geographies for analytical instruments and related services and consumables. Sales from existing businesses in the business’ chemical treatment solutions product line also grew on a year-over-year basis due primarily to continued sales force investments in the U.S. market, and to a lesser extent, continued international expansion. Sales from existing businesses in the business' ultraviolet water disinfection product line declined during 2013 due to continued weak demand in municipal end markets, primarily in North America and Western Europe. Sales from existing businesses in the segment's retail petroleum equipment business grew at a low-single digit rate during 2013 as compared to 2012. Demand for the businesses' dispenser and retail automation products was particularly strong in Western Europe, Asia and the Middle East. On a year-over-year basis, the business experienced strong increase in demand for its point-of-sale and payment systems and continued growth in demand for dispensers, which were partially offset by slight declines in demand for services. Operating profit margins declined 30 basis points during 2013 as compared to 2012. The following factors impacted year-over-year operating profit margin comparisons. 2013 vs. 2012 operating profit margin comparisons were favorably impacted by: • Higher 2013 sales volumes and incremental year-over-year cost savings associated with the restructuring actions and continuing productivity improvement initiatives taken in 2012 and 2013, net of incremental year-over-year costs associated with various product development, sales and marketing growth investments - 70 basis points 2013 vs. 2012 operating profit margin comparisons were unfavorably impacted by: • The incremental net dilutive effect in 2013 of acquired businesses - 100 basis points LIFE SCIENCES & DIAGNOSTICS The Company’s diagnostics business offers analytical instruments, reagents, consumables, software and services that hospitals, physicians' offices, reference laboratories and other critical care settings use to diagnose disease and make treatment decisions. The Company’s life sciences business offers a broad range of research tools that scientists use to study cells and cell components in order to understand the causes of disease, identify new therapies and test new drugs and vaccines. Life Sciences & Diagnostics Selected Financial Data Components of Sales Growth 2014 COMPARED TO 2013 Year-over-year price increases in the segment had a negligible impact on sales during 2014. Sales from existing businesses in the segment's diagnostics business grew at a mid-single digit rate during 2014 as compared to 2013. Demand in the clinical business increased on a year over-year-basis led by continuing strong demand in China and other high-growth markets and a return to growth in North America. Continued strong global consumable sales in 2014 related to the installed base of acute care instruments drove the majority of the year-over-year sales growth in the acute care diagnostic business, which was led by China and other high-growth markets as well as modest increases in Western Europe. Increased demand for advanced staining systems and consumables across all major geographies drove the majority of the year-over-year sales growth in the pathology diagnostics business. Slight overall increases in demand for core histology instruments, led by North America, also contributed to this growth. Sales from existing businesses in the segment's life sciences business grew at a mid-single digit rate during 2014 as compared to 2013 due primarily to continued strong demand for the business' recently introduced products. Geographically, sales grew on a year-over-year basis in North America and Western Europe but declined in China and Japan. Sales of the business' broad range of mass spectrometers continued to grow on a year-over-year basis led by strong sales growth in the applied markets in North America and Western Europe. Sales of confocal, stereo and surgical microscopy products increased on a year-over-year basis led by strong demand in the developed markets. Year-over-year demand for the business' cellular analysis and sample preparation product lines grew at a low single digit rate in 2014, led by increases in demand in North America and Western Europe that, were largely offset by sales declines in China and Japan. Operating profit margins increased 70 basis points during 2014 as compared to 2013. The following factors impacted year-over-year operating profit margin comparisons. 2014 vs. 2013 operating profit margin comparisons were favorably impacted by: • Higher 2014 sales volumes and incremental year-over-year cost savings associated with the restructuring actions and continuing productivity improvement initiatives taken in 2013 and 2014, net of incremental year-over-year costs associated with various product development, sales and marketing growth investments - 110 basis points 2014 vs. 2013 operating profit margin comparisons were unfavorably impacted by: • Incremental year-over-year costs associated with restructuring actions and continuing productivity improvement initiatives - 20 basis points • The incremental net dilutive effect in 2014 of acquired businesses - 20 basis points 2013 COMPARED TO 2012 Year-over-year price increases in the segment had a negligible impact on sales during 2013. Sales from existing businesses in the segment's diagnostics business grew at a mid-single digit rate during 2013 as compared to 2012 due to increased demand in the clinical, acute care and pathology diagnostic businesses. The clinical diagnostics business experienced strong sales of consumables and automation hardware in high-growth markets, particularly China, that more than offset slightly negative year-over-year sales performance in North America and Europe. Sales growth in the acute care diagnostic business was due primarily to continued robust global consumables sales related to the business' growing installed base of instrumentation as well as strong demand for compact blood gas analyzers and cardiac care instruments. The year-over-year sales growth in the pathology diagnostics business was driven by strong demand for advanced staining systems and consumables in North America, China and Japan and increased demand for core histology instruments and consumables in North America and China. Sales from existing businesses in the segment's life sciences business grew at a mid-single digit rate during 2013 as compared to 2012 due primarily to strong demand for new product introductions across the life sciences businesses. Fourth quarter 2013 growth rates lagged full year growth rates due to comparisons to the same period in 2012 which benefited from new product introductions. Sales of the business' broad range of mass spectrometers grew on a year-over-year basis as strong sales growth in the applied and clinical research markets and the pharmaceutical market were partially offset by sales declines in the academic research market. Geographically, year-over-year sales growth in the mass spectrometry business was strong in high-growth markets and in the second half of 2013 the business also experienced strong demand in Europe and Japan. The business' confocal microscopy, flow cytometry and sample preparation product lines also contributed to year-over-year growth, principally from demand in high-growth markets. Operating profit margins increased 140 basis points during 2013 as compared to 2012. The following factors impacted year-over-year operating profit margin comparisons. 2013 vs. 2012 operating profit margin comparisons were favorably impacted by: • Higher 2013 sales volumes and incremental year-over-year cost savings associated with the restructuring actions and continuing productivity improvement initiatives taken in 2012 and 2013, net of incremental year-over-year costs associated with various product development, sales and marketing growth investments and the new U.S. medical device excise tax that took effect in 2013 - 190 basis points 2013 vs. 2012 operating profit margin comparisons were unfavorably impacted by: • The incremental net dilutive effect in 2013 of acquired businesses - 50 basis points DENTAL The Company’s Dental segment provides products that are used to diagnose, treat and prevent disease and ailments of the teeth, gums and supporting bone, as well as to improve the aesthetics of the human smile. The Company is a leading worldwide provider of a broad range of dental consumables, equipment and services, and is dedicated to driving technological innovations that help dental professionals improve clinical outcomes and enhance productivity. Dental Selected Financial Data Components of Sales Growth 2014 COMPARED TO 2013 Price increases in the segment contributed 0.5% to sales growth on a year-over-year basis during 2014 as compared with 2013 and are reflected as a component of the change in sales from existing businesses. Sales from existing businesses grew on a year-over-year basis as a result of increased demand for all major product categories, with strong sales of imaging products, instruments and implant products, along with modest growth in dental consumables. Geographically, year-over-year sales grew in Europe and high-growth markets, specifically China and the Middle East. The acquisition of Nobel Biocare provides additional sales and earnings growth opportunities for the Company’s Dental segment by expanding the businesses’ geographic and product line diversity, including new and complementary product and service offerings in the area of implant based tooth replacements. As Nobel Biocare is integrated into the Company, the Company also expects to realize significant cost synergies through the application of the Danaher Business System and the combined purchasing power of the Company and Nobel Biocare. Operating profit margins declined 70 basis points during 2014 as compared to 2013. The following factors impacted year-over-year operating profit margin comparisons. 2014 vs. 2013 operating profit margin comparisons were favorably impacted by: • Higher 2014 sales volumes and incremental year-over-year cost savings associated with the restructuring actions and continuing productivity improvement initiatives taken in 2013 and 2014, net of incremental year-over-year costs associated with various product development, sales and marketing growth investments - 80 basis points 2014 vs. 2013 operating profit margin comparisons were unfavorably impacted by: • Incremental year-over-year costs associated with restructuring actions and continuing productivity improvement initiatives - 35 basis points • The incremental net dilutive effect in 2014 of acquired businesses - 40 basis points • Acquisition related charges recorded in 2014 associated with the Nobel Biocare acquisition, including transaction costs deemed significant and fair value adjustments to acquired inventory - 75 basis points 2013 COMPARED TO 2012 Price increases in the segment contributed 1.0% to sales growth on a year-over-year basis during 2013 as compared with 2012 and are reflected as a component of the change in sales from existing businesses. Sales from existing businesses in the segment's dental consumables businesses grew at a low-single digit rate during 2013 as compared to 2012, primarily due to increased sales of professional dental consumables and implant products. On a year-over-year basis, sales of dental consumables were strong in North America (although North America contracted slightly in the fourth quarter compared to the third quarter of 2013), China and other high-growth markets and contracted slightly in Western Europe. In addition, sales from existing businesses in the segment's dental technologies businesses grew at a low-single digit rate on a year-over-year basis primarily as a result of increased demand for imaging products and treatment units. Geographically, increased sales in North America, China and certain other high-growth markets more than offset lower demand in Europe. Operating profit margins increased 10 basis points during 2013 as compared to 2012. Year-over-year operating profit margin comparisons were favorably impacted by: • The incremental net accretive effect in 2013 of acquired businesses - 5 basis points • Higher 2013 sales volumes and incremental year-over-year cost savings associated with the restructuring actions and continuing productivity improvement initiatives taken in 2012 and 2013, net of incremental year-over-year costs associated with various product development, sales and marketing growth investments and the new U.S. medical device excise tax that took effect in 2013 - 5 basis points INDUSTRIAL TECHNOLOGIES The Company’s Industrial Technologies segment solutions help protect the world’s food supply, improve packaging design and quality, verify pharmaceutical dosages and authenticity and power innovative machines. Danaher's product identification business develops and manufactures equipment, consumables and software for various printing, marking, coding, design and color management applications on consumer and industrial products. Danaher's automation business provides mechanical and electromechanical motion control solutions for the automation market. In addition to the product identification and automation strategic lines of business, the segment also includes Danaher's sensors and controls, energetic materials and engine retarder businesses. Industrial Technologies Selected Financial Data Components of Sales Growth 2014 COMPARED TO 2013 Price increases in the segment contributed 1.0% to sales growth on a year-over-year basis during 2014 as compared with 2013 and are reflected as a component of the change in sales from existing businesses. Sales from existing businesses in the segment's product identification business grew at a mid-single digit rate during 2014 as compared to 2013. Continued increased demand for marking and coding equipment and related consumables as well as packaging and color solutions was partially offset by continued lower year-over-year demand in consumer electronics related equipment. Geographically, year-over-year sales growth was led by North America and Europe. Sales from existing businesses in the segment's automation business grew at a low-single digit rate during 2014 as compared to 2013. Improved year-over-year demand in industrial automation, in North America distribution and in medical related end-markets was partially offset by lower year-over-year demand in technology, agricultural and defense related end-markets and the effect of exiting certain low-margin original equipment manufacturer product lines which negatively impacted the first half of 2014. Geographically, strong year-over-year demand in China and other high-growth markets as well as moderate sales growth in North America, more than offset year-over-year sales declines in Europe. During the third quarter of 2014, the Company sold its EVS/hybrid business. The impact of this divestiture is reflected in "Acquisitions (divestitures), net" in the Components of Sales Growth table above as the disposition was not deemed a discontinued operation for financial reporting purposes. See Note 3 to the Consolidated Financial Statements for additional information related to this transaction. Sales from existing businesses in the segment's other businesses collectively grew at a mid-single digit rate during 2014 as compared to 2013, primarily due to strong demand in the segment's engine retarder business, and to a lesser extent, continued improving demand in the segment's sensors and controls businesses. Operating profit margins increased 160 basis points during 2014 as compared to 2013. Year-over-year operating profit margin comparisons were favorably impacted by: • Higher 2014 sales volumes and incremental year-over-year cost savings associated with the restructuring actions and continuing productivity improvement initiatives taken in 2013 and 2014, net of incremental year-over-year costs associated with various product development, sales and marketing growth investments - 115 basis points • Lower year-over-year costs associated with restructuring actions and continuing productivity improvement initiatives - 45 basis points • The incremental net dilutive effect in 2014 of acquired businesses was fully offset by the positive effect of the product line disposition in the third quarter of 2014 2013 COMPARED TO 2012 Price increases in the segment contributed 1.5% to sales growth on a year-over-year basis during 2013 and are reflected as a component of the change in sales from existing businesses. Sales from existing businesses in the segment's product identification businesses grew at a mid-single digit rate during 2013 as compared to 2012. Continued increased demand for marking and coding equipment and related consumables as well as packaging and color solutions in most end markets was partially offset by lower year-over-year demand in consumer electronics related equipment. Sales grew on a year-over-year basis in most major geographies, particularly in North America and Latin America. Sales from existing businesses in the segment's automation business declined at a high-single digit rate during 2013 as compared to 2012. Continued soft year-over-year demand in the majority of end markets served, particularly technology and defense related end markets, and the impact of exiting certain low-margin OEM product lines, was partially offset by increased sales of industrial automation products, primarily in North America. Geographically, year-over-year sales declines in Europe, China and certain end markets in North America more than offset improving demand in certain high-growth markets. Sales from existing businesses in the segment's other businesses collectively grew at a low-single digit rate during 2013 as compared to 2012. Strong year-over-year demand in the segment's energetic materials business was partially offset by lower year-over-year demand in the segment's engine retarder business. Sales from existing businesses in the segment's sensors and controls businesses were essentially flat on a year-over-year basis. Operating profit margins increased 40 basis points during 2013 as compared to 2012. The following factors impacted year-over-year operating profit margin comparisons. 2013 vs. 2012 operating profit margin comparisons were favorably impacted by: • Higher 2013 prices and incremental year-over-year cost savings associated with the restructuring actions and continuing productivity improvement initiatives taken in 2012 and 2013, net of incremental year-over-year costs associated with various product development, sales and marketing growth investments and the impact of lower 2013 unit sales - 80 basis points 2013 vs. 2012 operating profit margin comparisons were unfavorably impacted by: • The incremental net dilutive effect in 2013 of acquired businesses - 40 basis points COST OF SALES AND GROSS PROFIT Cost of sales increased approximately 3% on a year over year basis during 2014 as compared to 2013, due primarily to the impact of higher year-over-year sales volumes, acquisition related charges associated with fair value adjustments to acquired inventory in connection with the acquisition of Nobel Biocare during the fourth quarter of 2014 and incremental year-over-year costs associated with restructuring actions and continuing productivity improvement initiatives, partially offset by incremental year-over-year cost savings associated with the restructuring actions and continued productivity improvements taken in 2013 and 2014. Cost of sales increased approximately 4% on a year-over-year basis for 2013 as compared to 2012 due primarily to the impact of higher year-over-year sales volumes and the impact of the U.S. excise tax on medical devices imposed in 2013, partially offset by the year-over-year decline in costs associated with restructuring actions and continued productivity improvements. In 2013, the U.S. imposed a 2.3% excise tax on the sale or importation of certain medical devices, which affected various products in the Company's Life Sciences & Diagnostics and Dental segments. The excise tax increased the Company's 2013 cost of sales as a percentage of revenue on a year-over-year basis by approximately 20 basis points. The impact of the medical devices excise tax was partially mitigated by general price increases implemented during 2013. Gross profit margins increased 30 basis points on a year-over-year basis during 2014 as compared to 2013, due primarily to the favorable impact of higher year-over-year sales volumes and incremental year-over-year cost savings associated with the restructuring actions and continued productivity improvements taken in 2013 and 2014, partially offset by acquisition related charges associated with fair value adjustments to acquired inventory in connection with the acquisition of Nobel Biocare during the fourth quarter of 2014 and incremental year-over-year costs associated with restructuring actions and continuing productivity improvement initiatives. Gross profit margins increased 50 basis points on a year-over-year basis for 2013 as compared to 2012, due primarily to the favorable impact of higher year-over-year sales volumes and the year-over-year decline in costs relating to restructuring actions and continued productivity improvements. The excise tax noted above increased the Company's 2013 cost of sales as a percentage of revenue on a year-over-year basis by approximately 20 basis points. The impact of the medical devices excise tax was partially mitigated by general price increases implemented during 2013. OPERATING EXPENSES Selling, general and administrative expenses as a percentage of sales increased 20 basis points on a year-over-year basis for 2014 compared to 2013. The year-over-year increase reflects incremental year-over-year investments in the Company's sales and marketing growth initiatives, higher corporate expenses and incremental year-over-year costs associated with restructuring actions and continuing productivity improvement initiatives. In addition, transaction costs incurred in connection with the closing of the Nobel Biocare acquisition during the fourth quarter of 2014 unfavorably impacted the year-over-year comparison by approximately five basis points. These increases were partially offset by the benefit of increased leverage of the Company's general and administrative cost base resulting from higher 2014 sales, the effect of the 2013 impairment charge related to intangible assets associated with a communications business' technology investment and incremental year-over-year cost savings associated with 2013 and 2014 restructuring actions. Selling, general and administrative expenses as a percentage of sales remained flat from 2012 to 2013. The benefit of increased leverage of the Company's cost base resulting from higher 2013 sales and the year-over-year decline in restructuring costs was offset by incremental year-over-year increases in investments in sales and marketing growth initiatives. Year-over-year comparisons were also adversely impacted by an impairment charge related to intangible assets associated with a communications business' technology investment which increased selling, general and administrative expenses by 15 basis points in 2013. Research and development expenses (consisting principally of internal and contract engineering personnel costs) as a percentage of sales increased 10 basis points on a year-over-year basis in 2014 as compared to 2013. Incremental year-over-year increases in investments in the Company's new product development initiatives were the primary contributors to this increase. Research and development expenses as a percentage of sales increased 30 basis points on a year-over-year basis in 2013 as compared to 2012 due primarily to new product development initiatives. OTHER INCOME During 2014, the Company received cash proceeds of $167 million from the sale of certain marketable equity securities and recorded a pre-tax gain related to these sales of $123 million ($77 million after-tax or $0.11 per diluted share). In addition, the Company completed the divestiture of its EVS/hybrid product line for a sale price of $87 million in cash in August 2014. This product line, which was part of the Industrial Technologies segment, had revenues of approximately $60 million in 2014 prior to the divestiture and approximately $100 million in each of 2013 and 2012. Operating results of the product line were not significant to segment or overall Company reported results in 2014. The Company recorded a pre-tax gain on the sale of the product line of $34 million ($26 million after-tax or $0.04 per diluted share) in its third quarter 2014 results. Subsequent to the sale, the Company has no continuing involvement in the EVS/hybrid product line. During the fourth quarter of 2013, the Company sold approximately 5 million of the approximately 8 million shares of Align Technology, Inc. ("Align") common stock that the Company received in 2009 as a result of a settlement between Align and Ormco Corporation, a wholly-owned subsidiary of the Company. The Company received cash proceeds of $251 million from the sale of these marketable equity securities and recorded a pre-tax gain of $202 million ($125 million after-tax or $0.18 per diluted share). On July 4, 2010, the Company entered into a joint venture with Cooper Industries, plc (“Cooper”), combining certain of the Company’s hand tool businesses with Cooper’s Tools business to form a new entity called Apex Tool Group, LLC (“Apex”). Each of Cooper and the Company had owned a 50% interest in Apex, had an equal number of representatives on Apex’s Board of Directors and neither joint venture partner controlled the significant operating and financing activities of Apex. The Company had accounted for its investment in the joint venture based on the equity method of accounting. During 2012, the Company recorded $70 million of earnings from unconsolidated joint venture related to its interest in Apex. In February 2013, the Company and Cooper sold Apex to an unrelated third party for approximately $1.6 billion. The Company received $797 million from the sale, consisting of cash of $759 million (including $67 million of dividends received prior to closing) and a note receivable of $38 million (which has been subsequently collected). The Company recognized a pre-tax gain of $230 million ($144 million after-tax or $0.20 per diluted share) in its first quarter 2013 results in connection with this transaction. The Company's share of the 2013 earnings generated by Apex prior to the closing of the sale was insignificant. Subsequent to the sale of its investment in Apex, the Company has no continuing involvement in Apex's operations. INTEREST COSTS For a description of the Company’s outstanding indebtedness, refer to “-Liquidity and Capital Resources - Financing Activities and Indebtedness” below. Interest expense of $123 million for 2014 was $23 million lower than in 2013, due primarily to the repayment of the $400 million principal amount of 1.3% senior unsecured notes due 2014 (the "2014 Notes") upon maturity in June 2014 in addition to the repayment of the €500 million principal amount of Eurobond notes due 2013 (the "Eurobond Notes") and the $300 million principal amount of floating rate senior notes due 2013 (the "2013 Notes") upon maturity in July and June 2013, respectively. Interest expense of $146 million in 2013 was $12 million lower than the 2012 interest expense of $158 million due primarily to the repayment of the Eurobond Notes and the 2013 Notes. Interest income was $17 million, $6 million and $3 million in 2014, 2013 and 2012, respectively. The increase in interest income in 2014 compared to prior periods reflects higher overall cash holdings throughout 2014 compared to 2013 and 2012. INCOME TAXES General Income tax expense and deferred tax assets and liabilities reflect management’s assessment of future taxes expected to be paid on items reflected in the Company’s financial statements. The Company records the tax effect of discrete items and items that are reported net of their tax effects in the period in which they occur. The Company’s effective tax rate can be affected by changes in the mix of earnings in countries with differing statutory tax rates (including as a result of business acquisitions and dispositions), changes in the valuation of deferred tax assets and liabilities, accruals related to contingent tax liabilities and period-to-period changes in such accruals, the results of audits and examinations of previously filed tax returns (as discussed below), the expiration of statutes of limitations, the implementation of tax planning strategies, tax rulings, court decisions, settlements with tax authorities and changes in tax laws. For a description of the tax treatment of earnings that are planned to be reinvested indefinitely outside the United States, refer to “-Liquidity and Capital Resources - Cash and Cash Requirements” below. The amount of income taxes the Company pays is subject to ongoing audits by federal, state and foreign tax authorities, which often result in proposed assessments. Management performs a comprehensive review of its global tax positions on a quarterly basis. Based on these reviews, the results of discussions and resolutions of matters with certain tax authorities, tax rulings and court decisions, and the expiration of statutes of limitations, reserves for contingent tax liabilities are accrued or adjusted as necessary. For a discussion of risks related to these and other tax matters, please refer to “Item 1A. Risk Factors”. Year-Over-Year Changes in the Tax Provision and Effective Tax Rate The Company’s effective tax rate related to continuing operations for the years ended December 31, 2014, 2013 and 2012 was 25.4%, 24.4% and 23.6%, respectively. The Company’s effective tax rate for each of 2014, 2013 and 2012 differs from the U.S. federal statutory rate of 35.0% due principally to the Company’s earnings outside the United States that are indefinitely reinvested and taxed at rates lower than the U.S. federal statutory rate. The effective tax rates for 2014 and 2013 also include the benefit from the reinstatement of certain tax benefits and credits resulting from the enactments of the Tax Increase Prevention Act of 2014 and the America Tax Relief Act of 2012. In addition, the effective tax rate of 25.4% in 2014 includes tax expense for audit settlements in various jurisdictions and changes in estimates associated with prior period uncertain tax positions, partially offset by the release of valuation allowances and the release of reserves upon the expiration of statutes of limitations. The effective tax rates of 24.4% in 2013 and 23.6% in 2012 include recognition of tax benefits associated with favorable resolutions of certain international and domestic uncertain tax positions and the lapse of certain statutes of limitations, partially offset by adjustments of reserve estimates related to prior period uncertain tax positions. The matters referenced above have been treated as discrete items in the periods they occurred and in the aggregate increased the provision for income taxes by approximately 165 basis points in 2014 and reduced the provision for income taxes by approximately 20 basis points in 2013 and 30 basis points in 2012. The Company conducts business globally, and files numerous consolidated and separate income tax returns in the United States federal, state and foreign jurisdictions. The countries in which the Company has a significant presence that have significantly lower statutory tax rates than the United States include China, Denmark, Germany and the United Kingdom. The Company's ability to obtain a tax benefit from lower statutory tax rates outside of the United States is dependent on its levels of taxable income in these foreign countries. The Company believes that a change in the statutory tax rate of any individual foreign country would not have a material effect on the Company's financial statements given the geographic dispersion of the Company's taxable income. The Company and its subsidiaries are routinely examined by various domestic and international taxing authorities. The Internal Revenue Service (“IRS”) has completed examinations of certain of the Company's federal income tax returns through 2009 and is currently examining certain of the Company's federal income tax returns for 2010 and 2011. The Company's U.S. tax returns for 2012 and 2013 remain open for examination by the IRS. In addition, the Company has subsidiaries in Belgium, Brazil, Canada, China, Denmark, France, Finland, Germany, India, Italy, Japan, Norway, Singapore, Sweden, the United Kingdom and various other countries, states and provinces that are currently under audit for years ranging from 2002 through 2013. Tax authorities in Denmark have raised significant issues related to interest accrued by certain of the Company's subsidiaries. On December 10, 2013, the Company received assessments from the Danish tax authority (“SKAT”) totaling approximately DKK 1.2 billion (approximately $190 million based on exchange rates as of December 31, 2014) including interest through December 31, 2014, imposing withholding tax relating to interest accrued in Denmark on borrowings from certain of the Company's subsidiaries for the years 2004-2009. If the SKAT claims are successful, it is likely that the Company would be assessed additional amounts for years 2010-2012 totaling approximately DKK 650 million (approximately $106 million based on exchange rates as of December 31, 2014). Management believes the positions the Company has taken in Denmark are in accordance with the relevant tax laws and intends to vigorously defend its positions. The Company appealed these assessments with the National Tax Tribunal in 2014 and intends on pursuing this matter through the European Court of Justice should this appeal be unsuccessful. The ultimate resolution of this matter is uncertain, could take many years, and could result in a material adverse impact to the Company's financial statements, including its effective tax rate. As previously disclosed, German tax authorities had raised issues related to the deductibility and taxability of interest accrued by certain of the Company’s subsidiaries. In the fourth quarter of 2014, the Company entered into a settlement agreement with the German tax authorities to resolve these open matters through 2014. The Company recorded €49 million (approximately $60 million based on exchange rates as of December 31, 2014) of expense for taxes and interest related to this settlement during the fourth quarter of 2014. The Company's effective tax rate for 2015 is expected to be approximately 24.0%. This anticipated rate reflects no benefit from the research and experimentation credit in the United States which expired at the end of 2014. COMPREHENSIVE INCOME Comprehensive income decreased by $2.0 billion for 2014 as compared to 2013, primarily due to the impact of foreign currency translation adjustments resulting from the strengthening of the U.S. dollar compared to most major currencies during the year, in addition to pension and post-retirement plan benefit adjustments. The Company recorded a foreign currency translation loss of $1.2 billion for 2014 compared to a translation loss of $62 million for 2013. Pension and post-retirement plan benefit adjustments resulted in a loss of $361 million in 2014 compared to a gain of $289 million in 2013. Comprehensive income increased by $599 million for 2013 as compared to 2012, primarily due to increased net earnings for 2013 and the impact of pension and post-retirement plan benefit adjustments. The Company recorded a pension and post-retirement plan benefit gain of $289 million for 2013 compared to a loss of $140 million for 2012. INFLATION The effect of inflation on the Company’s revenues and net earnings was not significant in any of the years ended December 31, 2014, 2013 or 2012. FINANCIAL INSTRUMENTS AND RISK MANAGEMENT The Company is exposed to market risk from changes in interest rates, foreign currency exchange rates, credit risk, equity prices and commodity prices, each of which could impact its financial statements. The Company generally addresses its exposure to these risks through its normal operating and financing activities. In addition, the Company’s broad-based business activities help to reduce the impact that volatility in any particular area or related areas may have on its operating profit as a whole. Interest Rate Risk The Company manages interest cost using a mixture of fixed-rate and variable-rate debt. A change in interest rates on long-term debt impacts the fair value of the Company’s fixed-rate long-term debt but not the Company’s earnings or cash flow because the interest on such debt is fixed. Generally, the fair market value of fixed-rate debt will increase as interest rates fall and decrease as interest rates rise. As of December 31, 2014, an increase of 100 basis points in interest rates would have decreased the fair value of the Company’s fixed-rate long-term debt (excluding the LYONs, which have not been included in this calculation as the value of this convertible debt is primarily derived from the value of its underlying common stock) by approximately $90 million. However, since the Company currently has no plans to repurchase its outstanding fixed-rate instruments before their maturity, the impact of market interest rate fluctuations on the Company’s fixed-rate long-term debt does not affect the Company’s results of operations or stockholders’ equity. As of December 31, 2014, the Company’s variable-rate debt obligations consisted primarily of U.S. dollar and Euro-based commercial paper borrowings (refer to Note 9 to the Consolidated Financial Statements for information regarding the Company’s outstanding commercial paper balances as of December 31, 2014). As a result, the Company’s primary interest rate exposure results from changes in short-term interest rates. As these shorter duration obligations mature, the Company anticipates issuing additional short-term commercial paper obligations to refinance all or part of these borrowings. In 2014, a 10% increase in average market interest rates on the Company’s commercial paper borrowings would have increased the Company’s interest expense by approximately $0.1 million. A 10% hypothetical fluctuation is used as the Company’s actual commercial paper interest rates fluctuated near that amount during 2014. Currency Exchange Rate Risk The Company faces transactional exchange rate risk from transactions with customers in countries outside the United States and from intercompany transactions between affiliates. Transactional exchange rate risk arises from the purchase and sale of goods and services in currencies other than Danaher’s functional currency or the functional currency of our applicable subsidiary. The Company also faces translational exchange rate risk related to the translation of financial statements of our foreign operations into U.S. dollars, Danaher’s functional currency. Costs incurred and sales recorded by subsidiaries operating outside of the United States are translated into U.S. dollars using exchange rates effective during the respective period. As a result, the Company is exposed to movements in the exchange rates of various currencies against the U.S. dollar. In particular, the Company has more sales in European currencies than it has expenses in those currencies. Therefore, when European currencies strengthen or weaken against the U.S. dollar, operating profits are increased or decreased, respectively. The effect of a change in currency exchange rates on the Company’s net investment in international subsidiaries is reflected in the accumulated other comprehensive income component of stockholders’ equity. A 10% depreciation in major currencies relative to the U.S. dollar as of December 31, 2014 would have resulted in a reduction of stockholders’ equity of approximately $1.0 billion. Currency exchange rates negatively impacted 2014 reported sales by 1.0% on a year-over-year basis as the U.S. dollar was, on average, stronger against most major currencies during 2014 as compared to exchange rate levels during 2013. If the exchange rates in effect as of December 31, 2014 were to prevail throughout 2015, currency exchange rates would adversely impact 2015 estimated sales by approximately 3.5% relative to the Company’s performance in 2014 due to the continued strengthening of the U.S. dollar against most major currencies at the end of the fourth quarter of 2014. Additional strengthening of the U.S. dollar against other major currencies would further adversely impact the Company’s sales and results of operations on an overall basis. Any weakening of the U.S. dollar against other major currencies would positively impact the Company’s sales and results of operations. The Company has generally accepted the exposure to exchange rate movements without using derivative financial instruments to manage this risk. Both positive and negative movements in currency exchange rates against the U.S. dollar will therefore continue to affect the reported amount of sales, profit, and assets and liabilities in the Company’s Consolidated Financial Statements. On April 2, 2014, the Company terminated the Japanese Yen/U.S. dollar currency swap agreement that had been acquired in connection with a prior business acquisition. The currency swap agreement initially required the Company to purchase approximately 184 million Japanese Yen (JPY/¥) at a rate of $1/¥102.25 on a monthly basis through June 1, 2018. The currency swap did not qualify for hedge accounting, and as a result, changes in the fair value of the currency swap were reflected in selling, general and administrative expenses in the accompanying Consolidated Statements of Earnings each reporting period. The fair value of the currency swap as of the termination date was not significant and the fair value had not changed significantly during 2014 prior to the swap being terminated. During the years ended December 31, 2013 and 2012, the Company recorded pre-tax income of $14 million and $22 million, respectively, related to changes in the fair value of this currency swap. Credit Risk The Company is exposed to potential credit losses in the event of nonperformance by counterparties to its financial instruments. Financial instruments that potentially subject the Company to credit risk consist of cash and temporary investments, receivables from customers and derivatives. The Company places cash and temporary investments with various high-quality financial institutions throughout the world and exposure is limited at any one institution. Although the Company typically does not obtain collateral or other security to secure these obligations, it does regularly monitor the third party depository institutions that hold its cash and cash equivalents. The Company’s emphasis is primarily on safety and liquidity of principal and secondarily on maximizing yield on those funds. In addition, concentrations of credit risk arising from receivables from customers are limited due to the diversity of the Company’s customers. The Company’s businesses perform credit evaluations of their customers’ financial conditions as appropriate and also obtain collateral or other security when appropriate. The Company enters into derivative transactions infrequently and, with the exception of the Yen swap noted above, such transactions are generally insignificant to the Company's financial condition and results of operations. These transactions are entered into only with high-quality financial institutions and exposure at any one institution is limited. Equity Price Risk The Company’s available-for-sale investment portfolio includes publicly traded equity securities that are sensitive to fluctuations in market price. Changes in equity prices would result in changes in the fair value of the Company’s available-for-sale investments due to the difference between the current market price and the market price at the date of purchase or issuance of the equity securities. A 10% decline in the value of these equity securities as of December 31, 2014 would have reduced the fair value of the Company’s available-for-sale investment portfolio by $26 million. Commodity Price Risk For a discussion of risks relating to commodity prices, refer “Item 1A. Risk Factors.” LIQUIDITY AND CAPITAL RESOURCES Management assesses the Company’s liquidity in terms of its ability to generate cash to fund its operating, investing and financing activities. The Company continues to generate substantial cash from operating activities and believes that its operating cash flow and other sources of liquidity will be sufficient to allow it to continue investing in existing businesses, consummating strategic acquisitions, paying interest and servicing debt and managing its capital structure on a short and long-term basis. Following is an overview of the Company's cash flows and liquidity for the years ended December 31: Overview of Cash Flows and Liquidity • Operating cash flows from continuing operations increased $173 million, or approximately 5%, during 2014 as compared to 2013. Cash flow increases generated from higher operating profit, as well as higher non-cash charges for depreciation and amortization, were largely offset by increased investments in working capital. In addition, operating cash flows for 2013 benefited from $67 million of dividends received related to earnings of the Apex joint venture. • Cash paid for acquisitions constituted the most significant use of cash during 2014. The Company acquired seventeen businesses during 2014, including the acquisition of Nobel Biocare, for total consideration (net of cash acquired) of approximately $3.1 billion. • During 2014, the Company received cash proceeds of $254 million from the sale of certain marketable securities and the divestiture of its EVS/hybrid product line. • As of December 31, 2014, the Company held $3.0 billion of cash and cash equivalents. Operating Activities Cash flows from operating activities can fluctuate significantly from period to period as working capital needs and the timing of payments for income taxes, restructuring activities, pension funding and other items impact reported cash flows. Operating cash flows from continuing operations were $3.8 billion for 2014, an increase of $173 million, or 5% as compared to 2013. The year-over-year change in operating cash flows from 2013 to 2014 was primarily attributable to the following factors: • 2014 operating cash flows benefited from higher net earnings as compared to 2013 excluding the impacts of the gains included in other non-operating income in both years. While these non-operating gains are included in earnings, the proceeds from the sales of investments, product lines and discontinued operations are reflected in the investing activities section of the Statement of Cash Flows and, therefore, do not contribute to operating cash flows. • The aggregate of trade accounts receivable, inventories and trade accounts payable provided $27 million in operating cash flows during 2014, compared to $197 million provided in 2013. The amount of cash flow generated from or used by the aggregate of trade accounts receivable, inventories and trade accounts payable depends upon how effectively the Company manages the cash conversion cycle, which effectively represents the number of days that elapse from the day it pays for the purchase of raw materials and components to the collection of cash from its customers and can be significantly impacted by the timing of collections and payments in a period. • Net earnings for 2014 reflected an increase of $44 million of depreciation and amortization expense as compared to 2013. Amortization expense primarily relates to the amortization of intangible assets acquired in connection with acquisitions. Depreciation expense relates to both the Company's manufacturing and operating facilities as well as instrumentation leased to customers under operating-type lease arrangements. Depreciation and amortization are non-cash expenses that decrease earnings without a corresponding impact to operating cash flows. • 2013 operating cash flows included $67 million of dividends received related to earnings of the Apex joint venture, which was sold in 2013. These dividends increased the 2013 operating cash flows but did not repeat in 2014 due to the sale. Operating cash flows from continuing operations were $3.6 billion for 2013, an increase of $83 million, or 2% as compared to 2012. This increase was primarily attributable to the increase in operating profit in 2013 as compared to 2012. Investing Activities Cash flows relating to investing activities consist primarily of cash used for acquisitions and capital expenditures, including instruments leased to customers, and cash proceeds from divestitures of businesses or assets. Net cash used in investing activities was $3.4 billion during 2014 compared to $553 million and $1.9 billion of net cash used in 2013 and 2012, respectively. Acquisitions, Divestitures and Sale of Investments 2014 Acquisitions, Divestitures and Sale of Investments For a discussion of the Company’s 2014 acquisitions, divestitures and the sale of certain marketable equity securities, refer to “-Overview.” 2013 Acquisitions, Divestitures and Sale of Investments During 2013, the Company acquired fourteen businesses for total consideration of $957 million in cash, net of cash acquired. The businesses acquired complement existing units of the Industrial Technologies, Life Sciences & Diagnostics, Environmental and Test & Measurement segments. The aggregate annual sales of these fourteen businesses at the time of their respective acquisitions, in each case based on the company’s revenues for its last completed fiscal year prior to the acquisition, were approximately $300 million. During the fourth quarter of 2013, the Company sold approximately 5 million of the approximately 8 million shares of Align common stock that the Company received in 2009 as a result of a settlement between Align and Ormco. The Company received cash proceeds of $251 million from the sale of these securities and recorded a pre-tax gain of $202 million ($125 million after-tax or $0.18 per diluted share). On July 4, 2010, the Company entered into a joint venture with Cooper, combining certain of the Company’s hand tool businesses with Cooper’s Tools business to form a new entity, Apex. In February 2013, the Company and Cooper sold Apex to an unrelated third party for approximately $1.6 billion. The Company received $797 million from the sale, consisting of cash of $759 million (including $67 million of dividends received prior to closing) and a note receivable of $38 million (which has been subsequently collected). The Company recognized a pre-tax gain of $230 million ($144 million after-tax or $0.20 per diluted share) in its first quarter 2013 results in connection with this transaction. 2012 Acquisitions and Divestitures During 2012, the Company acquired fourteen businesses for total consideration of $1.8 billion in cash, net of cash acquired. The businesses acquired complement existing units of each of the Company's five segments. The aggregate annual sales of these fourteen businesses at the time of their respective acquisitions, in each case based on the acquired company’s revenues for its last completed fiscal year prior to the acquisition, were $666 million. In January 2012, the Company completed the sale of its integrated scanning system business (the ASI business) for $132 million in cash. In addition, in February 2012, the Company completed the sale of its KEO business for $205 million in cash. These businesses were part of the Industrial Technologies segment. The businesses had combined annual revenues of $275 million in 2011. The Company recorded an aggregate after-tax gain on the sale of these businesses of $94 million, or $0.13 per diluted share, in its first quarter 2012 results. The Company has reported the ASI and KEO businesses as discontinued operations in its consolidated financial statements. Accordingly, the results of operations for all periods presented reflect these businesses as discontinued operations. Capital Expenditures Capital expenditures are made primarily for increasing capacity, replacing equipment, supporting new product development, improving information technology systems and the manufacture of instruments that are used in operating-type lease arrangements that certain of the Company’s businesses enter into with customers. Capital expenditures totaled $598 million in 2014, $552 million in 2013 and $458 million in 2012. The increase in capital spending in 2014 and 2013 is due primarily to increases in equipment leased to customers. In 2015, the Company expects capital spending to be between $650 million and $700 million, though actual expenditures will ultimately depend on business conditions. Financing Activities and Indebtedness Cash flows from financing activities consist primarily of proceeds from the issuance of commercial paper, common stock and debt, excess tax benefits from stock-based compensation, payments of principal on indebtedness, payments for repurchases of common stock and payments of cash dividends to shareholders. Financing activities used cash of $218 million during 2014 compared to $1.6 billion of cash used during 2013. The year-over-year decrease was due primarily to the incrementally lower year-over-year repayment of borrowings with maturities longer than 90 days and incrementally higher year-over-year net proceeds received from the issuance of commercial paper borrowings. The Company repaid the 2014 Notes upon their maturity in June 2014. Total debt was $3.5 billion as of December 31, 2014 and 2013. The Company’s debt as of December 31, 2014 was as follows: • $765 million of outstanding commercial paper; • $500 million aggregate principal amount of 2.3% senior unsecured notes due 2016 (the “2016 Notes”); • $500 million aggregate principal amount of 5.625% senior unsecured notes due 2018 (the “2018 Notes”); • $750 million aggregate principal amount of 5.4% senior unsecured notes due 2019 (the “2019 Notes”); • $600 million aggregate principal amount of 3.9% senior unsecured notes due 2021 (the “2021 Notes” and together with the 2016 Notes, the “2011 Financing Notes”); • $130 million (CHF 120 million aggregate principal amount) of 4.0% bonds due 2016 (the “2016 Bonds”); • $111 million of zero coupon Liquid Yield Option Notes due 2021 (“LYONs”); and • $118 million of other borrowings. The 2011 Financing Notes, the 2018 Notes and the 2019 Notes are collectively referred to as the “Notes”. Commercial Paper Programs and Credit Facility The Company satisfies any short-term liquidity needs that are not met through operating cash flow and available cash primarily through issuances of commercial paper under its U.S. and Euro commercial paper programs. Under these programs, the Company or a subsidiary of the Company, as applicable, may issue and sell unsecured, short-term promissory notes. Interest expense on the notes is paid at maturity and is generally based on the ratings assigned to the Company by credit rating agencies at the time of the issuance and prevailing market rates measured by reference to LIBOR. Borrowings under the program are available for general corporate purposes, including acquisitions. During 2014, as commercial paper balances matured the Company either paid such balances from available cash or refinanced such balances by issuing new commercial paper. As of December 31, 2014, the Company had $450 million in U.S. dollar denominated commercial paper outstanding and $315 million (€260 million) of commercial paper outstanding under the Euro commercial paper program. As of December 31, 2014, borrowings outstanding under the Company’s U.S. and Euro commercial paper programs had a weighted average annual interest rate of 0.13% and a weighted average remaining maturity of approximately twelve days. Commercial paper outstanding at any one time during the year had balances ranging from $450 million to $822 million, carried interest at annual rates ranging between 0.04% and 0.2% and had original maturities between seven and thirty-four days. The Company has classified its borrowings outstanding under the commercial paper program as of December 31, 2014 as long-term debt in the Consolidated Balance Sheet as the Company had the intent and ability, as supported by availability under the Credit Facility referenced below, to refinance these borrowings for at least one year from the balance sheet date. Credit support for the commercial paper program is provided by a $2.5 billion unsecured multi-year revolving credit facility with a syndicate of banks that expires on July 15, 2016 (the “Credit Facility”). The Credit Facility can also be used for working capital and other general corporate purposes. Under the Credit Facility, borrowings (other than bid loans) bear interest at a rate equal to (at the Company’s option) either (1) a LIBOR-based rate plus a margin that varies according to the Company’s long-term debt credit rating (the “Eurodollar Rate”), or (2) the highest of (a) the Federal funds rate plus 1/2 of 1%, (b) the prime rate and (c) the Eurodollar Rate plus 1%, plus in each case a margin that varies according to the Company’s long-term debt credit rating. In addition to certain initial fees the Company paid at inception of the Credit Facility, the Company is obligated to pay an annual commitment fee that varies according to its long-term debt credit rating. The Credit Facility requires the Company to maintain a consolidated leverage ratio (as defined in the facility) of 0.65 to 1.00 or less, and also contains customary representations, warranties, conditions precedent, events of default, indemnities and affirmative and negative covenants. As of December 31, 2014, no borrowings were outstanding under the Credit Facility and the Company was in compliance with all covenants under the facility. The non-performance by any member of the Credit Facility syndicate would reduce the maximum capacity of the Credit Facility by such member's commitment amount. In addition to the Credit Facility, the Company has entered into reimbursement agreements with various commercial banks to support the issuance of letters of credit. The availability of the Credit Facility as a standby liquidity facility to repay maturing commercial paper is an important factor in maintaining the existing credit ratings of the Company’s commercial paper programs. The Company expects to limit any borrowings under the Credit Facility to amounts that would leave sufficient credit available under the facility to allow the Company to borrow, if needed, to repay all of the outstanding commercial paper as it matures. The Company’s ability to access the commercial paper market, and the related costs of these borrowings, is affected by the strength of the Company’s credit rating and market conditions. Any downgrade in the Company’s credit rating would increase the cost of borrowings under the Company’s commercial paper program and the Credit Facility, and could limit or preclude the Company’s ability to issue commercial paper. If the Company’s access to the commercial paper market is adversely affected due to a downgrade, change in market conditions or otherwise, the Company expects it would rely on a combination of available cash, operating cash flow and the Company’s Credit Facility to provide short-term funding. In such event, the cost of borrowings under the Company’s Credit Facility could be higher than the cost of commercial paper borrowings. Other Long-Term Indebtedness 2013 Notes, 2014 Notes, 2016 Notes and 2021 Notes-On June 23, 2011, the Company completed the underwritten public offering of the 2011 Financing Notes, the 2013 Notes and the 2014 Notes, all of which are (or in the case of the 2013 Notes and 2014 Notes were) unsecured. The 2013 Notes were issued at 100% of their principal amount, accrued interest at a floating rate equal to three-month LIBOR plus 0.25% per year and matured and were repaid in June 2013. The 2014 Notes were issued at 99.918% of their principal amount, accrued interest at the rate of 1.3% per year and matured and were repaid in June 2014. The 2016 Notes were issued at 99.84% of their principal amount, will mature on June 23, 2016 and accrue interest at the rate of 2.3% per year. The 2021 Notes were issued at 99.975% of their principal amount, will mature on June 23, 2021 and accrue interest at the rate of 3.9% per year. The net proceeds from the 2011 Financing Notes, 2013 Notes and 2014 Notes offering, after deducting expenses and the underwriters’ discount, were approximately $1.8 billion and were used to fund a portion of the purchase price for the acquisition of Beckman Coulter. The Company paid interest on the 2013 Notes quarterly in arrears on March 21, June 21, September 21 and December 21 of each year. The Company paid interest on the 2014 Notes, and pays interest on the 2016 Notes and 2021 Notes semi-annually in arrears, on June 23 and December 23 of each year. 2019 Notes-In March 2009, the Company completed an underwritten public offering of the 2019 Notes, which were issued at 99.93% of their principal amount, will mature on March 1, 2019 and accrue interest at the rate of 5.4% per year. The net proceeds, after expenses and the underwriters’ discount, were $745 million. A portion of the net proceeds were used to repay a portion of the Company’s outstanding commercial paper and the balance was used for general corporate purposes, including acquisitions. The Company pays interest on the 2019 Notes semi-annually in arrears, on March 1 and September 1 of each year. 2018 Notes-In December 2007, the Company completed an underwritten public offering of the 2018 Notes, which were issued at 99.39% of their principal amount, will mature on January 15, 2018 and accrue interest at the rate of 5.625% per year. The net proceeds, after expenses and the underwriters’ discount, were $493 million, which were used to repay a portion of the commercial paper issued to finance the acquisition of the Tektronix business. The Company pays interest on the 2018 Notes semi-annually in arrears, on January 15 and July 15 of each year. 2016 Bonds-In connection with the acquisition of Nobel Biocare in December 2014, the Company acquired bonds with an aggregate principal amount of CHF 120 million and a stated interest rate of 4.0% per year. In accordance with accounting for business combinations, the bonds were recorded at their fair value of CHF 127 million ($133 million based on exchange rates in effect at the time of the acquisition), as such, for accounting purposes interest charges recorded in the Company's statement of earnings reflect an effective interest rate of approximately 0.2% per year. The Company will pay interest on the 2016 Bonds annually in arrears on October 10 of each year (based on the stated 4.0% interest rate). The 2016 Bonds mature on October 10, 2016. LYONs-In 2001, the Company issued $830 million (value at maturity) in LYONs. The net proceeds to the Company were $505 million, of which $100 million was used to pay down debt and the balance was used for general corporate purposes, including acquisitions. The LYONs carry a yield to maturity of 2.375% (with contingent interest payable as described below). Holders of the LYONs may convert each $1,000 of principal amount at maturity into 29.0704 shares of the Company’s common stock (in the aggregate for all LYONs that were originally issued, approximately 24 million shares of the Company’s common stock) at any time on or before the maturity date of January 22, 2021. As of December 31, 2014, an aggregate of approximately 20 million shares of the Company’s common stock had been issued upon conversion of LYONs. As of December 31, 2014, the accreted value of the outstanding LYONs was lower than the traded market value of the underlying common stock issuable upon conversion. The Company may redeem all or a portion of the LYONs for cash at any time at scheduled redemption prices. Under the terms of the LYONs, the Company pays contingent interest to the holders of LYONs during any six month period from January 23 to July 22 and from July 23 to January 22 if the average market price of a LYON for a specified measurement period equals 120% or more of the sum of the issue price and accrued original issue discount for such LYON. The amount of contingent interest to be paid with respect to any quarterly period is equal to the higher of either 0.0315% of the bonds’ average market price during the specified measurement period or the amount of the common stock dividend paid during such quarterly period multiplied by the number of shares issuable upon conversion of a LYON. The Company paid $2 million, $1 million and $1 million of contingent interest on the LYONs for each of the years ended December 31, 2014, 2013 and 2012, respectively. Except for the contingent interest described above, the Company will not pay interest on the LYONs prior to maturity. Eurobond Notes-On July 21, 2006, a financing subsidiary of the Company issued the Eurobond Notes in a private placement outside the United States. Payment obligations under these Eurobond Notes were guaranteed by the Company. The net proceeds of the offering, after the deduction of underwriting commissions but prior to the deduction of other issuance costs, were €496 million ($627 million based on exchange rates in effect at the time the offering closed) and were used to pay down a portion of the Company’s outstanding commercial paper and for general corporate purposes, including acquisitions. The Eurobond Notes matured and were repaid in July 2013. Covenants and Redemption Provisions Applicable to the Notes and the 2016 Bonds The Company may redeem some or all of the 2016 Notes, the 2018 Notes and/or the 2019 Notes at any time by paying the principal amount and a “make-whole” premium, plus accrued and unpaid interest. Prior to March 23, 2021 (three months prior to their maturity date), the Company may redeem some or all of the 2021 Notes by paying the principal amount and a “make-whole” premium, plus accrued and unpaid interest. On or after March 23, 2021, the Company may redeem some or all of the 2021 Notes for their principal amount plus accrued and unpaid interest. At any time after 85% or more of the 2016 Bonds have been redeemed or purchased and canceled, the Company may redeem some or all of the remaining 2016 Bonds for their principal amount plus accrued and unpaid interest. If a change of control triggering event occurs with respect to the Notes, each holder of Notes may require the Company to repurchase some or all of its Notes at a purchase price equal to 101% of the principal amount of the Notes, plus accrued interest. A change of control triggering event means the occurrence of both a change of control and a rating event, each as defined in the applicable supplemental indenture. Except in connection with a change of control triggering event as described above, the Company does not have any credit rating downgrade triggers that would accelerate the maturity of a material amount of outstanding debt. The indentures pursuant to which the Notes were issued each contain customary covenants including, for example, limits on the incurrence of secured debt and sale/leaseback transactions, and the 2016 Bonds are subject to similar covenants. None of these covenants are considered restrictive to the Company’s operations and as of December 31, 2014, the Company was in compliance with all of its debt covenants. For additional details regarding the Company’s debt as of December 31, 2014 see Note 9 to the Consolidated Financial Statements. Shelf Registration Statement The Company has filed a “well-known seasoned issuer” shelf registration statement on Form S-3 with the SEC that registers an indeterminate amount of debt securities, common stock, preferred stock, warrants, depositary shares, purchase contracts and units for future issuance. The Company expects to use net proceeds realized by the Company from future securities sales off this shelf registration statement for general corporate purposes, including without limitation repayment or refinancing of debt or other corporate obligations, acquisitions, capital expenditures, share repurchases and dividends, and working capital. Stock Repurchase Program On July 16, 2013, the Company's Board of Directors approved a new repurchase program (the “2013 Repurchase Program”) authorizing the repurchase of up to 20 million shares of the Company's common stock from time to time on the open market or in privately negotiated transactions. The 2013 Repurchase Program replaced the repurchase program approved by the Company's Board of Directors in May 2010 (the “2010 Repurchase Program”). There is no expiration date for the 2013 Repurchase Program, and the timing and amount of any shares repurchased under the program will be determined by the Company's management based on its evaluation of market conditions and other factors. The 2013 Repurchase Program may be suspended or discontinued at any time. Any repurchased shares will be available for use in connection with the Company's equity compensation plans (or any successor plan) and for other corporate purposes. As of December 31, 2014, 20 million shares remained available for repurchase pursuant to the 2013 Repurchase Program. The Company expects to fund any future stock repurchases using the Company's available cash balances or proceeds from the issuance of commercial paper. Neither the Company nor any “affiliated purchaser” repurchased any shares of Company common stock during 2014 and 2013. During the year ended December 31, 2012, the Company repurchased approximately 12.5 million shares of Company common stock under the 2010 Repurchase Program in open market transactions at a cost of $648 million. Dividends The Company declared a regular quarterly dividend of $0.10 per share that was paid on January 30, 2015 to holders of record on December 26, 2014. Aggregate cash payments for dividends during 2014 were $228 million. Dividend payments were higher in 2014 as compared to 2013 as the Company increased its quarterly dividend rate in the first quarter of 2014 to $0.10 per share and because the Company made no cash payments for dividends during the first quarter of 2013. The Company's Board accelerated the quarterly dividend payment that normally would have been paid in January 2013 and paid it in December 2012. Cash and Cash Requirements As of December 31, 2014, the Company held approximately $3.0 billion of cash and cash equivalents that were invested in highly liquid investment grade debt instruments with a maturity of 90 days or less with an approximate weighted average annual interest rate of 0.4%. Of this amount $813 million was held within the United States and approximately $2.2 billion was held outside of the United States. The Company will continue to have cash requirements to support working capital needs, capital expenditures and acquisitions, to pay interest and service debt, pay taxes and any related interest or penalties, fund its restructuring activities and pension plans as required, repurchase shares of the Company’s common stock, pay dividends to shareholders and support other business needs. The Company generally intends to use available cash and internally generated funds to meet these cash requirements, but in the event that additional liquidity is required, particularly in connection with acquisitions, the Company may also borrow under its commercial paper programs or the Credit Facility, enter into new credit facilities and either borrow directly thereunder or use such credit facilities to backstop additional borrowing capacity under its commercial paper programs and/or access the capital markets. The Company also may from time to time access the capital markets, including to take advantage of favorable interest rate environments or other market conditions. While repatriation of some cash held outside the United States may be restricted by local laws, most of the Company's foreign cash balances could be repatriated to the United States but, under current law, could be subject to U.S. federal income taxes, less applicable foreign tax credits. For most of its foreign subsidiaries, the Company makes an election regarding the amount of earnings intended for indefinite reinvestment, with the balance available to be repatriated to the United States. A deferred tax liability has been accrued for the funds that are available to be repatriated to the United States. No provisions for U.S. income taxes have been made with respect to earnings that are planned to be reinvested indefinitely outside the United States, and the amount of U.S. income taxes that may be applicable to such earnings is not readily determinable given the various tax planning alternatives the Company could employ if it repatriated these earnings. The cash that the Company's foreign subsidiaries hold for indefinite reinvestment is generally used to finance foreign operations and investments, including acquisitions. As of December 31, 2014 and 2013, the total amount of earnings planned to be reinvested indefinitely outside the United States for which deferred taxes have not been provided was approximately $11.8 billion and $10.6 billion, respectively. As of December 31, 2014, management believes that it has sufficient liquidity to satisfy its cash needs, including its cash needs in the United States. During 2014, the Company contributed $52 million to its U.S. defined benefit pension plan and $62 million to its non-U.S. defined benefit pension plans. During 2015, the Company’s cash contribution requirements for its U.S. and its non-U.S. defined benefit pension plans are expected to be approximately $25 million and $55 million, respectively. The ultimate amounts to be contributed depend upon, among other things, legal requirements, underlying asset returns, the plan’s funded status, the anticipated tax deductibility of the contribution, local practices, market conditions, interest rates and other factors. Contractual Obligations The following table sets forth, by period due or year of expected expiration, as applicable, a summary of the Company’s contractual obligations relating to continuing operations as of December 31, 2014 under (1) long-term debt obligations, (2) leases, (3) purchase obligations and (4) other long-term liabilities reflected on the Company’s balance sheet under GAAP. The amounts presented in the table below do not reflect $804 million of gross unrecognized tax benefits, the timing of which is uncertain. Refer to Note 12 to the Consolidated Financial Statements for additional information on unrecognized tax benefits. Certain of our acquisitions also involve the potential payment of contingent consideration. The table below does not reflect any such obligations, as the timing and amounts of any such payments are uncertain. Refer to “-Off-Balance Sheet Arrangements” for a discussion of other contractual obligations that are not reflected in the table below. (a) As described in Note 9 to the Consolidated Financial Statements. (b) Amounts do not include interest payments. Interest on long-term debt and capital lease obligations is reflected in a separate line in the table. (c) Interest payments on long-term debt are projected for future periods using the interest rates in effect as of December 31, 2014. Certain of these projected interest payments may differ in the future based on changes in market interest rates. (d) As described in Note 15 to the Consolidated Financial Statements, certain leases require the Company to pay real estate taxes, insurance, maintenance and other operating expenses associated with the leased premises. These future costs are not included in the schedule above. (e) Consist of agreements to purchase goods or services that are enforceable and legally binding on the Company and that specify all significant terms, including fixed or minimum quantities to be purchased, fixed, minimum or variable price provisions and the approximate timing of the transaction. (f) Primarily consist of obligations under product service and warranty policies and allowances, performance and operating cost guarantees, estimated environmental remediation costs, self-insurance and litigation claims, post-retirement benefits, pension obligations, deferred tax liabilities (excluding unrecognized tax benefits) and deferred compensation obligations. The timing of cash flows associated with these obligations is based upon management’s estimates over the terms of these arrangements and is largely based upon historical experience. Off-Balance Sheet Arrangements The following table sets forth, by period due or year of expected expiration, as applicable, a summary of off-balance sheet commitments of the Company as of December 31, 2014. Guarantees consist primarily of outstanding standby letters of credit, bank guarantees and performance and bid bonds. These guarantees have been provided in connection with certain arrangements with vendors, customers, financing counterparties and governmental entities to secure the Company’s obligations and/or performance requirements related to specific transactions. Other Off-Balance Sheet Arrangements The Company has from time to time divested certain of its businesses and assets. In connection with these divestitures, the Company often provides representations, warranties and/or indemnities to cover various risks and unknown liabilities, such as claims for damages arising out of the use of products or relating to intellectual property matters, commercial disputes, environmental matters or tax matters. The Company has not included any such items in the contractual obligations table above because they relate to unknown conditions and the Company cannot estimate the potential liabilities from such matters, but the Company does not believe it is reasonably possible that any such liability will have a material effect on the Company’s financial statements. In addition, as a result of these divestitures, as well as restructuring activities, certain properties leased by the Company have been sublet to third parties. In the event any of these third parties vacate any of these premises, the Company would be legally obligated under master lease arrangements. The Company believes that the financial risk of default by such sub-lessors is individually and in the aggregate not material to the Company’s financial statements. In the normal course of business, the Company periodically enters into agreements that require it to indemnify customers, suppliers or other business partners for specific risks, such as claims for injury or property damage arising out of the Company’s products or services or claims alleging that Company products, services or software infringe third party intellectual property. The Company has not included any such indemnification provisions in the contractual obligations table above. Historically, the Company has not experienced significant losses on these types of indemnification obligations. The Company’s Restated Certificate of Incorporation requires it to indemnify to the full extent authorized or permitted by law any person made, or threatened to be made a party to any action or proceeding by reason of his or her service as a director or officer of the Company, or by reason of serving at the request of the Company as a director or officer of any other entity, subject to limited exceptions. Danaher’s Amended and Restated By-laws provide for similar indemnification rights. In addition, Danaher has executed with each director and executive officer of Danaher Corporation an indemnification agreement which provides for substantially similar indemnification rights and under which Danaher has agreed to pay expenses in advance of the final disposition of any such indemnifiable proceeding. While the Company maintains insurance for this type of liability, a significant deductible applies to this coverage and any such liability could exceed the amount of the insurance coverage. Legal Proceedings Please refer to Note 16 to the Consolidated Financial Statements included in this Annual Report for information regarding legal proceedings and contingencies, and for a discussion of risks related to legal proceedings and contingencies, please refer to “Item 1A. Risk Factors.” CRITICAL ACCOUNTING ESTIMATES Management’s discussion and analysis of the Company’s financial condition and results of operations is based upon the Company’s Consolidated Financial Statements, which have been prepared in accordance with accounting principles generally accepted in the United States. The preparation of these financial statements requires management to make estimates and judgments that affect the reported amounts of assets, liabilities, revenues and expenses, and related disclosure of contingent assets and liabilities. The Company bases these estimates and judgments on historical experience, the current economic environment and on various other assumptions that are believed to be reasonable under the circumstances. Actual results may differ materially from these estimates and judgments. The Company believes the following accounting estimates are most critical to an understanding of its financial statements. Estimates are considered to be critical if they meet both of the following criteria: (1) the estimate requires assumptions about material matters that are uncertain at the time the estimate is made, and (2) material changes in the estimate are reasonably likely from period to period. For a detailed discussion on the application of these and other accounting estimates, refer to Note 1 in the Company’s Consolidated Financial Statements. Accounts Receivable: The Company maintains allowances for doubtful accounts to reflect probable credit losses inherent in its portfolio of receivables. Determination of the allowances requires management to exercise judgment about the timing, frequency and severity of credit losses that could materially affect the allowances for doubtful accounts and, therefore, net income. The allowances for doubtful accounts represent management’s best estimate of the credit losses expected from the Company’s trade accounts, contract and finance receivable portfolios. The level of the allowances is based on many quantitative and qualitative factors including historical loss experience by receivable type, portfolio duration, delinquency trends, economic conditions and credit risk quality. The Company regularly performs detailed reviews of its accounts receivable portfolio to determine if an impairment has occurred and to assess the adequacy of the allowances. If the financial condition of the Company’s customers were to deteriorate with a severity, frequency and/or timing different from the Company's assumptions, additional allowances would be required and the Company’s financial statements would be adversely impacted. Inventories: The Company records inventory at the lower of cost or market value. The Company estimates the market value of its inventory based on assumptions of future demand and related pricing. Estimating the market value of inventory is inherently uncertain because levels of demand, technological advances and pricing competition in many of the Company’s markets can fluctuate significantly from period to period due to circumstances beyond the Company’s control. If actual market conditions are less favorable than those projected by management, the Company could be required to reduce the value of its inventory, which would adversely impact the Company’s financial statements. Acquired Intangibles: The Company’s business acquisitions typically result in the recognition of goodwill, in-process research and development and other intangible assets, which affect the amount of future period amortization expense and possible impairment charges that the Company may incur. Refer to Notes 1, 2 and 6 in the Company’s consolidated financial statements for a description of the Company’s policies relating to goodwill, acquired intangibles and acquisitions. In performing its goodwill impairment testing, the Company estimates the fair value of its reporting units primarily using a market based approach. The Company estimates fair value based on multiples of earnings before interest, taxes, depreciation and amortization (“EBITDA”) determined by current trading market multiples of earnings for companies operating in businesses similar to each of the Company’s reporting units, in addition to recent market available sale transactions of comparable businesses. In evaluating the estimates derived by the market based approach, management makes judgments about the relevance and reliability of the multiples by considering factors unique to its reporting units, including operating results, business plans, economic projections, anticipated future cash flows, and transactions and marketplace data as well as judgments about the comparability of the market proxies selected. In certain circumstances the Company also estimates fair value utilizing a discounted cash flow analysis (i.e., an income approach) in order to validate the results of the market approach. The discounted cash flow model requires judgmental assumptions about projected revenue growth, future operating margins, discount rates and terminal values. There are inherent uncertainties related to these assumptions and management’s judgment in applying them to the analysis of goodwill impairment. As of December 31, 2014, the Company had twenty-two reporting units for goodwill impairment testing. Reporting units resulting from recent acquisitions generally present the highest risk of impairment. Management believes the impairment risk associated with these reporting units decreases as these businesses are integrated into the Company and better positioned for potential future earnings growth. The carrying value of the goodwill included in each individual reporting unit ranges from $7 million to $4.3 billion. The Company’s annual goodwill impairment analysis in 2014 indicated that in all instances, the fair values of the Company’s reporting units exceeded their carrying values and consequently did not result in an impairment charge. The excess of the estimated fair value over carrying value (expressed as a percentage of carrying value for the respective reporting unit) for each of the Company’s reporting units as of the annual testing date ranged from approximately 10% to approximately 1140%. In order to evaluate the sensitivity of the fair value calculations used in the goodwill impairment test, the Company applied a hypothetical 10% decrease to the fair values of each reporting unit and compared those values to the reporting unit carrying values. Based on this hypothetical 10% decrease, the excess of the estimated fair value over carrying value (expressed as a percentage of carrying value for the respective reporting unit) for each of the Company’s reporting units ranged from approximately 2% to approximately 1015%. The Company reviews identified intangible assets for impairment whenever events or changes in circumstances indicate that the related carrying amounts may not be recoverable. The Company also tests intangible assets with indefinite lives at least annually for impairment. Determining whether an impairment loss occurred requires a comparison of the carrying amount to the sum of undiscounted cash flows expected to be generated by the asset. These analyses require management to make judgments and estimates about future revenues, expenses, market conditions and discount rates related to these assets. If actual results are not consistent with management’s estimates and assumptions, goodwill and other intangible assets may be overstated and a charge would need to be taken against net earnings which would adversely affect the Company’s financial statements. Contingent Liabilities: As discussed in Note 16 to the Consolidated Financial Statements, the Company is, from time to time, subject to a variety of litigation and similar contingent liabilities incidental to its business (or the business operations of previously owned entities). The Company recognizes a liability for any contingency that is known or probable of occurrence and reasonably estimable. These assessments require judgments concerning matters such as litigation developments and outcomes, the anticipated outcome of negotiations, the number of future claims and the cost of both pending and future claims. In addition, because most contingencies are resolved over long periods of time, liabilities may change in the future due to various factors, including those discussed in Note 16 to the Consolidated Financial Statements. If the reserves established by the Company with respect to these contingent liabilities are inadequate, the Company would be required to incur an expense equal to the amount of the loss incurred in excess of the reserves, which would adversely affect the Company’s financial statements. Revenue Recognition: The Company derives revenues from the sale of products and services. Refer to Note 1 to the Company’s Consolidated Financial Statements for a description of the Company’s revenue recognition policies. Although most of the Company’s sales agreements contain standard terms and conditions, certain agreements contain multiple elements or non-standard terms and conditions. As a result, judgment is sometimes required to determine the appropriate accounting, including whether the deliverables specified in these agreements should be treated as separate units of accounting for revenue recognition purposes, and, if so, how the consideration should be allocated among the elements and when to recognize revenue for each element. The Company allocates revenue to each element in the contractual arrangement based on the selling price hierarchy that, in some instances, may require the Company to estimate the selling price of certain deliverables that are not sold separately or where third party evidence of pricing is not observable. The Company’s estimate of selling price impacts the amount and timing of revenue recognized in multiple element arrangements. The Company also enters into lease arrangements with customers, which requires the Company to determine whether the arrangements are operating or sales-type leases. Certain of the Company’s lease contracts are customized for larger customers and often result in complex terms and conditions that typically require significant judgment in applying the lease accounting criteria. If the Company's judgments regarding revenue recognition prove incorrect, the Company's revenues in particular periods may be adversely affected. Stock-Based Compensation: For a description of the Company’s stock-based compensation accounting practices, refer to Note 17 to the Company’s Consolidated Financial Statements. Determining the appropriate fair value model and calculating the fair value of stock-based payment awards require subjective assumptions, including the expected life of the awards, stock price volatility and expected forfeiture rate. The assumptions used in calculating the fair value of stock-based payment awards represent the Company’s best estimates, but these estimates involve inherent uncertainties and the application of management judgment. If actual results are not consistent with management’s assumptions and estimates, the Company’s equity-based compensation expense could be materially different in the future. Pension and Other Post-retirement Benefits: For a description of the Company’s pension and other post-retirement benefit accounting practices, refer to Notes 10 and 11 in the Company’s Consolidated Financial Statements. Calculations of the amount of pension and other post-retirement benefit costs and obligations depend on the assumptions used in the actuarial valuations, including assumptions regarding discount rates, expected return on plan assets, rates of salary increases, health care cost trend rates, mortality rates, and other factors. If the assumptions used in calculating pension and other post-retirement benefits costs and obligations are incorrect or if the factors underlying the assumptions change (as a result of differences in actual experience, changes in key economic indicators or other factors) the Company’s financial statements could be materially affected. A 50 basis point reduction in the discount rates used for the plans would have increased the U.S. net obligation by $150 million ($94 million on an after tax basis) and the non-U.S. net obligation by $138 million ($107 million on an after tax basis) from the amounts recorded in the financial statements as of December 31, 2014. For 2014, the estimated long-term rate of return for the U.S. plan is 7.5%, and the Company intends to use an assumption of 7.5% for 2015. This expected rate of return reflects the asset allocation of the plan and the expected long-term returns on equity and debt investments included in plan assets. The U.S. plan targets to invest between 60% and 70% of its assets in equity portfolios which are invested in funds that are expected to mirror broad market returns for equity securities or in assets with characteristics similar to equity investments. The balance of the asset portfolio is generally invested in bond funds. The Company’s non-U.S. plan assets consist of various insurance contracts, equity and debt securities as determined by the administrator of each plan. The estimated long-term rate of return for the non-U.S. plans was determined on a plan by plan basis based on the nature of the plan assets and ranged from 1.25% to 7.10%. If the expected long-term rate of return on plan assets for 2014 was reduced by 50 basis points, pension expense for the U.S. and non-U.S. plans for 2014 would have increased $10 million ($6 million on an after-tax basis) and $4 million ($3 million on an after-tax basis), respectively. For a discussion of the Company’s 2014 and anticipated 2015 defined benefit pension plan contributions, please see “-Liquidity and Capital Resources - Cash and Cash Requirements”. Income Taxes: For a description of the Company's income tax accounting policies, refer to Notes 1 and 12 to the Company's Consolidated Financial Statements. The Company establishes valuation allowances for its deferred tax assets if it is more likely than not that some or all of the deferred tax asset will not be realized which requires management to make judgments and estimates regarding: (1) the timing and amount of the reversal of taxable temporary differences, (2) expected future taxable income, and (3) the impact of tax planning strategies. Future changes to tax rates would also impact the amounts of deferred tax assets and liabilities and could have an adverse impact on the Company’s financial statements. The Company provides for unrecognized tax benefits when, based upon the technical merits, it is “more-likely-than-not” that an uncertain tax position will not be sustained upon examination. Judgment is required in evaluating tax positions and determining income tax provisions. The Company re-evaluates the technical merits of its tax positions and may recognize an uncertain tax benefit in certain circumstances, including when: (i) a tax audit is completed; (ii) applicable tax laws change, including a tax case ruling or legislative guidance; or (iii) the applicable statute of limitations expires. In addition, certain of the Company's tax returns are currently under review by tax authorities including in Denmark (see “-Results of Operations - Income Taxes" and Note 12 of the Notes to the Consolidated Financial Statements). Management believes the positions taken in these returns are in accordance with the relevant tax laws. However, the outcome of these audits is uncertain and could result in the Company being required to record charges for prior year tax obligations which could have a material adverse impact to the Company's financial statements, including its effective tax rate. An increase in the Company's nominal tax rate of 1.0% would have resulted in an additional income tax provision for continuing operations for the fiscal year ended December 31, 2014 of $35 million. NEW ACCOUNTING STANDARDS In May 2014, the Financial Accounting Standards Board ("FASB") issued Accounting Standards Update ("ASU") No. 2014-09, Revenue from Contracts with Customers (Topic 606), which impacts virtually all aspects of an entity's revenue recognition. The core principle of the new standard is that revenue should be recognized to depict the transfer of promised goods or services to customers in an amount that reflects the consideration to which the entity expects to be entitled in exchange for those goods or services. The standard is effective for annual reporting periods beginning after December 15, 2016. Management has not yet completed its assessment of the impact of the new standard, including possible transition alternatives, on the Company's financial statements.

<s>[INST] Overview Results of Operations Liquidity and Capital Resources Critical Accounting Estimates New Accounting Standards OVERVIEW General Please see “Item 1. Business General” for a discussion of Danaher’s objectives and methodologies for delivering shareholder value. Danaher is a multinational corporation with global operations. During 2014, approximately 57% of Danaher’s sales were derived from customers outside the United States. As a diversified, global business, Danaher’s operations are affected by worldwide, regional and industryspecific economic and political factors. Danaher’s geographic and industry diversity, as well as the range of its products and services, typically help limit the impact of any one industry or the economy of any single country on the consolidated operating results. Given the broad range of products manufactured, software and services provided and geographies served, management does not use any indices other than general economic trends to predict the overall outlook for the Company. The Company’s individual businesses monitor key competitors and customers, including to the extent possible their sales, to gauge relative performance and the outlook for the future. As a result of the Company’s geographic and industry diversity, the Company faces a variety of opportunities and challenges, including rapid technological development (particularly with respect to computing, mobile connectivity, communications and digitization) in most of the Company’s served markets, the expansion and evolution of opportunities in highgrowth markets, trends and costs associated with a global labor force, consolidation of the Company’s competitors and increasing regulation. The Company operates in a highly competitive business environment in most markets, and the Company’s longterm growth and profitability will depend in particular on its ability to expand its business in highgrowth geographies and highgrowth market segments, identify, consummate and integrate appropriate acquisitions, develop innovative and differentiated new products, services and software with higher gross profit margins, expand and improve the effectiveness of the Company’s sales force, continue to reduce costs and improve operating efficiency and quality, and effectively address the demands of an increasingly regulated environment. The Company is making significant investments, organically and through acquisitions, to address the rapid pace of technological change in its served markets and to globalize its manufacturing, research and development and customerfacing resources (particularly in highgrowth markets) in order to be responsive to the Company’s customers throughout the world and improve the efficiency of the Company’s operations. Business Performance and Outlook While differences exist among the Company’s businesses, on an overall basis, demand for the Company’s products, software and services increased in 2014 compared to 2013 driving yearoveryear sales growth from existing businesses. The Company’s continued investments in sales growth initiatives and the other businessspecific factors discussed below also contributed to yearoveryear sales growth. Geographically, yearoveryear sales growth rates from existing businesses during 2014 were led primarily by the highgrowth markets. Sales from existing businesses in highgrowth markets grew at a midsingle digit rate in 2014 compared to 2013 and sales from highgrowth markets represented approximately 26% of the Company's total sales in 2014. Sales from existing businesses in developed markets grew at a lowsingle digit rate in 2014 compared to 2013 and were driven by North America and Western Europe. The Company expects overall sales growth to continue but remains cautious about challenges due to macroeconomic and geopolitical uncertainties and global uncertainties related to monetary and fiscal policies. While individual business results will vary, the Company expects sales from existing businesses to continue to grow on a yearoveryear basis during 2015 at a level in line with the growth levels experienced in 2014. Restructuring Activities Consistent with the Company's approach of positioning itself to provide superior products and services to its customers in a cost efficient manner, in the second half of 2014 the Company initiated actions to improve productivity and reduce costs in its businesses. The actions, which were substantially completed by December 31, 2014, resulted in pretax charges of approximately $155 million, the majority of which was incurred in the fourth quarter of 2014. [/INST] Positive. </s>

DANAHER CORP /DE/

2016-02-24

2015-12-31

ITEM 7. MANAGEMENT’S DISCUSSION AND ANALYSIS OF FINANCIAL CONDITION AND RESULTS OF OPERATIONS Management’s Discussion and Analysis of Financial Condition and Results of Operations (“MD&A”) is designed to provide a reader of Danaher’s financial statements with a narrative from the perspective of Company management. The Company’s MD&A is divided into five sections: • Overview • Results of Operations • Liquidity and Capital Resources • Critical Accounting Estimates • New Accounting Standards OVERVIEW General Please see “Item 1. Business - General” for a discussion of Danaher’s objectives and methodologies for delivering shareholder value. Danaher is a multinational corporation with global operations. During 2015, approximately 56% of Danaher’s sales were derived from customers outside the United States. As a diversified, global business, Danaher’s operations are affected by worldwide, regional and industry-specific economic and political factors. Danaher’s geographic and industry diversity, as well as the range of its products and services, typically help limit the impact of any one industry or the economy of any single country on the consolidated operating results. Given the broad range of products manufactured, software and services provided and geographies served, management does not use any indices other than general economic trends to predict the overall outlook for the Company. The Company’s individual businesses monitor key competitors and customers, including to the extent possible their sales, to gauge relative performance and the outlook for the future. As a result of the Company’s geographic and industry diversity, the Company faces a variety of opportunities and challenges, including rapid technological development (particularly with respect to computing, mobile connectivity, communications and digitization) in most of the Company’s served markets, the expansion and evolution of opportunities in high-growth markets, trends and costs associated with a global labor force, consolidation of the Company’s competitors and increasing regulation. The Company operates in a highly competitive business environment in most markets, and the Company’s long-term growth and profitability will depend in particular on its ability to expand its business in high-growth geographies and high-growth market segments, identify, consummate and integrate appropriate acquisitions, develop innovative and differentiated new products, services and software with higher gross profit margins, expand and improve the effectiveness of the Company’s sales force, continue to reduce costs and improve operating efficiency and quality, and effectively address the demands of an increasingly regulated environment. The Company is making significant investments, organically and through acquisitions, to address the rapid pace of technological change in its served markets and to globalize its manufacturing, research and development and customer-facing resources (particularly in high-growth markets) in order to be responsive to the Company’s customers throughout the world and improve the efficiency of the Company’s operations. Business Performance and Outlook While differences exist among the Company’s businesses, on an overall basis, demand for the Company’s products, software and services increased in 2015 as compared to 2014 resulting in aggregate year-over-year sales growth from existing businesses of 3.0%. The Company’s continued investments in sales growth initiatives and the other business-specific factors discussed below also contributed to year-over-year sales growth. Geographically, both high-growth and developed markets contributed to year-over-year sales growth from existing businesses during 2015. Sales growth rates from existing businesses in high-growth markets grew at a mid-single digit rate in 2015 as compared to 2014 led by strength in China and India, partially offset by weakness in Russia and Latin America. High-growth markets represented approximately 27% of the Company’s total sales in 2015. Sales from existing businesses in developed markets grew at a low-single digit rate in 2015 as compared to 2014 and were driven by North America and Western Europe. While individual business results will vary, the Company expects sales from existing businesses to continue to grow on a year-over-year basis during 2016 at a level in line with the growth levels experienced in 2015 but remains cautious about challenges due to macro-economic and geopolitical uncertainties, including global uncertainties related to monetary and fiscal policies. The acquisition of Pall, as further discussed below, provides additional sales and earnings growth opportunities for the Company’s Life Sciences and Diagnostics segment by expanding the segment’s geographic and product line diversity, including new and complementary product and service offerings in the area of filtration, separation and purification technologies, and through the potential acquisition of complementary businesses. As Pall is integrated into the Company, the Company also expects to realize significant cost synergies through the application of the Danaher Business System and the combined purchasing power of the Company and Pall. Danaher Separation On May 13, 2015, the Company announced its intention to separate into two independent, publicly traded companies (the “Separation”). Completion of the Separation will create: • a multi-industry, science and technology growth company that will retain the Danaher name and consist of Danaher’s existing Life Sciences & Diagnostics (including Pall) and Dental segments and water quality as well as the product identification businesses, which in aggregate generated approximately $16.5 billion of revenue in 2015 (adjusted to include the full annual revenues of Pall for 2015); and • a diversified industrial growth company (Fortive Corporation (“Fortive”)) that will consist of Danaher’s existing Test & Measurement segment, Industrial Technologies segment (excluding the product identification businesses) and retail/commercial petroleum business, which in aggregate generated approximately $6.0 billion of revenue in 2015. The transaction is expected to occur through a tax-free separation. The Company is targeting to complete the Separation in the third quarter of 2016, subject to final approval by Danaher’s Board of Directors and other customary conditions. The Separation will be in the form of a pro rata distribution to Danaher shareholders of 100% of the outstanding shares of Fortive. Acquisitions On August 31, 2015, Pentagon Merger Sub, Inc., a New York corporation and an indirect, wholly-owned subsidiary of the Company, acquired all of the outstanding shares of common stock of Pall, a New York corporation, for $127.20 per share in cash, for a total purchase price of approximately $13.6 billion, net of assumed debt of $417 million and acquired cash of approximately $1.2 billion (the “Pall Acquisition”). Pall is a leading global provider of filtration, separation and purification solutions that remove contaminants or separate substances from a variety of solids, liquids and gases, and is now part of the Company’s Life Sciences & Diagnostics segment. In its fiscal year ended July 31, 2015, Pall generated consolidated revenues of approximately $2.8 billion. Pall serves customers in the biopharmaceutical, food and beverage and medical markets as well as the process technologies, aerospace and microelectronics markets. The Company financed the approximately $13.6 billion acquisition price of Pall with approximately $2.5 billion of available cash, approximately $8.1 billion of net proceeds from the issuance and sale of U.S. dollar and Euro-denominated commercial paper and €2.7 billion (approximately $3.0 billion based on currency exchange rates as of the date of issuance) of net proceeds from the issuance and sale of Euro-denominated senior unsecured notes. Subsequent to the Pall Acquisition, the Company used the approximately $2.0 billion of net proceeds from the issuance of U.S. dollar-denominated senior unsecured notes and the approximately CHF 755 million ($732 million based on currency exchange rates as of date of issuance) of net proceeds, including the related premium, from the issuance and sale of Swiss franc-denominated senior unsecured bonds to repay a portion of the commercial paper issued to finance the Pall Acquisition. In addition to the Pall Acquisition, during 2015 the Company acquired 11 businesses for total consideration of approximately $727 million in cash, net of cash acquired. The businesses acquired complement existing units of each of the Company’s five segments. The aggregate annual sales of these 11 businesses at the time of their respective acquisitions, in each case based on the company’s revenues for its last completed fiscal year prior to the acquisition, were approximately $375 million. Disposition of Communications Business In July 2015, the Company consummated the split-off of the majority of its Test & Measurement segment’s communications business (other than the data communications cable installation business and the communication service provider business of Fluke Networks which are now part of the instruments business of the Company’s Test & Measurement segment) to Danaher shareholders who elected to exchange Danaher shares for ownership interests in the communications business, and the subsequent merger of the communications business with a subsidiary of NetScout. Danaher shareholders who participated in the exchange offer tendered 26 million shares of Danaher common stock (valued at approximately $2.3 billion based on the closing price of Danaher’s common stock on the date of tender) and received 62.5 million shares of NetScout common stock which represented approximately 60% of the shares of NetScout common stock outstanding following the combination. The accounting requirements for reporting the disposition of the communications business as a discontinued operation were met when the separation and merger were completed. Accordingly, the accompanying consolidated financial statements for all periods presented reflect this business as discontinued operations. The Company allocated a portion of the consolidated interest expense to discontinued operations based on the ratio of the discontinued business’ net assets to the Company’s consolidated net assets. The Company recorded an aggregate after-tax gain on the disposition of this business of $767 million, or $1.08 per diluted share, in its 2015 results in connection with the closing of this transaction representing the value of the 26 million shares of Company common stock tendered for the communications business in excess of the carrying value of the business’ net assets. This gain was included in the results of discontinued operations for the year ended December 31, 2015 and included $47 million of charges recorded in the fourth quarter of 2015 resulting from the reconciliation of deferred income tax balances used in calculating the gain recorded in the third quarter of 2015. The communications business had revenues of $346 million in 2015 prior to the disposition and $760 million in 2014. For a discussion of the Company’s 2014 and 2013 acquisition and divestiture activity, refer to “Liquidity and Capital Resources - Investing Activities”. Sale of Investments During 2015, the Company received cash proceeds of $43 million from the sale of certain marketable equity securities and recorded a pretax gain related to these sales of $12 million ($8 million after-tax or $0.01 per diluted share). For a discussion of the Company’s 2014 and 2013 sale of investments activity, refer to “Liquidity and Capital Resources - Investing Activities”. RESULTS OF OPERATIONS Consolidated sales for the year ended December 31, 2015 increased 7.5% compared to 2014. Sales from existing businesses contributed 3.0% growth and sales from acquired businesses contributed 10.5% growth on a year-over-year basis. The impact of currency translation reduced reported sales by 6.0% as the U.S. dollar was, on average, stronger against other major currencies during 2015 as compared to exchange rate levels during 2014. Consolidated sales for the year ended December 31, 2014 increased 5.0% compared to 2013. Sales from existing businesses contributed 4.0% growth and sales from acquired businesses contributed 1.5% growth on a year-over-year basis. The impact of currency translation reduced reported sales by 0.5% as the U.S. dollar was, on average, stronger against other major currencies during 2014 as compared to exchange rate levels during 2013. In this report, references to sales from existing businesses refers to sales from continuing operations calculated according to generally accepted accounting principles in the United States (“GAAP”) but excluding (1) sales from acquired businesses and (2) the impact of currency translation. References to sales or operating profit attributable to acquisitions or acquired businesses refer to GAAP sales or operating profit, as applicable, from acquired businesses recorded prior to the first anniversary of the acquisition less the amount of sales and operating profit, as applicable, attributable to divested product lines not considered discontinued operations. The portion of revenue attributable to currency translation is calculated as the difference between (a) the period-to-period change in revenue (excluding sales from acquired businesses) and (b) the period-to-period change in revenue (excluding sales from acquired businesses) after applying current period foreign exchange rates to the prior year period. Sales from existing businesses should be considered in addition to, and not as a replacement for or superior to, sales, and may not be comparable to similarly titled measures reported by other companies. Management believes that reporting the non-GAAP financial measure of sales from existing businesses provides useful information to investors by helping identify underlying growth trends in our business and facilitating easier comparisons of our revenue performance with our performance in prior and future periods and to our peers. The Company excludes the effect of currency translation from sales from existing businesses because currency translation is not under management’s control, is subject to volatility and can obscure underlying business trends, and excludes the effect of acquisitions and divestiture related items because the nature, size and number of acquisitions and divestitures can vary dramatically from period to period and between the Company and its peers and can also obscure underlying business trends and make comparisons of long-term performance difficult. References to sales volume refer to the impact of both price and unit sales. Operating profit margins were 16.9% for the year ended December 31, 2015 as compared to 17.5% in 2014. The following factors impacted year-over-year operating profit margin comparisons. 2015 vs. 2014 operating profit margin comparisons were favorably impacted by: • Higher 2015 sales volumes from existing businesses and incremental year-over-year cost savings associated with the restructuring actions and continuing productivity improvement initiatives taken in 2014 and 2015, net of incremental year-over-year costs associated with various product development, sales and marketing growth investments and the effect of a stronger U.S. dollar in 2015 - 75 basis points • Lower year-over-year costs associated with restructuring actions and continuing productivity improvement initiatives - 25 basis points 2015 vs. 2014 operating profit margin comparisons were unfavorably impacted by: • Acquisition related charges associated with Pall, including transaction costs deemed significant, change in control payments, and fair value adjustments to acquired inventory and deferred revenue, net of the positive impact of freezing pension benefits - 65 basis points • The incremental net dilutive effect in 2015 of acquired businesses, including Pall, net of the positive effect of the product line disposition in the third quarter of 2014 - 85 basis points • Charges associated with the anticipated 2016 Separation - 10 basis points The Company deems acquisition-related transaction costs incurred in a given period to be significant (generally relating to the Company’s larger acquisitions) if it determines that such costs exceed the range of acquisition-related transaction costs typical for the Company in a given period. Operating profit margins were 17.5% for the year ended December 31, 2014 as compared to 17.1% in 2013. The following factors impacted year-over-year operating profit margin comparisons. 2014 vs. 2013 operating profit margin comparisons were favorably impacted by: • Higher 2014 sales volumes from existing businesses and incremental year-over-year cost savings associated with the restructuring actions and continuing productivity improvement initiatives taken in 2013 and 2014, net of incremental year-over-year costs associated with various product development, sales and marketing growth investments - 95 basis points 2014 vs. 2013 operating profit margin comparisons were unfavorably impacted by: • Incremental year-over-year costs associated with restructuring actions and continuing productivity improvement initiatives - 15 basis points • The incremental net dilutive effect in 2014 of acquired businesses and acquisition-related charges recorded in 2014 associated with the Nobel Biocare acquisition, including transaction costs deemed significant and fair value adjustments to acquired inventory, net of the positive effect of the product line disposition in the third quarter of 2014 - 40 basis points Business Segments Sales by business segment for the years ended December 31 are as follows ($ in millions): TEST & MEASUREMENT The Company’s Test & Measurement segment offers essential products, software and services used to create actionable intelligence by measuring and monitoring a wide range of physical parameters in industrial applications, including electrical current, radio frequency signals, distance, pressure and temperature. The Company’s instruments products include a variety of compact professional test tools, thermal imaging and calibration equipment for electrical, industrial, electronic and calibration applications. These products and associated software solutions measure voltage, current, resistance, power quality, frequency, pressure, temperature and air quality, among other parameters. The Company also sells services and products that help developers and engineers convert concepts into finished products. The Company’s test, measurement and monitoring products are used in the design, manufacturing and development of electronics, industrial, video and other advanced technologies. Also included in the Test & Measurement segment are the Company’s professional tools and wheel service equipment businesses. As a result of the July 2015 split-off of the Company’s communications business, which was previously reported as part of the Test & Measurement segment, all current year and prior year results of the segment have been adjusted to exclude the results of this discontinued operation. See Note 3 to the Consolidated Financial Statements for additional information related to the disposition of the communications business. Test & Measurement Selected Financial Data Components of Sales Growth 2015 Compared to 2014 Price increases in the segment contributed 1.0% to sales growth on a year-over-year basis during 2015 as compared to 2014 and are reflected as a component of the change in sales from existing businesses. Sales from existing businesses in the segment’s instruments business were flat during 2015 as compared to 2014, due to increased year-over-year sales of calibration, thermography and biomedical products, primarily from sales in developed markets offset by year-over-year declines in sales in the government and the semi-conductor end-markets. Industrial end-market sales were essentially flat for the year but slowed during the second half of 2015 reflecting lower overall point of sale demand. Geographically, growth continued to be strong in Western Europe and China while demand remained weak in Russia and Latin America. Sales from existing businesses in the segment’s mobile tool and wheel service businesses grew at a low-double digit rate during 2015 as compared to 2014 due to continued strong demand for tool storage solutions as well as increases in the number of franchisees, primarily in the United States. Operating profit margins increased 190 basis points during 2015 as compared to 2014. The following factors favorably impacted year-over-year operating profit margin comparisons. • Higher 2015 sales volumes from existing businesses as well as incremental year-over-year cost savings associated with the restructuring actions and continuing productivity improvement initiatives taken in 2014 and 2015, net of incremental year-over-year costs associated with various new product development, sales and marketing growth investments and the effect of a stronger U.S. dollar in 2015 - 135 basis points • Reimbursement of costs related to finance and accounting, information technology and other services provided under a transition services agreement entered into with NetScout in connection with the disposition of the communications business (see Note 3 to the Consolidated Financial Statements) - 45 basis points • Lower year-over-year costs associated with restructuring actions and continuing productivity improvement initiatives - 10 basis points 2014 Compared to 2013 Price increases in the segment contributed 0.5% to sales growth on a year-over-year basis during 2014 as compared to 2013 and are reflected as a component of the change in sales from existing businesses. Sales from existing businesses in the segment’s instruments business grew at a low-single digit rate during 2014 as compared to 2013, due to increased year-over-year sales of electrical and calibration products, primarily from strong sales of new product offerings. Geographically, growth was led by increased demand in North America, China, and Western Europe. Sales from existing businesses in the segment’s mobile tool and wheel service businesses grew during 2014 as compared to 2013. Operating profit margins increased 130 basis points during 2014 as compared to 2013. The following factors impacted year-over-year operating profit margin comparisons. 2014 vs. 2013 operating profit margin comparisons were favorably impacted by: • Higher sales volumes from existing businesses as well as incremental year-over-year cost savings associated with the restructuring actions and continuing productivity improvement initiatives taken in 2014 and 2013, net of incremental year-over-year costs associated with various new product development, sales and marketing growth investments - 155 basis points 2014 vs. 2013 operating profit margin comparisons were unfavorably impacted by: • Incremental year-over-year costs associated with restructuring actions and continuing productivity improvement initiatives - 10 basis points • The incremental net dilutive effect in 2014 of acquired businesses - 15 basis points ENVIRONMENTAL The Company’s Environmental segment products and services help protect the global water supply, facilitate environmental stewardship, enhance the safety of personal data and improve business efficiencies. The Company’s water quality business provides instrumentation and disinfection systems to help analyze, treat and manage the quality of ultra-pure, potable, waste, ground and ocean water in residential, commercial, industrial and natural resource applications. The Company’s retail/commercial petroleum business is a leading worldwide provider of solutions and services focused on fuel dispensing, remote fuel management, point-of-sale and payment systems, environmental compliance, vehicle tracking and fleet management. Environmental Selected Financial Data Components of Sales Growth 2015 Compared to 2014 Price increases in the segment contributed 0.5% to sales growth on a year-over-year basis during 2015 as compared with 2014 and are reflected as a component of the change in sales from existing businesses. Sales from existing businesses in the segment’s water quality businesses grew at a mid-single digit rate during 2015 as compared with 2014. Sales growth in the analytical instrumentation product line continued to be led by strong sales of instruments and related consumables and services in North America, primarily in the U.S. municipal end market, Europe and China (although growth slowed sequentially in China during the fourth quarter of 2015, partly due to delays in government projects). Year-over-year sales growth in the business’ chemical treatment solutions product line was due to continued growth in the United States as well as continued business expansion in Latin America. Sales in the business’ ultraviolet water disinfection product line grew on a year-over-year basis due to continued demand in industrial disinfection end markets in the United States and municipal end markets in the United States and Western Europe. Sales from existing businesses in the segment’s retail petroleum business grew at a mid-single digit rate during 2015 as compared with 2014, as year-over-year demand for the business’ dispenser systems, service and point-of-sale systems continued to be strong, primarily in North America. Customers, predominantly in the United States, have begun to upgrade point-of-sale systems to comply with deadlines for enhanced security requirements based on the Europay, MasterCard and Visa (“EMV”) global standard and the Company expects this trend to continue to drive growth for the next several years. This growth was partially offset by lower year-over-year sales of retail petroleum products in the Middle East, Russia and Western Europe, largely due to softness in demand from integrated oil companies. Operating profit margins increased 160 basis points during 2015 as compared to 2014. The following factors impacted year-over-year operating profit margin comparisons. 2015 vs. 2014 operating profit margin comparisons were favorably impacted by: • Higher 2015 sales volumes from existing businesses and incremental year-over-year cost savings associated with the restructuring actions and continuing productivity improvement initiatives taken in 2014 and 2015, net of incremental year-over-year costs associated with various product development, sales and marketing growth investments and the effect of a stronger U.S. dollar in 2015 - 135 basis points • Lower year-over-year costs associated with restructuring actions and continuing productivity improvement initiatives - 70 basis points 2015 vs. 2014 operating profit margin comparisons were unfavorably impacted by: • The incremental net dilutive effect in 2015 of acquired businesses - 45 basis points 2014 Compared to 2013 Price increases in the segment contributed 0.5% to sales growth on a year-over-year basis during 2014 as compared with 2013 and are reflected as a component of the change in sales from existing businesses. Sales from existing businesses in the segment’s water quality business grew at a mid-single digit rate during 2014 as compared with 2013. Sales growth in the analytical instrumentation product line was led primarily by continued strong sales of instruments and related consumables and service in North America, China, Europe and Latin America. Sales in the business’ chemical treatment solutions product line grew on a year-over-year basis due primarily to continued sales force investments in the U.S. market, and to a lesser extent, continued international expansion. Year-over-year sales in the business’ ultraviolet water disinfection product line declined during 2014 due to continued weak demand in municipal end markets, primarily in North America and Western Europe. Sales from existing businesses in the segment’s retail petroleum equipment business grew at a mid-single digit rate during 2014 as compared with 2013. Demand for the business’ dispenser systems was particularly strong in North America and China during 2014. Continued strong demand for point-of-sale systems, service and vapor recovery products in most major geographies also contributed to year-over-year sales growth. Operating profit margins declined 110 basis points during 2014 as compared to 2013. The following factors impacted year-over-year operating profit margin comparisons. 2014 vs. 2013 operating profit margin comparisons were favorably impacted by: • Higher 2014 sales volumes from existing businesses and incremental year-over-year cost savings associated with the restructuring actions and continuing productivity improvement initiatives taken in 2013 and 2014, net of incremental year-over-year costs associated with various product development, sales and marketing growth investments - 35 basis points 2014 vs. 2013 operating profit margin comparisons were unfavorably impacted by: • Incremental year-over-year costs associated with restructuring actions and continuing productivity improvement initiatives - 50 basis points • The incremental net dilutive effect in 2014 of acquired businesses - 95 basis points Depreciation as a percentage of sales increased during 2014 as compared to 2013 primarily as a result of investments in assets leased to customers, largely in businesses acquired during the second half of 2013. The inclusion of a full year of depreciation expense in 2014 and continued investments in such assets drove the increase. LIFE SCIENCES & DIAGNOSTICS The Company’s diagnostics business offers analytical instruments, reagents, consumables, software and services that hospitals, physicians’ offices, reference laboratories and other critical care settings use to diagnose disease and make treatment decisions. The Company’s life sciences business offers a broad range of research tools that scientists use to study the basic building blocks of life, including genes, proteins, metabolites and cells in order to understand the causes of disease, identify new therapies and test new drugs and vaccines. The Company through its newly acquired Pall business is also a leading provider of products used to remove solid, liquid and gaseous contaminants from a variety of liquids and gases, consisting primarily of filtration consumables and to a lesser extent systems that incorporate filtration consumables and associated hardware. Life Sciences & Diagnostics Selected Financial Data Components of Sales Growth 2015 Compared to 2014 Price increases in the segment contributed 0.5% to sales growth on a year-over-year basis during 2015 as compared with 2014 and are reflected as a component of the change in sales from existing businesses. Sales from existing businesses in the segment’s diagnostics business grew at a mid-single digit rate during 2015 as compared to 2014. Demand in the clinical business increased on a year-over-year basis led by growth in the urinalysis and immunoassay consumable products primarily from continuing strong demand in China and other high-growth markets. Continued strong consumable sales in 2015 related to the installed base of blood gas instruments in developed markets as well as strong instrument placement particularly in China and the Middle East drove the majority of the year-over-year sales growth in the critical care diagnostic business. Increased demand for advanced staining systems and consumables as well as probes primarily in North America and China drove the majority of the year-over-year sales growth in the anatomical pathology diagnostics business. Sales from existing businesses in the segment’s life sciences business grew at a low-single digit rate during 2015 as compared to 2014. Geographically, sales grew on a year-over-year basis in North America and Western Europe partially offset by declines in the Middle East and Brazil. Sales of the business’ broad range of mass spectrometers continued to grow on a year-over-year basis led by strong sales growth in the clinical markets in North America, Western Europe and China. Sales of confocal and stereo microscopy products decreased on a year-over-year basis led by declines in Western Europe and high-growth markets which were partially offset by growth in surgical microscopy products, primarily in North America. Year-over-year demand for the business’ flow cytometry and sample preparation product lines grew in 2015, led by increases in demand in North America, Western Europe and China. The Pall Acquisition provides additional sales and earnings growth opportunities for the segment by expanding geographic and product line diversity, including new product and service offerings in the areas of filtration, separation and purification, and through the potential acquisition of complementary businesses. As Pall is integrated into the Company over the next several years, the Company expects to realize approximately $300 million in annual cost savings as compared to Pall’s annual expense level prior to acquisition, through the application of the Danaher Business System and the combined purchasing power of the Company and Pall. Operating profit margins decreased 210 basis points during 2015 as compared to 2014. The following factors impacted year-over-year operating profit margin comparisons. 2015 vs. 2014 operating profit margin comparisons were favorably impacted by: • Higher 2015 sales volumes from existing businesses and incremental year-over-year cost savings associated with the restructuring actions and continuing productivity improvement initiatives taken in 2014 and 2015, net of incremental year-over-year costs associated with various product development, sales and marketing growth investments and the effect of a stronger U.S. dollar in 2015 - 35 basis points • Lower year-over-year costs associated with restructuring actions and continuing productivity improvement initiatives - 30 basis points 2015 vs. 2014 operating profit margin comparisons were unfavorably impacted by: • Acquisition-related charges associated with Pall, including transaction costs deemed significant, change in control payments, and fair value adjustments to acquired inventory and deferred revenue, net of the positive impact of freezing pension benefits - 155 basis points • The incremental net dilutive effect in 2015 of acquired businesses (including Pall) - 120 basis points Depreciation and amortization expense increased during 2015 as compared to 2014 due primarily to the impact of recently acquired businesses, particularly Pall, and the resulting increase in depreciable and amortizable assets. 2014 Compared to 2013 Year-over-year price increases in the segment had a negligible impact during 2014. Sales from existing businesses in the segment’s diagnostics business grew at a mid-single digit rate during 2014 as compared to 2013. Demand in the clinical business increased on a year-over-year basis led by continuing strong demand in China and other high-growth markets and a return to growth in North America. Continued strong global consumable sales in 2014 related to the installed base of critical care instruments drove the majority of the year-over-year sales growth in the critical care diagnostic business, which was led by China and other high-growth markets as well as modest increases in Western Europe. Increased demand for advanced staining systems and consumables across all major geographies drove the majority of the year-over-year sales growth in the anatomical pathology diagnostics business. Slight overall increases in demand for core histology instruments, led by North America, also contributed to this growth. Sales from existing businesses in the segment’s life sciences business grew at a mid-single digit rate during 2014 as compared to 2013 due primarily to continued strong demand for the business’ recently introduced products. Geographically, sales grew on a year-over-year basis in North America and Western Europe but declined in China and Japan. Sales of the business’ broad range of mass spectrometers continued to grow on a year-over-year basis led by strong sales growth in the applied markets in North America and Western Europe. Sales of confocal, stereo and surgical microscopy products increased on a year-over-year basis led by strong demand in the developed markets. Year-over-year demand for the business’ cellular analysis and sample preparation product lines grew at a low single digit rate in 2014, led by increases in demand in North America and Western Europe that, were largely offset by sales declines in China and Japan. Operating profit margins increased 70 basis points during 2014 as compared to 2013. The following factors impacted year-over-year operating profit margin comparisons. 2014 vs. 2013 operating profit margin comparisons were favorably impacted by: • Higher 2014 sales volumes from existing businesses and incremental year-over-year cost savings associated with the restructuring actions and continuing productivity improvement initiatives taken in 2013 and 2014, net of incremental year-over-year costs associated with various product development, sales and marketing growth investments - 110 basis points 2014 vs. 2013 operating profit margin comparisons were unfavorably impacted by: • Incremental year-over-year costs associated with restructuring actions and continuing productivity improvement initiatives - 20 basis points • The incremental net dilutive effect in 2014 of acquired businesses - 20 basis points DENTAL The Company’s Dental segment provides products that are used to diagnose, treat and prevent disease and ailments of the teeth, gums and supporting bone, as well as to improve the aesthetics of the human smile. The Company is a leading worldwide provider of a broad range of dental consumables, equipment and services, and is dedicated to driving technological innovations that help dental professionals improve clinical outcomes and enhance productivity. Dental Selected Financial Data Components of Sales Growth 2015 Compared to 2014 Price increases in the segment contributed 0.5% to sales growth on a year-over-year basis during 2015 as compared with 2014 and are reflected as a component of the change in sales from existing businesses. Sales from existing businesses were flat on a year-over-year basis as increased demand for dental treatment units and consumable products, including orthodontic products, primarily in China and other high-growth markets, was offset by softness in demand for imaging products, largely due to destocking in the North American distribution channel, and weaker demand in Western Europe. Management believes the destocking impact will be less significant in 2016 as compared to 2015. Lower year-over-year demand for dental equipment in the Middle East due to slower project activity during 2015 also adversely impacted year-over-year performance. The acquisition of Nobel Biocare in December 2014 has provided additional sales and earnings growth opportunities for the Company’s Dental segment by expanding the businesses’ geographic and product line diversity, including new and complementary product and service offerings in the area of implant based tooth replacements. Operating profit margins declined 40 basis points during 2015 as compared to 2014. The following factors impacted year-over-year operating profit margin comparisons. 2015 vs. 2014 operating profit margin comparisons were favorably impacted by: • Incremental year-over-year cost savings associated with the restructuring actions and continuing productivity improvement initiatives taken in 2014 and 2015, net of incremental year-over-year costs associated with various product development, sales and marketing growth investments and the effect of a stronger U.S. dollar in 2015 - 45 basis points • Lower year-over-year costs associated with restructuring actions and continuing productivity improvement initiatives - 10 basis points 2015 vs. 2014 operating profit margin comparisons were unfavorably impacted by: • The incremental net dilutive effect in 2015 of acquired businesses - 95 basis points Depreciation and amortization increased during 2015 as compared with 2014 due primarily to the impact of recently acquired businesses, primarily Nobel Biocare. 2014 Compared to 2013 Price increases in the segment contributed 0.5% to sales growth on a year-over-year basis during 2014 as compared with 2013 and are reflected as a component of the change in sales from existing businesses. Sales from existing businesses grew on a year-over-year basis as a result of increased demand for all major product categories, with strong sales of imaging products, instruments and implant products, along with modest growth in dental consumables. Geographically, year-over-year sales grew in Europe and high-growth markets, specifically China and the Middle East. Operating profit margins declined 70 basis points during 2014 as compared to 2013. The following factors impacted year-over-year operating profit margin comparisons. 2014 vs. 2013 operating profit margin comparisons were favorably impacted by: • Higher 2014 sales volumes from existing businesses and incremental year-over-year cost savings associated with the restructuring actions and continuing productivity improvement initiatives taken in 2013 and 2014, net of incremental year-over-year costs associated with various product development, sales and marketing growth investments - 80 basis points 2014 vs. 2013 operating profit margin comparisons were unfavorably impacted by: • Incremental year-over-year costs associated with restructuring actions and continuing productivity improvement initiatives - 35 basis points • The incremental net dilutive effect in 2014 of acquired businesses - 40 basis points • Acquisition-related charges recorded in 2014 associated with the Nobel Biocare acquisition, including transaction costs deemed significant and fair value adjustments to acquired inventory - 75 basis points INDUSTRIAL TECHNOLOGIES The Company’s Industrial Technologies segment solutions help protect the world’s food supply, improve packaging design and quality, verify pharmaceutical dosages and authenticity and power innovative machines. The Company’s product identification businesses develop and manufacture equipment, consumables and software for various printing, marking, coding, packaging, design and color management applications on consumer and industrial products. The Company’s automation business provides electromechanical and electronic motion control products and mechanical components for the automation market. In addition to the product identification and automation strategic lines of business, the segment also includes the Company’s sensors and controls, energetic materials and engine retarder businesses. Industrial Technologies Selected Financial Data Components of Sales Growth 2015 Compared to 2014 Price increases in the segment contributed 1.0% to sales growth on a year-over-year basis during 2015 as compared with 2014 and are reflected as a component of the change in sales from existing businesses. Sales from existing businesses in the segment’s product identification businesses grew at a mid-single digit rate during 2015 as compared with 2014, due to continued increased demand for marking and coding equipment and related consumables as well as packaging and color solutions. Geographically, year-over-year sales growth was led by North America and Europe (although North America declined slightly in the fourth quarter of 2015), but was partly offset by softer demand for the business’ packaging and color solutions in Brazil and Russia. Sales from existing businesses in the segment’s automation business increased slightly during 2015 as compared to 2014. A strong increase in year-over-year demand in technology and defense related end-markets in North America and distribution-related end markets in Europe, was largely offset by lower demand in North American distribution and industrial automation related end-markets as well as agricultural-related end markets in North America and Europe. During the third quarter of 2014, the Company sold its electric vehicle systems (“EVS”)/hybrid product line. The impact of this divestiture is reflected in “Acquisitions (divestitures), net” in the Components of Sales Growth table above as the disposition was not deemed a discontinued operation for financial reporting purposes. See Note 3 to the Consolidated Financial Statements for additional information related to this transaction. Sales from existing businesses in the segment’s other businesses collectively declined at a low-single digit rate during 2015 as compared with 2014. Sales in the segment’s energetic materials and sensors and controls businesses declined on a year-over-year basis, while sales in the segment’s engine retarder business were essentially flat on a year-over-year basis. Operating profit margins increased 140 basis points during 2015 as compared to 2014. Year-over-year operating profit margin comparisons were favorably impacted by: • Higher 2015 sales volumes from existing businesses and incremental year-over-year cost savings associated with the restructuring actions and continuing productivity improvement initiatives taken in 2014 and 2015, net of incremental year-over-year costs associated with various product development, sales and marketing growth investments - 120 basis points • Lower year-over-year costs associated with restructuring actions and continuing productivity improvement initiatives - 20 basis points • The incremental net dilutive effect in 2015 of acquired businesses was fully offset by the positive effect of the product line disposition in the third quarter of 2014 2014 Compared to 2013 Price increases in the segment contributed 1.0% to sales growth on a year-over-year basis during 2014 as compared with 2013 and are reflected as a component of the change in sales from existing businesses. Sales from existing businesses in the segment’s product identification businesses grew at a mid-single digit rate during 2014 as compared to 2013. Continued increased demand for marking and coding equipment and related consumables as well as packaging and color solutions was partially offset by continued lower year-over-year demand in consumer electronics-related equipment. Geographically, year-over-year sales growth was led by North America and Europe. Sales from existing businesses in the segment’s automation business grew at a low-single digit rate during 2014 as compared to 2013. Improved year-over-year demand in industrial automation, in North America distribution and in medical related end-markets was partially offset by lower year-over-year demand in technology, agricultural and defense-related end-markets and the effect of exiting certain low-margin original equipment manufacturer product lines which negatively impacted the first half of 2014. Geographically, strong year-over-year demand in China and other high-growth markets as well as moderate sales growth in North America, more than offset year-over-year sales declines in Europe. Sales from existing businesses in the segment’s other businesses collectively grew at a mid-single digit rate during 2014 as compared to 2013, primarily due to strong demand in the segment’s engine retarder business, and to a lesser extent, continued improving demand in the segment’s sensors and controls businesses. Operating profit margins increased 160 basis points during 2014 as compared to 2013. Year-over-year operating profit margin comparisons were favorably impacted by: • Higher 2014 sales volumes from existing businesses and incremental year-over-year cost savings associated with the restructuring actions and continuing productivity improvement initiatives taken in 2013 and 2014, net of incremental year-over-year costs associated with various product development, sales and marketing growth investments - 115 basis points • Lower year-over-year costs associated with restructuring actions and continuing productivity improvement initiatives - 45 basis points • The incremental net dilutive effect in 2014 of acquired businesses was fully offset by the positive effect of the product line disposition in the third quarter of 2014 COST OF SALES AND GROSS PROFIT The year-over-year increase in cost of sales during 2015 as compared with 2014, is due primarily to the impact of higher year-over-year sales volumes, including sales volumes from recently acquired businesses, and 2015 acquisition-related charges associated with fair value adjustments to acquired inventory and deferred revenue in connection with the acquisition of Pall and Nobel Biocare during the third quarter of 2015 and the fourth quarter of 2014, respectively, which increased cost of sales by $111 million during 2015. These factors were partially offset by lower year-over-year costs associated with restructuring actions and continuing productivity improvement initiatives and incremental year-over-year cost savings associated with the restructuring actions and continuing productivity improvements taken in 2014 and 2015. The year-over-year increase in cost of sales during 2014 as compared with 2013, is due primarily to the impact of higher year-over-year sales volumes, acquisition-related charges associated with fair value adjustments to acquired inventory in connection with the acquisition of Nobel Biocare during the fourth quarter of 2014 and incremental year-over-year costs associated with restructuring actions and continuing productivity improvement initiatives, partially offset by incremental year-over-year cost savings associated with the restructuring actions and continuing productivity improvements taken in 2013 and 2014. Gross profit margins increased 70 basis points on a year-over-year basis during 2015 as compared with 2014, due primarily to the favorable impact of higher year-over-year sales volumes, higher gross profit margins of recently acquired businesses and incremental year-over-year cost savings associated with the restructuring actions and continuing productivity improvements taken in 2014 and 2015. These positive factors more than offset the 2015 acquisition-related charges associated with fair value adjustments to acquired inventory and deferred revenue in connection with the acquisition of Pall and Nobel Biocare during the third quarter of 2015 and the fourth quarter of 2014, respectively, which adversely impacted gross profit margins comparisons by 30 basis points during 2015 as compared with 2014. Gross profit margins increased 50 basis points on a year-over-year basis during 2014 as compared with 2013, due primarily to the favorable impact of higher year-over-year sales volumes and incremental year-over-year cost savings associated with the restructuring actions and continuing productivity improvements taken in 2013 and 2014, partially offset by acquisition-related charges associated with fair value adjustments to acquired inventory in connection with the acquisition of Nobel Biocare during the fourth quarter of 2014 and incremental year-over-year costs associated with restructuring actions and continuing productivity improvement initiatives. OPERATING EXPENSES Selling, general and administrative expenses as a percentage of sales increased 130 basis points on a year-over-year basis for 2015 compared with 2014. The increase in selling, general and administrative expenses as a percentage of sales from 2014 to 2015 was driven by continued investments in sales and marketing growth initiatives and higher relative spending levels at recently acquired businesses. In addition, costs incurred in connection with the Separation adversely impacted year-over-year comparisons by 10 basis points. Change in control payments to Pall employees in connection with the Pall Acquisition, as well as associated transaction costs and amortization charges associated with acquisition-related intangible assets, net of the positive impact of freezing pension benefits, adversely impacted selling, general and administrative expenses as a percentage of sales by 20 basis points during 2015. These increases were partially offset by the benefit of increased leverage of the Company’s general and administrative cost base resulting from higher 2015 sales, lower year-over-year costs associated with restructuring actions and continuing productivity improvement initiatives and incremental year-over-year cost savings associated with the restructuring actions and continuing productivity improvements taken in 2014 and 2015. Selling, general and administrative expenses as a percentage of sales increased 10 basis points on a year-over-year basis for 2014 compared with 2013. The increase in selling, general and administrative expenses as a percentage of sales from 2013 to 2014 reflects incremental year-over-year investments in the Company’s sales and marketing growth initiatives, higher corporate expenses and incremental year-over-year costs associated with restructuring actions and continuing productivity improvement initiatives. In addition, transaction costs incurred in connection with the closing of the Nobel Biocare acquisition during the fourth quarter of 2014 unfavorably impacted the year-over-year comparison by approximately five basis points. These increases were partially offset by the benefit of increased leverage of the Company’s general and administrative cost base resulting from higher 2014 sales and incremental year-over-year cost savings associated with 2013 and 2014 restructuring actions. Research and development expenses (consisting principally of internal and contract engineering personnel costs) as a percentage of sales remained flat in 2015 as compared with 2014 and 2013. OTHER INCOME During 2015, the Company received cash proceeds of $43 million from the sale of certain marketable equity securities and recorded a pretax gain related to these sales of $12 million ($8 million after-tax or $0.01 per diluted share). During 2014, the Company received cash proceeds of $167 million from the sale of certain marketable equity securities and recorded a pretax gain related to these sales of $123 million ($77 million after-tax or $0.11 per diluted share). In addition, the Company completed the divestiture of its EVS/hybrid product line for a sale price of $87 million in cash in August 2014. This product line, which was part of the Industrial Technologies segment, had revenues of approximately $60 million in 2014 prior to the divestiture and approximately $100 million in 2013. Operating results of the product line were not significant to segment or overall Company reported results. The Company recorded a pretax gain on the sale of the product line of $34 million ($26 million after-tax or $0.04 per diluted share) in its third quarter 2014 results. Subsequent to the sale, the Company has no continuing involvement in the EVS/hybrid product line. During the fourth quarter of 2013, the Company sold 5 million of the 8 million shares of Align Technology, Inc. (“Align”) common stock that the Company received in 2009 as a result of a settlement between Align and Ormco Corporation, a wholly-owned subsidiary of the Company. The Company received cash proceeds of $251 million from the sale of these marketable equity securities and recorded a pretax gain of $202 million ($125 million after-tax or $0.18 per diluted share). On July 4, 2010, the Company entered into a joint venture with Cooper Industries, plc (“Cooper”), combining certain of the Company’s hand tool businesses with Cooper’s Tools business to form a new entity, Apex Tool Group, LLC (“Apex”). Each of Cooper and the Company had owned a 50% interest in Apex, had an equal number of representatives on Apex’s Board of Directors and neither joint venture partner controlled the significant operating and financing activities of Apex. The Company had accounted for its investment in the joint venture based on the equity method of accounting. In February 2013, the Company and Cooper sold Apex to an unrelated third party for approximately $1.6 billion. The Company received $797 million from the sale, consisting of cash of $759 million (including $67 million of dividends received prior to closing) and a note receivable of $38 million (which has been subsequently collected). The Company recognized a pretax gain of $230 million ($144 million after-tax or $0.20 per diluted share) in its first quarter 2013 results in connection with this transaction. The Company’s share of the 2013 earnings generated by Apex prior to the closing of the sale was insignificant. Subsequent to the sale of its investment in Apex, the Company has no continuing involvement in Apex’s operations. INTEREST COSTS Interest expense of $163 million for 2015 was $44 million higher than in 2014, due primarily to the higher interest costs associated with the debt issued in connection with the Pall Acquisition. For a further description of the Company’s debt as of December 31, 2015 see Note 9 to the Consolidated Financial Statements. Interest expense of $119 million in 2014 was $22 million lower than the 2013 interest expense of $141 million due primarily to the repayment of the $400 million principal amount of 1.3% senior unsecured notes due 2014 upon maturity in June 2014 in addition to the repayment of the €500 million principal amount of Eurobond notes due 2013 and the $300 million principal amount of floating rate senior notes due 2013 upon maturity in July and June 2013, respectively. INCOME TAXES General Income tax expense and deferred tax assets and liabilities reflect management’s assessment of future taxes expected to be paid on items reflected in the Company’s financial statements. The Company records the tax effect of discrete items and items that are reported net of their tax effects in the period in which they occur. The Company’s effective tax rate can be affected by changes in the mix of earnings in countries with differing statutory tax rates (including as a result of business acquisitions and dispositions), changes in the valuation of deferred tax assets and liabilities, accruals related to contingent tax liabilities and period-to-period changes in such accruals, the results of audits and examinations of previously filed tax returns (as discussed below), the expiration of statutes of limitations, the implementation of tax planning strategies, tax rulings, court decisions, settlements with tax authorities and changes in tax laws, including legislative policy changes that may result from the Organization for Economic Co-operation and Development’s initiative on Base Erosion and Profit Shifting. For a description of the tax treatment of earnings that are planned to be reinvested indefinitely outside the United States, refer to “-Liquidity and Capital Resources - Cash and Cash Requirements” below. The amount of income taxes the Company pays is subject to ongoing audits by federal, state and foreign tax authorities, which often result in proposed assessments. Management performs a comprehensive review of its global tax positions on a quarterly basis. Based on these reviews, the results of discussions and resolutions of matters with certain tax authorities, tax rulings and court decisions and the expiration of statutes of limitations, reserves for contingent tax liabilities are accrued or adjusted as necessary. For a discussion of risks related to these and other tax matters, please refer to “Item 1A. Risk Factors”. Year-Over-Year Changes in the Tax Provision and Effective Tax Rate The Company’s effective tax rate related to continuing operations for the years ended December 31, 2015, 2014 and 2013 was 21.8%, 25.2% and 24.2%, respectively. The Company’s effective tax rate for each of 2015, 2014 and 2013 differs from the U.S. federal statutory rate of 35.0% due principally to the Company’s earnings outside the United States that are indefinitely reinvested and taxed at rates lower than the U.S. federal statutory rate. The effective tax rate of 21.8% in 2015 includes net tax benefits from foreign exchange losses, releases of valuation allowances related to foreign operating losses and the release of reserves upon the expiration of statutes of limitation, partially offset by changes in estimates associated with prior period uncertain tax positions and other matters. The effective tax rate of 25.2% in 2014 includes tax expense for audit settlements in various jurisdictions, partially offset by the release of valuation allowances and the release of reserves upon the expiration of statutes of limitation. The effective tax rate of 24.2% in 2013 includes recognition of tax benefits associated with favorable resolutions of certain international and domestic uncertain tax positions and the lapse of certain statutes of limitations, partially offset by adjustments of reserve estimates related to prior period uncertain tax positions. The matters referenced above have been treated as discrete items in the periods they occurred and in the aggregate reduced the provision for income taxes by approximately 140 and 20 basis points in 2015 and 2013, respectively, and increased the provision for income taxes by approximately 170 basis points in 2014. The Company conducts business globally, and files numerous consolidated and separate income tax returns in the United States federal, state and foreign jurisdictions. The countries in which the Company has a significant presence that have significantly lower statutory tax rates than the United States include China, Denmark, Germany, Singapore, Switzerland and the United Kingdom. The Company’s ability to obtain a tax benefit from lower statutory tax rates outside of the United States is dependent on its levels of taxable income in these foreign countries and the amount of foreign earnings which are indefinitely reinvested in those countries. The Company believes that a change in the statutory tax rate of any individual foreign country would not have a material effect on the Company’s consolidated financial statements given the geographic dispersion of the Company’s taxable income. The Company and its subsidiaries are routinely examined by various domestic and international taxing authorities. The Internal Revenue Service (“IRS”) has completed examinations of certain of the Company’s federal income tax returns through 2009 and is currently examining certain of the Company’s federal income tax returns for 2010 through 2013. In addition, the Company has subsidiaries in Belgium, Brazil, Canada, China, Denmark, Finland, France, Germany, India, Italy, Japan, Singapore, Sweden, the United Kingdom and various other countries, states and provinces that are currently under audit for years ranging from 2003 through 2014. Tax authorities in Denmark have raised significant issues related to interest accrued by certain of the Company’s subsidiaries. On December 10, 2013, the Company received assessments from the Danish tax authority (“SKAT”) totaling approximately DKK 1.2 billion (approximately $180 million based on exchange rates as of December 31, 2015) including interest through December 31, 2015, imposing withholding tax relating to interest accrued in Denmark on borrowings from certain of the Company’s subsidiaries for the years 2004-2009. If the SKAT claims are successful, it is likely that the Company would be assessed additional amounts for years 2010-2012 totaling approximately DKK 700 million (approximately $102 million based on exchange rates as of December 31, 2015). Management believes the positions the Company has taken in Denmark are in accordance with the relevant tax laws and intends to vigorously defend its positions. The Company appealed these assessments with the National Tax Tribunal in 2014 and intends on pursuing this matter through the European Court of Justice should this appeal be unsuccessful. The ultimate resolution of this matter is uncertain, could take many years, and could result in a material adverse impact to the Company’s financial statements, including its effective tax rate. As previously disclosed, German tax authorities had raised issues related to the deductibility and taxability of interest accrued by certain of the Company’s subsidiaries. In the fourth quarter of 2014, the Company entered into a settlement agreement with the German tax authorities to resolve these open matters through 2014. The Company recorded €49 million (approximately $60 million based on exchange rates as of December 31, 2014) of expense for taxes and interest related to this settlement during the fourth quarter of 2014. The Company’s effective tax rate for 2016 is expected to be approximately 23% to 24%. This anticipated rate reflects the benefit from the research and experimentation credit in the United States which was permanently extended in 2015. DISCONTINUED OPERATIONS As further discussed in Note 3 to the Consolidated Financial Statements, discontinued operations includes the results of the Company’s Test & Measurement segment’s communications business (other than the data communications cable installation business and the communication service provider business of Fluke Networks which are now part of the instruments business of the Company’s Test & Measurement segment) which was disposed of during the third quarter of 2015. All periods presented have been restated to reflect the communications business within discontinued operations. In 2015, earnings from operations of discontinued business, net of tax, were $759 million and reflected the operating results of the communications business as well as the gain on the sale of the communications business. In 2014 and 2013, earnings from operations of discontinued businesses, net of tax, were $55 million and $104 million, respectively and reflected the operations of the communications business. COMPREHENSIVE INCOME Comprehensive income increased by approximately $1.5 billion in 2015 as compared to 2014, primarily due to the impact of increases in net earnings, foreign currency translation adjustments resulting from the strengthening of the U.S. dollar compared to most major currencies during the year but at a lower rate than in the prior year, and pension and postretirement plan benefit adjustments. The Company recorded a foreign currency translation loss of approximately $1.0 billion for 2015 compared to a translation loss of approximately $1.2 billion for 2014. The Company recorded a pension and postretirement plan benefit gain of $81 million for 2015 compared to a loss of $361 million for 2014. Comprehensive income decreased by approximately $2.0 billion in 2014 as compared to 2013, primarily due to the impact of foreign currency translation adjustments resulting from the strengthening of the U.S. dollar compared to most major currencies during the year, in addition to the impact from pension and postretirement plan benefit adjustments. The Company recorded a foreign currency translation loss of approximately $1.2 billion for 2014 compared to a translation loss of $62 million for 2013. Pension and postretirement plan benefit adjustments resulted in a loss of $361 million in 2014 compared to a gain of $289 million in 2013. INFLATION The effect of inflation on the Company’s revenues and net earnings was not significant in any of the years ended December 31, 2015, 2014 or 2013. FINANCIAL INSTRUMENTS AND RISK MANAGEMENT The Company is exposed to market risk from changes in interest rates, foreign currency exchange rates, credit risk, equity prices and commodity prices, each of which could impact its financial statements. The Company generally addresses its exposure to these risks through its normal operating and financing activities. In addition, the Company’s broad-based business activities help to reduce the impact that volatility in any particular area or related areas may have on its operating profit as a whole. Interest Rate Risk The Company manages interest cost using a mixture of fixed-rate and variable-rate debt. A change in interest rates on long-term debt impacts the fair value of the Company’s fixed-rate long-term debt but not the Company’s earnings or cash flow because the interest on such debt is fixed. Generally, the fair market value of fixed-rate debt will increase as interest rates fall and decrease as interest rates rise. As of December 31, 2015, an increase of 100 basis points in interest rates would have decreased the fair value of the Company’s fixed-rate long-term debt (excluding the LYONs, which have not been included in this calculation as the value of this convertible debt is primarily derived from the value of its underlying common stock) by approximately $445 million. As of December 31, 2015, the Company’s variable-rate debt obligations consisted primarily of U.S. dollar and Euro-based commercial paper borrowings (refer to Note 9 to the Consolidated Financial Statements for information regarding the Company’s outstanding commercial paper balances as of December 31, 2015). As a result, the Company’s primary interest rate exposure results from changes in short-term interest rates. As these shorter duration obligations mature, the Company anticipates issuing additional short-term commercial paper obligations to refinance all or part of these borrowings. In 2015, the average annual interest rate associated with outstanding commercial paper borrowings was approximately 20 basis points. A hypothetical increase of this average to 40 basis points would have increased the Company’s interest expense by $7 million. Currency Exchange Rate Risk The Company faces transactional exchange rate risk from transactions with customers in countries outside the United States and from intercompany transactions between affiliates. Transactional exchange rate risk arises from the purchase and sale of goods and services in currencies other than Danaher’s functional currency or the functional currency of its applicable subsidiary. The Company also faces translational exchange rate risk related to the translation of financial statements of its foreign operations into U.S. dollars, Danaher’s functional currency. Costs incurred and sales recorded by subsidiaries operating outside of the United States are translated into U.S. dollars using exchange rates effective during the respective period. As a result, the Company is exposed to movements in the exchange rates of various currencies against the U.S. dollar. In particular, the Company has more sales in European currencies than it has expenses in those currencies. Therefore, when European currencies strengthen or weaken against the U.S. dollar, operating profits are increased or decreased, respectively. The effect of a change in currency exchange rates on the Company’s net investment in international subsidiaries is reflected in the accumulated other comprehensive income component of stockholders’ equity. A 10% depreciation in major currencies relative to the U.S. dollar as of December 31, 2015 would have resulted in a reduction of stockholders’ equity of approximately $1.4 billion. Currency exchange rates negatively impacted 2015 reported sales by 6.0% on a year-over-year basis as the U.S. dollar was, on average, stronger against most major currencies during 2015 as compared to exchange rate levels during 2014. If the exchange rates in effect as of December 31, 2015 were to prevail throughout 2016, currency exchange rates would adversely impact 2016 estimated sales by approximately 1.5% relative to the Company’s performance in 2015. Additional strengthening of the U.S. dollar against other major currencies would further adversely impact the Company’s sales and results of operations on an overall basis. Any weakening of the U.S. dollar against other major currencies would positively impact the Company’s sales and results of operations. The Company has generally accepted the exposure to exchange rate movements without using derivative financial instruments to manage this risk. Both positive and negative movements in currency exchange rates against the U.S. dollar will therefore continue to affect the reported amount of sales, profit, and assets and liabilities in the Company’s Consolidated Financial Statements. On April 2, 2014, the Company terminated the Japanese Yen/U.S. dollar currency swap agreement that had been acquired in connection with a prior business acquisition. The currency swap agreement initially required the Company to purchase approximately 184 million Japanese Yen (JPY/¥) at a rate of $1/¥102.25 on a monthly basis through June 1, 2018. The currency swap did not qualify for hedge accounting, and as a result, changes in the fair value of the currency swap were reflected in selling, general and administrative expenses in the accompanying Consolidated Statements of Earnings each reporting period. The fair value of the currency swap as of the termination date was not significant and the fair value had not changed significantly during 2014 prior to the swap being terminated. During the year ended December 31, 2013, the Company recorded pretax income of $14 million related to changes in the fair value of this currency swap. Credit Risk The Company is exposed to potential credit losses in the event of nonperformance by counterparties to its financial instruments. Financial instruments that potentially subject the Company to credit risk consist of cash and temporary investments, receivables from customers and derivatives. The Company places cash and temporary investments with various high-quality financial institutions throughout the world and exposure is limited at any one institution. Although the Company typically does not obtain collateral or other security to secure these obligations, it does regularly monitor the third party depository institutions that hold its cash and cash equivalents. The Company’s emphasis is primarily on safety and liquidity of principal and secondarily on maximizing yield on those funds. In addition, concentrations of credit risk arising from receivables from customers are limited due to the diversity of the Company’s customers. The Company’s businesses perform credit evaluations of their customers’ financial conditions as appropriate and also obtain collateral or other security when appropriate. The Company enters into derivative transactions infrequently and, with the exception of the Yen swap noted above, such transactions are generally insignificant to the Company’s financial condition and results of operations. These transactions are entered into only with high-quality financial institutions and exposure at any one institution is limited. Equity Price Risk The Company’s available-for-sale investment portfolio includes publicly traded equity securities that are sensitive to fluctuations in market price. Changes in equity prices would result in changes in the fair value of the Company’s available-for-sale investments due to the difference between the current market price and the market price at the date of purchase or issuance of the equity securities. A 10% decline in the value of these equity securities as of December 31, 2015 would have reduced the fair value of the Company’s available-for-sale investment portfolio by $34 million. Commodity Price Risk For a discussion of risks relating to commodity prices, refer “Item 1A. Risk Factors.” LIQUIDITY AND CAPITAL RESOURCES Management assesses the Company’s liquidity in terms of its ability to generate cash to fund its operating, investing and financing activities. The Company continues to generate substantial cash from operating activities and believes that its operating cash flow and other sources of liquidity will be sufficient to allow it to continue investing in existing businesses, consummating strategic acquisitions, paying interest and servicing debt and managing its capital structure on a short and long-term basis. Following is an overview of the Company’s cash flows and liquidity for the years ended December 31: Overview of Cash Flows and Liquidity • Operating cash flows from continuing operations increased $210 million, or approximately 6%, during 2015 as compared to 2014, due primarily to higher net earnings which also included higher noncash charges for depreciation, amortization, stock compensation and acquisition related costs. Lower levels of investment in working capital during 2015 compared with 2014 also contributed to the increase in operating cash flows for the year. • Cash paid for acquisitions constituted the most significant use of cash during 2015. The Company acquired 12 businesses during 2015, including the acquisition of Pall, for total consideration (including assumed debt and net of cash acquired) of approximately $14.3 billion. • The Company financed the approximately $13.6 billion acquisition price of Pall with approximately $2.5 billion of available cash, approximately $8.1 billion of net proceeds from the issuance and sale of U.S. dollar and Euro-denominated commercial paper and €2.7 billion (approximately $3.0 billion based on currency exchange rates as of the date of issuance) of net proceeds from the issuance and sale of Euro-denominated senior unsecured notes. Subsequent to the Pall Acquisition, the Company used the approximately $2.0 billion of net proceeds from the issuance of U.S. dollar-denominated senior unsecured notes and the approximately CHF 755 million ($732 million based on currency exchange rates as of the date of issuance) of net proceeds, including the related premium from the issuance and sale of Swiss franc-denominated senior unsecured bonds, to repay a portion of the commercial paper issued to finance a portion of the Pall Acquisition. • As of December 31, 2015, the Company held approximately $791 million of cash and cash equivalents. Operating Activities Cash flows from operating activities can fluctuate significantly from period to period as working capital needs and the timing of payments for income taxes, restructuring activities, pension funding and other items impact reported cash flows. Operating cash flows from continuing operations were approximately $3.8 billion for 2015, an increase of $210 million, or approximately 6%, as compared to 2014. The year-over-year change in operating cash flows from 2014 to 2015 was primarily attributable to the following factors: • 2015 operating cash flows benefited from higher net earnings as compared to 2014 excluding in both years the impact of gains included in other nonoperating income. These nonoperating gains, which include gains from sales of investments, product lines and discontinued operations, are reflected in the investing activities section of the Statement of Cash Flows and, therefore, do not contribute to operating cash flows. • The aggregate of trade accounts receivable, inventories and trade accounts payable provided $172 million in operating cash flows during 2015, compared to $45 million provided in 2014. The amount of cash flow generated from or used by the aggregate of trade accounts receivable, inventories and trade accounts payable depends upon how effectively the Company manages the cash conversion cycle, which effectively represents the number of days that elapse from the day it pays for the purchase of raw materials and components to the collection of cash from its customers and can be significantly impacted by the timing of collections and payments in a period. • The aggregate of prepaid expenses and other assets and accrued expenses and other liabilities provided $31 million in operating cash flows during 2015, compared to $18 million used in 2014. The timing of cash payments for income taxes and various employee related liabilities, including with respect to recently acquired companies, drove the majority of this change. • Net earnings from continuing operations for 2015 reflected an increase of $162 million of depreciation and amortization expense as compared to 2014. Amortization expense primarily relates to the amortization of intangible assets acquired in connection with acquisitions. Depreciation expense relates to both the Company’s manufacturing and operating facilities as well as instrumentation leased to customers under operating-type lease arrangements. Depreciation and amortization are noncash expenses that decrease earnings without a corresponding impact to operating cash flows. Operating cash flows from continuing operations were approximately $3.6 billion for 2014, an increase of $151 million, or 4% as compared to 2013. This increase was primarily attributable to the increase in operating profit in 2014 as compared to 2013. Investing Activities Cash flows relating to investing activities consist primarily of cash used for acquisitions and capital expenditures, including instruments leased to customers, cash used for investments and cash proceeds from divestitures of businesses or assets. Net cash used in investing activities was approximately $15.0 billion during 2015 compared to approximately $3.4 billion and $553 million of net cash used in 2014 and 2013, respectively. Acquisitions, Divestitures and Sale of Investments 2015 Acquisitions, Divestitures and Sale of Investments For a discussion of the Company’s 2015 acquisitions, divestitures and the sale of certain marketable equity securities, refer to “-Overview.” 2014 Acquisitions, Divestitures and Sale of Investments In December 2014, the Company successfully completed its tender offer for the outstanding shares of common stock of Nobel Biocare and acquired substantially all of the Nobel shares, with the remainder of the Nobel shares acquired in 2015 pursuant to a squeeze-out transaction, for an aggregate cash purchase price of approximately CHF 1.9 billion (approximately $1.9 billion based on exchange rates as of the date the shares of common stock were acquired) including debt assumed and net of cash acquired. Headquartered in Zurich, Switzerland, Nobel Biocare is a world leader in the field of innovative implant-based dental restorations with a portfolio of solutions that include dental implant systems, high-precision individualized prosthetics, biomaterials and digital diagnostics, treatment planning and guided surgery. Nobel Biocare had revenues of €567 million in 2013 (approximately $780 million based on exchange rates as of December 31, 2013), and is now part of the Company’s Dental segment. The Company financed the acquisition of Nobel Biocare from available cash. In addition to the acquisition of Nobel Biocare, during 2014 the Company acquired 16 businesses for total consideration of approximately $1.3 billion in cash, net of cash acquired. The businesses acquired complement existing units of the Test & Measurement, Environmental, Life Sciences & Diagnostics and Dental segments. The aggregate annual sales of these 16 businesses at the time of their respective acquisitions, in each case based on the company’s revenues for its last completed fiscal year prior to the acquisition, were approximately $420 million. In August 2014, the Company completed the divestiture of its electric vehicle systems (“EVS”)/hybrid product line for a sale price of $87 million in cash. This product line, which was part of the Industrial Technologies segment, had revenues of approximately $60 million in 2014 prior to the divestiture and approximately $100 million in 2013. Operating results of the product line were not significant to segment or overall Company reported results in 2014. The Company recorded a pretax gain on the sale of the product line of $34 million ($26 million after-tax or $0.04 per diluted share) in its third quarter 2014 results. Subsequent to the sale, the Company has no continuing involvement in the EVS/hybrid product line. In accordance with ASU No. 2014-08, Reporting Discontinued Operations and Disclosures of Disposals of Components of an Entity, which the Company adopted at the beginning of the third quarter of 2014, the divestiture of the EVS/hybrid product line was not classified as a discontinued operation in this Form 10-K since the disposition does not represent a strategic shift that will have a major effect on the Company’s operations and financial statements. During 2014, the Company received cash proceeds of $167 million from the sale of certain marketable equity securities and recorded a pretax gain related to these sales of $123 million ($77 million after-tax or $0.11 per diluted share). 2013 Acquisitions, Divestitures and Sale of Investments During 2013, the Company acquired 12 businesses for total consideration of $883 million in cash, net of cash acquired. The businesses acquired complement existing units of the Industrial Technologies, Life Sciences & Diagnostics, Environmental and Test & Measurement segments. The aggregate annual sales of these 12 businesses at the time of their respective acquisitions, in each case based on the company’s revenues for its last completed fiscal year prior to the acquisition, were approximately $300 million. During the fourth quarter of 2013, the Company sold approximately 5 million of the approximately 8 million shares of Align common stock that the Company received in 2009 as a result of a settlement between Align and Ormco. The Company received cash proceeds of $251 million from the sale of these securities and recorded a pretax gain of $202 million ($125 million after-tax or $0.18 per diluted share). On July 4, 2010, the Company entered into a joint venture with Cooper, combining certain of the Company’s hand tool businesses with Cooper’s Tools business to form a new entity, Apex. In February 2013, the Company and Cooper sold Apex to an unrelated third party for approximately $1.6 billion. The Company received $797 million from the sale, consisting of cash of $759 million (including $67 million of dividends received prior to closing) and a note receivable of $38 million (which has been subsequently collected). The Company recognized a pretax gain of $230 million ($144 million after-tax or $0.20 per diluted share) in its first quarter 2013 results in connection with this transaction. Capital Expenditures Capital expenditures are made primarily for increasing capacity, replacing equipment, supporting new product development, improving information technology systems and the manufacture of instruments that are used in operating-type lease arrangements that certain of the Company’s businesses enter into with customers. Capital expenditures totaled $633 million in 2015, $581 million in 2014 and $538 million in 2013. The increase in capital spending in 2015 is due to continued investments in other operating assets, including operating assets at newly acquired businesses such as Nobel Biocare and Pall, partially offset by year-over-year differences in the timing of investments in equipment leased to customers. The increase in capital spending in 2014 is due primarily to increases in equipment leased to customers. In 2016, the Company expects capital spending (including with respect to the Fortive businesses that the Company anticipates spinning-off in 2016) to be approximately $750 million, though actual expenditures will ultimately depend on business conditions. Financing Activities Cash flows from financing activities consist primarily of cash flows associated with the issuance and repayments of commercial paper and other debt, issuances and repurchases of common stock, excess tax benefits from stock-based compensation, and payments of cash dividends to shareholders. Financing activities provided cash of approximately $9.1 billion during 2015 compared to $218 million of cash used during 2014. Cash provided by financing activities in 2015 primarily relates to the approximately $5.0 billion of proceeds from the sale of U.S. dollar and Euro-denominated senior unsecured notes, $732 million of proceeds from the sale of Swiss franc-denominated senior unsecured bonds and approximately $5.7 billion of proceeds from the sale of U.S. dollar and Euro-denominated commercial paper, in each case related to the financing of the Pall Acquisition. U.S. and Euro-denominated commercial paper outstanding at any one time during the year ended December 31, 2015 had balances ranging from $450 million to approximately $9.8 billion, carried interest at annual rates ranging between -0.03% and 0.5% and had original maturities between one and 182 days. Total debt was approximately $12.9 billion and $3.5 billion as of December 31, 2015 and 2014, respectively. The Company had the ability to incur approximately an additional $2.0 billion of indebtedness in direct borrowings or under our outstanding commercial paper facilities based on the amounts available under the Company’s $6.0 billion of credit facilities which were not being used to backstop outstanding commercial paper balances as of December 31, 2015. Refer to Note 9 to the Consolidated Financial Statements for information regarding the Company’s financing activities and indebtedness, including the Company’s outstanding debt as of December 31, 2015, the financing for the Pall Acquisition and the Company’s commercial paper program and related credit facilities. Shelf Registration Statement The Company has filed a “well-known seasoned issuer” shelf registration statement on Form S-3 with the SEC that registers an indeterminate amount of debt securities, common stock, preferred stock, warrants, depositary shares, purchase contracts and units for future issuance. The Company utilized this shelf registration statement for the offering and sale of the U.S. dollar and Euro-denominated senior unsecured notes issued to finance the Pall Acquisition. The Company expects to use net proceeds realized by the Company from future securities sales off this shelf registration statement for general corporate purposes, including without limitation repayment or refinancing of debt or other corporate obligations, acquisitions, capital expenditures, share repurchases and dividends and working capital. Stock Repurchase Program On July 16, 2013, the Company’s Board of Directors approved a new repurchase program (the “Repurchase Program”) authorizing the repurchase of up to 20 million shares of the Company’s common stock from time to time on the open market or in privately negotiated transactions. There is no expiration date for the Repurchase Program, and the timing and amount of any shares repurchased under the program will be determined by the Company's management based on its evaluation of market conditions and other factors. The Repurchase Program may be suspended or discontinued at any time. Any repurchased shares will be available for use in connection with the Company's equity compensation plans (or any successor plan) and for other corporate purposes. As of December 31, 2015, 20 million shares remained available for repurchase pursuant to the Repurchase Program. The Company expects to fund any future stock repurchases using the Company's available cash balances or proceeds from the issuance of commercial paper. Except in connection with the disposition of the Company's communications business to NetScout, neither the Company nor any “affiliated purchaser” repurchased any shares of Company common stock during 2015, 2014 or 2013. Refer to Note 3 to the Consolidated Financial Statements for discussion of the 26 million shares of Danaher common stock tendered to and repurchased by the Company in connection with the disposition of the Company's communications business to NetScout. Dividends The Company declared a regular quarterly dividend of $0.135 per share that was paid on January 29, 2016 to holders of record on December 21, 2015. Aggregate cash payments for dividends during 2015 were $354 million. Dividend payments were higher in 2015 as compared to 2014 as the Company increased its quarterly dividend rate in the first quarter of 2015 to $0.135 per share. Cash and Cash Requirements As of December 31, 2015, the Company held approximately $791 million of cash and cash equivalents that were invested in highly liquid investment-grade debt instruments with a maturity of 90 days or less with an approximate weighted average annual interest rate of 0.01%. Of this amount, $36 million was held within the United States and $755 million was held outside of the United States. The Company will continue to have cash requirements to support working capital needs, capital expenditures and acquisitions, pay interest and service debt, pay taxes and any related interest or penalties, fund its restructuring activities and pension plans as required, repurchase shares of the Company’s common stock, pay dividends to shareholders and support other business needs. With respect to the Company’s other cash requirements, the Company generally intends to use available cash and internally generated funds to meet these cash requirements, but in the event that additional liquidity is required, particularly in connection with acquisitions, the Company may also borrow under its commercial paper programs or credit facilities, enter into new credit facilities and either borrow directly thereunder or use such credit facilities to backstop additional borrowing capacity under its commercial paper programs and/or access the capital markets. The Company also may from time to time access the capital markets, including to take advantage of favorable interest rate environments or other market conditions. While repatriation of some cash held outside the United States may be restricted by local laws, most of the Company’s foreign cash balances could be repatriated to the United States but, under current law, would be subject to U.S. federal income taxes, less applicable foreign tax credits. For most of its foreign subsidiaries, the Company makes an election regarding the amount of earnings intended for indefinite reinvestment, with the balance available to be repatriated to the United States. The Company has recorded a deferred tax liability for the funds that are available to be repatriated to the United States. No provisions for U.S. income taxes have been made with respect to earnings that are planned to be reinvested indefinitely outside the United States, and the amount of U.S. income taxes that may be applicable to such earnings is not readily determinable given the various tax planning alternatives the Company could employ if it repatriated these earnings. The cash that the Company’s foreign subsidiaries hold for indefinite reinvestment is generally used to finance foreign operations and investments, including acquisitions. As of December 31, 2015, the total amount of earnings planned to be reinvested indefinitely and the basis difference in investments outside of the United States for which deferred taxes have not been provided was approximately $23.5 billion. As of December 31, 2015, management believes that it has sufficient liquidity to satisfy its cash needs, including its cash needs in the United States. During 2015, the Company contributed $49 million to its U.S. defined benefit pension plan and $53 million to its non-U.S. defined benefit pension plans. During 2016, the Company’s cash contribution requirements for its U.S. and its non-U.S. defined benefit pension plans (including any pension plans to be assumed by the Fortive businesses that the Company anticipates spinning-off in 2016) are expected to be approximately $40 million and $55 million, respectively. The ultimate amounts to be contributed depend upon, among other things, legal requirements, underlying asset returns, the plan’s funded status, the anticipated tax deductibility of the contribution, local practices, market conditions, interest rates and other factors. Contractual Obligations The following table sets forth, by period due or year of expected expiration, as applicable, a summary of the Company’s contractual obligations as of December 31, 2015 under (1) long-term debt obligations, (2) leases, (3) purchase obligations and (4) other long-term liabilities reflected on the Company’s balance sheet under GAAP. The amounts presented in the table below include $971 million of noncurrent gross unrecognized tax benefits. However, the timing of these liabilities is uncertain, and therefore, they have been included in the “More Than 5 Years” column in the table below. Refer to Note 12 to the Consolidated Financial Statements for additional information on unrecognized tax benefits. Certain of the Company’s acquisitions also involve the potential payment of contingent consideration. The table below does not reflect any such obligations, as the timing and amounts of any such payments are uncertain. Refer to “-Off-Balance Sheet Arrangements” for a discussion of other contractual obligations that are not reflected in the table below. Off-Balance Sheet Arrangements The following table sets forth, by period due or year of expected expiration, as applicable, a summary of off-balance sheet commitments of the Company as of December 31, 2015. Guarantees consist primarily of outstanding standby letters of credit, bank guarantees and performance and bid bonds. These guarantees have been provided in connection with certain arrangements with vendors, customers, financing counterparties and governmental entities to secure the Company’s obligations and/or performance requirements related to specific transactions. Other Off-Balance Sheet Arrangements The Company has from time to time divested certain of its businesses and assets. In connection with these divestitures, the Company often provides representations, warranties and/or indemnities to cover various risks and unknown liabilities, such as claims for damages arising out of the use of products or relating to intellectual property matters, commercial disputes, environmental matters or tax matters. The Company has not included any such items in the contractual obligations table above because they relate to unknown conditions and the Company cannot estimate the potential liabilities from such matters, but the Company does not believe it is reasonably possible that any such liability will have a material effect on the Company’s financial statements. In addition, as a result of these divestitures, as well as restructuring activities, certain properties leased by the Company have been sublet to third parties. In the event any of these third parties vacate any of these premises, the Company would be legally obligated under master lease arrangements. The Company believes that the financial risk of default by such sub-lessors is individually and in the aggregate not material to the Company’s financial statements. In the normal course of business, the Company periodically enters into agreements that require it to indemnify customers, suppliers or other business partners for specific risks, such as claims for injury or property damage arising out of the Company’s products or services or claims alleging that Company products, services or software infringe third party intellectual property. The Company has not included any such indemnification provisions in the contractual obligations table above. Historically, the Company has not experienced significant losses on these types of indemnification obligations. The Company’s Restated Certificate of Incorporation requires it to indemnify to the full extent authorized or permitted by law any person made, or threatened to be made a party to any action or proceeding by reason of his or her service as a director or officer of the Company, or by reason of serving at the request of the Company as a director or officer of any other entity, subject to limited exceptions. Danaher’s Amended and Restated By-laws provide for similar indemnification rights. In addition, Danaher has executed with each director and executive officer of Danaher Corporation an indemnification agreement which provides for substantially similar indemnification rights and under which Danaher has agreed to pay expenses in advance of the final disposition of any such indemnifiable proceeding. While the Company maintains insurance for this type of liability, a significant deductible applies to this coverage and any such liability could exceed the amount of the insurance coverage. Legal Proceedings Please refer to Note 16 to the Consolidated Financial Statements for information regarding legal proceedings and contingencies, and for a discussion of risks related to legal proceedings and contingencies, please refer to “Item 1A. Risk Factors.” CRITICAL ACCOUNTING ESTIMATES Management’s discussion and analysis of the Company’s financial condition and results of operations is based upon the Company’s Consolidated Financial Statements, which have been prepared in accordance with accounting principles generally accepted in the United States. The preparation of these financial statements requires management to make estimates and judgments that affect the reported amounts of assets, liabilities, revenues and expenses, and related disclosure of contingent assets and liabilities. The Company bases these estimates and judgments on historical experience, the current economic environment and on various other assumptions that are believed to be reasonable under the circumstances. Actual results may differ materially from these estimates and judgments. The Company believes the following accounting estimates are most critical to an understanding of its financial statements. Estimates are considered to be critical if they meet both of the following criteria: (1) the estimate requires assumptions about material matters that are uncertain at the time the estimate is made, and (2) material changes in the estimate are reasonably likely from period to period. For a detailed discussion on the application of these and other accounting estimates, refer to Note 1 in the Company’s Consolidated Financial Statements. Acquired Intangibles-The Company’s business acquisitions typically result in the recognition of goodwill, in-process research and development and other intangible assets, which affect the amount of future period amortization expense and possible impairment charges that the Company may incur. Refer to Notes 1, 2 and 6 in the Company’s Consolidated Financial Statements for a description of the Company’s policies relating to goodwill, acquired intangibles and acquisitions. In performing its goodwill impairment testing, the Company estimates the fair value of its reporting units primarily using a market-based approach. The Company estimates fair value based on multiples of earnings before interest, taxes, depreciation and amortization (“EBITDA”) determined by current trading market multiples of earnings for companies operating in businesses similar to each of the Company’s reporting units, in addition to recent market available sale transactions of comparable businesses. In evaluating the estimates derived by the market-based approach, management makes judgments about the relevance and reliability of the multiples by considering factors unique to its reporting units, including operating results, business plans, economic projections, anticipated future cash flows, and transactions and marketplace data as well as judgments about the comparability of the market proxies selected. In certain circumstances the Company also estimates fair value utilizing a discounted cash flow analysis (i.e., an income approach) in order to validate the results of the market approach. The discounted cash flow model requires judgmental assumptions about projected revenue growth, future operating margins, discount rates and terminal values. There are inherent uncertainties related to these assumptions and management’s judgment in applying them to the analysis of goodwill impairment. As of December 31, 2015, the Company had 23 reporting units for goodwill impairment testing. Reporting units resulting from recent acquisitions generally present the highest risk of impairment. Management believes the impairment risk associated with these reporting units decreases as these businesses are integrated into the Company and better positioned for potential future earnings growth. The carrying value of the goodwill included in each individual reporting unit ranges from $7 million to approximately $9.4 billion. The Company’s annual goodwill impairment analysis in 2015 indicated that in all instances, the fair values of the Company’s reporting units exceeded their carrying values and consequently did not result in an impairment charge. The excess of the estimated fair value over carrying value (expressed as a percentage of carrying value for the respective reporting unit) for each of the Company’s reporting units as of the annual testing date ranged from approximately 0% to approximately 900%. In order to evaluate the sensitivity of the fair value calculations used in the goodwill impairment test, the Company applied a hypothetical 10% decrease to the fair values of each reporting unit and compared those hypothetical values to the reporting unit carrying values. Based on this hypothetical 10% decrease, the excess of the estimated fair value over carrying value (expressed as a percentage of carrying value for the respective reporting unit) for each of the Company’s reporting units ranged from approximately -10% to approximately 800%. After applying the hypothetical 10% decrease, two reporting units’ hypothetical fair values were lower than their respective carrying values. Management evaluated other factors relating to the fair value of these reporting units, including as applicable results of the estimate of fair value using an income approach, the short period of time since the acquisition of these businesses, market positions of the businesses, comparability of market sales transactions and financial and operating performance, and concluded no impairment charge was required. The Company reviews identified intangible assets for impairment whenever events or changes in circumstances indicate that the related carrying amounts may not be recoverable. The Company also tests intangible assets with indefinite lives at least annually for impairment. Determining whether an impairment loss occurred requires a comparison of the carrying amount to the sum of undiscounted cash flows expected to be generated by the asset. These analyses require management to make judgments and estimates about future revenues, expenses, market conditions and discount rates related to these assets. If actual results are not consistent with management’s estimates and assumptions, goodwill and other intangible assets may be overstated and a charge would need to be taken against net earnings which would adversely affect the Company’s financial statements. Contingent Liabilities-As discussed in Note 16 to the Consolidated Financial Statements, the Company is, from time to time, subject to a variety of litigation and similar contingent liabilities incidental to its business (or the business operations of previously owned entities). The Company recognizes a liability for any contingency that is known or probable of occurrence and reasonably estimable. These assessments require judgments concerning matters such as litigation developments and outcomes, the anticipated outcome of negotiations, the number of future claims and the cost of both pending and future claims. In addition, because most contingencies are resolved over long periods of time, liabilities may change in the future due to various factors, including those discussed in Note 16 to the Consolidated Financial Statements. If the reserves established by the Company with respect to these contingent liabilities are inadequate, the Company would be required to incur an expense equal to the amount of the loss incurred in excess of the reserves, which would adversely affect the Company’s financial statements. Revenue Recognition-The Company derives revenues from the sale of products and services. Refer to Note 1 to the Company’s Consolidated Financial Statements for a description of the Company’s revenue recognition policies. Although most of the Company’s sales agreements contain standard terms and conditions, certain agreements contain multiple elements or non-standard terms and conditions. As a result, judgment is sometimes required to determine the appropriate accounting, including whether the deliverables specified in these agreements should be treated as separate units of accounting for revenue recognition purposes, and, if so, how the consideration should be allocated among the elements and when to recognize revenue for each element. The Company allocates revenue to each element in the contractual arrangement based on the selling price hierarchy that, in some instances, may require the Company to estimate the selling price of certain deliverables that are not sold separately or where third party evidence of pricing is not observable. The Company’s estimate of selling price impacts the amount and timing of revenue recognized in multiple element arrangements. The Company also enters into lease arrangements with customers, which requires the Company to determine whether the arrangements are operating or sales-type leases. Certain of the Company’s lease contracts are customized for larger customers and often result in complex terms and conditions that typically require significant judgment in applying the lease accounting criteria. If the Company’s judgments regarding revenue recognition prove incorrect, the Company’s revenues in particular periods may be adversely affected. Pension and Other Postretirement Benefits-For a description of the Company’s pension and other postretirement benefit accounting practices, refer to Notes 10 and 11 in the Company’s Consolidated Financial Statements. Calculations of the amount of pension and other postretirement benefit costs and obligations depend on the assumptions used in the actuarial valuations, including assumptions regarding discount rates, expected return on plan assets, rates of salary increases, health care cost trend rates, mortality rates, and other factors. If the assumptions used in calculating pension and other postretirement benefits costs and obligations are incorrect or if the factors underlying the assumptions change (as a result of differences in actual experience, changes in key economic indicators or other factors) the Company’s financial statements could be materially affected. A 50 basis point reduction in the discount rates used for the plans would have increased the U.S. net obligation by $147 million ($92 million on an after-tax basis) and the non-U.S. net obligation by $157 million ($118 million on an after-tax basis) from the amounts recorded in the Consolidated Financial Statements as of December 31, 2015. For 2015, the estimated long-term rate of return for the U.S. plan is 7.5%, and the Company intends to use an assumption of 7.0% for 2016. Due to this decrease in the estimated long term rate of return on assets, there will be an increase in the expense of approximately $9 million in 2016. This expected rate of return reflects the asset allocation of the plan and the expected long-term returns on equity and debt investments included in plan assets. The U.S. plan targets to invest between 60% and 70% of its assets in equity portfolios which are invested in funds that are expected to mirror broad market returns for equity securities or in assets with characteristics similar to equity investments. The balance of the asset portfolio is generally invested in bond funds. The Company’s non-U.S. plan assets consist of various insurance contracts, equity and debt securities as determined by the administrator of each plan. The estimated long-term rate of return for the non-U.S. plans was determined on a plan by plan basis based on the nature of the plan assets and ranged from 1.10% to 6.00%. If the expected long-term rate of return on plan assets for 2015 was reduced by 50 basis points, pension expense for the U.S. and non-U.S. plans for 2015 would have increased $9 million ($6 million on an after-tax basis) and $5 million ($4 million on an after-tax basis), respectively. Effective December 31, 2015, the Company changed its estimate of the service and interest cost components of net periodic benefit cost for its U.S. and non-U.S. pension and other postretirement benefit plans. Previously, the Company estimated the service and interest cost components utilizing a single weighted-average discount rate derived from the yield curve used to measure the benefit obligation. The new estimate utilizes a full yield curve approach in the estimation of these components by applying the specific spot rates along the yield curve used in the determination of the benefit obligation to their underlying projected cash flows. The new estimate provides a more precise measurement of service and interest costs by improving the correlation between projected benefit cash flows and their corresponding spot rates. The change does not affect the measurement of the Company’s U.S. and non-U.S. pension and other postretirement benefit obligations and it is accounted for as a change in accounting estimate that is inseparable from a change in accounting principle, which is applied prospectively. For fiscal 2016, the change in estimate is expected to reduce U.S. and non-U.S. pension and other postretirement net periodic benefit plan cost by $25 million when compared to the prior estimate. For a discussion of the Company’s 2015 and anticipated 2016 defined benefit pension plan contributions, please see “-Liquidity and Capital Resources - Cash and Cash Requirements”. Income Taxes-For a description of the Company’s income tax accounting policies, refer to Notes 1 and 12 to the Company’s Consolidated Financial Statements. The Company establishes valuation allowances for its deferred tax assets if it is more likely than not that some or all of the deferred tax asset will not be realized which requires management to make judgments and estimates regarding: (1) the timing and amount of the reversal of taxable temporary differences, (2) expected future taxable income, and (3) the impact of tax planning strategies. Future changes to tax rates would also impact the amounts of deferred tax assets and liabilities and could have an adverse impact on the Company’s financial statements. The Company provides for unrecognized tax benefits when, based upon the technical merits, it is “more likely than not” that an uncertain tax position will not be sustained upon examination. Judgment is required in evaluating tax positions and determining income tax provisions. The Company re-evaluates the technical merits of its tax positions and may recognize an uncertain tax benefit in certain circumstances, including when: (1) a tax audit is completed; (2) applicable tax laws change, including a tax case ruling or legislative guidance; or (3) the applicable statute of limitations expires. In addition, certain of the Company’s tax returns are currently under review by tax authorities including in Denmark (see “-Results of Operations - Income Taxes” and Note 12 of the Notes to the Consolidated Financial Statements). Management believes the positions taken in these returns are in accordance with the relevant tax laws. However, the outcome of these audits is uncertain and could result in the Company being required to record charges for prior year tax obligations which could have a material adverse impact to the Company’s financial statements, including its effective tax rate. An increase in the Company’s nominal tax rate of 1.0% would have resulted in an additional income tax provision for continuing operations for the fiscal year ended December 31, 2015 of $33 million. NEW ACCOUNTING STANDARDS In December 2015, the Financial Accounting Standards Board (“FASB”) issued Accounting Standards Update (“ASU”) No. 2015-17, Income Taxes (Topic 740): Balance Sheet Classification of Deferred Taxes (“ASU 2015-17”). ASU 2015-17 simplifies the presentation of deferred income taxes by requiring that deferred tax liabilities and assets be classified as noncurrent in a classified statement of financial position. The standard is effective for financial statements issued for annual periods beginning after December 15, 2016, and interim periods within those annual periods and may be applied either prospectively to all deferred tax liabilities and assets or retrospectively to all periods presented. The Company has chosen to early adopt this ASU prospectively, and therefore, the 2015 Consolidated Balance Sheet reflects the new disclosure requirements. In September 2015, the FASB issued ASU No. 2015-16, Simplifying the Accounting for Measurement-Period Adjustments (Topic 805), which eliminates the requirement for an acquirer in a business combination to account for measurement-period adjustments retrospectively. The new guidance requires that the cumulative impact of a measurement-period adjustment (including the impact on prior periods) be recognized in the reporting period in which the adjustment is identified which eliminates the requirement to restate prior period financial statements. The ASU requires disclosure of the nature and amount of measurement-period adjustments as well as information with respect to the portion of the adjustments recorded in current-period earnings that would have been recorded in previous reporting periods if the adjustments to provisional amounts had been recognized as of the acquisition date. The Company has chosen to early adopt this ASU and therefore, disclosures included within these consolidated financial statements have been updated to reflect the new disclosure requirements. In May 2015, the FASB issued ASU No. 2015-07, Disclosures for Investments in Certain Entities that Calculate Net Asset Value Per Share (or its Equivalent) (“ASU 2015-07”). ASU 2015-07 removes the requirement to categorize within the fair value hierarchy investments for which fair values are estimated using the net asset value practical expedient provided by Accounting Standards Codification 820, Fair Value Measurement. Disclosures about investments in certain entities that calculate net asset value per share are limited under the new standard to those investments for which the Plan has elected to estimate the fair value using the net asset value practical expedient. The ASU is effective for entities (other than public business entities) for fiscal years beginning after December 15, 2016, with retrospective application to all periods presented, with early adoption permitted. The Company has chosen to early adopt this ASU and therefore, disclosures included within these consolidated financial statements have been updated to reflect the new disclosure requirements. In April 2015, the FASB issued ASU No. 2015-03, Interest - Imputation of Interest (Subtopic 835-30): Simplifying the Presentation of Debt Issuance Costs. This ASU requires that debt issuance costs related to a recognized debt liability be presented in the balance sheet as a direct deduction from the carrying amount of that debt liability, consistent with debt discounts. The ASU is effective for annual and interim periods beginning after December 15, 2015 but the Company has chosen to early adopt the standard and has applied the guidance to all 2015 debt issuances. The Company did not retrospectively apply this guidance to debt offerings prior to 2015 as the impact to the consolidated financial statements was not material. In May 2014, the FASB issued ASU No. 2014-09, Revenue from Contracts with Customers (Topic 606), which impacts virtually all aspects of an entity’s revenue recognition. The core principle of the new standard is that revenue should be recognized to depict the transfer of promised goods or services to customers in an amount that reflects the consideration to which the entity expects to be entitled in exchange for those goods or services. On July 9, 2015, the FASB deferred the effective date of the standard by one year which results in the new standard being effective for the Company at the beginning of its first quarter of fiscal year 2018. The Company is currently assessing the impact that the adoption of the new standard will have on its consolidated financial statements and related disclosures, including possible transition alternatives.

<s>[INST] Overview Results of Operations Liquidity and Capital Resources Critical Accounting Estimates New Accounting Standards OVERVIEW General Please see “Item 1. Business General” for a discussion of Danaher’s objectives and methodologies for delivering shareholder value. Danaher is a multinational corporation with global operations. During 2015, approximately 56% of Danaher’s sales were derived from customers outside the United States. As a diversified, global business, Danaher’s operations are affected by worldwide, regional and industryspecific economic and political factors. Danaher’s geographic and industry diversity, as well as the range of its products and services, typically help limit the impact of any one industry or the economy of any single country on the consolidated operating results. Given the broad range of products manufactured, software and services provided and geographies served, management does not use any indices other than general economic trends to predict the overall outlook for the Company. The Company’s individual businesses monitor key competitors and customers, including to the extent possible their sales, to gauge relative performance and the outlook for the future. As a result of the Company’s geographic and industry diversity, the Company faces a variety of opportunities and challenges, including rapid technological development (particularly with respect to computing, mobile connectivity, communications and digitization) in most of the Company’s served markets, the expansion and evolution of opportunities in highgrowth markets, trends and costs associated with a global labor force, consolidation of the Company’s competitors and increasing regulation. The Company operates in a highly competitive business environment in most markets, and the Company’s longterm growth and profitability will depend in particular on its ability to expand its business in highgrowth geographies and highgrowth market segments, identify, consummate and integrate appropriate acquisitions, develop innovative and differentiated new products, services and software with higher gross profit margins, expand and improve the effectiveness of the Company’s sales force, continue to reduce costs and improve operating efficiency and quality, and effectively address the demands of an increasingly regulated environment. The Company is making significant investments, organically and through acquisitions, to address the rapid pace of technological change in its served markets and to globalize its manufacturing, research and development and customerfacing resources (particularly in highgrowth markets) in order to be responsive to the Company’s customers throughout the world and improve the efficiency of the Company’s operations. Business Performance and Outlook While differences exist among the Company’s businesses, on an overall basis, demand for the Company’s products, software and services increased in 2015 as compared to 2014 resulting in aggregate yearoveryear sales growth from existing businesses of 3.0%. The Company’s continued investments in sales growth initiatives and the other businessspecific factors discussed below also contributed to yearoveryear sales growth. Geographically, both highgrowth and developed markets contributed to yearoveryear sales growth from existing businesses during 2015. Sales growth rates from existing businesses in highgrowth markets grew at a midsingle digit rate in 2015 as compared to 2014 led by strength in China and India, partially offset by weakness in Russia and Latin America. Highgrowth markets represented approximately 27% of the Company’s total sales in 2015. Sales from existing businesses in developed markets grew at a lowsingle digit rate in 2015 as compared to 2014 and were driven by North America and Western Europe. While individual business results will vary, the Company expects sales from existing businesses to continue to grow on a yearoveryear basis during 2016 at a level in line with the growth levels experienced in 2015 but remains cautious about challenges due to macroeconomic and geopolitical uncertainties, including global uncertainties related to monetary and fiscal policies. The acquisition of Pall, as further discussed below, provides additional sales and earnings growth opportunities for the Company’s Life Sciences and Diagnostics segment by expanding the segment’s geographic and product line diversity, including new and complementary product and service offerings in the area of filtration, separation and purification technologies, and through the potential acquisition of complementary businesses. As Pall is integrated into the Company [/INST] Negative. </s>

DANAHER CORP /DE/

2017-02-22

2016-12-31

ITEM 7. MANAGEMENT’S DISCUSSION AND ANALYSIS OF FINANCIAL CONDITION AND RESULTS OF OPERATIONS Management’s Discussion and Analysis of Financial Condition and Results of Operations (“MD&A”) is designed to provide a reader of Danaher’s financial statements with a narrative from the perspective of Company management. The Company’s MD&A is divided into five sections: • Overview • Results of Operations • Liquidity and Capital Resources • Critical Accounting Estimates • New Accounting Standards This discussion and analysis should be read along with Danaher’s audited financial statements and related Notes thereto as of December 31, 2016 and 2015 and for each of the three years in the period ended December 31, 2016 included in this Annual Report. Unless otherwise indicated, references to sales in this Annual Report refer to sales from continuing operations. OVERVIEW General Refer to “Item 1. Business-General” for a discussion of Danaher’s objectives and methodologies for delivering shareholder value. Danaher is a multinational corporation with global operations. During 2016, approximately 62% of Danaher’s sales were derived from customers outside the United States. As a diversified, global business, Danaher’s operations are affected by worldwide, regional and industry-specific economic and political factors. Danaher’s geographic and industry diversity, as well as the range of its products and services, help limit the impact of any one industry or the economy of any single country on its consolidated operating results. Given the broad range of products manufactured, services provided and geographies served, management does not use any indices other than general economic trends to predict the overall outlook for the Company. The Company’s individual businesses monitor key competitors and customers, including to the extent possible their sales, to gauge relative performance and the outlook for the future. As a result of the Company’s geographic and industry diversity, the Company faces a variety of opportunities and challenges, including rapid technological development (particularly with respect to computing, mobile connectivity, communications and digitization) in most of the Company’s served markets, the expansion and evolution of opportunities in high-growth markets, trends and costs associated with a global labor force, consolidation of the Company’s competitors and increasing regulation. The Company operates in a highly competitive business environment in most markets, and the Company’s long-term growth and profitability will depend in particular on its ability to expand its business in high-growth geographies and high-growth market segments, identify, consummate and integrate appropriate acquisitions, develop innovative and differentiated new products and services with higher gross profit margins, expand and improve the effectiveness of the Company’s sales force, continue to reduce costs and improve operating efficiency and quality, and effectively address the demands of an increasingly regulated environment. The Company is making significant investments, organically and through acquisitions, to address the rapid pace of technological change in its served markets and to globalize its manufacturing, research and development and customer-facing resources (particularly in high-growth markets) in order to be responsive to the Company’s customers throughout the world and improve the efficiency of the Company’s operations. Business Performance Consolidated sales for the year ended December 31, 2016 increased 17.0% as compared to 2015. While differences exist among the Company’s businesses, on an overall basis, demand for the Company’s products and services increased at a similar rate in 2016 as compared to 2015. This demand, together with the Company’s continued investments in sales growth initiatives and the other business-specific factors discussed below, contributed to year-over-year sales growth from existing businesses of 3.0% (for the definition of “sales from existing businesses,” refer to “-Results of Operations” below). Geographically, both high-growth and developed markets contributed to year-over-year sales growth from existing businesses during 2016. Sales growth rates from existing businesses in high-growth markets grew at a high-single digit rate in 2016 as compared to 2015 led by strength in China, India and Latin America partially offset by weakness in Eastern Europe. High-growth markets represented approximately 29% of the Company’s total sales in 2016. Sales from existing businesses in developed markets grew at a low-single digit rate in 2016 as compared to 2015 and were driven by North America and Western Europe. The acquisitions of Pall and Cepheid, as further discussed below, provide additional sales and earnings growth opportunities for the Company’s Life Sciences and Diagnostics segments, respectively, by expanding each segment’s geographic and product line diversity, including new and complementary product and service offerings in the area of life sciences, filtration, separation and purification technologies (in the case of Pall) and molecular diagnostics (in the case of Cepheid), and through the potential future acquisition of complementary businesses. As Pall and Cepheid are integrated into the Company, the Company also expects to realize significant cost synergies through the application of the Danaher Business System and the combined purchasing power of the Company, Pall and Cepheid. Fortive Separation On July 2, 2016, Danaher completed the Separation of its former Test & Measurement segment, Industrial Technologies segment (excluding the product identification businesses) and retail/commercial petroleum business by distributing to Danaher stockholders on a pro rata basis all of the issued and outstanding common stock of Fortive, the entity Danaher incorporated to hold such businesses. To effect the Separation, Danaher distributed to its stockholders one share of Fortive common stock for every two shares of Danaher common stock outstanding as of June 15, 2016, the record date for the distribution. During the second quarter of 2016, the Company received net cash distributions of approximately $3.0 billion from Fortive as consideration for the Company’s contribution of assets to Fortive in connection with the Separation (“Fortive Distribution”). Danaher used a portion of the cash distribution proceeds to repay the $500 million aggregate principal amount of 2.3% senior unsecured notes that matured in June 2016 and to redeem approximately $1.9 billion in aggregate principal amount of outstanding indebtedness in August 2016 (consisting of the Company’s 5.625% senior unsecured notes due 2018, 5.4% senior unsecured notes due 2019 and 3.9% senior unsecured notes due 2021 (collectively the “Redeemed Notes”)). Danaher also paid an aggregate of $188 million in make-whole premiums in connection with the August 2016 redemptions, plus accrued and unpaid interest. The Company has also used, and intends to use, the balance of the Fortive Distribution to fund certain of the Company’s regular, quarterly cash dividends to shareholders. The accounting requirements for reporting the Separation of Fortive as a discontinued operation were met when the Separation was completed. Accordingly, the accompanying consolidated financial statements for all periods presented reflect this business as a discontinued operation. The Company allocated a portion of the consolidated interest expense and income to discontinued operations based on the ratio of the discontinued business’ net assets to the Company’s consolidated net assets. Fortive had revenues of approximately $3.0 billion in 2016 prior to the Separation and approximately $6.1 billion in 2015. As a result of the Separation, the Company incurred $48 million in Separation-related costs during the year ended December 31, 2016 which are included in earnings from discontinued operations, net of income taxes in the accompanying Consolidated Statements of Earnings. These Separation costs primarily relate to professional fees associated with preparation of regulatory filings and Separation activities within finance, tax, legal and information system functions as well as certain investment banking fees and tax liabilities incurred upon the Separation. Acquisitions On November 4, 2016, Copper Merger Sub, Inc., a California corporation and an indirect, wholly-owned subsidiary of the Company acquired all of the outstanding shares of common stock of Cepheid, a California corporation, for $53.00 per share in cash, for a total purchase price of approximately $4.0 billion, including assumed debt and net of acquired cash (the “Cepheid Acquisition”). Cepheid is a leading global molecular diagnostics company that develops, manufactures and markets accurate and easy to use molecular systems and tests and is now part of the Company’s Diagnostics segment. Cepheid generated revenues of $539 million in 2015. The Company financed the Cepheid acquisition price with available cash and proceeds from the issuance of U.S. dollar and euro-denominated commercial paper. In addition to the Cepheid Acquisition, during 2016 the Company acquired seven businesses for total consideration of $882 million in cash, net of cash acquired. The businesses acquired complement existing units of each of the Company’s four segments. The aggregate annual sales of these seven businesses at the time of their respective acquisitions, in each case based on the company’s revenues for its last completed fiscal year prior to the acquisition, were $237 million. For a discussion of the Company’s 2015 and 2014 acquisition and disposition activity, refer to “Liquidity and Capital Resources-Investing Activities”. Sale of Investments The Company received $265 million of cash proceeds from the sale of certain marketable equity securities during 2016. The Company recorded a pretax gain related to this sale of $223 million ($140 million after-tax or $0.20 per diluted share). For a discussion of the Company’s 2015 and 2014 sale of investments activity, refer to “Liquidity and Capital Resources-Investing Activities”. RESULTS OF OPERATIONS In this report, references to sales from existing businesses refer to sales from continuing operations calculated according to generally accepted accounting principles in the United States (“GAAP”) but excluding (1) sales from acquired businesses and (2) the impact of currency translation. References to sales or operating profit attributable to acquisitions or acquired businesses refer to GAAP sales or operating profit, as applicable, from acquired businesses recorded prior to the first anniversary of the acquisition less the amount of sales and operating profit, as applicable, attributable to divested product lines not considered discontinued operations. The portion of revenue attributable to currency translation is calculated as the difference between (a) the period-to-period change in revenue (excluding sales from acquired businesses) and (b) the period-to-period change in revenue (excluding sales from acquired businesses) after applying current period foreign exchange rates to the prior year period. Sales from existing businesses should be considered in addition to, and not as a replacement for or superior to, sales, and may not be comparable to similarly titled measures reported by other companies. Management believes that reporting the non-GAAP financial measure of sales from existing businesses provides useful information to investors by helping identify underlying growth trends in Danaher’s business and facilitating easier comparisons of Danaher’s revenue performance with its performance in prior and future periods and to Danaher’s peers. The Company excludes the effect of currency translation from sales from existing businesses because currency translation is not under management’s control, is subject to volatility and can obscure underlying business trends, and excludes the effect of acquisitions and divestiture related items because the nature, size and number of acquisitions and divestitures can vary dramatically from period-to-period and between the Company and its peers and can also obscure underlying business trends and make comparisons of long-term performance difficult. Throughout this discussion, references to sales volume refer to the impact of both price and unit sales and references to productivity improvements generally refer to improved cost efficiencies resulting from the application of the Danaher Business System. Sales Growth (GAAP) Components of Sales Growth (non-GAAP) Sales from existing businesses grew on a year-over-year basis in all segments in both 2016 and 2015. Sales from acquired businesses grew on a year-over-year basis in both years primarily due to the acquisitions of Pall in the third quarter of 2015 and Cepheid in the fourth quarter of 2016. The impact of currency translation reduced on a year-over-year basis reported sales in both years as the U.S. dollar was, on average, stronger against other major currencies. Operating profit margins were 16.3% for the year ended December 31, 2016 as compared to 15.0% in 2015. The following factors impacted year-over-year operating profit margin comparisons. 2016 vs. 2015 operating profit margin comparisons were favorably impacted by: • Higher 2016 sales volumes from existing businesses and incremental year-over-year cost savings associated with the restructuring actions and continuing productivity improvement initiatives taken in 2016 and 2015, net of incremental year-over-year costs associated with various product development, sales and marketing growth investments and the effect of a stronger U.S. dollar in 2016 - 115 basis points • Acquisition-related charges in 2015 associated with the acquisition of Pall, including transaction costs deemed significant, change in control payments, and fair value adjustments to acquired inventory and deferred revenue, net of the positive impact of freezing pension benefits - 90 basis points • Acquisition-related charges in the first quarter of 2015 associated with the acquisition of Nobel Biocare, primarily related to fair value adjustments to acquired inventory - 15 basis points • The 2016 gains on resolution of acquisition-related matters - 10 basis points 2016 vs. 2015 operating profit margin comparisons were unfavorably impacted by: • Acquisition-related charges in 2016 associated primarily with the acquisition of Cepheid, including transaction costs deemed significant, change in control and restructuring payments, and fair value adjustments to acquired inventory and deferred revenue - 50 basis points • The incremental net dilutive effect in 2016 of acquired businesses - 50 basis points The Company deems acquisition-related transaction costs incurred in a given period to be significant (generally relating to the Company’s larger acquisitions) if it determines that such costs exceed the range of acquisition-related transaction costs typical for the Company in a given period. Operating profit margins were 15.0% for the year ended December 31, 2015 as compared to 15.9% in 2014. The following factors impacted year-over-year operating profit margin comparisons. 2015 vs. 2014 operating profit margin comparisons were favorably impacted by: • Higher 2015 sales volumes from existing businesses and incremental year-over-year cost savings associated with the restructuring actions and continuing productivity improvement initiatives taken in 2015 and 2014, net of incremental year-over-year costs associated with various product development, sales and marketing growth investments and the effect of a stronger U.S. dollar in 2015 - 85 basis points • Lower year-over-year costs associated with restructuring actions and continuing productivity improvement initiatives - 30 basis points 2015 vs. 2014 operating profit margin comparisons were unfavorably impacted by: • Acquisition-related charges in 2015 associated with the acquisition of Pall, including transaction costs deemed significant, change in control payments, and fair value adjustments to acquired inventory and deferred revenue, net of the positive impact of freezing pension benefits - 90 basis points • The incremental net dilutive effect in 2015 of acquired businesses, including Pall, net of the positive effect of the product line disposition in the third quarter of 2014 - 115 basis points Business Segments Sales by business segment for the years ended December 31 are as follows ($ in millions): LIFE SCIENCES The Company’s Life Sciences segment offers a broad range of research tools that scientists use to study the basic building blocks of life, including genes, proteins, metabolites and cells, in order to understand the causes of disease, identify new therapies and test new drugs and vaccines. The segment, through its Pall business, is also a leading provider of filtration, separation and purification technologies to the biopharmaceutical, food and beverage, medical, aerospace, microelectronics and general industrial sectors. Life Sciences Selected Financial Data Sales Growth (GAAP) Components of Sales Growth (non-GAAP) 2016 Compared to 2015 Price increases did not have a significant impact on sales growth on a year-over-year basis during 2016 as compared with 2015. Sales of the business’ broad range of mass spectrometers continued to grow on a year-over-year basis led by strong sales growth in the pharmaceutical market in China and India as well as the services businesses. This growth was partially offset by declines in the overall market in Japan and softness in demand in the clinical end-market in North America. Sales of microscopy products were essentially flat on a year-over-year basis with growth in demand in North America and China offset by declines in Japan. Year-over-year demand for the business’ flow cytometry and particle counting products grew in 2016, led by increases in demand in North America, Western Europe and China. The acquisition of Pall in August 2015 contributed the majority of the increase in sales from acquisitions. During the year ended December 31, 2016, Pall’s revenues grew on a year-over-year basis compared to the business’ 2015 results, led by continued growth in the life sciences business primarily due to demand for biopharmaceutical solutions including single-use technologies, partially offset by soft demand in the industrial business as a result of overall market weakness. Operating profit margins increased 540 basis points during 2016 as compared to 2015. The following factors impacted year-over-year operating profit margin comparisons. 2016 vs. 2015 operating profit margin comparisons were favorably impacted by: • Higher 2016 sales volumes from existing businesses and incremental year-over-year cost savings associated with the restructuring actions and continuing productivity improvement initiatives taken in 2016 and 2015, net of incremental year-over-year costs associated with various product development, sales and marketing growth investments and the effect of a stronger U.S. dollar in 2016 - 175 basis points • Acquisition-related charges in 2015 associated with the acquisition of Pall, including transaction costs deemed significant, change in control payments, and fair value adjustments to acquired inventory and deferred revenue, net of the positive impact of freezing pension benefits - 390 basis points 2016 vs. 2015 operating profit margin comparisons were unfavorably impacted by: • Acquisition-related charges in 2016, including transaction costs deemed significant, change in control and restructuring payments, and fair value adjustments to acquired inventory and deferred revenue - 10 basis points • The incremental net dilutive effect in 2016 of acquired businesses - 15 basis points Depreciation and amortization expense increased during 2016 as compared to 2015 due primarily to the impact of recently acquired businesses, particularly Pall. 2015 Compared to 2014 Price increases in the segment contributed 0.5% to sales growth on a year-over-year basis during 2015 as compared with 2014 and are reflected as a component of the change in sales from existing businesses. Sales from existing businesses in the segment’s life sciences business grew at a low-single digit rate during 2015 as compared to 2014. Geographically, sales grew on a year-over-year basis in North America and Western Europe partially offset by declines in the Middle East and Brazil. Sales of the business’ broad range of mass spectrometers continued to grow on a year-over-year basis led by strong sales growth in the clinical markets in North America, Western Europe and China. Sales of confocal and stereo microscopy products decreased on a year-over-year basis led by declines in Western Europe and high-growth markets which were partially offset by growth in surgical microscopy products, primarily in North America. Year-over-year demand for the business’ flow cytometry and sample preparation product lines grew in 2015, led by increases in demand in North America, Western Europe and China. The acquisition of Pall in August 2015 contributed the majority of the increase in sales from acquisitions for 2015. Operating profit margins declined 480 basis points during 2015 as compared to 2014. The following factors impacted year-over-year operating profit margin comparisons. 2015 vs. 2014 operating profit margin comparisons were favorably impacted by: • Higher 2015 sales volumes from existing businesses and incremental year-over-year cost savings associated with the restructuring actions and continuing productivity improvement initiatives taken in 2015 and 2014, net of incremental year-over-year costs associated with various product development, sales and marketing growth investments and the effect of a stronger U.S. dollar in 2015 - 30 basis points • Lower year-over-year costs associated with restructuring actions and continuing productivity improvement initiatives - 25 basis points 2015 vs. 2014 operating profit margin comparisons were unfavorably impacted by: • Acquisition-related charges in 2015 associated with the acquisition of Pall, including transaction costs deemed significant, change in control payments, and fair value adjustments to acquired inventory and deferred revenue, net of the positive impact of freezing pension benefits - 390 basis points • The incremental net dilutive effect in 2015 of acquired businesses (including Pall) - 145 basis points Depreciation and amortization expense increased during 2015 as compared to 2014 due primarily to the impact of recently acquired businesses, particularly Pall, and the resulting increase in depreciable and amortizable assets. DIAGNOSTICS The Company’s Diagnostics segment offers analytical instruments, reagents, consumables, software and services that hospitals, physicians’ offices, reference laboratories and other critical care settings use to diagnose disease and make treatment decisions. Diagnostics Selected Financial Data Sales Growth (GAAP) Components of Sales Growth (non-GAAP) 2016 Compared to 2015 Price increases in the segment contributed 0.5% to sales growth on a year-over-year basis during 2016 as compared with 2015 and are reflected as a component of the change in sales from existing businesses. Geographically, demand in the clinical lab business increased on a year-over-year basis led by continuing strong demand in high-growth markets, particularly China, partially offset by declines in North America. Increased demand in the immunoassay products drove the majority of growth for the year in the clinical business. Continued strong consumable sales in 2016 particularly in China, Western Europe, North America and Japan drove the majority of the year-over-year sales growth in the acute care diagnostic business. Increased demand for advanced staining consumables, particularly in North America and China, and core histology instruments across most major geographies, but particularly in China, drove the majority of the year-over-year sales growth in the pathology diagnostics business. The acquisition of Cepheid in November 2016 provides additional sales and earnings growth opportunities for the segment by expanding geographic and product line diversity, including new product and service offerings in the areas of molecular diagnostics. As Cepheid is integrated into the Company over the next several years, the Company expects to realize significant synergies through the application of the Danaher Business System. Operating profit margins increased 20 basis points during 2016 as compared to 2015. The following factors impacted year-over-year operating profit margin comparisons. 2016 vs. 2015 operating profit margin comparisons were favorably impacted by: • Higher 2016 sales volumes from existing businesses and incremental year-over-year cost savings associated with the restructuring actions and continuing productivity improvement initiatives taken in 2016 and 2015, net of incremental year-over-year costs associated with various product development, sales and marketing growth investments and the effect of a stronger U.S. dollar in 2016 - 200 basis points 2016 vs. 2015 operating profit margin comparisons were unfavorably impacted by: • Acquisition-related charges in 2016 associated with the acquisition of Cepheid, including transaction costs deemed significant, change in control and restructuring payments, and fair value adjustments to acquired inventory and deferred revenue - 150 basis points • The incremental net dilutive effect in 2016 of acquired businesses - 30 basis points Amortization increased during 2016 as compared with 2015 primarily due to the impact of recently acquired businesses including Cepheid and the resulting increase in amortizable assets. 2015 Compared to 2014 Price increases in the segment contributed 0.5% to sales growth on a year-over-year basis during 2015 as compared with 2014 and are reflected as a component of the change in sales from existing businesses. Sales from existing businesses in the segment’s diagnostics business grew at a mid-single digit rate during 2015 as compared to 2014. Demand in the clinical lab business increased on a year-over-year basis led by growth in the urinalysis and immunoassay consumable products primarily from continuing strong demand in China and other high-growth markets. Continued strong consumable sales in 2015 related to the installed base of blood gas instruments in developed markets as well as strong instrument placement particularly in China and the Middle East drove the majority of the year-over-year sales growth in the critical care diagnostic business. Increased demand for advanced staining systems and consumables as well as probes primarily in North America and China drove the majority of the year-over-year sales growth in the anatomical pathology diagnostics business. Operating profit margins declined 30 basis points during 2015 as compared to 2014. The following factors impacted year-over-year operating profit margin comparisons. 2015 vs. 2014 operating profit margin comparisons were favorably impacted by: • Higher 2015 sales volumes from existing businesses and incremental year-over-year cost savings associated with the restructuring actions and continuing productivity improvement initiatives taken in 2015 and 2014, net of incremental year-over-year costs associated with various product development, sales and marketing growth investments and the effect of a stronger U.S. dollar in 2015 - 40 basis points • Lower year-over-year costs associated with restructuring actions and continuing productivity improvement initiatives - 30 basis points 2015 vs. 2014 operating profit margin comparisons were unfavorably impacted by: • The incremental net dilutive effect in 2015 of acquired businesses - 100 basis points DENTAL The Company’s Dental segment provides products that are used to diagnose, treat and prevent disease and ailments of the teeth, gums and supporting bone, as well as to improve the aesthetics of the human smile. The Company is a leading worldwide provider of a broad range of dental consumables, equipment and services, and is dedicated to driving technological innovations that help dental professionals improve clinical outcomes and enhance productivity. Dental Selected Financial Data Sales Growth (GAAP) Components of Sales Growth (non-GAAP) 2016 Compared to 2015 Price increases in the segment contributed 0.5% to sales growth on a year-over-year basis during 2016 as compared with 2015 and are reflected as a component of the change in sales from existing businesses. Geographically, year-over-year sales growth was strong in China and other high-growth markets, with low-single digit growth in the United States partially offset by lower demand in Western Europe. Continued strong year-over-year demand for implant solutions, particularly in China and North America, and increased demand for orthodontic products, primarily in China and Russia, drove growth during 2016. Dental equipment sales also increased during 2016, primarily in high-growth markets and North America partially offset by weaker demand in Western Europe. Lower demand for dental consumable product lines in North America and the Middle East partially offset this year-over-year growth in 2016. Operating profit margins increased 160 basis points during 2016 as compared to 2015. The following factors impacted year-over-year operating profit margin comparisons. 2016 vs. 2015 operating profit margin comparisons were favorably impacted by: • Higher 2016 sales volumes from existing businesses and incremental year-over-year cost savings associated with the restructuring actions and continuing productivity improvement initiatives taken in 2016 and 2015, net of incremental year-over-year costs associated with various product development, sales and marketing growth investments and the effect of a stronger U.S. dollar in 2016 - 90 basis points • Acquisition-related charges in the first quarter of 2015 associated with the acquisition of Nobel Biocare, primarily related to fair value adjustments to acquired inventory - 80 basis points 2016 vs. 2015 operating profit margin comparisons were unfavorably impacted by: • The incremental net dilutive effect in 2016 of acquired businesses - 10 basis points 2015 Compared to 2014 Price increases in the segment contributed 0.5% to sales growth on a year-over-year basis during 2015 as compared with 2014 and are reflected as a component of the change in sales from existing businesses. Sales from existing businesses were flat on a year-over-year basis as increased demand for dental treatment units and consumable products, including orthodontic products, primarily in China and other high-growth markets, was offset by softness in demand for imaging products, largely due to destocking in the North American distribution channel, and weaker demand in Western Europe. Lower year-over-year demand for dental equipment in the Middle East due to slower project activity during 2015 also adversely impacted year-over-year performance. The acquisition of Nobel Biocare in December 2014 has provided additional sales and earnings growth opportunities for the Company’s Dental segment by expanding the businesses’ geographic and product line diversity, including new and complementary product and service offerings in the area of implant based tooth replacements. Operating profit margins declined 40 basis points during 2015 as compared to 2014. The following factors impacted year-over-year operating profit margin comparisons. 2015 vs. 2014 operating profit margin comparisons were favorably impacted by: • Incremental year-over-year cost savings associated with the restructuring actions and continuing productivity improvement initiatives taken in 2015 and 2014, net of incremental year-over-year costs associated with various product development, sales and marketing growth investments and the effect of a stronger U.S. dollar in 2015 - 45 basis points • Lower year-over-year costs associated with restructuring actions and continuing productivity improvement initiatives - 10 basis points 2015 vs. 2014 operating profit margin comparisons were unfavorably impacted by: • The incremental net dilutive effect in 2015 of acquired businesses - 95 basis points Depreciation and amortization increased during 2015 as compared with 2014 due primarily to the impact of recently acquired businesses, primarily Nobel Biocare, and the resulting increase in depreciable and amortizable assets. ENVIRONMENTAL & APPLIED SOLUTIONS The Company’s Environmental & Applied Solutions segment products and services help protect important resources and keep global food and water supplies safe. The Company’s water quality business provides instrumentation, services and disinfection systems to help analyze, treat and manage the quality of ultra-pure, potable, waste, ground, source and ocean water in residential, commercial, industrial and natural resource applications. The Company’s product identification business provides equipment, consumables, software and services for various printing, marking, coding, traceability, packaging, design and color management applications on consumer, pharmaceutical and industrial products. Environmental & Applied Solutions Selected Financial Data Sales Growth (GAAP) Components of Sales Growth (non-GAAP) 2016 Compared to 2015 Price increases in the segment contributed 1.0% to sales growth on a year-over-year basis during 2016 as compared with 2015 and are reflected as a component of the change in sales from existing businesses. Sales from existing businesses in the segment’s water quality businesses grew at a low-single digit rate during 2016 as compared with 2015. Year-over-year sales in the analytical instrumentation product line grew, as increases in sales to the U.S. municipal end-market and Western Europe were partially offset by lower demand in Eastern Europe and China. Year-over-year sales growth in the business’ chemical treatment solutions product line was due primarily to an expansion of the customer base in the United States. Chemical treatment solutions saw an improvement in commodity oriented end-markets in Latin America in the fourth quarter of 2016 after declining growth in the earlier portion of 2016. Sales in the business’ ultraviolet water disinfection product line grew on a year-over-year basis due primarily to higher demand in municipal and industrial end-markets in Western Europe, China and Australia. Sales from existing businesses in the segment’s product identification businesses grew at a mid-single digit rate during 2016 as compared with 2015. Continued strong year-over-year demand for marking and coding equipment and related consumables in most major geographies, led by North America, Western Europe and Latin America, drove the majority of the sales growth. Demand for the business’ packaging and color solutions was flat year-over-year, as sales growth in the second half of the year was offset by weakness in the first half of the year. Geographically, increased demand in the high-growth markets was offset by weaker demand in North America and Europe. Operating profit margins declined 80 basis points during 2016 as compared to 2015. The following factors unfavorably impacted year-over-year operating profit margin comparisons: • The incremental net dilutive effect in 2016 of acquired businesses - 75 basis points • Incremental year-over-year costs associated with various product development, sales and marketing growth investments and the effect of a stronger U.S. dollar in 2016, net of higher 2016 sales volumes from existing businesses and incremental year-over-year cost savings associated with the restructuring actions and continuing productivity improvement initiatives taken in 2016 and 2015 - 5 basis points 2015 Compared to 2014 Price increases in the segment contributed 1.0% to sales growth on a year-over-year basis during 2015 as compared with 2014 and are reflected as a component of the change in sales from existing businesses. Sales from existing businesses in the segment’s water quality businesses grew at a mid-single digit rate during 2015 as compared with 2014. Sales growth in the analytical instrumentation product line continued to be led by strong sales of instruments and related consumables and services in North America, primarily in the U.S. municipal end-market, Europe and China (although growth slowed sequentially in China during the fourth quarter of 2015, partly due to delays in government projects). Year-over-year sales growth in the business’ chemical treatment solutions product line was due to continued growth in the United States as well as continued business expansion in Latin America. Sales in the business’ ultraviolet water disinfection product line grew on a year-over-year basis due to continued demand in industrial disinfection end-markets in the United States and municipal end-markets in the United States and Western Europe. Sales from existing businesses in the segment’s product identification businesses grew at a mid-single digit rate during 2015 as compared with 2014, due to continued increased demand for marking and coding equipment and related consumables as well as packaging and color solutions. Geographically, year-over-year sales growth was led by North America and Europe (although North America declined slightly in the fourth quarter of 2015), but was partly offset by softer demand for the business’ packaging and color solutions in Brazil and Russia. Operating profit margins increased 230 basis points during 2015 as compared to 2014. The following factors impacted year-over-year operating profit margin comparisons. 2015 vs. 2014 operating profit margin comparisons were favorably impacted by: • Higher 2015 sales volumes from existing businesses and incremental year-over-year cost savings associated with the restructuring actions and continuing productivity improvement initiatives taken in 2015 and 2014, net of incremental year-over-year costs associated with various product development, sales and marketing growth investments and the effect of a stronger U.S. dollar in 2015 - 225 basis points • Lower year-over-year costs associated with restructuring actions and continuing productivity improvement initiatives - 50 basis points 2015 vs. 2014 operating profit margin comparisons were unfavorably impacted by: • The incremental net dilutive effect in 2015 of acquired businesses - 45 basis points COST OF SALES AND GROSS PROFIT The year-over-year increase in cost of sales during 2016 as compared with 2015, is due primarily to the impact of higher year-over-year sales volumes, including sales from recently acquired businesses. This increase in cost of sales was partially offset by year-over-year cost savings at recently acquired businesses, particularly Pall, incremental year-over-year cost savings associated with the restructuring and continued productivity improvement actions taken in 2016 and 2015, and the year-over-year decrease in acquisition-related charges associated with fair value adjustments to acquired inventory which decreased cost of sales by $85 million during 2016 as compared to 2015. The year-over-year increase in cost of sales during 2015 as compared with 2014, is due primarily to the impact of higher year-over-year sales volumes, including sales volumes from recently acquired businesses, and 2015 acquisition-related charges associated with fair value adjustments to acquired inventory in connection with the acquisition of Pall and Nobel Biocare during the third quarter of 2015 and the fourth quarter of 2014, respectively, which increased cost of sales by $106 million during 2015. These factors were partially offset by lower year-over-year costs associated with restructuring actions and continuing productivity improvement initiatives and incremental year-over-year cost savings associated with the restructuring actions and continuing productivity improvements taken in 2015 and 2014. The year-over-year increase in gross profit margins during 2016 as compared with 2015 is due primarily to the favorable impact of higher year-over-year sales volumes, incremental year-over-year cost savings associated with the restructuring actions and continuing productivity improvements taken in 2016 and 2015 and improved gross profit margins on a year-over-year basis at recently acquired businesses, particularly Pall. In addition, the acquisition-related charges associated with fair value adjustments to acquired inventory and deferred revenue were higher in 2015 than 2016, which improved gross profit margins by 50 basis points during 2016 as compared with 2015. The year-over-year increase in gross profit margins during 2015 as compared with 2014 is due primarily to the favorable impact of higher year-over-year sales volumes, higher gross profit margins of recently acquired businesses and incremental year-over-year cost savings associated with the restructuring actions and continuing productivity improvements taken in 2015 and 2014. These positive factors more than offset the increase in acquisition-related charges associated with fair value adjustments to acquired inventory and deferred revenue in connection with the acquisition of Pall and Nobel Biocare during the third quarter of 2015 and the fourth quarter of 2014, respectively, which adversely impacted gross profit margins comparisons by 80 basis points during 2015 as compared with 2014. OPERATING EXPENSES The increase in SG&A expenses as a percentage of sales from 2015 to 2016 was driven by continued investments in sales and marketing growth initiatives and higher relative spending levels at recently acquired businesses. Change in control payments and restructuring costs in connection with the acquisition of Cepheid, as well as associated transaction costs, also increased SG&A expenses as a percentage of sales by 35 basis points during 2016. These increases were partially offset by the benefit of increased leverage of the Company’s general and administrative cost base resulting from higher 2016 sales, lower year-over-year costs associated continuing productivity improvement initiatives and incremental year-over-year cost savings associated with the restructuring actions and continuing productivity improvements taken in 2016 and 2015 as well as the benefit of lower Pall acquisition charges in 2016 compared to 2015 as described below. SG&A expenses as a percentage of sales increased 150 basis points on a year-over-year basis for 2015 compared with 2014. The increase in SG&A expenses as a percentage of sales from 2014 to 2015 was driven by continued investments in sales and marketing growth initiatives and higher relative spending levels at recently acquired businesses. Change in control payments to Pall employees in connection with the acquisition of Pall, as well as associated transaction costs and amortization charges associated with acquisition-related intangible assets, net of the positive impact of freezing pension benefits, adversely impacted SG&A expenses as a percentage of sales by 30 basis points during 2015. These increases were partially offset by the benefit of increased leverage of the Company’s general and administrative cost base resulting from higher 2015 sales, lower year-over-year costs associated with restructuring actions and continuing productivity improvement initiatives and incremental year-over-year cost savings associated with the restructuring actions and continuing productivity improvements taken in 2015 and 2014. R&D expenses (consisting principally of internal and contract engineering personnel costs) as a percentage of sales declined in 2016 as compared with 2015 due primarily to lower R&D expenses as a percentage of sales in the businesses most recently acquired, particularly Pall, as well as year-over-year differences in the timing of investments in the Company’s new product development initiatives. R&D expenses as a percentage of sales were flat in 2015 as compared to 2014. NONOPERATING INCOME (EXPENSE) In the third quarter of 2016, the Company paid $188 million of make-whole premiums associated with the early extinguishment of the Redeemed Notes. The Company recorded a loss on extinguishment of these borrowings, net of certain deferred gains, of $179 million ($112 million after-tax or $0.16 per diluted share). The Company received $265 million of cash proceeds from the sale of certain marketable equity securities during the first quarter of 2016. The Company recorded a pretax gain related to this sale of $223 million ($140 million after-tax or $0.20 per diluted share). During 2015, the Company received cash proceeds of $43 million from the sale of certain marketable equity securities and recorded a pretax gain related to these sales of $12 million ($8 million after-tax or $0.01 per diluted share). During 2014, the Company received cash proceeds of $167 million from the sale of certain marketable equity securities and recorded a pretax gain related to these sales of $123 million ($77 million after-tax or $0.11 per diluted share). INTEREST COSTS Interest expense of $184 million for 2016 was $45 million higher than in 2015, due primarily to the higher interest costs associated with the debt issued in the second half of 2015 in connection with the 2015 acquisition of Pall, partially offset by decreases in interest costs as a result of the early extinguishment of the Redeemed Notes in the third quarter of 2016 using the proceeds from the Fortive Distribution. For a further description of the Company’s debt as of December 31, 2016 refer to Note 9 to the Consolidated Financial Statements. Interest expense of $140 million in 2015 was $45 million higher than the 2014 interest expense of $95 million due primarily to the higher interest costs associated with the debt issued in the second half of 2015 in connection with the acquisition of Pall. INCOME TAXES General Income tax expense and deferred tax assets and liabilities reflect management’s assessment of future taxes expected to be paid on items reflected in the Company’s financial statements. The Company records the tax effect of discrete items and items that are reported net of their tax effects in the period in which they occur. The Company’s effective tax rate can be affected by changes in the mix of earnings in countries with different statutory tax rates (including as a result of business acquisitions and dispositions), changes in the valuation of deferred tax assets and liabilities, accruals related to contingent tax liabilities and period-to-period changes in such accruals, the results of audits and examinations of previously filed tax returns (as discussed below), the expiration of statutes of limitations, the implementation of tax planning strategies, tax rulings, court decisions, settlements with tax authorities and changes in tax laws, including legislative policy changes that may result from the Organization for Economic Co-operation and Development’s initiative on Base Erosion and Profit Shifting and potential tax reform in the United States. For a description of the tax treatment of earnings that are planned to be reinvested indefinitely outside the United States, refer to “-Liquidity and Capital Resources - Cash and Cash Requirements” below. The amount of income taxes the Company pays is subject to ongoing audits by federal, state and foreign tax authorities, which often result in proposed assessments. Management performs a comprehensive review of its global tax positions on a quarterly basis. Based on these reviews, the results of discussions and resolutions of matters with certain tax authorities, tax rulings and court decisions and the expiration of statutes of limitations, reserves for contingent tax liabilities are accrued or adjusted as necessary. For a discussion of risks related to these and other tax matters, refer to “Item 1A. Risk Factors”. Year-Over-Year Changes in the Tax Provision and Effective Tax Rate The Company’s effective tax rate related to continuing operations for the years ended December 31, 2016, 2015 and 2014 was 17.5%, 14.4% and 21.5%, respectively. The Company’s effective tax rate for each of 2016, 2015 and 2014 differs from the U.S. federal statutory rate of 35.0% due principally to the Company’s earnings outside the United States that are indefinitely reinvested and taxed at rates lower than the U.S. federal statutory rate. • The effective tax rate of 17.5% in 2016 includes 350 basis points of net tax benefits from permanent foreign exchange losses and the release of reserves upon the expiration of statutes of limitation and audit settlements, partially offset by income tax expense related to repatriation of earnings and legal entity realignments associated with the Separation and changes in estimates associated with prior period uncertain tax positions. • The effective tax rate of 14.4% in 2015 includes 290 basis points of net tax benefits from permanent foreign exchange losses, releases of valuation allowances related to foreign operating losses and the release of reserves upon the expiration of statutes of limitation, partially offset by changes in estimates associated with prior period uncertain tax positions. • The effective tax rate of 21.5% in 2014 includes 250 basis points of tax expense for audit settlements in various jurisdictions, partially offset by the release of valuation allowances and the release of reserves upon the expiration of statutes of limitation. The Company conducts business globally, and files numerous consolidated and separate income tax returns in the United States federal, state and foreign jurisdictions. The countries in which the Company has a material presence that have significantly lower statutory tax rates than the United States include China, Denmark, Germany, Singapore, Switzerland and the United Kingdom. The Company’s ability to obtain a tax benefit from lower statutory tax rates outside of the United States depends on its levels of taxable income in these foreign countries and the amount of foreign earnings which are indefinitely reinvested in those countries. The Company believes that a change in the statutory tax rate of any individual foreign country would not have a material effect on the Company’s consolidated financial statements given the geographic dispersion of the Company’s taxable income. The Company and its subsidiaries are routinely examined by various domestic and international taxing authorities. The IRS has completed substantially all of the examinations of the Company’s federal income tax returns through 2010 and is currently examining certain of the Company’s federal income tax returns for 2011 through 2013. In addition, the Company has subsidiaries in Austria, Belgium, Canada, China, Denmark, Finland, France, Germany, Hong Kong, India, Italy, Japan, Singapore, Sweden, Switzerland, the United Kingdom and various other countries, states and provinces that are currently under audit for years ranging from 2004 through 2015. Tax authorities in Denmark have raised significant issues related to interest accrued by certain of the Company’s subsidiaries. On December 10, 2013, the Company received assessments from the Danish tax authority (“SKAT”) totaling approximately DKK 1.4 billion (approximately $195 million based on exchange rates as of December 31, 2016) including interest through December 31, 2016, imposing withholding tax relating to interest accrued in Denmark on borrowings from certain of the Company’s subsidiaries for the years 2004-2009. The Company is currently in discussions with SKAT and anticipates receiving an assessment for years 2010-2012 totaling approximately DKK 814 million (approximately $115 million based on exchange rates as of December 31, 2016). Management believes the positions the Company has taken in Denmark are in accordance with the relevant tax laws and is vigorously defending its positions. The Company appealed these assessments with the National Tax Tribunal in 2014 and intends on pursuing this matter through the European Court of Justice should this appeal be unsuccessful. The ultimate resolution of this matter is uncertain, could take many years, and could result in a material adverse impact to the Company’s financial statements, including its effective tax rate. As previously disclosed, German tax authorities had raised issues related to the deductibility and taxability of interest accrued by certain of the Company’s subsidiaries. In the fourth quarter of 2014, the Company entered into a settlement agreement with the German tax authorities to resolve these open matters through 2014. The Company recorded €49 million (approximately $60 million based on exchange rates as of December 31, 2014) of expense for taxes and interest related to this settlement during the fourth quarter of 2014. The Company’s effective tax rate for 2017 is expected to be approximately 21%. Any future legislative changes or potential tax reform in the United States or other jurisdictions could cause the Company’s effective tax rate to differ from this estimate. This expected rate reflects the anticipated discrete income tax benefits from excess tax deductions related to the Company’s stock compensation programs, which will be reflected as a reduction in tax expense beginning in 2017 (refer to Note 1 to the Consolidated Financial Statements for additional information related to this change in accounting guidance). DISCONTINUED OPERATIONS As further discussed in Note 3 to the Consolidated Financial Statements, discontinued operations includes the results of the Fortive businesses which were disposed of during the third quarter 2016 as well as the results of the Company’s former communications business which was disposed of during the third quarter of 2015. All periods presented have been restated to reflect the Fortive and communications businesses within discontinued operations. In 2016, earnings from discontinued operations, net of income taxes, were $400 million and reflected the operating results of the Fortive businesses prior to the Separation. In 2015 and 2014, earnings from discontinued operations, net of income taxes, were approximately $1.6 billion and $960 million, respectively and reflected the operations of both the Fortive and communications businesses as well as the gain on the sale of the communications business in 2015. COMPREHENSIVE INCOME Comprehensive income decreased by $617 million in 2016 as compared to 2015, primarily due to the impact of decreases in net earnings attributable to discontinued operations, foreign currency translation adjustments resulting from the strengthening of the U.S. dollar compared to most major currencies during the year but at a lower rate than in the prior year, and pension and postretirement plan benefit adjustments. The Company recorded a foreign currency translation loss of $517 million for 2016 compared to a translation loss of $976 million for 2015. The Company recorded a pension and postretirement plan benefit loss of $58 million for 2016 compared to a gain of $81 million for 2015. Comprehensive income increased by approximately $1.5 billion in 2015 as compared to 2014, primarily due to the impact of increases in net earnings (including those attributable to discontinued operations), foreign currency translation adjustments resulting from the strengthening of the U.S. dollar compared to most major currencies during the year but at a lower rate than in the prior year, and pension and postretirement plan benefit adjustments. The Company recorded a foreign currency translation loss of $976 million for 2015 compared to a translation loss of approximately $1.2 billion for 2014. Pension and postretirement plan benefit adjustments resulted in a gain of $81 million in 2015 compared to a loss of $361 million in 2014. INFLATION The effect of inflation on the Company’s revenues and net earnings was not significant in any of the years ended December 31, 2016, 2015 or 2014. FINANCIAL INSTRUMENTS AND RISK MANAGEMENT The Company is exposed to market risk from changes in interest rates, foreign currency exchange rates, equity prices and commodity prices as well as credit risk, each of which could impact its financial statements. The Company generally addresses its exposure to these risks through its normal operating and financing activities. In addition, the Company’s broad-based business activities help to reduce the impact that volatility in any particular area or related areas may have on its operating profit as a whole. Interest Rate Risk The Company manages interest cost using a mixture of fixed-rate and variable-rate debt. A change in interest rates on long-term debt impacts the fair value of the Company’s fixed-rate long-term debt but not the Company’s earnings or cash flow because the interest on such debt is fixed. Generally, the fair market value of fixed-rate debt will increase as interest rates fall and decrease as interest rates rise. As of December 31, 2016, an increase of 100 basis points in interest rates would have decreased the fair value of the Company’s fixed-rate long-term debt (excluding the LYONs, which have not been included in this calculation as the value of this convertible debt is primarily derived from the value of its underlying common stock) by approximately $335 million. As of December 31, 2016, the Company’s variable-rate debt obligations consisted primarily of U.S. dollar and euro-based commercial paper borrowings (refer to Note 9 to the Consolidated Financial Statements for information regarding the Company’s outstanding commercial paper balances as of December 31, 2016). As a result, the Company’s primary interest rate exposure results from changes in short-term interest rates. As these shorter duration obligations mature, the Company anticipates issuing additional short-term commercial paper obligations to refinance all or part of these borrowings. In 2016, the average annual interest rate associated with outstanding commercial paper borrowings was approximately 10 basis points. A hypothetical increase of this average to 20 basis points would have increased the Company’s annual interest expense by $7 million. Currency Exchange Rate Risk The Company faces transactional exchange rate risk from transactions with customers in countries outside the United States and from intercompany transactions between affiliates. Transactional exchange rate risk arises from the purchase and sale of goods and services in currencies other than Danaher’s functional currency or the functional currency of its applicable subsidiary. The Company also faces translational exchange rate risk related to the translation of financial statements of its foreign operations into U.S. dollars, Danaher’s functional currency. Costs incurred and sales recorded by subsidiaries operating outside of the United States are translated into U.S. dollars using exchange rates effective during the respective period. As a result, the Company is exposed to movements in the exchange rates of various currencies against the U.S. dollar. In particular, the Company has more sales in European currencies than it has expenses in those currencies. Therefore, when European currencies strengthen or weaken against the U.S. dollar, operating profits are increased or decreased, respectively. The effect of a change in currency exchange rates on the Company’s net investment in international subsidiaries is reflected in the accumulated other comprehensive income (loss) component of stockholders’ equity. A 10% depreciation in major currencies relative to the U.S. dollar as of December 31, 2016 would have resulted in a reduction of stockholders’ equity of approximately $1.6 billion. Currency exchange rates negatively impacted 2016 reported sales by 1.0% on a year-over-year basis as the U.S. dollar was, on average, stronger against most major currencies during 2016 as compared to exchange rate levels during 2015. If the exchange rates in effect as of December 31, 2016 were to prevail throughout 2017, currency exchange rates would adversely impact 2017 estimated sales by approximately 2.5% relative to the Company’s performance in 2016. Additional strengthening of the U.S. dollar against other major currencies would further adversely impact the Company’s sales and results of operations on an overall basis. Any weakening of the U.S. dollar against other major currencies would positively impact the Company’s sales and results of operations. The Company has generally accepted the exposure to exchange rate movements without using derivative financial instruments to manage this risk, although the Company’s foreign currency-denominated debt partially hedges its net investments in foreign operations against adverse movements in exchange rates. Both positive and negative movements in currency exchange rates against the U.S. dollar will therefore continue to affect the reported amount of sales, profit, and assets and liabilities in the Company’s Consolidated Financial Statements. Equity Price Risk The Company’s available-for-sale investment portfolio includes publicly traded equity securities that are sensitive to fluctuations in market price. Changes in equity prices would result in changes in the fair value of the Company’s available-for-sale investments due to the difference between the current market price and the market price at the date of purchase or issuance of the equity securities. A 10% decline in the value of these equity securities as of December 31, 2016 would have reduced the fair value of the Company’s available-for-sale investment portfolio by $17 million. Commodity Price Risk For a discussion of risks relating to commodity prices, refer “Item 1A. Risk Factors.” Credit Risk The Company is exposed to potential credit losses in the event of nonperformance by counterparties to its financial instruments. Financial instruments that potentially subject the Company to credit risk consist of cash and temporary investments, receivables from customers and derivatives. The Company places cash and temporary investments with various high-quality financial institutions throughout the world and exposure is limited at any one institution. Although the Company typically does not obtain collateral or other security to secure these obligations, it does regularly monitor the third-party depository institutions that hold its cash and cash equivalents. The Company’s emphasis is primarily on safety and liquidity of principal and secondarily on maximizing yield on those funds. In addition, concentrations of credit risk arising from receivables from customers are limited due to the diversity of the Company’s customers. The Company’s businesses perform credit evaluations of their customers’ financial conditions as appropriate and also obtain collateral or other security when appropriate. The Company enters into derivative transactions infrequently and such transactions are generally insignificant to the Company’s financial condition and results of operations. These transactions are typically entered into with high-quality financial institutions and exposure at any one institution is limited. LIQUIDITY AND CAPITAL RESOURCES Management assesses the Company’s liquidity in terms of its ability to generate cash to fund its operating, investing and financing activities. The Company continues to generate substantial cash from operating activities and believes that its operating cash flow and other sources of liquidity will be sufficient to allow it to continue investing in existing businesses, consummating strategic acquisitions, paying interest and servicing debt and managing its capital structure on a short and long-term basis. Following is an overview of the Company’s cash flows and liquidity for the years ended December 31: Overview of Cash Flows and Liquidity • Operating cash flows from continuing operations increased $255 million, or approximately 9%, during 2016 as compared to 2015, due primarily to higher net earnings which also included higher noncash charges for depreciation, amortization and stock compensation. Higher levels of investment in working capital during 2016 compared with 2015 partially offset the increase in operating cash flows for the year. • Cash paid for acquisitions constituted the most significant use of cash during 2016. The Company acquired eight businesses during 2016, including the acquisition of Cepheid, for total consideration (including assumed debt and net of cash acquired) of approximately $4.9 billion. • On July 2, 2016 Danaher completed the Fortive Separation. Prior to the Separation, Fortive provided approximately $3.0 billion of net cash distributions to Danaher. • The Company used a portion of the Fortive Distribution proceeds to repay the $500 million aggregate principal amount of 2.3% senior unsecured notes that matured in June 2016 and to redeem approximately $1.9 billion in aggregate principal amount of outstanding indebtedness in August 2016 (consisting of the Redeemed Notes). Danaher also paid an aggregate of $188 million in make-whole premiums in connection with the August 2016 redemptions, plus accrued and unpaid interest. • The Company also generated $2.2 billion of net proceeds from the issuances of commercial paper borrowings, which were primarily used to fund the Cepheid Acquisition. • The Company distributed cash of $485 million, in addition to approximately $2.0 billion of noncash net assets, to Fortive in connection with the Separation. • As of December 31, 2016, the Company held $964 million of cash and cash equivalents. Operating Activities Cash flows from operating activities can fluctuate significantly from period-to-period as working capital needs and the timing of payments for income taxes, restructuring activities, pension funding and other items impact reported cash flows. Operating cash flows from continuing operations were approximately $3.1 billion for 2016, an increase of $255 million, or approximately 9%, as compared to 2015. The year-over-year change in operating cash flows from 2015 to 2016 was primarily attributable to the following factors: • 2016 operating cash flows benefited from higher net earnings as compared to 2015 (excluding the 2016 impact of the gain from the sale of certain marketable equity securities and the loss on early extinguishment of borrowings which are included in nonoperating income (expense)). The cash flow impact of the nonoperating gain from the sale of certain marketable equity securities is reflected in investing activities while the cash flow impact of the nonoperating loss on the early extinguishment of borrowings is reflected in financing activities, and therefore, these do not contribute to operating cash flows. • The aggregate of trade accounts receivable, inventories and trade accounts payable used $96 million in operating cash flows during 2016, compared to providing operating cash flows of $198 million in 2015. The amount of cash flow generated from or used by the aggregate of trade accounts receivable, inventories and trade accounts payable depends upon how effectively the Company manages the cash conversion cycle, which effectively represents the number of days that elapse from the day it pays for the purchase of raw materials and components to the collection of cash from its customers and can be significantly impacted by the timing of collections and payments in a period. • The aggregate of prepaid expenses and other assets, deferred income taxes and accrued expenses and other liabilities used $184 million in operating cash flows during 2016, compared to $84 million used in 2015. The timing of cash payments for income taxes and various employee related liabilities, including with respect to recently acquired companies, drove the majority of this change. • Net earnings from continuing operations for 2016 reflected an increase of $247 million of depreciation and amortization expense as compared to 2015. Amortization expense primarily relates to the amortization of intangible assets acquired in connection with acquisitions. Depreciation expense relates to both the Company’s manufacturing and operating facilities as well as instrumentation leased to customers under operating-type lease arrangements. Depreciation and amortization are noncash expenses that decrease earnings without a corresponding impact to operating cash flows. Operating cash flows from continuing operations were approximately $2.8 billion for 2015, an increase of $161 million, or 6% as compared to 2014. This increase was primarily attributable to the increase in net earnings in 2015 as compared to 2014. Investing Activities Cash flows relating to investing activities consist primarily of cash used for acquisitions and capital expenditures, including instruments leased to customers, cash used for investments and cash proceeds from divestitures of businesses or assets. Net cash used in investing activities was approximately $5.2 billion during 2016 compared to approximately $15.0 billion and approximately $3.4 billion of net cash used in 2015 and 2014, respectively. Acquisitions, Divestitures and Sale of Investments 2016 Acquisitions, Divestitures and Sale of Investments For a discussion of the Company’s 2016 acquisitions, divestitures and the sale of certain marketable equity securities, refer to “-Overview.” 2015 Acquisitions, Divestitures and Sale of Investments On August 31, 2015, Pentagon Merger Sub, Inc., a New York corporation and an indirect, wholly-owned subsidiary of the Company, acquired all of the outstanding shares of common stock of Pall, a New York corporation, for $127.20 per share in cash, for a total purchase price of approximately $13.6 billion, net of assumed debt of $417 million and acquired cash of approximately $1.2 billion (the “Pall Acquisition”). Pall is part of the Company’s Life Sciences segment. In its fiscal year ended July 31, 2015, Pall generated consolidated revenues of approximately $2.8 billion. The Company financed the approximately $13.6 billion acquisition price of Pall with approximately $2.5 billion of available cash, approximately $8.1 billion of net proceeds from the issuance and sale of U.S. dollar and euro-denominated commercial paper and €2.7 billion (approximately $3.0 billion based on currency exchange rates as of the date of issuance) of net proceeds from the issuance and sale of euro-denominated senior unsecured notes. Subsequent to the Pall Acquisition, the Company used the approximately $2.0 billion of net proceeds from the issuance of U.S. dollar-denominated senior unsecured notes and the approximately CHF 755 million ($732 million based on currency exchange rates as of date of issuance) of net proceeds, including the related premium, from the issuance and sale of Swiss franc-denominated senior unsecured bonds to repay a portion of the commercial paper issued to finance the Pall Acquisition. In addition to the Pall Acquisition, during 2015 the Company acquired nine businesses for total consideration of approximately $670 million in cash, net of cash acquired. The businesses acquired complement existing units of each of the Company’s four segments. The aggregate annual sales of these nine businesses at the time of their respective acquisitions, in each case based on the company’s revenues for its last completed fiscal year prior to the acquisition, were approximately $355 million. In July 2015, the Company consummated the split-off of the majority of its former communications business to Danaher shareholders who elected to exchange Danaher shares for ownership interests in the communications business, and the subsequent merger of the communications business with a subsidiary of NetScout. Danaher shareholders who participated in the exchange offer tendered 26 million shares of Danaher common stock (approximately $2.3 billion on the date of tender) and received 62.5 million shares of NetScout common stock which represented approximately 60% of the shares of NetScout common stock outstanding following the combination. The accounting requirements for reporting the disposition of the communications business as a discontinued operation were met when the split-off and merger were completed. Accordingly, the accompanying consolidated financial statements for all periods presented reflect this business as discontinued operations. The Company allocated a portion of the consolidated interest expense to discontinued operations based on the ratio of the discontinued business’ net assets to the Company’s consolidated net assets. The Company recorded an aggregate after-tax gain on the disposition of this business of $767 million, or $1.08 per diluted share, in its 2015 results in connection with the closing of this transaction representing the value of the 26 million shares of Company common stock tendered for the communications business in excess of the carrying value of the business’ net assets. This gain was included in the results of discontinued operations for the year ended December 31, 2015. The communications business had revenues of $346 million in 2015 prior to the disposition and $760 million in 2014. During 2015, the Company received cash proceeds of $43 million from the sale of certain marketable equity securities and recorded a pretax gain related to these sales of $12 million. 2014 Acquisitions, Divestitures and Sale of Investments In December 2014, the Company completed its tender offer for the outstanding shares of common stock of Nobel Biocare and acquired substantially all of the Nobel Biocare shares, with the remainder of the Nobel Biocare shares acquired in 2015 pursuant to a squeeze-out transaction, for an aggregate cash purchase price of approximately CHF 1.9 billion (approximately $1.9 billion based on exchange rates as of the date the shares of common stock were acquired) including debt assumed and net of cash acquired. Nobel Biocare had revenues of €567 million in 2013 (approximately $780 million based on exchange rates as of December 31, 2013), and is now part of the Company’s Dental segment. The Company financed the acquisition of Nobel Biocare from available cash. In addition to the acquisition of Nobel Biocare, during 2014 the Company acquired 10 businesses for total consideration of $978 million in cash, net of cash acquired. The businesses acquired complement existing units of each of the Company’s four segments. The aggregate annual sales of these 10 businesses at the time of their respective acquisitions, in each case based on the company’s revenues for its last completed fiscal year prior to the acquisition, were approximately $285 million. During 2014, the Company received cash proceeds of $167 million from the sale of certain marketable equity securities and recorded a pretax gain related to these sales of $123 million ($77 million after-tax or $0.11 per diluted share). Capital Expenditures Capital expenditures are made primarily for increasing capacity, replacing equipment, supporting new product development, improving information technology systems and the manufacture of instruments that are used in operating-type lease arrangements that certain of the Company’s businesses enter into with customers. Capital expenditures totaled $590 million in 2016, $513 million in 2015 and $465 million in 2014. The increase in capital spending in 2016 is due to increased investments in machinery and equipment, including operating assets at newly acquired businesses such as Pall, and to a lesser extent, increases in equipment leased to customers. The increase in capital spending in 2015 is due to investments in machinery and equipment, including operating assets at newly acquired businesses such as Nobel Biocare and Pall, partially offset by year-over-year differences in the timing of investments in equipment leased to customers. In 2017, the Company expects capital spending to be approximately $750 million, though actual expenditures will ultimately depend on business conditions. Financing Activities Cash flows from financing activities consist primarily of cash flows associated with the issuance and repayments of commercial paper and other debt, issuances and repurchases of common stock, excess tax benefits from stock-based compensation, and payments of cash dividends to shareholders. Financing activities provided cash of approximately $2.0 billion during 2016 compared to approximately $9.1 billion of cash provided during 2015. Cash provided by financing activities in 2016 primarily relates to approximately $3.4 billion of net proceeds received from the issuance of the Fortive Debt in June 2016 and the net issuance of outstanding borrowings with maturities of 90 days or less, primarily commercial paper borrowings, of approximately $2.2 billion, and the issuance of approximately ¥29.9 billion aggregate principal amount (approximately $262 million based on the currency exchange rate as of the date of the issuance) of 0.352% senior unsecured notes. These issuances were partially offset by the repayment of the $500 million aggregate principal amount of 2.3% senior unsecured notes that matured in June 2016, the repayment of approximately $1.9 billion in aggregate principal amount of outstanding indebtedness in August 2016 (consisting of the Redeemed Notes), the repayment of the $124 million aggregate principal amount of the 4.0% senior unsecured notes due in October 2016 and $485 million of cash distributed to Fortive in connection with the Separation. Total debt was approximately $12.3 billion and $12.9 billion as of December 31, 2016 and 2015, respectively. The Company had the ability to incur approximately an additional $1.1 billion of indebtedness in direct borrowings or under outstanding commercial paper facilities based on the amounts available under the Company’s $7.0 billion of credit facilities which were not being used to backstop outstanding commercial paper balances as of December 31, 2016. Refer to Note 9 to the Consolidated Financial Statements for information regarding the Company’s financing activities and indebtedness, including the Company’s outstanding debt as of December 31, 2016, and the Company’s commercial paper program and related credit facilities. Shelf Registration Statement The Company has filed a “well-known seasoned issuer” shelf registration statement on Form S-3 with the SEC that registers an indeterminate amount of debt securities, common stock, preferred stock, warrants, depositary shares, purchase contracts and units for future issuance. The Company utilized this shelf registration statement for the offering and sale of the U.S. dollar and euro-denominated senior unsecured notes issued to finance the Pall Acquisition. The Company expects to use net proceeds realized by the Company from future securities sales off this shelf registration statement for general corporate purposes, including without limitation repayment or refinancing of debt or other corporate obligations, acquisitions, capital expenditures, share repurchases and dividends and working capital. Stock Repurchase Program On July 16, 2013, the Company’s Board of Directors approved a repurchase program (the “Repurchase Program”) authorizing the repurchase of up to 20 million shares of the Company’s common stock from time to time on the open market or in privately negotiated transactions. There is no expiration date for the Repurchase Program, and the timing and amount of any shares repurchased under the program will be determined by the Company’s management based on its evaluation of market conditions and other factors. The Repurchase Program may be suspended or discontinued at any time. Any repurchased shares will be available for use in connection with the Company’s equity compensation plans (or any successor plan) and for other corporate purposes. As of December 31, 2016, 20 million shares remained available for repurchase pursuant to the Repurchase Program. The Company expects to fund any future stock repurchases using the Company’s available cash balances or proceeds from the issuance of indebtedness. Except in connection with the disposition of the Company’s communications business to NetScout in 2015, neither the Company nor any “affiliated purchaser” repurchased any shares of Company common stock during 2016, 2015 or 2014. Refer to Note 3 to the Consolidated Financial Statements for discussion of the 26 million shares of Danaher common stock tendered to and repurchased by the Company in connection with the disposition of the Company’s communications business to NetScout. Dividends The Company declared a regular quarterly dividend of $0.125 per share that was paid on January 27, 2017 to holders of record on December 30, 2016. Aggregate cash payments for dividends during 2016 were $400 million. Dividend payments were higher in 2016 as compared to 2015 as the Company increased its quarterly dividend rate in the first quarter of 2016 to $0.16 per share. Following the Fortive Separation in the third quarter of 2016, the Company reduced its quarterly dividend rate to $0.125 per share. For a description of the dividend of Fortive shares in July 2016, refer to Note 3 to the Consolidated Financial Statements. Cash and Cash Requirements As of December 31, 2016, the Company held $964 million of cash and cash equivalents that were invested in highly liquid investment-grade debt instruments with a maturity of 90 days or less with an approximate weighted average annual interest rate of 0.10%. Of this amount, $316 million was held within the United States and $648 million was held outside of the United States. The Company will continue to have cash requirements to support working capital needs, capital expenditures and acquisitions, pay interest and service debt, pay taxes and any related interest or penalties, fund its restructuring activities and pension plans as required, pay dividends to shareholders, repurchase shares of the Company’s common stock and support other business needs. The Company generally intends to use available cash and internally generated funds to meet these cash requirements, but in the event that additional liquidity is required, particularly in connection with acquisitions, the Company may also borrow under its commercial paper programs or credit facilities, enter into new credit facilities and either borrow directly thereunder or use such credit facilities to backstop additional borrowing capacity under its commercial paper programs and/or access the capital markets. The Company also may from time to time access the capital markets to take advantage of favorable interest rate environments or other market conditions. While repatriation of some cash held outside the United States may be restricted by local laws, most of the Company’s foreign cash balances could be repatriated to the United States but, under current law, would be subject to U.S. federal income taxes, less applicable foreign tax credits. For most of its foreign subsidiaries, the Company makes an election regarding the amount of earnings intended for indefinite reinvestment, with the balance available to be repatriated to the United States. The Company has recorded a deferred tax liability for the funds that are available to be repatriated to the United States. No provisions for U.S. income taxes have been made with respect to earnings that are planned to be reinvested indefinitely outside the United States, and the amount of U.S. income taxes that may be applicable to such earnings is not readily determinable given the various tax planning alternatives the Company could employ if it repatriated these earnings. The cash that the Company’s foreign subsidiaries hold for indefinite reinvestment is generally used to finance foreign operations and investments, including acquisitions. As of December 31, 2016, the total amount of earnings planned to be reinvested indefinitely and the basis difference in investments outside of the United States for which deferred taxes have not been provided in aggregate was approximately $23.0 billion. As of December 31, 2016, management believes that it has sufficient liquidity to satisfy its cash needs, including its cash needs in the United States. During 2016, the Company contributed $58 million to its U.S. defined benefit pension plans and $44 million to its non-U.S. defined benefit pension plans. During 2017, the Company’s cash contribution requirements for its U.S. and its non-U.S. defined benefit pension plans are expected to be approximately $35 million and $40 million, respectively. The ultimate amounts to be contributed depend upon, among other things, legal requirements, underlying asset returns, the plan’s funded status, the anticipated tax deductibility of the contribution, local practices, market conditions, interest rates and other factors. Contractual Obligations The following table sets forth, by period due or year of expected expiration, as applicable, a summary of the Company’s contractual obligations as of December 31, 2016 under (1) debt obligations, (2) leases, (3) purchase obligations and (4) other long-term liabilities reflected on the Company’s balance sheet under GAAP. The amounts presented in the “Other long-term liabilities” line in the table below include $940 million of noncurrent gross unrecognized tax benefits and related interest (and do not include $172 million of current gross unrecognized tax benefits which are included in the “Accrued expenses and other liabilities” line on the Consolidated Balance Sheet). However, the timing of the long-term portion of these liabilities is uncertain, and therefore, they have been included in the “More Than 5 Years” column in the table below. Refer to Note 12 to the Consolidated Financial Statements for additional information on unrecognized tax benefits. Certain of the Company’s acquisitions also involve the potential payment of contingent consideration. The table below does not reflect any such obligations, as the timing and amounts of any such payments are uncertain. Refer to “-Off-Balance Sheet Arrangements” for a discussion of other contractual obligations that are not reflected in the table below. (a) As described in Note 9 to the Consolidated Financial Statements. (b) Amounts do not include interest payments. Interest on debt and capital lease obligations is reflected in a separate line in the table. (c) Interest payments on debt are projected for future periods using the interest rates in effect as of December 31, 2016. Certain of these projected interest payments may differ in the future based on changes in market interest rates. (d) As described in Note 15 to the Consolidated Financial Statements, certain leases require the Company to pay real estate taxes, insurance, maintenance and other operating expenses associated with the leased premises. These future costs are not included in the schedule above. (e) Consist of agreements to purchase goods or services that are enforceable and legally binding on the Company and that specify all significant terms, including fixed or minimum quantities to be purchased, fixed, minimum or variable price provisions and the approximate timing of the transaction. (f) Primarily consist of obligations under product service and warranty policies and allowances, performance and operating cost guarantees, estimated environmental remediation costs, self-insurance and litigation claims, postretirement benefits, pension obligations, deferred tax liabilities and deferred compensation obligations. The timing of cash flows associated with these obligations is based upon management’s estimates over the terms of these arrangements and is largely based upon historical experience. Off-Balance Sheet Arrangements Guarantees The following table sets forth, by period due or year of expected expiration, as applicable, a summary of guarantees of the Company as of December 31, 2016. Guarantees consist primarily of outstanding standby letters of credit, bank guarantees and performance and bid bonds. These guarantees have been provided in connection with certain arrangements with vendors, customers, insurance providers, financing counterparties and governmental entities to secure the Company’s obligations and/or performance requirements related to specific transactions. Other Off-Balance Sheet Arrangements The Company has from time to time divested certain of its businesses and assets. In connection with these divestitures, the Company often provides representations, warranties and/or indemnities to cover various risks and unknown liabilities, such as claims for damages arising out of the use of products or relating to intellectual property matters, commercial disputes, environmental matters or tax matters. In particular, in connection with the 2016 Fortive Separation and the 2015 split-off of the Company’s communications business, Danaher entered into separation and distribution and related agreements pursuant to which Danaher agreed to indemnify the other parties against certain damages and expenses that might occur in the future. These indemnification obligations cover a variety of liabilities, including, but not limited to, employee, tax and environmental matters. The Company has not included any such items in the contractual obligations table above because they relate to unknown conditions and the Company cannot estimate the potential liabilities from such matters, but the Company does not believe it is reasonably possible that any such liability will have a material effect on the Company’s financial statements. In addition, as a result of these divestitures, as well as restructuring activities, certain properties leased by the Company have been sublet to third-parties. In the event any of these third-parties vacate any of these premises, the Company would be legally obligated under master lease arrangements. The Company believes that the financial risk of default by such sub-lessors is individually and in the aggregate not material to the Company’s financial statements. In the normal course of business, the Company periodically enters into agreements that require it to indemnify customers, suppliers or other business partners for specific risks, such as claims for injury or property damage arising out of the Company’s products or services or claims alleging that Company products or services infringe third-party intellectual property. The Company has not included any such indemnification provisions in the contractual obligations table above. Historically, the Company has not experienced significant losses on these types of indemnification obligations. The Company’s Restated Certificate of Incorporation requires it to indemnify to the full extent authorized or permitted by law any person made, or threatened to be made a party to any action or proceeding by reason of his or her service as a director or officer of the Company, or by reason of serving at the request of the Company as a director or officer of any other entity, subject to limited exceptions. Danaher’s Amended and Restated By-laws provide for similar indemnification rights. In addition, Danaher has executed with each director and executive officer of Danaher Corporation an indemnification agreement which provides for substantially similar indemnification rights and under which Danaher has agreed to pay expenses in advance of the final disposition of any such indemnifiable proceeding. While the Company maintains insurance for this type of liability, a significant deductible applies to this coverage and any such liability could exceed the amount of the insurance coverage. Legal Proceedings Refer to Note 16 to the Consolidated Financial Statements for information regarding legal proceedings and contingencies, and for a discussion of risks related to legal proceedings and contingencies, refer to “Item 1A. Risk Factors.” CRITICAL ACCOUNTING ESTIMATES Management’s discussion and analysis of the Company’s financial condition and results of operations is based upon the Company’s Consolidated Financial Statements, which have been prepared in accordance with accounting principles generally accepted in the United States. The preparation of these financial statements requires management to make estimates and judgments that affect the reported amounts of assets, liabilities, revenues and expenses, and related disclosure of contingent assets and liabilities. The Company bases these estimates and judgments on historical experience, the current economic environment and on various other assumptions that are believed to be reasonable under the circumstances. Actual results may differ materially from these estimates and judgments. The Company believes the following accounting estimates are most critical to an understanding of its financial statements. Estimates are considered to be critical if they meet both of the following criteria: (1) the estimate requires assumptions about material matters that are uncertain at the time the estimate is made, and (2) material changes in the estimate are reasonably likely from period-to-period. For a detailed discussion on the application of these and other accounting estimates, refer to Note 1 to the Consolidated Financial Statements. Acquired Intangibles-The Company’s business acquisitions typically result in the recognition of goodwill, in-process research and development and other intangible assets, which affect the amount of future period amortization expense and possible impairment charges that the Company may incur. Refer to Notes 1, 2 and 6 to the Consolidated Financial Statements for a description of the Company’s policies relating to goodwill, acquired intangibles and acquisitions. In performing its goodwill impairment testing, the Company estimates the fair value of its reporting units primarily using a market-based approach. The Company estimates fair value based on multiples of earnings before interest, taxes, depreciation and amortization (“EBITDA”) determined by current trading market multiples of earnings for companies operating in businesses similar to each of the Company’s reporting units, in addition to recent market available sale transactions of comparable businesses. In evaluating the estimates derived by the market-based approach, management makes judgments about the relevance and reliability of the multiples by considering factors unique to its reporting units, including operating results, business plans, economic projections, anticipated future cash flows, and transactions and marketplace data as well as judgments about the comparability of the market proxies selected. In certain circumstances the Company also estimates fair value utilizing a discounted cash flow analysis (i.e., an income approach) in order to validate the results of the market approach. The discounted cash flow model requires judgmental assumptions about projected revenue growth, future operating margins, discount rates and terminal values. There are inherent uncertainties related to these assumptions and management’s judgment in applying them to the analysis of goodwill impairment. As of December 31, 2016, the Company had eight reporting units for goodwill impairment testing. Reporting units resulting from recent acquisitions generally present the highest risk of impairment. Management believes the impairment risk associated with these reporting units decreases as these businesses are integrated into the Company and better positioned for potential future earnings growth. As of the date of the 2016 annual impairment test, the carrying value of the goodwill included in each individual reporting unit ranged from $503 million to approximately $11.7 billion. The Company’s annual goodwill impairment analysis in 2016 indicated that in all instances, the fair values of the Company’s reporting units exceeded their carrying values and consequently did not result in an impairment charge. The excess of the estimated fair value over carrying value (expressed as a percentage of carrying value for the respective reporting unit) for each of the Company’s reporting units as of the annual testing date ranged from approximately 70% to approximately 380%. In order to evaluate the sensitivity of the fair value calculations used in the goodwill impairment test, the Company applied a hypothetical 10% decrease to the fair values of each reporting unit and compared those hypothetical values to the reporting unit carrying values. Based on this hypothetical 10% decrease, the excess of the estimated fair value over carrying value (expressed as a percentage of carrying value for the respective reporting unit) for each of the Company’s reporting units ranged from approximately 50% to approximately 330%. The Company reviews identified intangible assets for impairment whenever events or changes in circumstances indicate that the related carrying amounts may not be recoverable. The Company also tests intangible assets with indefinite lives at least annually for impairment. Determining whether an impairment loss occurred requires a comparison of the carrying amount to the sum of undiscounted cash flows expected to be generated by the asset. These analyses require management to make judgments and estimates about future revenues, expenses, market conditions and discount rates related to these assets. If actual results are not consistent with management’s estimates and assumptions, goodwill and other intangible assets may be overstated and a charge would need to be taken against net earnings which would adversely affect the Company’s financial statements. Contingent Liabilities-As discussed in Note 16 to the Consolidated Financial Statements, the Company is, from time to time, subject to a variety of litigation and similar contingent liabilities incidental to its business (or the business operations of previously owned entities). The Company recognizes a liability for any contingency that is known or probable of occurrence and reasonably estimable. These assessments require judgments concerning matters such as litigation developments and outcomes, the anticipated outcome of negotiations, the number of future claims and the cost of both pending and future claims. In addition, because most contingencies are resolved over long periods of time, liabilities may change in the future due to various factors, including those discussed in Note 16 to the Consolidated Financial Statements. If the reserves established by the Company with respect to these contingent liabilities are inadequate, the Company would be required to incur an expense equal to the amount of the loss incurred in excess of the reserves, which would adversely affect the Company’s financial statements. Revenue Recognition-The Company derives revenues from the sale of products and services. Refer to Note 1 to the Consolidated Financial Statements for a description of the Company’s revenue recognition policies. Although most of the Company’s sales agreements contain standard terms and conditions, certain agreements contain multiple elements or nonstandard terms and conditions. As a result, judgment is sometimes required to determine the appropriate accounting, including whether the deliverables specified in these agreements should be treated as separate units of accounting for revenue recognition purposes, and, if so, how the consideration should be allocated among the elements and when to recognize revenue for each element. The Company allocates revenue to each element in the contractual arrangement based on the selling price hierarchy that, in some instances, may require the Company to estimate the selling price of certain deliverables that are not sold separately or where third-party evidence of pricing is not observable. The Company’s estimate of selling price impacts the amount and timing of revenue recognized in multiple element arrangements. The Company also enters into lease arrangements with customers, which requires the Company to determine whether the arrangements are operating or sales-type leases. Certain of the Company’s lease contracts are customized for larger customers and often result in complex terms and conditions that typically require significant judgment in applying the lease accounting criteria. If the Company’s judgments regarding revenue recognition prove incorrect, the Company’s reported revenues in particular periods may be adversely affected. Pension and Other Postretirement Benefits-For a description of the Company’s pension and other postretirement benefit accounting practices, refer to Notes 10 and 11 to the Consolidated Financial Statements. Calculations of the amount of pension and other postretirement benefit costs and obligations depend on the assumptions used in the actuarial valuations, including assumptions regarding discount rates, expected return on plan assets, rates of salary increases, health care cost trend rates, mortality rates, and other factors. If the assumptions used in calculating pension and other postretirement benefits costs and obligations are incorrect or if the factors underlying the assumptions change (as a result of differences in actual experience, changes in key economic indicators or other factors) the Company’s financial statements could be materially affected. A 50 basis point reduction in the discount rates used for the plans would have increased the U.S. net obligation by $141 million ($88 million on an after-tax basis) and the non-U.S. net obligation by $140 million ($102 million on an after-tax basis) from the amounts recorded in the Consolidated Financial Statements as of December 31, 2016. A 50 basis point increase in the discount rates used for the plans would have decreased the U.S. net obligation by $131 million ($82 million on an after-tax basis) and the non-U.S. net obligation by $140 million ($102 million on an after-tax basis) from the amounts recorded in the Consolidated Financial Statements as of December 31, 2016. For 2016, the estimated long-term rate of return for the U.S. plans are 7.0%, and the Company intends to continue to use an assumption of 7.0% for 2017. This expected rate of return reflects the asset allocation of the plan and the expected long-term returns on equity and debt investments included in plan assets. The U.S. plan targets to invest between 60% and 70% of its assets in equity portfolios which are invested in funds that are expected to mirror broad market returns for equity securities or in assets with characteristics similar to equity investments. The balance of the asset portfolio is generally invested in bond funds. The Company’s non-U.S. plan assets consist of various insurance contracts, equity and debt securities as determined by the administrator of each plan. The estimated long-term rate of return for the non-U.S. plans was determined on a plan by plan basis based on the nature of the plan assets and ranged from 1.1% to 5.8%. If the expected long-term rate of return on plan assets for 2016 was reduced by 50 basis points, pension expense for the U.S. and non-U.S. plans for 2016 would have increased $9 million ($6 million on an after-tax basis) and $5 million ($4 million on an after-tax basis), respectively. For a discussion of the Company’s 2016 and anticipated 2017 defined benefit pension plan contributions, refer to “-Liquidity and Capital Resources - Cash and Cash Requirements”. Income Taxes-For a description of the Company’s income tax accounting policies, refer to Notes 1 and 12 to the Consolidated Financial Statements. The Company establishes valuation allowances for its deferred tax assets if it is more likely than not that some or all of the deferred tax asset will not be realized which requires management to make judgments and estimates regarding: (1) the timing and amount of the reversal of taxable temporary differences, (2) expected future taxable income, and (3) the impact of tax planning strategies. Future changes to tax rates would also impact the amounts of deferred tax assets and liabilities and could have an adverse impact on the Company’s financial statements. The Company provides for unrecognized tax benefits when, based upon the technical merits, it is “more likely than not” that an uncertain tax position will not be sustained upon examination. Judgment is required in evaluating tax positions and determining income tax provisions. The Company re-evaluates the technical merits of its tax positions and may recognize an uncertain tax benefit in certain circumstances, including when: (1) a tax audit is completed; (2) applicable tax laws change, including a tax case ruling or legislative guidance; or (3) the applicable statute of limitations expires. In addition, certain of the Company’s tax returns are currently under review by tax authorities including in Denmark (refer to “-Results of Operations - Income Taxes” and Note 12 to the Consolidated Financial Statements). Management believes the positions taken in these returns are in accordance with the relevant tax laws. However, the outcome of these audits is uncertain and could result in the Company being required to record charges for prior year tax obligations which could have a material adverse impact to the Company’s financial statements, including its effective tax rate. An increase in the Company’s nominal tax rate of 1.0% would have resulted in an additional income tax provision for continuing operations for the year ended December 31, 2016 of $26 million. NEW ACCOUNTING STANDARDS For a discussion of the new accounting standards impacting the Company, refer to Note 1 to the Consolidated Financial Statements.

<s>[INST] Overview Results of Operations Liquidity and Capital Resources Critical Accounting Estimates New Accounting Standards This discussion and analysis should be read along with Danaher’s audited financial statements and related Notes thereto as of December 31, 2016 and 2015 and for each of the three years in the period ended December 31, 2016 included in this Annual Report. Unless otherwise indicated, references to sales in this Annual Report refer to sales from continuing operations. OVERVIEW General Refer to “Item 1. BusinessGeneral” for a discussion of Danaher’s objectives and methodologies for delivering shareholder value. Danaher is a multinational corporation with global operations. During 2016, approximately 62% of Danaher’s sales were derived from customers outside the United States. As a diversified, global business, Danaher’s operations are affected by worldwide, regional and industryspecific economic and political factors. Danaher’s geographic and industry diversity, as well as the range of its products and services, help limit the impact of any one industry or the economy of any single country on its consolidated operating results. Given the broad range of products manufactured, services provided and geographies served, management does not use any indices other than general economic trends to predict the overall outlook for the Company. The Company’s individual businesses monitor key competitors and customers, including to the extent possible their sales, to gauge relative performance and the outlook for the future. As a result of the Company’s geographic and industry diversity, the Company faces a variety of opportunities and challenges, including rapid technological development (particularly with respect to computing, mobile connectivity, communications and digitization) in most of the Company’s served markets, the expansion and evolution of opportunities in highgrowth markets, trends and costs associated with a global labor force, consolidation of the Company’s competitors and increasing regulation. The Company operates in a highly competitive business environment in most markets, and the Company’s longterm growth and profitability will depend in particular on its ability to expand its business in highgrowth geographies and highgrowth market segments, identify, consummate and integrate appropriate acquisitions, develop innovative and differentiated new products and services with higher gross profit margins, expand and improve the effectiveness of the Company’s sales force, continue to reduce costs and improve operating efficiency and quality, and effectively address the demands of an increasingly regulated environment. The Company is making significant investments, organically and through acquisitions, to address the rapid pace of technological change in its served markets and to globalize its manufacturing, research and development and customerfacing resources (particularly in highgrowth markets) in order to be responsive to the Company’s customers throughout the world and improve the efficiency of the Company’s operations. Business Performance Consolidated sales for the year ended December 31, 2016 increased 17.0% as compared to 2015. While differences exist among the Company’s businesses, on an overall basis, demand for the Company’s products and services increased at a similar rate in 2016 as compared to 2015. This demand, together with the Company’s continued investments in sales growth initiatives and the other businessspecific factors discussed below, contributed to yearoveryear sales growth from existing businesses of 3.0% (for the definition of “sales from existing businesses,” refer to “Results of Operations” below). Geographically, both highgrowth and developed markets contributed to yearoveryear sales growth from existing businesses during 2016. Sales growth rates from existing businesses in highgrowth markets grew at a highsingle digit rate in 2016 as compared to 2015 led by strength in China, India and Latin America partially offset by weakness in Eastern Europe. Highgrowth markets represented approximately 29% of the Company’s total sales in 2016. Sales from existing businesses in developed markets grew at a lowsingle digit rate in 2016 as compared to 2015 and were driven by North America and Western Europe. The acquisitions of Pall and Cepheid, as further discussed below, provide additional sales and earnings growth opportunities for the Company’s Life Sciences and Diagnostics segments, respectively, by expanding [/INST] Positive. </s>

DANAHER CORP /DE/

2018-02-21

2017-12-31

ITEM 7. MANAGEMENT’S DISCUSSION AND ANALYSIS OF FINANCIAL CONDITION AND RESULTS OF OPERATIONS Management’s Discussion and Analysis of Financial Condition and Results of Operations (“MD&A”) is designed to provide a reader of Danaher’s financial statements with a narrative from the perspective of Company management. The Company’s MD&A is divided into five sections: • Overview • Results of Operations • Liquidity and Capital Resources • Critical Accounting Estimates • New Accounting Standards This discussion and analysis should be read along with Danaher’s audited financial statements and related Notes thereto as of December 31, 2017 and 2016 and for each of the three years in the period ended December 31, 2017 included in this Annual Report. OVERVIEW General Refer to “Item 1. Business-General” for a discussion of Danaher’s strategic objectives and methodologies for delivering long-term shareholder value. Danaher is a multinational business with global operations. During 2017, approximately 63% of Danaher’s sales were derived from customers outside the United States. As a diversified, global business, Danaher’s operations are affected by worldwide, regional and industry-specific economic and political factors. Danaher’s geographic and industry diversity, as well as the range of its products, software and services, help limit the impact of any one industry or the economy of any single country on its consolidated operating results. Given the broad range of products manufactured, software and services provided and geographies served, management does not use any indices other than general economic trends to predict the overall outlook for the Company. The Company’s individual businesses monitor key competitors and customers, including to the extent possible their sales, to gauge relative performance and the outlook for the future. As a result of the Company’s geographic and industry diversity, the Company faces a variety of opportunities and challenges, including rapid technological development (particularly with respect to computing, automation, artificial intelligence, mobile connectivity, communications and digitization) in most of the Company’s served markets, the expansion and evolution of opportunities in high-growth markets, trends and costs associated with a global labor force, consolidation of the Company’s competitors and increasing regulation. The Company operates in a highly competitive business environment in most markets, and the Company’s long-term growth and profitability will depend in particular on its ability to expand its business in high-growth geographies and high-growth market segments, identify, consummate and integrate appropriate acquisitions, develop innovative and differentiated new products and services with higher gross profit margins, expand and improve the effectiveness of the Company’s sales force, continue to reduce costs and improve operating efficiency and quality, and effectively address the demands of an increasingly regulated global environment. The Company is making significant investments, organically and through acquisitions, to address the rapid pace of technological change in its served markets and to globalize its manufacturing, research and development and customer-facing resources (particularly in high-growth markets) in order to be responsive to the Company’s customers throughout the world and improve the efficiency of the Company’s operations. Business Performance Consolidated sales for the year ended December 31, 2017 increased 8.5% as compared to 2016. While differences exist among the Company’s businesses, on an overall basis, demand for the Company’s products and services increased on a year-over-year basis in 2017 as compared to 2016. This demand, together with the Company’s continued investments in sales growth initiatives and the other business-specific factors discussed below, contributed to year-over-year core sales growth of 3.5% (for the definition of “core sales,” refer to “-Results of Operations” below). Geographically, both high-growth and developed markets contributed to year-over-year core sales growth during 2017. The Company defines high-growth markets as developing markets of the world experiencing rapid growth in gross domestic product and infrastructure which includes Eastern Europe, the Middle East, Africa, Latin America and Asia (with the exception of Japan and Australia). Core sales growth rates in high-growth markets grew at a high-single digit rate in 2017 as compared to 2016 led by strength in China, India, Eastern Europe and Latin America, partially offset by weakness in the Middle East. High-growth markets represented approximately 30% of the Company’s total sales in 2017. Core sales in developed markets grew at a low-single digit rate in 2017 as compared to 2016 and were driven by North America and Western Europe. The Company’s income from continuing operations for the year-ended December 31, 2017 totaled approximately $2.5 billion, or $3.50 per diluted share, compared to approximately $2.2 billion, or $3.08 per diluted share for the year ended December 31, 2016. During 2017, the Company made the strategic decision to discontinue a molecular diagnostic product line in its Diagnostics segment. As a result, the Company recorded $76 million of pretax restructuring, impairment and other related charges ($51 million after-tax or $0.07 per diluted share). These charges included $49 million of noncash charges for the impairment of certain technology-related intangible assets as well as related inventory and property, plant and equipment with no further use. In addition, the Company incurred $27 million of cash restructuring costs primarily related to employee severance and related charges. Substantially all restructuring activities related to this discontinued product line were completed in 2017. Acquisitions During 2017, the Company acquired ten businesses for total consideration of $386 million in cash, net of cash acquired. The businesses acquired complement existing units of the Company’s Life Sciences, Dental and Environmental & Applied Solutions segments. The aggregate annual sales of these ten businesses at the time of their respective acquisitions, in each case based on the company’s revenues for its last completed fiscal year prior to the acquisition, were $160 million. For a discussion of the Company’s 2016 and 2015 acquisition and disposition activity, refer to “Liquidity and Capital Resources-Investing Activities”. Fortive Separation On July 2, 2016, Danaher completed the Separation of its former Test & Measurement segment, Industrial Technologies segment (excluding the product identification businesses) and retail/commercial petroleum business by distributing to Danaher stockholders on a pro rata basis all of the issued and outstanding common stock of Fortive, the entity Danaher incorporated to hold such businesses. To effect the Separation, Danaher distributed to its stockholders one share of Fortive common stock for every two shares of Danaher common stock outstanding as of June 15, 2016, the record date for the distribution. During the second quarter of 2016, the Company received net cash distributions of approximately $3.0 billion from Fortive as consideration for the Company’s contribution of assets to Fortive in connection with the Separation (“Fortive Distribution”). Danaher used a portion of the cash distribution proceeds to repay the $500 million aggregate principal amount of 2.3% senior unsecured notes that matured in June 2016 and to redeem approximately $1.9 billion in aggregate principal amount of outstanding indebtedness in August 2016 (consisting of the Company’s 5.625% senior unsecured notes due 2018, 5.4% senior unsecured notes due 2019 and 3.9% senior unsecured notes due 2021 (collectively the “Redeemed Notes”)). Danaher also paid an aggregate of $188 million in make-whole premiums in connection with the August 2016 redemptions, plus accrued and unpaid interest. The Company used the balance of the Fortive Distribution to fund certain of the Company’s regular, quarterly cash dividends to shareholders. The accounting requirements for reporting the Separation of Fortive as a discontinued operation were met when the Separation was completed. Accordingly, the accompanying Consolidated Financial Statements for all periods presented reflect this business as a discontinued operation. The Company allocated a portion of the consolidated interest expense and income to discontinued operations based on the ratio of the discontinued business’ net assets to the Company’s consolidated net assets. Fortive had revenues of approximately $3.0 billion in 2016 prior to the Separation and approximately $6.2 billion in 2015. As a result of the Separation, the Company incurred $48 million in Separation-related costs during the year ended December 31, 2016 which are included in earnings from discontinued operations, net of income taxes in the accompanying Consolidated Statement of Earnings. These Separation costs primarily relate to professional fees associated with preparation of regulatory filings and Separation activities within finance, tax, legal and information system functions as well as certain investment banking fees incurred upon the Separation. In 2017, Danaher recorded a $22 million income tax benefit related to the release of previously provided reserves associated with uncertain tax positions on certain Danaher tax returns which were jointly filed with Fortive entities. These reserves were released due to the expiration of statutes of limitations for those returns. All Fortive entity-related balances were included in the income tax benefit related to discontinued operations. Sale of Investments The Company received $138 million of cash proceeds and recorded $22 million in short-term other receivables from the sale of certain marketable equity securities during 2017. The Company recorded a pretax gain related to this sale of $73 million ($46 million after-tax or $0.06 per diluted share). For a discussion of the Company’s 2016 and 2015 sales of investments activity, refer to “Liquidity and Capital Resources-Investing Activities”. U.S. Tax Cuts and Jobs Act On December 22, 2017, the TCJA was enacted, which substantially changes the U.S. tax system, including lowering the corporate tax rate from 35% to 21% (beginning in 2018), and affected the Company in a number of ways. As a result of the TCJA, the Company recognized a provisional tax liability of approximately $1.2 billion in 2017 for the Transition Tax, which is payable over a period of eight years. The Company also remeasured U.S. deferred tax assets and liabilities based on the income tax rates at which the deferred tax assets and liabilities are expected to reverse in the future (generally 21%), resulting in an income tax benefit of approximately $1.2 billion. After considering the effect of the TCJA, the Company expects its 2018 effective tax rate to be in the range of 20% to 21%. The Company does not expect the Transition Tax to significantly impact the Company’s cash flows from operations due to the payment period of eight years and the Company’s ability to use available credits to reduce the required payments. For further discussion of the TCJA, refer to “-Income Taxes.” RESULTS OF OPERATIONS In this report, references to the non-GAAP measure of core sales (also referred to as core revenues or sales from existing businesses) refer to sales from continuing operations calculated according to generally accepted accounting principles in the United States (“GAAP”) but excluding: • sales from acquired businesses; and • the impact of currency translation. References to sales or operating profit attributable to acquisitions or acquired businesses refer to sales or operating profit, as applicable, from acquired businesses recorded prior to the first anniversary of the acquisition less the amount of sales and operating profit, as applicable, attributable to divested product lines not considered discontinued operations. The portion of revenue attributable to currency translation is calculated as the difference between: • the period-to-period change in revenue (excluding sales from acquired businesses); and • the period-to-period change in revenue (excluding sales from acquired businesses) after applying current period foreign exchange rates to the prior year period. Core sales growth should be considered in addition to, and not as a replacement for or superior to, sales, and may not be comparable to similarly titled measures reported by other companies. Management believes that reporting the non-GAAP financial measure of core sales growth provides useful information to investors by helping identify underlying growth trends in Danaher’s business and facilitating comparisons of Danaher’s revenue performance with its performance in prior and future periods and to Danaher’s peers. Management also uses core sales growth to measure the Company’s operating and financial performance. The Company excludes the effect of currency translation from core sales because currency translation is not under management’s control, is subject to volatility and can obscure underlying business trends, and excludes the effect of acquisitions and divestiture-related items because the nature, size, timing and number of acquisitions and divestitures can vary dramatically from period-to-period and between the Company and its peers and can also obscure underlying business trends and make comparisons of long-term performance difficult. Throughout this discussion, references to sales volume refer to the impact of both price and unit sales and references to productivity improvements generally refer to improved cost efficiencies resulting from the ongoing application of DBS. Revenue Performance Core sales grew on a year-over-year basis in both 2017 and 2016. Sales from acquired businesses increased on a year-over-year basis in both years primarily due to the acquisitions of Cepheid in the fourth quarter of 2016 and Pall in the third quarter of 2015. Currency translation increased reported sales on a year-over-year basis in 2017 primarily due to the U.S. dollar weakening against the euro, partially offset by the U.S. dollar strengthening against the Japanese yen and Chinese renminbi. Currency translation reduced reported sales on a year-over-year basis in 2016 as the U.S. dollar was, on average, stronger against other major currencies. Operating profit margins were 16.5% for the year ended December 31, 2017 as compared to 16.3% in 2016. The following factors impacted year-over-year operating profit margin comparisons. 2017 vs. 2016 operating profit margin comparisons were favorably impacted by: • Higher 2017 sales volumes from existing businesses and incremental year-over-year cost savings associated with the continuing productivity improvement initiatives taken in 2017 and 2016, net of incremental year-over-year costs associated with various product development, sales and marketing growth investments - 70 basis points • Acquisition-related charges in 2016 - 50 basis points 2017 vs. 2016 operating profit margin comparisons were unfavorably impacted by: • Restructuring, impairment and other related charges related to discontinuing a product line in the second quarter of 2017 related to the Diagnostic segment - 40 basis points • Trade name impairments and related productivity improvement initiatives in the fourth quarter of 2017 related to the Dental segment - 5 basis points • Third quarter 2016 gain on resolution of acquisition-related matters less the impact of fourth quarter 2017 net gain on resolution of acquisition-related matters - 5 basis points • The incremental net dilutive effect in 2017 of acquired businesses - 50 basis points Operating profit margins were 16.3% for the year ended December 31, 2016 as compared to 15.0% in 2015. The following factors impacted year-over-year operating profit margin comparisons. 2016 vs. 2015 operating profit margin comparisons were favorably impacted by: • Higher 2016 sales volumes from existing businesses and incremental year-over-year cost savings associated with the continuing productivity improvement initiatives taken in 2016 and 2015, net of incremental year-over-year costs associated with various product development, sales and marketing growth investments and the effect of a stronger U.S. dollar in 2016 - 115 basis points • Acquisition-related charges in 2015 associated with the acquisition of Pall, including transaction costs deemed significant (the Company deems acquisition-related transaction costs incurred in a given period to be significant, generally relating to the Company’s larger acquisitions, if it determines that such costs exceed the range of acquisition-related transaction costs typical for the Company in a given period), change in control payments, and fair value adjustments to acquired inventory and deferred revenue, net of the positive impact of freezing pension benefits - 90 basis points • Acquisition-related charges in the first quarter of 2015 associated with the acquisition of Nobel Biocare, primarily related to fair value adjustments to acquired inventory - 15 basis points • 2016 gains on resolution of acquisition-related matters - 10 basis points 2016 vs. 2015 operating profit margin comparisons were unfavorably impacted by: • Acquisition-related charges in 2016 associated primarily with the acquisition of Cepheid, including transaction costs deemed significant, change in control and restructuring payments, and fair value adjustments to acquired inventory and deferred revenue - 50 basis points • The incremental net dilutive effect in 2016 of acquired businesses - 50 basis points Business Segments Sales by business segment for the years ended December 31 are as follows ($ in millions): LIFE SCIENCES The Company’s Life Sciences segment offers a broad range of research tools that scientists use to study the basic building blocks of life, including genes, proteins, metabolites and cells, in order to understand the causes of disease, identify new therapies and test new drugs and vaccines. The segment, through its Pall business, is also a leading provider of filtration, separation and purification technologies to the biopharmaceutical, food and beverage, medical, aerospace, microelectronics and general industrial sectors. Life Sciences Selected Financial Data Revenue Performance 2017 Compared to 2016 During the first quarter of 2017, a product line was transferred from the Life Sciences segment to the Environmental & Applied Solutions segment. While this change is not material to segment results in total, the resulting change in sales growth has been included in the “Acquisitions and other” line in the table above. Price increases in the segment contributed 0.5% to revenue growth on a year-over-year basis during 2017 as compared with 2016 and are reflected as a component of the change in core revenue growth. Core sales of the business’ broad range of mass spectrometers continued to grow on a year-over-year basis led by strong sales growth in the pharmaceutical market across Asia and North America as well as sales growth in the food and forensics markets across all major regions. This growth was partially offset by continuing declines in demand in the clinical market in North America. Core sales of microscopy products increased on a year-over-year basis with growth in demand across most end-markets particularly in Western Europe and the high-growth markets. Year-over-year sales for the business’ flow cytometry and particle counting products grew in 2017, primarily due to new product introductions and were led by increases in sales in North America, Western Europe and China. Core sales for filtration, separation and purification technologies grew on a year-over-year basis led by continued growth in biopharmaceuticals and microelectronics, partially offset by declines in the process, industrial and medical products particularly in the first half of 2017. Geographically, core sales in filtration, separation and purification technologies were primarily led by growth in North America and Asia, partially offset by declines in the Middle East largely due to a major project in 2016 which did not repeat in 2017. Operating profit margins increased 230 basis points during 2017 as compared to 2016. The following factors impacted year-over-year operating profit margin comparisons. 2017 vs. 2016 operating profit margin comparisons were favorably impacted by: • Higher 2017 sales volumes from existing businesses and incremental year-over-year cost savings associated with the continuing productivity improvement initiatives taken in 2017 and 2016, net of incremental year-over-year costs associated with various new product development, sales and marketing growth investments and the effect of year-over-year changes in currency exchange rates - 205 basis points • Acquisition-related charges in 2016, including transaction costs deemed significant, change in control and restructuring payments, and fair value adjustments to acquired inventory and deferred revenue - 10 basis points • The incremental net accretive effect in 2017 of acquired businesses and intersegment product line transfers - 20 basis points 2017 vs. 2016 operating profit margin comparisons were unfavorably impacted by: • Fourth quarter 2017 loss on resolution of acquisition-related matters - 5 basis points 2016 Compared to 2015 Price increases in the segment did not have a significant impact on sales growth on a year-over-year basis during 2016 as compared with 2015. Core sales of the business’ broad range of mass spectrometers continued to grow on a year-over-year basis led by strong core sales growth in the pharmaceutical market in China and India as well as the services businesses. This growth was partially offset by declines in the overall market in Japan and softness in demand in the clinical end-market in North America. Core sales of microscopy products were essentially flat on a year-over-year basis with growth in demand in North America and China offset by declines in Japan. Year-over-year demand for the business’ flow cytometry and particle counting products grew in 2016, led by increases in demand in North America, Western Europe and China. The acquisition of Pall in August 2015 contributed the majority of the increase in sales from acquisitions. During the year ended December 31, 2016, Pall’s revenues grew on a year-over-year basis compared to the business’ 2015 results, led by continued growth in the life sciences business primarily due to demand for biopharmaceutical solutions including single-use technologies, partially offset by soft demand in the industrial business as a result of overall market weakness. Operating profit margins increased 540 basis points during 2016 as compared to 2015. The following factors impacted year-over-year operating profit margin comparisons. 2016 vs. 2015 operating profit margin comparisons were favorably impacted by: • Higher 2016 sales volumes from existing businesses and incremental year-over-year cost savings associated with the continuing productivity improvement initiatives taken in 2016 and 2015, net of incremental year-over-year costs associated with various product development, sales and marketing growth investments and the effect of a stronger U.S. dollar in 2016 - 175 basis points • Acquisition-related charges in 2015 associated with the acquisition of Pall, including transaction costs deemed significant, change in control payments, and fair value adjustments to acquired inventory and deferred revenue, net of the positive impact of freezing pension benefits - 390 basis points 2016 vs. 2015 operating profit margin comparisons were unfavorably impacted by: • Acquisition-related charges in 2016, including transaction costs deemed significant, change in control and restructuring payments, and fair value adjustments to acquired inventory and deferred revenue - 10 basis points • The incremental net dilutive effect in 2016 of acquired businesses (including Pall) - 15 basis points Depreciation and amortization expense increased during 2016 as compared to 2015 due primarily to the impact of recently acquired businesses, particularly Pall, and the resulting increase in depreciable and amortizable assets. DIAGNOSTICS The Company’s Diagnostics segment offers analytical instruments, reagents, consumables, software and services that hospitals, physicians’ offices, reference laboratories and other critical care settings use to diagnose disease and make treatment decisions. Diagnostics Selected Financial Data Revenue Performance 2017 Compared to 2016 Price increases in the segment contributed 0.5% to sales growth on a year-over-year basis during 2017 as compared with 2016 and are reflected as a component of the change in core revenue growth. Core sales in the clinical lab business increased on a year-over-year basis. Geographically, continued strong demand in high-growth markets for the clinical lab business was partially offset by declines in Western Europe and Japan. Increased demand in the immunoassay product line drove the majority of the growth for the year in the clinical lab business. Growth in the acute care diagnostic business was driven by continued strong consumable sales in 2017 across most major geographies. Increased demand for advanced staining and core histology instruments and related consumables across most major geographies drove the majority of the year-over-year core sales growth in the pathology diagnostics business. The acquisition of Cepheid in November 2016 contributed the majority of the increase in sales from acquisitions. During 2017, Cepheid’s revenues compared to the business’ 2016 results grew on a year-over-year basis in most major geographies and product lines. As Cepheid is integrated into the Company, a process that will continue over the next several years, the Company has realized and expects to realize cost savings and other business process improvements through the application of DBS. During 2017, the Company made the strategic decision to discontinue a molecular diagnostic product line in its Diagnostics segment. As a result, the Company recorded $76 million of pretax restructuring, impairment and other related charges ($51 million after-tax or $0.07 per diluted share). These charges included $49 million of noncash charges for the impairment of certain technology-related intangible assets as well as related inventory and property, plant and equipment with no further use. In addition, the Company incurred $27 million of cash restructuring costs primarily related to employee severance and related charges. Substantially all restructuring activities related to this discontinued product line were completed in 2017. Operating profit margins declined 70 basis points during 2017 as compared to 2016. The following factors impacted year-over-year operating profit margin comparisons. 2017 vs. 2016 operating profit margin comparisons were favorably impacted by: • Higher 2017 sales volumes from existing businesses and incremental year-over-year cost savings associated with the continuing productivity improvement initiatives taken in 2017 and 2016, net of incremental year-over-year costs associated with various new product development, sales and marketing growth investments and the effect of year-over-year changes in currency exchange rates - 35 basis points • Acquisition-related charges in 2016 associated with the acquisition of Cepheid, including transaction costs deemed significant, change in control and restructuring payments, and fair value adjustments to acquired inventory and deferred revenue - 150 basis points • 2017 gain on resolution of acquisition-related matters - 25 basis points 2017 vs. 2016 operating profit margin comparisons were unfavorably impacted by: • Restructuring, impairment and other related charges related to discontinuing a product line in 2017 - 130 basis points • The incremental net dilutive effect in 2017 of acquired businesses - 150 basis points Depreciation and amortization increased during 2017 as compared with 2016 primarily due to the impact of recently acquired businesses, primarily Cepheid, and the resulting increase in depreciable and amortizable assets. 2016 Compared to 2015 Price increases in the segment contributed 0.5% to sales growth on a year-over-year basis during 2016 as compared with 2015 and are reflected as a component of the change in core revenue growth. Geographically, demand in the clinical lab business increased on a year-over-year basis led by continuing strong demand in high-growth markets, particularly China, partially offset by declines in North America. Increased demand in the immunoassay products drove the majority of growth for the year in the clinical business. Continued strong consumable sales in 2016 particularly in China, Western Europe, North America and Japan drove the majority of the year-over-year sales growth in the acute care diagnostic business. Increased demand for advanced staining consumables, particularly in North America and China, and core histology instruments across most major geographies, but particularly in China, drove the majority of the year-over-year sales growth in the pathology diagnostics business. Operating profit margins increased 20 basis points during 2016 as compared to 2015. The following factors impacted year-over-year operating profit margin comparisons. 2016 vs. 2015 operating profit margin comparisons were favorably impacted by: • Higher 2016 sales volumes from existing businesses and incremental year-over-year cost savings associated with the continuing productivity improvement initiatives taken in 2016 and 2015, net of incremental year-over-year costs associated with various product development, sales and marketing growth investments and the effect of a stronger U.S. dollar in 2016 - 200 basis points 2016 vs. 2015 operating profit margin comparisons were unfavorably impacted by: • Acquisition-related charges in 2016 associated with the acquisition of Cepheid, including transaction costs deemed significant, change in control and restructuring payments, and fair value adjustments to acquired inventory and deferred revenue - 150 basis points • The incremental net dilutive effect in 2016 of acquired businesses - 30 basis points Amortization increased during 2016 as compared with 2015 primarily due to the impact of recently acquired businesses including Cepheid and the resulting increase in amortizable assets. DENTAL The Company’s Dental segment provides products that are used to diagnose, treat and prevent disease and ailments of the teeth, gums and supporting bone, as well as to improve the aesthetics of the human smile. The Company is a leading worldwide provider of a broad range of dental consumables, equipment and services, and is dedicated to driving technological innovations that help dental professionals improve clinical outcomes and enhance productivity. Dental Selected Financial Data Revenue Performance 2017 Compared to 2016 Price increases in the segment did not have a significant impact on sales growth on a year-over-year basis during 2017 as compared with 2016. Geographically, year-over-year core revenue growth was strong in China, Russia and other high-growth markets, offset by lower demand in the United States and Western Europe. Strong year-over-year growth continued during 2017 for the specialty consumables business, which consists of implant solutions and orthodontic products. Core sales growth for the specialty consumables business was led by high-growth markets and North America. Dental equipment core sales were essentially flat during 2017, as increased demand in high-growth markets was offset by weaker demand in the United States and Western Europe, particularly later in the year for North America due to the realignment of dental equipment distributors and manufacturers. Demand was lower for traditional dental consumable product lines in North America and Western Europe reflecting inventory destocking by several distribution partners. While the impact of inventory destocking in the consumables business began to lessen late in 2017, the recent realignment of distributors and manufacturers in the dental industry, primarily in North America, may have a continued negative impact on revenues in the near-term. Operating profit margins declined 80 basis points during 2017 as compared to 2016. The following factors unfavorably impacted year-over-year operating profit margin comparisons: • Incremental year-over-year costs associated with various new product development, sales and marketing growth investments, the effect of year-over-year changes in currency exchange rates and unfavorable product mix due to lower sales of dental consumables in 2017, net of incremental year-over-year cost savings associated with the continuing productivity improvement initiatives taken in 2017 and 2016 - 35 basis points • Trade name impairments and related productivity improvement initiatives in 2017 - 35 basis points • The incremental net dilutive effect in 2017 of acquired businesses - 10 basis points 2016 Compared to 2015 Price increases in the segment contributed 0.5% to sales growth on a year-over-year basis during 2016 as compared with 2015 and are reflected as a component of the change in core revenue growth. Geographically, year-over-year core revenue growth was strong in China and other high-growth markets, with low-single digit growth in the United States partially offset by lower demand in Western Europe. Continued strong year-over-year demand for implant solutions, particularly in China and North America, and increased demand for orthodontic products, primarily in China and Russia, drove growth during 2016. Dental equipment core sales also increased during 2016, primarily in high-growth markets and North America partially offset by weaker demand in Western Europe. Lower demand for dental consumable product lines in North America and the Middle East partially offset this year-over-year growth in 2016. Operating profit margins increased 160 basis points during 2016 as compared to 2015. The following factors impacted year-over-year operating profit margin comparisons. 2016 vs. 2015 operating profit margin comparisons were favorably impacted by: • Higher 2016 sales volumes from existing businesses and incremental year-over-year cost savings associated with the continuing productivity improvement initiatives taken in 2016 and 2015, net of incremental year-over-year costs associated with various product development, sales and marketing growth investments and the effect of a stronger U.S. dollar in 2016 - 90 basis points • Acquisition-related charges in the first quarter of 2015 associated with the acquisition of Nobel Biocare, primarily related to fair value adjustments to acquired inventory - 80 basis points 2016 vs. 2015 operating profit margin comparisons were unfavorably impacted by: • The incremental net dilutive effect in 2016 of acquired businesses - 10 basis points ENVIRONMENTAL & APPLIED SOLUTIONS The Company’s Environmental & Applied Solutions segment products and services help protect important resources and keep global food and water supplies safe. The Company’s water quality business provides instrumentation, services and disinfection systems to help analyze, treat and manage the quality of ultra-pure, potable, industrial, waste, ground, source and ocean water in residential, commercial, municipal, industrial and natural resource applications. The Company’s product identification business provides equipment, software, services and consumables for various color and appearance management, packaging design and quality management, printing, marking, coding and traceability applications for consumer, pharmaceutical and industrial products. Environmental & Applied Solutions Selected Financial Data Revenue Performance 2017 Compared to 2016 During the first quarter of 2017, a product line was transferred from the Life Sciences segment to the Environmental & Applied Solutions segment. While this change is not material to segment results in total, the resulting change in sales growth has been included in the “Acquisitions and other” line in the table above. Price increases in the segment contributed 1.0% to sales growth on a year-over-year basis during 2017 as compared with 2016 and are reflected as a component of the change in core revenue growth. Core sales in the segment’s water quality businesses grew at a low-single digit rate during 2017 as compared with 2016. Year-over-year core sales in the analytical instrumentation product line grew, as increased demand in the industrial and municipal end-markets was partially offset by lower demand in the environmental end-markets. Geographically, year-over-year core revenue growth in the analytical instrumentation product line was driven by increased demand in China, Western Europe and North America, partially offset by lower demand in the Middle East and Latin America. Year-over-year core revenue growth in the business’ chemical treatment solutions product line was due primarily to an expansion of the customer base in the United States, driven by higher demand in food, steel and oil and gas-related end-markets. Core sales in the business’ ultraviolet water disinfection product line grew on a year-over-year basis due primarily to higher demand in municipal and industrial end-markets in North America, Western Europe and Asia. Core sales in the segment’s product identification businesses grew at a mid-single digit rate during 2017 as compared with 2016. Continued strong year-over-year demand for marking and coding equipment and related consumables in most major geographies, led by North America and Western Europe, drove the majority of the core revenue growth. Demand for the business’ packaging and color solutions also increased year-over-year. Geographically, core revenue growth for packaging and color solutions was led by North America, Western Europe and Asia. Operating profit margins declined 60 basis points during 2017 as compared to 2016. The following factors impacted year-over-year operating profit margin comparisons. 2017 vs. 2016 operating profit margin comparisons were favorably impacted by: • Higher 2017 sales volumes, incremental year-over-year cost savings associated with the continuing productivity improvement initiatives taken in 2017 and 2016, improved pricing and the effect of year-over-year changes in currency exchange rates, net of incremental year-over-year costs associated with various new product development and sales and marketing growth investments - 5 basis points 2017 vs. 2016 operating profit margin comparisons were unfavorably impacted by: • The incremental net dilutive effect in 2017 of acquired businesses - 65 basis points 2016 Compared to 2015 Price increases in the segment contributed 1.0% to sales growth on a year-over-year basis during 2016 as compared with 2015 and are reflected as a component of the change in core revenue growth. Core sales in the segment’s water quality businesses grew at a low-single digit rate during 2016 as compared with 2015. Year-over-year core sales in the analytical instrumentation product line grew, as increases in sales to the U.S. municipal end-market and Western Europe were partially offset by lower demand in Eastern Europe and China. Year-over-year core revenue growth in the business’ chemical treatment solutions product line was due primarily to an expansion of the customer base in the United States. Chemical treatment solutions saw an improvement in commodity oriented end-markets in Latin America in the fourth quarter of 2016 after declining growth in the earlier portion of 2016. Core sales in the business’ ultraviolet water disinfection product line grew on a year-over-year basis due primarily to higher demand in municipal and industrial end-markets in Western Europe, China and Australia. Core sales in the segment’s product identification businesses grew at a mid-single digit rate during 2016 as compared with 2015. Continued strong year-over-year demand for marking and coding equipment and related consumables in most major geographies, led by North America, Western Europe and Latin America, drove the majority of the core revenue growth. Demand for the business’ packaging and color solutions was flat year-over-year, as core revenue growth in the second half of the year was offset by weakness in the first half of the year. Geographically, increased demand in the high-growth markets was offset by weaker demand in North America and Europe. Operating profit margins declined 80 basis points during 2016 as compared to 2015. The following factors unfavorably impacted year-over-year operating profit margin comparisons. • The incremental net dilutive effect in 2016 of acquired businesses - 75 basis points • Incremental year-over-year costs associated with various product development, sales and marketing growth investments and the effect of a stronger U.S. dollar in 2016, net of higher 2016 sales volumes from existing businesses and incremental year-over-year cost savings associated with the continuing productivity improvement initiatives taken in 2016 and 2015 - 5 basis points COST OF SALES AND GROSS PROFIT The year-over-year increase in cost of sales during 2017 as compared with 2016 is due primarily to the impact of higher year-over-year sales volumes, including sales from recently acquired businesses and the impact of restructuring, impairment and other related charges associated with the Company’s strategic decision to discontinue a product line in its Diagnostics segment. This increase in cost of sales was partially offset by year-over-year cost savings at recently acquired businesses, incremental year-over-year cost savings associated with the continued productivity improvement actions taken in 2017 and 2016, and the year-over-year decrease in acquisition-related charges associated with fair value adjustments to acquired inventory which decreased cost of sales by $21 million during 2017 as compared to 2016. The year-over-year increase in cost of sales during 2016 as compared with 2015, is due primarily to the impact of higher year-over-year sales volumes, including sales from recently acquired businesses. This increase in cost of sales was partially offset by year-over-year cost savings at recently acquired businesses, particularly Pall, incremental year-over-year cost savings associated with the continued productivity improvement actions taken in 2016 and 2015, and the year-over-year decrease in acquisition-related charges associated with fair value adjustments to acquired inventory which decreased cost of sales by $85 million during 2016 as compared to 2015. The year-over-year increase in gross profit margins during 2017 as compared with 2016 is due primarily to the favorable impact of higher year-over-year sales volumes and incremental year-over-year cost savings associated with the continuing productivity improvements taken in 2017 and 2016. In addition, the acquisition-related charges associated with fair value adjustments to acquired inventory and deferred revenue were higher in 2016 than 2017, which improved gross profit margins by 10 basis points during 2017 as compared with 2016. The year-over-year increase in gross profit margins during 2016 as compared with 2015 is due primarily to the favorable impact of higher year-over-year sales volumes, incremental year-over-year cost savings associated with the continuing productivity improvements taken in 2016 and 2015 and improved gross profit margins on a year-over-year basis at recently acquired businesses, particularly Pall. In addition, the acquisition-related charges associated with fair value adjustments to acquired inventory and deferred revenue were higher in 2015 than 2016, which improved gross profit margins by 50 basis points during 2016 as compared with 2015. OPERATING EXPENSES SG&A expenses as a percentage of sales declined 20 basis points on a year-over-year basis for 2017 compared with 2016. The decline was driven by increased leverage of the Company’s general and administrative cost base resulting from higher 2017 sales volumes, continuing productivity improvements taken in 2017 and 2016 as well as the benefit of lower acquisition charges in 2017 compared to 2016, particularly change in control payments and restructuring costs in connection with the acquisition of Cepheid. The decline in SG&A expenses as a percentage of sales was partially offset by restructuring, impairment and other related charges associated with the Company’s strategic decision to discontinue a product line in its Diagnostics segment, higher relative spending levels at recently acquired companies, primarily Cepheid, and continued investments in sales and marketing growth initiatives. SG&A expenses as a percentage of sales increased 30 basis points on a year-over-year basis for 2016 compared with 2015. The increase in SG&A expenses as a percentage of sales from 2015 to 2016 was driven by continued investments in sales and marketing growth initiatives and higher relative spending levels at recently acquired businesses. Change in control payments and restructuring costs in connection with the acquisition of Cepheid, as well as associated transaction costs, also increased SG&A expenses as a percentage of sales by 35 basis points during 2016. These increases were partially offset by the benefit of increased leverage of the Company’s general and administrative cost base resulting from higher 2016 sales, lower year-over-year costs associated continuing productivity improvement initiatives and incremental year-over-year cost savings associated with the continuing productivity improvements taken in 2016 and 2015 as well as the benefit of lower Pall acquisition charges (change in control payments to Pall employees in connection with the acquisition of Pall, as well as associated transaction costs and amortization charges associated with acquisition-related intangible assets, net of the positive impact of freezing pension benefits) in 2016 compared to 2015. R&D expenses (consisting principally of internal and contract engineering personnel costs) as a percentage of sales increased in 2017 as compared with 2016 due primarily to higher R&D expenses as a percentage of sales in the businesses most recently acquired, primarily Cepheid, as well as year-over-year increases in spending in the Company’s new product development initiatives. R&D expenses as a percentage of sales declined in 2016 as compared to 2015 due primarily to lower R&D expenses as a percentage of sales in the businesses most recently acquired, particularly Pall, as well as year-over-year differences in the timing of investments in the Company’s new product development initiatives. NONOPERATING INCOME (EXPENSE) The Company received $138 million of cash proceeds and recorded $22 million in short-term other receivables from the sale of certain marketable equity securities during 2017. The Company recorded a pretax gain related to this sale of $73 million ($46 million after-tax or $0.06 per diluted share). During 2016, the Company received cash proceeds of $265 million from the sale of certain marketable equity securities and recorded a pretax gain related to this sale of $223 million ($140 million after-tax or $0.20 per diluted share). During 2016, the Company also paid $188 million of make-whole premiums associated with the early extinguishment of the Redeemed Notes. The Company recorded a loss on extinguishment of these borrowings, net of certain deferred gains, of $179 million ($112 million after-tax or $0.16 per diluted share). During 2015, the Company received cash proceeds of $43 million from the sale of certain marketable equity securities and recorded a pretax gain related to these sales of $12 million ($8 million after-tax or $0.01 per diluted share). INTEREST COSTS Interest expense of $163 million for 2017 was $22 million lower than in 2016, due primarily to the decrease in interest costs as a result of the early extinguishment of certain outstanding borrowings in the third quarter of 2016 using the proceeds from the Fortive Distribution and due to lower commercial paper borrowings in 2017 compared to 2016, partially offset by the cost of additional long-term debt refinancing relating to the acquisition of Cepheid. For a further description of the Company’s debt as of December 31, 2017 refer to Note 9 to the Consolidated Financial Statements. Interest expense of $184 million in 2016 was $45 million higher than the 2015 interest expense of $140 million due primarily to the higher interest costs associated with the debt issued in the second half of 2015 in connection with the 2015 acquisition of Pall, partially offset by decreases in interest costs as a result of the early extinguishment of the Redeemed Notes in the third quarter of 2016 using the proceeds from the Fortive Distribution. INCOME TAXES General Income tax expense and deferred tax assets and liabilities reflect management’s assessment of future taxes expected to be paid on items reflected in the Company’s Consolidated Financial Statements. The Company records the tax effect of discrete items and items that are reported net of their tax effects in the period in which they occur. The Company’s effective tax rate can be affected by changes in the mix of earnings in countries with different statutory tax rates (including as a result of business acquisitions and dispositions), changes in the valuation of deferred tax assets and liabilities, accruals related to contingent tax liabilities and period-to-period changes in such accruals, the results of audits and examinations of previously filed tax returns (as discussed below), the expiration of statutes of limitations, the implementation of tax planning strategies, tax rulings, court decisions, settlements with tax authorities and changes in tax laws and regulations, including the TCJA and legislative policy changes that may result from the OECD’s initiative on Base Erosion and Profit Shifting. For a description of the tax treatment of earnings that are planned to be reinvested indefinitely outside the United States, refer to “-Liquidity and Capital Resources - Cash and Cash Requirements” below. The amount of income taxes the Company pays is subject to ongoing audits by federal, state and foreign tax authorities, which often result in proposed assessments. Management performs a comprehensive review of its global tax positions on a quarterly basis. Based on these reviews, the results of discussions and resolutions of matters with certain tax authorities, tax rulings and court decisions and the expiration of statutes of limitations, reserves for contingent tax liabilities are accrued or adjusted as necessary. For a discussion of risks related to these and other tax matters, refer to “Item 1A. Risk Factors”. On December 22, 2017, the TCJA was enacted, substantially changing the U.S. tax system and affecting the Company in a number of ways. Notably, the TCJA: • establishes a flat corporate income tax rate of 21.0% on U.S. earnings; • imposes a one-time tax on unremitted cumulative non-U.S. earnings of foreign subsidiaries, which we refer to in this Annual Report as the Transition Tax; • imposes a new minimum tax on certain non-U.S. earnings, irrespective of the territorial system of taxation, and generally allows for the repatriation of future earnings of foreign subsidiaries without incurring additional U.S. taxes by transitioning to a territorial system of taxation; • subjects certain payments made by a U.S. company to a related foreign company to certain minimum taxes (Base Erosion Anti-Abuse Tax); • eliminates certain prior tax incentives for manufacturing in the United States and creates an incentive for U.S. companies to sell, lease or license goods and services abroad by allowing for a reduction in taxes owed on earnings related to such sales; • allows the cost of investments in certain depreciable assets acquired and placed in service after September 27, 2017 to be immediately expensed; and • reduces deductions with respect to certain compensation paid to specified executive officers. While the changes from the TCJA are generally effective beginning in 2018, U.S. GAAP accounting for income taxes requires the effect of a change in tax laws or rates to be recognized in income from continuing operations for the period that includes the enactment date. Due to the complexities involved in accounting for the enactment of the TCJA, the SEC Staff Accounting Bulletin No. 118 (“SAB No. 118”) allowed the Company to record provisional amounts in earnings for the year ended December 31, 2017. Where reasonable estimates can be made, the provisional accounting should be based on such estimates. When no reasonable estimate can be made, the provisional accounting may be based on the tax law in effect before the TCJA. The Company is required to complete its tax accounting for the TCJA within a one year period when it has obtained, prepared, and analyzed the information to complete the income tax accounting. The Company has not completed its accounting for the tax effects of enactment of the TCJA; however, as described below, the Company has made reasonable estimates of the effects of the TCJA on its Consolidated Financial Statements which are included as a component of income tax expense from continuing operations: • Deferred tax assets and liabilities: U.S. deferred tax assets and liabilities were remeasured based on the rates at which they are expected to reverse in the future, which is generally 21.0%, resulting in an income tax benefit of approximately $1.2 billion. The Company will continue to analyze certain aspects of the TCJA which could potentially affect the tax basis of the reported amounts. Additionally, the Company’s U.S. tax returns for 2017 will be filed during the fourth quarter of 2018 and any changes to the tax positions for temporary differences compared to the estimates used will result in an adjustment of the estimated tax benefit recorded as of December 31, 2017. • Transition Tax effects: The Transition Tax is based on the Company’s total post-1986 earnings and profits that were previously deferred from U.S. income taxes. The Company recorded a provisional amount for the Transition Tax expense resulting in an increase in income tax expense of approximately $1.2 billion. The Company will continue to evaluate the TCJA and any future guidance from the U.S. Treasury Department and IRS in the determination of the Transition Tax which could result in adjustment of the estimate recorded as of December 31, 2017. • Indefinite reinvestment: As of December 31, 2017, the Company held $593 million of cash and approximately $656 million of cash equivalents (as defined by the TCJA, including trade accounts receivable net of trade accounts payable balances and certain accrued expenses) outside the United States. While repatriation of some cash held outside the United States may be restricted by local laws, most of the Company’s foreign cash could be repatriated to the United States. Following enactment of the TCJA and the associated Transition Tax, in general, repatriation of cash to the United States can be completed with no incremental U.S. tax; however, repatriation of cash could subject the Company to non-U.S. jurisdictional taxes on distributions. The cash that the Company’s non-U.S. subsidiaries hold for indefinite reinvestment is generally used to finance foreign operations and investments, including acquisitions. The income taxes applicable to such earnings are not readily determinable or practicable. The Company continues to evaluate the impact of the TCJA on its election to indefinitely reinvest certain of its non-U.S. earnings. The Company will continue to analyze the effects of the TCJA on its Consolidated Financial Statements and operations. Additional impacts from the enactment of the TCJA will be recorded as they are identified during the measurement period as provided for in SAB No. 118, which extends up to one year from the enactment date. Year-Over-Year Changes in the Tax Provision and Effective Tax Rate The Company’s effective tax rate related to continuing operations for the years ended December 31, 2017, 2016 and 2015 was 16.0%, 17.5% and 14.4%, respectively. The Company’s effective tax rate for each of 2017, 2016 and 2015 differs from the U.S. federal statutory rate of 35.0% due principally to the Company’s earnings outside the United States that are indefinitely reinvested and taxed at rates lower than the U.S. federal statutory rate. In addition: • The effective tax rate of 16.0% in 2017 includes 500 basis points of net tax benefits related to the revaluation of net U.S. deferred tax liabilities from 35.0% to 21.0% due to the TCJA and release of reserves upon statute of limitation expiration, partially offset by income tax expense related to the Transition Tax on foreign earnings due to the TCJA and changes in estimates associated with prior period uncertain tax positions. • The effective tax rate of 17.5% in 2016 includes 350 basis points of net tax benefits from permanent foreign exchange losses and the release of reserves upon the expiration of statutes of limitation and audit settlements, partially offset by income tax expense related to repatriation of earnings and legal entity realignments associated with the Separation and changes in estimates associated with prior period uncertain tax positions. • The effective tax rate of 14.4% in 2015 includes 290 basis points of net tax benefits from permanent foreign exchange losses, releases of valuation allowances related to foreign operating losses and the release of reserves upon the expiration of statutes of limitation, partially offset by changes in estimates associated with prior period uncertain tax positions. The Company conducts business globally, and files numerous consolidated and separate income tax returns in the U.S. federal, state and foreign jurisdictions. The countries in which the Company has a material presence that have had significantly lower statutory tax rates than the United States include China, Denmark, Germany, Singapore, Switzerland and the United Kingdom. The Company’s ability to obtain a tax benefit from lower statutory tax rates outside of the United States depends on its levels of taxable income in these foreign countries and the amount of foreign earnings which are indefinitely reinvested in those countries. The Company believes that a change in the statutory tax rate of any individual foreign country would not have a material effect on the Company’s Consolidated Financial Statements given the geographic dispersion of the Company’s taxable income. The Company and its subsidiaries are routinely examined by various domestic and international taxing authorities. The IRS has completed substantially all of the examinations of the Company’s federal income tax returns through 2011 and is currently examining certain of the Company’s federal income tax returns for 2012 through 2015. In addition, the Company has subsidiaries in Austria, Belgium, Canada, China, Denmark, Finland, France, Germany, Hong Kong, India, Italy, Japan, New Zealand, Sweden, Switzerland, the United Kingdom and various other countries, states and provinces that are currently under audit for years ranging from 2004 through 2015. Tax authorities in Denmark have raised significant issues related to interest accrued by certain of the Company’s subsidiaries. On December 10, 2013, the Company received assessments from the Danish tax authority (“SKAT”) totaling approximately DKK 1.5 billion (approximately $245 million based on exchange rates as of December 31, 2017) including interest through December 31, 2017, imposing withholding tax relating to interest accrued in Denmark on borrowings from certain of the Company’s subsidiaries for the years 2004-2009. The Company is currently in discussions with SKAT and anticipates receiving an assessment for years 2010-2012 totaling approximately DKK 895 million (approximately $144 million based on exchange rates as of December 31, 2017) including interest through December 31, 2017. Management believes the positions the Company has taken in Denmark are in accordance with the relevant tax laws and is vigorously defending its positions. The Company appealed these assessments with the National Tax Tribunal in 2014 and intends on pursuing this matter through the European Court of Justice should this appeal be unsuccessful. The ultimate resolution of this matter is uncertain, could take many years, and could result in a material adverse impact to the Company’s financial statements, including its effective tax rate. After considering the effect of the TCJA, the Company expects its 2018 effective tax rate to be in the range of 20% to 21%. Any future legislative changes in the United States including regulations related to the TCJA or potential tax reform in other jurisdictions, could cause the Company’s effective tax rate to differ from this estimate. Refer to Note 12 to the Consolidated Financial Statements for additional information related to income taxes. DISCONTINUED OPERATIONS As further discussed in Note 3 to the Consolidated Financial Statements, discontinued operations includes the results of the Fortive businesses which were disposed of during the third quarter of 2016 as well as the results of the Company’s former communications business which was disposed of during the third quarter of 2015. All periods presented have been restated to reflect the Fortive and communications businesses within discontinued operations. In 2017, Danaher recorded a $22 million income tax benefit related to the release of previously provided reserves associated with uncertain tax positions on certain Danaher tax returns which were jointly filed with Fortive entities. These reserves were released due to the expiration of statutes of limitations for those returns. All Fortive entity-related balances were included in the income tax benefit related to discontinued operations. In 2016, earnings from discontinued operations, net of income taxes, were $400 million and reflected the operating results of the Fortive businesses prior to the Separation. In 2015, earnings from discontinued operations, net of income taxes, were approximately $1.6 billion and reflected the operations of both the Fortive and communications businesses as well as the gain on the sale of the communications business in 2015. COMPREHENSIVE INCOME Comprehensive income increased by approximately $1.7 billion in 2017 as compared to 2016, primarily due to increased earnings from continuing operations, an increased gain from foreign currency translation adjustments compared to 2016, pension and postretirement plan benefit adjustments and the decrease in the unrealized gains (losses) on available-for-sale securities from the sale of certain marketable equity securities, partially offset by lower net earnings attributable to discontinued operations in 2017 compared to 2016. The Company recorded a foreign currency translation gain of $976 million for 2017 compared to a translation loss of $517 million for 2016. The Company recorded a pension and postretirement plan benefit gain of $71 million for 2017 compared to a loss of $58 million for 2016. Comprehensive income decreased by $617 million in 2016 as compared to 2015, primarily due to the impact of decreases in net earnings attributable to discontinued operations, foreign currency translation adjustments resulting from the strengthening of the U.S. dollar compared to most major currencies during the year but at a lower rate than in the prior year, and pension and postretirement plan benefit adjustments. The Company recorded a foreign currency translation loss of $517 million for 2016 compared to a translation loss of $976 million for 2015. The Company recorded a pension and postretirement plan benefit loss of $58 million in 2016 compared to a gain of $81 million in 2015. INFLATION The effect of inflation on the Company’s revenues and net earnings was not significant in any of the years ended December 31, 2017, 2016 or 2015. FINANCIAL INSTRUMENTS AND RISK MANAGEMENT The Company is exposed to market risk from changes in interest rates, foreign currency exchange rates, equity prices and commodity prices as well as credit risk, each of which could impact its Consolidated Financial Statements. The Company generally addresses its exposure to these risks through its normal operating and financing activities. In addition, the Company’s broad-based business activities help to reduce the impact that volatility in any particular area or related areas may have on its operating profit as a whole. Interest Rate Risk The Company manages interest cost using a mixture of fixed-rate and variable-rate debt. A change in interest rates on long-term debt impacts the fair value of the Company’s fixed-rate long-term debt but not the Company’s earnings or cash flow because the interest on such debt is fixed. Generally, the fair market value of fixed-rate debt will increase as interest rates fall and decrease as interest rates rise. As of December 31, 2017, an increase of 100 basis points in interest rates would have decreased the fair value of the Company’s fixed-rate long-term debt (excluding the LYONs, which have not been included in this calculation as the value of this convertible debt is primarily derived from the value of its underlying common stock) by $470 million. As of December 31, 2017, the Company’s variable-rate debt obligations consisted primarily of U.S. dollar and euro-based commercial paper borrowings (refer to Note 9 to the Consolidated Financial Statements for information regarding the Company’s outstanding commercial paper balances as of December 31, 2017). As a result, the Company’s primary interest rate exposure results from changes in short-term interest rates. As these shorter duration obligations mature, the Company may issue additional short-term commercial paper obligations to refinance all or part of these borrowings. In 2017, the average annual interest rate associated with outstanding commercial paper borrowings was approximately 6 basis points. A hypothetical increase of this average to 18 basis points would have increased the Company’s annual interest expense by $4 million. The hypothetical increase used is the actual amount by which the Company’s commercial paper interest rates fluctuated during 2017. Currency Exchange Rate Risk The Company faces transactional exchange rate risk from transactions with customers in countries outside the United States and from intercompany transactions between affiliates. Transactional exchange rate risk arises from the purchase and sale of goods and services in currencies other than Danaher’s functional currency or the functional currency of its applicable subsidiary. The Company also faces translational exchange rate risk related to the translation of financial statements of its foreign operations into U.S. dollars, Danaher’s functional currency. Costs incurred and sales recorded by subsidiaries operating outside of the United States are translated into U.S. dollars using exchange rates effective during the respective period. As a result, the Company is exposed to movements in the exchange rates of various currencies against the U.S. dollar. In particular, the Company has more sales in European currencies than it has expenses in those currencies. Therefore, when European currencies strengthen or weaken against the U.S. dollar, operating profits are increased or decreased, respectively. The effect of a change in currency exchange rates on the Company’s net investment in international subsidiaries is reflected in the accumulated other comprehensive income (loss) component of stockholders’ equity. Currency exchange rates positively impacted 2017 reported sales by 0.5% on a year-over-year basis as the U.S. dollar weakened against the euro, partially offset by the effect of the U.S. dollar strengthening against the Japanese yen and Chinese renminbi. If the exchange rates in effect as of December 31, 2017 were to prevail throughout 2018, currency exchange rates would positively impact 2018 estimated sales by approximately 2.0% relative to the Company’s performance in 2017. Strengthening of the U.S. dollar against other major currencies would adversely impact the Company’s sales and results of operations on an overall basis. Any weakening of the U.S. dollar against other major currencies would positively impact the Company’s sales and results of operations. The Company has generally accepted the exposure to exchange rate movements without using derivative financial instruments to manage this risk. Both positive and negative movements in currency exchange rates against the U.S. dollar will therefore continue to affect the reported amount of sales and net earnings in the Company’s Consolidated Financial Statements. In addition, the Company has assets and liabilities held in foreign currencies. The Company’s foreign currency-denominated debt partially hedges its net investments in foreign operations against adverse movements in exchange rates. A 10% depreciation in major currencies relative to the U.S. dollar as of December 31, 2017 would have reduced foreign currency-denominated net assets and stockholders’ equity by $880 million. Equity Price Risk The Company’s available-for-sale investment portfolio has in the past included publicly traded equity securities that are sensitive to fluctuations in market price. However, during 2017 the Company sold substantially all of its available-for-sale equity securities. Commodity Price Risk For a discussion of risks relating to commodity prices, refer to “Item 1A. Risk Factors.” Credit Risk The Company is exposed to potential credit losses in the event of nonperformance by counterparties to its financial instruments. Financial instruments that potentially subject the Company to credit risk consist of cash and temporary investments, receivables from customers and derivatives. The Company places cash and temporary investments with various high-quality financial institutions throughout the world and exposure is limited at any one institution. Although the Company typically does not obtain collateral or other security to secure these obligations, it does regularly monitor the third-party depository institutions that hold its cash and cash equivalents. The Company’s emphasis is primarily on safety and liquidity of principal and secondarily on maximizing yield on those funds. In addition, concentrations of credit risk arising from receivables from customers are limited due to the diversity of the Company’s customers. The Company’s businesses perform credit evaluations of their customers’ financial conditions as appropriate and also obtain collateral or other security when appropriate. The Company enters into derivative transactions infrequently and such transactions are generally insignificant to the Company’s financial condition and results of operations. These transactions are typically entered into with high-quality financial institutions and exposure at any one institution is limited. LIQUIDITY AND CAPITAL RESOURCES Management assesses the Company’s liquidity in terms of its ability to generate cash to fund its operating, investing and financing requirements. The Company continues to generate substantial cash from operating activities and believes that its operating cash flow and other sources of liquidity will be sufficient to allow it to continue investing in existing businesses, consummating strategic acquisitions, paying interest and servicing debt and managing its capital structure on a short and long-term basis. Following is an overview of the Company’s cash flows and liquidity for the years ended December 31: Overview of Cash Flows and Liquidity • Operating cash flows from continuing operations increased $390 million, or approximately 13%, during 2017 as compared to 2016, due primarily to higher earnings which also included higher noncash charges for depreciation and amortization. The increase was partially offset by (1) the gain on sale of marketable equity securities in 2017, reduced by the net impact in 2016 of the gain from the sale of marketable equity securities and the loss on early extinguishment of borrowings; and (2) the increase in cash flows used for trade accounts receivable, inventories and accounts payable. • Net cash used in investing activities during 2017 consisted primarily of cash paid for acquisitions and additions to property, plant and equipment. The Company acquired ten businesses during 2017 for total consideration (including assumed debt and net of cash acquired) of approximately $386 million. Payments for additions to property, plant and equipment increased $30 million in 2017 compared to 2016 and include investments in other operating assets, particularly new facilities and operating assets at newly acquired businesses. These uses of cash were partially offset by proceeds from sales of investments, which includes cash proceeds of $138 million from the sale of certain marketable equity securities. • The Company used cash generated from operations as well as the proceeds from the long-term borrowings noted below to reduce net outstanding borrowings with maturities of 90 days or less, primarily commercial paper borrowings, by approximately $3.8 billion. • During 2017, the Company issued approximately $1.8 billion of euro, Japanese yen and Swiss franc-denominated long-term indebtedness (based on applicable exchange rates as of the pricing dates of the respective notes; refer to Note 9 of the accompanying Consolidated Financial Statements) and used the proceeds to repay commercial paper borrowings as well as the €500 million of senior unsecured bonds and the CHF 100 million of senior unsecured bonds that matured in 2017. • As of December 31, 2017, the Company held $630 million of cash and cash equivalents. Operating Activities Cash flows from operating activities can fluctuate significantly from period-to-period as working capital needs and the timing of payments for income taxes, restructuring activities, pension funding and other items impact reported cash flows. Operating cash flows from continuing operations were approximately $3.5 billion for 2017, an increase of $390 million, or approximately 13%, as compared to 2016. The year-over-year change in operating cash flows from 2016 to 2017 was primarily attributable to the following factors: • 2017 operating cash flows benefited from higher net earnings in 2017 as compared to 2016. The increase was partially offset by the gain on sale of marketable equity securities in 2017, reduced by the net impact in 2016 of the gain from the sale of marketable equity securities and the loss on early extinguishment of borrowings. The cash flow impacts of the gains from the sale of marketable equity securities is reflected in the investing activities section of the accompanying Consolidated Statements of Cash Flows, and the cash flow impact of the loss on early extinguishment of borrowings is reflected in the financing activities section of the accompanying Consolidated Statement of Cash Flows, and therefore, do not contribute to operating cash flows. • The aggregate of trade accounts receivable, inventories and trade accounts payable used $243 million in operating cash flows during 2017, compared to $96 million of operating cash flows used in 2016. The amount of cash flow generated from or used by the aggregate of trade accounts receivable, inventories and trade accounts payable depends upon how effectively the Company manages the cash conversion cycle, which effectively represents the number of days that elapse from the day it pays for the purchase of raw materials and components to the collection of cash from its customers and can be significantly impacted by the timing of collections and payments in a period. • The aggregate of prepaid expenses and other assets, deferred income taxes and accrued expenses and other liabilities used $110 million in operating cash flows during 2017, compared to $196 million used in 2016. The timing of cash payments for income taxes and various employee related liabilities drove the majority of this change. • Net earnings from continuing operations for 2017 reflected an increase of $110 million of depreciation and amortization expense as compared to 2016. Amortization expense primarily relates to the amortization of intangible assets acquired in connection with business acquisitions. Depreciation expense relates to both the Company’s manufacturing and operating facilities as well as instrumentation leased to customers under operating-type lease arrangements. Depreciation and amortization are noncash expenses that decrease earnings without a corresponding impact to operating cash flows. Operating cash flows from continuing operations were approximately $3.1 billion for 2016, an increase of $255 million, or 9% as compared to 2015. This increase was primarily attributable to the increase in net earnings from continuing operations in 2016 as compared to 2015. Investing Activities Cash flows relating to investing activities consist primarily of cash used for acquisitions and capital expenditures, including instruments leased to customers, cash used for investments and cash proceeds from divestitures of businesses or assets. Net cash used in investing activities was $843 million during 2017 compared to approximately $5.2 billion and approximately $15.0 billion of net cash used in 2016 and 2015, respectively. Acquisitions, Divestitures and Sale of Investments 2017 Acquisitions and Sale of Investments For a discussion of the Company’s 2017 acquisitions and sale of investments, refer to “-Overview.” 2016 Acquisitions, Divestitures and Sale of Investments For a discussion of the Company’s 2016 Separation of its former Test & Measurement segment, Industrial Technologies segment (excluding the product identification businesses) and retail/commercial petroleum business, refer to “-Overview.” On November 4, 2016, Copper Merger Sub, Inc., a California corporation and an indirect, wholly-owned subsidiary of the Company acquired all of the outstanding shares of common stock of Cepheid, a California corporation, for $53.00 per share in cash, for a total purchase price of approximately $4.0 billion, net of assumed debt and acquired cash (the “Cepheid Acquisition”). Cepheid is now part of the Company’s Diagnostics segment. Cepheid generated revenues of $539 million in 2015. The Company initially financed the Cepheid acquisition price with available cash and proceeds from the issuance of U.S. dollar and euro-denominated commercial paper. In addition to the Cepheid Acquisition, during 2016 the Company acquired seven businesses for total consideration of $882 million in cash, net of cash acquired. The businesses acquired complement existing units of each of the Company’s four segments. The aggregate annual sales of these seven businesses at the time of their respective acquisitions, in each case based on the company’s revenues for its last completed fiscal year prior to the acquisition, were $237 million. During 2016, the Company received cash proceeds of $265 million from the sale of certain marketable equity securities and recorded a pretax gain related to this sale of $223 million ($140 million after-tax or $0.20 per diluted share). 2015 Acquisitions, Divestitures and Sale of Investments On August 31, 2015, Pentagon Merger Sub, Inc., a New York corporation and an indirect, wholly-owned subsidiary of the Company, acquired all of the outstanding shares of common stock of Pall, a New York corporation, for $127.20 per share in cash, for a total purchase price of approximately $13.6 billion, net of assumed debt of $417 million and acquired cash of approximately $1.2 billion (the “Pall Acquisition”). Pall is part of the Company’s Life Sciences segment. In its fiscal year ended July 31, 2015, Pall generated consolidated revenues of approximately $2.8 billion. The Company initially financed the approximately $13.6 billion acquisition price of Pall with approximately $2.5 billion of available cash, approximately $8.1 billion of net proceeds from the issuance and sale of U.S. dollar and euro-denominated commercial paper and €2.7 billion (approximately $3.0 billion based on currency exchange rates as of the date of issuance) of net proceeds from the issuance and sale of euro-denominated senior unsecured notes. In addition to the Pall Acquisition, during 2015 the Company acquired nine businesses for total consideration of approximately $670 million in cash, net of cash acquired. The businesses acquired complement existing units of each of the Company’s four segments. The aggregate annual sales of these nine businesses at the time of their respective acquisitions, in each case based on the company’s revenues for its last completed fiscal year prior to the acquisition, were approximately $355 million. In July 2015, the Company consummated the split-off of the majority of its former communications business to Danaher shareholders who elected to exchange Danaher shares for ownership interests in the communications business, and the subsequent merger of the communications business with a subsidiary of NetScout. Danaher shareholders who participated in the exchange offer tendered 26 million shares of Danaher common stock (approximately $2.3 billion on the date of tender) and received 62.5 million shares of NetScout common stock which represented approximately 60% of the shares of NetScout common stock outstanding following the combination. The accounting requirements for reporting the disposition of the communications business as a discontinued operation were met when the split-off and merger were completed. Accordingly, the accompanying Consolidated Financial Statements for all periods presented reflect this business as discontinued operations. The Company allocated a portion of the consolidated interest expense to discontinued operations based on the ratio of the discontinued business’ net assets to the Company’s consolidated net assets. The Company recorded an aggregate after-tax gain on the disposition of this business of $767 million, or $1.08 per diluted share, in its 2015 results in connection with the closing of this transaction representing the value of the 26 million shares of Company common stock tendered for the communications business in excess of the carrying value of the business’ net assets. This gain was included in the results of discontinued operations for the year ended December 31, 2015. The communications business had revenues of $346 million in 2015 prior to the disposition. During 2015, the Company received cash proceeds of $43 million from the sale of certain marketable equity securities and recorded a pretax gain related to these sales of $12 million ($8 million after-tax or $0.01 per diluted share). Capital Expenditures Capital expenditures are made primarily for increasing capacity, replacing equipment, supporting new product development, improving information technology systems and the manufacture of instruments that are used in operating-type lease arrangements that certain of the Company’s businesses enter into with customers. Capital expenditures totaled $620 million in 2017, $590 million in 2016 and $513 million in 2015. The increase in capital spending in 2017 was due to increased investments in other operating assets, particularly new facilities, and operating assets at newly acquired businesses. The increase in capital spending in 2016 was due to increased investments in machinery and equipment, including operating assets at newly acquired businesses such as Pall, and to a lesser extent, increases in equipment leased to customers. In 2018, the Company expects capital spending to be approximately $700 million, though actual expenditures will ultimately depend on business conditions. Financing Activities Cash flows from financing activities consist primarily of cash flows associated with the issuance and repayments of commercial paper and other debt, issuances and repurchases of common stock, excess tax benefits from stock-based compensation, and payments of cash dividends to shareholders. Financing activities used cash of approximately $3.1 billion during 2017 compared to approximately $2.0 billion of cash provided during 2016. The year-over-year increase in cash used in financing activities was due primarily to higher net repayments of commercial paper borrowings in 2017 as compared to 2016 (as the Company increased its commercial paper borrowings in 2016 for the Cepheid acquisition) as well as lower proceeds from the issuance of debt in 2017 as compared to 2016. These impacts were partially offset by lower repayments of long-term debt in 2017 as compared to the comparable period of 2016 as the Company used a portion of the proceeds from the Fortive Distribution to repay outstanding long-term indebtedness in August 2016. Financing activities provided cash of approximately $2.0 billion during 2016 compared to approximately $9.1 billion of cash provided during 2015. Cash provided by financing activities in 2016 primarily relates to approximately $3.4 billion of net proceeds received from the issuance of the Fortive Debt in June 2016 and the net issuance of outstanding borrowings with maturities of 90 days or less, primarily commercial paper borrowings, of approximately $2.2 billion, and the issuance of approximately ¥29.9 billion aggregate principal amount (approximately $262 million based on the currency exchange rate as of the date of the issuance) of 0.352% senior unsecured notes. These issuances were partially offset by the repayment of the $500 million aggregate principal amount of 2.3% senior unsecured notes that matured in June 2016, the repayment of approximately $1.9 billion in aggregate principal amount of outstanding indebtedness in August 2016 (consisting of the Redeemed Notes), the repayment of the CHF 120 million ($124 million) aggregate principal amount of the 4.0% senior unsecured notes due in October 2016 and $485 million of cash distributed to Fortive in connection with the Separation. Total debt was approximately $10.5 billion and $12.3 billion as of December 31, 2017 and 2016, respectively. The Company had the ability to incur an additional $1.6 billion of indebtedness in direct borrowings or under the outstanding commercial paper facility based on the amounts available under the Company’s $4.0 billion credit facility which were not being used to backstop outstanding commercial paper balances as of December 31, 2017. Refer to Note 9 to the Consolidated Financial Statements for information regarding the Company’s financing activities and indebtedness, including the Company’s outstanding debt as of December 31, 2017, and the Company’s commercial paper program and related credit facility. Shelf Registration Statement The Company has filed a “well-known seasoned issuer” shelf registration statement on Form S-3 with the SEC that registers an indeterminate amount of debt securities, common stock, preferred stock, warrants, depositary shares, purchase contracts and units for future issuance. The Company utilized this shelf registration statement for the offering and sale of the U.S. dollar and euro-denominated senior unsecured notes issued in 2015 and 2017. The Company expects to use net proceeds realized by the Company from future securities sales off this shelf registration statement for general corporate purposes, including without limitation repayment or refinancing of debt or other corporate obligations, acquisitions, capital expenditures, share repurchases and dividends and/or working capital. Stock Repurchase Program Please see “Issuer Purchases of Equity Securities” in Item 5 of Part II of this Annual Report for a description of the Company’s stock repurchase program. Dividends The Company declared a regular quarterly dividend of $0.14 per share that was paid on January 26, 2018 to holders of record on December 29, 2017. Aggregate cash payments for dividends during 2017 were $378 million. Dividend payments were lower in 2017 as compared to 2016 as the Company decreased the per share amount of its quarterly dividend in the third quarter of 2016 as a result of the Fortive Separation. For a description of the dividend of Fortive shares in July 2016, refer to Note 3 to the Consolidated Financial Statements. Cash and Cash Requirements As of December 31, 2017, the Company held $630 million of cash and cash equivalents that were invested in highly liquid investment-grade debt instruments with a maturity of 90 days or less with an approximate weighted average annual interest rate of 0.9%. Of this amount, $37 million was held within the United States and $593 million was held outside of the United States. The Company will continue to have cash requirements to support working capital needs, capital expenditures and acquisitions, pay interest and service debt, pay taxes and any related interest or penalties, fund its restructuring activities and pension plans as required, pay dividends to shareholders, repurchase shares of the Company’s common stock and support other business needs. The Company generally intends to use available cash and internally generated funds to meet these cash requirements, but in the event that additional liquidity is required, particularly in connection with acquisitions, the Company may also borrow under its commercial paper programs or credit facility, enter into new credit facilities and either borrow directly thereunder or use such credit facilities to backstop additional borrowing capacity under its commercial paper programs and/or access the capital markets. The Company also may from time to time access the capital markets to take advantage of favorable interest rate environments or other market conditions. While repatriation of some cash held outside the United States may be restricted by local laws, most of the Company’s foreign cash could be repatriated to the United States. Following enactment of the TCJA and the associated Transition Tax, in general, repatriation of cash to the United States can be completed with no incremental U.S. tax; however, repatriation of cash could subject the Company to non-U.S. jurisdictional taxes on distributions. The cash that the Company’s non-U.S. subsidiaries hold for indefinite reinvestment is generally used to finance foreign operations and investments, including acquisitions. The income taxes applicable to such earnings are not readily determinable or practicable. The Company continues to evaluate the impact of the TCJA on its election to indefinitely reinvest certain of its non-U.S. earnings. As of December 31, 2017, management believes that it has sufficient liquidity to satisfy its cash needs, including its cash needs in the United States. During 2017, the Company contributed $53 million to its U.S. defined benefit pension plans and $45 million to its non-U.S. defined benefit pension plans. During 2018, the Company’s cash contribution requirements for its U.S. and its non-U.S. defined benefit pension plans are expected to be approximately $30 million and $50 million, respectively. The ultimate amounts to be contributed depend upon, among other things, legal requirements, underlying asset returns, the plan’s funded status, the anticipated tax deductibility of the contribution, local practices, market conditions, interest rates and other factors. Contractual Obligations The following table sets forth, by period due or year of expected expiration, as applicable, a summary of the Company’s contractual obligations as of December 31, 2017 under (1) debt obligations, (2) leases, (3) purchase obligations and (4) other long-term liabilities reflected on the Company’s Consolidated Balance Sheet The amounts presented in the “Other long-term liabilities” line in the table below include $670 million of noncurrent gross unrecognized tax benefits and related interest (and do not include $66 million of current gross unrecognized tax benefits which are included in the “Accrued expenses and other liabilities” line on the Consolidated Balance Sheet). However, the timing of the long-term portion of these liabilities is uncertain, and therefore, they have been included in the “More Than 5 Years” column in the table below. Refer to Note 12 to the Consolidated Financial Statements for additional information on unrecognized tax benefits. Certain of the Company’s acquisitions also involve the potential payment of contingent consideration. The table below does not reflect any such obligations, as the timing and amounts of any such payments are uncertain. Refer to “-Off-Balance Sheet Arrangements” for a discussion of other contractual obligations that are not reflected in the table below. (a) As described in Note 9 to the Consolidated Financial Statements. (b) Amounts do not include interest payments. Interest on debt and capital lease obligations is reflected in a separate line in the table. (c) Interest payments on debt are projected for future periods using the interest rates in effect as of December 31, 2017. Certain of these projected interest payments may differ in the future based on changes in market interest rates. (d) As described in Note 15 to the Consolidated Financial Statements, certain leases require the Company to pay real estate taxes, insurance, maintenance and other operating expenses associated with the leased premises. These future costs are not included in the table above. (e) Consist of agreements to purchase goods or services that are enforceable and legally binding on the Company and that specify all significant terms, including fixed or minimum quantities to be purchased, fixed, minimum or variable price provisions and the approximate timing of the transaction. (f) Primarily consist of obligations under product service and warranty policies and allowances, performance and operating cost guarantees, estimated environmental remediation costs, self-insurance and litigation claims, postretirement benefits, pension obligations, deferred tax liabilities and deferred compensation obligations. The timing of cash flows associated with these obligations is based upon management’s estimates over the terms of these arrangements and is largely based upon historical experience. Off-Balance Sheet Arrangements Guarantees and Related Instruments The following table sets forth, by period due or year of expected expiration, as applicable, a summary of guarantees and related instruments of the Company as of December 31, 2017. Guarantees and related instruments consist primarily of outstanding standby letters of credit, bank guarantees and performance and bid bonds. These have been provided in connection with certain arrangements with vendors, customers, insurance providers, financing counterparties and governmental entities to secure the Company’s obligations and/or performance requirements related to specific transactions. Other Off-Balance Sheet Arrangements The Company has from time to time divested certain of its businesses and assets. In connection with these divestitures, the Company often provides representations, warranties and/or indemnities to cover various risks and unknown liabilities, such as claims for damages arising out of the use of products or relating to intellectual property matters, commercial disputes, environmental matters or tax matters. In particular, in connection with the 2016 Fortive Separation and the 2015 split-off of the Company’s communications business, Danaher entered into separation and distribution and related agreements pursuant to which Danaher agreed to indemnify the other parties against certain damages and expenses that might occur in the future. These indemnification obligations cover a variety of liabilities, including, but not limited to, employee, tax and environmental matters. The Company has not included any such items in the contractual obligations table above because they relate to unknown conditions and the Company cannot estimate the potential liabilities from such matters, but the Company does not believe it is reasonably possible that any such liability will have a material effect on the Company’s financial statements. In addition, as a result of these divestitures, as well as restructuring activities, certain properties leased by the Company have been sublet to third-parties. In the event any of these third-parties vacate any of these premises, the Company would be legally obligated under master lease arrangements. The Company believes that the financial risk of default by such sub-lessors is individually and in the aggregate not material to the Company’s Consolidated Financial Statements. In the normal course of business, the Company periodically enters into agreements that require it to indemnify customers, suppliers or other business partners for specific risks, such as claims for injury or property damage arising out of the Company’s products or services or claims alleging that Company products or services infringe third-party intellectual property. The Company has not included any such indemnification provisions in the contractual obligations table above. Historically, the Company has not experienced significant losses on these types of indemnification obligations. The Company’s Restated Certificate of Incorporation requires it to indemnify to the full extent authorized or permitted by law any person made, or threatened to be made a party to any action or proceeding by reason of his or her service as a director or officer of the Company, or by reason of serving at the request of the Company as a director or officer of any other entity, subject to limited exceptions. Danaher’s Amended and Restated By-laws provide for similar indemnification rights. In addition, Danaher has executed with each director and executive officer of Danaher Corporation an indemnification agreement which provides for substantially similar indemnification rights and under which Danaher has agreed to pay expenses in advance of the final disposition of any such indemnifiable proceeding. While the Company maintains insurance for this type of liability, a significant deductible applies to this coverage and any such liability could exceed the amount of the insurance coverage. Legal Proceedings Refer to “Item 3. Legal Proceedings” and Note 16 to the Consolidated Financial Statements for information regarding legal proceedings and contingencies, and for a discussion of risks related to legal proceedings and contingencies, refer to “Item 1A. Risk Factors.” CRITICAL ACCOUNTING ESTIMATES Management’s discussion and analysis of the Company’s financial condition and results of operations is based upon the Company’s Consolidated Financial Statements, which have been prepared in accordance with accounting principles generally accepted in the United States. The preparation of these financial statements requires management to make estimates and judgments that affect the reported amounts of assets, liabilities, revenues and expenses, and related disclosure of contingent assets and liabilities. The Company bases these estimates and judgments on historical experience, the current economic environment and on various other assumptions that are believed to be reasonable under the circumstances. Actual results may differ materially from these estimates and judgments. The Company believes the following accounting estimates are most critical to an understanding of its financial statements. Estimates are considered to be critical if they meet both of the following criteria: (1) the estimate requires assumptions about material matters that are uncertain at the time the estimate is made, and (2) material changes in the estimate are reasonably likely from period-to-period. For a detailed discussion on the application of these and other accounting estimates, refer to Note 1 to the Consolidated Financial Statements. Acquired Intangibles-The Company’s business acquisitions typically result in the recognition of goodwill, in-process R&D and other intangible assets, which affect the amount of future period amortization expense and possible impairment charges that the Company may incur. Refer to Notes 1, 2 and 6 to the Consolidated Financial Statements for a description of the Company’s policies relating to goodwill, acquired intangibles and acquisitions. In performing its goodwill impairment testing, the Company estimates the fair value of its reporting units primarily using a market-based approach. In evaluating the estimates derived by the market-based approach, management makes judgments about the relevance and reliability of the multiples by considering factors unique to its reporting units, including operating results, business plans, economic projections, anticipated future cash flows, and transactions and marketplace data as well as judgments about the comparability of the market proxies selected. In certain circumstances the Company also estimates fair value utilizing a discounted cash flow analysis (i.e., an income approach) in order to validate the results of the market approach. The discounted cash flow model requires judgmental assumptions about projected revenue growth, future operating margins, discount rates and terminal values. There are inherent uncertainties related to these assumptions and management’s judgment in applying them to the analysis of goodwill impairment. As of December 31, 2017, the Company had eight reporting units for goodwill impairment testing. Reporting units resulting from recent acquisitions generally present the highest risk of impairment. Management believes the impairment risk associated with these reporting units decreases as these businesses are integrated into the Company and better positioned for potential future earnings growth. The Company’s annual goodwill impairment analysis in 2017 indicated that in all instances, the fair values of the Company’s reporting units exceeded their carrying values and consequently did not result in an impairment charge. The excess of the estimated fair value over carrying value (expressed as a percentage of carrying value for the respective reporting unit) for each of the Company’s reporting units as of the annual testing date ranged from approximately 50% to approximately 600%. In order to evaluate the sensitivity of the fair value calculations used in the goodwill impairment test, the Company applied a hypothetical 10% decrease to the fair values of each reporting unit and compared those hypothetical values to the reporting unit carrying values. Based on this hypothetical 10% decrease, the excess of the estimated fair value over carrying value (expressed as a percentage of carrying value for the respective reporting unit) for each of the Company’s reporting units ranged from approximately 35% to approximately 530%. The Company reviews identified intangible assets for impairment whenever events or changes in circumstances indicate that the related carrying amounts may not be recoverable. The Company also tests intangible assets with indefinite lives at least annually for impairment. Determining whether an impairment loss occurred requires a comparison of the carrying amount to the sum of undiscounted cash flows expected to be generated by the asset. These analyses require management to make judgments and estimates about future revenues, expenses, market conditions and discount rates related to these assets. If actual results are not consistent with management’s estimates and assumptions, goodwill and other intangible assets may be overstated and a charge would need to be taken against net earnings which would adversely affect the Company’s Consolidated Financial Statements. Historically, the Company’s estimates of goodwill and intangible assets have been materially correct. Contingent Liabilities-As discussed in “Item 3. Legal Proceedings” and Note 16 to the Consolidated Financial Statements, the Company is, from time to time, subject to a variety of litigation and similar contingent liabilities incidental to its business (or the business operations of previously owned entities). The Company recognizes a liability for any contingency that is known or probable of occurrence and reasonably estimable. These assessments require judgments concerning matters such as litigation developments and outcomes, the anticipated outcome of negotiations, the number of future claims and the cost of both pending and future claims. In addition, because most contingencies are resolved over long periods of time, liabilities may change in the future due to various factors, including those discussed in Note 16 to the Consolidated Financial Statements. If the reserves established by the Company with respect to these contingent liabilities are inadequate, the Company would be required to incur an expense equal to the amount of the loss incurred in excess of the reserves, which would adversely affect the Company’s financial statements. Revenue Recognition-The Company derives revenues from the sale of products and services. Refer to Note 1 to the Consolidated Financial Statements for a description of the Company’s revenue recognition policies. Although most of the Company’s sales agreements contain standard terms and conditions, certain agreements contain multiple elements or nonstandard terms and conditions. As a result, judgment is sometimes required to determine the appropriate accounting, including whether the deliverables specified in these agreements should be treated as separate units of accounting for revenue recognition purposes, and, if so, how the consideration should be allocated among the elements and when to recognize revenue for each element. The Company allocates revenue to each element in the contractual arrangement based on the selling price hierarchy that, in some instances, may require the Company to estimate the selling price of certain deliverables that are not sold separately or where third-party evidence of pricing is not observable. The Company’s estimate of selling price impacts the amount and timing of revenue recognized in multiple element arrangements. The Company also enters into lease arrangements with customers, which requires the Company to determine whether the arrangements are operating or sales-type leases. Certain of the Company’s lease contracts are customized for larger customers and often result in complex terms and conditions that typically require significant judgment in applying the lease accounting criteria. On January 1, 2018, the Company adopted Accounting Standards Update (“ASU”) No. 2014-09, Revenue from Contracts with Customers (Topic 606), which supersedes nearly all existing revenue recognition guidance. Refer to ‘New Accounting Standards’ in Note 1 to the Consolidated Financial Statements for additional information on the Company’s adoption of this ASU. If the Company’s judgments regarding revenue recognition prove incorrect, the Company’s reported revenues in particular periods may be incorrect. Historically, the Company’s estimates of revenue have been materially correct. Pension and Other Postretirement Benefits-For a description of the Company’s pension and other postretirement benefit accounting practices, refer to Notes 10 and 11 to the Consolidated Financial Statements. Calculations of the amount of pension and other postretirement benefit costs and obligations depend on the assumptions used in the actuarial valuations, including assumptions regarding discount rates, expected return on plan assets, rates of salary increases, health care cost trend rates, mortality rates, and other factors. If the assumptions used in calculating pension and other postretirement benefits costs and obligations are incorrect or if the factors underlying the assumptions change (as a result of differences in actual experience, changes in key economic indicators or other factors) the Company’s Consolidated Financial Statements could be materially affected. A 50 basis point reduction in the discount rates used for the plans would have increased the U.S. net obligation by $146 million ($111 million on an after-tax basis) and the non-U.S. net obligation by $142 million ($107 million on an after-tax basis) from the amounts recorded in the Consolidated Financial Statements as of December 31, 2017. A 50 basis point increase in the discount rates used for the plans would have decreased the U.S. net obligation by $134 million ($102 million on an after-tax basis) and the non-U.S. net obligation by $137 million ($104 million on an after-tax basis) from the amounts recorded in the Consolidated Financial Statements as of December 31, 2017. For 2017, the estimated long-term rate of return for the U.S. plans is 7.0%, and the Company intends to continue to use an assumption of 7.0% for 2018. The estimated long-term rate of return for the non-U.S. plans was determined on a plan-by-plan basis based on the nature of the plan assets and ranged from 1.0% to 5.8%. If the expected long-term rate of return on plan assets for 2017 was reduced by 50 basis points, pension expense for the U.S. and non-U.S. plans for 2017 would have increased $9 million ($6 million on an after-tax basis) and $5 million ($4 million on an after-tax basis), respectively. For a discussion of the Company’s 2017 and anticipated 2018 defined benefit pension plan contributions, refer to “-Liquidity and Capital Resources - Cash and Cash Requirements”. Income Taxes-For a description of the Company’s income tax accounting policies, refer to Notes 1 and 12 to the Consolidated Financial Statements. The Company establishes valuation allowances for its deferred tax assets if it is more likely than not that some or all of the deferred tax asset will not be realized. This requires management to make judgments and estimates regarding: (1) the timing and amount of the reversal of taxable temporary differences, (2) expected future taxable income, and (3) the impact of tax planning strategies. Future changes to tax rates would also impact the amounts of deferred tax assets and liabilities and could have an adverse impact on the Company’s Consolidated Financial Statements. The Company provides for unrecognized tax benefits when, based upon the technical merits, it is “more likely than not” that an uncertain tax position will not be sustained upon examination. Judgment is required in evaluating tax positions and determining income tax provisions. The Company re-evaluates the technical merits of its tax positions and may recognize an uncertain tax benefit in certain circumstances, including when: (1) a tax audit is completed; (2) applicable tax laws change, including a tax case ruling or legislative guidance; or (3) the applicable statute of limitations expires. On December 22, 2017, the TCJA was enacted, which substantially changes the U.S. tax system, including lowering the corporate tax rate from 35% to 21% (beginning in 2018), and affected the Company in a number of ways. Under U.S. GAAP, the Company is required to account for tax legislation when the legislation is enacted. Accordingly, the Company has reflected the provisional estimate of changes from the TCJA in the Consolidated Financial Statements as of December 31, 2017 based upon the Company’s analysis of the legislation using available information. Certain assumptions related to the impact of the TCJA will require continued monitoring and further analysis including the amount of foreign cash and undistributed earnings subject to the Transition Tax, the amount of available credits to reduce required payments of the Transition Tax and the impact of estimated temporary differences between book and taxable income in 2017 or prior periods under audit by the IRS. Although the Company believes that its estimates and judgments are reasonable, actual results may differ materially from these estimates. The Company will continue to refine these estimates throughout 2018 and record any required adjustments as they are determined as permitted by SAB No. 118. The U.S. Treasury Department and the IRS have not yet issued regulations implementing the new tax law, and these regulations could result in changes to the Company’s estimates. Some or all of these judgments are also subject to review by the IRS. If the IRS were to successfully challenge the Company’s right to realize some or all of the tax benefit the Company has recorded, based on current interpretation of the law regarding certain items, or if the amount of the Transition Tax or other tax liabilities are understated, it could have a material adverse effect on the Company’s financial statements. In addition, certain of the Company’s tax returns are currently under review by tax authorities including in Denmark (refer to “-Results of Operations - Income Taxes” and Note 12 to the Consolidated Financial Statements). Management believes the positions taken in these returns are in accordance with the relevant tax laws. However, the outcome of these audits is uncertain and could result in the Company being required to record charges for prior year tax obligations which could have a material adverse impact to the Company’s Consolidated Financial Statements, including its effective tax rate. An increase of 1.0% in the Company’s 2017 nominal tax rate would have resulted in an additional income tax provision for continuing operations for the year ended December 31, 2017 of $29 million. NEW ACCOUNTING STANDARDS For a discussion of the new accounting standards impacting the Company, refer to Note 1 to the Consolidated Financial Statements.

<s>[INST] Overview Results of Operations Liquidity and Capital Resources Critical Accounting Estimates New Accounting Standards This discussion and analysis should be read along with Danaher’s audited financial statements and related Notes thereto as of December 31, 2017 and 2016 and for each of the three years in the period ended December 31, 2017 included in this Annual Report. OVERVIEW General Refer to “Item 1. BusinessGeneral” for a discussion of Danaher’s strategic objectives and methodologies for delivering longterm shareholder value. Danaher is a multinational business with global operations. During 2017, approximately 63% of Danaher’s sales were derived from customers outside the United States. As a diversified, global business, Danaher’s operations are affected by worldwide, regional and industryspecific economic and political factors. Danaher’s geographic and industry diversity, as well as the range of its products, software and services, help limit the impact of any one industry or the economy of any single country on its consolidated operating results. Given the broad range of products manufactured, software and services provided and geographies served, management does not use any indices other than general economic trends to predict the overall outlook for the Company. The Company’s individual businesses monitor key competitors and customers, including to the extent possible their sales, to gauge relative performance and the outlook for the future. As a result of the Company’s geographic and industry diversity, the Company faces a variety of opportunities and challenges, including rapid technological development (particularly with respect to computing, automation, artificial intelligence, mobile connectivity, communications and digitization) in most of the Company’s served markets, the expansion and evolution of opportunities in highgrowth markets, trends and costs associated with a global labor force, consolidation of the Company’s competitors and increasing regulation. The Company operates in a highly competitive business environment in most markets, and the Company’s longterm growth and profitability will depend in particular on its ability to expand its business in highgrowth geographies and highgrowth market segments, identify, consummate and integrate appropriate acquisitions, develop innovative and differentiated new products and services with higher gross profit margins, expand and improve the effectiveness of the Company’s sales force, continue to reduce costs and improve operating efficiency and quality, and effectively address the demands of an increasingly regulated global environment. The Company is making significant investments, organically and through acquisitions, to address the rapid pace of technological change in its served markets and to globalize its manufacturing, research and development and customerfacing resources (particularly in highgrowth markets) in order to be responsive to the Company’s customers throughout the world and improve the efficiency of the Company’s operations. Business Performance Consolidated sales for the year ended December 31, 2017 increased 8.5% as compared to 2016. While differences exist among the Company’s businesses, on an overall basis, demand for the Company’s products and services increased on a yearoveryear basis in 2017 as compared to 2016. This demand, together with the Company’s continued investments in sales growth initiatives and the other businessspecific factors discussed below, contributed to yearoveryear core sales growth of 3.5% (for the definition of “core sales,” refer to “Results of Operations” below). Geographically, both highgrowth and developed markets contributed to yearoveryear core sales growth during 2017. The Company defines highgrowth markets as developing markets of the world experiencing rapid growth in gross domestic product and infrastructure which includes Eastern Europe, the Middle East, Africa, Latin America and Asia (with the exception of Japan and Australia). Core sales growth rates in highgrowth markets grew at a highsingle digit rate in 2017 as compared to 2016 led by strength in China, India, Eastern Europe and Latin America, partially offset by weakness in the Middle East. Highgrowth markets represented approximately 30% of the Company’s total sales in 2017. Core sales in developed markets grew at a lowsingle digit rate in 2017 as compared to 2016 and were driven by North America and Western Europe. The Company’s income [/INST] Positive. </s>

DANAHER CORP /DE/

2019-02-21

2018-12-31

ITEM 7. MANAGEMENT’S DISCUSSION AND ANALYSIS OF FINANCIAL CONDITION AND RESULTS OF OPERATIONS Management’s Discussion and Analysis of Financial Condition and Results of Operations (“MD&A”) is designed to provide a reader of Danaher’s financial statements with a narrative from the perspective of Company management. The Company’s MD&A is divided into five sections: • Overview • Results of Operations • Liquidity and Capital Resources • Critical Accounting Estimates • New Accounting Standards This discussion and analysis should be read along with Danaher’s audited financial statements and related Notes thereto as of December 31, 2018 and 2017 and for each of the three years in the period ended December 31, 2018 included in this Annual Report. OVERVIEW General Refer to “Item 1. Business-General” for a discussion of Danaher’s strategic objectives and methodologies for delivering long-term shareholder value. Danaher is a multinational business with global operations. During 2018, approximately 63% of Danaher’s sales were derived from customers outside the United States. As a diversified, global business, Danaher’s operations are affected by worldwide, regional and industry-specific economic and political factors. Danaher’s geographic and industry diversity, as well as the range of its products, software and services, help limit the impact of any one industry or the economy of any single country on its consolidated operating results. Given the broad range of products manufactured, software and services provided and geographies served, management does not use any indices other than general economic trends to predict the overall outlook for the Company. The Company’s individual businesses monitor key competitors and customers, including to the extent possible their sales, to gauge relative performance and the outlook for the future. As a result of the Company’s geographic and industry diversity, the Company faces a variety of opportunities and challenges, including rapid technological development (particularly with respect to computing, automation, artificial intelligence, mobile connectivity, communications and digitization) in most of the Company’s served markets, the expansion and evolution of opportunities in high-growth markets, trends and costs associated with a global labor force, consolidation of the Company’s competitors and increasing regulation. The Company operates in a highly competitive business environment in most markets, and the Company’s long-term growth and profitability will depend in particular on its ability to expand its business in high-growth geographies and high-growth market segments, identify, consummate and integrate appropriate acquisitions, develop innovative and differentiated new products and services with higher gross profit margins, expand and improve the effectiveness of the Company’s sales force, continue to reduce costs and improve operating efficiency and quality, and effectively address the demands of an increasingly regulated global environment. The Company is making significant investments, organically and through acquisitions, to address the rapid pace of technological change in its served markets and to globalize its manufacturing, research and development and customer-facing resources (particularly in high-growth markets) in order to be responsive to the Company’s customers throughout the world and improve the efficiency of the Company’s operations. Business Performance Consolidated sales for the year ended December 31, 2018 increased 8.5% as compared to 2017. While differences exist among the Company’s businesses, on an overall basis, demand for the Company’s products and services increased on a year-over-year basis in 2018 as compared to 2017. This demand, together with the Company’s continued investments in sales growth initiatives and the other business-specific factors discussed below, contributed to year-over-year core sales growth of 6.0% (for the definition of “core sales,” refer to “-Results of Operations” below). Geographically, both high-growth and developed markets contributed to year-over-year core sales growth during 2018. Core sales growth rates in high-growth markets grew at a high-single digit rate in 2018 as compared to 2017 led by strength in Asia, particularly China. High-growth markets represented approximately 31% of the Company’s total sales in 2018. Core sales in developed markets grew at a mid-single digit rate in 2018 as compared to 2017 and were driven by North America and Western Europe. The Company’s net earnings from continuing operations for the year ended December 31, 2018 totaled approximately $2.7 billion, or $3.74 per diluted share, compared to approximately $2.5 billion, or $3.50 per diluted share for the year ended December 31, 2017. The Company recorded a net increase to beginning retained earnings of $3 million as of January 1, 2018 due to the cumulative impact of adopting Accounting Standards Update (“ASU”) No. 2014-09, Revenue from Contracts with Customers (Topic 606). The impact to beginning retained earnings was primarily driven by the capitalization of certain costs to obtain a contract, primarily sales-related commissions, partially offset by the deferral of revenue for unfulfilled performance obligations. The adoption of this ASU did not have a significant impact on the Company’s Consolidated Financial Statements as of and for the year ended December 31, 2018 and, as a result, comparisons of revenues and operating profit performance between periods are not affected by the adoption of this ASU. Refer to Note 2 to the accompanying Consolidated Financial Statements. Acquisitions During 2018, the Company acquired two businesses for total consideration of approximately $2.2 billion in cash, net of cash acquired. The businesses acquired complement existing units of the Company’s Life Sciences and Environmental & Applied Solutions segments. The aggregate annual sales of these two businesses at the time of their respective acquisitions, in each case based on the company’s revenues for its last completed fiscal year prior to the acquisition, were $313 million. For a discussion of the Company’s 2017 and 2016 acquisition and disposition activity, refer to “Liquidity and Capital Resources-Investing Activities”. Fortive Separation and Proposed Dental Separation On July 2, 2016, Danaher completed the Separation of its former Test & Measurement segment, Industrial Technologies segment (excluding the product identification businesses) and retail/commercial petroleum business by distributing to Danaher stockholders on a pro rata basis all of the issued and outstanding common stock of Fortive, the entity Danaher incorporated to hold such businesses. To effect the Fortive Separation, Danaher distributed to its stockholders one share of Fortive common stock for every two shares of Danaher common stock outstanding as of June 15, 2016, the record date for the distribution. During the second quarter of 2016, the Company received net cash distributions of approximately $3.0 billion from Fortive as consideration for the Company’s contribution of assets to Fortive in connection with the Separation (“Fortive Distribution”). Danaher used a portion of the cash distribution proceeds to repay the $500 million aggregate principal amount of 2.3% senior unsecured notes that matured in June 2016 and to redeem approximately $1.9 billion in aggregate principal amount of outstanding indebtedness in August 2016 (consisting of the Company’s 5.625% senior unsecured notes due 2018, 5.4% senior unsecured notes due 2019 and 3.9% senior unsecured notes due 2021 (collectively the “Redeemed Notes”)). Danaher also paid an aggregate of $188 million in make-whole premiums in connection with the August 2016 redemptions, plus accrued and unpaid interest. The Company used the balance of the Fortive Distribution to fund certain of the Company’s regular, quarterly cash dividends to shareholders. The accounting requirements for reporting the Fortive Separation as a discontinued operation were met when the separation was completed. Accordingly, the accompanying Consolidated Financial Statements for all periods presented reflect this business as a discontinued operation. The Company allocated a portion of the consolidated interest expense and income to discontinued operations based on the ratio of the discontinued business’ net assets to the Company’s consolidated net assets. Fortive had revenues of approximately $3.0 billion in 2016 prior to the Fortive Separation. As a result of the Fortive Separation, the Company incurred $48 million in Fortive Separation-related costs during the year ended December 31, 2016 which are included in earnings from discontinued operations, net of income taxes in the accompanying Consolidated Statement of Earnings. These Fortive Separation costs primarily relate to professional fees associated with preparation of regulatory filings and Separation activities within finance, tax, legal and information system functions as well as certain investment banking fees incurred upon the Fortive Separation. In 2017, Danaher recorded a $22 million income tax benefit related to the release of previously provided reserves associated with uncertain tax positions on certain Danaher tax returns which were jointly filed with Fortive entities. These reserves were released due to the expiration of statutes of limitations for those returns. All Fortive entity-related balances were included in the income tax benefit related to discontinued operations. In July 2018, the Company announced its intention to spin-off its Dental business into an independent publicly-traded company. The transaction is expected to be tax-free to the Company’s shareholders. The Company is targeting to complete the Dental Separation in the second half of 2019, subject to the satisfaction of certain conditions, including obtaining final approval from the Danaher Board of Directors, satisfactory completion of financing, receipt of tax opinions, receipt of favorable rulings from the IRS and receipt of other regulatory approvals. Sale of Investments For a discussion of the Company’s 2017 and 2016 sales of investments activity, refer to “Liquidity and Capital Resources-Investing Activities”. U.S. Tax Cuts and Jobs Act On December 22, 2017, the TCJA was enacted, which substantially changed the U.S. tax system, including lowering the corporate tax rate from 35.0% to 21.0% (beginning in 2018). As a result of the TCJA, the Company recognized a provisional tax liability of approximately $1.2 billion in 2017 for the Transition Tax, which, after the application of available tax credits of approximately $1.0 billion, is payable over a period of eight years. The net Transition Tax payable as of December 31, 2018 of approximately $180 million is not expected to significantly impact the Company’s cash flows from operations. The Company also remeasured U.S. deferred tax assets and liabilities based on the income tax rates at which the deferred tax assets and liabilities are expected to reverse in the future (generally 21.0%), resulting in an income tax benefit of approximately $1.2 billion. In 2018, the Company recorded an additional charge related to finalizing the provisional accounting for the enactment of the TCJA of $6 million. For further discussion of the TCJA, refer to “-Income Taxes.” UK’s referendum decision to exit the EU (“Brexit”) In a referendum on June 23, 2016, voters approved for the UK to exit the EU and the UK is expected to depart the EU on March 29, 2019. With the terms of the UK’s withdrawal and the nature of its future relationship with the EU still being decided, the Company continues to monitor the status of the negotiations and plan for any impact. The ultimate impact of Brexit on the Company’s financial results is uncertain. For additional information, refer to the “Item 1A - Risk Factors” section of this Annual Report. RESULTS OF OPERATIONS In this report, references to the non-GAAP measure of core sales (also referred to as core revenues or sales/revenues from existing businesses) refer to sales from continuing operations calculated according to generally accepted accounting principles in the United States (“GAAP”) but excluding: • sales from acquired businesses; and • the impact of currency translation. References to sales or operating profit attributable to acquisitions or acquired businesses refer to sales or operating profit, as applicable, from acquired businesses recorded prior to the first anniversary of the acquisition less the amount of sales and operating profit, as applicable, attributable to divested product lines not considered discontinued operations. The portion of revenue attributable to currency translation is calculated as the difference between: • the period-to-period change in revenue (excluding sales from acquired businesses); and • the period-to-period change in revenue (excluding sales from acquired businesses) after applying current period foreign exchange rates to the prior year period. Core sales growth should be considered in addition to, and not as a replacement for or superior to, sales, and may not be comparable to similarly titled measures reported by other companies. Management believes that reporting the non-GAAP financial measure of core sales growth provides useful information to investors by helping identify underlying growth trends in Danaher’s business and facilitating comparisons of Danaher’s revenue performance with its performance in prior and future periods and to Danaher’s peers. Management also uses core sales growth to measure the Company’s operating and financial performance. The Company excludes the effect of currency translation from core sales because currency translation is not under management’s control, is subject to volatility and can obscure underlying business trends, and excludes the effect of acquisitions and divestiture-related items because the nature, size, timing and number of acquisitions and divestitures can vary dramatically from period-to-period and between the Company and its peers and can also obscure underlying business trends and make comparisons of long-term performance difficult. Throughout this discussion, references to sales volume refer to the impact of both price and unit sales and references to productivity improvements generally refer to improved cost efficiencies resulting from the ongoing application of DBS. Core Revenue Core sales grew on a year-over-year basis in both 2018 and 2017. Sales from acquired businesses increased on a year-over-year basis in 2018 due primarily to the acquisition of IDT in the second quarter of 2018 and in 2017 due primarily to the acquisition of Cepheid in the fourth quarter of 2016. Currency translation increased reported sales on a year-over-year basis in 2018 primarily due to the U.S. dollar weakening against other major currencies in the first half of 2018, partially offset by the U.S. dollar strengthening in the second half of 2018. Currency translation increased reported sales on a year-over-year basis in 2017 primarily due to the U.S. dollar weakening against the euro, partially offset by the U.S. dollar strengthening against the Japanese yen and Chinese renminbi. Operating profit margins were 17.1% for the year ended December 31, 2018 as compared to 16.3% in 2017. The following factors impacted year-over-year operating profit margin comparisons. 2018 vs. 2017 operating profit margin comparisons were favorably impacted by: • Higher 2018 sales volumes from existing businesses and incremental year-over-year cost savings associated with the continuing productivity improvement initiatives taken in 2018 and 2017, net of incremental year-over-year costs associated with various product development, sales and marketing growth investments and the impact of foreign exchange rates - 70 basis points • Restructuring, impairment and other related charges related to discontinuing a product line in the second quarter of 2017 related to the Diagnostic segment - 40 basis points • Trade name impairments and related productivity improvement initiatives in 2017 related to the Dental segment - 5 basis points 2018 vs. 2017 operating profit margin comparisons were unfavorably impacted by: • The incremental net dilutive effect in 2018 of acquired businesses - 20 basis points • Costs incurred in the fourth quarter of 2018 related to the anticipated separation of the Dental business - 5 basis points • Acquisition-related charges consisting of transaction costs and fair value adjustments to inventory for the acquisition of IDT in the second quarter of 2018 - 10 basis points Operating profit margins were 16.3% for the year ended December 31, 2017 as compared to 16.2% in 2016. The following factors impacted year-over-year operating profit margin comparisons. 2017 vs. 2016 operating profit margin comparisons were favorably impacted by: • Higher 2017 sales volumes from existing businesses and incremental year-over-year cost savings associated with the continuing productivity improvement initiatives taken in 2017 and 2016, net of incremental year-over-year costs associated with various product development, sales and marketing growth investments in 2017 - 60 basis points • Acquisition-related charges consisting of transaction costs and fair value adjustments to inventory and deferred revenue for the acquisition of Cepheid in 2016 - 50 basis points 2017 vs. 2016 operating profit margin comparisons were unfavorably impacted by: • Restructuring, impairment and other related charges related to discontinuing a product line in the second quarter of 2017 related to the Diagnostic segment - 40 basis points • Trade name impairments and related productivity improvement initiatives in the fourth quarter of 2017 related to the Dental segment - 5 basis points • Third quarter 2016 gain on resolution of acquisition-related matters less the fourth quarter 2017 net gain on resolution of acquisition-related matters - 5 basis points • The incremental net dilutive effect in 2017 of acquired businesses - 50 basis points Business Segments Sales by business segment for the years ended December 31 are as follows ($ in millions): LIFE SCIENCES The Company’s Life Sciences segment offers a broad range of research tools that scientists use to study the basic building blocks of life, including genes, proteins, metabolites and cells, in order to understand the causes of disease, identify new therapies and test new drugs and vaccines. The segment is also a leading provider of filtration, separation and purification technologies to the biopharmaceutical, food and beverage, medical, aerospace, microelectronics and general industrial sectors. Life Sciences Selected Financial Data Core Revenue 2018 Compared to 2017 Price increases in the segment contributed 0.5% to revenue growth on a year-over-year basis during 2018 as compared with 2017 and are reflected as a component of the change in core revenue growth. Core sales of the business’ broad range of mass spectrometers continued to grow on a year-over-year basis led by strong sales growth in high-growth markets, particularly China and the rest of Asia, and in North America. This growth was led by demand in the clinical, applied and pharmaceutical end-markets and by demand for service offerings. Core sales of microscopy products continued to grow on a year-over-year basis with growth in demand across most major end-markets partially driven by recent new product releases. Geographically, demand for microscopy products increased in North America and high-growth markets, particularly China. Year-over-year core sales for the business’ flow cytometry and particle counting products continued to grow in 2018 across most major end-markets, led by increases in sales in North America, China and Western Europe. New product launches in 2018 also contributed to the increased demand in these markets. Core sales for filtration, separation and purification technologies grew on a year-over-year basis led by growth in biopharmaceuticals, microelectronics and fluid technology and asset protection end-markets. Geographically, core sales in filtration, separation and purification technologies were led by growth in Western Europe, North America and high-growth markets. Sales growth from acquisitions is primarily due to the acquisition of IDT in April 2018. IDT provides additional sales and earnings growth opportunities for the segment by expanding the segment’s product line diversity, including new product and service offerings in the area of genomics consumables. During 2018, IDT’s revenues grew on a year-over-year basis with growth across all major geographies and product lines. Operating profit margins increased 140 basis points during 2018 as compared to 2017. The following factors impacted year-over-year operating profit margin comparisons. 2018 vs. 2017 operating profit margin comparisons were favorably impacted by: • Higher 2018 sales volumes from existing businesses and incremental year-over-year cost savings associated with the continuing productivity improvement initiatives taken in 2018 and 2017, net of incremental year-over-year costs associated with various new product development, sales and marketing growth investments - 180 basis points • 2018 gain on resolution of acquisition-related matters - 20 basis points 2018 vs. 2017 operating profit margin comparisons were unfavorably impacted by: • The incremental net dilutive effect in 2018 of acquired businesses - 35 basis points • Acquisition-related charges consisting of transaction costs and fair value adjustments to inventory for the acquisition of IDT in the second quarter of 2018 - 25 basis points 2017 Compared to 2016 During the first quarter of 2017, a product line was transferred from the Life Sciences segment to the Environmental & Applied Solutions segment. While this change is not material to segment results in total, the resulting change in sales growth has been included in the “Acquisitions and other” line in the table above. Price increases in the segment contributed 0.5% to revenue growth on a year-over-year basis during 2017 as compared with 2016 and are reflected as a component of the change in core revenue growth. Core sales of the business’ broad range of mass spectrometers continued to grow on a year-over-year basis led by strong sales growth in the pharmaceutical market across Asia and North America as well as sales growth in the food and forensics markets across all major regions. This growth was partially offset by continuing declines in demand in the clinical market in North America. Core sales of microscopy products increased on a year-over-year basis with growth in demand across most end-markets particularly in Western Europe and the high-growth markets. Year-over-year sales for the business’ flow cytometry and particle counting products grew in 2017, primarily due to new product introductions and were led by increases in sales in North America, Western Europe and China. Core sales for filtration, separation and purification technologies grew on a year-over-year basis led by continued growth in biopharmaceuticals and microelectronics, partially offset by declines in the process, industrial and medical products particularly in the first half of 2017. Geographically, core sales in filtration, separation and purification technologies were primarily led by growth in North America and Asia, partially offset by declines in the Middle East largely due to a major project in 2016 which did not repeat in 2017. Operating profit margins increased 230 basis points during 2017 as compared to 2016. The following factors impacted year-over-year operating profit margin comparisons. 2017 vs. 2016 operating profit margin comparisons were favorably impacted by: • Higher 2017 sales volumes from existing businesses and incremental year-over-year cost savings associated with the continuing productivity improvement initiatives taken in 2017 and 2016, net of incremental year-over-year costs associated with various product development, sales and marketing growth investments and the effect of year-over-year changes in currency exchange rates - 205 basis points • Acquisition-related charges including transaction costs deemed significant, change in control and restructuring payments, and fair value adjustment to acquired inventory and deferred revenue - 10 basis points • The incremental net accretive effect in 2017 of acquired businesses and intersegment product line transfers - 20 basis points 2017 vs. 2016 operating profit margin comparisons were unfavorably impacted by: • Fourth quarter 2017 loss on resolution of acquisition-related matters - 5 basis points DIAGNOSTICS The Company’s Diagnostics segment offers analytical instruments, reagents, consumables, software and services that hospitals, physicians’ offices, reference laboratories and other critical care settings use to diagnose disease and make treatment decisions. Diagnostics Selected Financial Data Core Revenue 2018 Compared to 2017 Price in the segment negatively impacted sales growth by 0.5% on a year-over-year basis during 2018 as compared with 2017 and is reflected as a component of the change in core revenue growth. Core sales in the molecular diagnostics business increased on a year-over-year basis, driven by strong growth in both developed and high-growth markets. The molecular diagnostics business experienced particularly strong growth in the infectious disease product line driven in part by the severity of the flu season during the first quarter of 2018. Core sales in the clinical lab business increased on a year-over-year basis due to increased demand in the high-growth markets, led by China, partially offset by lower sales in Western Europe. The increased demand in the clinical lab business was driven by the immunoassay product line. Core sales in the acute care diagnostic business increased, driven by continued strong sales of blood gas and immunoassay product lines across most major geographies, led by the high-growth markets. Core sales in the pathology diagnostics business increased across most major geographies, led by North America, Western Europe and China. Demand for new products in the advanced staining and core histology product lines drove the increased core sales in the pathology diagnostics business. Operating profit margins increased 230 basis points during 2018 as compared to 2017. The following factors impacted year-over-year operating profit margin comparisons. 2018 vs. 2017 operating profit margin comparisons were favorably impacted by: • Higher 2018 sales volumes from existing businesses and incremental year-over-year cost savings associated with the continuing productivity improvement initiatives taken in 2018 and 2017, net of incremental year-over-year costs associated with various new product development, sales and marketing growth investments and the effect of year-over-year changes in currency exchange rates - 125 basis points • Restructuring, impairment and other related charges related to discontinuing a product line in 2017 - 130 basis points 2018 vs. 2017 operating profit margin comparisons were unfavorably impacted by: • 2017 gain on resolution of acquisition-related matters - 25 basis points 2017 Compared to 2016 Price increases in the segment contributed 0.5% to sales growth on a year-over-year basis during 2017 as compared with 2016 and are reflected as a component of the change in core revenue growth. Core sales in the clinical lab business increased on a year-over-year basis. Geographically, continued strong demand in high-growth markets for the clinical lab business was partially offset by declines in Western Europe and Japan. Increased demand in the immunoassay product line drove the majority of the growth for the year in the clinical lab business. Growth in the acute care diagnostic business was driven by continued strong consumable sales in 2017 across most major geographies. Increased demand for advanced staining and core histology instruments and related consumables across most major geographies drove the majority of the year-over-year core sales growth in the pathology diagnostics business. The acquisition of Cepheid in November 2016 contributed the majority of the increase in sales from acquisitions. During 2017, Cepheid’s revenues compared to the business’ 2016 results grew on a year-over-year basis in most major geographies and product lines. As Cepheid is integrated into the Company, a process that will continue over the next several years, the Company has realized and expects to realize cost savings and other business process improvements through the application of DBS. During 2017, the Company made the strategic decision to discontinue a molecular diagnostic product line in its Diagnostics segment. As a result, the Company recorded $76 million of pretax restructuring, impairment and other related charges ($51 million after-tax or $0.07 per diluted share). These charges included $49 million of noncash charges for the impairment of certain technology-related intangible assets as well as related inventory and property, plant and equipment with no further use. In addition, the Company incurred $27 million of cash restructuring costs primarily related to employee severance and related charges. Substantially all restructuring activities related to this discontinued product line were completed in 2017. Operating profit margins declined 70 basis points during 2017 as compared to 2016. The following factors impacted year-over-year operating profit margin comparisons. 2017 vs. 2016 operating profit margin comparisons were favorably impacted by: • Higher 2017 sales volumes from existing businesses and incremental year-over-year cost savings associated with the continuing productivity improvement initiatives taken in 2017 and 2016, net of incremental year-over-year costs associated with various new product development, sales and marketing growth investments and the effect of year-over-year changes in currency exchange rates - 35 basis points • Acquisition-related charges in 2016 associated with the acquisition of Cepheid, including transaction costs deemed significant, change in control and restructuring payments, and fair value adjustments to acquired inventory and deferred revenue - 150 basis points • 2017 gain on resolution of acquisition-related matters - 25 basis points 2017 vs. 2016 operating profit margin comparisons were unfavorably impacted by: • Restructuring, impairment and other related charges related to discontinuing a product line in 2017 - 130 basis points • The incremental net dilutive effect in 2017 of acquired businesses - 150 basis points Depreciation and amortization increased during 2017 as compared with 2016 primarily due to the impact of recently acquired businesses, primarily Cepheid, and the resulting increase in depreciable and amortizable assets. DENTAL The Company’s Dental segment offers products and services that are used to diagnose, treat and prevent disease and ailments of the teeth, gums and supporting bone, as well as to improve the aesthetics of the human smile. With leading brand names, innovative technology and significant market positions, the Company is a leading worldwide provider of a broad range of dental consumables, equipment and services, and is dedicated to driving technological innovations that help dental professionals improve clinical outcomes and enhance productivity. Dental Selected Financial Data Core Revenue 2018 Compared to 2017 Price in the segment negatively impacted sales growth by 0.5% on a year-over-year basis during 2018 as compared with 2017 and is reflected as a component of the change in core revenue growth. Geographically, year-over-year core revenue growth was driven by growth in the high-growth markets, primarily China and Russia, which was partially offset by declines in North America and Western Europe. Core revenue growth for the specialty consumables business, which consists of implant solutions and orthodontic products, was led by the high-growth markets, primarily China, and North America. Dental equipment and traditional dental consumables core sales declined during 2018, primarily due to declines in North America, offset partially by growth in the high-growth markets, primarily China and Russia. Lower core sales of dental equipment and traditional dental consumables product lines in North America partially offset the core revenue growth in the specialty consumables business, primarily reflecting the impact of inventory reductions at several distribution partners as well as the impact from realignment of distributors and manufacturers in the dental industry. The Company has begun to see stability in the North America end-markets for dental equipment and traditional dental consumables. Operating profit margins declined 210 basis points during 2018 as compared to 2017. The following factors impacted year-over-year operating profit margin comparisons. 2018 vs. 2017 operating profit margin comparisons were favorably impacted by: • Trade name impairments and related productivity improvement initiatives in 2017 - 45 basis points 2018 vs. 2017 operating profit margin comparisons were unfavorably impacted by: • Lower 2018 core sales volumes of traditional dental equipment and consumables, incremental year-over-year costs associated with sales and marketing growth investments, lower overall pricing, and the effect of year-over-year changes in currency exchange rates, net of incremental year-over-year cost savings associated with the continuing productivity improvement initiatives taken in 2018 and 2017 and higher sales volumes in specialty consumables - 245 basis points • The incremental net dilutive effect in 2018 of acquired businesses - 10 basis points In July 2018, the Company announced its intention to spin-off its Dental business into an independent publicly-traded company. The transaction is expected to be tax-free to the Company’s shareholders. The Company is targeting to complete the Dental Separation in the second half of 2019, subject to the satisfaction of certain conditions, including obtaining final approval from the Danaher Board of Directors, satisfactory completion of financing, receipt of tax opinions, receipt of favorable rulings from the IRS and receipt of other regulatory approvals. 2017 Compared to 2016 Price increases in the segment did not have a significant impact on sales growth on a year-over-year basis during 2017 as compared with 2016. Geographically, year-over-year core revenue growth was strong in China, Russia and other high-growth markets, offset by lower demand in the United States and Western Europe. Strong year-over-year growth continued during 2017 for the specialty consumables business, which consists of implant solutions and orthodontic products. Core sales growth for the specialty consumables business was led by high-growth markets and North America. Dental equipment core sales were essentially flat during 2017, as increased demand in high-growth markets was offset by weaker demand in the United States and Western Europe, particularly later in the year for North America due to the realignment of dental equipment distributors and manufacturers. Demand was lower for traditional dental consumable product lines in North America and Western Europe reflecting inventory destocking by several distribution partners. Operating profit margins declined 80 basis points during 2017 as compared to 2016. The following factors unfavorably impacted year-over-year operating profit margin comparisons: • Incremental year-over-year costs associated with various new product development, sales and marketing growth investments, the effect of year-over-year changes in currency exchange rates and unfavorable product mix due to lower sales of dental consumables in 2017, net of incremental year-over-year cost savings associated with the continuing productivity improvement initiatives taken in 2017 and 2016 - 35 basis points • Trade name impairments and related productivity improvement initiatives in 2017 - 35 basis points • The incremental net dilutive effect in 2017 of acquired businesses - 10 basis points ENVIRONMENTAL & APPLIED SOLUTIONS The Company’s Environmental & Applied Solutions segment offers products and services that help protect important resources and keep global food and water supplies safe. The Company’s water quality business provides instrumentation, services and disinfection systems to help analyze, treat and manage the quality of ultra-pure, potable, industrial, waste, ground, source and ocean water in residential, commercial, municipal, industrial and natural resource applications. The Company’s product identification business provides equipment, software, services and consumables for various color and appearance management, packaging design and quality management, packaging converting, printing, marking, coding and traceability applications for consumer, pharmaceutical and industrial products. Environmental & Applied Solutions Selected Financial Data Core Revenue 2018 Compared to 2017 Price increases in the segment contributed 1.5% to sales growth on a year-over-year basis during 2018 as compared with 2017 and are reflected as a component of the change in core revenue growth. Core sales in the segment’s water quality businesses grew at a high-single digit rate during 2018 as compared with 2017. Year-over-year core sales in the analytical instrumentation product line increased, led by continued demand in the industrial and municipal end-markets. Geographically, year-over-year core revenue growth in the analytical instrumentation product line was driven by increased demand across all major geographies, led by China, North America and Western Europe. Year-over-year core revenue growth in the business’ chemical treatment solutions product line was driven by demand in the commercial and industrial, mining and primary metals end-markets. Geographically, year-over-year core revenue growth in the chemical treatment solutions product line was driven by North America and Latin America. Core sales in the business’ ultraviolet water disinfection product line grew on a year-over-year basis due primarily to demand in the municipal and consumer end-markets. Geographically, year-over year core revenue growth in the ultraviolet water disinfection product line was led by North America and China, partially offset by softer demand in Western Europe. Core sales in the segment’s product identification businesses grew at a mid-single digit rate during 2018 as compared with 2017. Year-over-year core revenue growth for marking and coding equipment and related consumables was driven by demand across all major end-markets and in all major geographies, particularly Western Europe, North America and high-growth markets. Demand for the business’ packaging and color solutions decreased slightly year-over-year. Geographically, core sales for packaging and color solutions decreased in North America and high-growth markets, partially offset by increased demand in Western Europe. Operating profit margins declined 10 basis points during 2018 as compared to 2017. The following factors impacted year-over-year operating profit margin comparisons: 2018 vs. 2017 operating profit margin comparisons were favorably impacted by: • Higher 2018 sales volumes, incremental year-over-year cost savings associated with the continuing productivity improvement initiatives taken in 2018 and 2017, and improved pricing, net of incremental year-over-year costs associated with various new product development and sales and marketing growth investments - 35 basis points 2018 vs. 2017 operating profit margin comparisons were unfavorably impacted by: • The incremental net dilutive effect in 2018 of acquired businesses - 45 basis points 2017 Compared to 2016 During the first quarter of 2017, a product line was transferred from the Life Sciences segment to the Environmental & Applied Solutions segment. While this change is not material to segment results in total, the resulting change in sales growth has been included in the “Acquisitions and other” line in the table above. Price increases in the segment contributed 1.0% to sales growth on a year-over-year basis during 2017 as compared with 2016 and are reflected as a component of the change in core revenue growth. Core sales in the segment’s water quality businesses grew at a low-single digit rate during 2017 as compared with 2016. Year-over-year core sales in the analytical instrumentation product line grew, as increased demand in the industrial and municipal end-markets was partially offset by lower demand in the environmental end-markets. Geographically, year-over-year core revenue growth in the analytical instrumentation product line was driven by increased demand in China, Western Europe and North America, partially offset by lower demand in the Middle East and Latin America. Year-over-year core revenue growth in the business’ chemical treatment solutions product line was due primarily to an expansion of the customer base in the United States, driven by higher demand in food, steel and oil and gas-related end-markets. Core sales in the business’ ultraviolet water disinfection product line grew on a year-over-year basis due primarily to higher demand in municipal and industrial end-markets in North America, Western Europe and Asia. Core sales in the segment’s product identification businesses grew at a mid-single digit rate during 2017 as compared with 2016. Continued strong year-over-year demand for marking and coding equipment and related consumables in most major geographies, led by North America and Western Europe, drove the majority of the core revenue growth. Demand for the business’ packaging and color solutions also increased year-over-year. Geographically, core revenue growth for packaging and color solutions was led by North America, Western Europe and Asia. Operating profit margins declined 60 basis points during 2017 as compared to 2016. The following factors impacted year-over-year operating profit margin comparisons: 2017 vs. 2016 operating profit margin comparisons were favorably impacted by: • Higher 2017 sales volumes, incremental year-over-year cost savings associated with the continuing productivity improvement initiatives taken in 2017 and 2016, improved pricing and the effect of year-over-year changes in currency exchange rates, net of incremental year-over-year costs associated with various new product development and sales and marketing growth investments - 5 basis points 2017 vs. 2016 operating profit margin comparisons were unfavorably impacted by: • The incremental net dilutive effect in 2017 of acquired businesses - 65 basis points COST OF SALES AND GROSS PROFIT The year-over-year increase in cost of sales during 2018 as compared with 2017 is due primarily to the impact of higher year-over-year sales volumes, including sales from recently acquired businesses, partially offset by incremental year-over-year cost savings associated with the continued productivity improvement actions taken in 2018 and 2017 and charges associated with the Company’s strategic decision to discontinue a product line in its Diagnostics segment in 2017. Cost of goods sold also increased as a result of tariffs in 2018, and tariffs are estimated to have a modest impact on cost of goods sold in 2019. The year-over-year increase in cost of sales during 2017 as compared with 2016, is due primarily to the impact of higher year-over-year sales volumes, including sales from recently acquired businesses and the impact of restructuring, impairment and other related charges associated with the Company’s strategic decision to discontinue a product line in its Diagnostics segment. This increase in cost of sales was partially offset by year-over-year cost savings at recently acquired businesses, incremental year-over-year cost savings associated with the continued productivity improvement actions taken in 2017 and 2016, and the year-over-year decrease in acquisition-related charges associated with fair value adjustments to acquired inventory which decreased cost of sales by $21 million during 2017 as compared to 2016. The year-over-year increase in gross profit margins during 2018 as compared with 2017 is due primarily to the favorable impact of higher year-over-year sales volumes, including sales from recently acquired businesses, increased leverage of certain manufacturing costs and incremental year-over-year cost savings associated with the continuing productivity improvements taken in 2018 and 2017. Gross margin improvements were partially offset by the impact of foreign exchange rates in 2018. The year-over-year increase in gross profit margins during 2017 as compared with 2016 is due primarily to the favorable impact of higher year-over-year sales volumes, incremental year-over-year cost savings associated with the continuing productivity improvements taken in 2017 and 2016. In addition, the acquisition-related charges associated with fair value adjustments to acquired inventory and deferred revenue were higher in 2016 than 2017, which improved gross profit margins by 10 basis points during 2017 as compared with 2016. OPERATING EXPENSES SG&A expenses as a percentage of sales declined 60 basis points on a year-over-year basis for 2018 compared with 2017. The decline was driven by increased leverage of the Company’s general and administrative cost base resulting from higher 2018 sales volumes, continuing productivity improvements taken in 2018 and 2017, and the impact of the restructuring, impairment and other related charges incurred in 2017 associated with the Company’s strategic decision to discontinue a product line in its Diagnostics segment. The decline in SG&A expenses as a percentage of sales was partially offset by higher relative spending levels at recently acquired companies and continued investments in sales and marketing growth initiatives. SG&A expenses as a percentage of sales declined 20 basis points on a year-over-year basis for 2017 compared with 2016. The decline was driven by increased leverage of the Company’s general and administrative cost base resulting from higher 2017 sales volumes, continuing productivity improvements taken in 2017 and 2016 as well as the benefit of lower acquisition charges in 2017 compared to 2016, particularly change in control payments and restructuring costs in connection with the acquisition of Cepheid. The decline in SG&A expenses as a percentage of sales was partially offset by restructuring, impairment and other related charges associated with the Company’s strategic decision to discontinue a product line in its Diagnostics segment, higher relative spending levels at recently acquired companies, primarily Cepheid, and continued investments in sales and marketing growth initiatives. R&D expenses (consisting principally of internal and contract engineering personnel costs) as a percentage of sales remained consistent in 2018 as compared with 2017 as year-over-year increases in spending in the Company’s new product development initiatives corresponded to the increase in sales. R&D expenses as a percentage of sales increased in 2017 as compared to 2016 due primarily to higher R&D expenses as a percentage of sales in the businesses most recently acquired, primarily Cepheid, as well as year-over-year increases in spending in the Company’s new product development initiatives. NONOPERATING INCOME (EXPENSE) As described in Note 1 and Note 11, in the first quarter of 2018, the Company adopted ASU No. 2017-07, Compensation- Retirement Benefits (Topic 715): Improving the Presentation of Net Periodic Pension Cost and Net Periodic Postretirement Benefit Cost. The ASU requires the Company to disaggregate the service cost component from the other components of net periodic benefit costs and requires the Company to present the other components of net periodic benefit cost in other income, net. The ASU also requires application on a retrospective basis. The other components of net periodic benefit costs included in other income, net for the years ended December 31, 2018, 2017 and 2016 were net gains of $37 million, $31 million and $16 million, respectively. During 2017, the Company received $138 million of cash proceeds and recorded $22 million in short-term other receivables from the sale of certain marketable equity securities during 2017. The Company recorded a pretax gain related to this sale of $73 million ($46 million after-tax or $0.06 per diluted share). During 2016, the Company received cash proceeds of $265 million from the sale of certain marketable equity securities and recorded a pretax gain related to this sale of $223 million ($140 million after-tax or $0.20 per diluted share). During 2016, the Company also paid $188 million of make-whole premiums associated with the early extinguishment of the Redeemed Notes. The Company recorded a loss on extinguishment of these borrowings, net of certain deferred gains, of $179 million ($112 million after-tax or $0.16 per diluted share). INTEREST COSTS Interest expense of $157 million for 2018 was $5 million lower than in 2017, due primarily to the decrease in interest costs as a result of the repayment of certain outstanding borrowings in the third quarter of 2018 and the second and fourth quarters of 2017, lower average outstanding U.S. commercial paper borrowings during 2018 compared to 2017, and the impact of foreign currency exchange rates in 2018 as compared to 2017, partially offset by the cost of additional non-U.S. debt issued during 2017. For a further description of the Company’s debt as of December 31, 2018 refer to Note 10 to the Consolidated Financial Statements. Interest expense of $163 million in 2017 was $21 million lower than the 2016 interest expense of $184 million due primarily to the decrease in interest costs as a result of the early extinguishment of certain outstanding borrowings in the third quarter of 2016 using the proceeds from the Fortive Distribution and lower commercial paper borrowings in 2017 compared to 2016, partially offset by the cost of additional long-term debt refinancing relating to the acquisition of Cepheid. In January 2019, the Company entered into approximately $1.9 billion of cross-currency swap derivative contracts on its U.S. dollar-denominated bonds to effectively convert the Company’s U.S. dollar-denominated bonds to obligations denominated in Danish kroner, Japanese yen, euro and Swiss franc. Based on the interest rates of the swaps and current currency exchange rates, the Company expects these contracts to effectively reduce the Company’s interest expense in 2019 by approximately $35 million versus the stated interest rates on the U.S. dollar denominated debt. INCOME TAXES General Income tax expense and deferred tax assets and liabilities reflect management’s assessment of future taxes expected to be paid on items reflected in the Company’s Consolidated Financial Statements. The Company records the tax effect of discrete items and items that are reported net of their tax effects in the period in which they occur. The Company’s effective tax rate can be affected by changes in the mix of earnings in countries with different statutory tax rates (including as a result of business acquisitions and dispositions), changes in the valuation of deferred tax assets and liabilities, accruals related to contingent tax liabilities and period-to-period changes in such accruals, the results of audits and examinations of previously filed tax returns (as discussed below), the expiration of statutes of limitations, the implementation of tax planning strategies, tax rulings, court decisions, settlements with tax authorities and changes in tax laws and regulations, including the TCJA and legislative policy changes that may result from the OECD’s initiative on Base Erosion and Profit Shifting. For a description of the tax treatment of earnings that are planned to be reinvested indefinitely outside the United States, refer to “-Liquidity and Capital Resources-Cash and Cash Requirements” below. The amount of income taxes the Company pays is subject to ongoing audits by federal, state and foreign tax authorities, which often result in proposed assessments. Management performs a comprehensive review of its global tax positions on a quarterly basis. Based on these reviews, the results of discussions and resolutions of matters with certain tax authorities, tax rulings and court decisions and the expiration of statutes of limitations, reserves for contingent tax liabilities are accrued or adjusted as necessary. For a discussion of risks related to these and other tax matters, refer to “Item 1A. Risk Factors”. On December 22, 2017, the TCJA was enacted, substantially changing the U.S. tax system and affecting the Company in a number of ways. Notably, the TCJA: • established a flat corporate income tax rate of 21.0% on U.S. earnings; • imposed a one-time tax on unremitted cumulative non-U.S. earnings of foreign subsidiaries, which we refer to in this Annual Report as the Transition Tax; • imposes a new minimum tax on certain non-U.S. earnings, irrespective of the territorial system of taxation, and generally allows for the repatriation of future earnings of foreign subsidiaries without incurring additional U.S. taxes by transitioning to a territorial system of taxation; • subjects certain payments made by a U.S. company to a related foreign company to certain minimum taxes (Base Erosion Anti-Abuse Tax); • eliminated certain prior tax incentives for manufacturing in the United States and creates an incentive for U.S. companies to sell, lease or license goods and services abroad by allowing for a reduction in taxes owed on earnings related to such sales; • allows the cost of investments in certain depreciable assets acquired and placed in service after September 27, 2017 to be immediately expensed; and • reduces deductions with respect to certain compensation paid to specified executive officers. While the changes from the TCJA were generally effective beginning in 2018, GAAP accounting for income taxes requires the effect of a change in tax laws or rates to be recognized in income from continuing operations for the period that includes the enactment date. Due to the complexities involved in accounting for the enactment of the TCJA, SEC Staff Accounting Bulletin No. 118 (“SAB No. 118”) allowed the Company to record provisional amounts in earnings for the year ended December 31, 2017. Where reasonable estimates could be made, the provisional accounting was based on such estimates. When no reasonable estimate could be made, SAB No. 118 required the accounting to be based on the tax law in effect before the TCJA. The Company was required to complete its tax accounting for the TCJA when it had obtained, prepared and analyzed the information to complete the income tax accounting but no later than December 22, 2018. Accordingly, during 2018, the Company completed its accounting for the tax effects of the enactment of the TCJA based on the Company’s interpretation of the new tax regulations and related guidance issued by the U.S. Department of the Treasury and the IRS. • The Transition Tax is based on the Company’s post-1986 earnings and profits that were previously deferred from U.S. income taxes. In the year ended December 31, 2017, the Company recorded a provision amount for the Transition Tax expense resulting in an increase in income tax expense of approximately $1.2 billion. During 2018, the Company finalized the calculations of the Transition Tax liability and increased the provisional amount recorded in 2017 by $40 million, with the increase included as a component of income tax expense from continuing operations in 2018. Regulations allow the Company to reduce the Transition Tax payable by applying available foreign tax credits and other tax attributes. The Company has elected to pay the net Transition Tax payable over an eight-year period as permitted by the TCJA. As of December 31, 2018, the remaining Transition Tax balance to be paid over the next seven years is approximately $180 million. • In connection with finalizing the calculation of tax credits available to reduce the Transition Tax and other U.S. taxable income, the Company recorded an additional provision of $13 million related to net unrealizable credits which is included as a component of income tax expense from continuing operations in 2018. • U.S. deferred tax assets and liabilities were remeasured as of December 31, 2017 based upon the tax rates at which the assets and liabilities are expected to reverse in the future, which is generally 21.0%, resulting in an income tax benefit of approximately $1.2 billion in 2017. Upon finalizing the provisional accounting for the remeasurement of U.S. deferred tax assets and liabilities in 2018, the Company recorded an additional tax benefit of $47 million, which is included as a component of income tax expense from continuing operations. • The TCJA imposes tax on U.S. shareholders for global intangible low-taxed income (“GILTI”) earned by certain foreign subsidiaries. The Company is required to make an accounting policy election of either: (1) treating taxes due on future amounts included in U.S. taxable income related to GILTI as a current period tax expense when incurred (the “period cost method”); or (2) factoring such amounts into the Company’s measurement of its deferred tax expense (the “deferred method”). As of December 31, 2017, the Company was still analyzing its global income and did not record a GILTI-related deferred tax amount. In 2018, the Company elected the period cost method for its accounting for GILTI. Due to the complexity and recent issuance of these tax regulations, management’s interpretations of the impact of these rules could be subject to challenge by the taxing authorities. Year-Over-Year Changes in the Tax Provision and Effective Tax Rate The Company’s effective tax rate for 2018, 2017 and 2016 differs from the U.S. federal statutory rates of 21.0% for 2018 and 35.0% for 2017 and 2016, due principally to the Company’s earnings outside the United States that are indefinitely reinvested and taxed at rates different than the U.S. federal statutory rate. In addition: • The effective tax rate of 19.5% in 2018 includes 70 basis points of tax benefits primarily related to the release of reserves upon the expiration of statutes of limitation, audit settlements and release of valuation allowance in a certain foreign tax jurisdiction. These tax benefits were partially offset by additional provisions related to completing the accounting for the enactment of the TCJA as summarized above and tax costs directly related to reorganization activities associated with preparing for the Dental Separation. • The effective tax rate of 16.0% in 2017 includes 500 basis points of net tax benefits due to the revaluation of deferred tax liabilities from 35.0% to 21.0% due to the TCJA and the release of reserves upon statute of limitation expiration, partially offset by income tax expense related to the Transition Tax on foreign earnings due to the TCJA and changes in estimates associated with prior period uncertain tax positions. • The effective tax rate of 17.5% in 2016 includes 350 basis points of net tax benefits from permanent foreign exchange losses and the release of reserves upon the expiration of statutes of limitation and audit settlements, partially offset by income tax expense related to repatriation of earnings and legal entity realignments associated with the Fortive Separation and changes in estimates associated with prior period uncertain tax positions. The Company conducts business globally, and files numerous consolidated and separate income tax returns in the U.S. federal, state and foreign jurisdictions. The non-U.S. countries in which the Company has a significant presence include China, Denmark, Germany, Singapore, Switzerland and the United Kingdom. The Company believes that a change in the statutory tax rate of any individual foreign country would not have a material effect on the Company’s Consolidated Financial Statements given the geographic dispersion of the Company’s taxable income. The Company and its subsidiaries are routinely examined by various domestic and international taxing authorities. The IRS has completed substantially all of the examinations of the Company’s federal income tax returns through 2011 and is currently examining certain of the Company’s federal income tax returns for 2012 through 2015. In addition, the Company has subsidiaries in Austria, Belgium, Canada, China, Denmark, Finland, France, Germany, Hong Kong, India, Italy, Japan, New Zealand, Sweden, Switzerland, the United Kingdom and various other countries, states and provinces that are currently under audit for years ranging from 2004 through 2017. In the fourth quarter of 2018, the IRS proposed significant adjustments to the Company’s taxable income for the years 2012 through 2015 with respect to the deferral of tax on certain premium income related to the Company’s self-insurance programs. The proposed adjustments would increase the Company’s taxable income over the 2012 through 2015 period by approximately $960 million. In addition, as of December 31, 2018, the IRS has notified the Company that it is considering additional taxable income adjustments related to other aspects of the Company’s self-insurance programs for the years 2012 through 2015. These additional proposed adjustments would increase the Company’s taxable income by approximately $1.7 billion. Management believes the positions the Company has taken in its U.S. tax returns are in accordance with the relevant tax laws, intends to vigorously defend these positions and is currently considering all of its alternatives. Due to the enactment of the TCJA in 2017 and the resulting reduction in the U.S. corporate tax rate for years after 2017, the Company revalued its deferred tax liabilities related to the temporary differences associated with this deferred premium income from 35.0% to 21.0%. If the Company is not successful in defending these assessments, the taxes owed to the IRS may be computed under the previous 35.0% statutory tax rate and the Company may be required to revalue the related deferred tax liabilities from 21.0% to 35.0%, which in addition to any interest due on the amounts assessed, would require a charge to future earnings. The ultimate resolution of this matter is uncertain, could take many years and could result in a material adverse impact to the Company’s Consolidated Financial Statements, including its cash flows and effective tax rate. Tax authorities in Denmark have raised significant issues related to interest accrued by certain of the Company’s subsidiaries. On December 10, 2013, the Company received assessments from the Danish tax authority (“SKAT”) totaling approximately DKK 1.6 billion (approximately $247 million based on exchange rates as of December 31, 2018) including interest through December 31, 2018, imposing withholding tax relating to interest accrued in Denmark on borrowings from certain of the Company’s subsidiaries for the years 2004 through 2009. The Company is currently in discussions with SKAT and anticipates receiving an assessment for years 2010 through 2012 totaling approximately DKK 954 million (approximately $146 million based on exchange rates as of December 31, 2018) including interest through December 31, 2018. Management believes the positions the Company has taken in Denmark are in accordance with the relevant tax laws and is vigorously defending its positions. The Company appealed these assessments with the National Tax Tribunal in 2014 and intends on pursuing this matter through the European Court of Justice should this appeal be unsuccessful. The ultimate resolution of this matter is uncertain, could take many years, and could result in a material adverse impact to the Company’s Consolidated Financial Statements, including its cash flows and effective tax rate. After considering the effect of the TCJA, the Company expects its 2019 effective tax rate to be approximately 19.5%. Any future legislative changes in the United States including new regulations related to the TCJA or potential tax reform in other jurisdictions, could cause the Company’s effective tax rate to differ from this estimate. Refer to Note 13 to the Consolidated Financial Statements for additional information related to income taxes. DISCONTINUED OPERATIONS As further discussed in Note 4 to the Consolidated Financial Statements, discontinued operations include the results of the Fortive businesses which were disposed of during the third quarter of 2016. In 2017, Danaher recorded a $22 million income tax benefit related to the release of previously provided reserves associated with uncertain tax positions on certain Danaher tax returns which were jointly filed with Fortive entities. These reserves were released due to the expiration of statutes of limitations for those returns. All Fortive entity-related balances were included in the income tax benefit related to discontinued operations. In 2016, earnings from discontinued operations, net of income taxes, were $400 million and reflected the operating results of the Fortive businesses prior to the Fortive Separation. COMPREHENSIVE INCOME Comprehensive income decreased by approximately $1.5 billion in 2018 as compared to 2017, primarily due to a loss from foreign currency translation adjustments in 2018 compared to a gain in 2017 and a loss from pension and postretirement plan benefit adjustments as compared to a gain in 2017, partially offset by higher net earnings from continuing operations and a decrease in unrealized losses on available-for-sale securities in 2018 compared to 2017. The Company recorded a foreign currency translation loss of $632 million for 2018 compared to a translation gain of $976 million for 2017. The Company recorded a pension and postretirement plan benefit loss of $13 million for 2018 compared to a gain of $71 million for 2017. These negative impacts were partially offset by higher net earnings in 2018 compared to 2017. Comprehensive income increased by approximately $1.7 billion in 2017 as compared to 2016, primarily due to increased earnings from continuing operations, an increased gain from foreign currency translation adjustments compared to 2016, pension and postretirement plan benefit adjustments and the decrease in unrealized losses on available-for-sale securities, partially offset by lower net earnings attributable to discontinued operations in 2017 compared to 2016. The Company recorded a foreign currency translation gain of $976 million for 2017 compared to a translation loss of $517 million for 2016. The Company recorded a pension and postretirement plan benefit gain of $71 million in 2017 compared to a loss of $58 million in 2016. INFLATION The effect of inflation on the Company’s revenues and net earnings was not significant in any of the years ended December 31, 2018, 2017 or 2016. FINANCIAL INSTRUMENTS AND RISK MANAGEMENT The Company is exposed to market risk from changes in interest rates, foreign currency exchange rates, equity prices and commodity prices as well as credit risk, each of which could impact its Consolidated Financial Statements. The Company generally addresses its exposure to these risks through its normal operating and financing activities. The Company may periodically use derivative financial instruments to manage foreign exchange risks. In addition, the Company’s broad-based business activities help to reduce the impact that volatility in any particular area or related areas may have on its operating profit as a whole. Interest Rate Risk The Company manages interest cost using a mixture of fixed-rate and variable-rate debt. A change in interest rates on long-term debt impacts the fair value of the Company’s fixed-rate long-term debt but not the Company’s earnings or cash flow because the interest on such debt is fixed. Generally, the fair market value of fixed-rate debt will increase as interest rates fall and decrease as interest rates rise. As of December 31, 2018, an increase of 100 basis points in interest rates would have decreased the fair value of the Company’s fixed-rate long-term debt (excluding the LYONs, which have not been included in this calculation as the value of this convertible debt is primarily derived from the value of its underlying common stock) by $460 million. As of December 31, 2018, the Company’s variable-rate debt obligations consisted primarily of U.S. dollar and euro-based commercial paper borrowings (refer to Note 10 to the Consolidated Financial Statements for information regarding the Company’s outstanding commercial paper balances as of December 31, 2018). As a result, the Company’s primary interest rate exposure results from changes in short-term interest rates. As these shorter duration obligations mature, the Company may issue additional short-term commercial paper obligations to refinance all or part of these borrowings. In 2018, the average annual interest rate associated with outstanding commercial paper borrowings was approximately negative 18 basis points. A hypothetical increase of this average to negative eight basis points would have increased the Company’s annual interest expense by $3 million. The hypothetical increase used is the actual amount by which the Company’s commercial paper interest rates fluctuated during 2018. In January 2019, the Company entered into approximately $1.9 billion of cross-currency swap derivative contracts on its U.S. dollar denominated bonds to effectively convert the Company’s U.S. dollar denominated bonds to obligations denominated in Danish kroner, Japanese yen, euro and Swiss franc. Based on the interest rates of the swaps and current currency exchange rates, the Company expects these contracts to reduce the Company’s interest expense in 2019 by approximately $35 million versus the stated interest rates on the U.S. dollar denominated debt. Currency Exchange Rate Risk The Company faces transactional exchange rate risk from transactions with customers in countries outside the United States and from intercompany transactions between affiliates. Transactional exchange rate risk arises from the purchase and sale of goods and services in currencies other than Danaher’s functional currency or the functional currency of its applicable subsidiary. The Company also faces translational exchange rate risk related to the translation of financial statements of its foreign operations into U.S. dollars, Danaher’s functional currency. Costs incurred and sales recorded by subsidiaries operating outside of the United States are translated into U.S. dollars using exchange rates effective during the respective period. As a result, the Company is exposed to movements in the exchange rates of various currencies against the U.S. dollar. In particular, the Company has more sales in European currencies than it has expenses in those currencies. Therefore, when European currencies strengthen or weaken against the U.S. dollar, operating profits are increased or decreased, respectively. The effect of a change in currency exchange rates on the Company’s net investment in international subsidiaries is reflected in the accumulated other comprehensive income (loss) component of stockholders’ equity. Currency exchange rates positively impacted 2018 reported sales by 0.5% on a year-over-year basis, primarily as a result of the U.S. dollar weakening against other major currencies in the first half of 2018. The U.S. dollar strengthened in the second half of 2018 which mitigated some of the benefit recorded in early 2018. If the exchange rates in effect as of December 31, 2018 were to prevail throughout 2019, currency exchange rates would adversely impact 2019 estimated sales by 1.5% relative to the Company’s performance in 2018. Strengthening of the U.S. dollar against other major currencies would adversely impact the Company’s sales and results of operations on an overall basis. Any weakening of the U.S. dollar against other major currencies would positively impact the Company’s sales and results of operations. The Company has generally accepted the exposure to exchange rate movements without using derivative financial instruments to manage this transactional exchange risk. Both positive and negative movements in currency exchange rates against the U.S. dollar will therefore continue to affect the reported amount of sales and net earnings in the Company’s Consolidated Financial Statements. In addition, the Company has assets and liabilities held in foreign currencies. The Company may also use foreign currency-denominated debt and cross-currency swaps to partially hedge its net investments in foreign operations against adverse movements in exchange rates. A 10% depreciation in major currencies relative to the U.S. dollar as of December 31, 2018 would have reduced foreign currency-denominated net assets and stockholders’ equity by $860 million. In 2019, the Company entered into approximately $1.9 billion of cross-currency swap derivative contracts on its U.S. dollar-denominated bonds to hedge its net investment in foreign operations against adverse changes in the exchange rates between the U.S. dollar and the Danish kroner, Japanese yen, euro and the Swiss franc. These contracts effectively convert the Company’s U.S. dollar-denominated bonds to obligations denominated in Danish kroner, Japanese yen, euro and Swiss franc, and will partially offset the impact of changes in currency rates on foreign currency-denominated net assets in future periods. Equity Price Risk The Company’s investment portfolio has in the past included publicly-traded equity securities that are sensitive to fluctuations in market price. However, during 2017 the Company sold substantially all of its available-for-sale marketable equity securities. The Company also holds investments in non-marketable equity instruments in privately held companies that may be impacted by equity price risks or other factors. These non-marketable equity investments are accounted for under the Fair Value Alternative method with changes in fair value recorded in earnings. Volatility in the equity markets or other fair value considerations could affect the value of these investments and require charges or gains to be recognized in earnings. Commodity Price Risk For a discussion of risks relating to commodity prices, refer to “Item 1A. Risk Factors.” Credit Risk The Company is exposed to potential credit losses in the event of nonperformance by counterparties to its financial instruments. Financial instruments that potentially subject the Company to credit risk consist of cash and temporary investments, receivables from customers and derivatives. The Company places cash and temporary investments with various high-quality financial institutions throughout the world and exposure is limited at any one institution. Although the Company typically does not obtain collateral or other security to secure these obligations, it does regularly monitor the third-party depository institutions that hold its cash and cash equivalents. The Company’s emphasis is primarily on safety and liquidity of principal and secondarily on maximizing yield on those funds. In addition, concentrations of credit risk arising from receivables from customers are limited due to the diversity of the Company’s customers. The Company’s businesses perform credit evaluations of their customers’ financial conditions as appropriate and also obtain collateral or other security when appropriate. The Company enters into derivative transactions infrequently and such transactions are generally insignificant to the Company’s financial condition and results of operations. These transactions are typically entered into with high-quality financial institutions and exposure at any one institution is limited. LIQUIDITY AND CAPITAL RESOURCES Management assesses the Company’s liquidity in terms of its ability to generate cash to fund its operating, investing and financing requirements. The Company continues to generate substantial cash from operating activities and believes that its operating cash flow and other sources of liquidity will be sufficient to allow it to continue investing in existing businesses, consummating strategic acquisitions and investments, paying interest and servicing debt and managing its capital structure on a short and long-term basis. Following is an overview of the Company’s cash flows and liquidity for the years ended December 31: Overview of Cash Flows and Liquidity • Operating cash flows from continuing operations increased $544 million, or 16%, during 2018 as compared to 2017, due primarily to higher net earnings, which included higher noncash charges for depreciation and amortization, the impact of a noncash gain from the sale of marketable equity securities in 2017, and lower cash used for funding trade accounts receivable, inventories and trade accounts payable in 2018 compared to 2017. This increase was partially offset by higher cash used for payments for various employee-related liabilities, customer funding and accrued expenses during 2018. • Net cash used in investing activities during 2018 consisted primarily of cash paid for acquisitions, additions to property, plant and equipment and payments for purchases of investments. The Company acquired two businesses during 2018 for total consideration (including assumed debt and net of cash acquired) of approximately $2.2 billion. Payments for additions to property, plant and equipment increased $36 million in 2018 compared to 2017 and included investments in operating assets, and new facilities across the Company. In addition, in 2018, the Company invested $149 million in non-marketable equity securities. • The Company repaid the $500 million aggregate principal amount of 2018 U.S. Notes (plus accrued interest) upon their maturity in September 2018 using available cash and proceeds from the issuance of commercial paper. • As of December 31, 2018, the Company held $788 million of cash and cash equivalents. Operating Activities Cash flows from operating activities can fluctuate significantly from period-to-period as working capital needs and the timing of payments for income taxes, restructuring activities and productivity improvement initiatives, pension funding and other items impact reported cash flows. Operating cash flows from continuing operations were approximately $4.0 billion for 2018, an increase of $544 million, or 16%, as compared to 2017. The year-over-year change in operating cash flows from 2017 to 2018 was primarily attributable to the following factors: • 2018 operating cash flows benefited from higher net earnings in 2018 as compared to 2017. Net earnings in 2017 also included a $73 million gain on sale of marketable equity securities for which the proceeds were reflected in the investing activities section of the accompanying Consolidated Statement of Cash Flows, and therefore, did not contribute to operating cash flows. • Net earnings from continuing operations for 2018 reflected an increase of $69 million of depreciation and amortization expense as compared to 2017. Amortization expense primarily relates to the amortization of intangible assets acquired in connection with acquisitions and increased due to recently acquired businesses. Depreciation expense relates to both the Company’s manufacturing and operating facilities as well as instrumentation leased to customers under operating-type lease arrangements and increased due primarily to the impact of increased capital expenditures. Depreciation and amortization are noncash expenses that decrease earnings without a corresponding impact to operating cash flows. • The aggregate of trade accounts receivable, inventories and trade accounts payable provided $24 million in operating cash flows during 2018, compared to $243 million of operating cash flows used in 2017. The amount of cash flow generated from or used by the aggregate of trade accounts receivable, inventories and trade accounts payable depends upon how effectively the Company manages the cash conversion cycle, which effectively represents the number of days that elapse from the day it pays for the purchase of raw materials and components to the collection of cash from its customers and can be significantly impacted by the timing of collections and payments in a period. • The aggregate of prepaid expenses and other assets, deferred income taxes and accrued expenses and other liabilities used $114 million in operating cash flows during 2018, compared to $110 million used in 2017. The timing of various employee-related liabilities, customer funding and accrued expenses drove the majority of this change. Operating cash flows from continuing operations were approximately $3.5 billion for 2017, an increase of $390 million, or 13%, as compared to 2016. This increase was primarily attributable to the increase in net earnings from continuing operations in 2017 as compared to 2016. Investing Activities Cash flows relating to investing activities consist primarily of cash used for acquisitions and capital expenditures, including instruments leased to customers, cash used for investments and cash proceeds from divestitures of businesses or assets. Net cash used in investing activities was approximately $2.9 billion during 2018 compared to $843 million and approximately $5.2 billion of net cash used in 2017 and 2016, respectively. Acquisitions, Divestitures and Sale of Investments 2018 Acquisitions and Sale of Investments For a discussion of the Company’s 2018 acquisitions refer to “-Overview.” In addition, in 2018, the Company invested $149 million in non-marketable equity securities and partnerships. The Company received cash proceeds of $22 million from the collection of short-term other receivables related to the sale of certain marketable equity securities during 2017. 2017 Acquisitions and Sale of Investments During 2017, the Company acquired ten businesses for total consideration of $386 million in cash, net of cash acquired. The businesses acquired complement existing units of the Life Sciences, Dental and Environmental & Applied Solutions segments. The aggregate annual sales of these ten businesses at the time of their respective acquisitions, in each case based on the company’s revenues for its last completed fiscal year prior to the acquisition, were $160 million. The Company received $138 million of cash proceeds and recorded $22 million in short-term other receivables from the sale of certain marketable equity securities during 2017. The Company recorded a pretax gain related to this sale of $73 million ($46 million after-tax or $0.06 per diluted share). 2016 Acquisitions, Divestitures and Sale of Investments For a discussion of the Company’s 2016 Separation of its former Test & Measurement segment, Industrial Technologies segment (excluding the product identification businesses) and retail/commercial petroleum business, refer to “-Overview.” On November 4, 2016, Copper Merger Sub, Inc., a California corporation and an indirect, wholly-owned subsidiary of the Company acquired all of the outstanding shares of common stock of Cepheid, a California corporation, for $53.00 per share in cash, for a total purchase price of approximately $4.0 billion, net of assumed debt and acquired cash (the “Cepheid Acquisition”). Cepheid is now part of the Company’s Diagnostics segment. Cepheid generated revenues of $539 million in 2015. The Company initially financed the Cepheid acquisition price with available cash and proceeds from the issuance of U.S. dollar and euro-denominated commercial paper. In addition to the Cepheid Acquisition, during 2016 the Company acquired seven businesses for total consideration of $882 million in cash, net of cash acquired. The businesses acquired complement existing units of each of the Company’s four segments. The aggregate annual sales of these seven businesses at the time of their respective acquisitions, in each case based on the company’s revenues for its last completed fiscal year prior to the acquisition, were $237 million. In addition, during 2016, the Company received cash proceeds of $265 million from the sale of certain marketable equity securities and recorded a pretax gain related to this sale of $223 million ($140 million after-tax or $0.20 per diluted share). Capital Expenditures Capital expenditures are made primarily for increasing capacity, replacing equipment, supporting new product development, improving information technology systems and the manufacture of instruments that are used in operating-type lease arrangements that certain of the Company’s businesses enter into with customers. Capital expenditures totaled $656 million in 2018, $620 million in 2017 and $590 million in 2016. The increase in capital spending in both 2018 and 2017 was due to increased investments in operating assets and new facilities across the Company. In 2019, the Company expects capital spending to be approximately $750 million, though actual expenditures will ultimately depend on business conditions. Financing Activities Cash flows from financing activities consist primarily of cash flows associated with the issuance and repayments of commercial paper and other debt, issuances and repurchases of common stock, excess tax benefits from stock-based compensation and payments of cash dividends to shareholders. Financing activities used cash of $797 million during 2018 compared to approximately $3.1 billion of cash used during 2017. The year-over-year decrease in cash used in financing activities was due primarily to lower net repayments of commercial paper borrowings in 2018, as the Company decreased its commercial paper borrowings in 2017 after increasing commercial paper borrowings for the Cepheid acquisition. The Company issued commercial paper early in 2018 to pay for a portion of the acquisition price of IDT and repaid substantially all of such commercial paper borrowings later in 2018. The cash outflow in 2017 for the net repayment of commercial paper was partially offset by proceeds from the issuance of long-term notes. In both 2018 and 2017, the Company repaid long-term debt, with slightly lower repayments in 2018 compared to 2017, as the Company repaid the $500 million aggregate principal amount of 2018 U.S. Notes with accrued interest upon their maturity in September 2018. Financing activities used cash of approximately $3.1 billion during 2017 compared to approximately $2.0 billion of cash provided during 2016. Cash provided by financing activities in 2017 primarily related to higher net repayments of commercial paper borrowings in 2017 as compared to 2016 (as the Company increased its commercial paper borrowings in 2016 for the Cepheid acquisition) as well as lower proceeds from the issuance of debt in 2017 as compared to 2016. These impacts were partially offset by lower repayments of long-term debt in 2017 as compared to 2016 as the Company used a portion of the proceeds from the Fortive Distribution to repay outstanding long-term indebtedness in August 2016. Total debt was approximately $9.7 billion and $10.5 billion as of December 31, 2018 and 2017, respectively. The Company had the ability to incur approximately an additional $1.5 billion of indebtedness in direct borrowings or under the outstanding commercial paper facility based on the amounts available under the Company’s $4.0 billion credit facility which were not being used to backstop outstanding commercial paper balances as of December 31, 2018. The Company has classified the 2019 Euronotes and approximately $2.5 billion of its borrowings outstanding under the commercial paper programs as of December 31, 2018 as long-term debt in the accompanying Consolidated Balance Sheet as the Company had the intent and ability, as supported by availability under the Credit Facility, to refinance these borrowings for at least one year from the balance sheet date. As commercial paper obligations mature, the Company may issue additional short-term commercial paper obligations to refinance all or part of these borrowings. Under the Company’s U.S. and euro-denominated commercial paper program, the notes are typically issued at a discount from par, generally based on the ratings assigned to the Company by credit rating agencies at the time of the issuance and prevailing market rates measured by reference to LIBOR or EURIBOR. Additionally, the Company’s floating rate senior unsecured notes due 2022 pay interest based upon the three-month EURIBOR plus 0.3%. In July 2017, the head of the United Kingdom Financial Conduct Authority announced the desire to phase out the use of LIBOR by the end of 2021. The U.S. Federal Reserve, in conjunction with the Alternative Reference Rates Committee, a steering committee comprised of large U.S. financial institutions, is considering replacing U.S. dollar LIBOR with the Secured Overnight Financing Rate, or SOFR, a new index calculated by short-term repurchase agreements, backed by Treasury securities. The Company has evaluated the immediate impact of the transition from LIBOR and does not expect the transition to be material. Refer to Note 10 to the Consolidated Financial Statements for information regarding the Company’s financing activities and indebtedness, including the Company’s outstanding debt as of December 31, 2018, and the Company’s commercial paper program and related credit facility. Shelf Registration Statement The Company has filed a “well-known seasoned issuer” shelf registration statement on Form S-3 with the SEC that registers an indeterminate amount of debt securities, common stock, preferred stock, warrants, depositary shares, purchase contracts and units for future issuance. The Company expects to use net proceeds realized by the Company from future securities sales off this shelf registration statement for general corporate purposes, including without limitation repayment or refinancing of debt or other corporate obligations, acquisitions, capital expenditures, share repurchases and dividends and/or working capital. Stock Repurchase Program Please see “Issuer Purchases of Equity Securities” in Item 5 of Part II of this Annual Report for a description of the Company’s stock repurchase program. Dividends The Company declared a regular quarterly dividend of $0.16 per share that was paid on January 25, 2019 to holders of record on December 28, 2018. Aggregate cash payments for dividends during 2018 were $433 million. Dividend payments were higher in 2018 as compared to 2017 due to increases in the quarterly dividend rate effective with respect to the dividend paid in the second quarter of 2017 and with respect to the dividend paid in the second quarter of 2018. Cash and Cash Requirements As of December 31, 2018, the Company held $788 million of cash and cash equivalents that were invested in highly liquid investment-grade debt instruments with a maturity of 90 days or less with an approximate weighted average annual interest rate of 1.3%. Of this amount, $38 million was held within the United States and $750 million was held outside of the United States. The Company will continue to have cash requirements to support working capital needs, capital expenditures, acquisitions and investments, pay interest and service debt, pay taxes and any related interest or penalties, fund its restructuring activities and pension plans as required, pay dividends to shareholders, repurchase shares of the Company’s common stock and support other business needs. The Company generally intends to use available cash and internally generated funds to meet these cash requirements, but in the event that additional liquidity is required, particularly in connection with acquisitions, the Company may also borrow under its commercial paper programs or credit facility, enter into new credit facilities and either borrow directly thereunder or use such credit facilities to backstop additional borrowing capacity under its commercial paper programs and/or issue debt and/or equity in the capital markets. The Company also may from time to time access the capital markets to take advantage of favorable interest rate environments or other market conditions. While repatriation of some cash held outside the United States may be restricted by local laws, most of the Company’s foreign cash could be repatriated to the United States. Following enactment of the TCJA and the associated Transition Tax, in general, repatriation of cash to the United States can be completed with no incremental U.S. tax; however, repatriation of cash could subject the Company to non-U.S. jurisdictional taxes on distributions. The cash that the Company’s non-U.S. subsidiaries hold for indefinite reinvestment is generally used to finance foreign operations, investments and acquisitions. The income taxes applicable to such earnings are not readily determinable. As of December 31, 2018, the Company continues to assert that principally all of its non-U.S. earnings are indefinitely reinvested and management believes that the Company has sufficient liquidity to satisfy its cash needs, including its cash needs in the United States. During 2018, the Company contributed $55 million to its U.S. defined benefit pension plans and $52 million to its non-U.S. defined benefit pension plans. During 2019, the Company’s cash contribution requirements for its U.S. and its non-U.S. defined benefit pension plans are expected to be approximately $10 million and $50 million, respectively. The ultimate amounts to be contributed depend upon, among other things, legal requirements, underlying asset returns, the plan’s funded status, the anticipated tax deductibility of the contribution, local practices, market conditions, interest rates and other factors. Contractual Obligations The following table sets forth, by period due or year of expected expiration, as applicable, a summary of the Company’s contractual obligations as of December 31, 2018 under (1) debt obligations, (2) leases, (3) purchase obligations and (4) other long-term liabilities reflected on the Company’s Consolidated Balance Sheet. The amounts presented in the “Other long-term liabilities” line in the table below include $911 million of noncurrent gross unrecognized tax benefits and related interest (and do not include $75 million of current gross unrecognized tax benefits which are included in the “Accrued expenses and other liabilities” line on the Consolidated Balance Sheet). However, the timing of the long-term portion of these tax liabilities is uncertain, and therefore, they have been included in the “More Than 5 Years” column in the table below. Refer to Note 13 to the Consolidated Financial Statements for additional information on unrecognized tax benefits. Certain of the Company’s acquisitions also involve the potential payment of contingent consideration. The table below does not reflect any such obligations, as the timing and amounts of any such payments are uncertain. Refer to “-Off-Balance Sheet Arrangements” for a discussion of other contractual obligations that are not reflected in the table below. (a) As described in Note 10 to the Consolidated Financial Statements. (b) Amounts do not include interest payments. Interest on debt and capital lease obligations is reflected in a separate line in the table. (c) Interest payments on debt are projected for future periods using the interest rates in effect as of December 31, 2018. Certain of these projected interest payments may differ in the future based on changes in market interest rates. (d) As described in Note 16 to the Consolidated Financial Statements, certain leases require the Company to pay real estate taxes, insurance, maintenance and other operating expenses associated with the leased premises. These future costs are not included in the table above. As discussed in Note 1 to the Consolidated Financial Statements, the Company adopted ASC 842 related to lease accounting on January 1, 2019. Future minimum lease payments differ from the future lease liability recognized under ASC 842, as the lease liability recognized under ASC 842 discounts the lease payments while the minimum lease payments are not discounted. Additionally, ASC 842 allows a lessee to elect to combine or separate any non-lease components in an arrangement with the lease components for the calculation of the lease liability while the minimum lease payments exclude any non-lease components. (e) Consist of agreements to purchase goods or services that are enforceable and legally binding on the Company and that specify all significant terms, including fixed or minimum quantities to be purchased, fixed, minimum or variable price provisions and the approximate timing of the transaction. (f) Primarily consist of obligations under product service and warranty policies and allowances, performance and operating cost guarantees, estimated environmental remediation costs, self-insurance and litigation claims, postretirement benefits, pension obligations, deferred tax liabilities and deferred compensation obligations. The timing of cash flows associated with these obligations is based upon management’s estimates over the terms of these arrangements and is largely based upon historical experience. Off-Balance Sheet Arrangements Guarantees and Related Instruments The following table sets forth, by period due or year of expected expiration, as applicable, a summary of guarantees and related instruments of the Company as of December 31, 2018. Guarantees and related instruments consist primarily of outstanding standby letters of credit, bank guarantees and performance and bid bonds. These have been provided in connection with certain arrangements with vendors, customers, insurance providers, financing counterparties and governmental entities to secure the Company’s obligations and/or performance requirements related to specific transactions. Other Off-Balance Sheet Arrangements The Company has from time to time divested certain of its businesses and assets. In connection with these divestitures, the Company often provides representations, warranties and/or indemnities to cover various risks and unknown liabilities, such as claims for damages arising out of the use of products or relating to intellectual property matters, commercial disputes, environmental matters or tax matters. In particular, in connection with the 2016 Fortive Separation and the 2015 split-off of the Company’s communications business, Danaher entered into separation and distribution and related agreements pursuant to which Danaher agreed to indemnify the other parties against certain damages and expenses that might occur in the future. These indemnification obligations cover a variety of liabilities, including, but not limited to, employee, tax and environmental matters. The Company has not included any such items in the contractual obligations table above because they relate to unknown conditions and the Company cannot estimate the potential liabilities from such matters, but the Company does not believe it is reasonably possible that any such liability will have a material effect on the Company’s financial statements. In addition, as a result of these divestitures, as well as restructuring activities, certain properties leased by the Company have been sublet to third-parties. In the event any of these third-parties vacate any of these premises, the Company would be legally obligated under master lease arrangements. The Company believes that the financial risk of default by such sub-lessors is individually and in the aggregate not material to the Company’s Consolidated Financial Statements. In the normal course of business, the Company periodically enters into agreements that require it to indemnify customers, suppliers or other business partners for specific risks, such as claims for injury or property damage arising out of the Company’s products, software or services or claims alleging that Company products or services infringe third-party intellectual property. The Company has not included any such indemnification provisions in the contractual obligations table above. Historically, the Company has not experienced significant losses on these types of indemnification obligations. The Company’s Restated Certificate of Incorporation requires it to indemnify to the full extent authorized or permitted by law any person made, or threatened to be made a party to any action or proceeding by reason of his or her service as a director or officer of the Company, or by reason of serving at the request of the Company as a director or officer of any other entity, subject to limited exceptions. Danaher’s Amended and Restated By-laws provide for similar indemnification rights. In addition, Danaher has executed with each director and executive officer of Danaher Corporation an indemnification agreement which provides for substantially similar indemnification rights and under which Danaher has agreed to pay expenses in advance of the final disposition of any such indemnifiable proceeding. While the Company maintains insurance for this type of liability, a significant deductible applies to this coverage and any such liability could exceed the amount of the insurance coverage. Legal Proceedings Refer to “Item 3. Legal Proceedings” and Note 17 to the Consolidated Financial Statements for information regarding legal proceedings and contingencies, and for a discussion of risks related to legal proceedings and contingencies, refer to “Item 1A. Risk Factors.” CRITICAL ACCOUNTING ESTIMATES Management’s discussion and analysis of the Company’s financial condition and results of operations is based upon the Company’s Consolidated Financial Statements, which have been prepared in accordance with accounting principles generally accepted in the United States. The preparation of these financial statements requires management to make estimates and judgments that affect the reported amounts of assets, liabilities, revenues and expenses, and related disclosure of contingent assets and liabilities. The Company bases these estimates and judgments on historical experience, the current economic environment and on various other assumptions that are believed to be reasonable under the circumstances. Actual results may differ materially from these estimates and judgments. The Company believes the following accounting estimates are most critical to an understanding of its financial statements. Estimates are considered to be critical if they meet both of the following criteria: (1) the estimate requires assumptions about material matters that are uncertain at the time the estimate is made, and (2) material changes in the estimate are reasonably likely from period-to-period. For a detailed discussion on the application of these and other accounting estimates, refer to Note 1 to the Consolidated Financial Statements. Acquired Intangibles-The Company’s business acquisitions typically result in the recognition of goodwill, in-process R&D and other intangible assets, which affect the amount of future period amortization expense and possible impairment charges that the Company may incur. Refer to Notes 1, 3 and 7 to the Consolidated Financial Statements for a description of the Company’s policies relating to goodwill, acquired intangibles and acquisitions. In performing its goodwill impairment testing, the Company estimates the fair value of its reporting units primarily using a market-based approach. In evaluating the estimates derived by the market-based approach, management makes judgments about the relevance and reliability of the multiples by considering factors unique to its reporting units, including operating results, business plans, economic projections, anticipated future cash flows, and transactions and marketplace data as well as judgments about the comparability of the market proxies selected. In certain circumstances the Company also estimates fair value utilizing a discounted cash flow analysis (i.e., an income approach) in order to validate the results of the market approach. The discounted cash flow model requires judgmental assumptions about projected revenue growth, future operating margins, discount rates and terminal values. There are inherent uncertainties related to these assumptions and management’s judgment in applying them to the analysis of goodwill impairment. As of December 31, 2018, the Company had eight reporting units for goodwill impairment testing. Reporting units resulting from recent acquisitions generally present the highest risk of impairment. Management believes the impairment risk associated with these reporting units generally decreases as these businesses are integrated into the Company and better positioned for potential future earnings growth. The Company’s annual goodwill impairment analysis in 2018 indicated that in all instances, the fair values of the Company’s reporting units exceeded their carrying values and consequently did not result in an impairment charge. The excess of the estimated fair value over carrying value (expressed as a percentage of carrying value for the respective reporting unit) for each of the Company’s reporting units as of the annual testing date ranged from approximately 15% to approximately 600%. In order to evaluate the sensitivity of the fair value calculations used in the goodwill impairment test, the Company applied a hypothetical 10% decrease to the fair values of each reporting unit and compared those hypothetical values to the reporting unit carrying values. Based on this hypothetical 10% decrease, the excess of the estimated fair value over carrying value (expressed as a percentage of carrying value for the respective reporting unit) for each of the Company’s reporting units ranged from approximately 5% to approximately 530%. The Company reviews identified intangible assets for impairment whenever events or changes in circumstances indicate that the related carrying amounts may not be recoverable. The Company also tests intangible assets with indefinite lives at least annually for impairment. Determining whether an impairment loss occurred requires a comparison of the carrying amount to the sum of undiscounted cash flows expected to be generated by the asset. These analyses require management to make judgments and estimates about future revenues, expenses, market conditions and discount rates related to these assets. If actual results are not consistent with management’s estimates and assumptions, goodwill and other intangible assets may be overstated and a charge would need to be taken against net earnings which would adversely affect the Company’s Consolidated Financial Statements. Historically, the Company’s estimates of goodwill and intangible assets have been materially correct. Contingent Liabilities-As discussed in “Item 3. Legal Proceedings” and Note 17 to the Consolidated Financial Statements, the Company is, from time to time, subject to a variety of litigation and similar contingent liabilities incidental to its business (or the business operations of previously owned entities). The Company recognizes a liability for any legal contingency that is known or probable of occurrence and reasonably estimable. These assessments require judgments concerning matters such as litigation developments and outcomes, the anticipated outcome of negotiations, the number of future claims and the cost of both pending and future claims. In addition, because most contingencies are resolved over long periods of time, liabilities may change in the future due to various factors, including those discussed in Note 17 to the Consolidated Financial Statements. If the reserves established by the Company with respect to these contingent liabilities are inadequate, the Company would be required to incur an expense equal to the amount of the loss incurred in excess of the reserves, which would adversely affect the Company’s financial statements. Revenue Recognition-On January 1, 2018, the Company adopted ASU No. 2014-09, Revenue from Contracts with Customers (Topic 606), which supersedes nearly all previous revenue recognition guidance. Refer to Note 2 to the Consolidated Financial Statements for additional information on the Company’s adoption of this ASU. The Company derives revenues from the sale of products and services. Revenue is recognized when control over the promised products or services is transferred to the customer in an amount that reflects the consideration that the Company expects to receive in exchange for those goods or services. In determining if control has transferred, the Company considers whether certain indicators of the transfer of control are present, such as the transfer of title, present right to payment, significant risks and rewards of ownership and customer acceptance when acceptance is not a formality. To determine the consideration that the customer owes the Company, the Company must make judgments regarding the amount of customer allowances and rebates, as well as an estimate for product returns. The Company also enters into lease arrangements with customers, which requires the Company to determine whether the arrangements are operating or sales-type leases. Certain of the Company’s lease contracts are customized for larger customers and often result in complex terms and conditions that typically require significant judgment in applying the lease accounting criteria. Refer to Note 1 to the Consolidated Financial Statements for a description of the Company’s revenue recognition policies. If the Company’s judgments regarding revenue recognition prove incorrect, the Company’s reported revenues in particular periods may be incorrect. Historically, the Company’s estimates of revenue have been materially correct. Pension and Other Postretirement Benefits-For a description of the Company’s pension and other postretirement benefit accounting practices, refer to Notes 11 and 12 to the Consolidated Financial Statements. Calculations of the amount of pension and other postretirement benefit costs and obligations depend on the assumptions used in the actuarial valuations, including assumptions regarding discount rates, expected return on plan assets, rates of salary increases, health care cost trend rates, mortality rates and other factors. If the assumptions used in calculating pension and other postretirement benefits costs and obligations are incorrect or if the factors underlying the assumptions change (as a result of differences in actual experience, changes in key economic indicators or other factors) the Company’s Consolidated Financial Statements could be materially affected. A 50 basis point reduction in the discount rates used for the plans would have increased the U.S. net obligation by $121 million ($92 million on an after-tax basis) and the non-U.S. net obligation by $125 million ($96 million on an after-tax basis) from the amounts recorded in the Consolidated Financial Statements as of December 31, 2018. A 50 basis point increase in the discount rates used for the plans would have decreased the U.S. net obligation by $111 million ($84 million on an after-tax basis) and the non-U.S. net obligation by $120 million ($93 million on an after-tax basis) from the amounts recorded in the Consolidated Financial Statements as of December 31, 2018. For 2018, the estimated long-term rate of return for the U.S. plans is 7.0%, and the Company intends to continue to use an assumption of 7.0% for 2019. The estimated long-term rate of return for the non-U.S. plans was determined on a plan-by-plan basis based on the nature of the plan assets and ranged from 1.0% to 5.8%. If the expected long-term rate of return on plan assets for 2018 was reduced by 50 basis points, pension expense for the U.S. and non-U.S. plans for 2018 would have increased $10 million ($8 million on an after-tax basis) and $6 million ($5 million on an after-tax basis), respectively. For a discussion of the Company’s 2018 and anticipated 2019 defined benefit pension plan contributions, refer to “-Liquidity and Capital Resources-Cash and Cash Requirements”. Income Taxes-For a description of the Company’s income tax accounting policies, refer to Notes 1 and 13 to the Consolidated Financial Statements. The Company establishes valuation allowances for its deferred tax assets if it is more likely than not that some or all of the deferred tax asset will not be realized. This requires management to make judgments and estimates regarding: (1) the timing and amount of the reversal of taxable temporary differences, (2) expected future taxable income, and (3) the impact of tax planning strategies. Future changes to tax rates would also impact the amounts of deferred tax assets and liabilities and could have an adverse impact on the Company’s Consolidated Financial Statements. The Company provides for unrecognized tax benefits when, based upon the technical merits, it is “more likely than not” that an uncertain tax position will not be sustained upon examination. Judgment is required in evaluating tax positions and determining income tax provisions. The Company re-evaluates the technical merits of its tax positions and may recognize an uncertain tax benefit in certain circumstances, including when: (1) a tax audit is completed; (2) applicable tax laws change, including a tax case ruling or legislative guidance; or (3) the applicable statute of limitations expires. On December 22, 2017, the TCJA was enacted, which substantially changed the U.S. tax system, including lowering the corporate tax rate from 35.0% to 21.0% (beginning in 2018). While the changes from the TCJA were generally effective beginning in 2018, GAAP accounting for income taxes requires the effect of a change in tax laws or rates to be recognized in income from continuing operations for the period that includes the enactment date. Due to the complexities involved in accounting for the enactment of the TCJA, SAB No. 118 allowed the Company to record provisional amounts in earnings for the year ended December 31, 2017. Where reasonable estimates could be made, the provisional accounting was based on such estimates. When no reasonable estimate could be made, SAB No. 118 required the accounting to be based on the tax law in effect before the TCJA. The Company was required to complete its tax accounting for the TCJA when it had obtained, prepared and analyzed the information to complete the income tax accounting but no later than December 22, 2018. The Company completed its accounting for the tax effects of the enactment of the TCJA based on the Company’s interpretation of the new tax regulations and related guidance. The net tax effect to adjust the prior year provisional amounts was not material to the Company’s financial statements. Due to the complexity and recent issuance of these tax regulations, management’s interpretations of the impact of these rules could be subject to challenge by the taxing authorities. Some or all of these judgments are also subject to review by the IRS. If the IRS were to successfully challenge the Company’s right to realize some or all of the tax benefit the Company has recorded, or its interpretation of the law regarding certain items, or if the amount of the Transition Tax or other tax liabilities are understated, it could have a material adverse effect on the Company’s financial statements. In addition, certain of the Company’s tax returns are currently under review by tax authorities including in Denmark and the United States (refer to “-Results of Operations-Income Taxes” and Note 13 to the Consolidated Financial Statements). Management believes the positions taken in these returns are in accordance with the relevant tax laws. However, the outcome of these audits is uncertain and could result in the Company being required to record charges for prior year tax obligations which could have a material adverse impact to the Company’s Consolidated Financial Statements, including its effective tax rate. An increase of 1.0% in the Company’s 2018 nominal tax rate would have resulted in an additional income tax provision for continuing operations for the year ended December 31, 2018 of $33 million. NEW ACCOUNTING STANDARDS For a discussion of the new accounting standards impacting the Company, refer to Note 1 to the Consolidated Financial Statements.

<s>[INST] Overview Results of Operations Liquidity and Capital Resources Critical Accounting Estimates New Accounting Standards This discussion and analysis should be read along with Danaher’s audited financial statements and related Notes thereto as of December 31, 2018 and 2017 and for each of the three years in the period ended December 31, 2018 included in this Annual Report. OVERVIEW General Refer to “Item 1. BusinessGeneral” for a discussion of Danaher’s strategic objectives and methodologies for delivering longterm shareholder value. Danaher is a multinational business with global operations. During 2018, approximately 63% of Danaher’s sales were derived from customers outside the United States. As a diversified, global business, Danaher’s operations are affected by worldwide, regional and industryspecific economic and political factors. Danaher’s geographic and industry diversity, as well as the range of its products, software and services, help limit the impact of any one industry or the economy of any single country on its consolidated operating results. Given the broad range of products manufactured, software and services provided and geographies served, management does not use any indices other than general economic trends to predict the overall outlook for the Company. The Company’s individual businesses monitor key competitors and customers, including to the extent possible their sales, to gauge relative performance and the outlook for the future. As a result of the Company’s geographic and industry diversity, the Company faces a variety of opportunities and challenges, including rapid technological development (particularly with respect to computing, automation, artificial intelligence, mobile connectivity, communications and digitization) in most of the Company’s served markets, the expansion and evolution of opportunities in highgrowth markets, trends and costs associated with a global labor force, consolidation of the Company’s competitors and increasing regulation. The Company operates in a highly competitive business environment in most markets, and the Company’s longterm growth and profitability will depend in particular on its ability to expand its business in highgrowth geographies and highgrowth market segments, identify, consummate and integrate appropriate acquisitions, develop innovative and differentiated new products and services with higher gross profit margins, expand and improve the effectiveness of the Company’s sales force, continue to reduce costs and improve operating efficiency and quality, and effectively address the demands of an increasingly regulated global environment. The Company is making significant investments, organically and through acquisitions, to address the rapid pace of technological change in its served markets and to globalize its manufacturing, research and development and customerfacing resources (particularly in highgrowth markets) in order to be responsive to the Company’s customers throughout the world and improve the efficiency of the Company’s operations. Business Performance Consolidated sales for the year ended December 31, 2018 increased 8.5% as compared to 2017. While differences exist among the Company’s businesses, on an overall basis, demand for the Company’s products and services increased on a yearoveryear basis in 2018 as compared to 2017. This demand, together with the Company’s continued investments in sales growth initiatives and the other businessspecific factors discussed below, contributed to yearoveryear core sales growth of 6.0% (for the definition of “core sales,” refer to “Results of Operations” below). Geographically, both highgrowth and developed markets contributed to yearoveryear core sales growth during 2018. Core sales growth rates in highgrowth markets grew at a highsingle digit rate in 2018 as compared to 2017 led by strength in Asia, particularly China. Highgrowth markets represented approximately 31% of the Company’s total sales in 2018. Core sales in developed markets grew at a midsingle digit rate in 2018 as compared to 2017 and were driven by North America and Western Europe. The Company’s net earnings from continuing operations for the year ended December 31, 2018 totaled approximately $2.7 billion, or $3.74 per diluted share, compared to approximately $2.5 billion, or $3.50 per diluted share for the year ended December 31, 20 [/INST] Positive. </s>

DANAHER CORP /DE/

2020-02-21

2019-12-31

ITEM 7. MANAGEMENT’S DISCUSSION AND ANALYSIS OF FINANCIAL CONDITION AND RESULTS OF OPERATIONS Management’s Discussion and Analysis of Financial Condition and Results of Operations (“MD&A”) is designed to provide a reader of Danaher’s financial statements with a narrative from the perspective of Company management. The Company’s MD&A is divided into five sections: • Overview • Results of Operations • Liquidity and Capital Resources • Critical Accounting Estimates • New Accounting Standards This discussion and analysis should be read along with Danaher’s audited financial statements and related Notes thereto as of December 31, 2019 and 2018 and for each of the three years in the period ended December 31, 2019 included in this Annual Report. Unless otherwise indicated, all financial results in this report refer to continuing operations. OVERVIEW General Refer to “Item 1. Business-General” for a discussion of Danaher’s strategic objectives and methodologies for delivering long-term shareholder value. Danaher is a multinational business with global operations. During 2019, approximately 63% of Danaher’s sales were derived from customers outside the United States. As a diversified, global business, Danaher’s operations are affected by worldwide, regional and industry-specific economic and political factors. Danaher’s geographic and industry diversity, as well as the range of its products, software and services, help limit the impact of any one industry or the economy of any single country on its consolidated operating results. The Company’s individual businesses monitor key competitors and customers, including to the extent possible their sales, to gauge relative performance and the outlook for the future. As a result of the Company’s geographic and industry diversity, the Company faces a variety of opportunities and challenges, including rapid technological development (particularly with respect to computing, automation, artificial intelligence, mobile connectivity, communications and digitization) in most of the Company’s served markets, the expansion and evolution of opportunities in high-growth markets, trends and costs associated with a global labor force, consolidation of the Company’s competitors and increasing regulation. The Company operates in a highly competitive business environment in most markets, and the Company’s long-term growth and profitability will depend in particular on its ability to expand its business in high-growth geographies and high-growth market segments, identify, consummate and integrate appropriate acquisitions, develop innovative and differentiated new products and services with higher gross profit margins, expand and improve the effectiveness of the Company’s sales force, continue to reduce costs and improve operating efficiency and quality, and effectively address the demands of an increasingly regulated global environment. The Company is making significant investments, organically and through acquisitions, to address the rapid pace of technological change in its served markets and to globalize its manufacturing, research and development and customer-facing resources (particularly in high-growth markets) in order to be responsive to the Company’s customers throughout the world and improve the efficiency of the Company’s operations. Business Performance Consolidated sales for the year ended December 31, 2019 increased 5.0% as compared to 2018. While differences exist among the Company’s businesses, on an overall basis, demand for the Company’s products and services increased on a year-over-year basis in 2019 as compared to 2018. This demand, together with the Company’s continued investments in sales growth initiatives and the other business-specific factors discussed below, contributed to year-over-year core sales growth of 6.0% (for the definition of “core sales,” refer to “-Results of Operations” below). Geographically, both high-growth and developed markets contributed to year-over-year core sales growth during 2019. Core sales in high-growth markets grew at a high-single digit rate in 2019 as compared to 2018 led by strength in China. High-growth markets represented approximately 32% of the Company’s total sales in 2019. Core sales in developed markets grew at a mid-single digit rate in 2019 as compared to 2018 and were driven by North America and Western Europe. The Company’s net earnings from continuing operations for the year ended December 31, 2019 totaled approximately $2.4 billion, or $3.26 per diluted share, compared to approximately $2.4 billion, or $3.39 per diluted share for the year ended December 31, 2018. Net earnings attributable to common stockholders for the year ended December 31, 2019 totaled approximately $2.9 billion or $4.05 per diluted share compared to approximately $2.7 billion or $3.74 per diluted share for the year ended December 31, 2018. The gain on the disposition of Envista, partially offset by the tax-related charges discussed below in “-Results of Operations-Income Taxes” are the primary reasons for the year-over-year increase in net earnings attributable to common stockholders and diluted earnings per share for the year ended December 31, 2019; refer to “-Results of Operations” for further discussion of year-over-year changes in net earnings and diluted earnings per share for the year ended December 31, 2019. Refer to “Results of Operations-Discontinued Operations” for further discussion of the disposition of Envista. Acquisitions and Dispositions On February 25, 2019, the Company entered into the GE Biopharma Purchase Agreement with GE to acquire the GE Biopharma Business for a cash purchase price of approximately $21.0 billion, subject to certain adjustments, and the assumption of approximately $0.4 billion of pension liabilities. The GE Biopharma Business, to be known as Cytiva following the closing of the acquisition, is a leading provider of instruments, consumables and software that support the research, discovery, process development and manufacturing workflows of biopharmaceutical drugs. Based on preliminary unaudited financial information provided by GE, the GE Biopharma Business generated revenues of approximately $3.3 billion in 2019. Though the timing of obtaining the final regulatory approvals necessary to close the GE Biopharma Acquisition is uncertain, the Company continues to make progress with respect thereto and expects to close the transaction in the first quarter of 2020. The acquisition is expected to provide additional sales and earnings growth opportunities for the Company’s Life Sciences segment by expanding the business’ geographic and product line diversity, including new product and service offerings that complement the Company’s current biologics workflow solutions. As a condition to obtaining certain regulatory approvals for the closing of the transaction, the Company expects it will be required to divest certain of its existing product lines that in the aggregate generated revenues of approximately $170 million in 2019. The Company plans to finance the GE Biopharma Acquisition with approximately $3.0 billion of proceeds from the March 1, 2019 underwritten public offerings of its Common Stock and MCPS, approximately $10.8 billion of proceeds from the issuance of euro-denominated and U.S. dollar-denominated long-term debt in the second half of 2019, and approximately $7.2 billion from the aggregate of cash on hand and proceeds from commercial paper borrowings. Refer to Note 11 in the Consolidated Financial Statements for additional information related to the issuance of debt and to Note 19 for additional information related to the March 1, 2019 public offerings. During 2019, the Company acquired five businesses for total consideration of $331 million in cash, net of cash acquired. The businesses acquired complement existing units of each of the Company’s three segments. The aggregate annual sales of these five businesses at the time of their respective acquisitions, in each case based on the company’s revenues for its last completed fiscal year prior to the acquisition, were $72 million. In addition, in 2019 the Company invested $241 million in non-marketable equity securities and a partnership. For a discussion of the Company’s 2018 and 2017 acquisition and disposition activity, refer to “Liquidity and Capital Resources-Investing Activities”. Envista Disposition On September 20, 2019, Envista completed an underwritten IPO of 30.8 million shares of its common stock, (the “IPO”), which represented 19.4% of Envista’s outstanding shares at the time of the offering, at a public offering price of $22.00 per share. Envista realized net proceeds of $643 million from the IPO, after deducting underwriting discounts and deal expenses. In connection with the completion of the IPO, through a series of equity and other transactions, the Company transferred its dental businesses to Envista (the “Separation”). In exchange, Envista transferred consideration of approximately $2.0 billion to the Company, which consisted primarily of the net proceeds from the IPO and approximately $1.3 billion of proceeds from Envista’s term debt financing. The excess of the net proceeds from the IPO over the net book value of the business transferred to Envista was $60 million and was recorded in additional paid-in capital. On December 18, 2019, Danaher completed the disposition of its remaining 80.6% ownership of Envista common stock through a split-off exchange offer, which resulted in Danaher’s repurchase of 22.9 million shares of Danaher common stock in exchange for the remaining shares of Envista common stock held by Danaher (the “Split-Off”). The IPO, Separation and Split-Off are collectively referred to as the “Envista Disposition”. As a result, the Company recognized a gain on the disposition of $451 million in the fourth quarter of 2019 equal to the difference between the fair value of the Danaher common stock tendered in the exchange offer and the carrying value of Envista common stock. The accounting requirements for reporting Envista as a discontinued operation were met when the Split-Off was completed. Accordingly, the Consolidated Financial Statements for all periods presented reflect this business as a discontinued operation. For each period presented, the Company allocated a portion of the consolidated interest expense to discontinued operations based on the ratio of the discontinued business’ net assets to the Company’s consolidated net assets. Envista had revenues of approximately $2.6 billion in 2019 prior to the Envista Disposition and approximately $2.8 billion in 2018. To effect the Envista Disposition, the Company incurred $69 million in costs during the year ended December 31, 2019 which are reflected in earnings from discontinued operations, net of income taxes in the accompanying Consolidated Statements of Earnings. These costs primarily relate to professional fees associated with preparation of regulatory filings and activities within finance, tax, legal and information technology functions as well as certain investment banking fees and tax costs. Refer to Note 4 to the Consolidated Financial Statements for further discussion. UK’s referendum decision to exit the EU In a referendum on June 23, 2016, voters approved for the UK to exit the EU. The UK formally withdrew from the EU on January 31, 2020 with a transition period through December 31, 2020. During the transition period, the UK will continue to follow EU law and will negotiate with the EU on the terms of its relationship post-2020. Failure to complete negotiations by the implementation deadline of December 31, 2020 relating to Brexit could result in the UK reverting to undesirable and adverse trade agreements with the EU. The nature of the UK’s future relationship with the EU is still uncertain. The Company continues to monitor the status of Brexit and plan for potential impacts. As of December 31, 2019, the Company had seven manufacturing facilities in the UK and the Company’s net investment in plant, property and equipment in the UK was $163 million. For the year ended December 31, 2019, less than 5% of the Company’s sales were derived from customers located in the UK, however, the impact of Brexit could also impact the Company’s sales and operations outside the UK. To mitigate the potential impact of Brexit on the import of goods to the UK, the Company has increased its level of inventory within the UK. The ultimate impact of Brexit on the Company’s financial results is uncertain. For additional information, refer to the “Item 1A - Risk Factors” section of this Annual Report. Coronavirus For information on the potential impact of the coronavirus to the Company’s operations, refer to the “Item 1A - Risk Factors” section of this Annual Report. RESULTS OF OPERATIONS In this report, references to the non-GAAP measure of core sales (also referred to as core revenues or sales/revenues from existing businesses) refer to sales from continuing operations calculated according to generally accepted accounting principles in the United States (“GAAP”) but excluding: • sales from acquired businesses; and • the impact of currency translation. References to sales or operating profit attributable to acquisitions or acquired businesses refer to sales or operating profit, as applicable, from acquired businesses recorded prior to the first anniversary of the acquisition less the amount of sales and operating profit, as applicable, attributable to divested product lines not considered discontinued operations. The portion of revenue attributable to currency translation is calculated as the difference between: • the period-to-period change in revenue (excluding sales from acquired businesses); and • the period-to-period change in revenue (excluding sales from acquired businesses) after applying current period foreign exchange rates to the prior year period. Core sales growth should be considered in addition to, and not as a replacement for or superior to, sales, and may not be comparable to similarly titled measures reported by other companies. Management believes that reporting the non-GAAP financial measure of core sales growth provides useful information to investors by helping identify underlying growth trends in Danaher’s business and facilitating comparisons of Danaher’s revenue performance with its performance in prior and future periods and to Danaher’s peers. Management also uses core sales growth to measure the Company’s operating and financial performance, and uses it as one of the performance measures in the Company’s executive short-term cash incentive program. The Company excludes the effect of currency translation from core sales because currency translation is not under management’s control, is subject to volatility and can obscure underlying business trends, and excludes the effect of acquisitions and divestiture-related items because the nature, size, timing and number of acquisitions and divestitures can vary dramatically from period-to-period and between the Company and its peers and can also obscure underlying business trends and make comparisons of long-term performance difficult. Throughout this discussion, references to sales volume refer to the impact of both price and unit sales and references to productivity improvements generally refer to improved cost efficiencies resulting from the ongoing application of DBS. Core Revenue Core sales grew on a year-over-year basis in both 2019 and 2018. Sales from acquired businesses increased on a year-over-year basis in both 2019 and 2018, primarily due to the acquisition of IDT in the second quarter of 2018. The impact of currency translation reduced reported sales on a year-over-year basis in 2019 as the U.S. dollar was, on average, stronger against other major currencies. Currency translation increased reported sales on a year-over-year basis in 2018, primarily due to the U.S. dollar weakening against other major currencies in the first half of 2018, partially offset by the U.S. dollar strengthening in the second half of 2018. Operating profit margins were 18.3% for the year ended December 31, 2019 as compared to 17.9% in 2018. The following factors impacted year-over-year operating profit margin comparisons. 2019 vs. 2018 operating profit margin comparisons were favorably impacted by: • Higher 2019 core sales volumes and incremental year-over-year cost savings associated with the continued productivity improvement initiatives taken in 2019 and 2018, net of incremental year-over-year costs associated with various new product development and sales, service and marketing growth investments and the impact of foreign exchange rates - 100 basis points • Acquisition-related transaction costs and fair value adjustments to inventory related to the acquisition of IDT in the second quarter of 2018 - 10 basis points 2019 vs. 2018 operating profit margin comparisons were unfavorably impacted by: • The incremental net dilutive effect in 2019 of acquired businesses - 15 basis points • Transaction costs and integration preparation costs related to the anticipated acquisition of the GE Biopharma Business - 50 basis points • Second quarter 2018 gain on resolution of acquisition-related matters - 5 basis points Operating profit margins were 17.9% for the year ended December 31, 2018 as compared to 16.6% in 2017. The following factors impacted year-over-year operating profit margin comparisons. 2018 vs. 2017 operating profit margin comparisons were favorably impacted by: • Higher 2018 core sales volumes and incremental year-over-year cost savings associated with the continued productivity improvement initiatives taken in 2018 and 2017, net of incremental year-over-year costs associated with various product development, sales and marketing growth investments and the impact of foreign exchange rates - 120 basis points • Restructuring, impairment and other related charges related to discontinuing a product line in the second quarter of 2017 related to the Diagnostic segment - 45 basis points 2018 vs. 2017 operating profit margin comparisons were unfavorably impacted by: • The incremental net dilutive effect in 2018 of acquired businesses - 25 basis points • Acquisition-related transaction costs and fair value adjustments to inventory related to the acquisition of IDT in the second quarter of 2018 - 10 basis points Business Segments Sales by business segment for the years ended December 31 are as follows ($ in millions): LIFE SCIENCES The Company’s Life Sciences segment offers a broad range of research tools that scientists use to study the basic building blocks of life, including genes, proteins, metabolites and cells, in order to understand the causes of disease, identify new therapies and test new drugs and vaccines. The segment is also a leading provider of filtration, separation and purification technologies to the biopharmaceutical, food and beverage, medical, aerospace, microelectronics and general industrial sectors. Life Sciences Selected Financial Data Core Revenue 2019 Compared to 2018 Price increases in the segment contributed 1.0% to revenue growth on a year-over-year basis during 2019 as compared with 2018 and are reflected as a component of the change in core revenue growth. Core sales for filtration, separation and purification technologies increased across most major geographies on a year-over-year basis led by growth in the biopharmaceuticals, aerospace and fluid technology and asset protection end-markets, partially offset by softness in the microelectronics end-market. Core sales of microscopy products grew on a year-over-year basis across most major product lines led by North America and the high-growth markets, particularly China. Year-over-year core sales for flow cytometry and particle counting products grew in 2019 across all major geographies and end-markets. Core sales of the business’ broad range of mass spectrometers increased on a year-over-year basis led by strong core sales growth in the high-growth markets, particularly China and the rest of Asia, partially offset by lower demand in North America. This growth was led by demand in the pharmaceutical and academic end-markets and for service offerings, partially offset by lower core sales in the clinical end-market. Sales growth from acquisitions was primarily due to the acquisition of IDT in April 2018. IDT provides additional sales and earnings growth opportunities for the segment by expanding the segment’s product line diversity, including new product and service offerings in the area of genomics consumables. During 2019, IDT’s revenues grew on a year-over-year basis across all major product lines and geographies, primarily driven by North America. Operating profit margins increased 120 basis points during 2019 as compared to 2018. The following factors impacted year-over-year operating profit margin comparisons. 2019 vs. 2018 operating profit margin comparisons were favorably impacted by: • Higher 2019 core sales volumes and incremental year-over-year cost savings associated with the continued productivity improvement initiatives taken in 2019 and 2018, net of incremental year-over-year costs associated with various new product development and sales and marketing growth investments and the impact of foreign exchange rates - 145 basis points • Acquisition-related transaction costs and fair value adjustments to inventory related to the acquisition of IDT in the second quarter of 2018 - 25 basis points 2019 vs. 2018 operating profit margin comparisons were unfavorably impacted by: • The incremental net dilutive effect in 2019 of acquired businesses - 35 basis points • Second quarter 2018 gain on resolution of acquisition-related matters - 15 basis points 2018 Compared to 2017 Price increases in the segment contributed 0.5% to revenue growth on a year-over-year basis during 2018 as compared with 2017 and are reflected as a component of the change in core revenue growth. Core sales of the business’ broad range of mass spectrometers grew on a year-over-year basis led by strong sales growth in high-growth markets, particularly China and the rest of Asia, and in North America. This growth was led by demand in the clinical, applied and pharmaceutical end-markets and by demand for service offerings. Core sales of microscopy products grew on a year-over-year basis with growth in demand across most major end-markets partially driven by recent new product releases. Geographically, demand for microscopy products increased in North America and high-growth markets, particularly China. Year-over-year core sales for the business’ flow cytometry and particle counting products grew in 2018 across most major end-markets, led by increases in sales in North America, China and Western Europe. New product launches in 2018 also contributed to the increased demand in these markets. Core sales for filtration, separation and purification technologies grew on a year-over-year basis led by growth in biopharmaceuticals, microelectronics and fluid technology and asset protection end-markets. Geographically, core sales in filtration, separation and purification technologies were led by growth in Western Europe, North America and high-growth markets. Sales growth from acquisitions was primarily due to the acquisition of IDT in April 2018. During 2018, IDT’s revenues grew on a year-over-year basis across all major geographies and product lines. Operating profit margins increased 140 basis points during 2018 as compared to 2017. The following factors impacted year-over-year operating profit margin comparisons. 2018 vs. 2017 operating profit margin comparisons were favorably impacted by: • Higher 2018 sales volumes from existing businesses and incremental year-over-year cost savings associated with the continued productivity improvement initiatives taken in 2018 and 2017, net of incremental year-over-year costs associated with various new product development, sales and marketing growth investments - 180 basis points • 2018 gain on resolution of acquisition-related matters - 20 basis points 2018 vs. 2017 operating profit margin comparisons were unfavorably impacted by: • The incremental net dilutive effect in 2018 of acquired businesses - 35 basis points • Acquisition-related charges consisting of transaction costs and fair value adjustments to inventory for the acquisition of IDT in the second quarter of 2018 - 25 basis points DIAGNOSTICS The Company’s Diagnostics segment offers analytical instruments, reagents, consumables, software and services that hospitals, physicians’ offices, reference laboratories and other critical care settings use to diagnose disease and make treatment decisions. Diagnostics Selected Financial Data Core Revenue 2019 Compared to 2018 Price increases in the segment did not have a significant impact on sales growth on a year-over-year basis during 2019 as compared with 2018. Geographically, core sales in the clinical lab business increased on a year-over-year basis due to continued demand in high-growth markets, led by China, and in North America, partially offset by modest declines in Western Europe. The increased demand in the clinical lab business was mainly driven by the immunoassay, chemistry and automation product lines. Core sales in the molecular diagnostics business increased on a year-over-year basis in most major product lines and across all major geographies. Year-over-year core sales growth in the acute care diagnostic business was driven by continued strong sales of blood gas and immunoassay product lines, primarily in China, Western Europe, Japan and North America. Increased demand for advanced staining and core histology product lines drove the majority of the year-over-year core sales growth in the pathology diagnostics business. Geographically, core revenue growth in the pathology diagnostics business was led by North America, Western Europe and China. Operating profit margins increased 10 basis points during 2019 as compared to 2018, due to higher 2019 core sales volumes and incremental year-over-year cost savings associated with the continued productivity improvement initiatives taken in 2019 and 2018, net of incremental year-over-year costs associated with various new product development and sales, service and marketing growth investments and the impact of foreign exchange rates. Depreciation and amortization as a percentage of sales decreased during 2019 as compared with 2018 largely due to the impact of increased sales in 2019. 2018 Compared to 2017 Price in the segment negatively impacted sales growth by 0.5% on a year-over-year basis during 2018 as compared with 2017 and is reflected as a component of the change in core revenue growth. Core sales in the molecular diagnostics business increased on a year-over-year basis, driven by strong growth in both developed and high-growth markets. The molecular diagnostics business experienced particularly strong growth in the infectious disease product line driven in part by the severity of the flu season during the first quarter of 2018. Core sales in the clinical lab business increased on a year-over-year basis due to increased demand in the high-growth markets, led by China, partially offset by lower sales in Western Europe. The increased demand in the clinical lab business was driven by the immunoassay product line. Core sales in the acute care diagnostic business increased, driven by continued strong sales of blood gas and immunoassay product lines across most major geographies, led by the high-growth markets. Core sales in the pathology diagnostics business increased across most major geographies, led by North America, Western Europe and China. Demand for new products in the advanced staining and core histology product lines drove the increased core sales in the pathology diagnostics business. Operating profit margins increased 230 basis points during 2018 as compared to 2017. The following factors impacted year-over-year operating profit margin comparisons. 2018 vs. 2017 operating profit margin comparisons were favorably impacted by: • Higher 2018 sales volumes from existing businesses and incremental year-over-year cost savings associated with the continued productivity improvement initiatives taken in 2018 and 2017, net of incremental year-over-year costs associated with various new product development, sales and marketing growth investments and the effect of year-over-year changes in foreign exchange rates - 125 basis points • Restructuring, impairment and other related charges related to discontinuing a product line in 2017 - 130 basis points 2018 vs. 2017 operating profit margin comparisons were unfavorably impacted by: • 2017 gain on resolution of acquisition-related matters - 25 basis points ENVIRONMENTAL & APPLIED SOLUTIONS The Company’s Environmental & Applied Solutions segment offers products and services that help protect important resources and keep global food and water supplies safe. The Company’s water quality business provides instrumentation, consumables, software, services and disinfection systems to help analyze, treat and manage the quality of ultra-pure, potable, industrial, waste, ground, source and ocean water in residential, commercial, municipal, industrial and natural resource applications. The Company’s product identification business provides equipment, software, services and consumables for various color and appearance management, packaging design and quality management, packaging converting, printing, marking, coding and traceability applications for consumer, pharmaceutical and industrial products. Environmental & Applied Solutions Selected Financial Data Core Revenue 2019 Compared to 2018 Price increases in the segment contributed 1.5% to sales growth on a year-over-year basis during 2019 as compared with 2018 and are reflected as a component of the change in core revenue growth. Core sales in the segment’s water quality businesses grew at a mid-single digit rate during 2019 as compared with 2018. Year-over-year core sales in the analytical instrumentation product line increased, driven by demand in North America, Western Europe, and high-growth markets, partially offset by lower core sales in China primarily as a result of strong regulatory driven demand in the prior year. Year-over-year core revenue growth in the business’ chemical treatment solutions product line was driven by demand in the oil and gas, primary metals, food and beverage, and commercial and industrial end-markets. Geographically, year-over-year core revenue growth in the chemical treatment solutions product line was driven by North America and Latin America. Core sales in the business’ ultraviolet water disinfection product line increased across all major end-markets on a year-over-year basis, driven by the completion of several municipal projects. Geographically, year-over year core revenue growth for ultraviolet water disinfection products was led by North America and China. Core sales in the segment’s product identification businesses grew at a low-single digit rate during 2019 as compared with 2018. Year-over-year core revenue growth for marking and coding equipment and related consumables was driven by demand in North America, Western Europe and high-growth markets. Core sales for the business’ packaging and color solutions increased year-over-year, driven by increased demand in North America, Western Europe and high-growth markets. Operating profit margins increased 100 basis points during 2019 as compared to 2018. The following factors impacted year-over-year operating profit margin comparisons: 2019 vs. 2018 operating profit margin comparisons were favorably impacted by: • Higher 2019 core sales volumes, incremental year-over-year cost savings associated with the continued productivity improvement initiatives taken in 2019 and 2018 and the impact of foreign exchange rates, net of incremental year-over-year costs associated with various new product development and sales, service and marketing growth investments - 115 basis points 2019 vs. 2018 operating profit margin comparisons were unfavorably impacted by: • The incremental net dilutive effect in 2019 of acquired businesses - 15 basis points 2018 Compared to 2017 Price increases in the segment contributed 1.5% to sales growth on a year-over-year basis during 2018 as compared with 2017 and are reflected as a component of the change in core revenue growth. Core sales in the segment’s water quality businesses grew at a high-single digit rate during 2018 as compared with 2017. Year-over-year core sales in the analytical instrumentation product line increased, led by continued demand in the industrial and municipal end-markets. Geographically, year-over-year core revenue growth in the analytical instrumentation product line was driven by increased demand across all major geographies, led by China, North America and Western Europe. Year-over-year core revenue growth in the business’ chemical treatment solutions product line was driven by demand in the commercial and industrial, mining and primary metals end-markets. Geographically, year-over-year core revenue growth in the chemical treatment solutions product line was driven by North America and Latin America. Core sales in the business’ ultraviolet water disinfection product line grew on a year-over-year basis due primarily to demand in the municipal and consumer end-markets. Geographically, year-over year core revenue growth in the ultraviolet water disinfection product line was led by North America and China, partially offset by softer demand in Western Europe. Core sales in the segment’s product identification businesses grew at a mid-single digit rate during 2018 as compared with 2017. Year-over-year core revenue growth for marking and coding equipment and related consumables was driven by demand across all major end-markets and in all major geographies, particularly Western Europe, North America and high-growth markets. Demand for the business’ packaging and color solutions decreased slightly year-over-year. Geographically, core sales for packaging and color solutions decreased in North America and high-growth markets, partially offset by increased demand in Western Europe. Operating profit margins declined 10 basis points during 2018 as compared to 2017. The following factors impacted year-over-year operating profit margin comparisons: 2018 vs. 2017 operating profit margin comparisons were favorably impacted by: • Higher 2018 sales volumes, incremental year-over-year cost savings associated with the continued productivity improvement initiatives taken in 2018 and 2017, and improved pricing, net of incremental year-over-year costs associated with various new product development and sales and marketing growth investments - 35 basis points 2018 vs. 2017 operating profit margin comparisons were unfavorably impacted by: • The incremental net dilutive effect in 2018 of acquired businesses - 45 basis points COST OF SALES AND GROSS PROFIT The year-over-year increase in cost of sales during 2019 as compared with 2018 was due primarily to the impact of higher year-over-year sales volumes, including sales from recently acquired businesses, product mix, and higher freight and tariff costs, partially offset by increased leverage of certain manufacturing costs and incremental year-over-year cost savings associated with the continued productivity improvement initiatives taken in 2019 and 2018. The year-over-year increase in cost of sales during 2018 as compared with 2017, was due primarily to the impact of higher year-over-year sales volumes, including sales from recently acquired businesses, partially offset by incremental year-over-year cost savings associated with the continued productivity improvement initiatives taken in 2018 and 2017 and charges associated with the Company’s strategic decision to discontinue a product line in its Diagnostics segment in 2017. Cost of goods sold also increased in 2018 as a result of higher tariffs. The slight year-over-year decrease in gross profit margins during 2019 as compared with 2018 was due primarily to the impact of product mix and higher freight and tariff costs, partially offset by the impact of higher year-over-year sales volumes, including sales from recently acquired businesses, increased leverage of certain manufacturing costs and incremental year-over-year cost savings associated with the continued productivity improvement initiatives taken in 2019 and 2018. The year-over-year increase in gross profit margins during 2018 as compared with 2017 was due primarily to the favorable impact of higher year-over-year sales volumes, including sales from recently acquired businesses, increased leverage of certain manufacturing costs and incremental year-over-year cost savings associated with the continued productivity improvement initiatives taken in 2018 and 2017. Gross margin improvements were partially offset by the impact of foreign exchange rates in 2018. OPERATING EXPENSES SG&A expenses as a percentage of sales declined 40 basis points on a year-over-year basis for 2019 compared with 2018. The decline was driven by increased leverage of the Company’s general and administrative cost base resulting from higher 2019 sales volumes and continuing productivity improvements taken in 2019 and 2018, partially offset by continued investments in sales and marketing growth initiatives and transaction costs and integration preparation costs associated with the anticipated GE Biopharma Acquisition, which increased SG&A as a percentage of sales by approximately 50 basis points during 2019. SG&A expenses as a percentage of sales declined 90 basis points on a year-over-year basis for 2018 compared with 2017. The decline was driven by increased leverage of the Company’s general and administrative cost base resulting from higher 2018 sales volumes, continuing productivity improvements taken in 2018 and 2017, and the impact of the restructuring, impairment and other related charges incurred in 2017 associated with the Company’s strategic decision to discontinue a product line in its Diagnostics segment. The decline in SG&A expenses as a percentage of sales was partially offset by higher relative spending levels at recently acquired companies and continued investments in sales and marketing growth initiatives. R&D expenses (consisting principally of internal and contract engineering personnel costs) as a percentage of sales increased slightly in 2019 as compared with 2018, as year-over-year increases in the Company’s investments in new product development initiatives approximated the year-over-year increase in sales. R&D expenses as a percentage of sales were flat in 2018 as compared to 2017. NONOPERATING INCOME (EXPENSE) As described in Note 1 and Note 13 to the Consolidated Financial Statements, in the first quarter of 2018, the Company adopted Accounting Standards Update (“ASU”) ASU No. 2017-07, Compensation- Retirement Benefits (Topic 715): Improving the Presentation of Net Periodic Pension Cost and Net Periodic Postretirement Benefit Cost. The ASU requires the Company to disaggregate the service cost component from the other components of net periodic benefit costs and requires the Company to present the other components of net periodic benefit cost in other income, net. The ASU required application on a retrospective basis. The other components of net periodic benefit costs included in other income, net for the years ended December 31, 2019, 2018 and 2017 were net gains of $12 million, $35 million and $31 million, respectively. The Company’s net periodic pension cost for the year-ended December 31, 2019 includes a settlement loss of $7 million pre-tax ($6 million after-tax, or $0.01 per diluted share) as a result of the transfer of a portion of its non-U.S. pension liabilities related to one defined benefit plan to a third party. During 2017, the Company received $138 million of cash proceeds and recorded $22 million in short-term other receivables from the sale of certain marketable equity securities during 2017. The Company recorded a pretax gain related to this sale of $73 million ($46 million after-tax or $0.06 per diluted share). LOSS ON EARLY EXTINGUISHMENT OF BORROWINGS In the fourth quarter of 2019, the Company redeemed the $500 million aggregate principal amount of 2.4% senior unsecured notes due 2020 and the $375 million aggregate principal amount of 5.0% senior unsecured notes due 2020. The Company recorded a loss on extinguishment of these borrowings, net of certain deferred gains, of $7 million ($5 million after-tax or $0.01 per diluted share). The Company funded the redemption using a portion of the cash distribution it received in connection with the Envista Disposition. INTEREST COSTS Interest expense of $109 million for 2019 was $28 million lower than in 2018, due primarily to the impact of the Company’s cross-currency swap derivative contracts and the repayment of certain outstanding borrowings in 2019, partially offset by interest expense from 2019 debt issuances. For a further description of the Company’s debt as of December 31, 2019 refer to Note 11 to the Consolidated Financial Statements. Interest expense of $137 million in 2018 was $3 million lower than the 2017 interest expense of $140 million due primarily to the decrease in interest costs as a result of the repayment of certain outstanding borrowings in the third quarter of 2018 and the second and fourth quarters of 2017, lower average outstanding U.S. commercial paper borrowings during 2018 compared to 2017, and the impact of foreign exchange rates in 2018 as compared to 2017, partially offset by the cost of additional non-U.S. debt issued during 2017. In January 2019, the Company entered into approximately $1.9 billion of cross-currency swap derivative contracts on its U.S. dollar-denominated bonds to effectively convert the Company’s U.S. dollar-denominated bonds to obligations denominated in Danish kroner, Japanese yen, euro and Swiss franc and reduce the interest rate from the stated interest rates on the U.S. dollar-denominated debt to the interest rates of the swaps. As of December 31, 2019, approximately $1.0 billion of the cross-currency swap derivative contracts remained outstanding. The Company used interest rate swap agreements to hedge the variability in cash flows due to changes in benchmark interest rates related to a portion of the U.S. debt the Company issued to fund the GE Biopharma Acquisition. The interest rate swap agreements are agreements in which the Company agrees to pay a fixed interest rate based on the rate specified in the agreement in exchange for receiving a floating interest rate from a third-party bank based upon a specified benchmark interest rate. In June 2019, the Company entered into interest rate swap agreements with a notional amount of $850 million. These contracts, which were settled in November 2019, effectively fixed the interest rate for a portion of the Company’s U.S. dollar-denominated debt issued in November 2019 equal to the notional amount of the swaps to the rate specified in the interest rate swap agreements. The changes in the fair value of these instruments resulting from the changes in interest rates were recorded as a loss of $38 million in accumulated other comprehensive income (loss) in stockholders’ equity prior to the issuance of the debt and are subsequently being reclassified to interest expense over the life of the related debt. INCOME TAXES General Income tax expense and deferred tax assets and liabilities reflect management’s assessment of future taxes expected to be paid on items reflected in the Company’s Consolidated Financial Statements. The Company records the tax effect of discrete items and items that are reported net of their tax effects in the period in which they occur. The Company’s effective tax rate can be affected by changes in the mix of earnings in countries with different statutory tax rates (including as a result of business acquisitions and dispositions), changes in the valuation of deferred tax assets and liabilities, accruals related to contingent tax liabilities and period-to-period changes in such accruals, the results of audits and examinations of previously filed tax returns (as further discussed below), the expiration of statutes of limitations, the implementation of tax planning strategies, tax rulings, court decisions, settlements with tax authorities and changes in tax laws and regulations, such as the TCJA and legislative policy changes that may result from the OECD’s initiative on Base Erosion and Profit Shifting. For a description of the tax treatment of earnings that are planned to be reinvested indefinitely outside the United States, refer to “-Liquidity and Capital Resources-Cash and Cash Requirements” below. The amount of income taxes the Company pays is subject to ongoing audits by federal, state and foreign tax authorities, which often result in proposed assessments. Management performs a comprehensive review of its global tax positions on a quarterly basis. Based on these reviews, the results of discussions and resolutions of matters with certain tax authorities, tax rulings and court decisions and the expiration of statutes of limitations, reserves for contingent tax liabilities are accrued or adjusted as necessary. For a discussion of risks related to these and other tax matters, refer to “Item 1A. Risk Factors”. On December 22, 2017, the TCJA was enacted, substantially changing the U.S. tax system. Under the SEC Staff Accounting Bulletin No. 118 (“SAB No. 118”) guidance, for the year ended December 31, 2017, the Company recorded provisional amounts in earnings for the enactment of the TCJA and during 2018, the Company completed its accounting for the TCJA based on the Company’s interpretation of the new tax regulations and related guidance issued by the U.S. Department of the Treasury and the IRS. The TCJA imposes tax on U.S. shareholders for global intangible low-taxed income (“GILTI”) earned by certain foreign subsidiaries. The Company has elected the period cost method for its accounting for GILTI. Due to the complexity and recent issuance of these tax regulations, management’s interpretations of the impact of these rules could be subject to challenge by the taxing authorities. Year-Over-Year Changes in the Tax Provision and Effective Tax Rate The Company’s effective tax rate for 2019, 2018 and 2017 differs from the U.S. federal statutory rates of 21.0% in 2019 and 2018 and 35.0% in 2017, due principally to the Company’s earnings outside the United States that are indefinitely reinvested and taxed at rates different than the U.S. federal statutory rate. In addition: • The effective tax rate of 26.4% in 2019 includes 650 basis points of net tax charges related primarily to changes in estimates associated with prior period uncertain tax positions, audit settlements, and Envista Disposition costs, net of the release of reserves for uncertain tax positions due to the expiration of statutes of limitation, release of valuation allowances associated with certain foreign tax credits, tax benefits resulting from changes in tax law and excess tax benefits from stock-based compensation. • The effective tax rate of 18.8% in 2018 includes 120 basis points of tax benefits primarily related to the release of reserves upon the expiration of statutes of limitation, audit settlements and release of a valuation allowance in a certain foreign tax jurisdiction. These tax benefits were partially offset by additional provisions related to completing the accounting for the enactment of the TCJA and tax costs directly related to reorganization activities associated with the Envista Disposition. • The effective tax rate of 14.6% in 2017 includes 560 basis points of net tax benefits due to the revaluation of deferred tax liabilities from 35.0% to 21.0% due to the TCJA and the release of reserves upon statute of limitation expiration, partially offset by income tax expense related to the Transition Tax on foreign earnings due to the TCJA and changes in estimates associated with prior period uncertain tax positions. The Company conducts business globally, and files numerous consolidated and separate income tax returns in the U.S. federal, state and foreign jurisdictions. The non-U.S. countries in which the Company has a significant presence include China, Denmark, Germany, Singapore, Switzerland and the United Kingdom. The Company believes that a change in the statutory tax rate of any individual foreign country would not have a material effect on the Company’s Consolidated Financial Statements given the geographic dispersion of the Company’s taxable income. The Company and its subsidiaries are routinely examined by various domestic and international taxing authorities. The IRS has completed substantially all of the examinations of the Company’s federal income tax returns through 2011 and is currently examining certain of the Company’s federal income tax returns for 2012 through 2017. In addition, the Company has subsidiaries in Austria, Belgium, Canada, China, Denmark, France, Germany, Hong Kong, India, Italy, Japan, Korea, Switzerland, the United Kingdom and various other countries, states and provinces that are currently under audit for years ranging from 2004 through 2018. In the fourth quarter of 2018 and the first quarter of 2019, the IRS proposed significant adjustments to the Company’s taxable income for the years 2012 through 2015 with respect to the deferral of tax on certain premium income related to the Company’s self-insurance programs. For income tax purposes, the recognition of premium income has been deferred in accordance with U.S. tax laws related to insurance. The IRS is challenging the deferral of premiums for certain types of the Company’s self-insurance policies. The proposed adjustments would increase the Company’s taxable income over the 2012 through 2015 period by approximately $2.7 billion. Management believes the positions the Company has taken in its U.S. tax returns are in accordance with the relevant tax laws and intends to vigorously defend these positions. Due to the enactment of the TCJA in 2017 and the resulting reduction in the U.S. corporate tax rate for years after 2017, the Company revalued its deferred tax liabilities related to the temporary differences associated with this deferred premium income from 35.0% to 21.0%. If the Company is not successful in defending these assessments, the taxes owed to the IRS may be computed under the previous 35.0% statutory tax rate and the Company may be required to revalue the related deferred tax liabilities from 21.0% to 35.0%, which in addition to any interest due on the amounts assessed, would require a charge to future earnings. The ultimate resolution of this matter is uncertain, could take many years and could result in a material adverse impact to the Company’s financial statements, including its cash flows and effective tax rate. Tax authorities in Denmark have raised significant issues related to interest accrued by certain of the Company’s subsidiaries. On December 10, 2013, the Company received assessments from the Danish tax authority (“SKAT”) of approximately DKK 1.8 billion (approximately $266 million based on exchange rates as of December 31, 2019) including interest through December 31, 2019, imposing withholding tax relating to interest accrued in Denmark on borrowings from certain of the Company’s subsidiaries for the years 2004-2009. The Company appealed these assessments to the Danish National Tax Tribunal in 2014. The appeal is pending, awaiting the final outcome of other, preceding withholding tax cases that were appealed to the Danish courts and subsequently to the Court of Justice of the European Union (“CJEU”). In February 2019, the CJEU decided several of these cases and ruled that the exemption of interest payments from withholding taxes provided in the applicable EU directive should be denied where taxpayers use the directive for abusive or fraudulent purposes, and that it is up to the national courts to make this determination. This decision of the CJEU now awaits application by the Danish High Court in the other, preceding withholding tax cases. SKAT has maintained a similar position related to withholding tax on interest accrued in Denmark on borrowings from certain of the Company’s subsidiaries with respect to tax years 2010-2012 and 2013-2015. On August 27, 2019 and December 16, 2019, the Company received assessments for these matters of approximately DKK 1.1 billion including interest through December 31, 2019 (approximately $159 million based on the exchange rate as of December 31, 2019) for tax years 2010-2012 and DKK 751 million including interest through December 31, 2019 (approximately $113 million based on the exchange rate as of December 31, 2019) for tax years 2013-2015, respectively. The Company is appealing these assessments as well. Management believes the positions the Company has taken in Denmark are in accordance with the relevant tax laws and is vigorously defending its positions. The Company intends on pursuing this matter through the Danish High Court should the appeal to the Danish National Tax Tribunal be unsuccessful. The Company will continue to monitor decisions of both the Danish courts and the CJEU and evaluate the impact of these court rulings on the Company’s tax positions in Denmark. The ultimate resolution of this matter is uncertain, could take many years, and could result in a material adverse impact to the Company’s financial statements, including its cash flow and effective tax rate. The Company expects its 2020 effective tax rate to be approximately 19.5%. Any future legislative changes in the United States including potential tax reform in other jurisdictions, could cause the Company’s effective tax rate to differ from this estimate. Refer to Note 15 to the Consolidated Financial Statements for additional information related to income taxes. DISCONTINUED OPERATIONS As further discussed in Note 4 to the Consolidated Financial Statements, discontinued operations include the results of Envista which was disposed of during the fourth quarter of 2019 as well as an income tax benefit in 2017 related to the Fortive businesses that were disposed of during the third quarter of 2016. In 2019, earnings from discontinued operations, net of income taxes, were $576 million and reflect the operating results of Envista prior to the Envista Disposition and a gain on the disposition of Envista of $451 million, net of certain costs associated with the Envista Disposition including costs related to establishing Envista as a stand-alone entity and legal, accounting and investment banking fees. In 2018 and 2017, earnings from discontinued operations, net of income taxes, were $245 million and $320 million, respectively, and reflect the operations of Envista as well as a $22 million income tax benefit in 2017 related to the release of previously provided reserves associated with uncertain tax positions on certain Danaher tax returns which were jointly filed with Fortive entities. These reserves were released due to the expiration of statutes of limitations for those returns. All Fortive entity-related balances are included in the income tax benefit related to discontinued operations for the year ended December 31, 2017. COMPREHENSIVE INCOME Comprehensive income increased by approximately $726 million in 2019 as compared to 2018, primarily due to a decrease in losses from foreign currency translation adjustments in 2019 compared to 2018 and higher net earnings (including those attributable to discontinued operations) partially offset by an increase in losses from pension and postretirement plan benefit adjustments in 2019 compared to 2018 and losses from cash flow hedge adjustments in 2019. The Company recorded a foreign currency translation loss of $75 million for 2019 compared to a translation loss of $632 million for 2018. The Company recorded a pension and postretirement plan benefit loss of $90 million for 2019 compared to a loss of $13 million for 2018. The Company recorded losses from cash flow hedge adjustments in 2019 of $113 million. Comprehensive income decreased by approximately $1.5 billion in 2018 as compared to 2017, primarily due to a loss from foreign currency translation adjustments in 2018 compared to a gain in 2017 and a loss from pension and postretirement plan benefit adjustments in 2018 as compared to a gain in 2017, partially offset by higher net earnings (including those attributable to discontinued operations) and a decrease in unrealized losses on available-for-sale securities in 2018 compared to 2017. The Company recorded a foreign currency translation loss of $632 million for 2018 compared to a translation gain of $976 million for 2017. The Company recorded a pension and postretirement plan benefit loss of $13 million in 2018 compared to a gain of $71 million in 2017. INFLATION The effect of inflation on the Company’s revenues and net earnings was not significant in any of the years ended December 31, 2019, 2018 or 2017. FINANCIAL INSTRUMENTS AND RISK MANAGEMENT The Company is exposed to market risk from changes in interest rates, foreign currency exchange rates, equity prices and commodity prices as well as credit risk, each of which could impact its Consolidated Financial Statements. The Company generally addresses its exposure to these risks through its normal operating and financing activities. The Company also periodically uses derivative financial instruments to manage foreign exchange risks and interest rate risks. In addition, the Company’s broad-based business activities help to reduce the impact that volatility in any particular area or related areas may have on its operating profit as a whole. Interest Rate Risk The Company manages interest cost using a mixture of fixed-rate and variable-rate debt. A change in interest rates on fixed rate long-term debt impacts the fair value of the debt but not the Company’s earnings or cash flow because the interest on such debt is fixed. Generally, the fair market value of fixed-rate debt will increase as interest rates fall and decrease as interest rates rise. As of December 31, 2019, an increase of 100 basis points in interest rates would have decreased the fair value of the Company’s fixed-rate long-term debt (excluding the LYONs, which have not been included in this calculation as the value of this convertible debt is primarily derived from the value of its underlying common stock) by approximately $1.7 billion. As of December 31, 2019, the Company’s variable-rate debt obligations consisted primarily of euro-based commercial paper borrowings (refer to Note 11 to the Consolidated Financial Statements for information regarding the Company’s outstanding commercial paper balances as of December 31, 2019). As a result, the Company’s primary interest rate exposure results from changes in short-term interest rates. As these shorter duration obligations mature, the Company may issue additional short-term commercial paper obligations to refinance all or part of these borrowings. In 2019, the average annual interest rate associated with outstanding commercial paper borrowings was approximately negative 19 basis points. A hypothetical increase of this average to negative 12 basis points would have increased the Company’s annual interest expense by $2 million. The hypothetical increase used is the actual amount by which the Company’s commercial paper interest rates fluctuated during 2019. Refer to “Results of Operations-Interest Costs” for discussion of the Company’s cross-currency swap derivative contracts and interest rate swap agreements. Currency Exchange Rate Risk The Company faces transactional exchange rate risk from transactions with customers in countries outside the United States and from intercompany transactions between affiliates. Transactional exchange rate risk arises from the purchase and sale of goods and services in currencies other than Danaher’s functional currency or the functional currency of its applicable subsidiary. The Company also faces translational exchange rate risk related to the translation of financial statements of its foreign operations into U.S. dollars, Danaher’s functional currency. Costs incurred and sales recorded by subsidiaries operating outside of the United States are translated into U.S. dollars using exchange rates effective during the respective period. As a result, the Company is exposed to movements in the exchange rates of various currencies against the U.S. dollar. In particular, the Company has more sales in European currencies than it has expenses in those currencies. Therefore, when European currencies strengthen or weaken against the U.S. dollar, operating profits are increased or decreased, respectively. The effect of a change in currency exchange rates on the Company’s net investment in international subsidiaries is reflected in the accumulated other comprehensive income (loss) component of stockholders’ equity. Currency exchange rates negatively impacted 2019 reported sales by 2.0% on a year-over-year basis, primarily as a result of the U.S. dollar strengthening against other major currencies. If the exchange rates in effect as of December 31, 2019 were to prevail throughout 2020, currency exchange rates would slightly increase 2020 estimated sales relative to 2019 sales. Strengthening of the U.S. dollar against other major currencies compared to the exchange rates in effect as of December 31, 2019 would adversely impact the Company’s sales and results of operations on an overall basis. Any weakening of the U.S. dollar against other major currencies compared to the exchange rates in effect as of December 31, 2019 would positively impact the Company’s sales and results of operations. The Company has generally accepted the exposure to exchange rate movements without using derivative financial instruments to manage this transactional exchange risk, although the Company has used foreign currency-denominated debt and cross-currency swaps to hedge a portion of its net investments in foreign operations against adverse movements in exchange rates. Both positive and negative movements in currency exchange rates against the U.S. dollar will continue to affect the reported amount of sales and net earnings in the Company’s Consolidated Financial Statements. In addition, the Company has assets and liabilities held in foreign currencies. A 10% depreciation in major currencies relative to the U.S. dollar as of December 31, 2019 would have reduced foreign currency-denominated net assets and stockholders’ equity by approximately $830 million. In 2019, the Company entered into approximately $1.9 billion of cross-currency swap derivative contracts on its U.S. dollar-denominated bonds to hedge its net investment in foreign operations against adverse changes in the exchange rates between the U.S. dollar and the Danish kroner, Japanese yen, euro and the Swiss franc. These contracts effectively convert the Company’s U.S. dollar-denominated bonds to obligations denominated in Danish kroner, Japanese yen, euro and Swiss franc, and partially offset the impact of changes in currency rates on foreign currency-denominated net assets during the term of the swap. As of December 31, 2019, approximately $1.0 billion of the cross-currency swap derivative contracts remained outstanding. The Company also uses cross-currency swap derivative contracts to hedge U.S. dollar-denominated long-term debt issuances in a foreign subsidiary whose functional currency is the euro against adverse movements in exchange rates between the U.S. dollar and the euro. In November 2019, the Company entered into cross-currency swap derivative contracts with respect to approximately $4.0 billion of its U.S. dollar-denominated bonds and all of these derivative contracts remained outstanding as of December 31, 2019. Equity Price Risk The Company’s investment portfolio from time to time includes publicly-traded equity securities that are sensitive to fluctuations in market price, though as of December 31, 2019, the Company held no available-for-sale marketable equity securities. The Company holds non-marketable equity investments in privately held companies that may be impacted by equity price risks or other factors. These non-marketable equity investments are accounted for under the Fair Value Alternative method with changes in fair value recorded in earnings. Volatility in the equity markets or other fair value considerations could affect the value of these investments and require charges or gains to be recognized in earnings. Commodity Price Risk For a discussion of risks relating to commodity prices, refer to “Item 1A. Risk Factors.” Credit Risk The Company is exposed to potential credit losses in the event of nonperformance by counterparties to its financial instruments. Financial instruments that potentially subject the Company to credit risk consist of cash and temporary investments, receivables from customers and derivatives. The Company places cash and temporary investments with various high-quality financial institutions throughout the world and exposure is limited at any one institution. Although the Company typically does not obtain collateral or other security to secure these obligations, it does regularly monitor the third-party depository institutions that hold its cash and cash equivalents. The Company’s emphasis is primarily on safety and liquidity of principal and secondarily on maximizing yield on those funds. In addition, concentrations of credit risk arising from receivables from customers are limited due to the diversity of the Company’s customers. The Company’s businesses perform credit evaluations of their customers’ financial conditions as deemed appropriate and also obtain collateral or other security when deemed appropriate. The Company enters into derivative transactions infrequently and typically with high-quality financial institutions, so that exposure at any one institution is limited. LIQUIDITY AND CAPITAL RESOURCES Management assesses the Company’s liquidity in terms of its ability to generate cash to fund its operating, investing and financing activities. The Company continues to generate substantial cash from operating activities and forecasts that its operating cash flow and other sources of liquidity will be sufficient to allow it to continue investing in existing businesses, consummating strategic acquisitions and investments, paying interest and servicing debt and managing its capital structure on a short and long-term basis. In addition, as discussed in further detail above, the Company received approximately $2.0 billion of cash from Envista as consideration for the transfer of the Company’s dental businesses to Envista, a portion of which consideration the Company used to redeem certain of the Company’s outstanding indebtedness in the fourth quarter of 2019. Following is an overview of the Company’s cash flows and liquidity for the years ended December 31: Overview of Cash Flows and Liquidity • Operating cash flows from continuing operations increased $13 million, or less than 1%, during 2019 as compared to 2018, due primarily to higher net earnings, which included higher noncash charges for depreciation, amortization, and stock compensation, and the impact of a noncash discrete income tax charge in 2019, net of higher cash used for funding trade accounts receivable, inventories and trade accounts payable in 2019 compared to 2018. In addition, lower cash used for payments for various employee-related liabilities, customer funding and accrued expenses increased operating cash flows from continuing operations in 2019 compared to 2018. • On March 1, 2019, the Company completed the underwritten public offering of 12.1 million shares of Danaher common stock at a price to the public of $123.00 per share resulting in net proceeds of approximately $1.4 billion, after deducting expenses and the underwriters’ discount. Simultaneously, the Company completed the underwritten public offering of 1.65 million shares of its MCPS resulting in net proceeds of approximately $1.6 billion, after deducting expenses and the underwriters’ discount. The Company intends to use the net proceeds from the underwritten public offerings of its Common Stock and MCPS (the “Common Stock Offering” and “MCPS Offering”, respectively) to fund a portion of the cash consideration payable for, and certain costs associated with, the GE Biopharma Acquisition. • In the second half of 2019, the Company issued approximately €6.2 billion of senior unsecured euronotes and approximately $4.0 billion of senior unsecured notes. The proceeds from these issuances will be used to fund a portion of the cash consideration payable for the GE Biopharma Acquisition. • On December 18, 2019, Danaher completed the Envista Disposition. Prior to the IPO, Envista borrowed $650 million under a senior unsecured term loan and €600 million under a three-year, senior unsecured term loan facility. Envista transferred the net proceeds from these borrowings along with the net proceeds of $643 million from the Envista IPO to the Company in consideration for the Company’s transfer of the dental businesses to Envista. • Danaher used a portion of the consideration received from Envista to redeem $882 million in aggregate principal amount of outstanding indebtedness in the fourth quarter of 2019 (consisting of the Company’s 2.4% senior unsecured notes due 2020 and 5.0% senior unsecured notes due 2020 (collectively the “Redeemed Notes”)), as well as the make-whole premiums and accrued and unpaid interest required to be paid in connection with such redemptions. The Company used the balance of the consideration it received from Envista to redeem commercial paper borrowings as they matured. • Net cash used in investing activities during 2019 consisted primarily of cash paid for acquisitions, additions to property, plant and equipment and payments for purchases of investments. The Company acquired five businesses during 2019 for total consideration (including assumed debt and net of cash acquired) of $331 million. Payments for additions to property, plant and equipment increased $52 million in 2019 compared to 2018 and included investments in operating assets and new facilities. In addition, in 2019, the Company invested $241 million in non-marketable equity securities and a partnership. • As of December 31, 2019, the Company held approximately $19.9 billion of cash and cash equivalents. Operating Activities Cash flows from operating activities can fluctuate significantly from period-to-period as working capital needs and the timing of payments for income taxes, restructuring activities and productivity improvement initiatives, pension funding and other items impact reported cash flows. Operating cash flows from continuing operations were approximately $3.7 billion for 2019, an increase of $13 million, or less than 1%, as compared to 2018. The year-over-year change in operating cash flows from 2018 to 2019 was primarily attributable to the following factors: • 2019 operating cash flows benefited from higher net earnings in 2019 as compared to 2018. Net earnings for 2019 include noncash discrete income tax charges totaling $215 million, which decreased net earnings without a corresponding impact to operating cash flows. • Net earnings for 2019 reflected an increase of $12 million of depreciation and amortization expense as compared to 2018. Amortization expense primarily relates to the amortization of intangible assets acquired in connection with acquisitions and increased due to recently acquired businesses. Depreciation expense relates to both the Company’s manufacturing and operating facilities as well as instrumentation leased to customers under operating-type lease arrangements and increased due primarily to the impact of increased capital expenditures. Depreciation and amortization are noncash expenses that decrease earnings without a corresponding impact to operating cash flows. • The aggregate of trade accounts receivable, inventories and trade accounts payable used $160 million in operating cash flows during 2019, compared to $41 million of operating cash flows provided in 2018. The amount of cash flow generated from or used by the aggregate of trade accounts receivable, inventories and trade accounts payable depends upon how effectively the Company manages the cash conversion cycle, which effectively represents the number of days that elapse from the day it pays for the purchase of raw materials and components to the collection of cash from its customers and can be significantly impacted by the timing of collections and payments in a period. • The aggregate of prepaid expenses and other assets, deferred income taxes and accrued expenses and other liabilities provided $37 million in operating cash flows during 2019, compared to $121 million used in 2018. The noncash discrete tax charge, the timing of cash payments for taxes, various employee-related liabilities, customer funding and accrued expenses drove the majority of this change. Operating cash flows from continuing operations were approximately $3.6 billion for 2018, an increase of $522 million, or 17%, as compared to 2017. This increase was primarily attributable to the increase in net earnings from continuing operations in 2018 as compared to 2017. Net earnings in 2017 also included a $73 million gain on sale of marketable equity securities for which the proceeds were reflected in the investing activities section of the accompanying Consolidated Statement of Cash Flows, and therefore, did not contribute to operating cash flows. Investing Activities Cash flows relating to investing activities consist primarily of cash used for acquisitions and capital expenditures, including instruments leased to customers, cash used for investments and cash proceeds from divestitures of businesses or assets. Net cash used in investing activities was approximately $1.2 billion during 2019 compared to approximately $2.9 billion and $843 million of net cash used in 2018 and 2017, respectively. Acquisitions, Divestitures and Sale of Investments For a discussion of the Company’s 2019 acquisitions refer to “-Overview.” In addition, in 2019, the Company invested $241 million in non-marketable equity securities and partnerships. During 2018, the Company acquired two businesses for total consideration of approximately $2.2 billion in cash, net of cash acquired. The businesses acquired complement existing units of the Company’s Life Sciences and Environmental & Applied Solutions segments. The aggregate annual sales of these two businesses at the time of their respective acquisitions, in each case based on the companies’ revenues for its last completed fiscal year prior to the acquisition, were $313 million. In addition, in 2018, the Company invested $146 million in non-marketable equity securities and partnerships. The Company received cash proceeds of $22 million from the collection of short-term other receivables related to the sale of certain marketable equity securities during 2017. During 2017, the Company acquired nine businesses for total consideration of $386 million in cash, net of cash acquired. The businesses acquired complement existing units of the Life Sciences and Environmental & Applied Solutions segments. The aggregate annual sales of these nine businesses at the time of their respective acquisitions, in each case based on the companies’ revenues for its last completed fiscal year prior to the acquisition, were $160 million. The Company received $138 million of cash proceeds and recorded $22 million in short-term other receivables from the sale of certain marketable equity securities during 2017. The Company recorded a pretax gain related to this sale of $73 million ($46 million after-tax or $0.06 per diluted share). Capital Expenditures Capital expenditures are made primarily for increasing capacity, replacing equipment, supporting new product development, improving information technology systems and the manufacture of instruments that are used in operating-type lease arrangements that certain of the Company’s businesses enter into with customers. Capital expenditures totaled $636 million in 2019 and $584 million in 2018. The year-over-year increase in capital spending in 2019 was due to increased investments in operating assets and new facilities across the Company. In 2020, the Company expects capital spending to be approximately $700 million, though actual expenditures will ultimately depend on business conditions. Financing Activities Cash flows from financing activities consist primarily of cash flows associated with the issuance and repayments of commercial paper, issuance and repayment of long-term debt, issuance and repurchases of common stock, issuance of preferred stock, payments of cash dividends to shareholders and proceeds from the Envista IPO. Financing activities provided cash of approximately $16.4 billion during 2019 compared to $797 million of cash used during 2018. The year-over-year increase in cash provided by financing activities was due primarily to the public offerings of the Company’s common and preferred stock during the first quarter of 2019, the issuance of debt by the Company in the second half of 2019, the proceeds received from the Envista IPO and Envista debt issuances, and net proceeds from commercial paper borrowings in 2019 compared to 2018. These sources of liquidity were partially offset by higher debt redemptions during 2019 compared to 2018 which included the impact of the early extinguishment of $882 million of borrowings through the use of the proceeds received from Envista as part of the disposition of this business. Financing activities used cash of $797 million during 2018 compared to approximately $3.1 billion of cash used during 2017. The year-over-year decrease in cash used in financing activities was due primarily to lower net repayments of commercial paper borrowings in 2018, as the Company decreased its commercial paper borrowings in 2017 after increasing commercial paper borrowings for the Cepheid acquisition in 2016. The Company issued commercial paper early in 2018 to pay for a portion of the acquisition price of IDT and repaid substantially all of such commercial paper borrowings later in 2018. The cash outflow in 2017 for the net repayment of commercial paper was partially offset by proceeds from the issuance of long-term notes. In both 2018 and 2017, the Company repaid long-term debt, including $500 million aggregate principal amount of U.S. Notes with accrued interest that matured in September 2018. Total debt was approximately $21.7 billion and $9.7 billion as of December 31, 2019 and 2018, respectively. The Company had the ability to incur approximately $4.9 billion of additional indebtedness in direct borrowings or under the outstanding commercial paper facilities based on the amounts available under the Company’s $10.0 billion of credit facilities which were not being used to backstop outstanding commercial paper balances as of December 31, 2019. The Company has classified approximately $5.0 billion of its borrowings outstanding under the euro-denominated commercial paper program as of December 31, 2019 as long-term debt in the accompanying Consolidated Balance Sheet as the Company has the intent and ability, as supported by availability under the revolving credit facility, to refinance these borrowings for at least one year from the balance sheet date. As commercial paper obligations mature, the Company may issue additional short-term commercial paper obligations to refinance all or part of these borrowings. Under the Company’s U.S. and euro-denominated commercial paper program, the notes are typically issued at a discount from par, generally based on the ratings assigned to the Company by credit rating agencies at the time of the issuance and prevailing market rates measured by reference to LIBOR or EURIBOR. Additionally, the Company’s floating rate senior unsecured notes due 2022 pay interest based upon the three-month EURIBOR plus 0.3%. In July 2017, the head of the United Kingdom Financial Conduct Authority announced the intent to phase out the use of LIBOR by the end of 2021. The U.S. Federal Reserve, in conjunction with the Alternative Reference Rates Committee, a steering committee comprised of large U.S. financial institutions, is considering replacing U.S. dollar LIBOR with the Secured Overnight Financing Rate, or SOFR, a new index calculated by short-term repurchase agreements, backed by Treasury securities. The Company has evaluated the anticipated impact of the transition from LIBOR and does not expect the transition to be material to the Company’s financial position. Refer to Note 11 to the Consolidated Financial Statements for additional information regarding the Company’s financing activities and indebtedness, including the Company’s outstanding debt as of December 31, 2019, and the Company’s commercial paper program and related credit facilities. Common Stock Offering and MCPS Offering For a description of the first quarter 2019 Common Stock and MCPS Offerings, refer to Note 19 to the Consolidated Financial Statements. Shelf Registration Statement The Company has filed a “well-known seasoned issuer” shelf registration statement on Form S-3 with the SEC that registers an indeterminate amount of debt securities, common stock, preferred stock, warrants, depositary shares, purchase contracts and units for future issuance. The Company expects to use net proceeds realized by the Company from future securities sales off this shelf registration statement for general corporate purposes, including without limitation repayment or refinancing of debt or other corporate obligations, acquisitions, capital expenditures, share repurchases and dividends and/or working capital. Stock Repurchase Program Please see “Issuer Purchases of Equity Securities” in Item 5 of Part II of this Annual Report for a description of the Company’s stock repurchase program. Dividends The Company declared a regular quarterly dividend of $0.17 per share of Company common stock that was paid on January 31, 2020 to holders of record on December 27, 2019. In addition, the Company declared a quarterly cash dividend of $11.875 per MCPS that was paid on January 15, 2020 to holders of record as of December 31, 2019. Aggregate cash payments for dividends on Company common stock during 2019 were $478 million. The year-over-year increase in dividend payments on common stock in 2019 results from increases in the quarterly dividend rate effective with respect to the dividend paid in the second quarter of 2019. Aggregate cash payments for dividends on the MCPS during 2019 were $49 million. Cash and Cash Requirements As of December 31, 2019, the Company held approximately $19.9 billion of cash and cash equivalents that were invested in highly liquid investment-grade debt instruments with a maturity of 90 days or less with an approximate weighted average annual interest rate of 1.5%. Of this amount, approximately $16.3 billion was held within the United States and approximately $3.6 billion was held outside of the United States. The Company will continue to have cash requirements to support working capital needs, capital expenditures, acquisitions and investments, pay interest and service debt, pay taxes and any related interest or penalties, fund its restructuring activities and pension plans as required, pay dividends to shareholders, repurchase shares of the Company’s common stock and support other business needs. The Company generally intends to use available cash and internally generated funds to meet these cash requirements, but in the event that additional liquidity is required, particularly in connection with acquisitions (including the GE Biopharma Acquisition), the Company may also borrow under its commercial paper programs or credit facilities, enter into new credit facilities and either borrow directly thereunder or use such credit facilities to backstop additional borrowing capacity under its commercial paper programs and/or issue debt and/or equity in the capital markets. The Company also may from time to time access the capital markets to take advantage of favorable interest rate environments or other market conditions. For a description of the Company’s anticipated financing of the GE Biopharma Acquisition, refer to Note 3 to the Consolidated Financial Statements. While repatriation of some cash held outside the United States may be restricted by local laws, most of the Company’s foreign cash could be repatriated to the United States. Following enactment of the TCJA and the associated Transition Tax, in general, repatriation of cash to the United States can be completed with no incremental U.S. tax; however, repatriation of cash could subject the Company to non-U.S. jurisdictional taxes on distributions. The cash that the Company’s non-U.S. subsidiaries hold for indefinite reinvestment is generally used to finance foreign operations, investments and acquisitions. The income taxes applicable to repatriating such earnings are not readily determinable. As of December 31, 2019, the Company continues to assert that principally all of its non-U.S. earnings are indefinitely reinvested and management believes that the Company has sufficient liquidity to satisfy its cash needs, including its cash needs in the United States. During 2019, the Company contributed $10 million to its U.S. defined benefit pension plans and $44 million to its non-U.S. defined benefit pension plans. During 2020, the Company’s cash contribution requirements for its U.S. and its non-U.S. defined benefit pension plans are expected to be approximately $95 million and $40 million, respectively. The ultimate amounts to be contributed depend upon, among other things, legal requirements, underlying asset returns, the plan’s funded status, the anticipated tax deductibility of the contribution, local practices, market conditions, interest rates and other factors. Contractual Obligations The following table sets forth, by period due or year of expected expiration, as applicable, a summary of the Company’s contractual obligations as of December 31, 2019 under (1) debt obligations, (2) leases, (3) purchase obligations and (4) other long-term liabilities reflected on the Company’s Consolidated Balance Sheet. The amounts presented in the “Other long-term liabilities” line in the table below include approximately $1.3 billion of noncurrent gross unrecognized tax benefits and related interest (and do not include $58 million of current gross unrecognized tax benefits which are included in accrued expenses and other liabilities on the accompanying Consolidated Balance Sheet). The timing of the long-term portion of these tax liabilities is uncertain, and therefore, they have been included in the “More Than 5 Years” column in the table below. Refer to Note 15 to the Consolidated Financial Statements for additional information on unrecognized tax benefits. Certain of the Company’s acquisitions also involve the potential payment of contingent consideration. The table below does not reflect any such obligations, as the timing and amounts of any such payments are uncertain. Refer to “-Off-Balance Sheet Arrangements” for a discussion of other contractual obligations that are not reflected in the table below. (a) As described in Note 11 to the Consolidated Financial Statements. (b) Amounts do not include interest payments. Interest on debt and capital lease obligations is reflected in a separate line in the table. (c) Interest payments on debt are projected for future periods using the interest rates in effect as of December 31, 2019. Certain of these projected interest payments may differ in the future based on changes in market interest rates. (d) Amounts reflect undiscounted future operating lease payments under Accounting Standards Update No. 2016-02, Leases (Topic 842), while the current and long-term operating lease liabilities in the accompanying Consolidated Balance Sheet reflect the discounted future operating lease payments. Refer to Note 5 to the Consolidated Financial Statements for further information. (e) Consist of agreements to purchase goods or services that are enforceable, legally binding on the Company, and that specify all significant terms, including fixed or minimum quantities to be purchased, fixed, minimum or variable price provisions and the approximate timing of the transaction. (f) Primarily consist of obligations under product service and warranty policies and allowances, performance and operating cost guarantees, estimated environmental remediation costs, self-insurance and litigation claims, postretirement benefits, pension obligations, deferred tax liabilities and deferred compensation obligations. The timing of cash flows associated with these obligations is based upon management’s estimates over the terms of these arrangements and is largely based upon historical experience. Other long-term liabilities reflected in the accompanying Consolidated Balance Sheet include the above amounts as well as the long-term operating lease liabilities, which are reflected on a discounted basis in the Consolidated Balance Sheet. Off-Balance Sheet Arrangements Guarantees and Related Instruments The following table sets forth, by period due or year of expected expiration, as applicable, a summary of guarantees and related instruments of the Company as of December 31, 2019. Guarantees and related instruments consist primarily of outstanding standby letters of credit, bank guarantees and performance and bid bonds. These have been provided in connection with certain arrangements with vendors, customers, insurance providers, financing counterparties and governmental entities to secure the Company’s obligations and/or performance requirements related to specific transactions. Other Off-Balance Sheet Arrangements The Company has from time to time divested certain of its businesses and assets. In connection with these divestitures, the Company often provides representations, warranties and/or indemnities to cover various risks and unknown liabilities, such as claims for damages arising out of the use of products or relating to intellectual property matters, employment matters, commercial disputes, environmental matters or tax matters. In particular, in connection with the 2019 Envista Disposition, the 2016 Fortive Disposition and the 2015 Communications disposition, Danaher entered into separation and related agreements pursuant to which Danaher agreed to indemnify the other parties against certain damages and expenses that might occur in the future. These indemnification obligations cover a variety of liabilities, including, but not limited to, employee, tax and environmental matters. The Company has not included any such items in the contractual obligations table above because they generally relate to unknown conditions and the Company cannot estimate the potential liabilities from such matters, but the Company does not believe it is reasonably possible that any such liability will have a material effect on the Company’s financial statements. In addition, as a result of these divestitures, as well as restructuring activities, certain properties leased by the Company have been sublet to third parties. In the event any of these third parties vacate any of these premises, the Company would be legally obligated under master lease arrangements. The Company believes that the financial risk of default by such sub-lessors is individually and in the aggregate not material to the Company’s financial statements. In the normal course of business, the Company periodically enters into agreements that require it to indemnify customers, suppliers or other business partners for specific risks, such as claims for injury or property damage arising out of the Company’s products, software or services or claims alleging that Company products or services infringe third-party intellectual property. The Company has not included any such indemnification provisions in the contractual obligations table above. Historically, the Company has not experienced significant losses on these types of indemnification obligations. The Company’s Restated Certificate of Incorporation requires it to indemnify to the full extent authorized or permitted by law any person made, or threatened to be made a party to any action or proceeding by reason of his or her service as a director or officer of the Company, or by reason of serving at the request of the Company as a director or officer of any other entity, subject to limited exceptions. Danaher’s Amended and Restated By-laws provide for similar indemnification rights. In addition, Danaher has executed with each director and executive officer of Danaher Corporation an indemnification agreement which provides for substantially similar indemnification rights and under which Danaher has agreed to pay expenses in advance of the final disposition of any such indemnifiable proceeding. While the Company maintains insurance for this type of liability, a significant deductible applies to this coverage and any such liability could exceed the amount of the insurance coverage. Legal Proceedings Refer to “Item 3. Legal Proceedings” and Note 18 to the Consolidated Financial Statements for information regarding legal proceedings and contingencies, and for a discussion of risks related to legal proceedings and contingencies, refer to “Item 1A. Risk Factors.” CRITICAL ACCOUNTING ESTIMATES Management’s discussion and analysis of the Company’s financial condition and results of operations is based upon the Company’s Consolidated Financial Statements, which have been prepared in accordance with accounting principles generally accepted in the United States. The preparation of these financial statements requires management to make estimates and judgments that affect the reported amounts of assets, liabilities, revenues and expenses, and related disclosure of contingent assets and liabilities. The Company bases these estimates and judgments on historical experience, the current economic environment and on various other assumptions that are believed to be reasonable under the circumstances. Actual results may differ materially from these estimates and judgments. The Company believes the following accounting estimates are most critical to an understanding of its financial statements. Estimates are considered to be critical if they meet both of the following criteria: (1) the estimate requires assumptions about material matters that are uncertain at the time the estimate is made, and (2) material changes in the estimate are reasonably likely from period-to-period. For a detailed discussion on the application of these and other accounting estimates, refer to Note 1 to the Consolidated Financial Statements. Acquired Intangibles-The Company’s business acquisitions typically result in the recognition of goodwill, in-process R&D and other intangible assets, which affect the amount of future period amortization expense and possible impairment charges that the Company may incur. Refer to Notes 1, 3 and 8 to the Consolidated Financial Statements for a description of the Company’s policies relating to goodwill, acquired intangibles and acquisitions. In performing its goodwill impairment testing, the Company estimates the fair value of its reporting units primarily using a market-based approach. In evaluating the estimates derived by the market-based approach, management makes judgments about the relevance and reliability of the multiples by considering factors unique to its reporting units, including operating results, business plans, economic projections, anticipated future cash flows, and transactions and marketplace data as well as judgments about the comparability of the market proxies selected. In certain circumstances the Company also estimates fair value utilizing a discounted cash flow analysis (i.e., an income approach) in order to validate the results of the market approach. The discounted cash flow model requires judgmental assumptions about projected revenue growth, future operating margins, discount rates and terminal values. There are inherent uncertainties related to these assumptions and management’s judgment in applying them to the analysis of goodwill impairment. As of December 31, 2019, the Company had five reporting units for goodwill impairment testing. Reporting units resulting from recent acquisitions generally present the highest risk of impairment. Management believes the impairment risk associated with these reporting units generally decreases as these businesses are integrated into the Company and better positioned for potential future earnings growth. The Company’s annual goodwill impairment analysis in 2019 indicated that in all instances, the fair values of the Company’s reporting units exceeded their carrying values and consequently did not result in an impairment charge. The excess of the estimated fair value over carrying value (expressed as a percentage of carrying value for the respective reporting unit) for each of the Company’s reporting units as of the annual testing date ranged from approximately 85% to approximately 600%. In order to evaluate the sensitivity of the fair value calculations used in the goodwill impairment test, the Company applied a hypothetical 10% decrease to the fair values of each reporting unit and compared those hypothetical values to the reporting unit carrying values. Based on this hypothetical 10% decrease, the excess of the estimated fair value over carrying value (expressed as a percentage of carrying value for the respective reporting unit) for each of the Company’s reporting units ranged from approximately 65% to approximately 530%. The Company reviews identified intangible assets for impairment whenever events or changes in circumstances indicate that the related carrying amounts may not be recoverable. The Company also tests intangible assets with indefinite lives at least annually for impairment. Determining whether an impairment loss occurred requires a comparison of the carrying amount to the sum of undiscounted cash flows expected to be generated by the asset. These analyses require management to make judgments and estimates about future revenues, expenses, market conditions and discount rates related to these assets. If actual results are not consistent with management’s estimates and assumptions, goodwill and other intangible assets may be overstated and a charge would need to be taken against net earnings which would adversely affect the Company’s financial statements. Historically, the Company’s estimates of goodwill and intangible assets have been materially correct. Contingent Liabilities-As discussed in “Item 3. Legal Proceedings” and Note 18 to the Consolidated Financial Statements, the Company is, from time to time, subject to a variety of litigation and similar contingent liabilities incidental to its business (or the business operations of previously owned entities). The Company recognizes a liability for any legal contingency that is known or probable of occurrence and reasonably estimable. These assessments require judgments concerning matters such as litigation developments and outcomes, the anticipated outcome of negotiations, the number of future claims and the cost of both pending and future claims. In addition, because most contingencies are resolved over long periods of time, liabilities may change in the future due to various factors, including those discussed in Note 18 to the Consolidated Financial Statements. If the reserves established by the Company with respect to these contingent liabilities are inadequate, the Company would be required to incur an expense equal to the amount of the loss incurred in excess of the reserves, which would adversely affect the Company’s financial statements. Revenue Recognition-The Company derives revenues from the sale of products and services. Revenue is recognized when control over the promised products or services is transferred to the customer in an amount that reflects the consideration that the Company expects to receive in exchange for those goods or services. In determining if control has transferred, the Company considers whether certain indicators of the transfer of control are present, such as the transfer of title, present right to payment, significant risks and rewards of ownership and customer acceptance when acceptance is not a formality. To determine the consideration that the customer owes the Company, the Company must make judgments regarding the amount of customer allowances and rebates, as well as an estimate for product returns. The Company also enters into lease arrangements with customers which requires the Company to determine whether the arrangements are operating or sales-type leases. Refer to Note 1 to the Consolidated Financial Statements for a description of the Company’s revenue recognition policies. If the Company’s judgments regarding revenue recognition prove incorrect, the Company’s reported revenues in particular periods may be incorrect. Historically, the Company’s estimates of revenue have been materially correct. Pension and Other Postretirement Benefits-For a description of the Company’s pension and other postretirement benefit accounting practices, refer to Notes 13 and 14 to the Consolidated Financial Statements. Calculations of the amount of pension and other postretirement benefit costs and obligations depend on the assumptions used in the actuarial valuations, including assumptions regarding discount rates, expected return on plan assets, rates of salary increases, health care cost trend rates, mortality rates and other factors. If the assumptions used in calculating pension and other postretirement benefits costs and obligations are incorrect or if the factors underlying the assumptions change (as a result of differences in actual experience, changes in key economic indicators or other factors) the Company’s financial statements could be materially affected. A 50 basis point reduction in the discount rates used for the plans would have increased the U.S. net obligation by $133 million ($99 million on an after-tax basis) and the non-U.S. net obligation by $137 million ($116 million on an after-tax basis) from the amounts recorded in the Consolidated Financial Statements as of December 31, 2019. A 50 basis point increase in the discount rates used for the plans would have decreased the U.S. net obligation by $122 million ($91 million on an after-tax basis) and the non-U.S. net obligation by $124 million ($105 million on an after-tax basis) from the amounts recorded in the Consolidated Financial Statements as of December 31, 2019. For 2019, the estimated long-term rate of return for the U.S. plans was 7.0%, and the Company intends to continue to use an assumption of 7.0% for 2020. The estimated long-term rate of return for the non-U.S. plans was determined on a plan-by-plan basis based on the nature of the plan assets and ranged from 0.8% to 5.0%. If the expected long-term rate of return on plan assets for 2019 was reduced by 50 basis points, pension expense for the U.S. and non-U.S. plans for 2019 would have increased $9 million ($7 million on an after-tax basis) and $5 million ($4 million on an after-tax basis), respectively. For a discussion of the Company’s 2019 and anticipated 2020 defined benefit pension plan contributions, refer to “-Liquidity and Capital Resources-Cash and Cash Requirements”. Income Taxes-For a description of the Company’s income tax accounting policies, refer to Notes 1 and 15 to the Consolidated Financial Statements. The Company establishes valuation allowances for its deferred tax assets if it is more likely than not that some or all of the deferred tax asset will not be realized. This requires management to make judgments and estimates regarding: (1) the timing and amount of the reversal of taxable temporary differences, (2) expected future taxable income, and (3) the impact of tax planning strategies. Future changes to tax rates would also impact the amounts of deferred tax assets and liabilities and could have an adverse impact on the Company’s financial statements. The Company provides for unrecognized tax benefits when, based upon the technical merits, it is “more likely than not” that an uncertain tax position will not be sustained upon examination. Judgment is required in evaluating tax positions and determining income tax provisions. The Company re-evaluates the technical merits of its tax positions and may recognize an uncertain tax benefit in certain circumstances, including when: (1) a tax audit is completed; (2) applicable tax laws change, including a tax case ruling or legislative guidance; or (3) the applicable statute of limitations expires. In addition, certain of the Company’s tax returns are currently under review by tax authorities including in Denmark and the United States (refer to “-Results of Operations-Income Taxes” and Note 15 to the Consolidated Financial Statements). Management believes the positions taken in these returns are in accordance with the relevant tax laws. However, the outcome of these audits is uncertain and could result in the Company being required to record charges for prior year tax obligations which could have a material adverse impact to the Company’s financial statements, including its effective tax rate. An increase of 1.0% in the Company’s 2019 nominal tax rate would have resulted in an additional income tax provision for continuing operations for the year ended December 31, 2019 of $33 million. NEW ACCOUNTING STANDARDS For a discussion of the new accounting standards impacting the Company, refer to Note 1 to the Consolidated Financial Statements.

<s>[INST] Overview Results of Operations Liquidity and Capital Resources Critical Accounting Estimates New Accounting Standards This discussion and analysis should be read along with Danaher’s audited financial statements and related Notes thereto as of December 31, 2019 and 2018 and for each of the three years in the period ended December 31, 2019 included in this Annual Report. Unless otherwise indicated, all financial results in this report refer to continuing operations. OVERVIEW General Refer to “Item 1. BusinessGeneral” for a discussion of Danaher’s strategic objectives and methodologies for delivering longterm shareholder value. Danaher is a multinational business with global operations. During 2019, approximately 63% of Danaher’s sales were derived from customers outside the United States. As a diversified, global business, Danaher’s operations are affected by worldwide, regional and industryspecific economic and political factors. Danaher’s geographic and industry diversity, as well as the range of its products, software and services, help limit the impact of any one industry or the economy of any single country on its consolidated operating results. The Company’s individual businesses monitor key competitors and customers, including to the extent possible their sales, to gauge relative performance and the outlook for the future. As a result of the Company’s geographic and industry diversity, the Company faces a variety of opportunities and challenges, including rapid technological development (particularly with respect to computing, automation, artificial intelligence, mobile connectivity, communications and digitization) in most of the Company’s served markets, the expansion and evolution of opportunities in highgrowth markets, trends and costs associated with a global labor force, consolidation of the Company’s competitors and increasing regulation. The Company operates in a highly competitive business environment in most markets, and the Company’s longterm growth and profitability will depend in particular on its ability to expand its business in highgrowth geographies and highgrowth market segments, identify, consummate and integrate appropriate acquisitions, develop innovative and differentiated new products and services with higher gross profit margins, expand and improve the effectiveness of the Company’s sales force, continue to reduce costs and improve operating efficiency and quality, and effectively address the demands of an increasingly regulated global environment. The Company is making significant investments, organically and through acquisitions, to address the rapid pace of technological change in its served markets and to globalize its manufacturing, research and development and customerfacing resources (particularly in highgrowth markets) in order to be responsive to the Company’s customers throughout the world and improve the efficiency of the Company’s operations. Business Performance Consolidated sales for the year ended December 31, 2019 increased 5.0% as compared to 2018. While differences exist among the Company’s businesses, on an overall basis, demand for the Company’s products and services increased on a yearoveryear basis in 2019 as compared to 2018. This demand, together with the Company’s continued investments in sales growth initiatives and the other businessspecific factors discussed below, contributed to yearoveryear core sales growth of 6.0% (for the definition of “core sales,” refer to “Results of Operations” below). Geographically, both highgrowth and developed markets contributed to yearoveryear core sales growth during 2019. Core sales in highgrowth markets grew at a highsingle digit rate in 2019 as compared to 2018 led by strength in China. Highgrowth markets represented approximately 32% of the Company’s total sales in 2019. Core sales in developed markets grew at a midsingle digit rate in 2019 as compared to 2018 and were driven by North America and Western Europe. The Company’s net earnings from continuing operations for the year ended December 31, 2019 totaled approximately $2.4 billion, or $3.26 per diluted share, compared to approximately $2.4 billion, or $3.39 per diluted share for the year ended December 31, 2018. Net earnings attributable to common stockholders for the year ended December 31, 20 [/INST] Positive. </s>

QUESTAR CORP

2015-02-20

2014-12-31

ITEM 7. MANAGEMENT'S DISCUSSION AND ANALYSIS OF FINANCIAL CONDITION AND RESULTS OF OPERATIONS. RESULTS OF OPERATIONS Following are comparisons of net income (loss) by line of business: (1) Third quarter 2013 impairment of the eastern segment of Questar Pipeline's Southern Trails Pipeline. Management believes that the above non-GAAP financial measures, indicated by the word "Adjusted" in their captions, provide an indication of the Company's ongoing results of operations because of the impairment charge's infrequent and nonrecurring nature. Refer to Note 16 to the financial statements included in Item 8 of Part II of this Annual Report for additional information on the impairment. QUESTAR GAS Questar Gas reported net income of $55.2 million in 2014 compared to $52.8 million in 2013 and $47.1 million in 2012. The increases were primarily due to additional margin from increased customers and a 2014 Utah general rate case. Questar 2014 Form 10-K Following is a summary of Questar Gas financial and operating results: Questar 2014 Form 10-K Margin Analysis Questar Gas's margin (revenues less gas costs) increased $20.9 million in 2014 compared to 2013 and increased $6.3 million in 2013 compared to 2012. Following is a summary of major changes in Questar Gas's margin for 2014 compared to 2013 and 2013 compared to 2012: At December 31, 2014, Questar Gas served 962,225 customers, up from 945,971 at December 31, 2013, and 930,760 at December 31, 2012. Customer growth increased the margin by $4.7 million in 2014 and $4.2 million in 2013. Transportation service revenues increased the margin during 2014 due to higher deliveries for electric generation and new transportation general rates. Effective March 1, 2014, Questar Gas increased its rates in Utah by $7.6 million annually as a result of a general rate case filed in Utah in July 2013. The order in this rate case authorized an allowed return on equity of 9.85%. Questar Gas has an infrastructure cost-tracking mechanism that allows the company to place into rate base and earn on capital expenditures associated with a multi-year natural gas infrastructure-replacement program, and do it upon the completion of each project. The Utah general rate case reset the recovery of costs under the infrastructure-replacement program into general rates until Questar Gas invested $84 million in new pipelines. The net change in Utah general service rates increased the margin by $2.7 million in 2014. Recovery of DSM costs increased Questar Gas margin in 2014 and reduced margin in 2013. DSM costs are incurred to promote energy conservation by customers. Changes in the margin contribution from DSM recovery revenues are offset by equivalent changes in program expenses. Temperature-adjusted usage per customer was essentially flat from 2012 through 2014. The impact on the company margin from changes in usage per customer has been mitigated by the CET. The CET adjustment decreased revenues by $11.1 million in 2014, decreased revenues by $1.1 million in 2013 and decreased revenues by $2.9 million in 2012, which offset changes in customer usage. Weather, as measured in degree days, was 17% warmer than normal in 2014, 8% colder than normal in 2013 and 16% warmer than normal in 2012. A weather-normalization adjustment on customer bills generally offsets financial impacts of temperature variations. Cost of Natural Gas Sold Cost of natural gas sold decreased 7% in 2014 compared to 2013 and increased 22% in 2013 compared to 2012. The 2014 decrease was due to a 14% decrease in volumes sold, partially offset by a 20% increase in the purchase cost of natural gas. The 2013 increase was due to an 18% increase in volumes sold and a 5% increase in the purchase cost of natural gas. Cost of natural gas from affiliates includes cost-of-service gas supplies from Wexpro and transportation and storage from Questar Pipeline. These costs increased 14% in 2014 and 7% in 2013 due to Wexpro's higher investment in gas development properties resulting in higher volumes of cost-of-service gas. Questar Gas accounts for purchased-gas costs in accordance with procedures authorized by the PSCU and the PSCW. Purchased-gas costs that are different from those provided for in present rates are accumulated and recovered or credited through future rate changes. As of December 31, 2014, Questar Gas had a $39.2 million under-collected balance in the purchased-gas adjustment account representing costs incurred in excess of costs recovered from customers. In October 2014, Questar Gas filed requests in Utah and Wyoming to reduce annualized gas costs collected from customers by $30.2 million. Gas purchase costs are expected to decline during the remainder of the heating season. Refer to Questar 2014 Form 10-K Note 1 to the financial statements included in Item 8 of Part II of this Annual Report for additional information regarding cost of natural gas sold. Other Expenses Operating and maintenance expenses increased 8% in 2014 compared to 2013 and decreased 5% in 2013 compared to 2012. The changes included DSM cost recoveries that were $8.1 million higher in 2014 and $6.9 million lower in 2013. Excluding DSM charges, operating and maintenance expenses increased 2% in 2014 and were essentially flat in 2013. General and administrative costs were largely unchanged in 2014 compared to 2013 and increased 3% in 2013 compared to 2012. The 2013 increase was primarily due to higher allocated corporate expenses. The sum of operating, maintenance, general and administrative expenses per customer, excluding DSM costs, was $143 in 2014 and 2012 and was $144 in 2013. Other taxes decreased slightly in 2014 compared to 2013 and increased 11% in 2013 compared to 2012. The 2013 increase was due to increased property tax valuations and rates. Depreciation and amortization expense was 8% higher in 2014 compared to 2013 and increased 5% in 2013 compared to 2012 due to higher depreciation expense from plant additions driven by customer growth and feeder-line replacements. Acquisition of Eagle Mountain City's Natural Gas System In June 2014, Questar Gas reached an understanding with Eagle Mountain City to purchase the municipality's natural gas system for approximately $11.4 million in early 2015. The acquisition is contingent upon finalizing the purchase-agreement terms. The city has about 6,500 natural gas customers. WEXPRO Wexpro reported net income of $122.8 million in 2014 compared to $110.6 million in 2013 and $103.9 million in 2012. The growth in net income resulted primarily from increased investment in cost-of-service gas development wells and the September 2013 Trail acquisition. Questar 2014 Form 10-K Following is a summary of Wexpro financial and operating results: Revenues Wexpro earned a 17.9% after-tax return on average investment base in 2014 compared to 19.7% in 2013 and 19.9% in 2012. The decline in the 2014 return was due to the addition of the Wexpro II investment, which earns a lower return on the acquisition cost. Pursuant to the Wexpro agreements, Wexpro recovers its costs and receives an after-tax return on its investment base. Wexpro's investment base is its costs of acquired properties and commercial wells and related facilities, adjusted for working capital and reduced for deferred income taxes and accumulated depreciation, depletion and amortization. Property acquisition costs only pertain to properties that have been approved under the Wexpro II Agreement by the Commissions. Wexpro's return on investment base for natural gas development drilling is determined based on authorized returns from a group of rate-regulated companies plus an 8% risk premium. The authorized returns for this group of companies have declined in recent years, resulting in lower returns on investment base for Wexpro. Wexpro's return on investment base for property acquisitions is determined based on Questar Gas's approved cost of capital. Questar 2014 Form 10-K Following is a summary of changes in the Wexpro investment base: The December 31, 2014 investment base includes the cost of the September 2013 Trail acquisition. The PSCU and PSCW authorized the inclusion of this acquisition in Wexpro II in the first quarter of 2014. The investment base does not include the cost of the Canyon Creek acquisition because it has not been approved for inclusion in the Wexpro II Agreement (see below under Property Acquisitions). Wexpro produced 63.5 Bcf of cost-of-service natural gas for Questar Gas during 2014, compared to 59.2 Bcf in 2013 and 57.5 Bcf in 2012. The higher production levels are due to increased investment in gas-development wells and additional production from the Trail properties that were included in Wexpro II in 2014. Cost-of-service natural gas production provided the majority of Questar Gas's supply requirements in 2012 through 2014. Revenues from oil and NGL sales decreased 27% in 2014 compared to 2013 after increasing 11% in 2013 compared to 2012. The 2014 decrease was driven by a 5% decrease in average selling price for oil and NGL and lower volumes of oil and NGL for which revenue is shared with Questar Gas customers pursuant to the Wexpro agreements. The 2013 increase was driven by a 6% increase in average selling price for oil and NGL and higher volumes of oil and NGL for which revenue is shared. Revenues from natural gas sales in 2014 and 2013 were primarily attributable to the Trail acquisition prior to its inclusion under the Wexpro II Agreement. The Canyon Creek acquisition also contributed a small amount of natural gas sales in 2014. See below and Note 17 to the financial statements included in Item 8 of Part II of this Annual Report for additional information regarding the Trail and Canyon Creek acquisitions. Expenses Operating and maintenance expenses were up 6% in 2014 compared to 2013 and were up 4% in 2013 compared to 2012. The 2014 increase was due largely to higher natural gas production volumes. The 2013 increase was due to higher workover and water-disposal costs. Lease operating expense was $0.44 per Mcfe in 2014 and 2012 and was $0.43 per Mcfe in 2013. General and administrative expenses were 14% higher in 2014 compared to 2013 and 7% higher in 2013 compared to 2012. The increases were due to higher employee-related and allocated corporate expenses. Production and other taxes were 33% higher in 2014 compared to 2013 and 36% higher in 2013 compared to 2012. These taxes were $0.56 per Mcfe in 2014, $0.44 per Mcfe in 2013 and $0.33 per Mcfe in 2012. The variability in production and other taxes is due to changes in the production volumes and the prices of natural gas, oil and NGL. The average price of natural gas used to calculate production taxes was $4.82 per Mcf in 2014, $3.85 per Mcf in 2013 and $2.87 per Mcf in 2012. Depreciation, depletion and amortization expense was $1.75 per Mcfe in 2014, $1.56 in 2013 and $1.49 per Mcfe in 2012. The increases were due to higher development costs and the depletion of older lower-cost natural gas reserves. Under the terms of the Wexpro agreements, Wexpro shares 54% of its operating income from oil and NGL production with Questar Gas after recovery of expenses and a return on Wexpro's investment in successful wells. Questar Gas received oil and NGL income sharing amounting to $0.6 million in 2013 and $2.5 million in 2012, which was credited to customers. No oil and NGL sharing amounts were reported for 2014. Wexpro incurred exploration expenses of $1.6 million in 2014 related to expenditures for geological and seismic data associated with the purchase of unproved properties. Questar 2014 Form 10-K In the second quarter of 2014, Wexpro recorded an abandonment and impairment charge of $2.0 million for its share of the remaining investment in the Brady field since the field had reached the end of its productive life. In the third quarter of 2014, Wexpro sold its investment in the Spearhead Ranch and Powell Pressure Maintenance oil fields in central Wyoming. Wexpro recorded a gain of $1.5 million on this sale and credited $1.8 million back to Questar Gas customers through a reduction in the operator service fee, for a total gain of $3.3 million. In 2012, Wexpro sold real estate for a gain of $2.4 million; however, this gain was credited back to Questar Gas customers through the operator service fee. Property Acquisitions In December 2014, Wexpro acquired an additional interest in its existing Wexpro-operated assets in the Canyon Creek Unit of southwestern Wyoming's Vermillion Basin for approximately $52.4 million. Essentially, this is a "bolt-on" acquisition to the company's current Canyon Creek assets, which are governed by the 1981 Wexpro Agreement. Under the terms of the Wexpro II Agreement, this property must be submitted to the Commissions to be considered for cost-of-service treatment for the benefit of Questar Gas customers. In September 2013, Wexpro acquired an additional interest in natural gas-producing properties in the Trail Unit of southwestern Wyoming's Vermillion Basin. In the first quarter of 2014, the Commissions approved a stipulation for inclusion of these properties in the Wexpro II Agreement. Refer to Note 17 to the financial statements included in Item 8 of Part II of this Annual Report for additional information regarding the Trail and Canyon Creek acquisitions. QUESTAR PIPELINE Questar Pipeline reported 2014 net income of $60.6 million compared to $8.2 million in 2013 and $64.7 million in 2012. The primary driver of the significantly lower 2013 earnings was a $52.4 million after-tax write-down of the eastern segment of Southern Trails Pipeline in the third quarter of 2013. Questar 2014 Form 10-K Following is a summary of Questar Pipeline financial and operating results: Revenues As of December 31, 2014, Questar Pipeline had firm transportation contracts of 5,198 Mdth per day, including 1,020 Mdth per day from Questar Pipeline's 50% ownership of White River Hub, compared with 5,121 Mdth per day as of December 31, 2013, and 5,039 Mdth per day as of December 31, 2012. Transportation contracts and revenues increased in 2014 primarily due to Questar 2014 Form 10-K new volumes for electric generation. During 2013, Questar Pipeline completed two system expansions, which added approximately 118 Mdth per day. Firm contract volumes associated with these expansions were partially offset by contract terminations. Transportation revenue for 2013 was flat with 2012 levels as new contracts offset decreases resulting from reduced-rate contracts and lower flexing revenue. Questar Pipeline earns more revenue from Questar Gas than from any other single customer, with contracts for 916 Mdth per day during the heating season and 841 Mdth per day during off-peak months. The majority of Questar Gas transportation contracts extend through mid-2017. Rockies Express Pipeline has leased capacity on the Questar Overthrust Pipeline for 625 Mdth per day through 2027. Wyoming Interstate Company has contracts on Questar Overthrust Pipeline for 429 Mdth per day with a weighted-average remaining life of 6.6 years. White River Hub’s contracts have a weighted-average remaining life of 11.3 years. Questar Pipeline owns and operates the Clay Basin underground storage complex in eastern Utah. This facility is 100% subscribed under long-term contracts. In addition to Clay Basin, Questar Pipeline owns and operates three smaller aquifer gas storage facilities. Questar Gas has contracted for 26% of firm storage capacity at Clay Basin with contracts expiring in 2017, 2019 and 2020 and 100% of the firm storage capacity at the aquifer facilities with contracts extending through 2018. For 2013, storage revenue fell 3% from 2012 levels due to an expired park-and-loan contract and lower interruptible volumes. Storage revenue was largely unchanged in 2014. Questar Pipeline charges FERC-approved transportation and storage rates that are based on straight-fixed-variable rate design. Under this rate design, all fixed costs of providing service, including depreciation and return on investment, are recovered through the demand charge. About 95% of Questar Pipeline costs are fixed and recovered through these demand charges. Questar Pipeline's earnings are driven primarily by demand revenues from firm shippers. Questar Pipeline has three primary sources of NGL revenue. These sources include two major regulated processing facilities (transportation NGL sales) and an unregulated subsidiary that provides third-party processing services (field services NGL sales). Regulated processing facilities at Clay Basin condition gas to meet pipeline gas-quality specifications. These facilities are part of an agreement that allows Questar Pipeline to recover any shortfall between the NGL revenues and the cost of service for conditioning the gas. Other processing facilities on Questar Pipeline's transmission system are not subject to the Clay Basin gas processing agreement. NGL sales for the regulated operations decreased 13% in 2014 compared to 2013 and increased 8% in 2013 compared to 2012. For 2014, volumes decreased 7%, and net revenue per barrel decreased by 6% when compared to 2013. For 2013, volumes increased 15% and net revenue per barrel decreased 5% when compared to 2012. NGL sales for the unregulated subsidiary decreased 89% in 2014 compared to 2013 and decreased 77% in 2013 compared to 2012. The significant decrease over the two years was driven by upstream processing. Energy services revenue was flat in 2014 when compared to 2013 and fell 17% when comparing 2013 with 2012. This decrease was driven by lower demand for products and services due to lower drilling activity in the Rockies. Gas processing revenue fell 41% in 2013 compared to 2012 due primarily to a terminated processing contract, and was essentially flat in 2014 relative to 2013. Periodically, Questar Pipeline sells natural gas to settle gas imbalances. Generally, revenue received from the sale of natural gas approximates cost; however Questar Pipeline realized a $1.3 million gain on the sale of 1.3 MMdth of natural gas in the fourth quarter of 2012. Questar Pipeline received this gas to settle the shortfall between NGL revenue and the cost of service for conditioning gas at Clay Basin. Other revenues increased in 2014 compared to 2013 due to receipt of incentive payments under renegotiated processing agreements to manage gas interchangeability on Questar Pipeline’s system and recovery of cost of service for conditioning gas at Clay Basin. Expenses Operating and maintenance expenses increased 5% in 2014 compared to 2013 and decreased 8% in 2013 compared to 2012. The increase in 2014 was due to higher regulatory compliance and maintenance activity. The decrease in 2013 was due to lower maintenance expense and lower processing product costs. General and administrative expenses decreased 6% in 2014 compared to 2013 and decreased 7% in 2013 compared to 2012. The decrease in 2014 was primarily due to lower employee-related expenses. The decrease in 2013 was primarily due to lower Questar 2014 Form 10-K communication expense. Operating, maintenance, general and administrative expenses per dth transported were $0.09 in 2014 and 2013 and $0.10 in 2012. Operating, maintenance, general and administrative expenses include processing and storage costs. Other taxes decreased 2% in 2014 compared to 2013 and increased 2% in 2013 compared to 2012 due to changes in property taxes. Depreciation and amortization expense decreased 2% in 2014 compared to 2013 and increased 2% in 2013 compared to 2012. The 2014 decrease resulted from lower average property, plant and equipment due to the impairment of the eastern segment of Southern Trails Pipeline. The 2013 increase was due to investment in pipeline expansions. In 2012, Questar Pipeline sold real estate for a gain of $2.4 million before income taxes. Questar Southern Trails Pipeline Questar Pipeline entered into an agreement with an affiliate of Spectra Energy Corp to evaluate and potentially recommission the western portion of its Southern Trails Pipeline to its original purpose as a crude oil transport pipeline and to develop a rail terminal to offload crude into the pipeline for transportation to refineries in Southern California. Questar Pipeline's net book value of the western segment of Southern Trails Pipeline is approximately $23 million. The partners continue to market the project and are currently working with refiners to outline the general framework for potential service agreements. To meet a 2017 in-service target date, the partners are working to finalize selection of a preferred unloading terminal site, complete preliminary engineering and submit conditional land-use applications. Questar Pipeline evaluated this asset for impairment in 2014 and does not believe that it is impaired. During the third quarter of 2013, Questar Pipeline recorded an $80.6 million pre-tax ($52.4 million after-tax) impairment of the eastern portion of its Southern Trails Pipeline. For additional information, refer to Note 16 to the financial statements included in Item 8 of Part II of this Annual Report. Other Consolidated Results Questar Fueling Other consolidated results include losses from the start-up of Questar Fueling Company (Questar Fueling) operations. Questar Fueling builds, owns and operates compressed natural gas (CNG) fueling stations for fleet operators with medium- and heavy-duty trucks and tractors. These stations are customized to provide high-volume, high-speed CNG fueling for fleet operators and are also open to the general public. In 2014, the company had five CNG stations in operation: Houston, DeSoto and Dallas, Texas; and Topeka and Kansas City, Kansas. Questar Fueling expects to open three more CNG stations in early 2015 in Salt Lake City, Utah; San Antonio, Texas; and Phoenix, Arizona. The company is planning and developing other stations along major transportation corridors in California, Colorado, Nevada, and Connecticut. Questar Fueling net losses included in other consolidated results are presented below: Environmental Liability In 2014, Questar increased its environmental liability by $5.0 million. This liability relates to a previously-owned chemical company and was increased due to changes in the costs of estimated future monitoring activities. Retirement Incentive In 2012, Questar offered a retirement incentive to eligible employees of six months additional salary. Approximately 100 employees accepted this offer and retired in early 2013. The $4.9 million incentive cost was recognized in 2012. Interest and Other Income Interest and other income decreased $3.3 million in 2014 compared to 2013 and increased $2.9 million in 2013 compared to 2012. Questar 2014 Form 10-K The details of interest and other income for the last three years are shown in the table below: Income from Unconsolidated Affiliate Income from White River Hub, Questar's sole unconsolidated affiliate, was $3.5 million in 2014 and was $3.7 million in 2013 and 2012. Interest Expense Interest expense increased 11% in 2014 compared to 2013 after decreasing 2% in 2013 compared to 2012. The increase in 2014 was due to higher long-term debt balances. The decrease in 2013 was due to the replacement of higher cost long-term debt with lower rates as long-term debt matured, and the use of short-term debt in the period between the retirement of long-term debt and the issuance of new long-term debt. Capitalized interest charges on construction projects amounted to $1.0 million in 2014, $0.8 million in 2013 and $0.2 million in 2012. Income Taxes The effective combined federal and state income tax rate was 35.7% in 2014, 38.6% in 2013 and 35.5% in 2012. The combined federal and state income tax rate was lower in 2014 due to research and development and state tax credits and an increase in the domestic production deduction. The 2013 combined effective federal and state income tax rate increased due to the impairment of Southern Trails Pipeline. There was no state tax benefit recorded in association with the impairment charge because the Company has limited state operations for Southern Trails Pipeline. The effective combined federal and state income tax rate also increased in 2013 due to adjustments to estimated state income taxes for the consolidated Questar return that were in excess of state income taxes calculated on a separate return basis for the operating companies. The Company's taxable income for 2012 was offset completely by a net operating loss (NOL) carryforward generated in 2011. The remaining NOL carryforward of $26.9 million was fully utilized in 2013. LIQUIDITY AND CAPITAL RESOURCES Operating Activities Following is a summary of net cash provided by operating activities for 2014, 2013 and 2012: Cash from changes in operating assets and liabilities was lower in 2014 compared to 2013 due to gas purchase payments in excess of amounts collected from customers and increased federal income tax payments. Cash from operating assets and liabilities was lower in 2012 compared to 2013 due to customer credits of gas costs previously collected from customers in excess of costs incurred and higher pension contributions. Questar 2014 Form 10-K Investing Activities Capital spending in 2014 amounted to $371.5 million compared to $503.7 million in 2013. The details of capital expenditures, including acquisitions, in 2014 and 2013 and a forecast for 2015 are shown in the table below: Questar Gas During 2014, Questar Gas added 377 miles of main, feeder and service lines to provide service to 16,254 additional customers. Capital expenditures for 2014 included $68.2 million to replace infrastructure. Questar Gas can earn on these expenditures through the infrastructure cost-tracking mechanism. The 2015 capital-spending forecast of about $215 million includes investments to provide service to approximately 24,100 additional customers, including about 6,500 new Eagle Mountain customers. The amount also includes investments for distribution-system upgrades and expansions and infrastructure replacements. Wexpro During 2014, Wexpro participated in 19 gross wells (13.5 net), resulting in 7.7 net successful gas wells and no net dry or abandoned wells. The 2014 net drilling-success rate was 100%. There were 8 gross wells (5.8 net) in progress at year-end. Wexpro expects to spend about $80 million in 2015 for developmental and exploratory drilling and property acquisitions. The 2014 Wexpro capital expenditure amount includes the cost of the Canyon Creek acquisition and the 2013 amount includes the cost of the Trail acquisition. Refer to Note 17 to the financial statements included in Item 8 of Part II of this Annual Report for further information on these acquisitions. Questar Pipeline Questar Pipeline invested in several system upgrade and replacement projects in 2014. Questar Pipeline's 2015 capital-spending forecast is about $50 million, primarily for pipeline upgrades and replacements. Financing Activities Following is a summary of financing activities for 2014, 2013 and 2012: In 2012 Questar repurchased 4.1 million shares of its common stock on the open market for $82.4 million. These repurchases were under a $100 million program approved by the Board of Directors to reduce the share count approximately to its June 30, 2010 level. The Board of Directors has authorized additional repurchases of up to 1 million shares per year to offset dilution from shares issued under Company incentive plans. Questar has made repurchases totaling $0.2 million under this program in 2014. There were no repurchases under the program in 2013. Questar 2014 Form 10-K In December 2013, Questar Gas issued $90.0 million of 30-year Senior Notes at 4.78% and $60.0 million of 35-year Senior Notes at 4.83% in the private placement market. The proceeds were used to repay existing indebtedness and for general corporate purposes. Questar Gas repaid $91.5 million of long-term debt that matured in 2012. An additional $40.0 million of maturing long-term debt was repaid in January 2013 and $2.0 million was repaid in September 2013. These maturities had a weighted-average interest rate of 6.06%. In December 2012, Questar Gas issued $110.0 million of 15-year notes at 3.28% and $40.0 million of 12-year notes at 2.98% in the private placement market to refinance these maturing amounts and for general corporate purposes. Questar's consolidated capital structure consisted of 57% combined short- and long-term debt and capital lease obligation, and 43% common shareholders' equity at December 31, 2014, unchanged from December 31, 2013. The Company does not expect the ratio of debt in the capital structure to materially change over the next several years. Questar issues commercial paper to meet short-term financing requirements. The commercial-paper program is supported by a revolving credit facility with various banks that provides back-up credit liquidity. Credit commitments under the revolving credit facility totaled $750.0 million at December 31, 2014, with no amounts borrowed. Commercial paper outstanding amounted to $347.0 million at December 31, 2014, compared with $276.0 million a year earlier. Availability under the revolving credit facility is reduced by outstanding commercial paper amounts, resulting in net availability under the facility of $403.0 million at December 31, 2014. Under the facility, consolidated funded debt cannot exceed 70% of consolidated capitalization. In April 2013, Questar amended and restated its revolving credit facility to increase its size from $500.0 million to $750.0 million and extend its maturity from August 31, 2016 to April 19, 2018. The Company believes current credit commitments are adequate for its working capital and short-term financing requirements during 2015. The Company's short-term financing requirements are seasonal and typically peak at December 31 because of Questar Gas's gas-purchasing requirements. The Company also believes it will have adequate access to long-term capital based on current credit markets and its investment-grade credit ratings. The Company increased its annualized dividend per share by 6% from $0.72 in 2013 to $0.76 in 2014. The Company has a dividend payout target of about 60%. The Company expects to increase future dividends as it is able to grow net income. Contractual Cash Obligations and Other Commitments In the course of ordinary business activities, Questar enters into a variety of contractual cash obligations and other commitments. Questar 2014 Form 10-K The following table summarizes the significant contractual cash obligations as of December 31, 2014: The Company's projected funding for its qualified defined benefit pension plan for 2015, which is not reflected in the above table, is $44.0 million. For more information regarding Questar's pension and other postretirement benefits, refer to Note 13 to the financial statements included in Item 8 of Part II of this Annual Report. CRITICAL ACCOUNTING POLICIES, ESTIMATES AND ASSUMPTIONS Questar's significant accounting policies are summarized in Note 1 to the financial statements included in Item 8 of Part II of this Annual Report. The Company's consolidated financial statements are prepared in accordance with U.S. generally accepted accounting principles. The preparation of consolidated financial statements requires management to make assumptions and estimates that affect the reported results of operations and financial position. The following accounting policies may involve a higher degree of complexity and judgment on the part of management. Gas and Oil Reserves Gas and oil reserve estimates require significant judgments in the evaluation of all available geological, geophysical, engineering and economic data. The data for a given field may change substantially over time as a result of numerous factors including, but not limited to, additional development activity, production history, and economic assumptions relating to commodity prices, production costs, severance and other taxes, capital expenditures and remediation costs. The subjective judgments and variances in data for various fields make these estimates less precise than other estimates included in the financial statement disclosures. Changes in expected performance from the properties and economic data can result in a revision to the amount of estimated reserves held by the Company. If reserves are revised upward, operating results could be affected due to lower depreciation, depletion and amortization expense per unit of production. Likewise, if reserves are revised downward, operating results could be affected due to higher depreciation, depletion and amortization expense or a potential write-down of a property's book value if an impairment is warranted. Questar 2014 Form 10-K Asset Impairments Questar evaluates assets for possible impairment when a triggering event occurs. Triggering events may include changes in market prices, recurring operating losses or significant changes in contracts, revenues or expenses for a specific asset. Impairment losses may be recorded if the undiscounted future cash flows are less than the current net book value of the asset. If impairment is indicated, fair value is estimated using a discounted cash flow approach that incorporates market interest rates or, if available, other market data. The amount of impairment loss recorded, if any, is the difference between the fair value of the asset and the current net book value. Estimates of the undiscounted future cash flows and fair value of the asset require significant assumptions for many years into the future regarding revenues and expenses. Changes in assumptions may make a difference in whether or not an asset is impaired and in the amount of the impairment. Unbilled Revenues Questar Gas estimates revenues on a calendar basis even though bills are sent to customers on a cycle basis throughout the month. The company estimates unbilled revenues for the period from the date meters are read to the end of the month using customer-usage history and weather information. Approximately one-half month of revenues is estimated in any period. The gas costs and other variable costs are recorded on the same basis to ensure proper matching of revenues and expenses. Questar Gas has a CET. Under the CET, Questar Gas non-gas revenues are decoupled from the volume of gas used by customers. The tariff specifies an allowed monthly revenue per customer, with differences to be deferred and recovered from or refunded to customers through periodic rate adjustments. Differences between Questar Gas's estimate of unbilled revenues and actual revenues subsequently billed do not have a significant impact on operating results because of the CET. Regulatory Assets and Liabilities Questar Gas and Questar Pipeline follow accounting standards on regulated operations that require the recording of regulatory assets and liabilities by companies subject to cost-based regulation. Regulatory assets are recorded if it is probable that a cost will be recoverable in the future through regulated rates. Regulatory liabilities are recorded if it is probable that future rates will be reduced for a current item. The Company makes assumptions about the probability of future rate changes. The Company's regulatory assets and liabilities are supported by orders, rulings and practices of the regulatory agencies. Employee Pension and Other Postretirement Benefit Plans The Company has a noncontributory defined benefit pension plan covering a majority of its employees and postretirement medical and life insurance plans providing coverage to less than half of its employees. The calculation of the Company's costs and liabilities associated with its benefit plans requires the use of assumptions that the Company deems to be critical. Changes in these assumptions can result in different costs and liabilities, and actual experience can differ from these assumptions. Independent consultants hired by the Company use actuarial models to calculate estimates of net pension and postretirement benefit costs. The models use key factors such as mortality estimations, liability discount rates, long-term rates of return on investments, rates of compensation increases, amortized gain or loss from investments and medical-cost trend rates. Management formulates assumptions based on market indicators and advice from consultants. The Company believes that the liability discount rate and the expected long-term rate of return on benefit plan assets are critical assumptions. The assumed liability discount rate reflects the current rate at which the pension benefit obligations could effectively be settled and considers the rates of return available on a portfolio of high-quality, fixed-income investments. The Company discounted its future qualified pension liabilities using rates of 4.10% as of December 31, 2014 and 4.90% as of December 31, 2013. A 0.25% decrease in the discount rate would increase the Company's 2015 estimated annual qualified net pension cost by about $3.0 million. The expected long-term rate of return on qualified benefit plan assets reflects the average rate of earnings expected on funds invested or to be invested for purposes of paying pension benefits. The Company establishes the expected long-term rate of return at the beginning of each fiscal year giving consideration to the benefit plan's investment mix and historical and forecast rates of return on these types of securities. The expected long-term rate of return determined by the Company was 7.00% as of January 1, 2015, and 7.25% as of January 1, 2014. Net benefit plan cost typically increases as the expected long-term rate of return on plan assets decreases. A 0.25% decrease in the expected long-term rate of return would cause an approximate $1.6 million increase in the 2015 qualified net pension cost.

<s>[INST] Following are comparisons of net income (loss) by line of business: (1) Third quarter 2013 impairment of the eastern segment of Questar Pipeline's Southern Trails Pipeline. Management believes that the above nonGAAP financial measures, indicated by the word "Adjusted" in their captions, provide an indication of the Company's ongoing results of operations because of the impairment charge's infrequent and nonrecurring nature. Refer to Note 16 to the financial statements included in Item 8 of Part II of this Annual Report for additional information on the impairment. QUESTAR GAS Questar Gas reported net income of $55.2 million in 2014 compared to $52.8 million in 2013 and $47.1 million in 2012. The increases were primarily due to additional margin from increased customers and a 2014 Utah general rate case. Questar 2014 Form 10K Following is a summary of Questar Gas financial and operating results: Questar 2014 Form 10K Margin Analysis Questar Gas's margin (revenues less gas costs) increased $20.9 million in 2014 compared to 2013 and increased $6.3 million in 2013 compared to 2012. Following is a summary of major changes in Questar Gas's margin for 2014 compared to 2013 and 2013 compared to 2012: At December 31, 2014, Questar Gas served 962,225 customers, up from 945,971 at December 31, 2013, and 930,760 at December 31, 2012. Customer growth increased the margin by $4.7 million in 2014 and $4.2 million in 2013. Transportation service revenues increased the margin during 2014 due to higher deliveries for electric generation and new transportation general rates. Effective March 1, 2014, Questar Gas increased its rates in Utah by $7.6 million annually as a result of a general rate case filed in Utah in July 2013. The order in this rate case authorized an allowed return on equity of 9.85%. Questar Gas has an infrastructure costtracking mechanism that allows the company to place into rate base and earn on capital expenditures associated with a multiyear natural gas infrastructurereplacement program, and do it upon the completion of each project. The Utah general rate case reset the recovery of costs under the infrastructurereplacement program into general rates until Questar Gas invested $84 million in new pipelines. The net change in Utah general service rates increased the margin by $2.7 million in 2014. Recovery of DSM costs increased Questar Gas margin in 2014 and reduced margin in 2013. DSM costs are incurred to promote energy conservation by customers. Changes in the margin contribution from DSM recovery revenues are offset by equivalent changes in program expenses. Temperatureadjusted usage per customer was essentially flat from 2012 through 2014. The impact on the company margin from changes in usage per customer has been mitigated by the CET. The CET adjustment decreased revenues by $11.1 million in 2014, decreased revenues by $1.1 million in 2013 and decreased revenues by $2.9 million in 2012, which offset changes in customer usage. Weather, as measured in degree days, was 17% warmer than normal in 2014, 8% colder than normal in 2013 and 16% warmer than normal in 2012. A weathernormalization adjustment on customer bills generally offsets financial impacts of temperature variations. Cost of Natural Gas Sold Cost of natural gas sold decreased 7% in 2014 compared to 2013 and increased 22% in 2013 compared to 2012. The 2014 decrease was due to a 14% decrease in volumes [/INST] Negative. </s>

QUESTAR CORP

2016-02-18

2015-12-31

ITEM 7. MANAGEMENT'S DISCUSSION AND ANALYSIS OF FINANCIAL CONDITION AND RESULTS OF OPERATIONS. RESULTS OF OPERATIONS Following are comparisons of net income (loss) by line of business: (1) Third quarter 2013 impairment of the eastern segment of Questar Pipeline's Southern Trails Pipeline. (2) Fourth quarter 2015 Wexpro's leasehold impairment. (3) Fourth quarter 2015 pension settlement costs. Management believes that the above non-GAAP financial measures, indicated by the word "Adjusted" in their captions, provide an indication of the Company's ongoing results of operations because of the pension settlement and impairment charges' infrequent and nonrecurring nature. Refer to Note 14 and Note 17 to the financial statements included in Item 8 of Part II of this Annual Report for additional information on the pension settlement and impairments charges. QUESTAR GAS Questar Gas reported net income of $64.3 million in 2015 compared to $55.2 million in 2014 and $52.8 million in 2013. The increases were primarily due to additional margin from increased customers and a 2014 Utah general rate case. Questar 2015 Form 10-K Following is a summary of Questar Gas financial and operating results: Questar 2015 Form 10-K Margin Analysis Questar Gas's margin (revenues less gas costs) increased $3.4 million in 2015 compared to 2014 and increased $20.9 million in 2014 compared to 2013. Following is a summary of major changes in Questar Gas's margin for 2015 compared to 2014 and 2014 compared to 2013: At December 31, 2015, Questar Gas served 990,381 customers, up from 962,225 at December 31, 2014, and 945,971 at December 31, 2013. The increase from 2014 to 2015 includes the purchase of Eagle Mountain City's natural gas system for $11.4 million on March 5, 2015. The acquisition added over 6,500 natural gas customers. Customer growth increased the margin by $7.4 million in 2015 and $4.7 million in 2014. Transportation service revenues increased the margin $3.1 million during 2015 due to higher rates more than offsetting the declining transportation volumes. Effective March 1, 2014, Questar Gas increased its rates in Utah by $7.6 million annually as a result of a general rate case filed in Utah in July 2013. The order in this rate case authorized an allowed return on equity of 9.85%. Questar Gas has an infrastructure cost-tracking mechanism that allows the company to place into rate base and earn on capital expenditures associated with a multi-year natural gas infrastructure-replacement program upon the completion of each project. The Utah general rate case reset the recovery of costs under the infrastructure-replacement program into general rates until Questar Gas invested $84 million in new pipelines. This dollar threshold was met in November 2014. Thereafter, Questar Gas was able to recover program capital expenditures through the infrastructure-replacement mechanism. Questar Gas margin, from the infrastructure-replacement program, decreased $2.7 million in 2015. In December 2014, Questar Gas held hearings on a general rate case in Wyoming. The Wyoming Public Service Commission (PSCW) ordered an increase in annualized revenues of $1.5 million and an authorized return on equity of 9.5%. The change in rates was effective March 1, 2015. As described above in the Utah and Wyoming rate cases, the change in general-service rates, excluding the infrastructure-replacement program, increased the margin by $11.8 million in 2015. Natural gas vehicle revenues decreased the margin by $1.4 million during 2015 due to lower volumes because of competing fuel prices partially offset by the fuel tax credits. Recovery of EEP costs reduced Questar Gas margin in 2015 by $14.3 million. EEP costs are incurred to promote energy conservation by customers. Changes in the margin contribution from EEP recovery revenues are offset by equivalent changes in program expenses. Questar Gas benefits from a conservation enabling (revenue decoupling) tariff. Under this tariff, Questar Gas is allowed to earn a specified revenue for each general-service customer per month. Differences between the allowed revenue and the amount billed to customers are recovered from customers or refunded to customers through future rate changes. Because of this tariff, changes in usage per customer do not impact the company's margin. In addition, a weather-normalization adjustment of customer bills offsets the revenue impact of temperature variations. Questar 2015 Form 10-K Temperature-adjusted usage per customer decreased by 5% in 2015 and was essentially flat in 2014 and 2013. The impact on the Company margin from changes in usage per customer has been mitigated by the CET. The CET adjustment increased revenues by $9.9 million in 2015, decreased revenues by $11.1 million in 2014 and decreased revenues by $1.1 million in 2013, offsetting changes in customer usage. Weather, as measured in degree days, was 19% warmer than normal in 2015, 17% warmer than normal in 2014 and 8% colder than normal in 2013. A weather-normalization adjustment on customer bills generally offsets financial impacts of temperature variations. Cost of Natural Gas Sold Cost of natural gas sold decreased 8% in 2015 compared to 2014 and decreased 7% in 2014 compared to 2013. The 2015 decrease was due to a 5% decrease in volumes sold and a 16% decrease in the purchase cost of natural gas. The 2014 decrease was due to a 14% decrease in volumes sold, partially offset by a 20% increase in the purchase cost of natural gas. Cost of natural gas from affiliates includes cost-of-service gas supplies from Wexpro and transportation and storage from Questar Pipeline. These costs decreased 7% in 2015 due to lower cost-of-service gas production volumes and increased 14% in 2014 due to Wexpro's higher investment in gas development properties resulting in higher volumes of cost-of-service gas. Questar Gas accounts for purchased-gas costs in accordance with procedures authorized by the PSCU and the PSCW (the Commissions). Purchased-gas costs that are different from those provided for in present rates are accumulated and recovered or credited through future rate changes. As of December 31, 2015, Questar Gas had an $18.9 million under-collected balance in the purchased-gas adjustment account representing costs incurred in excess of costs recovered from customers. In September 2015, Questar Gas filed requests in Utah and Wyoming to reduce annualized gas costs collected from customers by $18.1 million. This request was approved by the Commissions and became effective October 2015. Gas purchase costs are expected to stay at or near their current levels for the remainder of the heating season. Refer to Note 1 to the financial statements included in Item 8 of Part II of this Annual Report for additional information regarding cost of natural gas sold. Other Expenses Operating and maintenance expenses decreased 9% in 2015 compared to 2014 and increased 8% in 2014 compared to 2013. The changes included EEP cost recoveries that were $14.3 million lower in 2015 and $8.1 million higher in 2014. Excluding EEP charges, operating and maintenance expenses increased 4% in 2015 and 2% in 2014. General and administrative costs decreased 4% in 2015 compared to 2014 and were largely unchanged in 2014 compared to 2013. The 2015 decrease was primarily due to lower employee related and allocated corporate expenses. The sum of operating, maintenance, general and administrative expenses per customer, excluding EEP costs, was $140 in 2015, $143 in 2014 and $144 in 2013. Other taxes increased 8% in 2015 compared to 2014 and decreased slightly in 2014 compared to 2013. The 2015 increase was due to increased property tax valuations and rates. Depreciation and amortization expense was 3% higher in 2015 compared to 2014 and increased 8% in 2014 compared to 2013 due to higher depreciation expense from plant additions driven by customer growth and feeder-line replacements. Acquisition of Eagle Mountain City's Natural Gas System In March 2015, Questar Gas purchased Eagle Mountain City's municipal natural gas system for $11.4 million. At the time of acquisition, the city had over 6,500 natural gas customers. WEXPRO Wexpro reported net income of $98.9 million in 2015 compared to $122.8 million in 2014 and $110.6 million in 2013. The change in net income resulted primarily from decreased net investment in cost-of-service gas development wells and a leasehold impairment. Questar 2015 Form 10-K Following is a summary of Wexpro financial and operating results: Revenues Wexpro earned a 17.5% after-tax return on average investment base in 2015 compared to 17.9% in 2014 and 19.7% in 2013. The decline in the 2015 and 2014 return was due to the addition of Wexpro II investments, which earn a lower return on the acquisition cost. Pursuant to the Wexpro agreements, Wexpro recovers its costs and receives an after-tax return on its investment base. In 2015, Wexpro earned a return of 19.76% on successful gas development drilling and a return of 7.65% on acquisition costs of Wexpro II properties. Wexpro's investment base includes its costs of acquired properties and commercial wells and related facilities, adjusted for working capital, deferred income taxes and accumulated depreciation, depletion and amortization. Property acquisition costs only pertain to properties that have been approved under the Wexpro II Agreement by the Commissions. The investment base remained relatively flat in 2015 compared to 2014 after increasing 10% in 2014 compared to 2013. The consistent investment base over the past two years is primarily due to property acquisitions offset by depreciation, depletion and amortization. Questar 2015 Form 10-K Following is a summary of changes in the Wexpro investment base: The December 31, 2015 investment base includes the cost of the December 2014 Canyon Creek acquisition. The Commissions authorized the inclusion of this acquisition in Wexpro II in the fourth quarter of 2015. The December 31, 2014 investment base includes the cost of the September 2013 Trail acquisition that the Commissions authorized in the first quarter of 2014. Market prices for natural gas have declined significantly resulting in Wexpro's cost-of-service price exceeding the market price. Consequently, Wexpro has scaled back its gas development drilling program in 2015 and limited its investment to the completion of wells drilled in 2014. Wexpro designs its annual drilling program to provide cost-of-service production that is, on average, at or below the current 5-year Rockies-adjusted NYMEX forward price curve. Based on current natural gas market prices it would be difficult for new drilling under existing Wexpro and Wexpro II agreements to meet this standard. Until natural gas prices increase, Wexpro's ability to grow its investment base is limited and it is likely that the investment base will continue to decrease due to depreciation, depletion and amortization amounts exceeding continued investment. Wexpro produced 57.7 Bcf of cost-of-service natural gas for Questar Gas during 2015, compared to 63.5 Bcf in 2014 and 59.2 Bcf in 2013. The lower production level in 2015 is largely due to reduced investment in gas-development wells. Cost-of-service natural gas production provided the majority of Questar Gas's supply requirements in 2013 through 2015. Wexpro agreed to manage the combined production from the original Wexpro properties and the Trail acquisition to 65% of Questar Gas's annual forecasted demand. Beginning in June 2015 through May 2016 and for each subsequent 12-month period, if the combined annual production exceeds 65% of the forecasted demand and the cost-of-service price is greater than the Questar Gas purchased-gas price, an amount equal to the excess production times the excess price will be credited back to Questar Gas customers. Wexpro may also sell production on the market to manage the 65% level and credit back to Questar Gas customers the higher of market price or the cost-of-service price times the sales volumes. The 65% threshold will decrease to 55% in 2020. Revenues from oil and NGL sales decreased 62% in 2015 compared to 2014 after decreasing 27% in 2014 compared to 2013. The 2015 and 2014 decreases were driven by a respective 54% and 5% drop in the average selling price for oil and NGL and lower volumes for oil and NGL. Revenues from natural gas sales in 2015 and 2014 were primarily attributable to the Canyon Creek and Trail acquisitions prior to their inclusion under the Wexpro II Agreement. See below and Note 18 to the financial statements included in Item 8 of Part II of this Annual Report for additional information regarding the Trail and Canyon Creek acquisitions. Other revenues consist primarily of gains on the sale of property that were credited back to Questar Gas customers through reductions of the operator service fee. The sales of the Brady field and Spearhead Ranch and Powell Pressure Maintenance oil fields are described below. Expenses Operating and maintenance expenses were down 7% in 2015 compared to 2014 and were up 6% in 2014 compared to 2013. The 2015 decrease was due largely to lower workover expense. The 2014 increase was due largely to higher natural gas production volumes. Lease operating expense was $0.42 per Mcfe in 2015, $0.44 per Mcfe in 2014 and $0.43 per Mcfe in 2013. General and administrative expenses were 3% higher in 2015 compared to 2014 and 14% higher in 2014 compared to 2013. The increases were due to higher employee-related and allocated corporate expenses. Questar 2015 Form 10-K Production and other taxes were 44% lower in 2015 compared to 2014 and 33% higher in 2014 compared to 2013. These taxes were $0.33 per Mcfe in 2015, $0.56 per Mcfe in 2014 and $0.44 per Mcfe in 2013. The variability in production and other taxes is due to changes in the production volumes and the prices of natural gas, oil and NGL. The average price of natural gas used to calculate production taxes was $3.12 per Mcf in 2015, $4.82 per Mcf in 2014 and $3.85 per Mcf in 2013. Depreciation, depletion and amortization expense was $1.83 per Mcfe in 2015, $1.75 in 2014 and $1.56 per Mcfe in 2013. The increases were due to higher development costs and the depletion of older, lower-cost natural gas reserves. Under the terms of the Wexpro agreements, Wexpro shares 54% of its operating income from oil and NGL production with Questar Gas after recovery of expenses and a return on Wexpro's investment in successful wells. Questar Gas received oil and NGL income sharing amounting $0.6 million in 2013, which was credited to customers. No oil and NGL sharing amounts were reported for 2014 or 2015. Wexpro incurred exploration expenses of $0.7 million in 2015 and $1.6 million in 2014 related to expenditures for contract services and seismic data associated with the purchase of unproved properties. In the fourth quarter of 2015, Wexpro recorded an abandonment and impairment charge of $12.1 million for the South Moxa leasehold because current market prices do not support a drilling program. In the second quarter of 2014, Wexpro recorded an abandonment and impairment charge of $2.0 million for its share of the remaining investment in the Brady field since the field had reached the end of its productive life. On January 26, 2016, Xcel Energy Inc., a subsidiary of Public Service Co. of Colorado, proposed an arrangement with Wexpro to lock in low gas prices for its customers. In an application with the Colorado Public Utilities Commission, the Xcel Energy subsidiary highlighted Wexpro's experience developing gas reserves as a long-term physical hedging strategy. The utility emphasized that the investment would help diversify the utility's access to gas supplies. Sale of Assets In the second quarter of 2015, Wexpro sold its share of the Brady field, recognized a gain of $1.4 million and credited $3.8 million back to Questar Gas customers through a reduction in the operator service fee for a total gain of $5.2 million. In the third quarter of 2014, Wexpro sold its investment in the Spearhead Ranch and Powell Pressure Maintenance oil fields in central Wyoming. Wexpro recorded a gain of $1.5 million on this sale and credited $1.8 million back to Questar Gas customers through a reduction in the operator service fee, for a total gain of $3.3 million. Property Acquisitions and Modifications to Wexpro Agreements In December 2015, Wexpro acquired working interests in 75 producing wells and 112 future drilling locations in the Vermillion Basin in southwestern Wyoming for $16 million. In December 2014, Wexpro acquired an additional interest in its existing Wexpro-operated assets in the Canyon Creek Unit of southwestern Wyoming's Vermillion Basin. During 2015 Wexpro and Questar Gas submitted an application to the Commissions for approval to include the acquired Canyon Creek properties under the terms of the Wexpro II Agreement. As part of this application, Wexpro proposed significant changes to its cost-of-service program to enable future cost-of-service gas production to be more competitive with market prices. The proposed changes to the cost-of-service program were subsequently modified by a Settlement Stipulation among Questar Gas, Wexpro, the Utah Division of Public Utilities, the Utah Office of Consumer Services and the Wyoming Office of Consumer Advocate. The proposed modifications to the Wexpro Agreements, as modified by the Settlement Stipulation, were approved by the PSCU on November 17, 2015 and by the PSCW on November 24, 2015. As modified, the Wexpro Agreements include the Canyon Creek acquisition as a Wexpro II property and provide for the following changes to the cost-of-service program: • the return on post-2015 development drilling will be lowered to the Commission allowed rate of return on investment as defined in the Wexpro II Agreement (currently 7.64%), and the pre-2016 investment base and associated returns will not be affected; • Wexpro and Questar Gas will reduce the threshold of maximum combined production from Wexpro properties from 65% of Questar Gas's annual forecasted demand to 55% in 2020; • Dry-hole and non-commercial well costs will be shared on a 50%/50% basis between utility customers and Wexpro so long as the costs allocated to utility customers do not exceed 4.5% of Wexpro's annual development drilling program costs; Questar 2015 Form 10-K • Wexpro will share in 50% of the savings when the annual price of cost-of-service production is lower than the annual average market price. However Wexpro's 50% share of any annual savings will be limited so that Wexpro will not earn a return exceeding the return earned on gas development investment under the 1981 Wexpro Agreement. Although Wexpro's pre-2016 investment base continues to earn the higher return described above, the pre-2016 investment base will continue to decline over time due to depreciation. Wexpro's post-2015 investment base will earn the lower return described above. Due to these factors, the Company expects Wexpro's overall earnings to decrease compared to prior years. In September 2013, Wexpro acquired an additional interest in natural gas-producing properties in the Trail Unit of southwestern Wyoming's Vermillion Basin. In the first quarter of 2014, the Commissions approved a stipulation for inclusion of these properties in the Wexpro II Agreement. Refer to Note 18 to the financial statements included in Item 8 of Part II of this Annual Report for additional information regarding the Trail and Canyon Creek acquisitions. Agreement with Laramie Energy In September 2015 Wexpro entered into a Joint Development Agreement with Laramie Energy to jointly participate in drilling about 80 wells in four drilling pads in the Piceance Basin of western Colorado. The Agreement gives Wexpro options to elect not to participate on a pad-by-pad basis if certain market price, well costs and well performance levels are not met. The Agreement also provides Wexpro with options to obtain deeper drilling rights and expand the drilling program up to 300 wells, depending on commodity prices. In October 2015, Wexpro participated in the drilling of the first pad. In December 2015, Wexpro and Laramie Energy mutually agreed to suspend drilling of any future pads due to low market prices. QUESTAR PIPELINE Questar Pipeline reported 2015 net income of $59.6 million compared to $60.6 million in 2014 and $8.2 million in 2013. The primary driver of the significantly lower 2013 earnings was a $52.4 million after-tax write-down of the eastern segment of Southern Trails Pipeline in the third quarter of 2013. Questar 2015 Form 10-K Following is a summary of Questar Pipeline financial and operating results: Revenues As of December 31, 2015, Questar Pipeline had firm transportation contracts of 5,221 Mdth per day, including 1,020 Mdth per day from Questar Pipeline's 50% ownership of White River Hub, compared with 5,198 Mdth per day as of December 31, 2014, and 5,121 Mdth per day as of December 31, 2013. Transportation revenue decreased in 2015 when compared with 2014 primarily due to reduced rates on Southern Trails Pipeline. Transportation contracts and revenues increased in 2014 when compared to 2013 primarily due to new volumes for electric generation. During 2013, Questar Pipeline completed two system Questar 2015 Form 10-K expansions, which added approximately 118 Mdth per day. Firm contract volumes associated with these expansions were partially offset by contract terminations. Questar Pipeline earns significant revenue from Questar Gas, with contracts for 916 Mdth per day during the heating season and 841 Mdth per day during off-peak months. The majority of Questar Gas transportation contracts extend through mid-2017. Rockies Express Pipeline has leased capacity on the Questar Overthrust Pipeline for 625 Mdth per day through 2027. Wyoming Interstate Company has contracts on Questar Overthrust Pipeline for 429 Mdth per day with a weighted-average remaining life of 5.6 years. White River Hub’s contracts have a weighted-average remaining life of 10.3 years. Questar Pipeline owns and operates the Clay Basin underground storage complex in eastern Utah. This facility is 100% subscribed with a weighted-average contract life of 3.8 years. In addition to Clay Basin, Questar Pipeline owns and operates three smaller aquifer gas storage facilities. Questar Gas has contracted for 26% of firm storage capacity at Clay Basin with contracts expiring in 2017, 2019 and 2020 and 100% of the firm storage capacity at the aquifer facilities with contracts extending through August 2018. Storage revenue was largely unchanged in 2015 and 2014. Questar Pipeline charges FERC-approved transportation and storage rates that are based on straight-fixed-variable rate design. Under this rate design, all fixed costs of providing service, including depreciation and return on investment, are recovered through the demand charge. About 95% of Questar Pipeline costs are fixed and recovered through these demand charges. Questar Pipeline's earnings are driven primarily by demand revenues from firm shippers. Questar Pipeline has three primary sources of NGL revenue. These sources include two major regulated processing facilities and an unregulated subsidiary that provides third-party processing services. Regulated processing facilities at Clay Basin condition gas to meet pipeline gas-quality specifications. These facilities are part of an agreement that allows Questar Pipeline to recover any shortfall between the NGL revenues and the cost of service for conditioning the gas. Other processing facilities on Questar Pipeline's transmission system are not subject to the Clay Basin gas processing agreement. Proceeds from NGL sales decreased 64% in 2015 compared to 2014 and decreased 28% in 2014 compared to 2013. For 2015, volumes decreased 5%, and net revenue per barrel decreased by 61% when compared to 2014. For 2014, volumes decreased 21% and net revenue per barrel decreased 8% when compared to 2013. Periodically, Questar Pipeline sells natural gas received from conditioning gas at Clay Basin. Generally, revenue received from the sale of natural gas approximates cost. Other revenues decreased 4% in 2015 compared to 2014 and increased 24% in 2014 compared to 2013. The decrease in 2015 includes lower processing fuel revenue as a result of lower natural gas prices. The increase in 2014 was due to receipt of incentive payments under renegotiated processing agreements to manage gas interchangeability on Questar Pipeline’s system and recovery of cost of service for conditioning gas at Clay Basin. Expenses Operating and maintenance expenses decreased 4% in 2015 compared to 2014 and increased 5% in 2014 compared to 2013. The decrease in 2015 was driven by cost control initiatives and lower maintenance activity. The increase in 2014 was due to higher regulatory compliance and maintenance activity. General and administrative expenses were flat in 2015 compared to 2014 and decreased 6% in 2014 compared to 2013. The decrease in 2014 was primarily due to lower employee related expense. Operating, maintenance, general and administrative expenses per dth transported were $0.09 in 2015, 2014 and 2013. Operating, maintenance, general and administrative expenses include processing and storage costs. Other taxes decreased 3% in 2015 compared to 2014 and decreased 2% in 2014 compared to 2013 due to changes in property taxes. Depreciation and amortization expense was flat in 2015 compared to 2014 and decreased 2% in 2014 compared to 2013. The 2014 decrease resulted from lower average property, plant and equipment due to the impairment of the eastern segment of Southern Trails Pipeline. Questar 2015 Form 10-K Questar Southern Trails Pipeline Questar Pipeline has begun a process to sell Questar Southern Trails Pipeline assets. Questar Pipeline's net book value of the western segment of Southern Trails Pipeline is approximately $24 million. The eastern segment of Southern Trails Pipeline continues to operate at a loss. The Company recorded an impairment on the eastern segment of Southern Trails Pipeline in 2013, reducing its book value to zero. Assuming the Company can identify a buyer and negotiate acceptable terms, the Company's objective is to sale the Questar Southern Trails Pipeline during 2016. There is no assurance that the Company will be successful in selling Questar Southern Trails Pipeline. Other Consolidated Results Questar Fueling Other consolidated results include losses from the start-up of Questar Fueling Company (Questar Fueling) operations. Questar Fueling builds, owns and operates compressed natural gas (CNG) fueling stations for fleet operators with medium- and heavy-duty trucks and tractors. These stations are customized to provide high-volume, high-speed CNG fueling for fleet operators and are also open to the general public. In 2015, the company had nine CNG stations in operation: Houston, DeSoto, San Antonio and Dallas, Texas; Topeka and Kansas City, Kansas, Phoenix, Arizona; Salt Lake City, Utah; and Buttonwillow, California. The company is planning and developing other stations along major transportation corridors in California and Colorado. Questar Fueling net losses included in other consolidated results are presented below: Environmental Liability In 2014, Questar increased its environmental liability by $5.0 million. This liability relates to a previously-owned chemical company and was increased due to changes in the costs of estimated future monitoring activities. Interest and Other Income Interest and other income decreased $2.4 million in 2015 compared to 2014 and increased $3.3 million in 2014 compared to 2013. The details of interest and other income for the last three years are shown in the table below: Income from Unconsolidated Affiliate Income from White River Hub, Questar's sole unconsolidated affiliate, was $3.7 million in 2015, $3.5 million in 2014 and $3.7 million in 2013. Interest Expense Interest expense was flat in 2015 compared to 2014 after increasing 11% in 2014 compared to 2013. The increase in 2014 was due to higher long-term debt balances. Capitalized interest charges on construction projects amounted to $0.3 million in 2015, $1.0 million in 2014 and $0.8 million in 2013. Questar 2015 Form 10-K Pension Settlement Costs The qualified pension plan has settled benefits for some terminated vested employees and is offering lump-sum benefits to retiring employees starting January 1, 2015. Due to the number of employees that elected the lump-sum benefit, the Company incurred a one-time $16.7 million pre-tax noncash qualified pension settlement accounting cost in the the fourth quarter of 2015. Income Taxes The effective combined federal and state income tax rate was 34.6% in 2015, 35.7% in 2014 and 38.6% in 2013. The combined income tax rate decreased in 2015 due to an exclusion from taxable income of excise tax credits previously included in income and an increase in the domestic production deduction. The combined federal and state income tax rate was lower in 2014 due to research and development and state tax credits and an increase in the domestic production deduction. The 2013 combined effective federal and state income tax rate increased due to the impairment of Southern Trails Pipeline. There was no state tax benefit recorded in association with the impairment charge because the Company has limited state operations for Southern Trails Pipeline. The effective combined federal and state income tax rate also increased in 2013 due to adjustments to estimated state income taxes for the consolidated Questar return that were in excess of state income taxes calculated on a separate return basis for the operating companies. LIQUIDITY AND CAPITAL RESOURCES Operating Activities Following is a summary of net cash provided by operating activities for 2015, 2014 and 2013: Cash from changes in operating assets and liabilities was lower in 2015 compared to 2014 due to higher contributions to the pension plan. Cash from operating assets and liabilities was lower in 2014 compared to 2013 due to gas purchase payments in excess of amounts collected from customers and increased federal income tax payments. Investing Activities Capital spending in 2015 amounted to $330.4 million compared to $371.5 million in 2014. The details of capital expenditures, including acquisitions, in 2015 and 2014 and a forecast for 2016 are shown in the table below: Questar Gas During 2015, Questar Gas added 543 miles of main, feeder and service lines to provide service to 28,156 additional customers. Capital expenditures for 2015 included $66.5 million to replace infrastructure. Questar Gas can earn on these expenditures through the infrastructure cost-tracking mechanism. The 2016 capital-spending forecast of $240 million includes investments to provide service to approximately 20,600 additional customers. The amount also includes investments for distribution-system upgrades and expansions and infrastructure replacements. Questar 2015 Form 10-K Wexpro During 2015, Wexpro participated in 25 gross wells (14.3 net), resulting in 5.8 net successful gas wells and no net dry or abandoned wells. There were 17 gross wells (8.5 net) in progress at year-end. Wexpro expects to spend about $85 million in 2016 for developmental and property acquisitions. The 2015 Wexpro capital expenditure amount includes the $16.0 million cost of the Vermillion Basin acquisition and the 2014 amount includes the $52.6 million cost of the Canyon Creek acquisition. Refer to Note 18 to the financial statements included in Item 8 of Part II of this Annual Report for further information on these acquisitions. Questar Pipeline Questar Pipeline invested in several system upgrade and replacement projects in 2015. Questar Pipeline's 2016 capital-spending forecast is about $40 million, primarily for pipeline upgrades and replacements. Financing Activities Following is a summary of financing activities for 2015, 2014 and 2013: The Board of Directors has authorized repurchases of up to 1 million shares per year to offset dilutive shares. Questar repurchased 1 million shares on the open market for $19.1 million in 2015 and repurchased approximately 10,000 shares for $0.2 million in 2014. There were no repurchases under the program in 2013. In December 2013, Questar Gas issued $90.0 million of 30-year Senior Notes at 4.78% and $60.0 million of 35-year Senior Notes at 4.83% in the private placement market. The proceeds were used to repay existing indebtedness and for general corporate purposes. Questar's consolidated capital structure consisted of 57% combined short- and long-term debt and capital lease obligation, and 43% common shareholders' equity at December 31, 2015, unchanged from December 31, 2014. Questar issues commercial paper to meet short-term financing requirements. The commercial-paper program is supported by revolving credit facilities with various banks that provides back-up credit liquidity. Credit commitments under the revolving credit facilities totaled $500 million under the multi-year credit facility and $250 million under the 364-day facility at December 31, 2015, with no amounts borrowed. The credit facilities expire upon a change of control such as the proposed Merger with Dominion Resources. However, the Company has amended its credit facilities to extend through the closing of the proposed Merger with Dominion Resources. Commercial paper outstanding amounted to $457.6 million at December 31, 2015, compared with $347.0 million a year earlier. Availability under the revolving credit facilities is reduced by outstanding commercial paper amounts, resulting in net availability under the facilities of $292.4 million at December 31, 2015. Under the facilities, consolidated funded debt cannot exceed 70% of consolidated capitalization. On February 1, 2016, the Company repaid $250 million of the parent Company's 2.75% notes on their maturity date. The Company used commercial paper to fund the repayment. The Company plans to use a new bank term loan to repay the commercial paper. The Company believes current credit commitments are adequate for its working capital and short-term financing requirements during 2016. The Company's short-term financing requirements are seasonal and typically peak at December 31 because of Questar Gas's gas-purchasing requirements. The Company also believes it will have adequate access to long-term capital based on current credit markets and its investment-grade credit ratings. Questar 2015 Form 10-K The Company increased its annualized dividend per share by 11% from $0.76 in 2014 to $0.84 in 2015. The Company has a dividend payout target of about 65%. The Company expects to increase future dividends as it is able to grow net income. Contractual Cash Obligations and Other Commitments In the course of ordinary business activities, Questar enters into a variety of contractual cash obligations and other commitments. The following table summarizes the significant contractual cash obligations as of December 31, 2015: The Company's projected funding for its qualified defined benefit pension plan for 2016, which is not reflected in the above table, is $18.1 million. For more information regarding Questar's pension and other postretirement benefits, refer to Note 14 to the financial statements included in Item 8 of Part II of this Annual Report. CRITICAL ACCOUNTING POLICIES, ESTIMATES AND ASSUMPTIONS Questar's significant accounting policies are summarized in Note 1 to the financial statements included in Item 8 of Part II of this Annual Report. The Company's consolidated financial statements are prepared in accordance with U.S. generally accepted accounting principles. The preparation of consolidated financial statements requires management to make assumptions and estimates that affect the reported results of operations and financial position. The following accounting policies may involve a greater degree of complexity and judgment on the part of management. Gas and Oil Reserves Gas and oil reserve estimates require significant judgments in the evaluation of all available geological, geophysical, engineering and economic data. The data for a given field may change substantially over time as a result of numerous factors including, but not limited to, additional development activity, production history, and economic assumptions relating to commodity prices, production costs, severance and other taxes, capital expenditures and remediation costs. The subjective judgments and variances in data for various fields make these estimates less precise than other estimates included in the financial statement disclosures. Questar 2015 Form 10-K Changes in expected performance from the properties and economic data can result in a revision to the amount of estimated reserves held by the Company. If reserves are revised upward, operating results could be affected due to lower depreciation, depletion and amortization expense per unit of production. Likewise, if reserves are revised downward, operating results could be affected due to higher depreciation, depletion and amortization expense or a potential write-down of a property's book value if an impairment is warranted. Asset Impairments Questar evaluates assets for possible impairment when a triggering event occurs. Triggering events may include changes in market prices, recurring operating losses or significant changes in contracts, revenues or expenses for a specific asset. Impairment losses may be recorded if the undiscounted future cash flows are less than the current net book value of the asset. If impairment is indicated, fair value is estimated using a discounted cash flow approach that incorporates market interest rates or, if available, other market data. The amount of impairment loss recorded, if any, is the difference between the fair value of the asset and the current net book value. Estimates of the undiscounted future cash flows and fair value of the asset require significant assumptions for many years into the future regarding revenues and expenses. Changes in assumptions may make a difference in whether or not an asset is impaired and in the amount of the impairment. Unbilled Revenues Questar Gas estimates revenues on a calendar basis even though bills are sent to customers on a cycle basis throughout the month. The company estimates unbilled revenues for the period from the date meters are read to the end of the month using customer-usage history and weather information. Approximately one-half month of revenues is estimated in any period. The gas costs and other variable costs are recorded on the same basis to ensure proper matching of revenues and expenses. Questar Gas has a CET. Under the CET, Questar Gas non-gas revenues are decoupled from the volume of gas used by customers. The tariff specifies an allowed monthly revenue per customer, with differences to be deferred and recovered from or refunded to customers through periodic rate adjustments. Differences between Questar Gas's estimate of unbilled revenues and actual revenues subsequently billed do not have a significant impact on operating results because of the CET. Regulatory Assets and Liabilities Questar Gas and Questar Pipeline follow accounting standards on regulated operations that require the recording of regulatory assets and liabilities by companies subject to cost-based regulation. Regulatory assets are recorded if it is probable that a cost will be recoverable in the future through regulated rates. Regulatory liabilities are recorded if it is probable that future rates will be reduced for a current item. The Company makes assumptions about the probability of future rate changes. The Company's regulatory assets and liabilities are supported by orders, rulings and practices of the regulatory agencies. Employee Pension and Other Postretirement Benefit Plans The Company has a noncontributory defined benefit pension plan covering a majority of its employees and postretirement medical and life insurance plans providing coverage to less than half of its employees. The calculation of the Company's costs and liabilities associated with its benefit plans requires the use of assumptions that the Company deems to be critical. Changes in these assumptions can result in different costs and liabilities, and actual experience can differ from these assumptions. Independent consultants hired by the Company use actuarial models to calculate estimates of net pension and postretirement benefit costs. The models use key factors such as mortality estimations, liability discount rates, long-term rates of return on investments, rates of compensation increases, amortized gain or loss from investments and medical-cost trend rates. Management formulates assumptions based on market indicators and advice from consultants. The Company believes that the liability discount rate and the expected long-term rate of return on benefit plan assets are critical assumptions. The assumed liability discount rate reflects the current rate at which the pension benefit obligations could effectively be settled and considers the rates of return available on a portfolio of high-quality, fixed-income investments. The Company discounted its future qualified pension liabilities using rates of 4.50% as of December 31, 2015 and 4.10% as of December 31, 2014. A 0.25% decrease in the discount rate would increase the Company's 2016 estimated annual qualified net pension cost by about $2.7 million. The expected long-term rate of return on qualified benefit plan assets reflects the average rate of earnings expected on funds invested or to be invested for purposes of paying pension benefits. The Company establishes the expected long-term rate of return at the beginning of each fiscal year giving consideration to the benefit plan's investment mix and historical and forecast rates of return on these types of securities. The expected long-term rate of return determined by the Company was 7.00% as of January 1, 2016, and 7.00% as of January 1, 2015. Net benefit plan cost typically increases as the expected long-term rate of return on plan assets decreases. A 0.25% decrease in the expected long-term rate of return would cause an approximate $1.7 million increase in the 2016 qualified net pension cost. Questar 2015 Form 10-K

<s>[INST] Following are comparisons of net income (loss) by line of business: (1) Third quarter 2013 impairment of the eastern segment of Questar Pipeline's Southern Trails Pipeline. (2) Fourth quarter 2015 Wexpro's leasehold impairment. (3) Fourth quarter 2015 pension settlement costs. Management believes that the above nonGAAP financial measures, indicated by the word "Adjusted" in their captions, provide an indication of the Company's ongoing results of operations because of the pension settlement and impairment charges' infrequent and nonrecurring nature. Refer to Note 14 and Note 17 to the financial statements included in Item 8 of Part II of this Annual Report for additional information on the pension settlement and impairments charges. QUESTAR GAS Questar Gas reported net income of $64.3 million in 2015 compared to $55.2 million in 2014 and $52.8 million in 2013. The increases were primarily due to additional margin from increased customers and a 2014 Utah general rate case. Questar 2015 Form 10K Following is a summary of Questar Gas financial and operating results: Questar 2015 Form 10K Margin Analysis Questar Gas's margin (revenues less gas costs) increased $3.4 million in 2015 compared to 2014 and increased $20.9 million in 2014 compared to 2013. Following is a summary of major changes in Questar Gas's margin for 2015 compared to 2014 and 2014 compared to 2013: At December 31, 2015, Questar Gas served 990,381 customers, up from 962,225 at December 31, 2014, and 945,971 at December 31, 2013. The increase from 2014 to 2015 includes the purchase of Eagle Mountain City's natural gas system for $11.4 million on March 5, 2015. The acquisition added over 6,500 natural gas customers. Customer growth increased the margin by $7.4 million in 2015 and $4.7 million in 2014. Transportation service revenues increased the margin $3.1 million during 2015 due to higher rates more than offsetting the declining transportation volumes. Effective March 1, 2014, Questar Gas increased its rates in Utah by $7.6 million annually as a result of a general rate case filed in Utah in July 2013. The order in this rate case authorized an allowed return on equity of 9.85%. Questar Gas has an infrastructure costtracking mechanism that allows the company to place into rate base and earn on capital expenditures associated with a multiyear natural gas infrastructurereplacement program upon the completion of each project. The Utah general rate case reset the recovery of costs under the infrastructurereplacement program into general rates until Questar Gas invested $84 million in new pipelines. This dollar threshold was met in November 2014. Thereafter, Questar Gas was able to recover program capital expenditures through the infrastructurereplacement mechanism. Questar Gas margin, from the infrastructurereplacement program, decreased $2.7 million in 2015. In December 2014, Questar Gas held hearings on a general rate case in Wyoming. The Wyoming Public Service Commission (PSCW) ordered an increase in annualized revenues of $1.5 million and an authorized return on equity of 9.5%. The change in rates was effective March 1, 2015. As described above in the Utah and Wyoming rate cases, the change in generalservice rates, excluding the infrastructurereplacement program, increased the margin by $11.8 million in 2015. Natural gas vehicle revenues decreased the margin by $1.4 million during 2015 due to lower volumes because of competing fuel [/INST] Positive. </s>

STANLEY BLACK & DECKER, INC.

2015-02-19

2015-01-03

ITEM 7. MANAGEMENT’S DISCUSSION AND ANALYSIS OF FINANCIAL CONDITION AND RESULTS OF OPERATIONS The financial and business analysis below provides information which the Company believes is relevant to an assessment and understanding of its consolidated financial position, results of operations and cash flows. This financial and business analysis should be read in conjunction with the Consolidated Financial Statements and related notes. All references to “Notes” in this Item 7 refer to the Notes to Consolidated Financial Statements included in Item 8 of this Annual Report. The following discussion and certain other sections of this Annual Report on Form 10-K contain statements reflecting the Company’s views about its future performance that constitute “forward-looking statements” under the Private Securities Litigation Reform Act of 1995. These forward-looking statements are based on current expectations, estimates, forecasts and projections about the industry and markets in which the Company operates as well as management’s beliefs and assumptions. Any statements contained herein (including without limitation statements to the effect that Stanley Black & Decker, Inc. or its management “believes”, “expects”, “anticipates”, “plans” and similar expressions) that are not statements of historical fact should be considered forward-looking statements. These statements are not guarantees of future performance and involve certain risks, uncertainties and assumptions that are difficult to predict. There are a number of important factors that could cause actual results to differ materially from those indicated by such forward-looking statements. These factors include, without limitation, those set forth, or incorporated by reference, below under the heading “Cautionary Statements”. The Company does not intend to update publicly any forward-looking statements whether as a result of new information, future events or otherwise. Strategic Objectives The Company has maintained a consistent strategic framework over time: • Maintaining portfolio transition momentum by continuing diversification toward higher growth, higher profit businesses, and increasing relative weighting of emerging markets; • Being selective and operating in markets where brand is meaningful, the value proposition is definable and sustainable through innovation and global cost leadership is achievable; • Pursuing acquisitive growth on multiple fronts through opportunistically consolidating the tool industry, building on existing growth platforms such as engineered fastening and infrastructure, and opportunistically adding to security when the conditions are right; • Accelerating progress via the Stanley Fulfillment System. In 2012, the Company intensified its focus on organic growth in order to achieve its long-term objective of 4-6% organic growth. Stanley's strategy involves industry, geographic and customer diversification, in order to pursue sustainable revenue, earnings and cash flow growth. Two aspects of the Company’s vision are to be a consolidator within the tool industry and to increase its presence in emerging markets, with a goal of ultimately generating greater than 20% of annual revenues from emerging markets. These objectives have been significantly enhanced by the Black & Decker merger, which along with the impact from the Company’s diversification strategy has driven continued improvements in financial performance. Sales outside the U.S. represented 51% of total net sales in 2014, up from 29% in 2002. As further illustration of the Company's diversification strategy, 2014 sales to U.S. and international home centers and mass merchants were approximately 23%, including nearly 16% in sales to the Company’s two largest customers, which is down from 31% in 2010, including 20% in sales to the Company's two largest customers. As operations in the various growth platforms within the Industrial and Security segments continue to expand in future years, the proportion of sales to these valued U.S. and international home centers and mass merchants is expected to continue to decrease although they will remain important and highly valued customers. Execution of the above strategy has resulted in approximately $6.2 billion of acquisitions since 2002 (aside from the Black & Decker merger), several divestitures (including the sale of HHI in December 2012), increased brand investment, improved efficiency in the supply chain and manufacturing operation, and enhanced investments in organic growth, enabled by cash flow generation and increased debt capacity. Over the last decade, the Company has returned approximately 50% of normalized free cash flow to its shareowners. The Company’s long-term financial objectives are: • 4-6% organic revenue growth; 10-12% total revenue growth; • Double-digit earnings per share growth; • Free cash flow greater than or equal to net income; • Cash flow return on investment (CFROI) of 12-15%; • Continued dividend growth; and • Strong investment grade credit rating. The Company’s long-term capital allocation objectives pertaining to the deployment of free cash flow, defined as operating cash flow less capital expenditures, are: • Invest approximately 50% in acquisitions; and • Return approximately 50% to shareowners, as the Company remains committed to continued dividend growth and opportunistic share buybacks. As mentioned previously, the Company has intensified its focus on increasing organic growth, concentrated in five major areas during the next few years: (1) increase presence in emerging markets in the Power Tools, Hand Tools and Commercial Hardware mid-price point categories, (2) create a "smart" tools and storage market using radio frequency identification ("RFID") and real-time locating system ("RTLS") technology, (3) utilize technology to create differentiated solutions to satisfy vertical market demand for the electronic security business (focus on Banking, Retail, Healthcare & Education), (4) expand offshore oil and gas pipeline service revenue in the Company's Oil & Gas business, and (5) continue to identify and realize revenue synergies associated with several acquisitions and the Black & Decker Merger. In terms of capital allocation, the Company plans to return a significant amount of capital to shareholders by continuing its pause in strategic merger and acquisition activity (possibly commencing small bolt on acquisitions in the latter half of 2015), continued dividend growth, and reducing its basic share count by the share equivalent of up to $1 billion worth of shares by the end of 2015. The Company expects the impact of its share repurchase activities to include the efficient use of equity derivatives to reduce and manage the timing of the capital requirements of this program which could result in cash settlement through 2017. The following represents recent examples of executing on the Company's strategic objectives: 2013 Acquisitions In May 2013, the Company purchased a 60% controlling share in Jiangsu Guoqiang Tools Co., Ltd. ("GQ") for a total purchase price of $48.5 million, net of cash acquired. GQ is a manufacturer and seller of power tools, armatures and stators in both domestic and foreign markets. The acquisition of GQ complements the Company's existing power tools product offerings and further diversifies the Company's operations and international presence. This acquisition will allow the Company to accelerate its emerging market mid-price point product strategy. GQ is headquartered in Qidong, China and has been consolidated into the Company's CDIY segment. In February 2013, the Company acquired a 100% ownership interest in Infastech for a total purchase price of $826.4 million, net of cash acquired. Infastech designs, manufactures and distributes highly-engineered fastening technologies and applications for a diverse blue-chip customer base in the industrial, electronics, automotive, construction and aerospace end markets. The acquisition of Infastech adds to the Company's strong positioning in specialty engineered fastening, an industry with solid growth prospects, and further expands the Company's global footprint with its strong concentration in fast-growing emerging markets. Infastech is headquartered in Hong Kong and has been consolidated into the Company's Industrial segment. 2012 Acquisitions In August 2012, the Company acquired an 89% controlling share of Tong Lung Metal Industry ("Tong Lung") for $102.8 million, net of cash acquired, and assumed $20.0 million of short-term debt. The remaining outstanding shares of Tong Lung were purchased in January 2013 for approximately $12.0 million. Tong Lung manufactures and sells commercial and residential locksets. The residential portion of the business was part of the December 2012 sale of HHI and closed in April 2013, as discussed below. The commercial portion of Tong Lung was retained by the Company and is included within the Security segment and enhances the manufacturing footprint of the Company's mechanical lock business. In June 2012, the Company acquired AeroScout for $238.8 million, net of cash acquired. AeroScout is the market leader in Real-Time Location Systems ("RTLS") for healthcare and certain industrial markets and has been integrated into the Security and Industrial segments. This acquisition will be integral in enhancing the Company's technology offerings to many customers. In May 2012, the Company acquired Powers Fasteners ("Powers") for $220.5 million, net of cash acquired. Powers is a distributor of several complementary product groups, including mechanical anchors, adhesive anchoring systems and powered forced-entry systems, mainly for commercial construction end customers. Powers has been integrated into the CDIY segment. In January 2012, the Company acquired Lista North America ("Lista") for $89.7 million, net of cash acquired. Lista’s storage and workbench solutions complement the Industrial & Automotive Repair division’s tool, storage, radio frequency identification (“RFID”)-enabled systems, and specialty supply product and service offerings. Lista has been integrated into the Company’s Industrial segment. HHI and Tong Lung Residential Divestiture In December 2012, the Company sold HHI to Spectrum for approximately $1.4 billion in cash. HHI is a provider of residential locksets, residential builders hardware and plumbing products marketed under the Kwikset, Weiser, Baldwin, Stanley, National and Pfister brands. The majority of the HHI business was part of the Company's Security segment, while the remainder was part of the Company's CDIY segment. The divestiture of the HHI business is part of the continued diversification of the Company's revenue streams and geographic footprint consistent with the Company's strategic framework. The purchase and sale agreement stipulated that the sale occur in a First and Second Closing, for approximately $1.3 billion and approximately $94 million, respectively. The First Closing, which excluded the residential portion of the Tong Lung business, occurred on December 17, 2012. The Second Closing, relating to the residential portion of the Tong Lung business, occurred on April 8, 2013. The operating results of HHI, as well as the residential portion of Tong Lung, have been reported as discontinued operations in the Consolidated Financial Statements. During 2013, the Company completed the 2012 income tax return filings which included the final calculations of the tax gain on HHI sale which took place in 2012. As a result of these tax return filings, the Company recorded an income tax benefit of approximately $19.1 million within discontinued operations related to finalization of the taxable gain on the HHI sale. Changes to the original tax gain were driven primarily by the determination of the final purchase price allocation and the finalization of the U.S. tax basis calculation, both of which were finalized during 2013. The net proceeds from this divestiture were used to repurchase $850 million of the Company's common stock and for debt reduction, to ensure the Company's leverage ratios remain in its target range. Refer to Note E, Acquisitions, and Note T, Discontinued Operations, for further discussion of the Company's acquisitions and divestitures. Driving Further Profitable Growth Within Existing Platforms While diversifying the business portfolio through expansion in the Company’s specified growth platforms is important, management recognizes that the branded tool and storage product offerings in the CDIY and Industrial segment businesses are important foundations of the Company that continue to provide strong cash flow and growth prospects. Management is committed to growing these businesses through innovative product development, as evidenced by CDIY's success with leveraging brushless motor technology on DEWALT cordless application, BLACK+DECKER AutoSense Drill Driver and STANLEY TLM99 Laser Distance Measurer, which works in conjunction with the STANLEY Floor Plan smartphone app. Brand support, continued investment in emerging markets and a sharp focus on global cost-competitiveness are all expected to foster vitality over the long term. The Company’s IAR business within the Industrial segment continues to reap benefits from its vertical integration of hand and power tools used for industrial and automotive repair purposes as well as advanced industrial storage solutions. Furthermore, the CDIY and IAR businesses have benefited greatly from the Company's powerful family of brands, global scale and breadth of products across power and hand tools, storage and accessories. These businesses have also recently begun to realize benefits from the Company's diverse channel access across the spectrum of construction, DIY, industrial and automotive repair markets. As noted above, management believes that these businesses represent important foundations of the Company that will continue to provide strong cash flow and future growth. As a result, the Company made the decision in the first quarter of 2015 to combine the complementary elements of the CDIY and IAR businesses into one Tools and Storage business with revenues totaling approximately $7 billion. The combination of these two businesses is consistent with the Company's strategy to continue to gain market share and consolidate the tool industry. This combination will result in a change to the composition of the Company's reportable segments beginning in the first quarter of 2015. Continuing to Invest in the Stanley Black & Decker Brands The Company has a strong portfolio of brands associated with high-quality products including STANLEY®, BLACK+DECKER®, DEWALT®, Porter-Cable®, Bostitch®, Proto®, MAC®, Facom®, AeroScout®, Powers®, LISTA®, SIDCHROME®, Vidmar®, SONITROL®, and GQ®. The STANLEY®, BLACK+DECKER® and DEWALT® brands are recognized as three of the world's great brands and are amongst the Company's most valuable assets. Sustained brand support has yielded a steady improvement across the spectrum of brand awareness measures, most notably in unaided Stanley hand tool brand awareness. During 2014, the STANLEY® and DEWALT® brands had prominent signage at nine major league baseball stadiums and 30% of all Major League Baseball games. The Company has also maintained long-standing NASCAR and NHRA racing sponsorships, which provided brand exposure in over 62 race weekends in 2014. The Company has continued its ten-year alliance agreement with the Walt Disney World Resort® whereby STANLEY® logos are displayed on construction walls throughout the theme parks and STANLEY®, MAC®, Proto®, and Vidmar® brand logos and/or products are featured in various attractions where they are seen by approximately 45 million visitors each year. Additionally, Stanley is “The Official Tool Provider of the Walt Disney World Resort®.” In 2009, the Company also began advertising in the English Premier League, which is the number one soccer league in the world, watched weekly by 650 million people. From the beginning of 2012 through the end of 2014, the Company advertised in approximately 500 televised events. Starting in 2014, the Company became a sponsor of the world’s most popular football club, FC Barcelona, including player image rights, hospitality assets and stadium signage. The Company advertises in 53 televised Professional Bull Riders events in the US and Brazil, as well as the The Built Ford Tough Series, which is broadcast in 129 territories and to more than 400 million households globally. The Company also sponsors three professional bull riders, winning three of the last four world championships. Additionally, the Company sponsors a team and two riders in Moto GP, the world's premiere motorcycle racing series, and has entered a partnership with the Chinese Basketball Association (CBA). The Company will continue to allocate its brand and advertising spend wisely and it currently generates more than 230 billion brand impressions annually. The Stanley Fulfillment System (SFS) SFS employs continuous improvement techniques to streamline operations (front end & back office) and drive efficiency throughout the supply chain. SFS has five primary elements that work in concert: sales and operations planning (“S&OP”), operational lean, complexity reduction, global supply management, and order-to-cash excellence. S&OP is a dynamic and continuous unified process that links and balances supply and demand in a manner that produces world-class fill rates while minimizing DSI (Days Sales of Inventory). Operational lean is the systemic application of lean principles in progressive steps throughout the enterprise to optimize flow toward a pre-defined end state by eliminating waste, increasing efficiency and driving value. Complexity reduction is a focused and overt effort to eradicate costly and unnecessary complexity from the Company's products, supply chain and back room process and organizations. Complexity reduction enables all other SFS elements and, when successfully deployed, results in world-class cost, speed of execution and customer satisfaction. Global supply management focuses on strategically leveraging the company’s scale to achieve the best possible price and payment terms with the best possible quality, service and delivery among all categories of spend. Order-to-cash excellence is a methodical, process-based approach that provides a user-friendly, automated and error-proof customer experience from intent-to-purchase to shipping and billing to payment, while minimizing cash collection cycle time and DSO (Days Sales Outstanding). Other benefits of SFS include reductions in lead times, rapid realization of synergies during acquisition integrations, and focus on employee safety. SFS disciplines helped to mitigate the substantial impact of material and energy price inflation that was experienced in recent years. SFS is also instrumental in the reduction of working capital as evidenced by the 61% improvement in working capital turns for the Company from 5.7 at the end of 2010, after the merger with Black & Decker, to 9.2 at the end of 2014. The continued efforts to deploy SFS across the entire Company and increase turns have created significant opportunities to generate incremental free cash flow. Going forward, the Company plans to further leverage SFS to generate ongoing improvements both in the existing business and future acquisitions in working capital turns, cycle times, complexity reduction and customer service levels, with a goal of ultimately achieving 10 working capital turns. In addition, the Company is embarking on an initiative to drive from a more programmatic growth mentality to a true organic growth culture by more deeply embedding breakthrough innovation and commercial excellence into its businesses, and at the same time, becoming a significantly more digitally-enabled enterprise. A new breed of digital technologies is changing the competitive landscape at unprecedented rates, creating both threats and opportunities, and it is clear that organizations that stand still will be left behind. To that end, the Company has spent considerable time and effort developing the next iteration of the successful SFS program, which has driven working capital turns to world-class levels and vastly improved the supply chain and customer-facing metrics. Entitled “SFS 2.0” this refreshed and revitalized business system will continue the progress on core SFS, but importantly, provide resources and added focus into (1) commercial excellence, (2) breakthrough innovation, (3) digital excellence and (4) functional transformation. The Company is making a significant commitment to SFS 2.0 which will help drive further improvement to revenue, earnings and cash flow growth. Management believes that success in SFS 2.0 will be characterized by dependable organic growth in the 4-6% range as well as significantly expanded operating margin rates over the next 3 to 5 years as the Company leverages the growth and reduces structural SG&A levels. Certain Items Impacting Earnings Merger and Acquisition-Related and Other Charges Impacting 2014, 2013 and 2012 Earnings Throughout MD&A, the Company has provided a discussion of the outlook and results both inclusive and exclusive of the merger and acquisition-related and other charges. Merger and acquisition-related charges relate primarily to the Black & Decker merger and Niscayah and Infastech acquisitions, while other charges relate to the extinguishment of debt. The amounts and measures, including gross profit and segment profit, on a basis excluding such charges are considered relevant to aid analysis and understanding of the Company’s results aside from the material impact of these charges. In addition, these measures are utilized internally by management to understand business trends, as once the aforementioned anticipated cost synergies from the Black & Decker merger and other acquisitions are realized, such charges are not expected to recur. The merger and acquisition-related and other charges are as follows: The Company reported $54 million in pre-tax merger and acquisition-related charges during 2014, which were comprised of the following: • $2 million reducing Gross profit primarily pertaining to integration-related matters; • $31 million in Selling, general & administrative expenses primarily for integration-related administrative costs and consulting fees, as well as employee related matters; • $2 million in Other-net primarily related to transaction costs; and • $19 million in net Restructuring charges, which primarily represent cost reduction actions associated with the severance of employees. The tax effect on the above charges, some of which were not tax deductible, in 2014 was $5 million, resulting in an after-tax charge of $49 million, or $0.30 per diluted share. The Company reported $390 million in pre-tax merger and acquisition-related and other charges during 2013, which were comprised of the following: • $29 million reducing Gross profit primarily pertaining to integration-related matters and amortization of the inventory step-up adjustment for the Infastech acquisition; • $136 million in Selling, general & administrative expenses primarily for integration-related administrative costs and consulting fees, as well as employee related matters; • $51 million in Other-net primarily related to deal transaction costs and the $21 million pre-tax loss on the extinguishment of $300 million of debt in the fourth quarter of 2013; and • $174 million in net Restructuring charges, which primarily represent Niscayah integration-related restructuring charges and cost reduction actions associated with the severance of employees. The tax effect on the above charges, some of which were not tax deductible, in 2013 was $120 million, resulting in an after-tax charge of $270 million, or $1.70 per diluted share. The Company reported $442 million in pre-tax merger and acquisition-related and other charges during 2012, which were comprised of the following: • $30 million reducing Gross profit primarily pertaining to facility closure-related charges; • $138 million in Selling, general & administrative expenses primarily for integration-related administrative costs and consulting fees, as well as employee related matters; • $100 million in Other-net primarily related to transaction costs and the $45 million loss on the extinguishment of $900 million of debt in the third quarter of 2012; and • $174 million in Restructuring charges, which primarily represent Niscayah integration-related restructuring charges and cost reduction actions associated with the severance of employees. The tax effect on the above charges, some of which were not tax deductible, in 2012 was $113 million, resulting in an after-tax charge of $329 million, or $1.97 per diluted share. Outlook for 2015 This outlook discussion is intended to provide broad insight into the Company’s near-term earnings and cash flow generation prospects. The Company expects diluted earnings per share to approximate $5.65 to $5.85 in 2015, inclusive of $50 million or $0.25 EPS of restructuring charges. The Company expects free cash flow to be at least $1 billion. The 2015 outlook assumes that organic net sales will increase 3-4% from 2014 resulting in approximately $0.45 to $0.55 of diluted earnings per share accretion. Cost reduction actions within Security and other businesses, pricing, commodity deflation and anticipated synergies from the combination of the CDIY and IAR businesses are expected to yield approximately $0.50 of diluted earnings per share accretion. The Company anticipates an additional $0.09 to $0.12 of diluted EPS accretion resulting from lower average share count due to share repurchases during 2015. Foreign exchange rates are expected to negatively impact earnings by approximately $140 million, or $0.70 to $0.75 of diluted earnings per share. The tax rate is expected to be relatively consistent with the 2014 rate. RESULTS OF OPERATIONS Below is a summary of the Company’s operating results at the consolidated level, followed by an overview of business segment performance. Terminology: The term “organic” is utilized to describe results aside from the impacts of foreign currency fluctuations and acquisitions during their initial 12 months of ownership. This ensures appropriate comparability to operating results of prior periods. Net Sales: Net sales were $11.339 billion in 2014, up 4% compared to $10.890 billion in 2013. Organic sales and acquisitions (primarily Infastech) provided increases of 5% and 1% in net sales, respectively, while unfavorable effects of foreign currency translation resulted in a decrease of 2% in net sales. In the CDIY segment, organic sales increased 7% compared to 2013 as a result of higher volumes in North America and Europe primarily due to successful new product introductions and an expanded retail footprint, as well as significant market share gains driven by organic growth initiatives. In the Industrial segment, organic sales grew 5% relative to 2013 due to strong organic growth in the Industrial & Automotive Repair and Engineered Fastening businesses. In the Security segment, net sales decreased 2% compared to 2013 due to lower sales volumes in Europe and unfavorable effects of foreign currency translation, which more than offset modest increases in price. Net sales were $10.890 billion in 2013, up 9% compared to $10.022 billion in 2012. Acquisitions and organic sales volume provided increases of 6% and 3% in net sales, respectively, while pricing and the effects of foreign currency translation were relatively flat. In the CDIY segment, organic sales increased 4% compared to 2012, as a result of successful new product introductions and promotions within the DEWALT, Black & Decker and Bostitch power tool lines, as well as market share gains in the US, Europe and emerging markets due to the implementation of organic growth initiatives. In the Industrial segment, organic sales grew 5% relative to 2012 due to strong organic growth in the Oil & Gas, Industrial & Automotive Repair and Engineered Fastening businesses, while acquisitions (primarily Infastech) provided an additional 17% increase to net sales. In the Security segment, sales increased approximately 2% compared to 2012, mainly due to modest increases in price and acquisitions, as well as favorable impacts of foreign currency fluctuations, partially offset by lower sales volumes in the European business. Gross Profit: The Company reported gross profit of $4.103 billion, or 36.2% of net sales, in 2014 compared to $3.904 billion, or 35.8% of net sales, in 2013. Merger and acquisition-related charges, which reduced gross profit, were $1.8 million in 2014 and $29.5 million 2013. Excluding these charges, gross profit was 36.2% of net sales in 2014 and 36.1% of net sales in 2013. The slight increase in the profit rate reflects favorable impacts from sales volume, price, supply chain productivity and cost management, which more than offset negative impacts from foreign currency fluctuations and lower Security margins caused by field operations inefficiencies and negative installation and recurring revenue mix. The Company reported gross profit of $3.904 billion, or 35.8% of net sales, in 2013 compared to $3.657 billion, or 36.5% of net sales, in 2012. Merger and acquisition-related charges, which reduced gross profit, were approximately $30.0 million in both 2013 and 2012. Excluding these charges, gross profit was 36.1% of net sales in 2013 and 36.8% of net sales in 2012. The decrease in the profit rate year over year was primarily driven by lower Security margins due to sales volume decline, field service inefficiencies, and high European RMR attrition and negative impacts from foreign currency, which more than outweighed the positive impacts of higher volumes, productivity projects and cost synergies. SG&A Expense: Selling, general and administrative expenses, inclusive of the provision for doubtful accounts (“SG&A”), were $2.596 billion, or 22.9% of net sales, in 2014 as compared $2.691 billion, or 24.7% of net sales, in 2013. Within SG&A, merger and acquisition-related compensation costs and integration-related expenses totaled $31.6 million and $135.7 million in 2014 and 2013, respectively. Excluding these charges, SG&A was 22.6% of net sales in 2014 compared to 23.5% of net sales in 2013. The decrease in the SG&A rate was mainly attributable to increased volumes and the positive impacts from headcount reduction actions and the Company's efforts to significantly reduce indirect expenses. SG&A expenses were $2.691 billion, or 24.7% of net sales, in 2013 as compared with $2.474 billion, or 24.6% of net sales in 2012. Within SG&A, merger and acquisition-related compensation costs and integration-related expenses totaled $135.7 million in 2013 and $138.3 million in 2012. Excluding these charges, SG&A was 23.5% of net sales in 2013 compared to 23.3% of net sales in 2012. The slight increase in SG&A rate was mainly attributable to higher expenses associated with organic growth initiatives, partially offset by cost synergies and cost containment efforts. Distribution center costs (i.e. warehousing and fulfillment facility and associated labor costs) are classified within SG&A. This classification may differ from other companies who may report such expenses within cost of sales. Due to diversity in practice, to the extent the classification of these distribution costs differs from other companies, the Company’s gross margins may not be comparable. Such distribution costs classified in SG&A amounted to $243.2 million in 2014, $229.5 million in 2013 and $202.5 million in 2012. The increase over the years is primarily attributable to higher sales volume. Corporate Overhead: The corporate overhead element of SG&A and gross profit, which is not allocated to the business segments, amounted to $177.4 million in 2014, $254.0 million in 2013 and $252.3 million in 2012. The previously discussed merger and acquisition-related charges that unfavorably impacted corporate overhead totaled $18.7 million in 2014, $89.4 million in 2013 and $77.1 million in 2012. Corporate overhead, excluding merger and acquisition-related costs, represented 1.4%, 1.5%, and 1.8% of net sales in 2014, 2013 and 2012, respectively. Other-net: Other-net totaled $239.7 million of expense in 2014 compared to $283.9 million of expense in 2013. The decrease was primarily driven by lower amortization expense and acquisition-related costs in 2014 as compared to 2013. Other-net amounted to $283.9 million of expense in 2013 compared to $296.3 million of expense in 2012. The decrease was primarily driven by reduced negative impacts of foreign currency losses related to derivatives and lower deal transaction costs, partially offset by higher amortization expense from intangible assets associated with the Infastech acquisition and other 2013 acquisitions. Gain/Loss on Debt Extinguishment: During the fourth quarter of 2014, the Company extinguished $45.7 million of its notes payable and recognized a net pre-tax gain of $0.1 million on extinguishment. During the fourth quarter of 2013, the Company extinguished $300 million of its notes payable and recognized a $21 million pre-tax loss on extinguishment. In 2012, the Company repurchased $900 million of its senior notes and recognized a $45 million pre-tax loss on extinguishment. Interest, net: Net interest expense in 2014 was $163.6 million compared to $147.3 million in 2013 and $133.9 million in 2012. The increase in net interest expense in 2014 versus 2013 was primarily attributable to interest costs associated with the issuance of debt in the fourth quarter of 2013, partially offset by higher interest income. The increase in net interest expense in 2013 versus 2012 mainly relates to the incremental interest costs associated with the higher debt levels during 2013, partially offset by higher interest income. Income Taxes: The Company's effective tax rate was 20.9% in 2014, 11.7% in 2013, and 14.2% in 2012. The effective tax rate in 2014 differed from the US statutory rate primarily due to a portion of the Company's earnings being realized in lower-taxed foreign jurisdictions, the passage of U.S. tax legislation, settlement of various income tax audits and the reversal of valuation allowances for certain foreign net operating losses which have become realizable. The effective tax rate in 2013 differed from the US statutory rate primarily due to a portion of the Company's earnings being realized in lower-taxed foreign jurisdictions, the acceleration of certain tax credits, the recurring benefit of various foreign business integration structures and the reversal of certain foreign and U.S. state uncertain tax position reserves, related largely to statute expiration. The effective tax rate in 2012 differed from the US statutory rate primarily due to the distribution of domestic and foreign earnings and the inclusion of $48.9 million in benefits from a favorable settlement of certain tax contingencies. Business Segment Results The Company’s reportable segments are aggregations of businesses that have similar products, services and end markets, among other factors. The Company utilizes segment profit (which is defined as net sales minus cost of sales and SG&A aside from corporate overhead expense), and segment profit as a percentage of net sales to assess the profitability of each segment. Segment profit excludes the corporate overhead expense element of SG&A, Other-net (inclusive of intangible asset amortization expense), restructuring charges, interest income, interest expense, and income tax expense. Corporate overhead is comprised of world headquarters facility expense, cost for the executive management team and the expense pertaining to certain centralized functions that benefit the entire Company but are not directly attributable to the businesses, such as legal and corporate finance functions. Refer to Note O, Restructuring Charges, and Note F, Goodwill and Intangible Assets, of the Notes to Consolidated Financial Statements for the amount of net restructuring charges and intangibles amortization expense, respectively, attributable to each segment. As discussed previously, the Company’s operations are classified into three business segments: CDIY, Industrial and Security. CDIY: The CDIY segment is comprised of the Professional Power Tool business, the Consumer Products Group, which includes outdoor products, the Hand Tools & Storage business, and the Fastening & Accessories business. The Professional Power Tool business sells professional grade corded and cordless electric power tools and equipment including drills, impact wrenches and drivers, grinders, saws, routers and sanders. The Consumer Products Group sells corded and cordless electric power tools sold primarily under the Black & Decker brand, lawn and garden products and home products. Lawn and garden products include hedge trimmers, string trimmers, lawn mowers, edgers, and related accessories. Home products include hand held vacuums and cleaning appliances. The Hand Tools & Storage business sells measuring, leveling and layout tools, planes, hammers, demolition tools, knives, saws, and chisels. Storage products include tool boxes, sawhorses and storage units. The Fastening & Accessories business sells cordless power tools, pneumatic tools and fasteners including nail guns, nails, staplers and staples, concrete and masonry anchors, as well as power tool accessories which include drill bits, router bits, abrasives and saw blades. CDIY net sales increased $287.9 million, or 5%, in 2014 compared to 2013. Organic sales increased 7% primarily due to strong organic growth across all regions, most notably in North America and Europe, while unfavorable effects of foreign currency decreased net sales by 2%. North America achieved 7% organic growth driven primarily by new product introductions and expanded retail offerings and partnerships on top of a healthy underlying tool market. Organic sales in Europe increased 9% year over year due to successful new product introductions and an expanding retail footprint, which helped generate market share gains in spite of continued challenging economic conditions. Emerging markets grew 4% organically bolstered by new product launches in the mid-price point segment in 2014 despite persistently volatile economic conditions across all emerging markets. Segment profit amounted to $871.5 million, or 15.7% of net sales, in 2014 compared to $777.1 million, or 14.7% of net sales, in 2013. Excluding $1.0 million in merger and acquisition-related charges, segment profit totaled $872.5 million, or 15.7% of net sales, in 2014 compared to $790.1 million, or 15.0% of net sales, in 2013 (excluding $13.0 million in merger and acquisition-related charges). The increase in segment profit year over year was primarily driven by positive impacts during 2014 from volume, productivity and SG&A cost reductions, which more than offset the negative impacts from foreign currency. CDIY net sales increased $270.0 million, or 5%, in 2013 compared with 2012. Overall, CDIY grew 4% organically in 2013 largely due to successful new product introductions and promotions within the DEWALT, Black & Decker and Bostitch power tool lines. In North America, organic sales increased 4%, which was primarily driven by promotions, new products and a strengthening residential construction market. The segment also realized 8% organic growth in emerging markets as a result of increasing penetration in connection with the Company's growth initiatives. Europe volumes increased 2% due to new product introductions and market share gains despite continuing stagnant economic conditions. Acquisitions contributed an additional 2% of sales growth while the impacts from foreign currency translation negatively impacted sales by 1%. Segment profit amounted to $777.1 million, or 14.7% of net sales, in 2013 compared to $693.1 million, or 13.9% of net sales, in 2012. Excluding $13.0 million in merger and acquisition-related charges, segment profit totaled $790.1 million, or 15.0% of net sales, in 2013 compared to $734.8 million, or 14.7% of net sales, in 2012 (excluding $41.7 million in merger and acquisition-related charges). The increase in segment profit year over year resulted primarily from higher volumes and productivity, partially offset by incremental investments in organic growth initiatives and negative impacts from foreign currency. Industrial: The Industrial segment is comprised of the Industrial and Automotive Repair ("IAR"), Engineered Fastening and Infrastructure businesses. The IAR business sells professional hand tools, power tools, and engineered storage solution products. The Engineered Fastening business primarily sells engineered fastening products and systems designed for specific applications. The product lines include stud welding systems, blind rivets and tools, blind inserts and tools, drawn arc weld studs, engineered plastic and mechanical fasteners, self-piercing riveting systems, precision nut running systems, micro fasteners, and high-strength structural fasteners. The Infrastructure business consists of the Oil & Gas and Hydraulics businesses. The Oil & Gas business sells and rents custom pipe handling, joint welding and coating equipment used in the construction of large and small diameter pipelines, and provides pipeline inspection services. The Hydraulics business sells hydraulic tools and accessories. Industrial net sales increased $196.2 million, or 6%, in 2014 compared with 2013. Organic sales and acquisitions (primarily Infastech) provided increases of 5% and 3% in net sales, respectively, while unfavorable effects of foreign currency translation decreased net sales by 2%. IAR grew 5% organically due to strong performances across all geographies. The North American and European tools business benefited from new product introductions and strong industrial demand while emerging markets was supported by mid-price point tool launches. Engineered Fastening achieved organic growth of 6%, which was mainly attributable to strong global automotive and electronic revenues. Infrastructure organic sales were relatively flat year over year as solid hydraulic tools growth was offset by lower volumes in Oil & Gas due primarily to project delays resulting from geopolitical situations in certain emerging markets as well as the recent contraction in oil prices and resulting slowdown in pipeline construction. Segment profit totaled $553.5 million, or 15.8% of net sales, in 2014 compared to $456.7 million, or 13.8% of net sales, in 2013. Excluding $6.8 million of merger and acquisition-related charges, segment profit was $560.3 million, or 16.0% of net sales, in 2014 compared to $481.5 million (excluding merger and acquisition-related charges of $24.8 million), or 14.6% of net sales, in 2013. The year over year increase in segment profit rate was primarily due to favorable volume leverage, price, supply chain productivity gains and SG&A cost controls, partially offset by negative impacts from foreign currency fluctuations. Industrial net sales increased $563.3 million, or 20.6%, in 2013 compared with 2012. Organic sales and acquisitions (primarily Infastech) increased 5% and 17%, respectively, while foreign currency decreased net sales by 2%. IAR grew 3% organically as a result of volume increases in North America, which were driven by strong MRO vending sales and strength within the Mac Tools mobile distribution driven by new product introductions, and strong organic growth in emerging markets. These results were partially offset by the impact of budgetary cuts on IAR’s US Government business and lower volumes in Europe. Engineered Fastening achieved organic growth of 3%, which was mainly attributable to global automotive revenues outpacing global light vehicle production due to customer share gains. Organic sales for Infrastructure increased 17% as a result of strong growth in the Oil & Gas business, which was driven by a continued rebound in North America onshore operations as well as strong offshore growth performance. Segment profit totaled $456.7 million, or 13.8% of net sales, in 2013 compared to $440.7 million, or 16.1% of net sales, in 2012. Excluding $24.8 million of merger and acquisition-related charges, segment profit was $481.5 million, or 14.6% of net sales, in 2013 compared to $448.6 million (excluding merger and acquisition-related charges of $7.9 million), or 16.4% of net sales, in 2012. The decrease in the profit rate was driven by higher operating expenses associated with the organic growth initiatives, negative impacts from foreign currency and the impact of modestly below line average Infastech margins. Security: The Security segment is comprised of the Convergent Security Solutions ("CSS") and the Mechanical Access Solutions ("MAS") businesses. The CSS business designs, supplies and installs electronic security systems and provides electronic security services, including alarm monitoring, video surveillance, fire alarm monitoring, systems integration and system maintenance. Purchasers of these systems typically contract for ongoing security systems monitoring and maintenance at the time of initial equipment installation. The business also includes healthcare solutions, which markets medical cabinets, asset tracking, infant protection, pediatric protection, patient protection, wander management, fall management, and emergency call products. The MAS business sells automatic doors, commercial hardware, locking mechanisms, electronic keyless entry systems, keying systems, tubular and mortise door locksets. Security net sales decreased $35.0 million, or 2%, in 2014 compared to 2013. Organic sales were relatively flat year over year while foreign currency fluctuations resulted in a 2% decrease in net sales. Organic growth of 1% in North America and emerging markets was primarily due to growth within the commercial electronics business as a result of vertical selling solutions and the automatic doors business, partially offset by lower installation and recurring revenues in Europe in addition to declines in the U.S. commercial lock business as the business model transition continues to progress slowly. Segment profit amounted to $259.2 million, or 11.4% of net sales, in 2014 compared to $233.3 million, or 10.1% of net sales, in 2013. Excluding merger and acquisition-related charges of $6.9 million, segment profit was $266.1 million, or 11.7% of net sales, in 2014 compared to $271.3 million, or 11.7% of net sales, in 2013 (excluding $38.0 million in merger and acquisition-related charges). The segment profit rate was flat year over year as improved operating performances in North America and emerging markets were offset by installation field inefficiencies and negative installation and recurring revenue mix in Europe. Security net sales increased $33.8 million, or 1%, in 2013 compared to 2012. Pricing, acquisitions and foreign currency translation each resulted in a 1% increase to net sales, while lower volumes caused a 2% decrease. CSS North America realized organic revenue growth of 2%, while CSS Europe declined 5% organically due primarily to continued softness in certain regions. MAS organic sales were up 3% as a result of strong growth within the automatic door business due to successful door conversion wins and new product introductions and growth in the commercial mechanical lock business in the emerging markets. Segment profit amounted to $233.3 million, or 10.1% of net sales, in 2013 compared to $301.4 million, or 13.2% of net sales, in 2012. Excluding merger and acquisition-related charges of $38.0 million, segment profit was $271.3 million, or 11.7% of net sales, in 2013 compared to $342.7 million, or 15.0% of net sales, in 2012 (excluding $41.3 million in merger and acquisition-related charges). The year over year decline in margin was attributable to planned growth investments in vertical solutions and emerging markets, new product development, incremental costs associated with the distributor model transition, investments in field technicians in North America and impacts of volume pressures and field inefficiencies in Europe. RESTRUCTURING ACTIVITIES A summary of the restructuring reserve activity from December 28, 2013 to January 3, 2015 is as follows (in millions): During 2014, the Company recognized $18.8 million of net restructuring charges. Net severance charges of $15.1 million relate to cost reductions associated with the severance of employees, inclusive of reversals primarily related to changes in management's strategy for certain businesses as a result of new developments during 2014 as well as adjustments of severance accruals due to the finalization of prior year actions. Also included in net restructuring charges are facility closure costs of $3.7 million. Of the $97.6 million reserves remaining as of January 3, 2015, the majority are expected to be utilized by the end of 2015. Segments: The $18.8 million of net charges recognized in 2014 includes: $12.8 million of net charges pertaining to the CDIY segment; $2.2 million of net reserve reductions pertaining to the Industrial segment; $6.5 million of net charges pertaining to the Security segment; and $1.7 million of net charges pertaining to Corporate charges. In addition to the restructuring charges described in the preceding paragraphs, the Company recognized $33.4 million and $165.2 million of restructuring-related costs in 2014 and 2013, respectively, pertaining to acquisition-related activity. All of these charges impact gross profit or selling, general and administrative expenses, and include charges associated with facility closures as well as certain integration-related administration and consulting costs. FINANCIAL CONDITION Liquidity, Sources and Uses of Capital: The Company’s primary sources of liquidity are cash flows generated from operations and available lines of credit under various credit facilities. The Company's cash flows are presented on a consolidated basis and include cash flows from discontinued operations. Operating Activities: Cash flows from operations were $1.296 billion in 2014 compared to $868 million in 2013, representing a $428 million increase. The year over year increase was primarily driven by an increase in earnings and lower one-time restructuring and related payments, partially offset by higher employee benefit plan contributions. Furthermore, operating cash flows in 2014 were positively impacted by an increase in working capital turns from 8.1 at December 28, 2013 to 9.2 at January 3, 2015, demonstrating the continued success of SFS. In 2013, cash flows from operations were $868 million, a $98 million decrease compared to $966 million in 2012. Cash flows from operations were negatively impacted by merger and acquisition-related charges and payments of $280 million in 2013 and $357 million in 2012. Excluding these charges, cash flows from operations were $1.148 billion and $1.323 billion in 2013 and 2012, respectively. The year over year decrease was primarily driven by the divestiture of HHI in December 2012. Inflows from working capital (accounts receivable, inventory, accounts payable and deferred revenue) were $13 million in 2013 compared to $48 million in 2012. The 2013 inflows were primarily driven by strong cash collections in the fourth quarter of 2013, partially offset by increases in inventory balances due to higher year over year backlog predominantly in CDIY. Working capital turns improved to 8.1 times at December 28, 2013, as compared to 7.6 times for 2012, reflecting process-driven improvements from SFS. Operating cash flows in 2013 were also negatively impacted by increases in employee related payments and investments in organic growth initiatives. Free Cash Flow: Management considers free cash flow an important indicator of its liquidity, as well as its ability to fund future growth and provide dividends to shareowners. Operating cash flows included $152 million, $280 million and $357 million of merger and acquisition-related charges and payments in 2014, 2013, and 2012, respectively. Free cash flow does not include deductions for mandatory debt service, other borrowing activity, discretionary dividends on the Company’s common stock and business acquisitions, among other items. Investing Activities: Cash flows used in investing activities were $382 million in 2014, which primarily consisted of capital and software expenditures of $291 million and payments related to net investment hedge settlements of $61 million. The decrease in capital expenditures in 2014 was driven by management's continued focus to control spend in this area as well as lower integration related capital expenditures. The payments related to net investment hedge settlements were mainly driven by the significant fluctuations in foreign currency rates during 2014 associated with foreign exchange contracts hedging a portion of the Company's pound sterling denominated net investment. Cash flows used in investing activities in 2013 totaled $1.198 billion primarily due to capital and software expenditures of $340 million and acquisition spending of $934 million, which was mainly driven by the purchases of Infastech for $826 million, net of cash acquired, and GQ for $49 million, net of cash acquired. The Company also received net proceeds of $94 million in 2013 related to the Second Closing of the HHI sale. Cash flows provided by investing activities totaled $183 million in 2012, which primarily consisted of approximately $1.3 billion in net proceeds related to the First Closing of the HHI sale, partially offset by $373 million in capital and software expenditures and $707 million in acquisition spending related to the purchases of Powers, AeroScout, Tong Lung, Lista, and the remaining outstanding shares of Niscayah. The higher capital expenditures in 2012 was mainly due to several consolidations of distribution centers. Financing Activities: Cash flows used in financing activities were $766 million in 2014 compared to cash flows provided by financing activities of $156 million in 2013 and cash flows used in financing activities of $1.337 billion in 2012. Payments on long-term debt totaled $47 million, $302 million and $1.422 billion in 2014, 2013 and 2012, respectively. The 2014 payments relate to the repurchase of $46 million of 2022 Term Notes. The 2013 payments relate to the repurchase of $300 million of Black & Decker Corporation 5.75% senior notes, which resulted in the Company paying a premium on the debt extinguishment of $43 million. The 2012 payments primarily relate to the repurchase of three debt instruments with total outstanding principal of $900 million, which resulted in the Company paying a premium on the debt extinguishment of $91 million. The Company also repaid $320 million of its Convertible Notes at maturity, in cash, during 2012. The Company had net repayments of short-term borrowings totaling $391 million in 2014, net short-term borrowings of $389 million in 2013 and net short-term repayments of $19 million in 2012. Proceeds from issuances of long-term debt totaled $727 million and $1.524 billion in 2013 and 2012, respectively. In December 2013, the Company issued $400 million of 5.75% fixed-to-floating junior subordinated debentures bearing interest at a fixed rate of 5.75% and received $392.0 million of net proceeds. Additionally, the Company issued 3,450,000 Equity Units comprised of a 1/10, or 10%, undivided beneficial ownership in a $1,000 principal amount 2.25% junior subordinated note due 2018 and a forward common stock purchase contract in which the Company received $335 million in cash proceeds from the Equity Units, net of underwriting discounts and commission, before offering expenses, and recorded $345 million in long-term debt. The proceeds were used primarily to repay commercial paper borrowings. In November 2012, the Company issued $800 million of senior unsecured term notes with a fixed annual rate of 2.90% and received $794 million of net proceeds. The Company also issued $750 million of junior subordinated debentures in the third quarter of 2012 and received $729 million of net proceeds. The Company used these proceeds to pay down commercial paper. Refer to Note H, Long-Term Debt and Financing Arrangements, for further information regarding the Company's financing arrangements. In November 2013, the Company purchased from certain financial institutions “out-of-the-money” capped call options on 12.2 million shares of its common stock (subject to customary anti-dilution adjustments) for an aggregate premium of $74 million, or an average of $6.03 per share. The contracts for the options provide that they may, at the Company’s election, subject to certain conditions, be cash settled, physically settled, modified-physically settled, or net-share settled (the default settlement method). The capped call options have various expiration dates ranging from July 2015 through September 2016 and initially had an average lower strike price of $86.07 and an average upper strike price of $106.56, subject to customary market adjustments. In addition, contemporaneously with the issuance of the Equity Units described above and in Note J, Capital Stock, the Company paid $10 million, or an average of $2.77 per option, to enter into capped call transactions on 3.5 million shares of common stock with a major financial institution. The lower strike price is $98.80 and the upper strike price is $112.91. In 2012, the Company purchased from certain financial institutions over the counter “out-of-the-money” capped call options, subject to adjustments for customary anti-dilution adjustments, on 10.1 million shares of its common stock for an aggregate premium of $30 million, or an average of $2.92 per share. The capped call options were net-share settled and the Company received 0.6 million shares in April 2013. The purpose of the capped call options was to reduce share price volatility on potential future share repurchases. On February 10, 2015, the Company net-share settled 9.1 million of the 12.2 million capped call options on its common stock and received 911,077 shares using an average reference price of $96.46 per common share. Additionally, the Company purchased directly from the counterparties participating in the net-share settlement, 3,381,162 shares for $326.1 million, equating to an average price of $96.46 per share. Refer to Note J, Capital Stock, for further discussion. During 2013, the Company paid a $43 million premium to extinguish $300 million of its Black & Decker Corporation 5.75% senior notes due 2016. This premium was offset by gains of $12 million related to the release of fair value adjustments made in purchase accounting, $8 million from the recognition of gains on previously terminated derivatives and $2 million of accrued interest, resulting in a net pre-tax loss of $21 million. Additionally, as noted above, during 2012, the Company repurchased $900 million of outstanding debt by initiating an open market tender offer and paid a premium of $91 million to extinguish the notes. This premium was offset by gains of $35 million from fair value adjustments made in purchase accounting and $11 million from terminated derivatives, resulting in a net pre-tax loss of $46 million. Refer to Note H, Long-Term Debt and Financing Arrangements, for further discussion of the debt extinguishments. In 2014, the Company terminated $400 million of interest rate swaps hedging the Company's $400 million 5.20% notes due 2053, which resulted in cash payments of $33.4 million. During 2012, the Company received $58 million from the termination of interest rate swaps and paid $103 million in relation to the termination of forward starting interest rate swaps. Refer to Note I, Derivative Financial Instruments, for further discussion. The Company repurchased $28 million, $39 million and $1.074 billion of common stock in 2014, 2013 and 2012, respectively. In December 2012, the Company executed an accelerated share repurchase ("ASR") contract of $850 million, which was funded using proceeds from the sale of HHI. The ASR contract terms allowed for an initial delivery of 9.3 million shares, or the equivalent of 80% of the notional value of the contract. The Company received an additional 1.6 million shares upon settlement of the contract in April 2013. The Company also repurchased approximately 3.0 million shares of common stock during the second quarter of 2012 for $200 million. Proceeds from the issuance of common stock totaled $71 million, $155 million and $126 million in 2014, 2013 and 2012, respectively. These amounts received mainly relate to the exercises of stock options. In January 2013, the Company elected to prepay the forward share purchase contract for $363 million, comprised of the $350 million purchase price, plus an additional amount related to the forward component of the contract. In August 2013, the Company physically settled the contract, receiving 5.6 million shares and $19 million from the financial institution counterparty representing a purchase price adjustment. The reduction of common shares outstanding was recorded at the inception of the forward share purchase contract and factored into the calculation of weighted average shares outstanding. Cash payments for dividends were $321 million, $313 million and $304 million in 2014, 2013 and 2012, respectively. The increase in dividends in 2014 was primarily attributable to the increase in quarterly dividends per common share to $0.52 per share, as announced in July 2014. The dividend paid to shareholders of record in December 2014 extended the Company's record for the longest consecutive annual and quarterly dividend payments among industrial companies listed on the New York Stock Exchange. Fluctuations in foreign currency rates negatively impacted cash by $147 million and $45 million in 2014 and 2013, respectively. The negative impact in 2014 was primarily driven by the continued strengthening of the U.S. Dollar, particularly in the second half of the year, against the Company's major currencies, most notably the Euro, British Pound, Canadian Dollar, Swedish Krona and Japanese Yen. Credit Ratings and Liquidity: The Company maintains strong investment grade credit ratings from the major U.S. rating agencies on its senior unsecured debt (average A-), as well as its short-term commercial paper borrowings. In October 2014 Fitch changed their outlook on their A- rating of the Company’s Sr. Debt from Negative to Stable. There were no other changes in any of the Companies credit ratings during 2014. The Company's debt capacity for its current ratings is impacted by the level of long (including current maturities) and short-term debt, as presented in its financial statements as well as other obligations that ratings agencies and fixed income investors deem to increase the level of financial burden on the Company. Those other obligations include, among other things, post-retirement benefits, as presented in its financial statements. Post-retirement benefit obligations, and thereby the Company's debt capacity and its credit rating, could potentially be impacted by significant reductions in interest rates and revisions to mortality tables, as well as any corrections in the equity markets. The Company's projected benefit obligation at January 3, 2015 was relatively consistent compared to December 28, 2013 as the positive impacts from the favorable return on plan assets, higher employer contributions and foreign currency fluctuations offset the negative impacts from the revision in mortality tables and decrease in discount rates. Refer to Note L, Employee Benefit Plans for further discussion. Failure to maintain strong investment grade rating levels could adversely affect the Company’s cost of funds, liquidity and access to capital markets, but would not have an adverse effect on the Company’s ability to access committed credit facilities. On December 3, 2013, the Company issued $400 million 5.75% fixed-to-floating rate junior subordinated debentures maturing December 15, 2053 (“2053 Junior Subordinated Debentures”) that bear interest at a fixed rate of 5.75% per annum, up to, but excluding December 15, 2018. From and including December 15, 2018, the 2053 Junior Subordinated Debentures will bear interest at an annual rate equal to three-month LIBOR plus 4.304%. The debentures subordination and long tenor provides significant credit protection measures for senior creditors and as a result, the debentures were awarded a 50% equity credit by S&P and Fitch, and a 25% equity credit by Moody's. The net proceeds of $392.0 million from the offering were primarily used to repay commercial paper borrowings. On December 3, 2013, the Company issued 3,450,000 Equity Units (the “Equity Units”), each with a stated value of $100 which are initially comprised of a 1/10, or 10%, undivided beneficial ownership in a $1,000 principal amount 2.25% junior subordinated note due 2018 and a forward common stock purchase contract (the “Equity Purchase Contract”). Each Equity Purchase Contract obligates the holders to purchase approximately 3.5 to 4.3 million common shares. The subordination of the notes in the Equity Units combined with the Equity Purchase Contracts resulted in the Equity Units being awarded a 100% equity credit by S&P, and a 50% equity credit by Moody's. The Company received approximately $335 million in cash proceeds from the Equity Units, net of underwriting discounts and commission, before offering expenses, and recorded $345 million in long-term debt. The proceeds were used primarily to repay commercial paper borrowings. In the fourth quarter of 2014, the Company repurchased $46 million of 2022 Term Notes. In the fourth quarter of 2013, the Company extinguished $300 million of its Black & Decker Corporation 5.75% senior notes due 2016. In the third quarter of 2012, the Company repurchased $900 million of its long-term debt via open market tender and exercise of its right under the redemption provision of each of the notes. The initial funding of the repurchased debt was accomplished by utilizing excess cash on hand and the issuance of Commercial Paper. The Company has a five year $1.5 billion committed credit facility (the “Credit Agreement”). Borrowings under the Credit Agreement may include U.S. Dollars up to the $1.5 billion commitment or in Euro or Pounds Sterling subject to a foreign currency sublimit of $400.0 million and bear interest at a floating rate dependent upon the denomination of the borrowing. Repayments must be made on June 27, 2018 or upon an earlier termination date of the Credit Agreement, at the election of the Company. In June 2014, the Company’s $500.0 million 364 day committed credit facility (the “Facility”) expired. The Facility was designated to be part of a liquidity back-stop for the Company’s commercial paper program. Following an evaluation of the Company’s liquidity position, the Company elected not to negotiate a new 364 day committed credit facility. The Company’s $2.0 billion commercial paper program is backed by its $1.5 billion Credit Agreement. As of January 3, 2015, the Company has not drawn on the Credit Agreement. Refer to Note H, Long-Term Debt and Financing Arrangement, and Note J, Capital Stock, in the Notes to Consolidated Financial Statements in Item 8 for further discussion of the Company's financing arrangements. Cash and cash equivalents totaled $497 million as of January 3, 2015, comprised of $46 million in the U.S. and $451 million in foreign jurisdictions. As of December 28, 2013 cash and cash equivalents totaled $496 million, comprised of $57 million in the U.S. and $439 million in foreign jurisdictions. Concurrent with the Black & Decker merger, the Company made a determination to repatriate certain legacy Black & Decker foreign earnings, on which U.S. income taxes had not previously been provided. As a result of this repatriation decision, the Company has recorded approximately $369 million of associated deferred tax liabilities at January 3, 2015. Current plans and liquidity requirements do not demonstrate a need to repatriate other foreign earnings. Accordingly, all other undistributed foreign earnings of the Company are considered to be permanently reinvested, or will be remitted substantially free of additional tax, consistent with the Company’s overall growth strategy internationally, including acquisitions and long-term financial objectives. No provision has been made for taxes that might be payable upon remittance of these undistributed foreign earnings. However, should management determine at a later point to repatriate additional foreign earnings, the Company would be required to accrue and pay taxes at that time. Contractual Obligations: The following table summarizes the Company’s significant contractual obligations and commitments that impact its liquidity: (a) Future payments on long-term debt encompass all payments related to aggregate debt maturities, excluding certain fair value adjustments included in long-term debt, as discussed further in Note H, Long-Term Debt and Financing Arrangements. (b) Future interest payments on long-term debt reflect the applicable fixed interest rate or variable rate for floating rate debt in effect at January 3, 2015. (c) Inventory purchase commitments primarily consist of open purchase orders to purchase raw materials, components, and sourced products. (d) Future cash flows on derivative instruments reflect the fair value and accrued interest as of January 3, 2015. The ultimate cash flows on these instruments will differ, perhaps significantly, based on applicable market interest and foreign currency rates at their maturity. (e) The company is obligated to pay $150 million to the financial institution counterparty to the forward stock purchase contract in October 2016, or earlier at the company's option. See Note J. Capital Stock, for further discussion. (f) This amount principally represents contributions either required by regulations or laws or, with respect to unfunded plans, necessary to fund current benefits. The Company has not presented estimated pension and post-retirement funding beyond 2015 as funding can vary significantly from year to year based upon changes in the fair value of the plan assets, actuarial assumptions, and curtailment/settlement actions. (g) These amounts represent future contract adjustment payments to holders of the Company's Equity Purchase Contracts and Purchase Contracts. See Note H, Long-Term Debt and Financing Arrangements for further discussion. To the extent the Company can reliably determine when payments will occur pertaining to unrecognized tax liabilities, the related amount will be included in the table above. However, due to the high degree of uncertainty regarding the timing of potential future cash flows associated with the $341.4 million of such liabilities at January 3, 2015, the Company is unable to make a reliable estimate of when (if at all) amounts may be paid to the respective taxing authorities. Aside from debt payments, for which there is no tax benefit associated with repayment of principal, tax obligations and the equity purchase contract fees, payment of the above contractual obligations will typically generate a cash tax benefit such that the net cash outflow will be lower than the gross amounts summarized above. Other Significant Commercial Commitments: Short-term borrowings, long-term debt and lines of credit are explained in detail within Note H, Long-Term Debt and Financing Arrangements. MARKET RISK Market risk is the potential economic loss that may result from adverse changes in the fair value of financial instruments, currencies, commodities and other items traded in global markets. The Company is exposed to market risk from changes in foreign currency exchange rates, interest rates, stock prices, and commodity prices. Exposure to foreign currency risk results because the Company, through its global businesses, enters into transactions and makes investments denominated in multiple currencies. The Company’s predominant exposures are in European, Canadian, British, Australian, Latin American, and Asian currencies, including the Chinese Renminbi (“RMB”) and the Taiwan Dollar. Certain cross-currency trade flows arising from sales and procurement activities as well as affiliate cross-border activity are consolidated and netted prior to obtaining risk protection through the use of various derivative financial instruments which may include: purchased basket options, purchased options, collars, cross currency swaps and currency forwards. The Company is thus able to capitalize on its global positioning by taking advantage of naturally offsetting exposures and portfolio efficiencies to reduce the cost of purchasing derivative protection. At times, the Company also enters into forward exchange contracts and purchases options to reduce the earnings and cash flow impact of non-functional currency denominated receivables and payables, primarily for affiliate transactions. Gains and losses from these hedging instruments offset the gains or losses on the underlying net exposures, assets and liabilities being hedged. Management determines the nature and extent of currency hedging activities, and in certain cases, may elect to allow certain currency exposures to remain un-hedged. The Company may also enter into cross-currency swaps and forward contracts to hedge the net investments in certain subsidiaries and better match the cash flows of operations to debt service requirements. Management estimates the foreign currency impact from its derivative financial instruments outstanding at the end of 2014 would have been approximately $36 million pre-tax loss based on a hypothetical 10% adverse movement in all net derivative currency positions; this effect would occur from the strengthening of foreign currencies relative to the U.S. dollar. The Company follows risk management policies in executing derivative financial instrument transactions, and does not use such instruments for speculative purposes. The Company does not hedge the translation of its non-U.S. dollar earnings in foreign subsidiaries. As mentioned above, the Company routinely has cross-border trade and affiliate flows that cause an impact on earnings from foreign exchange rate movements. The Company is also exposed to currency fluctuation volatility from the translation of foreign earnings into U.S. dollars and the economic impact of foreign currency volatility on monetary assets held in foreign currencies. It is more difficult to quantify the transactional effects from currency fluctuations than the translational effects. Aside from the use of derivative instruments, which may be used to mitigate some of the exposure, transactional effects can potentially be influenced by actions the Company may take. For example, if an exposure occurs from a European entity sourcing product from a U.S. supplier it may be possible to change to a European supplier. Management estimates the combined translational and transactional impact, on pre-tax earnings, of a 10% overall movement in exchange rates is approximately $124 million, or approximately $0.62 per diluted share. In 2014, translational and transactional foreign currency fluctuations negatively impacted pre-tax earnings by approximately $85 million and diluted earnings per share by approximately $0.42. The Company’s exposure to interest rate risk results from its outstanding debt and derivative obligations, short-term investments, and derivative financial instruments employed in the management of its debt portfolio. The debt portfolio including both trade and affiliate debt, is managed to achieve capital structure targets and reduce the overall cost of borrowing by using a combination of fixed and floating rate debt as well as interest rate swaps, and cross-currency swaps. The Company’s primary exposure to interest rate risk comes from its floating rate debt and derivatives in the U.S. and is fairly represented by changes in LIBOR rates. At January 3, 2015, the impact of a hypothetical 10% increase in the interest rates associated with the Company’s floating rate derivative and debt instruments would have an immaterial effect on the Company’s financial position and results of operations. The Company has exposure to commodity prices in many businesses, particularly brass, nickel, resin, aluminum, copper, zinc, steel, and energy used in the production of finished goods. Generally, commodity price exposures are not hedged with derivative financial instruments, but instead are actively managed through customer product and service pricing actions, procurement-driven cost reduction initiatives and other productivity improvement projects. Fluctuations in the fair value of the Company’s common stock affect domestic retirement plan expense as discussed below in the Employee Stock Ownership Plan section of MD&A. Additionally, the Company has $54 million of liabilities as of January 3, 2015 pertaining to unfunded defined contribution plans for certain U.S. employees for which there is mark-to-market exposure. The assets held by the Company’s defined benefit plans are exposed to fluctuations in the market value of securities, primarily global stocks and fixed-income securities. The funding obligations for these plans would increase in the event of adverse changes in the plan asset values, although such funding would occur over a period of many years. In 2014, 2013 and 2012, there were $285 million, $102 million and $194 million, respectively, in investment returns on pension plan assets. The Company expects funding obligations on its defined benefit plans to be approximately $94 million in 2015. The Company employs diversified asset allocations to help mitigate this risk. Management has worked to minimize this exposure by freezing and terminating defined benefit plans where appropriate. The Company has access to financial resources and borrowing capabilities around the world. There are no instruments within the debt structure that would accelerate payment requirements due to a change in credit rating. The Company’s existing credit facilities and sources of liquidity, including operating cash flows, are considered more than adequate to conduct business as normal. Accordingly, based on present conditions and past history, management believes it is unlikely that operations will be materially affected by any potential deterioration of the general credit markets that may occur. The Company believes that its strong financial position, operating cash flows, committed long-term credit facilities and borrowing capacity, and ready access to equity markets provide the financial flexibility necessary to continue its record of annual dividend payments, to invest in the routine needs of its businesses, to make strategic acquisitions and to fund other initiatives encompassed by its growth strategy and maintain its strong investment grade credit ratings. OTHER MATTERS Employee Stock Ownership Plan As detailed in Note L, Employee Benefit Plans, the Company has an ESOP under which the ongoing U.S. Core and 401(k) defined contribution plans are funded. Overall ESOP expense is affected by the market value of the Company’s stock on the monthly dates when shares are released, among other factors. The Company’s net ESOP activity resulted in expense of $0.7 million in 2014, $1.9 million in 2013, and $25.9 million in 2012. The decrease in net ESOP expense in 2014 and 2013 is related to the release of 230,032 and 219,900 shares, respectively, of unallocated stock triggered by an additional contribution to the ESOP, which was used by the ESOP to make an additional payment on the associated loan as more fully discussed in Note L, Employee Benefit Plans. ESOP expense could increase in the future if the market value of the Company’s common stock declines. CRITICAL ACCOUNTING ESTIMATES - Preparation of the Company’s Consolidated Financial Statements requires management to make estimates and assumptions that affect the reported amounts of assets, liabilities, revenues and expenses. Significant accounting policies used in the preparation of the Consolidated Financial Statements are described in Note A, Significant Accounting Policies. Management believes the most complex and sensitive judgments, because of their significance to the Consolidated Financial Statements, result primarily from the need to make estimates about the effects of matters with inherent uncertainty. The most significant areas involving management estimates are described below. Actual results in these areas could differ from management’s estimates. ALLOWANCE FOR DOUBTFUL ACCOUNTS - The Company’s estimate for its allowance for doubtful accounts related to trade receivables is based on two methods. The amounts calculated from each of these methods are combined to determine the total amount reserved. First, a specific reserve is established for individual accounts where information indicates the customers may have an inability to meet financial obligations. In these cases, management uses its judgment, based on the surrounding facts and circumstances, to record a specific reserve for those customers against amounts due to reduce the receivable to the amount expected to be collected. These specific reserves are reevaluated and adjusted as additional information is received. Second, a reserve is determined for all customers based on a range of percentages applied to receivable aging categories. These percentages are based on historical collection and write-off experience. If circumstances change, for example, due to the occurrence of higher than expected defaults or a significant adverse change in a major customer’s ability to meet its financial obligation to the Company, estimates of the recoverability of receivable amounts due could be reduced. INVENTORIES - LOWER OF COST OR MARKET, SLOW MOVING AND OBSOLETE - Inventories in the U.S. are predominantly valued at the lower of LIFO cost or market, while non-U.S. inventories are valued at the lower of FIFO cost or market. The calculation of LIFO reserves, and therefore the net inventory valuation, is affected by inflation and deflation in inventory components. The Company ensures all inventory is valued at the lower of cost or market, and continually reviews the carrying value of discontinued product lines and stock-keeping-units (“SKUs”) to determine that these items are properly valued. The Company also continually evaluates the composition of its inventory and identifies obsolete and/or slow-moving inventories. Inventory items identified as obsolete and/or slow-moving are evaluated to determine if write-downs are required. The Company assesses the ability to dispose of these inventories at a price greater than cost. If it is determined that cost is less than market value, cost is used for inventory valuation. If market value is less than cost, the Company writes down the related inventory to that value. If a write down to the current market value is necessary, the market value cannot be greater than the net realizable value, or ceiling (defined as selling price less costs to sell and dispose), and cannot be lower than the net realizable value less a normal profit margin, also called the floor. If the Company is not able to achieve its expectations regarding net realizable value of inventory at its current value, further write-downs would be recorded. GOODWILL AND INTANGIBLE ASSETS - The Company acquires businesses in purchase transactions that result in the recognition of goodwill and intangible assets. The determination of the value of intangible assets requires management to make estimates and assumptions. In accordance with ASC 350-20, “Goodwill,” acquired goodwill and indefinite-lived intangible assets are not amortized but are subject to impairment testing at least annually and when an event occurs or circumstances change that indicate it is more likely than not an impairment exists. Definite-lived intangible assets are amortized and are tested for impairment when appropriate. Goodwill represents costs in excess of fair values assigned to the underlying net assets of acquired businesses. The Company reported $7.276 billion of goodwill, $1.593 billion of indefinite-lived trade names and $1.159 billion of definite-lived intangibles at January 3, 2015. Management tests goodwill for impairment at the reporting unit level. A reporting unit is an operating segment as defined in ASC 280, “Segment Reporting,” or one level below an operating segment (component level) as determined by the availability of discrete financial information that is regularly reviewed by operating segment management or an aggregate of component levels of an operating segment having similar economic characteristics. If the carrying value of a reporting unit (including the value of goodwill) is greater than its fair value, an impairment may exist. An impairment charge would be recorded to the extent that the recorded value of goodwill exceeded the implied fair value. As required by the Company’s policy, goodwill and indefinite-lived trade names were tested for impairment in the third quarter of 2014. Beginning in 2013, the Company adopted ASU 2011-08, “Intangibles - Goodwill and Other (Topic 350): Testing Goodwill for Impairment,” for its goodwill impairment testing. ASU 2011-08 permits companies to first assess qualitative factors to determine whether it is more-likely-than-not that the fair value of a reporting unit is less than its carrying amount as a basis for determining whether it is necessary to perform the two-step quantitative goodwill impairment test. Under the two-step quantitative goodwill impairment test, the fair value of the reporting unit is compared to its respective carrying amount including goodwill. If the fair value exceeds the carrying amount, then no impairment exists. If the carrying amount exceeds the fair value, further analysis is performed to assess impairment. Such tests are completed separately with respect to the goodwill of each of the Company’s reporting units. Accordingly, the Company applied the qualitative assessment for four of its reporting units, while performing the two-step quantitative test for the remaining two reporting units. Based on the results of the annual 2014 impairment testing, the Company determined that the fair values of each of its reporting units exceeded their respective carrying amounts. In performing the qualitative assessment, the Company identified and considered the significance of relevant key factors, events, and circumstances that could affect the fair value of each reporting unit. These factors include external factors such as macroeconomic, industry, and market conditions, as well as entity-specific factors, such as actual and planned financial performance. The Company also assessed changes in each reporting unit's fair value and carrying value since the most recent date a fair value measurement was performed. As a result of the qualitative assessments performed, the Company concluded that it is more-likely-than-not that the fair value of each reporting unit exceeded its respective carrying value and therefore, no additional quantitative impairment testing was performed. With respect to the two-step quantitative tests, the Company assessed the fair value of the two reporting units using a discounted cash flow valuation model, which is consistent with previous goodwill impairment tests. The key assumptions applied to the cash flow projections were discount rates, which ranged from 8.5% to 9.0%, near-term revenue growth rates over the next five years, which ranged from 0% to 7%, and a perpetual growth rate of 3.5%. These assumptions contemplated business, market and overall economic conditions. Management performed sensitivity analyses on the fair values resulting from the discounted cash flows valuation utilizing more conservative assumptions that reflect reasonably likely future changes in the discount rates and perpetual growth rate in each of the reporting units. The discount rates were increased by 100 basis points with no impairment indicated. The perpetual growth rate was decreased by 150 basis points with no impairment indicated. The fair values of indefinite-lived trade names were also assessed using a discounted cash flow valuation model. The key assumptions used included discount rates, royalty rates, and perpetual growth rates applied to the projected sales. Based on these quantitative impairment tests, the Company determined that the fair values of the indefinite-lived trade names exceeded their respective carrying amounts. In the event that the Company’s operating results in the future do not meet current expectations, management, based upon conditions at the time, would consider taking restructuring or other actions as necessary to maximize profitability. Accordingly, the above sensitivity analyses, while a useful tool, should not be used as a sole predictor of impairment. A thorough analysis of all the facts and circumstances existing at that time would need to be performed to determine if recording an impairment loss would be appropriate. DEFINED BENEFIT OBLIGATIONS - The valuation of pension and other postretirement benefits costs and obligations is dependent on various assumptions. These assumptions, which are updated annually, include discount rates, expected return on plan assets, future salary increase rates, and health care cost trend rates. The Company considers current market conditions, including interest rates, to establish these assumptions. Discount rates are developed considering the yields available on high-quality fixed income investments with maturities corresponding to the duration of the related benefit obligations. The Company’s weighted-average discount rates for the United States and international pension plans were 3.75% and 3.25%, respectively, at January 3, 2015. The Company’s weighted-average discount rate for the United States and international pension plans was 4.50% and 4.00%, respectively at December 28, 2013. As discussed further in Note L, Employee Benefit Plans, the Company develops the expected return on plan assets considering various factors, which include its targeted asset allocation percentages, historic returns, and expected future returns. The Company’s expected rate of return assumptions for the United States and international pension plans were 7.00% and 5.75%, respectively, at January 3, 2015. The Company will use a 5.90% weighted-average expected rate of return assumption to determine the 2015 net periodic benefit cost. A 25 basis point reduction in the expected rate of return assumption would increase 2015 net periodic benefit cost by approximately $5 million, pre-tax. The Company believes that the assumptions used are appropriate; however, differences in actual experience or changes in the assumptions may materially affect the Company’s financial position or results of operations. To the extent that actual (newly measured) results differ from the actuarial assumptions, the difference is recognized in accumulated other comprehensive income, and, if in excess of a specified corridor, amortized over future periods. The expected return on plan assets is determined using the expected rate of return and the fair value of plan assets. Accordingly, market fluctuations in the fair value of plan assets can affect the net periodic benefit cost in the following year. The projected benefit obligation for defined benefit plans exceeded the fair value of plan assets by $781 million at January 3, 2015. This projected benefit obligation reflects the adoption of new mortality tables used for the Company's US pension and post-retirement plans. A 25 basis point reduction in the discount rate would have increased the projected benefit obligation by approximately $103 million at January 3, 2015. The primary Black & Decker U.S pension and post employment benefit plans were curtailed in late 2010, as well as the only material Black & Decker international plan, and in their place the Company implemented defined contribution benefit plans. The vast majority of the projected benefit obligation pertains to plans that have been frozen; the remaining defined benefit plans that are not frozen are predominantly small domestic union plans and those that are statutorily mandated in certain international jurisdictions. The Company recognized $16 million of defined benefit plan expense in 2014, which may fluctuate in future years depending upon various factors including future discount rates and actual returns on plan assets. ENVIRONMENTAL - The Company incurs costs related to environmental issues as a result of various laws and regulations governing current operations as well as the remediation of previously contaminated sites. Future laws and regulations are expected to be increasingly stringent and will likely increase the Company’s expenditures related to environmental matters. The Company’s policy is to accrue environmental investigatory and remediation costs for identified sites when it is probable that a liability has been incurred and the amount of loss can be reasonably estimated. The amount of liability recorded is based on an evaluation of currently available facts with respect to each individual site and includes such factors as existing technology, presently enacted laws and regulations, and prior experience in remediation of contaminated sites. The liabilities recorded do not take into account any claims for recoveries from insurance or third parties. As assessments and remediation progress at individual sites, the amounts recorded are reviewed periodically and adjusted to reflect additional technical and legal information that becomes available. As of January 3, 2015, the Company had reserves of $177.3 million for remediation activities associated with Company-owned properties as well as for Superfund sites, for losses that are probable and estimable. The range of environmental remediation costs that is reasonably possible is $135.7 million to $268.9 million which is subject to change in the near term. The Company may be liable for environmental remediation of sites it no longer owns. Liabilities have been recorded on those sites in accordance with this policy. INCOME TAXES - Income taxes are accounted for in accordance with ASC 740, "Accounting for Income Taxes," which requires that deferred tax assets and liabilities be recognized, using enacted tax rates, for the effect of temporary differences between the book and tax bases of recorded assets and liabilities. Deferred tax assets, including net operating losses and capital losses, are reduced by a valuation allowance if it is “more likely than not” that some portion or all of the deferred tax assets will not be realized. In assessing the need for a valuation allowance, the Company considers all positive and negative evidence including: estimates of future taxable income, considering the feasibility of ongoing tax planning strategies, the realizability of tax loss carry-forwards and the future reversal of existing temporary differences. Valuation allowances related to deferred tax assets can be impacted by changes to tax laws, changes to statutory tax rates and future taxable income levels. In the event the Company were to determine that it would not be able to realize all or a portion of its deferred tax assets in the future, the unrealizable amount would be charged to earnings in the period in which that determination is made. By contrast, if the Company were to determine that it would be able to realize deferred tax assets in the future in excess of the net carrying amounts, it would decrease the recorded valuation allowance through a favorable adjustment to earnings in the period in which that determination is made. The Company is subject to tax in a number of locations, including many state and foreign jurisdictions. Significant judgment is required when calculating its worldwide provision for income taxes. The Company considers many factors when evaluating and estimating its tax positions and tax benefits, which may require periodic adjustments and which may not accurately anticipate actual outcomes. It is reasonably possible that the amount of the unrecognized benefit with respect to certain of the Company's unrecognized tax positions will significantly increase or decrease within the next 12 months. These changes may be the result of settlement of ongoing audits or final decisions in transfer pricing matters. The Company periodically assesses its liabilities and contingencies for all tax years still subject to audit based on the most current available information, which involves inherent uncertainty. For those tax positions where it is more likely than not that a tax benefit will be sustained, the Company has recorded the largest amount of tax benefit with a greater than 50% likelihood of being realized upon ultimate settlement with a taxing authority under the premise that the taxing authority has full knowledge of all relevant information. For those income tax positions where it is not more likely than not that a tax benefit will be sustained, no tax benefit has been recognized in the financial statements. The Company recognizes interest and penalties associated with uncertain tax positions as a component of income taxes in the Consolidated Statement of Operations. See Note Q, Income Taxes, in the Notes to Consolidated Financial Statements for further discussion. RISK INSURANCE - To manage its insurance costs efficiently, the Company self insures for certain U.S. business exposures and generally has low deductible plans internationally. For domestic workers’ compensation, automobile and product liability (liability for alleged injuries associated with the Company’s products), the Company generally purchases insurance coverage only for severe losses that are unlikely, and these lines of insurance involve the most significant accounting estimates. While different self insured retentions, in the form of deductibles and self insurance through its captive insurance company, exist for each of these lines of insurance, the maximum self insured retention is set at no more than $5 million per occurrence. The process of establishing risk insurance reserves includes consideration of actuarial valuations that reflect the Company’s specific loss history, actual claims reported, and industry trends among statistical and other factors to estimate the range of reserves required. Risk insurance reserves are comprised of specific reserves for individual claims and additional amounts expected for development of these claims, as well as for incurred but not yet reported claims discounted to present value. The cash outflows related to risk insurance claims are expected to occur over a period of approximately 13 years. The Company believes the liabilities recorded for these U.S. risk insurance reserves, totaling $102 million and $105 million as of January 3, 2015, and December 28, 2013, respectively, are adequate. Due to judgments inherent in the reserve estimation process it is possible the ultimate costs will differ from this estimate. WARRANTY - The Company provides product and service warranties which vary across its businesses. The types of warranties offered generally range from one year to limited lifetime, while certain products carry no warranty. Further, the Company sometimes incurs discretionary costs to service its products in connection with product performance issues. Historical warranty and service claim experience forms the basis for warranty obligations recognized. Adjustments are recorded to the warranty liability as new information becomes available. The Company believes the $110 million reserve for expected warranty claims as of January 3, 2015 is adequate, but due to judgments inherent in the reserve estimation process, including forecasting future product reliability levels and costs of repair as well as the estimated age of certain products submitted for claims, the ultimate claim costs may differ from the recorded warranty liability. The Company also establishes a reserve for product recalls on a product-specific basis during the period in which the circumstances giving rise to the recall become known and estimable for both company initiated actions and those required by regulatory bodies. OFF-BALANCE SHEET ARRANGEMENT SYNTHETIC LEASES - The Company is a party to synthetic leasing programs for certain locations, including one of its major distribution centers, as well as certain U.S. personal property, predominantly vehicles and equipment. The programs qualify as operating leases for accounting purposes, such that only the monthly rent expense is recorded in the Statement of Operations and the liability and value of the underlying assets are off-balance sheet. These lease programs are utilized primarily to reduce overall cost and to retain flexibility. The cash outflows for lease payments approximate the $1 million of rent expense recognized in fiscal 2014. As of January 3, 2015 the estimated fair value of assets and remaining obligations for these properties were $39 million and $34 million, respectively. CAUTIONARY STATEMENTS UNDER THE PRIVATE SECURITIES LITIGATION REFORM ACT OF 1995 Certain statements contained in this Annual Report on Form 10-K that are not historical, including but not limited to those regarding the Company’s ability to: (i) achieve full year 2015 diluted EPS of approximately $5.65 - $5.85 on a GAAP basis (inclusive of $50 million or $0.25 EPS of restructuring charges); (ii) generate at least $1.0 billion of free cash flow for 2015 ; (iii) deliver continued dividend growth; (iv) reduce its basic share count by the share equivalent of up to $1.0 billion worth of shares through 2015; and (v) achieve dependable organic growth in the 4-6% range as well as significantly expand operating margin rates over the next 3-5 years (collectively, the “Results”); are “forward looking statements” and subject to risk and uncertainty. The Company’s ability to deliver the Results as described above is based on current expectations and involves inherent risks and uncertainties, including factors listed below and other factors that could delay, divert, or change any of them, and could cause actual outcomes and results to differ materially from current expectations. In addition to the risks, uncertainties and other factors discussed elsewhere herein, the risks, uncertainties and other factors that could cause or contribute to actual results differing materially from those expressed or implied in the forward looking statements include, without limitation, those set forth under Item 1A Risk Factors hereto and any material changes thereto set forth in any subsequent Quarterly Reports on Form 10-Q, or those contained in the Company’s other filings with the Securities and Exchange Commission, and those set forth below. The Company’s ability to deliver the Results is dependent, or based, upon: (i) the Company’s ability to generate organic net sales increase of 3-4% driving approximately $0.45 to $0.55 of EPS accretion in 2015; (ii) the Company’s ability to successfully execute cost actions within Security and other businesses, as well as achieve the anticipated pricing, commodity deflation and synergies from the combination of the CDIY and IAR businesses yielding approximately $0.50 of EPS accretion in 2015; (iii) the Company’s ability to drive an additional $0.09 to $0.12 of EPS accretion from lower average share count due to share repurchases during 2015; (iv) foreign exchange headwinds being approximately $140 million, or $0.70 to $0.75 of EPS in 2015; (v) the Company’s tax rate being relatively consistent with the 2014 rate; (vi) the Company’s ability to limit one-time restructuring charges to approximately $50 million in 2015; (vii) the Company’s ability to capitalize on operational improvements in both Security Europe and North America as well as execute on its divestiture of Security’s operations in Spain and Italy; (viii) the Company’s ability to identify and realize revenue synergies associated with acquisitions; (ix) successful integration of completed acquisitions , as well as integration of existing businesses; (x) the continued acceptance of technologies used in the Company’s products and services; (xi) the Company’s ability to manage existing Sonitrol franchisee and Mac Tools relationships; (xii) the Company’s ability to minimize costs associated with any sale or discontinuance of a business or product line, including any severance, restructuring, legal or other costs; (xiii) the proceeds realized with respect to any business or product line disposals; (xiv) the extent of any asset impairments with respect to any businesses or product lines that are sold or discontinued; (xv) the success of the Company’s efforts to manage freight costs, steel and other commodity costs as well as capital expenditures; (xvi) the Company’s ability to sustain or increase prices in order to, among other things, offset or mitigate the impact of steel, freight, energy, non-ferrous commodity and other commodity costs and any inflation increases and/or currency impacts; (xvii) the Company’s ability to generate free cash flow and maintain a strong debt to capital ratio; (xviii) the Company’s ability to identify and effectively execute productivity improvements and cost reductions, while minimizing any associated restructuring charges; (xix) the Company’s ability to obtain favorable settlement of tax audits; (xx) the ability of the Company to generate earnings sufficient to realize future income tax benefits during periods when temporary differences become deductible; (xxi) the continued ability of the Company to access credit markets under satisfactory terms; (xxii) the Company’s ability to negotiate satisfactory payment terms under which the Company buys and sells goods, services, materials and products; (xxiii) the Company’s ability to successfully develop, market and achieve sales from new products and services; and (xxiv) the availability of cash to repurchase shares when conditions are right, as well as the Company's ability to effectively use equity derivative transactions to reduce the capital requirement associated with share repurchases . The Company’s ability to deliver the Results is also dependent upon: (i) the success of the Company’s marketing and sales efforts, including the ability to develop and market new and innovative products and solutions in both existing and new markets including emerging markets; (ii) the ability of the Company to maintain or improve production rates in the Company’s manufacturing facilities, respond to significant changes in product demand and fulfill demand for new and existing products; (iii) the Company’s ability to continue improvements in working capital through effective management of accounts receivable and inventory levels; (iv) the ability to continue successfully managing and defending claims and litigation; (v) the success of the Company’s efforts to mitigate adverse earnings impact resulting from any cost increases generated by, for example, increases in the cost of energy or significant Euro, Canadian Dollar, Chinese Renminbi or other currency fluctuations; (vi) the geographic distribution of the Company’s earnings; (vii) the commitment to and success of the Stanley Fulfillment System; and (viii) successful implementation with expected results of cost reduction programs. The Company’s ability to achieve the Results will also be affected by external factors. These external factors include: challenging global geopolitical and macroeconomic environment; the economic environment of emerging markets, particularly Latin America, Russia and Turkey; pricing pressure and other changes within competitive markets; the continued consolidation of customers particularly in consumer channels; inventory management pressures on the Company’s customers; the impact the tightened credit markets may have on the Company or its customers or suppliers; the extent to which the Company has to write off accounts receivable or assets or experiences supply chain disruptions in connection with bankruptcy filings by customers or suppliers; increasing competition; changes in laws, regulations and policies that affect the Company, including, but not limited to trade, monetary, tax and fiscal policies and laws; the timing and extent of any inflation or deflation; the impact of poor weather conditions on sales; currency exchange fluctuations; the impact of dollar/foreign currency exchange and interest rates on the competitiveness of products and the Company’s debt program; the strength of the U.S. and European economies; the extent to which world-wide markets associated with homebuilding and remodeling stabilize and rebound; the impact of events that cause or may cause disruption in the Company’s supply, manufacturing, distribution and sales networks such as war, terrorist activities, and political unrest; and recessionary or expansive trends in the economies of the world in which the Company operates. The Company undertakes no obligation to publicly update or revise any forward-looking statements to reflect events or circumstances that may arise after the date hereof. Unless required by applicable federal securities laws, the Company undertakes no obligation to publicly update or revise any forward looking statements to reflect events or circumstances that may arise after the date hereof. Investors are advised, however, to consult any further disclosures made on related subjects in the Company's reports filed with the Securities and Exchange Commission. In addition to the foregoing, some of the agreements included as exhibits to this Annual Report on Form 10-K (whether incorporated by reference to earlier filings or otherwise) may contain representations and warranties, recitals or other statements that appear to be statements of fact. These agreements are included solely to provide investors with information regarding their terms and are not intended to provide any other factual or disclosure information about the Company or the other parties to the agreements. Representations and warranties, recitals, and other common disclosure provisions have been included in the agreements solely for the benefit of the other parties to the applicable agreements and often are used as a means of allocating risk among the parties. Accordingly, such statements (i) should not be treated as categorical statements of fact; (ii) may be qualified by disclosures that were made to the other parties in connection with the negotiation of the applicable agreements, which disclosures are not necessarily reflected in the agreement or included as exhibits hereto; (iii) may apply standards of materiality in a way that is different from what may be viewed as material by or to investors in or lenders to the Company; and (iv) were made only as of the date of the applicable agreement or such other date or dates as may be specified in the agreement and are subject to more recent developments. Accordingly, representations and warranties, recitals or other disclosures contained in agreements may not describe the actual state of affairs as of the date they were made or at any other time and should not be relied on by any person other than the parties thereto in accordance with their terms. Additional information about the Company may be found in this Annual Report on Form 10-K and the Company's other public filings, which are available without charge through the SEC's website at http://www.sec.gov.

<s>[INST] The following discussion and certain other sections of this Annual Report on Form 10K contain statements reflecting the Company’s views about its future performance that constitute “forwardlooking statements” under the Private Securities Litigation Reform Act of 1995. These forwardlooking statements are based on current expectations, estimates, forecasts and projections about the industry and markets in which the Company operates as well as management’s beliefs and assumptions. Any statements contained herein (including without limitation statements to the effect that Stanley Black & Decker, Inc. or its management “believes”, “expects”, “anticipates”, “plans” and similar expressions) that are not statements of historical fact should be considered forwardlooking statements. These statements are not guarantees of future performance and involve certain risks, uncertainties and assumptions that are difficult to predict. There are a number of important factors that could cause actual results to differ materially from those indicated by such forwardlooking statements. These factors include, without limitation, those set forth, or incorporated by reference, below under the heading “Cautionary Statements”. The Company does not intend to update publicly any forwardlooking statements whether as a result of new information, future events or otherwise. Strategic Objectives The Company has maintained a consistent strategic framework over time: Maintaining portfolio transition momentum by continuing diversification toward higher growth, higher profit businesses, and increasing relative weighting of emerging markets; Being selective and operating in markets where brand is meaningful, the value proposition is definable and sustainable through innovation and global cost leadership is achievable; Pursuing acquisitive growth on multiple fronts through opportunistically consolidating the tool industry, building on existing growth platforms such as engineered fastening and infrastructure, and opportunistically adding to security when the conditions are right; Accelerating progress via the Stanley Fulfillment System. In 2012, the Company intensified its focus on organic growth in order to achieve its longterm objective of 46% organic growth. Stanley's strategy involves industry, geographic and customer diversification, in order to pursue sustainable revenue, earnings and cash flow growth. Two aspects of the Company’s vision are to be a consolidator within the tool industry and to increase its presence in emerging markets, with a goal of ultimately generating greater than 20% of annual revenues from emerging markets. These objectives have been significantly enhanced by the Black & Decker merger, which along with the impact from the Company’s diversification strategy has driven continued improvements in financial performance. Sales outside the U.S. represented 51% of total net sales in 2014, up from 29% in 2002. As further illustration of the Company's diversification strategy, 2014 sales to U.S. and international home centers and mass merchants were approximately 23%, including nearly 16% in sales to the Company’s two largest customers, which is down from 31% in 2010, including 20% in sales to the Company's two largest customers. As operations in the various growth platforms within the Industrial and Security segments continue to expand in future years, the proportion of sales to these valued U.S. and international home centers and mass merchants is expected to continue to decrease although they will remain important and highly valued customers. Execution of the above strategy has resulted in approximately $6.2 billion of acquisitions since 2002 (aside from the Black & Decker merger), several divestitures (including the sale of HHI in December 2012), increased brand investment, improved efficiency in the supply chain and manufacturing operation, and enhanced investments in organic growth, enabled by cash flow generation and increased debt capacity. Over the last decade, the Company has returned approximately 50% of normalized free cash flow to its shareowners. The Company’s longterm financial objectives are: 46% organic revenue growth; 1012% total revenue growth; Doubledigit earnings per share growth; Free cash flow greater than or equal to net income; Cash flow return on investment (CFROI) of 1215%; Continued dividend growth; and Strong investment grade credit rating. The Company’s longterm capital allocation objectives pertaining to the deployment of free cash flow, defined as operating cash flow less capital expend [/INST] Negative. </s>

STANLEY BLACK & DECKER, INC.

2016-02-19

2016-01-02

ITEM 7. MANAGEMENT’S DISCUSSION AND ANALYSIS OF FINANCIAL CONDITION AND RESULTS OF OPERATIONS The financial and business analysis below provides information which the Company believes is relevant to an assessment and understanding of its consolidated financial position, results of operations and cash flows. This financial and business analysis should be read in conjunction with the Consolidated Financial Statements and related notes. All references to “Notes” in this Item 7 refer to the Notes to Consolidated Financial Statements included in Item 8 of this Annual Report. The following discussion and certain other sections of this Annual Report on Form 10-K contain statements reflecting the Company’s views about its future performance that constitute “forward-looking statements” under the Private Securities Litigation Reform Act of 1995. These forward-looking statements are based on current expectations, estimates, forecasts and projections about the industry and markets in which the Company operates as well as management’s beliefs and assumptions. Any statements contained herein (including without limitation statements to the effect that Stanley Black & Decker, Inc. or its management “believes”, “expects”, “anticipates”, “plans” and similar expressions) that are not statements of historical fact should be considered forward-looking statements. These statements are not guarantees of future performance and involve certain risks, uncertainties and assumptions that are difficult to predict. There are a number of important factors that could cause actual results to differ materially from those indicated by such forward-looking statements. These factors include, without limitation, those set forth, or incorporated by reference, below under the heading “Cautionary Statements”. The Company does not intend to update publicly any forward-looking statements whether as a result of new information, future events or otherwise. Strategic Objectives The Company continues to employ the following strategic framework: • Maintaining organic growth momentum by utilizing SFS 2.0 as a catalyst, diversifying toward higher growth, higher profit businesses, and increasing relative weighting of emerging markets; • Being selective and operating in markets where brand is meaningful, the value proposition is definable and sustainable through innovation and global cost leadership is achievable; • Pursuing acquisitive growth on multiple fronts through opportunistically consolidating the tool industry and expanding the Industrial platform in Engineered Fastening and Infrastructure. The Company is continuing to pursue a growth and acquisition strategy that involves industry, geographic and customer diversification to foster sustainable revenue, earnings and cash flow growth. The Company is focused on growing organically, including increasing its presence in emerging markets, with a goal of generating greater than 20% of annual revenues from those markets, and leveraging the Stanley Fulfillment System, a now expanded program focused on breakthrough innovation and digital capabilities while accelerating commercial and supply chain excellence, and funding these required investments through functional transformation. These objectives have been significantly enhanced by the Black & Decker merger, which along with the impact from the Company’s diversification strategy has driven continued improvements in financial performance. Sales outside the U.S. represented 47% of total net sales in 2015, up from 29% in 2002. As further illustration of this diversification strategy, sales to U.S. and international home centers and mass merchants accounted for approximately 27% of total sales in 2015 compared to 31% in 2010. Execution of the above strategy has resulted in approximately $6.2 billion of acquisitions since 2002 (aside from the Black & Decker merger), several divestitures (including the sale of HHI in December 2012), increased brand investment, improved efficiency in the supply chain and manufacturing operation, and enhanced investments in organic growth, enabled by cash flow generation and increased debt capacity. Over the last decade, the Company has returned approximately 50% of normalized free cash flow to its shareowners. Each of the Company's franchises share common attributes: they have world-class brands and attractive growth characteristics, they are scalable and defensible, and they can differentiate through innovation. • The Tools & Storage business is the tool company to own with its strong brands, proven innovation machine, global scale, and broad offering of power and hand tools across many channels in both developed and developing markets. • The Engineered Fastening business is a highly profitable, GDP+ growth business offering high value-added innovative solutions with recurring revenue attributes and global scale. • The Convergent Security Solutions ("CSS") business, with its value-add vertical market offerings and attractive recurring revenue, presents a significant margin accretion opportunity over the longer term. The Security business, which has historically provided a stable revenue stream through economic cycles, is a gateway into the digital world and an avenue to capitalize on rapid digital changes. As communicated at the May 2015 Investor Day, the Company intends to provide further information on the state of its Security franchise and its fit within the Company's portfolio in the second half of 2016. The Company is encouraged by Security's recent favorable performance trends of improving operating margins, increasing order rates and stabilizing attrition at targeted levels. Operational enhancements are beginning to take hold across the segment and talent upgrades in many portions of the business are starting to pay dividends in terms of results and building a high performance culture. The Company’s three-year annual financial targets ("2018 Vision") communicated in May 2015, which assumes a relatively stable currency environment and approximately $50 million of annual restructuring costs, include: • 4-6% organic revenue growth, with total revenue growth enhanced by acquisitions; • 50-75 basis points of operating margin rate improvement to approximately 16% by 2018; • 10-12% earnings per share growth (including acquisitions), 7-9% organic growth; • Cash flow return on investment ("CFROI") expansion to 14-15%; and • Progress towards 10+ working capital turns. In terms of capital allocation, the Company remains committed to returning approximately 50% of free cash flow to shareholders through a strong and growing dividend as well as opportunistically repurchasing shares. The remaining free cash flow (approximately 50%) will be deployed towards acquisitions. Since the beginning of the fourth quarter of 2014, the Company has reduced its share count by the equivalent of approximately $1.2 billion worth of shares by utilizing both cash and equity derivatives. The following represents recent examples of executing on the Company's strategic objectives: Acquisitions In May 2013, the Company purchased a 60% controlling share in Jiangsu Guoqiang Tools Co., Ltd. ("GQ") for a total purchase price of $48.5 million, net of cash acquired. In December 2015, the Company purchased the remaining 40% interest for a total purchase price of $33.5 million. GQ is a manufacturer and seller of power tools in both domestic and foreign markets. The acquisition of GQ complements the Company's existing power tools product offerings and further diversifies the Company's operations and international presence. This acquisition allows the Company to accelerate its emerging market mid-price point product strategy. GQ is headquartered in Qidong, China and has been consolidated into the Company's Tools & Storage segment. In February 2013, the Company acquired a 100% ownership interest in Infastech for a total purchase price of $826.4 million, net of cash acquired. Infastech designs, manufactures and distributes highly-engineered fastening technologies and applications for a diverse blue-chip customer base in the industrial, electronics, automotive, construction and aerospace end markets. The acquisition of Infastech added to the Company's strong positioning in specialty engineered fastening, an industry with solid growth prospects, and further expanded the Company's global footprint with its strong concentration in fast-growing emerging markets. Infastech is headquartered in Hong Kong and has been consolidated into the Company's Industrial segment. HHI and Tong Lung Residential Divestiture In December 2012, the Company sold HHI to Spectrum for approximately $1.4 billion in cash. HHI is a provider of residential locksets, residential builders hardware and plumbing products marketed under the Kwikset, Weiser, Baldwin, Stanley, National and Pfister brands. The majority of the HHI business was part of the Company's Security segment. The divestiture of the HHI business is part of the continued diversification of the Company's revenue streams and geographic footprint consistent with the Company's strategic framework. The purchase and sale agreement stipulated that the sale occur in a First and Second Closing, for approximately $1.3 billion and approximately $94 million, respectively. The First Closing, which excluded the residential portion of the Tong Lung business, occurred on December 17, 2012. The Second Closing, relating to the residential portion of the Tong Lung business, occurred on April 8, 2013. During 2013, the Company completed the 2012 income tax return filings which included the final calculations of the tax gain on HHI sale which took place in 2012. As a result of these tax return filings, the Company recorded an income tax benefit of approximately $19.1 million within discontinued operations related to finalization of the taxable gain on the HHI sale. Changes to the original tax gain were driven primarily by the determination of the final purchase price allocation and the finalization of the U.S. tax basis calculation, both of which were finalized during 2013. The net proceeds from this divestiture were used to repurchase $850 million of the Company's common stock and for debt reduction, to ensure the Company's leverage ratios remain in its target range. Refer to Note E, Acquisitions, and Note T, Discontinued Operations, for further discussion of the Company's acquisitions and divestitures. Driving Further Profitable Growth By Fully Leveraging Existing Businesses While diversifying the business portfolio through expansion in the Company’s specified growth platforms remains important, management recognizes that the branded tool and storage product offerings in the Tools & Storage segment are important foundations that continue to provide strong cash flow and growth prospects. Management is committed to growing these businesses through innovative product development, brand support, continued investment in emerging markets and a sharp focus on global cost-competitiveness. As discussed previously, in the first quarter of 2015, the Company made the decision to combine the complementary elements of the CDIY and IAR businesses into one Tools & Storage business. The combination of these two businesses is consistent with the Company's strategy to continue to gain market share and consolidate the tool industry. The decision was based on the businesses' powerful family of brands, global scale and breadth of products across power and hand tools, storage and accessories, in addition to diverse channel access across the spectrum of construction, DIY, industrial and automotive repair markets. The Tools & Storage business represents an important foundation of the Company that will continue to provide strong cash flow and future growth. Continuing to Invest in the Stanley Black & Decker Brands The Company has a strong portfolio of brands associated with high-quality products including STANLEY®, BLACK+DECKER®, DEWALT®, Porter-Cable®, Bostitch®, Proto®, MAC®, FACOM®, AeroScout®, Powers®, LISTA®, SIDCHROME®, Vidmar®, SONITROL®, and GQ®. The STANLEY®, BLACK+DECKER® and DEWALT® brands are recognized as three of the world's great brands and are amongst the Company's most valuable assets. Sustained brand support has yielded a steady improvement across the spectrum of brand awareness measures, most notably in unaided Stanley hand tool brand awareness. During 2015, the STANLEY® and DEWALT® brands had prominent signage at nine major league baseball stadiums and 30% of all Major League Baseball games. The Company has also maintained long-standing NASCAR and NHRA racing sponsorships, which provided brand exposure during 42 events in 2015. The Company has continued its ten-year alliance agreement with the Walt Disney World Resort® whereby STANLEY® logos are displayed on construction walls throughout the theme parks and STANLEY®, MAC®, Proto®, and Vidmar® brand logos and/or products are featured in various attractions where they are seen by approximately 45 million visitors each year. Additionally, Stanley is “The Official Tool Provider of the Walt Disney World Resort®.” In 2009, the Company also began advertising in the English Premier League, which is the number one soccer league in the world, watched weekly by 650 million people. Starting in 2014, the Company became a sponsor of the world’s most popular football club, FC Barcelona, including player image rights, hospitality assets and stadium signage. The Company advertises in televised Professional Bull Riders events, one of the fastest growing sports with over 44 million fans, as well as the The Built Ford Tough Series, which is broadcast in 129 territories and to more than 400 million households globally. Additionally, the Company sponsors Moto GP, the world's premiere motorcycle racing series reaching 130 million fans per race and airing in over 200 countries, and the Monster Yamaha Tech3 team. The Company has entered a partnership with the Chinese Basketball Association (CBA), the most popular sport in China with over 800 million fans. The Company will continue to allocate its brand and advertising spend wisely and it currently generates more than 200 billion brand impressions annually. The Stanley Fulfillment System (SFS) SFS employs continuous improvement techniques to streamline operations (front end & back office) and drive efficiency throughout the supply chain. SFS has five core principles that work in concert: sales and operations planning (“S&OP”), operational lean, complexity reduction, global supply management, and order-to-cash excellence. S&OP is a dynamic and continuous unified process that links and balances supply and demand in a manner that produces world-class fill rates while minimizing DSI (Days Sales of Inventory). Operational lean is the systemic application of lean principles in progressive steps throughout the enterprise to optimize flow toward a pre-defined end state by eliminating waste, increasing efficiency and driving value. Complexity reduction is a focused and overt effort to eradicate costly and unnecessary complexity from the Company's products, supply chain and back room process and organizations. Complexity reduction enables all other SFS elements and, when successfully deployed, results in world-class cost, speed of execution and customer satisfaction. Global supply management focuses on strategically leveraging the company’s scale to achieve the best possible price and payment terms with the best possible quality, service and delivery among all categories of spend. Order-to-cash excellence is a methodical, process-based approach that provides a user-friendly, automated and error-proof customer experience from intent-to-purchase to shipping and billing to payment, while minimizing cash collection cycle time and DSO (Days Sales Outstanding). Other benefits of SFS include reductions in lead times, rapid realization of synergies during acquisition integrations, and focus on employee safety. The core SFS principles helped to mitigate the substantial impact of material and energy price inflation that was experienced in recent years. SFS is also instrumental in the reduction of working capital as evidenced by the 56% improvement in working capital turns for the Company from 5.9 (excluding HHI) at the end of 2010, after the merger with Black & Decker, to 9.2 at the end of 2015. The continued efforts to deploy SFS across the entire Company and increase turns have created significant opportunities to generate incremental free cash flow. Going forward, the Company plans to further leverage SFS to generate ongoing improvements both in the existing business and future acquisitions in working capital turns, cycle times, complexity reduction and customer service levels, with a goal of ultimately achieving 10 working capital turns. In addition, the Company has embarked on an initiative to drive from a more programmatic growth mentality to a true organic growth culture by more deeply embedding breakthrough innovation and commercial excellence into its businesses, and at the same time, becoming a significantly more digitally-enabled enterprise. A new breed of digital technologies is changing the competitive landscape at unprecedented rates, creating both threats and opportunities, and it is clear that organizations that stand still will be left behind. To that end, the Company has spent considerable time and effort developing the next iteration of the successful SFS program, which has driven working capital turns to world-class levels and vastly improved the supply chain and customer-facing metrics. Entitled “SFS 2.0” this refreshed and revitalized business system will continue the progress on core SFS, but importantly, provide resources and added focus into functional transformation, digital excellence, commercial excellence and breakthrough innovation. SFS 2.0 was launched in 2015 and immediately created a positive impact on 2015 results by driving organic growth, improving margins and reaching new levels of innovation and digitization across the entire organization. The Company is making a significant commitment to SFS 2.0 and management believes that its success will be characterized by more consistent organic growth in the 4-6% range as well as expanded operating margin rates over the next 3 to 5 years as the Company leverages the growth and reduces structural SG&A levels. The expanded SFS 2.0 will transform the Company by focusing its employees on the following five key pillars: • Core SFS, which targets asset efficiency, remains as the foundation for the Company's operating system and despite the significant advances made in improving working capital turns and free cash generation, opportunities still remain for further working capital improvements and supply chain efficiency to enhance the Company's already strong asset efficiency performance. • Functional Transformation takes a clean-sheet approach to redesigning the Company's key support functions such as Finance, HR, IT and others, which although highly effective, after 80 or so acquisitions are not as efficient as they can be, based on external benchmarks. This presents the Company with an opportunity to reduce its SG&A as a percent of sales and becomes a cost effectiveness enabler with the side benefit of providing the funding mechanism for the following other aspects of SFS 2.0, which together act as enablers for outsized organic growth and margin expansion. • Digital Excellence uses the power of digital to be disruptive and more effective and far reaching through the Company's products, solutions and analytics. Digital Excellence means leveraging the power of emerging technologies across the Company's businesses to connected devices, the Internet of Things, and big data, as well as social and mobile, even more than what is being done today. Digital will touch all aspects of the organization and feeds into and supports the other elements of SFS 2.0 - enabling better asset efficiency through core SFS, greater cost effectiveness via the Company's support functions, and improving revenues and margins via customer-facing opportunities. • Commercial Excellence is about how the Company becomes more effective and efficient in its customer-facing processes resulting in continued share gains and margin expansion throughout its businesses. The Company views Commercial Excellence as world-class execution across seven areas: customer insights, innovation and portfolio management, pricing and promotion, brand and marketing, sales force deployment and effectiveness, channel programs, and the customer experience. • Breakthrough Innovation is aimed at developing a breakthrough innovation culture to identify market disruptive technologies. Although the Company has a track record of being highly innovative, opportunities exist to be even more innovative. The Company's breakthrough innovation focus is on coming up with the next major breakthrough in the industries in which the Company operates which, when combined with its existing strong core innovation machine, will drive outsized share gains and margin expansion. These five pillars will serve as a powerful value driver in the years ahead, feeding the Company's new product innovation machine, embracing outstanding commercial and supply chain excellence, embedding digital into the various business models, and funding it all with world-class functional efficiency. Taken together, these pillars will directly support achievement of the Company's long-term financial objectives and further enable its shareholder-friendly capital allocation approach, which has served the Company well in the past and will continue to do so in the future. Certain Items Impacting Earnings Merger and Acquisition-Related and Other Charges Impacting 2013 Earnings Throughout MD&A, the Company has provided a discussion of its 2013 results both inclusive and exclusive of merger and acquisition-related and other charges. Merger and acquisition-related charges in 2013 related primarily to the Black & Decker merger and Niscayah and Infastech acquisitions, while other charges related to the extinguishment of debt. The amounts and measures, including gross profit and segment profit, on a basis excluding such charges are considered relevant to aid analysis and understanding of the Company’s 2013 results aside from the material impact of these charges. In addition, these measures are utilized internally by management to understand business trends, as once the anticipated cost synergies from the Black & Decker merger and other acquisitions were realized, such charges are not expected to recur. Merger and acquisition-related charges were not significant in 2015 or 2014 and therefore, are not discussed separately in MD&A for those years. During 2013, the Company reported $390 million in pre-tax merger and acquisition-related and other charges, which were comprised of the following: • $29 million reducing Gross profit primarily pertaining to integration-related matters and amortization of the inventory step-up adjustment for the Infastech acquisition; • $136 million in Selling, general & administrative expenses primarily for integration-related administrative costs and consulting fees, as well as employee related matters; • $30 million in Other-net primarily related to deal transaction costs; • $21 million pre-tax loss on the extinguishment of $300 million of debt in the fourth quarter of 2013; and • $174 million in net Restructuring charges, which primarily represent Niscayah integration-related restructuring charges and cost reduction actions associated with the severance of employees. The tax effect on the above charges, some of which were not tax deductible, in 2013 was $120 million, resulting in an after-tax charge of $270 million, or $1.70 per diluted share. Outlook for 2016 This outlook discussion is intended to provide broad insight into the Company’s near-term earnings and cash flow generation prospects. The Company expects diluted earnings per share to approximate $6.00 to $6.20 in 2016, with free cash flow conversion, defined as free cash flow divided by net income, approximating 100%. The 2016 outlook assumes organic sales growth of 3% resulting in approximately $0.45 to $0.50 of diluted earnings per share accretion. Commodity deflation, cost actions and productivity initiatives are expected to yield approximately $0.45 to $0.50 of diluted earnings per share accretion. The Company anticipates approximately $0.13 of diluted EPS accretion resulting from lower average share count, including approximately $300 million of share repurchases in 2016. Foreign exchange headwinds are expected to continue to negatively impact earnings by approximately $170 to $190 million, or $0.85 to $0.95 of diluted earnings per share. Restructuring charges and the tax rate are expected to be relatively consistent with 2015 levels. RESULTS OF OPERATIONS Below is a summary of the Company’s operating results at the consolidated level, followed by an overview of business segment performance. Terminology: The term “organic” is utilized to describe results aside from the impacts of foreign currency fluctuations and acquisitions during their initial 12 months of ownership. This ensures appropriate comparability to operating results of prior periods. Net Sales: Net sales were $11.172 billion in 2015, down 1% compared to $11.339 billion in 2014. Organic sales volume and pricing provided increases of 5% and 1%, respectively, but were more than offset by a 7% decrease due to negative impacts from foreign currency. In the Tools & Storage segment, organic sales increased 8% compared to 2014 as a result of strong growth across all regions primarily due to share gains from innovative new products and an expanded retail footprint. Net sales in the Security segment decreased 7% compared to 2014 primarily due to foreign currency declines of 7% and lower volumes in North America and emerging markets, which more than offset organic growth in Europe. In the Industrial segment, organic sales grew 2% relative to 2014 due to strong organic growth in the Engineered Fastening business primarily as a result of strong global automotive revenues. Net sales were $11.339 billion in 2014, up 4% compared to $10.890 billion in 2013. Organic sales and acquisitions (primarily Infastech) provided increases of 5% and 1% in net sales, respectively, while unfavorable effects of foreign currency translation resulted in a decrease of 2% in net sales. In the Tools & Storage segment, organic sales increased 6% compared to 2013 as a result of higher volumes in North America and Europe primarily due to successful new product introductions and an expanded retail footprint, as well as significant market share gains driven by organic growth initiatives. In the Industrial segment, organic sales grew 5% relative to 2013 due to strong organic growth in the Engineered Fastening business. In the Security segment, net sales decreased 2% compared to 2013 due to lower sales volumes in Europe and unfavorable effects of foreign currency translation, which more than offset modest increases in price. Gross Profit: The Company reported gross profit of $4.072 billion, or 36.4% of net sales, in 2015 compared to $4.103 billion, or 36.2% of net sales, in 2014. The increase in the profit rate reflects favorable impacts from volume leverage, price, productivity, cost actions and commodity deflation, which more than offset significant unfavorable foreign currency fluctuations. The Company reported gross profit of $4.103 billion, or 36.2% of net sales, in 2014 compared to $3.904 billion, or 35.8% of net sales, in 2013. Merger and acquisition-related charges, which reduced gross profit, were $29.5 million in 2013. Excluding these charges, gross profit was 36.1% of net sales in 2013. The increase in the 2014 profit rate reflects favorable impacts from sales volume, price, supply chain productivity and cost management, which more than offset negative impacts from foreign currency fluctuations and lower Security margins caused by field operations inefficiencies and negative installation and recurring revenue mix. SG&A Expense: Selling, general and administrative expenses, inclusive of the provision for doubtful accounts (“SG&A”), were $2.486 billion, or 22.3% of net sales, in 2015 compared to $2.596 billion, or 22.9% of net sales, in 2014. The decrease in the SG&A rate reflects the positive impacts of volume leverage and cost controls. SG&A expenses were $2.596 billion, or 22.9% of net sales, in 2014 compared to $2.691 billion, or 24.7% of net sales in 2013. Within SG&A, merger and acquisition-related compensation costs and integration-related expenses totaled $135.7 million in 2013. Excluding these charges, SG&A was 23.5% of net sales in 2013. The decrease in the SG&A rate was mainly attributable to increased volumes and the positive impacts from headcount reduction actions and the Company's efforts to significantly reduce indirect expenses. Distribution center costs (i.e. warehousing and fulfillment facility and associated labor costs) are classified within SG&A. This classification may differ from other companies who may report such expenses within cost of sales. Due to diversity in practice, to the extent the classification of these distribution costs differs from other companies, the Company’s gross margins may not be comparable. Such distribution costs classified in SG&A amounted to $229.3 million in 2015, $243.2 million in 2014 and $229.5 million in 2013. Corporate Overhead: The corporate overhead element of SG&A and gross profit, which is not allocated to the business segments, amounted to $164.0 million in 2015, $177.4 million in 2014 and $254.0 million in 2013. The decrease in 2015 compared to 2014 reflects the positive impacts from the Company's effort to reduce certain indirect expenses. Corporate overhead in 2013 included $89.4 million of merger and acquisition-related charges. Corporate overhead, excluding the 2013 merger and acquisition-related charges, represented 1.5%, 1.6%, and 1.5% of net sales in 2015, 2014 and 2013, respectively. Other-net: Other-net totaled $222.0 million of expense in 2015 compared to $239.7 million of expense in 2014. The decrease was primarily driven by lower amortization expense partially offset by negative impacts of foreign currency. Other-net amounted to $239.7 million of expense in 2014 compared to $283.9 million of expense in 2013. The decrease was primarily driven by lower amortization expense and acquisition-related costs in 2014 as compared to 2013. Gain/Loss on Debt Extinguishment: During the fourth quarter of 2014, the Company extinguished $45.7 million of its notes payable and recognized a net pre-tax gain of $0.1 million on extinguishment. During the fourth quarter of 2013, the Company extinguished $300 million of its notes payable and recognized a $20.6 million pre-tax loss on extinguishment. Interest, net: Net interest expense in 2015 was $165.2 million compared to $163.6 million in 2014 and $147.3 million in 2013. The increase in net interest expense in 2015 versus 2014 was primarily attributable to the termination of interest rate swaps in 2014 hedging the Company's $400 million 5.20% notes due 2040. The increase in net interest expense in 2014 versus 2013 mainly relates to interest costs associated with the issuance of debt in the fourth quarter of 2013, partially offset by higher interest income. Income Taxes: The Company's effective tax rate was 21.6% in 2015, 20.9% in 2014, and 11.7% in 2013. The effective tax rate in 2015 differed from the U.S. statutory rate primarily due to a portion of the Company's earnings being realized in lower-taxed foreign jurisdictions, adjustments to tax positions relating to undistributed foreign earnings, and reversals of valuation allowances for certain foreign and U.S. state net operating losses, which have become realizable. The effective tax rate in 2014 differed from the U.S. statutory rate primarily due to a portion of the Company's earnings being realized in lower-taxed foreign jurisdictions, the passage of U.S. tax legislation, settlement of various income tax audits and the reversal of valuation allowances for certain foreign net operating losses which have become realizable. The effective tax rate in 2013 differed from the U.S. statutory rate primarily due to a portion of the Company's earnings being realized in lower-taxed foreign jurisdictions, the acceleration of certain tax credits, the recurring benefit of various foreign business integration structures and the reversal of certain foreign and U.S. state uncertain tax position reserves, related largely to statute expiration. Business Segment Results The Company’s reportable segments are aggregations of businesses that have similar products, services and end markets, among other factors. The Company utilizes segment profit (which is defined as net sales minus cost of sales and SG&A aside from corporate overhead expense), and segment profit as a percentage of net sales to assess the profitability of each segment. Segment profit excludes the corporate overhead expense element of SG&A, Other-net (inclusive of intangible asset amortization expense), restructuring charges, interest income, interest expense, and income tax expense. Corporate overhead is comprised of world headquarters facility expense, cost for the executive management team and the expense pertaining to certain centralized functions that benefit the entire Company but are not directly attributable to the businesses, such as legal and corporate finance functions. Refer to Note O, Restructuring Charges and Asset Impairments, and Note F, Goodwill and Intangible Assets, for the amount of net restructuring charges and intangibles amortization expense, respectively, attributable to each segment. As previously discussed, in the first quarter of 2015, the Company combined the Construction & Do-It-Yourself ("CDIY") business with certain complementary elements of the Industrial and Automotive Repair ("IAR") and Healthcare businesses (formerly part of the Industrial and Security segments, respectively) to form one Tools & Storage business. The Company recast segment net sales and profit for 2014 and 2013 to align with this change in organizational structure. There was no impact to the consolidated financial statements of the Company as a result of this change. The Company classifies its business into three reportable segments, which also represent its operating segments: Tools & Storage, Security and Industrial. Tools & Storage: The Tools & Storage segment is comprised of the Power Tools and Hand Tools & Storage businesses. The Power Tools business includes professional products, consumer products and power tool accessories. Professional products include professional grade corded and cordless electric power tools and equipment including drills, impact wrenches and drivers, grinders, saws, routers and sanders, as well as pneumatic tools and fasteners including nail guns, nails, staplers, and staples, concrete and masonry anchors. Consumer products include corded and cordless electric power tools sold primarily under the BLACK+DECKER brand, lawn and garden products including hedge trimmers, string trimmers, lawn mowers, edgers, and related accessories and home products such as hand held vacuums, paint tools and cleaning appliances. Power tool accessories include drill bits, router bits, abrasives and saw blades. The Hand Tools & Storage business sells measuring, leveling and layout tools, planes, hammers, demolition tools, knives, saws, chisels and industrial and automotive tools. Storage products include tool boxes, sawhorses, medical cabinets and engineered storage solution products. Tools & Storage net sales increased $107.7 million, or 2%, in 2015 compared to 2014. Organic sales increased 8% primarily due to organic growth of 11% in North America, 7% in Europe, and 3% in emerging markets, while unfavorable effects of foreign currency decreased net sales by 6%. Share gains from innovative new products and brand extensions combined with a healthy underlying U.S. tool market fueled growth in North America despite downward pressure in the industrial channels and Canada. Europe achieved above-market organic growth due to share gains from new products, an expanded retail footprint and solid commercial momentum. Organic growth within the emerging markets was driven by favorable impacts of pricing and successful mid-price-point product releases, which more than offset weakness in certain markets, particularly Russia and China. Segment profit amounted to $1,170.1 million, or 16.4% of net sales, in 2015 compared to $1,074.4 million, or 15.3% of net sales, in 2014. The increase in segment profit year-over-year was primarily driven by volume leverage, price, productivity, cost management and lower commodity prices, which more than offset significant foreign currency headwinds. Tools & Storage net sales increased $328.0 million, or 5%, in 2014 compared with 2013. Organic sales and acquisitions provided increases of 6% and 1%, respectively, while unfavorable effects of foreign currency decreased net sales by 2%. North America achieved 8% organic growth driven primarily by new product introductions and expanded retail offerings and partnerships on top of a healthy underlying tool market. Organic sales in Europe increased 7% year-over-year due to successful new product introductions and an expanding retail footprint, which helped generate market share gains in spite of continued challenging economic conditions. Emerging markets grew 4% organically in 2014 bolstered by new product launches in the mid-price point segment despite persistently volatile economic conditions across all emerging markets. Segment profit amounted to $1,074.4 million, or 15.3% of net sales, in 2014 compared to $951.7 million, or 14.2% of net sales, in 2013. Excluding $17.9 million in merger and acquisition-related charges, segment profit totaled $969.6 million, or 14.5% of net sales, in 2013. The increase in segment profit year-over-year was primarily driven by positive impacts during 2014 from volume, productivity and SG&A cost reductions, which more than offset the negative impacts from foreign currency. Security: The Security segment is comprised of the CSS and the Mechanical Access Solutions ("MAS") businesses. The CSS business designs, supplies and installs electronic security systems and provides electronic security services, including alarm monitoring, video surveillance, fire alarm monitoring, systems integration and system maintenance. Purchasers of these systems typically contract for ongoing security systems monitoring and maintenance at the time of initial equipment installation. The business also includes healthcare solutions, which include asset tracking solutions, infant protection, pediatric protection, patient protection, wander management, fall management, and emergency call products. The MAS business sells automatic doors, commercial hardware, locking mechanisms, electronic keyless entry systems, keying systems, tubular and mortise door locksets. Security net sales decreased $168.3 million, or 7%, in 2015 compared to 2014. Organic sales were relatively flat year-over-year while foreign currency fluctuations resulted in a 7% decrease in net sales. Organic growth of 3% in Europe was primarily driven by higher installation revenues in a number of countries and a stable recurring revenue portfolio. North America organic sales were relatively flat year-over-year as modest price increases were offset by lower sales volume within the commercial electronics business as 2014 benefited from a large retail installation. Organic sales declined in emerging markets due to relatively weak market conditions in China. Segment profit amounted to $239.6 million, or 11.4% of net sales, in 2015 compared to $259.2 million, or 11.5% of net sales, in 2014. The segment profit rate was relatively flat year-over-year as improved operating performance within Europe was offset by field cost inefficiencies within the North America electronics business and the deleveraging impact of lower volumes in emerging markets. Security net sales decreased $34.7 million, or 2%, in 2014 compared to 2013. Organic sales were relatively flat year-over-year while foreign currency fluctuations resulted in a 2% decrease in net sales. Organic growth of 1% in North America and emerging markets was primarily due to growth within the commercial electronics business as a result of vertical selling solutions and the automatic doors business, partially offset by lower installation and recurring revenues in Europe in addition to declines in the U.S. commercial lock business due to a business model transition. Segment profit amounted to $259.2 million, or 11.5% of net sales, in 2014 compared to $235.2 million, or 10.2% of net sales, in 2013. Excluding merger and acquisition-related charges of $37.8 million, segment profit was $273.0 million, or 11.9% of net sales, in 2013. The decrease in segment profit rate year-over-year was driven by installation field inefficiencies and negative installation and recurring revenue mix in Europe, which offset improved operating performances in North America and emerging markets. Industrial: The Industrial segment is comprised of the Engineered Fastening and Infrastructure businesses. The Engineered Fastening business primarily sells engineered fastening products and systems designed for specific applications. The product lines include stud welding systems, blind rivets and tools, blind inserts and tools, drawn arc weld studs, engineered plastic and mechanical fasteners, self-piercing riveting systems, precision nut running systems, micro fasteners, and high-strength structural fasteners. The Infrastructure business consists of the Oil & Gas and Hydraulics businesses. The Oil & Gas business sells and rents custom pipe handling, joint welding and coating equipment used in the construction of large and small diameter pipelines, and provides pipeline inspection services. The Hydraulics business sells hydraulic tools and accessories. Industrial net sales decreased $106.2 million, or 5%, in 2015 compared with 2014 as organic growth of 2% was more than offset by unfavorable foreign currency of 7%. Engineered Fastening achieved organic growth of 4% during 2015, which was mainly attributable to strong global automotive revenues. Infrastructure organic sales decreased 4% primarily due to lower Hydraulics volumes as a result of difficult scrap steel market conditions, which more than offset modest organic growth in Oil & Gas. Segment profit totaled $339.9 million, or 17.5% of net sales, in 2015 compared to $350.6 million, or 17.1% of net sales, in 2014. The year-over-year increase in segment profit rate was primarily due to favorable volume leverage from Engineered Fastening, productivity gains and cost controls, which more than offset negative impacts from foreign currency and lower Hydraulics volumes. Industrial net sales increased $155.8 million, or 8%, in 2014 compared with 2013. Organic sales and acquisitions (primarily Infastech) provided increases of 5% and 4% in net sales, respectively, while unfavorable effects of foreign currency translation decreased net sales by 1%. Engineered Fastening achieved organic growth of 7%, which was mainly attributable to strong global automotive and electronic revenues. Infrastructure organic sales were relatively flat year-over-year as solid Hydraulics growth was offset by lower volumes in Oil & Gas due primarily to project delays resulting from geopolitical situations in certain emerging markets as well as the recent contraction in oil prices and resulting slowdown in pipeline construction. Segment profit totaled $350.6 million, or 17.1% of net sales, in 2014 compared to $280.2 million, or 14.8% of net sales, in 2013. Excluding $20.1 million of merger and acquisition-related charges, segment profit was $300.3 million, or 15.9% of net sales, in 2013. The year-over-year increase in segment profit rate was primarily due to favorable volume leverage, price, supply chain productivity gains and SG&A cost controls, partially offset by negative impacts from foreign currency fluctuations. RESTRUCTURING ACTIVITIES A summary of the restructuring reserve activity from January 3, 2015 to January 2, 2016 is as follows (in millions): During 2015, the Company recognized net restructuring charges and asset impairments of $47.6 million. Net severance charges totaled $32.7 million relating to the reduction of approximately 1,300 employees. The Company also recognized $5.1 million of facility closure costs and $9.8 million of asset impairments. The Company expects the 2015 actions to result in annual net cost savings of approximately $44 million by the end of 2016, primarily in the Security and Industrial segments. The majority of the $58.7 million reserves remaining as of January 2, 2016 is expected to be utilized within the next twelve months. During 2014, the Company recognized $18.8 million of net restructuring charges. Net severance charges totaled $15.1 million and related to cost reductions associated with the severance of employees. Also included in net restructuring charges were facility closure costs of $3.7 million. The 2014 actions resulted in annual net cost savings of approximately $50 million in 2015, which was primarily related to the Tools & Storage segment. During 2013, the Company recognized $173.7 million of net restructuring charges primarily associated with the Black & Decker merger, Niscayah and other acquisitions, as well as other cost reduction actions. Of those charges, $175.6 million related to severance charges associated with the reduction of approximately 2,650 employees, which was partially offset by reversals of $48.7 million primarily due to the termination of a previously approved restructuring action due to a shifting political and economic landscape in certain European countries. Also, included in those charges were facility closure costs of $28.1 million and asset impairment charges of $18.7 million. These 2013 restructuring actions have resulted in annual net cost savings of approximately $210 million, primarily in the Security segment. Segments: The $47.6 million restructuring charge for the twelve months ended January 2, 2016 includes: $17.6 million of net charges pertaining to the Tools & Storage segment; $28.7 million of net charges pertaining to the Security segment; $12.0 million of net charges pertaining to the Industrial segment; and $10.7 million of net reserve reductions pertaining to Corporate. FINANCIAL CONDITION Liquidity, Sources and Uses of Capital: The Company’s primary sources of liquidity are cash flows generated from operations and available lines of credit under various credit facilities. The Company's cash flows are presented on a consolidated basis and include cash flows from discontinued operations. Operating Activities: Cash flows from operations were $1.182 billion in 2015 compared to $1.296 billion in 2014, representing a $114 million decrease. The year-over-year decrease was primarily due to higher outflows from working capital (accounts receivable, inventory, accounts payable and deferred revenue) as a result of lower than expected sales volumes in the fourth quarter of 2015. In 2014, cash flows from operations were $1.296 billion, a $428 million increase compared to $868 million in 2013. The year-over-year increase was primarily driven by an increase in earnings and lower one-time restructuring and related payments, partially offset by higher employee benefit plan contributions. Furthermore, operating cash flows in 2014 were positively impacted by an increase in working capital turns from 8.1 at December 28, 2013 to 9.2 at January 3, 2015, demonstrating the continued success of SFS. Free Cash Flow: Management considers free cash flow an important indicator of its liquidity, as well as its ability to fund future growth and provide dividends to shareowners. Free cash flow does not include deductions for mandatory debt service, other borrowing activity, discretionary dividends on the Company’s common stock and business acquisitions, among other items. Investing Activities: Cash flows used in investing activities were $205 million in 2015, primarily due to capital and software expenditures of $311 million, partially offset by $137 million of cash proceeds related to net investment hedge settlements, which were primarily driven by the significant fluctuations in foreign currency rates during 2015 associated with foreign exchange contracts hedging a portion of the Company's pound sterling and Canadian dollar denominated net investments. Cash flows used in investing activities in 2014 totaled $382 million, which primarily consisted of capital and software expenditures of $291 million and payments related to net investment hedge settlements of $61 million. The decrease in capital expenditures in 2014 as compared to 2013 was driven by management's continued focus to control spend in this area as well as lower integration-related capital expenditures. The payments related to net investment hedge settlements were mainly driven by the significant fluctuations in foreign currency rates during 2014 associated with foreign exchange contracts hedging a portion of the Company's pound sterling denominated net investment. Cash flows used in investing activities in 2013 totaled $1.198 billion primarily due to capital and software expenditures of $340 million and acquisition spending of $934 million, which was mainly driven by the purchases of Infastech for $826 million, net of cash acquired, and GQ for $49 million, net of cash acquired. The Company also received net proceeds of $94 million in 2013 related to the Second Closing of the HHI sale. Financing Activities: Cash flows used in financing activities were $876 million in 2015, primarily due to the repurchase of 6.6 million common shares for $650 million and cash payments for dividends of $320 million, partially offset by proceeds from issuances of common stock of $164 million, which mainly related to the exercises of stock options. The increase in dividends in 2015 was primarily attributable to the increase in quarterly dividends per common share to $0.55 per share. The dividend paid to shareholders of record in December 2015 extended the Company's record for the longest consecutive annual and quarterly dividend payments among industrial companies listed on the New York Stock Exchange. The Company also paid approximately $34 million in December 2015 to purchase the remaining 40% interest in GQ. Cash flows used in financing activities in 2014 were $766 million, primarily due to net repayments of short-term borrowings of $391 million, cash payments for dividends of $321 million, and payments on long-term debt of $47 million related to the repurchase of $46 million of 2022 Term Notes. In 2014, the Company also terminated $400 million of interest rate swaps hedging the Company's $400 million, 5.20% notes due 2053, which resulted in cash payments of $33.4 million. Proceeds from issuances of common stock totaled $71 million, which was primarily related to stock option exercises. Cash flows provided by financing activities were $156 million in 2013, which was mainly driven by proceeds from issuances of long-term debt of $727 million, net short-term borrowings of $389 million, and proceeds from issuances of common stock of $155 million, partially offset by payments on long-term debt of $302 million, payment of a forward share purchase contract of $350 million and cash dividend payments of $313 million. In December 2013, the Company issued $400 million of 5.75% fixed-to-floating junior subordinated debentures bearing interest at a fixed rate of 5.75% and received $392.0 million of net proceeds. Additionally, the Company issued 3,450,000 Equity Units comprised of a 1/10, or 10%, undivided beneficial ownership in a $1,000 principal amount 2.25% junior subordinated note due 2018 and a forward common stock purchase contract in which the Company received $335 million in cash proceeds from the Equity Units, net of underwriting discounts and commission, before offering expenses. In November 2013, the Company purchased from certain financial institutions “out-of-the-money” capped call options on 12.2 million shares of its common stock (subject to customary anti-dilution adjustments) for an aggregate premium of $74 million, or an average of $6.03 per share. In addition, contemporaneously with the issuance of the Equity Units described above, the Company paid $10 million, or an average of $2.77 per option, to enter into capped call transactions on 3.5 million shares of common stock with a major financial institution. The $302 million of payments on long-term debt related to the repurchase of $300 million of Black & Decker Corporation 5.75% senior notes, which resulted in the Company paying a premium on the debt extinguishment of $43 million. In January 2013, the Company elected to prepay the forward share purchase contract for $363 million, comprised of the $350 million purchase price, plus an additional amount related to the forward component of the contract. In August 2013, the Company physically settled the contract, receiving 5.6 million shares and $19 million from the financial institution counterparty representing a purchase price adjustment. Fluctuations in foreign currency rates negatively impacted cash by $133 million, $147 million and $45 million in 2015, 2014 and 2013, respectively. These negative impacts were primarily driven by the continued strengthening of the U.S. Dollar, against the Company's other currencies. Refer to Note H, Long-Term Debt and Financing Arrangements, and Note J, Capital Stock, for further discussion regarding the Company's debt and equity arrangements. Credit Ratings and Liquidity: The Company maintains strong investment grade credit ratings from the major U.S. rating agencies on its senior unsecured debt (S&P A, Fitch A-, Moody's Baa1), as well as its commercial paper program (S&P A-1, Fitch, Moody's P-2). There have been no changes to any of the ratings during 2015. Failure to maintain strong investment grade rating levels could adversely affect the Company’s cost of funds, liquidity and access to capital markets, but would not have an adverse effect on the Company’s ability to access committed credit facilities. Cash and cash equivalents totaled $465 million as of January 2, 2016, comprised of $131 million in the U.S. and $334 million in foreign jurisdictions. As of January 3, 2015 cash and cash equivalents totaled $497 million, comprised of $46 million in the U.S. and $451 million in foreign jurisdictions. Concurrent with the Black & Decker merger, the Company made a determination to repatriate certain legacy Black & Decker foreign earnings, on which U.S. income taxes had not previously been provided. As a result of this repatriation decision, the Company has recorded approximately $320 million of associated deferred tax liabilities at January 2, 2016. Current plans and liquidity requirements do not demonstrate a need to repatriate other foreign earnings. Accordingly, all other undistributed foreign earnings of the Company are considered to be permanently reinvested, or will be remitted substantially free of additional tax, consistent with the Company’s overall growth strategy internationally, including acquisitions and long-term financial objectives. No provision has been made for taxes that might be payable upon remittance of these undistributed foreign earnings. However, should management determine at a later point to repatriate additional foreign earnings, the Company would be required to accrue and pay taxes at that time. In December 2015, the Company amended and restated its existing five-year $1.5 billion committed credit facility with the concurrent execution of a new five-year $1.75 billion committed credit facility (the “Credit Agreement”). Borrowings under the Credit Agreement may include U.S. Dollars up to the $1.75 billion commitment or in Euro or Pounds Sterling subject to a foreign currency sub-limit of $400.0 million and bear interest at a floating rate dependent upon the denomination of the borrowing. Repayments must be made on December 18, 2020 or upon an earlier termination date of the Credit Agreement, at the election of the Company. The Credit Agreement is designated to be a liquidity back-stop for the Company's $2.0 billion commercial paper program. As of January 2, 2016, the Company has not drawn on this commitment. In addition, the Company has short-term lines of credit that are primarily uncommitted, with numerous banks, aggregating $743.8 million, of which $644.1 million was available at January 2, 2016. Short-term arrangements are reviewed annually for renewal. At January 2, 2016, the aggregate amount of committed and uncommitted, long- and short-term lines was $2.7 billion, of which $2.5 million was recorded as short-term borrowings at January 2, 2016 excluding commercial paper borrowings outstanding. In addition, $99.8 million of the short-term credit lines was utilized primarily pertaining to outstanding letters of credit for which there are no required or reported debt balances. The weighted average interest rates on short-term borrowings, primarily commercial paper, for the fiscal years ended January 2, 2016 and January 3, 2015 were 0.4% and 0.2%, respectively. In March 2015, the Company entered into a forward share purchase contract on its common stock. The contract obligates the Company to pay $350.0 million, plus an additional amount related to the forward component of the contract, to the financial institution counterparty not later than March 2017, or earlier at the Company’s option, for the 3,645,510 shares purchased. In October 2014, the Company entered into a forward share purchase contract on its common stock that obligates the Company to pay $150.0 million, plus an additional amount related to the forward component of the contract, to the financial institution counterparty not later than October 2016, or earlier at the Company’s option, for the 1,603,822 shares purchased. On February 10, 2015, the Company net-share settled 9.1 million of the 12.2 million capped call options on its common stock and received 911,077 shares using an average reference price of $96.46 per common share. Additionally, the Company purchased 3,381,162 shares directly from the counterparties participating in the net-share settlement of the capped call options for $326.1 million, equating to an average price of $96.46 per share. In February 2016, the Company net-share settled the remaining 3.1 million capped call options on its common stock and received 293,142 shares using an average reference price of $94.34 per common share. Additionally, the Company purchased 1,316,858 shares directly from the counterparty participating in the net-share settlement for $124.2 million. The Company also repurchased 2,446,287 shares of common stock in February 2016 for $230.9 million, equating to an average price of $94.34. On December 3, 2013, the Company issued $400.0 million 5.75% fixed-to-floating rate junior subordinated debentures maturing December 15, 2053 (“2053 Junior Subordinated Debentures”) that bear interest at a fixed rate of 5.75% per annum, up to, but excluding December 15, 2018. From and including December 15, 2018, the 2053 Junior Subordinated Debentures will bear interest at an annual rate equal to three-month LIBOR plus 4.304%. The debentures subordination and long tenor provides significant credit protection measures for senior creditors and as a result, the debentures were awarded a 50% equity credit by S&P and Fitch, and 25% equity credit by Moody's. The net proceeds of $392.0 million from the offering were primarily used to repay commercial paper borrowings. On December 3, 2013, the Company issued 3,450,000 Equity Units (the “Equity Units”), each with a stated value of $100 which are initially comprised of a 1/10, or 10%, undivided beneficial ownership in a $1,000 principal amount 2.25% junior subordinated note due 2018 and a forward common stock purchase contract (the “Equity Purchase Contract”). Each Equity Purchase Contract obligates the holders to purchase on November 17, 2016 approximately 3.5 to 4.3 million common shares. The subordination of the notes in the Equity Units combined with the Equity Purchase Contracts resulted in the Equity Units being awarded a 100% equity credit by S&P, and 50% equity credit by Moody's. The Company received approximately $334.7 million in cash proceeds from the Equity Units, net of underwriting discounts and commission, before offering expenses, and recorded $345.0 million in long-term debt. The proceeds were used primarily to repay commercial paper borrowings. Upon settlement of the Equity Purchase Contracts on November 17, 2016, the Company will receive additional cash proceeds or debt extinguishment of $345.0 million. In November 2010, the Company issued Convertible Preferred Units comprised of $632.5 million of Notes due November 17, 2018 and Purchase Contracts, which obligated the holders to purchase, on November 17, 2015, 6.3 million shares, for $100 per share, of the Company's 4.75% Series B Cumulative Convertible Preferred Stock (the "Convertible Preferred Stock"). In accordance with the Purchase Contracts, on November 17, 2015, the Company issued 6.3 million shares of Convertible Preferred Stock and received cash proceeds of $632.5 million. On November 18, 2015, the Company informed holders that it would redeem all outstanding shares of Convertible Preferred Stock on December 24, 2015 (the “Redemption Date”) at $100.49 per share in cash (the “Redemption Price”), which is equal to the liquidation preference of $100 per share of Convertible Preferred Stock, plus all accrued and unpaid dividends thereon to, but excluding, the Redemption Date. The Company redeemed the Convertible Preferred Stock and settled all conversions on December 24, 2015 by paying cash for the $100 par value per share of Convertible Preferred Stock, or $632.5 million in total, and issuing 2.9 million common shares for the excess value of the conversion feature above the $100 face value per share of Convertible Preferred Stock. Refer to Note H, Long-Term Debt and Financing Arrangements, and Note J, Capital Stock, for further discussion regarding the Company's debt and equity arrangements. Contractual Obligations: The following table summarizes the Company’s significant contractual obligations and commitments that impact its liquidity: (a) Future payments on long-term debt encompass all payments related to aggregate debt maturities, excluding certain fair value adjustments included in long-term debt, as discussed further in Note H, Long-Term Debt and Financing Arrangements. (b) Future interest payments on long-term debt reflect the applicable fixed interest rate or variable rate for floating rate debt in effect at January 2, 2016. (c) Inventory purchase commitments primarily consist of open purchase orders to purchase raw materials, components, and sourced products. (d) Future cash flows on derivative instruments reflect the fair value and accrued interest as of January 2, 2016. The ultimate cash flows on these instruments will differ, perhaps significantly, based on applicable market interest and foreign currency rates at their maturity. (e) In October 2014 and March 2015, the Company entered into forward share purchase contracts which obligate the Company to pay $150.0 million and $350.0 million, respectively, plus additional amounts related to the forward component of the contracts to the respective financial institution counterparties not later than October 2016 or March 2017, respectively, or earlier at the Company's option. See Note J. Capital Stock for further discussion. (f) This amount principally represents contributions either required by regulations or laws or, with respect to unfunded plans, necessary to fund current benefits. The Company has not presented estimated pension and post-retirement funding beyond 2016 as funding can vary significantly from year to year based upon changes in the fair value of the plan assets, actuarial assumptions, and curtailment/settlement actions. (g) These amounts represent future contract adjustment payments to holders of the Company's Equity Purchase Contracts. See Note H, Long-Term Debt and Financing Arrangements for further discussion. To the extent the Company can reliably determine when payments will occur pertaining to unrecognized tax liabilities, the related amount will be included in the table above. However, due to the high degree of uncertainty regarding the timing of potential future cash flows associated with the $343.9 million of such liabilities at January 2, 2016, the Company is unable to make a reliable estimate of when (if at all) amounts may be paid to the respective taxing authorities. Aside from debt payments, for which there is no tax benefit associated with repayment of principal, tax obligations and the equity purchase contract fees, payment of the above contractual obligations will typically generate a cash tax benefit such that the net cash outflow will be lower than the gross amounts summarized above. Other Significant Commercial Commitments: Short-term borrowings, long-term debt and lines of credit are explained in detail within Note H, Long-Term Debt and Financing Arrangements. MARKET RISK Market risk is the potential economic loss that may result from adverse changes in the fair value of financial instruments, currencies, commodities and other items traded in global markets. The Company is exposed to market risk from changes in foreign currency exchange rates, interest rates, stock prices, bond prices and commodity prices, amongst others. Exposure to foreign currency risk results because the Company, through its global businesses, enters into transactions and makes investments denominated in multiple currencies. The Company’s predominant currency exposures are related to the Euro, Canadian Dollar, British Pound, Australian Dollar, Brazilian Real, Argentine Peso, the Chinese Renminbi (“RMB”) and the Taiwan Dollar. Certain cross-currency trade flows arising from sales and procurement activities, as well as affiliate cross-border activity, are consolidated and netted prior to obtaining risk protection through the use of various derivative financial instruments which may include: purchased basket options, purchased options, collars, cross currency swaps and currency forwards. The Company is thus able to capitalize on its global positioning by taking advantage of naturally offsetting exposures and portfolio efficiencies to reduce the cost of purchasing derivative protection. At times, the Company also enters into forward exchange contracts and purchases options to reduce the earnings and cash flow impact of non-functional currency denominated receivables and payables, primarily for affiliate transactions. Gains and losses from these hedging instruments offset the gains or losses on the underlying net exposures (the assets and liabilities being hedged). Management determines the nature and extent of currency hedging activities, and in certain cases, may elect to allow certain currency exposures to remain un-hedged. The Company may also enter into cross-currency swaps and forward contracts to hedge the net investments in certain subsidiaries and better match the cash flows of operations to debt service requirements. Management estimates the foreign currency impact from its derivative financial instruments outstanding at the end of 2015 would have been approximately $27 million pre-tax loss based on a hypothetical 10% adverse movement in all net derivative currency positions; this effect would occur from the strengthening of foreign currencies relative to the U.S. dollar. The Company follows risk management policies in executing derivative financial instrument transactions, and does not use such instruments for speculative purposes. The Company generally does not hedge the translation of its non-U.S. dollar earnings in foreign subsidiaries, but may choose to do so in certain instances. As mentioned above, the Company routinely has cross-border trade and affiliate flows that cause an impact on earnings from foreign exchange rate movements. The Company is also exposed to currency fluctuation volatility from the translation of foreign earnings into U.S. dollars and the economic impact of foreign currency volatility on monetary assets held in foreign currencies. It is more difficult to quantify the transactional effects from currency fluctuations than the translational effects. Aside from the use of derivative instruments, which may be used to mitigate some of the exposure, transactional effects can potentially be influenced by actions the Company may take. For example, if an exposure occurs from a European entity sourcing product from a U.S. supplier it may be possible to change to a European supplier. Management estimates the combined translational and transactional impact, on pre-tax earnings, of a 10% overall movement in exchange rates is approximately $132 million, or approximately $0.68 per diluted share. In 2015, translational and transactional foreign currency fluctuations negatively impacted pre-tax earnings by approximately $220 million and diluted earnings per share by approximately $1.13. The Company’s exposure to interest rate risk results from its outstanding debt and derivative obligations, short-term investments, and derivative financial instruments employed in the management of its debt portfolio. The debt portfolio including both trade and affiliate debt, is managed to achieve capital structure targets and reduce the overall cost of borrowing by using a combination of fixed and floating rate debt as well as interest rate swaps, and cross-currency swaps. The Company’s primary exposure to interest rate risk comes from its floating rate debt and derivatives in the U.S. and is fairly represented by changes in LIBOR rates. At January 2, 2016, the impact of a hypothetical 10% increase in the interest rates associated with the Company’s floating rate derivative and debt instruments would have an immaterial effect on the Company’s financial position and results of operations. The Company has exposure to commodity prices in many businesses, particularly brass, nickel, resin, aluminum, copper, zinc, steel, and energy used in the production of finished goods. Generally, commodity price exposures are not hedged with derivative financial instruments, but instead are actively managed through customer product and service pricing actions, procurement-driven cost reduction initiatives and other productivity improvement projects. Fluctuations in the fair value of the Company’s common stock affect domestic retirement plan expense as discussed below in the Employee Stock Ownership Plan section of MD&A. Additionally, the Company has $59 million of liabilities as of January 2, 2016 pertaining to unfunded defined contribution plans for certain U.S. employees for which there is mark-to-market exposure. The assets held by the Company’s defined benefit plans are exposed to fluctuations in the market value of securities, primarily global stocks and fixed-income securities. The funding obligations for these plans would increase in the event of adverse changes in the plan asset values, although such funding would occur over a period of many years. In 2015, 2014 and 2013, there was an $11.0 million decrease and $285 million and $102 million increase, respectively, in investment returns on pension plan assets. The Company expects funding obligations on its defined benefit plans to be approximately $52 million in 2016. The Company employs diversified asset allocations to help mitigate this risk. Management has worked to minimize this exposure by freezing and terminating defined benefit plans where appropriate. The Company has access to financial resources and borrowing capabilities around the world. There are no instruments within the debt structure that would accelerate payment requirements due to a change in credit rating. The Company’s existing credit facilities and sources of liquidity, including operating cash flows, are considered more than adequate to conduct business as normal. Accordingly, based on present conditions and past history, management believes it is unlikely that operations will be materially affected by any potential deterioration of the general credit markets that may occur. The Company believes that its strong financial position, operating cash flows, committed long-term credit facilities and borrowing capacity, and ready access to equity markets provide the financial flexibility necessary to continue its record of annual dividend payments, to invest in the routine needs of its businesses, to make strategic acquisitions and to fund other initiatives encompassed by its growth strategy and maintain its strong investment grade credit ratings. OTHER MATTERS Employee Stock Ownership Plan As detailed in Note L, Employee Benefit Plans, the Company has an ESOP under which the ongoing U.S. Core and 401(k) defined contribution plans are funded. Overall ESOP expense is affected by the market value of the Company’s stock on the monthly dates when shares are released, among other factors. The Company’s net ESOP activity resulted in expense of $0.8 million in 2015, $0.7 million in 2014, and $1.9 million in 2013. ESOP expense could increase in the future if the market value of the Company’s common stock declines. CRITICAL ACCOUNTING ESTIMATES - Preparation of the Company’s Consolidated Financial Statements requires management to make estimates and assumptions that affect the reported amounts of assets, liabilities, revenues and expenses. Significant accounting policies used in the preparation of the Consolidated Financial Statements are described in Note A, Significant Accounting Policies. Management believes the most complex and sensitive judgments, because of their significance to the Consolidated Financial Statements, result primarily from the need to make estimates about the effects of matters with inherent uncertainty. The most significant areas involving management estimates are described below. Actual results in these areas could differ from management’s estimates. ALLOWANCE FOR DOUBTFUL ACCOUNTS - The Company’s estimate for its allowance for doubtful accounts related to trade receivables is based on two methods. The amounts calculated from each of these methods are combined to determine the total amount reserved. First, a specific reserve is established for individual accounts where information indicates the customers may have an inability to meet financial obligations. In these cases, management uses its judgment, based on the surrounding facts and circumstances, to record a specific reserve for those customers against amounts due to reduce the receivable to the amount expected to be collected. These specific reserves are reevaluated and adjusted as additional information is received. Second, a reserve is determined for all customers based on a range of percentages applied to receivable aging categories. These percentages are based on historical collection and write-off experience. If circumstances change, for example, due to the occurrence of higher-than-expected defaults or a significant adverse change in a major customer’s ability to meet its financial obligation to the Company, estimates of the recoverability of receivable amounts due could be reduced. INVENTORIES - LOWER OF COST OR MARKET, SLOW MOVING AND OBSOLETE - Inventories in the U.S. are predominantly valued at the lower of Last-In First-Out (“LIFO”) cost or market, while non-U.S. inventories are valued at the lower of First-In, First-Out (“FIFO”) cost or market. The calculation of LIFO reserves, and therefore the net inventory valuation, is affected by inflation and deflation in inventory components. The Company ensures all inventory is valued at the lower of cost or market, and continually reviews the carrying value of discontinued product lines and stock-keeping-units (“SKUs”) to determine that these items are properly valued. The Company also continually evaluates the composition of its inventory and identifies obsolete and/or slow-moving inventories. Inventory items identified as obsolete and/or slow-moving are evaluated to determine if write-downs are required. The Company assesses the ability to dispose of these inventories at a price greater than cost. If it is determined that cost is less than market value, cost is used for inventory valuation. If market value is less than cost, the Company writes down the related inventory to that value. If a write-down to the current market value is necessary, the market value cannot be greater than the net realizable value, or ceiling (defined as selling price less costs to sell and dispose), and cannot be lower than the net realizable value less a normal profit margin, also called the floor. If the Company is not able to achieve its expectations regarding net realizable value of inventory at its current value, further write-downs would be recorded. GOODWILL AND INTANGIBLE ASSETS - The Company acquires businesses in purchase transactions that result in the recognition of goodwill and intangible assets. The determination of the value of intangible assets requires management to make estimates and assumptions. In accordance with ASC 350-20, “Goodwill,” acquired goodwill and indefinite-lived intangible assets are not amortized but are subject to impairment testing at least annually or when an event occurs or circumstances change that indicate it is more-likely-than-not an impairment exists. Definite-lived intangible assets are amortized and are tested for impairment when an event occurs or circumstances change that indicate it is more-likely-than-not that an impairment exists. Goodwill represents costs in excess of fair values assigned to the underlying net assets of acquired businesses. The Company reported $7.084 billion of goodwill, $1.578 billion of indefinite-lived trade names and $0.964 billion of definite-lived intangibles at January 2, 2016. Management tests goodwill for impairment at the reporting unit level. A reporting unit is an operating segment as defined in ASC 280, “Segment Reporting,” or one level below an operating segment (component level) as determined by the availability of discrete financial information that is regularly reviewed by operating segment management or an aggregate of component levels of an operating segment having similar economic characteristics. If the carrying value of a reporting unit (including the value of goodwill) is greater than its fair value, an impairment may exist. An impairment charge would be recorded to the extent that the recorded value of goodwill exceeded the implied fair value. During the third quarter of 2015, as required by the Company’s policy, goodwill and indefinite-lived trade names were tested for impairment. The Company assessed the fair value of its reporting units based on a discounted cash flow valuation model. The key assumptions applied to the cash flow projections were discount rates, which ranged from 8% to 10.5%, near-term revenue growth rates over the next five years, which ranged from 2% to 10%, and perpetual growth rates ranging from 3% to 3.5%. These assumptions contemplated business, market and overall economic conditions. Based on the results of this testing, the Company determined that the fair values of each of its reporting units exceeded their respective carrying amounts. Furthermore, management performed sensitivity analyses on the fair values resulting from the discounted cash flow valuation models utilizing more conservative assumptions that reflect reasonably likely future changes in the discount rates and perpetual growth rates in each of the reporting units. The discount rates were increased by 100 basis points with no impairment indicated. The perpetual growth rates were decreased by 150 basis points with no impairment indicated. The fair values of indefinite-lived trade names were also assessed using a discounted cash flow valuation model. The key assumptions used included discount rates, royalty rates, and perpetual growth rates applied to the projected sales. Based on these quantitative impairment tests, the Company determined that the fair values of the indefinite-lived trade names exceeded their respective carrying amounts. During the fourth quarter of 2015, in connection with its quarterly forecasting cycle, the Company updated the forecasted operating results for each of its businesses based on the most recent financial results and best estimates of future operations. The updated forecasts reflected an expected decline in near-term revenue growth and profitability for the Infrastructure reporting unit within the Industrial segment, primarily due to ongoing difficult market conditions in the oil & gas industry, particularly in certain markets such as China and Russia, as well as continued declines in scrap steel prices. Accordingly, in connection with the preparation of the Consolidated Financial Statements for the year ended January 2, 2016, the Company performed an updated impairment analysis with respect to the Infrastructure reporting unit, which included approximately $273 million of goodwill at year-end. Based on this analysis, which included revised assumptions of near-term revenue growth and profitability levels, it was determined that the fair value of the Infrastructure reporting unit exceeded its carrying value by 13%. Therefore, management concluded it was not more-likely-than-not that an impairment had occurred. Management is confident in the long-term viability and success of the Infrastructure reporting unit based on the strong long-term growth prospects of the markets and geographies served, the intensified focus and investments being made in organic growth initiatives (bolstered by the recently implemented SFS 2.0 program), and Infrastructure's leading market position in its respective industries. In the event that future operating results of any of the Company's reporting units do not meet current expectations, management, based upon conditions at the time, would consider taking restructuring or other actions as necessary to maximize revenue growth and profitability. Accordingly, the above sensitivity analyses, while useful, should not be used as a sole predictor of potential impairment. A thorough analysis of all the facts and circumstances existing at that time would need to be performed to determine if recording an impairment loss would be appropriate. DEFINED BENEFIT OBLIGATIONS - The valuation of pension and other postretirement benefits costs and obligations is dependent on various assumptions. These assumptions, which are updated annually, include discount rates, expected return on plan assets, future salary increase rates, and health care cost trend rates. The Company considers current market conditions, including interest rates, to establish these assumptions. Discount rates are developed considering the yields available on high-quality fixed income investments with maturities corresponding to the duration of the related benefit obligations. The Company’s weighted-average discount rates for the United States and international pension plans were 4.25% and 3.25%, respectively, at January 2, 2016. The Company’s weighted-average discount rate for the United States and international pension plans was 3.75% and 3.25%, respectively at January 3, 2015. As discussed further in Note L, Employee Benefit Plans, the Company develops the expected return on plan assets considering various factors, which include its targeted asset allocation percentages, historic returns, and expected future returns. The Company’s expected rate of return assumptions for the United States and international pension plans were 6.50% and 5.25%, respectively, at January 2, 2016. The Company will use a 5.60% weighted-average expected rate of return assumption to determine the 2016 net periodic benefit cost. A 25 basis point reduction in the expected rate of return assumption would increase 2016 net periodic benefit cost by approximately $5 million on a pre-tax basis. The Company believes that the assumptions used are appropriate; however, differences in actual experience or changes in the assumptions may materially affect the Company’s financial position or results of operations. To the extent that actual (newly measured) results differ from the actuarial assumptions, the difference is recognized in accumulated other comprehensive income, and, if in excess of a specified corridor, amortized over future periods. The expected return on plan assets is determined using the expected rate of return and the fair value of plan assets. Accordingly, market fluctuations in the fair value of plan assets can affect the net periodic benefit cost in the following year. The projected benefit obligation for defined benefit plans exceeded the fair value of plan assets by $692 million at January 2, 2016. A 25 basis point reduction in the discount rate would have increased the projected benefit obligation by approximately $85 million at January 2, 2016. The primary Black & Decker U.S pension and post employment benefit plans were curtailed in late 2010, as well as the only material Black & Decker international plan, and in their place the Company implemented defined contribution benefit plans. The vast majority of the projected benefit obligation pertains to plans that have been frozen; the remaining defined benefit plans that are not frozen are predominantly small domestic union plans and those that are statutorily mandated in certain international jurisdictions. The Company recognized $11 million of defined benefit plan expense in 2015, which may fluctuate in future years depending upon various factors including future discount rates and actual returns on plan assets. ENVIRONMENTAL - The Company incurs costs related to environmental issues as a result of various laws and regulations governing current operations as well as the remediation of previously contaminated sites. Future laws and regulations are expected to be increasingly stringent and will likely increase the Company’s expenditures related to environmental matters. The Company’s policy is to accrue environmental investigatory and remediation costs for identified sites when it is probable that a liability has been incurred and the amount of loss can be reasonably estimated. The amount of liability recorded is based on an evaluation of currently available facts with respect to each individual site and includes such factors as existing technology, presently enacted laws and regulations, and prior experience in remediation of contaminated sites. The liabilities recorded do not take into account any claims for recoveries from insurance or third parties. As assessments and remediation progress at individual sites, the amounts recorded are reviewed periodically and adjusted to reflect additional technical and legal information that becomes available. As of January 2, 2016, the Company had reserves of $170.7 million for remediation activities associated with Company-owned properties as well as for Superfund sites, for losses that are probable and estimable. The range of environmental remediation costs that is reasonably possible is $130.4 million to $260.8 million which is subject to change in the near term. The Company may be liable for environmental remediation of sites it no longer owns. Liabilities have been recorded on those sites in accordance with this policy. INCOME TAXES - Income taxes are accounted for in accordance with ASC 740, "Accounting for Income Taxes," which requires that deferred tax assets and liabilities be recognized, using enacted tax rates, for the effect of temporary differences between the book and tax bases of recorded assets and liabilities. Deferred tax assets, including net operating losses and capital losses, are reduced by a valuation allowance if it is “more likely than not” that some portion or all of the deferred tax assets will not be realized. In assessing the need for a valuation allowance, the Company considers all positive and negative evidence including: estimates of future taxable income, considering the feasibility of ongoing tax planning strategies, the realizability of tax loss carryforwards and the future reversal of existing temporary differences. Valuation allowances related to deferred tax assets can be impacted by changes to tax laws, changes to statutory tax rates and future taxable income levels. In the event the Company were to determine that it would not be able to realize all or a portion of its deferred tax assets in the future, the unrealizable amount would be charged to earnings in the period in which that determination is made. By contrast, if the Company were to determine that it would be able to realize deferred tax assets in the future in excess of the net carrying amounts, it would decrease the recorded valuation allowance through a favorable adjustment to earnings in the period in which that determination is made. The Company is subject to income tax in a number of locations, including many state and foreign jurisdictions. Significant judgment is required when calculating its worldwide provision for income taxes. The Company considers many factors when evaluating and estimating its tax positions and tax benefits, which may require periodic adjustments and which may not accurately anticipate actual outcomes. It is reasonably possible that the amount of the unrecognized benefit with respect to certain of the Company's unrecognized tax positions will significantly increase or decrease within the next 12 months. These changes may be the result of settlement of ongoing audits or final decisions in transfer pricing matters. The Company periodically assesses its liabilities and contingencies for all tax years still subject to audit based on the most current available information, which involves inherent uncertainty. For those tax positions where it is more likely than not that a tax benefit will be sustained, the Company has recorded the largest amount of tax benefit with a greater than 50% likelihood of being realized upon ultimate settlement with a taxing authority under the premise that the taxing authority has full knowledge of all relevant information. For those income tax positions where it is not more likely than not that a tax benefit will be sustained, no tax benefit has been recognized in the financial statements. The Company recognizes interest and penalties associated with income taxes as a component of income taxes in the Consolidated Statement of Operations. See Note Q, Income Taxes for further discussion. RISK INSURANCE - To manage its insurance costs efficiently, the Company self insures for certain U.S. business exposures and generally has low deductible plans internationally. For domestic workers’ compensation, automobile and product liability (liability for alleged injuries associated with the Company’s products), the Company generally purchases insurance coverage only for severe losses that are unlikely, and these lines of insurance involve the most significant accounting estimates. While different self insured retentions, in the form of deductibles and self insurance through its captive insurance company, exist for each of these lines of insurance, the maximum self insured retention is set at no more than $5 million per occurrence. The process of establishing risk insurance reserves includes consideration of actuarial valuations that reflect the Company’s specific loss history, actual claims reported, and industry trends among statistical and other factors to estimate the range of reserves required. Risk insurance reserves are comprised of specific reserves for individual claims and additional amounts expected for development of these claims, as well as for incurred but not yet reported claims discounted to present value. The cash outflows related to risk insurance claims are expected to occur over a period of approximately 13 years. The Company believes the liabilities recorded for these U.S. risk insurance reserves, totaling $96 million and $102 million as of January 2, 2016, and January 3, 2015, respectively, are adequate. Due to judgments inherent in the reserve estimation process, it is possible the ultimate costs will differ from this estimate. WARRANTY - The Company provides product and service warranties which vary across its businesses. The types of warranties offered generally range from one year to limited lifetime, while certain products carry no warranty. Further, the Company sometimes incurs discretionary costs to service its products in connection with product performance issues. Historical warranty and service claim experience forms the basis for warranty obligations recognized. Adjustments are recorded to the warranty liability as new information becomes available. The Company believes the $105 million reserve for expected warranty claims as of January 2, 2016 is adequate, but due to judgments inherent in the reserve estimation process, including forecasting future product reliability levels and costs of repair as well as the estimated age of certain products submitted for claims, the ultimate claim costs may differ from the recorded warranty liability. The Company also establishes a reserve for product recalls on a product-specific basis during the period in which the circumstances giving rise to the recall become known and estimable for both company-initiated actions and those required by regulatory bodies. OFF-BALANCE SHEET ARRANGEMENT SYNTHETIC LEASES - The Company is a party to synthetic leasing programs for certain locations, including one of its major distribution centers, as well as certain U.S. personal property, predominantly vehicles and equipment. The programs qualify as operating leases for accounting purposes, such that only the monthly rent expense is recorded in the Statement of Operations and the liability and value of the underlying assets are off-balance sheet. These lease programs are utilized primarily to reduce overall cost and to retain flexibility. The cash outflows for lease payments approximate the $1 million of rent expense recognized in fiscal 2015. As of January 2, 2016 the estimated fair value of assets and remaining obligations for these properties were $40 million and $34 million, respectively. CAUTIONARY STATEMENTS UNDER THE PRIVATE SECURITIES LITIGATION REFORM ACT OF 1995 Certain statements contained in this Annual Report on Form 10-K that are not historical, including but not limited to those regarding the Company’s ability to: (i) achieve full year 2016 diluted EPS of approximately $6.00 - $6.20 on a GAAP basis (inclusive of restructuring charges relatively consistent with 2015 levels); (ii) achieve free cash flow conversion of approximately 100% for 2016 ; (iii) reduce its basic share count by the share equivalent of approximately $300 million in 2016; (iv) achieve organic sales growth of 3% in 2016 ; (v) successfully achieve its three-year annual financial targets (“2018 Vision"), which assumes a relatively stable currency environment and approximately $50 million of annual restructuring costs, including: 4-6% organic revenue growth with total revenue growth enhanced by acquisitions; 50-75 basis points of annual operating margin rate improvement to approximately 16% in 2018; 10-12% earnings per share growth including acquisitions (7-9% organic growth); CFROI expansion to 14-15%; progress towards working capital turns of 10 or more; returning approximately 50% of free cash flow to shareholders through a strong and growing dividend as well as opportunistic share repurchases; and deploying the remaining roughly 50% of free cash flow to acquisitions (collectively, the “Results”); are “forward-looking statements” and subject to risk and uncertainty. The Company’s ability to deliver the Results as described above is based on current expectations and involves inherent risks and uncertainties, including factors listed below and other factors that could delay, divert, or change any of them, and could cause actual outcomes and results to differ materially from current expectations. In addition to the risks, uncertainties and other factors discussed elsewhere herein, the risks, uncertainties and other factors that could cause or contribute to actual results differing materially from those expressed or implied in the forward-looking statements include, without limitation, those set forth under Item 1A Risk Factors hereto and any material changes thereto set forth in any subsequent Quarterly Reports on Form 10-Q, or those contained in the Company’s other filings with the Securities and Exchange Commission, and those set forth below. The Company’s ability to deliver the Results is dependent, or based, upon: (i) the Company’s ability to generate organic net sales increase of 3% driving approximately $0.45 to $0.50 of EPS accretion in 2016; (ii) the Company’s ability to successfully execute cost actions and productivity initiatives, as well as achieve the anticipated commodity deflation all yielding approximately $0.45 to $0.50 of EPS accretion in 2016; (iii) the Company’s ability to drive an additional $0.13 of EPS accretion from lower average share count due to share repurchases during 2016; (iv) foreign exchange headwinds being approximately $170 - $190 million, or $0.85 to $0.95 of EPS in 2016; (v) the Company’s tax rate being relatively consistent with the 2015 rate; (vi) the Company’s ability to limit one-time restructuring charges to approximately $50 million in 2016; (vii) the Company’s ability to capitalize on operational improvements in both Security Europe and North America; (viii) the Company’s ability to identify and realize revenue synergies associated with acquisitions; (ix) successful identification of appropriate acquisition opportunities and completing them within time frames and at reasonable costs as well as the integration of completed acquisitions and reorganization of existing businesses; (x) the continued acceptance of technologies used in the Company’s products and services; (xi) the Company’s ability to manage existing Sonitrol franchisee and Mac Tools relationships; (xii) the Company’s ability to minimize costs associated with any sale or discontinuance of a business or product line, including any severance, restructuring, legal or other costs; (xiii) the proceeds realized with respect to any business or product line disposals; (xiv) the extent of any asset impairments with respect to any businesses or product lines that are sold or discontinued; (xv) the success of the Company’s efforts to manage freight costs, steel and other commodity costs as well as capital expenditures; (xvi) the Company’s ability to sustain or increase prices in order to, among other things, offset or mitigate the impact of steel, freight, energy, non-ferrous commodity and other commodity costs and any inflation increases and/or currency impacts; (xvii) the Company’s ability to generate free cash flow, maintain a conservative credit profile, and a strong investment grade rating; (xviii) the Company’s ability to identify and effectively execute productivity improvements and cost reductions, while minimizing any associated restructuring charges; (xix) the Company’s ability to obtain favorable settlement of tax audits; (xx) the ability of the Company to generate earnings sufficient to realize future income tax benefits during periods when temporary differences become deductible; (xxi) the continued ability of the Company to access credit markets under satisfactory terms; (xxii) the Company’s ability to negotiate satisfactory payment terms under which the Company buys and sells goods, services, materials and products; (xxiii) the Company’s ability to successfully develop, market and achieve sales from new products and services; and (xxiv) the availability of cash to repurchase shares when conditions are right, as well as the Company's ability to effectively use equity derivative transactions to reduce the capital requirement associated with share repurchases. The Company’s ability to deliver the Results is also dependent upon: (i) the success of the Company’s marketing and sales efforts, including the ability to develop and market new and innovative products and solutions in both existing and new markets including emerging markets; (ii) the ability of the Company to maintain or improve production rates in the Company’s manufacturing facilities, respond to significant changes in product demand and fulfill demand for new and existing products; (iii) the Company’s ability to continue improvements in working capital through effective management of accounts receivable and inventory levels; (iv) the ability to continue successfully managing and defending claims and litigation; (v) the success of the Company’s efforts to mitigate adverse earnings impact resulting from any cost increases generated by, for example, increases in the cost of energy or significant Euro, Canadian Dollar, Chinese Renminbi or other currency fluctuations; (vi) the geographic distribution of the Company’s earnings; (vii) the commitment to, and success of, the Stanley Fulfillment System; and (viii) successful implementation with expected results of cost reduction programs. The Company’s ability to achieve the Results will also be affected by external factors. These external factors include: challenging global geopolitical and macroeconomic environment; the economic environment of emerging markets, particularly Latin America, Russia, China and Turkey; pricing pressure and other changes within competitive markets; the continued consolidation of customers particularly in consumer channels; inventory management pressures on the Company’s customers; the impact the tightened credit markets may have on the Company or its customers or suppliers; the extent to which the Company has to write off accounts receivable or assets or experiences supply chain disruptions in connection with bankruptcy filings by customers or suppliers; increasing competition; changes in laws, regulations and policies that affect the Company, including, but not limited to trade, monetary, tax and fiscal policies and laws; the timing and extent of any inflation or deflation; the impact of poor weather conditions on sales; currency exchange fluctuations; the impact of dollar/foreign currency exchange and interest rates on the competitiveness of products and the Company’s debt program; the strength of the U.S. and European economies; the extent to which world-wide markets associated with homebuilding and remodeling stabilize and rebound; the impact of events that cause or may cause disruption in the Company’s supply, manufacturing, distribution and sales networks such as war, terrorist activities, and political unrest; and recessionary or expansive trends in the economies of the world in which the Company operates. Unless required by applicable federal securities laws, the Company undertakes no obligation to publicly update or revise any forward-looking statements to reflect events or circumstances that may arise after the date hereof. Investors are advised, however, to consult any further disclosures made on related subjects in the Company's reports filed with the Securities and Exchange Commission. In addition to the foregoing, some of the agreements included as exhibits to this Annual Report on Form 10-K (whether incorporated by reference to earlier filings or otherwise) may contain representations and warranties, recitals or other statements that appear to be statements of fact. These agreements are included solely to provide investors with information regarding their terms and are not intended to provide any other factual or disclosure information about the Company or the other parties to the agreements. Representations and warranties, recitals, and other common disclosure provisions have been included in the agreements solely for the benefit of the other parties to the applicable agreements and often are used as a means of allocating risk among the parties. Accordingly, such statements (i) should not be treated as categorical statements of fact; (ii) may be qualified by disclosures that were made to the other parties in connection with the negotiation of the applicable agreements, which disclosures are not necessarily reflected in the agreement or included as exhibits hereto; (iii) may apply standards of materiality in a way that is different from what may be viewed as material by or to investors in or lenders to the Company; and (iv) were made only as of the date of the applicable agreement or such other date or dates as may be specified in the agreement and are subject to more recent developments. Accordingly, representations and warranties, recitals or other disclosures contained in agreements may not describe the actual state of affairs as of the date they were made or at any other time and should not be relied on by any person other than the parties thereto in accordance with their terms. Additional information about the Company may be found in this Annual Report on Form 10-K and the Company's other public filings, which are available without charge through the SEC's website at http://www.sec.gov.

<s>[INST] The following discussion and certain other sections of this Annual Report on Form 10K contain statements reflecting the Company’s views about its future performance that constitute “forwardlooking statements” under the Private Securities Litigation Reform Act of 1995. These forwardlooking statements are based on current expectations, estimates, forecasts and projections about the industry and markets in which the Company operates as well as management’s beliefs and assumptions. Any statements contained herein (including without limitation statements to the effect that Stanley Black & Decker, Inc. or its management “believes”, “expects”, “anticipates”, “plans” and similar expressions) that are not statements of historical fact should be considered forwardlooking statements. These statements are not guarantees of future performance and involve certain risks, uncertainties and assumptions that are difficult to predict. There are a number of important factors that could cause actual results to differ materially from those indicated by such forwardlooking statements. These factors include, without limitation, those set forth, or incorporated by reference, below under the heading “Cautionary Statements”. The Company does not intend to update publicly any forwardlooking statements whether as a result of new information, future events or otherwise. Strategic Objectives The Company continues to employ the following strategic framework: Maintaining organic growth momentum by utilizing SFS 2.0 as a catalyst, diversifying toward higher growth, higher profit businesses, and increasing relative weighting of emerging markets; Being selective and operating in markets where brand is meaningful, the value proposition is definable and sustainable through innovation and global cost leadership is achievable; Pursuing acquisitive growth on multiple fronts through opportunistically consolidating the tool industry and expanding the Industrial platform in Engineered Fastening and Infrastructure. The Company is continuing to pursue a growth and acquisition strategy that involves industry, geographic and customer diversification to foster sustainable revenue, earnings and cash flow growth. The Company is focused on growing organically, including increasing its presence in emerging markets, with a goal of generating greater than 20% of annual revenues from those markets, and leveraging the Stanley Fulfillment System, a now expanded program focused on breakthrough innovation and digital capabilities while accelerating commercial and supply chain excellence, and funding these required investments through functional transformation. These objectives have been significantly enhanced by the Black & Decker merger, which along with the impact from the Company’s diversification strategy has driven continued improvements in financial performance. Sales outside the U.S. represented 47% of total net sales in 2015, up from 29% in 2002. As further illustration of this diversification strategy, sales to U.S. and international home centers and mass merchants accounted for approximately 27% of total sales in 2015 compared to 31% in 2010. Execution of the above strategy has resulted in approximately $6.2 billion of acquisitions since 2002 (aside from the Black & Decker merger), several divestitures (including the sale of HHI in December 2012), increased brand investment, improved efficiency in the supply chain and manufacturing operation, and enhanced investments in organic growth, enabled by cash flow generation and increased debt capacity. Over the last decade, the Company has returned approximately 50% of normalized free cash flow to its shareowners. Each of the Company's franchises share common attributes: they have worldclass brands and attractive growth characteristics, they are scalable and defensible, and they can differentiate through innovation. The Tools & Storage business is the tool company to own with its strong brands, proven innovation machine, global scale, and broad offering of power and hand tools across many channels in both developed and developing markets. The Engineered Fastening business is a highly profitable, GDP+ growth business offering high valueadded innovative solutions with recurring revenue attributes and global scale. The Convergent Security Solutions ("CSS") business, with its valueadd vertical market offerings and attractive recurring revenue, presents a significant margin accretion opportunity over the longer term. The Security business, which has historically provided a stable revenue stream through economic cycles, is a gateway into the digital world and an avenue to capitalize on rapid digital changes. As communicated at the May 2015 Investor Day, the Company intends to provide further [/INST] Positive. </s>

STANLEY BLACK & DECKER, INC.

2017-02-15

2016-12-31

ITEM 7. MANAGEMENT’S DISCUSSION AND ANALYSIS OF FINANCIAL CONDITION AND RESULTS OF OPERATIONS The financial and business analysis below provides information which the Company believes is relevant to an assessment and understanding of its consolidated financial position, results of operations and cash flows. This financial and business analysis should be read in conjunction with the Consolidated Financial Statements and related notes. All references to “Notes” in this Item 7 refer to the Notes to Consolidated Financial Statements included in Item 8 of this Annual Report. The following discussion and certain other sections of this Annual Report on Form 10-K contain statements reflecting the Company’s views about its future performance that constitute “forward-looking statements” under the Private Securities Litigation Reform Act of 1995. These forward-looking statements are based on current expectations, estimates, forecasts and projections about the industry and markets in which the Company operates as well as management’s beliefs and assumptions. Any statements contained herein (including without limitation statements to the effect that Stanley Black & Decker, Inc. or its management “believes”, “expects”, “anticipates”, “plans” and similar expressions) that are not statements of historical fact should be considered forward-looking statements. These statements are not guarantees of future performance and involve certain risks, uncertainties and assumptions that are difficult to predict. There are a number of important factors that could cause actual results to differ materially from those indicated by such forward-looking statements. These factors include, without limitation, those set forth, or incorporated by reference, below under the heading “Cautionary Statements.” The Company does not intend to update publicly any forward-looking statements whether as a result of new information, future events or otherwise. Strategic Objectives The Company continues to employ the following strategic framework: • Continue organic growth momentum by utilizing the Stanley Fulfillment System ("SFS"), a now expanded program ("SFS 2.0") as a catalyst, diversifying toward higher growth, higher margin businesses, and increasing the relative weighting of emerging markets; • Be selective and operate in markets where brand is meaningful, the value proposition is definable and sustainable through innovation and global cost leadership is achievable; and • Pursue acquisitive growth on multiple fronts by building upon its existing global tools platform, expanding the Industrial platform in Engineered Fastening and Infrastructure, and consolidating the commercial electronic security industry. The Company is continuing to pursue a growth and acquisition strategy that involves industry, geographic and customer diversification to foster sustainable revenue, earnings and cash flow growth. The Company also remains focused on growing organically, including increasing its presence in emerging markets, with a goal of generating greater than 20% of annual revenues from those markets over time, and leveraging SFS 2.0 focused on upgrading innovation and digital capabilities while maintaining commercial and supply chain excellence, and funding required investments, in part, through functional transformation. Strategic acquisitions, combined with strong organic growth performance, will help enable the Company to reach its objective of doubling its size to $22 billion in revenue by 2022 while expanding the margin rate. Furthermore, the Company's strategic framework, including its focus on diversification, has driven continued improvements in financial performance. Sales outside the U.S. represented 48% of total net sales in 2016, up from 29% in 2002, while sales to U.S. and international home centers and mass merchants have decreased to 28% of total sales in 2016 compared to 31% in 2010. Execution of the above strategy has resulted in approximately $6.3 billion of acquisitions since 2002 (excluding the Black & Decker merger and recently announced acquisitions discussed below), several divestitures, improved efficiency in the supply chain and manufacturing operations, and enhanced investments in organic growth, enabled by cash flow generation and increased debt capacity. The Company’s long-term financial objectives are as follows: • 4-6% organic revenue growth; • 10-12% total revenue growth; • 10-12% earnings per share growth including acquisitions (6-8% organic earnings per share growth); • Free cash flow equal to, or exceeding, net income; and • Sustain 10+ working capital turns. In terms of capital allocation, the Company remains committed, over time, to returning approximately 50% of free cash flow to shareholders through a strong and growing dividend as well as opportunistically repurchasing shares. The remaining free cash flow (approximately 50%) will be deployed towards acquisitions. The following represents recent examples of the Company executing its strategic objectives: Pending Acquisitions of Newell Tools and Craftsman Brand On October 12, 2016, the Company announced that it had entered into a definitive agreement to acquire the Tools business of Newell Brands ("Newell Tools"), which includes the highly attractive industrial cutting, hand tool and power tool accessory brands Irwin® and Lenox®, for $1.95 billion in cash. This acquisition will enhance the Company’s position within the global tools & storage industry and broadens the Company’s product offerings and solutions to customers and end-users, particularly within power tool accessories. The acquisition of Newell Tools is expected to be approximately $0.20 to $0.25 accretive to the Company's diluted earnings per share in 2017 (increasing to approximately $0.60 per diluted share by the third year), excluding approximately $125 to $140 million of restructuring and other deal related costs and approximately $40 million of non-cash inventory step-up charges, which in the aggregate will largely be incurred in the first two years. The transaction, which has received antitrust clearance under the Hart-Scott-Rodino Act in the U.S., is expected to close in the first quarter of 2017. On January 5, 2017, the Company announced that it had entered into a definitive agreement to purchase the Craftsman® brand from Sears Holdings, which provides the Company with the rights to develop, manufacture and sell Craftsman®-branded products in non-Sears Holdings channels. The agreement consists of cash payments of $525 million at closing and $250 million at the end of year three, and future payments to Sears Holdings of between 2.5% and 3.5% on new Stanley Black & Decker sales of Craftsman® products through year 15. The Company plans to significantly increase the availability of Craftsman®-branded products to consumers in previously underpenetrated channels, enhance innovation, and add manufacturing jobs in the U.S. to support growth. The transaction is expected to be accretive to earnings, excluding charges, by approximately $0.10 to $0.15 per share in year one, increasing to approximately $0.35 to $0.45 by year five and to approximately $0.70 to $0.80 by year ten. The transaction, which is subject to customary closing conditions, including regulatory approvals, is expected to close during 2017. Refer to Note E, Acquisitions, for further discussion of the Company's acquisitions. Pending Sale of Majority of Mechanical Security Businesses In December 2016, the Company announced the sale of the majority of its mechanical security businesses to Dormakaba for $725 million in cash. The sale, which includes the commercial hardware brands of Best Access, phi Precision and GMT, will allow the Company to sharpen its focus on the more strategically attractive commercial electronic security and automatic doors businesses, and to deploy capital in a more accretive and growth-oriented manner. This tax-efficient sale transaction is expected to generate net after-tax cash proceeds of approximately $700 million. The Company expects the 2017 diluted earnings per share impact of this transaction to be approximately $0.15 to $0.20 dilutive. The transaction is expected to close in the first quarter of 2017. The assets and liabilities expected to be included in the sale have been classified as held for sale on the Company's Consolidated Balance Sheets as of December 31, 2016. Refer to Note T, Divestitures, for further discussion of the Company's divestitures. Conclusion of Previously Announced Security Portfolio Assessment Concurrent with the announcement of the sale above, the Company announced its intent to retain its commercial electronic security and automatic doors businesses. The commercial electronic security business, with its inherent linkage to the digital world, provides both a stable recurring revenue stream and an opportunity to develop and market high-value, high-growth customer solutions, while the automatic doors business represents an attractive growth opportunity for market expansion through both core and breakthrough innovation. Driving Further Profitable Growth By Fully Leveraging Existing Franchises Each of the Company's franchises share common attributes: they have world-class brands and attractive growth characteristics, they are scalable and defensible, and they can differentiate through innovation. • The Tools & Storage business is the tool company to own with its strong brands, proven innovation machine, global scale, and broad offering of power and hand tools across many channels in both developed and developing markets. • The Engineered Fastening business is a highly profitable, GDP+ growth business offering highly engineered, value-added innovative solutions with recurring revenue attributes and global scale. • The Convergent Security Solutions ("CSS") business, with its value-add vertical market offerings and attractive recurring revenue, presents a significant margin accretion opportunity over the longer term. The Security business, which has historically provided a stable revenue stream through economic cycles, is a gateway into the digital world and an avenue to capitalize on rapid digital changes. While diversifying the business portfolio through strategic acquisitions remains important, management recognizes that the existing franchises described above are important foundations that continue to provide strong cash flow and growth prospects. Management is committed to growing these businesses through innovative product development via SFS 2.0, brand support via innovative and customer centric digital experience, continued investment in emerging markets and a sharp focus on global cost-competitiveness. Continuing to Invest in the Stanley Black & Decker Brands The Company has a strong portfolio of brands associated with high-quality products including STANLEY®, BLACK+DECKER®, DEWALT®, Porter-Cable®, Bostitch®, Proto®, MAC®, FACOM®, AeroScout®, Powers®, LISTA®, SIDCHROME®, Vidmar®, SONITROL®, DIYZ® and GQ®. The STANLEY®, BLACK+DECKER® and DEWALT® brands are recognized as three of the world's great brands and are amongst the Company's most valuable assets. The recently announced acquisitions above will further bolster the Company's portfolio with the addition of the Irwin®, Lenox® and Craftsman® brands. During 2016, the STANLEY® and DEWALT® brands had prominent signage at eight major league baseball stadiums and 27% of all Major League Baseball games. The Company has also maintained long-standing NASCAR and NHRA racing sponsorships, which provided brand exposure during 53 events in 2016. The Company has continued its ten-year alliance agreement with the Walt Disney World Resort® whereby STANLEY® logos are displayed on construction walls throughout the theme parks. Brand logos and/or products are featured in various attractions where they are seen by approximately 44 million visitors each year. In 2009, the Company also began advertising in the English Premier League, which is the number one soccer league in the world, watched weekly by approximately 648 million people. Starting in 2014, the Company became a sponsor for one of the world’s most popular football clubs, FC Barcelona, including player image rights, hospitality assets and stadium signage. The Company advertises in televised Professional Bull Riding events, as well as sponsoring 3 riders in 'The Built Ford Tough Series,' which is broadcast in 129 territories and to more than 400 million households globally. Additionally, the Company sponsors Moto GP, the world's premiere motorcycle racing series reaching 150 million fans per race and airing in over 200 countries, and the Monster Yamaha Tech3 team. The Company also has a partnership with the Chinese Basketball Association (CBA), the most popular sport in China with over 800 million fans. In 2016, STANLEY®, BLACK+DECKER® and DEWALT®, partnered with three of the fastest growing and thrilling extreme sports categories - BMX, Freeride Mountain Biking (MTB) and Skateboarding - supporting 18 athletes from grass-roots to professional level, to drive the Company's millennial marketing objectives. The above marketing initiatives highlight the Company's strong emphasis on brand building and support, which has resulted in more than 200 billion brand impressions annually and a steady improvement across the spectrum of brand awareness measures. The Company will continue allocating its brand and advertising spend wisely to capture the emerging digital landscape, whilst continuing to evolve proven marketing programs. The Stanley Fulfillment System and SFS 2.0 The core Stanley Fulfillment System ("SFS") employs continuous improvement techniques to streamline operations (front end & back office) and drive efficiency throughout the supply chain. SFS has five core principles that work in concert: sales and operations planning (“S&OP”), operational lean, complexity reduction, global supply management, and order-to-cash excellence. S&OP is a dynamic and continuous unified process that links and balances supply and demand in a manner that produces world-class fill rates while minimizing DSI (Days Sales of Inventory). Operational lean is the systemic application of lean principles in progressive steps throughout the enterprise to optimize flow toward a pre-defined end state by eliminating waste, increasing efficiency and driving value. Complexity reduction is a focused and overt effort to eradicate costly and unnecessary complexity from the Company's products, supply chain and back room process and organizations. Complexity reduction enables all other SFS elements and, when successfully deployed, results in world-class cost, speed of execution and customer satisfaction. Global supply management focuses on strategically leveraging the Company’s scale to achieve the best possible price and payment terms with the best possible quality, service and delivery among all categories of spend. Order-to-cash excellence is a methodical, process-based approach that provides a user-friendly, automated and error-proof customer experience from intent-to-purchase to shipping and billing to payment, while minimizing cash collection cycle time and DSO (Days Sales Outstanding). Other benefits of SFS include reductions in lead times, rapid realization of synergies during acquisition integrations, and focus on employee safety. The core SFS principles also help to mitigate the impact of material and energy price inflation. SFS is also instrumental in the reduction of working capital as evidenced by the 80% improvement in the Company's working capital turns from 5.9 at the end of 2010 (directly after the Merger) to 10.6 at the end of 2016, ahead of the Company's top-quartile goal of 10 turns. The continued efforts to deploy SFS across the entire Company and increase turns have created significant opportunities to generate incremental free cash flow. Going forward, the Company plans to further leverage the core SFS principles to generate ongoing improvements both in its existing businesses and future acquisitions in working capital turns, cycle times, complexity reduction and customer service levels, with a long-term goal of sustaining 10+ working capital turns. In late 2014, the Company embarked on an initiative to drive from a more programmatic growth mentality to a true organic growth culture by more deeply embedding breakthrough innovation and commercial excellence into its businesses, and at the same time, becoming a significantly more digitally-enabled enterprise. To that end, the Company spent considerable time and effort developing the next iteration of the successful SFS program, which has driven working capital turns to world-class levels and vastly improved the supply chain and customer-facing metrics. Entitled “SFS 2.0” this refreshed and revitalized business system continues the progress on core SFS, but importantly, provide resources and added focus into functional transformation, digital excellence, commercial excellence and breakthrough innovation. SFS 2.0 was launched in 2015 and immediately created a positive impact by driving organic growth, improving margins and reaching new levels of innovation and digitization across the entire organization. The positive impacts of SFS 2.0 continued into 2016, as evidenced by the launch of the DEWALT FLEXVOLT™ battery system in June 2016. This new battery technology, which is the first major output of the SFS 2.0 Breakthrough Innovation initiative, changes voltages as the user changes tools allowing for 20V - 60V - 120V (when two batteries are combined) power all within the same battery system and is fully backward compatible with the Company's existing 20V line of cordless tools. The Company has made a significant commitment to SFS 2.0 and management believes that its success will be characterized by more consistent organic growth in the 4-6% range as well as expanded operating margin rates over the next 3 to 5 years as the Company leverages the growth and reduces structural SG&A levels. SFS 2.0 is transforming the Company by focusing its employees on the following five key pillars: • Core SFS, which targets asset efficiency, remains as the foundation for the Company's operating system and has yielded significant advances in improving working capital turns and free cash flow generation. The Company plans to continue leveraging the core SFS principles to further enhance the Company's already strong asset efficiency performance. • Functional Transformation takes a clean-sheet approach to redesigning the Company's key support functions such as Finance, HR, IT and others, which although highly effective, after almost a hundred acquisitions are not as efficient as they can be, based on external benchmarks. This presents the Company with an opportunity to reduce its SG&A as a percent of sales and becomes a cost effectiveness enabler with the side benefit of helping to fund the following other aspects of SFS 2.0, which together act as enablers for outsized organic growth and margin expansion. • Digital Excellence uses the power of digital to be disruptive and more effective and far reaching through the Company's products, solutions and analytics. Digital Excellence means leveraging the power of emerging technologies across the Company's businesses to connected devices, the Internet of Things, and big data, as well as social and mobile, even more than what is being done today. Digital will touch all aspects of the organization and feeds into and supports the other elements of SFS 2.0 - enabling better asset efficiency through core SFS, greater cost effectiveness via the Company's support functions, and improving revenues and margins via customer-facing opportunities. • Commercial Excellence is about how the Company becomes more effective and efficient in its customer-facing processes resulting in continued share gains and margin expansion throughout its businesses. The Company views Commercial Excellence as world-class execution across seven areas: customer insights, innovation and portfolio management, pricing and promotion, brand and marketing, sales force deployment and effectiveness, channel programs, and the customer experience. • Breakthrough Innovation is aimed at developing a breakthrough innovation culture to identify market disruptive technologies. The Company's focus remains on coming up with the next major breakthrough in the industries in which the Company operates which, when combined with its existing strong core innovation machine, will drive outsized share gains and margin expansion. These five pillars will serve as a powerful value driver in the years ahead, feeding the Company's new product innovation machine, embracing outstanding commercial and supply chain excellence, embedding digital into the various business models, and funding it with world-class functional efficiency. Taken together, these pillars will directly support achievement of the Company's long-term financial objectives and further enable its shareholder-friendly capital allocation approach, which has served the Company well in the past and will continue to do so in the future. Outlook for 2017 This outlook discussion is intended to provide broad insight into the Company’s near-term earnings and cash flow generation prospects. The Company expects 2017 diluted earnings per share to approximate $6.85 to $7.05 (excluding the estimated earnings per share impacts of the pending acquisitions and divestiture discussed previously), up approximately 7% at the mid-point compared to 2016, with free cash flow conversion, defined as free cash flow divided by net income, approximating 100%. The 2017 outlook assumes organic sales growth of 4% resulting in approximately $0.45 to $0.55 of diluted earnings per share accretion. The net impact of cost and productivity actions, partially offset by higher share count, is expected to result in approximately $0.45 to $0.50 of diluted earnings per share accretion. Commodity inflation, approximating $50 to $55 million, and foreign exchange headwinds, approximating $50 million, are expected to negatively impact diluted earnings per share by $0.50 to $0.55. Core restructuring charges and the tax rate are expected to be relatively consistent with 2016 levels. RESULTS OF OPERATIONS Below is a summary of the Company’s operating results at the consolidated level, followed by an overview of business segment performance. Terminology: The term “organic” is utilized to describe results aside from the impacts of foreign currency fluctuations and acquisitions during their initial 12 months of ownership. This ensures appropriate comparability to operating results of prior periods. Net Sales: Net sales were $11.407 billion in 2016, up 2%, compared to $11.172 billion in 2015. Organic sales volume and pricing provided increases of 3% and 1%, respectively, partially offset by a 2% decrease due to negative impacts from foreign currency. In the Tools & Storage segment, net sales increased 5% compared to 2015 due to strong organic growth of 7%, driven by solid growth across all regions, bolstered by the launch of the DEWALT FLEXVOLT™ battery system, partially offset by foreign currency pressures of 2%. Net sales in the Security segment were relatively flat compared to 2015 as organic growth of 1% and small bolt-on electronic acquisitions of 1% were offset by foreign currency headwinds of 2%. Industrial net sales declined 5% relative to 2015 primarily due to a 4% decrease in organic sales volume, which was mainly driven by weaker electronics volumes attributable to a major customer and pressured industrial volumes in the Engineered Fastening business as well as fewer off-shore pipeline projects and an ongoing difficult scrap steel market in the Infrastructure business. Excluding the impact of the electronics customer, the Industrial segment's organic growth was relatively flat in 2016. Net sales were $11.172 billion in 2015, down 1% compared to $11.339 billion in 2014. Organic sales volume and pricing provided increases of 5% and 1%, respectively, but were more than offset by a 7% decrease due to negative impacts from foreign currency. In the Tools & Storage segment, organic sales increased 8% compared to 2014 as a result of strong growth across all regions primarily due to share gains from innovative new products and an expanded retail footprint. Net sales in the Security segment decreased 7% compared to 2014 primarily due to foreign currency declines of 7% and lower volumes in North America and emerging markets, which more than offset organic growth in Europe. In the Industrial segment, organic sales grew 2% relative to 2014 due to strong organic growth in the Engineered Fastening business primarily as a result of strong global automotive revenues. Gross Profit: The Company reported gross profit of $4.267 billion, or 37.4% of net sales, in 2016 compared to $4.072 billion, or 36.4% of net sales, in 2015. The increase in the profit rate reflects favorable impacts from price, productivity, cost actions and commodity deflation, which more than offset unfavorable foreign currency. The Company reported gross profit of $4.072 billion, or 36.4% of net sales, in 2015 compared to $4.103 billion, or 36.2% of net sales, in 2014. The increase in the profit rate reflects favorable impacts from volume leverage, price, productivity, cost actions and commodity deflation, which more than offset significant unfavorable foreign currency fluctuations. SG&A Expense: Selling, general and administrative expenses, inclusive of the provision for doubtful accounts (“SG&A”), were $2.624 billion, or 23.0% of net sales, in 2016 compared to $2.486 billion, or 22.3% of net sales, in 2015. The increase in the SG&A rate was driven by investments in key SFS 2.0 initiatives moderated by continued tight management of costs. SG&A expenses were $2.486 billion, or 22.3% of net sales, in 2015 compared to $2.596 billion, or 22.9% of net sales in 2014. The decrease in the SG&A rate reflects the positive impacts of volume leverage and cost controls. Distribution center costs (i.e. warehousing and fulfillment facility and associated labor costs) are classified within SG&A. This classification may differ from other companies who may report such expenses within cost of sales. Due to diversity in practice, to the extent the classification of these distribution costs differs from other companies, the Company’s gross margins may not be comparable. Such distribution costs classified in SG&A amounted to $235.6 million in 2016, $229.3 million in 2015 and $243.2 million in 2014. Corporate Overhead: The corporate overhead element of SG&A and gross profit, which is not allocated to the business segments, amounted to $197.2 million in 2016, $164.0 million in 2015 and $177.4 million in 2014. The increase in 2016 compared to 2015 was primarily due to investments in SFS 2.0 initiatives and higher employee-related costs. The decrease in 2015 compared to 2014 reflects positive impacts from the Company's effort to reduce certain indirect expenses. Corporate overhead represented 1.7%, 1.5%, and 1.6% of net sales in 2016, 2015 and 2014, respectively. Other-net: Other-net totaled $196.9 million in 2016, $222.0 million in 2015 and $239.6 million in 2014. The decrease in 2016 compared to 2015 was primarily driven by lower unfavorable impacts of foreign currency and lower amortization expense, partially offset by higher acquisition-related costs. The decrease in 2015 compared to 2014 was primarily driven by lower amortization expense partially offset by negative impacts of foreign currency. Interest, net: Net interest expense in 2016 was $171.3 million compared to $165.2 million in 2015 and $163.6 million in 2014. The increase in net interest expense in 2016 versus 2015 was primarily due to amortization of debt issuance costs partially offset by an increase in interest income as a result of higher average cash balances during 2016. The increase in net interest expense in 2015 versus 2014 was primarily attributable to the termination of interest rate swaps in 2014 hedging the Company's $400 million 5.20% notes due 2040. Income Taxes: The Company's effective tax rate was 21.3% in 2016, 21.6% in 2015, and 20.9% in 2014. The effective tax rate in both 2016 and 2015 differed from the U.S. statutory rate primarily due to a portion of the Company's earnings being realized in lower-taxed foreign jurisdictions, adjustments to tax positions relating to undistributed foreign earnings, and reversals of valuation allowances for certain foreign and U.S. state net operating losses, which have become realizable. The effective tax rate in 2014 differed from the U.S. statutory rate primarily due to a portion of the Company's earnings being realized in lower-taxed foreign jurisdictions, the passage of U.S. tax legislation, settlement of various income tax audits and the reversal of valuation allowances for certain foreign net operating losses which had become realizable. Business Segment Results The Company’s reportable segments are aggregations of businesses that have similar products, services and end markets, among other factors. The Company utilizes segment profit which is defined as net sales minus cost of sales and SG&A inclusive of the provision for doubtful accounts (aside from corporate overhead expense), and segment profit as a percentage of net sales to assess the profitability of each segment. Segment profit excludes the corporate overhead expense element of SG&A, other-net (inclusive of intangible asset amortization expense), restructuring charges, interest income, interest expense, and income tax expense. Corporate overhead is comprised of world headquarters facility expense, cost for the executive management team and the expense pertaining to certain centralized functions that benefit the entire Company but are not directly attributable to the businesses, such as legal and corporate finance functions. Refer to Note O, Restructuring Charges and Asset Impairments, and Note F, Goodwill and Intangible Assets, for the amount of net restructuring charges and intangibles amortization expense, respectively, attributable to each segment. As previously discussed, in the first quarter of 2015, the Company combined the Construction & Do-It-Yourself ("CDIY") business with certain complementary elements of the Industrial and Automotive Repair ("IAR") and Healthcare businesses (formerly part of the Industrial and Security segments, respectively) to form one Tools & Storage business. The Company recast segment net sales and profit for all periods presented to align with this change in organizational structure. There was no impact to the consolidated financial statements of the Company as a result of this change. The Company classifies its business into three reportable segments, which also represent its operating segments: Tools & Storage, Security and Industrial. Tools & Storage: The Tools & Storage segment is comprised of the Power Tools and Hand Tools, Accessories & Storage ("HTAS") businesses. The Power Tools business includes both professional and consumer products. Professional products include professional grade corded and cordless electric power tools and equipment including drills, impact wrenches and drivers, grinders, saws, routers and sanders, as well as pneumatic tools and fasteners including nail guns, nails, staplers, and staples, concrete and masonry anchors. Consumer products include corded and cordless electric power tools sold primarily under the BLACK+DECKER brand, lawn and garden products including hedge trimmers, string trimmers, lawn mowers, edgers, and related accessories and home products such as hand held vacuums, paint tools and cleaning appliances. The HTAS business sells measuring, leveling and layout tools, planes, hammers, demolition tools, knives, saws, chisels and industrial and automotive tools. Power tool accessories include drill bits, router bits, abrasives and saw blades. Storage products include tool boxes, sawhorses, medical cabinets and engineered storage solution products. Tools & Storage net sales increased $328.5 million, or 5%, in 2016 compared to 2015. Organic sales increased 7% primarily due to organic growth of 7% in North America, 8% in Europe, and 5% in emerging markets, while unfavorable effects of foreign currency decreased net sales by 2%. North America growth was fueled by share gains from the successful launch of the DEWALT FLEXVOLT system, core product innovation and strong commercial execution. Europe achieved above-market organic growth leveraging the benefits of new products, growth investments and an expanded retail footprint. Growth in emerging markets, led by Latin America and Asia, was driven by successful commercial execution surrounding mid-price point products and regional pricing actions. Segment profit amounted to $1,266.9 million, or 17.0% of net sales, in 2016 compared to $1,170.1 million, or 16.4% of net sales, in 2015. The increase in segment profit year-over-year was primarily driven by volume leverage, price, productivity, cost management and lower commodity prices, which more than offset currency and growth investments. Tools & Storage net sales increased $107.7 million, or 2%, in 2015 compared to 2014. Organic sales increased 8% primarily due to organic growth of 11% in North America, 7% in Europe, and 3% in emerging markets, while unfavorable effects of foreign currency decreased net sales by 6%. Share gains from innovative new products and brand extensions combined with a healthy underlying U.S. tool market fueled growth in North America despite downward pressure in the industrial channels and Canada. Europe achieved above-market organic growth due to share gains from new products, an expanded retail footprint and solid commercial momentum. Organic growth within the emerging markets was driven by favorable impacts of pricing and successful mid-price-point product releases, which more than offset weakness in certain markets, particularly Russia and China. Segment profit amounted to $1,170.1 million, or 16.4% of net sales, in 2015 compared to $1,074.4 million, or 15.3% of net sales, in 2014. The increase in segment profit year-over-year was primarily driven by volume leverage, price, productivity, cost management and lower commodity prices, which more than offset significant foreign currency headwinds. Security: The Security segment is comprised of the Convergent Security Solutions ("CSS") and the Mechanical Access Solutions ("MAS") businesses. The CSS business designs, supplies and installs electronic security systems and provides electronic security services, including alarm monitoring, video surveillance, fire alarm monitoring, systems integration and system maintenance. Purchasers of these systems typically contract for ongoing security systems monitoring and maintenance at the time of initial equipment installation. The business also sells healthcare solutions, which include asset tracking solutions, infant protection, pediatric protection, patient protection, wander management, fall management, and emergency call products. The MAS business sells automatic doors, commercial hardware, locking mechanisms, electronic keyless entry systems, keying systems, tubular and mortise door locksets. Security net sales increased $4.5 million in 2016 compared to 2015. Organic sales and small bolt-on electronic acquisitions each provided increases of 1%, while foreign currency decreased net sales by 2%. Europe posted positive organic growth of 2% on higher installation revenues, while North America declined 1% organically primarily due to lower sales volume within the commercial electronic security business partially offset by higher prices and volumes in the automatic doors business. The Security segment's organic growth in 2016 was also bolstered by double-digit growth within the emerging markets on easing comparables. Segment profit amounted to $269.2 million, or 12.8% of net sales, in 2016 compared to $239.6 million, or 11.4% of net sales, in 2015. The increase in segment profit year-over-year was mainly due to improved operating performance in both North America and Europe, driven by a more disciplined assessment of new commercial opportunities, improved field productivity, and cost actions, which in the aggregate more than offset currency headwinds. Security net sales decreased $168.3 million, or 7%, in 2015 compared to 2014. Organic sales were relatively flat year-over-year while foreign currency fluctuations resulted in a 7% decrease in net sales. Organic growth of 3% in Europe was primarily driven by higher installation revenues in a number of countries and a stable recurring revenue portfolio. North America organic sales were relatively flat year-over-year as modest price increases were offset by lower sales volume within the commercial electronics business as 2014 benefited from a large retail installation. Organic sales declined in emerging markets due to relatively weak market conditions in China. Segment profit amounted to $239.6 million, or 11.4% of net sales, in 2015 compared to $259.2 million, or 11.5% of net sales, in 2014. The segment profit rate was relatively flat year-over-year as improved operating performance within Europe was offset by field cost inefficiencies within the North America electronics business and the deleveraging impact of lower volumes in emerging markets. Industrial: The Industrial segment is comprised of the Engineered Fastening and Infrastructure businesses. The Engineered Fastening business primarily sells engineered fastening products and systems designed for specific applications. The product lines include stud welding systems, blind rivets and tools, blind inserts and tools, drawn arc weld studs, engineered plastic and mechanical fasteners, self-piercing riveting systems, precision nut running systems, micro fasteners, and high-strength structural fasteners. The Infrastructure business consists of the Oil & Gas and Hydraulics businesses. The Oil & Gas business sells and rents custom pipe handling, joint welding and coating equipment used in the construction of large and small diameter pipelines, and provides pipeline inspection services. The Hydraulics business sells hydraulic tools and accessories. Industrial net sales decreased $97.9 million, or 5%, in 2016 compared with 2015, due to a 4% decline in organic sales and a 1% decrease from foreign currency. Engineered Fastening organic revenues declined 4% primarily due to weaker electronics volumes attributable to a major customer and pressured industrial volumes, which more than offset higher automotive growth. Excluding the impact of the major electronics customer, Engineered Fastening's organic sales were slightly positive in 2016. Infrastructure organic revenues decreased 5% due to a slowdown in Oil & Gas off-shore project activity as well as ongoing difficult scrap steel market conditions in the Hydraulics business. Segment profit totaled $304.4 million, or 16.5% of net sales, in 2016 compared to $339.9 million, or 17.5% of net sales, in 2015. The year-over-year decrease in segment profit rate was primarily driven by lower volumes and currency, which more than offset productivity gains and cost control actions. Industrial net sales decreased $106.2 million, or 5%, in 2015 compared with 2014 as organic growth of 2% was more than offset by unfavorable foreign currency of 7%. Engineered Fastening achieved organic growth of 4% during 2015, which was mainly attributable to strong global automotive revenues. Infrastructure organic sales decreased 4% primarily due to lower Hydraulics volumes as a result of difficult scrap steel market conditions, which more than offset modest organic growth in Oil & Gas. Segment profit totaled $339.9 million, or 17.5% of net sales, in 2015 compared to $350.6 million, or 17.1% of net sales, in 2014. The year-over-year increase in segment profit rate was primarily due to favorable volume leverage from Engineered Fastening, productivity gains and cost controls, which more than offset negative impacts from foreign currency and lower Hydraulics volumes. RESTRUCTURING ACTIVITIES A summary of the restructuring reserve activity from January 2, 2016 to December 31, 2016 is as follows: During 2016, the Company recognized net restructuring charges and asset impairments of $49.0 million. This amount reflects $27.3 million of net severance charges associated with the reduction of 1,326 employees. The Company also recognized $11.0 million of facility closure costs and $10.7 million of asset impairments. The Company expects the 2016 actions to result in annual net cost savings of approximately $60 million by the end of 2017. The majority of the $35.6 million of reserves remaining as of December 31, 2016 is expected to be utilized within the next twelve months. During 2015, the Company recognized net restructuring charges and asset impairments of $47.6 million. Net severance charges totaled $32.7 million relating to the reduction of approximately 1,300 employees. The Company also recognized $5.1 million of facility closure costs and $9.8 million of asset impairments. The 2015 actions resulted in annual net cost savings of approximately $40 million in 2016, primarily in the Security and Industrial segments. During 2014, the Company recognized $18.8 million of net restructuring charges. Net severance charges totaled $15.1 million and related to cost reductions associated with the severance of employees. Also included in net restructuring charges were facility closure costs of $3.7 million. The 2014 actions resulted in annual net cost savings of approximately $50 million in 2015, which was primarily related to the Tools & Storage segment. Segments: The $49 million of net restructuring charges and asset impairments for the twelve months ended December 31, 2016 includes: $13 million of net charges pertaining to the Tools & Storage segment; $17 million of net charges pertaining to the Security segment; $9 million of net charges pertaining to the Industrial segment; and $10 million of net charges pertaining to Corporate. The anticipated annual net cost savings of approximately $60 million related to the 2016 restructuring actions include: $20 million pertaining to the Tools & Storage segment; $19 million relating to the Security segment; $18 million pertaining to the Industrial segment; and $3 million relating to Corporate. FINANCIAL CONDITION Liquidity, Sources and Uses of Capital: The Company’s primary sources of liquidity are cash flows generated from operations and available lines of credit under various credit facilities. The Company's cash flows are presented on a consolidated basis and include cash flows from discontinued operations in 2015 and 2014. Operating Activities: Cash flows from operations were $1.485 billion in 2016 compared to $1.182 billion in 2015, representing a $303 million increase. The year-over-year increase was primarily due to higher earnings and cash flows from working capital (accounts receivable, inventory, accounts payable and deferred revenue). As discussed previously, working capital turns increased to 10.6 as of December 31, 2016, an improvement of 1.4 turns over the prior year, demonstrating the Company's continued commitment to its core SFS principles. In 2015, cash flows from operations were $1.182 billion, a $114 million decrease compared to $1.296 billion in 2014. The year-over-year decrease was primarily due to higher outflows from working capital as a result of lower than expected sales volumes in the fourth quarter of 2015. In 2014, cash flows from operations were $1.296 billion, a $428 million increase compared to $868 million in 2013. The year-over-year increase was primarily driven by an increase in earnings and lower one-time restructuring and related payments, partially offset by higher employee benefit plan contributions. Furthermore, operating cash flows in 2014 were positively impacted by an increase in working capital turns from 8.1 at December 28, 2013 to 9.2 at January 3, 2015, demonstrating the continued success of SFS. Free Cash Flow: Management considers free cash flow an important indicator of its liquidity, as well as its ability to fund future growth and provide dividends to shareowners. Free cash flow does not include deductions for mandatory debt service, other borrowing activity, discretionary dividends on the Company’s common stock and business acquisitions, among other items. Investing Activities: Cash flows used in investing activities were $284 million in 2016, primarily due to capital and software expenditures of $347 million and business acquisitions of $59 million, partially offset by $105 million of cash proceeds related to net investment hedge settlements, which were primarily driven by the significant fluctuations in foreign currency rates during 2016 associated with foreign exchange contracts hedging a portion of the Company's pound sterling, Canadian dollar, and Euro denominated net investments. Cash flows used in investing activities in 2015 totaled $205 million, which primarily consisted of capital and software expenditures of $311 million partially offset by $137 million of cash proceeds related to net investment hedge settlements, which were primarily driven by the significant fluctuations in foreign currency rates during 2015 associated with foreign exchange contracts hedging a portion of the Company's pound sterling and Canadian dollar denominated net investments. Cash flows used in investing activities in 2014 totaled $382 million, which primarily consisted of capital and software expenditures of $291 million and payments related to net investment hedge settlements of $61 million. The lower capital expenditures in 2014 was driven by management's continued focus to control spend in this area as well as lower integration-related capital expenditures. The payments related to net investment hedge settlements were mainly driven by the significant fluctuations in foreign currency rates during 2014 associated with foreign exchange contracts hedging a portion of the Company's pound sterling denominated net investment. Financing Activities: Cash flows used in financing activities were $433 million in 2016 primarily due to share repurchases of $374 million, cash payments for dividends of $331 million, and the settlement of the October 2014 forward share purchase contract for $147 million, partially offset by proceeds from issuances of common stock of $419 million, which mainly related to the issuance of 3.5 million shares associated with the settlement of the 2013 Equity Purchase Contracts. The higher dividend payments in 2016 were driven by the increase in quarterly dividends per common share to $0.58. The dividend paid in December 2016 to shareholders of record extended the Company's record for the longest consecutive annual and quarterly dividend payments among industrial companies listed on the New York Stock Exchange. The Company also paid approximately $13 million in December 2016 to purchase the remaining 30% interest in GMT, which is included in the pending sale of the majority of the Company's mechanical security businesses, as discussed previously. Cash flows used in financing activities in 2015 were $876 million, primarily due to the repurchase of 6.6 million common shares for $650 million and cash payments for dividends of $320 million, partially offset by proceeds from issuances of common stock of $164 million, which mainly related to the exercises of stock options. The Company also paid approximately $34 million in December 2015 to purchase the remaining 40% interest in GQ. Cash flows used in financing activities in 2014 were $766 million, primarily due to net repayments of short-term borrowings of $391 million, cash payments for dividends of $321 million, and payments on long-term debt of $47 million related to the repurchase of $46 million of 2022 Term Notes. In 2014, the Company also terminated $400 million of interest rate swaps hedging the Company's $400 million, 5.20% notes due 2053, which resulted in cash payments of $33.4 million. Proceeds from issuances of common stock totaled $71 million, which was primarily related to stock option exercises. Fluctuations in foreign currency rates negatively impacted cash by $102 million, $133 million and $147 million in 2016, 2015 and 2014, respectively. These negative impacts were primarily driven by the continued strengthening of the U.S. Dollar, against the Company's other currencies. Refer to Note H, Long-Term Debt and Financing Arrangements, and Note J, Capital Stock, for further discussion regarding the Company's debt and equity arrangements. Credit Ratings and Liquidity: The Company maintains strong investment grade credit ratings from the major U.S. rating agencies on its senior unsecured debt (S&P A, Fitch A-, Moody's Baa1), as well as its commercial paper program (S&P A-1, Fitch, Moody's P-2). There have been no changes to any of the ratings during 2016. Failure to maintain strong investment grade rating levels could adversely affect the Company’s cost of funds, liquidity and access to capital markets, but would not have an adverse effect on the Company’s ability to access its existing committed credit facilities. Cash and cash equivalents totaled $1.132 billion as of December 31, 2016, which was predominantly held in foreign jurisdictions. As of January 2, 2016 cash and cash equivalents totaled $465 million, comprised of $131 million in the U.S. and $334 million in foreign jurisdictions. Concurrent with the Black & Decker merger, the Company made a determination to repatriate certain legacy Black & Decker foreign earnings, on which U.S. income taxes had not previously been provided. As a result of this repatriation decision, the Company has recorded approximately $261 million of associated deferred tax liabilities at December 31, 2016. Current plans and liquidity requirements do not demonstrate a need to repatriate other foreign earnings. Accordingly, all other undistributed foreign earnings of the Company are considered to be permanently reinvested, or will be remitted substantially free of additional tax, consistent with the Company’s overall growth strategy internationally, including acquisitions and long-term financial objectives. No provision has been made for taxes that might be payable upon remittance of these undistributed foreign earnings. However, should management determine at a later point to repatriate additional foreign earnings, the Company would be required to accrue and pay taxes at that time. At December 31, 2016 and January 2, 2016, the Company had no commercial paper borrowings outstanding against the Company's $2.0 billion commercial paper program. In January 2017, the Company amended its $2.0 billion commercial paper program to increase the maximum amount of notes authorized to be issued to $3.0 billion and to include Euro denominated borrowings in addition to U.S. Dollars. In February 2017, the Company issued €600.0 million in Euro denominated commercial paper under its $3.0 billion U.S. Dollar and Euro commercial paper program which has been designated as a Net Investment Hedge as described in more detail in Note I, Derivative Financial Instruments. Also, in January 2017, the Company executed a 364-day $1.3 billion committed credit facility (the "2017 Credit Agreement"). The 2017 Credit Agreement consists of a $1.3 billion revolving credit loan and a sub-limit of an amount equal to the EURO equivalent of $400 million for swing line advances. Borrowings under the 2017 Credit Agreement may be made in U.S. Dollars or Euros, pursuant to the terms of the agreement, and bear interest at a floating rate dependent on the denomination of the borrowing. Repayments must be made by January 17, 2018 or upon an earlier termination of the 2017 Credit Agreement at the election of the Company. The 2017 Credit Agreement serves as a liquidity back-stop for the Company’s $3.0 billion U.S. Dollar and Euro commercial paper program, also authorized and amended in January 2017, as discussed above. The Company has a five-year $1.75 billion committed credit facility (the “Credit Agreement”). Borrowings under the Credit Agreement may include U.S. Dollars up to the $1.75 billion commitment or in Euro or Pounds Sterling subject to a foreign currency sub-limit of $400.0 million and bear interest at a floating rate dependent upon the denomination of the borrowing. Repayments must be made on December 18, 2020 or upon an earlier termination date of the Credit Agreement, at the election of the Company. The Credit Agreement is designated to be a liquidity back-stop for the Company's $2.0 billion commercial paper program. As of December 31, 2016, the Company has not drawn on this commitment. In addition, the Company has short-term lines of credit that are primarily uncommitted, with numerous banks, aggregating $588.5 million, of which $493.8 million was available at December 31, 2016. Short-term arrangements are reviewed annually for renewal. At December 31, 2016, the aggregate amount of committed and uncommitted, long- and short-term lines was $2.3 billion. At December 31, 2016, $4.3 million was recorded as short-term borrowings outstanding against uncommitted lines excluding commercial paper. In addition, $94.7 million of the short-term credit lines was utilized primarily pertaining to outstanding letters of credit for which there are no required or reported debt balances. The weighted average interest rates on short-term borrowings, primarily commercial paper, for the fiscal years ended December 31, 2016 and January 2, 2016 were 0.6% and 0.4%, respectively. In March 2015, the Company entered into a forward share purchase contract with a financial institution counterparty for (3,645,510) shares of common stock. The contract obligates the Company to pay $350.0 million, plus an additional amount related to the forward component of the contract. In November 2016, the Company amended the settlement date to April 2019, or earlier at the Company's option. In October 2014, the Company entered into a forward share purchase contract on its common stock. The contract obligated the Company to pay $150.0 million, plus an additional amount related to the forward component of the contract, to the financial institution counterparty not later than October 2016, or earlier at the Company’s option, for the 1,603,822 shares purchased. In October 2016, the Company physically settled the contract, receiving 1,603,822 shares for a settlement amount of $147.4 million. On February 10, 2015, the Company net-share settled 9.1 million of the 12.2 million capped call options on its common stock and received 911,077 shares using an average reference price of $96.46 per common share. Additionally, the Company purchased 3,381,162 shares directly from the counterparties participating in the net-share settlement of the capped call options for $326.1 million, equating to an average price of $96.46 per share. In February 2016, the Company net-share settled the remaining 3.1 million capped call options on its common stock and received 293,142 shares using an average reference price of $94.34 per common share. Additionally, the Company purchased 1,316,858 shares directly from the counterparty participating in the net-share settlement for $124.2 million. The Company also repurchased 2,446,287 shares of common stock in February 2016 for $230.9 million, equating to an average price of $94.34. On December 3, 2013, the Company issued $400.0 million 5.75% fixed-to-floating rate junior subordinated debentures maturing December 15, 2053 (“2053 Junior Subordinated Debentures”) that bear interest at a fixed rate of 5.75% per annum, up to, but excluding December 15, 2018. From and including December 15, 2018, the 2053 Junior Subordinated Debentures will bear interest at an annual rate equal to three-month LIBOR plus 4.304%. The debentures subordination and long tenor provides significant credit protection measures for senior creditors and as a result, the debentures were awarded a 50% equity credit by S&P and Fitch, and 25% equity credit by Moody's. The net proceeds from the offering were primarily used to repay commercial paper borrowings. On December 3, 2013, the Company issued 3,450,000 Equity Units (the “Equity Units”), each with a stated value of $100. The Equity Units were initially comprised of a 1/10, or 10%, undivided beneficial ownership in a $1,000 principal amount 2.25% junior subordinated note due 2018 (the “2018 Junior Subordinated Note”) and a forward common stock purchase contract (the “Equity Purchase Contract”). The Company received approximately $334.7 million in cash proceeds from the Equity Units, net of underwriting discounts and commissions, before offering expenses, and recorded $345.0 million in long-term debt. The proceeds were used primarily to repay commercial paper borrowings. The Company also used $9.7 million of the proceeds to enter into capped call transactions utilized to hedge potential economic dilution associated with the common shares issuable upon settlement of the Equity Purchase Contracts. The Company successfully remarketed the 2018 Junior Subordinated Note on November 17, 2016 ("Subordinated Notes"), which resulted in the interest rate being reset, effective on the settlement date, to a rate of 1.622% per annum, payable semi-annually in arrears on May 17 and November 17 of each year, commencing May 17, 2017 and maturing on November 17, 2018. Following settlement of the remarketing, the Subordinated Notes remain the Company’s direct, unsecured general obligations and are subordinated and junior in right of payment to the Company’s existing and future senior indebtedness, but the Subordinated Notes rank senior in right of payment to specified junior indebtedness on the terms and to the extent set forth in the indentures governing such junior indebtedness. In addition, the Company settled all Equity Purchase Contracts on November 17, 2016 by issuing 3,504,165 million common shares and receiving $345.0 million in cash proceeds, generated from the remarketing described above. Lastly, in October and November 2016, the Company’s capped call options on its common stock expired and were net-share settled resulting in the Company receiving 418,234 shares of common stock. In November 2010, the Company issued 6,325,000 Convertible Preferred Units (the “Convertible Preferred Units”), each with a stated amount of $100. The Convertible Preferred Units were comprised of a 1/10, or 10%, undivided beneficial ownership in a $1,000 principal amount junior subordinated note (the “Note”) and a Purchase Contract (the “Purchase Contract”) obligating holders to purchase one share of the Company’s 4.75% Series B Perpetual Cumulative Convertible Preferred Stock (the “Convertible Preferred Stock”). The Company successfully remarketed the Notes on November 5, 2015, which resulted in the interest rate on the notes being reset, effective on the November 17, 2015 settlement date of the remarketing, to a rate of 2.45% per annum, payable semi-annually in arrears on May 17 and November 17 of each year, commencing May 17, 2016. Following settlement of the remarketing, the Notes remain the Company’s direct, unsecured general obligations subordinated and junior in right of payment to the Company’s existing and future senior indebtedness, but the Notes rank senior in right of payment to specified junior indebtedness on the terms and to the extent set forth in the indentures governing such junior indebtedness. In addition, the Company settled the Purchase Contracts on November 17, 2015 by issuing 6.3 million shares of Convertible Preferred Stock and receiving cash proceeds of $632.5 million. On November 18, 2015, the Company informed holders that it would redeem all outstanding shares of Convertible Preferred Stock on December 24, 2015 (the “Redemption Date”) at $100.49 per share in cash (the “Redemption Price”), which was equal to the liquidation preference of $100 per share of Convertible Preferred Stock, plus all accrued and unpaid dividends thereon to, but excluding, the Redemption Date. The Company redeemed the Convertible Preferred Stock and settled all conversions on December 24, 2015 by paying cash for the $100 par value per share of Convertible Preferred Stock, or $632.5 million in total, and issuing 2.9 million common shares for the excess value of the conversion feature above the $100 face value per share of Convertible Preferred Stock. Refer to Note H, Long-Term Debt and Financing Arrangements, and Note J, Capital Stock, for further discussion regarding the Company's debt and equity arrangements. Contractual Obligations: The following table summarizes the Company’s significant contractual obligations and commitments that impact its liquidity: (a) Future payments on long-term debt encompass all payments related to aggregate debt maturities, excluding certain fair value adjustments included in long-term debt, as discussed further in Note H, Long-Term Debt and Financing Arrangements. (b) Future interest payments on long-term debt reflect the applicable fixed interest rate or variable rate for floating rate debt in effect at December 31, 2016. (c) Inventory purchase commitments primarily consist of open purchase orders to purchase raw materials, components, and sourced products. (d) Future cash flows on derivative instruments reflect the fair value and accrued interest as of December 31, 2016. The ultimate cash flows on these instruments will differ, perhaps significantly, based on applicable market interest and foreign currency rates at their maturity. (e) In March 2015, the Company entered into a forward share purchase contract with a financial institution counterparty which obligates the Company to pay $350.0 million, plus an additional amount related to the forward component of the contract. In November 2016, the Company amended the final settlement date to April 2019, or earlier at the Company's option. See Note J, Capital Stock for further discussion. (f) This amount principally represents contributions either required by regulations or laws or, with respect to unfunded plans, necessary to fund current benefits. The Company has not presented estimated pension and post-retirement funding beyond 2017 as funding can vary significantly from year to year based upon changes in the fair value of the plan assets, actuarial assumptions, and curtailment/settlement actions. To the extent the Company can reliably determine when payments will occur pertaining to unrecognized tax liabilities, the related amount will be included in the table above. However, due to the high degree of uncertainty regarding the timing of potential future cash flows associated with the $375.4 million of such liabilities at December 31, 2016, the Company is unable to make a reliable estimate of when (if at all) amounts may be paid to the respective taxing authorities. Aside from debt payments, for which there is no tax benefit associated with repayment of principal, and tax obligations, payments of the above contractual obligations will typically generate a cash tax benefit such that the net cash outflow will be lower than the gross amounts summarized above. Other Significant Commercial Commitments: Short-term borrowings, long-term debt and lines of credit are explained in detail within Note H, Long-Term Debt and Financing Arrangements. MARKET RISK Market risk is the potential economic loss that may result from adverse changes in the fair value of financial instruments, currencies, commodities and other items traded in global markets. The Company is exposed to market risk from changes in foreign currency exchange rates, interest rates, stock prices, bond prices and commodity prices, amongst others. Exposure to foreign currency risk results because the Company, through its global businesses, enters into transactions and makes investments denominated in multiple currencies. The Company’s predominant currency exposures are related to the Euro, Canadian Dollar, British Pound, Australian Dollar, Brazilian Real, Argentine Peso, the Chinese Renminbi (“RMB”) and the Taiwan Dollar. Certain cross-currency trade flows arising from sales and procurement activities, as well as affiliate cross-border activity, are consolidated and netted prior to obtaining risk protection through the use of various derivative financial instruments which may include: purchased basket options, purchased options, collars, cross currency swaps and currency forwards. The Company is thus able to capitalize on its global positioning by taking advantage of naturally offsetting exposures and portfolio efficiencies to reduce the cost of purchasing derivative protection. At times, the Company also enters into forward exchange contracts and purchases options to reduce the earnings and cash flow impact of non-functional currency denominated receivables and payables, primarily for affiliate transactions. Gains and losses from these hedging instruments offset the gains or losses on the underlying net exposures (the assets and liabilities being hedged). Management determines the nature and extent of currency hedging activities, and in certain cases, may elect to allow certain currency exposures to remain un-hedged. The Company may also enter into cross-currency swaps and forward contracts to hedge the net investments in certain subsidiaries and better match the cash flows of operations to debt service requirements. Management estimates the foreign currency impact from its derivative financial instruments outstanding at the end of 2016 would have been approximately $6 million incremental pre-tax loss based on a hypothetical 10% adverse movement in all net derivative currency positions; this effect would occur from the strengthening of foreign currencies relative to the U.S. dollar. The Company follows risk management policies in executing derivative financial instrument transactions, and does not use such instruments for speculative purposes. The Company generally does not hedge the translation of its non-U.S. dollar earnings in foreign subsidiaries, but may choose to do so in certain instances in future periods. As mentioned above, the Company routinely has cross-border trade and affiliate flows that cause an impact on earnings from foreign exchange rate movements. The Company is also exposed to currency fluctuation volatility from the translation of foreign earnings into U.S. dollars and the economic impact of foreign currency volatility on monetary assets held in foreign currencies. It is more difficult to quantify the transactional effects from currency fluctuations than the translational effects. Aside from the use of derivative instruments, which may be used to mitigate some of the exposure, transactional effects can potentially be influenced by actions the Company may take. For example, if an exposure occurs from a European entity sourcing product from a U.S. supplier it may be possible to change to a European supplier. Management estimates the combined translational and transactional impact, on pre-tax earnings, of a 10% overall movement in exchange rates is approximately $123 million, or approximately $0.65 per diluted share. In 2016, translational and transactional foreign currency fluctuations negatively impacted pre-tax earnings by approximately $155 million and diluted earnings per share by approximately $0.82. The Company’s exposure to interest rate risk results from its outstanding debt and derivative obligations, short-term investments, and derivative financial instruments employed in the management of its debt portfolio. The debt portfolio including both trade and affiliate debt, is managed to achieve capital structure targets and reduce the overall cost of borrowing by using a combination of fixed and floating rate debt as well as interest rate swaps, and cross-currency swaps. The Company’s primary exposure to interest rate risk comes from its floating rate debt in the U.S. which is based on LIBOR rates. At December 31, 2016, the impact of a hypothetical 10% increase in the interest rates associated with the Company’s floating rate debt instruments would have an immaterial effect on the Company’s financial position and results of operations. The Company has exposure to commodity prices in many businesses, particularly brass, nickel, resin, aluminum, copper, zinc, steel, and energy used in the production of finished goods. Generally, commodity price exposures are not hedged with derivative financial instruments, but instead are actively managed through customer product and service pricing actions, procurement-driven cost reduction initiatives and other productivity improvement projects. Fluctuations in the fair value of the Company’s common stock affect domestic retirement plan expense as discussed below in the Employee Stock Ownership Plan section of MD&A. Additionally, the Company has $70 million of liabilities as of December 31, 2016 pertaining to unfunded defined contribution plans for certain U.S. employees for which there is mark-to-market exposure. The assets held by the Company’s defined benefit plans are exposed to fluctuations in the market value of securities, primarily global stocks and fixed-income securities. The funding obligations for these plans would increase in the event of adverse changes in the plan asset values, although such funding would occur over a period of many years. In 2016, 2015 and 2014, investment returns on pension plan assets resulted in a $260 million increase, an $11 million decrease, and a $285 million increase, respectively. The Company expects funding obligations on its defined benefit plans to be approximately $66 million in 2017. The Company employs diversified asset allocations to help mitigate this risk. Management has worked to minimize this exposure by freezing and terminating defined benefit plans where appropriate. The Company has access to financial resources and borrowing capabilities around the world. There are no instruments within the debt structure that would accelerate payment requirements due to a change in credit rating. The Company’s existing credit facilities and sources of liquidity, including operating cash flows, are considered more than adequate to conduct business as normal. Accordingly, based on present conditions and past history, management believes it is unlikely that operations will be materially affected by any potential deterioration of the general credit markets that may occur. The Company believes that its strong financial position, operating cash flows, committed long-term credit facilities and borrowing capacity, and ready access to equity markets provide the financial flexibility necessary to continue its record of annual dividend payments, to invest in the routine needs of its businesses, to make strategic acquisitions and to fund other initiatives encompassed by its growth strategy and maintain its strong investment grade credit ratings. OTHER MATTERS Employee Stock Ownership Plan As detailed in Note L, Employee Benefit Plans, the Company has an ESOP under which the ongoing U.S. Core and 401(k) defined contribution plans are funded. Overall ESOP expense is affected by the market value of the Company’s stock on the monthly dates when shares are released, among other factors. The Company’s net ESOP activity resulted in income of $3.1 million in 2016 and expense of $0.8 million in 2015 and $0.7 million in 2014. ESOP expense could increase in the future if the market value of the Company’s common stock declines. CRITICAL ACCOUNTING ESTIMATES - Preparation of the Company’s Consolidated Financial Statements requires management to make estimates and assumptions that affect the reported amounts of assets, liabilities, revenues and expenses. Significant accounting policies used in the preparation of the Consolidated Financial Statements are described in Note A, Significant Accounting Policies. Management believes the most complex and sensitive judgments, because of their significance to the Consolidated Financial Statements, result primarily from the need to make estimates about the effects of matters with inherent uncertainty. The most significant areas involving management estimates are described below. Actual results in these areas could differ from management’s estimates. ALLOWANCE FOR DOUBTFUL ACCOUNTS - The Company’s estimate for its allowance for doubtful accounts related to trade receivables is based on two methods. The amounts calculated from each of these methods are combined to determine the total amount reserved. First, a specific reserve is established for individual accounts where information indicates the customers may have an inability to meet financial obligations. In these cases, management uses its judgment, based on the surrounding facts and circumstances, to record a specific reserve for those customers against amounts due to reduce the receivable to the amount expected to be collected. These specific reserves are reevaluated and adjusted as additional information is received. Second, a reserve is determined for all customers based on a range of percentages applied to receivable aging categories. These percentages are based on historical collection and write-off experience. If circumstances change, for example, due to the occurrence of higher-than-expected defaults or a significant adverse change in a major customer’s ability to meet its financial obligation to the Company, estimates of the recoverability of receivable amounts due could be reduced. INVENTORIES - LOWER OF COST OR MARKET, SLOW MOVING AND OBSOLETE - Inventories in the U.S. are primarily valued at the lower of Last-In First-Out (“LIFO”) cost or market, while non-U.S. inventories are primarily valued at the lower of First-In, First-Out (“FIFO”) cost or market. The calculation of LIFO reserves, and therefore the net inventory valuation, is affected by inflation and deflation in inventory components. The Company ensures all inventory is valued at the lower of cost or market, and continually reviews the carrying value of discontinued product lines and stock-keeping-units (“SKUs”) to determine that these items are properly valued. The Company also continually evaluates the composition of its inventory and identifies obsolete and/or slow-moving inventories. Inventory items identified as obsolete and/or slow-moving are evaluated to determine if write-downs are required. The Company assesses the ability to dispose of these inventories at a price greater than cost. If it is determined that cost is less than market value, cost is used for inventory valuation. If market value is less than cost, the Company writes down the related inventory to that value. If a write-down to the current market value is necessary, the market value cannot be greater than the net realizable value, or ceiling (defined as selling price less costs to sell and dispose), and cannot be lower than the net realizable value less a normal profit margin, also called the floor. If the Company is not able to achieve its expectations regarding net realizable value of inventory at its current value, a write-down would be recorded. GOODWILL AND INTANGIBLE ASSETS - The Company acquires businesses in purchase transactions that result in the recognition of goodwill and intangible assets. The determination of the value of intangible assets requires management to make estimates and assumptions. In accordance with ASC 350-20, “Goodwill,” acquired goodwill and indefinite-lived intangible assets are not amortized but are subject to impairment testing at least annually or when an event occurs or circumstances change that indicate it is more likely than not an impairment exists. Definite-lived intangible assets are amortized and are tested for impairment when an event occurs or circumstances change that indicate it is more likely than not that an impairment exists. Goodwill represents costs in excess of fair values assigned to the underlying net assets of acquired businesses. At December 31, 2016, the Company reported $6,694.0 million of goodwill, $1,508.5 million of indefinite-lived trade names and $791.0 million of net definite-lived intangibles. These amounts exclude approximately $302.8 million of goodwill, $65.2 million of an indefinite-lived trade name and $31.8 million of net definite-lived intangibles that are classified within Assets held for sale on the Consolidated Balance Sheets at December 31, 2016. Refer to Note T, Divestitures, for further discussion. Management tests goodwill for impairment at the reporting unit level. A reporting unit is an operating segment as defined in ASC 280, “Segment Reporting,” or one level below an operating segment (component level) as determined by the availability of discrete financial information that is regularly reviewed by operating segment management or an aggregate of component levels of an operating segment having similar economic characteristics. If the carrying value of a reporting unit (including the value of goodwill) is greater than its estimated fair value, an impairment may exist. An impairment charge would be recorded to the extent that the recorded value of goodwill exceeded the implied fair value. As required by the Company’s policy, goodwill was tested for impairment in the third quarter of 2016. Beginning in 2013, the Company adopted ASU 2011-08, “Intangibles - Goodwill and Other (Topic 350): Testing Goodwill for Impairment,” for its goodwill impairment testing. ASU 2011-08 permits companies to first assess qualitative factors to determine whether it is more likely than not that the fair value of a reporting unit is less than its carrying amount as a basis for determining whether it is necessary to perform the two-step quantitative goodwill impairment test. Under the two-step quantitative goodwill impairment test, the fair value of the reporting unit is compared to its respective carrying amount including goodwill. If the fair value exceeds the carrying amount, then no impairment exists. If the carrying amount exceeds the fair value, further analysis is performed to assess impairment. Such tests are completed separately with respect to the goodwill of each of the Company’s reporting units. Accordingly, the Company applied the qualitative assessment for four of its reporting units, while performing the quantitative test for its Infrastructure reporting unit. Based on the results of the annual 2016 impairment testing, the Company determined that the fair values of each of its reporting units exceeded their respective carrying amounts. In performing the qualitative assessment, the Company identified and considered the significance of relevant key factors, events, and circumstances that could affect the fair value of each reporting unit. These factors include external factors such as macroeconomic, industry, and market conditions, as well as entity-specific factors, such as actual and planned financial performance. The Company also assessed changes in each reporting unit's fair value and carrying value since the most recent date a fair value measurement was performed. As a result of the qualitative assessments performed, the Company concluded that it is more likely than not that the fair value of each reporting unit exceeded its respective carrying value and therefore, no additional quantitative impairment testing was performed. With respect to the quantitative test, the Company assessed the fair value of the Infrastructure reporting unit using a discounted cash flow valuation model. The key assumptions applied to the cash flow projections included a 9% discount rate, near-term revenue growth rates over the next five years, which represented a cumulative annual growth rate of approximately 5%, and a 3% perpetual growth rate. These assumptions contemplated business, market and overall economic conditions. Based on the results of this testing, the Company determined that the fair value of the reporting unit exceeded its carrying amount. Furthermore, management performed sensitivity analyses on the fair value resulting from the discounted cash flow valuation model utilizing more conservative assumptions that reflect reasonably likely future changes in the discount rate and perpetual growth rate. The discount rate was increased by 100 basis points with no impairment indicated. The perpetual growth rate was decreased by 150 basis points with no impairment indicated. During the fourth quarter of 2016, in connection with its quarterly forecasting cycle, the Company updated the forecasted operating results for each of its businesses based on the most recent financial results and best estimates of future operations. The updated forecasts reflected an expected decline in near-term revenue growth and profitability for the Infrastructure reporting unit within the Industrial segment, primarily due to ongoing difficult market conditions in the oil & gas industry, mainly related to project delays as a result of continued geopolitical challenges and a cyclical slowdown in offshore pipeline activity, as well as a slower than expected recovery in the scrap steel market. Accordingly, in connection with the preparation of the Consolidated Financial Statements for the year ended December 31, 2016, the Company performed an updated impairment analysis with respect to the Infrastructure reporting unit, which included approximately $269 million of goodwill at year-end. Based on this analysis, which included revised assumptions of near-term revenue growth and profitability levels, it was determined that the fair value of the Infrastructure reporting unit exceeded its carrying value by 14%. Therefore, management concluded it was not more likely than not that an impairment had occurred. Management is confident in the long-term viability and success of the Infrastructure reporting unit based on the strong long-term growth prospects of the markets and geographies served, the Company's continued commitment to, and investments in, organic growth initiatives (including solid progress being made with respect to Breakthrough Innovation projects under the SFS 2.0 program), and Infrastructure's leading market position in its respective industries. In the event that future operating results of any of the Company's reporting units do not meet current expectations, management, based upon conditions at the time, would consider taking restructuring or other actions as necessary to maximize revenue growth and profitability. Accordingly, the above sensitivity analyses, while useful, should not be used as a sole predictor of potential impairment. A thorough analysis of all the facts and circumstances existing at that time would need to be performed to determine if recording an impairment loss would be appropriate. The Company also tested its indefinite-lived trade names for impairment during the third quarter of 2016, utilizing both qualitative assessments and quantitative tests. For the qualitative assessments, the Company identified and considered the significance of relevant key factors, events, and circumstances that could affect the fair value of each trade name. These factors primarily included macroeconomic, industry, and market conditions, as well as the trade names' actual and planned financial performance. As a result of the qualitative assessments performed, the Company concluded that it is more likely than not that the fair values of the trade names exceeded their respective carrying values and therefore, no additional quantitative impairment testing was performed. For the quantitative impairment tests, the Company utilized a discounted cash flow model. The key assumptions used included discount rates, royalty rates, and perpetual growth rates applied to the projected sales. Based on these quantitative impairment tests, the Company determined that the fair values of the indefinite-lived trade names exceeded their respective carrying amounts. DEFINED BENEFIT OBLIGATIONS - The valuation of pension and other postretirement benefits costs and obligations is dependent on various assumptions. These assumptions, which are updated annually, include discount rates, expected return on plan assets, future salary increase rates, and health care cost trend rates. The Company considers current market conditions, including interest rates, to establish these assumptions. Discount rates are developed considering the yields available on high-quality fixed income investments with maturities corresponding to the duration of the related benefit obligations. The Company’s weighted-average discount rates for the United States and international pension plans were 4.00% and 2.50%, respectively, at December 31, 2016. The Company’s weighted-average discount rate for the United States and international pension plans was 4.25% and 3.25%, respectively, at January 2, 2016. As discussed further in Note L, Employee Benefit Plans, the Company develops the expected return on plan assets considering various factors, which include its targeted asset allocation percentages, historic returns, and expected future returns. The Company’s expected rate of return assumptions for the United States and international pension plans were 6.50% and 4.75%, respectively, at December 31, 2016. The Company will use a 5.35% weighted-average expected rate of return assumption to determine the 2017 net periodic benefit cost. A 25 basis point reduction in the expected rate of return assumption would increase 2017 net periodic benefit cost by approximately $5 million on a pre-tax basis. The Company believes that the assumptions used are appropriate; however, differences in actual experience or changes in the assumptions may materially affect the Company’s financial position or results of operations. To the extent that actual (newly measured) results differ from the actuarial assumptions, the difference is recognized in accumulated other comprehensive income, and, if in excess of a specified corridor, amortized over future periods. The expected return on plan assets is determined using the expected rate of return and the fair value of plan assets. Accordingly, market fluctuations in the fair value of plan assets can affect the net periodic benefit cost in the following year. The projected benefit obligation for defined benefit plans exceeded the fair value of plan assets by $691 million at December 31, 2016. A 25 basis point reduction in the discount rate would have increased the projected benefit obligation by approximately $90 million at December 31, 2016. The primary Black & Decker U.S pension and post employment benefit plans were curtailed in late 2010, as well as the only material Black & Decker international plan, and in their place the Company implemented defined contribution benefit plans. The vast majority of the projected benefit obligation pertains to plans that have been frozen; the remaining defined benefit plans that are not frozen are predominantly small domestic union plans and those that are statutorily mandated in certain international jurisdictions. The Company recognized $12 million of defined benefit plan expense in 2016, which may fluctuate in future years depending upon various factors including future discount rates and actual returns on plan assets. ENVIRONMENTAL - The Company incurs costs related to environmental issues as a result of various laws and regulations governing current operations as well as the remediation of previously contaminated sites. Future laws and regulations are expected to be increasingly stringent and will likely increase the Company’s expenditures related to environmental matters. The Company’s policy is to accrue environmental investigatory and remediation costs for identified sites when it is probable that a liability has been incurred and the amount of loss can be reasonably estimated. The amount of liability recorded is based on an evaluation of currently available facts with respect to each individual site and includes such factors as existing technology, presently enacted laws and regulations, and prior experience in remediation of contaminated sites. The liabilities recorded do not take into account any claims for recoveries from insurance or third parties. As assessments and remediation progress at individual sites, the amounts recorded are reviewed periodically and adjusted to reflect additional technical and legal information that becomes available. As of December 31, 2016, the Company had reserves of $160.9 million for remediation activities associated with Company-owned properties as well as for Superfund sites, for losses that are probable and estimable. The range of environmental remediation costs that is reasonably possible is $128.3 million to $267.1 million which is subject to change in the near term. The Company may be liable for environmental remediation of sites it no longer owns. Liabilities have been recorded on those sites in accordance with this policy. INCOME TAXES - Income taxes are accounted for in accordance with ASC 740, "Accounting for Income Taxes," which requires that deferred tax assets and liabilities be recognized, using enacted tax rates, for the effect of temporary differences between the book and tax bases of recorded assets and liabilities. Deferred tax assets, including net operating losses and capital losses, are reduced by a valuation allowance if it is “more likely than not” that some portion or all of the deferred tax assets will not be realized. In assessing the need for a valuation allowance, the Company considers all positive and negative evidence including: estimates of future taxable income, considering the feasibility of ongoing tax planning strategies, the realizability of tax loss carryforwards and the future reversal of existing temporary differences. Valuation allowances related to deferred tax assets can be impacted by changes to tax laws, changes to statutory tax rates and future taxable income levels. In the event the Company were to determine that it would not be able to realize all or a portion of its deferred tax assets in the future, the unrealizable amount would be charged to earnings in the period in which that determination is made. By contrast, if the Company were to determine that it would be able to realize deferred tax assets in the future in excess of the net carrying amounts, it would decrease the recorded valuation allowance through a favorable adjustment to earnings in the period in which that determination is made. The Company is subject to income tax in a number of locations, including many state and foreign jurisdictions. Significant judgment is required when calculating its worldwide provision for income taxes. The Company considers many factors when evaluating and estimating its tax positions and tax benefits, which may require periodic adjustments and which may not accurately anticipate actual outcomes. It is reasonably possible that the amount of the unrecognized benefit with respect to certain of the Company's unrecognized tax positions will significantly increase or decrease within the next 12 months. These changes may be the result of settlement of ongoing audits or final decisions in transfer pricing matters. The Company periodically assesses its liabilities and contingencies for all tax years still subject to audit based on the most current available information, which involves inherent uncertainty. For those tax positions where it is more likely than not that a tax benefit will be sustained, the Company has recorded the largest amount of tax benefit with a greater than 50% likelihood of being realized upon ultimate settlement with a taxing authority under the premise that the taxing authority has full knowledge of all relevant information. For those income tax positions where it is not more likely than not that a tax benefit will be sustained, no tax benefit has been recognized in the financial statements. The Company recognizes interest and penalties associated with income taxes as a component of income taxes in the Consolidated Statement of Operations. See Note Q, Income Taxes, for further discussion. RISK INSURANCE - To manage its insurance costs efficiently, the Company self insures for certain U.S. business exposures and generally has low deductible plans internationally. For domestic workers’ compensation, automobile and product liability (liability for alleged injuries associated with the Company’s products), the Company generally purchases insurance coverage only for severe losses that are unlikely, and these lines of insurance involve the most significant accounting estimates. While different self insured retentions, in the form of deductibles and self insurance through its captive insurance company, exist for each of these lines of insurance, the maximum self insured retention is set at no more than $5 million per occurrence. The process of establishing risk insurance reserves includes consideration of actuarial valuations that reflect the Company’s specific loss history, actual claims reported, and industry trends among statistical and other factors to estimate the range of reserves required. Risk insurance reserves are comprised of specific reserves for individual claims and additional amounts expected for development of these claims, as well as for incurred but not yet reported claims discounted to present value. The cash outflows related to risk insurance claims are expected to occur over a period of approximately 13 years. The Company believes the liabilities recorded for these U.S. risk insurance reserves, totaling $89 million and $96 million as of December 31, 2016, and January 2, 2016, respectively, are adequate. Due to judgments inherent in the reserve estimation process, it is possible the ultimate costs will differ from this estimate. WARRANTY - The Company provides product and service warranties which vary across its businesses. The types of warranties offered generally range from one year to limited lifetime, while certain products carry no warranty. Further, the Company sometimes incurs discretionary costs to service its products in connection with product performance issues. Historical warranty and service claim experience forms the basis for warranty obligations recognized. Adjustments are recorded to the warranty liability as new information becomes available. The Company believes the $103 million reserve for expected warranty claims as of December 31, 2016 is adequate, but due to judgments inherent in the reserve estimation process, including forecasting future product reliability levels and costs of repair as well as the estimated age of certain products submitted for claims, the ultimate claim costs may differ from the recorded warranty liability. The Company also establishes a reserve for product recalls on a product-specific basis during the period in which the circumstances giving rise to the recall become known and estimable for both company-initiated actions and those required by regulatory bodies. OFF-BALANCE SHEET ARRANGEMENT SYNTHETIC LEASES - The Company is a party to synthetic leasing programs for certain locations, including one of its major distribution centers. The programs qualify as operating leases for accounting purposes, such that only the monthly rent expense is recorded in the Consolidated Statements of Operations and the liability and value of the underlying assets are off-balance sheet. These lease programs are utilized primarily to reduce overall cost and to retain flexibility. The cash outflows for lease payments approximate the $1 million of rent expense recognized in fiscal 2016. As of December 31, 2016 the estimated fair value of assets and remaining obligations for these properties were $67 million and $58 million, respectively. CAUTIONARY STATEMENTS UNDER THE PRIVATE SECURITIES LITIGATION REFORM ACT OF 1995 Certain statements contained in this Annual Report on Form 10-K that are not historical, including but not limited to those regarding the Company’s ability to: (i) close the Newell transaction in the first quarter of 2017 with the transaction being approximately $0.20 to $0.25 accretive to the Company’s diluted earnings per share in 2017 (increasing to approximately $0.60 per diluted share by the third year) excluding approximately $125 to $140 million of restructuring and other deal related costs and approximately $40 million of non-cash inventory step-up charges, which in the aggregate will largely be incurred in the first two years; (ii) close the acquisition of the Craftsman brand in 2017 thereafter significantly increasing the availability of Craftsman branded products in previously underpenetrated channels, enhance innovation and add manufacturing jobs in the U.S. to support growth with the transaction being accretive to earnings, excluding charges, by approximately $0.10 to $0.15 per diluted share in year one, increasing to approximately $0.35 to $0.45 by year five and to approximately $0.70 to $0.80 by year ten; (iii) close the sale of the majority of its mechanical security businesses in the first quarter of 2017 generating net after-tax cash proceeds of approximately $700 million with the earning per share impact of the transaction being approximately $0.15 to $0.20 dilutive; (iv) achieve its long-term financial objectives including: 4-6% organic revenue growth; 10-12% total revenue growth; 10-12% earnings per share growth including acquisitions (6-8% organic earnings per share growth); free cash flow equal to, or exceeding, net income; sustain 10+ working capital turns; and doubling the size of the Company to $22 billion in revenue by 2022 while expanding the margin rate; (v) return approximately 50% of free cash flow to shareholders through a strong and growing dividend as well as opportunistically repurchasing shares and deploying the remaining 50% toward acquisitions; (vi) expand operating margin rates over the next 3 to 5 years; (vii) achieve full year 2017 diluted EPS of approximately $6.85 - $7.05 (excluding the estimated earnings per share impacts of the pending acquisitions and divestiture previously discussed); and (viii) achieve free cash flow conversion of approximately 100% in 2017 (collectively, the “Results”); are “forward-looking statements” and subject to risk and uncertainty. The Company’s ability to deliver the Results as described above is based on current expectations and involves inherent risks and uncertainties, including factors listed below and other factors that could delay, divert, or change any of them, and could cause actual outcomes and results to differ materially from current expectations. In addition to the risks, uncertainties and other factors discussed elsewhere herein, the risks, uncertainties and other factors that could cause or contribute to actual results differing materially from those expressed or implied in the forward-looking statements include, without limitation, those set forth under Item 1A Risk Factors hereto and any material changes thereto set forth in any subsequent Quarterly Reports on Form 10-Q, or those contained in the Company’s other filings with the Securities and Exchange Commission, and those set forth below. The Company’s ability to deliver the Results is dependent, or based, upon: (i) the Company’s ability to generate organic sales growth of 4% resulting in approximately $0.45 to $0.55 of diluted earnings per share accretion in 2017; (ii) the net impact from cost and productivity actions, partially offset by higher share count, resulting in approximately $0.45 to $0.50 of EPS accretion in 2017; (iii) commodity inflation approximating $50 to $55 million, and foreign exchange headwinds approximating $50 million, negatively impacting 2017 diluted earnings per share by $0.50 to $0.55; (iv) the Company’s tax rate and core restructuring charges in 2017 being relatively consistent with the 2016 levels; (v) the Company’s ability to capitalize on operational improvements in both Security Europe and North America; (vi) the Company’s ability to identify and realize cost and revenue synergies associated with acquisitions; (vii) successful identification of appropriate acquisition opportunities and completing them within time frames and at reasonable costs as well as the integration of completed acquisitions and reorganization of existing businesses; (viii) the continued acceptance of technologies used in the Company’s products and services; (ix) the Company’s ability to manage existing Sonitrol franchisee and Mac Tools relationships; (x) the Company’s ability to minimize costs associated with any sale or discontinuance of a business or product line, including any severance, restructuring, legal or other costs; (xi) the proceeds realized with respect to any business or product line disposals; (xii) the extent of any asset impairments with respect to any businesses or product lines that are sold or discontinued; (xiii) the success of the Company’s efforts to manage freight costs, steel and other commodity costs as well as capital expenditures; (xiv) the Company’s ability to sustain or increase prices in order to, among other things, offset or mitigate the impact of steel, freight, energy, non-ferrous commodity and other commodity costs and any inflation increases and/or currency impacts; (xv) the Company’s ability to generate free cash flow, maintain a conservative credit profile, and a strong investment grade rating; (xvi) the Company’s ability to identify and effectively execute productivity improvements and cost reductions, while minimizing any associated restructuring charges; (xvii) the Company’s ability to obtain favorable settlement of tax audits; (xviii) the ability of the Company to generate earnings sufficient to realize future income tax benefits during periods when temporary differences become deductible; (xiv) the continued ability of the Company to access credit markets under satisfactory terms; (xv) the Company’s ability to negotiate satisfactory payment terms under which the Company buys and sells goods, services, materials and products; (xvi) the Company’s ability to successfully develop, market and achieve sales from new products and services; and (xvii) the availability of cash to repurchase shares when conditions are right, as well as the Company's ability to effectively use equity derivative transactions to reduce the capital requirement associated with share repurchases. The Company’s ability to deliver the Results is also dependent upon: (i) the success of the Company’s marketing and sales efforts, including the ability to develop and market new and innovative products and solutions in both existing and new markets including emerging markets; (ii) the ability of the Company to maintain or improve production rates in the Company’s manufacturing facilities, respond to significant changes in product demand and fulfill demand for new and existing products; (iii) the Company’s ability to continue improvements in working capital through effective management of accounts receivable and inventory levels; (iv) the ability to continue successfully managing and defending claims and litigation; (v) the success of the Company’s efforts to mitigate adverse earnings impact resulting from any cost increases generated by, for example, increases in the cost of energy or significant Euro, Canadian Dollar, Chinese Renminbi or other currency fluctuations; (vi) the geographic distribution of the Company’s earnings; (vii) the commitment to, and success of, the Stanley Fulfillment System and SFS 2.0 and focusing its employees on the related five key pillars of Core SFS, functional transformation, digital excellence, commercial excellence and breakthrough innovation; and (viii) successful implementation with expected results of cost reduction programs. The Company’s ability to achieve the Results will also be affected by external factors. These external factors include: challenging global geopolitical and macroeconomic environment; the economic environment of emerging markets, particularly Latin America, Russia, China and Turkey; pricing pressure and other changes within competitive markets; the continued consolidation of customers particularly in consumer channels; inventory management pressures on the Company’s customers; the impact the tightened credit markets may have on the Company or its customers or suppliers; the extent to which the Company has to write off accounts receivable or assets or experiences supply chain disruptions in connection with bankruptcy filings by customers or suppliers; increasing competition; changes in laws, regulations and policies that affect the Company, including, but not limited to trade, monetary, tax and fiscal policies and laws; the timing and extent of any inflation or deflation; the impact of poor weather conditions on sales; currency exchange fluctuations; the impact of dollar/foreign currency exchange and interest rates on the competitiveness of products and the Company’s debt program; the strength of the U.S. and European economies; the extent to which world-wide markets associated with homebuilding and remodeling stabilize and rebound; the impact of events that cause or may cause disruption in the Company’s supply, manufacturing, distribution and sales networks such as war, terrorist activities, and political unrest; and recessionary or expansive trends in the economies of the world in which the Company operates. Unless required by applicable federal securities laws, the Company undertakes no obligation to publicly update or revise any forward-looking statements to reflect events or circumstances that may arise after the date hereof. Investors are advised, however, to consult any further disclosures made on related subjects in the Company's reports filed with the Securities and Exchange Commission. In addition to the foregoing, some of the agreements included as exhibits to this Annual Report on Form 10-K (whether incorporated by reference to earlier filings or otherwise) may contain representations and warranties, recitals or other statements that appear to be statements of fact. These agreements are included solely to provide investors with information regarding their terms and are not intended to provide any other factual or disclosure information about the Company or the other parties to the agreements. Representations and warranties, recitals, and other common disclosure provisions have been included in the agreements solely for the benefit of the other parties to the applicable agreements and often are used as a means of allocating risk among the parties. Accordingly, such statements (i) should not be treated as categorical statements of fact; (ii) may be qualified by disclosures that were made to the other parties in connection with the negotiation of the applicable agreements, which disclosures are not necessarily reflected in the agreement or included as exhibits hereto; (iii) may apply standards of materiality in a way that is different from what may be viewed as material by or to investors in or lenders to the Company; and (iv) were made only as of the date of the applicable agreement or such other date or dates as may be specified in the agreement and are subject to more recent developments. Accordingly, representations and warranties, recitals or other disclosures contained in agreements may not describe the actual state of affairs as of the date they were made or at any other time and should not be relied on by any person other than the parties thereto in accordance with their terms. Additional information about the Company may be found in this Annual Report on Form 10-K and the Company's other public filings, which are available without charge through the SEC's website at http://www.sec.gov.

<s>[INST] The following discussion and certain other sections of this Annual Report on Form 10K contain statements reflecting the Company’s views about its future performance that constitute “forwardlooking statements” under the Private Securities Litigation Reform Act of 1995. These forwardlooking statements are based on current expectations, estimates, forecasts and projections about the industry and markets in which the Company operates as well as management’s beliefs and assumptions. Any statements contained herein (including without limitation statements to the effect that Stanley Black & Decker, Inc. or its management “believes”, “expects”, “anticipates”, “plans” and similar expressions) that are not statements of historical fact should be considered forwardlooking statements. These statements are not guarantees of future performance and involve certain risks, uncertainties and assumptions that are difficult to predict. There are a number of important factors that could cause actual results to differ materially from those indicated by such forwardlooking statements. These factors include, without limitation, those set forth, or incorporated by reference, below under the heading “Cautionary Statements.” The Company does not intend to update publicly any forwardlooking statements whether as a result of new information, future events or otherwise. Strategic Objectives The Company continues to employ the following strategic framework: Continue organic growth momentum by utilizing the Stanley Fulfillment System ("SFS"), a now expanded program ("SFS 2.0") as a catalyst, diversifying toward higher growth, higher margin businesses, and increasing the relative weighting of emerging markets; Be selective and operate in markets where brand is meaningful, the value proposition is definable and sustainable through innovation and global cost leadership is achievable; and Pursue acquisitive growth on multiple fronts by building upon its existing global tools platform, expanding the Industrial platform in Engineered Fastening and Infrastructure, and consolidating the commercial electronic security industry. The Company is continuing to pursue a growth and acquisition strategy that involves industry, geographic and customer diversification to foster sustainable revenue, earnings and cash flow growth. The Company also remains focused on growing organically, including increasing its presence in emerging markets, with a goal of generating greater than 20% of annual revenues from those markets over time, and leveraging SFS 2.0 focused on upgrading innovation and digital capabilities while maintaining commercial and supply chain excellence, and funding required investments, in part, through functional transformation. Strategic acquisitions, combined with strong organic growth performance, will help enable the Company to reach its objective of doubling its size to $22 billion in revenue by 2022 while expanding the margin rate. Furthermore, the Company's strategic framework, including its focus on diversification, has driven continued improvements in financial performance. Sales outside the U.S. represented 48% of total net sales in 2016, up from 29% in 2002, while sales to U.S. and international home centers and mass merchants have decreased to 28% of total sales in 2016 compared to 31% in 2010. Execution of the above strategy has resulted in approximately $6.3 billion of acquisitions since 2002 (excluding the Black & Decker merger and recently announced acquisitions discussed below), several divestitures, improved efficiency in the supply chain and manufacturing operations, and enhanced investments in organic growth, enabled by cash flow generation and increased debt capacity. The Company’s longterm financial objectives are as follows: 46% organic revenue growth; 1012% total revenue growth; 1012% earnings per share growth including acquisitions (68% organic earnings per share growth); Free cash flow equal to, or exceeding, net income; and Sustain 10+ working capital turns. In terms of capital allocation, the Company remains committed, over time, to returning approximately 50% of free cash flow to shareholders through a strong and growing dividend as well as opportunistically repurchasing shares. The remaining free cash flow (approximately 50%) will be deployed towards acquisitions. The following represents recent examples of the Company executing its strategic objectives: Pending Acquisitions of Newell Tools and Craftsman Brand On October 12, 2016, the Company announced that it had entered into a definit [/INST] Positive. </s>

STANLEY BLACK & DECKER, INC.

2018-02-27

2017-12-30

ITEM 7. MANAGEMENT’S DISCUSSION AND ANALYSIS OF FINANCIAL CONDITION AND RESULTS OF OPERATIONS The financial and business analysis below provides information which the Company believes is relevant to an assessment and understanding of its consolidated financial position, results of operations and cash flows. This financial and business analysis should be read in conjunction with the Consolidated Financial Statements and related notes. All references to “Notes” in this Item 7 refer to the Notes to Consolidated Financial Statements included in Item 8 of this Annual Report. The following discussion and certain other sections of this Annual Report on Form 10-K contain statements reflecting the Company’s views about its future performance that constitute “forward-looking statements” under the Private Securities Litigation Reform Act of 1995. These forward-looking statements are based on current expectations, estimates, forecasts and projections about the industry and markets in which the Company operates as well as management’s beliefs and assumptions. Any statements contained herein (including without limitation statements to the effect that Stanley Black & Decker, Inc. or its management “believes,” “expects,” “anticipates,” “plans” and similar expressions) that are not statements of historical fact should be considered forward-looking statements. These statements are not guarantees of future performance and involve certain risks, uncertainties and assumptions that are difficult to predict. There are a number of important factors that could cause actual results to differ materially from those indicated by such forward-looking statements. These factors include, without limitation, those set forth, or incorporated by reference, below under the heading “Cautionary Statements.” The Company does not intend to update publicly any forward-looking statements whether as a result of new information, future events or otherwise. Strategic Objectives The Company continues to pursue a growth and acquisition strategy, which involves industry, geographic and customer diversification to foster sustainable revenue, earnings and cash flow growth, and employ the following strategic framework in pursuit of its vision to reach $22 billion in revenue by 2022 while expanding its margin rate ("22/22 Vision"): • Continue organic growth momentum by utilizing the SFS 2.0 operating system, diversifying toward higher-growth, higher-margin businesses, and increasing the relative weighting of emerging markets; • Be selective and operate in markets where brand is meaningful, the value proposition is definable and sustainable through innovation and global cost leadership is achievable; and • Pursue acquisitive growth on multiple fronts by building upon its existing global tools platform, expanding the Industrial platform in Engineered Fastening and Infrastructure, consolidating the commercial electronic security industry and pursuing adjacencies with sound industrial logic. Execution of the above strategy has resulted in approximately $8.9 billion of acquisitions since 2002 (excluding the Black & Decker merger and pending acquisition of the Nelson Fastener Systems industrial business discussed below), several divestitures, improved efficiency in the supply chain and manufacturing operations, and enhanced investments in organic growth, enabled by cash flow generation and increased debt capacity. In addition, the Company's continued focus on diversification and organic growth has resulted in improved financial results and an increase in its global presence. The Company also remains focused on increasing its presence in emerging markets, with a goal of generating greater than 20% of annual revenues from those markets over time, and leveraging SFS 2.0 to upgrade innovation and digital capabilities, maintain commercial and supply chain excellence, and focus on reducing SG&A, in part, through functional transformation. The Company’s long-term financial objectives are as follows: • 4-6% organic revenue growth; • 10-12% total revenue growth; • 10-12% total EPS growth (7-9% organically) excluding acquisition-related charges; • Free cash flow equal to, or exceeding, net income; and • Sustain 10+ working capital turns. In terms of capital allocation, the Company remains committed, over time, to returning approximately 50% of free cash flow to shareholders through a strong and growing dividend as well as opportunistically repurchasing shares. The remaining free cash flow (approximately 50%) will be deployed towards acquisitions. The following represents recent examples of the Company executing its strategic objectives: Acquisitions of Newell Tools and Craftsman® Brand In March 2017, the Company acquired the Tools business of Newell Brands ("Newell Tools") for approximately $1.84 billion and acquired the Craftsman® brand from Sears Holdings Corporation ("Sears Holdings") for an estimated cash purchase price of approximately $900 million on a discounted basis. The Newell Tools acquisition, which includes the industrial cutting, hand tool and power tool accessory brands Irwin® and Lenox®, enhances the Company’s position within the global tools & storage industry and broadens the Company’s product offerings and solutions to customers and end users, particularly within power tool accessories. The results of Newell Tools are being consolidated into the Company's Tools & Storage segment. The Craftsman brand acquisition provides the Company with the rights to develop, manufacture and sell Craftsman®-branded products in non-Sears Holdings channels. The Company plans to significantly increase the availability of Craftsman®-branded products to consumers in previously underpenetrated channels, enhance innovation, and add manufacturing jobs in the U.S. to support growth. The results of Craftsman are being consolidated into the Company's Tools & Storage segment. Pending Acquisition On December 22, 2017, the Company reached an agreement to purchase the industrial business of Nelson Fastener Systems ("Nelson") from the Doncasters Group, which excludes Nelson's automotive stud welding business, for approximately $440 million in cash. Nelson is complementary to the Company's product offerings, enhances its presence in the general industrial end markets, expands its portfolio of highly engineered fastening solutions and will deliver cost synergies. This transaction is expected to close in the first half of 2018 subject to customary closing conditions, including regulatory approvals. Refer to Note E, Acquisitions, for further discussion of the Company's acquisitions. Divestitures On February 22, 2017, the Company sold the majority of its mechanical security businesses, which included the commercial hardware brands of Best Access, phi Precision and GMT, for net proceeds of approximately $717 million. The sale allowed the Company to deploy capital in a more accretive and growth-oriented manner. Refer to Note T, Divestitures, for further discussion of the Company's divestitures. Certain Items Impacting Earnings Throughout MD&A, the Company has provided a discussion of the outlook and results both inclusive and exclusive of acquisition-related charges, gains on sales of businesses, and a one-time net tax charge related to the recently enacted U.S. tax legislation. The acquisition-related charges relate primarily to the Newell Tools and Craftsman brand acquisitions, while the gain on sales of businesses primarily related to the divestiture of the mechanical security businesses. The amounts and measures, including gross profit and segment profit, on a basis excluding such charges are considered relevant to aid analysis and understanding of the Company's results aside from the material impact of these charges. In addition, these measures are utilized internally by management to understand business trends, as once the anticipated cost synergies from these acquisitions, as applicable, are realized, such charges are not expected to recur. During 2017, the Company reported $156 million in pre-tax acquisition-related charges, which were comprised of the following: • $47 million reducing Gross Profit primarily pertaining to amortization of the inventory step-up adjustment for the Newell Tools acquisition; • $38 million in SG&A primarily for integration-related costs and consulting fees; • $58 million in Other, net primarily for deal transaction and consulting costs; and • $13 million in Restructuring charges pertaining to facility closures and employee severance. The Company also reported a $264 million pre-tax gain on sales of businesses in 2017, primarily relating to the previously discussed sale of the majority of the mechanical security businesses. The net tax benefit of the acquisition-related charges and gain on sales of businesses was $7 million. Furthermore, in the fourth quarter of 2017, the Company recorded a $24 million net tax charge relating to the recently enacted U.S. tax legislation. The acquisition-related charges, gain on sales of businesses, and one-time net tax charge resulted in a net after-tax gain of $91 million, or $0.59 per diluted share. Driving Further Profitable Growth by Fully Leveraging Our Core Franchises Each of the Company's franchises share common attributes: they have world-class brands and attractive growth characteristics, they are scalable and defensible, they can differentiate through innovation, and they are powered by our SFS 2.0 operating system. • The Tools & Storage business is the tool company to own, with strong brands, proven innovation, global scale, and a broad offering of power tools, hand tools, accessories, and storage & digital products across many channels in both developed and developing markets. • The Engineered Fastening business is a highly profitable, GDP+ growth business offering highly engineered, value-added innovative solutions with recurring revenue attributes and global scale. • The Security business, with its attractive recurring revenue, presents a significant margin accretion opportunity over the longer term and has historically provided a stable revenue stream through economic cycles, is a gateway into the digital world and an avenue to capitalize on rapid digital changes. While diversifying the business portfolio through strategic acquisitions remains important, management recognizes that the core franchises described above are important foundations that continue to provide strong cash flow and growth prospects. Management is committed to growing these businesses through innovative product development, brand support, continued investment in emerging markets and a sharp focus on global cost-competitiveness. Continuing to Invest in the Stanley Black & Decker Brands The Company has a strong portfolio of brands associated with high-quality products including STANLEY®, BLACK+DECKER®, DEWALT®, FLEXVOLT®, Irwin®, Lenox®, Craftsman®, Porter-Cable®, Bostitch®, Proto®, Mac Tools®, FACOM®, AeroScout®, Powers®, Lista®, SIDCHROME®, Vidmar®, SONITROL®, DIYZ® and GQ®. The STANLEY®, BLACK+DECKER® and DEWALT® brands are recognized as three of the world's great brands and are amongst the Company's most valuable assets. During 2017, the STANLEY® and DEWALT® brands had prominent signage in Major League Baseball (MLB) stadiums appearing in 47% of all MLB games. The Company has also maintained long-standing NASCAR and NHRA racing sponsorships, which provided brand exposure during 60 events in 2017 with the STANLEY®, DEWALT®, Irwin® and Mac Tools® brands. The Company has continued its ten-year alliance agreement with the Walt Disney World Resort® whereby STANLEY® logos are displayed on construction walls throughout the theme parks. Brand logos and/or products are featured in various attractions where they are seen by millions of visitors each year. The Company also advertises in the English Premier League, which is the number one soccer league in the world, featuring STANLEY®, BLACK+DECKER® and DEWALT® brands to a global audience. Starting in 2014, the Company became a sponsor for one of the world’s most popular football clubs, FC Barcelona, including player image rights, hospitality assets and stadium signage. The Company also advertises in televised Professional Bull Riding events, and sponsors three riders in 'The Built Ford Tough Series,' one of the fastest growing sports in the U.S. with over 48 million fans. Additionally, the Company sponsors Moto GP, the world's premiere motorcycle racing series reaching 150 million fans per year and airing in over 200 countries, and the Monster Yamaha Tech3 team. In 2017, STANLEY®, BLACK+DECKER® and DEWALT®, continued to partner with three of the fastest growing and thrilling extreme sports categories, BMX, Freeride Mountain Biking (MTB) and Skateboarding, supporting over 18 athletes from grass-roots to professional level, to drive the Company's generation Z marketing objectives. The above marketing initiatives highlight the Company's strong emphasis on brand building and support, which has resulted in more than 240 billion brand impressions annually and a steady improvement across the spectrum of brand awareness measures. The Company will continue allocating its brand and advertising spend wisely to capture the emerging digital landscape, whilst continuing to evolve proven marketing programs. The Stanley Fulfillment System and SFS 2.0 Over the years, the Company has successfully leveraged the Stanley Fulfillment System ("SFS") to drive efficiency throughout the supply chain and improve working capital performance in order to generate incremental free cash flow. Historically, SFS focused on streamlining operations, which helped reduce lead times, realize synergies during acquisition integrations, and mitigate material and energy price inflation. In 2015, the Company launched a refreshed and revitalized SFS operating system, entitled SFS 2.0, to drive from a more programmatic growth mentality to a true organic growth culture by more deeply embedding breakthrough innovation and commercial excellence into its businesses, and at the same time, becoming a significantly more digitally-enabled enterprise. The positive impacts of SFS 2.0 began in 2016, as evidenced by the launch of the FLEXVOLT® battery system in June 2016, and have continued into 2017 as demonstrated by the robust levels of organic growth and margin expansion. Additionally, in 2017, the Company opened the Stanley Engineered Fastening Breakthrough Innovation Center in Friedrichsdorf, Germany and launched the Futures Innovation Factory, housed in one of Boston's centers for start-up activity and advanced research. The Engineered Fastening facility is the first Europe-based Breakthrough Innovation Center within the Company and will serve as the Center of Excellence for Engineered Fastening's "FIRST Innovation" team focusing on bringing disruptive technologies to the fastening industry. The Futures Innovation Factory is dedicated to advancing technological innovation in STANLEY Security's business. This group focuses on uncovering disruptive business models and exploring technologies to transform and secure the world. The Company has made a significant commitment to SFS 2.0 and management believes that its success will be characterized by continued organic growth in the 4-6% range as well as expanded operating margin rates over the next 3 to 5 years as the Company leverages the growth and reduces structural SG&A levels. SFS 2.0 is transforming the Company by focusing its employees on the following five key pillars: • Digital Excellence uses the power of digital to contemporize, be disruptive, and create value throughout the Company's array of products, processes and business models. Digital Excellence means leveraging the power of emerging technologies across the Company's businesses to connected devices, the Internet of Things ("IoT"), and big data, as well as social and mobile, even more than what is being done today. Digital is penetrating all aspects of the organization and feeds into and supports the other elements of SFS 2.0 - enabling better asset efficiency through Core SFS, greater cost effectiveness via the Company's support functions, and improving revenues and margins via customer-facing opportunities. • Commercial Excellence is about how the Company becomes more effective and efficient in its customer-facing processes resulting in continued share gains and margin expansion throughout its businesses. The Company views Commercial Excellence as world-class execution across seven areas: customer insights, innovation and portfolio management, pricing and promotion, brand and marketing, sales force deployment and effectiveness, channel programs, and the customer experience. • Breakthrough Innovation is aimed at developing a culture to identify and commercialize market disrupting innovations, each with revenue generation potential greater than $100 million annually. The Company's focus remains on utilizing technologies to come up with major breakthroughs in the industries in which the Company operates which, when combined with its existing strong core innovation machine, will drive outsized share gains and margin expansion. • Core SFS / Industry 4.0, which targets cost and asset efficiency, remains as the foundation for the Company's operating system and has yielded significant advances in improving working capital turns and free cash flow generation. The five operating principles encompassed by Core SFS, which work in concert, include: sales and operations planning ("S&OP"), operational lean, complexity reduction, global supply management, and order-to-cash excellence. The Company plans to continue leveraging these principles to further enhance the Company's already strong asset efficiency performance. Additionally, the Company is making investments behind the adoption of Industry 4.0 and advancing the Company's capabilities surrounding the automation of manufacturing that includes IoT, cloud computing, Artificial Intelligence ("AI"), 3-D printing, robotics, and advanced materials, among others. • Functional Transformation takes a clean-sheet approach to redesigning the Company's key support functions such as Finance, HR, IT and others, which although highly effective, after roughly a hundred acquisitions are not as efficient as they can be based on external benchmarks. This presents the Company with an opportunity to realize the benefits from scale, reduce its SG&A as a percent of sales, and become a cost effectiveness enabler with the side benefit of helping to fund the other aspects of SFS 2.0 and to support margin expansion. These five pillars will serve as a powerful value driver in the years ahead, feeding the Company's new product innovation machine, embracing outstanding commercial and supply chain excellence, embedding digital into the various business models, and funding it with world-class functional efficiency. Taken together, these pillars will directly support achievement of the Company's long-term financial objectives, including its 22/22 Vision, and further enable its shareholder-friendly capital allocation approach, which has served the Company well in the past and will continue to do so in the future. Outlook for 2018 This outlook discussion is intended to provide broad insight into the Company’s near-term earnings and cash flow generation prospects. The Company expects 2018 diluted earnings per share to approximate $7.80 to $8.00 ($8.30 to $8.50 excluding acquisition-related charges), and free cash flow conversion, defined as free cash flow divided by net income, to approximate 100%. The 2018 outlook assumes organic sales growth of approximately 5% resulting in approximately $0.50 to $0.60 of diluted earnings per share accretion. Commodity inflation of approximately $150 million, partially offset by price actions, is expected to negatively impact diluted earnings per share by $0.25 to $0.30. The net impact of closed acquisitions, cost actions and improved productivity, partially offset by higher share count, is expected to result in approximately $0.45 to $0.50 of diluted earnings per share accretion. The tax rate is expected to approximate 18%, reflecting the recently enacted U.S. tax legislation, which would result in approximately $0.20 of diluted earnings per share accretion. Embedded core restructuring charges are expected to be approximately $50 million. RESULTS OF OPERATIONS Below is a summary of the Company’s operating results at the consolidated level, followed by an overview of business segment performance. Terminology: The term “organic” is utilized to describe results aside from the impacts of foreign currency fluctuations, acquisitions during their initial 12 months of ownership, and divestitures. This ensures appropriate comparability to operating results of prior periods. Net Sales: Net sales were $12.747 billion in 2017 compared to $11.407 billion in 2016, representing an increase of 12% fueled by strong organic growth of 7%. In addition, acquisitions, primarily Newell Tools, and foreign currency increased sales by 7% and 1%, respectively, while the impact of divestitures decreased sales by 3%. Tools & Storage net sales increased 19% compared to 2016 due to strong innovation-fueled organic growth of 9%, with solid growth across all regions, and acquisition growth of 10%. Industrial net sales increased 6% relative to 2016 due to a 6% increase in sales volume, which was mainly driven by strong automotive system shipments in the Engineered Fastening business and successful commercial actions and higher inspection and onshore pipeline project activity in the Infrastructure business. Net sales in the Security segment decreased 8% compared to 2016 primarily due to a 12% decline from the sale of the majority of the mechanical security businesses, which more than offset increases from organic growth and small bolt-on commercial electronic security acquisitions of 1% and 3%, respectively. Net sales were $11.407 billion in 2016, up 2% compared to $11.172 billion in 2015. Organic sales volume and pricing provided increases of 3% and 1%, respectively, partially offset by a 2% decrease due to negative impacts from foreign currency. In the Tools & Storage segment, net sales increased 5% compared to 2015 due to strong organic growth of 7%, driven by solid growth across all regions, bolstered by the launch of the FLEXVOLT® battery system, partially offset by foreign currency pressures of 2%. Industrial net sales declined 5% relative to 2015 primarily due to a 4% decrease in organic sales volume, which was mainly driven by weaker electronics volumes attributable to a major customer and pressured industrial volumes in the Engineered Fastening business as well as fewer off-shore pipeline projects and an ongoing difficult scrap steel market in the Infrastructure business. Excluding the impact of the electronics customer, the Industrial segment's organic growth was relatively flat in 2016. Net sales in the Security segment were relatively flat compared to 2015 as organic growth of 1% and small bolt-on electronic acquisitions of 1% were offset by foreign currency headwinds of 2%. Gross Profit: The Company reported gross profit of $4.778 billion, or 37.5% of net sales, in 2017 compared to $4.267 billion, or 37.4% of net sales, in 2016. Acquisition-related charges, which reduced gross profit, were $46.8 million in 2017, primarily relating to the amortization of the inventory step-up adjustment for the Newell Tools acquisition. Excluding acquisition-related charges, gross profit was 37.8% of net sales in 2017, compared to 37.4% in 2016. The year-over-year increase in the profit rate was attributable to volume leverage, productivity and cost control, which more than offset increasing commodity inflation and the impact from the mechanical security business divestiture. The Company reported gross profit of $4.267 billion, or 37.4% of net sales, in 2016 compared to $4.072 billion, or 36.4% of net sales, in 2015. The increase in the profit rate reflects favorable impacts from price, productivity, cost actions and commodity deflation, which more than offset unfavorable foreign currency. SG&A Expense: Selling, general and administrative expenses, inclusive of the provision for doubtful accounts (“SG&A”), were $2.980 billion, or 23.4% of net sales, in 2017 compared to $2.624 billion, or 23.0% of net sales, in 2016. Within SG&A, acquisition-related integration and consulting costs totaled $37.7 million in 2017. Excluding these charges, SG&A was 23.1% of net sales in 2017 compared to 23.0% in 2016, as investments in growth initiatives were partially offset by continued tight cost management. SG&A expenses were $2.624 billion, or 23.0% of net sales, in 2016 compared to $2.486 billion, or 22.3% of net sales in 2015. The increase in the SG&A rate was driven by investments in key SFS 2.0 initiatives moderated by continued tight management of costs. Distribution center costs (i.e. warehousing and fulfillment facility and associated labor costs) are classified within SG&A. This classification may differ from other companies who may report such expenses within cost of sales. Due to diversity in practice, to the extent the classification of these distribution costs differs from other companies, the Company’s gross margins may not be comparable. Such distribution costs classified in SG&A amounted to $280.1 million in 2017, $235.6 million in 2016 and $229.3 million in 2015. Corporate Overhead: The corporate overhead element of SG&A and gross profit, which is not allocated to the business segments, amounted to $216.8 million in 2017, $197.2 million in 2016 and $164.0 million in 2015. The year-over-year increases in both 2017 and 2016 were primarily due to growth investments in SFS 2.0 initiatives. Corporate overhead represented 1.7% of net sales in both 2017 and 2016 and 1.5% of net sales in 2015. Other, net: Other, net totaled $289.7 million in 2017. Excluding acquisition-related transaction costs of $58.2 million, Other, net totaled $231.5 million in 2017 compared to $196.9 million in 2016 and $222.0 million in 2015. The increase in 2017 compared to 2016 was primarily driven by higher amortization expense related to the 2017 acquisitions, negative impacts of foreign currency and a one-time environmental remediation charge of $17 million recorded in the first quarter of 2017 relating to a legacy Black & Decker site. The decrease in 2016 compared to 2015 was primarily driven by lower unfavorable impacts of foreign currency and lower amortization expense, partially offset by higher acquisition due diligence costs. Gain on Sales of Businesses: During 2017, the Company reported a $264.1 million pre-tax gain primarily relating to the sale of the majority of the mechanical security businesses, as previously discussed. Pension Settlement: Pension settlement of $12.2 million in 2017 reflects losses previously reported in Accumulated other comprehensive loss related to a non-U.S. pension plan for which the Company settled its obligation by purchasing an annuity and making lump sum payments to participants. Interest, net: Net interest expense in 2017 was $182.5 million compared to $171.3 million in 2016 and $165.2 million in 2015. The increase in net interest expense in 2017 versus 2016 was primarily due to the termination of interest rate swaps in June 2016 hedging the Company's fixed rate debt. The increase in net interest expense in 2016 versus 2015 was primarily due to amortization of debt issuance costs partially offset by an increase in interest income as a result of higher average cash balances during 2016. Income Taxes: The Company's effective tax rate was 19.7% in 2017, 21.3% in 2016, and 21.6% in 2015. The 2017 effective tax rate includes a one-time net charge of $23.6 million relating to the provisional amounts recorded in the fourth quarter of 2017 associated with the recently enacted U.S. tax legislation. The net charge primarily relates to the re-measurement of existing deferred tax balances and the one-time transition tax. Excluding the impact of the divestitures, acquisition-related charges, and the one-time net charge related to the recently enacted U.S. tax legislation, the effective tax rate was 20.0% in 2017. This effective tax rate differed from the U.S. statutory rate primarily due to a portion of the Company's earnings being realized in lower-taxed foreign jurisdictions, the favorable settlement of certain income tax audits, and the acceleration of certain tax credits resulting in a tax benefit. The effective tax rate in both 2016 and 2015 differed from the U.S. statutory rate primarily due to a portion of the Company's earnings being realized in lower-taxed foreign jurisdictions, adjustments to tax positions relating to undistributed foreign earnings, and reversals of valuation allowances for certain foreign and U.S. state net operating losses, which had become realizable. Business Segment Results The Company’s reportable segments are aggregations of businesses that have similar products, services and end markets, among other factors. The Company utilizes segment profit which is defined as net sales minus cost of sales and SG&A inclusive of the provision for doubtful accounts (aside from corporate overhead expense), and segment profit as a percentage of net sales to assess the profitability of each segment. Segment profit excludes the corporate overhead expense element of SG&A, other, net (inclusive of intangible asset amortization expense), restructuring charges and asset impairments, gains on sales of businesses, pension settlement, interest income, interest expense, and income tax expense. Corporate overhead is comprised of world headquarters facility expense, cost for the executive management team and the expense pertaining to certain centralized functions that benefit the entire Company but are not directly attributable to the businesses, such as legal and corporate finance functions. Refer to Note O, Restructuring Charges and Asset Impairments, and Note F, Goodwill and Intangible Assets, for the amount of net restructuring charges and asset impairments and intangible assets amortization expense, respectively, attributable to each segment. The Company classifies its business into three reportable segments, which also represent its operating segments: Tools & Storage, Industrial and Security. Tools & Storage: The Tools & Storage segment is comprised of the Power Tools & Equipment ("PTE") and Hand Tools, Accessories & Storage ("HTAS") businesses. The PTE business includes both professional and consumer products. Professional products include professional grade corded and cordless electric power tools and equipment including drills, impact wrenches and drivers, grinders, saws, routers and sanders, as well as pneumatic tools and fasteners including nail guns, nails, staplers and staples, concrete and masonry anchors. Consumer products include corded and cordless electric power tools sold primarily under the BLACK+DECKER® brand, lawn and garden products, including hedge trimmers, string trimmers, lawn mowers, edgers and related accessories, and home products such as hand-held vacuums, paint tools and cleaning appliances. The HTAS business sells hand tools, power tool accessories and storage products. Hand tools include measuring, leveling and layout tools, planes, hammers, demolition tools, clamps, vises, knives, saws, chisels and industrial and automotive tools. Power tool accessories include drill bits, screwdriver bits, router bits, abrasives, saw blades and threading products. Storage products include tool boxes, sawhorses, medical cabinets and engineered storage solution products. Tools & Storage net sales increased $1.393 billion, or 19%, in 2017 compared to 2016. Organic sales increased 9%, with strong organic growth in each of the regions, and acquisitions, primarily Newell, increased net sales by 10%. North America growth was supported by share gains from strong commercial execution and market-leading innovation, including sales from the FLEXVOLT® system, as well as a healthy U.S. tool market. Europe delivered above-market organic growth enabled by successful commercial actions and new product launches. The strong organic growth in emerging markets was supported by mid-price-point product releases, higher e-commerce volumes and strong commercial execution. Foreign currency increased sales by 1% while the sales of two small businesses in 2017 resulted in a 1% decrease. Segment profit amounted to $1.450 billion, or 16.4% of net sales, in 2017 compared to $1.267 billion, or 17.0% of net sales, in 2016. Excluding acquisition-related charges of $81.8 million, segment profit amounted to 17.3% of net sales in 2017 compared to 17.0% in 2016, as volume leverage and productivity more than offset growth investments and increased commodity inflation. Tools & Storage net sales increased $328.5 million, or 5%, in 2016 compared to 2015. Organic sales increased 7% primarily due to organic growth of 7% in North America, 8% in Europe, and 5% in emerging markets, while unfavorable effects of foreign currency decreased net sales by 2%. North America growth was fueled by share gains from the successful launch of the FLEXVOLT® system, core product innovation and strong commercial execution. Europe achieved above-market organic growth leveraging the benefits of new products, growth investments and an expanded retail footprint. Growth in emerging markets, led by Latin America and Asia, was driven by successful commercial execution surrounding mid-price point products and regional pricing actions. Segment profit amounted to $1.267 billion, or 17.0% of net sales, in 2016 compared to $1.170 billion, or 16.4% of net sales, in 2015. The increase in segment profit year-over-year was primarily driven by volume leverage, price, productivity, cost management and lower commodity prices, which more than offset currency and growth investments. Industrial: The Industrial segment is comprised of the Engineered Fastening and Infrastructure businesses. The Engineered Fastening business primarily sells engineered fastening products and systems designed for specific applications. The product lines include blind rivets and tools, blind inserts and tools, drawn arc weld studs and systems, engineered plastic and mechanical fasteners, self-piercing riveting systems, precision nut running systems, micro fasteners, and high-strength structural fasteners. The Infrastructure business consists of the Oil & Gas and Hydraulics businesses. The Oil & Gas business sells and rents custom pipe handling, joint welding and coating equipment used in the construction of large and small diameter pipelines, and provides pipeline inspection services. The Hydraulics business sells hydraulic tools and accessories. Industrial net sales increased $105.7 million, or 6%, in 2017 compared with 2016, due to a 6% increase in organic sales. Engineered Fastening organic sales increased 4% as strong automotive system shipments and volume growth in general industrial markets more than offset lower volumes within electronics. Infrastructure organic sales increased 12% due to successful commercial actions and improved market conditions in the Hydraulics business and higher inspection and North American onshore pipeline project activity in the Oil & Gas business. Segment profit totaled $352.3 million, or 18.1% of net sales, in 2017 compared to $304.4 million, or 16.5% of net sales, in 2016. The year-over-year increase in segment profit rate was primarily due to volume leverage, productivity gains and cost control. Industrial net sales decreased $97.9 million, or 5%, in 2016 compared with 2015, due to a 4% decline in organic sales and a 1% decrease from foreign currency. Engineered Fastening organic revenues declined 4% primarily due to weaker electronics volumes attributable to a major customer and pressured industrial volumes, which more than offset higher automotive growth. Excluding the impact of the major electronics customer, Engineered Fastening's organic sales were slightly positive in 2016. Infrastructure organic revenues decreased 5% due to a slowdown in Oil & Gas off-shore project activity as well as ongoing difficult scrap steel market conditions in the Hydraulics business. Segment profit totaled $304.4 million, or 16.5% of net sales, in 2016 compared to $339.9 million, or 17.5% of net sales, in 2015. The year-over-year decrease in segment profit rate was primarily driven by lower volumes and currency, which more than offset productivity gains and cost control actions. Security: The Security segment is comprised of the Convergent Security Solutions ("CSS") and the Mechanical Access Solutions ("MAS") businesses. The CSS business designs, supplies and installs commercial electronic security systems and provides electronic security services, including alarm monitoring, video surveillance, fire alarm monitoring, systems integration and system maintenance. Purchasers of these systems typically contract for ongoing security systems monitoring and maintenance at the time of initial equipment installation. The business also sells healthcare solutions, which include asset tracking, infant protection, pediatric protection, patient protection, wander management, fall management, and emergency call products. The MAS business primarily sells automatic doors. Security net sales decreased $158.6 million, or 8%, in 2017 compared to 2016, primarily due to a 12% decline from the sale of the majority of the mechanical security businesses. Organic sales and small bolt-on commercial electronic security acquisitions provided increases of 1% and 3%, respectively. North America organic sales increased 2% on higher installation volumes within the commercial electronic security and automatic doors businesses and growth within healthcare. Europe organic growth was relatively flat as strength within the U.K. and the Nordics was mostly offset by anticipated ongoing weakness in France. Segment profit amounted to $212.3 million, or 11.0%, of net sales, in 2017 compared to $269.2 million, or 12.8% of net sales, in 2016. Excluding acquisition-related charges of $2.0 million, segment profit amounted to 11.1% of net sales in 2017 compared to 12.8% in 2016. The decrease in segment profit year-over-year reflects an approximate 90 basis point decline related to the sale of the mechanical security businesses, as well as impacts from mix and funding growth investments. Security net sales increased $4.5 million in 2016 compared to 2015. Organic sales and small bolt-on electronic acquisitions each provided increases of 1%, while foreign currency decreased net sales by 2%. Europe posted positive organic growth of 2% on higher installation revenues, while North America declined 1% organically primarily due to lower sales volume within the commercial electronic security business partially offset by higher prices and volumes in the automatic doors business. The Security segment's organic growth in 2016 was also bolstered by double-digit growth within the emerging markets on easing comparables. Segment profit amounted to $269.2 million, or 12.8% of net sales, in 2016 compared to $239.6 million, or 11.4% of net sales, in 2015. The increase in segment profit year-over-year was mainly due to improved operating performance in both North America and Europe, driven by a more disciplined assessment of new commercial opportunities, improved field productivity, and cost actions, which in the aggregate more than offset currency headwinds. RESTRUCTURING ACTIVITIES A summary of the restructuring reserve activity from December 31, 2016 to December 30, 2017 is as follows: During 2017, the Company recognized net restructuring charges and asset impairments of $51.5 million. This amount reflects $40.6 million of net severance charges associated with the reduction of 1,584 employees and $10.9 million of facility closure and other restructuring costs. The Company expects the 2017 actions to result in annual net cost savings of approximately $45 million by the end of 2018. The majority of the $23.2 million of reserves remaining as of December 30, 2017 is expected to be utilized within the next twelve months. During 2016, the Company recognized net restructuring charges and asset impairments of $49.0 million. This amount reflects $27.3 million of net severance charges associated with the reduction of 1,326 employees. The Company also recognized $11.0 million of facility closure costs and $10.7 million of asset impairments. The 2016 actions resulted in annual net cost savings of approximately $20 million in each segment in 2017. During 2015, the Company recognized net restructuring charges and asset impairments of $47.6 million. Net severance charges totaled $32.7 million relating to the reduction of approximately 1,300 employees. The Company also recognized $5.1 million of facility closure costs and $9.8 million of asset impairments. The 2015 actions resulted in annual net cost savings of approximately $40 million in 2016, primarily in the Industrial and Security segments. Segments: The $52 million of net restructuring charges for the year ended December 30, 2017 includes: $25 million of net charges pertaining to the Tools & Storage segment; $8 million of net charges pertaining to the Industrial segment; $18 million of net charges pertaining to the Security segment; and $1 million of net charges pertaining to Corporate. The anticipated annual net cost savings of approximately $45 million related to the 2017 restructuring actions include: $20 million pertaining to the Tools & Storage segment; $8 million pertaining to the Industrial segment; $16 million relating to the Security segment; and $1 million relating to Corporate. FINANCIAL CONDITION Liquidity, Sources and Uses of Capital: The Company’s primary sources of liquidity are cash flows generated from operations and available lines of credit under various credit facilities. The Company's cash flows are presented on a consolidated basis and include cash flows from discontinued operations in 2015. Operating Activities: Cash flows from operations were $1.419 billion in 2017 compared to $1.485 billion in 2016. The year-over-year decrease was primarily driven by higher cash outflows from working capital (accounts receivable, inventory, accounts payable and deferred revenue) to support outsized organic growth in the Tools & Storage segment, partially offset by higher earnings excluding the impacts of non-cash items (gain on sales of businesses and amortization of inventory step-up). In 2016, cash flows from operations were $1.485 billion compared to $1.182 billion in 2015, representing a $303 million increase. The year-over-year increase was primarily due to higher earnings and cash flows from working capital. In 2015, cash flows from operations were $1.182 billion, a $114 million decrease compared to $1.296 billion in 2014. The year-over-year decrease was primarily due to higher outflows from working capital as a result of lower than expected sales volumes in the fourth quarter of 2015. Free Cash Flow: Management considers free cash flow an important indicator of its liquidity, as well as its ability to fund future growth and provide dividends to shareowners. Free cash flow does not include deductions for mandatory debt service, other borrowing activity, discretionary dividends on the Company’s common stock and business acquisitions, among other items. Investing Activities: Cash flows used in investing activities totaled $2.289 billion in 2017, primarily due to business acquisitions of $2.601 billion, mainly related to the Newell Tools and Craftsman acquisitions, and capital and software expenditures of $443 million, partially offset by net cash proceeds from sales of businesses of $757 million. The increase in capital and software expenditures in 2017 was due to growth in the Company's supply chain and investments related to functional transformation. Cash flows used in investing activities in 2016 totaled $284 million, which primarily consisted of capital and software expenditures of $347 million and business acquisitions of $59 million, partially offset by $105 million of cash proceeds related to net investment hedge settlements, which were primarily driven by the significant fluctuations in foreign currency rates during 2016 associated with foreign exchange contracts hedging a portion of the Company's pound sterling, Canadian dollar, and Euro denominated net investments. Cash flows used in investing activities in 2015 totaled $205 million, which primarily consisted of capital and software expenditures of $311 million partially offset by $138 million of cash proceeds related to net investment hedge settlements, which were primarily driven by the significant fluctuations in foreign currency rates during 2015 associated with foreign exchange contracts hedging a portion of the Company's pound sterling and Canadian dollar denominated net investments. Financing Activities: Cash flows provided by financing activities totaled $295 million in 2017 mainly due to $726 million in proceeds from the issuance of equity units, partially offset by $363 million of cash dividend payments. The higher dividend payments in 2017 were driven by the increase in quarterly dividends per common share to $0.63. The dividend paid in December 2017 to shareholders of record extended the Company's record for the longest consecutive annual and quarterly dividend payments among industrial companies listed on the New York Stock Exchange. Cash flows used in financing activities totaled $433 million in 2016 primarily due to share repurchases of $374 million, cash payments for dividends of $331 million, and the settlement of the October 2014 forward share purchase contract for $147 million, partially offset by proceeds from issuances of common stock of $419 million, which mainly related to the issuance of 3.5 million shares associated with the settlement of the 2013 Equity Purchase Contracts. Cash flows used in financing activities in 2015 totaled $876 million, primarily due to the repurchase of 6.6 million common shares for $650 million and cash payments for dividends of $320 million, partially offset by proceeds from issuances of common stock of $164 million, which mainly related to the exercises of stock options. The Company also paid approximately $34 million in December 2015 to purchase the remaining 40% interest in GQ. Fluctuations in foreign currency rates positively impacted cash by $81 million in 2017 due to the weakening of the U.S. Dollar against the Company's other currencies. Foreign currency negatively impacted cash by $102 million and $133 million in 2016 and 2015, respectively, due to the strengthening of the U.S. Dollar during those years. Refer to Note H, Long-Term Debt and Financing Arrangements, and Note J, Capital Stock, for further discussion regarding the Company's debt and equity arrangements. Credit Ratings and Liquidity: The Company maintains strong investment grade credit ratings from the major U.S. rating agencies on its senior unsecured debt (S&P A, Fitch A-, Moody's Baa1), as well as its commercial paper program (S&P A-1, Fitch, Moody's P-2). There have been no changes to any of the ratings during 2017. Failure to maintain strong investment grade rating levels could adversely affect the Company’s cost of funds, liquidity and access to capital markets, but would not have an adverse effect on the Company’s ability to access its existing committed credit facilities. Cash and cash equivalents totaled $638 million as of December 30, 2017, comprised of $54 million in the U.S. and $584 million in foreign jurisdictions. As of December 31, 2016, cash and cash equivalents totaled $1.132 billion, which was predominantly held in foreign jurisdictions. As a result of the Tax Cuts and Jobs Act signed into law on December 22, 2017 (the "Act"), the Company recorded a provisional tax liability of $466 million for the one-time transition tax associated with unremitted foreign earnings and profits, which includes $5 million of foreign withholding taxes that will become payable upon distribution. The Company is still analyzing certain aspects of the Act and refining its estimate, which may change materially due to changes in interpretations and assumptions the Company has made, new guidance that may be issued in the future, and actions the Company may take as a result of the new legislation. The Act permits a U.S. company to elect to pay the net tax liability interest-free over a period of up to eight years. See the Contractual Obligations table below for the estimated amounts due by period. The Company has considered the implications of paying the required one-time transition tax, and believes it will not have a material impact on its liquidity. The Company is continuing to evaluate the impact of remitting foreign earnings and profits and may adjust its provisional estimate, upon completion of its evaluation, in its Consolidated Financial Statements within the measurement period provided for in Staff Accounting Bulletin No. 118 (“SAB 118”). Refer to Note A, Significant Accounting Policies, for further discussion of SAB 118, and Note Q, Income Taxes, for further discussion of the impacts of the Act. In May 2017, the Company issued 7,500,000 Equity Units with a total notional value of $750.0 million ("$750 million Equity Units"). Each unit has a stated amount of $100 and initially consisted of a three-year forward stock purchase contract for the purchase of a variable number of shares of common stock, on May 15, 2020, for a price of $100, and a 10% beneficial ownership interest in one share of 0% Series C Cumulative Perpetual Convertible Preferred Stock, without par, with a liquidation preference of $1,000 per share ("Series C Preferred Stock"). The Company received approximately $727.5 million in cash proceeds from the $750 million Equity Units, net of underwriting costs and commissions, before offering expenses, and issued 750,000 shares of Series C Preferred Stock, recording $750.0 million in preferred stock. The proceeds were used for general corporate purposes, including repayment of short-term borrowings. The Company also used $25.1 million of the proceeds to enter into capped call transactions utilized to hedge potential economic dilution. In January 2017, the Company amended its existing $2.0 billion commercial paper program to increase the maximum amount of notes authorized to be issued to $3.0 billion and to include Euro denominated borrowings in addition to U.S. Dollars. As of December 30, 2017, the Company had no borrowings outstanding against the $3.0 billion commercial paper program. At December 31, 2016, the Company had no borrowings outstanding against the Company’s $2.0 billion commercial paper program. The Company has a five-year $1.75 billion committed credit facility (the “Credit Agreement”). Borrowings under the Credit Agreement may include U.S. Dollars up to the $1.75 billion commitment or in Euro or Pounds Sterling subject to a foreign currency sub-limit of $400.0 million and bear interest at a floating rate dependent upon the denomination of the borrowing. Repayments must be made on December 18, 2020 or upon an earlier termination date of the Credit Agreement, at the election of the Company. The Credit Agreement is designated to be a liquidity back-stop for the Company's $3.0 billion U.S. Dollar and Euro commercial paper program. As of December 30, 2017 and December 31, 2016, the Company has not drawn on this commitment. The Company also has a 364-day $1.25 billion committed credit facility (the "2017 Credit Agreement") executed in December 2017. The 2017 Credit Agreement consists of a $1.25 billion revolving credit loan and a sub-limit of an amount equal to the Euro equivalent of $400 million for swing line advances. Borrowings under the 2017 Credit Agreement may be made in U.S. Dollars or Euros, pursuant to the terms of the agreement, and bear interest at a floating rate dependent on the denomination of the borrowing. Repayments must be made by December 19, 2018 or upon an earlier termination of the 2017 Credit Agreement at the election of the Company. The Company also has the option at the termination date to convert all advances into a term loan provided certain requirements are met. The 2017 Credit Agreement serves as a liquidity back-stop for the Company’s $3.0 billion U.S. Dollar and Euro commercial paper program. As of December 30, 2017, the Company had not drawn on this commitment. In January 2017, the Company executed a 364-day $1.3 billion committed credit facility which consisted of a $1.3 billion revolving credit loan and a sub-limit of an amount equal to the Euro equivalent of $400 million for swing line advances. Borrowings under this credit agreement could be made in U.S. Dollars or Euros, pursuant to the terms of the agreement, and bore interest at a floating rate dependent on the denomination of the borrowing. This credit agreement was terminated in December 2017 at the election of the Company. In addition, the Company has short-term lines of credit that are primarily uncommitted, with numerous banks, aggregating $624.9 million, of which $429.8 million was available at December 30, 2017. Short-term arrangements are reviewed annually for renewal. At December 30, 2017, the aggregate amount of committed and uncommitted, long- and short-term lines was $3.6 billion. At December 30, 2017, $5.3 million was recorded as short-term borrowings and amounts outstanding against uncommitted lines excluding commercial paper. In addition, $195.1 million of the short-term credit lines was utilized primarily pertaining to outstanding letters of credit for which there are no required or reported debt balances. The weighted-average interest rates on U.S. Dollar denominated short-term borrowings, primarily commercial paper, for the fiscal years ended December 30, 2017 and December 31, 2016 were 1.2% and 0.6%, respectively. The weighted-average interest rates on Euro denominated short-term borrowings, primarily commercial paper, for fiscal year ended December 30, 2017 was negative 0.3%. In March 2015, the Company entered into a forward share purchase contract with a financial institution counterparty for 3,645,510 shares of common stock. The contract obligates the Company to pay $350.0 million, plus an additional amount related to the forward component of the contract. In November 2016, the Company amended the settlement date to April 2019, or earlier at the Company's option. In October 2014, the Company entered into a forward share purchase contract on its common stock. The contract obligated the Company to pay $150.0 million, plus an additional amount related to the forward component of the contract, to the financial institution counterparty not later than October 2016, or earlier at the Company’s option, for the 1,603,822 shares purchased. In October 2016, the Company physically settled the contract, receiving 1,603,822 shares for a settlement amount of $147.4 million. On February 10, 2015, the Company net-share settled 9.1 million of the 12.2 million capped call options on its common stock and received 911,077 shares using an average reference price of $96.46 per common share. Additionally, the Company purchased 3,381,162 shares directly from the counterparties participating in the net-share settlement of the capped call options for $326.1 million, equating to an average price of $96.46 per share. In February 2016, the Company net-share settled the remaining 3.1 million capped call options on its common stock and received 293,142 shares using an average reference price of $94.34 per common share. Additionally, the Company purchased 1,316,858 shares directly from the counterparty participating in the net-share settlement for $124.2 million. The Company also repurchased 2,446,287 shares of common stock in February 2016 for $230.9 million, equating to an average price of $94.34. In December 2013, the Company issued $400.0 million 5.75% fixed-to-floating rate junior subordinated debentures maturing December 15, 2053 (“2053 Junior Subordinated Debentures”) that bear interest at a fixed rate of 5.75% per annum, up to, but excluding December 15, 2018. From and including December 15, 2018, the 2053 Junior Subordinated Debentures will bear interest at an annual rate equal to three-month LIBOR plus 4.304%. The debentures subordination and long tenor provides significant credit protection measures for senior creditors and as a result, the debentures were awarded a 50% equity credit by S&P and Fitch, and 25% equity credit by Moody's. The net proceeds from the offering were primarily used to repay commercial paper borrowings. In December 2013, the Company issued 3,450,000 Equity Units (the “Equity Units”), each with a stated value of $100. The Equity Units were initially comprised of a 1/10, or 10%, undivided beneficial ownership in a $1,000 principal amount 2.25% junior subordinated note due 2018 (the “2018 Junior Subordinated Note”) and a forward common stock purchase contract (the “Equity Purchase Contract”). The Company received approximately $334.7 million in cash proceeds from the Equity Units, net of underwriting discounts and commissions, before offering expenses, and recorded $345.0 million for the 2018 Junior Subordinated Note in long-term debt. The $345.0 million aggregate principal amount is due on November 17, 2018, and is included in Current maturities of long-term debt as of December 30, 2017, on the Consolidated Balance Sheets. The proceeds from the Equity Units were used primarily to repay commercial paper borrowings. The Company also used $9.7 million of the proceeds to enter into capped call transactions utilized to hedge potential economic dilution associated with the common shares issuable upon settlement of the Equity Purchase Contracts. The Company successfully remarketed the 2018 Junior Subordinated Note on November 17, 2016 ("Subordinated Notes"), which resulted in the interest rate being reset, effective on the settlement date, to a rate of 1.622% per annum, payable semi-annually in arrears on May 17 and November 17 of each year, commencing May 17, 2017 and maturing on November 17, 2018. Following settlement of the remarketing, the Subordinated Notes remain the Company’s direct, unsecured general obligations and are subordinated and junior in right of payment to the Company’s existing and future senior indebtedness, but the Subordinated Notes rank senior in right of payment to specified junior indebtedness on the terms and to the extent set forth in the indentures governing such junior indebtedness. In addition, the Company settled all Equity Purchase Contracts on November 17, 2016 by issuing 3,504,165 common shares and receiving $345.0 million in cash proceeds, generated from the remarketing described above. Lastly, in October and November 2016, the Company’s capped call options on its common stock expired and were net-share settled resulting in the Company receiving 418,234 shares of common stock. In November 2010, the Company issued 6,325,000 Convertible Preferred Units (the “Convertible Preferred Units”), each with a stated amount of $100. The Convertible Preferred Units were comprised of a 1/10, or 10%, undivided beneficial ownership in a $1,000 principal amount junior subordinated note (the “Note”) and a Purchase Contract (the “Purchase Contract”) obligating holders to purchase one share of the Company’s 4.75% Series B Perpetual Cumulative Convertible Preferred Stock (the “Convertible Preferred Stock”). The Company successfully remarketed the Notes on November 5, 2015, which resulted in the interest rate on the notes being reset, effective on the November 17, 2015 settlement date of the remarketing, to a rate of 2.45% per annum, payable semi-annually in arrears on May 17 and November 17 of each year, commencing May 17, 2016. Following settlement of the remarketing, the Notes remain the Company’s direct, unsecured general obligations subordinated and junior in right of payment to the Company’s existing and future senior indebtedness, but the Notes rank senior in right of payment to specified junior indebtedness on the terms and to the extent set forth in the indentures governing such junior indebtedness. In addition, the Company settled the Purchase Contracts on November 17, 2015 by issuing 6.3 million shares of Convertible Preferred Stock and receiving cash proceeds of $632.5 million. On November 18, 2015, the Company informed holders that it would redeem all outstanding shares of Convertible Preferred Stock on December 24, 2015 (the “Redemption Date”) at $100.49 per share in cash (the “Redemption Price”), which was equal to the liquidation preference of $100 per share of Convertible Preferred Stock, plus all accrued and unpaid dividends thereon to, but excluding, the Redemption Date. The Company redeemed the Convertible Preferred Stock and settled all conversions on December 24, 2015 by paying cash for the $100 par value per share of Convertible Preferred Stock, or $632.5 million in total, and issuing 2.9 million common shares for the excess value of the conversion feature above the $100 face value per share of Convertible Preferred Stock. The $632.5 million principal amount of the Notes is due November 17, 2018, and is included in Current maturities of long-term debt as of December 30, 2017, on the Consolidated Balance Sheets. Refer to Note H, Long-Term Debt and Financing Arrangements, and Note J, Capital Stock, for further discussion regarding the Company's debt and equity arrangements. Contractual Obligations: The following table summarizes the Company’s significant contractual obligations and commitments that impact its liquidity: (a) Future payments on long-term debt encompass all payments related to aggregate debt maturities, excluding certain fair value adjustments included in long-term debt, as discussed further in Note H, Long-Term Debt and Financing Arrangements. (b) Future interest payments on long-term debt reflect the applicable fixed interest rate or variable rate for floating rate debt in effect at December 30, 2017. (c) Inventory purchase commitments primarily consist of open purchase orders to purchase raw materials, components, and sourced products. (d) Future cash flows on derivative instruments reflect the fair value and accrued interest as of December 30, 2017. The ultimate cash flows on these instruments will differ, perhaps significantly, based on applicable market interest and foreign currency rates at their maturity. (e) In March 2015, the Company entered into a forward share purchase contract with a financial institution counterparty which obligates the Company to pay $350 million, plus an additional amount related to the forward component of the contract. In November 2016, the Company amended the final settlement date to April 2019, or earlier at the Company's option. See Note J, Capital Stock, for further discussion. (f) This amount principally represents contributions either required by regulations or laws or, with respect to unfunded plans, necessary to fund current benefits. The Company has not presented estimated pension and post-retirement funding beyond 2018 as funding can vary significantly from year to year based upon changes in the fair value of the plan assets, actuarial assumptions, and curtailment/settlement actions. (g) These amounts represent future contract adjustment payments to holders of the Company's 2020 Purchase Contracts. See Note J, Capital Stock, for further discussion. (h) The Company acquired the Craftsman® brand from Sears Holdings in March 2017. As part of the purchase price, the Company is obligated to pay $250 million in March 2020. See Note E, Acquisitions, for further discussion. (i) Provisional income tax liability for the one-time deemed repatriation tax on unremitted foreign earnings and profits, including foreign withholding taxes of $5 million which will become payable upon distribution. To the extent the Company can reliably determine when payments will occur, the related amounts will be included in the table above. However, due to the high degree of uncertainty regarding the timing of potential future cash flows associated with the contingent consideration liability of $114 million related to the Craftsman acquisition and the unrecognized tax liabilities of $458 million at December 30, 2017, the Company is unable to make a reliable estimate of when (if at all) these amounts may be paid. Refer to Note E, Acquisitions, and Note Q, Income Taxes, for further discussion. Payments of the above contractual obligations (with the exception of payments related to debt principal, the forward stock purchase contract, contract adjustment fees, the March 2020 purchase price, and tax obligations) will typically generate a cash tax benefit such that the net cash outflow will be lower than the gross amounts summarized above. Other Significant Commercial Commitments: Short-term borrowings, long-term debt and lines of credit are explained in detail within Note H, Long-Term Debt and Financing Arrangements. MARKET RISK Market risk is the potential economic loss that may result from adverse changes in the fair value of financial instruments, currencies, commodities and other items traded in global markets. The Company is exposed to market risk from changes in foreign currency exchange rates, interest rates, stock prices, bond prices and commodity prices, amongst others. Exposure to foreign currency risk results because the Company, through its global businesses, enters into transactions and makes investments denominated in multiple currencies. The Company’s predominant currency exposures are related to the Euro, Canadian Dollar, British Pound, Australian Dollar, Brazilian Real, Argentine Peso, Chinese Renminbi (“RMB”) and the Taiwan Dollar. Certain cross-currency trade flows arising from both trade and affiliate sales and purchases are consolidated and netted prior to obtaining risk protection through the use of various derivative financial instruments which may include: purchased basket options, purchased options, collars, cross-currency swaps and currency forwards. The Company is thus able to capitalize on its global positioning by taking advantage of naturally offsetting exposures and portfolio efficiencies to reduce the cost of purchasing derivative protection. At times, the Company also enters into foreign exchange derivative contracts to reduce the earnings and cash flow impact of non-functional currency denominated receivables and payables, primarily for affiliate transactions. Gains and losses from these hedging instruments offset the gains or losses on the underlying net exposures. Management determines the nature and extent of currency hedging activities, and in certain cases, may elect to allow certain currency exposures to remain un-hedged. The Company may also enter into cross-currency swaps and forward contracts to hedge the net investments in certain subsidiaries and better match the cash flows of operations to debt service requirements. Management estimates the foreign currency impact from its derivative financial instruments outstanding at the end of 2017 would have been an incremental pre-tax loss of approximately $50 million based on a hypothetical 10% adverse movement in all net derivative currency positions. The Company follows risk management policies in executing derivative financial instrument transactions, and does not use such instruments for speculative purposes. The Company generally does not hedge the translation of its non-U.S. dollar earnings in foreign subsidiaries, but may choose to do so in certain instances in future periods. As mentioned above, the Company routinely has cross-border trade and affiliate flows that cause an impact on earnings from foreign exchange rate movements. The Company is also exposed to currency fluctuation volatility from the translation of foreign earnings into U.S. dollars and the economic impact of foreign currency volatility on monetary assets held in foreign currencies. It is more difficult to quantify the transactional effects from currency fluctuations than the translational effects. Aside from the use of derivative instruments, which may be used to mitigate some of the exposure, transactional effects can potentially be influenced by actions the Company may take. For example, if an exposure occurs from a European entity sourcing product from a U.S. supplier it may be possible to change to a European supplier. Management estimates the combined translational and transactional impact, on pre-tax earnings, of a 10% overall movement in exchange rates is approximately $147 million, or approximately $0.77 per diluted share. In 2017, translational and transactional foreign currency fluctuations negatively impacted pre-tax earnings by approximately $12.4 million and diluted earnings per share by approximately $0.07. The Company’s exposure to interest rate risk results from its outstanding debt and derivative obligations, short-term investments, and derivative financial instruments employed in the management of its debt portfolio. The debt portfolio including both trade and affiliate debt, is managed to achieve capital structure targets and reduce the overall cost of borrowing by using a combination of fixed and floating rate debt as well as interest rate swaps, and cross-currency swaps. The Company’s primary exposure to interest rate risk comes from its floating rate debt in the U.S. which is based on LIBOR rates. At December 30, 2017, the impact of a hypothetical 10% increase in the interest rates associated with the Company’s floating rate debt instruments would have an immaterial effect on the Company’s financial position and results of operations. The Company has exposure to commodity prices in many businesses, particularly brass, nickel, resin, aluminum, copper, zinc, steel, and energy used in the production of finished goods. Generally, commodity price exposures are not hedged with derivative financial instruments, but instead are actively managed through customer product and service pricing actions, procurement-driven cost reduction initiatives and other productivity improvement projects. Fluctuations in the fair value of the Company’s common stock affect domestic retirement plan expense as discussed below in the Employee Stock Ownership Plan ("ESOP") section of MD&A. Additionally, the Company has $87 million of liabilities as of December 30, 2017 pertaining to unfunded defined contribution plans for certain U.S. employees for which there is mark-to-market exposure. The assets held by the Company’s defined benefit plans are exposed to fluctuations in the market value of securities, primarily global stocks and fixed-income securities. The funding obligations for these plans would increase in the event of adverse changes in the plan asset values, although such funding would occur over a period of many years. In 2017, 2016, and 2015, investment returns on pension plan assets resulted in a $217 million increase, a $260 million increase, and an $11 million decrease, respectively. The Company expects funding obligations on its defined benefit plans to be approximately $41 million in 2018. The Company employs diversified asset allocations to help mitigate this risk. Management has worked to minimize this exposure by freezing and terminating defined benefit plans where appropriate. The Company has access to financial resources and borrowing capabilities around the world. There are no instruments within the debt structure that would accelerate payment requirements due to a change in credit rating. The Company’s existing credit facilities and sources of liquidity, including operating cash flows, are considered more than adequate to conduct business as normal. Accordingly, based on present conditions and past history, management believes it is unlikely that operations will be materially affected by any potential deterioration of the general credit markets that may occur. The Company believes that its strong financial position, operating cash flows, committed long-term credit facilities and borrowing capacity, and ability to access equity markets, provide the financial flexibility necessary to continue its record of annual dividend payments, to invest in the routine needs of its businesses, to make strategic acquisitions and to fund other initiatives encompassed by its growth strategy and maintain its strong investment grade credit ratings. OTHER MATTERS Employee Stock Ownership Plan As detailed in Note L, Employee Benefit Plans, the Company has an ESOP under which the ongoing U.S. Core and 401(k) defined contribution plans are funded. Overall ESOP expense is affected by the market value of the Company’s stock on the monthly dates when shares are released, among other factors. The Company’s net ESOP activity resulted in expense of $1.3 million in 2017, income of $3.1 million in 2016, and expense of $0.8 million in 2015. ESOP expense could increase in the future if the market value of the Company’s common stock declines. CRITICAL ACCOUNTING ESTIMATES - Preparation of the Company’s Consolidated Financial Statements requires management to make estimates and assumptions that affect the reported amounts of assets, liabilities, revenues and expenses. Significant accounting policies used in the preparation of the Consolidated Financial Statements are described in Note A, Significant Accounting Policies. Management believes the most complex and sensitive judgments, because of their significance to the Consolidated Financial Statements, result primarily from the need to make estimates about the effects of matters with inherent uncertainty. The most significant areas involving management estimates are described below. Actual results in these areas could differ from management’s estimates. ALLOWANCE FOR DOUBTFUL ACCOUNTS - The Company’s estimate for its allowance for doubtful accounts related to trade receivables is based on two methods. The amounts calculated from each of these methods are combined to determine the total amount reserved. First, a specific reserve is established for individual accounts where information indicates the customers may have an inability to meet financial obligations. In these cases, management uses its judgment, based on the surrounding facts and circumstances, to record a specific reserve for those customers against amounts due to reduce the receivable to the amount expected to be collected. These specific reserves are reevaluated and adjusted as additional information is received. Second, a reserve is determined for all customers based on a range of percentages applied to receivable aging categories. These percentages are based on historical collection and write-off experience. If circumstances change, for example, due to the occurrence of higher-than-expected defaults or a significant adverse change in a major customer’s ability to meet its financial obligation to the Company, estimates of the recoverability of receivable amounts due could be reduced. INVENTORIES - LOWER OF COST OR MARKET, SLOW MOVING AND OBSOLETE - Inventories in the U.S. are primarily valued at the lower of Last-In First-Out (“LIFO”) cost or market, while non-U.S. inventories are primarily valued at the lower of First-In, First-Out (“FIFO”) cost and net realizable value. The calculation of LIFO reserves, and therefore the net inventory valuation, is affected by inflation and deflation in inventory components. The Company continually reviews the carrying value of discontinued product lines and stock-keeping-units (“SKUs”) to determine that these items are properly valued. The Company also continually evaluates the composition of its inventory and identifies obsolete and/or slow-moving inventories. Inventory items identified as obsolete and/or slow-moving are evaluated to determine if write-downs are required. The Company assesses the ability to dispose of these inventories at a price greater than cost. If it is determined that cost is less than market or net realizable value, as applicable, cost is used for inventory valuation. If market value or net realizable value, as applicable, is less than cost, the Company writes down the related inventory to that value. GOODWILL AND INTANGIBLE ASSETS - The Company acquires businesses in purchase transactions that result in the recognition of goodwill and intangible assets. The determination of the value of intangible assets requires management to make estimates and assumptions. In accordance with ASC 350-20, Goodwill, acquired goodwill and indefinite-lived intangible assets are not amortized but are subject to impairment testing at least annually or when an event occurs or circumstances change that indicate it is more likely than not an impairment exists. Definite-lived intangible assets are amortized and are tested for impairment when an event occurs or circumstances change that indicate it is more likely than not that an impairment exists. Goodwill represents costs in excess of fair values assigned to the underlying net assets of acquired businesses. At December 30, 2017, the Company reported $8.776 billion of goodwill, $2.206 billion of indefinite-lived trade names and $1.302 billion of net definite-lived intangibles. Management tests goodwill for impairment at the reporting unit level. A reporting unit is an operating segment as defined in ASC 280, Segment Reporting, or one level below an operating segment (component level) as determined by the availability of discrete financial information that is regularly reviewed by operating segment management or an aggregate of component levels of an operating segment having similar economic characteristics. If the carrying value of a reporting unit (including the value of goodwill) is greater than its estimated fair value, an impairment may exist. An impairment charge would be recorded to the extent that the recorded value of goodwill exceeded the implied fair value. As required by the Company’s policy, goodwill was tested for impairment in the third quarter of 2017. Beginning in 2013, the Company adopted ASU 2011-08, Intangibles - Goodwill and Other (Topic 350): Testing Goodwill for Impairment, for its goodwill impairment testing. ASU 2011-08 permits companies to first assess qualitative factors to determine whether it is more likely than not that the fair value of a reporting unit is less than its carrying amount as a basis for determining whether it is necessary to perform the two-step quantitative goodwill impairment test. Under the two-step quantitative goodwill impairment test, the fair value of the reporting unit is compared to its respective carrying amount including goodwill. If the fair value exceeds the carrying amount, then no impairment exists. If the carrying amount exceeds the fair value, further analysis is performed to assess impairment. Such tests are completed separately with respect to the goodwill of each of the Company’s reporting units. Accordingly, the Company applied the qualitative assessment for two of its reporting units, while performing the quantitative test for three of its reporting units. Based on the results of the annual impairment testing performed in the third quarter of 2017, the Company determined that the fair values of each of its reporting units exceeded their respective carrying amounts. In performing the qualitative assessments, the Company identified and considered the significance of relevant key factors, events, and circumstances that could affect the fair value of each reporting unit. These factors include external factors such as macroeconomic, industry, and market conditions, as well as entity-specific factors, such as actual and planned financial performance. The Company also assessed changes in each reporting unit's fair value and carrying value since the most recent date a fair value measurement was performed. As a result of the qualitative assessments performed, the Company concluded that it is more likely than not that the fair value of each reporting unit exceeded its respective carrying value and therefore, no additional quantitative impairment testing was performed. With respect to the quantitative tests, the Company assessed the fair values of the three reporting units based on a discounted cash flow valuation model. The key assumptions applied to the cash flow projections were discount rates, which ranged from 8.5% to 9.0%, near-term revenue growth rates over the next five years, which represented cumulative annual growth rates ranging from approximately 4% to 7%, and perpetual growth rates of 3%. These assumptions contemplated business, market and overall economic conditions. Based on the results of this testing, the Company determined that the fair values of each of the three reporting units exceeded their respective carrying amounts. Furthermore, management performed sensitivity analyses on the estimated fair values from the discounted cash flow valuation models utilizing more conservative assumptions that reflect reasonably likely future changes in the discount rate and perpetual growth rate. The discount rate was increased by 100 basis points with no impairment indicated. The perpetual growth rate was decreased by 150 basis points with no impairment indicated. As previously disclosed in the Company's Form 10-Q for the third quarter of 2017, the fair value of the Infrastructure reporting unit exceeded its carrying amount by 18%. In connection with the preparation of the Consolidated Financial Statements for the year ended December 30, 2017, the Company performed an updated impairment analysis with respect to the Infrastructure reporting unit, which included approximately $271 million of goodwill at year-end. Based on this analysis, which included updated assumptions of near-term revenue and profitability levels, it was determined that the fair value of the Infrastructure reporting unit exceeded its carrying value by 37%. The increase in excess fair value is reflective of an improved near-term outlook due to solid results in 2017, including robust organic growth of 12%. Management remains confident in the long-term viability and success of the Infrastructure reporting unit based on its leading market position in its respective industries and the Company's continued commitment to, and investments in, organic growth initiatives (including solid progress being made with respect to Breakthrough Innovation projects under SFS 2.0). The Company also tested its indefinite-lived trade names for impairment during the third quarter of 2017, utilizing both qualitative assessments and quantitative tests. For the qualitative assessments, the Company identified and considered the significance of relevant key factors, events, and circumstances that could affect the fair value of each trade name. These factors primarily included macroeconomic, industry, and market conditions, as well as the trade names' actual and planned financial performance. As a result of the qualitative assessments performed, the Company concluded that it is more likely than not that the fair values of the trade names exceeded their respective carrying values and therefore, no additional quantitative impairment testing was performed. For the quantitative impairment tests, the Company utilized a discounted cash flow model. The key assumptions used included discount rates, royalty rates, and perpetual growth rates applied to the projected sales. Based on these quantitative impairment tests, the Company determined that the fair values of the indefinite-lived trade names exceeded their respective carrying amounts. In the event that future operating results of any of the Company's reporting units or indefinite-lived trade names do not meet current expectations, management, based upon conditions at the time, would consider taking restructuring or other strategic actions, as necessary, to maximize revenue growth and profitability. A thorough analysis of all the facts and circumstances existing at that time would need to be performed to determine if recording an impairment loss would be appropriate. DEFINED BENEFIT OBLIGATIONS - The valuation of pension and other postretirement benefits costs and obligations is dependent on various assumptions. These assumptions, which are updated annually, include discount rates, expected return on plan assets, future salary increase rates, and health care cost trend rates. The Company considers current market conditions, including interest rates, to establish these assumptions. Discount rates are developed considering the yields available on high-quality fixed income investments with maturities corresponding to the duration of the related benefit obligations. The Company’s weighted-average discount rates used to determine benefit obligations at December 30, 2017 for the United States and international pension plans were 3.53% and 2.24%, respectively. The Company’s weighted-average discount rates used to determine benefit obligations at December 31, 2016 for the United States and international pension plans were 3.95% and 2.38%, respectively. As discussed further in Note L, Employee Benefit Plans, the Company develops the expected return on plan assets considering various factors, which include its targeted asset allocation percentages, historic returns, and expected future returns. The Company’s expected rate of return assumptions for the United States and international pension plans were 6.25% and 4.41%, respectively, at December 30, 2017. The Company will use a 5.30% weighted-average expected rate of return assumption to determine the 2018 net periodic benefit cost. A 25 basis point reduction in the expected rate of return assumption would increase 2018 net periodic benefit cost by approximately $5 million on a pre-tax basis. The Company believes that the assumptions used are appropriate; however, differences in actual experience or changes in the assumptions may materially affect the Company’s financial position or results of operations. To the extent that actual (newly measured) results differ from the actuarial assumptions, the difference is recognized in accumulated other comprehensive loss, and, if in excess of a specified corridor, amortized over future periods. The expected return on plan assets is determined using the expected rate of return and the fair value of plan assets. Accordingly, market fluctuations in the fair value of plan assets can affect the net periodic benefit cost in the following year. The projected benefit obligation for defined benefit plans exceeded the fair value of plan assets by $650 million at December 30, 2017. A 25 basis point reduction in the discount rate would have increased the projected benefit obligation by approximately $98 million at December 30, 2017. The primary Black & Decker U.S pension and post employment benefit plans were curtailed in late 2010, as well as the only material Black & Decker international plan, and in their place the Company implemented defined contribution benefit plans. The vast majority of the projected benefit obligation pertains to plans that have been frozen; the remaining defined benefit plans that are not frozen are predominantly small domestic union plans and those that are statutorily mandated in certain international jurisdictions. The Company recognized $19 million of defined benefit plan expense in 2017, which may fluctuate in future years depending upon various factors including future discount rates and actual returns on plan assets. ENVIRONMENTAL - The Company incurs costs related to environmental issues as a result of various laws and regulations governing current operations as well as the remediation of previously contaminated sites. The Company’s policy is to accrue environmental investigatory and remediation costs for identified sites when it is probable that a liability has been incurred and the amount of loss can be reasonably estimated. The amount of liability recorded is based on an evaluation of currently available facts with respect to each individual site and includes such factors as existing technology, presently enacted laws and regulations, and prior experience in remediation of contaminated sites. The liabilities recorded do not take into account any claims for recoveries from insurance or third parties. As assessments and remediation progress at individual sites, the amounts recorded are reviewed periodically and adjusted to reflect additional technical and legal information that becomes available. As of December 30, 2017, the Company had reserves of $176.1 million for remediation activities associated with Company-owned properties as well as for Superfund sites, for losses that are probable and estimable. The range of environmental remediation costs that is reasonably possible is $143.4 million to $277.1 million which is subject to change in the near term. The Company may be liable for environmental remediation of sites it no longer owns. Liabilities have been recorded on those sites in accordance with this policy. INCOME TAXES - The Company accounts for income taxes under the asset and liability method in accordance with ASC 740, Income Taxes, which requires the recognition of deferred tax assets and liabilities for the expected future tax consequences of events that have been included in the financial statements. Deferred tax assets and liabilities are determined based on the differences between the financial statements and tax basis of assets and liabilities using the enacted tax rates in effect for the year in which the differences are expected to reverse. Any changes in tax rates on deferred tax assets and liabilities are recognized in income in the period that includes the enactment date. The Company records net deferred tax assets to the extent that it is more likely than not that these assets will be realized. In making this determination, management considers all available positive and negative evidence, including future reversals of existing temporary differences, estimates of future taxable income, tax-planning strategies, and the realizability of net operating loss carryforwards. In the event that it is determined that an asset is not more likely that not to be realized, a valuation allowance is recorded against the asset. Valuation allowances related to deferred tax assets can be impacted by changes to tax laws, changes to statutory tax rates and future taxable income levels. In the event the Company were to determine that it would not be able to realize all or a portion of its deferred tax assets in the future, the unrealizable amount would be charged to earnings in the period in which that determination is made. Conversely, if the Company were to determine that it would be able to realize deferred tax assets in the future in excess of the net carrying amounts, it would decrease the recorded valuation allowance through a favorable adjustment to earnings in the period that the determination was made. The Company records uncertain tax positions in accordance with ASC 740, which requires a two-step process. First, management determines whether it is more likely than not that a tax position will be sustained based on the technical merits of the position and second, for those tax positions that meet the more likely than not threshold, management recognizes the largest amount of the tax benefit that is greater than 50 percent likely to be realized upon ultimate settlement with the related taxing authority. The Company maintains an accounting policy of recording interest and penalties on uncertain tax positions as a component of Income taxes on continuing operations in the Consolidated Statements of Operations. The Company is subject to income tax in a number of locations, including many state and foreign jurisdictions. Significant judgment is required when calculating the worldwide provision for income taxes. Many factors are considered when evaluating and estimating the Company's tax positions and tax benefits, which may require periodic adjustments and which may not accurately anticipate actual outcomes. It is reasonably possible that the amount of the unrecognized benefit with respect to certain of the Company's unrecognized tax positions will significantly increase or decrease within the next twelve months. These changes may be the result of settlements of ongoing audits or final decisions in transfer pricing matters. The Company periodically assesses its liabilities and contingencies for all tax years still subject to audit based on the most current available information, which involves inherent uncertainty. On December 22, 2017, the U.S. government enacted comprehensive tax legislation commonly referred to as the Tax Cuts and Jobs Act (the “Act”). The Act contains a new tax law that may subject the Company to a tax on global intangible low-taxed income (“GILTI”) beginning in 2018. GILTI is a tax on foreign income in excess of a deemed return on tangible assets of foreign corporations. Companies subject to GILTI have the option to account for the GILTI tax as a period cost if and when incurred, or to recognize deferred taxes for temporary differences including outside basis differences expected to reverse as GILTI. The Company has elected to account for GILTI as a period cost. Additional information regarding income taxes is available in Note Q, Income Taxes. RISK INSURANCE - To manage its insurance costs efficiently, the Company self insures for certain U.S. business exposures and generally has low deductible plans internationally. For domestic workers’ compensation, automobile and product liability (liability for alleged injuries associated with the Company’s products), the Company generally purchases insurance coverage only for severe losses that are unlikely, and these lines of insurance involve the most significant accounting estimates. While different self insured retentions, in the form of deductibles and self insurance through its captive insurance company, exist for each of these lines of insurance, the maximum self insured retention is set at no more than $5 million per occurrence. The process of establishing risk insurance reserves includes consideration of actuarial valuations that reflect the Company’s specific loss history, actual claims reported, and industry trends among statistical and other factors to estimate the range of reserves required. Risk insurance reserves are comprised of specific reserves for individual claims and additional amounts expected for development of these claims, as well as for incurred but not yet reported claims discounted to present value. The cash outflows related to risk insurance claims are expected to occur over a period of approximately 14 years. The Company believes the liabilities recorded for these U.S. risk insurance reserves, totaling $87 million and $89 million as of December 30, 2017, and December 31, 2016, respectively, are adequate. Due to judgments inherent in the reserve estimation process, it is possible the ultimate costs will differ from this estimate. WARRANTY - The Company provides product and service warranties which vary across its businesses. The types of warranties offered generally range from one year to limited lifetime, and certain branded products recently acquired carry a lifetime warranty. There are also certain products with no warranty. Further, the Company sometimes incurs discretionary costs to service its products in connection with product performance issues. Historical warranty and service claim experience forms the basis for warranty obligations recognized. Adjustments are recorded to the warranty liability as new information becomes available. The Company believes the $176 million reserve for expected warranty claims as of December 30, 2017 is adequate, but due to judgments inherent in the reserve estimation process, including forecasting future product reliability levels and costs of repair as well as the estimated age of certain products submitted for claims, the ultimate claim costs may differ from the recorded warranty liability. The Company also establishes a reserve for product recalls on a product-specific basis during the period in which the circumstances giving rise to the recall become known and estimable for both company-initiated actions and those required by regulatory bodies. OFF-BALANCE SHEET ARRANGEMENT SYNTHETIC LEASES - The Company is a party to synthetic leasing programs for certain locations, including one of its major distribution centers and two of its office buildings. The programs qualify as operating leases for accounting purposes, where only the monthly lease expense is recorded in the Consolidated Statements of Operations and the liability and value of the underlying assets are off-balance sheet. These lease programs are utilized primarily to reduce overall cost and to retain flexibility. The cash outflows for lease payments approximate the $2 million of rent expense recognized in fiscal 2017. As of December 30, 2017, the estimated fair value of the underlying assets and lease guarantees of the residual values for these properties were $119 million and $103 million, respectively. CAUTIONARY STATEMENTS UNDER THE PRIVATE SECURITIES LITIGATION REFORM ACT OF 1995 Certain statements contained in this Annual Report on Form 10-K that are not historical, including but not limited to those regarding the Company’s ability to: (i) close the Nelson transaction in the first half of 2018; (ii) achieve its long-term financial objectives including: 4-6% organic revenue growth; 10-12% total revenue growth; 10-12% total earnings per share growth (7-9% organically) excluding acquisition-related charges; free cash flow equal to, or exceeding, net income; sustain 10+ working capital turns; and $22 billion in revenue by 2022 while expanding the margin rate; (iii) return approximately 50% of free cash flow to shareholders through a strong and growing dividend as well as opportunistically repurchasing shares and deploying the remaining 50% toward acquisitions; (iv) significantly increase the availability of Craftsman®-branded products to consumers in previously underpenetrated channels, enhance innovation, and add manufacturing jobs in the U.S. to support growth; (v) achieve 2018 diluted earnings per share of approximately $7.80 to $8.00 ($8.30 to $8.50 excluding acquisition-related charges); (vi) achieve free cash flow conversion, defined as free cash flow divided by net income, of approximately 100% in 2018 (collectively, the “Results”); are “forward-looking statements” and subject to risk and uncertainty. The Company’s ability to deliver the Results as described above is based on current expectations and involves inherent risks and uncertainties, including factors listed below and other factors that could delay, divert, or change any of them, and could cause actual outcomes and results to differ materially from current expectations. In addition to the risks, uncertainties and other factors discussed elsewhere herein, the risks, uncertainties and other factors that could cause or contribute to actual results differing materially from those expressed or implied in the forward-looking statements include, without limitation, those set forth under Item 1A Risk Factors hereto and any material changes thereto set forth in any subsequent Quarterly Reports on Form 10-Q, or those contained in the Company’s other filings or other submissions with the Securities and Exchange Commission, and those set forth below. The Company’s ability to deliver the Results is dependent, or based, upon: (i) the Company’s ability to generate organic sales growth of approximately 5% resulting in approximately $0.50 to $0.60 of diluted earnings per share accretion in 2018; (ii) commodity inflation of approximately $150 million, partially offset by price actions, negatively impacting diluted earnings per share by $0.25 to $0.30 in 2018; (iii) the net impact of closed acquisitions, cost actions and improved productivity, partially offset by higher share count, resulting in approximately $0.45 to $0.50 of diluted earnings per share accretion in 2018; (iv) core (excluding acquisitions) restructuring charges being approximately $50 million; (v) the Company’s 2018 tax rate being approximately 18%, which would result in approximately $0.20 of diluted earnings per share accretion; (vi) the Company’s ability to capitalize on operational improvements in both Security Europe and North America; (vii) the Company’s ability to identify and realize cost and revenue synergies associated with acquisitions; (viii) successful identification of appropriate acquisition opportunities and completing them within time frames and at reasonable costs as well as the integration of completed acquisitions and reorganization of existing businesses; (ix) the continued acceptance of technologies used in the Company’s products and services including FLEXVOLT® product; (x) the Company’s ability to manage existing Sonitrol franchisee and Mac Tools relationships; (xi) the Company’s ability to minimize costs associated with any sale or discontinuance of a business or product line, including any severance, restructuring, legal or other costs; (xii) the proceeds realized with respect to any business or product line disposals; (xiii) the extent of any asset impairments with respect to any businesses or product lines that are sold or discontinued; (xiv) the success of the Company’s efforts to manage freight costs, steel and other commodity costs as well as capital expenditures; (xv) the Company’s ability to sustain or increase prices in order to, among other things, offset or mitigate the impact of steel, freight, energy, non-ferrous commodity and other commodity costs and any inflation increases and/or currency impacts; (xvi) the Company’s ability to generate free cash flow, maintain a conservative credit profile, and a strong investment grade rating; (xvii) the Company’s ability to identify and effectively execute productivity improvements and cost reductions, while minimizing any associated restructuring charges; (xviii) the Company’s ability to obtain favorable settlement of tax audits; (xix) the ability of the Company to generate earnings sufficient to realize future income tax benefits during periods when temporary differences become deductible; (xx) the continued ability of the Company to access credit markets under satisfactory terms; (xxi) the Company’s ability to negotiate satisfactory payment terms under which the Company buys and sells goods, services, materials and products; (xxii) the Company’s ability to successfully develop, market and achieve sales from new products and services; (xxiii) the availability of cash to repurchase shares when conditions are right, as well as the Company's ability to effectively use equity derivative transactions to reduce the capital requirement associated with share repurchases; and (xxiv) the impact of the enacted U.S. Tax Cuts and Jobs Act on the provisional estimate recorded in 2017 based on legislative developments and refined calculations. The Company’s ability to deliver the Results is also dependent upon: (i) the success of the Company’s marketing and sales efforts, including the ability to develop and market new and innovative products and solutions in both existing and new markets including emerging markets; (ii) the ability of the Company to maintain or improve production rates in the Company’s manufacturing facilities, respond to significant changes in product demand and fulfill demand for new and existing products; (iii) the Company’s ability to continue improvements in working capital through effective management of accounts receivable and inventory levels; (iv) the ability to continue successfully managing and defending claims and litigation; (v) the success of the Company’s efforts to mitigate adverse earnings impact resulting from any cost increases generated by, for example, increases in the cost of energy or significant Euro, Canadian Dollar, Chinese Renminbi or other currency fluctuations; (vi) the geographic distribution of the Company’s earnings; (vii) the commitment to, and success of, the Stanley Fulfillment System, SFS 2.0 and focusing its employees on the related five key pillars of digital excellence, commercial excellence, breakthrough innovation, Core SFS / Industry 4.0, and functional transformation; and (viii) successful implementation with expected results of cost reduction programs. The Company’s ability to achieve the Results will also be affected by external factors. These external factors include: challenging global geopolitical and macroeconomic environment possibly including impact from "Brexit" or other similar actions from other EU member states; the economic environment of emerging markets, particularly Latin America, Russia, China and Turkey; pricing pressure and other changes within competitive markets; the continued consolidation of customers particularly in consumer channels; inventory management pressures on the Company’s customers; the impact the tightened credit markets may have on the Company or its customers or suppliers; the extent to which the Company has to write off accounts receivable or assets or experiences supply chain disruptions in connection with bankruptcy filings by customers or suppliers; increasing competition; changes in laws, regulations and policies that affect the Company, including, but not limited to trade, monetary, tax and fiscal policies and laws; the timing and extent of any inflation or deflation; the impact of poor weather conditions on sales; currency exchange fluctuations; the impact of dollar/foreign currency exchange and interest rates on the competitiveness of products and the Company’s debt program; the strength of the U.S. and European economies; the extent to which world-wide markets associated with homebuilding and remodeling stabilize and rebound; the impact of events that cause or may cause disruption in the Company’s supply, manufacturing, distribution and sales networks such as war, terrorist activities, political unrest and possible hostilities on the Korean Peninsula; and recessionary or expansive trends in the economies of the world in which the Company operates. Unless required by applicable federal securities laws, the Company undertakes no obligation to publicly update or revise any forward-looking statements to reflect events or circumstances that may arise after the date hereof. Investors are advised, however, to consult any further disclosures made on related subjects in the Company's reports filed with the Securities and Exchange Commission. In addition to the foregoing, some of the agreements included as exhibits to this Annual Report on Form 10-K (whether incorporated by reference to earlier filings or otherwise) may contain representations and warranties, recitals or other statements that appear to be statements of fact. These agreements are included solely to provide investors with information regarding their terms and are not intended to provide any other factual or disclosure information about the Company or the other parties to the agreements. Representations and warranties, recitals, and other common disclosure provisions have been included in the agreements solely for the benefit of the other parties to the applicable agreements and often are used as a means of allocating risk among the parties. Accordingly, such statements (i) should not be treated as categorical statements of fact; (ii) may be qualified by disclosures that were made to the other parties in connection with the negotiation of the applicable agreements, which disclosures are not necessarily reflected in the agreement or included as exhibits hereto; (iii) may apply standards of materiality in a way that is different from what may be viewed as material by or to investors in or lenders to the Company; and (iv) were made only as of the date of the applicable agreement or such other date or dates as may be specified in the agreement and are subject to more recent developments. Accordingly, representations and warranties, recitals or other disclosures contained in agreements may not describe the actual state of affairs as of the date they were made or at any other time and should not be relied on by any person other than the parties thereto in accordance with their terms. Additional information about the Company may be found in this Annual Report on Form 10-K and the Company's other public filings, which are available without charge through the SEC's website at http://www.sec.gov.

<s>[INST] The following discussion and certain other sections of this Annual Report on Form 10K contain statements reflecting the Company’s views about its future performance that constitute “forwardlooking statements” under the Private Securities Litigation Reform Act of 1995. These forwardlooking statements are based on current expectations, estimates, forecasts and projections about the industry and markets in which the Company operates as well as management’s beliefs and assumptions. Any statements contained herein (including without limitation statements to the effect that Stanley Black & Decker, Inc. or its management “believes,” “expects,” “anticipates,” “plans” and similar expressions) that are not statements of historical fact should be considered forwardlooking statements. These statements are not guarantees of future performance and involve certain risks, uncertainties and assumptions that are difficult to predict. There are a number of important factors that could cause actual results to differ materially from those indicated by such forwardlooking statements. These factors include, without limitation, those set forth, or incorporated by reference, below under the heading “Cautionary Statements.” The Company does not intend to update publicly any forwardlooking statements whether as a result of new information, future events or otherwise. Strategic Objectives The Company continues to pursue a growth and acquisition strategy, which involves industry, geographic and customer diversification to foster sustainable revenue, earnings and cash flow growth, and employ the following strategic framework in pursuit of its vision to reach $22 billion in revenue by 2022 while expanding its margin rate ("22/22 Vision"): Continue organic growth momentum by utilizing the SFS 2.0 operating system, diversifying toward highergrowth, highermargin businesses, and increasing the relative weighting of emerging markets; Be selective and operate in markets where brand is meaningful, the value proposition is definable and sustainable through innovation and global cost leadership is achievable; and Pursue acquisitive growth on multiple fronts by building upon its existing global tools platform, expanding the Industrial platform in Engineered Fastening and Infrastructure, consolidating the commercial electronic security industry and pursuing adjacencies with sound industrial logic. Execution of the above strategy has resulted in approximately $8.9 billion of acquisitions since 2002 (excluding the Black & Decker merger and pending acquisition of the Nelson Fastener Systems industrial business discussed below), several divestitures, improved efficiency in the supply chain and manufacturing operations, and enhanced investments in organic growth, enabled by cash flow generation and increased debt capacity. In addition, the Company's continued focus on diversification and organic growth has resulted in improved financial results and an increase in its global presence. The Company also remains focused on increasing its presence in emerging markets, with a goal of generating greater than 20% of annual revenues from those markets over time, and leveraging SFS 2.0 to upgrade innovation and digital capabilities, maintain commercial and supply chain excellence, and focus on reducing SG&A, in part, through functional transformation. The Company’s longterm financial objectives are as follows: 46% organic revenue growth; 1012% total revenue growth; 1012% total EPS growth (79% organically) excluding acquisitionrelated charges; Free cash flow equal to, or exceeding, net income; and Sustain 10+ working capital turns. In terms of capital allocation, the Company remains committed, over time, to returning approximately 50% of free cash flow to shareholders through a strong and growing dividend as well as opportunistically repurchasing shares. The remaining free cash flow (approximately 50%) will be deployed towards acquisitions. The following represents recent examples of the Company executing its strategic objectives: Acquisitions of Newell Tools and Craftsman® Brand In March 2017, the Company acquired the Tools business of Newell Brands ("Newell Tools") for approximately $1.84 billion and acquired the Craftsman® brand from Sears Holdings Corporation ("Sears Holdings") for an estimated cash purchase price of approximately $900 million on a discounted basis. The Newell Tools acquisition, which includes the industrial cutting, hand tool and power tool accessory brands Irwin® and Lenox®, enhances the Company’s position within the global tools & storage industry and broadens the Company’s product offer [/INST] Positive. </s>

STANLEY BLACK & DECKER, INC.

2019-02-26

2018-12-29

ITEM 7. MANAGEMENT’S DISCUSSION AND ANALYSIS OF FINANCIAL CONDITION AND RESULTS OF OPERATIONS The financial and business analysis below provides information which the Company believes is relevant to an assessment and understanding of its consolidated financial position, results of operations and cash flows. This financial and business analysis should be read in conjunction with the Consolidated Financial Statements and related notes. All references to “Notes” in this Item 7 refer to the Notes to Consolidated Financial Statements included in Item 8 of this Annual Report. The following discussion and certain other sections of this Annual Report on Form 10-K contain statements reflecting the Company’s views about its future performance that constitute “forward-looking statements” under the Private Securities Litigation Reform Act of 1995. These forward-looking statements are based on current expectations, estimates, forecasts and projections about the industry and markets in which the Company operates as well as management’s beliefs and assumptions. Any statements contained herein (including without limitation statements to the effect that Stanley Black & Decker, Inc. or its management “believes,” “expects,” “anticipates,” “plans” and similar expressions) that are not statements of historical fact should be considered forward-looking statements. These statements are not guarantees of future performance and involve certain risks, uncertainties and assumptions that are difficult to predict. There are a number of important factors that could cause actual results to differ materially from those indicated by such forward-looking statements. These factors include, without limitation, those set forth, or incorporated by reference, below under the heading “Cautionary Statements Under The Private Securities Litigation Reform Act Of 1995.” The Company does not intend to update publicly any forward-looking statements whether as a result of new information, future events or otherwise. Strategic Objectives The Company continues to pursue a growth and acquisition strategy, which involves industry, geographic and customer diversification to foster sustainable revenue, earnings and cash flow growth, and employ the following strategic framework in pursuit of its vision to reach $22 billion in revenue by 2022 while expanding its margin rate ("22/22 Vision"): • Continue organic growth momentum by utilizing the Stanley Fulfillment System ("SFS") 2.0 operating system, diversifying toward higher-growth, higher-margin businesses, and increasing the relative weighting of emerging markets; • Be selective and operate in markets where brand is meaningful, the value proposition is definable and sustainable through innovation, and global cost leadership is achievable; and • Pursue acquisitive growth on multiple fronts by building upon its existing global tools platform, expanding the Industrial platform in Engineered Fastening and Infrastructure, consolidating the commercial electronic security industry, and pursuing adjacencies with sound industrial logic. Execution of the above strategy has resulted in approximately $9.4 billion of acquisitions since 2002 (excluding the Black & Decker merger), several divestitures, improved efficiency in the supply chain and manufacturing operations, and enhanced investments in organic growth, enabled by cash flow generation and increased debt capacity. In addition, the Company's continued focus on diversification and organic growth has resulted in improved financial results and an increase in its global presence. The Company also remains focused on increasing its presence in emerging markets, with a goal of generating greater than 20% of annual revenues from those markets over time, and leveraging SFS 2.0 to upgrade innovation and digital capabilities, maintain commercial and supply chain excellence, and focus on reducing SG&A, in part, through functional transformation. Lastly, the Company continues to make strides towards achieving its 22/22 Vision by becoming known as one of the world’s leading innovators, delivering top-quartile financial performance and elevating its commitment to social responsibility. The Company’s long-term financial objectives remain as follows: • 4-6% organic revenue growth; • 10-12% total revenue growth; • 10-12% total EPS growth (7-9% organically) excluding acquisition-related charges; • Free cash flow equal to, or exceeding, net income; and • Sustain 10+ working capital turns. In terms of capital allocation, the Company remains committed, over time, to returning approximately 50% of free cash flow to shareholders through a strong and growing dividend as well as opportunistically repurchasing shares. The remaining free cash flow (approximately 50%) will be deployed towards acquisitions. The following represents recent examples of the Company executing its strategic objectives: Acquisitions and Other Transactions On January 2, 2019, the Company acquired a 20 percent interest in MTD Holdings Inc. ("MTD"), a privately held global manufacturer of outdoor power equipment, for $234 million in cash. With 2017 revenues of $2.4 billion, MTD manufactures and distributes gas-powered lawn tractors, zero turn mowers, walk behind mowers, snow throwers, trimmers, chain saws, utility vehicles and other outdoor power equipment. Under the terms of the agreement, the Company has the option to acquire the remaining 80 percent of MTD beginning on July 1, 2021 and ending on January 2, 2029. In the event the option is exercised, the companies have agreed to a valuation multiple based on MTD’s 2018 EBITDA, with an equitable sharing arrangement for future EBITDA growth. The investment in MTD increases the Company's presence in the $20 billion global lawn and garden segment and will allow the two companies to work together to pursue revenue and cost opportunities, improve operational efficiency, and introduce new and innovative products for professional and residential outdoor equipment customers, utilizing each company's respective portfolios of strong brands. On April 2, 2018, the Company acquired Nelson Fastener Systems (“Nelson”) from the Doncasters Group for approximately $430 million. This acquisition is complementary to the Company's product offerings, enhances its presence in the general industrial end markets, expands its portfolio of highly-engineered fastening solutions, and will deliver cost synergies. The results of Nelson are being consolidated into the Industrial segment. On March 9, 2017, the Company acquired the Tools business of Newell Brands ("Newell Tools") for approximately $1.86 billion, which included the highly attractive industrial cutting, hand tool and power tool accessory brands IRWIN® and LENOX®. The acquisition enhanced the Company’s position within the global tools & storage industry and broadened the Company’s product offerings and solutions to customers and end-users, particularly within power tool accessories. The Newell Tools results have been consolidated into the Company's Tools & Storage segment. On March 8, 2017, the Company purchased the Craftsman® brand from Sears Holdings Corporation (“Sears Holdings”) for an estimated cash purchase price of approximately $937 million on a discounted basis. The acquisition provided the Company with the rights to develop, manufacture and sell Craftsman®-branded products in non-Sears Holdings channels. The Company plans to significantly increase the availability of Craftsman®-branded products to consumers in previously underpenetrated channels, enhance innovation, and add manufacturing jobs in the U.S. to support growth. The Craftsman results have been consolidated into the Company's Tools & Storage segment. Pending Acquisition On August 6, 2018, the Company reached an agreement to acquire International Equipment Solutions Attachments Group ("IES Attachments"), a manufacturer of high quality, performance-driven heavy equipment attachment tools for off-highway applications. On January 29, 2019, the agreement was amended to exclude the mobile processors business. The Company expects the acquisition to further diversify the Company's presence in the industrial markets, expand its portfolio of attachment solutions and provide a meaningful platform for continued growth. This transaction is expected to close in the first half of 2019 subject to customary closing conditions, including regulatory approvals. Refer to Note E, Acquisitions, for further discussion of the Company's acquisitions. Divestitures On February 22, 2017, the Company sold the majority of its mechanical security businesses, which included the commercial hardware brands of Best Access, phi Precision and GMT, for net proceeds of approximately $717 million. The sale allowed the Company to deploy capital in a more accretive and growth-oriented manner. Refer to Note T, Divestitures, for further discussion of the Company's divestitures. Certain Items Impacting Earnings Throughout MD&A, the Company has provided a discussion of the outlook and results both inclusive and exclusive of acquisition-related charges, a non-cash fair value adjustment, gains or losses on sales of businesses, an environmental remediation settlement, charges associated with a cost reduction program, an incremental freight charge related to a service provider's bankruptcy, and tax charges primarily related to the Tax Cuts and Jobs Act ("the Act"). The results and measures, including gross profit and segment profit, on a basis excluding these amounts are considered relevant to aid analysis and understanding of the Company's results aside from the material impact of these items. These amounts are as follows: The Company reported $450 million in pre-tax charges during 2018, which were comprised of the following: • $66 million reducing Gross Profit primarily pertaining to amortization of the inventory step-up adjustment for the Nelson acquisition and an incremental freight charge recorded in the fourth quarter of 2018 due to nonperformance by a third-party service provider; • $158 million in SG&A primarily for integration-related costs, consulting fees, and a non-cash fair value adjustment; • $108 million in Other, net primarily related to deal transaction costs and the settlement with the Environmental Protection Agency ("EPA"); • $1 million related to a previously divested business; and • $117 million in Restructuring charges which primarily related to a cost reduction program in the fourth quarter of 2018. The Company also recorded a net tax charge of $181 million, which is comprised of charges related to the Act partially offset by the tax benefit of the above pre-tax charges. The above amounts resulted in net after-tax charges of $631 million, or $4.16 per diluted share. The Company reported $156 million in pre-tax acquisition-related charges, which were comprised of the following: • $47 million reducing Gross Profit primarily pertaining to amortization of the inventory step-up adjustment for the Newell Tools acquisition; • $38 million in SG&A primarily for integration-related costs and consulting fees; • $58 million in Other, net primarily for deal transaction and consulting costs; and • $13 million in Restructuring charges pertaining to facility closures and employee severance. The Company also reported a $264 million pre-tax gain on sales of businesses in 2017, primarily relating to the sale of the majority of the mechanical security businesses. The net tax benefit of the acquisition-related charges and gain on sales of businesses was $7 million. Furthermore, in the fourth quarter of 2017, the Company recorded a $24 million net tax charge relating to the Act. The acquisition-related charges, gain on sales of businesses, and net tax charge relating to the Act resulted in a net after-tax gain of $91 million, or $0.59 per diluted share. Driving Further Profitable Growth by Fully Leveraging Our Core Franchises Each of the Company's franchises share common attributes: they have world-class brands and attractive growth characteristics, they are scalable and defensible, they can differentiate through innovation, and they are powered by our SFS 2.0 operating system. • The Tools & Storage business is the tool company to own, with strong brands, proven innovation, global scale, and a broad offering of power tools, hand tools, accessories, and storage & digital products across many channels in both developed and developing markets. • The Engineered Fastening business is a highly profitable, GDP+ growth business offering highly engineered, value-added innovative solutions with recurring revenue attributes and global scale. • The Security business, with its attractive recurring revenue, presents a significant margin accretion opportunity over the longer term and has historically provided a stable revenue stream through economic cycles, is a gateway into the digital world and an avenue to capitalize on rapid digital changes. Security has embarked on a business transformation which will apply technology to lower its cost to serve and create new offerings for its small to medium enterprise and large key account customers. While diversifying the business portfolio through strategic acquisitions remains important, management recognizes that the core franchises described above are important foundations that continue to provide strong cash flow and growth prospects. Management is committed to growing these businesses through innovative product development, brand support, continued investment in emerging markets and a sharp focus on global cost-competitiveness. Continuing to Invest in the Stanley Black & Decker Brands The Company has a strong portfolio of brands associated with high-quality products including STANLEY®, BLACK+DECKER®, DEWALT®, FLEXVOLT®, IRWIN®, LENOX®, CRAFTSMAN®, PORTER-CABLE®, BOSTITCH®, PROTO®, MAC TOOLS®, FACOM®, AeroScout®, Powers®, LISTA®, SIDCHROME®, Vidmar®, SONITROL®, and GQ®. Among the Company's most valuable assets, the STANLEY®, BLACK+DECKER® and DEWALT® brands are recognized as three of the world's great brands, while the CRAFTSMAN® brand is recognized as a premier American brand. During 2018, the STANLEY®, DEWALT® and CRAFTSMAN® brands had prominent signage in Major League Baseball ("MLB") stadiums appearing in many MLB games. The Company has also maintained long-standing NASCAR and NHRA racing sponsorships, which provided brand exposure during nearly 60 events in 2018 with the STANLEY®, DEWALT®, CRAFTSMAN®, IRWIN® and MAC TOOLS® brands. The Company also advertises in the English Premier League, which is the number one soccer league in the world, featuring STANLEY®, STANLEY Security, BLACK+DECKER® and DEWALT® brands to a global audience. Starting in 2014, the Company became a sponsor for one of the world’s most popular football clubs, FC Barcelona ("FCB"), including player image rights, hospitality assets and stadium signage. In 2018, the Company was announced as the first ever shirt sponsor for the FCB Women's team in support of its commitment to global diversity and inclusion. Also in 2018, the Company joined forces by sponsoring the Envision Virgin Racing Formula E team, in support of the Company's commitment to sustainability and the future of electric mobility. The above marketing initiatives highlight the Company's strong emphasis on brand building and support, which has resulted in more than 300 billion brand impressions via digital and traditional advertising annually and a steady improvement across the spectrum of brand awareness measures. The Company will continue allocating its brand and advertising spend wisely to capture the emerging digital landscape, whilst continuing to evolve proven marketing programs to deliver famous global brands that are deeply committed to societal improvement, along with transformative technologies to build relevant and meaningful 1:1 customer, consumer, employee and shareholder relationships in support of the Company's 22/22 Vision. The Stanley Fulfillment System and SFS 2.0 Over the years, the Company has successfully leveraged SFS to drive efficiency throughout the supply chain and improve working capital performance in order to generate incremental free cash flow. Historically, SFS focused on streamlining operations, which helped reduce lead times, realize synergies during acquisition integrations, and mitigate material and energy price inflation. In 2015, the Company launched a refreshed and revitalized SFS operating system, entitled SFS 2.0, to drive from a more programmatic growth mentality to a true organic growth culture by more deeply embedding breakthrough innovation and commercial excellence into its businesses, and at the same time, becoming a significantly more digitally-enabled enterprise. Leveraging SFS 2.0, the Company is building a culture in which it strives to become known as one of the world’s great innovative companies by embracing the current environment of rapid innovation and digital transformation. To pursue faster innovation, the Company is building a vast ecosystem to remain aware of and open to new technologies and advances by leveraging both internal initiatives and external partnerships. The innovation ecosystem and focus on digital disruption will allow the Company to apply innovation to its core processes in manufacturing and back office functions to reduce operating costs and inefficiencies, develop core and breakthrough product innovations within each of its businesses, and pursue disruptive business models to either push into new markets or change existing business models before competition or new market entrants capture the opportunity. The Company has already made progress towards these objectives, as evidenced by the creation of breakthrough innovation teams in each business, the Stanley Ventures group, which invests capital in new and emerging start-ups in core focus areas, the Techstars partnership, which selects start-ups from around the world with the goal of bringing breakthrough manufacturing technologies to market, and a Silicon Valley based team, which is building its own set of disruptive initiatives and exploring new business models. The Company has made a significant commitment to SFS 2.0 and management believes that its success will be characterized by continued organic growth in the 4-6% range as well as expanded operating margin rates over the next 3 to 5 years as the Company leverages the growth and reduces structural SG&A levels. SFS 2.0 is transforming the Company by focusing its employees on the following five key pillars: • Digital Excellence uses the power of digital to contemporize, be disruptive, and create value throughout the Company's array of products, processes and business models. Digital Excellence means leveraging the power of emerging technologies across the Company's businesses to connected devices, the Internet of Things ("IoT"), and big data, as well as social and mobile, even more than what is being done today. Digital is penetrating all aspects of the organization and feeds into and supports the other elements of SFS 2.0 - enabling better asset efficiency through Core SFS / Industry 4.0, greater cost effectiveness via the Company's support functions, and improving revenues and margins via customer-facing opportunities. • Commercial Excellence is about how the Company becomes more effective and efficient in its customer-facing processes resulting in continued share gains and margin expansion throughout its businesses. The Company views Commercial Excellence as world-class execution across seven areas: customer insights, innovation and portfolio management, pricing and promotion, brand and marketing, sales force deployment and effectiveness, channel programs, and the customer experience. • Breakthrough Innovation is aimed at developing a culture to identify and commercialize market disrupting innovations, each with revenue generation potential greater than $100 million annually. The Company's focus remains on utilizing technologies to come up with major breakthroughs in the industries in which the Company operates which, when combined with its existing strong core innovation machine, will drive outsized share gains and margin expansion. • Core SFS / Industry 4.0, which targets cost and asset efficiency, remains as the foundation for the Company's operating system and has yielded significant advances in improving working capital turns and free cash flow generation. The five operating principles encompassed by Core SFS / Industry 4.0, which work in concert, include: sales and operations planning ("S&OP"), operational lean, complexity reduction, global supply management, and order-to-cash excellence. The Company plans to continue leveraging these principles to further enhance the Company's already strong asset efficiency performance. Additionally, the Company is making investments behind the adoption of Industry 4.0 and advancing the Company's capabilities surrounding the automation of manufacturing that includes IoT, cloud computing, Artificial Intelligence ("AI"), 3-D printing, robotics, and advanced materials, among others. • Functional Transformation takes a clean-sheet approach to redesigning the Company's key support functions such as Finance, HR, IT and others, which although highly effective, after roughly a hundred acquisitions are not as efficient as they can be based on external benchmarks. This presents the Company with an opportunity to reduce complexity in order to realize the benefits from scale, reduce its SG&A as a percent of sales, and become a cost effectiveness enabler with the side benefit of helping to fund the other aspects of SFS 2.0 over the long term and to support margin expansion. SFS 2.0 will serve as a powerful value driver in the years ahead, feeding the Company's innovation ecosystem, embracing outstanding commercial and supply chain excellence, embedding digital into the various business models, and funding it with world-class functional efficiency. Taken together, the five pillars above will directly support achievement of the Company's long-term financial objectives, including its 22/22 Vision, and further enable its shareholder-friendly capital allocation approach, which has served the Company well in the past and will continue to do so in the future. Outlook for 2019 This outlook discussion is intended to provide broad insight into the Company’s near-term earnings and cash flow generation prospects. The Company expects 2019 diluted earnings per share to approximate $7.45 to $7.65 ($8.45 to $8.65 excluding acquisition-related and other charges), and free cash flow conversion, defined as free cash flow divided by net income, to approximate 85% to 90%. The 2019 outlook for adjusted diluted earnings per share assumes approximately $0.30 to $0.40 of accretion related to organic sales volume growth; approximately $1.05 of accretion due to the benefit from the cost reduction program partially offset by modest investments; approximately $0.10 of accretion related to the benefits from the MTD partnership and lower shares partially offset by higher interest expense; approximately $0.90 to $1.00 of dilution from incremental tariffs, commodity inflation, and currency partially offset by pricing actions; and approximately $0.15 of dilution due to an expected tax rate of approximately 17.5%. RESULTS OF OPERATIONS Below is a summary of the Company’s operating results at the consolidated level, followed by an overview of business segment performance. Certain amounts reported in the previous years have been recast as a result of the retrospective adoption of new accounting standards in the first quarter of 2018. Refer to Note A, Significant Accounting Policies, for further discussion. Terminology: The term “organic” is utilized to describe results aside from the impacts of foreign currency fluctuations, acquisitions during their initial 12 months of ownership, and divestitures. This ensures appropriate comparability to operating results of prior periods. Net Sales: Net sales were $13.982 billion in 2018 compared to $12.967 billion in 2017, representing an increase of 8% with strong organic growth of 5%. Acquisitions, primarily Newell Tools and Nelson, increased sales by 3%. Tools & Storage net sales increased 9% compared to 2017 due to strong organic growth of 7%, fueled by solid growth across all regions, and acquisition growth of 2%. Industrial net sales increased 11% compared to 2017 primarily due to acquisition growth of 9% and favorable currency of 2%. Security net sales increased 2% compared to 2017 due to increases of 1% in price, 3% in small bolt-on commercial electronic security acquisitions and 1% in foreign currency, partially offset by declines of 1% from the sale of the majority of the mechanical security businesses and 2% from lower volumes. Net sales were $12.967 billion in 2017 compared to $11.594 billion in 2016, representing an increase of 12% fueled by strong organic growth of 7%. Acquisitions, primarily Newell Tools, and foreign currency increased sales by 7% and 1%, respectively, while the impact of divestitures decreased sales by 3%. Tools & Storage net sales increased 19% compared to 2016 due to strong innovation-fueled organic growth of 9%, with solid growth across all regions, and acquisition growth of 10%. Industrial net sales increased 6% relative to 2016 due to a 6% increase in sales volume, which was mainly driven by strong automotive system shipments in the Engineered Fastening business and successful commercial actions and higher inspection and onshore pipeline project activity in the Infrastructure business. Net sales in the Security segment decreased 8% compared to 2016 primarily due to a 12% decline from the sale of the majority of the mechanical security businesses, which more than offset increases from organic growth and small bolt-on commercial electronic security acquisitions of 1% and 3%, respectively. Gross Profit: The Company reported gross profit of $4.851 billion, or 34.7% of net sales, in 2018 compared to $4.778 billion, or 36.9% of net sales, in 2017. Acquisition-related and other charges, which reduced gross profit, were $65.7 million in 2018 and $46.8 million in 2017. Excluding these charges, gross profit was 35.2% of net sales in 2018, compared to 37.2% in 2017, as volume leverage, productivity and price were more than offset by external headwinds, including commodity inflation, foreign exchange and tariffs. The Company reported gross profit of $4.778 billion, or 36.9% of net sales, in 2017 compared to $4.268 billion, or 36.8% of net sales, in 2016. Excluding acquisition-related charges of $46.8 million, which primarily related to the amortization of the inventory step-up adjustment for the Newell Tools acquisition, gross profit was 37.2% of net sales in 2017. The year-over-year increase in the profit rate was attributable to volume leverage, productivity and cost control, which more than offset increasing commodity inflation and the impact from the mechanical security business divestiture. SG&A Expense: Selling, general and administrative expenses, inclusive of the provision for doubtful accounts (“SG&A”), were $3.172 billion, or 22.7% of net sales, in 2018 compared to $2.999 billion, or 23.1% of net sales, in 2017. Within SG&A, acquisition-related and other charges totaled $157.8 million in 2018 and $37.7 million in 2017. Excluding these charges, SG&A was 21.6% of net sales in 2018 compared to 22.8% in 2017, due primarily to prudent cost management and volume leverage. SG&A expenses were $2.999 billion, or 23.1% of net sales, in 2017 compared to $2.633 billion, or 22.7% of net sales, in 2016. Excluding acquisition-related charges of $37.7 million, SG&A was 22.8% of net sales in 2017. The slight year-over-year increase was driven by investments in growth initiatives partially offset by continued tight cost management. Distribution center costs (i.e. warehousing and fulfillment facility and associated labor costs) are classified within SG&A. This classification may differ from other companies who may report such expenses within cost of sales. Due to diversity in practice, to the extent the classification of these distribution costs differs from other companies, the Company’s gross margins may not be comparable. Such distribution costs classified in SG&A amounted to $316.0 million in 2018, $279.8 million in 2017 and $235.3 million in 2016. Corporate Overhead: The corporate overhead element of SG&A, which is not allocated to the business segments, amounted to $202.8 million, or 1.5% of net sales, in 2018, $217.4 million, or 1.7% of net sales, in 2017 and $190.9 million, or 1.6% of net sales, in 2016. Excluding acquisition-related charges of $12.7 million and $0.7 million in 2018 and 2017, respectively, the corporate overhead element of SG&A was 1.4% of net sales in 2018 compared to 1.7% of net sales in 2017 reflecting cost management. The increase in 2017 compared to 2016 was primarily due to investments in SFS 2.0 initiatives. Other, net: Other, net totaled $287.0 million in 2018 compared to $269.2 million in 2017 and $185.9 million in 2016. Excluding the aforementioned EPA settlement charge and acquisition-related charges which totaled $108.1 million in 2018 and acquisition-related charges of $58.2 million in 2017, Other, net totaled $178.9 million and $211.0 million in 2018 and 2017, respectively. The year-over-year decrease in 2018 was driven by an environmental remediation charge of $17 million in 2017 relating to a legacy Black & Decker site and a favorable resolution of a prior claim in 2018, which more than offset higher intangible amortization expense in 2018. The increase in 2017 compared to 2016 was primarily driven by higher amortization expense related to the 2017 acquisitions, negative impacts of foreign currency and the environmental remediation charge of $17 million discussed above. Refer to Note S, Contingencies, for additional information regarding the EPA settlement discussed above. Loss (Gain) on Sales of Businesses: During 2018, the Company reported a $0.8 million pre-tax loss relating to a previously divested business. During 2017, the Company reported a $264.1 million pre-tax gain primarily relating to the sale of the majority of the Company's mechanical security businesses, as previously discussed. Pension Settlement: Pension settlement of $12.2 million in 2017 reflects losses previously reported in Accumulated other comprehensive loss related to a non-U.S. pension plan for which the Company settled its obligation by purchasing an annuity and making lump sum payments to participants. Interest, net: Net interest expense in 2018 was $209.2 million compared to $182.5 million in 2017 and $171.3 million in 2016. The increase in 2018 compared to 2017 was primarily due to higher interest rates and higher average balances relating to the Company's U.S. commercial paper borrowings partially offset by higher interest income. The increase in net interest expense in 2017 versus 2016 was primarily due to the termination of interest rate swaps in June 2016 hedging the Company's fixed rate debt. Income Taxes: The Company's effective tax rate was 40.7% in 2018, 19.7% in 2017, and 21.3% in 2016. The 2018 effective tax rate includes net charges associated with the Act, which primarily related to the re-measurement of existing deferred tax balances, adjustments to the one-time transition tax, and the provision of deferred taxes on unremitted foreign earnings and profits for which the Company no longer asserts indefinite reinvestment. Excluding the impacts of the net charge related to the Act as well as the acquisition-related and other charges previously discussed, the effective tax rate in 2018 was 16.0%. This effective tax rate differs from the U.S. statutory tax rate primarily due to a portion of the Company's earnings being realized in lower-taxed foreign jurisdictions and the favorable effective settlements of income tax audits. The 2017 effective tax rate included a one-time net charge relating to the provisional amounts recorded associated with the U.S. tax legislation enacted in December 2017. The net charge primarily related to the re-measurement of existing deferred tax balances and the one-time transition tax. Excluding the impact of the divestitures, acquisition-related charges, and the net charge related to the Act, the effective tax rate was 20.0% in 2017. This effective tax rate differed from the U.S. statutory rate primarily due to a portion of the Company's earnings being realized in lower-taxed foreign jurisdictions, the favorable settlement of certain income tax audits, and the acceleration of certain tax credits resulting in a tax benefit. The effective tax rate in 2016 differed from the U.S. statutory rate primarily due to a portion of the Company's earnings being realized in lower-taxed foreign jurisdictions, adjustments to tax positions relating to undistributed foreign earnings, and reversals of valuation allowances for certain foreign and U.S. state net operating losses, which had become realizable. Business Segment Results The Company’s reportable segments are aggregations of businesses that have similar products, services and end markets, among other factors. The Company utilizes segment profit which is defined as net sales minus cost of sales and SG&A inclusive of the provision for doubtful accounts (aside from corporate overhead expense), and segment profit as a percentage of net sales to assess the profitability of each segment. Segment profit excludes the corporate overhead expense element of SG&A, other, net (inclusive of intangible asset amortization expense), loss (gain) on sales of businesses, pension settlement, restructuring charges and asset impairments, interest income, interest expense, and income taxes. Corporate overhead is comprised of world headquarters facility expense, cost for the executive management team and expenses pertaining to certain centralized functions that benefit the entire Company but are not directly attributable to the businesses, such as legal and corporate finance functions. Refer to Note F, Goodwill and Intangible Assets, and Note O, Restructuring Charges and Asset Impairments, for the amount of intangible asset amortization expense and net restructuring charges and asset impairments, respectively, attributable to each segment. The Company classifies its business into three reportable segments, which also represent its operating segments: Tools & Storage, Industrial and Security. Tools & Storage: The Tools & Storage segment is comprised of the Power Tools & Equipment ("PTE") and Hand Tools, Accessories & Storage ("HTAS") businesses. The PTE business includes both professional and consumer products. Professional products include professional grade corded and cordless electric power tools and equipment including drills, impact wrenches and drivers, grinders, saws, routers and sanders, as well as pneumatic tools and fasteners including nail guns, nails, staplers and staples, concrete and masonry anchors. Consumer products include corded and cordless electric power tools sold primarily under the BLACK+DECKER® brand, lawn and garden products, including hedge trimmers, string trimmers, lawn mowers, edgers and related accessories, and home products such as hand-held vacuums, paint tools and cleaning appliances. The HTAS business sells hand tools, power tool accessories and storage products. Hand tools include measuring, leveling and layout tools, planes, hammers, demolition tools, clamps, vises, knives, saws, chisels and industrial and automotive tools. Power tool accessories include drill bits, screwdriver bits, router bits, abrasives, saw blades and threading products. Storage products include tool boxes, sawhorses, medical cabinets and engineered storage solution products. Tools & Storage net sales increased $769.0 million, or 9%, in 2018 compared to 2017. Organic sales increased 7%, with a 6% increase in volume and 1% increase in price, reflecting strong growth in each of the regions, and acquisitions, primarily Newell Tools, increased net sales by 2%. North America growth was driven by new product innovation, the rollout of the Craftsman brand and price realization. Europe growth was supported by new products and successful commercial actions. The growth in emerging markets was driven by mid-price-point product releases, e-commerce strategies and pricing actions. Segment profit amounted to $1.393 billion, or 14.2% of net sales, in 2018 compared to $1.439 billion, or 15.9% of net sales, in 2017. Excluding acquisition-related and other charges of $142.6 million and $81.8 million in 2018 and 2017, respectively, segment profit amounted to 15.6% of net sales in 2018 compared to 16.8% in 2017, as the benefits from volume leverage, pricing and cost control were more than offset by the impacts from currency, commodity inflation and tariffs. Tools & Storage net sales increased $1.426 billion, or 19%, in 2017 compared to 2016. Organic sales increased 9%, with strong organic growth in each of the regions, and acquisitions, primarily Newell, increased net sales by 10%. North America growth was supported by share gains from strong commercial execution and market-leading innovation, including sales from the FLEXVOLT® system, as well as a healthy U.S. tool market. Europe delivered above-market organic growth enabled by successful commercial actions and new product launches. The strong organic growth in emerging markets was supported by mid-price-point product releases, higher e-commerce volumes and strong commercial execution. Foreign currency increased sales by 1% while the sales of two small businesses in 2017 resulted in a 1% decrease. Segment profit amounted to $1.439 billion, or 15.9% of net sales, in 2017 compared to $1.258 billion, or 16.5% of net sales, in 2016. Excluding acquisition-related charges of $81.8 million, segment profit amounted to 16.8% of net sales in 2017 compared to 16.5% in 2016, as volume leverage and productivity more than offset growth investments and increased commodity inflation. Industrial: The Industrial segment is comprised of the Engineered Fastening and Infrastructure businesses. The Engineered Fastening business primarily sells engineered fastening products and systems designed for specific applications. The product lines include blind rivets and tools, blind inserts and tools, drawn arc weld studs and systems, engineered plastic and mechanical fasteners, self-piercing riveting systems, precision nut running systems, micro fasteners, and high-strength structural fasteners. The Infrastructure business consists of the Oil & Gas and Hydraulics businesses. The Oil & Gas business sells and rents custom pipe handling, joint welding and coating equipment used in the construction of large and small diameter pipelines, and provides pipeline inspection services. The Hydraulics business sells hydraulic tools and accessories. Industrial net sales increased $213.5 million, or 11%, in 2018 compared to 2017, due to acquisition growth of 9% and favorable foreign currency of 2%. Engineered Fastening organic revenues increased 1% due primarily to industrial and automotive fastener penetration gains which were partially offset by the expected impact from lower automotive system shipments. Infrastructure organic revenues were down 1% due to anticipated lower pipeline project activity in the Oil & Gas business, partially offset by volume growth within the Hydraulics business. Segment profit totaled $319.8 million, or 14.6% of net sales, in 2018 compared to $345.9 million, or 17.5% of net sales, in 2017. Excluding acquisition-related and other charges of $26.0 million in 2018, segment profit amounted to 15.8% of net sales in 2018 compared to 17.5% in 2017, as productivity gains and cost control were more than offset by commodity inflation and the modestly dilutive impact from the Nelson acquisition. Industrial net sales increased $110.3 million, or 6%, in 2017 compared to 2016, due to a 6% increase in organic sales. Engineered Fastening organic sales increased 4% as strong automotive system shipments and volume growth in general industrial markets more than offset lower volumes within electronics. Infrastructure organic sales increased 12% due to successful commercial actions and improved market conditions in the Hydraulics business and higher inspection and North American onshore pipeline project activity in the Oil & Gas business. Segment profit totaled $345.9 million, or 17.5% of net sales, in 2017 compared to $300.1 million, or 16.1% of net sales, in 2016. The year-over-year increase in segment profit rate was primarily due to volume leverage, productivity gains and cost control. Security: The Security segment is comprised of the Convergent Security Solutions ("CSS") and the Mechanical Access Solutions ("MAS") businesses. The CSS business designs, supplies and installs commercial electronic security systems and provides electronic security services, including alarm monitoring, video surveillance, fire alarm monitoring, systems integration and system maintenance. Purchasers of these systems typically contract for ongoing security systems monitoring and maintenance at the time of initial equipment installation. The business also sells healthcare solutions, which include asset tracking, infant protection, pediatric protection, patient protection, wander management, fall management, and emergency call products. The MAS business primarily sells automatic doors. Security net sales increased $33.3 million, or 2%, in 2018 compared to 2017, primarily due to increases of 1% in price, 3% in small bolt-on commercial electronic security acquisitions and 1% in foreign currency, partially offset by declines of 1% from the sale of the majority of the mechanical security businesses and 2% from lower volumes. Organic sales for North America decreased 1% as higher volumes within automatic doors were offset by lower installations in commercial electronic security. Europe declined 1% organically as strength within the Nordics was offset by weakness in the U.K. and France. Segment profit amounted to $169.3 million, or 8.5% of net sales, in 2018 compared to $211.7 million, or 10.9% of net sales, in 2017. Excluding acquisition-related and other charges of $42.2 million and $2.0 million in 2018 and 2017, respectively, segment profit amounted to 10.7% of net sales in 2018 compared to 11.0% in 2017. The year-over-year change in segment profit rate reflects investments to support business transformation in commercial electronic security and the impact from the sale of the majority of the mechanical security business, partially offset by a continued focus on cost containment. Security net sales decreased $163.0 million, or 8%, in 2017 compared to 2016, primarily due to a 12% decline from the sale of the majority of the mechanical security businesses. Organic sales and small bolt-on commercial electronic security acquisitions provided increases of 1% and 3%, respectively. North America organic sales increased 2% on higher installation volumes within the commercial electronic security and automatic doors businesses and growth within healthcare. Europe organic growth was relatively flat as strength within the U.K. and the Nordics was mostly offset by anticipated ongoing weakness in France. Segment profit amounted to $211.7 million, or 10.9% of net sales, in 2017 compared to $267.9 million, or 12.7% of net sales, in 2016. Excluding acquisition-related charges of $2.0 million in 2017, segment profit amounted to 11.0% of net sales in 2017 compared to 12.7% in 2016. The decrease in the 2017 segment profit rate reflected an approximate 90 basis point decline related to the sale of the mechanical security businesses, as well as impacts from mix and funding growth investments. RESTRUCTURING ACTIVITIES A summary of the restructuring reserve activity from December 30, 2017 to December 29, 2018 is as follows: During 2018, the Company recognized net restructuring charges and asset impairments of $160.3 million, which primarily relates to the cost reduction program in the fourth quarter of 2018. This amount reflects $151.0 million of net severance charges associated with the reduction of 4,184 employees and $9.3 million of facility closure and other restructuring costs. The Company expects the 2018 actions to result in annual net cost savings of approximately $230 million by the end of 2019. The majority of the $108.8 million of reserves remaining as of December 29, 2018 is expected to be utilized within the next twelve months. During 2017, the Company recognized net restructuring charges and asset impairments of $51.5 million. This amount reflected $40.6 million of net severance charges associated with the reduction of 1,584 employees and $10.9 million of facility closure and other restructuring costs. The 2017 actions resulted in annual net cost savings of approximately $45 million in 2018, primarily in the Tools & Storage and Security segments. During 2016, the Company recognized net restructuring charges and asset impairments of $49.0 million. This amount reflected $27.3 million of net severance charges associated with the reduction of 1,326 employees. The Company also recognized $11.0 million of facility closure costs and $10.7 million of asset impairments. The 2016 actions resulted in annual net cost savings of approximately $20 million in each segment. Segments: The $160 million of net restructuring charges and asset impairments for the year ended December 29, 2018 includes: $80 million pertaining to the Tools & Storage segment; $30 million pertaining to the Industrial segment; $36 million pertaining to the Security segment; and $14 million pertaining to Corporate. The anticipated annual net cost savings of approximately $230 million related to the 2018 restructuring actions include: $115 million pertaining to the Tools & Storage segment; $30 million pertaining to the Industrial segment; $55 million relating to the Security segment; and $30 million relating to Corporate. FINANCIAL CONDITION Liquidity, Sources and Uses of Capital: The Company’s primary sources of liquidity are cash flows generated from operations and available lines of credit under various credit facilities. Below is a summary of the Company’s cash flow results. Certain amounts reported in the previous years have been recast as a result of the adoption of new accounting standards in the first quarter of 2018. Refer to Note A, Significant Accounting Policies, for further discussion. Operating Activities: Cash flows provided by operations were $1.261 billion in 2018 compared to $669 million in 2017. As discussed further in Note A, Significant Accounting Policies, operating cash flows in 2017 have decreased by approximately $750 million as a result of the retrospective adoption of new cash flow standards in the first quarter of 2018. Excluding the impact of the new standards, cash flows provided by operations in 2018 decreased year-over-year primarily due to higher income tax payments and higher payments associated with acquisition-related and other charges. In 2017, cash flows from operations were $669 million compared to $1.186 billion in 2016. Excluding the impacts of the new cash flow standards described above, operating cash flows in 2017 decreased slightly compared to 2016 due primarily to higher cash outflows from working capital to support outsized organic growth in the Tools & Storage segment, partially offset by higher earnings excluding the impacts of non-cash items (gain on sales of businesses and amortization of inventory step-up). Free Cash Flow: Free cash flow, as defined in the table below, was $769 million in 2018 compared to $226 million in 2017 and $839 million in 2016. Excluding the retrospective impacts of the previously discussed new cash flow standards adopted in the first quarter of 2018, free cash flow totaled $976 million in 2017 and $1.138 billion in 2016. Management considers free cash flow an important indicator of its liquidity, as well as its ability to fund future growth and provide dividends to shareowners. Free cash flow does not include deductions for mandatory debt service, other borrowing activity, discretionary dividends on the Company’s common stock and business acquisitions, among other items. 1 Certain amounts reported in the previous years have been recast as a result of the adoption of new accounting standards in the first quarter of 2018. Refer to Note A, Significant Accounting Policies, for further discussion. Investing Activities: Cash flows used in investing activities totaled $989 million in 2018, primarily due to business acquisitions of $525 million, mainly related to the Nelson acquisition, and capital and software expenditures of $492 million. The increase in capital and software expenditures in 2018 was primarily due to technology-related and capacity investments to support the Company's strong organic growth and its SFS 2.0 initiatives. Cash flows used in investing activities in 2017 totaled $1.567 billion, which primarily consisted of business acquisitions of $2.584 billion, mainly related to the Newell Tools and Craftsman acquisitions, and capital and software expenditures of $443 million, partially offset by proceeds of $757 million from sales of businesses and $705 million from the deferred purchase price receivable related to an accounts receivable sales program, which was terminated in February 2018. The increase in capital and software expenditures in 2017 was due to growth in the Company's supply chain and investments related to functional transformation. Cash flows provided by investing activities in 2016 totaled $61 million, which primarily consisted of $345 million of proceeds from the deferred purchase price receivable related to the terminated accounts receivable sales program discussed above and net investment hedge settlements of $105 million, partially offset by capital and software expenditures of $347 million. The proceeds from net investment hedge settlements were primarily driven by the significant fluctuations in foreign currency rates during 2016 associated with foreign exchange contracts hedging a portion of the Company's pound sterling, Canadian dollar, and Euro denominated net investments. Financing Activities: Cash flows used in financing activities totaled $562 million in 2018 due primarily to the repurchase of common shares for $527 million and cash dividend payments of $385 million, partially offset by $433 million of net proceeds from short-term borrowings under the Company's commercial paper program. Cash flows provided by financing activities totaled $295 million in 2017 primarily due to $726 million in proceeds from the issuance of equity units, partially offset by $363 million of cash payments for dividends and $77 million of net repayments of short-term borrowings under the Company's commercial paper program. Cash flows used in financing activities in 2016 totaled $433 million, primarily due to share repurchases of $374 million, cash payments for dividends of $331 million, and the settlement of the October 2014 forward share purchase contract for $147 million, partially offset by proceeds from issuances of common stock of $419 million, which mainly related to the issuance of 3.5 million shares associated with the settlement of the 2013 Equity Purchase Contracts. Fluctuations in foreign currency rates negatively impacted cash by $54 million in 2018 due to the strengthening of the U.S. Dollar against the Company's other currencies. Foreign currency positively impacted cash by $81 million in 2017 and negatively impacted cash by $102 million in 2016 due to movements in the U.S. Dollar against other currencies. Refer to Note H, Long-Term Debt and Financing Arrangements, and Note J, Capital Stock, for further discussion regarding the Company's debt and equity arrangements. Credit Ratings and Liquidity: The Company maintains strong investment grade credit ratings from the major U.S. rating agencies on its senior unsecured debt (S&P A, Fitch A-, Moody's Baa1), as well as its commercial paper program (S&P A-1, Fitch, Moody's P-2). There have been no changes to any of the ratings during 2018. Failure to maintain strong investment grade rating levels could adversely affect the Company’s cost of funds, liquidity and access to capital markets, but would not have an adverse effect on the Company’s ability to access its existing committed credit facilities. Cash and cash equivalents totaled $289 million as of December 29, 2018, comprised of $60 million in the U.S. and $229 million in foreign jurisdictions. As of December 30, 2017, cash and cash equivalents totaled $638 million, comprised of $54 million in the U.S. and $584 million in foreign jurisdictions. As a result of the Act, the Company's tax liability related to the one-time transition tax associated with unremitted foreign earnings and profits totaled $366 million at December 29, 2018. The Act permits a U.S. company to elect to pay the net tax liability interest-free over a period of up to eight years. See the Contractual Obligations table below for the estimated amounts due by period. The Company has considered the implications of paying the required one-time transition tax, and believes it will not have a material impact on its liquidity. Refer to Note Q, Income Taxes, for further discussion of the impacts of the Act. In November 2018, the Company issued $500 million of senior unsecured notes, maturing on November 15, 2028 ("2028 Term Notes") and $500 million of senior unsecured notes, maturing on November 15, 2048 ("2048 Term Notes"). The 2028 Term Notes and 2048 Term Notes will accrue interest at fixed rates of 4.25% per annum and 4.85% per annum, respectively, with interest payable semi-annually in arrears on both notes. The notes are unsecured and rank equally with all of the Company's existing and future unsecured and unsubordinated debt. The Company received net proceeds of $990.0 million which reflects a discount of $0.9 million and $9.1 million of underwriting expenses and other fees associated with the transaction. The Company used the net proceeds from the offering for general corporate purposes, including repayment of other borrowings. Contemporaneously with the issuance of the 2028 Term Notes and 2048 Term Notes, the Company paid $977.5 million to settle its remaining obligations of two unsecured notes that matured in November 2018, which related to the Equity Units issued in December 2013 and the Convertible Preferred Units issued in November 2010. Refer to Note H, Long-Term Debt and Financing Arrangements, for further discussion of these arrangements. In May 2017, the Company issued 7,500,000 Equity Units with a total notional value of $750.0 million ("$750 million Equity Units"). Each unit has a stated amount of $100 and initially consisted of a three-year forward stock purchase contract ("2020 Purchase Contracts") for the purchase of a variable number of shares of common stock, on May 15, 2020, for a price of $100, and a 10% beneficial ownership interest in one share of 0% Series C Cumulative Perpetual Convertible Preferred Stock, without par, with a liquidation preference of $1,000 per share ("Series C Preferred Stock"). The Company received approximately $726 million in cash proceeds from the $750 million Equity Units, net of underwriting costs and commissions, before offering expenses, and issued 750,000 shares of Series C Preferred Stock, recording $750.0 million in preferred stock. The proceeds were used for general corporate purposes, including repayment of short-term borrowings. The Company also used $25.1 million of the proceeds to enter into capped call transactions utilized to hedge potential economic dilution. On and after May 15, 2020, the Series C Preferred Stock may be converted into common stock at the option of the holder. At the election of the Company, upon conversion, the Company may deliver cash, common stock, or a combination thereof. On or after June 22, 2020, the Company may elect to redeem for cash, all or any portion of the outstanding shares of the Series C Preferred Stock at a redemption price equal to 100% of the liquidation preference, plus any accumulated and unpaid dividends. If the Company calls the Series C Preferred Stock for redemption, holders may convert their shares immediately preceding the redemption date. Upon settlement of the 2020 Purchase Contracts, the Company will receive additional cash proceeds of $750 million. The Company will pay the holders of the 2020 Purchase Contracts quarterly contract adjustment payments, which commenced in August 2017. As of December 29, 2018, the present value of the contract adjustment payments was $58.8 million. In January 2017, the Company amended its existing $2.0 billion commercial paper program to increase the maximum amount of notes authorized to be issued to $3.0 billion and to include Euro denominated borrowings in addition to U.S. Dollars. As of December 29, 2018, the Company had $373.0 million of borrowings outstanding against the Company's $3.0 billion commercial paper program, of which approximately $228.9 million in Euro denominated commercial paper was designated as a Net Investment Hedge as described in more detailed in Note I, Financial Instruments. At December 30, 2017, the Company had no borrowings outstanding against the Company’s $3.0 billion commercial paper program. In September 2018, the Company amended and restated its existing five-year $1.75 billion committed credit facility with the concurrent execution of a new five-year $2.0 billion committed credit facility (the "5 Year Credit Agreement"). Borrowings under the Credit Agreement may be made in U.S. Dollars, Euros or Pounds Sterling. A sub-limit of $653.3 million is designated for swing line advances which may be drawn in Euros pursuant to the terms of the 5 Year Credit Agreement. Borrowings bear interest at a floating rate plus an applicable margin dependent upon the denomination of the borrowing and specific terms of the 5 Year Credit Agreement. The Company must repay all advances under the 5 Year Credit Agreement by the earlier of September 12, 2023 or upon termination. The 5 Year Credit Agreement is designated to be a liquidity back-stop for the Company's $3.0 billion U.S. Dollar and Euro commercial paper program. As of December 29, 2018 and December 30, 2017, the Company had not drawn on its five-year committed credit facility. In September 2018, the Company terminated its previous 364-day $1.25 billion committed credit facility and concurrently executed a new 364-Day $1.0 billion committed credit facility (the "364 Day Credit Agreement"). Borrowings under the 364 Day Credit Agreement may be made in U.S. Dollars or Euros and bear interest at a floating rate plus an applicable margin dependent upon the denomination of the borrowing and pursuant to the terms of the 364 Day Credit Agreement. The Company must repay all advances under the 364 Day Credit Agreement by the earlier of September 11, 2019 or upon termination. The Company may, however, convert all advances outstanding upon termination, into a term loan that shall be repaid in full no later than the first anniversary of the termination date, provided that the Company, among other things, pays a fee to the administrative agent for the account of each lender. The 364 Day Credit Agreement serves as a liquidity back-stop for the Company's $3.0 billion U.S. Dollar and Euro commercial paper program. As of December 29, 2018, the Company had not drawn on its 364-Day committed credit facility. In addition, the Company has other short-term lines of credit that are primarily uncommitted, with numerous banks, aggregating $455.4 million, of which $357.8 million was available at December 29, 2018. Short-term arrangements are reviewed annually for renewal. At December 29, 2018, the aggregate amount of committed and uncommitted lines of credit, long-term and short-term, was $3.5 billion. At December 29, 2018, $376.1 million was recorded as short-term borrowings relating to commercial paper and amounts outstanding against uncommitted lines. In addition, $97.6 million of the short-term credit lines was utilized primarily pertaining to outstanding letters of credit for which there are no required or reported debt balances. The weighted-average interest rates on U.S. dollar denominated short-term borrowings for the years ended December 29, 2018 and December 30, 2017 were 2.3% and 1.2%, respectively. The weighted-average interest rate on Euro denominated short-term borrowings for the years ended December 29, 2018 and December 30, 2017 was negative 0.3%. In March 2015, the Company entered into a forward share purchase contract with a financial institution counterparty for 3,645,510 shares of common stock. The contract obligates the Company to pay $350.0 million, plus an additional amount related to the forward component of the contract. In June 2018, the Company amended the settlement date to April 2021, or earlier at the Company's option. In December 2013, the Company issued $400.0 million 5.75% fixed-to-floating rate junior subordinated debentures maturing December 15, 2053 (“2053 Junior Subordinated Debentures”) that bore interest at a fixed rate of 5.75% per annum, up to, but excluding December 15, 2018. From and including December 15, 2018, the 2053 Junior Subordinated Debentures will bear interest at an annual rate equal to three-month LIBOR plus 4.304%. The debentures subordination and long tenor provides significant credit protection measures for senior creditors and as a result, the debentures were awarded a 50% equity credit by S&P and Fitch, and 25% equity credit by Moody's. The net proceeds from the offering were primarily used to repay commercial paper borrowings. On February 25, 2019, the Company redeemed all of the outstanding 2053 Junior Subordinated Debentures for $405.7 million, which represented 100% of the principal amount plus accrued and unpaid interest to the redemption date. Refer to Note H, Long-Term Debt and Financing Arrangements, and Note J, Capital Stock, for further discussion regarding the Company's debt and equity arrangements. Contractual Obligations: The following table summarizes the Company’s significant contractual obligations and commitments that impact its liquidity: (a) Future payments on long-term debt encompass all payments related to aggregate debt maturities, excluding certain fair value adjustments included in long-term debt. As previously discussed, the Company redeemed all of the outstanding 2053 Junior Subordinated Debentures on February 25, 2019. Accordingly, the payment related to the redemption has been reflected in 2019 in the table above. Refer to Note H, Long-Term Debt and Financing Arrangements, for further discussion. (b) Future interest payments on long-term debt reflect the applicable fixed interest rate or variable rate for floating rate debt in effect at December 29, 2018. In addition, interest payments related to the 2053 Junior Subordinated Debentures have been adjusted accordingly as a result of the February 25, 2019 redemption discussed in (a) above. (c) Inventory purchase commitments primarily consist of open purchase orders to purchase raw materials, components, and sourced products. (d) Future cash flows on derivative instruments reflect the fair value and accrued interest as of December 29, 2018. The ultimate cash flows on these instruments will differ, perhaps significantly, based on applicable market interest and foreign currency rates at their maturity. (e) In March 2015, the Company entered into a forward share purchase contract with a financial institution counterparty which obligates the Company to pay $350 million, plus an additional amount related to the forward component of the contract. In June 2018, the Company amended the settlement date to April 2021, or earlier at the Company's option. See Note J, Capital Stock, for further discussion. (f) This amount principally represents contributions either required by regulations or laws or, with respect to unfunded plans, necessary to fund current benefits. The Company has not presented estimated pension and post-retirement funding beyond 2019 as funding can vary significantly from year to year based upon changes in the fair value of the plan assets, actuarial assumptions, and curtailment/settlement actions. (g) These amounts represent future contract adjustment payments to holders of the Company's 2020 Purchase Contracts. See Note J, Capital Stock, for further discussion. (h) The Company acquired the Craftsman® brand from Sears Holdings in March 2017. As part of the purchase price, the Company is obligated to pay $250 million in March 2020. See Note E, Acquisitions, for further discussion. (i) Income tax liability for the one-time deemed repatriation tax on unremitted foreign earnings and profits. See Note Q, Income Taxes, for further discussion. To the extent the Company can reliably determine when payments will occur, the related amounts will be included in the table above. However, due to the high degree of uncertainty regarding the timing of potential future cash flows associated with the contingent consideration liability related to the Craftsman acquisition and the unrecognized tax liabilities of $169 million and $460 million, respectively, at December 29, 2018, the Company is unable to make a reliable estimate of when (if at all) these amounts may be paid. Refer to Note E, Acquisitions, Note M, Fair Value Measurements, and Note Q, Income Taxes, for further discussion. Payments of the above contractual obligations (with the exception of payments related to debt principal, the forward stock purchase contract, contract adjustment fees, the March 2020 purchase price, and tax obligations) will typically generate a cash tax benefit such that the net cash outflow will be lower than the gross amounts summarized above. Other Significant Commercial Commitments: Short-term borrowings, long-term debt and lines of credit are explained in detail within Note H, Long-Term Debt and Financing Arrangements. MARKET RISK Market risk is the potential economic loss that may result from adverse changes in the fair value of financial instruments, currencies, commodities and other items traded in global markets. The Company is exposed to market risk from changes in foreign currency exchange rates, interest rates, stock prices, bond prices and commodity prices, amongst others. Exposure to foreign currency risk results because the Company, through its global businesses, enters into transactions and makes investments denominated in multiple currencies. The Company’s predominant currency exposures are related to the Euro, Canadian Dollar, British Pound, Australian Dollar, Brazilian Real, Argentine Peso, Chinese Renminbi (“RMB”) and the Taiwan Dollar. Certain cross-currency trade flows arising from both trade and affiliate sales and purchases are consolidated and netted prior to obtaining risk protection through the use of various derivative financial instruments which may include: purchased basket options, purchased options, collars, cross-currency swaps and currency forwards. The Company is thus able to capitalize on its global positioning by taking advantage of naturally offsetting exposures and portfolio efficiencies to reduce the cost of purchasing derivative protection. At times, the Company also enters into foreign exchange derivative contracts to reduce the earnings and cash flow impact of non-functional currency denominated receivables and payables, primarily for affiliate transactions. Gains and losses from these hedging instruments offset the gains or losses on the underlying net exposures. Management determines the nature and extent of currency hedging activities, and in certain cases, may elect to allow certain currency exposures to remain un-hedged. The Company may also enter into cross-currency swaps and forward contracts to hedge the net investments in certain subsidiaries and better match the cash flows of operations to debt service requirements. Management estimates the foreign currency impact from its derivative financial instruments outstanding at the end of 2018 would have been an incremental pre-tax loss of approximately $52 million based on a hypothetical 10% adverse movement in all net derivative currency positions. The Company follows risk management policies in executing derivative financial instrument transactions, and does not use such instruments for speculative purposes. The Company generally does not hedge the translation of its non-U.S. dollar earnings in foreign subsidiaries, but may choose to do so in certain instances in future periods. As mentioned above, the Company routinely has cross-border trade and affiliate flows that cause an impact on earnings from foreign exchange rate movements. The Company is also exposed to currency fluctuation volatility from the translation of foreign earnings into U.S. dollars and the economic impact of foreign currency volatility on monetary assets held in foreign currencies. It is more difficult to quantify the transactional effects from currency fluctuations than the translational effects. Aside from the use of derivative instruments, which may be used to mitigate some of the exposure, transactional effects can potentially be influenced by actions the Company may take. For example, if an exposure occurs from a European entity sourcing product from a U.S. supplier it may be possible to change to a European supplier. Management estimates the combined translational and transactional impact, on pre-tax earnings, of a 10% overall movement in exchange rates is approximately $174 million, or approximately $0.96 per diluted share. In 2018, translational and transactional foreign currency fluctuations negatively impacted pre-tax earnings by approximately $100.0 million and diluted earnings per share by approximately $0.55. The Company’s exposure to interest rate risk results from its outstanding debt and derivative obligations, short-term investments, and derivative financial instruments employed in the management of its debt portfolio. The debt portfolio including both trade and affiliate debt, is managed to achieve capital structure targets and reduce the overall cost of borrowing by using a combination of fixed and floating rate debt as well as interest rate swaps, and cross-currency swaps. The Company’s primary exposure to interest rate risk comes from its floating rate debt in the U.S. which is based on LIBOR rates. At December 29, 2018, the impact of a hypothetical 10% increase in the interest rates associated with the Company’s floating rate debt instruments would have an immaterial effect on the Company’s financial position and results of operations. The Company has exposure to commodity prices in many businesses, particularly brass, nickel, resin, aluminum, copper, zinc, steel, and energy used in the production of finished goods. Generally, commodity price exposures are not hedged with derivative financial instruments, but instead are actively managed through customer product and service pricing actions, procurement-driven cost reduction initiatives and other productivity improvement projects. Fluctuations in the fair value of the Company’s common stock affect domestic retirement plan expense as discussed below in the Employee Stock Ownership Plan ("ESOP") section of MD&A. Additionally, the Company has $85 million of liabilities as of December 29, 2018 pertaining to unfunded defined contribution plans for certain U.S. employees for which there is mark-to-market exposure. The assets held by the Company’s defined benefit plans are exposed to fluctuations in the market value of securities, primarily global stocks and fixed-income securities. The funding obligations for these plans would increase in the event of adverse changes in the plan asset values, although such funding would occur over a period of many years. In 2018, 2017, and 2016, investment returns on pension plan assets resulted in a $72 million decrease, a $217 million increase, and a $260 million increase, respectively. The Company expects funding obligations on its defined benefit plans to be approximately $44 million in 2019. The Company employs diversified asset allocations to help mitigate this risk. Management has worked to minimize this exposure by freezing and terminating defined benefit plans where appropriate. The Company has access to financial resources and borrowing capabilities around the world. There are no instruments within the debt structure that would accelerate payment requirements due to a change in credit rating. The Company’s existing credit facilities and sources of liquidity, including operating cash flows, are considered more than adequate to conduct business as normal. Accordingly, based on present conditions and past history, management believes it is unlikely that operations will be materially affected by any potential deterioration of the general credit markets that may occur. The Company believes that its strong financial position, operating cash flows, committed long-term credit facilities and borrowing capacity, and ability to access equity markets, provide the financial flexibility necessary to continue its record of annual dividend payments, to invest in the routine needs of its businesses, to make strategic acquisitions and to fund other initiatives encompassed by its growth strategy and maintain its strong investment grade credit ratings. OTHER MATTERS Employee Stock Ownership Plan ("ESOP") - As detailed in Note L, Employee Benefit Plans, the Company has an ESOP under which the ongoing U.S. Core and 401(k) defined contribution plans are funded. Overall ESOP expense is affected by the market value of the Company’s stock on the monthly dates when shares are released, among other factors. The Company’s net ESOP activity resulted in expense of $0.4 million in 2018, income of $1.3 million in 2017, and expense of $3.1 million in 2016. ESOP expense could increase in the future if the market value of the Company’s common stock declines. In addition, ESOP expense will increase once all remaining unallocated shares are released, which could occur as early as 2019. CRITICAL ACCOUNTING ESTIMATES - Preparation of the Company’s Consolidated Financial Statements requires management to make estimates and assumptions that affect the reported amounts of assets, liabilities, revenues and expenses. Significant accounting policies used in the preparation of the Consolidated Financial Statements are described in Note A, Significant Accounting Policies. Management believes the most complex and sensitive judgments, because of their significance to the Consolidated Financial Statements, result primarily from the need to make estimates about the effects of matters with inherent uncertainty. The most significant areas involving management estimates are described below. Actual results in these areas could differ from management’s estimates. ALLOWANCE FOR DOUBTFUL ACCOUNTS - The Company’s estimate for its allowance for doubtful accounts related to trade receivables is based on two methods. The amounts calculated from each of these methods are combined to determine the total amount reserved. First, a specific reserve is established for individual accounts where information indicates the customers may have an inability to meet financial obligations. In these cases, management uses its judgment, based on the surrounding facts and circumstances, to record a specific reserve for those customers against amounts due to reduce the receivable to the amount expected to be collected. These specific reserves are reevaluated and adjusted as additional information is received. Second, a reserve is determined for all customers based on a range of percentages applied to receivable aging categories. These percentages are based on historical collection and write-off experience. If circumstances change, for example, due to the occurrence of higher-than-expected defaults or a significant adverse change in a major customer’s ability to meet its financial obligation to the Company, estimates of the recoverability of receivable amounts due could be reduced. INVENTORIES - Inventories in the U.S. are primarily valued at the lower of Last-In First-Out (“LIFO”) cost or market, while non-U.S. inventories are primarily valued at the lower of First-In, First-Out (“FIFO”) cost and net realizable value. The calculation of LIFO reserves, and therefore the net inventory valuation, is affected by inflation and deflation in inventory components. The Company continually reviews the carrying value of discontinued product lines and stock-keeping-units (“SKUs”) to determine that these items are properly valued. The Company also continually evaluates the composition of its inventory and identifies obsolete and/or slow-moving inventories. Inventory items identified as obsolete and/or slow-moving are evaluated to determine if write-downs are required. The Company assesses the ability to dispose of these inventories at a price greater than cost. If it is determined that cost is less than market or net realizable value, as applicable, cost is used for inventory valuation. If market value or net realizable value, as applicable, is less than cost, the Company writes down the related inventory to that value. GOODWILL AND INTANGIBLE ASSETS - The Company acquires businesses in purchase transactions that result in the recognition of goodwill and intangible assets. The determination of the value of intangible assets requires management to make estimates and assumptions. In accordance with ASC 350-20, Goodwill, acquired goodwill and indefinite-lived intangible assets are not amortized but are subject to impairment testing at least annually or when an event occurs or circumstances change that indicate it is more likely than not an impairment exists. Definite-lived intangible assets are amortized and are tested for impairment when an event occurs or circumstances change that indicate it is more likely than not that an impairment exists. Goodwill represents costs in excess of fair values assigned to the underlying net assets of acquired businesses. At December 29, 2018, the Company reported $8.957 billion of goodwill, $2.199 billion of indefinite-lived trade names and $1.286 billion of net definite-lived intangibles. Management tests goodwill for impairment at the reporting unit level. A reporting unit is an operating segment as defined in ASC 280, Segment Reporting, or one level below an operating segment (component level) as determined by the availability of discrete financial information that is regularly reviewed by operating segment management or an aggregate of component levels of an operating segment having similar economic characteristics. If the carrying value of a reporting unit (including the value of goodwill) is greater than its estimated fair value, an impairment may exist. An impairment charge would be recorded to the extent that the recorded value of goodwill exceeded the implied fair value. As required by the Company’s policy, goodwill was tested for impairment in the third quarter of 2018. In accordance with Accounting Standards Update ("ASU") 2011-08, Intangibles - Goodwill and Other (Topic 350): Testing Goodwill for Impairment, companies are permitted to first assess qualitative factors to determine whether it is more likely than not that the fair value of a reporting unit is less than its carrying amount as a basis for determining whether it is necessary to perform the two-step quantitative goodwill impairment test. Under the two-step quantitative goodwill impairment test, the fair value of the reporting unit is compared to its respective carrying amount including goodwill. If the fair value exceeds the carrying amount, then no impairment exists. If the carrying amount exceeds the fair value, further analysis is performed to assess impairment. Such tests are completed separately with respect to the goodwill of each of the Company’s reporting units. Accordingly, for its annual impairment testing performed in the third quarter of 2018, the Company applied the qualitative assessment for two of its reporting units, while performing the quantitative test for three of its reporting units. Based on the results of this testing, the Company determined that the fair values of each of its reporting units exceeded their respective carrying amounts. In performing the qualitative assessments, the Company identified and considered the significance of relevant key factors, events, and circumstances that could affect the fair value of each reporting unit. These factors include external factors such as macroeconomic, industry, and market conditions, as well as entity-specific factors, such as actual and planned financial performance. The Company also assessed changes in each reporting unit's fair value and carrying value since the most recent date a fair value measurement was performed. As a result of the qualitative assessments performed, the Company concluded that it is more likely than not that the fair value of each reporting unit exceeded its respective carrying value and therefore, no additional quantitative impairment testing was performed. With respect to the quantitative tests, the Company assessed the fair values of the three reporting units based on a discounted cash flow valuation model. The key assumptions applied to the cash flow projections were discount rates, which ranged from 8.0% to 9.5%, near-term revenue growth rates over the next five years, which represented cumulative annual growth rates ranging from approximately 5% to 8%, and perpetual growth rates of 3%. These assumptions contemplated business, market and overall economic conditions. Based on the results of this testing, the Company determined that the fair values of each of the three reporting units exceeded their respective carrying amounts. Furthermore, management performed sensitivity analyses on the estimated fair values from the discounted cash flow valuation models utilizing more conservative assumptions that reflect reasonably likely future changes in the discount rate and perpetual growth rate. The discount rate was increased by 100 basis points with no impairment indicated. The perpetual growth rate was decreased by 150 basis points with no impairment indicated. The Company also tested its indefinite-lived trade names for impairment during the third quarter of 2018 utilizing a discounted cash flow model. The key assumptions used included discount rates, royalty rates, and perpetual growth rates applied to the projected sales. Based on these quantitative impairment tests, the Company determined that the fair values of the indefinite-lived trade names exceeded their respective carrying amounts. In the event that future operating results of any of the Company's reporting units or indefinite-lived trade names do not meet current expectations, management, based upon conditions at the time, would consider taking restructuring or other strategic actions, as necessary, to maximize revenue growth and profitability. A thorough analysis of all the facts and circumstances existing at that time would need to be performed to determine if recording an impairment loss would be appropriate. DEFINED BENEFIT OBLIGATIONS - The valuation of pension and other postretirement benefits costs and obligations is dependent on various assumptions. These assumptions, which are updated annually, include discount rates, expected return on plan assets, future salary increase rates, and health care cost trend rates. The Company considers current market conditions, including interest rates, to establish these assumptions. Discount rates are developed considering the yields available on high-quality fixed income investments with maturities corresponding to the duration of the related benefit obligations. The Company’s weighted-average discount rates used to determine benefit obligations at December 29, 2018 for the United States and international pension plans were 4.20% and 2.62%, respectively. The Company’s weighted-average discount rates used to determine benefit obligations at December 30, 2017 for the United States and international pension plans were 3.53% and 2.24%, respectively. As discussed further in Note L, Employee Benefit Plans, the Company develops the expected return on plan assets considering various factors, which include its targeted asset allocation percentages, historic returns, and expected future returns. The Company’s expected rate of return assumptions for the United States and international pension plans were 6.25% and 4.37%, respectively, at December 29, 2018. The Company will use a 5.51% weighted-average expected rate of return assumption to determine the 2019 net periodic benefit cost. A 25 basis point reduction in the expected rate of return assumption would increase 2019 net periodic benefit cost by approximately $5 million on a pre-tax basis. The Company believes that the assumptions used are appropriate; however, differences in actual experience or changes in the assumptions may materially affect the Company’s financial position or results of operations. To the extent that actual (newly measured) results differ from the actuarial assumptions, the difference is recognized in accumulated other comprehensive loss, and, if in excess of a specified corridor, amortized over future periods. The expected return on plan assets is determined using the expected rate of return and the fair value of plan assets. Accordingly, market fluctuations in the fair value of plan assets can affect the net periodic benefit cost in the following year. The projected benefit obligation for defined benefit plans exceeded the fair value of plan assets by $616 million at December 29, 2018. A 25 basis point reduction in the discount rate would have increased the projected benefit obligation by approximately $81 million at December 29, 2018. The primary Black & Decker U.S. pension and post employment benefit plans were curtailed in late 2010, as well as the only material Black & Decker international plan, and in their place the Company implemented defined contribution benefit plans. The vast majority of the projected benefit obligation pertains to plans that have been frozen; the remaining defined benefit plans that are not frozen are predominantly small domestic union plans and those that are statutorily mandated in certain international jurisdictions. The Company recognized $4 million of defined benefit plan income in 2018, which may fluctuate in future years depending upon various factors including future discount rates and actual returns on plan assets. ENVIRONMENTAL - The Company incurs costs related to environmental issues as a result of various laws and regulations governing current operations as well as the remediation of previously contaminated sites. The Company’s policy is to accrue environmental investigatory and remediation costs for identified sites when it is probable that a liability has been incurred and the amount of loss can be reasonably estimated. The amount of liability recorded is based on an evaluation of currently available facts with respect to each individual site and includes such factors as existing technology, presently enacted laws and regulations, and prior experience in remediation of contaminated sites. The liabilities recorded do not take into account any claims for recoveries from insurance or third parties. As assessments and remediation progress at individual sites, the amounts recorded are reviewed periodically and adjusted to reflect additional technical and legal information that becomes available. As of December 29, 2018, the Company had reserves of $246.6 million for remediation activities associated with Company-owned properties as well as for Superfund sites, for losses that are probable and estimable. The range of environmental remediation costs that is reasonably possible is $214.0 million to $344.3 million which is subject to change in the near term. The Company may be liable for environmental remediation of sites it no longer owns. Liabilities have been recorded on those sites in accordance with this policy. INCOME TAXES - The Company accounts for income taxes under the asset and liability method in accordance with ASC 740, Income Taxes, which requires the recognition of deferred tax assets and liabilities for the expected future tax consequences of events that have been included in the financial statements. Deferred tax assets and liabilities are determined based on the differences between the financial statements and tax basis of assets and liabilities using the enacted tax rates in effect for the year in which the differences are expected to reverse. Any changes in tax rates on deferred tax assets and liabilities are recognized in income in the period that includes the enactment date. The Company records net deferred tax assets to the extent that it is more likely than not that these assets will be realized. In making this determination, management considers all available positive and negative evidence, including future reversals of existing temporary differences, estimates of future taxable income, tax-planning strategies, and the realizability of net operating loss carryforwards. In the event that it is determined that an asset is not more likely that not to be realized, a valuation allowance is recorded against the asset. Valuation allowances related to deferred tax assets can be impacted by changes to tax laws, changes to statutory tax rates and future taxable income levels. In the event the Company were to determine that it would not be able to realize all or a portion of its deferred tax assets in the future, the unrealizable amount would be charged to earnings in the period in which that determination is made. Conversely, if the Company were to determine that it would be able to realize deferred tax assets in the future in excess of the net carrying amounts, it would decrease the recorded valuation allowance through a favorable adjustment to earnings in the period that the determination was made. The Act subjects a U.S. shareholder to current tax on global intangible low-taxed income (“GILTI”) earned by certain foreign subsidiaries. The Financial Accounting Standards Board ("FASB") Staff Q&A, Topic 740 No. 5, Accounting for Global Intangible Low-Taxed Income, states that an entity can make an accounting policy election to either recognize deferred taxes for temporary differences expected to reverse as GILTI in future years or provide for the tax expense related to GILTI in the year the tax is incurred. The Company has elected to recognize the tax on GILTI as a period expense in the period the tax is incurred. The Company records uncertain tax positions in accordance with ASC 740, which requires a two-step process. First, management determines whether it is more likely than not that a tax position will be sustained based on the technical merits of the position and second, for those tax positions that meet the more likely than not threshold, management recognizes the largest amount of the tax benefit that is greater than 50 percent likely to be realized upon ultimate settlement with the related taxing authority. The Company maintains an accounting policy of recording interest and penalties on uncertain tax positions as a component of Income taxes in the Consolidated Statements of Operations. The Company is subject to income tax in a number of locations, including many state and foreign jurisdictions. Significant judgment is required when calculating the worldwide provision for income taxes. Many factors are considered when evaluating and estimating the Company's tax positions and tax benefits, which may require periodic adjustments, and which may not accurately anticipate actual outcomes. It is reasonably possible that the amount of the unrecognized benefit with respect to certain of the Company's unrecognized tax positions will significantly increase or decrease within the next twelve months. These changes may be the result of settlements of ongoing audits or final decisions in transfer pricing matters. The Company periodically assesses its liabilities and contingencies for all tax years still subject to audit based on the most current available information, which involves inherent uncertainty. Additional information regarding income taxes is available in Note Q, Income Taxes. RISK INSURANCE - To manage its insurance costs efficiently, the Company self insures for certain U.S. business exposures and generally has low deductible plans internationally. For domestic workers’ compensation, automobile and product liability (liability for alleged injuries associated with the Company’s products), the Company generally purchases insurance coverage only for severe losses that are unlikely, and these lines of insurance involve the most significant accounting estimates. While different self insured retentions, in the form of deductibles and self insurance through its captive insurance company, exist for each of these lines of insurance, the maximum self insured retention is set at no more than $5 million per occurrence. The process of establishing risk insurance reserves includes consideration of actuarial valuations that reflect the Company’s specific loss history, actual claims reported, and industry trends among statistical and other factors to estimate the range of reserves required. Risk insurance reserves are comprised of specific reserves for individual claims and additional amounts expected for development of these claims, as well as for incurred but not yet reported claims discounted to present value. The cash outflows related to risk insurance claims are expected to occur over a period of approximately 14 years. The Company believes the liabilities recorded for these U.S. risk insurance reserves, totaling $86 million and $87 million as of December 29, 2018, and December 30, 2017, respectively, are adequate. Due to judgments inherent in the reserve estimation process, it is possible the ultimate costs will differ from this estimate. WARRANTY - The Company provides product and service warranties which vary across its businesses. The types of warranties offered generally range from one year to limited lifetime, and certain branded products recently acquired carry a lifetime warranty. There are also certain products with no warranty. Further, the Company sometimes incurs discretionary costs to service its products in connection with product performance issues. Historical warranty and service claim experience forms the basis for warranty obligations recognized. Adjustments are recorded to the warranty liability as new information becomes available. The Company believes the $102 million reserve for expected warranty claims as of December 29, 2018 is adequate, but due to judgments inherent in the reserve estimation process, including forecasting future product reliability levels and costs of repair as well as the estimated age of certain products submitted for claims, the ultimate claim costs may differ from the recorded warranty liability. The Company also establishes a reserve for product recalls on a product-specific basis during the period in which the circumstances giving rise to the recall become known and estimable for both company-initiated actions and those required by regulatory bodies. OFF-BALANCE SHEET ARRANGEMENT SYNTHETIC LEASES - The Company is a party to synthetic leasing programs for certain locations, including one of its major distribution centers and two of its office buildings. The programs qualify as operating leases for accounting purposes, where only the monthly lease expense is recorded in the Consolidated Statements of Operations and the liability and value of the underlying assets are off-balance sheet. These lease programs are utilized primarily to reduce overall cost and to retain flexibility. The cash outflows for lease payments approximate the $2 million of rent expense recognized in fiscal 2018. As of December 29, 2018, the estimated fair value of the underlying assets and lease guarantees of the residual values for these properties were $117 million and $100 million, respectively. CAUTIONARY STATEMENTS UNDER THE PRIVATE SECURITIES LITIGATION REFORM ACT OF 1995 This document contains “forward-looking statements” within the meaning of Section 27A of the Securities Act of 1933, as amended, and Section 21E of the Securities Exchange Act of 1934, as amended. All statements other than statements of historical fact are “forward-looking statements” for purposes of federal and state securities laws, including any projections or guidance of earnings, revenue or other financial items; any statements of the plans, strategies and objectives of management for future operations; any statements concerning proposed new products, services or developments; any statements regarding future economic conditions or performance; any statements of belief; and any statements of assumptions underlying any of the foregoing. Forward-looking statements may include, among other, the words “may,” “will,” “estimate,” “intend,” “continue,” “believe,” “expect,” “anticipate” or any other similar words. Although the Company believes that the expectations reflected in any of its forward-looking statements are reasonable, actual results could differ materially from those projected or assumed in any of its forward-looking statements. The Company's future financial condition and results of operations, as well as any forward-looking statements, are subject to change and to inherent risks and uncertainties, such as those disclosed or incorporated by reference in the Company's filings with the Securities and Exchange Commission. Important factors that could cause the Company's actual results, performance and achievements, or industry results to differ materially from estimates or projections contained in its forward-looking statements include, among others, the following: (i) successfully developing, marketing and achieving sales from new products and services and the continued acceptance of current products and services; (ii) macroeconomic factors, including global and regional business conditions (such as Brexit), commodity prices, inflation, and currency exchange rates; (iii) laws, regulations and governmental policies affecting the Company's activities in the countries where it does business, including those related to tariffs, taxation, and trade controls, including section 301 tariffs and section 232 steel and aluminum tariffs; (iv) the economic environment of emerging markets, particularly Latin America, Russia, China and Turkey; (v) realizing the anticipated benefits of mergers, acquisitions, joint ventures, strategic alliances or divestitures; (vi) pricing pressure and other changes within competitive markets; (vii) availability and price of raw materials, component parts, freight, energy, labor and sourced finished goods; (viii) the impact the tightened credit markets may have on the Company or its customers or suppliers; (ix) the extent to which the Company has to write off accounts receivable or assets or experiences supply chain disruptions in connection with bankruptcy filings by customers or suppliers; (x) the Company's ability to identify and effectively execute productivity improvements and cost reductions; (xi) potential business and distribution disruptions, including those related to physical security threats, information technology or cyber-attacks, epidemics, sanctions or natural disasters; (xii) the continued consolidation of customers, particularly in consumer channels; (xiii) managing franchisee relationships; (xiv) the impact of poor weather conditions; (xv) maintaining or improving production rates in the Company's manufacturing facilities, responding to significant changes in product demand and fulfilling demand for new and existing products; (xvi) changes in the competitive landscape in the Company's markets; (xvii) the Company's non-U.S. operations, including sales to non-U.S. customers; (xviii) the impact from demand changes within world-wide markets associated with homebuilding and remodeling; (xix) potential adverse developments in new or pending litigation and/or government investigations; (xx) changes in the Company's ability to obtain debt on commercially reasonable terms and at competitive rates; (xxi) substantial pension and other postretirement benefit obligations; (xxii) potential environmental liabilities; (xxiii) work stoppages or other labor disruptions; and (xxiv) changes in accounting estimates. Additional factors that could cause actual results to differ materially from forward-looking statements are set forth in this Annual Report on Form 10-K, including under the heading “Risk Factors,” “Management’s Discussion and Analysis of Financial Condition and Results of Operations” and in the Consolidated Financial Statements and the related Notes. Forward-looking statements in this Annual Report on Form 10-K speak only as of the date hereof, and forward-looking statements in documents attached that are incorporated by reference speak only as of the date of those documents. The Company does not undertake any obligation to update or release any revisions to any forward-looking statement or to report any events or circumstances after the date hereof or to reflect the occurrence of unanticipated events, except as required by law.

<s>[INST] The following discussion and certain other sections of this Annual Report on Form 10K contain statements reflecting the Company’s views about its future performance that constitute “forwardlooking statements” under the Private Securities Litigation Reform Act of 1995. These forwardlooking statements are based on current expectations, estimates, forecasts and projections about the industry and markets in which the Company operates as well as management’s beliefs and assumptions. Any statements contained herein (including without limitation statements to the effect that Stanley Black & Decker, Inc. or its management “believes,” “expects,” “anticipates,” “plans” and similar expressions) that are not statements of historical fact should be considered forwardlooking statements. These statements are not guarantees of future performance and involve certain risks, uncertainties and assumptions that are difficult to predict. There are a number of important factors that could cause actual results to differ materially from those indicated by such forwardlooking statements. These factors include, without limitation, those set forth, or incorporated by reference, below under the heading “Cautionary Statements Under The Private Securities Litigation Reform Act Of 1995.” The Company does not intend to update publicly any forwardlooking statements whether as a result of new information, future events or otherwise. Strategic Objectives The Company continues to pursue a growth and acquisition strategy, which involves industry, geographic and customer diversification to foster sustainable revenue, earnings and cash flow growth, and employ the following strategic framework in pursuit of its vision to reach $22 billion in revenue by 2022 while expanding its margin rate ("22/22 Vision"): Continue organic growth momentum by utilizing the Stanley Fulfillment System ("SFS") 2.0 operating system, diversifying toward highergrowth, highermargin businesses, and increasing the relative weighting of emerging markets; Be selective and operate in markets where brand is meaningful, the value proposition is definable and sustainable through innovation, and global cost leadership is achievable; and Pursue acquisitive growth on multiple fronts by building upon its existing global tools platform, expanding the Industrial platform in Engineered Fastening and Infrastructure, consolidating the commercial electronic security industry, and pursuing adjacencies with sound industrial logic. Execution of the above strategy has resulted in approximately $9.4 billion of acquisitions since 2002 (excluding the Black & Decker merger), several divestitures, improved efficiency in the supply chain and manufacturing operations, and enhanced investments in organic growth, enabled by cash flow generation and increased debt capacity. In addition, the Company's continued focus on diversification and organic growth has resulted in improved financial results and an increase in its global presence. The Company also remains focused on increasing its presence in emerging markets, with a goal of generating greater than 20% of annual revenues from those markets over time, and leveraging SFS 2.0 to upgrade innovation and digital capabilities, maintain commercial and supply chain excellence, and focus on reducing SG&A, in part, through functional transformation. Lastly, the Company continues to make strides towards achieving its 22/22 Vision by becoming known as one of the world’s leading innovators, delivering topquartile financial performance and elevating its commitment to social responsibility. The Company’s longterm financial objectives remain as follows: 46% organic revenue growth; 1012% total revenue growth; 1012% total EPS growth (79% organically) excluding acquisitionrelated charges; Free cash flow equal to, or exceeding, net income; and Sustain 10+ working capital turns. In terms of capital allocation, the Company remains committed, over time, to returning approximately 50% of free cash flow to shareholders through a strong and growing dividend as well as opportunistically repurchasing shares. The remaining free cash flow (approximately 50%) will be deployed towards acquisitions. The following represents recent examples of the Company executing its strategic objectives: Acquisitions and Other Transactions On January 2, 2019, the Company acquired a 20 percent interest in MTD Holdings Inc. ("MTD"), a privately held global manufacturer of outdoor power equipment, for $234 million in cash. With 2017 revenues of $2.4 billion, [/INST] Negative. </s>

STANLEY BLACK & DECKER, INC.

2020-02-21

2019-12-28

ITEM 7. MANAGEMENT’S DISCUSSION AND ANALYSIS OF FINANCIAL CONDITION AND RESULTS OF OPERATIONS The financial and business analysis below provides information which the Company believes is relevant to an assessment and understanding of its consolidated financial position, results of operations and cash flows. This financial and business analysis should be read in conjunction with the Consolidated Financial Statements and related notes. All references to “Notes” in this Item 7 refer to the Notes to Consolidated Financial Statements included in Item 8 of this Annual Report. The following discussion and certain other sections of this Annual Report on Form 10-K contain statements reflecting the Company’s views about its future performance that constitute “forward-looking statements” under the Private Securities Litigation Reform Act of 1995. These forward-looking statements are based on current expectations, estimates, forecasts and projections about the industry and markets in which the Company operates as well as management’s beliefs and assumptions. Any statements contained herein (including without limitation statements to the effect that Stanley Black & Decker, Inc. or its management “believes,” “expects,” “anticipates,” “plans” and similar expressions) that are not statements of historical fact should be considered forward-looking statements. These statements are not guarantees of future performance and involve certain risks, uncertainties and assumptions that are difficult to predict. There are a number of important factors that could cause actual results to differ materially from those indicated by such forward-looking statements. These factors include, without limitation, those set forth, or incorporated by reference, below under the heading “Cautionary Statements Under The Private Securities Litigation Reform Act Of 1995.” The Company does not intend to update publicly any forward-looking statements whether as a result of new information, future events or otherwise. Strategic Objectives The Company continues to pursue a growth and acquisition strategy, which involves industry, geographic and customer diversification to foster sustainable revenue, earnings and cash flow growth, and employ the following strategic framework in pursuit of its vision to deliver top-quartile financial performance, become known as one of the world’s leading innovators and elevate its commitment to social responsibility: • Continue organic growth momentum by leveraging the SBD Operating Model to drive innovation and commercial excellence, while diversifying toward higher-growth, higher-margin businesses; • Be selective and operate in markets where brand is meaningful, the value proposition is definable and sustainable through innovation, and global cost leadership is achievable; and • Pursue acquisitive growth on multiple fronts by building upon its existing global tools platform, expanding the Industrial platform in Engineered Fastening and Infrastructure, consolidating the commercial electronic security industry, and pursuing adjacencies with sound industrial logic. Execution of the above strategy has resulted in approximately $10.1 billion of acquisitions since 2002 (excluding the Black & Decker merger and pending acquisition of Consolidated Aerospace Manufacturing, LLC, as discussed below), a 20 percent investment in MTD Holdings Inc. ("MTD"), several divestitures, improved efficiency in the supply chain and manufacturing operations, and enhanced investments in organic growth, enabled by cash flow generation and increased debt capacity. In addition, the Company's continued focus on diversification and organic growth has resulted in improved financial results and an increase in its global presence. The Company also remains focused on leveraging its SBD Operating Model to deliver success in the 2020s and beyond. The latest evolution of the SBD Operating Model, formerly Stanley Fulfillment System ("SFS") 2.0, builds on the strength of the Company's past while embracing changes in the external environment to ensure the Company has the right skillsets, incorporates technology advances in all areas, maintains operational excellence, drives efficiency in business processes and resiliency into its culture, delivers extreme innovation and ensures the customer experience is world class. As it has in the past, the new operating model will underpin the Company's ability to deliver above-market organic growth with margin expansion, maintain efficient levels of selling, general and administrative expenses ("SG&A") and deliver top-quartile asset efficiency. The Company’s long-term financial objectives remain as follows: • 4-6% organic revenue growth; • 10-12% total revenue growth; • 10-12% total EPS growth (7-9% organically) excluding acquisition-related charges; • Free cash flow equal to, or exceeding, net income; • Sustain 10+ working capital turns; and • Cash Flow Return On Investment ("CFROI") between 12-15%. In terms of capital allocation, the Company remains committed, over time, to returning approximately 50% of free cash flow to shareholders through a strong and growing dividend as well as opportunistically repurchasing shares. The remaining free cash flow (approximately 50%) will be deployed towards acquisitions. Share Repurchases In April 2018, the Company repurchased 1,399,732 shares of common stock for approximately $200 million. In July 2018, the Company repurchased 2,086,792 shares of common stock for approximately $300 million. Acquisitions and Investments On March 8, 2019, the Company acquired the International Equipment Solutions Attachments businesses, Paladin and Pengo, ("IES Attachments"), a manufacturer of high quality, performance-driven heavy equipment attachment tools for off-highway applications. The acquisition further diversifies the Company's presence in the industrial markets, expands its portfolio of attachment solutions and provides a meaningful platform for continued growth. On January 2, 2019, the Company acquired a 20 percent interest in MTD, a privately held global manufacturer of outdoor power equipment. MTD manufactures and distributes gas-powered lawn tractors, zero turn mowers, walk behind mowers, snow throwers, trimmers, chain saws, utility vehicles and other outdoor power equipment. Under the terms of the agreement, the Company has the option to acquire the remaining 80 percent of MTD beginning on July 1, 2021 and ending on January 2, 2029. In the event the option is exercised, the companies have agreed to a valuation multiple based on MTD’s 2018 Earnings Before Interest, Taxes, Depreciation and Amortization ("EBITDA"), with an equitable sharing arrangement for future EBITDA growth. The investment in MTD increases the Company's presence in the $20 billion outdoor power equipment market and allows the two companies to work together to pursue revenue and cost opportunities, improve operational efficiency, and introduce new and innovative products for professional and residential outdoor equipment customers, utilizing each company's respective portfolios of strong brands. On April 2, 2018, the Company acquired Nelson Fastener Systems (“Nelson”), which excluded Nelson's automotive stud welding business. This acquisition, which has been integrated into the Engineered Fastening business, is complementary to the Company's product offerings, enhances its presence in the general industrial end markets, expands its portfolio of highly-engineered fastening solutions, and is delivering cost synergies. On March 9, 2017, the Company acquired the Tools business of Newell Brands ("Newell Tools") which included the highly attractive industrial cutting, hand tool and power tool accessory brands IRWIN® and LENOX®. The acquisition enhanced the Company’s position within the global tools & storage industry and broadened the Company’s product offerings and solutions to customers and end users, particularly within power tool accessories. On March 8, 2017, the Company purchased the Craftsman® brand from Sears Holdings Corporation (“Sears Holdings”). The acquisition provided the Company with the rights to develop, manufacture and sell Craftsman®-branded products in non-Sears Holdings channels. The acquisition significantly increased the availability of Craftsman®-branded products to consumers in previously underpenetrated channels, enhanced innovation, and added manufacturing jobs in the U.S. to support growth. Pending Acquisition On January 3, 2020, the Company entered into an agreement to purchase Consolidated Aerospace Manufacturing, LLC ("CAM"). CAM is an industry-leading manufacturer of specialty fasteners and components for the aerospace and defense markets. The Company expects the acquisition to further diversify the Company's presence in the industrial markets and expand its portfolio of specialty fasteners in the high-growth, high-margin aerospace and defense market. The acquisition will provide well-recognized brands, a proven business model, deep customer relationships, an experienced management team and compelling cash flow characteristics, which will create an attractive pathway for profitable organic and acquisitive growth and shareholder returns. This transaction is subject to customary closing conditions, including regulatory approval, and is expected to close in late February 2020. Refer to Note E, Acquisitions and Investments, for further discussion. Divestitures On May 30, 2019, the Company sold its Sargent and Greenleaf mechanical locks business within the Security segment. The divestiture allows the Company to invest in other areas of the Company that fit into its long-term growth strategy. On February 22, 2017, the Company sold the majority of its mechanical security businesses, which included the commercial hardware brands of Best Access, phi Precision and GMT. The sale allowed the Company to deploy capital in a more accretive and growth-oriented manner. Refer to Note T, Divestitures, for further discussion of the Company's divestitures. Certain Items Impacting Earnings Throughout MD&A, the Company has provided a discussion of the outlook and results both inclusive and exclusive of acquisition-related and other charges. The results and measures, including gross profit and segment profit, on a basis excluding these amounts are considered relevant to aid analysis and understanding of the Company's results aside from the material impact of these items. These amounts are as follows: The Company reported $363 million in pre-tax charges during 2019, which were comprised of the following: • $40 million reducing Gross Profit pertaining to facility-related and inventory step-up charges; • $139 million in SG&A primarily for integration-related costs, Security business transformation and margin resiliency initiatives; • $30 million in Other, net primarily related to deal transaction costs; • $17 million gain related to the sale of the Sargent & Greenleaf business; • $153 million in Restructuring charges pertaining to severance and facility closures associated with a cost reduction program; and • $18 million related to a non-cash loss on the extinguishment of debt. The tax effect on the above net charges was approximately $78 million. In addition, the Company's share of MTD's net earnings included an after-tax charge of approximately $24 million primarily related to an inventory step-up adjustment. The amounts above resulted in net after-tax charges of $309 million, or $2.05 per diluted share. The Company reported $450 million in pre-tax charges during 2018, which were comprised of the following: • $66 million reducing Gross Profit primarily pertaining to inventory step-up charges for the Nelson acquisition and an incremental freight charge due to nonperformance by a third-party service provider; • $158 million in SG&A primarily for integration-related costs, consulting fees, and a non-cash fair value adjustment; • $108 million in Other, net primarily related to deal transaction costs and a settlement with the Environmental Protection Agency ("EPA"); • $1 million related to a previously divested business; and • $117 million in Restructuring charges which primarily related to a cost reduction program. The Company also recorded a net tax charge of $181 million, which was comprised of charges related to the Tax Cuts and Jobs Act ("the Act") partially offset by the tax benefit of the above pre-tax charges. The above amounts resulted in net after-tax charges of $631 million, or $4.16 per diluted share. The Company reported $156 million in pre-tax charges during 2017, which were comprised of the following: • $47 million reducing Gross Profit primarily pertaining to inventory step-up charges for the Newell Tools acquisition; • $38 million in SG&A primarily for integration-related costs and consulting fees; • $58 million in Other, net primarily for deal transaction and consulting costs; and • $13 million in Restructuring charges pertaining to facility closures and employee severance. The Company also reported a $264 million pre-tax gain on sales of businesses in 2017, primarily relating to the sale of the majority of the mechanical security businesses. The net tax benefit of the acquisition-related charges and gain on sales of businesses was $7 million. Furthermore, the Company recorded a $24 million net tax charge relating to the Act. The acquisition-related charges, gain on sales of businesses, and net tax charge relating to the Act resulted in a net after-tax gain of $91 million, or $0.59 per diluted share. Driving Further Profitable Growth by Fully Leveraging Our Core Franchises Each of the Company's franchises share common attributes: they have world-class brands and attractive growth characteristics, they are scalable and defensible, they can differentiate through innovation, and they are powered by the SBD Operating Model. • The Tools & Storage business is the tool company to own, with strong brands, proven innovation, global scale, and a broad offering of power tools, hand tools, accessories, and storage & digital products across many channels in both developed and developing markets. • The Engineered Fastening business is a highly profitable, GDP+ growth business offering highly engineered, value-added innovative solutions with recurring revenue attributes and global scale. • The Security business, with its attractive recurring revenue, presents a significant margin accretion opportunity over the longer term and has historically provided a stable revenue stream through economic cycles, is a gateway into the digital world and an avenue to capitalize on rapid digital changes. Security has embarked on a business transformation which will apply technology to lower its cost to serve and create new commercial offerings for its small to medium enterprise and large key account customers. While diversifying the business portfolio through strategic acquisitions remains important, management recognizes that the core franchises described above are important foundations that continue to provide strong cash flow and growth prospects. Management is committed to growing these businesses through innovative product development, brand support, continued investment in emerging markets and a sharp focus on global cost competitiveness. Continuing to Invest in the Stanley Black & Decker Brands The Company has a strong portfolio of brands associated with high-quality products including STANLEY®, BLACK+DECKER®, DEWALT®, FLEXVOLT®, IRWIN®, LENOX®, CRAFTSMAN®, PORTER-CABLE®, BOSTITCH®, PROTO®, MAC TOOLS®, FACOM®, AeroScout®, Powers®, LISTA®, SIDCHROME®, Vidmar®, SONITROL®, and GQ®. Among the Company's most valuable assets, the STANLEY®, BLACK+DECKER® and DEWALT® brands are recognized as three of the world's great brands, while the CRAFTSMAN® brand is recognized as a premier American brand. During 2019, the STANLEY®, DEWALT® and CRAFTSMAN® brands had prominent signage in Major League Baseball ("MLB") stadiums appearing in many MLB games. The Company has also maintained long-standing NASCAR and NHRA racing sponsorships, which provided brand exposure during nearly 60 events in 2019 with the STANLEY®, DEWALT®, CRAFTSMAN®, IRWIN® and MAC TOOLS® brands. The Company also advertises in the English Premier League, which is the number one soccer league in the world, featuring STANLEY®, BLACK+DECKER® and DEWALT® brands to a global audience. In 2014, the Company became a sponsor for one of the world’s most popular football clubs, FC Barcelona ("FCB"), including player image rights, hospitality assets and stadium signage. In 2018, the Company was announced as the first ever shirt sponsor for the FCB Women's team in support of its commitment to global diversity and inclusion. In addition, the Company continues to sponsor the Envision Virgin Racing Formula E team in support of the Company's commitment to sustainability and the future of electric mobility. The above marketing initiatives highlight the Company's strong emphasis on brand building and commercial support, which has resulted in more than 300 billion global brand impressions annually via digital and traditional advertising and strong brand awareness. The Company will continue allocating its brand and advertising spend wisely to capture the emerging digital landscape, whilst continuing to evolve proven marketing programs to deliver famous global brands that are deeply committed to societal improvement, along with transformative technologies to build relevant and meaningful 1:1 customer, consumer, employee and shareholder relationships in support of the Company's long-term vision. The SBD Operating Model: Winning in the 2020s Over the past 15 years, the Company has successfully leveraged its proven and continually evolving operating model to focus the organization to sustain top-quartile performance, resulting in asset efficiency, above-market organic growth and expanding operating margins. In its first evolution, the Stanley Fulfillment System ("SFS") focused on streamlining operations, which helped reduce lead times, realize synergies during acquisition integrations, and mitigate material and energy price inflation. In 2015, the Company launched a refreshed and revitalized SFS operating system, entitled SFS 2.0, to drive from a more programmatic growth mentality to a true organic growth culture by more deeply embedding breakthrough innovation and commercial excellence into its businesses, and at the same time, becoming a significantly more digitally-enabled enterprise. Now in 2020, recognizing the changing dynamics of the world in which the Company operates, including the acceleration of technological change, geopolitical instability and the changing nature of work, the Company has launched the new SBD Operating Model: Winning in the 2020s. At the center of the model is the concept of the interrelationship between people and technology. The remaining four categories are: Performance Resiliency; Extreme Innovation; Operations Excellence and Extraordinary Customer Experience. Each of these elements co-exists synergistically with the others in a systems-based approach. People and Technology This pillar emphasizes the Company's belief that the right combination of digitally proficient people applying technology such as artificial intelligence, machine learning, advanced analytics, IOT and others in focused ways can be an enormous source of value creation and sustainability for the Company. It also brings to light the changing nature of work and the talent and skillsets required for individuals and institutions to thrive in the future. With technology infiltrating the workplace at an increasingly rapid pace, the Company believes that the winners in the 2020s will invest heavily in reskilling, upskilling and lifelong learning with an emphasis on the places where people and technology intersect. In other words, technology can make humans more powerful and productive if, and only if, humans know how to apply the technology to maximum advantage. The Company has created plans and programs, as well as a new leadership model to ensure people have the right skills, tools and mindsets to thrive in this era. The ability for employees to embrace technology, learn and relearn new skills and take advantage of the opportunities presented in this new world will be critical to the Company's success. Performance Resiliency The Company views performance resiliency as the agility, flexibility and adaptability to sustain strong performance regardless of the operating environment conditions, which requires planning for the unexpected and anticipating exogenous volatility as the new normal. Technology, applied to key business processes, products and business models, will be a key enabler for value creation and performance resiliency as the Company executes sustainable, ongoing transformation across the enterprise. Extreme Innovation The Company has a historically strong foundation in innovation, launching more than 1,000 products a year, including breakthroughs such as DEWALT Flexvolt, Atomic and Xtreme. In recent years, the Company has expanded its innovation-focused internal teams and external partnerships, but now it is growing that innovation ecosystem at a rapid pace, expanding the number of external collaborations with start-ups and entrepreneurs, academic institutions, research labs and others. This innovation culture, which includes a focus on social impact in addition to the Company's traditional product and customer focus, enables the Company to introduce products to market faster and reimagine how to operate in today’s technology-enabled, fast-paced world. Operations Excellence An intense focus on operations excellence and asset efficiency is mandatory in a dynamic world in which the bar for competitiveness is always moving higher. To help maintain the Company's edge, a much more agile, adaptable and technology-enabled supply chain is necessary. Industry 4.0 is essential to this transformation. For several years, the Company has been moving to a “Make Where We Sell” and “Buy Where We Make” system, where more products are being manufactured in local markets. Today, about 50% of the products sold in North America are made in North America and the target is to continue to push that higher. This will improve customer responsiveness, lower lead times, reduce costs and mitigate geopolitical and currency risk while facilitating major improvements in carbon footprint. Extraordinary Customer Experience Customers are increasingly demanding world-class experiences from their brands and expectations for execution at the customer level are growing every day. It is no longer sufficient to have great products on the shelf or in the catalog. The Company knows that to sustain market share growth, it needs to evolve and adapt to provide the types of experiences that customers now expect. While commercial excellence has always been an important part of SFS 2.0 and will continue to be part of the Company's new model, the Company's new thrust in this area takes it to another level. Each of the Company's businesses is making a baseline assessment and segmentation of its various customer experiences while systematically gaining insights into what can be done to elevate those customer experiences to the extraordinary level. As previously noted, the interaction between people and technology will define success in this area. Leveraging the SBD Operating Model, the Company is building a culture in which it strives to become known as one of the world’s great innovative companies by embracing the current environment of rapid innovation and digital transformation. The Company continues to build a vast innovation focused ecosystem to pursue faster innovation and to remain aware of and open to new technologies and advances by leveraging both internal initiatives and external partnerships. The innovation ecosystem used in concert with the SBD Operating Model is anticipated to allow the Company to apply innovation to its core processes in manufacturing and back office functions to reduce operating costs and inefficiencies, develop core and breakthrough product innovations within each of its businesses, and pursue disruptive business models to either push into new markets or change existing business models before competition or new market entrants capture the opportunity. The Company continues to make progress towards this vision, as evidenced by the creation of Innovation Everywhere, a program that encourages and empowers all employees to implement value creation and cost savings using collaborative and innovative solutions, breakthrough innovation teams in each business, the Stanley Ventures group, which invests capital in new and emerging start-ups in core focus areas, the Techstars partnership, which selects start-ups from around the world with the goal of bringing breakthrough technologies to market, the Manufactory 4.0, which is the Company's epicenter for Industry 4.0 technology development and partnership, and STANLEY X, a Silicon Valley based team, which is building its own set of disruptive initiatives and exploring new business models. The Company has made a significant commitment to the SBD Operating Model and management believes that its success will be characterized by continued asset efficiency, organic growth in the 4-6% range as well as expanded operating margin rates over the next 3 to 5 years as the Company leverages the growth and reduces structural SG&A levels. The Company believes that the SBD Operating Model will serve as a powerful value driver in the years ahead, ensuring the Company is positioned to win in the 2020s by developing and obtaining the right people and technology to deliver performance resiliency, extreme innovation, operations excellence and an extraordinary customer experience. The new operating model, in concert with the Company's innovation ecosystem, will enable the Company to change as rapidly as the external environment which directly supports achievement of the Company's long-term financial objectives, including its vision, and further enables its shareholder-friendly capital allocation approach, which has served the Company well in the past and will continue to do so in the future. Outlook for 2020 This outlook discussion is intended to provide broad insight into the Company’s near-term earnings and cash flow generation prospects. The Company expects 2020 diluted earnings per share to approximate $8.05 to $8.35 ($8.80 to $9.00 excluding acquisition-related and other charges), and free cash flow conversion, defined as free cash flow divided by net income, to approximate 90% to 100%, reflecting the impact of restructuring payments associated with the 2019 cost reduction program. The 2020 outlook for adjusted diluted earnings per share assumes approximately $0.95 of accretion due to the benefit from the cost reduction program; approximately $0.40 to $0.50 of accretion related to organic growth; approximately $0.60 to $0.70 of dilution from incremental tariffs and currency headwinds; and approximately $0.25 of dilution due to the expected tax rate, financing costs and other items below operating margin. The difference between the 2020 diluted earnings per share outlook and the diluted earnings per share range, excluding charges, is $0.65 to $0.75, consisting of acquisition-related and other charges. These forecasted charges primarily relate to restructuring, deal and integration costs, as well as Security business transformation and key margin resiliency initiatives. RESULTS OF OPERATIONS Below is a summary of the Company’s operating results at the consolidated level, followed by an overview of business segment performance. Terminology: The term “organic” is utilized to describe results aside from the impacts of foreign currency fluctuations, acquisitions during their initial 12 months of ownership, and divestitures. This ensures appropriate comparability to operating results of prior periods. Net Sales: Net sales were $14.442 billion in 2019 compared to $13.982 billion in 2018, representing an increase of 3% driven by organic growth of 3%, including a 2% increase in volume and 1% increase in price. Acquisitions, primarily IES Attachments, increased sales by 2%, while the impact of foreign currency decreased sales by 2%. Tools & Storage net sales increased 3% compared to 2018 due to increases in volume and price of 4% and 1%, respectively, partially offset by a 2% decrease from foreign currency. Industrial net sales increased 11% compared to 2018 primarily due to acquisition growth of 16%, partially offset by decreases of 3% from lower volumes and 2% from foreign currency. Security net sales declined 2% compared to 2018 as 1% increases in both price and small bolt-on commercial electronic security acquisitions were more than offset by a 3% decrease due to foreign currency and a 1% decrease from the sale of the Sargent & Greenleaf business. Net sales were $13.982 billion in 2018 compared to $12.967 billion in 2017, representing an increase of 8% with strong organic growth of 5%. Acquisitions, primarily Newell Tools and Nelson, increased sales by 3%. Tools & Storage net sales increased 9% compared to 2017 due to strong organic growth of 7%, fueled by solid growth across all regions, and acquisition growth of 2%. Industrial net sales increased 11% compared to 2017 primarily due to acquisition growth of 9% and favorable currency of 2%. Security net sales increased 2% compared to 2017 due to increases of 1% in price, 3% in small bolt-on commercial electronic security acquisitions and 1% in foreign currency, partially offset by declines of 1% from the sale of the majority of the mechanical security businesses and 2% from lower volumes. Gross Profit: The Company reported gross profit of $4.806 billion, or 33.3% of net sales, in 2019 compared to $4.851 billion, or 34.7% of net sales, in 2018. Acquisition-related and other charges, which reduced gross profit, were $39.7 million in 2019 and $65.7 million in 2018. Excluding these charges, gross profit was 33.5% of net sales in 2019 compared to 35.2% in 2018, as volume, productivity and price were more than offset by tariffs, commodity inflation and foreign exchange. The Company reported gross profit of $4.851 billion, or 34.7% of net sales, in 2018 compared to $4.778 billion, or 36.9% of net sales, in 2017. Acquisition-related and other charges, which reduced gross profit, were $65.7 million in 2018 and $46.8 million in 2017. Excluding these charges, gross profit was 35.2% of net sales in 2018, compared to 37.2% in 2017, as volume leverage, productivity and price were more than offset by external headwinds, including commodity inflation, foreign exchange and tariffs. SG&A Expense: Selling, general and administrative expenses, inclusive of the provision for doubtful accounts (“SG&A”), were $3.041 billion, or 21.1% of net sales, in 2019 compared to $3.172 billion, or 22.7% of net sales, in 2018. Within SG&A, acquisition-related and other charges totaled $139.5 million in 2019 and $157.8 million in 2018. Excluding these charges, SG&A was 20.1% of net sales in 2019 compared to 21.6% in 2018, primarily reflecting disciplined cost management and actions taken in response to external headwinds. SG&A expenses were $3.172 billion, or 22.7% of net sales, in 2018 compared to $2.999 billion, or 23.1% of net sales, in 2017. Acquisition-related and other charges totaled $157.8 million in 2018 and $37.7 million in 2017. Excluding these charges, SG&A was 21.6% of net sales in 2018 compared to 22.8% in 2017, due primarily to prudent cost management and volume leverage. Distribution center costs (i.e. warehousing and fulfillment facility and associated labor costs) are classified within SG&A. This classification may differ from other companies who may report such expenses within cost of sales. Due to diversity in practice, to the extent the classification of these distribution costs differs from other companies, the Company’s gross margins may not be comparable. Such distribution costs classified in SG&A amounted to $326.7 million in 2019, $316.0 million in 2018 and $279.8 million in 2017. Corporate Overhead: The corporate overhead element of SG&A, which is not allocated to the business segments, amounted to $229.5 million, or 1.6% of net sales, in 2019, $202.8 million, or 1.5% of net sales, in 2018 and $217.4 million, or 1.7% of net sales, in 2017. Excluding acquisition-related charges of $23.4 million in 2019, $12.7 million in 2018, and $0.7 million in 2017, the corporate overhead element of SG&A was 1.4% of net sales in 2019 and 2018, compared to 1.7% in 2017, reflecting continued cost management. Other, net: Other, net totaled $249.1 million in 2019 compared to $287.0 million in 2018 and $269.2 million in 2017. Excluding acquisition-related and other charges, Other, net totaled $218.9 million, $178.9 million, and $211.0 million in 2019, 2018, and 2017, respectively. The year-over-year increase in 2019 was driven by higher intangible amortization and a favorable resolution of a prior claim in 2018. The year-over-year decrease in 2018 was driven by an environmental remediation charge of $17 million in 2017 relating to a legacy Black & Decker site and a favorable resolution of a prior claim in 2018, which more than offset higher intangible amortization expense in 2018. (Gain) Loss on Sales of Businesses: During 2019, the Company reported a $17.0 million gain relating to the sale of the Sargent and Greenleaf business. During 2018, the Company reported a $0.8 million loss relating to a previously divested business. During 2017, the Company reported a $264.1 million gain primarily relating to the sale of the majority of the Company's mechanical security businesses. Pension Settlement: Pension settlement of $12.2 million in 2017 reflects losses previously reported in Accumulated other comprehensive loss related to a non-U.S. pension plan for which the Company settled its obligation by purchasing an annuity and making lump sum payments to participants. Loss on Debt Extinguishment: During the fourth quarter of 2019, the Company extinguished $750 million of its notes payable and recognized a $17.9 million pre-tax loss related to the write-off of deferred financing fees. Interest, net: Net interest expense in 2019 was $230.4 million compared to $209.2 million in 2018 and $182.5 million in 2017. The increase in 2019 compared to 2018 was primarily driven by interest on the senior unsecured notes issued in November 2018 and lower interest income on deposits due to a decline in rates. The increase in net interest expense in 2018 versus 2017 was primarily due to higher interest rates and higher average balances relating to the Company's U.S. commercial paper borrowings partially offset by higher interest income. Income Taxes: The Company's effective tax rate was 14.2% in 2019, 40.7% in 2018, and 19.7% in 2017. Excluding the impact of divestitures and acquisition-related and other charges previously discussed, the effective tax rate in 2019 is 16.0%. This effective tax rate differs from the U.S. statutory tax rate primarily due to a portion of the Company's earnings being realized in lower-taxed foreign jurisdictions, and the favorable effective settlements of income tax audits. The 2018 effective tax rate included net charges associated with the Act, which primarily related to the re-measurement of existing deferred tax balances, adjustments to the one-time transition tax, and the provision of deferred taxes on unremitted foreign earnings and profits for which the Company no longer asserted indefinite reinvestment. Excluding the impacts of the net charge related to the Act as well as the acquisition-related and other charges previously discussed, the effective tax rate in 2018 was 16.0%. This effective tax rate differed from the U.S. statutory tax rate primarily due to a portion of the Company's earnings being realized in lower-taxed foreign jurisdictions and the favorable effective settlements of income tax audits. The 2017 effective tax rate included a one-time net charge relating to the provisional amounts recorded associated with the Act, which was enacted in December 2017. The net charge primarily related to the re-measurement of existing deferred tax balances and the one-time transition tax. Excluding the impact of the divestitures, acquisition-related charges, and the net charge related to the Act, the effective tax rate was 20.0% in 2017. This effective tax rate differed from the U.S. statutory rate primarily due to a portion of the Company's earnings being realized in lower-taxed foreign jurisdictions, the favorable settlement of certain income tax audits, and the acceleration of certain tax credits resulting in a tax benefit. Business Segment Results The Company’s reportable segments are aggregations of businesses that have similar products, services and end markets, among other factors. The Company utilizes segment profit which is defined as net sales minus cost of sales and SG&A inclusive of the provision for doubtful accounts (aside from corporate overhead expense), and segment profit as a percentage of net sales to assess the profitability of each segment. Segment profit excludes the corporate overhead expense element of SG&A, other, net (inclusive of intangible asset amortization expense), gain or loss on sales of businesses, pension settlement, restructuring charges, loss on debt extinguishment, interest income, interest expense, income taxes and share of net loss of equity method investment. Corporate overhead is comprised of world headquarters facility expense, cost for the executive management team and expenses pertaining to certain centralized functions that benefit the entire Company but are not directly attributable to the businesses, such as legal and corporate finance functions. Refer to Note F, Goodwill and Intangible Assets, and Note O, Restructuring Charges, for the amount of intangible asset amortization expense and net restructuring charges, respectively, attributable to each segment. The Company classifies its business into three reportable segments, which also represent its operating segments: Tools & Storage, Industrial and Security. Tools & Storage: The Tools & Storage segment is comprised of the Power Tools & Equipment ("PTE") and Hand Tools, Accessories & Storage ("HTAS") businesses. The PTE business includes both professional and consumer products. Professional products include professional grade corded and cordless electric power tools and equipment including drills, impact wrenches and drivers, grinders, saws, routers and sanders, as well as pneumatic tools and fasteners including nail guns, nails, staplers and staples, concrete and masonry anchors. Consumer products include corded and cordless electric power tools sold primarily under the BLACK+DECKER® brand, lawn and garden products, including hedge trimmers, string trimmers, lawn mowers, edgers and related accessories, and home products such as hand-held vacuums, paint tools and cleaning appliances. The HTAS business sells hand tools, power tool accessories and storage products. Hand tools include measuring, leveling and layout tools, planes, hammers, demolition tools, clamps, vises, knives, saws, chisels and industrial and automotive tools. Power tool accessories include drill bits, screwdriver bits, router bits, abrasives, saw blades and threading products. Storage products include tool boxes, sawhorses, medical cabinets and engineered storage solution products. Tools & Storage net sales increased $248.1 million, or 3%, in 2019 compared to 2018 due to a 4% increase in volume and 1% increase in price, partially offset by unfavorable currency of 2%. The 5% organic growth was led by North America and Europe, more than offsetting a decline in emerging markets. North America organic growth was driven by the roll-out of the Craftsman brand and new product innovation, such as DEWALT Flexvolt, Atomic and Xtreme, partially offset by declines in Canada and industrial-focused businesses. Europe growth was supported by new products and successful commercial actions. The organic decline in emerging markets was driven by weak market conditions in Turkey, China and certain countries in Latin America, which more than offset the benefits from price, new product launches and e-commerce expansion. Segment profit amounted to $1.533 billion, or 15.2% of net sales, in 2019 compared to $1.393 billion, or 14.2% of net sales, in 2018. Excluding acquisition-related and other charges of $44.3 million and $142.6 million in 2019 and 2018, respectively, segment profit amounted to 15.7% of net sales in 2019 compared to 15.6% in 2018, as the benefits from volume leverage, actions taken in response to external headwinds and price were partially offset by tariffs, commodity inflation, and foreign exchange. Tools & Storage net sales increased $769.0 million, or 9%, in 2018 compared to 2017. Organic sales increased 7%, with a 6% increase in volume and 1% increase in price, reflecting strong growth in each of the regions, and acquisitions, primarily Newell Tools, increased net sales by 2%. North America growth was driven by new product innovation, the roll-out of the Craftsman brand and price realization. Europe growth was supported by new products and successful commercial actions. The growth in emerging markets was driven by mid-price-point product releases, e-commerce strategies and pricing actions. Segment profit amounted to $1.393 billion, or 14.2% of net sales, in 2018 compared to $1.439 billion, or 15.9% of net sales, in 2017. Excluding acquisition-related and other charges of $142.6 million and $81.8 million in 2018 and 2017, respectively, segment profit amounted to 15.6% of net sales in 2018 compared to 16.8% in 2017, as the benefits from volume leverage, pricing and cost control were more than offset by the impacts from currency, commodity inflation and tariffs. Industrial: The Industrial segment is comprised of the Engineered Fastening and Infrastructure businesses. The Engineered Fastening business primarily sells engineered fastening products and systems designed for specific applications. The product lines include blind rivets and tools, blind inserts and tools, drawn arc weld studs and systems, engineered plastic and mechanical fasteners, self-piercing riveting systems, precision nut running systems, micro fasteners, and high-strength structural fasteners. The Infrastructure business consists of the Oil & Gas and Attachment Tools product lines. Oil & Gas sells and rents custom pipe handling, joint welding and coating equipment used in the construction of large and small diameter pipelines, and provides pipeline inspection services. Attachment Tools sells hydraulic tools, attachments and accessories. Industrial net sales increased $246.9 million, or 11%, in 2019 compared to 2018, due to acquisition growth of 16%, partially offset by declines of 3% in volume and 2% from foreign currency. Engineered Fastening organic revenues decreased 3% as fastener penetration gains were more than offset by inventory reductions and lower production levels within industrial and automotive customers. Infrastructure organic revenues were down 2%, as growth within Oil & Gas was offset by declines in hydraulic tools from a difficult scrap steel market. Segment profit totaled $334.1 million, or 13.7% of net sales, in 2019 compared to $319.8 million, or 14.6% of net sales, in 2018. Excluding acquisition-related and other charges of $25.8 million and $26.0 million in 2019 and 2018, respectively, segment profit amounted to 14.8% of net sales in 2019 compared to 15.8% in 2018, as productivity gains and cost control were more than offset by lower volume and externally driven cost inflation. Industrial net sales increased $213.5 million, or 11%, in 2018 compared to 2017, due to acquisition growth of 9% and favorable foreign currency of 2%. Engineered Fastening organic revenues increased 1% due primarily to industrial and automotive fastener penetration gains which were partially offset by the expected impact from lower automotive system shipments. Infrastructure organic revenues were down 1% due to anticipated lower pipeline project activity in Oil & Gas, partially offset by volume growth in hydraulic tools. Segment profit totaled $319.8 million, or 14.6% of net sales, in 2018 compared to $345.9 million, or 17.5% of net sales, in 2017. Excluding acquisition-related and other charges of $26.0 million in 2018, segment profit amounted to 15.8% of net sales in 2018 compared to 17.5% in 2017, as productivity gains and cost control were more than offset by commodity inflation and the modestly dilutive impact from the Nelson acquisition. Security: The Security segment is comprised of the Convergent Security Solutions ("CSS") and the Mechanical Access Solutions ("MAS") businesses. The CSS business designs, supplies and installs commercial electronic security systems and provides electronic security services, including alarm monitoring, video surveillance, fire alarm monitoring, systems integration and system maintenance. Purchasers of these systems typically contract for ongoing security systems monitoring and maintenance at the time of initial equipment installation. The business also sells healthcare solutions, which include asset tracking, infant protection, pediatric protection, patient protection, wander management, fall management, and emergency call products. The MAS business primarily sells automatic doors. Security net sales decreased $35.2 million, or 2%, in 2019 compared to 2018, as 1% increases in both price and small bolt-on commercial electronic security acquisitions were more than offset by a 3% decrease due to foreign currency and a 1% decrease from the sale of the Sargent & Greenleaf business. Organic sales for North America increased 3% driven by increased installations within commercial electronic security and higher volumes in healthcare and automatic doors. Europe declined 1% organically as growth in France was offset by continued market weakness in the Nordics and the UK. Segment profit amounted to $126.6 million, or 6.5% of net sales, in 2019 compared to $169.3 million, or 8.5% of net sales, in 2018. Excluding acquisition-related and other charges of $85.7 million and $42.2 million in 2019 and 2018, respectively, segment profit amounted to 10.9% of net sales in 2019 compared to 10.7% in 2018, as the benefits of organic growth and a focus on cost containment were partially offset by investments to support the business transformation in commercial electronic security and the dilutive impact from the Sargent & Greenleaf divestiture. Security net sales increased $33.3 million, or 2%, in 2018 compared to 2017, primarily due to increases of 1% in price, 3% in small bolt-on commercial electronic security acquisitions and 1% in foreign currency, partially offset by declines of 1% from the sale of the majority of the mechanical security businesses and 2% from lower volumes. Organic sales for North America decreased 1% as higher volumes within automatic doors were offset by lower installations in commercial electronic security. Europe declined 1% organically as strength within the Nordics was offset by weakness in the UK and France. Segment profit amounted to $169.3 million, or 8.5% of net sales, in 2018 compared to $211.7 million, or 10.9% of net sales, in 2017. Excluding acquisition-related and other charges of $42.2 million and $2.0 million in 2018 and 2017, respectively, segment profit amounted to 10.7% of net sales in 2018 compared to 11.0% in 2017. The year-over-year change in segment profit rate reflects investments to support business transformation in commercial electronic security and the impact from the sale of the majority of the mechanical security business, partially offset by a continued focus on cost containment. RESTRUCTURING ACTIVITIES A summary of the restructuring reserve activity from December 29, 2018 to December 28, 2019 is as follows: During 2019, the Company recognized net restructuring charges of $154.1 million, primarily related to severance costs associated with a cost reduction program announced in the third quarter of 2019. Current and expected actions of the program include headcount reductions across the Company as well as footprint rationalization opportunities. The Company expects the 2019 actions to result in annual net cost savings of approximately $185 million by the end of 2020. The majority of the $147.8 million of reserves remaining as of December 28, 2019 is expected to be utilized within the next twelve months. During 2018, the Company recognized net restructuring charges of $160.3 million, which primarily related to a cost reduction program executed in the fourth quarter of 2018. This amount reflected $151.0 million of net severance charges associated with the reduction of 4,184 employees and $9.3 million of facility closure and other restructuring costs. The 2018 actions resulted in annual net cost savings of approximately $230 million, primarily in the Tools & Storage and Security segments. During 2017, the Company recognized net restructuring charges of $51.5 million. This amount reflected $40.6 million of net severance charges associated with the reduction of 1,584 employees and $10.9 million of facility closure and other restructuring costs. The 2017 actions resulted in annual net cost savings of approximately $45 million in 2018, primarily in the Tools & Storage and Security segments. Segments: The $154 million of net restructuring charges in 2019 includes: $63 million pertaining to the Tools & Storage segment; $27 million pertaining to the Industrial segment; $18 million pertaining to the Security segment; and $46 million pertaining to Corporate. The anticipated annual net cost savings of approximately $185 million related to the 2019 restructuring actions include: $89 million in the Tools & Storage segment; $34 million in the Industrial segment; $28 million in the Security segment; and $34 million in Corporate. FINANCIAL CONDITION Liquidity, Sources and Uses of Capital: The Company’s primary sources of liquidity are cash flows generated from operations and available lines of credit under various credit facilities. Operating Activities: Cash flows provided by operations were $1.506 billion in 2019 compared to $1.261 billion in 2018. The year-over-year increase was mainly attributable to improved working capital (accounts receivable, inventory, accounts payable and deferred revenue) as a result of an intense focus on working capital management and lower inventory investment associated with recent Tools & Storage brand roll-outs. In 2018, cash flows from operations were $1.261 billion compared to $669 million in 2017. The year-over-year increase related primarily to the retrospective adoption of new cash flow accounting standards in the first quarter of 2018, which decreased 2017 operating cash flows by approximately $750 million. Excluding the impact of these new standards, cash flows provided by operations in 2018 decreased year-over-year primarily due to higher income tax payments and higher payments associated with acquisition-related and other charges. Free Cash Flow: Free cash flow, as defined in the table below, was $1.081 billion in 2019 compared to $769 million in 2018 and $226 million in 2017. Excluding the retrospective impacts of the previously discussed new cash flow standards adopted in the first quarter of 2018, free cash flow totaled $976 million in 2017. The improvement in free cash flow in 2019 was driven by higher operating cash flows as discussed above and lower capital expenditures due to higher investments in the Company's supply chain and SFS 2.0 initiatives in both 2018 and 2017. Management considers free cash flow an important indicator of its liquidity, as well as its ability to fund future growth and provide dividends to shareowners. Free cash flow does not include deductions for mandatory debt service, other borrowing activity, discretionary dividends on the Company’s common stock and business acquisitions, among other items. Investing Activities: Cash flows used in investing activities totaled $1.209 billion in 2019, driven by business acquisitions of $685 million, primarily related to IES Attachments, capital and software expenditures of $425 million and purchases of investments of $261 million, which mainly related to the 20 percent investment in MTD. Cash flows used in investing activities in 2018 totaled $989 million, primarily due to business acquisitions of $525 million, mainly related to the Nelson acquisition, and capital and software expenditures of $492 million. The increase in capital and software expenditures in 2018 was primarily due to technology-related and capacity investments to support the Company's strong organic growth and its SFS 2.0 initiatives. Cash flows used in investing activities in 2017 totaled $1.567 billion, which primarily consisted of business acquisitions of $2.584 billion, mainly related to the Newell Tools and Craftsman acquisitions, and capital and software expenditures of $443 million, partially offset by proceeds of $757 million from sales of businesses and $705 million from the deferred purchase price receivable related to an accounts receivable sales program, which was terminated in February 2018. Financing Activities: Cash flows used in financing activities totaled $293 million in 2019 driven by payments on long-term debt of $1.150 billion and cash dividend payments of $402 million, partially offset by $735 million in net proceeds from the issuance of equity units and net proceeds from debt issuances of $496 million. Cash flows used in financing activities totaled $562 million in 2018 primarily related to the repurchase of common shares for $527 million and cash dividend payments of $385 million, partially offset by $433 million of net proceeds from short-term borrowings under the Company's commercial paper program. Cash flows provided by financing activities in 2017 totaled $295 million, primarily due to $726 million in net proceeds from the issuance of equity units, partially offset by $363 million of cash payments for dividends and $77 million of net repayments of short-term borrowings under the Company's commercial paper program. Fluctuations in foreign currency rates negatively impacted cash by $1 million and $54 million in 2019 and 2018, respectively, due to the strengthening of the U.S. Dollar against the Company's other currencies, while positively impacting cash by $81 million in 2017 due to the weakening of the U.S. Dollar against other currencies. Refer to Note H, Long-Term Debt and Financing Arrangements, and Note J, Capital Stock, for further discussion regarding the Company's debt and equity arrangements. Credit Ratings and Liquidity: The Company maintains strong investment grade credit ratings from the major U.S. rating agencies on its senior unsecured debt (S&P A, Fitch A-, Moody's Baa1), as well as its commercial paper program (S&P A-1, Fitch, Moody's P-2). The Company's Fitch short-term credit rating was upgraded to during the third quarter of 2019 from the previous rating of. Failure to maintain strong investment grade rating levels could adversely affect the Company’s cost of funds, liquidity and access to capital markets, but would not have an adverse effect on the Company’s ability to access its existing committed credit facilities. Cash and cash equivalents totaled $298 million as of December 28, 2019, comprised of $57 million in the U.S. and $241 million in foreign jurisdictions. As of December 29, 2018, cash and cash equivalents totaled $289 million, comprised of $60 million in the U.S. and $229 million in foreign jurisdictions. As a result of the Act, the Company's tax liability related to the one-time transition tax associated with unremitted foreign earnings and profits totaled $344 million at December 28, 2019. The Act permits a U.S. company to elect to pay the net tax liability interest-free over a period of up to eight years. See the Contractual Obligations table below for the estimated amounts due by period. The Company has considered the implications of paying the required one-time transition tax, and believes it will not have a material impact on its liquidity. Refer to Note Q, Income Taxes, for further discussion of the impacts of the Act. The Company has a $3.0 billion commercial paper program which includes Euro denominated borrowings in addition to U.S. Dollars. As of December 28, 2019, the Company had approximately $336 million of borrowings outstanding representing Euro denominated commercial paper, which was designated as a net investment hedge. As of December 29, 2018, the Company had approximately $373 million of borrowings outstanding, of which approximately $229 million in Euro denominated commercial paper was designated as a net investment hedge. Refer to Note I, Financial Instruments, for further discussion. The Company has a five-year $2.0 billion committed credit facility (the “5-Year Credit Agreement”). Borrowings under the 5-Year Credit Agreement may be made in U.S. Dollars, Euros or Pounds Sterling. A sub-limit amount of $653.3 million is designated for swing line advances which may be drawn in Euros pursuant to the terms of the 5-Year Credit Agreement. Borrowings bear interest at a floating rate plus an applicable margin dependent upon the denomination of the borrowing and specific terms of the 5-Year Credit Agreement. The Company must repay all advances under the 5-Year Credit Agreement by the earlier of September 12, 2023 or upon termination. The 5-Year Credit Agreement is designated to be part of the liquidity back-stop for the Company's $3.0 billion U.S. Dollar and Euro commercial paper program. As of December 28, 2019, and December 29, 2018, the Company had not drawn on its five-year committed credit facility. In September 2019, the Company terminated its 364-Day $1.0 billion committed credit facility and concurrently executed a new 364-Day $1.0 billion committed credit facility (the "September 364-Day Credit Agreement"). Borrowings under the September 364-Day Credit Agreement may be made in U.S. Dollars or Euros and bear interest at a floating rate plus an applicable margin dependent upon the denomination of the borrowing and pursuant to the terms of the September 364-Day Credit Agreement. The Company must repay all advances under the September 364-Day Credit Agreement by the earlier of September 9, 2020 or upon termination. The Company may, however, convert all advances outstanding upon termination into a term loan that shall be repaid in full no later than the first anniversary of the termination date provided that the Company, among other things, pays a fee to the administrative agent for the account of each lender. The September 364-Day Credit Agreement serves as part of the liquidity back-stop for the Company’s $3.0 billion U.S. Dollar and Euro commercial paper program previously discussed. As of December 28, 2019, and December 29, 2018, the Company had not drawn on its 364-Day committed credit facilities. In addition, the Company has other short-term lines of credit that are primarily uncommitted, with numerous banks, aggregating $521 million, of which approximately $433 million was available at December 28, 2019. Short-term arrangements are reviewed annually for renewal. At December 28, 2019, the aggregate amount of committed and uncommitted lines of credit, long-term and short-term, was $3.5 billion. At December 28, 2019, $337 million was recorded as short-term borrowings relating to commercial paper and amounts outstanding against uncommitted lines. In addition, $89 million of the short-term credit lines was utilized primarily pertaining to outstanding letters of credit for which there are no required or reported debt balances. The weighted-average interest rate on U.S. dollar denominated short-term borrowings for 2019 and 2018 was 2.3%. The weighted-average interest rate on Euro denominated short-term borrowings for 2019 and 2018 was negative 0.3%. In February 2020, the Company issued $750 million of senior unsecured term notes maturing March 15, 2030 ("2030 Term Notes") and $750 million of fixed-to-fixed reset rate junior subordinated debentures maturing March 15, 2060 (“2060 Junior Subordinated Debentures”). The 2030 Term Notes will accrue interest at a fixed rate of 2.3% per annum, with interest payable semi-annually in arrears, and rank equally in right of payment with all of the Company's existing and future unsecured and unsubordinated debt. The 2060 Junior Subordinated Debentures will bear interest at a fixed rate of 4.0% per annum, payable semi-annually in arrears, up to but excluding March 15, 2025. From and including March 15, 2025, the interest rate will be reset for each subsequent five-year reset period equal to the Five-Year Treasury Rate plus 2.657%. The Five-Year Treasury Rate is based on the average yields on actively traded U.S. treasury securities adjusted to constant maturity, for five-year maturities. On each five-year reset date, the 2060 Junior Subordinated Debentures can be called at par value. The 2060 Junior Subordinated Debentures are unsecured and rank subordinate and junior in right of payment to all of the Company’s existing and future senior debt. The Company received total net proceeds from these offerings of approximately $1.487 billion, which reflected approximately $13 million of underwriting expenses and other fees associated with the transactions. The net proceeds from the offering will be used for general corporate purposes, including acquisition funding and repayment of short-term borrowings. In December 2019, the Company redeemed all of the outstanding 2052 Junior Subordinated Debentures for approximately $760 million, which represented 100% of the principal amount plus accrued and unpaid interest. In March 2019, the Company issued $500 million of senior unsecured notes, maturing on March 1, 2026 ("2026 Term Notes"). The 2026 Term Notes accrue interest at a fixed rate of 3.40% per annum with interest payable semi-annually in arrears. The 2026 Term Notes rank equally in right of payment with all of the Company's existing and future unsecured and unsubordinated debt. The Company received net cash proceeds of $496 million which reflects the notional amount offset by a discount, underwriting expenses, and other fees associated with the transaction. The Company used the net proceeds from the offering for general corporate purposes, including repayment of other borrowings. In February 2019, the Company redeemed all of the outstanding 2053 Junior Subordinated Debentures for approximately $406 million, which represented 100% of the principal amount plus accrued and unpaid interest. In November 2019, the Company issued 7,500,000 Equity Units with a total notional value of $750 million ("2019 Equity Units"). Each unit has a stated amount of $100 and initially consisted of a three-year forward stock purchase contract ("2022 Purchase Contracts") for the purchase of a variable number of shares of common stock, on November 15, 2022, for a price of $100, and a 10% beneficial ownership interest in one share of 0% Series D Cumulative Perpetual Convertible Preferred Stock, without par, with a liquidation preference of $1,000 per share ("Series D Preferred Stock"). The Company received approximately $735 million in cash proceeds from the 2019 Equity Units, net of underwriting costs and commissions, before offering expenses, and issued 750,000 shares of Series D Preferred Stock, recording $750 million in preferred stock. The proceeds were used, together with cash on hand, to redeem the 2052 Junior Subordinated Debentures in December 2019, as previously discussed. The Company also used $19 million of the proceeds to enter into capped call transactions utilized to hedge potential economic dilution. On and after November 15, 2022, the Series D Preferred Stock may be converted into common stock at the option of the holder. At the election of the Company, upon conversion, the Company may deliver cash, common stock, or a combination thereof. On or after December 22, 2022, the Company may elect to redeem for cash, all or any portion of the outstanding shares of the Series D Preferred Stock at a redemption price equal to 100% of the liquidation preference, plus any accumulated and unpaid dividends. If the Company calls the Series D Preferred Stock for redemption, holders may convert their shares immediately preceding the redemption date. Upon settlement of the 2022 Purchase Contracts, the Company will receive additional cash proceeds of $750 million. The Company will pay the holders of the 2022 Purchase Contracts quarterly contract adjustment payments, which will commence February 15, 2020. As of December 28, 2019, the present value of the contract adjustment payments was approximately $114 million. In March 2018, the Company purchased from a financial institution “at-the-money” capped call options with an approximate term of three years, on 3.2 million shares of its common stock (subject to customary anti-dilution adjustments) for an aggregate premium of $57 million. As of December 28, 2019, the capped call has an adjusted lower strike price of $156.59 and an adjusted upper strike price of $203.57. The purpose of the capped call options was to hedge the risk of stock price appreciation between the lower and upper strike prices of the capped call options for a future share repurchase. In May 2017, the Company issued 7,500,000 Equity Units with a total notional value of $750 million ("2017 Equity Units"). Each unit has a stated amount of $100 and initially consisted of a three-year forward stock purchase contract ("2020 Purchase Contracts") for the purchase of a variable number of shares of common stock, on May 15, 2020, for a price of $100, and a 10% beneficial ownership interest in one share of 0% Series C Cumulative Perpetual Convertible Preferred Stock, without par, with a liquidation preference of $1,000 per share ("Series C Preferred Stock"). The Company received approximately $726 million in cash proceeds from the 2017 Equity Units, net of underwriting costs and commissions, before offering expenses, and issued 750,000 shares of Series C Preferred Stock, recording $750 million in preferred stock. The proceeds were used for general corporate purposes, including repayment of short-term borrowings. The Company also used $25 million of the proceeds to enter into capped call transactions utilized to hedge potential economic dilution. On and after May 15, 2020, the Series C Preferred Stock may be converted into common stock at the option of the holder. At the election of the Company, upon conversion, the Company may deliver cash, common stock, or a combination thereof. On or after June 22, 2020, the Company may elect to redeem for cash, all or any portion of the outstanding shares of the Series C Preferred Stock at a redemption price equal to 100% of the liquidation preference, plus any accumulated and unpaid dividends. If the Company calls the Series C Preferred Stock for redemption, holders may convert their shares immediately preceding the redemption date. Upon settlement of the 2020 Purchase Contracts, the Company will receive additional cash proceeds of $750 million. The Company pays the holders of the 2020 Purchase Contracts quarterly contract adjustment payments, which commenced in August 2017. As of December 28, 2019, the present value of the contract adjustment payments was approximately $20 million. In March 2015, the Company entered into a forward share purchase contract with a financial institution counterparty for 3,645,510 shares of common stock. The contract obligates the Company to pay $350 million, plus an additional amount related to the forward component of the contract. In February 2020, the Company amended the settlement date to April 2022, or earlier at the Company's option. Refer to Note H, Long-Term Debt and Financing Arrangements, and Note J, Capital Stock, for further discussion regarding the Company's debt and equity arrangements. Contractual Obligations: The following table summarizes the Company’s significant contractual obligations and commitments that impact its liquidity: (a) Future payments on long-term debt encompass all payments related to aggregate debt maturities, excluding certain fair value adjustments included in long-term debt. As previously discussed, the Company issued the 2030 Term Notes and 2060 Junior Subordinated Debentures in February 2020. Accordingly, the future payments related to these issuances have been reflected in the table above. Refer to Note H, Long-Term Debt and Financing Arrangements. (b) Future interest payments on long-term debt reflect the applicable interest rate in effect at December 28, 2019. In addition, the amounts above reflect future interest payments associated with the previously discussed 2030 Term Notes and 2060 Junior Subordinated Debentures issued in February 2020. (c) Inventory purchase commitments primarily consist of open purchase orders to purchase raw materials, components, and sourced products. (d) Future cash flows on derivative instruments reflect the fair value and accrued interest as of December 28, 2019. The ultimate cash flows on these instruments will differ, perhaps significantly, based on applicable market interest and foreign currency rates at their maturity. (e) In March 2015, the Company entered into a forward share purchase contract with a financial institution counterparty which obligates the Company to pay $350 million, plus an additional amount related to the forward component of the contract. In February 2020, the Company amended the settlement date to April 2022, or earlier at the Company's option. See Note J, Capital Stock, for further discussion. (f) This amount principally represents contributions either required by regulations or laws or, with respect to unfunded plans, necessary to fund current benefits. The Company has not presented estimated pension and post-retirement funding beyond 2020 as funding can vary significantly from year to year based upon changes in the fair value of the plan assets, actuarial assumptions, and curtailment/settlement actions. (g) These amounts represent future contract adjustment payments to holders of the Company's 2020 and 2022 Purchase Contracts. See Note J, Capital Stock, for further discussion. (h) The Company acquired the Craftsman® brand from Sears Holdings in March 2017. As part of the purchase price, the Company is obligated to pay $250 million in March 2020. See Note E, Acquisitions and Investments, for further discussion. (i) Income tax liability for the one-time deemed repatriation tax on unremitted foreign earnings and profits. See Note Q, Income Taxes, for further discussion. To the extent the Company can reliably determine when payments will occur, the related amounts will be included in the table above. However, due to the high degree of uncertainty regarding the timing of potential future cash flows associated with the contingent consideration liability related to the Craftsman acquisition and the unrecognized tax liabilities of $196 million and $454 million, respectively, at December 28, 2019, the Company is unable to make a reliable estimate of when (if at all) these amounts may be paid. Refer to Note E, Acquisitions and Investments, Note M, Fair Value Measurements, and Note Q, Income Taxes, for further discussion. Payments of the above contractual obligations (with the exception of payments related to debt principal, the forward stock purchase contract, contract adjustment fees, the March 2020 purchase price, and tax obligations) will typically generate a cash tax benefit such that the net cash outflow will be lower than the gross amounts summarized above. Other Significant Commercial Commitments: Short-term borrowings, long-term debt and lines of credit are explained in detail within Note H, Long-Term Debt and Financing Arrangements. MARKET RISK Market risk is the potential economic loss that may result from adverse changes in the fair value of financial instruments, currencies, commodities and other items traded in global markets. The Company is exposed to market risk from changes in foreign currency exchange rates, interest rates, stock prices, bond prices and commodity prices, amongst others. Exposure to foreign currency risk results because the Company, through its global businesses, enters into transactions and makes investments denominated in multiple currencies. The Company’s predominant currency exposures are related to the Euro, Canadian Dollar, British Pound, Australian Dollar, Brazilian Real, Argentine Peso, Chinese Renminbi (“RMB”) and the Taiwan Dollar. Certain cross-currency trade flows arising from both trade and affiliate sales and purchases are consolidated and netted prior to obtaining risk protection through the use of various derivative financial instruments which may include: purchased basket options, purchased options, collars, cross-currency swaps and currency forwards. The Company is thus able to capitalize on its global positioning by taking advantage of naturally offsetting exposures and portfolio efficiencies to reduce the cost of purchasing derivative protection. At times, the Company also enters into foreign exchange derivative contracts to reduce the earnings and cash flow impacts of non-functional currency denominated receivables and payables, primarily for affiliate transactions. Gains and losses from these hedging instruments offset the gains or losses on the underlying net exposures. Management determines the nature and extent of currency hedging activities, and in certain cases, may elect to allow certain currency exposures to remain un-hedged. The Company may also enter into cross-currency swaps and forward contracts to hedge the net investments in certain subsidiaries and better match the cash flows of operations to debt service requirements. Management estimates the foreign currency impact from its derivative financial instruments outstanding at the end of 2019 would have been an incremental pre-tax loss of approximately $37 million based on a hypothetical 10% adverse movement in all net derivative currency positions. The Company follows risk management policies in executing derivative financial instrument transactions, and does not use such instruments for speculative purposes. The Company generally does not hedge the translation of its non-U.S. dollar earnings in foreign subsidiaries, but may choose to do so in certain instances in future periods. As mentioned above, the Company routinely has cross-border trade and affiliate flows that cause an impact on earnings from foreign exchange rate movements. The Company is also exposed to currency fluctuation volatility from the translation of foreign earnings into U.S. dollars and the economic impact of foreign currency volatility on monetary assets held in foreign currencies. It is more difficult to quantify the transactional effects from currency fluctuations than the translational effects. Aside from the use of derivative instruments, which may be used to mitigate some of the exposure, transactional effects can potentially be influenced by actions the Company may take. For example, if an exposure occurs from a European entity sourcing product from a U.S. supplier it may be possible to change to a European supplier. Management estimates the combined translational and transactional impact, on pre-tax earnings, of a 10% overall movement in exchange rates is approximately $158 million, or approximately $0.88 per diluted share. In 2019, translational and transactional foreign currency fluctuations negatively impacted pre-tax earnings by approximately $120 million, or approximately $0.67 per diluted share. The Company’s exposure to interest rate risk results from its outstanding debt and derivative obligations, short-term investments, and derivative financial instruments employed in the management of its debt portfolio. The debt portfolio including both trade and affiliate debt, is managed to achieve capital structure targets and reduce the overall cost of borrowing by using a combination of fixed and floating rate debt as well as interest rate swaps, and cross-currency swaps. The Company’s primary exposure to interest rate risk comes from its commercial paper program in which the pricing is partially based on short-term U.S. interest rates. At December 28, 2019, the impact of a hypothetical 10% increase in the interest rates associated with the Company’s commercial paper borrowings would have an immaterial effect on the Company’s financial position and results of operations. The Company has exposure to commodity prices in many businesses, particularly brass, nickel, resin, aluminum, copper, zinc, steel, and energy used in the production of finished goods. Generally, commodity price exposures are not hedged with derivative financial instruments, but instead are actively managed through customer product and service pricing actions, procurement-driven cost reduction initiatives and other productivity improvement projects. Fluctuations in the fair value of the Company’s common stock affect domestic retirement plan expense as discussed below in the Employee Stock Ownership Plan ("ESOP") section of MD&A. Additionally, the Company has $108 million of liabilities as of December 28, 2019 pertaining to unfunded defined contribution plans for certain U.S. employees for which there is mark-to-market exposure. The assets held by the Company’s defined benefit plans are exposed to fluctuations in the market value of securities, primarily global stocks and fixed-income securities. The funding obligations for these plans would increase in the event of adverse changes in the plan asset values, although such funding would occur over a period of many years. In 2019, 2018, and 2017, investment returns on pension plan assets resulted in a $323 million increase, a $72 million decrease, and a $217 million increase, respectively. The Company expects funding obligations on its defined benefit plans to be approximately $38 million in 2020. The Company employs diversified asset allocations to help mitigate this risk. Management has worked to minimize this exposure by freezing and terminating defined benefit plans where appropriate. The Company has access to financial resources and borrowing capabilities around the world. There are no instruments within the debt structure that would accelerate payment requirements due to a change in credit rating. The Company’s existing credit facilities and sources of liquidity, including operating cash flows, are considered more than adequate to conduct business as normal. Accordingly, based on present conditions and past history, management believes it is unlikely that operations will be materially affected by any potential deterioration of the general credit markets that may occur. The Company believes that its strong financial position, operating cash flows, committed long-term credit facilities and borrowing capacity, and ability to access equity markets, provide the financial flexibility necessary to continue its record of annual dividend payments, to invest in the routine needs of its businesses, to make strategic acquisitions and to fund other initiatives encompassed by its growth strategy and maintain its strong investment grade credit ratings. OTHER MATTERS Employee Stock Ownership Plan ("ESOP") - As detailed in Note L, Employee Benefit Plans, the Company has an ESOP under which the ongoing U.S. Core and 401(k) defined contribution plans are funded. Overall ESOP expense is affected by the market value of the Company’s stock on the monthly dates when shares are released, among other factors. The Company’s net ESOP activity resulted in income of $0.5 million in 2019 and expense of $0.4 million in 2018 and $1.3 million in 2017. ESOP expense could increase in the future if the market value of the Company’s common stock declines. In addition, ESOP expense will increase once all remaining unallocated shares are released, which will occur in the first quarter of 2020. CRITICAL ACCOUNTING ESTIMATES - Preparation of the Company’s Consolidated Financial Statements requires management to make estimates and assumptions that affect the reported amounts of assets, liabilities, revenues and expenses. Significant accounting policies used in the preparation of the Consolidated Financial Statements are described in Note A, Significant Accounting Policies. Management believes the most complex and sensitive judgments, because of their significance to the Consolidated Financial Statements, result primarily from the need to make estimates about the effects of matters with inherent uncertainty. The most significant areas involving management estimates are described below. Actual results in these areas could differ from management’s estimates. ALLOWANCE FOR DOUBTFUL ACCOUNTS - The Company’s estimate for its allowance for doubtful accounts related to trade receivables is based on two methods. The amounts calculated from each of these methods are combined to determine the total amount reserved. First, a specific reserve is established for individual accounts where information indicates the customers may have an inability to meet financial obligations. In these cases, management uses its judgment, based on the surrounding facts and circumstances, to record a specific reserve for those customers against amounts due to reduce the receivable to the amount expected to be collected. These specific reserves are reevaluated and adjusted as additional information is received. Second, a reserve is determined for all customers based on a range of percentages applied to receivable aging categories. These percentages are based on historical collection and write-off experience. If circumstances change, for example, due to the occurrence of higher-than-expected defaults or a significant adverse change in a major customer’s ability to meet its financial obligation to the Company, estimates of the recoverability of receivable amounts due could be reduced. INVENTORIES - Inventories in the U.S. are primarily valued at the lower of Last-In First-Out (“LIFO”) cost or market, while non-U.S. inventories are primarily valued at the lower of First-In, First-Out (“FIFO”) cost and net realizable value. The calculation of LIFO reserves, and therefore the net inventory valuation, is affected by inflation and deflation in inventory components. The Company continually reviews the carrying value of discontinued product lines and stock-keeping-units (“SKUs”) to determine that these items are properly valued. The Company also continually evaluates the composition of its inventory and identifies obsolete and/or slow-moving inventories. Inventory items identified as obsolete and/or slow-moving are evaluated to determine if write-downs are required. The Company assesses the ability to dispose of these inventories at a price greater than cost. If it is determined that cost is less than market or net realizable value, as applicable, cost is used for inventory valuation. If market value or net realizable value, as applicable, is less than cost, the Company writes down the related inventory to that value. GOODWILL AND INTANGIBLE ASSETS - The Company acquires businesses in purchase transactions that result in the recognition of goodwill and intangible assets. The determination of the value of intangible assets requires management to make estimates and assumptions. In accordance with Accounting Standards Codification ("ASC") 350-20, Goodwill, acquired goodwill and indefinite-lived intangible assets are not amortized but are subject to impairment testing at least annually or when an event occurs or circumstances change that indicate it is more likely than not an impairment exists. Definite-lived intangible assets are amortized and are tested for impairment when an event occurs or circumstances change that indicate it is more likely than not that an impairment exists. Goodwill represents costs in excess of fair values assigned to the underlying net assets of acquired businesses. At December 28, 2019, the Company reported $9.238 billion of goodwill, $2.186 billion of indefinite-lived trade names and $1.436 billion of net definite-lived intangibles. Management tests goodwill for impairment at the reporting unit level. A reporting unit is an operating segment as defined in ASC 280, Segment Reporting, or one level below an operating segment (component level) as determined by the availability of discrete financial information that is regularly reviewed by operating segment management or an aggregate of component levels of an operating segment having similar economic characteristics. If the carrying value of a reporting unit (including the value of goodwill) is greater than its estimated fair value, an impairment may exist. An impairment charge would be recorded to the extent that the recorded value of goodwill exceeded the implied fair value. As required by the Company’s policy, goodwill was tested for impairment in the third quarter of 2019. In accordance with Accounting Standards Update ("ASU") 2011-08, Intangibles - Goodwill and Other (Topic 350): Testing Goodwill for Impairment, companies are permitted to first assess qualitative factors to determine whether it is more likely than not that the fair value of a reporting unit is less than its carrying amount as a basis for determining whether it is necessary to perform the two-step quantitative goodwill impairment test. Under the two-step quantitative goodwill impairment test, the fair value of the reporting unit is compared to its respective carrying amount including goodwill. If the fair value exceeds the carrying amount, then no impairment exists. If the carrying amount exceeds the fair value, further analysis is performed to assess impairment. Such tests are completed separately with respect to the goodwill of each of the Company’s reporting units. Accordingly, for its annual impairment testing performed in the third quarter of 2019, the Company applied the qualitative assessment for three of its reporting units, while performing the quantitative test for two of its reporting units. For the reporting units in which a quantitative test was performed, it was noted that the fair value for each of these reporting units exceeded its carrying amount by in excess of 45%. Based on the results of the Company’s annual impairment testing, it was determined that the fair value of each of its reporting units is substantially in excess of its carrying amount. In performing the qualitative assessments, the Company identified and considered the significance of relevant key factors, events, and circumstances that could affect the fair value of each reporting unit. These factors include external factors such as macroeconomic, industry, and market conditions, as well as entity-specific factors, such as actual and planned financial performance. The Company also assessed changes in each reporting unit's fair value and carrying value since the most recent date a fair value measurement was performed. As a result of the qualitative assessments performed, the Company concluded that it is more likely than not that the fair value of each of these reporting units exceeded its respective carrying value and therefore, no additional quantitative impairment testing was performed. With respect to the quantitative tests, the Company assessed the fair values of the two reporting units based on a discounted cash flow valuation model. The key assumptions applied to the cash flow projections were discount rates, which ranged from 7.5% to 9.5%, near-term revenue growth rates over the next five years, which represented cumulative annual growth rates ranging from approximately 2% to 7%, and perpetual growth rates of 3%. These assumptions contemplated business, market and overall economic conditions. Based on the results of this testing, the Company determined that the fair value for each of these reporting units exceeded its carrying amount by in excess of 45%. Furthermore, management performed sensitivity analyses on the estimated fair values from the discounted cash flow valuation models utilizing more conservative assumptions that reflect reasonably likely future changes in the discount rate and perpetual growth rate. The discount rate was increased by 100 basis points with no impairment indicated. The perpetual growth rate was decreased by 150 basis points with no impairment indicated. The Company also tested its indefinite-lived trade names for impairment during the third quarter of 2019 utilizing a discounted cash flow model. The key assumptions used included discount rates, royalty rates, and perpetual growth rates applied to the projected sales. Based on these quantitative impairment tests, the Company determined that the fair values of the indefinite-lived trade names exceeded their respective carrying amounts. In the event that future operating results of any of the Company's reporting units or indefinite-lived trade names do not meet current expectations, management, based upon conditions at the time, would consider taking restructuring or other strategic actions, as necessary, to maximize revenue growth and profitability. A thorough analysis of all the facts and circumstances existing at that time would need to be performed to determine if recording an impairment loss would be appropriate. DEFINED BENEFIT OBLIGATIONS - The valuation of pension and other postretirement benefits costs and obligations is dependent on various assumptions. These assumptions, which are updated annually, include discount rates, expected return on plan assets, future salary increase rates, and health care cost trend rates. The Company considers current market conditions, including interest rates, to establish these assumptions. Discount rates are developed considering the yields available on high-quality fixed income investments with maturities corresponding to the duration of the related benefit obligations. The Company’s weighted-average discount rates used to determine benefit obligations at December 28, 2019 for the United States and international pension plans were 3.20% and 1.80%, respectively. The Company’s weighted-average discount rates used to determine benefit obligations at December 29, 2018 for the United States and international pension plans were 4.20% and 2.62%, respectively. As discussed further in Note L, Employee Benefit Plans, the Company develops the expected return on plan assets considering various factors, which include its targeted asset allocation percentages, historic returns, and expected future returns. The Company’s expected rate of return assumptions for the United States and international pension plans were 6.25% and 4.73%, respectively, at December 28, 2019. The Company will use a 4.70% weighted-average expected rate of return assumption to determine the 2020 net periodic benefit cost. A 25 basis point reduction in the expected rate of return assumption would increase 2020 net periodic benefit cost by approximately $5 million on a pre-tax basis. The Company believes that the assumptions used are appropriate; however, differences in actual experience or changes in the assumptions may materially affect the Company’s financial position or results of operations. To the extent that actual (newly measured) results differ from the actuarial assumptions, the difference is recognized in accumulated other comprehensive loss, and, if in excess of a specified corridor, amortized over future periods. The expected return on plan assets is determined using the expected rate of return and the fair value of plan assets. Accordingly, market fluctuations in the fair value of plan assets can affect the net periodic benefit cost in the following year. The projected benefit obligation for defined benefit plans exceeded the fair value of plan assets by $631 million at December 28, 2019. A 25 basis point reduction in the discount rate would have increased the projected benefit obligation by approximately $93 million at December 28, 2019. The primary Black & Decker U.S. pension and post employment benefit plans were curtailed in late 2010, as well as the only material Black & Decker international plan, and in their place the Company implemented defined contribution benefit plans. The vast majority of the projected benefit obligation pertains to plans that have been frozen; the remaining defined benefit plans that are not frozen are predominantly small domestic union plans and those that are statutorily mandated in certain international jurisdictions. The Company recognized approximately $15 million of defined benefit plan expense in 2019, which may fluctuate in future years depending upon various factors including future discount rates and actual returns on plan assets. ENVIRONMENTAL - The Company incurs costs related to environmental issues as a result of various laws and regulations governing current operations as well as the remediation of previously contaminated sites. The Company’s policy is to accrue environmental investigatory and remediation costs for identified sites when it is probable that a liability has been incurred and the amount of loss can be reasonably estimated. The amount of liability recorded is based on an evaluation of currently available facts with respect to each individual site and includes such factors as existing technology, presently enacted laws and regulations, and prior experience in remediation of contaminated sites. The liabilities recorded do not take into account any claims for recoveries from insurance or third parties. As assessments and remediation progress at individual sites, the amounts recorded are reviewed periodically and adjusted to reflect additional technical and legal information that becomes available. As of December 28, 2019, the Company had reserves of $213.8 million for remediation activities associated with Company-owned properties as well as for Superfund sites, for losses that are probable and estimable. The range of environmental remediation costs that is reasonably possible is $149.1 million to $286.1 million which is subject to change in the near term. The Company may be liable for environmental remediation of sites it no longer owns. Liabilities have been recorded on those sites in accordance with this policy. INCOME TAXES - The Company accounts for income taxes under the asset and liability method in accordance with ASC 740, Income Taxes, which requires the recognition of deferred tax assets and liabilities for the expected future tax consequences of events that have been included in the financial statements. Deferred tax assets and liabilities are determined based on the differences between the financial statements and tax basis of assets and liabilities using the enacted tax rates in effect for the year in which the differences are expected to reverse. Any changes in tax rates on deferred tax assets and liabilities are recognized in income in the period that includes the enactment date. The Company records net deferred tax assets to the extent that it is more likely than not that these assets will be realized. In making this determination, management considers all available positive and negative evidence, including future reversals of existing temporary differences, estimates of future taxable income, tax-planning strategies, and the realizability of net operating loss carryforwards. In the event that it is determined that an asset is not more likely that not to be realized, a valuation allowance is recorded against the asset. Valuation allowances related to deferred tax assets can be impacted by changes to tax laws, changes to statutory tax rates and future taxable income levels. In the event the Company were to determine that it would not be able to realize all or a portion of its deferred tax assets in the future, the unrealizable amount would be charged to earnings in the period in which that determination is made. Conversely, if the Company were to determine that it would be able to realize deferred tax assets in the future in excess of the net carrying amounts, it would decrease the recorded valuation allowance through a favorable adjustment to earnings in the period that the determination was made. The Act subjects a U.S. shareholder to current tax on global intangible low-taxed income (“GILTI”) earned by certain foreign subsidiaries. The Financial Accounting Standards Board ("FASB") Staff Q&A, Topic 740 No. 5, Accounting for Global Intangible Low-Taxed Income, states that an entity can make an accounting policy election to either recognize deferred taxes for temporary differences expected to reverse as GILTI in future years or provide for the tax expense related to GILTI in the year the tax is incurred. The Company has elected to recognize the tax on GILTI as a period expense in the period the tax is incurred. The Company records uncertain tax positions in accordance with ASC 740, which requires a two-step process. First, management determines whether it is more likely than not that a tax position will be sustained based on the technical merits of the position and second, for those tax positions that meet the more likely than not threshold, management recognizes the largest amount of the tax benefit that is greater than 50 percent likely to be realized upon ultimate settlement with the related taxing authority. The Company maintains an accounting policy of recording interest and penalties on uncertain tax positions as a component of Income taxes in the Consolidated Statements of Operations. The Company is subject to income tax in a number of locations, including many state and foreign jurisdictions. Significant judgment is required when calculating the worldwide provision for income taxes. Many factors are considered when evaluating and estimating the Company's tax positions and tax benefits, which may require periodic adjustments, and which may not accurately anticipate actual outcomes. It is reasonably possible that the amount of the unrecognized benefit with respect to certain of the Company's unrecognized tax positions will significantly increase or decrease within the next twelve months. These changes may be the result of settlements of ongoing audits or final decisions in transfer pricing matters. The Company periodically assesses its liabilities and contingencies for all tax years still subject to audit based on the most current available information, which involves inherent uncertainty. Additional information regarding income taxes is available in Note Q, Income Taxes. RISK INSURANCE - To manage its insurance costs efficiently, the Company self insures for certain U.S. business exposures and generally has low deductible plans internationally. For domestic workers’ compensation, automobile and product liability (liability for alleged injuries associated with the Company’s products), the Company generally purchases insurance coverage only for severe losses that are unlikely, and these lines of insurance involve the most significant accounting estimates. While different self insured retentions, in the form of deductibles and self insurance through its captive insurance company, exist for each of these lines of insurance, the maximum self insured retention is set at no more than $5 million per occurrence. The process of establishing risk insurance reserves includes consideration of actuarial valuations that reflect the Company’s specific loss history, actual claims reported, and industry trends among statistical and other factors to estimate the range of reserves required. Risk insurance reserves are comprised of specific reserves for individual claims and additional amounts expected for development of these claims, as well as for incurred but not yet reported claims discounted to present value. The cash outflows related to risk insurance claims are expected to occur over a period of approximately 15 years. The Company believes the liabilities recorded for these U.S. risk insurance reserves, totaling $87 million and $86 million as of December 28, 2019, and December 29, 2018, respectively, are adequate. Due to judgments inherent in the reserve estimation process, it is possible the ultimate costs will differ from this estimate. WARRANTY - The Company provides product and service warranties which vary across its businesses. The types of warranties offered generally range from one year to limited lifetime, and certain branded products carry a lifetime warranty. There are also certain products with no warranty. Further, the Company sometimes incurs discretionary costs to service its products in connection with product performance issues. Historical warranty and service claim experience forms the basis for warranty obligations recognized. Adjustments are recorded to the warranty liability as new information becomes available. The Company believes the $100 million reserve for expected product warranty claims as of December 28, 2019 is adequate, but due to judgments inherent in the reserve estimation process, including forecasting future product reliability levels and costs of repair as well as the estimated age of certain products submitted for claims, the ultimate claim costs may differ from the recorded warranty liability. The Company also establishes a reserve for product recalls on a product-specific basis during the period in which the circumstances giving rise to the recall become known and estimable for both company-initiated actions and those required by regulatory bodies. OFF-BALANCE SHEET ARRANGEMENT The Company has no off-balance sheet arrangements as of December 28, 2019. CAUTIONARY STATEMENTS UNDER THE PRIVATE SECURITIES LITIGATION REFORM ACT OF 1995 This document contains “forward-looking statements” within the meaning of Section 27A of the Securities Act of 1933, as amended, and Section 21E of the Securities Exchange Act of 1934, as amended. All statements other than statements of historical fact are “forward-looking statements” for purposes of federal and state securities laws, including any projections or guidance of earnings, revenue or other financial items; any statements of the plans, strategies and objectives of management for future operations; any statements concerning proposed new products, services or developments; any statements regarding future economic conditions or performance; any statements of belief; and any statements of assumptions underlying any of the foregoing. Forward-looking statements may include, among others, the words “may,” “will,” “estimate,” “intend,” “continue,” “believe,” “expect,” “anticipate” or any other similar words. Although the Company believes that the expectations reflected in any of its forward-looking statements are reasonable, actual results could differ materially from those projected or assumed in any of its forward-looking statements. The Company's future financial condition and results of operations, as well as any forward-looking statements, are subject to change and to inherent risks and uncertainties, such as those disclosed or incorporated by reference in the Company's filings with the Securities and Exchange Commission. Important factors that could cause the Company's actual results, performance and achievements, or industry results to differ materially from estimates or projections contained in its forward-looking statements include, among others, the following: (i) successfully developing, marketing and achieving sales from new products and services and the continued acceptance of current products and services; (ii) macroeconomic factors, including global and regional business conditions (such as Brexit), commodity prices, inflation, and currency exchange rates; (iii) laws, regulations and governmental policies affecting the Company's activities in the countries where it does business, including those related to tariffs, taxation, and trade controls, including section 301 tariffs and section 232 steel and aluminum tariffs; (iv) the economic environment of emerging markets, particularly Latin America, Russia, China and Turkey; (v) realizing the anticipated benefits of mergers, acquisitions, joint ventures, strategic alliances or divestitures, including the closing of the CAM acquisition, its successful integration into the Company and the return to production of the Boeing 737 MAX; (vi) pricing pressure and other changes within competitive markets; (vii) availability and price of raw materials, component parts, freight, energy, labor and sourced finished goods; (viii) the impact the tightened credit markets may have on the Company or its customers or suppliers; (ix) the extent to which the Company has to write off accounts receivable or assets or experiences supply chain disruptions in connection with bankruptcy filings by customers or suppliers; (x) the Company's ability to identify and effectively execute productivity improvements and cost reductions; (xi) potential business and distribution disruptions, including those related to physical security threats, information technology or cyber-attacks, epidemics, sanctions or natural disasters; (xii) the continued consolidation of customers, particularly in consumer channels; (xiii) managing franchisee relationships; (xiv) the impact of poor weather conditions; (xv) maintaining or improving production rates in the Company's manufacturing facilities, responding to significant changes in product demand and fulfilling demand for new and existing products; (xvi) changes in the competitive landscape in the Company's markets; (xvii) the Company's non-U.S. operations, including sales to non-U.S. customers; (xviii) the impact from demand changes within world-wide markets associated with homebuilding and remodeling; (xix) potential adverse developments in new or pending litigation and/or government investigations; (xx) changes in the Company's ability to obtain debt on commercially reasonable terms and at competitive rates; (xxi) substantial pension and other postretirement benefit obligations; (xxii) potential environmental liabilities; (xxiii) work stoppages or other labor disruptions; and (xxiv) changes in accounting estimates. Additional factors that could cause actual results to differ materially from forward-looking statements are set forth in this Annual Report on Form 10-K, including under the heading “Risk Factors,” “Management’s Discussion and Analysis of Financial Condition and Results of Operations” and in the Consolidated Financial Statements and the related Notes. Forward-looking statements in this Annual Report on Form 10-K speak only as of the date hereof, and forward-looking statements in documents attached that are incorporated by reference speak only as of the date of those documents. The Company does not undertake any obligation to update or release any revisions to any forward-looking statement or to report any events or circumstances after the date hereof or to reflect the occurrence of unanticipated events, except as required by law.

<s>[INST] The following discussion and certain other sections of this Annual Report on Form 10K contain statements reflecting the Company’s views about its future performance that constitute “forwardlooking statements” under the Private Securities Litigation Reform Act of 1995. These forwardlooking statements are based on current expectations, estimates, forecasts and projections about the industry and markets in which the Company operates as well as management’s beliefs and assumptions. Any statements contained herein (including without limitation statements to the effect that Stanley Black & Decker, Inc. or its management “believes,” “expects,” “anticipates,” “plans” and similar expressions) that are not statements of historical fact should be considered forwardlooking statements. These statements are not guarantees of future performance and involve certain risks, uncertainties and assumptions that are difficult to predict. There are a number of important factors that could cause actual results to differ materially from those indicated by such forwardlooking statements. These factors include, without limitation, those set forth, or incorporated by reference, below under the heading “Cautionary Statements Under The Private Securities Litigation Reform Act Of 1995.” The Company does not intend to update publicly any forwardlooking statements whether as a result of new information, future events or otherwise. Strategic Objectives The Company continues to pursue a growth and acquisition strategy, which involves industry, geographic and customer diversification to foster sustainable revenue, earnings and cash flow growth, and employ the following strategic framework in pursuit of its vision to deliver topquartile financial performance, become known as one of the world’s leading innovators and elevate its commitment to social responsibility: Continue organic growth momentum by leveraging the SBD Operating Model to drive innovation and commercial excellence, while diversifying toward highergrowth, highermargin businesses; Be selective and operate in markets where brand is meaningful, the value proposition is definable and sustainable through innovation, and global cost leadership is achievable; and Pursue acquisitive growth on multiple fronts by building upon its existing global tools platform, expanding the Industrial platform in Engineered Fastening and Infrastructure, consolidating the commercial electronic security industry, and pursuing adjacencies with sound industrial logic. Execution of the above strategy has resulted in approximately $10.1 billion of acquisitions since 2002 (excluding the Black & Decker merger and pending acquisition of Consolidated Aerospace Manufacturing, LLC, as discussed below), a 20 percent investment in MTD Holdings Inc. ("MTD"), several divestitures, improved efficiency in the supply chain and manufacturing operations, and enhanced investments in organic growth, enabled by cash flow generation and increased debt capacity. In addition, the Company's continued focus on diversification and organic growth has resulted in improved financial results and an increase in its global presence. The Company also remains focused on leveraging its SBD Operating Model to deliver success in the 2020s and beyond. The latest evolution of the SBD Operating Model, formerly Stanley Fulfillment System ("SFS") 2.0, builds on the strength of the Company's past while embracing changes in the external environment to ensure the Company has the right skillsets, incorporates technology advances in all areas, maintains operational excellence, drives efficiency in business processes and resiliency into its culture, delivers extreme innovation and ensures the customer experience is world class. As it has in the past, the new operating model will underpin the Company's ability to deliver abovemarket organic growth with margin expansion, maintain efficient levels of selling, general and administrative expenses ("SG&A") and deliver topquartile asset efficiency. The Company’s longterm financial objectives remain as follows: 46% organic revenue growth; 1012% total revenue growth; 1012% total EPS growth (79% organically) excluding acquisitionrelated charges; Free cash flow equal to, or exceeding, net income; Sustain 10+ working capital turns; and Cash Flow Return On Investment ("CFROI") between 1215%. In terms of capital allocation, the Company remains committed, over time, to returning approximately 50% of free cash flow to shareholders through a strong and growing dividend as well as opportunistically repurchasing shares. The remaining free cash flow (approximately 50%) will [/INST] Negative. </s>

SCHWAB CHARLES CORP

2015-02-23

2014-12-31

Item 7. Management’s Discussion and Analysis of Financial Condition and Results of Operations FORWARD-LOOKING STATEMENTS In addition to historical information, this Annual Report on Form 10-K contains “forward-looking statements” within the meaning of Section 27A of the Securities Act, and Section 21E of the Securities Exchange Act of 1934. Forward-looking statements are identified by words such as “believe,” “anticipate,” “expect,” “intend,” “plan,” “will,” “may,” “estimate,” “appear,” “aim,” “target,” “could,” and other similar expressions. In addition, any statements that refer to expectations, projections, or other characterizations of future events or circumstances are forward-looking statements. These forward-looking statements, which reflect management’s beliefs, objectives, and expectations as of the date hereof, are necessarily estimates based on the best judgment of the Company’s senior management. These statements relate to, among other things: · the Company’s ability to pursue its business strategy and maintain its market leadership position (see “Part I - Item 1. - Business - Business Strategy and Competitive Environment”); · the expected impact of the new regulatory capital and LCR rules (see “Part I - Item 1A. - Risk Factors” and “Current Market and Regulatory Environment and Other Developments”); · the impact of legal proceedings and regulatory matters (see “Part I - Item 3. - Legal Proceedings” and “Item 8 - Financial Statements and Supplementary Data - Notes to Consolidated Financial Statements -14. Commitments and Contingencies - Legal contingencies”); · the impact of current market conditions on the Company’s results of operations (see “Current Market and Regulatory Environment and Other Developments,” “Results of Operations - Net Interest Revenue,” and “Item 8 - Financial Statements and Supplementary Data - Notes to Consolidated Financial Statements - 5. Securities Available for Sale and Securities Held to Maturity”); · sources of liquidity, capital, and level of dividends (see “Part I - Item 1. - Business - Regulation,” “Liquidity and Capital Resources,” “Contractual Obligations,” and “Item 8 - Financial Statements and Supplementary Data - Notes to Consolidated Financial Statements - 22. Regulatory Requirements”); · target capital and debt ratios (see “Liquidity and Capital Resources” and “Item 8 - Financial Statements and Supplementary Data - Notes to Consolidated Financial Statements - 22. Regulatory Requirements”); · capital expenditures (see “Liquidity and Capital Resources - Capital Resources - Capital Expenditures”); · the impact of the revised underwriting criteria on the credit quality of the Company’s mortgage portfolio (see “Risk Management - Credit Risk”); · the impact of changes in management’s estimates on the Company’s results of operations (see “Critical Accounting Estimates”); · the impact of changes in the likelihood of indemnification and guarantee payment obligations on the Company’s results of operations (see “Item 8 - Financial Statements and Supplementary Data - Notes to Consolidated Financial Statements - 14. Commitments and Contingencies”); and · the impact on the Company’s results of operations of recording stock option expense (see “Item 8 - Financial Statements and Supplementary Data - Notes to Consolidated Financial Statements - 19. Employee Incentive, Retirement, and Deferred Compensation Plans”). Achievement of the expressed beliefs, objectives and expectations described in these statements is subject to certain risks and uncertainties that could cause actual results to differ materially from the expressed beliefs, objectives, and expectations. Readers are cautioned not to place undue reliance on these forward-looking statements, which speak only as of the date of this Annual Report on Form 10-K or, in the case of documents incorporated by reference, as of the date of those documents. Important factors that may cause actual results to differ include, but are not limited to: · changes in general economic and financial market conditions; · changes in revenues and profit margin due to changes in interest rates; · adverse developments in litigation or regulatory matters; · the extent of any charges associated with litigation and regulatory matters; - 18 - THE CHARLES SCHWAB CORPORATION Management’s Discussion and Analysis of Financial Condition and Results of Operations (Tabular Amounts in Millions, Except Ratios, or as Noted) · amounts recovered on insurance policies; · the Company’s ability to attract and retain clients and grow client assets and relationships; · the Company’s ability to develop and launch new products, services and capabilities in a timely and successful manner, including Schwab Intelligent Portfolios™; · fluctuations in client asset values due to changes in equity valuations; · the Company’s ability to monetize client assets; · the performance or valuation of securities available for sale and securities held to maturity; · trading activity; · the level of interest rates, including yields available on money market mutual fund eligible instruments; · the adverse impact of financial reform legislation and related regulations; · investment, structural and capital adjustments made by the Company in connection with the new LCR rule; · the amount of loans to the Company’s brokerage and banking clients; · the extent to which past performance of the Company’s mortgage portfolio is indicative of future performance; · the level of the Company’s stock repurchase activity; · the level of brokerage client cash balances and deposits from banking clients; · the availability and terms of external financing; · capital needs and management; · timing and amount of severance and other costs related to reducing the Company’s San Francisco footprint; · the Company’s ability to manage expenses; · regulatory guidance; · the level of client assets, including cash balances; · competitive pressures on rates and fees; · acquisition integration costs; · the timing and impact of changes in the Company’s level of investments in buildings, land, and leasehold improvements; · potential breaches of contractual terms for which the Company has indemnification and guarantee obligations; and · client use of the Company’s investment advisory services and other products and services. Certain of these factors, as well as general risk factors affecting the Company, are discussed in greater detail in this Annual Report on Form 10-K, including “Item 1A - Risk Factors.” - 19 - THE CHARLES SCHWAB CORPORATION Management’s Discussion and Analysis of Financial Condition and Results of Operations (Tabular Amounts in Millions, Except Ratios, or as Noted) OVERVIEW Management of the Company focuses on several key client activity and financial metrics in evaluating the Company’s financial position and operating performance. Management believes that net revenue growth, pre-tax profit margin, earnings per common share, and return on common stockholders’ equity provide broad indicators of the Company’s overall financial health, operating efficiency, and ability to generate acceptable returns within the context of a given operating environment. Expenses excluding interest as a percentage of average client assets is considered by management to be a measure of operating efficiency. Results for the years ended December 31, 2014, 2013, and 2012 are: Growth Rate 1-Year Year Ended December 31, 2013-2014 Client Metrics: Net new client assets (1) (in billions) N/M $ 124.8 $ 41.6 $ 139.7 Client assets (2) (in billions, at year end) % $ 2,463.6 $ 2,249.4 $ 1,951.6 New brokerage accounts (3) (in thousands) % Active brokerage accounts (4) (in thousands, at year end) % 9,386 9,093 8,787 Assets receiving ongoing advisory services (5) (in billions, at year end) % $ 1,228.1 $ 1,101.4 $ 915.2 Client cash as a percentage of client assets (6) (at year end) 12.3 % 13.1 % 14.7 % Company Financial Metrics: Net revenues % $ 6,058 $ 5,435 $ 4,883 Expenses excluding interest % 3,943 3,730 3,433 Income before taxes on income % 2,115 1,705 1,450 Taxes on income % Net income % $ 1,321 $ 1,071 $ Preferred stock dividends (2) % Net income available to common stockholders % $ 1,261 $ 1,010 $ Earnings per common share - diluted % $ .95 $ .78 $ .69 Net revenue growth from prior year % % % Pre-tax profit margin 34.9 % 31.4 % 29.7 % Return on average common stockholders’ equity (7) % % % Expenses excluding interest as a percentage of average client assets 0.17 % 0.18 % 0.19 % (1) Net new client assets is defined as the total inflows of client cash and securities to the firm less client outflows. Management believes that this metric, along with core net new assets, depicts how well the Company’s products and services appeal to new and existing clients. Core net new assets totaled $124.8 billion, $140.8 billion, and $112.4 billion in 2014, 2013, and 2012, respectively. See below for items excluded from core net new assets. (2) Client assets represent the market value of all client assets custodied at the Company. Management considers client assets to be indicative of the Company’s appeal in the marketplace. Additionally, fluctuations in certain components of client assets (e.g., Mutual Fund OneSource® funds) directly impact asset management and administration fees. (3) New brokerage accounts include all brokerage accounts opened during the period, as well as any accounts added via acquisition. This metric measures the Company’s effectiveness in attracting new clients and building stronger relationships with existing clients. (4) Active brokerage accounts include accounts with balances or activity within the preceding eight months. This metric is an indicator of the Company’s success in both attracting and retaining clients. (5) Assets receiving ongoing advisory services include relationships under the guidance of independent advisors and assets enrolled in one of the Company’s retail or other advisory solutions. This metric depicts how well the Company’s advisory products and services appeal to new and existing clients. (6) Client cash as a percentage of client assets includes Schwab One®, certain cash equivalents, deposits from banking clients and money market fund balances, as a percentage of client assets. This measure is an indicator of clients’ engagement in the fixed income and equity markets. (7) Calculated as net income available to common stockholders divided by average common stockholders’ equity. N/M Not meaningful. - 20 - THE CHARLES SCHWAB CORPORATION Management’s Discussion and Analysis of Financial Condition and Results of Operations (Tabular Amounts in Millions, Except Ratios, or as Noted) Core net new client assets is defined as net new client assets before significant one-time flows. Management considers this to be a useful metric when comparing period-to-period client asset flows. The following one-time flows were excluded from core net new assets. · 2013 excludes outflows of $74.5 billion relating to the planned transfer of a mutual fund clearing services client. The Company also reduced its reported total for overall client assets by $24.7 billion in 2013 to reflect the estimated impact of the consolidation of its retirement plan recordkeeping technology platforms and subsequent resignation from certain retirement plan clients. · 2012 excludes inflows of $27.7 billion from mutual fund clearing services clients and $900 million from the acquisition of ThomasPartners, Inc., and outflows of $1.3 billion from the closure and/or sale of certain subsidiaries of optionsXpress. The Company’s major sources of net revenues are asset management and administration fees, net interest revenue, and trading revenue. The Company generates asset management and administration fees through its proprietary and third-party mutual fund offerings, as well as fee-based advisory solutions. Net interest revenue is the difference between interest earned on interest-earning assets and interest paid on funding sources, the majority of which is derived from client cash balances. Asset management and administration fees and net interest revenue are impacted by securities valuations, interest rates, the amount and mix of interest-earning assets and interest-bearing funding sources, the Company’s ability to attract new clients, and client activity levels. The Company generates trading revenue through commissions earned for executing trades for clients and principal transaction revenue primarily from trading activity in client fixed income securities. Trading revenue is impacted by trading volumes, the volatility of prices in the equity and fixed income markets, and commission rates. 2014 Compared to 2013 The Company operated in an environment of mixed market conditions during 2014 compared to 2013, as the Nasdaq Composite Index, Standard & Poor’s 500 Index, and Dow Jones Industrial Average showed periods of volatility before ending the year up 13%, 11%, and 8%, respectively. The federal funds target rate remained unchanged at a range of zero to 0.25% during 2014. The average 10-year Treasury yield increased by 20 basis points to 2.53% during 2014 compared to 2013, while the yield ended the year down 86 basis points to 2.17%. In the same period, the average three-month Treasury Bill yield decreased by 3 basis points to 0.02%. The Company’s steady focus on serving investor needs through its full-service investing model continued to drive growth during 2014. Total client assets ended the year at $2.46 trillion, up 10% from 2013, reflecting net new client assets of $124.8 billion and a rising equity market environment. In addition, the Company added almost 1 million new brokerage accounts to its client base during 2014. Active brokerage accounts reached 9.4 million in 2014, up 3% from 2013. As a result of the Company’s strong key client activity metrics, the Company achieved a pre-tax profit margin of 34.9% in 2014. Overall, net income increased by 23% in 2014 from 2013 and the return on average common stockholders’ equity was 12% in 2014. Overall, net revenues increased by 11% in 2014 from 2013, primarily due to increases in net interest revenue, asset management and administration fees, and other revenue - net. Net interest revenue increased primarily due to higher balances of interest-earning assets, including margin loans and the Company’s investment portfolio (securities available for sale and securities held to maturity), and the effect higher average interest rates on securities held to maturity had on the Company’s average net interest margin. Asset management and administration fees increased due to fees from mutual fund services, advice solutions, and other asset management and administration services. Other revenue - net increased primarily due to a net insurance settlement of $45 million, net litigation proceeds of $28 million related to the Company’s non-agency residential mortgage-backed securities portfolio, and increases in order flow revenue. Expenses excluding interest increased by 6% in 2014 from 2013 primarily due to an increase in compensation and benefits expense as a result of a charge of $68 million for estimated future severance benefits resulting from changes in the Company’s geographic footprint and an increase in professional services expense. - 21 - THE CHARLES SCHWAB CORPORATION Management’s Discussion and Analysis of Financial Condition and Results of Operations (Tabular Amounts in Millions, Except Ratios, or as Noted) 2013 Compared to 2012 Valuations in the broad equity markets improved during 2013 compared to 2012, as the Nasdaq Composite Index, Standard & Poor’s 500 Index, and Dow Jones Industrial Average increased 38%, 30%, and 26%, respectively. While the federal funds target rate remained unchanged at a range of zero to 0.25%, the average 10-year Treasury yield increased by 55 basis points to 2.33% during 2013 compared to 2012. In the same period however, the average three-month Treasury Bill yield decreased by 3 basis points to 0.05%. The Company continued to experience growth in its client base during 2013 - core net new client assets totaled $140.8 billion, up 25% from $112.4 billion in 2012. Total client assets ended the year at a record $2.25 trillion, up 15% from 2012. In addition, the Company added almost 1 million new brokerage accounts during 2013, and active brokerage accounts reached 9.1 million, up 3% from 2012. As a result of the Company’s strong key client activity metrics, the Company achieved a pre-tax profit margin of 31.4% in 2013. Overall, net income increased by 15% in 2013 from 2012 and the return on average common stockholders’ equity was 11% in 2013. Along with the growth in its client base, enrollments in client advisory solutions and stability in the economic environment helped the Company achieve increases in all three major revenue lines in 2013 compared to 2012. Overall, net revenues increased by 11% in 2013 from 2012, primarily due to increases in asset management and administration fees, net interest revenue, and trading revenue, partially offset by a decrease in other revenue - net. Asset management and administration fees increased primarily due to increases in mutual fund service fees and advice solutions fees. Net interest revenue increased primarily due to higher balances of interest-earning assets and higher interest rates on new fixed-rate investments. This increase was partially offset by the effect lower average short-term interest rates and the maturity of short-term interest-earning assets had on the Company’s average net interest margin. Trading revenue increased primarily due to higher daily average revenue trades and two additional trading days during the year. Other revenue - net decreased primarily due to a non-recurring gain of $70 million relating to a confidential resolution of a vendor dispute in 2012. Expenses excluding interest increased by 9% in 2013 from 2012 primarily due to increases in compensation and benefits, professional services, advertising and market development, and other expense. Compensation and benefits expense increased in 2013 from 2012 primarily due to higher incentive compensation relating to the transition to a new payout schedule for field incentive plans, increased individual sales performance compensation as a result of field sales volume, increased and accelerated health savings account (HSA) contributions, equity incentive plan changes to vesting for retirement-eligible employees, and increased funding for the corporate bonus plan commensurate with achieving higher earnings per common share. Advertising and market development expense increased primarily due to investment in the Company’s new advertising and branding initiative, Own your tomorrow™. CURRENT MARKET AND REGULATORY ENVIRONMENT AND OTHER DEVELOPMENTS To the extent short-term interest rates remain at current low levels, the Company’s net interest revenue will continue to be constrained, even as growth in average balances helps to increase such revenue. The low short-term interest rate environment also affects asset management and administration fees. The Company continues to waive a portion of its management fees, as the overall yields on certain Schwab-sponsored money market mutual funds have remained at levels at or below the management fees on those funds. These and certain other Schwab-sponsored money market mutual funds may not be able to replace maturing securities with securities of equal or higher yields. As a result, the yields on such funds may remain around or decline from their current levels, and therefore below the stated management fees on those funds. To the extent this occurs, asset management and administration fees may continue to be negatively affected. In July 2013, the U.S. banking agencies issued regulatory capital rules that implemented BASEL III and relevant provisions of the Dodd-Frank Act (Final Regulatory Capital Rules), which are applicable to savings and loan holding companies, such as CSC, and federal savings banks, such as Schwab Bank. The implementation of the rules began on January 1, 2015. The - 22 - THE CHARLES SCHWAB CORPORATION Management’s Discussion and Analysis of Financial Condition and Results of Operations (Tabular Amounts in Millions, Except Ratios, or as Noted) Company does not expect the Final Regulatory Capital Rules to have a material impact on the Company’s business, financial condition, and results of operations. The Final Regulatory Capital Rules, among other things: · subject savings and loan holding companies to consolidated capital requirements; · revise the required minimum risk-based and leverage capital requirements by (1) establishing a new minimum Common Equity Tier 1 Risk-Based Capital Ratio (common equity Tier 1 capital to total risk-weighted assets) of 4.5%; (2) raising the minimum Tier 1 Risk-Based Capital Ratio from 4.0% to 6.0%; (3) maintaining the minimum Total Risk-Based Capital Ratio of 8.0%; and (4) maintaining a minimum Tier 1 Leverage Ratio (Tier 1 capital to adjusted average consolidated assets) of 4.0%; · add a requirement to maintain a minimum capital conservation buffer, composed of common equity Tier 1 capital, of 2.5% of risk-weighted assets, which means that banking organizations, on a fully phased-in basis no later than January 1, 2019, must maintain a Common Equity Tier 1 Risk-Based Capital Ratio greater than 7.0%; a Tier 1 Risk-Based Capital Ratio greater than 8.5% and a Total Risk-Based Capital Ratio greater than 10.5%; and · change the definition of capital categories for insured depository: to be considered “well-capitalized”, Schwab Bank must have a Common Equity Tier 1 Risk-Based Capital Ratio of at least 6.5%, a Tier 1 Risk-Based Capital Ratio of at least 8%, a Total Risk-Based Capital Ratio of at least 10% and a Tier 1 Leverage Ratio of at least 5%. The new minimum regulatory capital ratios and changes to the calculation of risk-weighted assets were effective beginning January 1, 2015. The required minimum capital conservation buffer will be phased in incrementally, starting at 0.625% on January 1, 2016 and increasing to 1.25% on January 1, 2017, 1.875% on January 1, 2018 and 2.5% on January 1, 2019. The Final Regulatory Capital Rules provide that the failure to maintain the minimum capital conservation buffer will result in restrictions on capital distributions and discretionary cash bonus payments to executive officers. In September 2014, the Federal Reserve, in collaboration with the OCC and the FDIC, issued a rule implementing a quantitative liquidity requirement generally consistent with the LCR standard established by Basel III. The LCR applies to all internationally active banking organizations. The Federal Reserve also issued a modified LCR that applies to the Company. Under the modified LCR, a depository institution holding company is required to maintain high-quality liquid assets in an amount related to its total estimated net cash outflows over a prospective period. The modified LCR will be phased in beginning on January 1, 2016, with a minimum requirement of 90%, increasing to 100% at January 1, 2017. The Company is currently evaluating the impact of the final rule but does not expect a material impact to the Company’s business, financial condition, and results of operations. The Company is pursuing lawsuits in state court in San Francisco for rescission and damages against issuers, underwriters, and dealers of individual non-agency residential mortgage-backed securities on which the Company has experienced realized and unrealized losses. The lawsuits allege that offering documents for the securities contained material untrue and misleading statements about the securities and the underwriting standards and credit quality of the underlying loans. On January 27, 2012, and July 24, 2012, the court denied defendants’ motions to dismiss the claims and discovery is proceeding. To date, the Company has realized $28 million in net settlement proceeds on such claims, and an initial trial date relating to certain of the defendants who remain in the case is set for August 2015. - 23 - THE CHARLES SCHWAB CORPORATION Management’s Discussion and Analysis of Financial Condition and Results of Operations (Tabular Amounts in Millions, Except Ratios, or as Noted) RESULTS OF OPERATIONS The following discussion is an analysis of the Company’s results of operations for the years ended December 31, 2014, 2013, and 2012. Net Revenues The Company’s major sources of net revenues are asset management and administration fees, net interest revenue, and trading revenue. Asset management and administration fees and net interest revenue increased, while trading revenue remained relatively flat in 2014 as compared to 2013. Asset management and administration fees, net interest revenue, and trading revenue all increased in 2013 as compared to 2012. Year Ended December 31, % of % of % of Growth Rate Total Net Total Net Total Net 2013-2014 Amount Revenues Amount Revenues Amount Revenues Asset management and administration fees Schwab money market funds before fee waivers % $ $ $ Fee waivers % (751) (674) (587) Schwab money market funds after fee waivers (21) % % % % Equity and bond funds % % % % Mutual Fund OneSource® % % % % Total mutual fund service fees % 1,237 % 1,193 % 1,109 % Advice solutions % % % % Other % % % % Asset management and administration fees % 2,533 % 2,315 % 2,043 % Net interest revenue Interest revenue % 2,374 % 2,085 % 1,914 % Interest expense (3) % (102) (1) % (105) (2) % (150) (3) % Net interest revenue % 2,272 % 1,980 % 1,764 % Trading revenue Commissions (1) % % % % Principal transactions % % % % Trading revenue (1) % % % % Other - net % % % % Provision for loan losses N/M - - (16) - Net impairment losses on securities (90) % (1) - (10) - (32) (1) % Total net revenues % $ 6,058 % $ 5,435 % $ 4,883 % Asset Management and Administration Fees Asset management and administration fees include mutual fund service fees and fees for other asset-based financial services provided to individual and institutional clients. The Company earns mutual fund service fees for shareholder services, administration, and investment management provided to its proprietary funds, and recordkeeping and shareholder services provided to third-party funds. These fees are based upon the daily balances of client assets invested in these funds. The Company also earns asset management fees for advice solutions, which include advisory and managed account services that are based on the daily balances of client assets subject to the specific fee for service. The fair values of client assets included in proprietary and third-party mutual funds are based on quoted market prices and other observable market data. Other asset management and administration fees include various asset based fees, such as third-party mutual fund service fees, trust fees, 401(k) record keeping fees, and mutual fund clearing and other service fees. Asset management and administration fees vary with changes in the balances of client assets due to market fluctuations and client activity. For a discussion of the impact of current market conditions on asset management and administration fees, see “Current Market and Regulatory Environment and Other Developments.” Asset management and administration fees increased by $218 million, or 9%, in 2014 from 2013 due to fees from mutual fund services, advice solutions, and other asset management and administration services. Asset management and - 24 - THE CHARLES SCHWAB CORPORATION Management’s Discussion and Analysis of Financial Condition and Results of Operations (Tabular Amounts in Millions, Except Ratios, or as Noted) administration fees increased by $272 million, or 13%, in 2013 from 2012 primarily due to fees from mutual fund services and advice solutions. Mutual fund service fees increased by $44 million, or 4%, in 2014 from 2013 and by $84 million, or 8%, in 2013 from 2012, due to growth in client assets invested in the Company’s Mutual Fund OneSource funds and equity and bond funds, partially offset by a decrease in net money market mutual fund fees as a result of continued low yields on fund assets. Advice solutions fees increased by $122 million, or 17%, in 2014 from 2013 due to growth in client assets enrolled in advisory offers, including Schwab Private Client™, ThomasPartners®, and Schwab Managed Portfolios™. Advice solutions fees increased by $138 million, or 24%, in 2013 from 2012 primarily due to growth in client assets enrolled in advisory offers, including Windhaven®, Schwab Private Client™, and ThomasPartners®. Other asset management and administration fees increased by $52 million, or 13%, in 2014 from 2013 and $50 million, or 14%, in 2013 from 2012 primarily due to third-party mutual fund service fees on higher client asset balances invested in other third-party mutual funds. Net Interest Revenue Net interest revenue is the difference between interest earned on interest-earning assets and interest paid on funding sources. Net interest revenue is affected by changes in the volume and mix of these assets and liabilities, as well as by fluctuations in interest rates and portfolio management strategies. The majority of the Company’s interest-earnings assets and interest-bearing liabilities are sensitive to changes in short-term interest rates. The Company’s investment strategy is structured to produce an increase in net interest revenue when interest rates rise and, conversely, a decrease in net interest revenue when interest rates fall, from current levels. When interest rates fall, the Company may attempt to mitigate some of this negative impact by extending the maturities of assets in investment portfolios to lock in asset yields, and by lowering rates paid to clients on interest-bearing liabilities. Since the Company establishes the rates paid on certain brokerage client cash balances and deposits from banking clients, as well as the rates charged on receivables from brokerage clients, and also controls the composition of its investment securities, it has some ability to manage its net interest spread. However, the spread is influenced by external factors such as the interest rate environment and competition. The current low interest rate environment limits the extent to which the Company can reduce interest expense paid on funding sources. To a lesser degree, the Company is sensitive to changes in long-term interest rates through some of its investment portfolios. To mitigate the related risk, the Company may alter the types of investments purchased. For discussion of the impact of current market conditions on net interest revenue, see “Current Market and Regulatory Environment and Other Developments.” The Company’s interest-earning assets are financed primarily by brokerage client cash balances and Schwab Bank deposits. Non-interest-bearing funding sources include non-interest-bearing brokerage client cash balances, stockholders’ equity, and proceeds from stock-lending activities. Revenue from stock-lending activities is included in other interest revenue. Schwab Bank maintains available for sale and held to maturity investment portfolios for liquidity as well as to earn interest by investing funds from deposits that are in excess of loans to banking clients and liquidity requirements. Schwab Bank lends funds to banking clients primarily in the form of mortgage loans, HELOCs, and personal loans secured by securities. These loans are largely funded by interest-bearing deposits from banking clients. In clearing their clients’ trades, Schwab and optionsXpress, Inc. hold cash balances payable to clients. In most cases, Schwab and optionsXpress, Inc. pay their clients interest on cash balances awaiting investment, and in turn invest these funds and earn interest revenue. Receivables from brokerage clients consist primarily of margin loans to brokerage clients. Margin loans are loans made to clients on a secured basis to purchase securities. Pursuant to applicable regulations, client cash balances that are not used for margin lending are generally segregated into investment accounts that are maintained for the exclusive benefit of clients, which are recorded in cash and investments segregated on the Company’s consolidated balance sheets. When investing segregated client cash balances, Schwab and optionsXpress, Inc. must adhere to applicable regulations that restrict investments to securities guaranteed by the full faith and credit of the U.S. government, participation certificates, mortgage-backed securities guaranteed by the Government National Mortgage Association, deposits held at U.S. - 25 - THE CHARLES SCHWAB CORPORATION Management’s Discussion and Analysis of Financial Condition and Results of Operations (Tabular Amounts in Millions, Except Ratios, or as Noted) banks and thrifts, and resale agreements collateralized by qualified securities. Additionally, Schwab and optionsXpress, Inc. have established policies for the minimum credit quality and maximum maturity of these investments. The following table presents net interest revenue information corresponding to interest-earning assets and funding sources on the consolidated balance sheets: Year Ended December 31, Interest Average Interest Average Interest Average Average Revenue/ Yield/ Average Revenue/ Yield/ Average Revenue/ Yield/ Balance Expense Rate Balance Expense Rate Balance Expense Rate Interest-earning assets: Cash and cash equivalents $ 7,179 $ 0.22 % $ 6,943 $ 0.23 % $ 7,130 $ 0.25 % Cash and investments segregated 20,268 0.12 % 25,419 0.14 % 25,263 0.18 % Broker-related receivables (1) - 0.09 % - 0.04 % - 0.04 % Receivables from brokerage clients 13,778 3.50 % 11,800 3.68 % 10,928 4.08 % Securities available for sale (2) 52,057 1.05 % 49,114 1.13 % 39,745 1.47 % Securities held to maturity 32,361 2.56 % 24,915 2.45 % 15,371 2.58 % Loans to banking clients 12,906 2.75 % 11,758 2.80 % 10,053 3.07 % Loans held for sale - - - - - - 4.12 % Total interest-earning assets 138,874 2,251 1.62 % 130,326 1,981 1.52 % 108,859 1,800 1.65 % Other interest revenue Total interest-earning assets $ 138,874 $ 2,374 1.71 % $ 130,326 $ 2,085 1.60 % $ 108,859 $ 1,914 1.76 % Funding sources: Deposits from banking clients $ 95,842 $ 0.03 % $ 85,465 $ 0.04 % $ 65,546 $ 0.06 % Payables to brokerage clients 26,731 0.01 % 30,258 0.01 % 29,831 0.01 % Long-term debt 1,901 3.84 % 1,751 3.94 % 1,934 5.33 % Total interest-bearing liabilities 124,474 0.08 % 117,474 0.09 % 97,311 0.15 % Non-interest-bearing funding sources 14,400 12,852 11,548 Other interest expense (3) (3) Total funding sources $ 138,874 $ 0.07 % $ 130,326 $ 0.08 % $ 108,859 $ 0.14 % Net interest revenue $ 2,272 1.64 % $ 1,980 1.52 % $ 1,764 1.62 % (1) Interest revenue was less than $500,000 in the periods presented. (2) Amounts have been calculated based on amortized cost. (3) Includes the impact of capitalizing interest on building construction and software development. Net interest revenue increased in 2014 from 2013 primarily due to higher balances of interest-earning assets, including margin loans and the Company’s investment portfolio, and the effect higher average interest rates on securities held to maturity had on the Company’s average net interest margin. The growth in the average balance of deposits from banking clients funded the increase in the balances of securities held to maturity and securities available for sale. Net interest revenue increased in 2013 from 2012 primarily due to higher balances of interest-earning assets and higher interest rates on new fixed-rate investments, including securities available for sale and securities held to maturity, partially offset by the effect lower average short-term interest rates and the maturity of short-term interest-earning assets had on the Company’s average net interest margin. The growth in the average balance of deposits from banking clients funded the increase in the balance of securities available for sale and securities held to maturity. Net interest revenue also increased due to the redemption of higher rate trust preferred securities and the exchange of higher rate Senior Notes during the third quarter of 2012. Trading Revenue Trading revenue includes commission and principal transaction revenues. Commission revenue is affected by the number of revenue trades executed and the average revenue earned per revenue trade. Principal transaction revenue is primarily comprised of revenue from trading activity in client fixed income securities. To accommodate clients’ fixed income trading activity, the Company maintains positions in fixed income securities, including state and municipal debt obligations, U.S. Government, corporate debt, and other securities. The difference between the price at which the Company buys and sells securities to and from its clients and other broker-dealers is recognized as principal transaction revenue. Principal transaction - 26 - THE CHARLES SCHWAB CORPORATION Management’s Discussion and Analysis of Financial Condition and Results of Operations (Tabular Amounts in Millions, Except Ratios, or as Noted) revenue also includes adjustments to the fair value of these securities positions. Factors that influence principal transaction revenue include the volume of client trades and market price volatility. Trading revenue remained relatively flat in 2014 from 2013. Trading revenue increased by $45 million, or 5%, in 2013 from 2012 primarily due to higher daily average revenue trades and two additional trading days in 2013. Daily average revenue trades were relatively flat in 2014 from 2013 primarily due to a higher volume of equity trades, offset by a lower volume of mutual fund trades. Daily average revenue trades increased by 4% in 2013 from 2012 primarily due to a higher volume of equity and mutual fund trades, partially offset by a lower volume of future and option trades. Average revenue per revenue trade remained relatively flat from 2012 to 2014. Growth Rate Year Ended December 31, 2013-2014 Daily average revenue trades (1) (in thousands) % 298.2 295.0 282.7 Clients’ daily average trades (2) (in thousands) % 516.8 490.5 440.9 Number of trading days (3) - 250.5 250.5 248.5 Average revenue per revenue trade (1) % $ 12.13 $ 12.31 $ 12.35 (1) Includes all client trades that generate trading revenue (i.e., commission revenue or principal transaction revenue). (2) Includes daily average revenue trades, trades by clients in asset-based pricing relationships, and all commission-free trades, including the Company’s Mutual Fund OneSource funds and ETFs, and other proprietary products. Clients’ daily average trades is an indicator of client engagement with securities markets. (3) October 29 and 30, 2012, were not included as trading days due to weather-related market closures. Other Revenue - Net Other revenue - net includes order flow revenue, nonrecurring gains, software fees from the Company’s portfolio management services, exchange processing fees, realized gains or losses on sales of securities available for sale, and other service fees. Other revenue - net increased by $107 million, or 45%, in 2014 compared to 2013 primarily due to a net insurance settlement of $45 million, net litigation proceeds of $28 million related to the Company’s non-agency residential mortgage-backed securities portfolio, and increases in order flow revenue. Other revenue - net decreased by $20 million, or 8%, in 2013 compared to 2012 primarily due to a non-recurring gain of $70 million relating to a confidential resolution of a vendor dispute in the second quarter of 2012 and realized gains of $35 million from the sales of securities available for sale in 2012, partially offset by an increase in order flow revenue that Schwab began receiving in November 2012. Provision for Loan Losses The provision for loan losses decreased by $3 million in 2014, from $(1) million to $(4) million in 2013 and 2014, respectively, primarily due to improved residential real estate mortgage and HELOC credit quality in the Company’s loan portfolio. Charge-offs were $5 million, $11 million, and $16 million in 2014, 2013, and 2012, respectively. For further discussion on the Company’s credit risk and the allowance for loan losses, see “Risk Management - Credit Risk” and “Item 8 - Financial Statements and Supplementary Data - Notes to Consolidated Financial Statements - 6. Loans to Banking Clients and Related Allowance for Loan Losses.” Net Impairment Losses on Securities Net impairment losses on securities were $1 million, $10 million, and $32 million in 2014, 2013, and 2012, respectively. These charges were lower in 2014 compared to 2013, reflecting a stabilization of the credit characteristics of certain non-agency residential mortgage-backed securities’ underlying loans. For further discussion, see “Item 8 - Financial Statements - 27 - THE CHARLES SCHWAB CORPORATION Management’s Discussion and Analysis of Financial Condition and Results of Operations (Tabular Amounts in Millions, Except Ratios, or as Noted) and Supplementary Data - Notes to Consolidated Financial Statements - 5. Securities Available for Sale and Securities Held to Maturity.” Expenses Excluding Interest As shown in the table below, expenses excluding interest were higher in 2014 compared to 2013 primarily due to increases in compensation and benefits and professional services expense. Expenses excluding interest were higher in 2013 compared to 2012 primarily due to increases in compensation and benefits, professional services, advertising and market development, and other expense. Growth Rate Year Ended December 31, 2013-2014 Compensation and benefits % $ 2,184 $ 2,027 $ 1,803 Professional services % Occupancy and equipment % Advertising and market development (5) % Communications % Depreciation and amortization (1) % Other % Total expenses excluding interest % $ 3,943 $ 3,730 $ 3,433 Expenses as a percentage of total net revenues: Compensation and benefits % % % Advertising and market development % % % Compensation and Benefits Compensation and benefits expense includes salaries and wages, incentive compensation, and related employee benefits and taxes. Incentive compensation includes variable compensation, discretionary bonuses, and stock-based compensation. Variable compensation includes payments to certain individuals based on their sales performance. Discretionary bonuses are based on the Company’s overall performance as measured by earnings per common share, and therefore will fluctuate with this measure. Stock-based compensation primarily includes employee and board of director stock options and restricted stock. The following table shows a comparison of certain compensation and benefits components and employee data: Growth Rate Year Ended December 31, 2013-2014 Salaries and wages % $ 1,245 $ 1,110 $ 1,043 Incentive compensation % Employee benefits and other % Total compensation and benefits expense % $ 2,184 $ 2,027 $ 1,803 Full-time equivalent employees (in thousands) (1) At year end % 14.6 13.8 13.8 Average % 14.2 13.9 13.8 (1) Includes full-time, part-time and temporary employees, and persons employed on a contract basis, and excludes employees of outsourced service providers. Salaries and wages increased in 2014 from 2013 primarily due to a $68 million charge in 2014 for estimated future severance benefits resulting from changes in the Company’s geographic footprint and due to annual salary increases. Incentive compensation was relatively flat in 2014 from 2013 primarily due to an increase in discretionary bonus costs, offset by higher 2013 expense related to a new payout schedule for field incentive plans. - 28 - THE CHARLES SCHWAB CORPORATION Management’s Discussion and Analysis of Financial Condition and Results of Operations (Tabular Amounts in Millions, Except Ratios, or as Noted) Salaries and wages increased in 2013 from 2012 primarily due to annual salary increases. Incentive compensation increased in 2013 from 2012 primarily due to the transition to a new payout schedule for field incentive plans, increased individual sales performance compensation as a result of higher field sales volume, and increased funding for the corporate bonus plan commensurate with achieving higher earnings per common share. Employee benefits and other expense increased in 2013 from 2012 primarily due to payroll taxes related to the increase in incentive compensation, and increased contributions to new employee HSAs. The Company was converting to HSA-based healthcare and employee enrollment in these plans rose significantly in 2013. Expenses Excluding Compensation and Benefits Professional services expense increased in 2014 from 2013 primarily due to higher spending on technology services and an increase in fees paid to outsourced service providers and consultants. Professional services expense increased in 2013 from 2012 primarily due to an increase in fees paid to outsourced service providers and consultants and higher spending on printing and fulfillment services. Occupancy and equipment expense increased in 2014 from 2013 primarily due to an increase in software maintenance expense relating to the Company’s information technology systems. Occupancy and equipment expense was relatively flat in 2013 compared to 2012. Advertising and market development expense decreased in 2014 from 2013 primarily due to production costs incurred in 2013 relating to the development of the Company’s advertising and branding initiative, Own your tomorrowTM, partially offset by higher 2014 spending on customer promotions. Advertising and market development expense increased in 2013 from 2012 primarily due to higher spending on media relating to the launch of the Company’s new advertising and branding initiative, Own your tomorrowTM. Other expense increased in 2014 from 2013 primarily due to an increase in travel costs as a result of increased employee headcount and travel. Other expense increased in 2013 from 2012 primarily due to an increase in regulatory assessments. Taxes on Income The Company’s effective income tax rate on income before taxes was 37.5% in 2014, 37.2% in 2013, and 36.0% in 2012. The increase in 2014 from 2013 was primarily due to the impact of a non-recurring state tax benefit of $4 million from 2013. The increase in 2013 from 2012 was primarily due to the impact of a non-recurring state tax benefit of $20 million in 2012, partially offset by the recognition of the additional state tax benefit of $4 million in 2013. Segment Information The Company provides financial services to individuals and institutional clients through two segments - Investor Services and Advisor Services. The Investor Services segment provides retail brokerage and banking services to individual investors, retirement plan services, and corporate brokerage services. The Advisor Services segment provides custodial, trading, and support services to independent investment advisors, and retirement business services to independent retirement plan advisors and recordkeepers whose plan assets are held at Schwab Bank. Banking revenues and expenses are allocated to the Company’s two segments based on which segment services the client. The Company evaluates the performance of its segments on a pre-tax basis, excluding items such as significant nonrecurring gains, impairment charges on non-financial assets, discontinued operations, extraordinary items, and significant restructuring and other charges. Segment assets and liabilities are not used for evaluating segment performance or in deciding how to allocate resources to segments. - 29 - THE CHARLES SCHWAB CORPORATION Management’s Discussion and Analysis of Financial Condition and Results of Operations (Tabular Amounts in Millions, Except Ratios, or as Noted) Financial information for the Company’s reportable segments is presented in the following tables: Investor Services Advisor Services Growth Rate Growth Rate Year Ended December 31, 2013-2014 2013-2014 Net Revenues Asset management and administration fees % $ 1,775 $ 1,627 $ 1,436 % $ $ $ Net interest revenue % 2,030 1,756 1,559 % Trading revenue - (1) % Other - net % % Provision for loan losses N/M (15) - - - (1) Net impairment losses on securities (89) % (1) (9) (29) (100) % - (1) (3) Total net revenues % 4,647 4,174 3,686 % 1,360 1,261 1,125 Expenses Excluding Interest % 2,974 2,899 2,693 % Income before taxes on income % $ 1,673 $ 1,275 $ % $ $ $ Unallocated Total Growth Rate Growth Rate Year Ended December 31, 2013-2014 2013-2014 Net Revenues Asset management and administration fees N/M $ - $ (1) $ - % $ 2,533 $ 2,315 $ 2,043 Net interest revenue N/M - - - % 2,272 1,980 1,764 Trading revenue N/M - - (1) % Other - net N/M % Provision for loan losses N/M - - - N/M (16) Net impairment losses on securities N/M - - - (90) % (1) (10) (32) Total net revenues N/M - % 6,058 5,435 4,883 Expenses Excluding Interest N/M - % 3,943 3,730 3,433 Income before taxes on income N/M $ (17) $ - $ % $ 2,115 $ 1,705 $ 1,450 N/M Not meaningful. Investor Services Net revenues increased by $473 million, or 11%, in 2014 from 2013 primarily due to increases in net interest revenue, asset management and administration fees, and other revenue - net. Net interest revenue increased primarily due to higher balances of interest-earning assets, including margin loans and the Company’s investment portfolio, and the effect higher average interest rates on securities held to maturity had on the Company’s average net interest margin. Asset management and administration fees increased due to fees from mutual fund services, advice solutions, and other asset management and administration services. Mutual fund service fees increased due to growth in client assets invested in the Company’s Mutual Fund OneSource funds and equity and bond funds, partially offset by a decrease in net money market mutual fund fees as a result of continued low yields on fund assets. Advice solution fees increased due to growth in client assets enrolled in advisory offers. Other asset management and administration fees increased primarily due to third-party mutual fund service fees on higher client asset balances invested in other third-party mutual funds. Other revenue - net increased primarily due to litigation proceeds related to the Company’s non-agency residential mortgage-backed securities portfolio and increases in - 30 - THE CHARLES SCHWAB CORPORATION Management’s Discussion and Analysis of Financial Condition and Results of Operations (Tabular Amounts in Millions, Except Ratios, or as Noted) order flow revenue. Expenses excluding interest increased by $75 million, or 3%, in 2014 from 2013 primarily due to increases in compensation and benefits and professional services expense, partially offset by a decrease in advertising and market development expense. Net revenues increased by $488 million, or 13%, in 2013 from 2012 primarily due to increases in net interest revenue, asset management and administration fees, and other revenue. Net interest revenue increased primarily due to higher balances of interest-earning assets, partially offset by the effect lower average short-term interest rates had on the Company’s average net interest margin. Asset management and administration fees increased primarily due to increases in advice solutions fees and mutual fund service fees. Advice solutions fees increased due to growth in client assets enrolled in advisory offers, including Windhaven and Schwab Private Client. Mutual fund service fees increased due to market appreciation and growth in client assets invested in the Company’s Mutual Fund OneSource funds, and equity and bond funds, partially offset by a decrease in net money market mutual fund fees as a result of lower yields on fund assets. Other revenue - net increased primarily due to an increase in order flow revenue that Schwab began receiving in November 2012. Expenses excluding interest increased by $206 million, or 8%, in 2013 from 2012 primarily due to increases in compensation and benefits, professional services, advertising and market development, and other expenses. Advisor Services Net revenues increased by $99 million, or 8%, in 2014 from 2013 primarily due to an increase in asset management and administration fees, net interest revenue, and other revenue - net. Asset management and administration fees increased due to fees from mutual fund services, advice solutions, and other asset management and administration services. Mutual fund service fees increased due to growth in client assets invested in the Company’s Mutual Fund OneSource funds and equity and bond funds, partially offset by a decrease in net money market mutual fund fees as a result of continued low yields on fund assets. Advice solutions fees increased due to growth in client assets enrolled in advisory offers. Other asset management and administration fees increased primarily due to third-party mutual fund service fees on higher client asset balances invested in other third-party mutual funds. Net interest revenue increased primarily due to higher balances of interest-earning assets, including margin loans and the Company’s investment portfolio, and the effect higher average interest rates on securities held to maturity had on the Company’s average net interest margin. Other revenue - net increased primarily due to increases in order flow revenue. Expenses excluding interest increased by $70 million, or 8%, in 2014 from 2013 primarily due to increases in compensation and benefits and professional services expense. Net revenues increased by $136 million, or 12%, in 2013 from 2012 primarily due to increases in asset management and administration fees, trading revenue, and net interest revenue. Asset management and administration fees increased primarily due to increases in mutual fund service fees and advice solutions fees. Mutual fund service fees increased due to market appreciation and growth in client assets invested in the Company’s Mutual Fund OneSource funds, and equity and bond funds. Advice solutions fees increased due to growth in client assets enrolled in advisory offers. Trading revenue increased primarily due to higher daily average revenue trades and two additional trading days in 2013. Net interest revenue increased primarily due to higher balances of interest-earning assets, partially offset by the effect lower average short-term interest rates had on the Company’s average net interest margin. Expenses excluding interest increased by $92 million, or 12%, in 2013 from 2012 primarily due to increases in compensation and benefits, professional services, advertising and market development expenses, and other expenses. Unallocated Other revenue - net in 2014 includes a net insurance settlement of $45 million. Other revenue - net in 2012 includes a non-recurring gain of $70 million relating to a confidential resolution of a vendor dispute. Expenses excluding interest increased in 2014 from 2013 as a result of a charge of $68 million in the third quarter of 2014 for estimated future severance benefits resulting from changes in the Company’s geographic footprint. - 31 - THE CHARLES SCHWAB CORPORATION Management’s Discussion and Analysis of Financial Condition and Results of Operations (Tabular Amounts in Millions, Except Ratios, or as Noted) LIQUIDITY AND CAPITAL RESOURCES CSC conducts substantially all of its business through its wholly-owned subsidiaries. The Company’s capital structure is designed to provide each subsidiary with capital and liquidity to meet its operational needs and regulatory requirements. CSC is a savings and loan holding company and Schwab Bank, CSC’s depository institution, is a federal savings bank. CSC is subject to supervision and regulation by the Federal Reserve and Schwab Bank is subject to supervision and regulation by the OCC. Liquidity CSC CSC’s liquidity needs arise from funding its subsidiaries’ operations, including margin and mortgage lending, and transaction settlement, in addition to funding cash dividends, acquisitions, investments, short- and long-term debt, and managing statutory capital requirements. CSC’s liquidity needs are generally met through cash generated by its subsidiaries, as well as cash provided by external financing. CSC has a universal automatic shelf registration statement (Shelf Registration Statement) on file with the SEC which enables CSC to issue debt, equity, and other securities. CSC maintains excess liquidity in the form of overnight cash deposits and short-term investments to cover daily funding needs and to support growth in the Company’s business. Generally, CSC does not hold liquidity at its subsidiaries in excess of amounts deemed sufficient to support the subsidiaries’ operations, including any regulatory capital requirements. Schwab, Schwab Bank, and optionsXpress, Inc. are subject to regulatory requirements that may restrict them from certain transactions with CSC, as further discussed below. Management believes that funds generated by the operations of CSC’s subsidiaries will continue to be the primary funding source in meeting CSC’s liquidity needs, providing adequate liquidity to meet Schwab Bank’s capital guidelines, and maintaining Schwab and optionsXpress, Inc.’s net capital. On July 25, 2013, CSC issued $275 million of Senior Notes that mature in 2018 under its Shelf Registration Statement. The Senior Notes have a fixed interest rate of 2.20% with interest payable semi-annually. CSC is required to serve as a source of strength for Schwab Bank and must have the ability to provide financial assistance if Schwab Bank experiences financial distress. To manage capital adequacy, the Company currently utilizes a target Tier 1 Leverage Ratio for CSC, as currently defined by the Federal Reserve, of at least 6%. At December 31, 2014, CSC’s Tier 1 Leverage Ratio was 6.9%, Tier 1 Capital Ratio was 18.0%, and Total Capital Ratio was 18.1%. Prior to January 1, 2015, CSC, as a savings and loan holding company, was not subject to specific statutory capital requirements. Beginning on January 1, 2015, CSC is subject to new capital requirements set by the Federal Reserve. The following are details of CSC’s long-term debt: Par Standard December 31, 2014 Outstanding Maturity Interest Rate Moody’s & Poor’s Fitch Senior Notes $ 1,581 2015 - 2022 0.850% to 4.45% fixed A2 A A Medium-Term Notes $ 6.375% fixed A2 A A CSC has authorization from its Board of Directors to issue unsecured commercial paper notes (Commercial Paper Notes) not to exceed $1.5 billion. Management has set a current limit for the commercial paper program of $800 million. The maturities of the Commercial Paper Notes may vary, but are not to exceed 270 days from the date of issue. The commercial paper is not redeemable prior to maturity and cannot be voluntarily prepaid. The proceeds of the commercial paper program are to be used for general corporate purposes. There were no borrowings of Commercial Paper Notes outstanding at December 31, 2014. CSC’s ratings for these short-term borrowings are P1 by Moody’s, A1 by Standard & Poor’s, and by Fitch. - 32 - THE CHARLES SCHWAB CORPORATION Management’s Discussion and Analysis of Financial Condition and Results of Operations (Tabular Amounts in Millions, Except Ratios, or as Noted) CSC maintains an $800 million committed, unsecured credit facility with a group of 12 banks, which is scheduled to expire in June 2015. This facility replaced a similar facility that expired in June 2014 and both facilities were unused during 2014. The funds under this facility are available for general corporate purposes. The financial covenants under this facility require Schwab to maintain a minimum net capital ratio, as defined, Schwab Bank to be well capitalized, as defined, and CSC to maintain a minimum level of stockholders’ equity, excluding accumulated other comprehensive income. At December 31, 2014, the minimum level of stockholders’ equity required under this facility was $7.8 billion (CSC’s stockholders’ equity, excluding accumulated other comprehensive income, at December 31, 2014, was $11.6 billion). Management believes that these restrictions will not have a material effect on CSC’s ability to meet foreseeable dividend or funding requirements. CSC also has direct access to certain of the uncommitted, unsecured bank credit lines discussed below, that are primarily utilized by Schwab to manage short-term liquidity. These lines were not used by CSC during 2014. In addition, Schwab provided CSC with a $1.0 billion credit facility, which was scheduled to expire in December 2014. Schwab terminated this credit facility in July 2014. Schwab Schwab’s liquidity needs relating to client trading and margin borrowing activities are met primarily through cash balances in brokerage client accounts, which were $32.0 billion and $33.2 billion at December 31, 2014 and 2013, respectively. Management believes that brokerage client cash balances and operating earnings will continue to be the primary sources of liquidity for Schwab. Schwab is subject to regulatory requirements of Rule 15c3-1 under the Securities Exchange Act of 1934 (the Uniform Net Capital Rule) that are intended to ensure the general financial soundness and liquidity of broker-dealers. These regulations prohibit Schwab from repaying subordinated borrowings from CSC, paying cash dividends, or making unsecured advances or loans to its parent company or employees if such payment would result in a net capital amount of less than 5% of aggregate debit balances or less than 120% of its minimum dollar requirement of $250,000. At December 31, 2014, Schwab’s net capital was $1.6 billion (10% of aggregate debit balances), which was $1.2 billion in excess of its minimum required net capital and $739 million in excess of 5% of aggregate debit balances. Schwab is also subject to Rule 15c3-3 under the Securities Exchange Act of 1934 and other applicable regulations that require it to maintain cash or qualified securities in a segregated reserve account for the exclusive benefit of clients. These funds are included in cash and investments segregated and on deposit for regulatory purposes in the Company’s consolidated balance sheets and are not available as a general source of liquidity. Most of Schwab’s assets are readily convertible to cash, consisting primarily of short-term investment-grade, interest-earning investments (the majority of which are segregated for the exclusive benefit of clients pursuant to regulatory requirements), receivables from brokerage clients, and receivables from brokers, dealers, and clearing organizations. Client margin loans are demand loan obligations secured by readily marketable securities. Receivables from and payables to brokers, dealers, and clearing organizations primarily represent current open transactions, which usually settle, or can be closed out, within a few business days. Schwab has a finance lease obligation related to an office building and land under a 20-year lease. The remaining finance lease obligation of $83 million at December 31, 2014, is being reduced by a portion of the lease payments over the remaining lease term of ten years. To manage short-term liquidity, Schwab maintains uncommitted, unsecured bank credit lines with a group of banks. The need for short-term borrowings arises primarily from timing differences between cash flow requirements, scheduled liquidation of interest-earnings investments, and movements of cash to meet regulatory brokerage client cash segregation requirements. Schwab used such borrowings for three days in 2014, with average daily amounts borrowed of $25 million. There were no borrowings outstanding under these lines at December 31, 2014. - 33 - THE CHARLES SCHWAB CORPORATION Management’s Discussion and Analysis of Financial Condition and Results of Operations (Tabular Amounts in Millions, Except Ratios, or as Noted) To partially satisfy the margin requirement of client option transactions with the Options Clearing Corporation, Schwab has unsecured standby letter of credit agreements (LOCs) with five banks in favor of the Options Clearing Corporation aggregating $225 million at December 31, 2014. There were no funds drawn under any of these LOCs during 2014. In connection with its securities lending activities, Schwab is required to provide collateral to certain brokerage clients. Schwab satisfies the collateral requirements by providing cash as collateral. To manage Schwab’s regulatory capital requirement, CSC provides Schwab with a $1.4 billion subordinated revolving credit facility, which is scheduled to expire in March 2016. The amount outstanding under this facility at December 31, 2014, was $315 million. Borrowings under this subordinated lending arrangement qualify as regulatory capital for Schwab. In addition, CSC provides Schwab with a $2.5 billion credit facility. In December 2014, CSC and Schwab agreed to extend the expiration date of this facility from December 2014 to December 2017. Borrowings under this facility do not qualify as regulatory capital for Schwab. There were no funds drawn under this facility at December 31, 2014. Schwab Bank Schwab Bank’s liquidity needs are met through deposits from banking clients and equity capital. Deposits from banking clients at December 31, 2014 were $102.8 billion, which includes the excess cash held in certain Schwab and optionsXpress, Inc. brokerage accounts that is swept into deposit accounts at Schwab Bank. At December 31, 2014, these balances totaled $82.1 billion. Schwab Bank is subject to regulatory requirements that restrict and govern the terms of affiliate transactions, such as extensions of credit and repayment of loans between Schwab Bank and CSC or CSC’s other subsidiaries. In addition, Schwab Bank is required to provide notice to and may be required to obtain approval of the OCC and the Federal Reserve to declare dividends to CSC. Schwab Bank is required to maintain capital levels as specified in federal banking laws and regulations. Failure to meet the minimum levels could result in certain mandatory and possibly additional discretionary actions by the regulators that, if undertaken, could have a direct material effect on Schwab Bank. The Company currently utilizes a target Tier 1 Leverage Ratio for Schwab Bank of at least 6.25%. Beginning on January 1, 2015, Schwab Bank is subject to new capital requirements set by the OCC. Based on its regulatory capital ratios at December 31, 2014, Schwab Bank is considered well capitalized. Schwab Bank’s regulatory capital and ratios are as follows: Minimum to be Minimum Capital Actual Well Capitalized Requirement December 31, 2014 Amount Ratio Amount Ratio Amount Ratio Tier 1 Risk-Based Capital $ 7,700 22.1 % $ 2,095 6.0 % $ 1,397 4.0 % Total Risk-Based Capital $ 7,744 22.2 % $ 3,492 10.0 % $ 2,793 8.0 % Tier 1 Leverage $ 7,700 6.9 % $ 5,548 5.0 % $ 4,438 4.0 % Tangible Equity $ 7,700 6.9 % N/A $ 2,219 2.0 % N/A Not applicable. Schwab Bank has access to traditional funding sources such as deposits, federal funds purchased, and repurchase agreements. Additionally, Schwab Bank has access to short-term funding through the Federal Reserve Bank (FRB) discount window. Amounts available under the FRB discount window are dependent on the fair value of certain of Schwab Bank’s securities available for sale and/or securities held to maturity that are pledged as collateral to the FRB. Schwab Bank maintains policies and procedures necessary to access this funding and tests discount window borrowing procedures annually. At December 31, 2014, $2.3 billion was available under this arrangement. There were no funds drawn under this arrangement during 2014. Schwab Bank maintains a credit facility with the Federal Home Loan Bank System. Amounts available under this facility are dependent on the amount of Schwab Bank’s residential real estate mortgages and HELOCs that are pledged as collateral. - 34 - THE CHARLES SCHWAB CORPORATION Management’s Discussion and Analysis of Financial Condition and Results of Operations (Tabular Amounts in Millions, Except Ratios, or as Noted) Schwab Bank maintains policies and procedures necessary to access this funding and tests borrowing procedures annually. At December 31, 2014, $9.0 billion was available under this facility. There were no funds drawn under this facility during 2014. optionsXpress, Inc. optionsXpress, Inc.’s liquidity needs relating to client trading and margin borrowing activities are met primarily through cash balances in brokerage client accounts, which were $942 million at December 31, 2014. Management believes that brokerage client cash balances and operating earnings will continue to be the primary sources of liquidity for optionsXpress, Inc. optionsXpress, Inc., is subject to regulatory requirements of the Uniform Net Capital Rule that are intended to ensure the general financial soundness and liquidity of broker-dealers. These regulations prohibit optionsXpress, Inc. from paying cash dividends or making unsecured advances or loans to its parent company or employees if such payment would result in a net capital amount of less than 5% of aggregate debit balances or less than 120% of its minimum dollar requirement of $250,000. At December 31, 2014, optionsXpress Inc.’s net capital was $123 million (38% of aggregate debit balances), which was $117 million in excess of its minimum required net capital and $107 million in excess of 5% of aggregate debit balances. optionsXpress, Inc. is also subject to Commodity Futures Trading Commission Regulation 1.17 (Reg. 1.17) under the Commodity Exchange Act, which also requires the maintenance of minimum net capital. optionsXpress, Inc. as a futures commission merchant, is required to maintain minimum net capital equal to the greater of its net capital requirement under Reg. 1.17 ($1 million), or the sum of 8% of the total risk margin requirements for all positions carried in customer accounts and 8% of the total risk margin requirements for all positions carried in non-customer accounts (as defined in Reg. 1.17). At December 31, 2014, optionsXpress, Inc. met the requirements of Reg. 1.17. Additionally, optionsXpress, Inc. is subject to Rule 15c3-3 under the Securities Exchange Act of 1934 and other applicable regulations that require it to maintain cash or qualified securities in a segregated reserve account for the exclusive benefit of clients. These funds are included in cash and investments segregated and on deposit for regulatory purposes in the Company’s consolidated balance sheets and are not available as a general source of liquidity. To partially satisfy the margin requirement of client option transactions with the Options Clearing Corporation, optionsXpress, Inc. has an unsecured standby LOC with one bank in favor of the Options Clearing Corporation in the amount of $15 million at December 31, 2014. There were no funds drawn under this LOC during 2014. CSC provides optionsXpress, Inc. with a $200 million credit facility. In December 2014, CSC and optionsXpress, Inc. agreed to extend the expiration date of this facility from December 2014 to December 2016. Borrowings under this facility do not qualify as regulatory capital for optionsXpress, Inc. There were no borrowings outstanding under this facility at December 31, 2014. optionsXpress has a term loan with CSC, of which $12 million was outstanding at December 31, 2014, and it matures in December 2017. Capital Resources The Company’s cash position (reported as cash and cash equivalents on its consolidated balance sheets) and cash flows are affected by changes in brokerage client cash balances and the associated amounts required to be segregated under regulatory guidelines. Timing differences between cash and investments actually segregated on a given date and the amount required to be segregated for that date may arise in the ordinary course of business, and are addressed by the Company in accordance with applicable regulations. Other factors which affect the Company’s cash position and cash flows include investment activity in security portfolios, levels of capital expenditures, acquisition and divestiture activity, banking client deposit activity, brokerage and banking client loan activity, financing activity in long-term debt, payments of dividends, and repurchases and issuances of CSC’s preferred and common stock. The combination of these factors can cause significant fluctuations in the cash position during specific time periods. - 35 - THE CHARLES SCHWAB CORPORATION Management’s Discussion and Analysis of Financial Condition and Results of Operations (Tabular Amounts in Millions, Except Ratios, or as Noted) The Company monitors both the relative composition and absolute level of its capital structure. Management is focused on optimizing the Company’s use of capital and currently targets a long-term debt to total financial capital ratio not to exceed 30%. The Company’s total financial capital (long-term debt plus stockholders’ equity) at December 31, 2014 was $13.7 billion, up $1.4 billion, or 12%, from December 31, 2013. Long-term Debt At December 31, 2014, the Company had long-term debt of $1.9 billion, or 14% of total financial capital, that bears interest at a weighted-average rate of 3.60%. At December 31, 2013, the Company had long-term debt of $1.9 billion, or 15% of total financial capital. On July 25, 2013, CSC issued $275 million of Senior Notes that mature in 2018 under its Shelf Registration Statement. The Senior Notes have a fixed interest rate of 2.20% with interest payable semi-annually. The Company repaid $6 million of other long-term debt in 2014. For further discussion of the Company’s long-term debt, see “Liquidity and Capital Resources - Liquidity” and “Item 8 - Financial Statements and Supplementary Data - Notes to Consolidated Financial Statements - 13. Borrowings.” Capital Expenditures The Company’s capital expenditures were $405 million (7% of net revenues) and $270 million (5% of net revenues) in 2014 and 2013, respectively. Capital expenditures in 2014 were primarily for buildings and land relating to changes in the Company’s geographic footprint, developing internal-use software, and software and equipment relating to the Company’s information technology systems. Capital expenditures in 2013 were primarily for buildings and land, capitalized costs for developing internal-use software, and software and equipment relating to the Company’s information technology systems. Capitalized costs for developing internal-use software were $81 million and $74 million in 2014 and 2013, respectively. Management currently anticipates that 2015 capital expenditures will be approximately 15% lower than 2014 primarily due to decreased spending on buildings and furniture and equipment. A majority of this decrease is due to the construction of the Company’s new office campus in Denver, Colorado in 2014. As in recent years, the Company adjusts its capital expenditures periodically as business conditions change. Management believes that funds generated by its operations will continue to be the primary funding source of its capital expenditures. Dividends CSC paid common stock cash dividends of $316 million ($0.24 per share) and $311 million ($0.24 per share) in 2014 and 2013, respectively. Since the initial dividend in 1989, CSC has paid 103 consecutive quarterly dividends and has increased the quarterly dividend rate 19 times, resulting in a 21% compounded annual growth rate, excluding the special cash dividend of $1.00 per common share in 2007. While the payment and amount of dividends are at the discretion of the Board of Directors, subject to certain regulatory and other restrictions, the Company currently targets its common stock cash dividend at approximately 20% to 30% of net income. CSC paid Series A Preferred Stock cash dividends of $28 million ($70.00 per share) in 2014 and 2013, respectively. CSC paid Series B Preferred Stock cash dividends of $29 million ($60.00 per share) in 2014 and 2013, respectively. Share Repurchases There were no repurchases of CSC’s common stock in 2014 or 2013. As of December 31, 2014, CSC had remaining authority from the Board of Directors to repurchase up to $596 million of its common stock, which is not subject to expiration. Business Acquisition On December 14, 2012, the Company acquired ThomasPartners, Inc., a growth and dividend income-focused asset management firm, for $85 million in cash. - 36 - THE CHARLES SCHWAB CORPORATION Management’s Discussion and Analysis of Financial Condition and Results of Operations (Tabular Amounts in Millions, Except Ratios, or as Noted) For more information on this acquisition, see “Item 8 - Financial Statements and Supplementary Data - Notes to Consolidated Financial Statements - 24. Business Acquisition.” Off-Balance Sheet Arrangements The Company enters into various off-balance sheet arrangements in the ordinary course of business, primarily to meet the needs of its clients. These arrangements include firm commitments to extend credit. Additionally, the Company enters into guarantees and other similar arrangements as part of transactions in the ordinary course of business. For information on each of these arrangements, see “Item 8 - Financial Statements and Supplementary Data - Notes to Consolidated Financial Statements - 14. Commitments and Contingencies and 15. Financial Instruments Subject to Off-Balance Sheet Credit Risk or Concentration Risk.” Contractual Obligations The Company’s principal contractual obligations as of December 31, 2014, are shown in the following table. Management believes that funds generated by its continuing operations, as well as cash provided by external financing, will continue to be the primary funding sources in meeting these obligations. Excluded from this table are liabilities recorded on the consolidated balance sheet that are generally short-term in nature (e.g., payables to brokers, dealers, and clearing organizations) or without contractual payment terms (e.g., deposits from banking clients, payables to brokerage clients, and deferred compensation). Less than 1-3 3-5 More than 1 Year Years Years 5 Years Total Credit-related financial instruments (1) $ $ $ 3,119 $ 2,063 $ 6,965 Long-term debt (2) 1,013 2,160 Leases (3) Purchase obligations (4) Total $ 1,542 $ 1,660 $ 3,623 $ 3,468 $ 10,293 (1) Represents Schwab Bank’s commitments to extend credit to banking clients and purchase mortgage loans. (2) Includes estimated future interest payments through 2017 for Medium-Term Notes and through 2022 for Senior Notes. Amounts exclude maturities under a finance lease obligation and unamortized discounts and premiums. (3) Represents minimum rental commitments, net of sublease commitments, and includes facilities under the Company’s past restructuring initiatives and rental commitments under a finance lease obligation. (4) Consists of purchase obligations for services such as advertising and marketing, telecommunications, professional services, and hardware- and software-related agreements. Includes purchase obligations that can be canceled by the Company without penalty. Risk MANAGEMENT The Company’s business activities expose it to a variety of risks, including operational, credit, market, liquidity, compliance and legal risk. The Company has a comprehensive risk management program to identify and manage these risks and their associated potential for financial and reputational impact. Despite the Company’s efforts to identify areas of risk and implement risk management policies and procedures, there can be no assurance that the Company will not suffer unexpected losses due to these risks. The Company’s risk management process is comprised of risk identification and assessment, risk measurement, risk monitoring and reporting and risk mitigation. The activities and organizations that comprise the risk management process are described below. Risk Culture The Company’s Board of Directors sets the tone for effective risk management and has approved an Enterprise Risk Management (ERM) Framework commensurate with the size, risk profile, complexity, and continuing growth of the - 37 - THE CHARLES SCHWAB CORPORATION Management’s Discussion and Analysis of Financial Condition and Results of Operations (Tabular Amounts in Millions, Except Ratios, or as Noted) Company. The ERM Framework and governance structure constitute a comprehensive approach to managing risks encountered by the Company in its business activities. Risk appetite, which is defined as the amount of risk the Company is willing to accept in pursuit of its corporate strategy, is set by executive management and approved by the Board of Directors. The Company has established risk metrics and reporting that enable the measurement of the impact of strategy execution against risk appetite. The risk metrics, with risk limits and tolerance levels, are established for key risk categories by the Global Risk Committee and its functional risk sub-committees. Risk Governance Senior management takes an active role in the risk management process and has developed policies and procedures under which specific business and control units are responsible for identifying, measuring and controlling risks. The Global Risk Committee, which is comprised of senior executives from each major business and control function, is responsible for the oversight of risk management. This includes identifying emerging risks, assessing risk management practices and the control environment, reinforcing business accountability for risk management, supervisory controls and regulatory compliance, supporting resource prioritization across the Company, and escalating significant issues to the Board of Directors. The Global Risk Committee reports regularly to the Risk Committee of the Board of Directors. The Risk Committee assists the Board of Directors in fulfilling its oversight responsibilities with respect to the Company’s risk management program, including approving risk appetite statements and reviewing reports relating to risk issues from functional areas of risk management, legal, compliance, and internal audit. Functional risk sub-committees focusing on specific areas of risk report into the Global Risk Committee. These sub-committees include the: · Asset-Liability Management and Pricing Committee, which establishes strategies and policies for the management of corporate capital, liquidity, interest rate risk, and investments; · Credit and Market Risk Oversight Committee, which provides oversight of and approves credit and market risk policies, limits, and exposures in loan, investment, and positioning portfolios; · New Products and Services Risk Oversight Committee, which provides oversight of, and approves corporate policy and procedures relating to the risk governance of new products and services; and the · Operational Risk Oversight Committee, which provides oversight of and approves operational risk management policies, risk tolerance levels, and operational risk governance processes, and includes the following sub-committees: o Client Fiduciary Risk Sub-Committee, which provides oversight of fiduciary risk throughout the Company; o Information Security and Privacy Sub-Committee, which provides oversight of the information security and privacy programs and policies; o Model Governance Sub-Committee, which provides oversight of model risk throughout the Company; and the o Vendor Management Sub-Committee, which provides oversight of the Company’s vendor management and outsourcing program and policies. Senior management has also created an Incentive Compensation Risk Oversight Committee, which establishes policy and provides oversight of incentive compensation risk. The committee reviews and approves the Annual Risk Assessment of incentive compensation plans, and reports directly to the Board Compensation Committee. The Company’s compliance, finance, internal audit, legal, and corporate risk management departments assist management and the various risk committees in evaluating, testing, and monitoring the Company’s risk management. In addition, the Company’s Disclosure Committee is responsible for monitoring and evaluating the effectiveness of the Company’s (a) disclosure controls and procedures and (b) internal control over financial reporting as of the end of each fiscal - 38 - THE CHARLES SCHWAB CORPORATION Management’s Discussion and Analysis of Financial Condition and Results of Operations (Tabular Amounts in Millions, Except Ratios, or as Noted) quarter. The Disclosure Committee reports on this evaluation to the CEO and CFO prior to their certification required by Sections 302 and 906 of the Sarbanes Oxley Act of 2002. Operational Risk Operational risks arise due to potentially inadequate or failed internal processes, people, and systems or from external events and relationships impacting the Company and/or any of its key business partners and vendors. Operational risk includes model and fiduciary risk, and each is also described in detail below. The Company’s operations are highly dependent on the integrity of its technology systems and the Company’s success depends, in part, on its ability to make timely enhancements and additions to its technology in anticipation of evolving client needs. To the extent the Company experiences system interruptions, errors or downtime (which could result from a variety of causes, including changes in client use patterns, technological failure, changes to its systems, linkages with third-party systems, and power failures), the Company’s business and operations could be significantly negatively impacted. To minimize business interruptions, Schwab has two data centers intended, in part, to further improve the recovery of business processing in the event of an emergency. The Company is committed to an ongoing process of upgrading, enhancing, and testing its technology systems. This effort is focused on meeting client needs, meeting market and regulatory changes, and deploying standardized technology platforms. Operational risk also includes the risk of human error, employee misconduct, external fraud, computer viruses, cyber attacks, terrorist attacks, and natural disaster. Employee misconduct could include fraud and misappropriation of client or Company assets, improper use or disclosure of confidential client or Company information, and unauthorized activities, such as transactions exceeding acceptable risks or authorized limits. External fraud includes misappropriation of client or Company assets by third parties, including through unauthorized access to Company systems and data and client accounts. The frequency and sophistication of such fraud attempts continue to increase. Operational risk is mitigated through a system of internal controls and risk management practices that are designed to keep operational risk and operational losses at levels appropriate to the inherent risk of the business in which the Company operates. The Company has specific policies and procedures to identify and manage operational risk, and uses periodic risk self-assessments and internal audit reviews to evaluate the effectiveness of these internal controls. The Company maintains backup and recovery functions, including facilities for backup and communications, and conducts periodic testing of disaster recovery plans. The Company also maintains policies and procedures and technology to protect against fraud and unauthorized access to systems and data. Despite the Company’s risk management efforts, it is not always possible to deter or prevent technological or operational failure, or fraud or other misconduct, and the precautions taken by the Company may not be effective in all cases. The Company may be subject to litigation, losses, and regulatory actions in such cases, and may be required to expend significant additional resources to remediate vulnerabilities or other exposures. The Company also faces operational risk when it employs the services of various external vendors, including domestic and international outsourcing of certain technology, processing, servicing, and support functions. The Company manages its exposure to external vendor risk through contractual provisions, control standards, and ongoing monitoring of vendor performance. The Company maintains policies and procedures regarding the standard of care expected with Company data, whether the data is internal company information, employee information, or non-public client information. The Company clearly defines for employees, contractors, and vendors the Company’s expected standards of care for confidential data. Regular training is provided by the Company in regard to data security. The Company is actively engaged in the research and development of new technologies, services, and products. The Company endeavors to protect its research and development efforts, and its brands, through the use of copyrights, patents, trade secrets, and contracts. - 39 - THE CHARLES SCHWAB CORPORATION Management’s Discussion and Analysis of Financial Condition and Results of Operations (Tabular Amounts in Millions, Except Ratios, or as Noted) Model Risk Model risk is the potential for adverse consequences from decisions based on incorrect or misused model outputs and reports. Models are owned by several business units throughout the Company, and are used for a variety of purposes. Model use includes, but is not limited to, calculating capital requirements for hypothetical stressful environments, estimating interest and credit risk for loans and other balance sheet assets, and providing guidance in the management of client portfolios. The Company has established a policy to describe the roles and responsibilities of all key stakeholders in model development, management, and use. All models at the Company are registered in a centralized database and classified into different risk ratings depending on their potential financial, reputational, or regulatory impact to the Company. The model risk rating informs the scope of all model governance activities. Fiduciary Risk Fiduciary risk is the potential for financial or reputational loss through breach of fiduciary duties to a client. Fiduciary activities include, but are not limited to, individual and institutional trust, investment management, custody, and cash and securities processing. The Company attempts to manage this risk by establishing procedures to ensure that obligations to clients are discharged faithfully and in compliance with applicable legal and regulatory requirements. Business units have the primary responsibility for adherence to the procedures applicable to their business. Guidance and control are provided through the creation, approval, and ongoing review of applicable policies by business units and various risk committees. Credit Risk Credit risk is the potential for loss due to a borrower, counterparty, or issuer failing to perform its contractual obligations. The Company’s direct exposure to credit risk mainly results from margin lending and client option and futures activities, securities lending activities, mortgage lending activities, its role as a counterparty in financial contracts and other investing activities. To manage the risks of such losses, the Company has established policies and procedures which include: establishing and reviewing credit limits, monitoring of credit limits and quality of counterparties, and adjusting margin, option, and futures requirements for certain securities. Collateral arrangements relating to margin loans, option positions, securities lending agreements, and resale agreements include provisions that require additional collateral in the event that market fluctuations result in declines in the value of collateral received. Additionally, for margin loan and securities lending agreements, collateral arrangements require that the fair value of such collateral exceeds the amounts loaned. The Company’s credit risk exposure related to loans to banking clients is actively managed through individual and portfolio reviews performed by management. Management regularly reviews asset quality, including concentrations, delinquencies, nonaccrual loans, charge-offs, and recoveries. All are factors in the determination of an appropriate allowance for loan losses. The Company’s mortgage loan portfolios primarily include First Mortgages of $8.1 billion and HELOCs of $3.0 billion at December 31, 2014. The Company’s underwriting guidelines include maximum loan-to-value (LTV) ratios, cash out limits, and minimum Fair Isaac Corporation (FICO) credit scores. The specific guidelines are dependent on the individual characteristics of a loan (for example, whether the property is a primary or secondary residence, whether the loan is for investment property, whether the loan is for an initial purchase of a home or refinance of an existing home, and whether the loan is conforming or jumbo). These credit underwriting standards have limited the exposure to the types of loans that experienced high foreclosures and loss rates elsewhere in the industry in recent years. In January 2014, the Company revised its First Mortgage underwriting criteria in conformance with the CFPB’s new guidance on Qualified Mortgage lending and a borrower’s ability to repay. Revisions were made to requirements affecting debt to income ratio, loan to value ratio, and liquid asset holdings. These revised underwriting criteria are not expected to have a material impact on the credit quality of the Company’s First Mortgage or HELOC portfolios. The Company does not purchase loans that allow for negative amortization and does not purchase subprime loans (generally defined as extensions of credit to borrowers with a FICO score of less than 620 at origination), unless the borrower has compensating credit factors. At December 31, 2014, approximately 1% of both the First Mortgage and HELOC portfolios consisted of loans to borrowers with updated FICO scores of less than 620. - 40 - THE CHARLES SCHWAB CORPORATION Management’s Discussion and Analysis of Financial Condition and Results of Operations (Tabular Amounts in Millions, Except Ratios, or as Noted) At December 31, 2014, the weighted-average originated LTV ratio was 59% for both the First Mortgage and HELOC portfolios. The computation of the origination LTV ratio for a HELOC includes any first lien mortgage outstanding on the same property at the time of origination. At December 31, 2014, 21% of HELOCs ($635 million of the HELOC portfolio) were in a first lien position. The weighted-average originated FICO score was 770 and 769 for the First Mortgage and HELOC portfolios, respectively. The Company monitors the estimated current LTV ratios of its First Mortgage and HELOC portfolios on an ongoing basis. At December 31, 2014, the weighted-average estimated current LTV ratios were 50% and 55% for the First Mortgage and HELOC portfolios, respectively. The computation of the estimated current LTV ratio for a HELOC includes any first lien mortgage outstanding on the same property at the time of the HELOC’s origination. The Company estimates the current LTV ratio for each loan by reference to a home price appreciation index. The Company also monitors updated borrower FICO scores, delinquency trends, and verified liquid assets held by individual borrowers. At December 31, 2014, the weighted-average updated FICO scores were 773 and 769 for the First Mortgage and HELOC portfolios, respectively. A portion of the Company’s HELOC portfolio is secured by second liens on the associated properties. Second lien mortgage loans possess a higher degree of credit risk given the subordination to the first lien holder in the event of default. At December 31, 2014, $2.3 billion, or 79%, of the HELOC portfolio was in a second lien position. In addition to the credit monitoring activities described above, the Company also monitors credit risk on second lien HELOC loans by reviewing the delinquency status of the first lien loan on the associated property. Additionally, at December 31, 2014, approximately 30% of the HELOC borrowers that had a balance only paid the minimum amount due. For more information on the Company’s credit quality indicators relating to its First Mortgage and HELOC portfolios, including delinquency characteristics, borrower FICO scores at origination, updated borrower FICO scores, LTV ratios at origination, and estimated current LTV ratios, see “Item 8 - Financial Statements and Supplementary Data - Notes to Consolidated Financial Statements - 6. Loans to Banking Clients and Related Allowance for Loan Losses.” The following table presents certain of the Company’s loan quality metrics as a percentage of total outstanding loans: December 31, Loan delinquencies (1) 0.27 % 0.48 % Nonaccrual loans 0.26 % 0.39 % Allowance for loan losses 0.31 % 0.39 % (1) Loan delinquencies include loans that are 30 days or more past due and other nonaccrual loans. The Company has exposure to credit risk associated with its securities available for sale and securities held to maturity portfolios, whose fair values totaled $54.8 billion and $34.7 billion at December 31, 2014, respectively. These portfolios include U.S. agency and non-agency mortgage-backed securities, asset-backed securities, corporate debt securities, U.S. agency notes, certificates of deposit, and treasury securities. U.S. agency mortgage-backed securities do not have explicit credit ratings; however, management considers these to be of the highest credit quality and rating given the guarantee of principal and interest by the U.S. government-sponsored enterprises. At December 31, 2014, with the exception of certain non-agency residential mortgage-backed securities, all securities in the available for sale and held to maturity portfolios were rated investment grade (defined as a rating equivalent to a Moody’s rating of “Baa” or higher, or a Standard & Poor’s rating of “BBB-” or higher). In the fourth quarter of 2014, the Company sold $504 million of its non-agency residential mortgage-backed securities, resulting in a net realized loss of $8 million. The Company marked the remaining $15 million of these securities to market and recorded a $0.6 million other-than-temporary impairment charge in the fourth quarter. The decision was made to sell the securities in the fourth quarter as market valuations on these non-agency residential mortgage-backed securities became more consistent with actual performance. In addition, the Company has reached an initial settlement in legal claims it is pursuing to recover losses relating to certain of these securities. - 41 - THE CHARLES SCHWAB CORPORATION Management’s Discussion and Analysis of Financial Condition and Results of Operations (Tabular Amounts in Millions, Except Ratios, or as Noted) Schwab performs clearing services for all securities transactions in its client accounts. Schwab has exposure to credit risk due to its obligation to settle transactions with clearing corporations, mutual funds, and other financial institutions even if Schwab’s client or a counterparty fails to meet its obligations to Schwab. Concentration Risk The Company has exposure to concentration risk when holding large positions in financial instruments collateralized by assets with similar economic characteristics or in securities of a single issuer or within a particular industry. The fair value of the Company’s investments in mortgage-backed securities totaled $53.8 billion at December 31, 2014. Of these, $52.5 billion were issued by U.S. agencies and $1.3 billion were issued by private entities (non-agency securities). These U.S. agency and non-agency securities are included in securities available for sale and securities held to maturity. The fair value of the Company’s investments in asset-backed securities totaled $19.4 billion at December 31, 2014. Of these, $11.7 billion were securities backed by student loans, the majority of which are guaranteed by the U.S. federal government. These asset-backed securities are included in securities available for sale. The fair value of the Company’s investments in corporate debt securities and commercial paper totaled $8.1 billion at December 31, 2014, with the majority issued by institutions in the financial services industry. These securities are included in securities available for sale, cash and cash equivalents, and other securities owned in the Company’s consolidated balance sheets. Issuer, geographic, and sector concentrations are controlled by established credit policy limits to each concentration type. The Company’s loans to banking clients include $7.4 billion of adjustable rate First Mortgage loans at December 31, 2014. The Company’s adjustable rate mortgages have initial fixed interest rates for three to ten years and interest rates that adjust annually thereafter. Approximately 40% of these mortgages consisted of loans with interest-only payment terms. The interest rates on approximately 65% of these interest-only loans are not scheduled to reset for three or more years. The Company’s mortgage loans do not include interest terms described as temporary introductory rates below current market rates. The Company’s HELOC product has a 30-year loan term with an initial draw period of ten years from the date of origination. After the initial draw period, the balance outstanding at such time is converted to a 20-year amortizing loan. The interest rate during the initial draw period and the 20-year amortizing period is a floating rate based on the prime rate plus a margin. HELOCs that convert to an amortizing loan may experience higher delinquencies and higher loss rates than those in the initial draw period. The Company’s allowance for loan loss methodology takes this increased inherent risk into consideration. The following table presents when current outstanding HELOCs will convert to amortizing loans: December 31, 2014 Balance Converted to amortizing loan by period end $ Within 1 year > 1 year - 3 years > 3 years - 5 years 1,139 > 5 years Total $ 2,955 The Company also has exposure to concentration risk from its margin and securities lending and client option and futures activities collateralized by or referencing securities of a single issuer, an index, or within a single industry. This concentration risk is mitigated by collateral arrangements that require the fair value of such collateral exceeds the amounts loaned. The Company has indirect exposure to U.S. Government and agency securities held as collateral to secure its resale agreements. The Company’s primary credit exposure on these resale transactions is with its counterparty. The Company would have exposure to the U.S. Government and agency securities only in the event of the counterparty’s default on the resale agreements. The fair value of U.S. Government and agency securities held as collateral for resale agreements totaled $10.4 billion at December 31, 2014. - 42 - THE CHARLES SCHWAB CORPORATION Management’s Discussion and Analysis of Financial Condition and Results of Operations (Tabular Amounts in Millions, Except Ratios, or as Noted) European Holdings The Company has exposure to non-sovereign financial and non-financial institutions in Europe. The following table shows the balances of this exposure by each country in Europe in which the issuer or counterparty is domiciled. The Company has no direct exposure to sovereign governments in Europe. The Company does not have unfunded commitments to counterparties in Europe, nor does it have exposure as a result of credit default protection purchased or sold separately as of December 31, 2014. The determination of the domicile of exposure varies by the type of investment. For time deposits and certificates of deposit, the exposure is grouped in the country in which the financial institution is chartered under the regulatory framework of the European country. For asset-backed commercial paper, the exposure is grouped by the country of the sponsoring bank that provides the credit and liquidity support for such instruments. For corporate debt securities, the exposure is grouped by the country in which the issuer is domiciled. In situations in which the Company invests in a corporate debt security of a U.S. subsidiary of a European parent company, such holdings will be attributable to the European country only if significant reliance is placed on the European parent company for credit support underlying the security. For substantially all of the holdings listed below, the issuers or counterparties were financial institutions. All of the Company’s resale agreements, which are included in investments segregated and on deposit for regulatory purposes, are collateralized by U.S. government securities. Additionally, the Company’s securities lending activities are collateralized by cash. Therefore, the Company’s resale agreements and securities lending activities are not included in the table below even if the counterparty is a European institution. Fair Value as of December 31, 2014 United France Netherlands Norway Sweden Switzerland Kingdom Total Cash equivalents $ $ - $ - $ - $ - $ - $ Securities available for sale 1,726 Total fair value $ $ $ $ $ $ $ 1,926 Total amortized cost $ $ $ $ $ $ $ 1,924 Maturities: Overnight $ $ - $ - $ - $ - $ - $ 1 day - < 6 months - - - - - 6 months - < 1 year - - - - 1 year - 2 years - - - > 2 years - Total fair value $ $ $ $ $ $ $ 1,926 In addition to the direct holdings of European companies listed above, the Company also has indirect exposure to Europe through its investments in Schwab sponsored money market funds (collectively, the Funds) resulting from clearing activities. At December 31, 2014, the Company had $224 million in investments in these Funds. Certain of the Funds’ positions include certificates of deposits, time deposits, commercial paper and corporate debt securities issued by counterparties in Europe. Management mitigates exposure to European holdings by employing a separate team of credit analysts that evaluate each issuer, counterparty, and country. Management monitors its exposure to European issuers by 1) performing risk assessments of the foreign countries, which include evaluating the size of the country and economy, currency trends, political landscape and the countries’ regulatory environment and developments; 2) performing ad hoc stress tests that evaluate the impact of sovereign governments’ debt write-downs on financial issuers and counterparties the Company has exposure to through its investments; 3) reviewing publicly available stress tests that are published by various regulators in the European market; 4) establishing credit and maturity limits by issuer; and 5) establishing and monitoring aggregate credit limits by geography and sector. Market Risk Market risk is the potential for changes in earnings or the value of financial instruments held by the Company as a result of fluctuations in interest rates, equity prices or market conditions. Included in market risk is interest rate risk, which is the risk - 43 - THE CHARLES SCHWAB CORPORATION Management’s Discussion and Analysis of Financial Condition and Results of Operations (Tabular Amounts in Millions, Except Ratios, or as Noted) to earnings or capital arising from movement of interest rates. For discussion of the Company’s market risk, see “

<s>[INST] Operations FORWARDLOOKING STATEMENTS In addition to historical information, this Annual Report on Form 10K contains “forwardlooking statements” within the meaning of Section 27A of the Securities Act, and Section 21E of the Securities Exchange Act of 1934. Forwardlooking statements are identified by words such as “believe,” “anticipate,” “expect,” “intend,” “plan,” “will,” “may,” “estimate,” “appear,” “aim,” “target,” “could,” and other similar expressions. In addition, any statements that refer to expectations, projections, or other characterizations of future events or circumstances are forwardlooking statements. These forwardlooking statements, which reflect management’s beliefs, objectives, and expectations as of the date hereof, are necessarily estimates based on the best judgment of the Company’s senior management. These statements relate to, among other things: · the Company’s ability to pursue its business strategy and maintain its market leadership position (see “Part I Item 1. Business Business Strategy and Competitive Environment”); · the expected impact of the new regulatory capital and LCR rules (see “Part I Item 1A. Risk Factors” and “Current Market and Regulatory Environment and Other Developments”); · the impact of legal proceedings and regulatory matters (see “Part I Item 3. Legal Proceedings” and “Item 8 Financial Statements and Supplementary Data Notes to Consolidated Financial Statements 14. Commitments and Contingencies Legal contingencies”); · the impact of current market conditions on the Company’s results of operations (see “Current Market and Regulatory Environment and Other Developments,” “Results of Operations Net Interest Revenue,” and “Item 8 Financial Statements and Supplementary Data Notes to Consolidated Financial Statements 5. Securities Available for Sale and Securities Held to Maturity”); · sources of liquidity, capital, and level of dividends (see “Part I Item 1. Business Regulation,” “Liquidity and Capital Resources,” “Contractual Obligations,” and “Item 8 Financial Statements and Supplementary Data Notes to Consolidated Financial Statements 22. Regulatory Requirements”); · target capital and debt ratios (see “Liquidity and Capital Resources” and “Item 8 Financial Statements and Supplementary Data Notes to Consolidated Financial Statements 22. Regulatory Requirements”); · capital expenditures (see “Liquidity and Capital Resources Capital Resources Capital Expenditures”); · the impact of the revised underwriting criteria on the credit quality of the Company’s mortgage portfolio (see “Risk Management Credit Risk”); · the impact of changes in management’s estimates on the Company’s results of operations (see “Critical Accounting Estimates”); · the impact of changes in the likelihood of indemnification and guarantee payment obligations on the Company’s results of operations (see “Item 8 Financial Statements and Supplementary Data Notes to Consolidated Financial Statements 14. Commitments and Contingencies”); and · the impact on the Company’s results of operations of recording stock option expense (see “Item 8 Financial Statements and Supplementary Data Notes to Consolidated Financial Statements 19. Employee Incentive, Retirement, and Deferred Compensation Plans”). Achievement of the expressed beliefs, objectives and expectations described in these statements is subject to certain risks and uncertainties that could cause actual results to differ materially from the expressed beliefs, objectives, and expectations. Readers are cautioned not to place undue reliance on these forwardlooking statements, which speak only as of the date of this Annual Report on Form 10K or, in the case of documents incorporated by reference, as of the date of those documents. Important factors that may cause actual results to differ include, but are not limited to: · changes in general economic and financial market conditions; · changes in revenues [/INST] Positive. </s>

SCHWAB CHARLES CORP

2016-02-24

2015-12-31

Item 7. Management’s Discussion and Analysis of Financial Condition and Results of Operations FORWARD-LOOKING STATEMENTS In addition to historical information, this Annual Report on Form 10-K contains “forward-looking statements” within the meaning of Section 27A of the Securities Act, and Section 21E of the Securities Exchange Act of 1934. Forward-looking statements are identified by words such as “believe,” “anticipate,” “expect,” “intend,” “plan,” “will,” “may,” “estimate,” “appear,” “aim,” “target,” “could,” “would,” “continue,” and other similar expressions. In addition, any statements that refer to expectations, projections, or other characterizations of future events or circumstances are forward-looking statements. These forward-looking statements, which reflect management’s beliefs, objectives, and expectations as of the date hereof, are estimates based on the best judgment of the Company’s senior management. These statements relate to, among other things: · the Company’s aim to maximize the Company’s value and returns over time; the Company’s ability to pursue its business strategy and maintain its market leadership position; and the Company’s belief that offering more value and a better investing experience will translate into more client assets which drives revenue (see “Item 1. - Business - Business Strategy and Competitive Environment”); · the impact of legal proceedings and regulatory matters (see “Item 3. - Legal Proceedings” and “Item 8. - Financial Statements and Supplementary Data - Notes to Consolidated Financial Statements -15. Commitments and Contingencies - Legal contingencies”); · the impact of current market conditions and interest rates on the Company’s results of operations (see “Item 7. - Management’s Discussion and Analysis of Financial Condition and Results of Operations - Overview” and “- Results of Operations - Net Interest Revenue”); · 2016 capital expenditures (see “Item 7. - Management’s Discussion and Analysis of Financial Condition and Results of Operations - Results of Operations - Expenses Excluding Compensation and Benefits”); · sources of liquidity, capital, and level of dividends (see “Item 7. - Management’s Discussion and Analysis of Financial Condition and Results of Operations - Liquidity - Additional Funding Sources,” “- Contractual Obligations,” and “- Capital Management - Dividends”); · target capital ratios (see “Item 7. - Management’s Discussion and Analysis of Financial Condition and Results of Operations - Capital Management - Regulatory Capital Requirements”); · the impact of changes in management’s estimates on the Company’s results of operations (see “Item 7. - Management’s Discussion and Analysis of Financial Condition and Results of Operations - Critical Accounting Estimates”); · the expected impact of new accounting standards not yet adopted (see “Item 8. - Financial Statements and Supplementary Data - Notes to Consolidated Financial Statements - 2. Summary of Significant Accounting Policies - New Accounting Standards - New Accounting Standards Not Yet Adopted”); and · the impact of changes in the likelihood of indemnification and guarantee payment obligations on the Company’s results of operations (see “Item 8. - Financial Statements and Supplementary Data - Notes to Consolidated Financial Statements - 15. Commitments and Contingencies - Guarantees and indemnifications”). Achievement of the expressed beliefs, objectives and expectations described in these statements is subject to certain risks and uncertainties that could cause actual results to differ materially from the expressed beliefs, objectives, and expectations. Readers are cautioned not to place undue reliance on these forward-looking statements, which speak only as of the date of this Annual Report on Form 10-K or, in the case of documents incorporated by reference, as of the date of those documents. Important factors that may cause actual results to differ include, but are not limited to: · changes in general economic and financial market conditions; · changes in revenues and profit margin due to changes in interest rates; · adverse developments in litigation or regulatory matters; · the extent of any charges associated with litigation and regulatory matters; · amounts recovered on insurance policies; · the Company’s ability to attract and retain clients and grow client assets and relationships; - 21 - THE CHARLES SCHWAB CORPORATION Management’s Discussion and Analysis of Financial Condition and Results of Operations (Tabular Amounts in Millions, Except Ratios, or as Noted) · the Company’s ability to develop and launch new products, services and capabilities in a timely and successful manner; · fluctuations in client asset values due to changes in equity valuations; · the performance or valuation of securities available for sale and securities held to maturity; · trading activity; · the level of interest rates, including yields available on money market mutual fund eligible instruments; · the timing and impact of changes in the Company’s level of investments in land, leasehold improvements, information technology equipment and software; · the adverse impact of financial reform legislation and related regulations; · the amount of loans to the Company’s brokerage and banking clients; · the level of the Company’s stock repurchase activity; · the availability and terms of external financing; · capital needs and management; · client sensitivity to interest rates; · timing, amount and impact of the migration of certain balances from brokerage accounts and sweep money market funds into Schwab Bank; · the Company’s ability to manage expenses; · regulatory guidance; · the level of client assets, including cash balances; · competitive pressures on rates and fees; · acquisition integration costs; · potential breaches of contractual terms for which the Company has indemnification and guarantee obligations; · client use of the Company’s investment advisory services and other products and services; · the volume of prepayments in the Company’s mortgage-backed securities portfolio; and · the impact of changes in market conditions on money market fund fee waivers, revenues and pre-tax profit margin. Certain of these factors, as well as general risk factors affecting the Company, are discussed in greater detail in this Annual Report on Form 10-K, including “Item 1A - Risk Factors.” - 22 - THE CHARLES SCHWAB CORPORATION Management’s Discussion and Analysis of Financial Condition and Results of Operations (Tabular Amounts in Millions, Except Ratios, or as Noted) GLOSSARY OF TERMS Active brokerage accounts: Brokerage accounts with balances or activity within the preceding eight months. Asset-backed securities: Debt securities backed by financial assets such as loans or receivables. Assets receiving ongoing advisory services: Client relationships under the guidance of independent advisors and assets enrolled in one of the Company’s retail or other advisory solutions. Average client assets: The daily average client asset balance for the period. Basel III: Global regulatory standards on bank capital adequacy and liquidity issued by the Basel Committee on Banking Supervision. Basis point: One basis point equals 1/100th of 1%, or 0.01%. Cash and investments segregated and on deposit for regulatory purposes: Client cash or qualified securities balances not used for margin lending are generally segregated and maintained for the exclusive benefit of clients, pursuant to Rule 15c3-3 of the Securities Exchange Act of 1934 (commonly referred to as the Customer Protection Rule), by the Company’s broker-dealer subsidiaries. Client assets: The market value of all client assets custodied at the Company, which includes both cash and securities. Client cash as a percentage of client assets: Calculated as money market fund balances, bank deposits, Schwab One® balances, and certain cash equivalents as a percentage of client assets. Clients’ daily average trades: Includes daily average revenue trades by clients, trades by clients in asset-based pricing relationships, and all commission-free trades, including the Company’s Mutual Fund OneSource® funds and exchange-traded funds, and other proprietary products. Commitments to extend credit: Legally binding agreements to extend credit for unused HELOCs, pledged asset lines and other lines of credit. Common Equity Tier 1 (CET1) Capital: The sum of common stock and related surplus net of treasury stock, retained earnings, accumulated other comprehensive income and qualifying minority interests, less applicable regulatory adjustments and deductions. Common Equity Tier 1 (CET1) Risk-Based Capital Ratio: The ratio of CET1 Capital to total risk-weighted assets. Concentration risk: The Company’s risk exposure resulting from holding large positions in financial instruments collateralized by assets with similar economic characteristics or in securities of a single issuer or particular industry or geographical area. Core net new client assets: Net new client assets before significant one-time inflows or outflows, such as acquisitions/divestitures or extraordinary (generally, greater than $10 billion) mutual fund clearing transfers. Credit risk: The potential for loss due to a borrower, counterparty, or issuer failing to perform its contractual obligations. Daily average revenue trades: Total revenue trades during a certain period, divided by the number of trading days in that period. Revenue trades include all client trades that generate trading revenue (i.e., commission revenue or principal transaction revenue). Debt to total capital ratio: Calculated as long-term debt divided by stockholders’ equity and long-term debt. - 23 - THE CHARLES SCHWAB CORPORATION Management’s Discussion and Analysis of Financial Condition and Results of Operations (Tabular Amounts in Millions, Except Ratios, or as Noted) Delinquency roll rates: The rates at which loans transition through delinquency stages, ultimately resulting in a loss. The Company considers a loan to be delinquent if it is 30 days or more past due. Dodd-Frank Wall Street Reform and Consumer Protection Act (Dodd-Frank): Regulatory reform legislation signed into federal law in 2010 containing numerous provisions aimed at promoting financial stability in the U.S. financial system through enhanced prudential regulation of large financial services companies. Final Regulatory Capital Rules: Refers to the regulatory capital rules issued by U.S. banking agencies in July 2013 that implemented Basel III and relevant provisions of Dodd-Frank, which apply to savings and loan holding companies, as well as federal savings banks. Implementation began on January 1, 2015. First Mortgages: Refers to first lien residential real estate mortgage loans, which include two loan classes: first mortgages and purchased first mortgages. Full-time equivalent employees: Includes full-time, part-time and temporary employees, and persons employed on a contract basis, and excludes employees of outsourced service providers. Interest rate risk: The risk to earnings or capital arising from changes in interest rates. Interest-bearing liabilities: Includes bank deposits, payables to brokerage clients, and long-term debt on which the Company pays interest. Interest-earning assets: Includes cash and cash equivalents, cash and investments segregated, broker-related receivables, receivables from brokerage clients, securities available for sale, securities held to maturity, and bank loans. Investment grade: Defined as a rating equivalent to a Moody’s rating of “Baa” or higher, or a Standard & Poor’s or Fitch rating of “BBB-” or higher. Liquidity risk: Risk that the Company will be unable to meet obligations when they come due without incurring unacceptable losses. Loan-to-value ratio: Ratio shown as a percentage and calculated as the principal amount of a loan divided by the appraised value of the collateral securing the loan. Margin loans: Loans made to brokerage clients on a secured basis to purchase securities reflected in receivables from brokerage clients on the Company’s balance sheet. Market risk: The potential for changes in earnings or the value of financial instruments held by the Company as a result of fluctuations in interest rates, equity prices or market conditions. Master netting arrangement: An agreement between two counterparties that have multiple contracts with each other that provides for net settlement of all contracts through a single cash payment in the event of default or termination of any one contract. Mortgage-backed securities: A type of asset-backed security that is secured by a mortgage or group of mortgages. Net interest margin: Net interest revenue divided by average interest-earning assets. Net new client assets: Total inflows of client cash and securities to the Company less client outflows. Management believes that this metric depicts how well the Company’s products and services appeal to new and existing clients. New brokerage accounts: All brokerage accounts opened during the period, as well as any accounts added via acquisition. Nonperforming assets: The total of nonaccrual loans and other real estate owned. - 24 - THE CHARLES SCHWAB CORPORATION Management’s Discussion and Analysis of Financial Condition and Results of Operations (Tabular Amounts in Millions, Except Ratios, or as Noted) Operational risk: Potential for loss due to inadequate or failed internal processes, systems, and firms or exchanges handling client orders, or loss from external events and relationships impacting the Company and/or any of its key business partners and vendors. Order flow revenue: Net compensation received from markets and firms to which Schwab and optionsXpress, Inc. send equity and options orders. Reflects rebates received for certain types of orders, minus fees paid for execution of orders for which exchange fees or other charges apply. Pledged Asset Line®: A non-purpose revolving line of credit from Schwab Bank secured by eligible assets held in a separate pledged asset account maintained at Schwab. Return on average common stockholders’ equity: Calculated as net income available to common stockholders divided by average common stockholders’ equity. Return on average total assets: Calculated as net income divided by average total assets for the period. Risk-weighted assets: Primarily computed by assigning specific risk-weightings as determined by the regulators to assets and off-balance sheet instruments for capital adequacy calculations. Tier 1 Capital: The sum of CET1 Capital and additional Tier 1 Capital instruments and related surplus, less applicable adjustments and deductions. Tier 1 Leverage Ratio: Tier 1 capital divided by adjusted average total consolidated assets at the end of the quarter. Trading days: Days in which the markets/exchanges are open for the buying and selling of securities. Early market closures are counted as half-days. U.S. federal banking agencies: Refers to the Board of Governors of the Federal Reserve System, the Office of the Comptroller of the Currency, the Federal Deposit Insurance Corporation, and the Consumer Financial Protection Bureau. Uniform Net Capital Rule: Refers to Rule 15c3-1 under the Securities Exchange Act of 1934 which specifies minimum capital requirements that are intended to ensure the general financial soundness and liquidity of broker-dealers. - 25 - THE CHARLES SCHWAB CORPORATION Management’s Discussion and Analysis of Financial Condition and Results of Operations (Tabular Amounts in Millions, Except Ratios, or as Noted) OVERVIEW Management of the Company focuses on several key client activity and financial metrics in evaluating the Company’s financial position and operating performance. Management believes that net revenue growth, pre-tax profit margin, earnings per common share (EPS), and return on average common stockholders’ equity provide broad indicators of the Company’s overall financial health, operating efficiency, and ability to generate acceptable returns. Expenses excluding interest as a percentage of average client assets are considered by management to be a measure of operating efficiency. Results for the years ended December 31, 2015, 2014, and 2013 are: (1) 2015 excludes an inflow of $6.1 billion to reflect the final impact of the consolidation of its retirement plan recordkeeping platforms, an inflow of $10.2 million relating to a mutual fund clearing services client, and an outflow of $11.6 billion relating to the Company’s planned resignation from an Advisor Services cash management relationship netting to an adjustment of ($4.7) billion. (2) 2013 excludes an outflow of $74.5 billion relating to the planned transfer of a mutual fund clearing client and $24.7 billion to reflect the estimated impact of the consolidation of its retirement plan recordkeeping technology platforms and subsequent resignation from certain retirement plan clients for a total adjustment of $99.2 billion. The Company’s financial results are highly correlated to the general overall strength of economic conditions and, more specifically, to the direction of the U.S. equity and fixed income markets, the mortgage lending markets and residential credit trends. Overall market conditions, interest rates, economic, political and regulatory trends, and industry competition are among the factors that could affect results and which are unpredictable. Interest rates have a direct correlation to the Company’s ability to generate net interest revenue, as interest-earning assets and funding sources are sensitive to changes in the rate environment. To the extent short-term interest rates remain at current low levels, the Company’s net interest revenue will continue to be constrained, even as growth in average balances helps to - 26 - THE CHARLES SCHWAB CORPORATION Management’s Discussion and Analysis of Financial Condition and Results of Operations (Tabular Amounts in Millions, Except Ratios, or as Noted) increase such revenue. Net interest revenue is also impacted by the amount and mix of interest-earning assets and interest-bearing funding sources, as well as the Company’s ability to attract assets from new and existing clients. The interest rate environment also affects asset management and administration fees through the fees earned on the Company’s lineup of proprietary money market funds. In 2015, 2014 and 2013, the low interest rate environment caused the Company to waive a portion of its money fund fees. To the extent that short-term rates remain low, asset management and administration fees may continue to be negatively affected. Other drivers of asset management and administration fees include securities valuations and the Company’s ability to attract assets from new and existing clients. The Company generates trading revenue through commissions earned for executing trades for clients and principal transaction revenue primarily from trading activity in client fixed income securities. Trading revenue is impacted by trading volumes, the volatility of prices in the equity and fixed income markets, and commission rates. Volatility in the markets can influence client behavior in terms of investment decisions and volume of trading activity. 2015 Compared to 2014 In 2015, the Company’s revenue and net income grew despite an environment that included significant equity market volatility and continued low interest rates. The Standard & Poor’s 500 Index declined as much as 9% during the year and ultimately ended the year down 1% when compared to the prior year. The federal funds short-term target rate increased 25 basis points in December 2015, however, the increase had limited effect on 2015 results. The average 3-month London Interbank Offered Rate (LIBOR) yield improved 8 basis points to .32% compared to 2014. Long-term interest rates decreased in 2015 compared to the same period in 2014. The average 10-year U.S. Treasury yield during 2015 was 2.13%, 40 basis points lower than the average yield during 2014. Strong client momentum continued as the Company’s innovative, full-service model continued to resonate with clients and drive growth during the year. Core net new assets totaled $134.7 billion in 2015 compared to $124.8 billion in 2014. Total client assets ended 2015 at $2.51 trillion, up 2% from the year ended 2014, despite the $89.2 billion impact of reduced market valuation on client assets during the year. The Company added 1.1 million new brokerage accounts to its client base during 2015, up 10% compared to 2014. Active brokerage accounts ended 2015 at 9.8 million, up 4% on a year-over-year basis. Faced with economic uncertainty and the resulting market volatility, investors increasingly turned to advice offerings throughout the year. Over 155,000 accounts enrolled in one of the Company’s retail advisory solutions during 2015, 60% more than the year-earlier period, and total accounts using these solutions reached 560,000, up 14% year-over-year. During 2015, the Company’s net revenues increased 5% compared to 2014 primarily due to increases in net interest revenue and asset management and administration fees, partially offset by a decrease in trading revenue. · Net interest revenue increased primarily due to higher client cash balances generating increased interest-earning assets, partially offset by lower average interest rate margins. · Asset management and administration fees increased due to higher client asset balances and higher net yields earned on money market funds. · Trading revenue decreased for 2015 primarily due to lower commissions per revenue trade and lower daily average revenue trades. Growth in expenses, excluding interest, was limited to a 4% increase in 2015 primarily reflecting business growth related increases in compensation, benefits and other expenses. The combined effect of market conditions, strong business growth, and the Company’s overall spending discipline resulted in a pre-tax profit margin of 35.7% in 2015. 2014 Compared to 2013 The Company operated in an environment of mixed market conditions during 2014 compared to 2013, as the Nasdaq Composite Index, Standard & Poor’s 500 Index, and Dow Jones Industrial Average showed periods of volatility before - 27 - THE CHARLES SCHWAB CORPORATION Management’s Discussion and Analysis of Financial Condition and Results of Operations (Tabular Amounts in Millions, Except Ratios, or as Noted) ending the year up 13%, 11%, and 8%, respectively. The federal funds target rate remained unchanged at a range of zero to .25% during 2014. The average 10-year U.S. Treasury yield increased by 20 basis points to 2.53% during 2014 compared to 2013, while the yield ended the year down 86 basis points to 2.17%. In the same period, the average three-month U.S. Treasury Bill yield decreased by 3 basis points to .02%. The Company’s steady focus on serving investor needs through its full-service investing model continued to drive growth during 2014. Total client assets ended the year at $2.46 trillion, up 10% from 2013, reflecting net new client assets of $124.8 billion and a rising equity market environment. In addition, the Company added almost 1 million new brokerage accounts to its client base during 2014. Active brokerage accounts reached 9.4 million in 2014, up 3% from 2013. As a result of the Company’s strong key client activity metrics, the Company achieved a pre-tax profit margin of 34.9% in 2014. Overall, net income increased by 23% in 2014 from 2013 and the return on average common stockholders’ equity was 12% in 2014. Overall, net revenues increased by 11% in 2014 from 2013, primarily due to increases in net interest revenue, asset management and administration fees, and other revenue. · Net interest revenue increased primarily due to higher balances of interest-earning assets, including margin loans and the Company’s investment portfolio (securities available for sale and securities held to maturity), and the effect higher average interest rates on securities held to maturity had on the Company’s average net interest margin. · Asset management and administration fees increased due to fees from mutual fund services, advice solutions, and other asset management and administration services. · Other revenue increased primarily due to a net insurance settlement of $45 million, net litigation proceeds of $28 million related to the Company’s non-agency residential mortgage-backed securities (RMBS) portfolio, and increases in order flow revenue. Expenses excluding interest increased by 6% in 2014 from 2013 primarily due to an increase in compensation and benefits expense as a result of a charge of $68 million for estimated future severance benefits resulting from changes in the Company’s geographic footprint and an increase in professional services expense. Current Regulatory Environment and Other Developments In December 2015, the OCC issued proposed guidelines to establish standards for recovery planning by national banks and federal savings banks with total consolidated assets of $50 billion or more. The proposed guidelines would require each bank to develop and maintain a recovery plan that sets forth the bank’s plan for how it will remain a going concern when it is experiencing considerable financial or operational stress. The comment period for the proposed guidelines ended on February 16, 2016 and the guidelines are subject to further modification. The Company is currently evaluating the impact of the proposed guidelines. In October 2015, the Federal Reserve issued a notice of proposed rulemaking that would require certain financial institutions that are subject to the Federal Reserve’s capital rules to apply a regulatory capital deduction treatment to their investments in unsecured debt issued by U.S. bank holding companies identified as global systemically important banking organizations. The comment period for the rule proposal ended on February 19, 2016 and the rule proposal is subject to further modification. The Company is currently evaluating the impact of the proposed rule. In October 2015, the FDIC issued a notice of proposed rulemaking that would impose a surcharge on the quarterly assessments of insured depository institutions with total assets of $10 billion or more. The surcharge would equal an annual rate of 4.5 basis points applied to the institution’s assessment base, with certain adjustments. The FDIC expects the proposed surcharge to commence in the third quarter of 2016 and continue through the quarter that the reserve ratio of the DIF reaches 1.35%. Under the proposed rule, if by year-end 2018, the reserve ratio has not reached 1.35%, the FDIC would impose a shortfall assessment on the institutions subject to the surcharge. The comment period for the rule proposal ended on January 5, 2016 and the rule proposal is subject to further modification. The Company will continue to evaluate the impact of the proposed rule. - 28 - THE CHARLES SCHWAB CORPORATION Management’s Discussion and Analysis of Financial Condition and Results of Operations (Tabular Amounts in Millions, Except Ratios, or as Noted) In April 2015, the Department of Labor published notice of a rule proposal to significantly broaden the definition of “fiduciary” under the Employee Retirement Income Security Act of 1974. If adopted, among other things, the new rule would subject broker-dealers who provide non-discretionary investment advice to retirement plans and accounts to a “best interest” standard, as well as other conditions and requirements. The second comment period for the rule proposal ended on September 24, 2015 and the rule proposal is subject to further modification. The Company will continue to evaluate the impact of the proposed rule. RESULTS OF OPERATIONS Net Revenues (1) In 2015, Other third-party mutual funds were reclassified to Mutual funds and ETFs. Related revenues have been reclassified from Other asset management and administration fees. Prior-period information has been recast to reflect this change. Asset Management and Administration Fees Asset management and administration fees include mutual fund service fees and fees for other asset-based financial services provided to individual and institutional clients. The Company earns mutual fund and ETF service fees for shareholder services, administration, and investment management provided to its proprietary funds, and recordkeeping and shareholder services provided to third-party funds. These fees are based upon the daily balances of client assets invested in these funds. The Company also earns asset management fees for advice solutions, which include advisory and managed account services that are based on the daily balances of client assets subject to the specific fee for service. The fair values of client assets included in proprietary and third-party mutual funds and ETFs are based on quoted market prices and other observable market data. Other asset management and administration fees include various asset based fees such as mutual fund clearing fees, trust fees, collective trust fund fees, 401(k) record keeping fees, and non-balance based service and transaction fees. Asset management and administration fees vary with changes in the balances of client assets due to market fluctuations and client activity. For a discussion of the impact of current market conditions on asset management and administration fees, see “

<s>[INST] Operations FORWARDLOOKING STATEMENTS In addition to historical information, this Annual Report on Form 10K contains “forwardlooking statements” within the meaning of Section 27A of the Securities Act, and Section 21E of the Securities Exchange Act of 1934. Forwardlooking statements are identified by words such as “believe,” “anticipate,” “expect,” “intend,” “plan,” “will,” “may,” “estimate,” “appear,” “aim,” “target,” “could,” “would,” “continue,” and other similar expressions. In addition, any statements that refer to expectations, projections, or other characterizations of future events or circumstances are forwardlooking statements. These forwardlooking statements, which reflect management’s beliefs, objectives, and expectations as of the date hereof, are estimates based on the best judgment of the Company’s senior management. These statements relate to, among other things: · the Company’s aim to maximize the Company’s value and returns over time; the Company’s ability to pursue its business strategy and maintain its market leadership position; and the Company’s belief that offering more value and a better investing experience will translate into more client assets which drives revenue (see “Item 1. Business Business Strategy and Competitive Environment”); · the impact of legal proceedings and regulatory matters (see “Item 3. Legal Proceedings” and “Item 8. Financial Statements and Supplementary Data Notes to Consolidated Financial Statements 15. Commitments and Contingencies Legal contingencies”); · the impact of current market conditions and interest rates on the Company’s results of operations (see “Item 7. Management’s Discussion and Analysis of Financial Condition and Results of Operations Overview” and “ Results of Operations Net Interest Revenue”); · 2016 capital expenditures (see “Item 7. Management’s Discussion and Analysis of Financial Condition and Results of Operations Results of Operations Expenses Excluding Compensation and Benefits”); · sources of liquidity, capital, and level of dividends (see “Item 7. Management’s Discussion and Analysis of Financial Condition and Results of Operations Liquidity Additional Funding Sources,” “ Contractual Obligations,” and “ Capital Management Dividends”); · target capital ratios (see “Item 7. Management’s Discussion and Analysis of Financial Condition and Results of Operations Capital Management Regulatory Capital Requirements”); · the impact of changes in management’s estimates on the Company’s results of operations (see “Item 7. Management’s Discussion and Analysis of Financial Condition and Results of Operations Critical Accounting Estimates”); · the expected impact of new accounting standards not yet adopted (see “Item 8. Financial Statements and Supplementary Data Notes to Consolidated Financial Statements 2. Summary of Significant Accounting Policies New Accounting Standards New Accounting Standards Not Yet Adopted”); and · the impact of changes in the likelihood of indemnification and guarantee payment obligations on the Company’s results of operations (see “Item 8. Financial Statements and Supplementary Data Notes to Consolidated Financial Statements 15. Commitments and Contingencies Guarantees and indemnifications”). Achievement of the expressed beliefs, objectives and expectations described in these statements is subject to certain risks and uncertainties that could cause actual results to differ materially from the expressed beliefs, objectives, and expectations. Readers are cautioned not to place undue reliance on these forwardlooking statements, which speak only as of the date of this Annual Report on Form 10K or, in the case of documents incorporated by reference, as of the date of those documents. Important factors that may cause actual results to differ include, but are not limited to: · changes in general economic and financial market conditions; · changes in revenues and profit margin due to changes in interest rates; · adverse developments in litigation or regulatory matters; [/INST] Negative. </s>

SCHWAB CHARLES CORP

2017-02-23

2016-12-31

Item 7. Management’s Discussion and Analysis of Financial Condition and Results of  Operations  FORWARD-LOOKING STATEMENTS  In addition to historical information, this Annual Report on Form 10-K contains “forward-looking statements” within the meaning of Section 27A of the Securities Act, and Section 21E of the Securities Exchange Act of 1934. Forward-looking statements are identified by words such as “believe,” “anticipate,” “expect,” “intend,” “plan,” “will,” “may,” “estimate,” “appear,” “aim,” “target,” “seek”, “could,” “would,” “continue,” and other similar expressions. In addition, any statements that refer to expectations, projections, or other characterizations of future events or circumstances are forward-looking statements.  These forward-looking statements, which reflect management’s beliefs, objectives, and expectations as of the date hereof, are estimates based on the best judgment of the Company’s senior management. These statements relate to, among other things:  · The Company’s aim to maximize its market valuation and stockholder returns over time; the Company’s belief that developing trusted relationships will translate into more client assets which drives revenue and, along with expense discipline, generates earnings growth and builds stockholder value; and the Company’s ability to pursue its business strategy and maintain its market leadership position; (see Business Strategy and Competitive Environment in Part I, Item 1); · The impact of legal proceedings and regulatory matters (see Legal Proceedings in Part I, Item 3 and Item 8 - Note 14); · The adjustment of rates paid on client-related liabilities; the stability, rate sensitivity, and duration of client-related liabilities; the opportunity to migrate non-rate sensitive cash in sweep money market funds to Schwab Bank; increasing the duration of interest-earning assets; and the Company’s positioning to benefit from an increase in interest rates and limit its exposure to falling rates; (see Net Interest Revenue in Part II, Item 7); · Sources of liquidity, capital, and level of dividends (see Liquidity Risk in Part II, Item 7); · Capital ratios (see Capital Management in Part II, Item 7); · The impact of changes in management’s estimates on the Company’s results of operations (see Critical Accounting Estimates in Part II, Item 7); · The expected impact of new accounting standards not yet adopted (see Item 8 - Note 2); and · The impact of changes in the likelihood of indemnification and guarantee payment obligations on the Company’s results of operations (see Item 8 - Note 14).  Achievement of the expressed beliefs, objectives and expectations described in these statements is subject to certain risks and uncertainties that could cause actual results to differ materially from the expressed beliefs, objectives, and expectations. Readers are cautioned not to place undue reliance on these forward-looking statements, which speak only as of the date of this Annual Report on Form 10-K or, in the case of documents incorporated by reference, as of the date of those documents.  Important factors that may cause actual results to differ include, but are not limited to:  · General market conditions, including the level of interest rates, equity valuations and trading activity; · The Company’s ability to attract and retain clients, develop trusted relationships, and grow client assets; · Client use of the Company’s investment advisory services and other products and services; · The level of client assets, including cash balances; · Competitive pressure on rates and fees; · Client sensitivity to interest rates; · Regulatory guidance; · Timing, amount, and impact of the migration of certain balances from brokerage accounts and sweep money market funds into Schwab Bank; · Capital and liquidity needs and management; · The Company’s ability to manage expenses; - 20 - THE CHARLES SCHWAB CORPORATION Management’s Discussion and Analysis of Financial Condition and Results of Operations (Tabular Amounts in Millions, Except Ratios, or as Noted) · The effect of adverse developments in litigation or regulatory matters and the extent of any related charges; · The availability and terms of external financing; · Potential breaches of contractual terms for which the Company has indemnification and guarantee obligations; and · The Company’s ability to develop and launch new products, services and capabilities in a timely and successful manner.  Certain of these factors, as well as general risk factors affecting the Company, are discussed in greater detail in Risk Factors in Part I, Item 1A.   - 21 - THE CHARLES SCHWAB CORPORATION Management’s Discussion and Analysis of Financial Condition and Results of Operations (Tabular Amounts in Millions, Except Ratios, or as Noted)    GLOSSARY OF TERMS  Active brokerage accounts: Brokerage accounts with activity within the preceding eight months.  Asset-backed securities: Debt securities backed by financial assets such as loans or receivables.  Assets receiving ongoing advisory services: Client relationships under the guidance of independent advisors and assets enrolled in one of the Company’s retail or other advisory solutions.  Basel III: Global regulatory standards on bank capital adequacy and liquidity issued by the Basel Committee on Banking Supervision.  Basis point: One basis point equals 1/100th of 1%, or 0.01%.  Cash and investments segregated and on deposit for regulatory purposes: Client cash or qualified securities balances not used for margin lending are segregated into investment accounts maintained for the exclusive benefit of clients, pursuant to Rule 15c3-3 of the Securities Exchange Act of 1934, by the Company’s broker-dealer subsidiaries.  Client assets: The market value of all client assets in the Company’s custody and in the Company’s proprietary products, which includes both cash and securities. Average client assets are the daily average client asset balance for the period.  Client cash as a percentage of client assets: Calculated as money market fund balances, bank deposits, Schwab One® balances, and certain cash equivalents as a percentage of client assets.  Clients’ daily average trades: Includes daily average revenue trades by clients, trades by clients in asset-based pricing relationships, and all commission-free trades.  Commitments to extend credit: Legally binding agreements to extend credit for unused HELOCs, PALs, and other lines of credit.  Common Equity Tier 1 Capital (CET1): The sum of common stock and related surplus net of treasury stock, retained earnings, AOCI and qualifying minority interests, less applicable regulatory adjustments and deductions. The Company made a one-time election to opt-out of the requirement to include most components of AOCI in CET1 Capital.  Common Equity Tier 1 Risk-Based Capital Ratio: The ratio of CET1 Capital to total risk-weighted assets.  Core net new client assets: Net new client assets before significant one-time inflows or outflows, such as acquisitions/divestitures or extraordinary flows (generally greater than $10 billion) relating to a specific client.  Customer Protection Rule: Refers to Rule 15c3-3 of the Securities Exchange Act of 1934.  Daily average revenue trades: Total revenue trades during a certain period, divided by the number of trading days in that period. Revenue trades include all client trades that generate trading revenue (i.e., commission revenue or principal transaction revenue).  Debt to total capital ratio: Calculated as long-term debt divided by stockholders’ equity and long-term debt.  Delinquency roll rates: The rates at which loans transition through delinquency stages, ultimately resulting in a loss. The Company considers a loan to be delinquent if it is 30 days or more past due.  Dodd-Frank Wall Street Reform and Consumer Protection Act: Regulatory reform legislation signed into federal law in 2010 containing numerous provisions which expanded prudential regulation of large financial services companies.  Duration: The change in value of a financial instrument for a modeled 1% change in interest rates, expressed in years.  - 22 - THE CHARLES SCHWAB CORPORATION Management’s Discussion and Analysis of Financial Condition and Results of Operations (Tabular Amounts in Millions, Except Ratios, or as Noted) Final Regulatory Capital Rules: Refers to the regulatory capital rules issued by U.S. banking agencies in 2013 that implemented Basel III and relevant provisions of Dodd-Frank, which apply to savings and loan holding companies, as well as federal savings banks. Implementation began on January 1, 2015.  First Mortgages: Refers to first lien residential real estate mortgage loans.  Full-time equivalent employees: Represents the total number of hours worked divided by a 40-hour work week for the following categories: full-time, part-time and temporary employees and persons employed on a contract basis.  High Quality Liquid Assets (HQLA): Assets with a high potential to be converted easily and quickly into cash.  Interest-bearing liabilities: Includes bank deposits, payables to brokerage clients, short-term borrowings, and long-term debt on which the Company pays interest.  Interest-earning assets: Includes cash and cash equivalents, cash and investments segregated, broker-related receivables, receivables from brokerage clients, investment securities, and bank loans on which the Company earns interest.  Investment grade: Defined as a rating equivalent to a Moody’s Investors Service (Moody’s) rating of “Baa” or higher, or a Standard & Poor’s Rating Group (Standard & Poor’s) or Fitch Ratings, Ltd (Fitch) rating of “BBB-” or higher.  Liquidity Coverage Ratio (LCR): The ratio of HQLA to projected net cash outflows during a 30-day stress scenario.  Loan-to-value (LTV) ratio: Calculated as the principal amount of a loan divided by the value of the collateral securing the loan.  Margin loans: Advances made to brokerage clients on a secured basis to purchase securities reflected in receivables from brokerage clients on the Company’s consolidated balance sheets.  Master netting arrangement: An agreement between two counterparties that have multiple contracts with each other that provides for net settlement of all contracts through a single cash payment in the event of default or termination of any one contract.  Mortgage-backed securities: A type of asset-backed security that is secured by a mortgage or group of mortgages.  Net interest margin: Net interest revenue divided by average interest-earning assets.  Net new client assets: Total inflows of client cash and securities to the Company less client outflows.  Net Stable Funding Ratio (NSFR): Measures an organization’s “available” amount of stable funding relative to its “required” amount of stable funding over a one-year time horizon.  New brokerage accounts: All brokerage accounts opened during the period, as well as any accounts added via acquisition.  Nonperforming assets: The total of nonaccrual loans and other real estate owned.  Order flow revenue: Net compensation received from markets and firms to which Schwab and optionsXpress send equity and options orders. Reflects rebates received for certain types of orders, minus fees paid for types of orders for which exchange fees or other charges apply.  Pledged Asset Line (PAL): A non-purpose revolving line of credit from Schwab Bank secured by eligible assets held in a separate pledged asset account maintained at Schwab.  Return on average common stockholders’ equity: Calculated as net income available to common stockholders annualized divided by average common stockholders’ equity.  - 23 - THE CHARLES SCHWAB CORPORATION Management’s Discussion and Analysis of Financial Condition and Results of Operations (Tabular Amounts in Millions, Except Ratios, or as Noted) Risk-weighted assets: Primarily computed by assigning specific risk-weightings as specified by the U.S. federal banking agencies to assets and off-balance sheet instruments for capital adequacy calculations.  Tier 1 Capital: The sum of CET1 Capital and additional Tier 1 Capital instruments and related surplus, less applicable adjustments and deductions.  Tier 1 Leverage Ratio: Tier 1 Capital divided by adjusted average total consolidated assets for the quarter.  Trading days: Days in which the markets/exchanges are open for the buying and selling of securities. Early market closures are counted as half-days.  U.S. federal banking agencies: Refers to the Federal Reserve, the OCC, the FDIC, and the CFPB.  Uniform Net Capital Rule: Refers to Rule 15c3-1 under the Securities Exchange Act of 1934, which specifies minimum capital requirements that are intended to ensure the general financial soundness and liquidity of broker-dealers.   - 24 - THE CHARLES SCHWAB CORPORATION Management’s Discussion and Analysis of Financial Condition and Results of Operations (Tabular Amounts in Millions, Except Ratios, or as Noted)    OVERVIEW  Management of the Company focuses on several client activity and financial metrics in evaluating the Company’s financial position and operating performance. Management believes that metrics relating to net new and total client assets, as well as client cash levels and utilization of advisory services, offer perspective on the Company’s business momentum and client engagement. Data on new and total client brokerage accounts provides additional perspective on the Company’s ability to attract and retain new business. Management believes that net revenue growth, pre-tax profit margin, EPS, and return on average common stockholders’ equity provide broad indicators of the Company’s overall financial health, operating efficiency, and ability to generate acceptable returns. Management considers expenses, excluding interest, as a percentage of average client assets to be a measure of operating efficiency. Finally, management believes the Consolidated Tier 1 Leverage Ratio is the most restrictive capital constraint currently imposed by regulators. Results for the years ended December 31, 2016, 2015, and 2014 are:   (1) 2015 excludes an inflow of $6.1 billion to reflect the final impact of the consolidation of its retirement plan recordkeeping platforms, an inflow of $10.2 million relating to a mutual fund clearing services client, and an outflow of $11.6 billion relating to the Company’s planned resignation from an Advisor Services cash management relationship netting to an adjustment of ($4.7) billion. N/A Not applicable.  The Company’s financial results are highly correlated to the general overall strength of economic conditions and, more specifically, to the direction of the U.S. equity and fixed income markets, interest rates, the mortgage lending markets and residential credit trends. These factors, as well as political and regulatory trends and industry competition, are unpredictable. - 25 - THE CHARLES SCHWAB CORPORATION Management’s Discussion and Analysis of Financial Condition and Results of Operations (Tabular Amounts in Millions, Except Ratios, or as Noted)  2016 Compared to 2015  In 2016, net income available to common stockholders increased $382 million, or 28%, from the prior year, resulting in diluted EPS of $1.31 in 2016 compared to $1.03 in 2015. Net revenues improved by $1.1 billion, or 17%, while expenses excluding interest increased $384 million, or 9%, compared to 2015.  Strong client momentum continued as the Company’s innovative, full-service model resonated with clients and drove growth during the year. The Company added 1.1 million new brokerage accounts to its client base during 2016, which contributed to bringing the total active brokerage accounts to 10.2 million by year-end. Core net new assets from new and existing clients totaled $125.5 billion in 2016, which helped grow total client assets to $2.78 trillion as of December 31, 2016. Also during 2016, investors increasingly turned to the Company’s advice offerings resulting in a 12% increase in client assets enrolled in one of the Company’s retail advisory solutions and those guided by independent advisors, to $1.40 trillion at the end of the year.  The Company expanded client assets by 11% during an environment that had periods of marked volatility, but ultimately included improving economic conditions. The Standard & Poor’s 500 Index ended 2016 10% higher than the prior year end. After years of ultra-low interest rates, the Federal Reserve’s move to increase the overnight federal funds target rate by 25 basis points in December 2015 helped throughout 2016; the Federal Reserve’s subsequent additional 25 basis point increase in December 2016 had little time to impact 2016 results. Other short-term rates also rose in 2016. The one-month London Interbank Offered Rate (LIBOR) improved 34 basis points to .77% at December 31, 2016 compared to December 31, 2015.  These external drivers and the solid client growth helped produce strong net revenue growth. The Company’s 17% net revenue growth was led by increased net interest revenue and asset management and administration fees, which more than offset lower revenue from trading and other revenue. Net interest revenue improved $797 million, or 32%, in 2016 compared to 2015 primarily due to a 21% increase in average interest earning assets and a 13 basis point improvement in the average net interest margin from year to year, to 1.73%. The lift in interest-earning assets was due to a combination of the Company’s ongoing asset gathering efforts, additional bulk transfers of client cash sweep balances from money market funds to Schwab Bank, and the designation of Schwab Bank as the default sweep option for virtually all new brokerage accounts as of June 2016. Asset management and administration fees improved $405 million, or 15%, primarily due to higher short-term interest rates affecting the yield on money market funds.  Strong net revenue growth provided room for increased investment in people and technology, resulting in a 9% expense growth for 2016. This increase allowed for a 780 basis point gap between net revenue and expense growth and a pre-tax profit margin of 40.0% in 2016, compared to 35.7% in 2015.  2015 Compared to 2014  In 2015, the Company’s net revenue and net income grew despite an environment that included significant equity market volatility and continued low interest rates. The Standard & Poor’s 500 Index declined as much as 9% during the year and ultimately ended the year down 1% when compared to the prior year. The overnight federal funds target rate increased 25 basis points in December 2015; however, the increase had limited effect on 2015 results. The year end 2015 one-month LIBOR yield improved 28 basis points to .43% compared to 2014. Long-term interest rates decreased in 2015 compared to the same period in 2014. The average 10-year U.S. Treasury yield during 2015 was 2.13%, 40 basis points lower than the average yield during 2014.  Core net new assets totaled $134.7 billion in 2015 compared to $124.8 billion in 2014. Total client assets ended 2015 at $2.51 trillion, up 2% from the year ended 2014, despite the $89.2 billion impact of reduced market valuation on client assets during the year.  The Company added 1.1 million new brokerage accounts to its client base during 2015, up 10% compared to 2014. Active brokerage accounts ended 2015 at 9.8 million, up 4% on a year-over-year basis. Faced with economic uncertainty and the resulting market volatility, investors increasingly turned to advice offerings throughout the year. Over 155,000 accounts enrolled in one of the Company’s retail advisory solutions during 2015, 60% more than the year-earlier period, and total accounts using these solutions reached 560,000, up 14% year-over-year. - 26 - THE CHARLES SCHWAB CORPORATION Management’s Discussion and Analysis of Financial Condition and Results of Operations (Tabular Amounts in Millions, Except Ratios, or as Noted) During 2015, the Company’s net revenues increased 5% compared to 2014 primarily due to increases in net interest revenue and asset management and administration fees, partially offset by a decrease in trading revenue.  Growth in expenses excluding interest was limited to a 4% increase in 2015 primarily reflecting business growth related increases in compensation, benefits and other expenses.  The combined effect of market conditions, strong business growth, and the Company’s overall spending discipline resulted in a pre-tax profit margin of 35.7% in 2015.  Subsequent Event  On January 26, 2017, the Company announced that Mr. Peter Crawford, Executive Vice President - Finance, will succeed Mr. Joseph R. Martinetto as the Company’s Chief Financial Officer, effective May 16, 2017.  Mr. Martinetto will continue as Senior Executive Vice President at CSC, maintaining oversight of several functions including the Company’s banking, technology and operations units.  Current Regulatory Environment and Other Developments  In September 2016, the OCC issued final guidelines for recovery planning by national banks and federal savings banks with total consolidated assets of $50 billion or more. The guidelines require each bank to develop and maintain a recovery plan that describes how the bank will restore itself to financial health and viability in response to a wide range of external and internal financial and operational stress scenarios. The guidelines went into effect on January 1, 2017, and Schwab Bank has until the end of 2017 to develop and prepare a recovery plan.  In May 2016, the Federal Reserve, the OCC and the FDIC jointly issued a notice of proposed rulemaking that would impose a minimum NSFR on certain banking organizations, including CSC. The effective date of the rule would be January 1, 2018. The comment period for the proposed rule ended on August 5, 2016 and the impact to the Company cannot be assessed until the final rule is released.  In October 2015, the Federal Reserve issued a notice of proposed rulemaking on Total Loss-Absorbing Capacity and long-term debt that, among other things, would have required certain financial institutions that are subject to the Federal Reserve’s capital rules to deduct from their regulatory capital the amount of any investments in or exposure to unsecured debt issued by U.S. bank holding companies identified as global systemically important banking organizations (GSIBs). In December 2016, the Federal Reserve issued a final rule that did not include this regulatory capital deduction proposal. At the same time, the Federal Reserve did indicate its intent to work with the OCC and FDIC to develop a proposed interagency approach towards the regulatory capital treatment of GSIB unsecured debt. The Company will evaluate any such proposal when it is issued.   - 27 - THE CHARLES SCHWAB CORPORATION Management’s Discussion and Analysis of Financial Condition and Results of Operations (Tabular Amounts in Millions, Except Ratios, or as Noted) RESULTS OF OPERATIONS  Net Revenues   Asset Management and Administration Fees  Asset management and administration fees include mutual fund and ETF service fees and fees for other asset-based financial services provided to individual and institutional clients. The Company earns mutual fund and ETF service fees for shareholder services, administration, and investment management provided to its proprietary funds, and recordkeeping and shareholder services provided to third-party funds. Asset management and administration fees are based upon the daily balances of client assets invested in these funds and do not include securities lending revenues earned by proprietary mutual funds and ETFs, as those amounts, net of program fees, are credited to the fund shareholders. The fair values of client assets included in proprietary and third-party mutual funds and ETFs are based on quoted market prices and other observable market data.  The Company also earns asset management fees for advice solutions, which include managed portfolios, specialized strategies and customized investment advice. Other asset management and administration fees include various asset-based fees such as trust fees, 401(k) recordkeeping fees, mutual fund clearing fees, collective trust fund fees, and non-balance based service and transaction fees.  Asset management and administration fees vary with changes in the balances of client assets due to market fluctuations and client activity. For a discussion of the impact of current market conditions on asset management and administration fees, see Risk Management in Part II, Item 7.  - 28 - THE CHARLES SCHWAB CORPORATION Management’s Discussion and Analysis of Financial Condition and Results of Operations (Tabular Amounts in Millions, Except Ratios, or as Noted) The following table presents a roll forward of client assets for the Schwab money market funds, Schwab equity and bond funds and ETFs, and Mutual Fund OneSource®:   The following table presents asset management and administration fees, average client assets, and average fee yields:    (1) Includes Schwab ETF OneSourceTM. (2) Average client assets for advice solutions may also include the asset balances contained in the mutual fund and/or ETF categories listed above. (3) Includes various asset-based fees, such as trust fees, 401(k) recordkeeping fees, and mutual fund clearing fees and other service fees. (4) Includes miscellaneous service and transaction fees relating to mutual funds and ETFs that are not balance-based.  Asset management and administration fees increased by $405 million, or 15%, in 2016 from 2015, and by $117 million, or 5%, in 2015 from 2014. The increases in both years were due to higher net yields on money market fund assets as short-term interest rates rose in 2016 and 2015, and growth in client assets enrolled in advisory offers, partially offset by a reduction in client assets in Mutual Fund OneSource.  The average fee rate on advice solutions decreased in 2016 and 2015 from the prior years primarily due to the growth in Intelligent Portfolios, which do not charge advisory fees. Net Interest Revenue  The Company’s primary interest-earning assets include cash and cash equivalents; segregated cash and investments; margin loans, which constitute the majority of receivables from brokerage clients; investment securities; and bank loans. Revenue on interest-earning assets is affected by various factors, such as the composition of assets, prevailing interest rates at the time of origination or purchase, changes in interest rates on floating rate securities, and changes in prepayment levels for mortgage-related securities and loans. Fees earned on securities borrowing and lending activities, which are conducted by the - 29 - THE CHARLES SCHWAB CORPORATION Management’s Discussion and Analysis of Financial Condition and Results of Operations (Tabular Amounts in Millions, Except Ratios, or as Noted) Company’s broker-dealer subsidiaries on assets held in client brokerage accounts, are included in other interest revenue and expense.  The Company’s interest-bearing liabilities include bank deposits, payables to brokerage clients, short-term borrowings, and long-term debt. The Company establishes the rates paid on client-related liabilities, and management expects that it will generally adjust the rates paid on these liabilities at some fraction of any movement in short-term rates. Client-related liabilities have historically been very stable and are largely expected to remain so. Given the stability and low rate sensitivity of these liabilities, management believes their duration is relatively long, somewhere in excess of three and a half years.  Management believes that the extended period of extraordinarily low interest rates running from the financial crisis to the present has likely resulted in certain sweep cash balances retaining some level of latent rate sensitivity. To the extent short-term rates increase, management expects some sweep cash balances to migrate to purchased money market funds or other higher-yielding alternatives. At the same time, the Company will retain the opportunity to migrate the remaining non-rate sensitive cash in sweep money market funds to Schwab Bank.  Management has positioned the Company to benefit from an increase in interest rates, especially short-term interest rates, by managing the duration of interest-earning assets to be shorter than that of interest-bearing liabilities, so that asset yields will move faster than liability costs.  In order to keep the Company’s interest-rate sensitivity within established limits, management monitors and responds to changes in the balance sheet. As the Company builds its client base, it attracts a significant amount of new client sweep cash, which, along with the bulk transfer of existing sweep cash balances from money market funds, is a primary driver of balance sheet growth. As the proportion of sweep cash balances to total liabilities has grown, the measured duration of liabilities has grown as well. By increasing the duration of interest-earning assets as necessary, management has kept the Company positioned to continue to gain from increasing rates while limiting its exposure to falling rates to an acceptable level. Management currently manages the balance sheet so that just over half of the Company’s investment securities and loans re-price or reset based on short-term interest rates such as one-month LIBOR.  Non-interest-bearing funding sources include certain cash balances, stockholders’ equity and other miscellaneous assets and liabilities.  - 30 - THE CHARLES SCHWAB CORPORATION Management’s Discussion and Analysis of Financial Condition and Results of Operations (Tabular Amounts in Millions, Except Ratios, or as Noted) The following table presents net interest revenue information corresponding to interest-earning assets and funding sources on the consolidated balance sheets:   (1) Interest revenue or expense was less than $500,000 in the period or periods presented. (2) Amounts calculated based on amortized cost. (3) Certain prior period amounts were reclassified to conform to the 2016 presentation. (4) Adjusted for the retrospective adoption of Accounting Standards Update (ASU) 2015-03. See Item 8 - Note 2.  Net interest revenue increased $797 million, or 32%, in 2016 from 2015 due primarily to higher interest-earning assets driven by growth in bank deposits. The Company has grown bank deposits through a combination of:  · Gathering additional assets from new and current clients; · Transferring uninvested cash balances in certain client brokerage accounts to Schwab Bank; and · Establishing the Schwab Bank sweep feature as the default investment option for uninvested cash balances within all new brokerage accounts as of June 2016.  The Company has invested the cash from the growth in bank deposits and from recent short-term borrowings in investment securities. These incremental investments, coupled with an increase in short-term interest rates, have resulted in a 13 basis point improvement in the net interest margin to 1.73% in 2016.  Net interest revenue increased $253 million, or 11%, in 2015 from 2014 primarily due to higher average balances of interest-earning assets, partially offset by the effect of lower net interest margins. The growth in the average balances in bank deposits resulted from an increase in the uninvested cash balances in certain client brokerage accounts swept to Schwab Bank. Trading Revenue  Trading revenue includes commission and principal transaction revenues. Commission revenue is affected by the number of revenue trades executed and the average revenue earned per revenue trade. Principal transaction revenue is primarily comprised of revenue from trading activity in fixed income securities with clients. To accommodate clients’ fixed income trading activity, the Company maintains positions in fixed income securities, including U.S. state and municipal debt obligations, U.S. Government and corporate debt, and other securities. The difference between the price at which the - 31 - THE CHARLES SCHWAB CORPORATION Management’s Discussion and Analysis of Financial Condition and Results of Operations (Tabular Amounts in Millions, Except Ratios, or as Noted) Company buys and sells securities to and from its clients and other broker-dealers is recognized as principal transaction revenue. Principal transaction revenue also includes adjustments to the fair value of these securities positions.  The following table presents trading revenue and the related drivers:   Trading revenue decreased in both 2016 and 2015 by $41 million primarily due to a decrease in commission revenue as a result of lower commissions per revenue trade.  Daily average revenue trades remained relatively flat in 2016 from 2015. Daily average revenue trades decreased in 2015 from 2014 primarily due to a lower volume of equity trades. Average revenue per revenue trade decreased 5% in 2016 compared to 2015, due to a higher proportion of trades from active traders, who typically pay a lower commission rate, as well as increased client utilization of discounted trade offers. Average revenue per revenue trade decreased 2% in 2015 compared to 2014. Over time, the percentage of trading revenue has declined from a peak of 50%-60% of total net revenue in the early 1990s to the current low of 11% at December 31, 2016.  Other Revenue  Other revenue includes order flow revenue, other service fees, software fees from the Company’s portfolio management solutions, exchange processing fees, and nonrecurring gains.  Other revenue decreased by $57 million, or 17%, in 2016 compared to 2015, primarily due to lower litigation proceeds of $16 million in 2016 compared to $75 million in 2015 related to the Company’s non-agency residential mortgage-backed securities (RMBS) portfolio. Order flow revenue was $103 million during both 2016 and 2015.  Other revenue decreased by $15 million, or 4%, in 2015 compared to 2014 primarily due to lower order flow revenue. Order flow revenue was $103 million during 2015 compared to $114 million during 2014. The decrease was primarily due to changes in the composition and volume of different types of orders and the fees and rebates for such orders. Other revenue in 2015 also includes net litigation proceeds of $75 million related to the Company’s non-agency RMBS portfolio. Other revenue in 2014 includes a net insurance settlement of $45 million and net litigation proceeds of $28 million related to the Company’s non-agency RMBS portfolio.   - 32 - THE CHARLES SCHWAB CORPORATION Management’s Discussion and Analysis of Financial Condition and Results of Operations (Tabular Amounts in Millions, Except Ratios, or as Noted) Expenses Excluding Interest  The following table shows a comparison of expenses excluding interest:   Compensation and Benefits  Compensation and benefits expense includes salaries and wages, incentive compensation, and related employee benefits. Incentive compensation includes variable compensation, discretionary bonuses, and share-based compensation. Variable compensation includes payments to certain individuals based on their sales performance. Discretionary bonuses are based on the Company’s overall performance as measured by EPS. Share-based compensation primarily includes employee and board of director stock options and restricted stock.  The following table shows a comparison of certain compensation and benefits components and employee data:   Salaries and wages increased in 2016 from 2015 primarily due to higher employee headcount to support the growth in the business and annual salary increases. Incentive compensation increased in 2016 from 2015 primarily due to higher discretionary bonus expenses, long-term incentive plan costs, and field incentive plan costs relating to increased net client asset flows. Employee benefits and other expense increased in 2016 from 2015 due to increases in healthcare costs and higher employee headcount.  Salaries and wages increased in 2015 from 2014 primarily due to higher employee headcount and annual salary increases, partially offset by a $68 million charge in 2014 for estimated future severance benefits resulting from changes in the Company’s geographic footprint. Incentive compensation increased in 2015 from 2014 primarily due to the earlier recognition of certain equity-based incentives due to plan changes offset by a reduction in long-term incentive plan expenses. Employee benefits and other expense increased in 2015 from 2014 due to increases in healthcare costs and higher employee headcount.  - 33 - THE CHARLES SCHWAB CORPORATION Management’s Discussion and Analysis of Financial Condition and Results of Operations (Tabular Amounts in Millions, Except Ratios, or as Noted) Expenses Excluding Compensation and Benefits  Professional services expense increased in 2016 compared to 2015 primarily due to higher spending on technology services and an increase in fees paid to outsourced service providers and consultants as the Company continued to invest in the business. Professional services remained relatively flat in 2015 compared to 2014.  Occupancy and equipment expense increased in 2016 and 2015 from the prior year primarily due to increased software maintenance expense relating to the Company’s information technology systems and an increase in property taxes and rent attributable to the ongoing growth in the Company’s geographic footprint.  Advertising and market development, communications, and depreciation and amortization expenses combined grew a modest 4% in 2016 and 6% in 2015, from the prior years as a result of growth in the business, new product media campaigns and higher amortization of internally developed software associated with the Company’s investment in software and technology enhancements.  The Company’s capital expenditures were $353 million, $285 million, and $405 million in 2016, 2015, and 2014, respectively. The increase in capital expenditures in 2016 from 2015 was primarily due to higher investment in land and internal-use software, partially offset by a decrease in investment in buildings. The decrease in capital expenditures in 2015 from 2014 was primarily due to lower investment in buildings and land relating to the growth in the Company’s geographic footprint beginning in 2014. Capitalized costs for developing internal-use software were $130 million, $107 million, and $81 million in 2016, 2015, and 2014.  Other expense increased in 2016 and 2015 from the prior year primarily due to an increase in the Company’s FDIC insurance assessments which rose as a result of higher bank deposits and the effect of a new surcharge that commenced in the third quarter of 2016. Taxes on Income  The Company’s effective income tax rate was 36.9% in 2016, 36.5% in 2015, and 37.5% in 2014. The 2016 effective income tax rate includes tax benefits on tax exempt income from investments in U.S. state and municipal securities.  The 2015 effective income tax rate includes the recognition of net tax benefits relating to certain current and prior-year matters. Segment Information  The Company provides financial services to individuals and institutional clients through two segments - Investor Services and Advisor Services. The Investor Services segment provides retail brokerage and banking services, retirement plan services, and other corporate brokerage services. The Advisor Services segment provides custodial, trading, banking, and support services as well as retirement business services. Revenues and expenses are attributed to the Company’s two segments based on which segment services the client. The Company evaluates the performance of its segments on a pre-tax basis. Segment assets and liabilities are not used for evaluating segment performance or in deciding how to allocate resources to segments. Net revenues in both segments are generated from the underlying client assets and trading activity; differences in the composition of net revenues between the segments are based on the composition of client assets, client trading frequency, and pricing unique to each. While both segments leverage the scale and efficiency of the Company’s platforms, segment expenses reflect the dynamics of serving millions of clients in Investor Services versus the thousands of RIAs on the advisor platform.   - 34 - THE CHARLES SCHWAB CORPORATION Management’s Discussion and Analysis of Financial Condition and Results of Operations (Tabular Amounts in Millions, Except Ratios, or as Noted) Financial information for the Company’s reportable segments is presented in the following tables:    (1) The Corporate Brokerage Retirement Services business was transferred from the Investor Services segment to the Advisor Services segment in the fourth quarter of 2015. Prior period information has been recast to reflect these changes.  Investor Services Net revenues increased by $640 million, or 13%, in 2016 from 2015 primarily due to increases in net interest revenue and asset management and administration fees. Net interest revenue increased primarily due to higher balances of interest-earning assets and higher interest rates on those assets. Asset management and administration fees increased primarily due to higher net yields on money market fund assets, partially offset by a reduction in client assets in Mutual Fund OneSource®. Expenses excluding interest increased by $290 million, or 9%, in 2016 from 2015 primarily due to growth in the business resulting in increases in compensation and benefits, depreciation and amortization, and occupancy and equipment expenses.  Net revenues increased by $174 million, or 4%, in 2015 from 2014 primarily due to increases in net interest revenue, asset management and administration fees, and other revenue, partially offset by a decrease in trading revenue. Net interest revenue increased mainly due to higher balances of interest-earning assets, partially offset by the effect of lower net interest margins. - 35 - THE CHARLES SCHWAB CORPORATION Management’s Discussion and Analysis of Financial Condition and Results of Operations (Tabular Amounts in Millions, Except Ratios, or as Noted) Asset management and administration fees increased primarily due to fees from advice solutions, which increased mainly due to growth in client assets enrolled in advisory offers. Other revenue increased primarily due to litigation proceeds relating to the Company’s non-agency RMBS portfolio. Trading revenue decreased in 2015 from 2014 largely due to lower commissions per revenue trade and lower daily average revenue trades. Expenses excluding interest increased by $153 million, or 5%, in 2015 from 2014 primarily due to growth in the business resulting in increases in compensation and benefits and other expenses.  Advisor Services Net revenues increased by $458 million, or 28%, in 2016 from 2015 primarily due to increases in net interest revenue and asset management and administration fees. Net interest revenue increased primarily due to higher balances of interest-earning assets and higher interest rates on those assets. This growth in assets was bolstered by the migration of more uninvested client cash balances in the segment to Schwab Bank. Asset management and administration fees increased primarily due to higher net yields on money market fund assets. Expenses excluding interest increased by $94 million, or 9%, in 2016 from 2015 primarily due to increases in growth in the business resulting in increases in compensation and benefits, occupancy and equipment, and other expenses.  Net revenues increased by $199 million, or 14%, in 2015 from 2014 primarily due to increases in net interest revenue, asset management and administration fees, and other revenue. Net interest revenue increased primarily due to higher balances of interest-earning assets, partially offset by the effect of lower net interest margins. Interest-earning assets have grown due to growth in brokerage client cash swept to Schwab Bank. Asset management and administration fees increased primarily due to higher net yields on money market fund assets and growth in client assets in equity and bond funds. Other revenue increased primarily due to litigation proceeds relating to the Company’s non-agency RMBS portfolio. Expenses excluding interest increased by $73 million, or 8%, in 2015 from 2014 primarily due to increases in growth in the business resulting in increases in compensation and benefits, advertising and marketing, other expenses.  Unallocated Other revenue decreased in 2015 from 2014 due to a net insurance settlement of $45 million in 2014.  Expenses excluding interest decreased in 2015 from 2014 as a result of a $68 million charge in 2014 for estimated future severance benefits resulting from changes in the Company’s geographic footprint.  Risk MANAGEMENT  The Company’s business activities expose it to a variety of risks, including operational, credit, market, liquidity, and compliance risk. The Company has a comprehensive risk management program to identify and manage these risks and their associated potential for financial and reputational impact. Despite the Company’s efforts to identify areas of risk and implement risk management policies and procedures, there can be no assurance that the Company will not suffer unexpected losses due to these risks.  The Company’s risk management process is comprised of risk identification and assessment, risk measurement, risk monitoring and reporting and risk mitigation. The activities and organizations that comprise the risk management process are described below.  Culture  The Board of Directors has approved an Enterprise Risk Management (ERM) framework that incorporates the Company’s purpose, vision, and values that form the bedrock of its corporate culture and set the tone for the organization.  The ERM Framework and governance structure constitute a comprehensive approach to managing risks encountered by the Company in its business activities. The framework incorporates key concepts commensurate with the size, risk profile, complexity, and continuing growth of the Company. Risk appetite, which is defined as the amount of risk the Company is - 36 - THE CHARLES SCHWAB CORPORATION Management’s Discussion and Analysis of Financial Condition and Results of Operations (Tabular Amounts in Millions, Except Ratios, or as Noted) willing to accept in pursuit of its corporate strategy, is developed by executive management and approved by the Board of Directors.  Risk Governance  Senior management takes an active role in the risk management process and has developed policies and procedures under which specific business and control units are responsible for identifying, measuring, and controlling risks.  The Global Risk Committee, which is comprised of senior executives from each major business and control function, is responsible for the oversight of risk management. This includes identifying emerging risks, assessing risk management practices and the control environment, reinforcing business accountability for risk management, supervisory controls and regulatory compliance, supporting resource prioritization across the Company, and escalating significant issues to the Board of Directors.  The Company has established risk metrics and reporting that enable measurement of the impact of strategy execution against risk appetite. The risk metrics, with risk limits and tolerance levels, are established for key risk categories by the Global Risk Committee and its functional risk sub-committees.  The Global Risk Committee reports regularly to the Risk Committee of the Board of Directors. The Risk Committee in turn assists the Board of Directors in fulfilling its oversight responsibilities with respect to the Company’s risk management program, including approving risk appetite statements and reviewing reports relating to risk issues from functional areas of risk management, legal, compliance, and internal audit.  Functional risk sub-committees focusing on specific areas of risk report to the Global Risk Committee. These sub-committees include the:  · Asset-Liability Management and Pricing Committee - establishes strategies and policies for the management of corporate capital, liquidity, interest rate risk, and investments; · Compliance Risk Committee - provides oversight of compliance risk management programs and policies providing an aggregate view of compliance risk exposure; · Credit and Market Risk Oversight Committee - provides oversight of and approves credit and market risk policies, limits, and exposures in loan, investment, and positioning portfolios; · New Products and Services Risk Oversight Committee - provides oversight of, and approves corporate policy and procedures relating to the risk governance of new products and services; and · Operational Risk Oversight Committee - provides oversight of and approves operational risk management policies, risk tolerance levels, and operational risk governance processes, and includes sub-committees covering Fiduciary, Data, Information Security, Model Governance, and Third-Party risk.  Senior management has also created an Incentive Compensation Risk Oversight Committee, which establishes policy and reviews and approves the Annual Risk Assessment of incentive compensation plans, and reports directly to the Board Compensation Committee.  The Company’s compliance, finance, internal audit, legal, and corporate risk management departments assist management and the various risk committees in evaluating, testing, and monitoring the Company’s risk management.  In addition, the Company’s Disclosure Committee is responsible for monitoring and evaluating the effectiveness of the Company’s disclosure controls and procedures and internal control over financial reporting as of the end of each fiscal quarter. The Disclosure Committee reports on this evaluation to the CEO and CFO prior to their certification required by Sections 302 and 906 of the Sarbanes Oxley Act of 2002.  - 37 - THE CHARLES SCHWAB CORPORATION Management’s Discussion and Analysis of Financial Condition and Results of Operations (Tabular Amounts in Millions, Except Ratios, or as Noted) Operational Risk  Operational risks arise due to potentially inadequate or failed internal processes, people, and systems or from external events and relationships impacting the Company and/or any of its key business partners and third-parties. While operational risk is inherent in all business activities, the Company relies on a system of internal controls and risk management practices designed to keep operational risk and operational losses within the Company’s risk appetite. The Company has specific policies and procedures to identify and manage operational risk, and uses periodic risk and control self-assessments, control testing programs, and internal audit reviews to evaluate the effectiveness of these internal controls. Where appropriate, the Company manages the impact of operational loss and litigation expense through the purchase of insurance. The insurance program is specifically designed to address the key operational risks of the Company, and to maintain compliance with local laws and regulation.  The Company’s operations are highly dependent on the integrity and resiliency of its critical business functions and technology systems. To the extent the Company experiences business or system interruptions, errors or downtime (which could result from a variety of causes, including natural disasters, terrorist attacks, technological failure, cyber attacks, changes to systems, linkages with third-party systems, and power failures), the Company’s business and operations could be negatively impacted. To minimize business interruptions, the Company maintains a backup and recovery infrastructure which includes facilities for backup and communications, a geographically dispersed workforce, and routine testing of business continuity and disaster recovery plans.  Information Security risk is the potential for unauthorized access, use, disclosure, disruption, modification, perusal, inspection, recording or destruction of the Company’s information or systems. The Company has designed and implemented an information security program that knits together complementary tools, controls and technologies to protect systems, client accounts and data. The Company continuously monitors the systems and works collaboratively with government agencies, law enforcement and other financial institutions to address potential threats. The Company uses advanced monitoring systems to identify suspicious activity and deter unauthorized access by internal or external actors. The Company limits the number of employees who have access to clients’ personal information and enforces internal authentication measures to protect against the potential for social engineering. All employees who handle sensitive information are trained in privacy and security. Schwab’s fraud and cyber security teams monitor activity looking for suspicious behavior. These capabilities allow the Company to identify and quickly act on any attempted intrusions.  The Company also faces operational risk when it employs the services of various external vendors, including domestic and international outsourcing of certain technology, processing, servicing, and support functions. The Company manages its exposure to external vendor risk through contractual provisions, control standards, and ongoing monitoring of vendor performance. The Company maintains policies and procedures regarding the standard of care expected with Company data, whether the data is internal company information, employee information, or non-public client information. The Company clearly defines for employees, contractors, and vendors the Company’s expected standards of care for confidential data. Regular training is provided by the Company in regard to data security.  Fiduciary risk is the potential for financial or reputational loss through breach of fiduciary duties to a client. Fiduciary activities include, but are not limited to, individual and institutional trust, investment management, custody, and cash and securities processing. The Company attempts to manage this risk by establishing procedures to ensure that obligations to clients are discharged faithfully and in compliance with applicable legal and regulatory requirements. Business units have the primary responsibility for adherence to the procedures applicable to their business. Guidance and control are provided through the creation, approval, and ongoing review of applicable policies by business units and various risk committees.  Model risk is the potential for adverse consequences from decisions based on incorrect or misused model outputs and reports. Models are owned by several business units throughout the Company, and are used for a variety of purposes. Model use includes, but is not limited to, calculating capital requirements for hypothetical stressful environments, estimating interest and credit risk for loans and other balance sheet assets, and providing guidance in the management of client portfolios. The Company has established a policy to describe the roles and responsibilities of all key stakeholders in model development, management, and use. All models at the Company are registered in a centralized database and classified into different risk - 38 - THE CHARLES SCHWAB CORPORATION Management’s Discussion and Analysis of Financial Condition and Results of Operations (Tabular Amounts in Millions, Except Ratios, or as Noted) ratings depending on their potential financial, reputational, or regulatory impact to the Company. The model risk rating determines the scope of model governance activities.  Compliance Risk  The Company faces significant compliance risk in its business, that is, the risk of legal or regulatory sanctions, fines or penalties, financial loss, or damage to reputation resulting from the failure to comply with laws, regulations, rules, or other regulatory requirements. Among other things, compliance risks relate to the suitability of client investments, conflicts of interest, disclosure obligations and performance expectations for Company products and services, supervision of employees, and the adequacy of the Company’s controls. The Company and its affiliates are subject to extensive regulation by federal, state and foreign regulatory authorities, including SROs. Such regulation is becoming increasingly extensive and complex, and regulatory proceedings and sanctions against financial services firms continue to increase.  The Company attempts to manage compliance risk through policies, procedures and controls reasonably designed to achieve and/or monitor compliance with applicable legal and regulatory requirements. These procedures address issues such as business conduct and ethics, sales and trading practices, marketing and communications, extension of credit, client funds and securities, books and records, anti-money laundering, client privacy, and employment policies. Despite the Company’s efforts to maintain an effective compliance program and internal controls, legal breaches and rule violations could result in reputational harm, significant losses and disciplinary sanctions, including limitations on the Company’s business activities.  Credit and Concentration Risk  Credit risk is the potential for loss due to a borrower, counterparty, or issuer failing to perform on its contractual obligations. The Company’s exposure to credit risk mainly results from margin lending and client option and futures activities, securities lending activities, mortgage lending activities, pledged asset lending, its role as a counterparty in financial contracts and other investing activities. To manage the risks of such losses, the Company has established policies and procedures, which include establishing and reviewing credit limits, monitoring of credit limits and quality of counterparties, and adjusting margin, PAL, option, and futures requirements for certain securities. Collateral arrangements relating to margin loans, PALs, option positions, securities lending agreements, and resale agreements include provisions that require additional collateral in the event market fluctuations result in declines in the value of collateral received. Additionally, for margin loan, PAL and securities lending agreements, collateral arrangements require that the fair value of such collateral exceeds the amounts loaned.  Schwab performs clearing services for all securities transactions in its client accounts. Schwab has exposure to credit risk due to its obligation to settle transactions with clearing corporations, mutual funds, and other financial institutions even if Schwab’s clients or a counterparty fail to meet their obligations to Schwab.  The Company’s bank loan portfolio includes First Mortgages, HELOCs, PALs and other loans. The credit risk exposure related to loans is actively managed through individual loan and portfolio reviews. Management regularly reviews asset quality, including concentrations, delinquencies, nonaccrual loans, charge-offs, and recoveries. All are factors in the determination of an appropriate allowance for loan losses.  The Company’s residential loan underwriting guidelines include maximum LTV ratios, cash out limits, and minimum Fair Isaac Corporation (FICO) credit scores. The specific guidelines are dependent on the individual characteristics of a loan (for example, whether the property is a primary or secondary residence, whether the loan is for investment property, whether the loan is for an initial purchase of a home or refinance of an existing home, and whether the loan size is conforming or jumbo).  The Company does not originate or purchase residential loans that allow for negative amortization and does not originate or purchase subprime loans (generally defined as extensions of credit to borrowers with a FICO score of less than 620 at origination), unless the borrower has compensating credit factors.  The Company’s bank loans include $8.2 billion of adjustable rate First Mortgage loans at December 31, 2016. The Company’s adjustable rate mortgages have initial fixed interest rates for three to ten years and interest rates that adjust - 39 - THE CHARLES SCHWAB CORPORATION Management’s Discussion and Analysis of Financial Condition and Results of Operations (Tabular Amounts in Millions, Except Ratios, or as Noted) annually thereafter. Approximately 36% of these mortgages consisted of loans with interest-only payment terms. The interest rates on approximately 58% of these interest-only loans are not scheduled to reset for three or more years. The Company’s mortgage loans do not include interest terms described as temporary introductory rates below current market rates.  The Company’s HELOC product has a 30-year loan term with an initial draw period of ten years from the date of origination. After the initial draw period, the balance outstanding at such time is converted to a 20-year amortizing loan. The interest rate during the initial draw period and the 20-year amortizing period is a floating rate based on the prime rate plus a margin. HELOCs that convert to an amortizing loan may experience higher delinquencies and higher loss rates than those in the initial draw period. The Company’s allowance for loan loss methodology takes this increased inherent risk into consideration.  The following table presents when current outstanding HELOCs will convert to amortizing loans:   At December 31, 2016, $1.8 billion of the HELOC portfolio was secured by second liens on the associated properties. Second lien mortgage loans typically possess a higher degree of credit risk given the subordination to the first lien holder in the event of default. In addition to the credit monitoring activities described previously, the Company also monitors credit risk by reviewing the delinquency status of the first lien loan on the associated property. At December 31, 2016, approximately 39% of the HELOC borrowers that had a balance only paid the minimum amount of interest due.  For more information on the Company’s credit quality indicators relating to its bank loans, see Item 8 - Note 6.  The Company has exposure to credit risk associated with its investment portfolios, which include U.S. agency, and non-agency mortgage-backed securities, asset-backed securities, corporate debt securities, U.S. agency notes, U.S. Treasury securities, certificates of deposit, U.S. state and municipal securities, and commercial paper.  At December 31, 2016, substantially all securities in the investment portfolios were rated investment grade. U.S. agency mortgage-backed securities do not have explicit credit ratings; however, management considers these to be of the highest credit quality and rating given the guarantee of principal and interest by the U.S. government-sponsored enterprises.  The Company has exposure to concentration risk when holding large positions in financial instruments collateralized by assets with similar economic characteristics or in securities of a single issuer or within a particular industry or geographical area.  The fair value of the Company’s investments in mortgage-backed securities totaled $105.9 billion at December 31, 2016. Of these, $104.9 billion were issued by U.S. agencies and $1.0 billion were issued by private entities (non-agency securities).  The fair value of the Company’s investments in asset-backed securities totaled $21.3 billion at December 31, 2016. Schwab holds $10.1 billion floating rate Federal Family Education Loan Program Asset-Backed Securities (FFELP ABS). Beginning in 2015, two Nationally Recognized Statistical Rating Organizations began placing a portion of FFELP ABS on review for downgrade. At December 31, 2016, five securities with an aggregate fair value of $1.2 billion were below investment grade. Both agencies have indicated that additional classes could be downgraded below investment grade due to the risk that some remainder of the securities could be outstanding after their legal final maturity dates. The timing of FFELP ABS principal payment is inherently uncertain given the variety of payment options available to student loan borrowers. Loans collateralizing these securities continue to be covered by a guarantee from the Department of Education of at least 97% of principal and interest. The Company holds only senior class notes that have additional credit enhancement of 3% or more - 40 - THE CHARLES SCHWAB CORPORATION Management’s Discussion and Analysis of Financial Condition and Results of Operations (Tabular Amounts in Millions, Except Ratios, or as Noted) that, together with the Department of Education guarantee, provide 100% or more credit enhancement. The Company has an independent credit assessment function and does not consider these securities to be impaired because it expects full payment of principal and interest. Therefore, the Company continues to assign them the highest internal credit rating.  The fair value of the Company’s investments in corporate debt securities and commercial paper totaled $10.6 billion at December 31, 2016, with 48% issued by institutions in the financial services industry. These securities are included in AFS securities, cash and cash equivalents, and other securities owned in the Company’s consolidated balance sheets. Issuer, geographic, and sector concentrations are controlled by established credit policy limits to each concentration type.  Foreign Holdings  At December 31, 2016, the Company had exposure to non-sovereign financial and non-financial institutions in foreign countries of $6.8 billion, with the fair value of the top three exposures being to issuers and counterparties domiciled in France at $1.9 billion, Sweden at $1.3 billion and Australia at $1.0 billion. The Company has no direct exposure to sovereign foreign governments. The Company does not have unfunded commitments to counterparties in foreign countries, nor does it have exposure as a result of credit default protection purchased or sold separately as of December 31, 2016.  In addition to the direct holdings in foreign companies, the Company has indirect exposure to foreign countries through its investments in CSIM money market funds (collectively, the Funds) resulting from brokerage clearing activities. At December 31, 2016, the Company had $108 million in investments in these Funds. Certain of the Funds’ positions include certificates of deposits, time deposits, commercial paper and corporate debt securities issued by counterparties in foreign countries. Additionally, at December 31, 2016, the Company had outstanding margin loans to foreign residents of $366 million, which are fully collateralized.  Market Risk  Market risk is the potential for changes in earnings or the value of financial instruments held by the Company as a result of fluctuations in interest rates, equity prices, or market conditions.  The Company is exposed to interest rate risk primarily from changes in market interest rates on its interest-earning assets relative to changes in the costs of its funding sources that finance these assets. The majority of the Company’s interest-earning assets and interest-bearing liabilities are sensitive to changes in short-term interest rates. A portion of the Company’s investment portfolios is sensitive to changes in long-term interest rates.  Net interest revenue is affected by various factors, such as the distribution and composition of interest-earning assets and interest-bearing liabilities, the spread between yields earned on interest-earning assets and rates paid on interest-bearing liabilities, which may reprice at different times or by different amounts, and the spread between short and long-term interest rates. Interest-earning assets primarily include investment securities, margin loans and bank loans. These assets are sensitive to changes in interest rates and changes in prepayment levels that tend to increase in a declining rate environment and decrease in a rising rate environment. Because the Company establishes the rates paid on certain brokerage client cash balances and bank deposits and the rates charged on certain margin loans and bank loans, and controls the composition of its investment securities, it has some ability to manage its net interest spread, depending on competitive factors and market conditions.  To mitigate the risk of declining interest revenue, the Company has established policies and procedures, which include setting guidelines on the amount of net interest revenue at risk, and monitoring the net interest margin and average maturity of its interest-earning assets and funding sources. To remain within these guidelines, the Company manages the maturity, repricing, and cash flow characteristics of the investment portfolios.  Financial instruments held by the Company are also subject to the risk that valuations will be negatively affected by changes in demand and the underlying market for a financial instrument. The Company is indirectly exposed to option, futures, and equity market fluctuations in connection with client option and futures accounts, securities collateralizing margin loans to brokerage customers, and client securities loaned out as part of the Company’s brokerage securities lending activities. Equity market valuations may also affect the level of brokerage client trading activity, margin borrowing, and overall client - 41 - THE CHARLES SCHWAB CORPORATION Management’s Discussion and Analysis of Financial Condition and Results of Operations (Tabular Amounts in Millions, Except Ratios, or as Noted) engagement with the Company. Additionally, the Company earns mutual fund and ETF service fees and asset management fees based upon daily balances of certain client assets. Fluctuations in these client asset balances caused by changes in equity valuations directly impact the amount of fee revenue earned by the Company.  The Company’s market risk related to financial instruments held for trading is not material.  Net Interest Revenue Simulation  For the Company’s net interest revenue sensitivity analysis, the Company uses net interest revenue simulation modeling techniques to evaluate and manage the effect of changing interest rates. The simulation includes all interest-sensitive assets and liabilities. Key variables in the simulation include the repricing of financial instruments, prepayment, reinvestment, and product pricing assumptions. The Company uses constant balances and market rates in the simulation assumptions in order to minimize the number of variables and to better isolate risks. The simulations involve assumptions that are inherently uncertain and, as a result, cannot precisely estimate net interest revenue or predict the impact of changes in interest rates on net interest revenue. Actual results may differ from simulated results due to balance growth or decline and the timing, magnitude, and frequency of interest rate changes, as well as changes in market conditions and management strategies, including changes in asset and liability mix.  If the Company’s guidelines for its net interest revenue sensitivity are breached, management must report the breach to the Company’s Corporate Asset-Liability Management and Pricing Committee and establish a plan to address the interest rate risk. There were no breaches of the Company’s net interest revenue sensitivity guidelines during the years ended December 31, 2016 or 2015.  As represented by the simulations presented below, the Company’s investment strategy is structured to produce an increase in net interest revenue when interest rates rise and, conversely, a decrease in net interest revenue when interest rates fall.  The simulations in the following table assume that the asset and liability structure of the consolidated balance sheet would not be changed as a result of the simulated changes in interest rates. As the Company actively manages its consolidated balance sheet and interest rate exposure, in all likelihood the Company would take steps to manage additional interest rate exposure that could result from changes in the interest rate environment. The following table shows the simulated net interest revenue change over the next 12 months beginning December 31, 2016 and 2015 of a gradual 100 basis point increase or decrease in market interest rates relative to prevailing market rates at the end of each reporting period.   The change in net interest revenue sensitivities as of December 31, 2016 reflects the increase in interest rates across all terms. The low client deposit rates under current Federal fund levels limits the extent to which the Company can reduce interest expense paid on funding sources. A decline in interest rates could negatively impact the yield on the Company’s investment and loan portfolio to a greater degree than any offsetting reduction in interest expense, further compressing net interest margin. The increase of short-term interest rates positively impacts net interest revenue as yields on interest-earning assets rise faster than the cost of funding sources.  Liquidity Risk  Liquidity risk is the potential that the Company will be unable to sell assets or meet cash flow obligations when they come due without incurring unacceptable losses.  Due to its role as a source of financial strength, CSC’s liquidity needs are primarily driven by the liquidity and capital needs of the brokerage subsidiaries, the capital needs of Schwab Bank, the amount of dividend payments on CSC’s common and preferred stock and principal and interest due on corporate debt. The liquidity needs of its brokerage subsidiaries are - 42 - THE CHARLES SCHWAB CORPORATION Management’s Discussion and Analysis of Financial Condition and Results of Operations (Tabular Amounts in Millions, Except Ratios, or as Noted) primarily driven by client activity including trading and margin borrowing activities and capital expenditures, and the capital needs of its bank subsidiary are primarily driven by client deposits.  The Company has established liquidity policies to support the successful execution of its business strategies, while ensuring ongoing and sufficient liquidity to meet its operational needs and satisfy applicable regulatory requirements under both normal and stress conditions. The Company seeks to maintain client confidence in its balance sheet and the safety of client assets by maintaining liquidity and diversity of funding sources to allow the Company to meet its obligations. To this end, the Company has established limits and contingency funding scenarios to support liquidity levels during both expected and stressed scenarios.  The Company employs a variety of methodologies to monitor and manage liquidity. The Company conducts regular liquidity stress testing to develop a consolidated view of liquidity risk exposures and to ensure the Company’s ability to maintain sufficient liquidity during market-related or company-specific liquidity stress events. Liquidity is also tested at key subsidiaries and results are reported on a monthly basis to the Company’s Corporate Asset-Liability Management and Pricing Committee. A number of early warning indicators are monitored to help identify emerging liquidity stresses in the market or within the Company and are reviewed with management as appropriate.  Beginning on January 1, 2016, the Company became subject to the modified LCR rule, which was fully phased in on January 1, 2017 and requires CSC to hold HQLAs equal to at least 70% of projected net cash outflows over a 30-day period, as defined by the rule. At December 31, 2016, the Company was in compliance with the fully phased-in modified LCR rule.  Primary Funding Sources  The Company’s primary source of funds is cash generated by client activity: bank deposits and cash balances in client brokerage accounts. In 2016, bank deposits swept from brokerage accounts increased $33.0 billion. These funds were used to purchase investment securities, thereby funding a significant portion of the 22% growth in the Company’s consolidated balance sheet.  Other sources of funds may include cash flows from operations, maturities and sales of investment securities, repayments on loans, securities lending of assets held in client brokerage accounts, and cash provided by external financing or equity offerings.  To meet daily funding needs, the Company maintains liquidity in the form of overnight cash deposits and short-term investments. For unanticipated liquidity needs, the Company maintains a buffer of highly liquid investments, currently comprised of U.S. Treasury notes.  Additional Funding Sources  In addition to internal sources of liquidity, the Company has sources of external funding. CSC maintains a $750 million committed, unsecured credit facility with a group of banks that is scheduled to expire in June 2017. Other than an overnight borrowing to test the availability of this facility, it was unused during 2016. The funds under this facility are available for general corporate purposes. The financial covenants require Schwab to maintain a minimum net capital ratio, Schwab Bank to be well capitalized, and CSC to maintain a minimum level of stockholders’ equity, adjusted to exclude AOCI. At December 31, 2016, the minimum level of stockholders’ equity required under this facility was $10.2 billion (CSC’s stockholders’ equity, excluding AOCI, at December 31, 2016 was $16.6 billion). Management believes these restrictions will not have a material effect on CSC’s ability to meet foreseeable dividend or funding requirements.  CSC and Schwab also have access to uncommitted, unsecured bank credit lines with several banks. The need for short-term borrowings from these sources arises primarily from timing differences between cash flow requirements, scheduled liquidation of interest-earning investments, and movements of cash to meet regulatory brokerage client cash segregation requirements. These lines were not used by CSC during 2016. Schwab used such borrowings for one day in 2016, for $15 million and there were no borrowings outstanding under these lines at December 31, 2016.  - 43 - THE CHARLES SCHWAB CORPORATION Management’s Discussion and Analysis of Financial Condition and Results of Operations (Tabular Amounts in Millions, Except Ratios, or as Noted) To partially satisfy the margin requirement of client option transactions with the Options Clearing Corporation, the broker-dealer subsidiaries have unsecured standby letter of credit agreements (LOCs) with several banks in favor of the Options Clearing Corporation aggregating $295 million at December 31, 2016. There were no funds drawn under any of these LOCs during 2016 or 2015. In connection with its securities lending activities, the Company is required to provide collateral to certain brokerage clients. The collateral requirements were satisfied by providing cash as collateral.  Schwab Bank has access to short-term secured funding through the Federal Reserve’s discount window. Amounts available under the Federal Reserve discount window are dependent on the fair value of certain of Schwab Bank’s investment securities that are pledged as collateral. Schwab Bank maintains policies and procedures necessary to access this funding and tests discount window borrowing procedures on a periodic basis. At December 31, 2016, $849 million was available under this arrangement. Schwab Bank used such borrowings for one day during 2016 for $1 million and there were no borrowings outstanding under these lines at December 31, 2016.  Schwab Bank also maintains a secured credit facility with the Federal Home Loan Bank of San Francisco (FHLB). Amounts available under this facility are dependent on the amount of Schwab Bank’s First Mortgages, HELOCs, and the fair value of certain of Schwab Bank’s investment securities that are pledged as collateral. Schwab Bank maintains policies and procedures necessary to access this funding and tests borrowing procedures on a periodic basis. During 2016, Schwab Bank used borrowings under this agreement to purchase investment securities prior to bulk transfers. As the bulk transfers were completed, the proceeds were used to pay down advances. There were no amounts outstanding under this facility at December 31, 2016 with $16.5 billion available based on the loans and securities currently pledged. This credit facility is also available as backup financing in the event of unexpected client cash outflow from Schwab Bank’s balance sheet.  CSC has authorization from its Board of Directors to issue unsecured commercial paper notes (Commercial Paper Notes) not to exceed $1.5 billion. Management has set a current limit for the commercial paper program not to exceed the amount of the committed, unsecured credit facility, which was $750 million at December 31, 2016. The maturities of the Commercial Paper Notes may vary, but are not to exceed 270 days from the date of issue. The commercial paper is not redeemable prior to maturity and cannot be voluntarily prepaid. The proceeds of the commercial paper program are to be used for general corporate purposes. CSC’s ratings for these short-term borrowings are P1 by Moody’s, A1 by Standard & Poor’s, and by Fitch. CSC had no Commercial Paper Notes outstanding at December 31, 2016 or 2015.  CSC had long-term debt of $2.9 billion at December 31, 2016 and 2015 bearing a weighted-average interest rate of 3.37%. CSC has a universal automatic shelf registration statement (Shelf Registration Statement) on file with the SEC, which enables it to issue debt, equity, and other securities.  On March 10, 2015, CSC issued $625 million aggregate principal amount of Senior Notes that mature in 2018 and $375 million aggregate principal amount of Senior Notes that mature in 2025. The Senior Notes due 2018 and 2025 have a fixed interest rate of 1.50% and 3.00%, respectively, with interest payable semi-annually. Additionally, on November 13, 2015, CSC issued $350 million aggregate amount of 3.450% Senior Notes that mature in 2026, with interest payable semi-annually.  The following are details of CSC’s Senior and Medium-Term Notes:    On October 31, 2016, the Company issued and sold 600,000 depositary shares, each representing a 1/100th ownership interest in a share of fixed-to-floating rate non-cumulative perpetual preferred stock (Series E Preferred Stock), $0.01 par value, with a liquidation preference of $100,000 per share (equivalent to $1,000 per depositary share). The Series E Preferred Stock has a fixed dividend rate of 4.625% through February 28, 2022, payable semi-annually, and thereafter at a floating rate of three-month LIBOR plus a fixed spread of 3.315%, payable quarterly. Net proceeds received from the sale were $591 million.  - 44 - THE CHARLES SCHWAB CORPORATION Management’s Discussion and Analysis of Financial Condition and Results of Operations (Tabular Amounts in Millions, Except Ratios, or as Noted) On March 7, 2016, CSC completed an equity offering of 30 million depositary shares, each representing a 1/40th ownership interest in a share of 5.95% non-cumulative perpetual preferred stock (Series D Preferred Stock). The net proceeds from the sale were $725 million.  On August 3, 2015, CSC completed an equity offering of 24 million depositary shares, each representing a 1/40th ownership interest in a share of 6.00% non-cumulative perpetual preferred stock (Series C Preferred Stock). The net proceeds from the sale were $581 million. CSC’s preferred stock is rated Baa2 by Moody’s, BBB by Standard & Poor’s and BB+ by Fitch.  For further discussion of CSC’s long-term debt and information on the equity offerings, see Item 8 - Note 13 and Note 17.  Off-Balance Sheet Arrangements  The Company enters into various off-balance sheet arrangements in the ordinary course of business, primarily to meet the needs of its clients. These arrangements include firm commitments to extend credit. Additionally, the Company enters into guarantees and other similar arrangements in the ordinary course of business. For information on each of these arrangements, see Item 8 - Note 6, Note 10, Note 13, Note 14, and Note 15.  Contractual Obligations  The Company’s principal contractual obligations as of December 31, 2016 are shown in the following table. Management believes that funds generated by its continuing operations, as well as cash provided by external financing, will continue to be the primary funding sources in meeting these obligations. Excluded from this table are liabilities recorded on the consolidated balance sheet that are generally short-term in nature (e.g., payables to brokers, dealers, and clearing organizations) or without contractual payment terms (e.g., bank deposits, payables to brokerage clients, and deferred compensation).   (1) Represents Schwab Bank’s commitments to extend credit to banking clients and purchase mortgage loans. (2) Includes estimated future interest payments through 2017 for Medium-Term Notes and through 2026 for Senior Notes. Amounts exclude maturities under a finance lease obligation and unamortized discounts and premiums. (3) Represents minimum rental commitments, net of sublease commitments, and includes facilities under the Company’s past restructuring initiatives and rental commitments under a finance lease obligation. (4) Consists of purchase obligations for services such as advertising and marketing, telecommunications, professional services, and hardware- and software-related agreements. Includes purchase obligations that can be canceled by the Company without penalty.  CAPITAL MANAGEMENT  The Company seeks to manage capital to a level and composition sufficient to support execution of its business strategy, including anticipated balance sheet growth, providing financial support to its subsidiaries, and sustained access to the capital markets, while at the same time meeting its regulatory capital requirements and serving as a source of financial strength to Schwab Bank. The Company’s primary sources of capital are funds generated by the operations of its subsidiaries and securities issuances by CSC in the capital markets. To ensure that it has a sufficient amount of capital to absorb unanticipated losses or declines in asset values, the Company has adopted a policy to remain well capitalized even in stressed scenarios.  Internal guidelines are set, for both the Company and its regulated subsidiaries, to ensure capital levels are in line with the Company’s strategy and regulatory requirements, and capital forecasts are reviewed monthly at Capital Planning and Asset- - 45 - THE CHARLES SCHWAB CORPORATION Management’s Discussion and Analysis of Financial Condition and Results of Operations (Tabular Amounts in Millions, Except Ratios, or as Noted) Liability Management and Pricing Committee meetings. A number of early warning indicators are monitored to help identify potential problems that could impact capital. In addition, the Company monitors its subsidiaries’ capital levels and requirements. Subject to regulatory capital requirements and any required approvals, any excess capital held by subsidiaries is transferred to CSC in the form of dividends and returns of capital. When subsidiaries have need of additional capital, funds are provided by CSC as equity investments and also as subordinated loans (in a form approved as regulatory capital by regulators) for Schwab. The details and method used for each cash infusion are based on an analysis of the particular entity’s needs and financing alternatives. The amounts and structure of infusions must take into consideration maintenance of regulatory capital requirements, debt/equity ratios, and equity double leverage ratios.  The Company conducts regular capital stress testing to assess the potential financial impacts of various adverse macroeconomic and company-specific events to which the Company could be subjected. The objective of the Company’s capital stress testing is (1) to explore various potential outcomes - including rare and extreme events and (2) to assess impacts of potential stressful outcomes on both capital and liquidity. Additionally, the Company has a comprehensive Capital Contingency Plan to provide action plans for certain low probability/high impact capital events that the Company might face. The Capital Contingency Plan is issued under the authority of the Asset-Liability Management and Pricing Committee and provides guidelines for sustained capital events. It does not specifically address every contingency, but is designed to provide a framework for responding to any capital stress. The results of the stress testing indicate there are two scenarios which could stress the Company’s capital: (1) inflows of balance sheet cash during a period of very low interest rates and (2) outflows of balance sheet cash when other sources of financing are not available and the Company is required to sell assets to fund the flows at a loss. The Capital Contingency Plan is reviewed annually and updated as appropriate.  For additional information, see Business - Regulation in Part I, Item 1.  Regulatory Capital Requirements  CSC is subject to capital requirements set by the Federal Reserve and is required to serve as a source of strength for Schwab Bank and to provide financial assistance if Schwab Bank experiences financial distress. The Company is required to maintain a Tier 1 Leverage Ratio for CSC of at least 4%; however, management seeks to maintain the ratio of at least 6%. Due to the relatively low risk of the Company’s balance sheet assets and risk-based capital ratios at CSC and Schwab Bank that are well in excess of regulatory requirements, the Tier 1 Leverage Ratio is the most restrictive capital constraint on CSC’s asset growth.  Schwab Bank is subject to capital requirements set by the OCC that are substantially similar to those imposed on CSC by the Federal Reserve. Schwab Bank’s failure to remain well capitalized could result in certain mandatory and possibly additional discretionary actions by the regulators that could have a direct material effect on the bank. The Company is required to maintain a Tier 1 Leverage Ratio for Schwab Bank of at least 5% to be well capitalized, but seeks to maintain the ratio of at least 6.25%. Based on its regulatory capital ratios at December 31, 2016, Schwab Bank is considered well capitalized.  See Item 8 - Note 22 for a summary of both CSC and Schwab Bank’s capital ratios.  - 46 - THE CHARLES SCHWAB CORPORATION Management’s Discussion and Analysis of Financial Condition and Results of Operations (Tabular Amounts in Millions, Except Ratios, or as Noted) The following table details CSC’s and Schwab Bank’s capital ratios:    (1) CSC and Schwab Bank have elected to opt-out of the requirement to include most components of AOCI in CET1 Capital.  Schwab Bank is also subject to regulatory requirements that restrict and govern the terms of affiliate transactions. In addition, Schwab Bank is required to provide notice to, and may be required to obtain approval from, the OCC and the Federal Reserve to declare dividends to CSC.  The Company’s broker-dealer subsidiaries (Schwab and optionsXpress) are subject to regulatory requirements of the Uniform Net Capital Rule. The rule is intended to ensure the general financial soundness and liquidity of broker-dealers. These regulations prohibit the broker-dealer subsidiaries from paying cash dividends, making unsecured advances and loans to their parent company and employees, and repaying subordinated borrowings from CSC if such payment would result in a net capital amount of less than 5% of aggregate debit balances or less than 120% of its minimum dollar requirement of $250,000. As such, the broker-dealer subsidiaries are required to maintain, at all times, at least the minimum level of net capital required under Rule 15c3-1. At December 31, 2016, Schwab and optionsXpress met and exceeded their net capital requirements.  In addition to the capital requirements above, the Company’s subsidiaries are subject to various regulatory requirements that are intended to ensure financial soundness and liquidity. See Item 8 - Note 22 for additional information on the components of stockholders’ equity and information on the capital requirements of each of the subsidiaries.  Dividends  Since the initial dividend in 1989, CSC has paid 111 consecutive quarterly dividends and has increased the quarterly dividend rate 20 times, resulting in a 20% compounded annual growth rate, excluding the special cash dividend of $1.00 per common share in 2007. While the payment and amount of dividends are at the discretion of the Board of Directors, subject to certain regulatory and other restrictions, CSC currently targets its common stock cash dividend at approximately 20% to 30% of net income.  On April 21, 2016 the Board of Directors of the Company declared a one cent, or 17%, increase in the quarterly cash dividend to $0.07 per common share. On January 26, 2017, the Board of Directors of the Company declared a one cent, or 14%, increase in the quarterly cash dividend to $0.08 per common share. - 47 - THE CHARLES SCHWAB CORPORATION Management’s Discussion and Analysis of Financial Condition and Results of Operations (Tabular Amounts in Millions, Except Ratios, or as Noted) The following table details the CSC cash dividends paid and per share amounts:    (1) Dividends paid semi-annually until February 1, 2022 and quarterly thereafter. (2) Dividends paid quarterly. (3) Series D Preferred Stock was issued on March 7, 2016. (4) Series E Preferred Stock was issued on October 31, 2016. Dividends paid semi-annually until March 1, 2022 and quarterly thereafter.  Share Repurchases  There were no repurchases of CSC’s common stock in 2016 or 2015. As of December 31, 2016, CSC had remaining authority from the Board of Directors to repurchase up to $596 million of its common stock, which is not subject to expiration.  FAIR VALUE OF FINANCIAL INSTRUMENTS  The Company uses the market approach to determine the fair value of certain financial assets and liabilities recorded at fair value, and to determine fair value disclosures. See Item 8 - Note 2 and Note 16 for more information on the Company’s assets and liabilities recorded at fair value.  When available, the Company uses quoted prices in active markets to measure the fair value of assets and liabilities. When utilizing market data and bid-ask spread, the Company uses the price within the bid-ask spread that best represents fair value. When quoted prices do not exist, the Company uses prices obtained from independent third-party pricing services to measure the fair value of investment assets. The Company generally obtains prices from at least three independent pricing sources for assets recorded at fair value. The Company’s primary independent pricing service provides prices based on observable trades and discounted cash flows that incorporate observable information such as yields for similar types of securities (a benchmark interest rate plus observable spreads) and weighted-average maturity for the same or similar “to-be-issued” securities. The Company compares the prices obtained from its primary independent pricing service to the prices obtained from the additional independent pricing services to determine if the price obtained from the primary independent pricing service is reasonable. The Company does not adjust the prices received from independent third-party pricing services unless such prices are inconsistent with the definition of fair value and result in a material difference in the recorded amounts. At December 31, 2016 and 2015, the Company did not adjust prices received from the primary independent third-party pricing service.  CRITICAL ACCOUNTING ESTIMATES  The consolidated financial statements of the Company have been prepared in accordance with accounting principles generally accepted in the U.S. While the majority of the Company’s revenues, expenses, assets and liabilities are not based on estimates, there are certain accounting principles that require management to make estimates regarding matters that are uncertain and susceptible to change where such change may result in a material adverse impact on the Company’s financial position and reported financial results. These critical accounting estimates are described below. Management regularly - 48 - THE CHARLES SCHWAB CORPORATION Management’s Discussion and Analysis of Financial Condition and Results of Operations (Tabular Amounts in Millions, Except Ratios, or as Noted) reviews the estimates and assumptions used in the preparation of the Company’s financial statements for reasonableness and adequacy.  Other-than-Temporary Impairment of Investment Securities  The Company internally conducts pre-purchase analyses and ongoing, post-purchase monitoring of investments that it owns. The Company assigns a risk rating to each issuer of the securities in the Company’s investment securities portfolio based on these analyses. On an ongoing basis, the Company monitors credit indicators related to its securities portfolio and adjusts the internal ratings accordingly.  Management evaluates whether investment securities are OTTI on a quarterly basis. Debt securities with unrealized losses are considered OTTI if the Company intends to sell the security or if it is more likely than not that the Company will be required to sell such security before any anticipated recovery. If management determines that a security is OTTI under these circumstances, the impairment recognized in earnings is measured as the entire difference between the amortized cost and the then-current fair value.  A security is also OTTI if management does not expect to recover the amortized cost of the security. In this circumstance, the impairment recognized in earnings represents the estimated credit loss, and is measured by the difference between the present value of expected cash flows and the amortized cost of the security. Management utilizes cash flow models to estimate the expected future cash flow from the securities and to estimate the credit loss. Expected cash flows are discounted using the security’s effective interest rate.  The evaluation of whether the Company expects to recover the amortized cost of a security is inherently judgmental. The evaluation includes the consideration of multiple factors including: the magnitude and duration of the unrealized loss; the financial condition of the issuer; the payment structure of the security; external credit ratings; internal credit ratings; for asset-backed securities, the amount of credit support provided by the structure of the security to absorb credit losses on the underlying collateral; recent events specific to the issuer and the issuer’s industry; and whether the Company has received all scheduled principal and interest payments.  Valuation of Goodwill  The Company tests goodwill for impairment at least annually, or whenever indications of impairment exist. Impairment exists when the carrying amount of goodwill exceeds its implied fair value, resulting in an impairment charge for this excess. Adverse changes in the Company’s planned business operations such as unanticipated competition, a loss of key personnel, the sale of a reporting unit or a significant portion of a reporting unit, or other unforeseen developments could result in an impairment of the Company’s recorded goodwill.  The Company can elect to qualitatively assess goodwill for impairment if it is more likely than not that the fair value of a reporting unit exceeds its carrying value. A qualitative assessment considers macroeconomic and other industry-specific factors, such as trends in short-term and long-term interest rates and the ability to access capital, and Company specific factors such as market capitalization in excess of net assets, trends in revenue generating activities, and merger or acquisition activity. If the Company elects to bypass qualitatively assessing goodwill, or it is not more likely than not that the fair value of a reporting unit exceeds its carrying value, management estimates the fair values of each of the Company’s reporting units (defined as the Company’s businesses for which financial information is available and reviewed regularly by management) and compares it to their carrying values. The estimated fair values of the reporting units are established using an income approach based on a discounted cash flow model that includes significant assumptions about the future operating results and cash flows of each reporting unit, a market approach which compares each reporting unit to comparable companies in their respective industries, as well as a market capitalization analysis.  The Company’s annual goodwill impairment testing date is April 1st. In 2016, the Company elected to bypass the qualitative assessment. As of April 1, 2016, the Company determined through quantitative testing that the fair value significantly exceeded the carrying value of each of the Company’s reporting units, and concluded that goodwill was not impaired.  - 49 - THE CHARLES SCHWAB CORPORATION Management’s Discussion and Analysis of Financial Condition and Results of Operations (Tabular Amounts in Millions, Except Ratios, or as Noted) Allowance for Loan Losses  The appropriateness of the allowance is reviewed quarterly by management, taking into consideration current economic conditions, the existing loan portfolio composition, past loss experience, and risks inherent in the portfolios.  The methodology to establish an allowance for loan losses related to the First Mortgage and HELOC portfolios utilizes statistical models that estimate prepayments, defaults, and probable losses for the loan types based on predicted behavior of individual loans within the types. The methodology considers the effects of borrower behavior and a variety of factors including, but not limited to, interest rates, housing price movements as measured by a housing price index, economic conditions, estimated defaults and foreclosures measured by historical and expected delinquencies, changes in prepayment speeds, LTV ratios, past loss experience, estimates of future loss severities, borrower credit risk, and the adequacy of collateral. The methodology also evaluates concentrations in the loan types, including loan products within those types, year of origination, and geographical distribution of collateral.  Probable losses are forecast using a loan-level simulation of the delinquency status of the loans over the term of the loans. The simulation starts with the current relevant risk indicators, including the current delinquent status of each loan, the estimated current LTV ratio of each loan, the term and structure of each loan, current key interest rates including U.S. Treasury and LIBOR rates, and borrower FICO scores. The more significant variables in the simulation include delinquency roll rates, loss severity, housing prices, and interest rates. Delinquency roll rates are estimated from the Company’s historical loss experience adjusted for current trends and market information. Loss severity estimates are based on the Company’s historical loss experience and market trends. The estimated loss severity (i.e., loss given default) used in the allowance for loan loss for HELOCs is higher than that used for First Mortgages. Housing price trends are derived from historical home price indices and econometric forecasts of future home values. Factors affecting the home price index include housing inventory, unemployment, interest rates, and inflation expectations. Interest rate projections are based on the current term structure of interest rates and historical volatilities to project various possible future interest rate paths. This methodology results in loss factors that are applied to the outstanding balances to determine the allowance for loan loss for each loan type.  Legal and Regulatory Reserves  Reserves for legal and regulatory claims and proceedings reflect an estimate of probable losses for each matter, after considering, among other factors, the progress of the case, prior experience and the experience of others in similar cases, available defenses, insurance coverage and indemnification, and the opinions and views of legal counsel. In many cases, including most class action lawsuits, it is not possible to determine whether a loss will be incurred, or to estimate the range of that loss, until the matter is close to resolution, in which case no accrual is made until that time. Reserves are adjusted as more information becomes available. Significant judgment is required in making these estimates, and the actual cost of resolving a matter may ultimately differ materially from the amount reserved.  The Company’s management has discussed the development and selection of these critical accounting estimates with the Audit Committee. Additionally, management has reviewed with the Audit Committee the Company’s significant estimates discussed in this Management’s Discussion and Analysis of Financial Condition and Results of Operations.  See Item 8 - Note 2 for more information on critical accounting estimates.   - 50 - THE CHARLES SCHWAB CORPORATION   

<s>[INST]  Operations  FORWARDLOOKING STATEMENTS  In addition to historical information, this Annual Report on Form 10K contains “forwardlooking statements” within the meaning of Section 27A of the Securities Act, and Section 21E of the Securities Exchange Act of 1934. Forwardlooking statements are identified by words such as “believe,” “anticipate,” “expect,” “intend,” “plan,” “will,” “may,” “estimate,” “appear,” “aim,” “target,” “seek”, “could,” “would,” “continue,” and other similar expressions. In addition, any statements that refer to expectations, projections, or other characterizations of future events or circumstances are forwardlooking statements.  These forwardlooking statements, which reflect management’s beliefs, objectives, and expectations as of the date hereof, are estimates based on the best judgment of the Company’s senior management. These statements relate to, among other things:  · The Company’s aim to maximize its market valuation and stockholder returns over time; the Company’s belief that developing trusted relationships will translate into more client assets which drives revenue and, along with expense discipline, generates earnings growth and builds stockholder value; and the Company’s ability to pursue its business strategy and maintain its market leadership position; (see Business Strategy and Competitive Environment in Part I, Item 1); · The impact of legal proceedings and regulatory matters (see Legal Proceedings in Part I, Item 3 and Item 8 Note 14); · The adjustment of rates paid on clientrelated liabilities; the stability, rate sensitivity, and duration of clientrelated liabilities; the opportunity to migrate nonrate sensitive cash in sweep money market funds to Schwab Bank; increasing the duration of interestearning assets; and the Company’s positioning to benefit from an increase in interest rates and limit its exposure to falling rates; (see Net Interest Revenue in Part II, Item 7); · Sources of liquidity, capital, and level of dividends (see Liquidity Risk in Part II, Item 7); · Capital ratios (see Capital Management in Part II, Item 7); · The impact of changes in management’s estimates on the Company’s results of operations (see Critical Accounting Estimates in Part II, Item 7); · The expected impact of new accounting standards not yet adopted (see Item 8 Note 2); and · The impact of changes in the likelihood of indemnification and guarantee payment obligations on the Company’s results of operations (see Item 8 Note 14).  Achievement of the expressed beliefs, objectives and expectations described in these statements is subject to certain risks and uncertainties that could cause actual results to differ materially from the expressed beliefs, objectives, and expectations. Readers are cautioned not to place undue reliance on these forwardlooking statements, which speak only as of the date of this Annual Report on Form 10K or, in the case of documents incorporated by reference, as of the date of those documents.  Important factors that may cause actual results to differ include, but are not limited to:  · General market conditions, including the level of interest rates, equity valuations and trading activity; · The Company’s ability to attract and retain clients, develop trusted relationships, and grow client assets; · Client use of the Company’s investment advisory services and other products and services; · The level of client assets, including cash balances; · Competitive pressure on rates and fees; · Client sensitivity to interest rates; · Regulatory guidance; · Timing, amount, and impact of the migration of certain balances from brokerage accounts and sweep money market funds into Schwab Bank; · Capital and liquidity needs and management; · The Company’s ability to manage expenses; 20 THE CHARLES SCHWAB CORPORATION Management’s Discussion and Analysis of Financial Condition and Results of Operations (Tabular Amounts in Millions, Except Ratios, or as Noted) · The effect of adverse developments in litigation or regulatory matters and the extent of any related charges [/INST] Negative. </s>

SCHWAB CHARLES CORP

2018-02-22

2017-12-31

Item 7. Management’s Discussion and Analysis of Financial Condition and Results of Operations FORWARD-LOOKING STATEMENTS In addition to historical information, this Annual Report on Form 10-K contains “forward-looking statements” within the meaning of Section 27A of the Securities Act, and Section 21E of the Securities Exchange Act of 1934. Forward-looking statements are identified by words such as “believe,” “anticipate,” “expect,” “intend,” “plan,” “will,” “may,” “estimate,” “appear,” “aim,” “target,” “seek”, “could,” “would,” “continue,” and other similar expressions. In addition, any statements that refer to expectations, projections, or other characterizations of future events or circumstances are forward-looking statements. These forward-looking statements, which reflect management’s beliefs, objectives, and expectations as of the date hereof, are estimates based on the best judgment of Schwab’s senior management. These statements relate to, among other things: • Schwab seeking to maximize its market valuation and stockholder returns over time; the belief that developing trusted relationships will translate into more client assets which drives revenue and, along with expense discipline, generates earnings growth and builds stockholder value; and Schwab’s ability to pursue its business strategy and maintain its market leadership position; (see Business Strategy and Competitive Environment in Part I, Item 1); • The impact of legal proceedings and regulatory matters (see Legal Proceedings in Part I, Item 3 and Item 8 - Note 13); • The adjustment of rates paid on client-related liabilities; the stability, rate sensitivity, and duration of client-related liabilities; the opportunity to migrate non-rate sensitive cash in sweep money market funds to banking subsidiaries; increasing the duration of interest-earning assets; and Schwab’s positioning to benefit from an increase in interest rates and limit its exposure to falling rates; (see Net Interest Revenue in Part II, Item 7); • The estimated net reduction in Schwab’s effective income tax rate for 2018; (see Taxes on Income in Part II, Item 7); • Sources of liquidity, capital, and level of dividends (see Liquidity Risk in Part II, Item 7); • Capital ratios (see Regulatory Capital Requirements in Part II, Item 7); • The impact of changes in management’s estimates on Schwab’s results of operations (see Critical Accounting Estimates in Part II, Item 7); • The expected impact of new accounting standards not yet adopted (see Item 8 - Note 2); and • The impact of changes in the likelihood of indemnification and guarantee payment obligations on Schwab’s results of operations (see Item 8 - Note 13). Achievement of the expressed beliefs, objectives and expectations described in these statements is subject to certain risks and uncertainties that could cause actual results to differ materially from the expressed beliefs, objectives, and expectations. Readers are cautioned not to place undue reliance on these forward-looking statements, which speak only as of the date of this Annual Report on Form 10-K or, in the case of documents incorporated by reference, as of the date of those documents. Important factors that may cause actual results to differ include, but are not limited to: • General market conditions, including the level of interest rates, equity valuations and trading activity; • Our ability to attract and retain clients, develop trusted relationships, and grow client assets; • Client use of our investment advisory services and other products and services; • The level of client assets, including cash balances; • Competitive pressure on pricing, including deposit rates; • Client sensitivity to interest rates; • Regulatory guidance; • Timing, amount, and impact of the migration of certain balances from sweep money market funds into Schwab Bank; • Changes to tax deductions; • Capital and liquidity needs and management; • Our ability to manage expenses; • The effect of adverse developments in litigation or regulatory matters and the extent of any related charges; • The availability and terms of external financing; - 19 - THE CHARLES SCHWAB CORPORATION Management’s Discussion and Analysis of Financial Condition and Results of Operations (Tabular Amounts in Millions, Except Ratios, or as Noted) • Potential breaches of contractual terms for which we have indemnification and guarantee obligations; and • Our ability to develop and launch new products, services and capabilities in a timely and successful manner. Certain of these factors, as well as general risk factors affecting the Company, are discussed in greater detail in Risk Factors in Part I, Item 1A. - 20 - THE CHARLES SCHWAB CORPORATION Management’s Discussion and Analysis of Financial Condition and Results of Operations (Tabular Amounts in Millions, Except Ratios, or as Noted) GLOSSARY OF TERMS Active brokerage accounts: Brokerage accounts with activity within the preceding eight months. Accumulated other comprehensive income (AOCI): A component of stockholders’ equity which includes unrealized gains and losses on AFS securities and net gains or losses associated with pension obligations. Asset-backed securities: Debt securities backed by financial assets such as loans or receivables. Assets receiving ongoing advisory services: Client relationships under the guidance of independent advisors and assets enrolled in one of Schwab’s retail or other advisory solutions. Basel III: Global regulatory standards on bank capital adequacy and liquidity issued by the Basel Committee on Banking Supervision. Basis point: One basis point equals 1/100th of 1%, or 0.01%. Client assets: The market value of all client assets in our custody and proprietary products, which includes both cash and securities. Average client assets are the daily average client asset balance for the period. Client cash as a percentage of client assets: Calculated as money market fund balances, bank deposits, Schwab One® balances, and certain cash equivalents as a percentage of client assets. Clients’ daily average trades: Includes daily average revenue trades by clients, trades by clients in asset-based pricing relationships, and all commission-free trades. Common Equity Tier 1 Capital (CET1): The sum of common stock and related surplus net of treasury stock, retained earnings, AOCI and qualifying minority interests, less applicable regulatory adjustments and deductions. Schwab made a one-time election to opt-out of the requirement to include most components of AOCI in CET1 Capital under the “standardized approach” framework. Common Equity Tier 1 Risk-Based Capital Ratio: The ratio of CET1 Capital to total risk-weighted assets. Core net new client assets: Net new client assets before significant one-time inflows or outflows, such as acquisitions/divestitures or extraordinary flows (generally greater than $10 billion) relating to a specific client. Customer Protection Rule: Refers to Rule 15c3-3 of the Securities Exchange Act of 1934. Daily average revenue trades (DARTs): Total revenue trades during a certain period, divided by the number of trading days in that period. Revenue trades include all client trades that generate trading revenue (i.e., commission revenue or principal transaction revenue). Debt to total capital ratio: Calculated as total debt divided by stockholders’ equity and total debt. Delinquency roll rates: The rates at which loans transition through delinquency stages, ultimately resulting in a loss. Schwab considers a loan to be delinquent if it is 30 days or more past due. Dodd-Frank Wall Street Reform and Consumer Protection Act (Dodd-Frank): Regulatory reform legislation containing numerous provisions which expanded prudential regulation of large financial services companies. Duration: The expected change in value of a financial instrument for a 1% change in interest rates, expressed in years. Final Regulatory Capital Rules: Refers to the regulatory capital rules issued by U.S. banking agencies which implemented Basel III and relevant provisions of Dodd-Frank, which apply to savings and loan holding companies, as well as federal savings banks. - 21 - THE CHARLES SCHWAB CORPORATION Management’s Discussion and Analysis of Financial Condition and Results of Operations (Tabular Amounts in Millions, Except Ratios, or as Noted) First mortgages: Refers to first lien residential real estate mortgage loans. Full-time equivalent employees: Represents the total number of hours worked divided by a 40-hour work week for the following categories: full-time, part-time and temporary employees and persons employed on a contract basis. High quality liquid assets (HQLA): Assets with a high potential to be converted easily and quickly into cash. Interest-bearing liabilities: Includes bank deposits, payables to brokerage clients, short-term borrowings, and long-term debt on which Schwab pays interest. Interest-earning assets: Includes cash and cash equivalents, cash and investments segregated, broker-related receivables, receivables from brokerage clients, investment securities, and bank loans on which Schwab earns interest. Investment grade: Defined as a rating equivalent to a Moody’s Investors Service (Moody’s) rating of “Baa” or higher, or a Standard & Poor’s Rating Group (Standard & Poor’s) or Fitch Ratings, Ltd (Fitch) rating of “BBB-” or higher. Liquidity Coverage Ratio (LCR): The ratio of HQLA to projected net cash outflows during a 30-day stress scenario. Loan-to-value (LTV) ratio: Calculated as the principal amount of a loan divided by the value of the collateral securing the loan. Margin loans: Advances made to brokerage clients on a secured basis to purchase securities reflected in receivables from brokerage clients on the consolidated balance sheets. Master netting arrangement: An agreement between two counterparties that have multiple contracts with each other that provides for net settlement of all contracts through a single cash payment in the event of default or termination of any one contract. Mortgage-backed securities: A type of asset-backed security that is secured by a mortgage or group of mortgages. Net interest margin: Net interest revenue divided by average interest-earning assets. Net new client assets: Total inflows of client cash and securities to Schwab less client outflows. Inflows include dividends and interest; outflows include commissions and fees. Capital gains distributions are excluded. Net Stable Funding Ratio (NSFR): Measures an organization’s “available” amount of stable funding relative to its “required” amount of stable funding over a one-year time horizon. New brokerage accounts: All brokerage accounts opened during the period, as well as any accounts added via acquisition. Nonperforming assets: The total of nonaccrual loans and other real estate owned. Order flow revenue: Net compensation received from markets and firms to which the broker-dealer subsidiaries send equity and options orders. Reflects rebates received for certain types of orders, minus fees paid for types of orders for which exchange fees or other charges apply. Pledged Asset Line® (PAL): A non-purpose revolving line of credit from Schwab Bank secured by eligible assets held in a separate pledged brokerage account maintained at the broker-dealer subsidiaries. Return on average common stockholders’ equity: Calculated as net income available to common stockholders annualized divided by average common stockholders’ equity. Risk-weighted assets: Computed by assigning specific risk-weightings to assets and off-balance sheet instruments for capital adequacy calculations. - 22 - THE CHARLES SCHWAB CORPORATION Management’s Discussion and Analysis of Financial Condition and Results of Operations (Tabular Amounts in Millions, Except Ratios, or as Noted) Tier 1 Capital: The sum of CET1 Capital and additional Tier 1 Capital instruments and related surplus, less applicable adjustments and deductions. Tier 1 Leverage Ratio: Tier 1 end of period capital divided by adjusted average total consolidated assets for the quarter. Trading days: Days in which the markets/exchanges are open for the buying and selling of securities. Early market closures are counted as half-days. U.S. federal banking agencies: Refers to the Federal Reserve, the OCC, the FDIC, and the CFPB. Uniform Net Capital Rule: Refers to Rule 15c3-1 under the Securities Exchange Act of 1934, which specifies minimum capital requirements that are intended to ensure the general financial soundness and liquidity of broker-dealers. - 23 - THE CHARLES SCHWAB CORPORATION Management’s Discussion and Analysis of Financial Condition and Results of Operations (Tabular Amounts in Millions, Except Ratios, or as Noted) OVERVIEW Management focuses on several client activity and financial metrics in evaluating Schwab’s financial position and operating performance. We believe that metrics relating to net new and total client assets, as well as client cash levels and utilization of advisory services, offer perspective on our business momentum and client engagement. Data on new and total client brokerage accounts provides additional perspective on our ability to attract and retain new business. Total net revenue growth, pre-tax profit margin, EPS, and return on average common stockholders’ equity provide broad indicators of Schwab’s overall financial health, operating efficiency, and ability to generate acceptable returns. Total expenses, excluding interest, as a percentage of average client assets, is a measure of operating efficiency. Finally, management believes the Consolidated Tier 1 Leverage Ratio is the most restrictive capital constraint currently imposed by regulators. Results for the years ended December 31, 2017, 2016, and 2015 are: (1) 2017 excludes an inflow of $34.5 billion relating to mutual fund clearing services clients. 2015 excludes an inflow of $6.1 billion to reflect the final impact of the consolidation of its retirement plan recordkeeping platforms, an inflow of $10.2 billion relating to a mutual fund clearing services client, and an outflow of $11.6 billion relating to the Company’s planned resignation from an Advisor Services cash management relationship netting to an adjustment of ($4.7) billion. 2017 Compared to 2016 Net income available to common stockholders rose in 2017 by $434 million, or 25%, from the prior year, resulting in diluted EPS of $1.61 in 2017 - an increase of 23% compared to $1.31 in 2016. Net revenues improved by $1.1 billion, or 15%, while expenses excluding interest increased $483 million, or 11%, compared to 2016. Our steady focus on operating ‘through clients’ eyes’ and our goal to continually challenge the status quo helped Schwab achieve another strong growth year in 2017. Clients opened 1.4 million new brokerage accounts in 2017 and trusted Schwab with $198.6 billion of core net new assets in 2017, up 58% from 2016. Total assets receiving ongoing advisory services grew 21% in 2017 to $1.70 trillion. Our success with clients was bolstered by strength in the equity markets - the Standard & Poor’s 500® Index (S&P 500) finished 2017 up 19% from the prior year end. Also in 2017, the Federal Reserve increased - 24 - THE CHARLES SCHWAB CORPORATION Management’s Discussion and Analysis of Financial Condition and Results of Operations (Tabular Amounts in Millions, Except Ratios, or as Noted) the overnight federal funds target interest rate three times for a total of 75 basis points. Strong client activity and the positive economic environment resulted in total client assets rising to $3.36 trillion as of December 31, 2017 - a 21% increase since the end of 2016. Schwab’s 2017 financial results demonstrate the power of our financial formula working as designed: our robust business growth supported strong revenue growth through multiple sources in 2017, which we combined with continued expense discipline to drive significantly improved profitability. Net revenues grew by 15% in 2017 compared to 2016 through contributions from our two largest revenue sources. Net interest revenue rose 29% while asset management and administration fees grew 11% in 2017 when compared to the prior year. Trading revenue declined in 2017 by 21% due to price reductions announced early in 2017. Consistent with our expectations, expenses grew 11% in 2017 compared to the prior year. This increase was primarily due to higher incentive compensation and higher staffing related to our strong asset gathering, as well as expenses related to project spending and third-party fees tied to higher balances in our asset management business. This combination of revenue growth and expense discipline drove the pre-tax profit margin to 42.4% - an increase of 240 basis points over the prior year. Earnings before income taxes rose 22% to $3.7 billion in 2017 compared to $3.0 billion in the prior year. The effective tax rate in 2017 was 35.5% compared to 36.9% in 2016 reflecting the benefit from the adoption of new accounting standards requiring the recognition of a portion of tax deductions related to equity compensation partially offset by the remeasurement of deferred tax assets and other tax adjustments associated with the enactment in 2017 of a new tax act (see Current Regulatory Environment and Other Developments for more information). 2016 Compared to 2015 In 2016, net income available to common stockholders increased $382 million, or 28%, from the prior year, resulting in diluted EPS of $1.31 in 2016 compared to $1.03 in 2015. Net revenues improved by $1.1 billion, or 17%, while expenses excluding interest increased $384 million, or 9%, compared to 2015. Strong client momentum continued as our innovative, full-service model resonated with clients and drove growth during the year. We added 1.1 million new brokerage accounts to our client base during 2016, which contributed to bringing the total active brokerage accounts to 10.2 million by year-end. Core net new assets from new and existing clients totaled $125.5 billion in 2016, which helped grow total client assets to $2.78 trillion as of December 31, 2016. Also during 2016, investors increasingly turned to Schwab’s advice offerings resulting in a 12% increase in client assets enrolled in one of our retail advisory solutions and those guided by independent advisors, to $1.40 trillion at the end of the year. Client assets grew by 11% during an environment that had periods of marked volatility, but ultimately included improving economic conditions. The S&P 500 ended 2016 10% higher than the prior year end. After years of ultra-low interest rates, the Federal Reserve’s move to increase the overnight federal funds target rate by 25 basis points in December 2015 helped throughout 2016; the Federal Reserve’s subsequent additional 25 basis point increase in December 2016 had little time to impact 2016 results. Other short-term rates also rose in 2016. The one-month London Interbank Offered Rate (LIBOR) improved 34 basis points to .77% at December 31, 2016 compared to December 31, 2015. These external drivers and the solid client growth helped produce strong net revenue growth. Schwab’s 17% net revenue growth was led by increased net interest revenue and asset management and administration fees, which more than offset lower revenue from trading and other revenue. Net interest revenue improved $797 million, or 32%, in 2016 compared to 2015, and asset management and administration fees improved $405 million, or 15%. Strong net revenue growth provided room for increased investment in people and technology, resulting in a 9% expense growth for 2016. This increase allowed for a 780 basis point gap between net revenue and expense growth and a pre-tax profit margin of 40.0% in 2016, compared to 35.7% in 2015. - 25 - THE CHARLES SCHWAB CORPORATION Management’s Discussion and Analysis of Financial Condition and Results of Operations (Tabular Amounts in Millions, Except Ratios, or as Noted) Subsequent Event On February 8, 2018, CSC redeemed all of its outstanding 1.500% Senior Notes due March 10, 2018. The aggregate principal amount of the notes was $625 million. Current Regulatory Environment and Other Developments On December 22, 2017, P.L.115-97, known as the Tax Cuts and Jobs Act (the Tax Act), was signed into law. Among other things, the Tax Act lowers the federal corporate income tax rate from 35% to 21%, effective for tax years including or commencing January 1, 2018. As a result of the reduction of the federal corporate income tax rate, generally accepted accounting principles in the U.S. (GAAP) require companies to remeasure their deferred tax assets and deferred tax liabilities as of the date of enactment, with the resulting tax effects accounted for in the reporting period of enactment. Schwab has recorded a one-time non-cash charge to taxes on income associated with the remeasurement of net deferred tax assets and other tax adjustments related to the tax reform legislation in the fourth quarter of 2017. Our 2018 effective income tax rate will be reduced as a result of these changes. In May 2016, the Federal Reserve, the OCC and the FDIC jointly issued a notice of proposed rulemaking that would impose a minimum NSFR on certain banking organizations, including CSC. The comment period for the proposed rule ended on August 5, 2016 and the impact to the Company cannot be assessed until the final rule is released. In October 2015, the Federal Reserve issued a notice of proposed rulemaking on Total Loss-Absorbing Capacity and long-term debt that, among other things, would have required certain financial institutions that are subject to the Federal Reserve’s capital rules to deduct from their regulatory capital the amount of any investments in or exposure to unsecured debt issued by U.S. bank holding companies identified as global systemically important banking organizations (GSIBs). In December 2016, the Federal Reserve issued a final rule that did not include this regulatory capital deduction proposal. At the same time, the Federal Reserve did indicate its intent to work with the OCC and FDIC to develop a proposed interagency approach towards the regulatory capital treatment of GSIB unsecured debt. The Company will evaluate any such proposal when it is issued. - 26 - THE CHARLES SCHWAB CORPORATION Management’s Discussion and Analysis of Financial Condition and Results of Operations (Tabular Amounts in Millions, Except Ratios, or as Noted) RESULTS OF OPERATIONS Total Net Revenues Total net revenues of $8.6 billion and $7.5 billion for the years ended December 31, 2017 and 2016, respectively, grew 15% and 17% from the prior periods, reflecting significant improvements in both net interest revenue and asset management and administration fees. Net Interest Revenue Schwab’s primary interest-earning assets include cash and cash equivalents; cash and investments segregated; margin loans, which constitute the majority of receivables from brokerage clients; investment securities; and bank loans. Revenue on interest-earning assets is affected by various factors, such as the composition of assets, prevailing interest rates at the time of origination or purchase, changes in interest rates on floating rate securities, and changes in prepayment levels for mortgage-related securities and loans. Fees earned on securities borrowing and lending activities, which are conducted by CS&Co on assets held in client brokerage accounts, are included in other interest revenue and expense. Schwab’s interest-bearing liabilities include bank deposits, payables to brokerage clients, short-term borrowings, and long-term debt. We establish the rates paid on client-related liabilities, and management expects that it will generally adjust the rates paid on these liabilities at some fraction of any movement in short-term rates. Client-related liabilities have historically been very stable and are largely expected to remain so. Given the stability and low rate sensitivity of these liabilities, management believes their duration is relatively long, somewhere in excess of three and a half years. Management believes that the extended period of extraordinarily low interest rates running from the financial crisis to the present has likely resulted in certain sweep cash balances retaining some level of latent rate sensitivity. To the extent short-term rates increase, management expects some sweep cash balances to migrate to purchased money market funds or other higher-yielding alternatives. At the same time, Schwab will retain the opportunity to migrate the remaining non-rate sensitive cash in sweep money market funds to bank sweep deposits. We have positioned Schwab to benefit from an increase in interest rates, especially short-term interest rates, by managing the duration of interest-earning assets to be shorter than that of interest-bearing liabilities, so that asset yields will move faster than liability costs. In order to keep interest-rate sensitivity within established limits, management monitors and responds to changes in the balance sheet. As Schwab builds its client base, we attract new client sweep cash, which, along with the bulk transfer of - 27 - THE CHARLES SCHWAB CORPORATION Management’s Discussion and Analysis of Financial Condition and Results of Operations (Tabular Amounts in Millions, Except Ratios, or as Noted) existing sweep cash balances from money market funds, is a primary driver of balance sheet growth. As the proportion of sweep cash balances to total liabilities has grown, the measured duration of liabilities has grown as well. By increasing the duration of interest-earning assets as necessary, we are positioned to continue to gain from increasing rates while limiting exposure to falling rates to an acceptable level. Approximately half of our investment securities and loans re-price or reset based on short-term interest rates such as one-month LIBOR. Non-interest-bearing funding sources include certain cash balances, stockholders’ equity and other miscellaneous assets and liabilities. The following table presents net interest revenue information corresponding to interest-earning assets and funding sources on the consolidated balance sheets: (1) Interest revenue or expense was less than $500,000 in the period or periods presented. (2) Amounts calculated based on amortized cost. Net interest revenue increased $960 million or 29%, in 2017 from 2016, and $797 million, or 32%, in 2016 from 2015, primarily due to higher interest rates and growth in interest-earning assets driven by bank deposits. Higher short-term interest rates reflecting the Federal Reserve’s December, June, and March 2017 and December 2016 interest rate hikes, coupled with growth in interest-earning assets, have resulted in a 24 basis point improvement in net interest margin to 1.97% in 2017. Net interest margin was 1.73% in 2016, representing an improvement of 13 basis points compared to 2015. - 28 - THE CHARLES SCHWAB CORPORATION Management’s Discussion and Analysis of Financial Condition and Results of Operations (Tabular Amounts in Millions, Except Ratios, or as Noted) In 2017 and 2016, average interest earning assets have grown by 14% and 21%, respectively, from the prior years. This growth has been driven primarily by higher bank deposits, which increased through a combination of: • Gathering additional assets from new and current clients; • Transferring uninvested cash balances in certain client brokerage accounts to the bank sweep feature; and • Establishing the bank sweep feature as the default investment option for uninvested cash balances within all new Investor and Advisor Services brokerage accounts during 2016. In 2017, clients allocated more of their cash to equity, fixed income and other investments which affected growth in bank sweep deposits. In March 2017, $24.7 billion of debt securities were transferred from the AFS category to the HTM category. The transfer had no effect on the overall net interest margin. For additional information on the transfer, see Item 8 - Note 5. Asset Management and Administration Fees Asset management and administration fees include mutual fund and ETF service fees and fees for other asset-based financial services provided to individual and institutional clients. Schwab earns mutual fund and ETF service fees for shareholder services, administration, and investment management provided to its proprietary funds, and recordkeeping and shareholder services provided to third-party funds. Asset management and administration fees are based upon the daily balances of client assets invested in these funds and do not include securities lending revenues earned by proprietary mutual funds and ETFs, as those amounts, net of program fees, are credited to the fund shareholders. The fair values of client assets included in proprietary and third-party mutual funds and ETFs are based on quoted market prices and other observable market data. We also earn asset management fees for advice solutions, which include managed portfolios, specialized strategies, and customized investment advice. Other asset management and administration fees include various asset-based fees such as trust fees, 401(k) recordkeeping fees, mutual fund clearing fees, collective trust fund fees, and non-balance based service and transaction fees. Asset management and administration fees vary with changes in the balances of client assets due to market fluctuations and client activity. The following table presents a roll forward of client assets for the Schwab money market funds, Schwab equity and bond funds and ETFs, and Mutual Fund OneSource® and other non-transaction fee (NTF) funds. The following funds generated 53% of the asset management and administration fees earned during 2017 and 2016 and 47% during 2015: (1) Non-transaction fee. (2) Includes transfers from other third-party mutual funds to Mutual Fund OneSource® in the second quarter of 2017. - 29 - THE CHARLES SCHWAB CORPORATION Management’s Discussion and Analysis of Financial Condition and Results of Operations (Tabular Amounts in Millions, Except Ratios, or as Noted) The following table presents asset management and administration fees, average client assets, and average fee yields: (1) Includes Schwab ETF OneSource™. (2) Beginning in the fourth quarter of 2017, a change was made to add non-fee based average assets from managed portfolios. Average client assets for advice solutions may also include the asset balances contained in the mutual fund and/or ETF categories listed above. Prior periods have been adjusted to accommodate this change. (3) Includes various asset-related fees, such as trust fees, 401(k) recordkeeping fees, and mutual fund clearing fees and other service fees. Beginning in the first quarter of 2017, a prospective methodology change was made to average client assets relating to 401(k) recordkeeping fees to provide improved insight into the associated fee driver, which resulted in an increase of approximately $25 billion. There was no impact to revenue or the average fee. (4) Includes miscellaneous service and transaction fees relating to mutual funds and ETFs that are not balance-based. Asset management and administration fees increased by $337 million, or 11%, in 2017 from 2016, primarily due to higher average client assets invested in advice solutions, mutual funds, and ETFs, and lower fee waivers on money market funds. Partially offsetting these increases were lower fee rates on proprietary money funds and other indexed mutual funds and ETFs due to fee reductions implemented by Schwab in 2017. Asset management and administration fees increased by $405 million, or 15%, in 2016 from 2015 due to higher net yields on money market fund assets as short-term interest rates rose in 2016, and growth in client assets enrolled in advisory offers, partially offset by a reduction in client assets in Mutual Fund OneSource. Trading Revenue Trading revenue includes commission and principal transaction revenues. Commission revenue is affected by the number of revenue trades executed and the average revenue earned per revenue trade. Principal transaction revenue is primarily comprised of revenue from trading activity in fixed income securities with clients. To accommodate clients’ fixed income trading activity, Schwab maintains positions in fixed income securities, including U.S. state and municipal debt obligations, U.S. Government and corporate debt, and other securities. The difference between the price at which the Company buys and sells securities to and from its clients and other broker-dealers is recognized as principal transaction revenue. Principal transaction revenue also includes adjustments to the fair value of these securities positions. - 30 - THE CHARLES SCHWAB CORPORATION Management’s Discussion and Analysis of Financial Condition and Results of Operations (Tabular Amounts in Millions, Except Ratios, or as Noted) The following table presents trading revenue and the related drivers: Trading revenue decreased by $171 million and $41 million in 2017 and 2016, respectively, when compared to the prior years primarily due to lower commissions rates on DARTs. During the first quarter of 2017, we announced two trading price reductions which lowered standard equity, ETF, and option trade commissions from $8.95 to $4.95 and lowered the per contract option fee from $.75 to $.65. These reductions in commission rates reflect our continuing belief that pricing should never be an obstacle for choosing Schwab and our commitment to share the benefits of scale with clients. With these changes, trading revenue has declined from a peak of 50%-60% of total revenue in the early 1990’s to the current low of 8% in 2017, 11% in 2016 and 14% in 2015. Other Revenue Other revenue includes order flow revenue, other service fees, software fees from our portfolio management solutions, exchange processing fees, and nonrecurring gains. Order flow revenue was $114 million during 2017, and $103 million for both 2016 and 2015. In 2016 and 2015, other revenue also included net litigation proceeds of $16 and $75 million, respectively, relating to our non-agency residential mortgage-backed securities portfolios. - 31 - THE CHARLES SCHWAB CORPORATION Management’s Discussion and Analysis of Financial Condition and Results of Operations (Tabular Amounts in Millions, Except Ratios, or as Noted) Total Expenses Excluding Interest The following table shows a comparison of total expenses excluding interest: ໿ Expenses excluding interest increased in 2017 and 2016 from the prior years by 11% and 9%, respectively. The largest drivers of the increase in both years were compensation and benefits and professional services. Salaries and wages increased in 2017 and 2016 from the prior years, primarily due to increases in employee headcount to support the growth in the business and annual salary increases. Incentive compensation increased in 2017 and 2016 from the prior years, primarily due to increased net client asset flows and increased employee headcount. Employee benefits and other expenses increased in 2017 and 2016 from the prior years as a result of the increases in employee headcount, salaries, wages and incentive compensation. Professional services expense increased in 2017 and 2016 from the prior years, primarily due to higher spending on technology projects and an increase in asset management and administration related expenses resulting from growth in the Schwab Funds® and Schwab ETFs™. Occupancy and equipment expense increased in 2017 and 2016 from the prior years, primarily due to increased software maintenance expense relating to information technology systems and increases in facility operational expenses attributable to growth in Schwab’s geographic footprint. Depreciation and amortization expenses were higher in 2017 and 2016 from the prior years, due to higher amortization of internally developed software associated with our investment in software and technology enhancements. - 32 - THE CHARLES SCHWAB CORPORATION Management’s Discussion and Analysis of Financial Condition and Results of Operations (Tabular Amounts in Millions, Except Ratios, or as Noted) Regulatory fees assessments increased in 2017 and 2016 from the prior years, primarily due to an increase in FDIC insurance assessments which rose as a result of higher bank deposits and the effect of a new surcharge that commenced in the third quarter of 2016. Other expenses have increased in 2017 from the prior year due to travel and entertainment, asset volume-related increases, and some miscellaneous items. Capital expenditures were $412 million, $353 million, and $285 million in 2017, 2016, and 2015, respectively. The increase in capital expenditures in both 2017 and 2016 from the prior years was due to our growing geographical expansion in the U.S. and investments in technology projects. The largest component of capital expenditures was capitalized costs for developing internal-use software of $157 million, $130 million, and $107 million in 2017, 2016, and 2015, respectively. Taxes on Income Effective January 1, 2017, Schwab adopted Accounting Standards Update (ASU) 2016-09, which prospectively changes the accounting treatment of a portion of the tax deductions relating to equity compensation. These deductions were previously reflected directly in additional paid-in capital, a component of stockholders’ equity, and are now included in taxes on income, a component of net income. As a result of this change, our tax expense was reduced by approximately $87 million in 2017. Future effects will depend on our share price, restricted stock vesting, and the volume of equity incentive options exercised. As previously discussed under Current Regulatory Environment and Other Developments, the Tax Act was signed into law during 2017. Among other things, the Tax Act lowers the federal corporate income tax rate from 35% to 21%, effective for tax years including or commencing January 1, 2018. In connection with our initial analysis of the impact of the Tax Act, Schwab recognized a $46 million one-time non-cash charge to taxes on income in the fourth quarter of 2017 associated with the remeasurement of net deferred tax assets and other tax adjustments related to the Tax Act. Schwab’s effective income tax rate on income before taxes was 35.5% in 2017 compared to 36.9% in 2016. The decrease in rates between the two years reflects the net impact of the above two items. The effective rate in 2015 was 36.5%. We estimate our effective income tax rate to be between 23% and 24% in 2018 as a result of the Tax Act. Segment Information Schwab provides financial services to individuals and institutional clients through two segments - Investor Services and Advisor Services. The Investor Services segment provides retail brokerage and banking services, retirement plan services, and other corporate brokerage services to individual investors. The Advisor Services segment provides custodial, trading, banking, and support services as well as retirement business services to independent RIAs, independent retirement advisors and recordkeepers. Revenues and expenses are attributed to the two segments based on which segment services the client. Management evaluates the performance of the segments on a pre-tax basis. Segment assets and liabilities are not used for evaluating segment performance or in deciding how to allocate resources to segments. Net revenues in both segments are generated from the underlying client assets and trading activity; differences in the composition of net revenues between the segments are based on the composition of client assets, client trading frequency, and pricing unique to each. While both segments leverage the scale and efficiency of our platforms, segment expenses reflect the dynamics of serving millions of clients in Investor Services versus the thousands of RIAs on the advisor platform. - 33 - THE CHARLES SCHWAB CORPORATION Management’s Discussion and Analysis of Financial Condition and Results of Operations (Tabular Amounts in Millions, Except Ratios, or as Noted) Financial information for our segments is presented in the following table: Investor Services Total net revenues increased by $789 million, or 15%, in 2017 from 2016 primarily due to increases in net interest revenue and asset management and administration fees, partially offset by a decrease in trading revenue. Net interest revenue increased primarily due to higher net interest margins and higher balances of interest-earning assets. Asset management and administration fees increased primarily due to higher client assets enrolled in advisory solutions and higher net fees on money market fund assets. Trading revenue decreased primarily due to lower commission rates. Expenses excluding interest increased by $345 million, or 10%, in 2017 from 2016 primarily due to higher compensation and benefits, technology project spend, asset management and administration related expenses and regulatory fee assessments. Total net revenues increased by $640 million, or 13%, in 2016 from 2015 primarily due to increases in net interest revenue and asset management and administration fees. Net interest revenue increased primarily due to higher balances of interest-earning assets and higher interest rates on those assets. Asset management and administration fees increased primarily due to higher net yields on money market fund assets, partially offset by a reduction in client assets in Mutual Fund OneSource®. Expenses excluding interest increased by $290 million, or 9%, in 2016 from 2015 primarily due to growth in the business resulting in increases in compensation and benefits, depreciation and amortization, and occupancy and equipment expenses. Advisor Services Total net revenues increased by $351 million, or 17%, in 2017 from 2016 primarily due to increases in net interest revenue and asset management and administration fees, partially offset by a decrease in trading revenue. Net interest revenue increased primarily due to higher balances of interest-earning assets and higher net interest margins. Asset management and administration fees increased primarily due to higher fees from growth in client assets invested in ETFs and equity and bond funds, and higher net fees on money market fund assets. Trading revenue decreased primarily due to lower commission rates. Expenses excluding interest increased by $138 million, or 12%, in 2017 from 2016 primarily due to higher compensation and benefits, technology project spend, asset management and administration related expenses, and regulatory fee assessments. Total net revenues increased by $458 million, or 28%, in 2016 from 2015 primarily due to increases in net interest revenue and asset management and administration fees. Net interest revenue increased primarily due to higher balances of interest-earning assets and higher interest rates on those assets. This growth in assets was bolstered by the migration of more uninvested client cash balances in the segment to Schwab Bank. Asset management and administration fees increased primarily due to higher net yields on money market fund assets. Expenses excluding interest increased by $94 million, or 9%, in 2016 from 2015 primarily due to increases in growth in the business resulting in increases in compensation and benefits, occupancy and equipment, and other expenses. - 34 - THE CHARLES SCHWAB CORPORATION Management’s Discussion and Analysis of Financial Condition and Results of Operations (Tabular Amounts in Millions, Except Ratios, or as Noted) RISK MANAGEMENT Schwab’s business activities expose it to a variety of risks, including operational, credit, market, liquidity, and compliance risk. The Company has a comprehensive risk management program to identify and manage these risks and their associated potential for financial and reputational impact. Despite our efforts to identify areas of risk and implement risk management policies and procedures, there can be no assurance that Schwab will not suffer unexpected losses due to these risks. Our risk management process is comprised of risk identification and assessment, risk measurement, risk monitoring and reporting, and risk mitigation. The activities and governance that comprise the risk management process are described below. Culture The Board of Directors has approved an Enterprise Risk Management (ERM) framework that incorporates our purpose, vision, and values that form the bedrock of our corporate culture and set the tone for the organization. We designed the ERM Framework to enable a comprehensive approach to managing risks encountered by Schwab in its business activities. The framework incorporates key concepts commensurate with the size, risk profile, complexity, and continuing growth of the Company. Risk appetite, which is defined as the amount of risk the Company is willing to accept in pursuit of its corporate strategy, is developed by executive management and approved by the Board of Directors. Risk Governance Senior management takes an active role in the risk management process and has developed policies and procedures under which specific business and control units are responsible for identifying, measuring, and controlling risks. The Global Risk Committee, which is comprised of senior executives from each major business and control function, is responsible for the oversight of risk management. This includes identifying emerging risks, assessing risk management practices and the control environment, reinforcing business accountability for risk management, supervisory controls and regulatory compliance, supporting resource prioritization across the organization, and escalating significant issues to the Board of Directors. We have established risk metrics and reporting that enable measurement of the impact of strategy execution against risk appetite. The risk metrics, with risk limits and tolerance levels, are established for key risk categories by the Global Risk Committee and its functional risk sub-committees. The Global Risk Committee reports, through the Chief Risk Officer, regularly to the Risk Committee of the Board of Directors. The Risk Committee in turn assists the Board of Directors in fulfilling its oversight responsibilities with respect to our risk management program, including approving risk appetite statements and related key risk appetite metrics and reviewing reports relating to risk issues from functional areas of risk management, legal, compliance, and internal audit. Functional risk sub-committees focusing on specific areas of risk report to the Global Risk Committee. These sub-committees include the: • Compliance Risk Committee - provides oversight of compliance risk management programs and policies providing an aggregate view of compliance risk exposure; • Financial Risk Oversight Committee - provides oversight of and approves credit, liquidity, capital and market risk policies, limits, and exposures; • New Products and Services Risk Oversight Committee - provides oversight of, and approves corporate policy and procedures relating to the risk governance of new products and services; and • Operational Risk Oversight Committee - provides oversight of and approves operational risk management policies, risk tolerance levels, and operational risk governance processes, and includes sub-committees covering Fiduciary, Data, Information Security, Model Governance, and Third-Party risk. - 35 - THE CHARLES SCHWAB CORPORATION Management’s Discussion and Analysis of Financial Condition and Results of Operations (Tabular Amounts in Millions, Except Ratios, or as Noted) Senior management has also created an Incentive Compensation Risk Oversight Committee, which establishes policy and reviews and approves the Annual Risk Assessment of incentive compensation plans, and reports directly to the Compensation Committee of the Board of Directors. The Company’s compliance, finance, internal audit, legal, and corporate risk management departments assist management and the various risk committees in evaluating, testing, and monitoring risk management. In addition, the Disclosure Committee is responsible for monitoring and evaluating the effectiveness of our disclosure controls and procedures and internal control over financial reporting as of the end of each fiscal quarter. The Disclosure Committee reports on this evaluation to the CEO and CFO prior to their certification required by Sections 302 and 906 of the Sarbanes Oxley Act of 2002. Operational Risk Operational risks arise due to potential inadequacies or failures related to people, internal processes, and systems, or from external events or relationships impacting the Company and/or any of its key business partners and third parties. While operational risk is inherent in all business activities, we rely on a system of internal controls and risk management practices designed to keep operational risk and operational losses within the Company’s risk appetite. We have specific policies and procedures to identify and manage operational risk, and use periodic risk and control self-assessments, control testing programs, and internal audit reviews to evaluate the effectiveness of these internal controls. Where appropriate, we manage the impact of operational loss and litigation expense through the purchase of insurance. The insurance program is specifically designed to address our key operational risks and to maintain compliance with local laws and regulation. Schwab’s operations are highly dependent on the integrity and resiliency of our critical business functions and technology systems. To the extent Schwab experiences business or system interruptions, errors or downtime (which could result from a variety of causes, including natural disasters, terrorist attacks, technological failure, cyber attacks, changes to systems, linkages with third-party systems, and power failures), our business and operations could be negatively impacted. To minimize business interruptions, Schwab maintains a backup and recovery infrastructure which includes facilities for backup and communications, a geographically dispersed workforce, and routine testing of business continuity and disaster recovery plans. Information Security risk is the risk of unauthorized access, use, disclosure, disruption, modification, recording or destruction of the firm’s information or systems. We have designed and implemented an information security program that knits together complementary tools, controls and technologies to protect systems, client accounts and data. We continuously monitor the systems and work collaboratively with government agencies, law enforcement and other financial institutions to address potential threats. We use advanced monitoring systems to identify suspicious activity and deter unauthorized access by internal or external actors. We limit the number of employees who have access to clients’ personal information and internal authentication measures are enforced to protect against the potential for social engineering. All employees who handle sensitive information are trained in privacy and security. Schwab’s fraud and cyber security teams monitor activity looking for suspicious behavior. These capabilities allow us to identify and quickly act on any attempted intrusions. Schwab also faces operational risk when we employ the services of various third parties, including domestic and international outsourcing of certain technology, processing, servicing, and support functions. We manage the exposure to third party risk through contractual provisions, control standards, ongoing monitoring of third party performance, and appropriate testing. We maintain policies and procedures regarding the standard of care expected with all data, whether the data is internal company information, employee information, or non-public client information. We clearly define for employees, contractors, and third parties the expected standards of care for confidential data. We also provide regular training on data security. Fiduciary risk is the potential for financial or reputational loss through breach of fiduciary duties to a client. Fiduciary activities include, but are not limited to, individual and institutional trust, investment management, custody, and cash and securities processing. We manage this risk by establishing policy and procedures to ensure that obligations to clients are discharged faithfully and in compliance with applicable legal and regulatory requirements. Business units have the primary responsibility for adherence to the policy and procedures applicable to their business. Guidance and control are provided through the creation, approval, and ongoing review of applicable policies by business units and various risk committees. - 36 - THE CHARLES SCHWAB CORPORATION Management’s Discussion and Analysis of Financial Condition and Results of Operations (Tabular Amounts in Millions, Except Ratios, or as Noted) Model risk is the potential for adverse consequences from decisions based on incorrect or misused model outputs and reports. Models are owned by several business units throughout the organization, and are used for a variety of purposes. Model use includes, but is not limited to, calculating capital requirements for hypothetical stressful environments, estimating interest and credit risk for loans and other balance sheet assets, and providing guidance in the management of client portfolios. We have established a policy to describe the roles and responsibilities of all key stakeholders in model development, management, and use. All models are registered in a centralized database and classified into different risk ratings depending on their potential financial, reputational, or regulatory impact to the Company. The model risk rating determines the scope of model governance activities. Compliance Risk Schwab faces compliance risk which is the potential exposure to legal or regulatory sanctions, fines or penalties, financial loss, or damage to reputation resulting from the failure to comply with laws, regulations, rules, or other regulatory requirements. Among other things, compliance risks relate to the suitability of client investments, conflicts of interest, disclosure obligations and performance expectations for products and services, supervision of employees, and the adequacy of our controls. The Company and its affiliates are subject to extensive regulation by federal, state and foreign regulatory authorities, including SROs. We manage compliance risk through policies, procedures and controls reasonably designed to achieve and/or monitor compliance with applicable legal and regulatory requirements. These procedures address issues such as business conduct and ethics, sales and trading practices, marketing and communications, extension of credit, client funds and securities, books and records, anti-money laundering, client privacy, and employment policies. Credit Risk Credit risk is the potential for loss due to a borrower, counterparty, or issuer failing to perform on its contractual obligations. Our exposure to credit risk mainly results from investing activities in our liquidity and investment portfolios, mortgage lending, margin lending and client option and futures activities, pledged asset lending, securities lending activities, and our role as a counterparty in other financial contracts. To manage the risks of such losses, we have established policies and procedures, which include establishing and reviewing credit limits, monitoring of credit limits and quality of counterparties, and adjusting margin, PAL, option, and futures requirements for certain securities and instruments. Liquidity and Investment Portfolios Schwab has exposure to credit risk associated with its investment portfolios, which include U.S. agency, and non-agency mortgage-backed securities, asset-backed securities, corporate debt securities, U.S. agency notes, U.S. Treasury securities, certificates of deposit, U.S. state and municipal securities, and commercial paper. At December 31, 2017, substantially all securities in the investment portfolios were rated investment grade. U.S. agency mortgage-backed securities do not have explicit credit ratings; however, management considers these to be of the highest credit quality and rating given the guarantee of principal and interest by the U.S. government-sponsored enterprises. Mortgage Lending Portfolio The bank loan portfolio includes First Mortgages, HELOCs, and other loans. The credit risk exposure related to loans is actively managed through individual loan and portfolio reviews. Management regularly reviews asset quality, including concentrations, delinquencies, nonaccrual loans, charge-offs, and recoveries. All are factors in the determination of an appropriate allowance for loan losses. Our residential loan underwriting guidelines include maximum LTV ratios, cash out limits, and minimum Fair Isaac Corporation (FICO) credit scores. The specific guidelines are dependent on the individual characteristics of a loan (for example, whether the property is a primary or secondary residence, whether the loan is for investment property, whether the loan is for an initial purchase of a home or refinance of an existing home, and whether the loan size is conforming or jumbo). - 37 - THE CHARLES SCHWAB CORPORATION Management’s Discussion and Analysis of Financial Condition and Results of Operations (Tabular Amounts in Millions, Except Ratios, or as Noted) Schwab does not originate or purchase residential loans that allow for negative amortization and does not originate or purchase subprime loans (generally defined as extensions of credit to borrowers with a FICO score of less than 620 at origination), unless the borrower has compensating credit factors. For more information on credit quality indicators relating to Schwab’s bank loans, see Item 8 - Note 6. Securities and Instrument-Based Lending Portfolios Collateral arrangements relating to margin loans, PALs, option and futures positions, securities lending agreements, and resale agreements include provisions that require additional collateral in the event of market fluctuations. Additionally, for margin loans, PALs, options and futures positions, and securities lending agreements, collateral arrangements require that the fair value of such collateral sufficiently exceeds the credit exposure in order to maintain a fully secured position. Other Counterparty Exposures Schwab performs clearing services for all securities transactions in its client accounts. Schwab has exposure to credit risk due to its obligation to settle transactions with clearing corporations, mutual funds, and other financial institutions even if Schwab’s clients or a counterparty fail to meet their obligations to Schwab. Market Risk Market risk is the potential for changes in earnings or the value of financial instruments held by Schwab as a result of fluctuations in interest rates, equity prices, or market conditions. We are exposed to interest rate risk primarily from changes in market interest rates on our interest-earning assets relative to changes in the costs of its funding sources that finance these assets. Net interest revenue is affected by various factors, such as the distribution and composition of interest-earning assets and interest-bearing liabilities, the spread between yields earned on interest-earning assets and rates paid on interest-bearing liabilities, which may reprice at different times or by different amounts, and the spread between short and long-term interest rates. Interest-earning assets primarily include investment securities, margin loans and bank loans. These assets are sensitive to changes in interest rates and changes in prepayment levels that tend to increase in a declining rate environment and decrease in a rising rate environment. Because we establish the rates paid on certain brokerage client cash balances and bank deposits and the rates charged on certain margin and bank loans, and control the composition of our investment securities, we have some ability to manage our net interest spread, depending on competitive factors and market conditions. To mitigate the risk of declining interest revenue, we have established policies and procedures, which include setting guidelines on the amount of net interest revenue at risk, and monitoring the net interest margin and average maturity of our interest-earning assets and funding sources. To remain within these guidelines, we manage the maturity, repricing, and cash flow characteristics of the investment portfolios. Financial instruments are also subject to the risk that valuations will be negatively affected by changes in demand and the underlying market for a financial instrument. We are indirectly exposed to option, futures, and equity market fluctuations in connection with client option and futures accounts, securities collateralizing margin loans to brokerage customers, and client securities loaned out as part of the brokerage securities lending activities. Equity market valuations may also affect the level of brokerage client trading activity, margin borrowing, and overall client engagement with Schwab. Additionally, we earn mutual fund and ETF service fees and asset management fees based upon daily balances of certain client assets. Fluctuations in these client asset balances caused by changes in equity valuations directly impact the amount of fee revenue we earn. Our market risk related to financial instruments held for trading is not material. - 38 - THE CHARLES SCHWAB CORPORATION Management’s Discussion and Analysis of Financial Condition and Results of Operations (Tabular Amounts in Millions, Except Ratios, or as Noted) Net Interest Revenue Simulation For Schwab’s net interest revenue sensitivity analysis, we use net interest revenue simulation modeling techniques to evaluate and manage the effect of changing interest rates. The simulation includes all interest-sensitive assets and liabilities. Key variables in the simulation include the repricing of financial instruments, prepayment, reinvestment, and product pricing assumptions. The simulations involve assumptions that are inherently uncertain and, as a result, cannot precisely estimate net interest revenue or predict the impact of changes in interest rates on net interest revenue. Actual results may differ from simulated results due to balance growth or decline and the timing, magnitude, and frequency of interest rate changes, as well as changes in market conditions and management strategies, including changes in asset and liability mix. If our guidelines for net interest revenue sensitivity are breached, management must report the breach to the Financial Risk Oversight Committee and establish a plan to address the interest rate risk. There were no breaches of our net interest revenue sensitivity risk limits during the years ended December 31, 2017 or 2016. As represented by the simulations presented below, our investment strategy is structured to produce an increase in net interest revenue when interest rates rise and, conversely, a decrease in net interest revenue when interest rates fall. The simulations in the following table assume that the asset and liability structure of the consolidated balance sheets would not be changed as a result of the simulated changes in interest rates. As we actively manage the consolidated balance sheets and interest rate exposure, in all likelihood we would take steps to manage additional interest rate exposure that could result from changes in the interest rate environment. The following table shows the simulated net interest revenue change over the next 12 months beginning December 31, 2017 and 2016 of a gradual 100 basis point increase or decrease in market interest rates relative to prevailing market rates at the end of each reporting period. The change in net interest revenue sensitivities as of December 31, 2017 reflects the increase in short-term interest rates. An increase in short-term interest rates positively impacts net interest revenue as yields on interest-earning assets rise faster than the cost of funding sources. A decline in interest rates could negatively impact the yield on the investment and loan portfolio to a greater degree than any offsetting reduction in interest expense from funding sources, compressing net interest margin. Liquidity Risk Liquidity risk is the potential that Schwab will be unable to meet cash flow obligations when they come due without incurring unacceptable losses. Due to its role as a source of financial strength, CSC’s liquidity needs are primarily driven by the liquidity and capital needs of CS&Co, the capital needs of the bank subsidiaries, the amount of dividend payments on CSC’s common and preferred stock and principal and interest due on corporate debt. The liquidity needs of CS&Co are primarily driven by client activity including trading and margin borrowing activities and capital expenditures, and the capital needs of the bank subsidiaries are primarily driven by client deposits. We have established liquidity policies to support the successful execution of business strategies, while ensuring ongoing and sufficient liquidity to meet operational needs and satisfy applicable regulatory requirements under both normal and stressed conditions. We seek to maintain client confidence in the balance sheet and the safety of client assets by maintaining liquidity and diversity of funding sources to allow the Company to meet its obligations. To this end, we have established limits and contingency funding scenarios to support liquidity levels during both business as usual and stressed conditions. We employ a variety of methodologies to monitor and manage liquidity. We conduct regular liquidity stress testing to develop a consolidated view of liquidity risk exposures and to ensure our ability to maintain sufficient liquidity during market-related or company-specific liquidity stress events. Liquidity is also tested at key subsidiaries and results are reported to the Financial Risk Oversight Committee. A number of early warning indicators are monitored to help identify emerging liquidity stresses in the market or within the organization and are reviewed with management as appropriate. The Company is subject to and was in compliance with the modified LCR rule at December 31, 2017. - 39 - THE CHARLES SCHWAB CORPORATION Management’s Discussion and Analysis of Financial Condition and Results of Operations (Tabular Amounts in Millions, Except Ratios, or as Noted) Primary Funding Sources Schwab’s primary source of funds is cash generated by client activity: bank deposits and cash balances in client brokerage accounts. These funds are used to purchase investment securities and extend loans to clients. Other sources of funds may include cash flows from operations, maturities and sales of investment securities, repayments on loans, securities lending of assets held in client brokerage accounts, and cash provided by external financing or equity offerings. To meet daily funding needs, we maintain liquidity in the form of overnight cash deposits and short-term investments. For unanticipated liquidity needs, a buffer of highly liquid investments, currently comprised of U.S. Treasury notes, is also maintained. Additional Funding Sources In addition to internal sources of liquidity, Schwab has access to external funding. The need for short-term borrowings from these facilities arises primarily from timing differences between cash flow requirements, scheduled liquidation of interest-earning investments, movements of cash to meet regulatory brokerage client cash segregation requirements and general corporate purposes. We maintain policies and procedures necessary to access funding and test discount window borrowing procedures on a periodic basis. The following table describes external debt facilities are available at December 31, 2017: (1) Other than an overnight borrowing to test availability, this facility was unused during 2017. (2) Amounts available are dependent on the fair value of certain investment securities that are pledged as collateral. (3) Amounts available are dependent on the amount of First Mortgages, HELOCs, and the fair value of certain investment securities that are pledged as collateral. (4) CSC has authorization from its Board of Directors to issue Commercial Paper Notes to not exceed $1.5 billion. Management has set a current limit not to exceed the amount of the committed, unsecured credit facility. The financial covenants for the $750 million committed credit facility require CS&Co to maintain a minimum net capital ratio, Schwab Bank to be well capitalized, and CSC to maintain a minimum level of stockholders’ equity, adjusted to exclude AOCI. At December 31, 2017, the minimum level of stockholders’ equity required under this facility was $12.5 billion (CSC’s stockholders’ equity, excluding AOCI, at December 31, 2017 was $18.7 billion). Management believes these restrictions will not have a material effect on CSC’s ability to meet foreseeable dividend or funding requirements. Schwab Bank has access to short-term secured funding through the Federal Reserve’s discount window. Amounts available under the Federal Reserve discount window are dependent on the fair value of certain of Schwab Bank’s investment securities that are pledged as collateral. Schwab Bank also maintains a secured credit facility with the Federal Home Loan Bank of San Francisco (FHLB). Amounts available under this facility are dependent on the amount of Schwab Bank’s First Mortgages, HELOCs, and the fair value of certain of Schwab Bank’s investment securities that are pledged as collateral. During 2017, Schwab Bank used borrowings under this agreement to purchase investment securities prior to bulk transfers. This credit facility is also available as backup financing in the event of the outflow of client cash from Schwab Bank’s balance sheet. CSC has a commercial paper program of which proceeds are used for general corporate purposes. The maturities of the Commercial Paper Notes may vary, but are not to exceed 270 days from the date of issue. CSC’s ratings for these short-term borrowings are P1 by Moody’s, A1 by Standard & Poor’s, and by Fitch. CSC had no Commercial Paper Notes outstanding at December 31, 2017 or 2016. - 40 - THE CHARLES SCHWAB CORPORATION Management’s Discussion and Analysis of Financial Condition and Results of Operations (Tabular Amounts in Millions, Except Ratios, or as Noted) To partially satisfy the margin requirement of client option transactions with the Options Clearing Corporation, CS&Co has unsecured standby letter of credit agreements (LOCs) with several banks in favor of the Options Clearing Corporation aggregating $225 million at December 31, 2017. There were no funds drawn under any of these LOCs during 2017 or 2016. In connection with its securities lending activities, the Company is required to provide collateral to certain brokerage clients. The collateral requirements were satisfied by providing cash as collateral. CSC has a universal automatic shelf registration statement (Shelf Registration Statement) on file with the SEC, which enables it to issue debt, equity, and other securities. Borrowings Long-term debt outstanding was $4.8 billion and $2.9 billion at December 31, 2017 and 2016, respectively. Short-term borrowings outstanding from FHLB were $15.0 billion at December 31, 2017 and there were none at December 31, 2016. The following are details of the Senior Notes and short-term borrowings: N/A Not Applicable. New Debt Issuances All debt issuances in 2017 were senior unsecured obligations with interest payable semi-annually. Additional details are as follows: Equity Issuances and Redemptions CSC’s preferred stock issued and net proceeds for the years ending December 31, 2017 and 2016 are as follows: On December 1, 2017, CSC redeemed all of the 485,000 outstanding shares of its 6.00% Non-Cumulative Perpetual Preferred Stock, Series B (“Series B Preferred Stock”), and the corresponding 19,400,000 depositary shares, each representing a 1/40th interest in a share of the Series B Preferred Stock. For further discussion of CSC’s long-term debt and information on the equity offerings, see Item 8 - Note 12 and Note 16. - 41 - THE CHARLES SCHWAB CORPORATION Management’s Discussion and Analysis of Financial Condition and Results of Operations (Tabular Amounts in Millions, Except Ratios, or as Noted) Off-Balance Sheet Arrangements Schwab enters into various off-balance sheet arrangements in the ordinary course of business, primarily to meet the needs of our clients. These arrangements include firm commitments to extend credit. Additionally, Schwab enters into guarantees and other similar arrangements in the ordinary course of business. For information on each of these arrangements, see Item 8 - Note 6, Note 10, Note 12, Note 13, and Note 14. Contractual Obligations Schwab’s principal contractual obligations as of December 31, 2017 are shown in the following table. We believe that funds generated by continuing operations, as well as cash provided by external financing, will continue to be the primary funding sources in meeting these obligations. Excluded from this table are liabilities recorded on the consolidated balance sheets that are generally short-term in nature (e.g., payables to brokers, dealers, and clearing organizations and short-term borrowings) or without contractual payment terms (e.g., bank deposits, payables to brokerage clients, and deferred compensation). (1) Represents Schwab Bank’s commitments to extend credit to banking clients, purchase mortgage loans, and commitments to fund CRA investments. (2) Includes estimated future interest payments through 2028 for Senior Notes. Amounts exclude maturities under a finance lease obligation and unamortized discounts and premiums. (3) Consists of purchase obligations for services such as advertising and marketing, telecommunications, professional services, and hardware- and software-related agreements. Includes purchase obligations that can be canceled by the Company without penalty. (4) Represents minimum rental commitments, net of sublease commitments, and includes facilities under past restructuring initiatives and rental commitments under a finance lease obligation. CAPITAL MANAGEMENT Schwab seeks to manage capital to a level and composition sufficient to support execution of our business strategy, including anticipated balance sheet growth, providing financial support to the subsidiaries, and sustained access to the capital markets, while at the same time meeting our regulatory capital requirements and serving as a source of financial strength to Schwab Bank. Schwab’s primary sources of capital are funds generated by the operations of subsidiaries and securities issuances by CSC in the capital markets. To ensure that Schwab has sufficient capital to absorb unanticipated losses or declines in asset values, we have adopted a policy to remain well capitalized even in stressed scenarios. Internal guidelines are set, for both CSC and its regulated subsidiaries, to ensure capital levels are in line with our strategy and regulatory requirements. Capital forecasts are reviewed monthly at Asset-Liability Management and Pricing Committee and Financial Risk Oversight Committee meetings. A number of early warning indicators are monitored to help identify potential problems that could impact capital. In addition, we monitor the subsidiaries’ capital levels and requirements. Subject to regulatory capital requirements and any required approvals, any excess capital held by subsidiaries is transferred to CSC in the form of dividends and returns of capital. When subsidiaries have need of additional capital, funds are provided by CSC as equity investments and also as subordinated loans (in a form approved as regulatory capital by regulators) for CS&Co. The details and method used for each cash infusion are based on an analysis of the particular entity’s needs and financing alternatives. The amounts and structure of infusions must take into consideration maintenance of regulatory capital requirements, debt/equity ratios, and equity double leverage ratios. Schwab conducts regular capital stress testing to assess the potential financial impacts of various adverse macroeconomic and company-specific events to which the Company could be subjected. The objective of the capital stress testing is (1) to explore various potential outcomes - including rare and extreme events and (2) to assess impacts of potential stressful outcomes on both capital and liquidity. Additionally, we have a comprehensive Capital Contingency Plan to provide action plans for certain low probability/high impact capital events that the Company might face. The Capital Contingency Plan is issued under the authority of the Financial Risk Oversight Committee and provides guidelines for sustained capital events. It - 42 - THE CHARLES SCHWAB CORPORATION Management’s Discussion and Analysis of Financial Condition and Results of Operations (Tabular Amounts in Millions, Except Ratios, or as Noted) does not specifically address every contingency, but is designed to provide a framework for responding to any capital stress. The results of the stress testing indicate there are two scenarios which could stress the Company’s capital: (1) inflows of balance sheet cash during a period of very low interest rates and (2) outflows of balance sheet cash when other sources of financing are not available and the Company is required to sell assets to fund the flows at a loss. The Capital Contingency Plan is reviewed annually and updated as appropriate. For additional information, see Business - Regulation in Part I, Item 1. Regulatory Capital Requirements CSC is subject to capital requirements set by the Federal Reserve and is required to serve as a source of strength for Schwab Bank and to provide financial assistance if Schwab Bank experiences financial distress. Schwab is required to maintain a Tier 1 Leverage Ratio for CSC of at least 4%; however, management seeks to maintain the ratio of at least 6%. Due to the relatively low risk of our balance sheet assets and risk-based capital ratios at CSC and Schwab Bank that are well in excess of regulatory requirements, the Tier 1 Leverage Ratio is the most restrictive capital constraint on CSC’s asset growth. Banking subsidiaries are subject to capital requirements set by their regulators that are substantially similar to those imposed on CSC by the Federal Reserve. Banking subsidiaries’ failure to remain well capitalized could result in certain mandatory and possibly additional discretionary actions by the regulators that could have a direct material effect on the bank. Schwab’s principal banking subsidiary, Schwab Bank, is required to maintain a Tier 1 Leverage Ratio of at least 5% to be well capitalized, but seeks to maintain the ratio of at least 6.25%. Based on its regulatory capital ratios at December 31, 2017, Schwab Bank is considered well capitalized. The following table details CSC’s consolidated and Schwab Bank’s capital ratios: (1) CSC and Schwab Bank have elected to opt-out of the requirement to include most components of AOCI in CET1 Capital. Schwab Bank is also subject to regulatory requirements that restrict and govern the terms of affiliate transactions. In addition, Schwab Bank is required to provide notice to, and may be required to obtain approval from, the OCC and the Federal Reserve to declare dividends to the parent company. As a broker-dealer, CS&Co is subject to regulatory requirements of the Uniform Net Capital Rule. The rule is intended to ensure the general financial soundness and liquidity of broker-dealers. These regulations prohibit CS&Co from paying cash dividends, making unsecured advances and loans to the parent company and employees, and repaying subordinated borrowings from CSC if such payment would result in a net capital amount of less than 5% of aggregate debit balances or - 43 - THE CHARLES SCHWAB CORPORATION Management’s Discussion and Analysis of Financial Condition and Results of Operations (Tabular Amounts in Millions, Except Ratios, or as Noted) less than 120% of its minimum dollar requirement of $250,000. As such, CS&Co is required to maintain, at all times, at least the minimum level of net capital required under Rule 15c3-1. At December 31, 2017, CS&Co exceeded the net capital requirements. In addition to the capital requirements above, the Company’s subsidiaries are subject to various regulatory requirements that are intended to ensure financial soundness and liquidity. See Item 8 - Note 21 for additional information on the components of stockholders’ equity and information on the capital requirements of each of the subsidiaries. Dividends Since the initial dividend in 1989, CSC has paid 115 consecutive quarterly dividends and has increased the quarterly dividend rate 21 times, resulting in a 20% compounded annual growth rate, excluding the special cash dividend of $1.00 per common share in 2007. While the payment and amount of dividends are at the discretion of the Board of Directors, subject to certain regulatory and other restrictions, CSC currently targets its common stock cash dividend at approximately 20% to 30% of net income. On April 21, 2016 the Board of Directors of the Company declared a one cent, or 17%, increase in the quarterly cash dividend to $0.07 per common share. On January 26, 2017, the Board of Directors of the Company declared a one cent, or 14%, increase in the quarterly cash dividend to $0.08 per common share. On January 25, 2018, the Board of Directors of the Company declared a two cent, or 25% increase in the quarterly cash dividend to $0.10 per common share. The following table details the CSC cash dividends paid and per share amounts: (1) Dividends paid semi-annually until February 1, 2022 and quarterly thereafter. (2) Dividends paid quarterly. (3) Series D Preferred Stock was issued on March 7, 2016. (4) Series E Preferred Stock was issued on October 31, 2016. Dividends paid semi-annually until March 1, 2022 and quarterly thereafter. (5) Series F Preferred Stock was issued on October 31, 2017. Dividends paid semi-annually beginning on June 1, 2018 until December 1, 2027, and quarterly thereafter. (6) Series B Preferred Stock was redeemed on December 1, 2017. N/A Not applicable. Share Repurchases There were no repurchases of CSC’s common stock in 2017 or 2016. As of December 31, 2017, CSC had remaining authority from the Board of Directors to repurchase up to $596 million of its common stock, which is not subject to expiration. - 44 - THE CHARLES SCHWAB CORPORATION Management’s Discussion and Analysis of Financial Condition and Results of Operations (Tabular Amounts in Millions, Except Ratios, or as Noted) FOREIGN HOLDINGS At December 31, 2017, Schwab had exposure to non-sovereign financial and non-financial institutions in foreign countries of $5.7 billion, with the fair value of the top three exposures being to issuers and counterparties domiciled in Sweden at $1.6 billion, France at $1.3 billion and Canada at $0.8 billion. At December 31, 2017, Schwab held AFS and HTM securities with a total fair value of $99 million issued by agencies of foreign governments. These securities are explicitly guaranteed by governments of issuing agencies. In addition to the direct holdings in foreign companies and securities issued by foreign government agencies, Schwab has indirect exposure to foreign countries through its investments in CSIM money market funds (collectively, the Funds) resulting from brokerage clearing activities. At December 31, 2017, the Company had $135 million in investments in these Funds. Certain of the Funds’ positions include certificates of deposits, time deposits, commercial paper and corporate debt securities issued by counterparties in foreign countries. Schwab had outstanding margin loans to foreign residents of $660 million at December 31, 2017. FAIR VALUE OF FINANCIAL INSTRUMENTS Schwab uses the market approach to determine the fair value of certain financial assets and liabilities recorded at fair value, and to determine fair value disclosures. See Item 8 - Note 2 and Note 15 for more information on our assets and liabilities recorded at fair value. When available, Schwab uses quoted prices in active markets to measure the fair value of assets and liabilities. When utilizing market data and bid-ask spread, we use the price within the bid-ask spread that best represents fair value. When quoted prices do not exist, prices are obtained from independent third-party pricing services to measure the fair value of investment assets. We generally obtain prices from at least three independent pricing sources for assets recorded at fair value. Our primary independent pricing service provides prices based on observable trades and discounted cash flows that incorporate observable information such as yields for similar types of securities (a benchmark interest rate plus observable spreads) and weighted-average maturity for the same or similar “to-be-issued” securities. The prices obtained from its primary independent pricing service are compared to the prices obtained from the additional independent pricing services to determine if the price obtained from the primary independent pricing service is reasonable. We do not adjust the prices received from independent third-party pricing services unless such prices are inconsistent with the definition of fair value and result in a material difference in the recorded amounts. At December 31, 2017 and 2016, we did not adjust prices received from the primary independent third-party pricing service. CRITICAL ACCOUNTING ESTIMATES The consolidated financial statements of Schwab have been prepared in accordance with GAAP. Item 8 - Note 2 contains more information on our significant accounting policies made in connection with its application of these accounting principles. While the majority of the revenues, expenses, assets and liabilities are not based on estimates, there are certain accounting principles that require management to make estimates regarding matters that are uncertain and susceptible to change where such change may result in a material adverse impact on Schwab’s financial position and reported financial results. These critical accounting estimates are described below. Management regularly reviews the estimates and assumptions used in the preparation of the financial statements for reasonableness and adequacy. Management has discussed the development and selection of these critical accounting estimates with the Audit Committee of the Board of Directors. Additionally, management has reviewed with the Audit Committee the Company’s significant estimates discussed in this Management’s Discussion and Analysis of Financial Condition and Results of Operations. - 45 - THE CHARLES SCHWAB CORPORATION Management’s Discussion and Analysis of Financial Condition and Results of Operations (Tabular Amounts in Millions, Except Ratios, or as Noted) Income Taxes Schwab estimates income tax expense based on amounts expected to be owed to the various tax jurisdictions in which we operate, including federal, state and local domestic jurisdictions, and immaterial amounts owed to several foreign jurisdictions. The estimated income tax expense is reported in the consolidated statements of income in Taxes on income. Accrued taxes are reported in Other assets or Accrued expenses and other liabilities on the consolidated balance sheets and represent the net estimated amount due to or to be received from taxing jurisdictions either currently or deferred to future periods. Deferred taxes arise from differences between assets and liabilities measured for financial reporting purposes versus income tax reporting purposes. Deferred tax assets are recognized if, in management’s judgment, their realizability is determined to be more likely than not. Uncertain tax positions that meet the more likely than not recognition threshold are measured to determine the amount of benefit to recognize. An uncertain tax position is measured at the largest amount of benefit management believes is more likely than not to be realized upon settlement. In estimating accrued taxes, we assess the relative merits and risks of the appropriate tax treatment considering statutory, judicial and regulatory guidance in the context of the tax position. Because of the complexity of tax laws and regulations, interpretation can be difficult and subject to legal judgment given specific facts and circumstances. Changes in the estimate of accrued taxes occur periodically due to changes in tax rates, interpretations of tax laws, the status of examinations being conducted by various taxing authorities, and newly enacted statutory, judicial and regulatory guidance that impacts the relative merits and risks of tax positions. These changes, when they occur, affect accrued taxes and can be significant to the operating results of the Company. See Item 8 - Note 19 for more information on the Company’s income taxes. Legal and Regulatory Reserves Reserves for legal and regulatory claims and proceedings reflect an estimate of probable losses for each matter, after considering, among other factors, the progress of the case, prior experience and the experience of others in similar cases, available defenses, insurance coverage and indemnification, and the opinions and views of legal counsel. In many cases, including most class action lawsuits, it is not possible to determine whether a loss will be incurred, or to estimate the range of that loss, until the matter is close to resolution, in which case no accrual is made until that time. Reserves are adjusted as more information becomes available. Significant judgment is required in making these estimates, and the actual cost of resolving a matter may ultimately differ materially from the amount reserved. See Item 8 - Note 13 for more information on the Company’s contingencies related to legal and regulatory reserves. - 46 - THE CHARLES SCHWAB CORPORATION

<s>[INST] FORWARDLOOKING STATEMENTS In addition to historical information, this Annual Report on Form 10K contains “forwardlooking statements” within the meaning of Section 27A of the Securities Act, and Section 21E of the Securities Exchange Act of 1934. Forwardlooking statements are identified by words such as “believe,” “anticipate,” “expect,” “intend,” “plan,” “will,” “may,” “estimate,” “appear,” “aim,” “target,” “seek”, “could,” “would,” “continue,” and other similar expressions. In addition, any statements that refer to expectations, projections, or other characterizations of future events or circumstances are forwardlooking statements. These forwardlooking statements, which reflect management’s beliefs, objectives, and expectations as of the date hereof, are estimates based on the best judgment of Schwab’s senior management. These statements relate to, among other things: Schwab seeking to maximize its market valuation and stockholder returns over time; the belief that developing trusted relationships will translate into more client assets which drives revenue and, along with expense discipline, generates earnings growth and builds stockholder value; and Schwab’s ability to pursue its business strategy and maintain its market leadership position; (see Business Strategy and Competitive Environment in Part I, Item 1); The impact of legal proceedings and regulatory matters (see Legal Proceedings in Part I, Item 3 and Item 8 Note 13); The adjustment of rates paid on clientrelated liabilities; the stability, rate sensitivity, and duration of clientrelated liabilities; the opportunity to migrate nonrate sensitive cash in sweep money market funds to banking subsidiaries; increasing the duration of interestearning assets; and Schwab’s positioning to benefit from an increase in interest rates and limit its exposure to falling rates; (see Net Interest Revenue in Part II, Item 7); The estimated net reduction in Schwab’s effective income tax rate for 2018; (see Taxes on Income in Part II, Item 7); Sources of liquidity, capital, and level of dividends (see Liquidity Risk in Part II, Item 7); Capital ratios (see Regulatory Capital Requirements in Part II, Item 7); The impact of changes in management’s estimates on Schwab’s results of operations (see Critical Accounting Estimates in Part II, Item 7); The expected impact of new accounting standards not yet adopted (see Item 8 Note 2); and The impact of changes in the likelihood of indemnification and guarantee payment obligations on Schwab’s results of operations (see Item 8 Note 13). Achievement of the expressed beliefs, objectives and expectations described in these statements is subject to certain risks and uncertainties that could cause actual results to differ materially from the expressed beliefs, objectives, and expectations. Readers are cautioned not to place undue reliance on these forwardlooking statements, which speak only as of the date of this Annual Report on Form 10K or, in the case of documents incorporated by reference, as of the date of those documents. Important factors that may cause actual results to differ include, but are not limited to: General market conditions, including the level of interest rates, equity valuations and trading activity; Our ability to attract and retain clients, develop trusted relationships, and grow client assets; Client use of our investment advisory services and other products and services; The level of client assets, including cash balances; Competitive pressure on pricing, including deposit rates; Client sensitivity to interest rates; Regulatory guidance; Timing, amount, and impact of the migration of certain balances from sweep money market funds into Schwab Bank; Changes to tax deductions; Capital and liquidity needs and management; Our ability to manage expenses; The effect of adverse developments in litigation or regulatory matters and the extent of any related charges; The availability and terms of external financing; 19 THE CHARLES SCHWAB CORPORATION Management’s Discussion and Analysis of Financial Condition and Results of Operations (Tabular Amounts in Millions, Except Ratios, or as Noted) Potential breaches of contractual [/INST] Negative. </s>

SCHWAB CHARLES CORP

2019-02-22

2018-12-31

Item 7. Management’s Discussion and Analysis of Financial Condition and Results of Operations FORWARD-LOOKING STATEMENTS In addition to historical information, this Annual Report on Form 10-K contains “forward-looking statements” within the meaning of Section 27A of the Securities Act, and Section 21E of the Securities Exchange Act of 1934. Forward-looking statements are identified by words such as “believe,” “anticipate,” “expect,” “intend,” “plan,” “will,” “may,” “estimate,” “appear,” “could,” “would,” and other similar expressions. In addition, any statements that refer to expectations, projections, or other characterizations of future events or circumstances are forward-looking statements. These forward-looking statements, which reflect management’s beliefs, objectives, and expectations as of the date hereof, are estimates based on the best judgment of Schwab’s senior management. These statements relate to, among other things: • Maximizing our market valuation and stockholder returns over time; our belief that developing trusted relationships will translate into more client assets which drives revenue and, along with expense discipline and thoughtful capital management, generates earnings growth and builds stockholder value; and Schwab’s ability to pursue its business strategy and maintain its market leadership position; (see Business Strategy and Competitive Environment in Part I, Item 1); • The impact of legal proceedings and regulatory matters (see Item 8 - Note 14); • Effective capital management supporting business growth and capital returns to stockholders (see Overview in Part II, Item 7); • The adjustment of rates paid on client-related liabilities; the stability, rate sensitivity, and duration of client-related liabilities; managing the duration of interest-earning assets; and Schwab’s positioning to benefit from an increase in interest rates and limit its exposure to falling rates (see Net Interest Revenue in Part II, Item 7); • 2019 capital expenditures (see Total Expenses Excluding Interest in Part II, Item 7); • Sources of liquidity, capital, and level of dividends (see Liquidity Risk in Part II, Item 7); • Capital ratios (see Regulatory Capital Requirements in Part II, Item 7); • The impact of changes in management’s estimates on Schwab’s results of operations (see Critical Accounting Estimates in Part II, Item 7); • The expected impact of new accounting standards not yet adopted (see Item 8 - Note 2); and • The impact of changes in the likelihood of indemnification and guarantee payment obligations on Schwab’s results of operations (see Item 8 - Note 14). Achievement of the expressed beliefs, objectives and expectations described in these statements is subject to certain risks and uncertainties that could cause actual results to differ materially from the expressed beliefs, objectives, and expectations. Readers are cautioned not to place undue reliance on these forward-looking statements, which speak only as of the date of this Annual Report on Form 10-K or, in the case of documents incorporated by reference, as of the date of those documents. Important factors that may cause actual results to differ include, but are not limited to: • General market conditions, including the level of interest rates, equity valuations and trading activity; • Our ability to attract and retain clients, develop trusted relationships, and grow client assets; • Client use of our advisory solutions and other products and services; • The level of client assets, including cash balances; • Competitive pressure on pricing, including deposit rates; • Client sensitivity to interest rates; • Regulatory guidance; • Timing and amount of transfers to bank sweep deposits; • Capital and liquidity needs and management; • Our ability to manage expenses; • Our ability to develop and launch new products, services, and capabilities, as well as implement infrastructure, in a timely and successful manner; • The timing of campus expansion work and technology projects; • The effect of adverse developments in litigation or regulatory matters and the extent of any related charges; and • Potential breaches of contractual terms for which we have indemnification and guarantee obligations. - 20 - THE CHARLES SCHWAB CORPORATION Management’s Discussion and Analysis of Financial Condition and Results of Operations (Tabular Amounts in Millions, Except Ratios, or as Noted) Certain of these factors, as well as general risk factors affecting the Company, are discussed in greater detail in Risk Factors in Part I, Item 1A. - 21 - THE CHARLES SCHWAB CORPORATION Management’s Discussion and Analysis of Financial Condition and Results of Operations (Tabular Amounts in Millions, Except Ratios, or as Noted) GLOSSARY OF TERMS Active brokerage accounts: Brokerage accounts with activity within the preceding 270 days. Accumulated Other Comprehensive Income (AOCI): A component of stockholders’ equity which includes unrealized gains and losses on AFS securities and net gains or losses associated with pension obligations. Asset-backed securities: Debt securities backed by financial assets such as loans or receivables. Assets receiving ongoing advisory services: Market value of all client assets custodied at the Company under the guidance of an independent advisor or enrolled in one of Schwab’s retail or other advisory solutions. Basel III: Global regulatory standards on bank capital adequacy and liquidity issued by the Basel Committee on Banking Supervision. Basis point: One basis point equals 1/100th of 1%, or 0.01%. Client assets: The market value, as of the end of the reporting period, of all client assets in our custody and proprietary products, which includes both cash and securities. Average client assets are the daily average client asset balance for the period. Client cash as a percentage of client assets: Calculated as money market fund balances, bank deposits, Schwab One® balances, and certain cash equivalents as a percentage of client assets. Clients’ daily average trades: Includes daily average revenue trades by clients, trades by clients in asset-based pricing relationships, and all commission-free trades. Common Equity Tier 1 (CET1) Capital: The sum of common stock and related surplus net of treasury stock, retained earnings, AOCI and qualifying minority interests, less applicable regulatory adjustments and deductions. Schwab made a one-time election to opt-out of the requirement to include most components of AOCI in CET1 Capital under the “standardized approach” framework. Beginning in 2019, Schwab must include AOCI in CET1 Capital. Common Equity Tier 1 Risk-Based Capital Ratio: The ratio of CET1 Capital to total risk-weighted assets as of the end of the period. Core net new client assets: Net new client assets before significant one-time inflows or outflows, such as acquisitions/divestitures or extraordinary flows (generally greater than $10 billion) relating to a specific client. These flows may span multiple reporting periods. Customer Protection Rule: Refers to Rule 15c3-3 of the Securities Exchange Act of 1934. Daily Average Revenue Trades (DARTs): Total revenue trades during a certain period, divided by the number of trading days in that period. Revenue trades include all client trades that generate trading revenue (i.e., commission revenue or principal transaction revenue). Debt to total capital ratio: Calculated as total debt divided by stockholders’ equity and total debt. Delinquency roll rates: The rates at which loans transition through delinquency stages, ultimately resulting in a loss. Schwab considers a loan to be delinquent if it is 30 days or more past due. Dodd-Frank Wall Street Reform and Consumer Protection Act (Dodd-Frank): Regulatory reform legislation containing numerous provisions which expanded prudential regulation of large financial services companies. Duration: Duration is typically used to measure the expected change in value of a financial instrument for a 1% change in interest rates, expressed in years. - 22 - THE CHARLES SCHWAB CORPORATION Management’s Discussion and Analysis of Financial Condition and Results of Operations (Tabular Amounts in Millions, Except Ratios, or as Noted) Final Regulatory Capital Rules: Refers to the regulatory capital rules issued by U.S. banking agencies which implemented Basel III and relevant provisions of Dodd-Frank, which apply to savings and loan holding companies, as well as federal savings banks. First mortgages: Refers to first lien residential real estate mortgage loans. Full-time equivalent employees: Represents the total number of hours worked divided by a 40-hour work week for the following categories: full-time, part-time and temporary employees and persons employed on a contract basis. High Quality Liquid Assets (HQLA): Assets with a high potential to be converted easily and quickly into cash. Interest-bearing liabilities: Includes bank deposits, payables to brokerage clients, short-term borrowings, and long-term debt on which Schwab pays interest. Interest-earning assets: Includes cash and cash equivalents, cash and investments segregated, broker-related receivables, receivables from brokerage clients, investment securities, and bank loans on which Schwab earns interest. Investment grade: Defined as a rating equivalent to a Moody’s Investors Service (Moody’s) rating of “Baa” or higher, or a Standard & Poor’s Rating Group (Standard & Poor’s) or Fitch Ratings, Ltd (Fitch) rating of “BBB-” or higher. Liquidity Coverage Ratio (LCR): The ratio of HQLA to projected net cash outflows during a 30-day stress scenario. Loan-To-Value (LTV) ratio: Calculated as the principal amount of a loan divided by the value of the collateral securing the loan. Margin loans: Advances made to brokerage clients on a secured basis to purchase securities reflected in receivables from brokerage clients on the consolidated balance sheets. Master netting arrangement: An agreement between two counterparties that have multiple contracts with each other that provides for net settlement of all contracts through a single cash payment in the event of default or termination of any one contract. Mortgage-backed securities: A type of asset-backed security that is secured by a mortgage or group of mortgages. Net interest margin: Net interest revenue (annualized for interim periods) divided by average interest-earning assets. Net new client assets: Total inflows of client cash and securities to Schwab less client outflows. Inflows include dividends and interest; outflows include commissions and fees. Capital gains distributions are excluded. Net Stable Funding Ratio (NSFR): Measures an organization’s “available” amount of stable funding relative to its “required” amount of stable funding over a one-year time horizon. New brokerage accounts: All brokerage accounts opened during the period, as well as any accounts added via acquisition. Nonperforming assets: The total of nonaccrual loans and other real estate owned. Order flow revenue: Net compensation received from markets and firms to which CS&Co sends equity and options orders. The amount reflects rebates received for certain types of orders, less fees paid for orders where exchange fees or other charges apply. Pledged Asset Line® (PAL): A non-purpose revolving line of credit from CSB secured by eligible assets held in a separate pledged brokerage account maintained at CS&Co. Return on average common stockholders’ equity: Calculated as net income available to common stockholders (annualized for interim periods) divided by average common stockholders’ equity. - 23 - THE CHARLES SCHWAB CORPORATION Management’s Discussion and Analysis of Financial Condition and Results of Operations (Tabular Amounts in Millions, Except Ratios, or as Noted) Risk-weighted assets: Computed by assigning specific risk-weightings to assets and off-balance sheet instruments for capital adequacy calculations. Tier 1 Capital: The sum of CET1 Capital and additional Tier 1 Capital instruments and related surplus, less applicable adjustments and deductions. Tier 1 Leverage Ratio: End-of-period Tier 1 Capital divided by adjusted average total consolidated assets for the quarter. Trading days: Days in which the markets/exchanges are open for the buying and selling of securities. Early market closures are counted as half-days. U.S. federal banking agencies: Refers to the Federal Reserve, the OCC, the FDIC, and the CFPB. Uniform Net Capital Rule: Refers to Rule 15c3-1 under the Securities Exchange Act of 1934, which specifies minimum capital requirements that are intended to ensure the general financial soundness and liquidity of broker-dealers at all times. - 24 - THE CHARLES SCHWAB CORPORATION Management’s Discussion and Analysis of Financial Condition and Results of Operations (Tabular Amounts in Millions, Except Ratios, or as Noted) OVERVIEW Management focuses on several client activity and financial metrics in evaluating Schwab’s financial position and operating performance. We believe that metrics relating to net new and total client assets, as well as client cash levels and utilization of advisory services, offer perspective on our business momentum and client engagement. Data on new and total client brokerage accounts provides additional perspective on our ability to attract and retain new business. Total net revenue growth, pre-tax profit margin, EPS, return on average common stockholders’ equity, and the Consolidated Tier 1 Leverage Ratio provide broad indicators of Schwab’s overall financial health, operating efficiency, and ability to generate acceptable returns. Total expenses, excluding interest, as a percentage of average client assets, is a measure of operating efficiency. Results for the years ended December 31, 2018, 2017, and 2016 are as follows: (1) 2018 includes outflows of $93.9 billion from certain mutual fund clearing services clients. 2017 includes inflows of $34.5 billion from certain mutual fund clearing services clients. 2018 Compared to 2017 Net income increased by $1.2 billion, or 49%, in 2018, driven primarily by business momentum, a supportive economic environment for much of the year, and lower corporate tax rates. Continued execution of our ‘Through Clients’ Eyes’ strategy helped us succeed with clients. In 2018, clients opened 1.6 million new brokerage accounts, helping bring active brokerage accounts to 11.6 million at the end of the year, and core net new assets totaled $227.8 billion, up 15% from the 2017 total. Our strong net new assets largely offset lower market valuations, and we ended 2018 at $3.25 trillion in total client assets. Total net revenue grew by $1.5 billion, or 18%, in 2018 primarily due to an increase of $1.5 billion, or 36%, in net interest revenue. The Fed raised the overnight federal funds target interest rate four times in 2018 for a total of 100 basis points. The growth of total net revenue resulted from higher interest rates due to the Fed’s rate normalization, and also from higher - 25 - THE CHARLES SCHWAB CORPORATION Management’s Discussion and Analysis of Financial Condition and Results of Operations (Tabular Amounts in Millions, Except Ratios, or as Noted) interest-earning assets, which reflect both client cash allocations and the transfer of sweep money market funds to bank and broker-dealer sweep. As we progressed with these transfers, the corresponding money market fund asset management and administration fee revenue naturally declined, yet positive inflows in advice solutions, Schwab equity and bond funds and ETFs, and other third-party mutual funds and ETFs kept asset management fees at $3.2 billion, limiting the decrease to 5% from 2017. Record trading activity from our clients resulted in trading revenue reaching $763 million, an increase of 17% from the prior year. Our increase in total expenses excluding interest of $602 million, or 12%, reflected our 2018 investments to support and fuel our business growth, including hiring additional client-facing and other employees and technology project spending, as well as an increase in marketing and a special stock award of $36 million to our employees. Even with these increases, expenses as a percentage of client assets remained consistent at 16 basis points, and pre-tax income increased 25% to $4.6 billion in 2018, resulting in a pre-tax profit margin of 45.0%. As a result of the Tax Cuts and Jobs Act of 2017 (the Tax Act), taxes on income decreased 19% in 2018, resulting in an effective tax rate of 23.1%. Overall, we generated a 19% return on equity and diluted EPS of $2.45 for the year. During 2018, the Board of Directors raised the quarterly cash dividend 63% to $0.13 per share and authorized a $1.0 billion Share Repurchase Program, which we completed during the fourth quarter. These actions reflected the Company’s strong financial performance and our confidence in its long-term success; they also demonstrated that effective capital management at Schwab can support both healthy business growth and more meaningful capital returns to stockholders. 2017 Compared to 2016 Net income available to common stockholders rose in 2017 by $434 million, or 25%, from the prior year, resulting in diluted EPS of $1.61 in 2017 - an increase of 23% compared to $1.31 in 2016. Net revenues improved by $1.1 billion, or 15%, while expenses excluding interest increased $483 million, or 11%, compared to 2016. Our steady focus on operating ‘through clients’ eyes’ and our goal to continually challenge the status quo helped Schwab achieve another strong growth year in 2017. Clients opened 1.4 million new brokerage accounts in 2017 and trusted Schwab with $198.6 billion of core net new assets in 2017, up 58% from 2016. Total assets receiving ongoing advisory services grew 21% in 2017 to $1.70 trillion. Our success with clients was bolstered by strength in the equity markets - the Standard & Poor’s 500® Index (S&P 500) finished 2017 up 19% from the prior year end. Also in 2017, the Federal Reserve increased the overnight federal funds target interest rate three times for a total of 75 basis points. Strong client activity and the positive economic environment resulted in total client assets rising to $3.36 trillion as of December 31, 2017 - a 21% increase since the end of 2016. Schwab’s 2017 financial results demonstrate the power of our financial formula working as designed: our robust business growth supported strong revenue growth through multiple sources in 2017, which we combined with continued expense discipline to drive significantly improved profitability. Net revenues grew by 15% in 2017 compared to 2016 through contributions from our two largest revenue sources. Net interest revenue rose 29% while asset management and administration fees grew 11% in 2017 when compared to the prior year. Trading revenue declined in 2017 by 21% due to price reductions announced early in 2017. Consistent with our expectations, expenses grew 11% in 2017 compared to the prior year. This increase was primarily due to higher incentive compensation and higher staffing related to our strong asset gathering, as well as expenses related to project spending and third-party fees tied to higher balances in our asset management business. This combination of revenue growth and expense discipline drove the pre-tax profit margin to 42.4% - an increase of 240 basis points over the prior year. Earnings before income taxes rose 22% to $3.7 billion in 2017 compared to $3.0 billion in the prior year. The effective tax rate in 2017 was 35.5% compared to 36.9% in 2016 reflecting the benefit from the adoption of new accounting standards requiring the recognition of a portion of tax deductions related to equity compensation partially offset by the remeasurement of deferred tax assets and other tax adjustments associated with the 2017 enactment of the Tax Act. - 26 - THE CHARLES SCHWAB CORPORATION Management’s Discussion and Analysis of Financial Condition and Results of Operations (Tabular Amounts in Millions, Except Ratios, or as Noted) Subsequent Event On January 30, 2019, CSC publicly announced that its Board of Directors authorized a new Share Repurchase Program to repurchase up to $4.0 billion of common stock, and declared a four cent, or 31%, increase in the quarterly cash dividend to $0.17 per common share. The share repurchase authorization does not have an expiration date. Current Regulatory Environment and Other Developments On October 31, 2018, the Federal Reserve issued a notice of proposed rulemaking and the Federal Reserve, the OCC and the FDIC jointly issued another notice of proposed rulemaking. The two proposals would establish a revised framework for applying enhanced prudential standards to large U.S. banking organizations, with four categories of standards that reflect the risks of banking organizations in each group. CSC would be in Category III based on having $250 billion - $700 billion in total assets. The Federal Reserve proposal, which would make large savings and loan holding companies such as CSC subject to enhanced prudential standards, would tailor those regulatory requirements relating to capital stress testing, risk management, liquidity risk management, and single-counterparty credit limits based on the category of the banking organization. The proposal provides that Category III banking organizations would be subject to annual supervisory stress testing and biennial company-run stress testing. The interagency proposal would similarly tailor requirements under the agencies’ capital rule, LCR rule, and the proposed net stable funding ratio rule for banking organizations in each category. Under the proposal, banking organizations in Category III would not be required to calculate their risk-weighted assets using the “advanced approaches” framework or to include AOCI in calculating their regulatory capital; however, they would continue to be subject to the supplementary leverage ratio and any future countercyclical capital buffer imposed by the banking agencies. Although the Federal Reserve announced in its proposal that additional capital planning and resolution planning proposals would be issued at a later date, the agency did indicate that all Category III firms, including savings and loan holding companies, would be required to submit annual capital plans that would be subject to qualitative and quantitative assessments evaluated as part of the CCAR process. The comment period for both proposed rules ended on January 22, 2019 and the impact to Schwab cannot be assessed until the final rule is released. On December 22, 2017, P.L.115-97, the Tax Act, was signed into law, and became effective on January 1, 2018. Among other things, the Tax Act lowered the federal corporate income tax rate from 35% to 21%. As a result of the reduction of the federal corporate income tax rate, generally accepted accounting principles in the U.S. (GAAP) require companies to remeasure their deferred tax assets and deferred tax liabilities as of the date of enactment, with the resulting tax effects accounted for in the reporting period of enactment. Schwab recorded a one-time non-cash charge to taxes on income associated with the remeasurement of net deferred tax assets and other tax adjustments related to the tax reform legislation in the fourth quarter of 2017. Our 2018 effective income tax rate was reduced as a result of these changes. In May 2016, the Federal Reserve, the OCC and the FDIC jointly issued a notice of proposed rulemaking that would impose a minimum NSFR on certain banking organizations, including CSC. The comment period for the proposed rule ended on August 5, 2016 and the impact to the Company cannot be assessed until the final rule is released. - 27 - THE CHARLES SCHWAB CORPORATION Management’s Discussion and Analysis of Financial Condition and Results of Operations (Tabular Amounts in Millions, Except Ratios, or as Noted) RESULTS OF OPERATIONS Total Net Revenues Total net revenues of $10.1 billion and $8.6 billion for the years ended December 31, 2018 and 2017, respectively, represented growth of 18% and 15% from the prior periods, primarily due to increases in net interest revenue. Net Interest Revenue Schwab’s primary interest-earning assets include cash and cash equivalents; cash and investments segregated; margin loans, which constitute the majority of receivables from brokerage clients; investment securities; and bank loans. Revenue on interest-earning assets is affected by various factors, such as the composition of assets, prevailing interest rates at the time of origination or purchase, changes in interest rates on floating rate securities and loans, and changes in prepayment levels for mortgage-related securities and loans. Fees earned on securities borrowing and lending activities, which are conducted by CS&Co using assets held in client brokerage accounts, are included in other interest revenue and expense. Schwab’s interest-bearing liabilities include bank deposits, payables to brokerage clients, short-term borrowings, and long-term debt. We establish the rates paid on client-related liabilities, and management expects that it will generally adjust the rates paid on these liabilities at some fraction of any movement in short-term rates. During 2018, these liabilities rose by a total of $63.3 billion, largely reflecting the effect of: our transferring a total of $72 billion sweep money market funds to bank and broker-dealer sweep; clients choosing to reallocate assets between cash, equities, fixed income and other investments; and the Company gathering additional flows from new and current clients. Overall, management believes that the extended period of extraordinarily low interest rates running from the financial crisis until recently has likely resulted in certain sweep cash balances retaining some level of latent rate sensitivity. With the Federal Funds Target Rate having increased to 2.25 - 2.50%, management expects some sweep cash balances could migrate to alternatives, including purchased money market funds, that offer higher yields to clients but lower revenue to Schwab. Given the general stability and relatively low rate sensitivity of client-related liabilities, management believes their duration is at least several years. We have positioned Schwab to benefit from an increase in interest rates, especially short-term interest rates, by managing the duration of interest-earning assets to be shorter than that of interest-bearing liabilities, so that asset yields are expected to move faster than liability costs. - 28 - THE CHARLES SCHWAB CORPORATION Management’s Discussion and Analysis of Financial Condition and Results of Operations (Tabular Amounts in Millions, Except Ratios, or as Noted) In order to keep interest-rate sensitivity within established limits, management monitors and responds to changes in the balance sheet. As Schwab builds its client base, we attract new client sweep cash, which, along with the transfers of existing sweep cash balances from money market funds, is a primary driver of balance sheet growth. By managing the duration of interest-earning assets as necessary, we are positioned to continue to gain from increasing rates while limiting exposure to falling rates to an acceptable level. Approximately half of our interest earning assets re-price or reset based on short-term interest rates such as one-month LIBOR. Non-interest-bearing funding sources include certain cash balances, stockholders’ equity and other miscellaneous assets and liabilities. The following table presents net interest revenue information corresponding to interest-earning assets and funding sources on the consolidated balance sheets: (1) Amounts have been calculated based on amortized cost. Net interest revenue increased $1.5 billion or 36%, in 2018 from 2017, and $960 million, or 29%, in 2017 from 2016, primarily due to higher interest rates and growth in interest-earning assets. Our net interest margin improved 32 basis points to 2.29% in 2018, primarily as a result of the Federal Reserve’s 2017 and 2018 interest rate increases, partially offset by higher interest rates paid on bank deposits and other interest-bearing liabilities. Our net interest margin was 1.97% in 2017, representing an improvement of 24 basis points compared to 2016, primarily due to the Federal Reserve’s interest rate increases in 2016 and 2017. Average interest earning assets grew 16% and 14% during 2018 and 2017, respectively, compared with the sequential prior years. These increases primarily reflect higher bank deposits due to transfers from sweep money market funds to bank sweep balances, as well as changes in client cash allocations, partially offset by client purchases of other assets. In March 2017, $24.7 billion of debt securities were transferred from the AFS category to the HTM category. The transfer had no effect on the overall net interest margin. For additional information on the transfer, see Item 8 - Note 6. - 29 - THE CHARLES SCHWAB CORPORATION Management’s Discussion and Analysis of Financial Condition and Results of Operations (Tabular Amounts in Millions, Except Ratios, or as Noted) Asset Management and Administration Fees Asset management and administration fees include mutual fund and ETF service fees and fees for other asset-based financial services provided to individual and institutional clients. Schwab earns mutual fund and ETF service fees for shareholder services, administration, and investment management provided to its proprietary funds, and recordkeeping and shareholder services provided to third-party funds. Asset management and administration fees are based upon the daily balances of client assets invested in these funds and do not include securities lending revenues earned by proprietary mutual funds and ETFs, as those amounts, net of program fees, are credited to the fund shareholders. The fair values of client assets included in proprietary and third-party mutual funds and ETFs are based on quoted market prices and other observable market data. We also earn asset management fees for advice solutions, which include managed portfolios, specialized strategies, and customized investment advice. Other asset management and administration fees include various asset-based fees such as trust fees, 401(k) recordkeeping fees, mutual fund clearing fees, collective trust fund fees, and non-balance based service and transaction fees. Asset management and administration fees vary with changes in the balances of client assets due to market fluctuations and client activity. The following table presents asset management and administration fees, average client assets, and average fee yields: (1) Includes Schwab ETF OneSource™. (2) Beginning in the fourth quarter of 2017, a change was made to add non-fee based average assets from managed portfolios. Average client assets for advice solutions may also include the asset balances contained in the mutual fund and/or ETF categories listed above. Prior periods have been adjusted to accommodate this change. (3) Includes various asset-related fees, such as trust fees, 401(k) recordkeeping fees, and mutual fund clearing fees and other service fees. Beginning in the first quarter of 2017, a prospective methodology change was made to average client assets relating to 401(k) recordkeeping fees to provide improved insight into the associated fee driver, which resulted in an increase of approximately $25 billion. There was no impact to revenue or the average fee. (4) Includes miscellaneous service and transaction fees relating to mutual funds and ETFs that are not balance-based. Asset management and administration fees decreased by $163 million, or 5%, in 2018 from 2017, primarily due to lower money market fund revenue as a result of transfers to bank sweep, client asset allocation choices, and our 2017 fee reductions. Part of the decline was offset by revenue from growing asset balances in advice solutions, Schwab equity and bond funds and ETFs, and other third-party mutual funds and ETFs. - 30 - THE CHARLES SCHWAB CORPORATION Management’s Discussion and Analysis of Financial Condition and Results of Operations (Tabular Amounts in Millions, Except Ratios, or as Noted) Asset management and administration fees increased by $337 million, or 11%, in 2017 from 2016 due to higher average client assets invested in advice solutions, mutual funds and ETFs, and lower fee waivers on money market funds. Partially offsetting these increases were lower fee rates on proprietary money funds and other indexed mutual funds and ETFs due to fee reductions implemented by Schwab in 2017. The following table presents a roll forward of client assets for the Schwab money market funds, Schwab equity and bond funds and ETFs, and Mutual Fund OneSource® and other non-transaction fee (NTF) funds. The following funds generated 47%, 53%, and 53% of the asset management and administration fees earned during 2018, 2017, and 2016, respectively: (1) Includes net inflows from other third-party mutual funds to Mutual Fund OneSource® in the second quarter of 2017. Trading Revenue Trading revenue includes commission and principal transaction revenues. Commission revenue is affected by the number of revenue trades executed and the average revenue earned per revenue trade. Principal transaction revenue is primarily comprised of revenue from trading activity in fixed income securities with clients. To accommodate clients’ fixed income trading activity, Schwab maintains positions in fixed income securities, including U.S. state and municipal debt obligations, U.S. Government and corporate debt, and other securities. The difference between the price at which the Company buys and sells securities to and from its clients and other broker-dealers is recognized as principal transaction revenue. Principal transaction revenue also includes adjustments to the fair value of these securities positions. The following table presents trading revenue and the related drivers: Trading revenue increased by $109 million, or 17%, in 2018 compared to 2017. DART volumes increased 31% in 2018, which more than offset Schwab’s commission pricing reductions implemented in the first quarter of 2017. Trading revenue decreased by $171 million in 2017 from 2016, primarily due to lower commissions rates on DARTs. During the first quarter of 2017, we announced two trading price reductions which lowered standard equity, ETF, and option trade commissions from $8.95 to $4.95 and lowered the per contract option fee from $.75 to $.65. These reductions in commission rates reflect our continuing belief that pricing should never be an obstacle for choosing Schwab and our commitment to share the benefits of scale with clients. With these changes, trading revenue has declined from a peak of 50%-60% of total revenue in the early 1990’s to the current low of 8% in 2018, 8% in 2017, and 11% in 2016. Other Revenue Other revenue includes order flow revenue, other service fees, software fees from our portfolio management solutions, exchange processing fees, and non-recurring gains. Order flow revenue was $139 million during 2018, $114 million for 2017, and $103 million in 2016. These increases were primarily due to higher rebate rates received on certain types of - 31 - THE CHARLES SCHWAB CORPORATION Management’s Discussion and Analysis of Financial Condition and Results of Operations (Tabular Amounts in Millions, Except Ratios, or as Noted) orders and higher volume of trades. In 2016, other revenue also included net litigation proceeds of $16 million related to our non-agency residential mortgage-backed securities portfolios. Total Expenses Excluding Interest The following table shows a comparison of total expenses excluding interest: ໿ Expenses excluding interest increased in 2018 and 2017 from the prior years by 12% and 11%, respectively. The largest drivers of the increase in both years were compensation and benefits and professional services. Total compensation and benefits increased in 2018 and 2017 from prior years, primarily due to increases in employee headcount to support our expanding client base. Additionally, in 2018 non-officer employees were issued special stock awards totaling $36 million. Professional services expense increased in 2018 and 2017 from the prior years, primarily due to higher spending on technology projects as well as an increase in asset management and administration related expenses resulting from growth in the Schwab Funds® and Schwab ETFs™. Occupancy and equipment expense increased in 2018 and 2017 from the prior years, primarily due to an increase in software maintenance expenses and additional licenses to support growth in the business. Advertising and market development expense rose in 2018, primarily reflecting management’s decision to increase television advertising and digital media spending in the fourth quarter. Depreciation and amortization expenses grew in 2018 and 2017 from the prior years, primarily due to higher amortization of internally developed software associated with our investments in software and technology enhancements. - 32 - THE CHARLES SCHWAB CORPORATION Management’s Discussion and Analysis of Financial Condition and Results of Operations (Tabular Amounts in Millions, Except Ratios, or as Noted) Regulatory fees assessments increased in 2018 and 2017 from the prior years, due to an increase in FDIC insurance assessments which rose as a result of higher average assets in deposit balances. This increase in 2018 was partially offset by the elimination of the FDIC surcharge in the fourth quarter of 2018. Other expenses increased in 2018 from 2017 due to travel and entertainment and miscellaneous items due to overall growth in our business. Other expenses increased in 2017 from 2016 due to travel and entertainment, asset volume-related increases, and some miscellaneous items. Capital expenditures were $576 million, $412 million, and $353 million in 2018, 2017, and 2016, respectively. The increase in capital expenditures in both 2018 and 2017 from the prior years was primarily due to the expansion of our campuses in the U.S. and investments in technology projects. The largest component of capital expenditures in 2018 was investment in buildings of $253 million. Capitalized costs for developing internal-use software totaled $167 million, $157 million, and $130 million in 2018, 2017, and 2016, respectively. Our capital expenditures for 2018 came in at the lower end of our estimated range of 6-7% of total net revenues, largely due to the timing of our campus expansion work. As we carry this work forward in 2019 and invest further in technology projects, we anticipate capital expenditures for the year will reach approximately 7-9% of total net revenues. Our longer term expectation for capital expenditures remains in the range of 3-5% of total net revenues. Taxes on Income As previously discussed under Current Regulatory Environment and Other Developments, the Tax Act was signed into law during 2017. Among other things, the Tax Act lowered the federal corporate income tax rate from 35% to 21%, beginning in 2018. Also as a result of the Tax Act, Schwab recognized a $46 million one-time non-cash charge to taxes on income in the fourth quarter of 2017 associated with the remeasurement of net deferred tax assets and other tax adjustments related to the Tax Act. Effective January 1, 2017, Schwab adopted Accounting Standards Update (ASU) 2016-09, which prospectively changed the accounting treatment of a portion of the tax deductions relating to equity compensation. These deductions were previously reflected directly in additional paid-in capital, a component of stockholders’ equity, and are now included in taxes on income, a component of net income. As a result of this change, our tax expense was reduced by approximately $46 million and $87 million in 2018 and 2017, respectively. Future effects will depend on our share price, restricted stock vesting, and the volume of equity incentive options exercised. Schwab’s effective income tax rate on income before taxes was 23.1% in 2018, 35.5% in 2017, and 36.9% in 2016. The decrease in rates over this three-year time period was primarily due to the net impact of the above items. Segment Information Schwab provides financial services to individuals and institutional clients through two segments - Investor Services and Advisor Services. The Investor Services segment provides retail brokerage and banking services, retirement plan services, and other corporate brokerage services to individual investors. The Advisor Services segment provides custodial, trading, banking, and support services as well as retirement business services to independent RIAs, independent retirement advisors and recordkeepers. Revenues and expenses are attributed to the two segments based on which segment services the client. Management evaluates the performance of the segments on a pre-tax basis. Segment assets and liabilities are not used for evaluating segment performance or in deciding how to allocate resources to segments. Net revenues in both segments are generated from the underlying client assets and trading activity; differences in the composition of net revenues between the segments are based on the composition of client assets, client trading frequency, and pricing unique to each. While both segments leverage the scale and efficiency of our platforms, segment expenses reflect the dynamics of serving millions of clients in Investor Services versus the thousands of RIAs on the advisor platform. - 33 - THE CHARLES SCHWAB CORPORATION Management’s Discussion and Analysis of Financial Condition and Results of Operations (Tabular Amounts in Millions, Except Ratios, or as Noted) Financial information for our segments is presented in the following table: Investor Services Total net revenues increased by $1.1 billion, or 18%, in 2018 from 2017 primarily due to an increase in net interest revenue, partially offset by lower asset management and administration fees. Net interest revenue increased primarily due to higher net interest margins and higher balances of interest-earning assets. Asset management and administration fees decreased primarily due to lower money market fund revenue as a result of transfers to bank sweep, client asset allocation choices, and our 2017 fee reductions. Expenses excluding interest increased by $420 million, or 11%, in 2018 from 2017 primarily due to higher compensation and benefits, technology project spend, and asset management and administration related expenses to support our expanding client base. Total net revenues increased by $789 million, or 15%, in 2017 from 2016 primarily due to increases in net interest revenue and asset management and administration fees, partially offset by a decrease in trading revenue. Net interest revenue increased primarily due to higher net interest margins and higher balances of interest-earning assets. Asset management and administration fees increased primarily due to higher client assets enrolled in advisory solutions and higher net fees on money market fund assets. Trading revenue decreased primarily due to lower commission rates. Expenses excluding interest increased by $345 million, or 10%, in 2017 from 2016 primarily due to higher compensation and benefits, technology project spend, asset management and administration related expenses, and regulatory fee assessments. Advisor Services Total net revenues increased by $393 million or 16%, in 2018 from 2017 primarily due to an increase in net interest revenue, partially offset by lower asset management and administration fees. Net interest revenue increased primarily due to higher net interest margins and higher balances of interest-earning assets. Asset management and administration fees decreased primarily due to lower money market fund revenue as a result of transfers to bank sweep, client asset allocation choices, and our 2017 fee reductions. Expenses excluding interest increased by $182 million, or 15%, in 2018 from 2017 primarily due to higher compensation and benefits, technology project spend, and asset management and administration related expenses to support our expanding client base. Total net revenues increased by $351 million, or 17%, in 2017 from 2016 primarily due to increases in net interest revenue and asset management and administration fees, partially offset by a decrease in trading revenue. Net interest revenue increased primarily due to higher balances of interest-earning assets and higher net interest margins. Asset management and administration fees increased primarily due to higher fees from growth in client assets invested in ETFs and equity and bond funds, and higher net fees on money market fund assets. Trading revenue decreased primarily due to lower commission rates. Expenses excluding interest increased by $138 million, or 12%, in 2017 from 2016 primarily due to higher compensation and benefits, technology project spend, asset management and administration related expenses, and regulatory fee assessments. - 34 - THE CHARLES SCHWAB CORPORATION Management’s Discussion and Analysis of Financial Condition and Results of Operations (Tabular Amounts in Millions, Except Ratios, or as Noted) RISK MANAGEMENT Schwab’s business activities expose it to a variety of risks, including operational, credit, market, liquidity, and compliance risks. The Company has a comprehensive risk management program to identify and manage these risks and their associated potential for financial and reputational impact. Despite our efforts to identify areas of risk and implement risk management policies and procedures, there can be no assurance that Schwab will not suffer unexpected losses due to these risks. Our risk management process is comprised of risk identification and assessment, risk measurement, risk monitoring and reporting, and risk mitigation. The activities and governance that comprise the risk management process are described below. Culture The Board of Directors has approved an Enterprise Risk Management (ERM) framework that incorporates our purpose, vision, and values, which form the bedrock of our corporate culture and set the tone for the organization. We designed the ERM Framework to enable a comprehensive approach to managing risks encountered by Schwab in its business activities. The framework incorporates key concepts commensurate with the size, risk profile, complexity, and continuing growth of the Company. Risk appetite, which is defined as the amount of risk the Company is willing to accept in pursuit of its corporate strategy, is developed by executive management and approved by the Board of Directors. Risk Governance Senior management takes an active role in the risk management process and has developed policies and procedures under which specific business and control units are responsible for identifying, measuring, and controlling risks. The Global Risk Committee, which is comprised of senior executives from each major business and control function, is responsible for the oversight of risk management. This includes identifying emerging risks, assessing risk management practices and the control environment, reinforcing business accountability for risk management, supervisory controls and regulatory compliance, supporting resource prioritization across the organization, and escalating significant issues to the Board of Directors. We have established risk metrics and reporting that enable measurement of the impact of strategy execution against risk appetite. The risk metrics, with risk limits and tolerance levels, are established for key risk categories by the Global Risk Committee and its functional risk sub-committees. The Chief Risk Officer regularly reports activities of the Global Risk Committee to the Risk Committee of the Board of Directors. The Board Risk Committee in turn assists the Board of Directors in fulfilling its oversight responsibilities with respect to our risk management program, including approving risk appetite statements and related key risk appetite metrics and reviewing reports relating to risk issues from functional areas of risk management, legal, compliance, and internal audit. Functional risk sub-committees focusing on specific areas of risk report to the Global Risk Committee. These sub-committees include the: • Compliance Risk Committee - provides oversight of compliance risk management programs and policies providing an aggregate view of compliance risk exposure, and includes a subcommittee covering Fiduciary Risk; • Financial Risk Oversight Committee - provides oversight of and approves capital, credit, liquidity, and market risk policies, limits, and exposures; • New Products and Services Risk Oversight Committee - provides oversight of, and approves corporate policy and procedures relating to the risk governance of new products and services; and • Operational Risk Oversight Committee - provides oversight of and approves operational risk management policies, risk tolerance levels, and operational risk governance processes, and includes sub-committees covering Fraud, Data, Information Security, Model Governance, and Third-Party risk. - 35 - THE CHARLES SCHWAB CORPORATION Management’s Discussion and Analysis of Financial Condition and Results of Operations (Tabular Amounts in Millions, Except Ratios, or as Noted) Senior management has also created an Incentive Compensation Risk Oversight Committee, which establishes policy and reviews and approves the Annual Risk Assessment of incentive compensation plans, and reports directly to the Compensation Committee of the Board of Directors. The Company’s compliance, finance, internal audit, legal, and corporate risk management departments assist management and the various risk committees in evaluating, testing, and monitoring risk management. In addition, the Disclosure Committee is responsible for monitoring and evaluating the effectiveness of our disclosure controls and procedures and internal control over financial reporting as of the end of each fiscal quarter. The Disclosure Committee reports on this evaluation to the CEO and CFO prior to their certification required by Sections 302 and 906 of the Sarbanes Oxley Act of 2002. Operational Risk Operational risks arise due to potential inadequacies or failures related to people, internal processes, and systems, or from external events or relationships impacting the Company and/or any of its key business partners and third parties. While operational risk is inherent in all business activities, we rely on a system of internal controls and risk management practices designed to keep operational risk and operational losses within the Company’s risk appetite. We have specific policies and procedures to identify and manage operational risk, and use periodic risk and control self-assessments, control testing programs, and internal audit reviews to evaluate the effectiveness of these internal controls. Where appropriate, we manage the impact of operational loss and litigation expense through the purchase of insurance. The insurance program is specifically designed to address our key operational risks and to maintain compliance with local laws and regulation. Schwab’s operations are highly dependent on the integrity and resilience of our critical business functions and technology systems. To the extent Schwab experiences business or system interruptions, errors or downtime (which could result from a variety of causes, including natural disasters, terrorist attacks, technological failure, cyber attacks, changes to systems, linkages with third-party systems, and power failures), our business and operations could be negatively impacted. To minimize business interruptions and ensure the capacity to continue operations during an incident regardless of duration, Schwab maintains a backup and recovery infrastructure which includes facilities for backup and communications, a geographically dispersed workforce, and routine testing of business continuity and disaster recovery plans and a well-established incident management program. Information Security risk is the risk of unauthorized access, use, disclosure, disruption, modification, recording or destruction of the firm’s information or systems. We have designed and implemented an information security program that knits together complementary tools, controls and technologies to protect systems, client accounts and data. We continuously monitor the systems and work collaboratively with government agencies, law enforcement and other financial institutions to address potential threats. We use advanced monitoring systems to identify suspicious activity and deter unauthorized access by internal or external actors. We limit the number of employees who have access to clients’ personal information and internal authentication measures are enforced to protect against the potential for social engineering. All employees who handle sensitive information are trained in privacy and security. Schwab’s fraud and cyber security teams monitor activity looking for suspicious behavior. These capabilities allow us to identify and quickly act on any attempted intrusions. Schwab also faces operational risk when we employ the services of various third parties, including domestic and international outsourcing of certain technology, processing, servicing, and support functions. We manage the exposure to third party risk and promote a culture of resiliency through contractual provisions, control standards, ongoing monitoring of third party performance, and appropriate testing. We maintain policies and procedures regarding the standard of care expected with all data, whether the data is internal company information, employee information, or non-public client information. We clearly define for employees, contractors, and third parties the expected standards of care for confidential data. We also provide regular training on data security. Model risk is the potential for adverse consequences from decisions based on incorrect or misused model outputs and reports. Models are owned by several business units throughout the organization, and are used for a variety of purposes. Model use includes, but is not limited to, calculating capital requirements for hypothetical stressful environments, estimating interest and credit risk for loans and other balance sheet assets, and providing guidance in the management of client portfolios. We have established a policy to describe the roles and responsibilities of all key stakeholders in model development, management, and use. All models are registered in a centralized database and classified into different risk - 36 - THE CHARLES SCHWAB CORPORATION Management’s Discussion and Analysis of Financial Condition and Results of Operations (Tabular Amounts in Millions, Except Ratios, or as Noted) ratings depending on their potential financial, reputational, or regulatory impact to the Company. The model risk rating determines the scope of model governance activities. Compliance Risk Schwab faces compliance risk which is the potential exposure to legal or regulatory sanctions, fines or penalties, financial loss, or damage to reputation resulting from the failure to comply with laws, regulations, rules, or other regulatory requirements. Among other things, compliance risks relate to the suitability of client investments, conflicts of interest, disclosure obligations and performance expectations for products and services, supervision of employees, and the adequacy of our controls. The Company and its affiliates are subject to extensive regulation by federal, state and foreign regulatory authorities, including SROs. We manage compliance risk through policies, procedures and controls reasonably designed to achieve and/or monitor compliance with applicable legal and regulatory requirements. These procedures address issues such as business conduct and ethics, sales and trading practices, marketing and communications, extension of credit, client funds and securities, books and records, anti-money laundering, client privacy, and employment policies. Fiduciary risk is the potential for financial or reputational loss through breach of fiduciary duties to a client. Fiduciary activities include, but are not limited to, individual and institutional trust, investment management, custody, and cash and securities processing. We manage this risk by establishing policy and procedures to ensure that obligations to clients are discharged faithfully and in compliance with applicable legal and regulatory requirements. Business units have the primary responsibility for adherence to the policy and procedures applicable to their business. Guidance and control are provided through the creation, approval, and ongoing review of applicable policies by business units and various risk committees. Credit Risk Credit risk is the potential for loss due to a borrower, counterparty, or issuer failing to perform on its contractual obligations. Our exposure to credit risk mainly results from investing activities in our liquidity and investment portfolios, mortgage lending, margin lending and client option and futures activities, pledged asset lending, securities lending activities, and our role as a counterparty in other financial contracts. To manage the risks of such losses, we have established policies and procedures, which include establishing and reviewing credit limits, monitoring of credit limits and quality of counterparties, and adjusting margin, PAL, option, and futures requirements for certain securities and instruments. Liquidity and Investment Portfolios Schwab has exposure to credit risk associated with its investment portfolios, which include U.S. agency, and non-agency mortgage-backed securities, asset-backed securities, corporate debt securities, U.S. agency notes, U.S. Treasury securities, certificates of deposit, U.S. state and municipal securities, commercial paper, and foreign government agency securities. At December 31, 2018, substantially all securities in the investment portfolios were rated investment grade. U.S. agency mortgage-backed securities do not have explicit credit ratings; however, management considers these to be of the highest credit quality and rating given the guarantee of principal and interest by the U.S. government or U.S. government-sponsored enterprises. Mortgage Lending Portfolio The bank loan portfolio includes First Mortgages, HELOCs, and other loans. The credit risk exposure related to loans is actively managed through individual loan and portfolio reviews. Management regularly reviews asset quality, including concentrations, delinquencies, nonaccrual loans, charge-offs, and recoveries. All are factors in the determination of an appropriate allowance for loan losses. Our residential loan underwriting guidelines include maximum LTV ratios, cash out limits, and minimum Fair Isaac Corporation (FICO) credit scores. The specific guidelines are dependent on the individual characteristics of a loan (for example, whether the property is a primary or secondary residence, whether the loan is for investment property, whether the loan is for an initial purchase of a home or refinance of an existing home, and whether the loan size is conforming or jumbo). - 37 - THE CHARLES SCHWAB CORPORATION Management’s Discussion and Analysis of Financial Condition and Results of Operations (Tabular Amounts in Millions, Except Ratios, or as Noted) Schwab does not originate or purchase residential loans that allow for negative amortization and does not originate or purchase subprime loans (generally defined as extensions of credit to borrowers with a FICO score of less than 620 at origination), unless the borrower has compensating credit factors. For more information on credit quality indicators relating to Schwab’s bank loans, see Item 8 - Note 7. Securities and Instrument-Based Lending Portfolios Collateral arrangements relating to margin loans, PALs, option and futures positions, securities lending agreements, and resale agreements include provisions that require additional collateral in the event of market fluctuations. Additionally, for margin loans, PALs, options and futures positions, and securities lending agreements, collateral arrangements require that the fair value of such collateral sufficiently exceeds the credit exposure in order to maintain a fully secured position. Other Counterparty Exposures Schwab performs clearing services for all securities transactions in its client accounts. Schwab has exposure to credit risk due to its obligation to settle transactions with clearing corporations, mutual funds, and other financial institutions even if Schwab’s clients or a counterparty fail to meet their obligations to Schwab. Market Risk Market risk is the potential for changes in earnings or the value of financial instruments held by Schwab as a result of fluctuations in interest rates, equity prices, or market conditions. We are exposed to interest rate risk primarily from changes in market interest rates on our interest-earning assets relative to changes in the costs of its funding sources that finance these assets. Net interest revenue is affected by various factors, such as the distribution and composition of interest-earning assets and interest-bearing liabilities, the spread between yields earned on interest-earning assets and rates paid on interest-bearing liabilities, which may reprice at different times or by different amounts, and the spread between short and long-term interest rates. Interest-earning assets primarily include investment securities, margin loans and bank loans. These assets are sensitive to changes in interest rates and changes in prepayment levels that tend to increase in a declining rate environment and decrease in a rising rate environment. Because we establish the rates paid on certain brokerage client cash balances and bank deposits and the rates charged on certain margin and bank loans, and control the composition of our investment securities, we have some ability to manage our net interest spread, depending on competitive factors and market conditions. To mitigate the risk of declining interest revenue, we have established policies and procedures, which include setting guidelines on the amount of net interest revenue at risk, and monitoring the net interest margin and average maturity of our interest-earning assets and funding sources. To remain within these guidelines, we manage the maturity, repricing, and cash flow characteristics of the investment portfolios. Financial instruments are also subject to the risk that valuations will be negatively affected by changes in demand and the underlying market for a financial instrument. We are indirectly exposed to option, futures, and equity market fluctuations in connection with client option and futures accounts, securities collateralizing margin loans to brokerage customers, and client securities loaned out as part of the brokerage securities lending activities. Equity market valuations may also affect the level of brokerage client trading activity, margin borrowing, and overall client engagement with Schwab. Additionally, we earn mutual fund and ETF service fees and asset management fees based upon daily balances of certain client assets. Fluctuations in these client asset balances caused by changes in equity valuations directly impact the amount of fee revenue we earn. Our market risk related to financial instruments held for trading is not material. Net Interest Revenue Simulation For Schwab’s net interest revenue sensitivity analysis, we use net interest revenue simulation modeling techniques to evaluate and manage the effect of changing interest rates. The simulation includes all interest-sensitive assets and liabilities. Key variables in the simulation include the repricing of financial instruments, prepayment, reinvestment, and product pricing assumptions. The simulations involve assumptions that are inherently uncertain and, as a result, cannot precisely estimate the impact of changes in interest rates on net interest revenue. Actual results may differ from simulated results due - 38 - THE CHARLES SCHWAB CORPORATION Management’s Discussion and Analysis of Financial Condition and Results of Operations (Tabular Amounts in Millions, Except Ratios, or as Noted) to balance growth or decline and the timing, magnitude, and frequency of interest rate changes, as well as changes in market conditions and management strategies, including changes in asset and liability mix. If our guidelines for net interest revenue sensitivity are breached, management must report the breach to the Financial Risk Oversight Committee and establish a plan to address the interest rate risk. There were no breaches of Schwab’s net interest revenue sensitivity risk limits during the years ended December 31, 2018 or 2017. As represented by the simulations presented below, our investment strategy is structured to produce an increase in net interest revenue when interest rates rise and, conversely, a decrease in net interest revenue when interest rates fall. The simulations in the following table assume that the asset and liability structure of the consolidated balance sheets would not be changed as a result of the simulated changes in interest rates. As we actively manage the consolidated balance sheets and interest rate exposure, in all likelihood we would take steps to manage additional interest rate exposure that could result from changes in the interest rate environment. The following table shows the simulated net interest revenue change over the next 12 months beginning December 31, 2018 and 2017 of a gradual 100 basis point increase or decrease in market interest rates relative to prevailing market rates at the end of each reporting period. The year-over-year change in net interest revenue sensitivities reflects higher interest rates across the yield curve, and particularly, higher short-term interest rates. Liquidity Risk Liquidity risk is the potential that Schwab will be unable to meet cash flow obligations when they come due without incurring unacceptable losses. Due to its role as a source of financial strength, CSC’s liquidity needs are primarily driven by the liquidity and capital needs of CS&Co, the capital needs of the banking subsidiaries, principal and interest due on corporate debt, dividend payments on CSC’s preferred stock, and returns of capital to common stockholders. The liquidity needs of CS&Co are primarily driven by client activity including trading and margin borrowing activities and capital expenditures. The capital needs of the banking subsidiaries are primarily driven by client deposits. We have established liquidity policies to support the successful execution of business strategies, while ensuring ongoing and sufficient liquidity to meet operational needs and satisfy applicable regulatory requirements under both normal and stressed conditions. We seek to maintain client confidence in the balance sheet and the safety of client assets by maintaining liquidity and diversity of funding sources to allow the Company to meet its obligations. To this end, we have established limits and contingency funding scenarios to support liquidity levels during both business as usual and stressed conditions. We employ a variety of methodologies to monitor and manage liquidity. We conduct regular liquidity stress testing to develop a consolidated view of liquidity risk exposures and to ensure our ability to maintain sufficient liquidity during market-related or company-specific liquidity stress events. Liquidity is also tested at key subsidiaries and results are reported to the Financial Risk Oversight Committee. A number of early warning indicators are monitored to help identify emerging liquidity stresses in the market or within the organization and are reviewed with management as appropriate. - 39 - THE CHARLES SCHWAB CORPORATION Management’s Discussion and Analysis of Financial Condition and Results of Operations (Tabular Amounts in Millions, Except Ratios, or as Noted) The Company was subject to, and was in compliance with, the modified LCR rule at December 31, 2018. As Schwab’s consolidated balance sheet assets were above $250 billion at December 31, 2018, Schwab will become subject to the full LCR rule in the second quarter of 2019. The table below presents information about our average LCR: (1) This amount represents modified net cash outflows as defined by the LCR rule, which requires that HQLA cover 70% of total stressed net cash outflows. Primary Funding Sources Schwab’s primary source of funds is cash generated by client activity which includes bank deposits and cash balances in client brokerage accounts. These funds are used to purchase investment securities and extend loans to clients. Other sources of funds may include cash flows from operations, maturities and sales of investment securities, repayments on loans, securities lending of assets held in client brokerage accounts, repurchase agreements, and cash provided by external financing. To meet daily funding needs, we maintain liquidity in the form of overnight cash deposits and short-term investments. For unanticipated liquidity needs, a buffer of highly liquid investments, currently comprised of U.S. Treasury notes, is also maintained. Additional Funding Sources In addition to internal sources of liquidity, Schwab has access to external funding. The need for short-term borrowings from these facilities arises primarily from timing differences between cash flow requirements, scheduled liquidation of interest-earning investments, movements of cash to meet regulatory brokerage client cash segregation requirements and general corporate purposes. We maintain policies and procedures necessary to access funding and test discount window borrowing procedures on a periodic basis. The following table describes external debt facilities available at December 31, 2018: (1) Amounts available are dependent on the amount of First Mortgages, HELOCs, and the fair value of certain investment securities that are pledged as collateral. (2) CSC has authorization from its Board of Directors to issue Commercial Paper Notes to not exceed $1.5 billion. Management has set a current limit not to exceed the amount of the committed, unsecured credit facility. (3) Other than an overnight borrowing to test availability, this facility was unused during 2018. (4) Amounts available are dependent on the fair value of certain investment securities that are pledged as collateral. Certain banking subsidiaries maintain secured credit facilities with the Federal Home Loan Bank of San Francisco (FHLB). Amounts available under these facilities are dependent on the value of our First Mortgages, HELOCs, and the fair value of certain of our investment securities that are pledged as collateral. During 2018, CSB used borrowings under this agreement to purchase investment securities in advance of bank sweep transfers. This credit facility is also available as backup financing in the event the outflow of client cash from the banking subsidiaries’ respective balance sheets is greater than maturities and paydowns on investment securities and bank loans. - 40 - THE CHARLES SCHWAB CORPORATION Management’s Discussion and Analysis of Financial Condition and Results of Operations (Tabular Amounts in Millions, Except Ratios, or as Noted) CSB also has access to short-term secured funding through the Federal Reserve’s discount window. Amounts available under the Federal Reserve discount window are dependent on the fair value of certain investment securities that are pledged as collateral. CSC has a commercial paper program of which proceeds are used for general corporate purposes. The maturities of the Commercial Paper Notes may vary, but are not to exceed 270 days from the date of issue. CSC’s ratings for these short-term borrowings are P1 by Moody’s, A1 by Standard & Poor’s, and by Fitch. CSC had no Commercial Paper Notes outstanding at December 31, 2018 or 2017. The financial covenants for the $750 million committed credit facility require CS&Co to maintain a minimum net capital ratio, CSB to be well capitalized, and CSC to maintain a minimum level of stockholders’ equity, adjusted to exclude AOCI. At December 31, 2018, the minimum level of stockholders’ equity required under this facility was $14.5 billion (CSC’s stockholders’ equity, excluding AOCI, at December 31, 2018 was $20.9 billion). Management believes these restrictions will not have a material effect on CSC’s ability to meet foreseeable dividend or funding requirements. To partially satisfy the margin requirement of client option transactions with the Options Clearing Corporation, CS&Co has unsecured standby letter of credit agreements (LOCs) with several banks in favor of the Options Clearing Corporation aggregating $225 million at December 31, 2018. There were no funds drawn under any of these LOCs during 2018 or 2017. In connection with its securities lending activities, the Company is required to provide collateral to certain brokerage clients. The collateral requirements were satisfied by providing cash as collateral. CSC has a universal automatic shelf registration statement (Shelf Registration Statement) on file with the SEC, which enables it to issue debt, equity, and other securities. Borrowings Long-term debt outstanding was $6.9 billion and $4.8 billion at December 31, 2018 and 2017, respectively. No short-term borrowings were outstanding as of December 31, 2018. Short-term borrowings outstanding from the FHLB were $15.0 billion at December 31, 2017. The following are details of the Senior Notes: New Debt Issuances All debt issuances in 2018 and 2017 were senior unsecured obligations with interest payable quarterly or semi-annually. Additional details are as follows: - 41 - THE CHARLES SCHWAB CORPORATION Management’s Discussion and Analysis of Financial Condition and Results of Operations (Tabular Amounts in Millions, Except Ratios, or as Noted) Equity Issuances and Redemptions CSC did not issue any equity through external offerings during the year ended December 31, 2018. CSC’s preferred stock issued and net proceeds for the year ended December 31, 2017 are as follows: On December 1, 2017, CSC redeemed all of the 485,000 outstanding shares of its 6.00% Non-Cumulative Perpetual Preferred Stock, Series B (“Series B Preferred Stock”), and the corresponding 19,400,000 depositary shares, each representing a 1/40th interest in a share of the Series B Preferred Stock. For further discussion of CSC’s long-term debt and information on the equity offerings, see Item 8 - Note 13 and Note 17. Off-Balance Sheet Arrangements Schwab enters into various off-balance sheet arrangements in the ordinary course of business, primarily to meet the needs of our clients. These arrangements include firm commitments to extend credit. Additionally, Schwab enters into guarantees and other similar arrangements in the ordinary course of business. For information on each of these arrangements, see Item 8 - Note 7, Note 11, Note 13, Note 14, and Note 15. Contractual Obligations Schwab’s principal contractual obligations as of December 31, 2018 are shown in the following table. Excluded from this table are liabilities recorded on the consolidated balance sheets that are generally short-term in nature (e.g., payables to brokers, dealers, and clearing organizations and short-term borrowings) or without contractual payment terms (e.g., bank deposits, payables to brokerage clients, and deferred compensation). (1) Represents CSB’s commitments to extend credit to banking clients, purchase mortgage loans, and commitments to fund CRA investments. (2) Includes estimated future interest payments through 2029 for Senior Notes. Amounts exclude maturities under a finance lease obligation and unamortized discounts and premiums. (3) Consists of purchase obligations for services such as advertising and marketing, telecommunications, professional services, and hardware- and software-related agreements. (4) Represents minimum rental commitments, net of sublease commitments, and includes facilities under past restructuring initiatives and rental commitments under a finance lease obligation. CAPITAL MANAGEMENT Schwab seeks to manage capital to a level and composition sufficient to support execution of our business strategy, including anticipated balance sheet growth, providing financial support to the subsidiaries, and sustained access to the capital markets, while at the same time meeting our regulatory capital requirements and serving as a source of financial strength to our banking subsidiaries. Schwab’s primary sources of capital are funds generated by the operations of subsidiaries and securities issuances by CSC in the capital markets. To ensure that Schwab has sufficient capital to absorb unanticipated losses or declines in asset values, we have adopted a policy to remain well capitalized even in stressed scenarios. - 42 - THE CHARLES SCHWAB CORPORATION Management’s Discussion and Analysis of Financial Condition and Results of Operations (Tabular Amounts in Millions, Except Ratios, or as Noted) Internal guidelines are set, for both CSC and its regulated subsidiaries, to ensure capital levels are in line with our strategy and regulatory requirements. Capital forecasts are reviewed monthly at Asset-Liability Management and Pricing Committee and Financial Risk Oversight Committee meetings. A number of early warning indicators are monitored to help identify potential problems that could impact capital. In addition, we monitor the subsidiaries’ capital levels and requirements. Subject to regulatory capital requirements and any required approvals, any excess capital held by subsidiaries is transferred to CSC in the form of dividends and returns of capital. When subsidiaries have need of additional capital, funds are provided by CSC as equity investments and also as subordinated loans (in a form approved as regulatory capital by regulators) for CS&Co. The details and method used for each cash infusion are based on an analysis of the particular entity’s needs and financing alternatives. The amounts and structure of infusions must take into consideration maintenance of regulatory capital requirements, debt/equity ratios, and equity double leverage ratios. Schwab conducts regular capital stress testing to assess the potential financial impacts of various adverse macroeconomic and company-specific events to which the Company could be subjected. The objective of the capital stress testing is (1) to explore various potential outcomes - including rare and extreme events and (2) to assess impacts of potential stressful outcomes on both capital and liquidity. Additionally, we have a comprehensive Capital Contingency Plan to provide action plans for certain low probability/high impact capital events that the Company might face. The Capital Contingency Plan is issued under the authority of the Financial Risk Oversight Committee and provides guidelines for sustained capital events. It does not specifically address every contingency, but is designed to provide a framework for responding to any capital stress. The results of the stress testing indicate there are two scenarios which could stress the Company’s capital: (1) inflows of balance sheet cash during a period of very low interest rates and (2) outflows of balance sheet cash when other sources of financing are not available and the Company is required to sell assets to fund the flows at a loss. The Capital Contingency Plan is reviewed annually and updated as appropriate. For additional information, see Business - Regulation in Part I, Item 1. Regulatory Capital Requirements CSC is subject to capital requirements set by the Federal Reserve and is required to serve as a source of strength for our banking subsidiaries and to provide financial assistance if our banking subsidiaries experience financial distress. Schwab is required to maintain a Tier 1 Leverage Ratio for CSC of at least 4%; however, management seeks to maintain the ratio of at least 6%. Due to the relatively low risk of our balance sheet assets and risk-based capital ratios at CSC and CSB that are well in excess of regulatory requirements, the Tier 1 Leverage Ratio is the most restrictive capital constraint on CSC’s asset growth. Our banking subsidiaries are subject to capital requirements set by their regulators that are substantially similar to those imposed on CSC by the Federal Reserve. Our banking subsidiaries’ failure to remain well capitalized could result in certain mandatory and possibly additional discretionary actions by the regulators that could have a direct material effect on the banks. Schwab’s principal banking subsidiary, CSB, is required to maintain a Tier 1 Leverage Ratio of at least 5% to be well capitalized, but seeks to maintain the ratio of at least 6.25%. Based on its regulatory capital ratios at December 31, 2018, CSB is considered well capitalized. - 43 - THE CHARLES SCHWAB CORPORATION Management’s Discussion and Analysis of Financial Condition and Results of Operations (Tabular Amounts in Millions, Except Ratios, or as Noted) The following table details CSC’s consolidated and CSB’s capital ratios: (1) CSC and CSB elected to opt-out of the requirement to include most components of AOCI in CET1 Capital. Beginning in 2019, CSC is required to include all components of AOCI in regulatory capital. CSB is also subject to regulatory requirements that restrict and govern the terms of affiliate transactions. In addition, CSB is required to provide notice to, and may be required to obtain approval from, the OCC and the Federal Reserve to declare dividends to CSC. As a broker-dealer, CS&Co is subject to regulatory requirements of the Uniform Net Capital Rule, which is intended to ensure the general financial soundness and liquidity of broker-dealers. These regulations prohibit CS&Co from paying cash dividends, making unsecured advances and loans to the parent company and employees, and repaying subordinated borrowings from CSC if such payment would result in a net capital amount below prescribed thresholds. At December 31, 2018, CS&Co was in compliance with its net capital requirements. In addition to the capital requirements above, Schwab’s subsidiaries are subject to other regulatory requirements intended to ensure financial soundness and liquidity. See Item 8 - Note 21 for additional information on the components of stockholders’ equity and information on the capital requirements of significant subsidiaries. Dividends Since the initial dividend in 1989, CSC has paid 119 consecutive quarterly dividends and has increased the quarterly dividend rate 23 times, resulting in a 21% compounded annual growth rate, excluding the special cash dividend of $1.00 per common share in 2007. While the payment and amount of dividends are at the discretion of the Board of Directors, subject to certain regulatory and other restrictions, CSC currently targets its common stock cash dividend at approximately 20% to 30% of net income. - 44 - THE CHARLES SCHWAB CORPORATION Management’s Discussion and Analysis of Financial Condition and Results of Operations (Tabular Amounts in Millions, Except Ratios, or as Noted) The Board of Directors of the Company declared quarterly cash dividend increases per common share during 2017 and 2018 as shown below: In addition, on January 30, 2019, the Board of Directors of the Company declared a four cent, or 31%, increase in the quarterly cash dividend to $0.17 per common share. The following table details the CSC cash dividends paid and per share amounts: (1) Dividends paid semi-annually until February 1, 2022 and quarterly thereafter. (2) Dividends paid quarterly. (3) Dividends paid semi-annually until March 1, 2022 and quarterly thereafter. (4) Series F Preferred Stock was issued on October 31, 2017. Dividends paid semi-annually beginning on June 1, 2018 until December 1, 2027, and quarterly thereafter. (5) Series B Preferred Stock was redeemed on December 1, 2017. N/A Not applicable. Share Repurchases On October 25, 2018, CSC publicly announced that its Board of Directors terminated the existing two share repurchase authorizations and replaced them with a new authorization to repurchase up to $1.0 billion of common stock. CSC repurchased 22 million shares of its common stock for $1.0 billion in 2018, completing all repurchases under this authorization. There were no repurchases of CSC’s common stock in 2018 prior to the fourth quarter, or in 2017. On January 30, 2019, CSC publicly announced that its Board of Directors authorized the repurchase of up to $4.0 billion of common stock. The authorization does not have an expiration date. FOREIGN HOLDINGS At December 31, 2018, Schwab had exposure to non-sovereign financial and non-financial institutions in foreign countries, as well as agencies of foreign governments. At December 31, 2018, the fair value of these holdings totaled $7.6 billion, with the top three exposures being to issuers and counterparties domiciled in France at $2.8 billion, Sweden at $1.3 billion, and Canada at $0.8 billion. In addition to the direct holdings in foreign companies and securities issued by foreign government agencies, Schwab has indirect exposure to foreign countries through its investments in CSIM money market funds (collectively, the Funds) resulting from brokerage clearing activities. At December 31, 2018, the Company had $21 million in investments in these Funds. Certain of the Funds’ positions include certificates of deposits, time deposits, commercial paper and corporate debt securities issued by counterparties in foreign countries. Schwab had outstanding margin loans to foreign residents of $746 million at December 31, 2018. - 45 - THE CHARLES SCHWAB CORPORATION Management’s Discussion and Analysis of Financial Condition and Results of Operations (Tabular Amounts in Millions, Except Ratios, or as Noted) FAIR VALUE OF FINANCIAL INSTRUMENTS Schwab uses the market approach to determine the fair value of certain financial assets and liabilities recorded at fair value, and to determine fair value disclosures. See Item 8 - Note 2 and Note 16 for more information on our assets and liabilities recorded at fair value. When available, Schwab uses quoted prices in active markets to measure the fair value of assets and liabilities. When utilizing market data and bid-ask spread, we use the price within the bid-ask spread that best represents fair value. When quoted prices do not exist, prices are obtained from independent third-party pricing services to measure the fair value of investment assets. We generally obtain prices from three independent pricing sources for assets recorded at fair value. Our primary third-party pricing service provides prices based on observable trades and discounted cash flows that incorporate observable information such as yields for similar types of securities (a benchmark interest rate plus observable spreads) and weighted-average maturity for the same or similar “to-be-issued” securities. We compare the prices obtained from the primary independent pricing service to the prices obtained from the additional independent pricing services to determine if the price obtained from the primary independent pricing service is reasonable. Schwab does not adjust the prices received from independent third-party pricing services unless such prices are inconsistent with the definition of fair value and result in material differences in the amounts recorded. At December 31, 2018 and 2017, we did not adjust prices received from the primary independent third-party pricing service. CRITICAL ACCOUNTING ESTIMATES The consolidated financial statements of Schwab have been prepared in accordance with GAAP. Item 8 - Note 2 contains more information on our significant accounting policies made in connection with its application of these accounting principles. While the majority of the revenues, expenses, assets and liabilities are not based on estimates, there are certain accounting principles that require management to make estimates regarding matters that are uncertain and susceptible to change where such change may result in a material adverse impact on Schwab’s financial position and reported financial results. These critical accounting estimates are described below. Management regularly reviews the estimates and assumptions used in the preparation of the financial statements for reasonableness and adequacy. Management has discussed the development and selection of these critical accounting estimates with the Audit Committee of the Board of Directors. Additionally, management has reviewed with the Audit Committee the Company’s significant estimates discussed in this Management’s Discussion and Analysis of Financial Condition and Results of Operations. Income Taxes Schwab estimates income tax expense based on amounts expected to be owed to the various tax jurisdictions in which we operate, including federal, state and local domestic jurisdictions, and immaterial amounts owed to several foreign jurisdictions. The estimated income tax expense is reported in the consolidated statements of income in taxes on income. Accrued taxes are reported in other assets or accrued expenses and other liabilities on the consolidated balance sheets and represent the net estimated amount due to or to be received from taxing jurisdictions either currently or deferred to future periods. Deferred taxes arise from differences between assets and liabilities measured for financial reporting purposes versus income tax reporting purposes. Deferred tax assets are recognized if, in management’s judgment, their realizability is determined to be more likely than not. Uncertain tax positions that meet the more likely than not recognition threshold are measured to determine the amount of benefit to recognize. An uncertain tax position is measured at the largest amount of benefit management believes is more likely than not to be realized upon settlement. In estimating accrued taxes, we assess the relative merits and risks of the appropriate tax treatment considering statutory, judicial and regulatory guidance in the context of the tax position. Because of the complexity of tax laws and regulations, interpretation can be difficult and subject to legal judgment given specific facts and circumstances. Changes in the estimate of accrued taxes occur periodically due to changes in tax rates, interpretations of tax laws, the status of examinations being conducted by various taxing authorities, and newly enacted statutory, judicial and regulatory guidance that impacts the relative merits and risks of tax positions. These changes, when they occur, affect accrued taxes and can be - 46 - THE CHARLES SCHWAB CORPORATION Management’s Discussion and Analysis of Financial Condition and Results of Operations (Tabular Amounts in Millions, Except Ratios, or as Noted) significant to the operating results of the Company. See Item 8 - Note 20 for more information on the Company’s income taxes. Legal and Regulatory Reserves Reserves for legal and regulatory claims and proceedings reflect an estimate of probable losses for each matter, after considering, among other factors, the progress of the case, prior experience and the experience of others in similar cases, available defenses, and the opinions and views of legal counsel. In many cases, including most class action lawsuits, it is not possible to determine whether a loss will be incurred, or to estimate the range of that loss, until the matter is close to resolution, in which case no accrual is made until that time. Reserves are adjusted as more information becomes available. Significant judgment is required in making these estimates, and the actual cost of resolving a matter may ultimately differ materially from the amount reserved. See Item 8 - Note 14 for more information on the Company’s contingencies related to legal and regulatory reserves. - 47 - THE CHARLES SCHWAB CORPORATION

<s>[INST] FORWARDLOOKING STATEMENTS In addition to historical information, this Annual Report on Form 10K contains “forwardlooking statements” within the meaning of Section 27A of the Securities Act, and Section 21E of the Securities Exchange Act of 1934. Forwardlooking statements are identified by words such as “believe,” “anticipate,” “expect,” “intend,” “plan,” “will,” “may,” “estimate,” “appear,” “could,” “would,” and other similar expressions. In addition, any statements that refer to expectations, projections, or other characterizations of future events or circumstances are forwardlooking statements. These forwardlooking statements, which reflect management’s beliefs, objectives, and expectations as of the date hereof, are estimates based on the best judgment of Schwab’s senior management. These statements relate to, among other things: Maximizing our market valuation and stockholder returns over time; our belief that developing trusted relationships will translate into more client assets which drives revenue and, along with expense discipline and thoughtful capital management, generates earnings growth and builds stockholder value; and Schwab’s ability to pursue its business strategy and maintain its market leadership position; (see Business Strategy and Competitive Environment in Part I, Item 1); The impact of legal proceedings and regulatory matters (see Item 8 Note 14); Effective capital management supporting business growth and capital returns to stockholders (see Overview in Part II, Item 7); The adjustment of rates paid on clientrelated liabilities; the stability, rate sensitivity, and duration of clientrelated liabilities; managing the duration of interestearning assets; and Schwab’s positioning to benefit from an increase in interest rates and limit its exposure to falling rates (see Net Interest Revenue in Part II, Item 7); 2019 capital expenditures (see Total Expenses Excluding Interest in Part II, Item 7); Sources of liquidity, capital, and level of dividends (see Liquidity Risk in Part II, Item 7); Capital ratios (see Regulatory Capital Requirements in Part II, Item 7); The impact of changes in management’s estimates on Schwab’s results of operations (see Critical Accounting Estimates in Part II, Item 7); The expected impact of new accounting standards not yet adopted (see Item 8 Note 2); and The impact of changes in the likelihood of indemnification and guarantee payment obligations on Schwab’s results of operations (see Item 8 Note 14). Achievement of the expressed beliefs, objectives and expectations described in these statements is subject to certain risks and uncertainties that could cause actual results to differ materially from the expressed beliefs, objectives, and expectations. Readers are cautioned not to place undue reliance on these forwardlooking statements, which speak only as of the date of this Annual Report on Form 10K or, in the case of documents incorporated by reference, as of the date of those documents. Important factors that may cause actual results to differ include, but are not limited to: General market conditions, including the level of interest rates, equity valuations and trading activity; Our ability to attract and retain clients, develop trusted relationships, and grow client assets; Client use of our advisory solutions and other products and services; The level of client assets, including cash balances; Competitive pressure on pricing, including deposit rates; Client sensitivity to interest rates; Regulatory guidance; Timing and amount of transfers to bank sweep deposits; Capital and liquidity needs and management; Our ability to manage expenses; Our ability to develop and launch new products, services, and capabilities, as well as implement infrastructure, in a timely and successful manner; The timing of campus expansion work and technology projects; The effect of adverse developments in litigation or regulatory matters and the extent of any related charges; and Potential breaches of contractual terms for which we have indemnification and guarantee obligations. 20 THE CHARLES SCHWAB CORPORATION Management’s Discussion and Analysis of Financial Condition and Results of Operations (Tabular Amounts in Millions, Except Ratios, or as Noted) Certain of these factors [/INST] Negative. </s>

SCHWAB CHARLES CORP

2020-02-26

2019-12-31

Item 7. Management’s Discussion and Analysis of Financial Condition and Results of Operations FORWARD-LOOKING STATEMENTS In addition to historical information, this Annual Report on Form 10-K contains “forward-looking statements” within the meaning of Section 27A of the Securities Act, and Section 21E of the Securities Exchange Act of 1934. Forward-looking statements are identified by words such as “believe,” “anticipate,” “expect,” “intend,” “plan,” “will,” “may,” “estimate,” “appear,” “could,” “would,” “expand”, “maintain,” and other similar expressions. In addition, any statements that refer to expectations, projections, or other characterizations of future events or circumstances are forward-looking statements. These forward-looking statements, which reflect management’s beliefs, objectives, and expectations as of the date hereof, are estimates based on the best judgment of Schwab’s senior management. These statements relate to, among other things: • The acquisition of TD Ameritrade; the acquisition of assets of USAA-IMCO, the related funding, and entering into a referral agreement; and the expected closing dates of the acquisitions (see Business Acquisitions in Part I, Item 1; Overview and Capital Management in Part II, Item 7; Commitments and Contingencies in Part II, Item 8 - Notes to Consolidated Financial Statements (Item 8) - Note 14); • Maximizing our market valuation and stockholder returns over time; our belief that developing trusted relationships will translate into more client assets which drives revenue and, along with expense discipline and thoughtful capital management, generates earnings growth and builds stockholder value; and maintaining our market position (see Business Strategy and Competitive Environment and Products and Services in Part I, Item 1); • The impact of pricing reductions on our value proposition, competitive positioning and long-term growth in client assets and accounts (see Sources of Net Revenues in Part I, Item I; Overview in Part II, Item 7); • The impact of legal proceedings and regulatory matters (see Legal Proceedings in Part I, Item 3 and Commitments and Contingencies in Part II, Item 8 - Note 14); • Commitment to balancing long-term profitability with reinvesting for growth; business growth; meaningful capital returns; and intent to return excess capital above our long-term operating objective of 6.75% - 7.00% (see Overview in Part II, Item 7); • The adjustment of rates paid on client-related liabilities; client cash sorting; reducing exposure to lower rates; and the duration difference between liabilities and assets (see Net Interest Revenue in Part II, Item 7); • Capital expenditures (see Total Expenses Excluding Interest in Part II, Item 7); • The phase-out of the use of LIBOR (see Expected Phase-out of LIBOR in Part II, Item 7); • Sources of liquidity, capital, and level of dividends (see Liquidity Risk in Part II, Item 7); • Capital ratios (see Regulatory Capital Requirements in Part II, Item 7); • The expected impact of new accounting standards not yet adopted (see Summary of Significant Accounting Policies in Part II, Item 8 - Note 2); and • The likelihood of indemnification and guarantee payment obligations (see Commitments and Contingencies in Part II, Item 8 - Note 14). Achievement of the expressed beliefs, objectives and expectations described in these statements is subject to certain risks and uncertainties that could cause actual results to differ materially from the expressed beliefs, objectives, and expectations. Readers are cautioned not to place undue reliance on these forward-looking statements, which speak only as of the date of this Annual Report on Form 10-K or, in the case of documents incorporated by reference, as of the date of those documents. Important factors that may cause actual results to differ include, but are not limited to: • The timing and the ability of us and TD Ameritrade to satisfy the closing conditions in the merger agreement, including stockholder and regulatory approvals; • The timing and the ability of us and USAA-IMCO to satisfy the closing conditions in the purchase agreement, including regulatory approvals and the implementation of conversion plans; • The timing and extent to which we realize expected revenue, expense and other synergies from our acquisitions; • General market conditions, including the level of interest rates, equity valuations, and trading activity; • Our ability to attract and retain clients, develop trusted relationships, and grow client assets; • Client use of our advisory solutions and other products and services; • The level of client assets, including cash balances; - 25 - THE CHARLES SCHWAB CORPORATION Management’s Discussion and Analysis of Financial Condition and Results of Operations (Tabular Amounts in Millions, Except Ratios, or as Noted) • Competitive pressure on pricing, including deposit rates; • Client sensitivity to rates; • Regulatory guidance; • Capital and liquidity needs and management; • Our ability to manage expenses; • Our ability to develop and launch new and enhanced products, services, and capabilities, as well as implement infrastructure, in a timely and successful manner; • The effect of pricing reductions on client acquisition, retention and asset levels, including cash balances; • The Company’s ability to monetize client assets; • The timing of campus expansion work and technology projects; • Adverse developments in litigation or regulatory matters and any related charges; • Potential breaches of contractual terms for which we have indemnification and guarantee obligations; and • Client cash sorting and net equity sales. Certain of these factors, as well as general risk factors affecting the Company, are discussed in greater detail in Risk Factors in Part I, Item 1A. - 26 - THE CHARLES SCHWAB CORPORATION Management’s Discussion and Analysis of Financial Condition and Results of Operations (Tabular Amounts in Millions, Except Ratios, or as Noted) GLOSSARY OF TERMS Active brokerage accounts: Brokerage accounts with activity within the preceding 270 days. Accumulated Other Comprehensive Income (AOCI): A component of stockholders’ equity which includes unrealized gains and losses on available for sale (AFS) securities and net gains or losses associated with pension obligations. Asset-backed securities: Debt securities backed by financial assets such as loans or receivables. Assets receiving ongoing advisory services: Market value of all client assets custodied at the Company under the guidance of an independent advisor or enrolled in one of Schwab’s advice solutions at the end of the reporting period. Basel III: Global regulatory standards on bank capital adequacy and liquidity issued by the Basel Committee on Banking Supervision. Basis point: One basis point equals 1/100th of 1%, or 0.01%. Client assets: The market value, as of the end of the reporting period, of all client assets in our custody and proprietary products, which includes both cash and securities. Average client assets are the daily average client asset balance for the reporting period. Client cash as a percentage of client assets: Calculated as the value, at the end of the reporting period, of all proprietary money market fund balances, bank deposits, Schwab One® balances, and certain cash equivalents divided by client assets. Common Equity Tier 1 (CET1) Capital: The sum of common stock and related surplus net of treasury stock, retained earnings, AOCI and qualifying minority interests, less applicable regulatory adjustments and deductions. See Current Regulatory Environment and Other Developments for information on recently issued rules that will impact Schwab’s regulatory capital requirements. Common Equity Tier 1 Risk-Based Capital Ratio: The ratio of CET1 Capital to total risk-weighted assets as of the end of the period. Core net new client assets: Net new client assets before significant one-time inflows or outflows, such as acquisitions/divestitures or extraordinary flows (generally greater than $10 billion) relating to a specific client. These flows may span multiple reporting periods. Customer Protection Rule: Refers to Rule 15c3-3 of the Securities Exchange Act of 1934. Daily Average Revenue Trades (DARTs): Total revenue trades during a certain period, divided by the number of trading days in that period. Revenue trades include all client trades that generate trading revenue (i.e., commission revenue or principal transaction revenue). Daily Average Trades (DATs): Includes daily average revenue trades by clients, trades by clients in asset-based pricing relationships, and all commission-free trades. Debt to total capital ratio: Calculated as total debt divided by stockholders’ equity and total debt. Delinquency roll rates: The rates at which loans transition through delinquency stages, ultimately resulting in a loss. Schwab considers a loan to be delinquent if it is 30 days or more past due. Dodd-Frank Wall Street Reform and Consumer Protection Act (Dodd-Frank): Regulatory reform legislation containing numerous provisions which expanded prudential regulation of large financial services companies. Duration: Duration is typically used to measure the expected change in value of a financial instrument for a 1% change in interest rates, expressed in years. - 27 - THE CHARLES SCHWAB CORPORATION Management’s Discussion and Analysis of Financial Condition and Results of Operations (Tabular Amounts in Millions, Except Ratios, or as Noted) Final Regulatory Capital Rules: Refers to the regulatory capital rules issued by U.S. banking agencies which implemented Basel III and relevant provisions of Dodd-Frank, which apply to savings and loan holding companies, as well as federal savings banks. First mortgages: Refers to first lien residential real estate mortgage loans. Full-time equivalent employees: Represents the total number of hours worked divided by a 40-hour work week for the following categories: full-time, part-time and temporary employees and persons employed on a contract basis. High Quality Liquid Assets (HQLA): HQLA is defined by the Federal Reserve, but includes assets with low market- and credit risk that are actively traded and readily convertible to cash in times of stress. Interest-bearing liabilities: Includes bank deposits, payables to brokerage clients, short-term borrowings, and long-term debt on which Schwab pays interest. Interest-earning assets: Includes cash and cash equivalents, cash and investments segregated, broker-related receivables, receivables from brokerage clients, investment securities, and bank loans on which Schwab earns interest. Investment grade: Defined as a rating equivalent to a Moody’s Investors Service (Moody’s) rating of “Baa” or higher, or a Standard & Poor’s Rating Group (Standard & Poor’s) or Fitch Ratings, Ltd (Fitch) rating of “BBB-” or higher. Liquidity Coverage Ratio (LCR): The ratio of HQLA to projected net cash outflows during a 30-day stress scenario. Loan-To-Value (LTV) ratio: Calculated as the principal amount of a loan divided by the value of the collateral securing the loan. Margin loans: Advances made to brokerage clients on a secured basis to purchase or carry securities reflected in receivables from brokerage clients on the consolidated balance sheets. Master netting arrangement: An agreement between two counterparties that have multiple contracts with each other that provides for net settlement of all contracts through a single cash payment in the event of default or termination of any one contract. Mortgage-backed securities: A type of asset-backed security that is secured by a mortgage or group of mortgages. Net interest margin: Net interest revenue (annualized for interim periods) divided by average interest-earning assets. Net new client assets: Total inflows of client cash and securities to Schwab less client outflows. Inflows include dividends and interest; outflows include commissions and fees. Capital gains distributions are excluded. Net Stable Funding Ratio (NSFR): Measures an organization’s “available” amount of stable funding relative to its “required” amount of stable funding over a one-year time horizon. New brokerage accounts: All brokerage accounts opened during the period, as well as any accounts added via acquisition. Nonperforming assets: The total of nonaccrual loans and other real estate owned. Order flow revenue: Net compensation received from markets and firms to which CS&Co sends equity and options orders. The amount reflects rebates received for certain types of orders, less fees paid for orders where exchange fees or other charges apply. Pledged Asset Line® (PAL): A non-purpose revolving line of credit from CSB secured by eligible assets held in a separate pledged brokerage account maintained at CS&Co. Return on average common stockholders’ equity: Calculated as net income available to common stockholders (annualized for interim periods) divided by average common stockholders’ equity. - 28 - THE CHARLES SCHWAB CORPORATION Management’s Discussion and Analysis of Financial Condition and Results of Operations (Tabular Amounts in Millions, Except Ratios, or as Noted) Risk-weighted assets: Computed by assigning specific risk-weightings to assets and off-balance sheet instruments for capital adequacy calculations. Tier 1 Capital: The sum of CET1 Capital and additional Tier 1 Capital instruments and related surplus, less applicable adjustments and deductions. Tier 1 Leverage Ratio: End-of-period Tier 1 Capital divided by adjusted average total consolidated assets for the quarter. Trading days: Days in which the markets/exchanges are open for the buying and selling of securities. Early market closures are counted as half-days. U.S. federal banking agencies: Refers to the Federal Reserve, the OCC, the FDIC, and the CFPB. Uniform Net Capital Rule: Refers to Rule 15c3-1 under the Securities Exchange Act of 1934, which specifies minimum capital requirements that are intended to ensure the general financial soundness and liquidity of broker-dealers at all times. - 29 - THE CHARLES SCHWAB CORPORATION Management’s Discussion and Analysis of Financial Condition and Results of Operations (Tabular Amounts in Millions, Except Ratios, or as Noted) OVERVIEW Management focuses on several client activity and financial metrics in evaluating Schwab’s financial position and operating performance. We believe that metrics relating to net new and total client assets, as well as client cash levels and utilization of advisory services, offer perspective on our business momentum and client engagement. Data on new and total client brokerage accounts provides additional perspective on our ability to attract and retain new business. Total net revenue growth, pre-tax profit margin, EPS, return on average common stockholders’ equity, and the Consolidated Tier 1 Leverage Ratio provide broad indicators of Schwab’s overall financial health, operating efficiency, and ability to generate acceptable returns. Total expenses, excluding interest, as a percentage of average client assets, is a measure of operating efficiency. Results for the years ended December 31, 2019, 2018, and 2017 are as follows: (1) 2019 and 2017 include inflows of $11.1 billion and $34.5 billion, respectively, from certain mutual fund clearing services clients. 2018 includes outflows of $93.9 billion from certain mutual fund clearing services clients. 2019 Compared to 2018 Schwab delivered solid financial results in 2019 while taking significant steps to further enhance our offer to clients and help position the Company to build value for our stakeholders over the long-term. Throughout the year, investor sentiment reflected a complex market environment that included global trade negotiations and an uncertain domestic economic outlook. The Federal Reserve ended up cutting the federal funds target interest rate three times, in a reversal of the increases seen in 2018. At the same time, stocks continued to rise, with the S&P 500 increasing 29% during the year. Core net new assets totaled $211.7 billion for the year, representing an organic growth rate of 7% and our second consecutive year over $200 billion. Clients opened 1.6 million new brokerage accounts in 2019, while active brokerage accounts grew 6% to 12.3 million. Our success in asset gathering combined with strong market returns drove total client assets to reach $4.04 trillion at December 31, 2019, closing the year up 24%. - 30 - THE CHARLES SCHWAB CORPORATION Management’s Discussion and Analysis of Financial Condition and Results of Operations (Tabular Amounts in Millions, Except Ratios, or as Noted) Company actions to benefit clients and build long-term value during 2019 included the elimination of online trading commissions for U.S. and Canadian-listed stocks and ETFs, as well as the base charge on options, which became effective October 7th. The Company also announced two significant acquisitions during the year. In July, the Company agreed to acquire assets of USAA-IMCO and agreed to enter into a long-term referral agreement. In late November, we entered into a definitive agreement to acquire TD Ameritrade. Against the backdrop of the more challenging than expected macroeconomic environment and our own pricing decisions, Schwab’s net income totaled $3.7 billion in 2019, an increase of $197 million, or 6%. Diluted earnings per common share grew to $2.67, representing an increase of 9% from 2018. Total net revenues reached $10.7 billion, up 6% in 2019. Net interest revenue increased 12% in 2019 to $6.5 billion, driven by higher average investment yields and also by an increase in client cash balances held at our bank and broker-dealer subsidiaries. While trading revenue declined 19% to $617 million due to our pricing actions, asset management and administration fees remained essentially flat with 2018 at $3.2 billion, decreasing 1%. Growing enrollment in advice solutions, along with rising balances in other third-party mutual funds, helped to largely offset declines in Mutual Fund OneSource® and lower sweep money market fund revenue due to transfers of sweep money market funds to our balance sheet in 2018 and early 2019. Total expenses excluding interest increased 5% in 2019 to $5.9 billion, which included $62 million in severance charges associated with a 3% reduction in our workforce and $25 million in costs relating to the announced acquisitions of assets of USAA-IMCO and TD Ameritrade. Our ongoing focus on driving efficiency while managing our spending in a disciplined manner helped us maintain a ratio of expenses to client assets of 16 bps for 2019. Reflecting our commitment to balancing long-term profitability with reinvesting for growth, we achieved a 45.2% pre-tax profit margin and a 19% return on equity in 2019, representing our second consecutive year of at least 45% and 19%, respectively. Disciplined balance sheet management remains core to our strategy as we continue to support business growth and meaningful capital returns across a range of conditions. In early 2019, the Board of Directors raised the quarterly cash dividend 31% to $0.17 per share and authorized the repurchase of up to $4.0 billion of common stock; during 2019 we repurchased 55 million shares for $2.2 billion under this authorization. As of December 31, 2019, our balance sheet assets were $294 billion, down 1% from a year ago; our Tier 1 Leverage Ratio was 7.3% at year-end. As the Company continues to grow both organically and through our pending acquisitions, our intent to return excess capital above our long-term operating objective of 6.75%-7.00% remains in place. Planned Acquisitions TD Ameritrade: On November 25, 2019, CSC announced a definitive agreement to acquire TD Ameritrade in an all-stock transaction. At the time of announcement, TD Ameritrade had approximately twelve million brokerage accounts and $1.3 trillion in total client assets. Under the agreement, TD Ameritrade stockholders will receive 1.0837 CSC shares for each TD Ameritrade share. Based on the closing price of CSC common stock on November 20, 2019, the merger consideration represented approximately $26 billion. The Company anticipates this transaction will add scale to help support the Company’s ongoing efforts to enhance the client experience, provide deeper resources for RIAs, and continue to improve our operating efficiency. The transaction is expected to close in the second half of 2020, subject to satisfaction of closing conditions. Under certain circumstances, CSC or TD Ameritrade could be required to pay the other party a termination fee of $950 million or reimburse the other party’s fees up to $50 million. Assets of USAA-IMCO: On July 25, 2019, the Company announced a definitive agreement to acquire assets of USAA-IMCO, including over one million brokerage and managed portfolio accounts with approximately $90 billion in client assets at the time of announcement, for $1.8 billion in cash. The companies have also agreed to enter into a long-term referral agreement, effective at closing of the acquisition, which would make Schwab the exclusive wealth management and brokerage provider for USAA members. The transaction is expected to close in mid-2020, subject to satisfaction of closing conditions, including regulatory approvals and the implementation of conversion plans. The Company expects to recognize significant amounts of goodwill and amortizable intangible assets as part of the planned acquisitions. - 31 - THE CHARLES SCHWAB CORPORATION Management’s Discussion and Analysis of Financial Condition and Results of Operations (Tabular Amounts in Millions, Except Ratios, or as Noted) 2018 Compared to 2017 Net income increased by $1.2 billion, or 49%, in 2018, driven primarily by business momentum, a supportive economic environment for much of the year, and lower corporate tax rates. Continued execution of our ‘Through Clients’ Eyes’ strategy helped us succeed with clients. In 2018, clients opened 1.6 million new brokerage accounts, helping bring active brokerage accounts to 11.6 million at the end of the year, and core net new assets totaled $227.8 billion, up 15% from the 2017 total. Our strong net new assets largely offset lower market valuations, and we ended 2018 at $3.25 trillion in total client assets. Total net revenue grew by $1.5 billion, or 18%, in 2018 primarily due to an increase of $1.5 billion, or 36%, in net interest revenue. The Fed raised the federal funds target interest rate four times in 2018 for a total of 100 basis points. The growth of total net revenue resulted from higher interest rates due to the Fed’s rate increases, and also from higher interest-earning assets, which reflect both client cash allocations and the transfer of sweep money market funds to bank and broker-dealer sweep. As we progressed with these transfers, the corresponding money market fund asset management and administration fee revenue naturally declined, yet positive inflows in advice solutions, Schwab equity and bond funds and ETFs, and other third-party mutual funds and ETFs kept asset management fees at $3.2 billion, limiting the decrease to 5% from 2017. Record trading activity from our clients resulted in trading revenue reaching $763 million, an increase of 17% from the prior year. Our increase in total expenses excluding interest of $602 million, or 12%, reflected our 2018 investments to support and fuel our business growth, including hiring additional client-facing and other employees and technology project spending, as well as an increase in marketing and a special stock award of $36 million to our employees. Even with these increases, expenses as a percentage of client assets remained consistent at 16 basis points, and pre-tax income increased 25% to $4.6 billion in 2018, resulting in a pre-tax profit margin of 45.0%. As a result of the Tax Cuts and Jobs Act of 2017 (the Tax Act), taxes on income decreased 19% in 2018, resulting in an effective tax rate of 23.1%. Overall, we generated a 19% return on equity and diluted EPS of $2.45 for the year. During 2018, the Board of Directors raised the quarterly cash dividend 63% to $0.13 per share and authorized a $1.0 billion Share Repurchase Program, which we completed during the fourth quarter of 2018. These actions reflected the Company’s strong financial performance and our confidence in its long-term success; they also demonstrated that effective capital management at Schwab can support both healthy business growth and more meaningful capital returns to stockholders. Subsequent Events In October 2019, the Federal Reserve issued a final enhanced prudential standards rule, and the Federal Reserve, OCC, and the FDIC jointly issued a final regulatory capital and liquidity rule. With total consolidated assets of $294.0 billion at December 31, 2019, CSC is designated as a Category III firm pursuant to the framework established by the final rules. Accordingly, the Company opted to exclude AOCI from its regulatory capital as permitted by the regulatory capital and liquidity rule beginning January 1, 2020. In accordance with ASC 320, Investments - Debt and Equity Securities (ASC 320) and as of January 1, 2020, the Company transferred all of its investment securities designated as held to maturity (HTM) to the AFS category without tainting our intent to hold other debt securities to maturity. At the date of transfer, these securities had a total amortized cost of $134.7 billion and a total net unrealized gain of $1.4 billion. CURRENT REGULATORY ENVIRONMENT AND OTHER DEVELOPMENTS In December 2019, the FDIC issued a proposed rule that would modernize its brokered deposits regulations. Among other things, the proposed rule would clarify the “primary purpose” exception from the definition of a deposit broker for securities broker-dealers such as CS&Co that place deposits through brokerage sweep arrangements under certain conditions. In addition, the proposed rule would create a streamlined application process for obtaining a primary purpose exception where less than 25 percent of a broker-dealer’s customer assets are placed with a depository institution. Schwab is currently evaluating the impact of the proposed rule on its bank sweep program. In January 2020, the OCC and the FDIC published their jointly proposed revisions to the regulations implementing the CRA. The proposed regulations (i) clarify and expand what qualifies for CRA credit; (ii) expand where CRA activity counts; (iii) provide an objective method to measure CRA activity; and (iv) revise data collection, recordkeeping, and reporting. The - 32 - THE CHARLES SCHWAB CORPORATION Management’s Discussion and Analysis of Financial Condition and Results of Operations (Tabular Amounts in Millions, Except Ratios, or as Noted) Federal Reserve did not join the OCC and the FDIC in the proposed regulations. The comment period for the proposed regulations ends on March 9, 2020. Schwab is currently evaluating the impact of the proposed regulations. In May 2016, the Federal Reserve, the OCC and the FDIC jointly issued a notice of proposed rulemaking that would impose a minimum NSFR on certain banking organizations, including CSC. The comment period for the proposed rule ended on August 5, 2016 and the impact to the Company cannot be assessed until the final rule is released. The agencies indicated in the October 2019 interagency regulatory capital and liquidity rule their intention to utilize the four category tiering framework when the NSFR rule is adopted. RESULTS OF OPERATIONS Total Net Revenues Total net revenues of $10.7 billion and $10.1 billion for the years ended December 31, 2019 and 2018, respectively, represented growth of 6% and 18% from the prior periods, primarily due to increases in net interest revenue. (1) Beginning in 2019, a change was made to move CTFs from other asset management and administration fees. Prior periods have been recast to reflect this change. Net Interest Revenue Schwab’s primary interest-earning assets include cash and cash equivalents; cash and investments segregated; margin loans, which constitute the majority of receivables from brokerage clients; investment securities; and bank loans. Revenue on interest-earning assets is affected by various factors, such as the composition of assets, prevailing interest rates and spreads at the time of origination or purchase, changes in interest rates on floating rate securities and loans, and changes in prepayment levels for mortgage-backed and other asset-backed securities and loans. Fees earned on securities borrowing and lending activities, which are conducted by CS&Co using assets held in client brokerage accounts, are primarily included in other interest revenue and expense. Schwab’s interest-bearing liabilities include bank deposits, payables to brokerage clients, short-term borrowings (e.g., Federal Home Loan Bank (FHLB) advances), and long-term debt. Non-interest-bearing funding sources include stockholders’ equity, certain client cash balances, and other miscellaneous liabilities. We establish the rates paid on client-related liabilities, and management expects that it will generally adjust the rates paid on these liabilities at some fraction of any movement in short-term rates. Schwab deploys the funds from these sources into the - 33 - THE CHARLES SCHWAB CORPORATION Management’s Discussion and Analysis of Financial Condition and Results of Operations (Tabular Amounts in Millions, Except Ratios, or as Noted) assets outlined above. We do not use short-term, wholesale borrowings to support our long-term investment activity, but may use such funding, including FHLB advances, for short-term liquidity purposes or to provide temporary funding (e.g., for investment purchases) ahead of anticipated balance sheet deposit growth. In order to keep interest-rate sensitivity within established limits, management actively monitors and adjusts interest-rate sensitivity through changes in the balance sheet, primarily by adjusting the composition of our banking subsidiaries’ investment portfolios. As Schwab builds its client base, we attract new client sweep cash, which is a primary driver of funding balance sheet growth. Towards the end of 2018, the federal funds target interest rate increased to levels not seen in over a decade, leading us to expect some clients would shift more of their cash holdings from brokerage deposits swept to our banking subsidiaries to higher-yielding alternatives like purchased money market funds. We therefore expected brokerage deposits swept to our banking subsidiaries, excluding organic growth, to decline during the first part of 2019. As a result, we held a higher amount of short-term liquidity at our banking subsidiaries at the end of 2018 to accommodate this potential client cash sorting. While average interest rates throughout the year in 2019 were higher than average rates in 2018, interest rates across maturities declined from December 2018 to December 2019. Lower interest rates typically result in longer durations on our client-related liabilities and shorter durations on our investment securities, especially mortgage-related securities with options to prepay without penalty. During 2019, to maintain our overall targeted interest rate risk profile, we began positioning our banking entities’ investment portfolios to include a higher percentage of fixed-rate, longer duration investments to reduce our interest rate sensitivities which would naturally increase as market rates declined. We did, however, once again hold a higher level of short-term liquidity at the end of 2019 to accommodate a typical seasonal buildup of client cash, much of which then generally moves to other assets within a few months. We believe that the process of clients sorting between transactional cash and cash held for investment is subsiding. Aligned with market consensus, we do not expect to see a significant increase in market rates in the near term. Over the course of 2020, we expect to further reduce our exposure to lower rates primarily by adding a larger percentage of fixed-rate securities with relatively longer duration to our ongoing purchases as a result of maturities, prepayments, organic deposit growth, on-boarding of USAA-IMCO client cash to our balance sheet, and any potential asset-liability-management-driven investment portfolio re-balancing. As such, we expect the duration difference between our liabilities and assets to decline over the course of 2020. - 34 - THE CHARLES SCHWAB CORPORATION Management’s Discussion and Analysis of Financial Condition and Results of Operations (Tabular Amounts in Millions, Except Ratios, or as Noted) The following table presents net interest revenue information corresponding to interest-earning assets and funding sources on the consolidated balance sheets: (1) Amounts have been calculated based on amortized cost. (2) Interest revenue or expense was less than $500,000 in the period or periods presented. Net interest revenue increased $693 million or 12%, in 2019 from 2018, and $1.5 billion, or 36%, in 2018 from 2017, due to higher average investment yields and growth in interest earning assets. Our net interest margin improved 12 basis points to 2.41% in 2019, driven primarily by higher average yields received on interest-earning assets in 2019 due largely to the net impact of the Federal Reserve’s interest rate increases in 2018 and decreases in the third and fourth quarters of 2019. The increase in average yields on interest-earning assets was partially offset by higher average interest rates paid on bank deposits and other interest-bearing liabilities. The portfolio adjustments made in 2019 as described above helped to moderate the impact of the declining rate environment on our net interest margin. Average interest-earning assets grew 6% from 2018 to 2019, primarily driven by higher bank deposits due to transfers from sweep money market funds to bank sweep, as well as higher client cash balances. Our net interest margin improved 32 basis points to 2.29% in 2018, primarily as a result of the Federal Reserve’s 2017 and 2018 interest rate increases, partially offset by higher interest rates paid on bank deposits and other interest-bearing liabilities. Average interest earning assets grew 16% from 2017 to 2018, primarily reflecting higher bank deposits due to transfers from sweep money market funds to bank sweep, as well as changes in client cash allocations, partially offset by client purchases of other assets. In March 2017, the Company transferred $24.7 billion of debt securities from the AFS category to the HTM category. The transfer had no effect on the overall net interest margin. Short-term borrowings in 2018 and 2017 primarily included FHLB advances, which were used to provide temporary funding for investments ahead of deposit growth. - 35 - THE CHARLES SCHWAB CORPORATION Management’s Discussion and Analysis of Financial Condition and Results of Operations (Tabular Amounts in Millions, Except Ratios, or as Noted) Asset Management and Administration Fees Asset management and administration fees include mutual fund, ETF, and CTF service fees and fees for other asset-based financial services provided to individual and institutional clients. Schwab earns mutual fund, ETF, and CTF service fees for shareholder services, administration, and investment management provided to its proprietary funds, and recordkeeping and shareholder services provided to third-party funds. Asset management and administration fees are based upon the daily balances of client assets invested in these funds and do not include securities lending revenues earned by proprietary mutual funds, ETFs, and CTFs, as those amounts, net of program fees, are credited to the fund shareholders. Proprietary CTFs may, but generally do not, directly participate in securities lending. The fair values of client assets included in proprietary and third-party mutual funds, ETFs, and CTFs are based on quoted market prices and other observable market data. We also earn asset management fees for advice solutions, which include managed portfolios, specialized strategies, and customized investment advice. Other asset management and administration fees include various asset-based fees such as trust fees, 401(k) recordkeeping fees, mutual fund clearing fees, and non-balance based service and transaction fees. Asset management and administration fees vary with changes in the balances of client assets due to market fluctuations and client activity. The following table presents asset management and administration fees, average client assets, and average fee yields: (1) Beginning in the first quarter of 2019, a change was made to move CTFs from other balance-based fees. Prior periods have been recast to reflect this change. (2) Beginning in the fourth quarter of 2019, Schwab ETF OneSourceTM was discontinued as a result of the elimination of online trading commissions for U.S. and Canadian-listed ETFs. (3) Average client assets for advice solutions may also include the asset balances contained in the mutual fund and/or ETF categories listed above. (4) Includes various asset-related fees, such as trust fees, 401(k) recordkeeping fees, and mutual fund clearing fees and other service fees. (5) Includes miscellaneous service and transaction fees relating to mutual funds and ETFs that are not balance-based. Asset management and administration fees decreased by $18 million, or 1%, in 2019 from 2018, primarily due to lower sweep money market fund revenue as a result of transfers to bank and broker-dealer sweep in 2018 and early 2019, as well as client asset allocation choices including continued reduced usage of Mutual Fund OneSource®. Part of the decline was offset by revenue from growing asset balances in purchased money market funds, other third-party mutual funds and ETFs, and in advice solutions. Asset management and administration fees decreased by $163 million, or 5%, in 2018 from 2017, primarily due to lower money market fund revenue as a result of transfers to bank sweep, client asset allocation choices, and lower fee rates on - 36 - THE CHARLES SCHWAB CORPORATION Management’s Discussion and Analysis of Financial Condition and Results of Operations (Tabular Amounts in Millions, Except Ratios, or as Noted) proprietary money funds and other indexed mutual funds and ETFs due to fee reductions implemented by the Company in 2017. Part of the decline was offset by revenue from growing asset balances in advice solutions, Schwab equity and bond funds, ETFs, and CTFs, and other third-party mutual funds and ETFs. The following table presents a roll forward of client assets for the Schwab money market funds, Schwab equity and bond funds, ETFs, and CTFs, and Mutual Fund OneSource® and other non-transaction fee (NTF) funds. The following funds generated 45%, 48%, and 54% of the asset management and administration fees earned during 2019, 2018, and 2017, respectively: (1) Beginning in the first quarter of 2019, CTFs are included in these balances. Prior periods have been recast to reflect this change. (2) Includes net inflows from other third-party mutual funds to Mutual Fund OneSource® in the second quarter of 2017. Trading Revenue Trading revenue includes commission and principal transaction revenues. Commission revenue is affected by the number of revenue trades executed and the average revenue earned per revenue trade. Principal transaction revenue is primarily comprised of revenue from trading activity in fixed income securities with clients. To accommodate clients’ fixed income trading activity, Schwab maintains positions in fixed income securities, including U.S. state and municipal debt obligations, U.S. Government and corporate debt, and other securities. The difference between the price at which the Company buys and sells securities to and from its clients and other broker-dealers is recognized as principal transaction revenue. Principal transaction revenue also includes adjustments to the fair value of these securities positions. The following table presents trading revenue and the related drivers: Trading revenue decreased by $146 million, or 19%, in 2019 compared to 2018. The decrease was primarily due to a 20% decrease in DART volumes in 2019 as a result of the elimination of online trading commissions for U.S. and Canadian-listed stocks and ETFs, as well as the base charge on options effective October 7, 2019. Trading revenue increased by $109 million, or 17%, in 2018 compared to 2017. This increase was due primarily to a 31% increase in DART volumes in 2018, which more than offset Schwab’s 2017 commission pricing reductions to lower standard equity, ETF, and option trade commissions from $8.95 to $4.95 and lower the per contract option fee from $.75 to $.65. Other Revenue Other revenue includes order flow revenue, other service fees, software fees from our portfolio management solutions, exchange processing fees, and non-recurring gains. Other revenue increased $60 million, or 19%, in 2019 compared to 2018 due primarily to a gain from the sale of a portfolio management and reporting software solution for advisors to Tamarac Inc. in the second quarter of 2019 and a gain from the assignment of leased office space in the first quarter of 2019. Order flow revenue was $135 million during 2019, $139 million for 2018, and $114 million in 2017. The increase in 2018 from 2017 was primarily due to higher rebate rates received on certain types of orders and higher volume of trades. - 37 - THE CHARLES SCHWAB CORPORATION Management’s Discussion and Analysis of Financial Condition and Results of Operations (Tabular Amounts in Millions, Except Ratios, or as Noted) Total Expenses Excluding Interest The following table shows a comparison of total expenses excluding interest: ໿ Expenses excluding interest increased in 2019 and 2018 from the prior years by 5% and 12%, respectively. The largest driver of the increase in both years was compensation and benefits costs. Total compensation and benefits increased in 2019 from 2018, primarily due to both an overall increase in employee headcount to support our expanding client base and higher severance costs, which included $62 million associated with a 3% reduction in our workforce in the third quarter of 2019. The increase in 2018 from 2017 was primarily due to increases in employee headcount; additionally, special stock awards were issued in 2018 to non-officer employees, totaling $36 million. Professional services expense increased in 2019 from 2018, primarily due to overall growth in the business, investments in projects to further drive efficiency and scale, and certain costs relating to pending acquisitions. The increase in 2018 from 2017 was primarily due to higher spending on technology projects as well as an increase in asset management and administration related expenses resulting from growth in the Schwab Funds® and Schwab ETFs™. Occupancy and equipment expense increased in 2019 and 2018 from the prior years, primarily due to increases in software maintenance expenses and additional licenses to support growth in the business. Advertising and market development expense increased in 2018 from 2017, primarily reflecting management’s decision to increase television advertising and digital media spending in the fourth quarter of 2018. Depreciation and amortization expenses grew in 2019 and 2018 from the prior years, primarily due to higher amortization of internally developed software associated with continued investments in software and technology enhancements. Regulatory fees and assessments decreased in 2019 from 2018, primarily due to a decrease in FDIC insurance assessments resulting from the elimination of the FDIC surcharge in the fourth quarter of 2018. Regulatory fees and assessments - 38 - THE CHARLES SCHWAB CORPORATION Management’s Discussion and Analysis of Financial Condition and Results of Operations (Tabular Amounts in Millions, Except Ratios, or as Noted) increased in 2018 from 2017, due to an increase in FDIC insurance assessments which rose as a result of higher average assets in deposit balances, partially offset by the elimination of the FDIC surcharge. Other expenses decreased in 2019 from 2018, primarily due to lower travel and entertainment expense and bad debt expense. Other expenses increased in 2018 from 2017 due to travel and entertainment and miscellaneous items due to overall growth in the business. Capital expenditures were $753 million, $576 million, and $412 million in 2019, 2018, and 2017, respectively. The increases in capital expenditures in 2019 and 2018 from the prior years were primarily due to the expansion of our campuses in the U.S., with investments in buildings totaling $397 million and $253 million in 2019 and 2018, respectively. Capitalized costs for developing internal-use software totaled $165 million, $167 million, and $157 million in 2019, 2018, and 2017, respectively. Our capital expenditures for 2019 equaled 7% of total net revenues, within our estimated range for the year. Along with continued campus expansion, we will continue to invest further in technology projects in 2020. Excluding any potential impact of the pending acquisition of TD Ameritrade, we anticipate capital expenditures in 2020 to be approximately 5-6% of total net revenues, while our longer term expectation for capital expenditures remains in the range of 3-5% of total net revenues. Taxes on Income On December 22, 2017, P.L.115-97, the Tax Act, was signed into law, and became effective on January 1, 2018. Among other things, the Tax Act lowered the federal corporate income tax rate from 35% to 21% beginning in 2018. As a result of the Tax Act, Schwab recognized a $46 million one-time non-cash charge to taxes on income in the fourth quarter of 2017 associated with the remeasurement of net deferred tax assets and other tax adjustments related to the Tax Act. Schwab’s effective income tax rate on income before taxes was 23.6% in 2019, 23.1% in 2018, and 35.5% in 2017. The change in rates in 2019 from 2018 was primarily due to a decrease in equity compensation tax deduction benefits which reduced our tax expense by approximately $23 million and $46 million in 2019 and 2018, respectively. The change in rates in 2018 from 2017 was primarily due to impacts of the Tax Act and a decrease in equity compensation tax deduction benefits, which totaled $87 million in 2017. Segment Information Schwab provides financial services to individuals and institutional clients through two segments - Investor Services and Advisor Services. The Investor Services segment provides retail brokerage and banking services to individual investors, and retirement plan services, as well as other corporate brokerage services to businesses and their employees. The Advisor Services segment provides custodial, trading, banking, and support services, as well as retirement business services, to independent RIAs, independent retirement advisors, and recordkeepers. Revenues and expenses are attributed to the two segments based on which segment services the client. Management evaluates the performance of the segments on a pre-tax basis. Segment assets and liabilities are not used for evaluating segment performance or in deciding how to allocate resources to segments. Net revenues in both segments are generated from the underlying client assets and trading activity; differences in the composition of net revenues between the segments are based on the composition of client assets, client trading frequency, and pricing unique to each. While both segments leverage the scale and efficiency of our platforms, segment expenses reflect the dynamics of serving millions of clients in Investor Services versus the thousands of RIAs on the advisor platform. - 39 - THE CHARLES SCHWAB CORPORATION Management’s Discussion and Analysis of Financial Condition and Results of Operations (Tabular Amounts in Millions, Except Ratios, or as Noted) Financial information for our segments is presented in the following table: (1) Investor Services includes inflows of $11.1 billion and $34.5 billion in 2019 and 2017, respectively, and outflows of $93.9 billion in 2018 from certain mutual fund clearing services clients. N/M Not meaningful. Investor Services Total net revenues increased by 4% in 2019 from 2018 primarily due to an increase in net interest revenue and higher asset management and administrations fees, partially offset by lower trading revenue. Net interest revenue increased primarily due to higher average investment yields and higher interest-earning assets. Asset management and administration fees increased primarily due to growing asset balances in advice solutions, partially offset by lower mutual fund and ETF service fee revenue as a result of client cash allocation choices, including reduced usage of Mutual Fund OneSource®. Trading revenue decreased as a result of the elimination of online trading commissions for U.S. and Canadian-listed stocks and ETFs, as well as the base charge on options in the fourth quarter of 2019. Expenses excluding interest increased by 3% in 2019 compared to 2018, primarily as a result of higher compensation and benefits due to increased headcount in 2019 and severance charges in the third quarter of 2019, higher occupancy and equipment expenses due to an increase in software maintenance expenses and additional licenses to support growth in the business, and higher amortization of internally developed software associated with continued investments in software and technology enhancements. These increases were partially offset by a decrease in FDIC insurance assessments due to the elimination of the FDIC surcharge in the fourth quarter of 2018 and lower travel and entertainment expenses. Total net revenues increased by $1.1 billion, or 18%, in 2018 from 2017 primarily due to an increase in net interest revenue, partially offset by lower asset management and administration fees. Net interest revenue increased primarily due to higher net interest margins and higher balances of interest-earning assets. Asset management and administration fees decreased primarily due to lower money market fund revenue as a result of transfers to bank sweep, client asset allocation choices, and our 2017 fee reductions. Expenses excluding interest increased by $420 million, or 11%, in 2018 from 2017 primarily due to higher compensation and benefits, technology project spend, and asset management and administration related expenses to support the Company’s expanding client base. Advisor Services Total net revenues increased by 10%, in 2019 from 2018 primarily due to an increase in net interest revenue and other revenue, partially offset by lower asset management and administration fees and lower trading revenue. Net interest revenue increased primarily due to higher average investment yields and higher interest-earning assets. Other revenue increased primarily due to a gain from the sale of a portfolio management and reporting software solution for advisors to Tamarac Inc. in the second quarter of 2019. Asset management and administration fees decreased primarily due to lower sweep money market fund revenue as a result of transfers to bank and broker-dealer sweep, as well as client asset allocation choices, including reduced usage of Mutual Fund OneSource®, partially offset by increased revenue from growing asset balances in purchased money market funds and in other third-party mutual funds and ETFs. Trading revenue decreased as a result of the - 40 - THE CHARLES SCHWAB CORPORATION Management’s Discussion and Analysis of Financial Condition and Results of Operations (Tabular Amounts in Millions, Except Ratios, or as Noted) elimination of online trading commissions for U.S. and Canadian-listed stocks and ETFs, as well as the base charge on options in the fourth quarter of 2019. Expenses excluding interest increased by 12% of 2019 compared to 2018, primarily due to higher compensation and benefits due to increased headcount in 2019 and severance charges in the third quarter of 2019, higher professional services expense due to overall growth in the business and investments in projects to further drive efficiency and scale, and higher occupancy and equipment expense due to an increase in software maintenance expenses and additional licenses to support growth in the business. These increases were partially offset by a decrease in FDIC insurance assessments due to the elimination of the FDIC surcharge in the fourth quarter of 2018, lower bad debt expenses, and lower travel and entertainment expenses. Total net revenues increased by $393 million or 16%, in 2018 from 2017 primarily due to an increase in net interest revenue, partially offset by lower asset management and administration fees. Net interest revenue increased primarily due to higher net interest margins and higher balances of interest-earning assets. Asset management and administration fees decreased primarily due to lower money market fund revenue as a result of transfers to bank sweep, client asset allocation choices, and our 2017 fee reductions. Expenses excluding interest increased by $182 million, or 15%, in 2018 from 2017 primarily due to higher compensation and benefits, technology project spend, and asset management and administration related expenses to support the Company’s expanding client base. RISK MANAGEMENT Schwab’s business activities expose it to a variety of risks, including operational, credit, market, liquidity, and compliance risks. The Company has a comprehensive risk management program to identify and manage these risks and their associated potential for financial and reputational impact. Despite our efforts to identify areas of risk and implement risk management policies and procedures, there can be no assurance that Schwab will not suffer unexpected losses due to these risks. Our risk management process is comprised of risk identification and assessment, risk measurement, risk monitoring and reporting, and risk mitigation controls; we use periodic risk and control self-assessments, control testing programs, and internal audit reviews to evaluate the effectiveness of these internal controls. The activities and governance that comprise the risk management process are described below. Culture The Board of Directors has approved an Enterprise Risk Management (ERM) framework that incorporates our purpose, vision, and values, which form the bedrock of our corporate culture and set the tone for the organization. We designed the ERM Framework to enable a comprehensive approach to managing risks encountered by Schwab in its business activities. The framework incorporates key concepts commensurate with the size, risk profile, complexity, and continuing growth of the Company. Risk appetite, which is defined as the amount of risk the Company is willing to accept in pursuit of its corporate strategy, is developed by executive management and approved by the Board of Directors. Risk Governance Senior management takes an active role in the risk management process and has developed policies and procedures under which specific business and control units are responsible for identifying, measuring, and controlling risks. The Global Risk Committee, which is comprised of senior executives from each major business and control function, is responsible for the oversight of risk management. This includes identifying emerging risks, assessing risk management practices and the control environment, reinforcing business accountability for risk management, supervisory controls and regulatory compliance, supporting resource prioritization across the organization, and escalating significant issues to the Board of Directors. We have established risk metrics and reporting that enable measurement of the impact of strategy execution against risk appetite. The risk metrics, with risk limits and tolerance levels, are established for key risk categories by the Global Risk Committee and its functional risk sub-committees. - 41 - THE CHARLES SCHWAB CORPORATION Management’s Discussion and Analysis of Financial Condition and Results of Operations (Tabular Amounts in Millions, Except Ratios, or as Noted) The Chief Risk Officer regularly reports activities of the Global Risk Committee to the Risk Committee of the Board of Directors. The Board Risk Committee in turn assists the Board of Directors in fulfilling its oversight responsibilities with respect to our risk management program, including approving risk appetite statements and related key risk appetite metrics and reviewing reports relating to risk issues from functional areas of corporate risk management, legal, compliance, and internal audit. Functional risk sub-committees focusing on specific areas of risk report to the Global Risk Committee. These sub-committees include the: • Operational Risk Oversight Committee - provides oversight of and approves operational risk management policies, risk tolerance levels, and operational risk governance processes, and includes sub-committees covering Information Security, Fraud, Third-Party Risk, Data, and Model Governance; • Compliance Risk Committee - provides oversight of compliance risk management programs and policies providing an aggregate view of compliance risk exposure and employee conduct, including subcommittees covering Fiduciary and Conflicts of Interest Risk and International Compliance Risk; • Financial Risk Oversight Committee - provides oversight of and approves credit, market, liquidity, and capital risk policies, limits, and exposures; and • New Products and Services Risk Oversight Committee - provides oversight of, and approves corporate policy and procedures relating to, the risk governance of new products and services. Senior management has also created an Incentive Compensation Risk Oversight Committee, which establishes policy and reviews and approves the Annual Risk Assessment of incentive compensation plans, and reports directly to the Compensation Committee of the Board of Directors. The Company’s compliance, finance, internal audit, legal, and corporate risk management departments assist management and the various risk committees in evaluating, testing, and monitoring risk management. In addition, the Disclosure Committee is responsible for monitoring and evaluating the effectiveness of our disclosure controls and procedures and internal control over financial reporting as of the end of each fiscal quarter. The Disclosure Committee reports on this evaluation to the CEO and CFO prior to their certification required by Sections 302 and 906 of the Sarbanes Oxley Act of 2002. Operational Risk Operational risk arises due to potential inadequacies or failures related to people, internal processes, and systems, or from external events or relationships impacting the Company and/or any of its key business partners and third parties. While operational risk is inherent in all business activities, we rely on a system of internal controls and risk management practices designed to keep operational risk and operational losses within the Company’s risk appetite. We have specific policies and procedures to identify and manage operational risk, and use control testing programs, and internal audit reviews to evaluate the effectiveness of these internal controls. Where appropriate, we manage the impact of operational loss and litigation expense through the purchase of insurance. The insurance program is specifically designed to address our key operational risks and to maintain compliance with local laws and regulation. Schwab’s operations are highly dependent on the integrity and resilience of our critical business functions and technology systems. To the extent Schwab experiences business or system interruptions, errors or downtime (which could result from a variety of causes, including natural disasters, terrorist attacks, technological failure, cyber attacks, changes to systems, linkages with third-party systems, and power failures), our business and operations could be negatively impacted. To minimize business interruptions and ensure the capacity to continue operations during an incident regardless of duration, Schwab maintains a backup and recovery infrastructure which includes facilities for backup and communications, a geographically dispersed workforce, and routine testing of business continuity and disaster recovery plans and a well-established incident management program. Information Security risk is the risk of unauthorized access, use, disclosure, disruption, modification, recording or destruction of the firm’s information or systems. We have designed and implemented an information security program that knits together complementary tools, controls and technologies to protect systems, client accounts and data. We continuously - 42 - THE CHARLES SCHWAB CORPORATION Management’s Discussion and Analysis of Financial Condition and Results of Operations (Tabular Amounts in Millions, Except Ratios, or as Noted) monitor the systems and work collaboratively with government agencies, law enforcement and other financial institutions to address potential threats. We use advanced monitoring systems to identify suspicious activity and deter unauthorized access by internal or external actors. We limit the number of employees who have access to clients’ personal information and internal authentication measures are enforced to protect against the potential for social engineering. All employees who handle sensitive information are trained in privacy and security. Schwab’s conduct and cybersecurity teams monitor activity looking for suspicious behavior. These capabilities allow us to identify and quickly act on any attempted intrusions. Fraud risk arises from attempted or actual theft of financial assets or other property of any client or the Company. Schwab is committed to protecting the Company’s and its clients’ assets from fraud, and complying with all applicable laws and regulations to prevent, detect and report fraudulent activity. Schwab manages fraud risk through policies, procedures and controls. We also take affirmative steps to prevent and detect fraud and report, to appropriate authorities, any known or suspected acts of fraud in accordance with existing laws and requirements. Schwab also faces operational risk when we employ the services of various third parties, including domestic and international outsourcing of certain technology, processing, servicing, and support functions. We manage the exposure to third party risk and promote a culture of resiliency through contractual provisions, control standards, ongoing monitoring of third party performance, and appropriate testing. We also maintain policies and procedures regarding the standard of care expected with all data, whether the data is internal company information, employee information, or non-public client information. We clearly define for employees, contractors, and third parties the expected standards of care for critical and confidential data. We also provide regular training on data security. Model risk is the potential for adverse consequences from decisions based on incorrect or misused model outputs and reports. Models are owned by several business units throughout the organization, and are used for a variety of purposes. Model use includes, but is not limited to, calculating capital requirements for hypothetical stressful environments, estimating interest and credit risk for loans and other balance sheet assets, and providing guidance in the management of client portfolios. We have established a policy to describe the roles and responsibilities of all key stakeholders in model development, management, and use. All models are registered in a centralized database and classified into different risk ratings depending on their potential financial, reputational, or regulatory impact to the Company. The model risk rating determines the scope of model governance activities. Incentive Compensation risk is the potential for adverse consequences resulting from compensation plans that do not balance the execution of our strategy with risk and financial rewards, potentially encouraging imprudent risk-taking by employees. We have implemented risk management processes, including a policy, to identify, evaluate, assess, and manage risks associated with incentive compensation plans and the activities of certain employees, defined as Covered Employees, who have the authority to expose the Company to material amounts of risk. Compliance Risk Schwab faces compliance risk which is the potential exposure to legal or regulatory sanctions, fines or penalties, financial loss, or damage to reputation resulting from the failure to comply with laws, regulations, rules, or other regulatory requirements. Among other things, compliance risks relate to the suitability of client investments, conflicts of interest, disclosure obligations and performance expectations for products and services, supervision of employees, and the adequacy of our controls. The Company and its affiliates are subject to extensive regulation by federal, state and foreign regulatory authorities, including SROs. We manage compliance risk through policies, procedures and controls reasonably designed to achieve and/or monitor compliance with applicable legal and regulatory requirements. These procedures address issues such as conduct and ethics, sales and trading practices, marketing and communications, extension of credit, client funds and securities, books and records, anti-money laundering, client privacy, and employment policies. Conduct risk arises from inappropriate, unethical, or unlawful behavior of the Company, its employees or third parties acting on the Company’s behalf that may result in detriment to the Company’s clients, financial markets, the Company, and/or the Company’s employees. We manage this risk through a policy, procedures, a system of internal controls, including personnel monitoring and surveillance. Conduct-related matters are escalated through appropriate channels by the Corporate Responsibility Officer. - 43 - THE CHARLES SCHWAB CORPORATION Management’s Discussion and Analysis of Financial Condition and Results of Operations (Tabular Amounts in Millions, Except Ratios, or as Noted) Fiduciary risk is the potential for financial or reputational loss through breach of fiduciary duties to a client. Fiduciary activities include, but are not limited to, individual and institutional trust, investment management, custody, and cash and securities processing. We manage this risk by establishing policy and procedures to ensure that obligations to clients are discharged faithfully and in compliance with applicable legal and regulatory requirements. Business units have the primary responsibility for adherence to the policy and procedures applicable to their business. Guidance and control are provided through the creation, approval, and ongoing review of applicable policies by business units and various risk committees. Credit Risk Credit risk is the potential for loss due to a borrower, counterparty, or issuer failing to perform its contractual obligations. Our exposure to credit risk mainly results from investing activities in our liquidity and investment portfolios, mortgage lending, margin lending and client option and futures activities, pledged asset lending, securities lending activities, and our role as a counterparty in other financial contracts. To manage the risks of such losses, we have established policies and procedures, which include setting and reviewing credit limits, monitoring of credit limits and quality of counterparties, and adjusting margin, PAL, option, and futures requirements for certain securities and instruments. Liquidity and Investment Portfolios Schwab has exposure to credit risk associated with its investment portfolios, which include U.S. agency and non-agency mortgage-backed securities, asset-backed securities, corporate debt securities, U.S. agency notes, U.S. Treasury securities, certificates of deposit, U.S. state and municipal securities, commercial paper, and foreign government agency securities. At December 31, 2019, substantially all securities in the investment portfolios were rated investment grade. U.S. agency mortgage-backed securities do not have explicit credit ratings; however, management considers these to be of the highest credit quality and rating given the guarantee of principal and interest by the U.S. government or U.S. government-sponsored enterprises. Mortgage Lending Portfolio The bank loan portfolio includes First Mortgages, HELOCs, and other loans. The credit risk exposure related to loans is actively managed through individual loan and portfolio reviews. Management regularly reviews asset quality, including concentrations, delinquencies, nonaccrual loans, charge-offs, and recoveries. All are factors in the determination of an appropriate allowance for loan losses. Our residential loan underwriting guidelines include maximum LTV ratios, cash out limits, and minimum Fair Isaac Corporation (FICO) credit scores. The specific guidelines are dependent on the individual characteristics of a loan (for example, whether the property is a primary or secondary residence, whether the loan is for investment property, whether the loan is for an initial purchase of a home or refinance of an existing home, and whether the loan size is conforming or jumbo). Schwab does not originate or purchase residential loans that allow for negative amortization and does not originate or purchase subprime loans (generally defined as extensions of credit to borrowers with a FICO score of less than 620 at origination), unless the borrower has compensating credit factors. For more information on credit quality indicators relating to Schwab’s bank loans, see Item 8 - Note 6. Securities and Instrument-Based Lending Portfolios Collateral arrangements relating to margin loans, PALs, option and futures positions, securities lending agreements, and securities purchased under agreements to resell (resale agreements) include provisions that require additional collateral in the event of market fluctuations. Additionally, for margin loans, PALs, options and futures positions, and securities lending agreements, collateral arrangements require that the fair value of such collateral sufficiently exceeds the credit exposure in order to maintain a fully secured position. - 44 - THE CHARLES SCHWAB CORPORATION Management’s Discussion and Analysis of Financial Condition and Results of Operations (Tabular Amounts in Millions, Except Ratios, or as Noted) Other Counterparty Exposures Schwab performs clearing services for all securities transactions in its client accounts. Schwab has exposure to credit risk due to its obligation to settle transactions with clearing corporations, mutual funds, and other financial institutions even if Schwab’s clients or a counterparty fail to meet their obligations to Schwab. Market Risk Market risk is the potential for changes in earnings or the value of financial instruments held by Schwab as a result of fluctuations in interest rates, equity prices, or market conditions. Schwab is exposed to interest rate risk primarily from changes in market interest rates on our interest-earning assets relative to changes in the costs of funding sources that finance these assets. To manage interest rate risk, we have established policies and procedures, which include setting limits on net interest revenue risk and economic value of equity risk. To remain within these limits, we manage the maturity, repricing, and cash flow characteristics of the investment portfolios. Management monitors established guidelines to stay within the Company’s risk appetite. Our measurement of interest rate risk involves assumptions that are inherently uncertain and, as a result, cannot precisely estimate the impact of changes in interest rates on net interest revenue or economic value of equity. Actual results may differ from simulated results due to balance growth or decline and the timing, magnitude, and frequency of interest rate changes, as well as changes in market conditions and management strategies, including changes in asset and liability mix. Financial instruments are also subject to the risk that valuations will be negatively affected by changes in demand and the underlying market for a financial instrument. We are indirectly exposed to option, futures, and equity market fluctuations in connection with client option and futures accounts, securities collateralizing margin loans to brokerage customers, and client securities loaned out as part of the brokerage securities lending activities. Equity market valuations may also affect the level of brokerage client trading activity, margin borrowing, and overall client engagement with Schwab. Additionally, we earn mutual fund and ETF service fees and asset management fees based upon daily balances of certain client assets. Fluctuations in these client asset balances caused by changes in equity valuations directly impact the amount of fee revenue we earn. Our market risk related to financial instruments held for trading is not material. Net Interest Revenue Simulation For our net interest revenue sensitivity analysis, we use net interest revenue simulation modeling techniques to evaluate and manage the effect of changing interest rates. The simulations include all interest rate-sensitive assets and liabilities. Key assumptions include the projection of interest rate scenarios with rate floors, prepayment speeds of mortgage-related investments, repricing of financial instruments, and reinvestment of matured or paid-down securities and loans. Net interest revenue is affected by various factors, such as the distribution and composition of interest-earning assets and interest-bearing liabilities, the spread between yields earned on interest-earning assets and rates paid on interest-bearing liabilities, which may reprice at different times or by different amounts, and the spread between short and long-term interest rates. Interest-earning assets primarily include investment securities, margin loans and bank loans. These assets are sensitive to changes in interest rates and changes in prepayment levels that tend to increase in a declining rate environment and decrease in a rising rate environment. Because we establish the rates paid on certain brokerage client cash balances and bank deposits and the rates charged on certain margin and bank loans, and control the composition of our investment securities, we have some ability to manage our net interest spread, depending on competitive factors and market conditions. - 45 - THE CHARLES SCHWAB CORPORATION Management’s Discussion and Analysis of Financial Condition and Results of Operations (Tabular Amounts in Millions, Except Ratios, or as Noted) Net interest revenue sensitivity analysis assumes the asset and liability structure of the consolidated balance sheet would not be changed as a result of the simulated changes in interest rates. As we actively manage the consolidated balance sheet and interest rate exposure, in all likelihood we would take steps to manage additional interest rate exposure that could result from changes in the interest rate environment. The following table shows the simulated net interest revenue change over the next 12 months beginning December 31, 2019 and 2018 of a gradual 100 basis point increase or decrease in market interest rates relative to prevailing market rates at the end of each reporting period: The year-over-year change in net interest revenue sensitivities reflects lower interest rates across the yield curve, producing higher adverse sensitivity to lower rates as funding costs more rapidly reach rate floor assumptions. In addition to measuring the effect of a gradual 100 basis point parallel increase or decrease in current interest rates, we regularly simulate the effects of larger parallel- and non-parallel shifts in interest rates on net interest revenue. Economic Value of Equity Simulation Management also uses economic value of equity (EVE) simulations to measure interest rate risk. EVE sensitivity measures the long-term impact of interest rate changes on the net present value of assets and liabilities. EVE is calculated by subjecting the balance sheet to hypothetical instantaneous shifts in the level of interest rates. This analysis is highly dependent upon asset and liability assumptions based on historical behaviors as well as our expectations of the economic environment. Key assumptions in our EVE calculation include projection of interest rate scenarios with rate floors, prepayment speeds of mortgage-related investments, term structure models of interest rates, non-maturity deposit behavior, and pricing assumptions. Expected Phase-out of LIBOR The Company has established a firm-wide team to address the likely discontinuation of LIBOR. As part of our efforts, we have inventoried our LIBOR exposures, the largest of which are certain investment securities and loans. In purchasing new investment securities, we ensure that appropriate fall-back language is in the security’s prospectus in the event that LIBOR is unavailable or deemed unreliable. We are updating loan agreements to ensure new LIBOR-based loans adequately provide for an alternative to LIBOR. Furthermore, we plan to phase-out the use of LIBOR as a reference rate in our new lending products before December 2021. Consistent with our “Through Clients’ Eyes” strategy, our focus throughout the LIBOR transition process is to ensure clients are treated fairly and consistently as this major change is occurring in the financial markets. The market transition process has not yet progressed to a point at which the impact to the Company’s consolidated financial statements of LIBOR’s discontinuation can be estimated. Liquidity Risk Liquidity risk is the potential that Schwab will be unable to sell assets or meet cash flow obligations when they come due without incurring unacceptable losses. Due to its role as a source of financial strength, CSC’s liquidity needs are primarily driven by the liquidity and capital needs of CS&Co, the capital needs of the banking subsidiaries, principal and interest due on corporate debt, dividend payments on CSC’s preferred stock, and returns of capital to common stockholders. The liquidity needs of CS&Co are primarily driven by client activity including trading and margin borrowing activities and capital expenditures. The capital needs of the banking subsidiaries are primarily driven by client deposits. We have established liquidity policies to support the successful execution of business strategies, while ensuring ongoing and sufficient liquidity to meet operational needs and satisfy applicable regulatory requirements under both normal and stressed conditions. We seek to maintain client confidence in the balance sheet and the safety of client assets by maintaining liquidity and diversity of funding sources to allow the Company to meet its obligations. To this end, we have established limits and contingency funding scenarios to support liquidity levels during both business as usual and stressed conditions. - 46 - THE CHARLES SCHWAB CORPORATION Management’s Discussion and Analysis of Financial Condition and Results of Operations (Tabular Amounts in Millions, Except Ratios, or as Noted) We employ a variety of methodologies to monitor and manage liquidity. We conduct regular liquidity stress testing to develop a consolidated view of liquidity risk exposures and to ensure our ability to maintain sufficient liquidity during market-related or company-specific liquidity stress events. Liquidity is also tested at key subsidiaries and results are reported to the Financial Risk Oversight Committee. A number of early warning indicators are monitored to help identify emerging liquidity stresses in the market or within the organization and are reviewed with management as appropriate. Primary Funding Sources Schwab’s primary source of funds is cash generated by client activity which includes bank deposits and cash balances in client brokerage accounts. These funds are used to purchase investment securities and extend loans to clients. Other sources of funds may include cash flows from operations, maturities and sales of investment securities, repayments on loans, securities lending of assets held in client brokerage accounts, repurchase agreements, and cash provided by external financing. To meet daily funding needs, we maintain liquidity in the form of overnight cash deposits and short-term investments. For unanticipated liquidity needs, we also maintain a buffer of highly liquid investments, including U.S. Treasury securities. Additional Funding Sources In addition to internal sources of liquidity, Schwab has access to external funding. The need for short-term borrowings from external debt facilities arises primarily from timing differences between cash flow requirements, scheduled liquidation of interest-earning investments, movements of cash to meet regulatory brokerage client cash segregation requirements and general corporate purposes. We maintain policies and procedures necessary to access funding and test discount window borrowing procedures on a periodic basis. The following table describes external debt facilities available at December 31, 2019: (1) Amounts available are dependent on the amount of First Mortgages, HELOCs, and the fair value of certain investment securities that are pledged as collateral. (2) Amounts available are dependent on the fair value of certain investment securities that are pledged as collateral. (3) CSC has authorization from its Board of Directors to issue Commercial Paper Notes not to exceed $1.5 billion. Management has set a current limit not to exceed the amount of the committed, unsecured credit facility. (4) Other than an overnight borrowing to test availability, this facility was unused during 2019. Our banking subsidiaries maintain secured credit facilities with the FHLB. Amounts available under these facilities are dependent on the value of our First Mortgages, HELOCs, and the fair value of certain of our investment securities that are pledged as collateral. These credit facilities are also available as backup financing in the event the outflow of client cash from the banking subsidiaries’ respective balance sheets is greater than maturities and paydowns on investment securities and bank loans. Our banking subsidiaries also have access to short-term secured funding through the Federal Reserve discount window. Amounts available under the Federal Reserve discount window are dependent on the fair value of certain investment securities that are pledged as collateral. CSC has a commercial paper program of which proceeds are used for general corporate purposes. The maturities of the Commercial Paper Notes may vary, but are not to exceed 270 days from the date of issue. CSC’s ratings for these short-term borrowings were P1 by Moody’s, A1 by Standard & Poor’s, and by Fitch at December 31, 2019 and 2018, and CSC had no Commercial Paper Notes outstanding at December 31, 2019 or 2018. - 47 - THE CHARLES SCHWAB CORPORATION Management’s Discussion and Analysis of Financial Condition and Results of Operations (Tabular Amounts in Millions, Except Ratios, or as Noted) The financial covenants for the $750 million committed credit facility require CS&Co to maintain a minimum net capital ratio, all bank subsidiaries to be well capitalized, and CSC to maintain a minimum level of stockholders’ equity, adjusted to exclude AOCI. At December 31, 2019, the minimum level of stockholders’ equity required under this facility was $16.0 billion (CSC’s stockholders’ equity, excluding AOCI, at December 31, 2019 was $21.7 billion). Management believes these restrictions will not have a material effect on CSC’s ability to meet foreseeable dividend or funding requirements. To partially satisfy the margin requirement of client option transactions with the Options Clearing Corporation, CS&Co has unsecured standby letter of credit agreements (LOCs) with several banks in favor of the Options Clearing Corporation aggregating $20 million at December 31, 2019. There were no funds drawn under any of these LOCs during 2019 or 2018. In connection with its securities lending activities, the Company is required to provide collateral to certain brokerage clients. The collateral requirements were satisfied by providing cash as collateral. CSC has a universal automatic shelf registration statement on file with the SEC, which enables it to issue debt, equity, and other securities. Liquidity Coverage Ratio As Schwab’s consolidated balance sheet assets were above $250 billion at December 31, 2018, Schwab became subject to the non-modified LCR rule on April 1, 2019. The Company was in compliance with the LCR rule at December 31, 2019. See Business - Regulation in Part I, Item 1 for information on recently issued rules that impact Schwab’s LCR requirements. The table below presents information about our average LCR: Borrowings The Company had no short-term borrowings outstanding as of December 31, 2019 or 2018. Long-term debt outstanding was $7.4 billion and $6.9 billion at December 31, 2019 and 2018, respectively. The following are details of the Senior Notes: - 48 - THE CHARLES SCHWAB CORPORATION Management’s Discussion and Analysis of Financial Condition and Results of Operations (Tabular Amounts in Millions, Except Ratios, or as Noted) New Debt Issuances All debt issuances in 2019, 2018, and 2017 were senior unsecured obligations. Additional details are as follows: Equity Issuances and Redemptions CSC did not issue any equity through external offerings during 2019 or 2018. CSC’s preferred stock issued and net proceeds for 2017 are as follows: On December 1, 2017, CSC redeemed all of the 485,000 outstanding shares of its 6.00% Non-Cumulative Perpetual Preferred Stock, Series B (Series B Preferred Stock), and the corresponding 19,400,000 depositary shares, each representing a 1/40th interest in a share of the Series B Preferred Stock. For further discussion of CSC’s long-term debt and information on the equity offerings, see Item 8 - Note 12 and Note 17. Acquisition of USAA-IMCO We expect to utilize cash generated from operations to fund the $1.8 billion purchase of assets from USAA-IMCO. The transaction is expected to close in mid-2020, subject to satisfaction of closing conditions, including regulatory approvals and the implementation of conversion plans. Off-Balance Sheet Arrangements Schwab enters into various off-balance sheet arrangements in the ordinary course of business, primarily to meet the needs of our clients. These arrangements include firm commitments to extend credit. Additionally, Schwab enters into guarantees and other similar arrangements in the ordinary course of business. For information on each of these arrangements, see Item 8 - Note 6, Note 10, Note 12, Note 14, and Note 15. - 49 - THE CHARLES SCHWAB CORPORATION Management’s Discussion and Analysis of Financial Condition and Results of Operations (Tabular Amounts in Millions, Except Ratios, or as Noted) Contractual Obligations Schwab’s principal contractual obligations as of December 31, 2019 are shown in the following table. Excluded from this table are liabilities recorded on the consolidated balance sheets that are generally short-term in nature or without contractual payment terms (e.g., bank deposits, payables to brokerage clients, and deferred compensation). The below table also excludes the planned all-stock acquisition of TD Ameritrade and any expenses related to the acquisition. (1) Represents CSB’s commitments to extend credit to banking clients, purchase mortgage loans, and commitments to fund CRA investments. (2) Includes estimated future interest payments through 2029 for Senior Notes. Amounts exclude unamortized discounts and premiums. (3) Consists of purchase obligations for services such as advertising and marketing, telecommunications, professional services, and hardware- and software-related agreements. Also includes $1.8 billion for the planned acquisition of USAA-IMCO assets; other costs related to the USAA-IMCO acquisition are excluded. (See Item 8 - Note 14). (4) Represents operating lease payments including legally-binding minimum lease payments for leases signed but not yet commenced. CAPITAL MANAGEMENT Schwab seeks to manage capital to a level and composition sufficient to support execution of our business strategy, including anticipated balance sheet growth, providing financial support to our subsidiaries, and sustained access to the capital markets, while at the same time meeting our regulatory capital requirements and serving as a source of financial strength to our banking subsidiaries. Schwab’s primary sources of capital are funds generated by the operations of subsidiaries and securities issuances by CSC in the capital markets. To ensure that Schwab has sufficient capital to absorb unanticipated losses or declines in asset values, we have adopted a policy to remain well capitalized even in stressed scenarios. Our capital management in coming quarters will incorporate preparations for closing the USAA-IMCO transaction, including the allocation of capital to support client cash that will be added to our balance sheet. Internal guidelines are set, for both CSC and its regulated subsidiaries, to ensure capital levels are in line with our strategy and regulatory requirements. Capital forecasts are reviewed monthly at Asset-Liability Management and Pricing Committee and Financial Risk Oversight Committee meetings. A number of early warning indicators are monitored to help identify potential problems that could impact capital. In addition, we monitor the subsidiaries’ capital levels and requirements. Subject to regulatory capital requirements and any required approvals, any excess capital held by subsidiaries is transferred to CSC in the form of dividends and returns of capital. When subsidiaries have need of additional capital, funds are provided by CSC as equity investments and also as subordinated loans (in a form approved as regulatory capital by regulators) for CS&Co. The details and method used for each cash infusion are based on an analysis of the particular entity’s needs and financing alternatives. The amounts and structure of infusions must take into consideration maintenance of regulatory capital requirements, debt/equity ratios, and equity double leverage ratios. Schwab conducts regular capital stress testing to assess the potential financial impacts of various adverse macroeconomic and company-specific events to which the Company could be subjected. The objective of the capital stress testing is (1) to explore various potential outcomes - including rare and extreme events and (2) to assess impacts of potential stressful outcomes on both capital and liquidity. Additionally, we have a comprehensive Capital Contingency Plan to provide action plans for certain low probability/high impact capital events that the Company might face. The Capital Contingency Plan is issued under the authority of the Financial Risk Oversight Committee and provides guidelines for sustained capital events. It does not specifically address every contingency, but is designed to provide a framework for responding to any capital stress. The results of the stress testing indicate there are two scenarios which could stress the Company’s capital: (1) inflows of balance sheet cash during a period of very low interest rates and (2) outflows of balance sheet cash when other sources of financing are not available and the Company is required to sell assets to fund the flows at a loss. The Capital Contingency Plan is reviewed annually and updated as appropriate. - 50 - THE CHARLES SCHWAB CORPORATION Management’s Discussion and Analysis of Financial Condition and Results of Operations (Tabular Amounts in Millions, Except Ratios, or as Noted) For additional information, see Business - Regulation in Part I, Item 1. Regulatory Capital Requirements CSC is subject to capital requirements set by the Federal Reserve and is required to serve as a source of strength for our banking subsidiaries and to provide financial assistance if our banking subsidiaries experience financial distress. Schwab is required to maintain a Tier 1 Leverage Ratio for CSC of at least 4%; however, management seeks to maintain a ratio of at least 6%. Due to the relatively low risk of our balance sheet assets and risk-based capital ratios at CSC and CSB that are well in excess of regulatory requirements, the Tier 1 Leverage Ratio is the most restrictive capital constraint on CSC’s asset growth. Our banking subsidiaries are subject to capital requirements set by their regulators that are substantially similar to those imposed on CSC by the Federal Reserve. Our banking subsidiaries’ failure to remain well capitalized could result in certain mandatory and possibly additional discretionary actions by the regulators that could have a direct material effect on the banks. Schwab’s principal banking subsidiary, CSB, is required to maintain a Tier 1 Leverage Ratio of at least 5% to be well capitalized, but seeks to maintain a ratio of at least 6.25%. Based on its regulatory capital ratios at December 31, 2019, CSB is considered well capitalized. The following table details the capital ratios for CSC consolidated and CSB: (1) Beginning in 2019, CSC and CSB were required to include all components of AOCI in regulatory capital and report our supplementary leverage ratio, which is calculated as Tier 1 capital divided by total leverage exposure. Total leverage exposure includes all on-balance sheet assets and certain off-balance sheet exposures, including unused commitments. Prior to 2019, CSC and CSB elected to opt-out of the requirement to include most components of AOCI in Common Equity Tier 1 Capital; the amounts and ratios for December 31, 2018 are presented on this basis. In the interagency regulatory capital and liquidity rules adopted in October 2019, Category III banking organizations such as CSC were given the ability to opt-out of the inclusion of AOCI in regulatory capital, and CSC made this opt-out election effective as of January 1, 2020. See Business - Regulation in Part I, Item 1 for additional information on recently issued rules that impact Schwab’s regulatory capital requirements. N/A Not applicable. CSB is also subject to regulatory requirements that restrict and govern the terms of affiliate transactions. In addition, CSB is required to provide notice to, and may be required to obtain approval from, the OCC and the Federal Reserve to declare dividends to CSC. - 51 - THE CHARLES SCHWAB CORPORATION Management’s Discussion and Analysis of Financial Condition and Results of Operations (Tabular Amounts in Millions, Except Ratios, or as Noted) As a broker-dealer, CS&Co is subject to regulatory requirements of the Uniform Net Capital Rule, which is intended to ensure the general financial soundness and liquidity of broker-dealers. These regulations prohibit CS&Co from paying cash dividends, making unsecured advances and loans to the parent company and employees, and repaying subordinated borrowings from CSC if such payment would result in a net capital amount below prescribed thresholds. At December 31, 2019, CS&Co was in compliance with its net capital requirements. In addition to the capital requirements above, Schwab’s subsidiaries are subject to other regulatory requirements intended to ensure financial soundness and liquidity. See Item 8 - Note 21 for additional information on the components of stockholders’ equity and information on the capital requirements of significant subsidiaries. Dividends Since the initial dividend in 1989, CSC has paid 123 consecutive quarterly dividends and has increased the quarterly dividend rate 24 times, resulting in a 21% compounded annual growth rate, excluding the special cash dividend of $1.00 per common share in 2007. While the payment and amount of dividends are at the discretion of the Board of Directors, subject to certain regulatory and other restrictions, CSC currently targets its common stock cash dividend at approximately 20% to 30% of net income. The Board of Directors of the Company declared quarterly cash dividend increases per common share during 2018 and 2019 as shown below: In addition, on January 30, 2020, the Board of Directors of the Company declared a one cent, or 6%, increase in the quarterly cash dividend to $0.18 per common share. The following table details the CSC cash dividends paid and per share amounts: (1) Dividends paid semi-annually until February 1, 2022 and quarterly thereafter. (2) Dividends paid quarterly. (3) Dividends paid semi-annually until March 1, 2022 and quarterly thereafter. (4) Dividends paid semi-annually beginning on June 1, 2018 until December 1, 2027, and quarterly thereafter. Share Repurchases On January 30, 2019, CSC publicly announced that its Board of Directors authorized the repurchase of up to $4.0 billion of common stock. The authorization does not have an expiration date. During 2019, CSC repurchased 55 million shares of its common stock for $2.2 billion, leaving $1.8 billion remaining on our existing authorization as of December 31, 2019. - 52 - THE CHARLES SCHWAB CORPORATION Management’s Discussion and Analysis of Financial Condition and Results of Operations (Tabular Amounts in Millions, Except Ratios, or as Noted) On October 25, 2018, CSC publicly announced that its Board of Directors terminated the existing two share repurchase authorizations and replaced them with a new authorization to repurchase up to $1.0 billion of common stock. CSC repurchased 22 million shares of its common stock for $1.0 billion in 2018, completing all repurchases under this authorization. FOREIGN EXPOSURE At December 31, 2019, Schwab had exposure to non-sovereign financial and non-financial institutions in foreign countries, as well as agencies of foreign governments. At December 31, 2019, the fair value of these holdings totaled $6.4 billion, with the top three exposures being to issuers and counterparties domiciled in France at $3.1 billion, the Netherlands at $845 million, and Sweden at $684 million. In addition to the direct holdings in foreign companies and securities issued by foreign government agencies, Schwab had outstanding margin loans to foreign residents of $437 million at December 31, 2019. FAIR VALUE OF FINANCIAL INSTRUMENTS Schwab uses the market approach to determine the fair value of certain financial assets and liabilities recorded at fair value, and to determine fair value disclosures. See Item 8 - Notes 2 and 16 for more information on our assets and liabilities recorded at fair value. When available, Schwab uses quoted prices in active markets to measure the fair value of assets and liabilities. Quoted prices for investments in exchange-traded securities represent end-of-day close prices published by exchanges. Quoted prices for money market funds and other mutual funds represent reported net asset values. When utilizing market data and bid-ask spread, we use the price within the bid-ask spread that best represents fair value. When quoted prices in active markets do not exist, prices are obtained from independent third-party pricing services to measure the fair value of investment assets. We generally obtain prices from three independent pricing sources for assets recorded at fair value. Our primary third-party pricing service provides prices for our fixed income investments such as commercial paper; certificates of deposits; U.S. government and agency securities; state and municipal securities; corporate debt securities; asset-backed securities; foreign government agency securities; and non-agency commercial mortgage-backed securities. Such prices are based on observable trades, broker/dealer quotes, and discounted cash flows that incorporate observable information such as yields for similar types of securities (a benchmark interest rate plus observable spreads) and weighted-average maturity for the same or similar “to-be-issued” securities. We compare the prices obtained from the primary independent pricing service to the prices obtained from the additional independent pricing services to determine if the price obtained from the primary independent pricing service is reasonable. Schwab does not adjust the prices received from independent third-party pricing services unless such prices are inconsistent with the definition of fair value and result in material differences in the amounts recorded. At December 31, 2019 and 2018, we did not adjust prices received from the primary independent third-party pricing service. CRITICAL ACCOUNTING ESTIMATES The consolidated financial statements of Schwab have been prepared in accordance with GAAP. Item 8 - Note 2 contains more information on our significant accounting policies made in connection with its application of these accounting principles. While the majority of the revenues, expenses, assets and liabilities are not based on estimates, there are certain accounting principles that require management to make estimates regarding matters that are uncertain and susceptible to change where such change may result in a material adverse impact on Schwab’s financial position and reported financial results. These critical accounting estimates are described below. Management regularly reviews the estimates and assumptions used in the preparation of the financial statements for reasonableness and adequacy. - 53 - THE CHARLES SCHWAB CORPORATION Management’s Discussion and Analysis of Financial Condition and Results of Operations (Tabular Amounts in Millions, Except Ratios, or as Noted) Management has discussed the development and selection of these critical accounting estimates with the Audit Committee of the Board of Directors. Additionally, management has reviewed with the Audit Committee the Company’s significant estimates discussed in this Management’s Discussion and Analysis of Financial Condition and Results of Operations. Income Taxes Schwab estimates income tax expense based on amounts expected to be owed to the various tax jurisdictions in which we operate, including federal, state and local domestic jurisdictions, and immaterial amounts owed to several foreign jurisdictions. The estimated income tax expense is reported in the consolidated statements of income in taxes on income. Accrued taxes are reported in other assets or accrued expenses and other liabilities on the consolidated balance sheets and represent the net estimated amount due to or to be received from taxing jurisdictions either currently or deferred to future periods. Deferred taxes arise from differences between assets and liabilities measured for financial reporting purposes versus income tax reporting purposes. Deferred tax assets are recognized if, in management’s judgment, their realizability is determined to be more likely than not. Uncertain tax positions that meet the more likely than not recognition threshold are measured to determine the amount of benefit to recognize. An uncertain tax position is measured at the largest amount of benefit management believes is more likely than not to be realized upon settlement. In estimating accrued taxes, we assess the relative merits and risks of the appropriate tax treatment considering statutory, judicial and regulatory guidance in the context of the tax position. Because of the complexity of tax laws and regulations, interpretation can be difficult and subject to legal judgment given specific facts and circumstances. Changes in the estimate of accrued taxes occur periodically due to changes in tax rates, interpretations of tax laws, the status of examinations being conducted by various taxing authorities, and newly enacted statutory, judicial and regulatory guidance that impacts the relative merits and risks of tax positions. These changes, when they occur, affect accrued taxes and can be significant to the operating results of the Company. See Item 8 - Note 20 for more information on the Company’s income taxes. Legal and Regulatory Reserves Reserves for legal and regulatory claims and proceedings reflect an estimate of probable losses for each matter, after considering, among other factors, the progress of the case, prior experience and the experience of others in similar cases, available defenses, and the opinions and views of legal counsel. In many cases, including most class action lawsuits, it is not possible to determine whether a loss will be incurred, or to estimate the range of that loss, until the matter is close to resolution, in which case no accrual is made until that time. Reserves are adjusted as more information becomes available. Significant judgment is required in making these estimates, and the actual cost of resolving a matter may ultimately differ materially from the amount reserved. See Item 8 - Note 14 for more information on the Company’s contingencies related to legal and regulatory reserves. - 54 - THE CHARLES SCHWAB CORPORATION

<s>[INST] FORWARDLOOKING STATEMENTS In addition to historical information, this Annual Report on Form 10K contains “forwardlooking statements” within the meaning of Section 27A of the Securities Act, and Section 21E of the Securities Exchange Act of 1934. Forwardlooking statements are identified by words such as “believe,” “anticipate,” “expect,” “intend,” “plan,” “will,” “may,” “estimate,” “appear,” “could,” “would,” “expand”, “maintain,” and other similar expressions. In addition, any statements that refer to expectations, projections, or other characterizations of future events or circumstances are forwardlooking statements. These forwardlooking statements, which reflect management’s beliefs, objectives, and expectations as of the date hereof, are estimates based on the best judgment of Schwab’s senior management. These statements relate to, among other things: The acquisition of TD Ameritrade; the acquisition of assets of USAAIMCO, the related funding, and entering into a referral agreement; and the expected closing dates of the acquisitions (see Business Acquisitions in Part I, Item 1; Overview and Capital Management in Part II, Item 7; Commitments and Contingencies in Part II, Item 8 Notes to Consolidated Financial Statements (Item 8) Note 14); Maximizing our market valuation and stockholder returns over time; our belief that developing trusted relationships will translate into more client assets which drives revenue and, along with expense discipline and thoughtful capital management, generates earnings growth and builds stockholder value; and maintaining our market position (see Business Strategy and Competitive Environment and Products and Services in Part I, Item 1); The impact of pricing reductions on our value proposition, competitive positioning and longterm growth in client assets and accounts (see Sources of Net Revenues in Part I, Item I; Overview in Part II, Item 7); The impact of legal proceedings and regulatory matters (see Legal Proceedings in Part I, Item 3 and Commitments and Contingencies in Part II, Item 8 Note 14); Commitment to balancing longterm profitability with reinvesting for growth; business growth; meaningful capital returns; and intent to return excess capital above our longterm operating objective of 6.75% 7.00% (see Overview in Part II, Item 7); The adjustment of rates paid on clientrelated liabilities; client cash sorting; reducing exposure to lower rates; and the duration difference between liabilities and assets (see Net Interest Revenue in Part II, Item 7); Capital expenditures (see Total Expenses Excluding Interest in Part II, Item 7); The phaseout of the use of LIBOR (see Expected Phaseout of LIBOR in Part II, Item 7); Sources of liquidity, capital, and level of dividends (see Liquidity Risk in Part II, Item 7); Capital ratios (see Regulatory Capital Requirements in Part II, Item 7); The expected impact of new accounting standards not yet adopted (see Summary of Significant Accounting Policies in Part II, Item 8 Note 2); and The likelihood of indemnification and guarantee payment obligations (see Commitments and Contingencies in Part II, Item 8 Note 14). Achievement of the expressed beliefs, objectives and expectations described in these statements is subject to certain risks and uncertainties that could cause actual results to differ materially from the expressed beliefs, objectives, and expectations. Readers are cautioned not to place undue reliance on these forwardlooking statements, which speak only as of the date of this Annual Report on Form 10K or, in the case of documents incorporated by reference, as of the date of those documents. Important factors that may cause actual results to differ include, but are not limited to: The timing and the ability of us and TD Ameritrade to satisfy the closing conditions in the merger agreement, including stockholder and regulatory approvals; The timing and the ability of us and USAAIMCO to satisfy the closing conditions in the purchase agreement, including regulatory approvals and the implementation of conversion plans; The timing and extent to which we realize expected revenue, expense and other [/INST] Positive. </s>

PLUM CREEK TIMBER CO INC

2015-02-26

2014-12-31

ITEM 7. MANAGEMENT’S DISCUSSION AND ANALYSIS OF FINANCIAL CONDITION AND RESULTS OF OPERATIONS Forward-Looking Statement This Report contains forward-looking statements within the meaning of the Private Litigation Reform Act of 1995. Some of the forward-looking statements can be identified by the use of forward-looking words such as “believes,” “expects,” “may,” “will,” “should,” “seeks,” “approximately,” “intends,” “plans,” “estimates,” “projects,” “strategy,” or “anticipates,” or the negative of those words or other comparable terminology. Forward-looking statements involve inherent risks and uncertainties. A number of important factors could cause actual results to differ materially from those described in the forward-looking statements, including those factors described in “Risk Factors” under Item 1A in this Form 10-K. Some factors include changes in governmental, legislative and environmental restrictions, catastrophic losses from fires, floods, windstorms, earthquakes, volcanic eruptions, insect infestations or diseases, as well as changes in economic conditions and competition in our domestic and export markets and other factors described from time to time in our filings with the Securities and Exchange Commission. In addition, factors that could cause our actual results to differ from those contemplated by our projected, forecasted, estimated or budgeted results as reflected in forward-looking statements relating to our operations and business include, but are not limited to: • the failure to meet our expectations with respect to our likely future performance; • an unanticipated reduction in the demand for timber products and/or an unanticipated increase in supply of timber products; • an unanticipated reduction in demand for higher and better use or non-strategic timberlands; • our failure to make strategic acquisitions or to integrate any such acquisitions effectively or, conversely, our failure to make strategic divestitures; and • our failure to qualify as a real estate investment trust, or REIT. It is likely that if one or more of the risks materializes, or if one or more assumptions prove to be incorrect, the current expectations of Plum Creek and its management will not be realized. Forward-looking statements speak only as of the date made, and neither Plum Creek nor its management undertakes any obligation to update or revise any forward-looking statements. Organization of the Company In management’s discussion and analysis of financial condition and results of operations (Item 7 of this form), when we refer to “Plum Creek,” “the company,” “we,” “us,” or “our,” we mean Plum Creek Timber Company, Inc. and its consolidated subsidiaries. References to Notes to Consolidated Financial Statements refer to the Notes to the Consolidated Financial Statements of Plum Creek Timber Company, Inc. included in Item 8 of this Form 10-K. Plum Creek Timber Company, Inc., a Delaware Corporation and a real estate investment trust, or “REIT”, for federal income tax purposes, is the parent company of Plum Creek Timberlands, L.P., a Delaware Limited Partnership (the “Operating Partnership” or “Partnership”), and Plum Creek Ventures I, LLC, a Delaware Limited Liability Company (“PC Ventures”). Plum Creek conducts substantially all of its activities through the Operating Partnership and various wholly-owned subsidiaries of the Operating Partnership. The Operating Partnership has borrowed and has currently outstanding $2.5 billion principal amount of debt, including $1.3 billion of publicly issued notes. PC Ventures has borrowed and has currently outstanding $783 million in principal amount of debt (“the Note Payable to Timberland Venture”) from an entity (“the Timberland Venture”) in which a subsidiary of the Operating Partnership has a common and preferred equity interest. See Note 18 of the Notes to Consolidated Financial Statements. PC Ventures used the proceeds from the borrowing to make a $783 million capital contribution to the Operating Partnership in exchange for a preferred equity interest in the Operating Partnership. PC Ventures has no other activities and the Operating Partnership has no ownership interest in PC Ventures. The Note Payable to Timberland Venture is an obligation of PC Ventures and not an obligation of the Operating Partnership. Therefore, any discussion of the Note Payable to Timberland Venture below is not applicable to the Operating Partnership. Unless otherwise specified, all other discussion and analysis below are applicable to both Plum Creek and the Operating Partnership. PLUM CREEK 2014 FORM 10-K | 26 PART II / ITEM 7 Overview 2014 Performance Compared to 2013 Our operating income for 2014 was $322 million compared to $295 million for 2013. Prices for nearly all the logs and wood products we sell continued to improve during 2014 due primarily to the improving U.S. economy and the increase in housing starts. U.S. housing starts for all of 2014 were just over 1 million units, which was an increase of 9% over the prior year and have increased by over 80% compared to the record low starts of 554,000 units in 2009 (lowest since 1945). We expect this positive trend to continue in 2015. Real estate markets during 2014 were generally comparable to the prior year. Real estate revenue for both 2014 and 2013 was slightly less than $300 million; however, during 2014 we sold approximately 10% more acres while operating income decreased by approximately 20% due primarily to selling properties which have a higher book basis. In addition to improving prices for logs and wood products, our 2014 operating results were favorably impacted by the following: • In December 2013, we acquired approximately 501,000 acres of timberland from MeadWestvaco Corporation ("MWV"), along with related minerals and wind power leases and an equity interest in approximately 109,000 acres of high-value rural and development quality lands (see Note 2 of the Notes to Consolidated Financial Statements). Of the MWV timberlands acquired, approximately 147,000 acres are included in the Northern Resources Segment and approximately 354,000 acres are included in the Southern Resources Segment. The total purchase price was approximately $1.1 billion, which consisted of a $221 million cash payment and the issuance of an installment note payable for $860 million. • In September 2013, we acquired mineral rights in approximately 255 million tons of aggregate reserves at four quarries in Georgia for approximately $156 million (see Note 6 of the Notes to Consolidated Financial Statements). • On June 10, 2014, we experienced a fire at our MDF facility and recorded a $2 million loss related to the building and equipment damaged or destroyed by the fire. During 2014, we also recorded a $13 million gain related to insurance recoveries that we received, which, when combined with the building and equipment loss, resulted in a net gain of $11 million for 2014. See Note 17 of the Notes to Consolidated Financial Statements. Operating income in our Northern Resources Segment increased $12 million to $44 million in 2014. During 2014, harvest volumes in our Northern Resources Segment were 3.9 million tons, of which approximately 0.2 million tons were harvested from the MWV timberlands. Excluding the impact of the MWV timberlands, operating income in the Northern Resources Segment increased by $8 million to $40 million. The increase in operating performance was due primarily to higher sawlog prices as a result of continued strong demand and a limited log supply. Operating income in our Southern Resources Segment increased $29 million to $137 million in 2014. During 2014, harvest volumes in our Southern Resources Segment were 15.8 million tons, of which 2.6 million tons were harvested from the MWV timberlands. Excluding the impact of the MWV timberlands, operating income in the Southern Resources Segment increased by $13 million to $121 million. This increase was due primarily to higher sawlog and pulpwood prices as a result of improving demand. Operating income in our Manufacturing Segment increased $6 million to $49 million in 2014. Excluding the net gains from the MDF fire, operating income in our Manufacturing Segment decreased $5 million to $38 million in 2014. This decrease was due primarily to lower MDF and plywood sales volumes and higher raw material costs. Operating income in our Real Estate Segment decreased $36 million to $133 million in 2014. This decrease was due primarily to selling properties in 2014 with a lower operating margin compared to the prior year. The lower operating margin was due primarily to selling properties which had a higher book basis compared to the properties that were sold during 2013. Revenues in our Real Estate Segment increased $3 million to $289 million in 2014. Operating income in our Energy and Natural Resources Segment increased $6 million to $25 million in 2014. This increase was due primarily to royalties from our September 2013 acquisition of mineral rights and royalties from our MWV acquisition of coal and wind assets. PLUM CREEK 2014 FORM 10-K | 27 PART II / ITEM 7 Our net income for 2014 was $214 million, unchanged from our net income in 2013. Interest expense increased $25 million to $166 million in 2014. This increase was due primarily to interest expense on our $860 million installment note payable. Our provision for income taxes increased $9 million to $8 million in 2014. This increase was due primarily to higher earnings by our taxable REIT subsidiaries. Our net cash flows from operating activities increased $53 million to $457 million in 2014. This increase was due primarily to improved earnings before depletion from our Resources and Energy and Natural Resources Segments ($67 million) partially offset by higher payments for interest expense ($25 million). We expect net cash provided by operating activities in 2015 to be similar to 2014. Key Economic Factors Impacting Our Resources and Manufacturing Businesses Our operating performance for the Resources and Manufacturing Segments is impacted primarily by the supply and demand for logs and wood products in the United States. The short-term supply of logs is impacted primarily by weather and the level of harvesting activities. The demand for logs and wood products in the United States is impacted by housing starts, repair and remodeling activities and industrial activity. The demand for U.S. logs and lumber is reduced, in part, by the amount of imported lumber, primarily from Canada. Selected U.S. housing economic data for the last five years was as follows at December 31: Housing starts continued to improve during 2014, increasing by 9% over the prior year and by more than 80% over the record low housing starts experienced during 2009. The improvement in housing starts was due primarily to the improving U.S. economy, declining unemployment, near record low mortgage interest rates, and improving consumer confidence. Despite the improvement in housing starts to slightly over 1 million starts for 2014, housing starts remain at recessionary levels. Housing starts are at recessionary levels due primarily to the low labor participation rate, weak wage growth, high debt levels, the high cost of a new home, along with strict lending standards, all factors which have prevented young families from purchasing a new home. The unemployment rate has steadily declined during the past several years and was 5.6% at the end of 2014. However, a better measure of employment as it relates to housing is the labor participation rate, which was 62.7% at the end of 2014 (its lowest level in the past 25 years). The low participation rate is due in part to individuals dropping out of the workforce as a result of the disappointing job opportunities. Furthermore, a large percentage of the jobs created since the end of the recession have been in low-paying sectors, such as retail and hospitality. Also, stagnant wage growth has impacted the housing sector. The challenges of finding a well paying job have especially impacted young families. As a result of weak job opportunities along with high levels of student debt, first-time home buyers, which historically have accounted for 40% of home sales, currently account for less than 30% of sales. The decline in first-time home buyers is also causing a significant shift in the mix of housing starts. Historically, single-family starts have accounted for approximately 80% and multifamily starts have accounted for approximately 20% of the total starts. However, because more households are renting instead of owning a home, the multifamily share of housing starts is currently above 30%. This trend negatively impacts the demand for wood products since multifamily starts use only about one-third as much wood as is used in single-family starts. Another trend that could negatively impact the demand for logs in the U.S. in the future is the level of lumber imports. Recently, the U.S. dollar hit an 11-year high compared to other major currencies, which is likely to result in greater lumber imports. At the same time, China’s economic growth during 2014 slowed to levels not seen in the past 25 years. The decline in China’s economic growth, along with the strong U.S. dollar, are several of the key reasons why Canada increased their lumber imports to the U.S. during 2014. Canada recently increased their lumber imports to the U.S. by over 10% and currently represents approximately 28% of the lumber available in the U.S. PLUM CREEK 2014 FORM 10-K | 28 PART II / ITEM 7 The recessionary level of housing starts has most significantly impacted our Southern Resources Segment. Average sawlog prices in our Northern Resources Segment during 2014 were $85 per ton (delivered basis), which is the highest average sales realization during the past ten years. In comparison, average sawlog prices in our Southern Resources Segment were $22 per ton (stumpage basis), which was approximately 40% lower than our 2005 average of $37 per ton. Some key reasons for this difference is that in our Northern Resources Segment, mill owners have added more shifts, and there has been relatively strong export demand for logs and wood products (primarily in the Northwestern U.S.) throughout most of 2014. However, in our Southern Resources Segment, log prices have increased modestly since our recent low prices in 2011 when the average sales realization for the year was $19 per ton. This limited price improvement is due primarily to Southern mill owners being more reluctant to add shifts or restart mills, and due to the readily available supply of logs for the current level of lumber and plywood production. During 2015, we expect the rebound in housing starts to continue at a slow pace. Housing starts are expected to continue to improve during 2015 due primarily to the growth in the U.S. economy, improving consumer confidence, and low interest rates. We expect sawlog prices in our Northern Resources Segment to remain strong and we expect sawlog prices in our Southern Resources Segment to continue to gradually improve during 2015 due in part to an expected increase in demand. The demand for sawlogs in our Southern Resources Segment is expected to improve partially due to the increase in sawmill capacity. During 2014, numerous mills in the South invested capital to expand their production capacity along with the start-up of a major new lumber mill in Florida. Furthermore, we believe favorable demographics will bode well for the wood products business in the long-run and that eventually housing starts will return to normal levels (i.e., annual housing starts of between 1.5 million and 1.6 million). However, due to the low labor participation rate, stagnant wage growth, high levels of student debt, and the slowing world economy, there remains considerable uncertainty regarding the extent and timing of the recovery in the housing sector. Therefore, as long as housing starts remain at recessionary levels and there is an adequate supply of sawlogs to meet the current demand, we believe sawlog prices and operating results in our Southern Resources segment will not significantly improve from 2014 levels. We use independent third-party contract loggers and haulers to deliver our logs to our customers. Following the weak business conditions in the timber business that persisted for several years, there are fewer of these contractors available in certain markets to produce and deliver logs. While we continue to enhance strong working relationships with the independent loggers and haulers, as log markets continue to improve there may be production and delivery constraints that could impact log prices and/or delivery. Furthermore, despite the recent sharp decline in diesel fuel prices, we do not expect this decline to favorably impact our operating results due to the higher costs resulting from an overall shortage of loggers and haulers. Higher Value and Non-Strategic Timberlands We review our timberlands to identify properties that may have higher values other than as commercial timberlands (see discussion in Item 1 - Real Estate Segment). We estimate that included in the company's 6.6 million acres of timberlands at December 31, 2014, are approximately 775,000 acres of higher value timberlands which are expected to be sold, exchanged, and/or developed over the next fifteen years for recreational, conservation, commercial and residential purposes. Included within the 775,000 acres of higher value timberlands are approximately 500,000 acres we expect to sell for recreational uses, approximately 200,000 acres we expect to sell for conservation and approximately 75,000 acres that are identified as having development potential. Furthermore, the company has approximately 225,000 acres of non-strategic timberlands, which are expected to be sold over the near and medium term in smaller scale transactions (“small non-strategic”). Not included in the above 775,000 higher value acres and 225,000 small non-strategic acres are other acres that may be sold, from time to time, in large acreage transactions to commercial timberland buyers as opportunities arise (“large non-strategic”). Some of our real estate activities, including our real estate development business, are conducted through our wholly-owned taxable REIT subsidiaries. In the meantime, all of our timberlands continue to be managed productively in our business of growing and selling timber. During 2014, we sold approximately 65,000 acres of higher and better use / recreational properties for proceeds of $126 million, approximately 66,000 acres of conservation properties for proceeds of $63 million, approximately 30,000 acres of small non-strategic properties for proceeds of $27 million, along with approximately 23,000 acres of large non-strategic properties for proceeds of $65 million. We expect revenue from real estate sales during 2015 to range PLUM CREEK 2014 FORM 10-K | 29 PART II / ITEM 7 between $250 million and $300 million. Revenue from large non-strategic sales during 2014 was approximately 22% of total real estate revenue. In 2015, we expect revenues from large non-strategic sales to be approximately one-third of total real estate revenue. Our land development business slowed dramatically starting in 2008 and has since remained weak. We do not expect any significant proceeds from the sale of real estate development properties in 2015. Harvest Levels The volume of trees we harvest each year and the percentage of sawlogs and pulpwood (product mix) included in our annual harvest also impact our operating performance. During 2014, we harvested a total of 19.6 million tons, which was comprised of 45% sawlogs and 55% pulpwood. We expect total 2015 harvest levels to be comparable to 2014 harvest volumes, ranging between 19 million and 20 million tons. While we have the flexibility to modify our annual harvest volumes, based on market conditions, we expect harvest levels beyond 2015 in the near-term (next five years) to improve modestly (less than 5%) compared to 2014 harvest levels, and we expect harvest levels in the longer-term (ten years and beyond) to improve by nearly 10% over 2014 harvest levels. Additionally, over the longer-term we expect the percentage of sawlogs to increase from 45% to nearly 50%. Future harvest levels may vary from historic or expected levels due to weaker or stronger than anticipated markets or other factors outside of our control, such as weather and fires. Future harvest levels may also be impacted by the acquisition of timberlands or the disposition of timberlands beyond the 1.0 million acres described above in the Higher Value and Non-Strategic Timberlands section. Critical Accounting Policies Our discussion and analysis of our financial condition and results of operations are based upon our consolidated financial statements which have been prepared in accordance with U.S. generally accepted accounting principles. The preparation of these financial statements requires us to make estimates and judgments that affect the reported amounts of assets, liabilities, revenues and expenses, and related disclosure of contingent assets and liabilities. Under different assumptions or conditions, actual results may differ from these estimates. We believe the following critical accounting policies affect our most significant judgments and estimates used in preparation of our consolidated financial statements: Revenue Recognition for Timber Sales Timber sales revenues are recognized when legal ownership and the risk of loss transfer to the purchaser and the quantity sold is determinable. We sell timber under delivered log agreements and through sales of standing timber (or “stumpage”) using pay-as-cut sales contracts or, less frequently, timber deed sale agreements. Delivered Log Sales. Under a delivered log sale agreement, we harvest the timber and deliver it to the buyer. Revenue is recognized when the log is delivered as risk of loss and title transfer to the buyer. With delivered log sales, we incur the cost of logging and hauling. Pay-as-Cut Sales Contracts. Pay-as-cut sales contracts are agreements in which the buyer agrees to purchase and harvest specified timber on a tract of land for an agreed upon price for each type of tree over the term of the contract (usually 12 to 18 months). In some cases, an advance is received in connection with pay-as-cut sales contracts. In other cases, the buyer agrees to harvest only certain trees on a tract of land. Under pay-as-cut sales contracts, the buyer is responsible for all logging and hauling costs. Revenue is recognized when the timber is harvested, as title and risk of loss has transferred to the buyer. Total revenue recognized under a pay-as-cut sales contract is the total volume of wood removed multiplied by the unit price for each type of tree. Timber Deeds. Timber deed sales are agreements in which the buyer agrees to purchase and harvest specified timber (i.e. mature pulpwood and/or sawlogs) on a tract of land over the term of the contract (usually 18 months or less). Unlike a pay-as-cut sales contract, risk of loss and title to the trees transfer to the buyer when the contract is signed. The buyer pays the full purchase price when the contract is signed and we do not have any additional performance PLUM CREEK 2014 FORM 10-K | 30 PART II / ITEM 7 obligations. Under a timber deed, the buyer is responsible for all logging and hauling costs and the timing of such activity. Revenue from a timber deed sale is recognized when the contract is signed because the earnings process is complete. Timber deeds are generally marketed and sold to the highest bidder. Bids are typically based on a timber cruise which is an estimate of the total volume of timber on a tract of land broken down by the various types of trees (such as softwood sawlogs, hardwood pulpwood, etc.). Total revenue recognized under a timber deed is not dependent upon the volume or types of trees actually harvested. The following table summarizes amounts recognized under each method from sales to external customers in the company’s consolidated financial statements for the years ended December 31 (in millions): Substantially all of our timber sales in the Northern Resources Segment are under delivered log sale agreements. In our Southern Resources Segment, approximately 11% of our timber sales in 2014 and 13% of our timber sales in 2013 and 2012 consisted of pay-as-cut sales contracts and timber deed sales. Under sales of stumpage, the buyer is responsible for the logging and hauling costs; therefore, the operating profit as a percentage of revenue is typically higher in our Southern Resources Segment. Real Estate Sales The timing of real estate sales is a function of many factors, including the general state of the economy, demand in local real estate markets, the ability to obtain entitlements, the ability of buyers to obtain financing, the number of competing properties listed for sale, the seasonal nature of sales (particularly in the northern states), the plans of adjacent landowners, our expectation of future price appreciation, the timing of harvesting activities, and the availability of government and not-for-profit funding (especially for conservation sales). As a result, the timing of our real estate sales may materially impact our reported operating income and net income. During 2014, the Real Estate Segment reported an operating profit percentage of approximately 46%. Over the last ten years, the Real Estate Segment’s annual operating profit percentage has ranged from 45% to 65% of revenues. The operating profit percentage depends on the nature of the interest sold and how much the market value of the property has risen over its book value. For example, sales of properties that have been held by the company for a long time (i.e. decades) will tend to have relatively higher operating profit percentages than properties that have been held by the company for shorter time periods. In contrast, the sale of conservation easements will generally have an operating profit percentage of close to 100% because historically no book basis was allocated to these development rights. In general, timberlands are acquired primarily for long-term use in our timber operations. In connection with timberland acquisitions, we are generally not able to identify, with any level of precision, our future real estate sales (i.e. specific properties with a higher value than for use in timber production). However, our purchase price allocation and related appraisals for these acquisitions may reflect greater values for real estate which may be sold in the future but are not yet specifically identified. Therefore, in connection with our purchase price allocation for timberland acquisitions, the greater values for real estate are allocated proportionately among all of the acres acquired. Specific properties cannot be identified in advance because their value is dependent upon numerous factors, most of which are not known at the acquisition date, including current and future zoning restrictions, current and future environmental restrictions, future changes in demographics, future changes in the economy, current and future plans of adjacent landowners, and current and future funding of government and not-for-profit conservation and recreation programs. We believe that current and future results of operations could be materially different under different purchase price allocation assumptions. In connection with the sale of timberlands, a portion of the original cost of the underlying land and standing timber is included in the real estate segment cost of goods sold. The book basis related to the land being sold is generally based on a specific identification of the costs allocated to the acres being sold. However, the book basis related to the standing timber is based on timber depletion rates. The company has a separate depletion rate for each geographic region in which the company operates (i.e., seven rates in our Northern Resources Segment and six rates in our PLUM CREEK 2014 FORM 10-K | 31 PART II / ITEM 7 Southern Resources Segment). In connection with an acquisition, the company will either establish new depletion rate(s) or average the acquisition cost and timber inventory with existing depletion rate(s) depending upon how the timberlands will be managed. For example, in connection with our December 6, 2013, acquisition of approximately 501,000 acres of timberlands from MeadWestvaco (see Note 2 of the Notes to Consolidated Financial Statements), the company created a new depletion rate associated with the approximately 126,000 acres acquired in Virginia. The remaining timberlands acquired from MeadWestvaco were combined with existing timberlands in computing new depletion rates for 2014. Management believes that current and future results of operations could be materially different depending upon how depletion rates are established in connection with major acquisitions. For example, in 2014, cost of real estate sales would have been approximately $5 million higher if new depletion rates had been established for all 501,000 acres of the acquired MeadWestvaco timberlands. Impairment of Long-Lived Assets We evaluate our ability to recover the net investment in long-lived assets when required by the accounting standards. We recognize an impairment loss in connection with long-lived assets used in our business when the carrying value (net book value) of the assets exceeds the estimated future undiscounted cash flows attributable to those assets over their expected useful life. Impairment losses are measured by the extent to which the carrying value of a group of assets exceeds the fair value of such assets at a given point in time. Generally, our fair value measurements used in calculating an impairment loss are categorized as Level 3 measurements (i.e. unobservable inputs that are supported by little or no market activity) under the fair value hierarchy in the Accounting Standards Codification. Typically, we will use a discounted cash flow model or an external appraisal to estimate the fair value of the affected assets. Furthermore, we recognize an impairment loss in connection with long-lived assets held for sale when the carrying value of the assets exceeds an amount equal to their fair value less selling costs. The company has had a long history of acquiring timberlands. Management is required to estimate the fair values of acquired assets and liabilities as of the acquisition date. These estimates of fair value are typically derived from external appraisals and are based on significant assumptions and estimates. Any changes in these estimates and assumptions could impact current and future depletion rates, basis for real estate sales, and our impairment analysis. Subsequent to the original allocation, assets are tested for impairment whenever events or changes in circumstances indicate that the carrying value of the assets may not be recoverable through future operations. Our long-lived assets are grouped and evaluated for impairment at the lowest level for which there are independent cash flows. We track cash flows for our approximately 6.6 million acres of timberlands by grouping them into seven geographic areas in the Northern Resources Segment and six geographic areas in the Southern Resources Segment. Additionally, we track cash flows for each of our manufacturing facilities. Timber and Timberlands Used in Our Business. For assets used in our business, an impairment loss is recorded only when the carrying value of those assets is not recoverable through future operations. The recoverability test is based on undiscounted future cash flows over the expected life of the assets. We use one harvest cycle (which ranges between 20 and 90 years) for evaluating the recoverability of our timber and timberlands. Because of the inherently long life of timber and timberlands, we do not expect to incur an impairment loss in the future for the timber and timberlands used in our timber business. Timber and Timberlands Held for Sale. An impairment loss is recognized for long-lived assets held for sale when the carrying value of those assets exceeds an amount equal to its fair value less selling costs. An asset is generally considered to be held for sale when we have committed to a plan to sell the asset, the asset is available for immediate sale in its present condition, we have initiated an active program to locate a buyer (e.g., listed with a broker), and the sale is expected to close within one year. During the last several years, the above criteria have been met by some of our timberland properties, and we recognized annual impairment losses of $7 million and $4 million in 2014 and 2013, respectively (see Note 5 of the Notes to Consolidated Financial Statements). No impairment losses were recognized in 2012. An impairment loss is generally not recorded until management expects that the timberlands will be sold within the next 12 months. For many properties that are currently listed for sale, it is difficult to conclude whether they will be sold within one year and to estimate the price. Nevertheless, management performs a probability assessment for all properties that are listed for sale and records an impairment loss (to the extent the property’s book basis exceeds its PLUM CREEK 2014 FORM 10-K | 32 PART II / ITEM 7 estimated fair value net of selling cost) in the quarter in which management expects the property will be sold within twelve months. We expect to continue to sell or exchange timberlands to other forest products companies or non-industrial buyers, and it is probable that we will recognize additional impairment losses, some of which could be material, in the future in connection with sales of timberlands. Property, Plant and Equipment. The carrying value of Property, Plant and Equipment primarily represents the net book value of our seven manufacturing facilities. Each manufacturing facility is tested for impairment whenever events or changes in circumstances indicate that the carrying amount may not be recoverable through future operations. The estimated future cash flows over the remaining useful life of a manufacturing facility is highly subjective and is dependent upon estimates for future product pricing, raw material costs and availability, volumes of product sold, and residual value of the facility. No impairment losses were recorded during 2014, 2013 or 2012. We currently estimate that the carrying value for our seven facilities is recoverable through future operations and that our estimate of future cash flows is reasonable. However, if wood product prices were to weaken for an extended period of time, or if log or raw material availability declines, we may record an impairment loss for one or more of our manufacturing facilities in a future period. Capitalized Real Estate Development Costs. Current and future costs associated with specific real estate development projects are capitalized once management has concluded it is probable that a project will be successful. Real estate development costs are expensed as incurred when management is not able to conclude that it is probable a project will be successful. Furthermore, previously capitalized costs for specific projects are written off when management revises its prior assessment and concludes that it is probable a project will not be successful and costs will not be recovered. For many of our projects, there is less judgment in making this determination due to prior experience in the local market or advice from consultants. However, for some of our larger projects where we have limited experience in the local market or for projects in environmentally sensitive areas, there is significant judgment in assessing the expected outcome for the projects. At December 31, 2014, we have $37 million of capitalized costs associated with projects that management expects will be successful. Depletion Depletion, or costs attributed to timber harvested, is recorded as trees are harvested and sold. Depletion rates for each geographic area are adjusted at least annually. Depletion rates are computed by dividing (A) the sum of (1) the original cost of the timber less previously recorded depletion plus (2) estimated future silviculture costs, including the impact of inflation, that are expected to be incurred over the next harvest cycle, by (B) the total timber volume that is estimated to be harvested over the harvest cycle. Additionally, the depletion rate calculations do not include future volume that is environmentally and/or legally restricted from being harvested. The original cost of the timber includes capitalized costs associated with the purchase of timber along with reforestation costs and other costs associated with the planting and growing of trees. When timberlands are purchased, management is required, as part of its purchase price allocation, to estimate the fair value of the timber as of the acquisition date. There are significant assumptions and estimates associated with the allocation of purchase price, which in turn, could significantly impact our current and future depletion rates. The harvest cycle can be as short as 20 years in the South to as long as 90 years in the North. The estimate of future silviculture costs is limited to the expenditures that are expected to impact growth rates over the harvest cycle. The depletion rate calculations do not include an estimate for either future reforestation costs associated with a stand’s final harvest or future volume in connection with the replanting of a stand subsequent to its final harvest. We establish separate depletion rates for purchased timber deeds in order to allocate the cost of a timber deed over its term (based on harvest volumes). PLUM CREEK 2014 FORM 10-K | 33 PART II / ITEM 7 The following table summarizes depletion expense recognized in the company’s financial statements, key assumptions and sensitivities to changes in assumptions for the years ended December 31 (dollars in millions, except per ton amounts): (A) Depletion expense for 2013 includes a $4 million loss, representing the book basis of timber volume destroyed as a result of forest fires in Montana and Oregon. Average depletion rate (per ton) does not include the fire loss. (B) Increase from 2013 was due primarily to the December 2013 MeadWestvaco timberland acquisition (see further discussion below and Note 2 of the Notes to Consolidated Financial Statements). (C) Depletion expense does not include the depletion associated with the long-term timber deeds we purchased in 2013 and 2012. Depletion expense associated with these timber deeds was $11 million and $16 million for 2014 and 2013, respectively. We expect 2015 depletion expense associated with these timber deeds to be approximately $15 million. (D) Does not include the long-term timber deeds we purchased in 2013 and 2012. (E) Assumes future timber volumes do not change. (F) Assumes future silviculture costs do not change. Significant estimates and judgments are required to determine both future silviculture costs and the volume of timber available for harvest over the harvest cycle. Some of the factors impacting the estimates are changes in inflation rates, the cost of fertilizers, the cost of capital, the actual and estimated increase in growth rates from fertilizer applications, the relative price of sawlogs and pulpwood, the actual and expected real price appreciation of timber, the scientific advancement in seedling and growing technology, and changes in harvest cycles. Management updates all of the above estimates at least annually, or whenever new and supportable information becomes known. Management PLUM CREEK 2014 FORM 10-K | 34 PART II / ITEM 7 believes that current and future timber depletion (and therefore, current and future results of operations) could be materially impacted by the timing and extent the above assumptions are revised. In connection with an acquisition, the company will either establish new depletion rate(s) or average the acquisition cost and timber inventory with existing depletion rate(s) depending upon how the timberlands will be managed. For example, in connection with our December 6, 2013, acquisition of approximately 501,000 acres of timberlands from MeadWestvaco (see Note 2 of the Notes to Consolidated Financial Statements), the company created a new depletion rate associated with the approximately 126,000 acres acquired in Virginia. The remaining timberlands acquired from MeadWestvaco were combined with existing timberlands in computing new depletion rates for 2014. Management believes that current and future results of operations could be materially different depending upon how depletion rates are established in connection with major acquisitions. For example, in 2014, depletion expense would have been approximately $4 million higher if new depletion rates had been established for all 501,000 acres of the acquired MeadWestvaco timberlands. Equity Method Investments The company has two material equity method investments: (1) an investment in MWV-Charleston Land Partners, LLC (Real Estate Development Joint Ventures) and (2) an investment in Southern Diversified Timber, LLC (Timberland Venture). See Note 18 of the Notes to Consolidated Financial Statements. These investments are presented separately in both our consolidated statements of income and our consolidated balance sheets. On December 6, 2013, in connection with the MeadWestvaco timberland acquisition, the company and MeadWestvaco Corporation (“MWV”) formed a limited liability company (MWV-Charleston Land Partners, LLC or “MWV-CLP”). Plum Creek contributed cash to MWV-CLP and MWV contributed approximately 109,000 acres of real estate development properties. The book basis of Plum Creek’s initial investment in MWV-CLP was $139 million (based on the December 6, 2013 purchase price allocation), and Plum Creek’s share of MWV-CLP’s net book basis as of December 6, 2013, was approximately $52 million (based on MWV’s historical cost in the contributed properties). In accordance with the Accounting Standards Codification, this basis difference of $87 million is being amortized (i.e., additional expense) into equity earnings (losses) in future periods as either the real estate development properties are sold or timber on the real estate properties is harvested and sold. On October 1, 2008, Plum Creek and The Campbell Group LLC formed a limited liability company (Southern Diversified Timber, LLC or “the Timberland Venture”). Plum Creek contributed approximately 454,000 acres of timberlands and The Campbell Group LLC contributed cash. Plum Creek’s initial book basis in the Timberland Venture was $174 million (Plum Creek’s basis in the timberlands at the date of transfer) and Plum Creek’s share of the Timberland Venture’s initial net book basis was $783 million (based on fair value of contributed properties). In accordance with the Accounting Standards Codification, this basis difference of $609 million is being amortized (i.e., additional earnings) into equity earnings in future periods as either timber on these properties is harvested and sold or timberlands are sold. There are significant judgments in determining the amount of basis amortization to be recognized each period for our equity method investments. The judgments primarily relate to the allocations of both the book basis in our equity method investment and our share of the venture’s net book basis among the various assets held by the venture. For example, the key judgments associated with our investment in MWV-CLP were the allocations of our investment in MWV-CLP ($139 million) and our share of MWV-CLP’s net book basis ($52 million) among the various assets of MWV-CLP, which consists primarily of various real estate development properties and standing timber. Additionally, since generally there is a wide range of per acre values within each real estate development property, there is judgment in determining how many homogenous groupings of acres there are within each development property, and then, how much book basis should be allocated to each unique grouping. Finally, there is judgment in estimating the amount of timber volume the venture expects to harvest in the future. The judgments related to our investment in the Timberland Venture primarily relates to the allocations of our investment in the Timberland Venture ($174 million) and our share of the Timberland Venture’s net book basis ($783 million) among the various assets of the Timberland Venture, which consists primarily of land and standing timber. Additionally, there is judgment in estimating the amount of timber volume the venture expects to harvest in the future. PLUM CREEK 2014 FORM 10-K | 35 PART II / ITEM 7 During 2014, the basis amortization included in equity earnings related to our investment in MWV-CLP was $11 million (additional expense) and the basis amortization included in equity earnings related to our investment in the Timberland Venture was $9 million (additional earnings). During 2013, there was no basis amortization included in equity earnings related to our investment in MWV-CLP, and the basis amortization included in equity earnings related to our investment in the Timberland Venture was $10 million (additional earnings). Management believes that current and future equity earnings (losses) could be materially different depending upon the assumptions used in allocating both our book basis in our equity method investments and our share of the ventures’ net book basis among the assets of the ventures. Accounting for Share-Based Compensation Plum Creek has a stockholder approved Stock Incentive Plan that provides for the award of shares of the company's stock including, but not limited to, common stock awards, restricted stock units and value management awards. See Note 15 of the Notes to Consolidated Financial Statements. Grants of value management awards are classified and accounted for as liabilities. As a result, the expense recognized over the performance period will equal the fair value (i.e., cash value) of an award as of the last day of the performance period multiplied by the number of awards that are earned. Furthermore, the quarterly expense recognized during the performance period is based on the fair value as of the end of the most recent quarter. Prior to the end of the performance period, compensation cost for value management awards is based on the awards’ most recent quarterly fair values and the number of months of service rendered during the performance period. Fair values for value management awards are computed based on our historical relative total shareholder return and simulated relative total shareholder return compared to the performance of peer groups consisting of forest products companies, the S&P 500 Index and the MSCI U.S. REIT Index over the same period (“Peer Group”). The simulated total shareholder return of the company and the Peer Group is computed using a Monte Carlo simulation. The key assumptions used in the simulation of the company’s and the Peer Group’s total shareholder return are volatility, beta (the measure of how Plum Creek’s stock moves relative to the market as a whole) and risk-free interest rate. The fair value of the liability for outstanding value management awards as of December 31, 2014 was $4 million, which is based on the current fair value of outstanding awards multiplied by the percentage of months that services were provided during the performance period. The liability as of December 31, 2014 could range between $0.3 and $26 million based on the possible fair value of all outstanding liability based awards. We could have a material adjustment to our share-based compensation liability to the extent there is a material change in the fair value of our value management awards during the quarter. Pensions Pension Plans Overview. Plum Creek provides pension benefits under defined benefit pension plans that cover substantially all of our employees. See Note 14 of the Notes to Consolidated Financial Statements. We maintain a qualified defined benefit pension plan and two non-qualified defined benefit pension plans. Participants’ benefits vest after three years of service. The cash balance benefits for salaried employees is determined based primarily on certain percentages of compensation, age, years of service and interest accrued based on the 30-year Treasury bond rate. Participants who were employees of the company on September 1, 2000, earn benefits based on the greater of the cash balance benefits or a monthly pension benefit that is principally based on the highest monthly average earnings during any consecutive sixty-month out of the last 120-month period and the number of years of service credit. The benefits to hourly employees are generally based on a fixed amount per year of service. Plum Creek’s contributions to its qualified pension plan vary from year to year, but the company has made at least the minimum contributions required by law in each year. It is generally the company’s policy to fund the qualified pension plan annually such that the fair value of plan assets equals or exceeds the actuarially computed accumulated benefit obligation (the approximate actuarially computed current pension obligation if the plan was discontinued) over a market cycle (generally 3 to 5 years). The company has the same funding policy for the non-qualified plan. However, assets related to the non-qualified plans are held in a grantor trust and are subject to the claims of creditors and, therefore, are not considered plan assets. PLUM CREEK 2014 FORM 10-K | 36 PART II / ITEM 7 Under current U.S. generally accepted accounting principles (U.S. GAAP), the company makes estimates and assumptions that can have a significant impact on the amounts reflected in our financial statements. These assumptions and their sensitivities, along with the application of the accounting principles and impact to our financial statements, are discussed in the next several sections. Current Year Impact and Analysis. During 2014, our pension liability increased from $178 million to $218 million and our pension assets increased from $144 million to $154 million. Our pension liability represents the present value of expected future benefit payments and is remeasured annually as of December 31. Each year, our pension liability increases due to employees working for one more year (service cost), and getting one year closer to receiving benefit payments (interest cost), and decreases as pension benefits are paid. Our pension liability is also adjusted due to changes in interest rates and mortality assumptions. During 2014, our pension liability increased by $32 million (an actuarial loss) due primarily to declining interest rates, and to a lesser extent, a change in our mortality assumptions (plan participants are living longer). Actuarial losses are initially recognized in other comprehensive income (loss) and then subsequently amortized (charged) to pension expense over future periods. Annually, our plan assets increase due to cash contributions from the company, decrease due to pension benefit payments, and will increase or decrease as a result of realized and unrealized gains and losses for the assets. Our pension expense is reduced by the expected returns on plan assets. We currently estimate that our long-term return on plan assets will average 7.25% per year. Based on the plan assets balance, our 2014 pension expense was reduced by $9 million (the expected return on plan assets in dollars). The actual return on plan assets was a gain of $7 million for 2014. We initially recognize this difference (shortfall) of $2 million in other comprehensive income (loss) and then subsequently will amortize (charge) to pension expense over future periods. At December 31, 2014, our cumulative net actuarial pension loss recognized in accumulated other comprehensive income (loss) was $54 million (includes both unrecognized changes in our pension liability and plan assets), of which $4 million will be amortized (charged) to 2015 pension expense. Each year the future amortization of our actuarial pension loss recognized in pension expense will increase or decrease due to changes in interest rates and actual returns on plan assets compared to expected returns. Additionally, while not expected, future company contributions may need to be increased to the extent interest rates remain low or to the extent that actual investment returns on plan assets do not meet our expectations. Significant Assumptions. The computation of the company’s benefit obligation, pension cost and accrued pension liability under U.S. GAAP requires us to make certain assumptions involving primarily the following (weighted-average rates): (A) The December 31, 2014 discount rate for annuity distributions was determined by the resulting yield of a hypothetical bond portfolio at December 31, 2014, matched to the expected benefit payments under the plans. Bonds selected for this portfolio had a Moody’s or Standard & Poor’s credit rating of “AA” or better as of December 31, 2014. The December 31, 2014 discount rate for lump-sum distributions is based on yields on 30-year U.S. Treasury bonds. PLUM CREEK 2014 FORM 10-K | 37 PART II / ITEM 7 (B) The assumed rate of increase of future compensation levels represents our long-term estimate of such increases on the basis of the composition of plan participants, past results and market expectations. (C) The expected long-term rate of return on plan assets assumption is based on the current level of expected returns on risk free investments (primarily government bonds), the historical level of the risk premium associated with the other asset classes in which the portfolio is invested and the expectations for future returns on each asset class. The expected return for each asset class was then weighted based on the target asset allocation to develop the expected long-term rate of return on plan assets assumption for the portfolio. Since pension benefits may be settled in either a single lump-sum or an annuity distribution, both the estimated percentage of participants electing a lump-sum payment and the assumed interest rate (discount rate) used in computing the lump-sum benefit are key assumptions. We currently estimate that approximately half of the qualified plan participants will elect a lump-sum distribution upon termination. Other key assumptions used in the estimate include primarily those underlying the mortality table, and expected long-term rates for inflation, retirement and withdrawals, all of which are based on plan experience and standard actuarial methods but which are nevertheless subject to uncertainty. It is likely that the actual return on plan assets and the outcome of other uncertain variables will differ from those used in estimating our pension costs and pension obligation. Furthermore, the company may, from time to time, adjust the asset allocation, which may have an impact on the long-term rate of return on plan assets. Financial Measures and Sensitivities. The following table summarizes key financial measures and sensitivities to changes in assumptions for the years ended December 31 (in millions): Assuming an average long-term rate of return on plan assets of 7.25%, and weighted-average discount rates of 4.15% for annuity distributions (and 3.04% for lump-sum distributions) and a 3.45% rate of increase in compensation levels for 2015 and beyond, we project our annual pension expense for 2015 will be approximately $10 million and will range between $8 million and $9 million each year for 2016 through 2019. Based on current interest rates and expected returns, in 2015, we expect our cash funding for the qualified pension plan to range between $4 million and $8 million and our cash funding for the non-qualified pension plans to range between $1 million and $4 million. Assuming no change to our disclosure assumptions, under our present funding policy and current funding rules for the qualified pension plan we would expect cash contributions to range between $6 million and $7 million each year in 2016 through 2019. We expect to fund between $2 million and $3 million each year for 2016 through 2019 to our non-qualified pension plans. PLUM CREEK 2014 FORM 10-K | 38 PART II / ITEM 7 Off-Balance Sheet Arrangements, Contractual Obligations, Contingent Liabilities and Commitments The company has no off-balance sheet debt. Our consolidated financial statements reflect all of the operations and assets and liabilities of the company. The company has equity investments in unconsolidated entities, discussed below. Otherwise, the company has no other relationships with unconsolidated entities or financial partnerships, such as entities referred to as structured finance or special purpose entities. On December 6, 2013, in connection with the MWV timberland acquisition (see Note 2 of the Notes to Consolidated Financial Statements) the company and MWV formed a limited liability company (MWV-Charleston Land Partners, LLC or “MWV-CLP”). Plum Creek contributed cash to MWV-CLP and MWV contributed real estate development properties, which consisted of both residential and commercial properties currently under development (“Class A Properties”) and high-value development lands (“Class B Properties”). Plum Creek contributed $12 million in exchange for a 5% interest in Class A Properties and $140 million in exchange for a 50% interest in Class B Properties. Plum Creek has committed to contribute capital of at least $39 million over the next six years in connection with its interest in Class B Properties. The company uses the equity method of accounting for both its Class A and Class B interests. See Notes 18 and 19 of the Notes to Consolidated Financial Statements. On October 1, 2008, the company contributed 454,000 acres of timberlands located in its Southern Resources Segment to a timberland venture in exchange for an equity interest. The company accounts for its interests under the equity method of accounting. See Notes 18 and 19 of the Notes to Consolidated Financial Statements. During 2013, the company entered into several treasury lock transactions to hedge against interest rate risk on its Installment Note Payable. These transactions are accounted for as cash flow hedges, and we are amortizing the $5 million gain on these transactions as a reduction to interest expense on the installment note over its term of ten years. See Notes 11 and 13 of the Notes to Consolidated Financial Statements. The company is not a party to any other derivative transactions. Contractual Obligations. The following table summarizes our contractual obligations at December 31, 2014 (in millions): (A) In addition to principal, long-term debt includes related interest obligations based on the coupon or stated interest rate for our fixed rate debt and the variable interest rate as of December 31, 2014 of 1.67% for our term credit agreement. During 2014, the company accrued patronage distributions related to 2014, which resulted in an effective net interest rate on the term loan of approximately 1%. See Note 11 of the Notes to Consolidated Financial Statements. Interest obligations are $108 million (less than one year), $172 million (1-3 years), $170 million (3-5 years), and $242 million (more than 5 years). As we expect borrowings outstanding under our line of credit to vary, only repayment of the principal is included. In 2014, interest expense related to our line of credit was less than $1 million. PLUM CREEK 2014 FORM 10-K | 39 PART II / ITEM 7 (B) On October 1, 2008, the company borrowed $783 million from the Timberland Venture (a related party). The annual interest rate on the note payable is fixed at 7.375%. Interest obligations are $58 million (less than one year), $115 million (1-3 years), and $58 million (3-5 years). (C) Purchase obligations are comprised primarily of $135 million for timber harvest contracts, $44 million for long-term timber leases, $21 million for fiber supply agreements to supply our manufacturing facilities, approximately $15 million for electricity and natural gas for our MDF facilities, $9 million for fiber supply agreements to supply external customers, and $7 million for raw materials (wood fiber and resin) for our manufacturing facilities. (D) We have not included any amounts for our other long-term liabilities, as we cannot estimate when we will be obligated to satisfy these liabilities. At December 31, 2014, other long-term liabilities include workers’ compensation of $7 million, deferred compensation obligations of $5 million and pension obligations of $64 million (including $5 million classified as a current liability). We expect to fund approximately $1 million for workers’ compensation payments in 2015. We have two grantor trusts, which hold assets associated with our deferred compensation obligations and non-qualified pension obligations. At December 31, 2014, the fair value of assets in one of our grantor trusts is approximately equal to our deferred compensation obligation of $5 million. The December 31, 2014 fair value of assets in the other grantor trust was approximately $43 million and the actuarially computed accumulated benefit obligation for our non-qualified pension plans was $45 million. Assets in our grantor trusts have been reserved for the above obligations. However, grantor trust assets are subject to the claims of creditors in the event of bankruptcy. Additionally, based on current interest rates and expected returns, the company expects 2015 contributions to the qualified pension plan to range between $4 million and $8 million and between $1 million and $4 million for the grantor trust associated with the non-qualified plans. See Notes 12 and 14 of the Notes to Consolidated Financial Statements. PLUM CREEK 2014 FORM 10-K | 40 PART II / ITEM 7 Events and Trends Affecting Operating Results Gain Recognized in Connection with Redemption of Member’s Interest On October 1, 2008, Plum Creek contributed approximately 454,000 acres of timberlands to Southern Diversified Timber, LLC (“Timberland Venture”) in exchange for a $705 million preferred interest and a 9% common interest valued at $78 million. The other member contributed cash of $783 million in exchange for a 91% common interest. Following the contribution of cash by the other member, Plum Creek borrowed $783 million from the Timberland Venture (“Note Payable to Timberland Venture”). No gain was recognized by Plum Creek in 2008 in connection with the contribution of its timberlands to the Timberland Venture. See Notes 18 and 19 of the Notes to Consolidated Financial Statements. Under the terms of the Timberland Venture agreement, the other member has the option of having the Timberland Venture redeem its interest during the period October 1, 2015 to March 31, 2016. Plum Creek has a similar option during the period October 1, 2017 to March 31, 2018. The Timberland Venture agreement also provides that in connection with a redemption, all of the timberlands held by the Timberland Venture will be distributed to the other member, subject to adjustments to capital accounts in connection with the revaluation of the Timberland Venture’s assets at the time of the redemption. If the other member exercises its right, depending upon the fair value of the Timberland Venture’s net assets on the date of redemption, Plum Creek expects to recognize a non-operating book gain (and an increase in reported net income) of between $500 million and $600 million. The company believes the earliest this book gain could be recognized is 2016. However, while the company believes the potential redemption would result in the recognition of a book gain, the company does not believe a redemption would result in a taxable gain nor would it impact the company’s quarterly dividend distributions. Harvest Plans We determine our annual timber (sawlogs and pulpwood, including stumpage sales) harvesting plans based on a number of factors. At the stand level, ranging in size from 10 to 200 acres, we consider the age, size, density, health and economic maturity of the timber. A stand is a contiguous block of trees of a similar age, species mix or silvicultural regime. At the forest level, ranging in size from 100,000 to almost 1 million acres, we consider the long-term sustainability and environmental impact of certain levels of harvesting, certain external conditions such as supply agreements, and the level of demand for wood within the region. A forest is a broad administrative unit, made up of a large number of stands. Harvest scheduling is the technical approach using computer modeling that considers all of the above factors along with forest growth rates and financial assumptions to project future harvest plans for a number of years forward. Our actual harvest levels may vary from planned levels due to log demand, sales prices, the availability of timber from other sources, the level of timberland sales and acquisitions, the availability of legal access, abnormal weather conditions, fires and other factors outside of our control. We believe that our harvest plans are sufficiently flexible to permit modification in response to short-term fluctuations in the markets for logs. Furthermore, future harvest levels will be impacted by sales and purchases of timberlands. The impact of timberland sales will depend on the level and extent we reinvest proceeds in productive timberlands and the stocking levels and age class distribution of any newly acquired timberlands. For example, in December 2013 we acquired approximately 501,000 acres of timberlands in Alabama, Georgia, South Carolina, Virginia, and West Virginia from MeadWestvaco Corporation ("MWV"). Of the MWV timberlands acquired, approximately 147,000 acres are included in the Northern Resources Segment and approximately 354,000 acres are included in the Southern Resources Segment. The volume harvested from the MWV timberlands in 2014 was nearly 3 million tons. Harvest levels are also impacted by purchases of long-term timber deeds. In 2013, we purchased a timber deed in the Southern Resources Segment, which encompasses approximately 0.9 million tons of standing timber. In 2012, we acquired approximately 4.7 million tons of standing timber in our Southern Resources Segment. The volume acquired under a timber deed, plus the related growth, is harvested over the term of each timber deed. Both timber deeds expire in 2020. Northern Resources Segment. Sawlog harvest levels during 2014 were 2.3 million tons and pulpwood harvest levels were 1.6 million tons. Sawlog harvest levels during 2015 are expected to decrease between 5% and 10% due primarily to recent land sales and harvest schedule updates. Pulpwood harvest levels during 2015 are expected to PLUM CREEK 2014 FORM 10-K | 41 PART II / ITEM 7 be comparable to 2014 harvest levels. While the company has flexibility to modify annual harvest volumes based on market conditions, we expect sawlog harvest levels beyond 2015 in the near-term (next five years) to decrease by between 5% and 10% compared to 2014 harvest levels, and we expect sawlog harvest levels in the longer-term (ten years and beyond) to decrease by between 15% and 20% compared to 2014 harvest levels. Additionally, we expect pulpwood harvest levels beyond 2015 in the near-term to be comparable to 2014 harvest levels and in the longer-term we expect pulpwood harvest levels to decrease by between 5% and 10% compared to 2014 harvest levels. Southern Resources Segment. Sawlog harvest levels during 2014 were 6.5 million tons and pulpwood harvest levels were 9.3 million tons. Both sawlog and pulpwood harvest levels during 2015 are expected to be comparable to 2014 harvest levels. While the company has flexibility to modify annual harvest volumes based on market conditions, we expect sawlog harvest levels beyond 2015 in the near-term (next five years) to increase by nearly 15% compared to 2014 harvest levels, and we expect sawlog harvest levels in the longer-term (ten years and beyond) to increase by nearly 50% compared to 2014 harvest levels. Additionally, we expect pulpwood harvest levels beyond 2015 in the near-term and long-term to be comparable to 2014 harvest levels. Comparability of Financial Statement Periods Acquisitions and Divestitures. We have pursued and expect to continue to pursue both the acquisition and divestiture of timberlands to increase the value of our assets. Accordingly, the comparability of periods covered by the company’s financial statements is, and in the future may be, affected by the impact of timberland acquisitions and divestitures. The following table summarizes timberland acquisitions and dispositions for each of the past three years, along with our total acres owned at each of the past three year ends (in acres): PLUM CREEK 2014 FORM 10-K | 42 PART II / ITEM 7 Results of Operations The following table compares Operating Income (Loss) by Segment and other items impacting our net income for the years ended December 31 (in millions): 2014 Compared to 2013 Northern Resources Segment. In December 2013, we acquired approximately 501,000 acres of timberland from MeadWestvaco Corporation ("MWV"). Of the MWV timberlands acquired, approximately 147,000 acres are included in the Northern Resources Segment. Revenues increased by $4 million, or 2%, to $264 million in 2014 compared to 2013. Excluding the acquired MWV timberlands, revenues decreased by $11 million, or 4% to $249 million. The decrease was due primarily to lower sawlog volumes ($23 million), partially offset by higher sawlog prices ($11 million) and higher pulpwood prices ($3 million). Sawlog harvest volumes decreased 7% during 2014 compared to 2013. Excluding the MWV timberlands, sawlog harvest volumes decreased 12% during 2014 compared to 2013 due primarily to recent land sales and harvest schedule and timber inventory updates. Pulpwood harvest volumes increased 12% during 2014 compared to 2013. Excluding the MWV timberlands, pulpwood harvest volumes were essentially flat during 2014 compared to 2013. Sawlog prices increased 8% during 2014 compared to 2013. Sawlog prices increased due primarily to improved demand and, to a lesser extent, limited supply. The demand for sawlogs has improved due primarily to improving U.S. housing starts, which increased by 9% compared to 2013. Furthermore, sawlog prices were favorably impacted throughout most of the year by the export of logs and lumber to China. The supply of sawlogs in our Northern Segment PLUM CREEK 2014 FORM 10-K | 43 PART II / ITEM 7 remained limited throughout most of 2014 due in part to weather-related harvesting restrictions. Pulpwood prices increased 3% during 2014 compared to 2013 due primarily to weather-related harvesting constraints. Excluding the MWV timberlands, Northern Resources Segment operating income was 16% of its revenues for 2014 compared to 12% of its revenues for 2013. The increase in operating performance was due to improved log prices and lower operating expenses, offset in part by lower sawlog harvest volumes and higher log and haul rates. Additionally, during 2013 we incurred a $4 million charge for timber losses from forest fires. Segment costs and expenses decreased by $8 million, or 4%, to $220 million. Excluding the MWV timberlands, segment costs and expenses decreased by $19 million, or 8%, to $209 million due primarily to lower sawlog harvest volumes, lower operating expenses and a $4 million forest fire loss in 2013, offset in part by higher log and haul rates. Operating expenses decreased by $7 million due primarily to lower logging road costs, as a result of lower sawlog harvest volumes, and lower share-based compensation costs. During 2013, we recorded a $4 million loss (i.e. the book basis of timber volume destroyed) related to forest fires on approximately 12,000 acres in Oregon and Montana. No forest fire losses were experienced during 2014. Log and haul rates per ton increased 4% ($5 million) due primarily to salvage logging on our Montana and Oregon timberlands that were impacted by fires in 2013. For 2015, we expect sawlog harvest volumes to decrease between 5% and 10% compared to the 2.3 million tons we harvested in 2014 due primarily to recent land sales and harvest schedule updates. We expect pulpwood harvest volumes in 2015 to approximate the 1.6 million tons we harvested in 2014. Southern Resources Segment. In December 2013, we acquired approximately 501,000 acres of timberland from MWV. Of the MWV timberlands acquired, approximately 354,000 acres are included in the Southern Resources Segment. Key operating statistics for the segment are as follows: Revenues increased by $96 million, or 22%, to $531 million in 2014 compared to 2013. Excluding the acquired MWV timberlands, revenues increased by $11 million, or 3% to $446 million. This increase was due primarily to higher sawlog prices ($7 million), an increased proportion of delivered log sales ($7 million), higher pulpwood prices ($6 million) and higher pulpwood volumes ($5 million), partially offset by lower sawlog volumes ($13 million). In certain markets during 2014, demand for delivered log sales, particularly sawlogs, was generally stronger than markets for the sale of standing timber (or “stumpage”). Under delivered log sale agreements, we are responsible for log and haul costs, while under agreements to sell standing timber, the buyer is responsible for log and haul costs. While revenues are higher under a delivered log sale, a large portion of the increase is to cover the related increase in cost of sales. Sawlog prices increased approximately 4% during 2014 compared to 2013 due primarily to modestly increased log demand resulting from improved U.S. housing starts, which increased by 9% compared to 2013. Despite the continued increase in lumber mill production capacity expansions and a 5% increase in lumber production in the Southern U.S. during 2014, the price improvement for sawlogs has been modest because at current production levels there remains an adequate supply of logs. Pulpwood prices increased 10% during 2014 compared to 2013. This increase was due primarily to continued good demand from our paper and packaging customers and increased fiber demand from competing uses, such as Oriented Strand Board and the export of wood pellets used to produce bioenergy. PLUM CREEK 2014 FORM 10-K | 44 PART II / ITEM 7 Sawlog harvest volumes increased 10% during 2014 compared to 2013. Excluding the MWV timberlands, sawlog harvest volumes decreased 5% during 2014 compared to 2013 due primarily to the deferral of harvest volumes until sawlog prices improve. Pulpwood harvest volumes increased 23% during 2014 compared to 2013. Excluding the MWV timberlands, pulpwood harvest volumes were comparable to the tons harvested in 2013. Excluding the MWV timberlands, Southern Resources Segment operating income was 27% of its revenues for 2014 compared to 25% of its revenues for 2013. This increase was due primarily to higher sawlog and pulpwood prices. Segment costs and expenses increased by $67 million, or 21%, to $394 million for 2014 due primarily to higher harvest volumes and, to a lesser extent, increased forest management expenses ($6 million) related to the MWV timberlands and higher depletion rates ($4 million). Excluding the MWV timberlands, segment costs and expenses decreased by $2 million, or 1%, to $325 million due primarily to lower depletion rates, offset in part by higher log and haul rates. Depletion rates per ton decreased by 12% ($7 million) in 2014 compared to 2013 due primarily to harvesting lower volume from the timber deeds the company acquired in 2013 and 2012. During 2014, the company harvested approximately 700,000 tons related to timber deeds compared to harvesting approximately 1 million tons in 2013. Log and haul rates per ton increased by 2% ($4 million) in 2014 compared to 2013. Despite the sharp decline in diesel fuel prices during the second half of 2014, log and haul rates per ton increased due primarily to a shortage of loggers and haulers. For 2015, we expect sawlog harvest volumes to approximate the 6.5 million tons we harvested in 2014. We expect pulpwood harvest volumes in 2015 to approximate the 9.3 million tons we harvested in 2014. Additionally, during 2015 we expect to harvest a higher percentage of sawlogs and pulpwood from our Gulf South Region, which generally has lower sales realizations. Real Estate Segment. Revenues increased by $3 million, or 1%, to $289 million in 2014. Revenues were slightly higher; however, the mix changed as revenues decreased from large non-strategic land sales by $41 million and by $27 million from small non-strategic sales, offset by an increase in the revenues from conservation sales of $37 million and sales of higher and better use / recreational properties of $31 million. Revenues from the sale of large non-strategic timberlands were $65 million in 2014 compared to $106 million during 2013. This decrease of $41 million was due primarily to selling fewer large non-strategic acres during 2014 as a result of improved demand for higher and better use / recreational properties and higher conservation sales. Additionally, the price per acre for large non-strategic timberlands can vary significantly due to the geographic location, the stocking level including timber species and age class distribution, the timber growth rates, and the demand and supply of wood fiber in the local market. Revenues from small non-strategic sales decreased due primarily to selling approximately 13,600 (31%) fewer acres during 2014 compared to 2013 and realizing a lower sales price per acre in 2014. We sold nearly 22,000 acres during 2013 to a single buyer. Our average sales price per acre for small non-strategic properties decreased by 29% for 2014 compared to 2013 due primarily to selling approximately 17,000 acres in Wisconsin to a single buyer. Per acre values in the Lake States are generally lower than most other regions of the country in which we hold properties. PLUM CREEK 2014 FORM 10-K | 45 PART II / ITEM 7 Revenues from the sale of conservation properties were $63 million in 2014 compared to $26 million during 2013. Occasionally, the company is approached by a conservation organization to purchase a substantial portion of our ownership in one or more states, which is being held for timber production. During 2014, we agreed to sell approximately 165,000 acres of timberlands located in Montana and Washington to The Nature Conservancy. The sale closed in two phases. The first phase closed during the fourth quarter of 2014 for approximately $46 million and consisted of nearly 48,000 acres in Washington State. The second phase closed in January 2015 for $85 million and consisted of 117,000 acres in Montana. In general, conservation sales vary significantly from period to period and are primarily impacted by government and not-for-profit funding and the limited number of conservation buyers. Additionally, the price per acre for conservation properties can vary significantly due to the geographic location and the rationale for the conservation designation. Revenue from our higher and better use / recreational properties increased as a result of selling approximately 17,650 (38%) more acres compared to 2013. This increase was due primarily to selling 22,400 acres for approximately $29 million as part of a collection of properties sold to a timberland investor in Wisconsin during the second quarter of 2014. The demand for our premium higher and better use / recreational properties remains soft. The timing of real estate sales is a function of many factors, including the general state of the economy, demand in local real estate markets, the ability to obtain entitlements, the ability of buyers to obtain financing, the number of competing properties listed for sale, the seasonal nature of sales (particularly in the northern states), the plans of adjacent landowners, our expectation of future price appreciation, the timing of harvesting activities, and the availability of government and not-for-profit funding (especially for conservation sales). In any period the average sales price per acre will vary based on the location and physical characteristics of the parcels sold. At December 31, 2014, the company owns approximately 6.6 million acres of timberlands. Included in the 6.6 million acres are approximately 775,000 acres of higher value timberlands (approximately 675,000 acres of higher value timberlands after adjusting for the January 2015 sale to The Nature Conservancy) which are expected to be sold over the next fifteen years and 225,000 acres of non-strategic timberlands which are expected to be sold in smaller acreage transactions over the near and medium term (“small non-strategic”). Not included in the above 775,000 higher value acres and 225,000 small non-strategic acres are acres that are expected to be sold in large acreage transactions to commercial timberland buyers as opportunities arise (“large non-strategic”). We expect revenue from real estate sales during 2015 to range between $250 million and $300 million with approximately one-third of the revenue from the sale of large non-strategic land sales. The proceeds from the sale of large non-strategic properties is expected to be used for capital allocation, such as stock repurchases and debt repayments. The Real Estate Segment operating income as a percent of revenue was 46% for 2014 compared to 59% for 2013. This decrease was due primarily to selling properties in 2014 with a lower operating margin compared to the operating margin of properties sold in 2013. This decline in operating margins resulted primarily from the fourth quarter sale of conservation lands in Washington State that had basis in excess of the selling price, and selling approximately 8,800 acres that had high book value from the recent MeadWestvaco acquisition. Conversely, the properties sold in 2013 were generally from regions with lower book value as the properties had been owned for decades. Real Estate Segment costs and expenses increased by $39 million to $156 million in 2014 due primarily to selling property with higher book value and selling more acres during 2014. Similar to the sale of Washington properties to The Nature Conservancy in 2014, the sale of Montana properties to The Nature Conservancy in January 2015 had high book values, which will likely cause our real estate segment operating income as a percent of revenue for 2015 to be comparable to 2014. PLUM CREEK 2014 FORM 10-K | 46 PART II / ITEM 7 Manufacturing Segment. On June 10, 2014, we experienced a fire at our MDF facility and recorded a $2 million loss representing the net book value of the building and equipment damaged or destroyed by the fire. During 2014, we also recorded a $13 million gain related to insurance recoveries that we received, which, when combined with the building and equipment loss, resulted in a net gain of $11 million for the year ended December 31, 2014. Insurance recoveries were $10 million for the costs incurred during 2014 to rebuild or replace the damaged building and equipment and $3 million for business interruption costs. Substantially all of the costs incurred to rebuild or replace the damaged building and equipment were capitalized during 2014. Both the building and equipment loss and the insurance recoveries are reported as Other Operating Gain in the Manufacturing Segment and are included in Other Operating Income (Expense), net in the Consolidated Statements of Income. See Note 17 of the Notes to Consolidated Financial Statements. (A) Represents product prices at the mill level. Revenues increased by $6 million, or 2%, to $368 million in 2014. This increase in revenues was due primarily to higher lumber prices ($9 million), higher lumber sales volumes ($5 million), higher plywood prices ($5 million) and higher MDF prices ($4 million), partially offset by lower plywood sales volumes ($10 million), and lower MDF sales volumes ($7 million). Lumber sales prices increased 8% during 2014 compared to 2013 due primarily to a limited supply of boards. The supply of boards has been limited, in part, as many lumber manufacturers switched to producing dimension lumber instead of boards due to improved demand for dimension lumber. Lumber sales volume was 5% higher during 2014 compared to 2013 due primarily to resuming operations at our Evergreen, Montana (stud lumber) sawmill in April 2013. Plywood sales volume was 11% lower during 2014 compared to 2013 due primarily to a declining supply of logs in the region. Plywood average prices were 6% higher during 2014 compared to 2013 due primarily to continued strong demand for our specialty plywood products along with a reduced supply. The supply of plywood has also declined due to a competing West Coast plywood mill that was destroyed by fire in July 2014. MDF sales volume was 5% lower during 2014 compared to 2013 due primarily to a fire at our MDF facility in June 2014. The fire suspended production at the facility until early July. MDF average prices were 2% higher during 2014 compared to 2013. Excluding the $11 million net gain from insurance recoveries, Manufacturing Segment operating income was 10% of its revenues for 2014 compared to 12% of its revenues for 2013. This decrease in operating performance was due primarily to lower MDF and plywood sales volumes and higher raw material costs. Excluding insurance recoveries, Manufacturing Segment costs and expenses increased by $11 million, or 3%, to $330 million. The increase in costs and expenses was due primarily to increased lumber sales volumes and higher raw material costs (in all of our product lines), partially offset by lower MDF and plywood sales volumes. Plywood and lumber raw material costs increased by approximately $17 million during 2014 compared to 2013. The higher plywood raw material costs ($10 million) were due primarily to a combination of higher log costs and additional purchases of veneer from other plywood manufacturers, both as a result of the declining supply of logs in the region. The higher lumber raw material costs ($7 million) were due primarily to higher cost of boards for our remanufacturing mill and higher log costs for our other lumber mills as a result of the declining supply of logs in the region. PLUM CREEK 2014 FORM 10-K | 47 PART II / ITEM 7 Energy and Natural Resources Segment. Revenues increased by $11 million, or 48%, to $34 million in 2014. This increase was due primarily to royalties from our recent acquisition of mineral rights in approximately 255 million tons of aggregate reserves in September 2013 ($6 million), and royalties from recently acquired coal and wind assets in the MeadWestvaco acquisition ($5 million). Operating income was $25 million for 2014 compared to $19 million in 2013. Costs and expenses increased by $5 million to $9 million in 2014 due primarily to higher depletion expense associated with our newly acquired mineral rights and coal and wind assets ($7 million), offset in part by a gain associated with a contract termination ($2 million). See Note 21 of the Notes to Consolidated Financial Statements. Other Segment. The Other Segment includes revenues and expenses associated with our new business of providing timber and wood-fiber procurement services by the harvesting and selling of trees from timberlands that are not owned by the company. Additionally, equity earnings (losses) associated with the company's investment in MWV-Charleston Land Partners, LLC (see Note 18 of the Notes to Consolidated Financial Statements) are reported in the Other Segment. In 2014, the Other Segment reported operating income of $2 million that was due primarily to recording our share of equity earnings from our investment in MWV-CLP. There were no similar activities in 2013. Other Costs and Eliminations. Other costs and eliminations (which consists of corporate overhead and intercompany profit elimination) decreased operating income by $67 million during 2014 compared to $73 million during 2013. The decrease of $6 million was due primarily to lower transaction expenses related to our timberland acquisition in 2013 from MWV ($4 million) and lower share-based compensation costs ($4 million) partially offset by an increase in information technology costs, compliance costs and charitable contributions ($2 million). See Note 2 of the Notes to Consolidated Financial Statements for discussion of the timberland acquisition. The decrease in share-based compensation expense was due primarily to fair value adjustments associated with our value management plan. We adjust the fair value of our liability quarterly based on our relative total shareholder return compared to the performance of several peer groups. Other Unallocated Operating Income (Expense), net. Other unallocated operating income and expense (which consists of income and expenses not allocated to the operating segments) increased operating income by $2 million during 2014 and decreased operating income by $3 million during 2013. The decrease in expense of $5 million compared to 2013 was due primarily to a loss related to the early termination of an equipment lease in 2013. The equipment lease was accounted for as an operating lease prior to termination. Other unallocated operating income and expense items are included in Other Operating Income (Expense), net in the Consolidated Statements of Income. Selling, General and Administrative Expenses. Corporate overhead costs along with Segment specific selling, general, and administrative costs are reported in total on our Consolidated Statements of Income and decreased operating income by $115 million in 2014 compared to $123 million in 2013. This decrease in expense of $8 million was due primarily to lower share-based compensation costs ($7 million) and transaction expenses related to our timberland acquisition from MWV in 2013 ($4 million) offset in part by higher wage costs ($3 million). The decrease in share-based compensation costs is primarily a result of fair value adjustments associated with our value management plan. Interest Expense, net. In December 2013, we issued an $860 million installment note to MWV CDLM in connection with the acquisition of certain timberland assets. Our effective net interest rate on this note is approximately 4.5%. Also during 2013, we paid off our remaining Private Debt ($260 million), paid down $225 million of our term credit agreement and made pre-payments of approximately $24 million of principal on our Public Debt. As a result of the above transactions, interest expense, net of interest income, increased $25 million, or 18%, to $166 million in 2014 compared to $141 million in 2013. This increase was due primarily to interest expense on our $860 million installment note payable ($35 million), offset by a reduction in interest expense as a result of the debt repayments in 2013 ($10 million). Loss on Extinguishment of Debt. During 2013, we prepaid approximately $10 million of principal of Private Debt, $24 million of principal of Public Debt and $225 million of principal of the term credit agreement. These prepayments resulted in a $4 million loss. See Notes 2 and 11 of the Notes to Consolidated Financial Statements. PLUM CREEK 2014 FORM 10-K | 48 PART II / ITEM 7 Provision (Benefit) for Income Taxes. The provision for income taxes was $8 million for income taxes in 2014 compared to a benefit for income taxes of $1 million in 2013. This $9 million increase in expense for income taxes was due primarily to higher earnings from real estate sales by our taxable REIT subsidiaries ($3 million), higher earnings from harvesting and log selling operations conducted by our taxable REIT subsidiaries ($3 million) and higher earnings from our manufacturing businesses ($2 million). Real estate sales are made by both our taxable REIT subsidiaries and various wholly-owned subsidiaries of our REIT depending upon the nature and characteristics of the timberlands being sold. Earnings increased for our harvesting and log selling operations due primarily to higher harvest volumes following our timberland acquisition from MWV in December 2013. Higher earnings for our manufacturing businesses are due primarily to gains for insurance recoveries recognized during 2014 related to our MDF facility. See Note 17 of the Notes to Consolidated Financial Statements. Our determination of the realization of deferred tax assets is based upon management's judgment of various future events and uncertainties, including the timing, nature and amount of future taxable income earned by certain wholly-owned subsidiaries. A valuation allowance is recognized if management believes it is more likely than not that some portion, or all, of the deferred tax asset will not be realized. At December 31, 2014, we have recorded deferred tax assets of $65 million (net of a $12 million valuation allowance) and deferred tax liabilities of $36 million. Management believes that due to the reversal of various taxable temporary differences and/or the planned execution of prudent and feasible tax planning strategies, sufficient taxable income can be generated to utilize the company's remaining deferred tax assets of $65 million for which a valuation allowance was determined to be unnecessary. 2013 COMPARED TO 2012 Northern Resources Segment. Revenues increased by $14 million, or 6%, to $260 million in 2013 compared to 2012. This increase was due primarily to higher sawlog prices ($25 million), partially offset by lower sawlog harvest volumes ($7 million) and by lower pulpwood harvest volumes ($7 million). Sawlog prices increased 15% in 2013 compared to 2012 due primarily to improved demand and limited supply. The demand for sawlogs on the West coast improved due primarily to lumber and plywood mills increasing production along with the strengthening demand for export logs, primarily to China. Lumber and plywood production increased compared to 2012 primarily as a result of near record high lumber and plywood prices during the first half of 2013 and improving U.S. housing starts. Housing starts during 2013 increased by 18% compared to 2012 and increased by over 60% to almost 1 million starts from the record low housing starts of 554,000 in 2009. The supply of logs was limited during most of 2013 due to weather-related harvesting restrictions earlier in the year and harvesting restrictions related to forest fires later in the year. Sawlog harvest volumes were 4% lower in 2013 compared to 2012. Sawlog harvest volumes decreased from 2012 due primarily to harvest schedule and timber inventory updates, and recent land sales. Pulpwood harvest volumes were 11% lower in 2013 compared to 2012 due primarily to an excess supply of wood chips on the West coast and, to a lesser extent, harvest schedule updates and recent land sales in the Northeastern U.S. Throughout most of 2013, there was an excess supply of wood chips on the West coast due to an increase in lumber and plywood production. Northern Resources Segment operating income was 12% of its revenues for 2013 compared to 8% of its revenues for 2012 due primarily to higher sawlog prices, partially offset by a loss related to several forest fires and higher log and PLUM CREEK 2014 FORM 10-K | 49 PART II / ITEM 7 haul rates. Segment costs and expenses increased by $2 million, or 1%, to $228 million for 2013. Segment costs and expenses were impacted by a $4 million fire loss and higher log and haul rates per ton ($7 million); however, these increases were almost entirely offset by lower harvest volumes. The $4 million fire loss represents the book basis of timber volume destroyed as a result of forest fires on approximately 12,000 acres in Oregon and Montana. Log and haul rates increased 5% during 2013 compared to 2012 due primarily to longer haul distances, harvesting stands that require more expensive logging methods, and lower volumes per acre on certain harvest units. Southern Resources Segment. Revenues increased by $18 million, or 4%, to $435 million in 2013 compared to 2012. This increase was due primarily to higher sawlog harvest volumes ($14 million), higher sawlog prices ($11 million), and higher pulpwood prices ($10 million), partially offset by lower pulpwood harvest volumes ($22 million). Sawlog harvest volumes increased 3% in 2013 compared to 2012 due primarily to planned harvest volume increases and modest increases in sawlog demand. Sawlog prices increased 9% during 2013 compared to 2012 due primarily to a modest increase in lumber production and, to a lesser extent, wet weather in the eastern areas of the Segment that temporarily limited harvesting activities. Despite near record high lumber prices during the first half of 2013 and the significant improvement in U.S. housing starts, sawlog prices improved at a slower pace, compared to sawlog prices in our Northern Resources Segment, due primarily to only a modest increase in regional demand. During 2013, lumber production in the South increased by only 4% as mill owners in the South have reacted more slowly (compared to mill owners in the North) to add shifts or reopen curtailed facilities. Pulpwood prices increased 13% during 2013 compared to 2012. This increase was due primarily to continued good demand from our paper and packaging customers and increased fiber demand from competing uses, such as Oriented Strand Board production and the export of wood pellets used to produce bioenergy. Pulpwood harvest volumes decreased 6% in 2013 compared to 2012 due primarily to adequate mill inventories. Despite improving demand, most mills in the western areas of the Segment had an ample supply of pulpwood due to favorable harvesting conditions as a result of unusually dry weather. Southern Resources Segment operating income was 25% of its revenues for 2013 compared to 22% of its revenues for 2012. The increase was due primarily to higher sawlog and pulpwood prices. Segment costs and expenses were $327 million for both 2013 and 2012. PLUM CREEK 2014 FORM 10-K | 50 PART II / ITEM 7 Real Estate Segment. Revenues decreased by $66 million, or 19%, to $286 million in 2013. This decrease was due primarily to a decrease in large non-strategic land sales ($103 million), offset in part by an increase in the revenue from higher and better use / recreational properties ($43 million). Revenues from the sale of large non-strategic timberlands were $106 million in 2013 compared to $209 million during 2012. This decrease of $103 million was due primarily to selling fewer large non-strategic acres during 2013 as a result of improving demand for higher and better use / recreational properties. Additionally, the price per acre for large non-strategic timberlands can vary significantly due to the geographic location, the stocking level including timber species and age class distribution, the timber growth rates, and the demand and supply of wood fiber in the local market. Revenue from our higher and better use / recreational properties increased as a result of selling approximately 21,100 (81%) more acres compared to 2012. This increase was due primarily to the improving demand for some of our properties, selling a large parcel (8,600 acres) to an adjacent landowner and selling several other smaller packages to timberland investors. The demand for some of our higher and better use properties modestly improved in 2013 due to improving consumer sentiment as a result of the improving U.S. economy and 2013 stock market gains. However, the improvement in demand had not yet resulted in upward price pressure for our higher and better use / recreational properties. Furthermore, the demand for our premium higher and better use / recreational properties remained soft. The timing of real estate sales is a function of many factors, including the general state of the economy, demand in local real estate markets, the ability to obtain entitlements, the ability of buyers to obtain financing, the number of competing properties listed for sale, the seasonal nature of sales (particularly in the northern states), the plans of adjacent landowners, our expectation of future price appreciation, the timing of harvesting activities, and the availability of government and not-for-profit funding (especially for conservation sales). In any period the average sales price per acre will vary based on the location and physical characteristics of the parcels sold. Also, conservation sales vary significantly from period to period and are primarily impacted by government and not-for-profit funding and the limited number of conservation buyers. Additionally, the price per acre for conservation properties can vary significantly due to the geographic location and the rationale for the conservation designation. The Real Estate Segment operating income as a percent of revenue was 59% for the year ended December 31, 2013 compared to 53% for 2012. Real Estate Segment costs and expenses decreased by $48 million to $117 million in 2013 due primarily to selling fewer acres during 2013. PLUM CREEK 2014 FORM 10-K | 51 PART II / ITEM 7 Manufacturing Segment. (A) Represents product prices at the mill level. Revenues increased by $38 million, or 12%, to $362 million in 2013. This increase in revenues was due primarily to higher lumber sales volumes ($10 million), higher MDF sales volumes ($9 million), higher MDF prices ($8 million), higher plywood prices ($7 million) and higher lumber (boards) prices ($6 million), partially offset by lower plywood sales volumes ($5 million). Lumber sales volume was 27% higher during 2013 compared to 2012 due primarily to resuming operations at our Evergreen, Montana stud lumber sawmill in April 2013. Our average lumber sales realizations were flat due to the lower-valued stud lumber produced by the re-opened Evergreen sawmill. However, sales realizations from our board sawmill (which produces higher-value products) increased 10% during 2013 compared to 2012 due primarily to limited supply. The supply of boards was limited because many lumber manufacturers switched to producing dimension lumber instead of boards due to improving demand for dimension lumber. MDF sales volume was 7% higher during 2013 compared to 2012 due primarily to a modest increase in demand and limited supply. MDF demand increased in many specialty markets for products, such as cabinet components, molding and architectural doors, due primarily to a strengthening U.S. economy and an increase in U.S. housing starts. The supply of MDF in North America was limited due primarily to low imports and the closure of several high-cost domestic mills. This supply and demand imbalance allowed for MDF price increases during 2013. MDF average prices were 6% higher during 2013 compared to the prior year. Plywood prices were 9% higher during 2013 compared to 2012. Plywood prices increased due primarily to an improvement in demand and limited supply. The demand from both our industrial (e.g., truck trailers and recreational vehicles) and commercial (e.g., concrete form) customers improved in 2013 due primarily to an improving U.S. economy. The supply of specialty plywood in North America was limited due primarily to low imports, domestic mill curtailments, and many plywood manufacturers switching to produce commodity panels. As a result of commodity plywood prices reaching historically high levels which peaked in April 2013, many plywood producers switched from producing specialty plywood to manufacturing commodity plywood, which resulted in a reduced supply for the specialty plywood products we produce. Plywood sales volume was 6% lower during 2013 due primarily to a declining regional supply of logs. Manufacturing Segment operating income was 12% of its revenues for 2013 compared to 9% of its revenues for 2012. This increase in operating performance was due primarily to higher product prices. Manufacturing Segment costs and expenses increased by $24 million, or 8%, to $319 million due primarily to increased MDF and lumber sales volumes and, to a lesser extent, higher lumber and plywood log costs ($8 million). The per ton cost for logs increased due primarily to improving lumber and plywood demand and the declining regional supply of logs. PLUM CREEK 2014 FORM 10-K | 52 PART II / ITEM 7 Energy and Natural Resources Segment. Revenues increased by $1 million, or 5%, to $23 million in 2013. This increase was due primarily to royalties from our acquisition of mineral rights in approximately 144 million tons of aggregate reserves in December 2012 ($3 million) and approximately 255 million tons of aggregate reserves in September 2013 ($2 million), offset by lower revenue from bonus payments ($4 million). Periodically, we receive bonus payments associated with exploration rights on oil and gas leases for which we recognize the payments as revenue over the term of the exploration rights. Operating income was flat at $19 million in both 2013 and 2012. Costs and expenses increased by $1 million to $4 million in 2013 due primarily to higher depletion expense associated with our acquired mineral rights ($2 million). Additionally, we sold certain mineral reserves for a gain of $1 million during 2013. This gain is reported as Other Operating Gain in our Energy and Natural Resources Segment and is included in Other Operating Income (Expense), net in the Consolidated Statements of Income. See Note 21 of the Notes to Consolidated Financial Statements. Other Costs and Eliminations. Other costs and eliminations (which consists of corporate overhead and intercompany profit elimination) decreased operating income by $73 million during 2013 compared to $65 million during 2012. The increase of $8 million was due primarily to transaction expenses related to our timberland acquisition from MeadWestvaco Corporation ($5 million) and higher corporate communications and information technology costs ($3 million). See Note 2 of the Notes to Consolidated Financial Statements for discussion of the timberland acquisition. Other Unallocated Operating Income (Expense), net. Other unallocated operating income and expense (which consists of income and expenses not allocated to the operating segments) decreased operating income by $3 million during 2013 and increased operating income by $1 million during 2012. The increase in expense of $4 million was due primarily to a loss related to the early termination of an equipment lease ($5 million), offset in part by a litigation settlement payment received by the company ($1 million). The equipment lease was accounted for as an operating lease prior to termination. These items are included in Other Operating Income (Expense), net in the Consolidated Statements of Income. Selling, General and Administrative Expenses. Corporate overhead costs along with Segment specific selling, general, and administrative costs are reported in total on our Consolidated Statements of Income and decreased operating income by $123 million in 2013 compared to $116 million in 2012. This increase in expense of $7 million was due primarily to transaction expenses related to our timberland acquisition from MeadWestvaco Corporation ($5 million) and higher corporate communications and information technology costs ($3 million). See Note 2 of the Notes to Consolidated Financial Statements for discussion of the timberland acquisition. Equity Earnings from Timberland Venture. During 2013, we recorded our share of equity earnings from the Timberland Venture of $63 million, which includes amortization of $10 million for the difference between the book value of the company's investment and its proportionate share of the Timberland Venture's net assets. Our share of equity earnings from the Timberland Venture was $59 million, including $8 million of amortization, for 2012. This increase in equity earnings of $4 million in 2013 was due primarily to an increase in product prices, and gains on sales of timber and timberlands realized by the Timberland Venture, and increased amortization of our basis difference. See Note 18 of the Notes to Consolidated Financial Statements. Interest Expense, net. Interest expense, net of interest income, was $141 million in 2013. This was essentially flat compared to 2012. Loss on Extinguishment of Debt. During 2013, we prepaid approximately $10 million of principal of Private Debt, $24 million of principal of Public Debt and $225 million of principal of the term credit agreement. These prepayments resulted in a $4 million loss. See Notes 2 and 11 of the Notes to Consolidated Financial Statements. Provision (Benefit) for Income Taxes. The benefit for income taxes was $1 million for 2013 compared to a benefit for income taxes of $3 million in 2012. The benefit for income taxes decreased $2 million from 2012 due primarily to increased operating income from our manufacturing business of $14 million, which increased tax expense by $6 million, offset by lower earnings from real estate sales by our taxable REIT subsidiaries, which reduced tax expense by $3 million. PLUM CREEK 2014 FORM 10-K | 53 PART II / ITEM 7 Financial Condition and Liquidity Our cash flows from operations are impacted by the cyclical nature of the forest products industry and by general economic conditions in the United States, including interest rate levels and availability of financing. We generate cash primarily from sales of delivered logs and standing timber, sales of our finished manufactured wood products, and sales of our timberlands. Our principal cash requirements are primarily for: • expenditures for logging and hauling of logs, • employee compensation and related benefits, • purchases of logs, fiber and other raw materials used in our manufacturing facilities, • reforestation, silviculture, road construction and road maintenance on our timberlands, and • energy and operating expenditures to run our manufacturing facilities. Our Resources and Manufacturing Segments have significant uses of cash, and as a result, our operating income (excluding depletion and depreciation) approximates these Segments' operating cash flows. In contrast, our cash outflows in our Real Estate Segment are very small, and as a result, our revenues from this Segment approximate operating cash flows. In our Energy and Natural Resources Segment, cash may be received in upfront payments but revenues will be recognized over several reporting periods (quarters or years). We have summarized our sources and uses of cash in a table later in this section. Net cash provided by operating activities for 2014 was $457 million compared to $404 million for 2013. This increase of $53 million was due primarily to improved earnings before depletion from our Resources and Energy and Natural Resources Segments ($67 million) partially offset by higher payments for interest expense ($25 million). We expect net cash provided by operating activities in 2015 to be similar to 2014. We also prepare annual Segment comparisons of Adjusted EBITDA, which is a supplemental non-GAAP measure of operating performance and liquidity. Adjusted EBITDA for 2014 was $605 million compared to Adjusted EBITDA of $502 million for 2013. See Performance and Liquidity Measures (Non-GAAP Measures) later in this section. We ended 2014 with a strong balance sheet; we had a cash balance of $92 million and availability on our line of credit of $603 million. We believe that our cash flows from operating activities will be more than adequate to fund 2015 planned capital expenditures and our dividend. Cash Flow The following table summarizes total cash flows for operating, investing and financing activities for the years ended December 31 (in millions): Cash Flows from Operating Activities (2014). Net cash provided by operating activities for the year ended December 31, 2014 totaled $457 million compared to $404 million in 2013. The increase of $53 million was due primarily to improved earnings before depletion from our Resources and Energy and Natural Resources Segments ($67 million) and lower expenditures for the purchase of timber deeds ($18 million), offset in part by higher payments for interest expense ($25 million) and an increase in pension contributions ($9 million). See Results of Operations for a discussion of factors impacting operating income for our Resources and Energy and Natural Resources Segments and for a discussion of changes in interest expense. In March 2013, the company acquired, for $18 million, approximately 0.9 million tons of standing timber under a timber deed that expires in 2020. No timber deeds were acquired in 2014. In January 2012, we purchased an eight-year timber deed encompassing 4.7 million tons of standing timber in the Southern Resources Segment for $103 million, PLUM CREEK 2014 FORM 10-K | 54 PART II / ITEM 7 $5 million of which was paid as a deposit in December 2011. The volume acquired under a timber deed, along with future growth, is harvested over the term of the deed. The timber deed purchase price has been reflected in our Consolidated Statements of Cash Flows as an outflow under Cash Provided by Operating Activities. Cash Flows from Operating Activities (2013). Net cash provided by operating activities for the year ended December 31, 2013 totaled $404 million compared to $353 million in 2012. The increase of $51 million was due primarily to lower expenditures ($80 million) for the purchase of standing timber (timber deed), higher operating income from both of our Resources Segments and from our Manufacturing Segment ($44 million) and a decrease in pension contributions ($20 million), offset in part by lower proceeds from real estate sales ($62 million) and a negative working capital change ($32 million). See Results of Operations for a discussion of factors impacting operating income for our Resources and Manufacturing Segments and factors impacting real estate proceeds for our Real Estate Segment. Working capital was negatively impacted by changes in our outstanding accounts receivable balances ($13 million), our wages payable balances ($9 million), and our inventory balances ($5 million). Our accounts receivable balance was unusually low as of December 31, 2012, due primarily to mill curtailments for maintenance and unusually low timber sales in December 2012, which resulted in a favorable accounts receivable working capital variance for 2012, and in turn, an unfavorable variance for 2013. Our wages payable balance as of December 31, 2011 was lower than our wages payable balances as of December 31, 2012 and December 31, 2013 due to a lower bonus accrual for 2011. Earning a lower bonus in 2011 (which is paid in the following year) compared to 2012 and 2013 resulted in a favorable working capital variance in 2012 with no comparable favorable variance in 2013. The negative inventory working capital variance is primarily due to resuming operations at our Evergreen sawmill in April 2013. Capital Expenditures. Capital expenditures were as follows for the years ended December 31 (in millions): Planned capital expenditures for 2015 (excluding timberland acquisitions) are expected to range between $90 million and $95 million and include approximately $72 million for our timberlands, $10 million for our manufacturing facilities, $4 million for real estate development investments, and $6 million for investments in information technology. The timberland expenditures are primarily for reforestation and other expenditures associated with the planting and growing of trees. Approximately 55% of planned capital expenditures in 2015 are discretionary, primarily expenditures for silviculture. Capital expenditures at our manufacturing facilities consist primarily of expenditures to sustain operating activities. Expenditures for Real Estate Development are included in Other Operating Activities, net on the Consolidated Statements of Cash Flows. During 2014, we incurred a fire loss at our MDF facility. Included in 2014 capital expenditures above are approximately $12 million of capital expenditures that we incurred to rebuild or replace the damaged building and equipment. The majority of the capital expenditures for the MDF fire loss were spent in 2014 and there are no significant costs included in 2015 planned capital expenditures for this project. Timberland Acquisitions. There were no significant timberland acquisitions in 2014. During 2013, we acquired approximately 501,000 acres of timberlands in Alabama, Georgia, South Carolina, Virginia, and West Virginia from MeadWestvaco Corporation ("MWV") for $869 million. This acquisition was accounted for as a business combination and is described in Note 2 of the Notes to Consolidated Financial Statements. Also during 2013, we acquired approximately 50,000 acres of timberlands primarily located in Georgia and Alabama for a total of $81 million. These purchases of $81 million were financed primarily from the company's line of credit and have been accounted for as asset acquisitions. During 2012, we acquired approximately 13,000 acres of timberlands primarily located in Georgia and South Carolina for a total of $18 million. These purchases were financed primarily from our line of credit and have been accounted for as asset acquisitions. PLUM CREEK 2014 FORM 10-K | 55 PART II / ITEM 7 Real Estate Development Ventures. In connection with the timberland acquisition from MWV (see Timberland Acquisitions above), the company and MWV formed a limited liability company (MWV-Charleston Land Partners, LLC or “MWV-CLP”). Plum Creek contributed cash to MWV-CLP and MWV contributed real estate development properties, which consisted of both residential and commercial properties currently under development (“Class A Properties”) and high-value development lands (“Class B Properties”). Plum Creek contributed $12 million in exchange for a 5% interest in Class A Properties and $140 million in exchange for a 50% interest in Class B Properties. MWV contributed 22,000 acres of Class A Properties with an agreed upon value of $252 million in exchange for a 95% interest in Class A Properties and 87,000 acres of Class B Properties with an agreed upon value of $279 million in exchange for a 50% interest in Class B Properties. During 2014, the company’s ownership interest in the Class A Properties decreased from 5% to 4% due to capital calls by MWV-CLP for which the company declined to participate. Plum Creek has agreed to make additional capital contributions to MWV-CLP with respect to the Class B Properties through the year 2020, with minimum required contributions of $6 million during 2015. Minerals. In connection with the timberland acquisition from MWV (see Timberland Acquisitions above), we acquired certain proven and probable coal reserves along with related surface leases. The coal reserves had an acquisition date fair value of $50 million, and the surface leases had an acquisition date fair value of $7 million. Mineral Rights Acquisitions. In September 2013, we acquired mineral rights in approximately 255 million tons of aggregate reserves at four quarries in Georgia for approximately $156 million. We are entitled to an overriding royalty in connection with the gross proceeds from the sale of crushed stone from these quarries. The purchase was financed from our line of credit and has been accounted for as an asset acquisition. In December 2012, we acquired mineral rights in approximately 144 million tons of aggregate reserves at four quarries in South Carolina for approximately $76 million. We are entitled to an overriding royalty in connection with the gross proceeds from the sale of crushed stone from these quarries. The purchase was financed from our 2012 public debt offering and has been accounted for as an asset acquisition. Future Cash Requirements. Cash required to meet our future financial needs will be significant. Our next scheduled debt principal payment is our 5.875% Senior Notes ($439 million), which matures in November 2015. We may refinance all or a portion of this borrowing at or near maturity. Debt principal not refinanced by new borrowings or by the then available borrowing capacity under our line of credit will be paid using cash generated from operations. We believe that our cash flows from operating activities will be more than adequate to fund 2015 planned capital expenditures and our dividend. PLUM CREEK 2014 FORM 10-K | 56 PART II / ITEM 7 Sources and Uses of Cash. The following table summarizes our sources and uses of cash for the years ended December 31 (in millions): (A) Calculated from the Consolidated Statements of Cash Flows by adding Depreciation, Depletion and Amortization, Basis of Real Estate Sold, Earnings from Unconsolidated Entities, Loss on Extinguishment of Debt, Deferred Income Taxes and Other Operating Activities (excluding Expenditures for Real Estate Development - see discussion in Footnote D below) to Net Income. (B) On December 6, 2013, we acquired timberland, minerals and wind power leases from MWV, along with acquiring an equity interest in approximately 109,000 acres of high-value rural and development quality lands. The total purchase price for the MWV assets was approximately $1.1 billion, which consisted of $226 million in cash ($221 million in cash after considering post-closing adjustments) and an installment note payable of $860 million. The table above includes the $860 million as an Increase in Debt Obligations and as part of the Acquisition of MeadWestvaco Timberland Assets. In our Consolidated Statements of Cash Flows, these amounts are presented as Non-Cash Investing and Financing Activities. See also Note 2 of the Notes to Consolidated Financial Statements. (C) From the Consolidated Statements of Cash Flows, Other Investing Activities and Other Financing Activities. (D) Capital Expenditures include Real Estate Development costs (see Capital Expenditures section above for calculation). Expenditures for Real Estate Development are included in Other Operating Activities, net on the Consolidated Statements of Cash Flows. For 2014, Capital Expenditures in the table above are presented net of $10 million of insurance recoveries received to rebuild / replace the building and equipment damaged by the fire at our MDF facility in 2014. See Note 17 of the Notes to Consolidated Financial Statements. PLUM CREEK 2014 FORM 10-K | 57 PART II / ITEM 7 Borrowings Debt Financing. We strive to maintain a balance sheet that provides the financial flexibility to pursue our strategic objectives. In order to maintain this financial flexibility, our objective is to maintain an investment grade credit rating. This is reflected in our moderate use of debt, established access to credit markets and no material covenant restrictions in our debt agreements that would prevent us from prudently using debt capital. All of our borrowings, except for the Note Payable to Timberland Venture, are made by Plum Creek Timberlands, L.P., the company's wholly-owned operating partnership (“the Partnership”). Furthermore, all of the outstanding indebtedness of the Partnership is unsecured. Line of Credit. We have a $700 million revolving line of credit agreement that matures on January 15, 2019. Subject to customary covenants, the line of credit allows for borrowings from time to time up to $700 million, including up to $60 million of standby letters of credit. Borrowings on the line of credit fluctuate daily based on cash needs. The interest rate on the line of credit is currently LIBOR plus 1.25%, including the facility fee. This rate can range from LIBOR plus 1% to LIBOR plus 2% depending on our debt ratings. The weighted-average interest rate for the borrowings on the line of credit was 1.34% and 1.37% as of December 31, 2014 and December 31, 2013, respectively. As of December 31, 2014, we had $95 million of borrowings and $2 million of standby letters of credit outstanding; $603 million remained available for borrowing under our line of credit. As of January 2, 2015, all of the borrowings under our line of credit were repaid. Term Credit Agreement. The company has a $225 million term credit agreement that matures on April 3, 2019. The interest rate on the term credit agreement was 1.67% and 1.66% as of December 31, 2014 and 2013, respectively. The interest rate on the term credit agreement is based on LIBOR plus 1.50%. After giving effect to patronage distributions, the effective net interest rate on the term loan was approximately 1% as of both December 31, 2014 and 2013. See "Patronage" below. The term loan agreement is subject to covenants that are substantially the same as those of our revolving line of credit. The term credit agreement allows for prepayment of the borrowings at any time prior to the maturity date without premium or penalty. Senior Notes. The company has outstanding Senior Notes with various maturities and fixed interest rates. During 2013, the company repaid all of its privately placed borrowings with various lenders ("Private Debt"). See "Debt Principal Payments" below for a discussion of these repayments. As of December 31, 2014, the company had publicly issued and outstanding approximately $1.3 billion aggregate principal amount of Senior Notes (“Public Debt”). The Public Debt is issued by the Partnership and is fully and unconditionally guaranteed by Plum Creek Timber Company, Inc. This amount includes $439 million of 5.875% Public Debt which matures in 2015, $569 million of 4.70% Public Debt which matures in 2021 and $325 million of 3.25% Public Debt which matures in 2023. The Senior Notes are redeemable prior to maturity; however, they are subject to a premium on redemption, which is based upon interest rates of U.S. Treasury securities having similar average maturities. The premium that would have been due upon early retirement approximated $114 million at December 31, 2014 and $117 million at December 31, 2013. Plum Creek Timber Company, Inc. and the Partnership have filed a shelf registration statement with the Securities and Exchange Commission. Under the shelf registration statement, Plum Creek Timber Company, Inc., from time to time, may offer and sell any combination of preferred stock, common stock, depositary shares, warrants and guarantees, and the Partnership, from time to time, may offer and sell debt securities. The company and the Partnership intend to maintain a shelf registration statement with respect to such securities. Installment Note Payable. The company has an $860 million installment note payable to MWV Community Development and Land Management, LLC ("MWV CDLM"), which was issued in connection with the acquisition of certain timberland assets (see Note 2 of the Notes to Consolidated Financial Statements). Following the acquisition, MWV CDLM pledged the installment note to certain banks in the farm credit system. The annual interest rate on the installment note is fixed at 5.207%. After giving effect to patronage distributions, the company's effective net interest rate on the installment note was approximately 4.5% as of December 31, 2014 and December 31, 2013. See “Patronage” below. PLUM CREEK 2014 FORM 10-K | 58 PART II / ITEM 7 During the ten-year term of the note, interest is paid semi-annually with the principal due upon maturity. The installment note matures on December 6, 2023, but may be extended at the request of the holder if the company at the time of the request intends to refinance all or a portion of the installment note for a term of five years or more. The installment note is generally not redeemable prior to maturity except in certain limited circumstances and could be subject to a premium on redemption. The installment note is subject to covenants similar to those of our revolving line of credit and term credit agreement. Note Payable to Timberland Venture. The company has a $783 million note payable to a timberland venture (a related party). The annual interest rate on the note payable is fixed at 7.375%. During the ten-year term of the note, interest is paid quarterly with the principal due upon maturity. The note matures on October 1, 2018 but may be extended until October 1, 2020 at the election of Plum Creek. The note is not redeemable prior to maturity. The note is structurally subordinated to all other indebtedness of the company at December 31, 2014. See Note 18 of the Notes to Consolidated Financial Statements. Patronage. The company receives patronage refunds under the term credit agreement and the installment note payable. Patronage refunds are distributions of profits from banks in the farm credit system, which are cooperatives that are required to distribute profits to their members. Patronage distributions, which are made in either cash or stock, are received in the year after they were earned. The company earned approximately $8 million of patronage during 2014. The company earned approximately $3 million of patronage during 2013. Patronage refunds are recorded as a reduction to interest expense in the year earned. Debt Principal Payments. The table below summarizes the debt principal payments made for the years ended December 31 (in millions): During 2013, the company prepaid approximately $10 million of principal of Private Debt, $24 million of principal of Public Debt and $225 million of principal of the term credit agreement. These prepayments resulted in a $4 million loss. The $4 million loss is classified as Loss on Extinguishment of Debt in the Consolidated Statements of Income. Debt Covenants. Our Senior Notes, Term Credit Agreement, Line of Credit and Installment Note Payable contain various restrictive covenants, none of which are expected to materially impact the financing of our ongoing operations. We are in compliance with all of our borrowing agreement covenants as of December 31, 2014. Our Term Credit Agreement, Line of Credit and Installment Note Payable require that we maintain certain interest coverage and maximum leverage ratios. We have no covenants and restrictions associated with changes in our debt ratings. Our Term Credit Agreement, Line of Credit and Installment Note Payable each contain a covenant restricting our ability to make any restricted payments, which includes dividend payments, if we are in default under our debt agreements. Furthermore, there are no material covenants associated with our Note Payable to Timberland Venture, and this indebtedness is not considered in computing any of our debt covenants since the debt is an obligation of Plum Creek Timber Company, Inc. and not the Partnership. As of December 31, 2014, we can borrow the entire amount available under our Line of Credit, and we expect to be able to incur at least this level of additional indebtedness for the next twelve months. PLUM CREEK 2014 FORM 10-K | 59 PART II / ITEM 7 Equity Dividends. On February 4, 2015, the Board of Directors declared a dividend of $0.44 per share, or approximately $77 million, which will be paid on February 27, 2015 to stockholders of record on February 13, 2015. Future dividends will be determined by our Board of Directors, in its sole discretion, based on consideration of a number of factors. The primary factors considered by the Board in declaring the current dividend amount were current quarter and full year cash flow and operating results, as measured by Funds from Operations (defined as net income plus non-cash charges for depletion, depreciation and amortization, and the cost basis of land sales), along with the amount of cash on hand. In addition, the Board also considers the following factors when determining dividends: the company's capital requirements; economic conditions; tax considerations; borrowing capacity; changes in the prices of, and demand for, our products; changes in our ability to sell timberlands at attractive prices; and the appropriate timing of timber harvests, acquisition and divestiture opportunities, stock repurchases, debt repayment and other means by which the company could deliver value to its stockholders. Share Repurchases. Plum Creek's Board of Directors has authorized a common stock repurchase program that may be increased from time to time at the Board of Directors' discretion. For the year ended December 31, 2014, we repurchased 1.2 million shares of common stock at a total cost of $50 million, or an average cost per share of $40.21. At December 31, 2014, $125 million is available for share repurchases under the current Board of Directors' authorization. See Note 13 of the Notes to Consolidated Financial Statements. Other Information Accounting Standards Issued and Not Yet Implemented. In May 2014, the Financial Accounting Standards Board (FASB) issued Accounting Standards Update (ASU) No. 2014-09, Revenue from Contracts with Customers (Topic 606). The new standard is effective for reporting periods beginning after December 15, 2016 and early adoption is not permitted. The comprehensive new standard will supersede existing revenue recognition guidance, including industry-specific requirements, and require revenue to be recognized when promised goods or services are transferred to customers in amounts that reflect the consideration to which the company expects to be entitled in exchange for those goods or services. Adoption of the new rules could affect the timing of revenue recognition for certain transactions. For Plum Creek, the standard will be effective in the first quarter of 2017. The guidance permits two implementation approaches: (1) a retrospective application of the new standard with restatement of prior years; or (2) a modified retrospective basis whereby the new standard would be applied to new contracts and existing contracts with remaining performance obligations as of the effective date, with a cumulative catch-up adjustment recorded to beginning retained earnings. The company is currently evaluating the impact that adoption of this standard will have on our consolidated financial statements and disclosures, and the implementation approach to be used. PLUM CREEK 2014 FORM 10-K | 60 PART II / ITEM 7 Performance and Liquidity Measures (Non-GAAP Measures) For a discussion of the factors impacting our operating performance, see the discussion included in this Item under Results of Operations. For a discussion of the factors impacting our liquidity, see the discussion included previously in Item 7 under Financial Condition and Liquidity. We have included the following Non-GAAP measurements because we believe these are commonly used by investors, lenders and rating agencies to assess our financial performance. Adjusted EBITDA. We define Adjusted EBITDA as earnings from continuing operations, excluding Equity Earnings from the Timberland Venture, and before interest expense (including any gains or losses from extinguishment of debt), taxes, depreciation, depletion, amortization, and basis in real estate sold. In addition to including Equity Earnings from Real Estate Development Ventures in Adjusted EBITDA, we also include, as an add back to Operating Income for the Other Segment, our proportional share of depreciation, depletion, amortization, and basis in real estate sold from this equity method investment. Adjusted EBITDA is not considered a measure of financial performance under U.S. generally accepted accounting principles (U.S. GAAP) and the items excluded from Adjusted EBITDA are significant components of our consolidated financial statements. We present Adjusted EBITDA as a supplemental performance measure because we believe it facilitates operating performance comparisons from period to period, and each business segment’s contribution to that performance, by eliminating non-cash charges to earnings, which can vary significantly by business segment. These non-cash charges include timber depletion, depreciation of fixed assets and the basis in lands sold. We also use Adjusted EBITDA as a supplemental liquidity measure because we believe it is useful in measuring our ability to generate cash. In addition, we believe Adjusted EBITDA is commonly used by investors, lenders and rating agencies to assess our financial performance. The following table compares Adjusted EBITDA by segment for the years ended December 31 (in millions): PLUM CREEK 2014 FORM 10-K | 61 PART II / ITEM 7 The following schedules provide a reconciliation of Adjusted EBITDA to net income and net cash from operating activities, the most directly comparable U.S. GAAP performance and liquidity measures, for the years ended December 31 (in millions): (1) Includes Equity Earnings from Real Estate Development Ventures ($3 million) in Operating Income for the Other Segment, along with our proportional share of depreciation, depletion, amortization ($2 million), and basis in real estate sold ($13 million) from this equity method investment. (2) Includes reconciling items not allocated to segments for financial reporting purposes. PLUM CREEK 2014 FORM 10-K | 62 PART II / ITEM 7 (1) Includes a $4 million loss due to forest fire damages in the Northern Resources Segment. (2) Includes reconciling items not allocated to segments for financial reporting purposes. PLUM CREEK 2014 FORM 10-K | 63 PART II / ITEM 7 (1) Includes reconciling items not allocated to segments for financial reporting purposes. PLUM CREEK 2014 FORM 10-K | 64 PART II /

<s>[INST] This Report contains forwardlooking statements within the meaning of the Private Litigation Reform Act of 1995. Some of the forwardlooking statements can be identified by the use of forwardlooking words such as “believes,” “expects,” “may,” “will,” “should,” “seeks,” “approximately,” “intends,” “plans,” “estimates,” “projects,” “strategy,” or “anticipates,” or the negative of those words or other comparable terminology. Forwardlooking statements involve inherent risks and uncertainties. A number of important factors could cause actual results to differ materially from those described in the forwardlooking statements, including those factors described in “Risk Factors” under Item 1A in this Form 10K. Some factors include changes in governmental, legislative and environmental restrictions, catastrophic losses from fires, floods, windstorms, earthquakes, volcanic eruptions, insect infestations or diseases, as well as changes in economic conditions and competition in our domestic and export markets and other factors described from time to time in our filings with the Securities and Exchange Commission. In addition, factors that could cause our actual results to differ from those contemplated by our projected, forecasted, estimated or budgeted results as reflected in forwardlooking statements relating to our operations and business include, but are not limited to: the failure to meet our expectations with respect to our likely future performance; an unanticipated reduction in the demand for timber products and/or an unanticipated increase in supply of timber products; an unanticipated reduction in demand for higher and better use or nonstrategic timberlands; our failure to make strategic acquisitions or to integrate any such acquisitions effectively or, conversely, our failure to make strategic divestitures; and our failure to qualify as a real estate investment trust, or REIT. It is likely that if one or more of the risks materializes, or if one or more assumptions prove to be incorrect, the current expectations of Plum Creek and its management will not be realized. Forwardlooking statements speak only as of the date made, and neither Plum Creek nor its management undertakes any obligation to update or revise any forwardlooking statements. Organization of the Company In management’s discussion and analysis of financial condition and results of operations (Item 7 of this form), when we refer to “Plum Creek,” “the company,” “we,” “us,” or “our,” we mean Plum Creek Timber Company, Inc. and its consolidated subsidiaries. References to Notes to Consolidated Financial Statements refer to the Notes to the Consolidated Financial Statements of Plum Creek Timber Company, Inc. included in Item 8 of this Form 10K. Plum Creek Timber Company, Inc., a Delaware Corporation and a real estate investment trust, or “REIT”, for federal income tax purposes, is the parent company of Plum Creek Timberlands, L.P., a Delaware Limited Partnership (the “Operating Partnership” or “Partnership”), and Plum Creek Ventures I, LLC, a Delaware Limited Liability Company (“PC Ventures”). Plum Creek conducts substantially all of its activities through the Operating Partnership and various whollyowned subsidiaries of the Operating Partnership. The Operating Partnership has borrowed and has currently outstanding $2.5 billion principal amount of debt, including $1.3 billion of publicly issued notes. PC Ventures has borrowed and has currently outstanding $783 million in principal amount of debt (“the Note Payable to Timberland Venture”) from an entity (“the Timberland Venture”) in which a subsidiary of the Operating Partnership has a common and preferred equity interest. See Note 18 of the Notes to Consolidated Financial Statements. PC Ventures used the proceeds from the borrowing to make a $783 million capital contribution to the Operating Partnership in exchange for a preferred equity interest in the Operating Partnership. PC Ventures has no other activities and the Operating Partnership has no ownership interest in PC Ventures. The Note Payable to Timberland Venture is an obligation of PC Ventures and not an obligation of the Operating Partnership. Therefore, any discussion of the Note Payable to Timberland Venture below is not applicable to the Operating Partners [/INST] Positive. </s>

PLUM CREEK TIMBER CO INC

2016-02-18

2015-12-31

ITEM 7. MANAGEMENT’S DISCUSSION AND ANALYSIS OF FINANCIAL CONDITION AND RESULTS OF OPERATIONS Forward-Looking Statement This Report contains forward-looking statements within the meaning of the Private Litigation Reform Act of 1995. Some of the forward-looking statements can be identified by the use of forward-looking words such as “believes,” “expects,” “may,” “will,” “should,” “seeks,” “approximately,” “intends,” “plans,” “estimates,” “projects,” “strategy,” or “anticipates,” or the negative of those words or other comparable terminology. Forward-looking statements involve inherent risks and uncertainties. A number of important factors could cause actual results to differ materially from those described in the forward-looking statements, including those factors described in “Risk Factors” under Item 1A in this Form 10-K. Some factors include changes in governmental, legislative and environmental restrictions, catastrophic losses from fires, floods, windstorms, earthquakes, volcanic eruptions, insect infestations or diseases, as well as changes in economic conditions and competition in our domestic and export markets and other factors described from time to time in our filings with the Securities and Exchange Commission. In addition, factors that could cause our actual results to differ from those contemplated by our projected, forecasted, estimated or budgeted results as reflected in forward-looking statements relating to our operations and business include, but are not limited to: • the failure to meet our expectations with respect to our likely future performance; • an unanticipated reduction in the demand for timber products and/or an unanticipated increase in supply of timber products; • an unanticipated reduction in demand for higher and better use or non-strategic timberlands; • our failure to make strategic acquisitions or to integrate any such acquisitions effectively or, conversely, our failure to make strategic divestitures; and • our failure to qualify as a real estate investment trust, or REIT. It is likely that if one or more of the risks materializes, or if one or more assumptions prove to be incorrect, the current expectations of Plum Creek and its management will not be realized. Forward-looking statements speak only as of the date made, and neither Plum Creek nor its management undertakes any obligation to update or revise any forward-looking statements. Organization of the Company In management’s discussion and analysis of financial condition and results of operations (Item 7 of this form), when we refer to “Plum Creek,” “the company,” “we,” “us,” or “our,” we mean Plum Creek Timber Company, Inc. and its consolidated subsidiaries. References to Notes to Consolidated Financial Statements refer to the Notes to the Consolidated Financial Statements of Plum Creek Timber Company, Inc. included in Item 8 of this Form 10-K. Plum Creek Timber Company, Inc., a Delaware Corporation and a real estate investment trust, or “REIT”, for federal income tax purposes, is the parent company of Plum Creek Timberlands, L.P., a Delaware Limited Partnership (the “Operating Partnership” or “Partnership”), and Plum Creek Ventures I, LLC, a Delaware Limited Liability Company (“PC Ventures”). Plum Creek conducts substantially all of its activities through the Operating Partnership and various wholly-owned subsidiaries of the Operating Partnership. The Operating Partnership has borrowed and has currently outstanding $2.5 billion principal amount of debt, including $894 million of publicly issued notes. PC Ventures has borrowed and has currently outstanding $783 million in principal amount of debt (“the Note Payable to Timberland Venture”) from an entity (“the Timberland Venture”) in which a subsidiary of the Operating Partnership has a common and preferred equity interest. See Note 17 of the Notes to Consolidated Financial Statements. PC Ventures used the proceeds from the borrowing to make a $783 million capital contribution to the Operating Partnership in exchange for a preferred equity interest in the Operating Partnership. PC Ventures has no other activities and the Operating Partnership has no ownership interest in PC Ventures. The Note Payable to Timberland Venture is an obligation of PC Ventures and not an obligation of the Operating Partnership. Therefore, any discussion of the Note Payable to Timberland Venture below is not applicable to the PLUM CREEK 2015 FORM 10-K | 25 PART II / ITEM 7 Operating Partnership. Unless otherwise specified, all other discussion and analysis below are applicable to both Plum Creek and the Operating Partnership. Overview Recent Events Weyerhaeuser Merger. On November 8, 2015, Plum Creek and Weyerhaeuser Company (“Weyerhaeuser") announced each of its Board of Directors approved an Agreement and Plan of Merger (the "Merger Agreement"). Under the Merger Agreement, Weyerhaeuser is the surviving entity and Plum Creek will cease to be a publicly-traded company as of the merger date. On the merger date, each outstanding share of Plum Creek will be exchanged for 1.60 shares of Weyerhaeuser. The merger was approved by the shareholders of both Plum Creek and Weyerhaeuser on February 12, 2016, and is expected to close on February 19, 2016. In connection with the merger, Weyerhaeuser will be assuming the assets and liabilities of Plum Creek. During 2015, we incurred merger-related costs of approximately $8 million primarily for financial advisory and legal fees. Between January 1, 2016, and the closing of the merger, we expect to incur additional financial advisory and legal fees of $30 million to $35 million. The additional financial advisory fees are contingent on the closing of the merger. The Merger Agreement also provides for the payment of severance and the accelerated vesting of certain share-based compensation awards. Most officers of the company are covered by a change-in-control agreement and all other employees are covered by the Merger Agreement. The amount of severance and the value of share-based compensation that vests early is contingent on the closing of the merger, and in most cases, a termination of employment by Weyerhaeuser. As a result, these amounts cannot be estimated because in most cases it is not known which employees Weyerhaeuser will terminate. See Item No. 11, Executive Compensation, for a more complete summary of the change-in-control provisions that apply to the executive officers of Plum Creek. Furthermore, the Merger Agreement places certain restrictions on how Plum Creek conducts its business from the date of the agreement (November 6, 2015) to the closing of the merger. In general, Plum Creek is allowed to conduct its business in the normal course but generally has certain restrictions in the following areas: (1) declaring special dividends, (2) repurchasing outstanding shares of Plum Creek’s stock, (3) issuing additional shares of stock, (4) amending any material contracts (including any employee benefit and incentive plans), (5) making acquisitions, (6) selling assets, (7) incurring indebtedness, (8) making capital expenditures, (9) settling claims, and (10) entering into a new line of business. None of the above restrictions are expected to materially impact how Plum Creek currently conducts its business. For a detailed description of the terms of the merger, see the Agreement and Plan of Merger between Weyerhaeuser and Plum Creek, incorporated by reference as Exhibit 2.5 under Item No. 15, Exhibits and Financial Statement Schedules. Twin Creeks Timberland Venture. On September 15, 2015, we announced the formation of a timberland venture, Twin Creeks Timber, LLC (“Twin Creeks Timber”), with several institutional investors (i.e., several state investment funds). In connection with the formation of the venture, we agreed to sell and contribute approximately 260,000 acres of our southern timberland property (approximately 8% of the timberlands currently included in our Southern Resources Segment) in exchange for cash of approximately $420 million and a common ownership interest in Twin Creeks Timber, valued at approximately $140 million. Plum Creek's aggregate capital commitment (including the value of contributed timberlands) to Twin Creeks Timber is approximately $201 million, representing a common ownership interest in Twin Creeks Timber of approximately 21%. The institutional investors have agreed to contribute cash of $752.5 million in exchange for a common ownership interest in Twin Creeks Timber of approximately 79%. Plum Creek may, in its sole discretion and without the consent of the other members, increase its capital commitment to achieve or maintain up to a 25% ownership interest in the venture. The initial capital contributions were expected to occur in January 2016. However, due to the pending merger with Weyerhaeuser, the parties have agreed to extend the sale and contribution of the property, deferring initial capital contributions until the earlier to occur of 30 days after the merger (or 30 days after an announcement that the merger is not taking place) or June 30, 2016. Further, the parties agreed to allow Plum Creek to continue certain harvest activity on the property, subject to volume limitations and a credit at closing. Assuming the merger closes on February 19, 2016, as planned, the property closing and initial capital contributions PLUM CREEK 2015 FORM 10-K | 26 PART II / ITEM 7 are expected to occur in March 2016. Unless extended by a unanimous vote of all investors, the term of Twin Creeks Timber is 15 years. In addition to Plum Creek’s ownership interest in Twin Creeks Timber, Plum Creek will also be responsible for managing the day-to-day operations of the timberland venture. We do not believe that any compensation received in connection with the management functions will be material to consolidated net income. Upon the closing of the merger, Weyerhaeuser will assume the rights and obligations associated with the Twin Creeks Timberland Venture. 2015 Performance Compared to 2014 Our operating income for 2015 was $274 million compared to $322 million for 2014. Despite the more than 10% improvement in housing starts during 2015 compared to the prior year, sawlog prices and lumber prices during 2015 were generally under downward pressure as a result of oversupplied lumber markets. Lumber markets in the U.S. were generally oversupplied during most of 2015 due primarily to increased lumber imports from Canada and lower exports of logs and lumber to China. Prices for our pulpwood continued to improve during 2015 due to stronger demand. Prices for our plywood and MDF panels remained strong due to the premium products we sell. Real estate markets during 2015 were generally comparable to the prior year; however, the mix of acres we sold was materially different. Operating income in our Northern Resources Segment decreased by $17 million to $27 million. This decrease in operating performance was due primarily to an 18% decrease in sawlog harvest volume as a result of recent land sales and harvest schedule updates, and due to weaker sawlog prices as a result of oversupplied lumber markets. Operating income in our Southern Resources Segment decreased by $14 million to $123 million. This decrease in operating performance was due primarily to a 6% decrease in sawlog harvest volume as a result of deferring some volume to future periods due to relatively weak sawlog prices, and due to higher operating expenses and higher depletion expense. Operating income in our Real Estate Segment increased by $11 million to $144 million. The increase was due primarily to selling more acres. During 2015, we sold approximately 284,000 acres compared to selling approximately 184,000 acres during 2014. Operating income in our Manufacturing Segment decreased by $14 million to $35 million. During 2014, we incurred a fire loss at our MDF facility, and when netted against insurance recoveries, we reported a gain of $11 million, compared to reporting a gain from insurance recoveries of $3 million in 2015. Excluding the net gains from the MDF fire, operating income decreased from $38 million to $32 million. This decrease of $6 million was due primarily to weaker lumber prices as a result of oversupplied markets. Operating income was also negatively impacted by higher corporate expenses. Corporate expenses for 2015 were $93 million compared to $67 million in the prior year. This increase of $26 million is due primarily to higher share-based compensation expense of $13 million as a result of our relative total shareholder return compared to our peer groups and expenses of $8 million related to our announced merger with Weyerhaeuser. Partially offsetting these higher corporate expenses is a realized gain of $10 million in 2015 associated with selling investments held by our grantor trust in anticipation of higher pension benefit payments during 2016. The realized gain of $10 million is reported in our Consolidated Statements of Income as Other Operating Income (Expense), net. Despite our 2015 reported operating income decreasing by $48 million as compared to the prior year, our reported net income decreased by only $17 million from $214 million in 2014 to $197 million in 2015. This smaller decline is due primarily to reporting higher equity earnings and lower tax expense. Reported equity earnings for 2015 were $83 million compared to $66 million for 2014. This increase of $17 million primarily relates to higher land sales by the Timberland Venture which generally results in higher reported equity earnings but only minimal additional cash flow. During 2014, we recorded a tax expense of $8 million compared to recording a tax benefit of $3 million for 2015. This difference of $11 million is due primarily to lower operating income from our Manufacturing Segment and higher corporate expenses. PLUM CREEK 2015 FORM 10-K | 27 PART II / ITEM 7 Net cash provided by operating activities was $463 million for 2015 compared to $457 million for 2014. This increase of $6 million was due primarily to higher proceeds from real estate sales and a favorable working capital variance, offset in part by lower operating results from our Resources and Manufacturing Segments. Key Economic Factors Impacting Our Resources and Manufacturing Businesses Our operating performance for the Resources and Manufacturing Segments is impacted primarily by the supply and demand for logs and wood products in the United States. The short-term supply of logs is impacted primarily by weather and the level of harvesting activities. The demand for logs and wood products in the United States is impacted by housing starts, repair and remodeling activities and industrial activity. The demand for U.S. logs and lumber is reduced, in part, by the amount of imported lumber, primarily from Canada. Selected U.S. housing economic data for the last five years was as follows at December 31: Housing starts continued to improve during 2015, increasing by 11% over the prior year. The improvement in housing starts was due primarily to the gradually improving U.S. economy, declining unemployment, near record low mortgage interest rates, and the increase in household formations. However, despite the improvement in housing starts to approximately 1.1 million starts, housing starts remain at recessionary levels. Housing starts remain at recessionary levels due primarily to the low labor participation rate, weak wage growth, high debt levels, rising home prices, and strict lending standards, all factors which have prevented many young families from purchasing a first home. The unemployment rate has steadily declined during the past several years and was approximately 5% at the end of 2015. However, a better measure of employment as it relates to housing is the labor participation rate, which was at 62.6% at the end of 2015 (a near 30-year low). The low labor participation rate is due in part to individuals dropping out of the workforce as a result of the disappointing job opportunities, as a large percentage of the jobs created since the recession ended in 2009 have been in low-paying sectors, such as retail and hospitality. Also, wage growth during this protracted recovery has been constrained to unusually low levels, which is also negatively impacting the housing sector. The challenges of finding a well-paying job have especially impacted young families. As a result of weak job opportunities along with high student debt, first-time home buyers, which historically have accounted for 40% of home sales, currently account for approximately 30% of sales. The decline in first-time home buyers is also causing a significant shift in the mix of housing starts. Historically, single-family starts have accounted for approximately 80% and multifamily starts have accounted for approximately 20% of the total starts. However, because more households are renting instead of buying a home, the multifamily share of housing starts is currently around 35%. This trend negatively impacts the demand for wood products since multifamily starts use only about one-third as much wood as is used in single-family starts. Another trend that negatively impacted the demand for logs and wood products in the U.S. during 2015 was the increase in lumber imports and the decrease in lumber exports. During 2015, most foreign economies were weakening while the U.S. economy was modestly improving, which is one of the reasons why the U.S. dollar strengthened considerably against most other world currencies during 2015. The improving U.S. economy along with the strong dollar caused many global companies to target more of their sales to the U.S., while U.S. manufacturers found it more difficult to sell their products in foreign markets. U.S. log and lumber markets were most severely impacted by a decline in exports to China and increasing imports from Canada. The slowing Chinese economy along with increased competition from Russian and European wood suppliers have caused log and lumber exports to China from North America to decline significantly during 2015. During the first ten-months of 2015 as compared to the same period in the prior year, lumber exports to China from Canada decreased by 17% (to 2.3 billion board feet) and lumber exports from the U.S. decreased by 38% (to 178 million board feet). The slowdown in China’s economic growth along with the strong U.S. dollar caused Canada to target more of their lumber PLUM CREEK 2015 FORM 10-K | 28 PART II / ITEM 7 sales to U.S. markets. The Canadian dollar is currently at a 12-year low compared to the U.S. dollar. As a result of the decline in Canadian lumber exports to China combined with the weak Canadian dollar, Canada increased their lumber exports to the U.S. by 7% during the first ten-months of 2015 compared to the same period in the prior year. Additionally, prior to October 13, 2015, Canadian lumber exports were generally constrained under the U.S. - Canadian Softwood Lumber Agreement by a system of tiered taxes and/or volume restrictions. However, as a result of the ten-year agreement expiring on October 12, 2015, Canada has greater economic incentives to increase their lumber exports to the U.S. Furthermore, it appears that Canada has taken advantage of the expired agreement by increasing lumber shipments to the U.S. during the fourth quarter of 2015. Average sawlog prices in our Northern Resources Segment during 2015 were $82 per ton (delivered basis), and while this was a 4% decrease from our 2014 average sawlog prices, it was still our second highest average in the past ten years. By comparison, average sawlog prices in our Southern Resources segment were $22 per ton (stumpage basis), which was approximately 40% lower than our 2005 average of $37 per ton. Some of the key reasons for this difference is that in our Northern Resources Segment mill owners have added more shifts, log and lumber exports have been higher (although lower in 2015 compared to 2014), and the supply of logs has been more constrained. However, in our Southern Resources Segment, log prices have increased only modestly since recent low prices in 2011, when the average sales realization for the year was $19 per ton. This limited price improvement is due primarily to Southern mill owners being more reluctant to add shifts or restart mills, and due to the readily available supply of logs for the current level of lumber and plywood production. During 2016, we expect the rebound in housing starts to continue at a slow pace. Housing starts are expected to continue to improve during 2016 due primarily to the growth of the U.S. economy, low interest rates, and the increase in household formations. The demand for wood products used in the repair and remodeling sector is also expected to improve during 2016 due primarily to rising home equity, the aging of housing stock, and the relatively high cost to purchase a new home. However, despite the anticipated improvement in the demand for lumber, lumber prices during 2016 may remain weak if the improvement in demand is satisfied by higher imports. Furthermore, as long as lumber prices remain weak, this will likely have a negative impact on sawlog prices. In the long-run, we believe favorable demographics will bode well for the wood products business and that eventually housing starts will return to normal levels (i.e., annual housing starts of between 1.5 million and 1.6 million). However, due to the low labor participation rate, stagnant wage growth, high levels of student debt, and the slowing world economy, there remains considerable uncertainty regarding the extent and timing of the recovery in the housing sector. Therefore, as long as housing starts remain at current levels and there is an adequate supply of sawlogs to meet the current demand, we believe sawlog prices and operating results in our Southern Resources Segment will not significantly improve from 2015 levels. We use independent third-party contract loggers and haulers to deliver our logs to our customers. Following the weak business conditions in the timber business that persisted for several years, there are fewer of these contractors available in certain markets to produce and deliver logs. While we continue to enhance strong working relationships with the independent loggers and haulers, as log markets continue to improve there may be production and delivery constraints that could impact log prices and/or delivery. Furthermore, despite the decline in diesel fuel prices, we do not expect this decline to favorably impact our operating results due to the higher costs resulting from an overall shortage of loggers and haulers. Higher Value and Non-Strategic Timberlands We review our timberlands to identify properties that may have higher values other than as commercial timberlands (see discussion in Item 1 - Real Estate Segment). We estimate that included in the company's 6.3 million acres of timberlands at December 31, 2015, are approximately 675,000 acres of higher value timberlands which are expected to be sold, exchanged, and/or developed over the next fifteen years for recreational, conservation, commercial and residential purposes. Included within the 675,000 acres of higher value timberlands are approximately 500,000 acres we expect to sell for recreational uses, approximately 100,000 acres we expect to sell for conservation and approximately 75,000 acres that are identified as having development potential. Furthermore, the company has approximately 200,000 acres of non-strategic timberlands, which are expected to be sold over the near and medium term in smaller scale transactions (“small non-strategic”). Not included in the above 675,000 higher value acres and 200,000 small non-strategic acres are other acres that may be sold, from time to time, in large acreage transactions PLUM CREEK 2015 FORM 10-K | 29 PART II / ITEM 7 to commercial timberland buyers as opportunities arise (“large non-strategic”). Some of our real estate activities, including our real estate development business, are conducted through our wholly-owned taxable REIT subsidiaries. In the meantime, all of our timberlands continue to be managed productively in our business of growing and selling timber. During 2015, we sold approximately 132,000 acres of conservation properties for proceeds of $98 million, approximately 37,000 acres of higher and better use / recreational properties for proceeds of $76 million, approximately 17,000 acres of small non-strategic properties for proceeds of $22 million, along with selling approximately 98,000 acres of large non-strategic properties for proceeds of $120 million. During 2008, our land development business slowed dramatically and remained weak during 2015. Assuming the merger with Weyerhaeuser is consummated (expected to close on February 19, 2016), future real estate sales will be at the discretion of Weyerhaeuser’s management. Harvest Levels The volume of trees we harvest each year and the percentage of sawlogs and pulpwood (product mix) included in our annual harvest also impacts our operating performance. During 2015, we harvested a total of 18.7 million tons, which was comprised of 43% sawlogs and 57% pulpwood, compared to harvesting 19.6 million tons in 2014, which was comprised of 45% sawlogs and 55% pulpwood. Future harvest levels may vary from historic levels due to weaker or stronger than anticipated markets or other factors outside of our control, such as weather and fires. Future harvest levels may also be impacted by the acquisition of timberlands or the disposition of timberlands beyond the 875,000 acres described above in the Higher Value and Non-Strategic Timberlands section. Assuming the merger with Weyerhaeuser is consummated (expected to close on February 19, 2016), future harvest levels will be at the discretion of Weyerhaeuser’s management. Critical Accounting Policies Our discussion and analysis of our financial condition and results of operations are based upon our consolidated financial statements which have been prepared in accordance with U.S. generally accepted accounting principles. The preparation of these financial statements requires us to make estimates and judgments that affect the reported amounts of assets, liabilities, revenues and expenses, and related disclosure of contingent assets and liabilities. Under different assumptions or conditions, actual results may differ from these estimates. We believe the following critical accounting policies affect our most significant judgments and estimates used in preparation of our consolidated financial statements: Revenue Recognition for Timber Sales Timber sales revenues are recognized when legal ownership and the risk of loss transfer to the purchaser and the quantity sold is determinable. We sell timber under delivered log agreements and through sales of standing timber (or “stumpage”) using pay-as-cut sales contracts or, less frequently, timber deed sale agreements. Delivered Log Sales. Under a delivered log sale agreement, we harvest the timber and deliver it to the buyer. Revenue is recognized when the log is delivered as risk of loss and title transfer to the buyer. With delivered log sales, we incur the cost of logging and hauling. Pay-as-Cut Sales Contracts. Pay-as-cut sales contracts are agreements in which the buyer agrees to purchase and harvest specified timber on a tract of land for an agreed upon price for each type of tree over the term of the contract (usually 12 to 18 months). In some cases, an advance is received in connection with pay-as-cut sales contracts. In other cases, the buyer agrees to harvest only certain trees on a tract of land. Under pay-as-cut sales contracts, the buyer is responsible for all logging and hauling costs. Revenue is recognized when the timber is harvested, as title and risk of loss has transferred to the buyer. Total revenue recognized under a pay-as-cut sales contract is the total volume of wood removed multiplied by the unit price for each type of tree. PLUM CREEK 2015 FORM 10-K | 30 PART II / ITEM 7 The following table summarizes amounts recognized under each method from sales to external customers in the company’s consolidated financial statements for the years ended December 31 (in millions): Substantially all of our timber sales in the Northern Resources Segment are under delivered log sale agreements. Over the last several years in our Southern Resources Segment, we have increased the proportion of delivered log sales, as approximately 91% of our timber sales in 2015, 89% of our timber sales in 2014 and 87% of our timber sales in 2013 were from delivered log sales. While revenues are higher under a delivered log sale, a large portion of the increase is to cover the related increase in cost of sales. Under sales of stumpage revenues are lower since the buyer is responsible for the logging and hauling costs. As a result of this sales method mix in our Southern Resources Segment, the operating profit as a percentage of revenue is typically higher compared to our Northern Resources Segment. Real Estate Sales The timing of real estate sales is a function of many factors, including the general state of the economy, demand in local real estate markets, the ability to obtain entitlements, the ability of buyers to obtain financing, the number of competing properties listed for sale, the seasonal nature of sales (particularly in the northern states), the plans of adjacent landowners, our expectation of future price appreciation, the timing of harvesting activities, and the availability of government and not-for-profit funding (especially for conservation sales). As a result, the timing of our real estate sales may materially impact our reported operating income and net income. During 2015, the Real Estate Segment reported an operating profit percentage of approximately 45%. Over the last ten years, the Real Estate Segment’s annual operating profit percentage has ranged from 45% to 65% of revenues. The operating profit percentage depends on the nature of the interest sold and how much the market value of the property has risen over its book value. For example, sales of properties that have been held by the company for a long time (i.e. decades) will tend to have relatively higher operating profit percentages than properties that have been held by the company for shorter time periods. In contrast, the sale of conservation easements will generally have an operating profit percentage of close to 100% because historically no book basis was allocated to these development rights. In general, timberlands are acquired primarily for long-term use in our timber operations. In connection with timberland acquisitions, we are generally not able to identify, with any level of precision, our future real estate sales (i.e. specific properties with a higher value than for use in timber production). However, our purchase price allocation and related appraisals for these acquisitions may reflect greater values for real estate which may be sold in the future but are not yet specifically identified. Therefore, in connection with our purchase price allocation for timberland acquisitions, the greater values for real estate are allocated proportionately among all of the acres acquired. Specific properties cannot be identified in advance because their value is dependent upon numerous factors, most of which are not known at the acquisition date, including current and future zoning restrictions, current and future environmental restrictions, future changes in demographics, future changes in the economy, current and future plans of adjacent landowners, and current and future funding of government and not-for-profit conservation and recreation programs. We believe that current and future results of operations could be materially different under different purchase price allocation assumptions. In connection with the sale of timberlands, a portion of the original cost of the underlying land and standing timber is included in the real estate segment cost of goods sold. The book basis related to the land being sold is generally based on a specific identification of the costs allocated to the acres being sold. However, the book basis related to the standing timber is based on timber depletion rates. The company has a separate depletion rate for each geographic region in which the company operates (i.e., seven rates in our Northern Resources Segment and six rates in our Southern Resources Segment). In connection with an acquisition, the company will either establish new depletion rate(s) or average the acquisition cost and timber inventory with existing depletion rate(s) depending upon how the timberlands will be managed. For example, in connection with our December 6, 2013, acquisition of approximately 501,000 acres of timberlands from MeadWestvaco, the company created a new depletion rate associated with the PLUM CREEK 2015 FORM 10-K | 31 PART II / ITEM 7 approximately 126,000 acres acquired in Virginia. The remaining timberlands acquired were combined with existing timberlands in computing new depletion rates for 2014. Management believes that current and future results of operations could be materially different depending upon how depletion rates are established in connection with major acquisitions. For example, in 2014, cost of real estate sales would have been approximately $5 million higher if new depletion rates had been established for all 501,000 acres of the acquired MeadWestvaco timberlands. Impairment of Long-Lived Assets We evaluate our ability to recover the net investment in long-lived assets when required by the accounting standards. We recognize an impairment loss in connection with long-lived assets used in our business when the carrying value (net book value) of the assets exceeds the estimated future undiscounted cash flows attributable to those assets over their expected useful life. Impairment losses are measured by the extent to which the carrying value of a group of assets exceeds the fair value of such assets at a given point in time. Generally, our fair value measurements used in calculating an impairment loss are categorized as Level 3 measurements (i.e. unobservable inputs that are supported by little or no market activity) under the fair value hierarchy in the Accounting Standards Codification. Typically, we will use a discounted cash flow model or an external appraisal to estimate the fair value of the affected assets. Furthermore, we recognize an impairment loss in connection with long-lived assets held for sale when the carrying value of the assets exceeds an amount equal to their fair value less selling costs. The company has had a long history of acquiring timberlands. Management is required to estimate the fair values of acquired assets and liabilities as of the acquisition date. These estimates of fair value are typically derived from external appraisals and are based on significant assumptions and estimates. Any changes in these estimates and assumptions could impact current and future depletion rates, basis for real estate sales, and our impairment analysis. Subsequent to the original allocation, assets are tested for impairment whenever events or changes in circumstances indicate that the carrying value of the assets may not be recoverable through future operations. Our long-lived assets are grouped and evaluated for impairment at the lowest level for which there are independent cash flows. We track cash flows for our approximately 6.3 million acres of timberlands by grouping them into seven geographic areas in the Northern Resources Segment and six geographic areas in the Southern Resources Segment. Additionally, we track cash flows for each of our manufacturing facilities. Timber and Timberlands Used in Our Business. For assets used in our business, an impairment loss is recorded only when the carrying value of those assets is not recoverable through future operations. The recoverability test is based on undiscounted future cash flows over the expected life of the assets. We use one harvest cycle (which ranges between 20 and 90 years) for evaluating the recoverability of our timber and timberlands. Because of the inherently long life of timber and timberlands, we do not expect to incur an impairment loss in the future for the timber and timberlands used in our timber business. Timber and Timberlands Held for Sale. An impairment loss is recognized for long-lived assets held for sale when the carrying value of those assets exceeds an amount equal to its fair value less selling costs. An asset is generally considered to be held for sale when we have committed to a plan to sell the asset, the asset is available for immediate sale in its present condition, we have initiated an active program to locate a buyer (e.g., listed with a broker), and the sale is expected to close within one year. During the last several years, the above criteria have been met by some of our timberland properties, and we recognized annual impairment losses of $7 million and $4 million in 2014 and 2013, respectively (see Note 4 of the Notes to Consolidated Financial Statements). No impairment losses were recognized in 2015. An impairment loss is generally not recorded until management expects that the timberlands will be sold within the next 12 months. For many properties that are currently listed for sale, it is difficult to conclude whether they will be sold within one year and to estimate the price. Nevertheless, management performs a probability assessment for all properties that are listed for sale and records an impairment loss (to the extent the property’s book basis exceeds its estimated fair value net of selling cost) in the quarter in which management expects the property will be sold within twelve months. We expect to continue to sell or exchange timberlands to other forest products companies or non-industrial buyers, and it is probable that we will recognize additional impairment losses, some of which could be material, in the future in connection with sales of timberlands. PLUM CREEK 2015 FORM 10-K | 32 PART II / ITEM 7 Property, Plant and Equipment. The carrying value of Property, Plant and Equipment primarily represents the net book value of our five manufacturing facilities. Each manufacturing facility is tested for impairment whenever events or changes in circumstances indicate that the carrying amount may not be recoverable through future operations. The estimated future cash flows over the remaining useful life of a manufacturing facility is highly subjective and is dependent upon estimates for future product pricing, raw material costs and availability, volumes of product sold, and residual value of the facility. No impairment losses were recorded during 2015, 2014 or 2013. We currently estimate that the carrying value for our five facilities is recoverable through future operations and that our estimate of future cash flows is reasonable. However, if wood product prices were to weaken for an extended period of time, or if log or raw material availability declines, we may record an impairment loss for one or more of our manufacturing facilities in a future period. Capitalized Real Estate Development Costs. Current and future costs associated with specific real estate development projects are capitalized once management has concluded it is probable that a project will be successful. Real estate development costs are expensed as incurred when management is not able to conclude that it is probable a project will be successful. Furthermore, previously capitalized costs for specific projects are written off when management revises its prior assessment and concludes that it is probable a project will not be successful and costs will not be recovered. For many of our projects, there is less judgment in making this determination due to prior experience in the local market or advice from consultants. However, for some of our larger projects where we have limited experience in the local market or for projects in environmentally sensitive areas, there is significant judgment in assessing the expected outcome for the projects. At December 31, 2015, we have $39 million of capitalized costs associated with projects that management expects will be successful. Depletion Depletion, or costs attributed to timber harvested, is recorded as trees are harvested and sold. Depletion rates for each geographic area are adjusted at least annually. Depletion rates are computed by dividing (A) the sum of (1) the original cost of the timber less previously recorded depletion plus (2) estimated future silviculture costs, including the impact of inflation, that are expected to be incurred over the next harvest cycle, by (B) the total timber volume that is estimated to be harvested over the harvest cycle. Additionally, the depletion rate calculations do not include future volume that is environmentally and/or legally restricted from being harvested. The original cost of the timber includes capitalized costs associated with the purchase of timber along with reforestation costs and other costs associated with the planting and growing of trees. When timberlands are purchased, management is required, as part of its purchase price allocation, to estimate the fair value of the timber as of the acquisition date. There are significant assumptions and estimates associated with the allocation of the purchase price, which in turn, could significantly impact our current and future depletion rates. The harvest cycle can be as short as 20 years in the South to as long as 90 years in the North. The estimate of future silviculture costs is limited to the expenditures that are expected to impact growth rates over the harvest cycle. The depletion rate calculations do not include an estimate for either future reforestation costs associated with a stand’s final harvest or future volume in connection with the replanting of a stand subsequent to its final harvest. In connection with a timberland acquisition, we will either establish new depletion rate(s) or average the acquisition cost and timber inventory with existing depletion rate(s) depending upon how the timberlands will be managed. For example, we will create a new depletion rate if we intend to manage the timberlands as a new geographic area (i.e. a new operating unit). If the timberlands acquired are combined with existing timberlands (i.e. an existing operating unit), we will combine the timberlands together in computing new depletion rates. Current and future results of operations could be materially different depending upon how depletion rates are established in connection with major acquisitions. We establish separate depletion rates for purchased timber deeds in order to allocate the cost of a timber deed over its term (based on harvest volumes). PLUM CREEK 2015 FORM 10-K | 33 PART II / ITEM 7 The following table summarizes depletion expense recognized in the company’s financial statements, key assumptions and sensitivities to changes in assumptions for the years ended December 31 (dollars in millions, except per ton amounts): (A) Depletion expense does not include the depletion associated with the long-term timber deeds we purchased in 2013 and 2012. Depletion expense associated with these timber deeds was $16 million and $11 million for 2015 and 2014, respectively. (B) Does not include the long-term timber deeds. (C) Decrease from 2014 is due primarily to timberland dispositions. (D) Assumes future timber volumes do not change. (E) Assumes future silviculture costs do not change. Significant estimates and judgments are required to determine both future silviculture costs and the volume of timber available for harvest over the harvest cycle. Some of the factors impacting the estimates are changes in inflation rates, the cost of fertilizers, the cost of capital, the actual and estimated increase in growth rates from fertilizer applications, the relative price of sawlogs and pulpwood, the actual and expected real price appreciation of timber, the scientific advancement in seedling and growing technology, and changes in harvest cycles. Management updates all of the above estimates at least annually, or whenever new and supportable information becomes known. Management believes that current and future timber depletion (and therefore, current and future results of operations) could be materially impacted by the timing and extent the above assumptions are revised. PLUM CREEK 2015 FORM 10-K | 34 PART II / ITEM 7 Equity Method Investments The company has two material equity method investments: (1) an investment in MWV-Charleston Land Partners, LLC (Real Estate Development Joint Ventures) and (2) an investment in Southern Diversified Timber, LLC (Timberland Venture). See Note 17 of the Notes to Consolidated Financial Statements. These investments are presented separately in both our consolidated statements of income and our consolidated balance sheets. On December 6, 2013, the company and WestRock Company (formerly MeadWestvaco Corporation) formed a limited liability company (MWV-Charleston Land Partners, LLC or “MWV-CLP”). Plum Creek contributed cash to MWV-CLP and WestRock contributed approximately 109,000 acres of real estate development properties. The book basis of Plum Creek’s initial investment in MWV-CLP was $139 million (based on the December 6, 2013 purchase price allocation), and Plum Creek’s share of MWV-CLP’s net book basis as of December 6, 2013, was approximately $52 million (based on WestRock’s historical cost in the contributed properties). In accordance with the Accounting Standards Codification, this basis difference of $87 million is being amortized (i.e., additional expense) into equity earnings (losses) in future periods as either the real estate development properties are sold or timber on the real estate properties is harvested and sold. On October 1, 2008, Plum Creek and Campbell Global, LLC formed a limited liability company (Southern Diversified Timber, LLC or “the Timberland Venture”). Plum Creek contributed approximately 454,000 acres of timberlands and Campbell Global, LLC contributed cash. Plum Creek’s initial book basis in the Timberland Venture was $174 million (Plum Creek’s basis in the timberlands at the date of transfer) and Plum Creek’s share of the Timberland Venture’s initial net book basis was $783 million (based on fair value of contributed properties). In accordance with the Accounting Standards Codification, this basis difference of $609 million is being amortized (i.e., additional earnings) into equity earnings in future periods as either timber on these properties is harvested and sold or timberlands are sold. There are significant judgments in determining the amount of basis amortization to be recognized each period for our equity method investments. The judgments primarily relate to the allocations of both the book basis in our equity method investment and our share of the venture’s net book basis among the various assets held by the venture. For example, the key judgments associated with our investment in MWV-CLP were the allocations of our investment in MWV-CLP ($139 million) and our share of MWV-CLP’s net book basis ($52 million) among the various assets of MWV-CLP, which consists primarily of various real estate development properties and standing timber. Additionally, since generally there is a wide range of per acre values within each real estate development property, there is judgment in determining how many homogenous groupings of acres there are within each development property, and then, how much book basis should be allocated to each unique grouping. Finally, there is judgment in estimating the amount of timber volume the venture expects to harvest in the future. The judgments related to our investment in the Timberland Venture primarily relates to the allocations of our investment in the Timberland Venture ($174 million) and our share of the Timberland Venture’s net book basis ($783 million) among the various assets of the Timberland Venture, which consists primarily of land and standing timber. Additionally, there is judgment in estimating the amount of timber volume the venture expects to harvest in the future. During 2015, the basis amortization included in equity earnings related to our investment in MWV-CLP was $15 million (additional expense) and the basis amortization included in equity earnings related to our investment in the Timberland Venture was $18 million (additional earnings). During 2014, the basis amortization included in equity earnings related to our investment in MWV-CLP was $11 million (additional expense) and the basis amortization included in equity earnings related to our investment in the Timberland Venture was $9 million (additional earnings). Management believes that current and future equity earnings (losses) could be materially different depending upon the assumptions used in allocating both our book basis in our equity method investments and our share of the ventures’ net book basis among the assets of the ventures. Accounting for Share-Based Compensation Plum Creek has a stockholder approved Stock Incentive Plan that provides for the award of shares of the company's stock including, but not limited to, common stock awards, restricted stock units and value management awards. See Note 14 of the Notes to Consolidated Financial Statements. PLUM CREEK 2015 FORM 10-K | 35 PART II / ITEM 7 Grants of value management awards are classified and accounted for as liabilities. As a result, the expense recognized over the performance period will equal the fair value (i.e., cash value) of an award as of the last day of the performance period multiplied by the number of awards that are earned. Furthermore, the quarterly expense recognized during the performance period is based on the fair value as of the end of the most recent quarter. Prior to the end of the performance period, compensation cost for value management awards is based on the awards’ most recent quarterly fair values and the number of months of service rendered during the performance period. Fair values for value management awards are computed based on our historical relative total shareholder return and simulated relative total shareholder return compared to the performance of peer groups consisting of forest products companies, the S&P 500 Index and the MSCI U.S. REIT Index over the same period (“Peer Group”). The simulated total shareholder return of the company and the Peer Group is computed using a Monte Carlo simulation. The key assumptions used in the simulation of the company’s and the Peer Group’s total shareholder return are volatility, beta (the measure of how Plum Creek’s stock moves relative to the market as a whole) and risk-free interest rate. The fair value of the liability for outstanding value management awards as of December 31, 2015 was $23 million, which is based on the current fair value of outstanding awards multiplied by the percentage of months that services were provided during the performance period. The liability as of December 31, 2015 could range between $8 and $36 million based on the possible fair value of all outstanding liability based awards. We could have a material adjustment to our share-based compensation liability to the extent there is a material change in the fair value of our value management awards during the quarter. Pensions Pension Plans Overview. Plum Creek provides pension benefits under defined benefit pension plans that cover substantially all of our employees. See Note 13 of the Notes to Consolidated Financial Statements. We maintain a qualified defined benefit pension plan and two non-qualified defined benefit pension plans. Participants’ benefits vest after three years of service. The cash balance benefits for salaried employees is determined based primarily on certain percentages of compensation, age, years of service and interest accrued based on the 30-year Treasury bond rate. Participants who were employees of the company on September 1, 2000, earn benefits based on the greater of the cash balance benefits or a monthly pension benefit that is principally based on the highest monthly average earnings during any consecutive sixty-month out of the last 120-month period and the number of years of service credit. The benefits to hourly employees are generally based on a fixed amount per year of service. Plum Creek’s contributions to its qualified pension plan vary from year to year, but the company has made at least the minimum contributions required by law in each year. It is generally the company’s policy to fund the qualified pension plan annually such that the fair value of plan assets equals or exceeds the actuarially computed accumulated benefit obligation (the approximate actuarially computed current pension obligation if the plan was discontinued) over a market cycle (generally 3 to 5 years). The company has the same funding policy for the non-qualified plan. However, assets related to the non-qualified plans are held in a grantor trust and are subject to the claims of creditors and, therefore, are not considered plan assets. Under current U.S. generally accepted accounting principles (U.S. GAAP), the company makes estimates and assumptions that can have a significant impact on the amounts reflected in our financial statements. These assumptions and their sensitivities, along with the application of the accounting principles and impact to our financial statements, are discussed in the next several sections. Current Year Impact and Analysis. During 2015, our pension liability decreased from $218 million to $210 million and our pension assets decreased from $154 million to $146 million. Our pension liability represents the present value of expected future benefit payments and is remeasured annually as of December 31. Each year, our pension liability increases due to employees working for one more year (service cost), and getting one year closer to receiving benefit payments (interest cost), and decreases as pension benefits are paid. Our pension liability is also adjusted due to changes in interest rates and mortality assumptions. During 2015, our pension liability decreased by $7 million (an actuarial gain) due primarily to rising interest rates. Actuarial gains and losses are initially recognized in other comprehensive income (loss) and are then subsequently amortized (charged) to pension expense over future periods. PLUM CREEK 2015 FORM 10-K | 36 PART II / ITEM 7 Annually, our plan assets increase due to cash contributions from the company, decrease due to pension benefit payments, and will increase or decrease as a result of realized and unrealized gains and losses for the assets. Our pension expense is reduced by the expected returns on plan assets. We currently estimate that our long-term return on plan assets will average 7.0% per year. Based on the plan assets balance, our 2015 pension expense was reduced by $10 million (the expected return on plan assets in dollars). The actual return on plan assets was a loss of $1 million for 2015. We initially recognize this difference (shortfall) of $11 million in other comprehensive income (loss) and then subsequently will amortize (charge) to pension expense over future periods. At December 31, 2015, our cumulative net actuarial pension loss recognized in accumulated other comprehensive income (loss) was $53 million (includes both unrecognized changes in our pension liability and plan assets), of which $3 million will be amortized (charged) to 2016 pension expense. Each year the future amortization of our actuarial pension loss recognized in pension expense will increase or decrease due to changes in interest rates and actual returns on plan assets compared to expected returns. Additionally, while not expected, future company contributions may need to be increased to the extent interest rates remain low or to the extent that actual investment returns on plan assets do not meet our expectations. Significant Assumptions. The computation of the company’s benefit obligation, pension cost and accrued pension liability under U.S. GAAP requires us to make certain assumptions involving primarily the following (weighted-average rates): (A) The December 31, 2015 discount rate for annuity distributions was determined by the resulting yield of a hypothetical bond portfolio at December 31, 2015, matched to the expected benefit payments under the plans. Bonds selected for this portfolio had a Moody’s or Standard & Poor’s credit rating of “AA” or better as of December 31, 2015. The December 31, 2015 discount rate for lump-sum distributions is based on yields on 30-year U.S. Treasury bonds. (B) The assumed rate of increase of future compensation levels represents our long-term estimate of such increases on the basis of the composition of plan participants, past results and market expectations. (C) The expected long-term rate of return on plan assets assumption is based on the current level of expected returns on risk free investments (primarily government bonds), the historical level of the risk premium associated with the other asset classes in which the portfolio is invested and the expectations for future returns on each asset class. The expected return for each asset class was then weighted based on the target asset allocation to develop the expected long-term rate of return on plan assets assumption for the portfolio. Since pension benefits may be settled in either a single lump-sum or an annuity distribution, both the estimated percentage of participants electing a lump-sum payment and the assumed interest rate (discount rate) used in computing the lump-sum benefit are key assumptions. We currently estimate that approximately half of the qualified plan participants will elect a lump-sum distribution upon termination. Other key assumptions used in the estimate include primarily those underlying the mortality table, and expected long-term rates for inflation, retirement and withdrawals, all of which are based on plan experience and standard actuarial methods but which are nevertheless subject to uncertainty. PLUM CREEK 2015 FORM 10-K | 37 PART II / ITEM 7 It is likely that the actual return on plan assets and the outcome of other uncertain variables will differ from those used in estimating our pension costs and pension obligation. Furthermore, the company may, from time to time, adjust the asset allocation, which may have an impact on the long-term rate of return on plan assets. Financial Measures and Sensitivities. The following table summarizes key financial measures and sensitivities to changes in assumptions for the years ended December 31 (in millions): Assuming an average long-term rate of return on plan assets of 7.0%, and weighted-average discount rates of 4.60% for annuity distributions (and 3.03% for lump-sum distributions) and a 3.45% rate of increase in compensation levels for 2016 and beyond, we project our annual pension expense for 2016 will be approximately $8 million and will range between $8 million and $9 million each year for 2017 through 2020. On the date the merger with Weyerhaeuser becomes effective (expected to be February 19, 2016), the qualified and nonqualified plans will be closed to new participants and frozen to all future benefit accruals. As such, future contributions to the qualified pension plan or to its grantor trust associated with the non-qualified plans in 2016 or beyond will be determined by Weyerhaeuser. PLUM CREEK 2015 FORM 10-K | 38 PART II / ITEM 7 Off-Balance Sheet Arrangements, Contractual Obligations, Contingent Liabilities and Commitments The company has no off-balance sheet debt. Our consolidated financial statements reflect all of the operations and assets and liabilities of the company. The company has equity investments in unconsolidated entities, discussed below. Otherwise, the company has no other relationships with unconsolidated entities or financial partnerships, such as entities referred to as structured finance or special purpose entities. In connection with the WestRock Company (formerly MeadWestvaco) timberland acquisition in 2013, the company and WestRock Company formed a limited liability company (MWV-Charleston Land Partners, LLC or “MWV-CLP”). Plum Creek contributed cash to MWV-CLP and WestRock Company contributed real estate development properties, which consisted of both residential and commercial properties currently under development (“Class A Properties”) and high-value development lands (“Class B Properties”). Plum Creek contributed $12 million in exchange for a 5% interest in Class A Properties and $140 million in exchange for a 50% interest in Class B Properties. Plum Creek has committed to contribute capital of at least $29 million over the next five years in connection with its interest in Class B Properties. The company uses the equity method of accounting for both its Class A and Class B interests. See Notes 17 and 18 of the Notes to Consolidated Financial Statements. In 2008, the company contributed 454,000 acres of timberlands located in its Southern Resources Segment to a timberland venture in exchange for an equity interest. The company accounts for its interests under the equity method of accounting. See Notes 17 and 18 of the Notes to Consolidated Financial Statements. During 2013, the company entered into several treasury lock transactions to hedge against interest rate risk on its Installment Note Payable. These transactions are accounted for as cash flow hedges, and the $5 million gain on these transactions is being amortized as a reduction to interest expense on the installment note over its term of ten years. See Notes 10 and 12 of the Notes to Consolidated Financial Statements. The company is not a party to any other derivative transactions. In September 2015, we announced the formation of a timberland venture, Twin Creeks Timber, LLC (“Twin Creeks Timber”), with several institutional investors (i.e., several state investment funds). Assuming the merger with Weyerhaeuser closes on February 19, 2016 as planned, initial capital contributions are expected to occur in March 2016. Plum Creek has agreed to contribute approximately 260,000 acres of its southern timberlands in exchange for cash of approximately $420 million and a 25% common ownership interest in Twin Creeks Timber. Twin Creeks Timber is expected to raise total committed capital of approximately $1 billion from either existing investors or new investors. Plum Creek intends to maintain its 25% common ownership; and therefore, expects over the next several years to make future cash contributions of approximately $110 million to Twin Creeks Timber. Unless extended by a unanimous vote of all investors, the term of Twin Creeks Timber is 15 years. Contractual Obligations. The following table summarizes our contractual obligations at December 31, 2015 (in millions): PLUM CREEK 2015 FORM 10-K | 39 PART II / ITEM 7 (A) In addition to principal, long-term debt includes related interest obligations based on the coupon or stated interest rate for our fixed rate debt and the variable interest rate as of December 31, 2015 of 1.92% for our term credit agreement. During 2015, the company accrued patronage distributions related to 2015, which resulted in an effective net interest rate on the term loan of approximately 1%. See Note 10 of the Notes to Consolidated Financial Statements. Interest obligations are $87 million (less than one year), $173 million (1-3 years), $166 million (3-5 years), and $160 million (more than 5 years). As we expect borrowings outstanding under our line of credit to vary, only repayment of the principal is included. In 2015, interest expense related to our line of credit was less than $1 million. (B) On October 1, 2008, the company borrowed $783 million from the Timberland Venture (a related party). The annual interest rate on the note payable is fixed at 7.375%. Interest obligations are $58 million (less than one year) and $115 million (1-3 years). (C) Purchase obligations are comprised primarily of $149 million for raw materials (resin, veneer and wood fiber) for our manufacturing facilities, $112 million for timber harvest contracts, $40 million for long-term timber leases, approximately $14 million for electricity and natural gas for our MDF facilities, and $8 million for fiber supply agreements to supply external customers. (D) We have not included any amounts for our other long-term liabilities, as we cannot estimate when we will be obligated to satisfy these liabilities. At December 31, 2015, other long-term liabilities include workers’ compensation of $4 million, deferred compensation obligations of $5 million and pension obligations of $64 million (including $34 million classified as a current liability). We expect to fund approximately $1 million for workers’ compensation payments in 2016. We have two grantor trusts, which hold assets associated with our deferred compensation obligations and non-qualified pension obligations. At December 31, 2015, the fair value of assets in one of our grantor trusts is approximately equal to our deferred compensation obligation of $5 million. The December 31, 2015 fair value of assets in the other grantor trust was approximately $49 million and the actuarially computed accumulated benefit obligation for our non-qualified pension plans was $48 million. Assets in our grantor trusts have been reserved for the above obligations. However, grantor trust assets are subject to the claims of creditors in the event of bankruptcy. See Notes 11 and 13 of the Notes to Consolidated Financial Statements. PLUM CREEK 2015 FORM 10-K | 40 PART II / ITEM 7 Events and Trends Affecting Operating Results Harvest Plans We determine our annual timber (sawlogs and pulpwood, including stumpage sales) harvesting plans based on a number of factors. At the stand level, ranging in size from 10 to 200 acres, we consider the age, size, density, health and economic maturity of the timber. A stand is a contiguous block of trees of a similar age, species mix or silvicultural regime. At the forest level, ranging in size from 100,000 to almost 1 million acres, we consider the long-term sustainability and environmental impact of certain levels of harvesting, certain external conditions such as supply agreements, and the level of demand for wood within the region. A forest is a broad administrative unit, made up of a large number of stands. Harvest scheduling is the technical approach using computer modeling that considers all of the above factors along with forest growth rates and financial assumptions to project future harvest plans for a number of years forward. Our actual harvest levels may vary from planned levels due to log demand, sales prices, the availability of timber from other sources, the level of timberland sales and acquisitions, the availability of legal access, abnormal weather conditions, fires and other factors outside of our control. We believe that our harvest plans are sufficiently flexible to permit modification in response to short-term fluctuations in the markets for logs. Furthermore, future harvest levels will be impacted by sales and purchases of timberlands. The impact of timberland sales will depend on the level and extent we reinvest proceeds in productive timberlands and the stocking levels and age class distribution of any newly acquired timberlands. For example, in December 2013 we acquired approximately 501,000 acres of timberlands in Alabama, Georgia, South Carolina, Virginia, and West Virginia from WestRock Company (formerly MeadWestvaco Corporation). Of the WestRock timberlands acquired, approximately 147,000 acres are included in the Northern Resources Segment and approximately 354,000 acres are included in the Southern Resources Segment. The volume harvested from the WestRock timberlands in 2014 was nearly 3 million tons. Harvest levels are also impacted by purchases of long-term timber deeds. In 2013, we purchased a timber deed in the Southern Resources Segment, which encompasses approximately 0.9 million tons of standing timber. In 2012, we acquired approximately 4.7 million tons of standing timber in our Southern Resources Segment. The volume acquired under a timber deed, plus the related growth, is harvested over the term of each timber deed. Both timber deeds expire in 2020. Sawlog harvest levels in our Northern Resources Segment were 1.9 million tons during 2015 compared to 2.3 million tons during 2014. This decrease was due primarily to prior year land sales and recent harvest schedule updates. Sawlog harvest levels in our Southern Resources Segment were 6.1 million tons during 2015 compared to 6.5 million during 2014. This decrease was due primarily to deferring some planned harvesting as a result of weak sawlog prices. Pulpwood harvest levels in our Northern Resources Segment were 1.6 million tons during both 2015 and 2014. Pulpwood harvest levels in our Southern Resources Segment were 9.1 million during 2015 which was generally comparable to the 9.3 million tons we harvested during 2014. Assuming the merger with Weyerhaeuser is consummated (expected to close on February 19, 2016), future harvest levels will be at the discretion of Weyerhaeuser’s management. PLUM CREEK 2015 FORM 10-K | 41 PART II / ITEM 7 Comparability of Financial Statement Periods Acquisitions and Divestitures. We have pursued and expect to continue to pursue both the acquisition and divestiture of timberlands to increase the value of our assets. Accordingly, the comparability of periods covered by the company’s financial statements is, and in the future may be, affected by the impact of timberland acquisitions and divestitures. The following table summarizes timberland acquisitions and dispositions for each of the past three years, along with our total acres owned at each of the past three year ends (in acres): Results of Operations The following table compares Operating Income (Loss) by Segment and other items impacting our net income for the years ended December 31 (in millions): PLUM CREEK 2015 FORM 10-K | 42 PART II / ITEM 7 2015 Compared to 2014 Northern Resources Segment. Key operating statistics for the segment are as follows: Revenues decreased by $36 million, or 14%, to $228 million for 2015 compared to 2014. The decrease was due primarily to lower sawlog harvest volumes ($34 million) and lower sawlog prices ($7 million) offset, in part, by higher pulpwood prices ($7 million). Sawlog harvest volumes decreased 18% during 2015 compared to 2014 due primarily to recent land sales, harvest schedule updates, and to a lesser extent, fire restrictions during the third quarter followed by unseasonably wet weather during the fourth quarter. Sawlog prices decreased 4% during 2015 compared to 2014 due primarily to lower demand for logs. Demand for sawlogs decreased during 2015 as a result of oversupplied lumber markets, weak lumber prices, and high mill inventories. Despite an 11% increase in U.S. housing starts during 2015 compared to the prior year, lumber markets were generally oversupplied during most of 2015 as a result of increased lumber imports from Canada and decreased exports of logs and lumber to China. Lumber imports to the U.S. from Canada increased approximately 7% in 2015 due primarily to the slowdown in lumber demand from China and a relatively strong U.S. dollar. Pulpwood prices increased 10% during 2015 compared to 2014 due primarily to a continued limited supply of pulpwood in the Lake States and Northeastern regions of the U.S., partially as a result of a shortage of loggers and haulers. Although many of our pulpwood customers continued to build adequate log inventories through the third quarter of 2015, demand slowed during the fourth quarter of 2015 following several announced mill closures and curtailments. Northern Resources Segment operating income was 12% of its revenues for 2015 compared to 17% of its revenues for 2014. The decrease in operating performance was due primarily to lower sawlog prices and sawlog harvest volumes. Segment costs and expenses decreased by $19 million, or 9%, to $201 million due primarily to lower sawlog harvest volumes. Southern Resources Segment. Key operating statistics for the segment are as follows: Revenues decreased by $10 million, or 2%, to $521 million for 2015 compared to 2014. The decrease was due primarily to lower sawlog harvest volumes ($19 million) offset, in part, by an increased proportion of delivered sales ($9 million) and higher pulpwood prices ($3 million). Sawlog volumes decreased 6% during 2015 compared to 2014 due primarily to reducing harvest levels as a result of weak sawlog prices. During the fourth quarter of 2015, sawlog prices were under downward pressure due to high mill inventories and reduced lumber production as a result of weak lumber prices. Despite an 11% increase in U.S. housing starts during of 2015, demand for sawlogs remained relatively weak throughout most of 2015. While lumber production PLUM CREEK 2015 FORM 10-K | 43 PART II / ITEM 7 in the Southern U.S. increased approximately 3% in 2015, many domestic lumber mills were negatively impacted by increased lumber imports. U.S. lumber imports from Canada increased approximately 7% in 2015 compared to 2014. These factors along with high lumber inventories in the first half of 2015, resulted in generally declining lumber prices during 2015. As a result, sawlog prices in 2015 were generally flat compared to 2014, but were under downward pressure late in the year. For the last several years, sawlog prices have remained at recessionary levels because at current lumber production levels there continues to be an ample supply of sawlogs. During 2015, demand for delivered log sales was generally stronger than markets for the sale of standing timber (or “stumpage”). Under delivered log sale agreements, we are responsible for log and haul costs, while under agreements to sell standing timber, the buyer is responsible for log and haul costs. While revenues are higher under a delivered log sale, a large portion of the increase is to cover the related increase in cost of sales. Pulpwood prices increased 5% during 2015 compared to 2014. This increase was due primarily to continued good demand from our paper and packaging customers and increased fiber demand from competing uses, primarily wood pellet producers. For our paper and packaging customers, primarily in the Southeastern U.S., a desire to maintain adequate log inventories, along with somewhat limited pulpwood availability, resulted in steady demand. Southern Resources Segment operating income was 24% of its revenues for 2015 compared to 26% of its revenues for 2014. The decrease in operating margin was due primarily to higher depletion expense, higher costs and operating expenses, and lower sawlog volumes. Segment costs and expenses increased by $4 million, or 1%, to $398 million during 2015 due primarily to higher average depletion rates ($5 million non-cash impact) and higher costs and operating expenses ($5 million), partially offset by lower harvest volumes and lower log and haul rates. The increase in average depletion rates was due primarily to increased harvest volumes from our long-term timber deeds, which have a higher depletion rate compared to depletion rates on timberlands we own. Costs increased due primarily to higher share-based compensation expense ($5 million) and road maintenance expenses ($1 million). Log and haul rates decreased by 1% ($3 million) due primarily to lower diesel fuel costs. Real Estate Segment. Revenues increased by $29 million, or 10%, to $318 million in 2015 compared to 2014. This increase is due primarily to an increase in revenues from large non-strategic timberland sales ($55 million) and conservation sales ($35 million), offset in part by a decrease in revenues from higher and better use / recreational sales ($50 million) and small non-strategic sales ($5 million). Revenues from the sale of large non-strategic timberlands were $120 million in 2015 compared to $65 million in 2014. The company sells large non-strategic timberlands from time to time to commercial timberland buyers as opportunities arise. The increase in large non-strategic revenues is due primarily to the company selling more acres during 2015. During 2015, the company sold approximately 98,000 large non-strategic acres in Florida compared to selling approximately 15,000 acres in Alabama and approximately 8,000 acres in Oregon during 2014. Additionally, the price per acre for sales of large non-strategic timberlands can vary significantly due to the geographic location, the stocking levels (including the timber species and age class distribution), the timber growth rates, and the demand and supply of wood fiber in the local markets. PLUM CREEK 2015 FORM 10-K | 44 PART II / ITEM 7 Revenues from the sale of conservation properties were $98 million in 2015 compared to $63 million in 2014. The increase was due primarily to a two-phased sale to The Nature Conservancy. Occasionally, the company is approached by a conservation organization to purchase a substantial portion of our ownership in one or more states, which is being held for timber production. During 2014, we agreed to sell approximately 165,000 acres of timberlands located in Montana and Washington to The Nature Conservancy. The sale closed in two phases with the first phase closing during the fourth quarter of 2014 for approximately $46 million and consisted of nearly 48,000 acres in Washington State. The second phase closed during the first quarter of 2015 for $85 million and consisted of approximately 117,000 acres in Montana. In general, conservation sales vary significantly from period to period and are primarily impacted by government and not-for-profit funding and the limited number of conservation buyers. Additionally, the price per acre for conservation properties can vary significantly due to the geographic location and the rationale for the conservation designation. Revenues from our higher and better use / recreational properties were $76 million in 2015 compared to $126 million in 2014. The decrease was due primarily to selling fewer acres whereby the company sold approximately 37,000 acres of higher and better use / recreational properties in 2015 compared to selling approximately 65,000 acres in 2014. The decrease in acres sold is due primarily to a combination of retaining our most valuable higher and better use / recreational acres until markets improve and overall owning fewer higher and better use / recreational acres. In the South, (excluding our most valuable properties) we own fewer acres in which recreational and alternative use values significantly exceed timberland values. This is primarily due to a combination of our improved outlook for timber values and an increased supply of rural real estate for sale due to many small landowners’ desire to monetize their real estate investments. Furthermore, on a company-wide basis, (other than our most valuable properties), we own fewer large blocks of contiguous acres with unique characteristics which are attractive to institutional investors and wealthy individuals, we own fewer acres in the most active and attractive rural real estate markets, and our fiber supply agreements limit the number of acres we can sell in certain areas. Revenues from our small non-strategic sales were $22 million in 2015 compared to $27 million in 2014. This decrease was due primarily to selling fewer acres in 2015 ($12 million), partially offset by realizing a higher sales price per acre in 2015 ($7 million). During 2015 we sold approximately 17,000 small non-strategic acres compared to selling approximately 30,000 in 2014. This decrease is due primarily to owning fewer small non-strategic acres, and for the acres owned, having fewer large contiguous blocks of small non-strategic acres that can be sold as large packages. The price per acre was lower in 2014 due primarily to the sale of approximately 17,000 acres in Wisconsin during 2014 to a single buyer and the fact that per acre values in the Lake States are generally lower than most other regions of the country in which we hold properties. The timing of real estate sales is a function of many factors, including the general state of the economy, demand in local real estate markets, the ability to obtain entitlements, the ability of buyers to obtain financing, the number of competing properties listed for sale, the seasonal nature of sales (particularly in the northern states), the plans of adjacent landowners, our expectation of future price appreciation, the timing of harvesting activities, and the availability of government and not-for-profit funding (especially for conservation sales). In any period the average sales price per acre will vary based on the location and physical characteristics of parcels sold. At December 31, 2015, the company owns approximately 6.3 million acres of timberlands. Included in the 6.3 million acres are approximately 675,000 acres of higher value timberlands which are expected to be sold over the next fifteen years and 200,000 acres of non-strategic timberlands which are expected to be sold in smaller acreage transactions over the near and medium term (“small non-strategic”). Not included in the above 675,000 higher value acres and 200,000 small non-strategic acres are acres that may be sold in large acreage transactions to commercial timberland buyers as opportunities arise (“large non-strategic”). Assuming the merger with Weyerhaeuser is consummated (expected to close on February 19, 2016), future real estate sales will be at the discretion of Weyerhaeuser’s management. The Real Estate Segment operating income as a percentage of revenue was 45% for 2015 compared to 46% for 2014. Real Estate Segment costs and expenses increased by $18 million to $174 million in 2015 due primarily to selling more acres during 2015. PLUM CREEK 2015 FORM 10-K | 45 PART II / ITEM 7 Manufacturing Segment. During the second quarter of 2014, we experienced a fire at our MDF facility and recorded a $2 million loss representing the net book value of the building and equipment damaged or destroyed by the fire. For the year ended December 31, 2015, we recorded gains related to insurance recoveries of $3 million. For the year ended December 31, 2014, we recorded gains related to insurance recoveries of $13 million, which, when combined with the building and equipment loss, resulted in a net gain of $11 million. Insurance recoveries were received for costs incurred to rebuild or replace the damaged building and equipment and for business interruption costs. Both the building and equipment loss and the insurance recoveries are reported as Other Operating Gain in the Manufacturing Segment and are included in Other Operating Income (Expense), net in the Consolidated Statements of Income. See Note 20 of the Notes to Consolidated Financial Statements. Key operating statistics for the segment are as follows: (A) Represents product prices at the mill level. Revenues decreased by $18 million, or 5%, to $350 million in 2015. This decrease in revenues was due primarily to lower lumber sales volumes ($28 million) and lower lumber prices ($15 million), partially offset by higher MDF sales volumes ($15 million), higher plywood sales volumes ($5 million) and higher plywood prices ($5 million). On January 29, 2015, we announced the permanent closure of our remanufacturing facility in Idaho. The mill stopped manufacturing boards by March 31, 2015 and sold all of its inventory by June 30, 2015. In October 2015, this facility was sold for $4 million, which approximated its net book value. Excluding our Idaho remanufacturing facility, lumber sales volume decreased by 8% ($4 million) during 2015 compared to 2014 due primarily to the declining supply of logs in the region. Excluding our Idaho remanufacturing facility, lumber prices decreased by 15% ($8 million) during 2015 compared to 2014 due primarily to an excess supply of lumber. The supply of lumber available in the U.S. has increased due primarily to increased imports (primarily Canada) as a result of the strong U.S. dollar, along with an increase in domestic lumber production. During the first ten months of 2015, Canada increased its exports to the United States by 7%. MDF sales volume was 9% higher during 2015 compared to 2014 due primarily to the fire at our MDF facility on June 10, 2014, which temporarily suspended production. Plywood sales volume was 7% higher during 2015 compared to 2014 due primarily to increased purchases of veneer. Plywood production volumes decreased during the first six months of 2014 due to the declining regional supply of logs; however, production volumes were restored to normal levels during the second half of 2014 as a result of higher veneer purchases (which accounted for approximately 40% of the volume produced in 2015). Plywood average prices were 6% higher during 2015 compared to 2014 due primarily to continued strong demand from our industrial customers (e.g., recreational vehicle manufacturers) and an even greater focus on manufacturing higher value products as a result of increased purchases of veneer. Excluding the impact of the net insurance recoveries, Manufacturing Segment operating income was 9% of its revenues for 2015 and 10% of its revenues for 2014. Excluding the net insurance recoveries during 2015 and 2014, Manufacturing Segment costs and expenses decreased by $12 million, or 4%, to $318 million. The decrease in costs and expenses is due primarily to lower lumber sales volumes, lower MDF depreciation ($3 million), and a favorable workers' compensation adjustment ($3 million) offset in part by higher MDF sales volumes and increased plywood raw material and manufacturing costs. The lower MDF depreciation expense is due to a portion of the equipment being fully depreciated at the end of 2014. The higher plywood raw material and manufacturing costs are a result of increased veneer purchases due to the declining supply of logs in the region. PLUM CREEK 2015 FORM 10-K | 46 PART II / ITEM 7 Energy and Natural Resources Segment. Revenues increased by $3 million, or 9%, to $37 million in 2015 compared to 2014. This increase was due primarily to the sale of a pipeline right-of-way ($4 million) and increased royalties associated with our construction materials mineral rights ($3 million), offset in part by lower royalties associated with our natural gas, oil, and coal reserves ($4 million). From time to time the company grants communication and transportation right-of-ways. During 2015, the company sold a permanent gas pipeline right-of-way and recognized revenue of $4 million compared to similar right-of-way revenue in 2014 of less than $1 million. Construction materials royalties continue to improve due primarily to renewed investments in roads and highways, and the increase in home construction. Royalties from natural gas, oil, and coal reserves decreased during 2015 due primarily to the global decline in commodity prices. Operating income was $25 million for both 2015 and 2014. Cost and expenses increased by $3 million to $12 million in 2015 due primarily to higher depletion expense for construction materials. Operating income for 2014 included a gain associated with the early termination of a land lease ($2 million). See Note 20 of the Notes to Consolidated Financial Statements. Other Segment. The Other Segment includes revenues and expenses associated with our business of providing timber and wood-fiber procurement services by the harvesting and selling of trees from timberlands that are not owned by the company. Additionally, equity earnings (losses) associated with the company's investment in MWV-Charleston Land Partners, LLC are reported in the Other Segment. Other Segment operating income for 2015 was $6 million compared to $2 million for 2014. This change of $4 million is due primarily to increased equity earnings related to our investment in MWV-CLP. During 2015, we recorded equity earnings of $6 million compared to equity earnings of $3 million in 2014. The increase of $3 million is due primarily to several large land sales by MWV-CLP during 2015. See Note 17 of the Notes to Consolidated Financial Statements. Other Costs and Eliminations. Other costs and eliminations (which consists of corporate overhead) decreased operating income by $93 million during 2015 compared to $67 million during 2014. The $26 million increase in costs was due primarily to higher share-based compensation costs ($13 million), transaction expenses related to our upcoming merger with Weyerhaeuser ($8 million), higher wage and pension expenses ($2 million), and a donation to an institution of higher education ($1 million). The increase in share-based compensation expense is due primarily to fair value adjustments associated with our value management plan. We adjust the fair value of our liability quarterly based on our relative total shareholder return compared to the performance of several peer groups. Other Unallocated Operating Income (Expense), net. Other unallocated operating income and expense (which consists of income and expenses not allocated to the operating segments) increased operating income by $13 million during 2015 and increased operating income by $2 million during 2014. The increase in operating income of $11 million compared to 2014 was due primarily to realized gains on sales of available-for-sale securities in 2015. Available-for-sale securities valued at $30 million were sold during December 2015 in anticipation of benefit payouts in 2016 as a result of the pending merger with Weyerhaeuser. Unallocated operating income and expense items are included in Other Operating Income (Expense), net in the Consolidated Statements of Income. See Notes 1 and 11 of the Notes to Consolidated Financial Statements. Selling, General and Administrative Expenses. Corporate overhead costs along with Segment specific selling, general, and administrative costs are reported in total on our Consolidated Statements of Income and decreased operating income by $150 million in 2015 compared to $115 million in 2014. This increase in expense of $35 million was due primarily to higher share-based compensation costs ($23 million), transaction expenses related to our upcoming merger with Weyerhaeuser ($8 million) and higher wage and pension expenses ($3 million). The increase in share-based compensation costs is primarily a result of fair value adjustments associated with our value management plan. Equity Earnings from Timberland Venture. Equity earnings from the Timberland Venture were $77 million in 2015 compared to $63 million in 2014. The increase in equity earnings of $14 million is due primarily to increased amortization of our basis difference ($8 million), and a decrease in depletion expense ($4 million). Depletion expense decreased primarily due to a shift in harvest mix during 2015. The Timberland Venture harvested a higher percentage of pulpwood in 2015 compared to 2014, which has a lower depletion rate. PLUM CREEK 2015 FORM 10-K | 47 PART II / ITEM 7 In 2008, the company contributed 454,000 acres of timberlands to the Timberland Venture in exchange for a $705 million preferred interest and a 9% common interest valued at $78 million. The Timberland Venture recorded the timberlands based on their fair value ($783 million). No gain was recognized by the company in 2008 in connection with the contribution of timberlands, and as a result, our book basis in the timberlands of $174 million became the basis for the company’s initial investment in the Timberland Venture. The initial basis difference (i.e., deferred gain) of $609 million was allocated among the land and standing timber based on fair value. The deferred gain is being amortized into equity earnings as standing timber is harvested and sold, and as land is sold. During 2015, there was a large land sale by the Timberland Venture. Our basis difference amortization (deferred gain) recognized during 2015 in connection with the large land sale was $8 million. Furthermore, proceeds from land sales are allocated among the investors based on their common interest (i.e., Plum Creek is entitled to 9% of the proceeds). Interest Expense, net. Interest expense, net of interest income, decreased $3 million, or 2%, to $163 million in 2015 compared to $166 million in 2014 due primarily to refinancing the maturity of our 5.875% Senior Notes on our Line of Credit in the fourth quarter of 2015. The Line of Credit had a weighted-average interest rate of 1.63% at December 31, 2015. Provision (Benefit) for Income Taxes. The benefit for income taxes was $3 million in 2015 compared to a provision for income taxes of $8 million in 2014. This $11 million decrease in expense for income taxes was due primarily to lower earnings from our manufacturing businesses in 2015 ($5 million), higher corporate expenses in 2015 ($3 million)and lower earnings from real estate sales by our taxable REIT subsidiaries in 2015 ($2 million). Real estate sales are made by both our taxable REIT subsidiaries and various wholly-owned subsidiaries of our REIT depending upon the nature and characteristics of the timberlands being sold. The higher corporate expenses are due primarily to higher share-based compensation costs. Our determination of the realization of deferred tax assets is based upon management's judgment of various future events and uncertainties, including the timing, nature and amount of future taxable income earned by certain wholly-owned subsidiaries of the company. A valuation allowance is recognized if management believes it is more likely than not that some portion, or all, of the deferred tax asset will not be realized. At December 31, 2015, we have recorded deferred tax assets of $67 million (net of a $11 million valuation allowance) and deferred tax liabilities of $30 million. Management believes that due to the reversal of various taxable temporary differences and/or the planned execution of prudent and feasible tax planning strategies, sufficient taxable income can be generated to utilize the company's remaining deferred tax assets of $67 million for which a valuation allowance was determined to be unnecessary as of December 31, 2015. PLUM CREEK 2015 FORM 10-K | 48 PART II / ITEM 7 2014 COMPARED TO 2013 Northern Resources Segment. In December 2013, we acquired approximately 501,000 acres of timberland from WestRock Company (formerly MeadWestvaco Corporation). Of the WestRock Company timberlands acquired, approximately 147,000 acres were included in the Northern Resources Segment. Revenues increased by $4 million, or 2%, to $264 million in 2014 compared to 2013. Excluding the acquired WestRock Company timberlands, revenues decreased by $11 million, or 4% to $249 million. The decrease was due primarily to lower sawlog volumes ($23 million), partially offset by higher sawlog prices ($11 million) and higher pulpwood prices ($3 million). Sawlog harvest volumes decreased 7% during 2014 compared to 2013. Excluding the WestRock Company timberlands, sawlog harvest volumes decreased 12% during 2014 compared to 2013 due primarily to land sales and harvest schedule and timber inventory updates. Pulpwood harvest volumes increased 12% during 2014 compared to 2013. Excluding the WestRock Company timberlands, pulpwood harvest volumes were essentially flat during 2014 compared to 2013. Sawlog prices increased 8% during 2014 compared to 2013. Sawlog prices increased due primarily to improved demand and, to a lesser extent, limited supply. The demand for sawlogs improved due primarily to improving U.S. housing starts, which increased by 9% compared to 2013. Furthermore, sawlog prices were favorably impacted throughout most of the year by the export of logs and lumber to China. The supply of sawlogs in our Northern Segment remained limited throughout most of 2014 due in part to weather-related harvesting restrictions. Pulpwood prices increased 3% during 2014 compared to 2013 due primarily to weather-related harvesting constraints. Excluding the WestRock Company timberlands, Northern Resources Segment operating income was 16% of its revenues for 2014 compared to 12% of its revenues for 2013. The increase in operating performance was due to improved log prices and lower operating expenses, offset in part by lower sawlog harvest volumes and higher log and haul rates. Additionally, during 2013 we incurred a $4 million charge for timber losses from forest fires. Segment costs and expenses decreased by $8 million, or 4%, to $220 million. Excluding the WestRock Company timberlands, segment costs and expenses decreased by $19 million, or 8%, to $209 million due primarily to lower sawlog harvest volumes, lower operating expenses and a $4 million forest fire loss in 2013, offset in part by higher log and haul rates. Operating expenses decreased by $7 million due primarily to lower logging road costs, as a result of lower sawlog harvest volumes, and lower share-based compensation costs. During 2013, we recorded a $4 million loss (i.e. the book basis of timber volume destroyed) related to forest fires on approximately 12,000 acres in Oregon and Montana. No forest fire losses were experienced during 2014. Log and haul rates per ton increased 4% ($5 million) due primarily to salvage logging on our Montana and Oregon timberlands that were impacted by fires in 2013. PLUM CREEK 2015 FORM 10-K | 49 PART II / ITEM 7 Southern Resources Segment. In December 2013, we acquired approximately 501,000 acres of timberland from WestRock Company. Of the WestRock Company timberlands acquired, approximately 354,000 acres were included in the Southern Resources Segment. Key operating statistics for the segment are as follows: Revenues increased by $96 million, or 22%, to $531 million in 2014 compared to 2013. Excluding the acquired WestRock Company timberlands, revenues increased by $11 million, or 3% to $446 million. This increase was due primarily to higher sawlog prices ($7 million), an increased proportion of delivered log sales ($7 million), higher pulpwood prices ($6 million) and higher pulpwood volumes ($5 million), partially offset by lower sawlog volumes ($13 million). In certain markets during 2014, demand for delivered log sales, particularly sawlogs, was generally stronger than markets for the sale of standing timber (or “stumpage”). Under delivered log sale agreements, we are responsible for log and haul costs, while under agreements to sell standing timber, the buyer is responsible for log and haul costs. While revenues are higher under a delivered log sale, a large portion of the increase is to cover the related increase in cost of sales. Sawlog prices increased approximately 4% during 2014 compared to 2013 due primarily to modestly increased log demand resulting from improved U.S. housing starts, which increased by 9% compared to 2013. Despite the continued increase in lumber mill production capacity expansions and a 5% increase in lumber production in the Southern U.S. during 2014, the price improvement for sawlogs was modest because at established production levels there remained an adequate supply of logs. Pulpwood prices increased 10% during 2014 compared to 2013. This increase was due primarily to good demand from our paper and packaging customers and increased fiber demand from competing uses, such as Oriented Strand Board and the export of wood pellets used to produce bioenergy. Sawlog harvest volumes increased 10% during 2014 compared to 2013. Excluding the WestRock Company timberlands, sawlog harvest volumes decreased 5% during 2014 compared to 2013 due primarily to the deferral of harvest volumes until sawlog prices improve. Pulpwood harvest volumes increased 23% during 2014 compared to 2013. Excluding the WestRock Company timberlands, pulpwood harvest volumes were comparable to the tons harvested in 2013. Excluding the WestRock Company timberlands, Southern Resources Segment operating income was 27% of its revenues for 2014 compared to 25% of its revenues for 2013. This increase was due primarily to higher sawlog and pulpwood prices. Segment costs and expenses increased by $67 million, or 21%, to $394 million for 2014 due primarily to higher harvest volumes and, to a lesser extent, increased forest management expenses ($6 million) related to the WestRock Company timberlands and higher depletion rates ($4 million). Excluding the WestRock Company timberlands, segment costs and expenses decreased by $2 million, or 1%, to $325 million due primarily to lower depletion rates, offset in part by higher log and haul rates. Depletion rates per ton decreased by 12% ($7 million) in 2014 compared to 2013 due primarily to harvesting lower volume from the timber deeds the company acquired in 2013 and 2012. During 2014, the company harvested approximately 700,000 tons related to timber deeds compared to harvesting approximately 1 million tons in 2013. Log and haul rates per ton increased by 2% ($4 million) in 2014 compared to 2013. Despite the sharp decline in diesel fuel prices during the second half of 2014, log and haul rates per ton increased due primarily to a shortage of loggers and haulers. PLUM CREEK 2015 FORM 10-K | 50 PART II / ITEM 7 Real Estate Segment. Revenues increased by $3 million, or 1%, to $289 million in 2014. Revenues were slightly higher; however, the mix changed as revenues decreased from large non-strategic land sales by $41 million and by $27 million from small non-strategic sales, offset by an increase in the revenues from conservation sales of $37 million and sales of higher and better use / recreational properties of $31 million. Revenues from the sale of large non-strategic timberlands were $65 million in 2014 compared to $106 million during 2013. This decrease of $41 million was due primarily to selling fewer large non-strategic acres during 2014 as a result of improved demand for higher and better use / recreational properties and higher conservation sales. Additionally, the price per acre for large non-strategic timberlands can vary significantly due to the geographic location, the stocking level including timber species and age class distribution, the timber growth rates, and the demand and supply of wood fiber in the local market. Revenues from small non-strategic sales decreased due primarily to selling approximately 13,600 (31%) fewer acres during 2014 compared to 2013 and realizing a lower sales price per acre in 2014. We sold nearly 22,000 acres during 2013 to a single buyer. Our average sales price per acre for small non-strategic properties decreased by 29% for 2014 compared to 2013 due primarily to selling approximately 17,000 acres in Wisconsin to a single buyer. Per acre values in the Lake States are generally lower than most other regions of the country in which we hold properties. Revenues from the sale of conservation properties were $63 million in 2014 compared to $26 million during 2013. Occasionally, the company is approached by a conservation organization to purchase a substantial portion of our ownership in one or more states, which is being held for timber production. During 2014, we agreed to sell approximately 165,000 acres of timberlands located in Montana and Washington to The Nature Conservancy. The sale closed in two phases. The first phase closed during the fourth quarter of 2014 for approximately $46 million and consisted of nearly 48,000 acres in Washington State. The second phase closed in January 2015 for $85 million and consisted of 117,000 acres in Montana. In general, conservation sales vary significantly from period to period and are primarily impacted by government and not-for-profit funding and the limited number of conservation buyers. Additionally, the price per acre for conservation properties can vary significantly due to the geographic location and the rationale for the conservation designation. Revenue from our higher and better use / recreational properties increased as a result of selling approximately 17,650 (38%) more acres compared to 2013. This increase was due primarily to selling 22,400 acres for approximately $29 million as part of a collection of properties sold to a timberland investor in Wisconsin during the second quarter of 2014. The demand for our premium higher and better use / recreational properties remained soft. The timing of real estate sales is a function of many factors, including the general state of the economy, demand in local real estate markets, the ability to obtain entitlements, the ability of buyers to obtain financing, the number of competing properties listed for sale, the seasonal nature of sales (particularly in the northern states), the plans of adjacent landowners, our expectation of future price appreciation, the timing of harvesting activities, and the availability of government and not-for-profit funding (especially for conservation sales). In any period the average sales price per acre will vary based on the location and physical characteristics of the parcels sold. PLUM CREEK 2015 FORM 10-K | 51 PART II / ITEM 7 The Real Estate Segment operating income as a percent of revenue was 46% for 2014 compared to 59% for 2013. This decrease was due primarily to selling properties in 2014 with a lower operating margin compared to the operating margin of properties sold in 2013. This decline in operating margins resulted primarily from the fourth quarter sale of conservation lands in Washington State that had basis in excess of the selling price, and selling approximately 8,800 acres that had high book value from the recent WestRock Company acquisition. Conversely, the properties sold in 2013 were generally from regions with lower book value as the properties had been owned for decades. Real Estate Segment costs and expenses increased by $39 million to $156 million in 2014 due primarily to selling property with higher book value and selling more acres during 2014. Manufacturing Segment. On June 10, 2014, we experienced a fire at our MDF facility and recorded a $2 million loss representing the net book value of the building and equipment damaged or destroyed by the fire. During 2014, we also recorded a $13 million gain related to insurance recoveries that we received, which, when combined with the building and equipment loss, resulted in a net gain of $11 million for the year ended December 31, 2014. Insurance recoveries were $10 million for the costs incurred during 2014 to rebuild or replace the damaged building and equipment and $3 million for business interruption costs. Substantially all of the costs incurred to rebuild or replace the damaged building and equipment were capitalized during 2014. Both the building and equipment loss and the insurance recoveries are reported as Other Operating Gain in the Manufacturing Segment and are included in Other Operating Income (Expense), net in the Consolidated Statements of Income. See Note 20 of the Notes to Consolidated Financial Statements. Key operating statistics for the segment are as follows: (A) Represents product prices at the mill level. Revenues increased by $6 million, or 2%, to $368 million in 2014. This increase in revenues was due primarily to higher lumber prices ($9 million), higher lumber sales volumes ($5 million), higher plywood prices ($5 million) and higher MDF prices ($4 million), partially offset by lower plywood sales volumes ($10 million), and lower MDF sales volumes ($7 million). Lumber sales prices increased 8% during 2014 compared to 2013 due primarily to a limited supply of boards. The supply of boards has been limited, in part, as many lumber manufacturers switched to producing dimension lumber instead of boards due to improved demand for dimension lumber. Lumber sales volume was 5% higher during 2014 compared to 2013 due primarily to resuming operations at our Evergreen, Montana (stud lumber) sawmill in April 2013. Plywood sales volume was 11% lower during 2014 compared to 2013 due primarily to a declining supply of logs in the region. Plywood average prices were 6% higher during 2014 compared to 2013 due primarily to continued strong demand for our specialty plywood products along with a reduced supply. The supply of plywood also declined due to a competing West Coast plywood mill that was destroyed by fire in July 2014. MDF sales volume was 5% lower during 2014 compared to 2013 due primarily to a fire at our MDF facility in June 2014. The fire suspended production at the facility until early July. MDF average prices were 2% higher during 2014 compared to 2013. Excluding the $11 million net gain from insurance recoveries, Manufacturing Segment operating income was 10% of its revenues for 2014 compared to 12% of its revenues for 2013. This decrease in operating performance was due primarily to lower MDF and plywood sales volumes and higher raw material costs. Excluding insurance recoveries, Manufacturing Segment costs and expenses increased by $11 million, or 3%, to $330 million. The increase in costs and expenses was due primarily to increased lumber sales volumes and higher raw material costs (in all of our product PLUM CREEK 2015 FORM 10-K | 52 PART II / ITEM 7 lines), partially offset by lower MDF and plywood sales volumes. Plywood and lumber raw material costs increased by approximately $17 million during 2014 compared to 2013. The higher plywood raw material costs ($10 million) were due primarily to a combination of higher log costs and additional purchases of veneer from other plywood manufacturers, both as a result of the declining supply of logs in the region. The higher lumber raw material costs ($7 million) were due primarily to higher cost of boards for our remanufacturing mill and higher log costs for our other lumber mills as a result of the declining supply of logs in the region. Energy and Natural Resources Segment. Revenues increased by $11 million, or 48%, to $34 million in 2014. This increase was due primarily to royalties from our acquisition of mineral rights in approximately 255 million tons of aggregate reserves in September 2013 ($6 million), and royalties from recently acquired coal and wind assets in the WestRock Company acquisition ($5 million). Operating income was $25 million for 2014 compared to $19 million in 2013. Costs and expenses increased by $5 million to $9 million in 2014 due primarily to higher depletion expense associated with our acquired mineral rights and coal and wind assets ($7 million), offset in part by a gain associated with a contract termination ($2 million). See Note 20 of the Notes to Consolidated Financial Statements. Other Segment. The Other Segment includes revenues and expenses associated with our business of providing timber and wood-fiber procurement services by the harvesting and selling of trees from timberlands that are not owned by the company. Additionally, equity earnings (losses) associated with the company's investment in MWV-Charleston Land Partners, LLC (see Note 17 of the Notes to Consolidated Financial Statements) are reported in the Other Segment. In 2014, the Other Segment reported operating income of $2 million that was due primarily to recording our share of equity earnings from our investment in MWV-CLP. There were no similar activities in 2013. Other Costs and Eliminations. Other costs and eliminations (which consists of corporate overhead) decreased operating income by $67 million during 2014 compared to $73 million during 2013. The decrease of $6 million was due primarily to lower transaction expenses related to our timberland acquisition in 2013 from WestRock Company ($4 million) and lower share-based compensation costs ($4 million) partially offset by an increase in information technology costs, compliance costs and charitable contributions ($2 million). The decrease in share-based compensation expense was due primarily to fair value adjustments associated with our value management plan. We adjust the fair value of our liability quarterly based on our relative total shareholder return compared to the performance of several peer groups. Other Unallocated Operating Income (Expense), net. Other unallocated operating income and expense (which consists of income and expenses not allocated to the operating segments) increased operating income by $2 million during 2014 and decreased operating income by $3 million during 2013. The decrease in expense of $5 million compared to 2013 was due primarily to a loss related to the early termination of an equipment lease in 2013. The equipment lease was accounted for as an operating lease prior to termination. Other unallocated operating income and expense items are included in Other Operating Income (Expense), net in the Consolidated Statements of Income. Selling, General and Administrative Expenses. Corporate overhead costs along with Segment specific selling, general, and administrative costs are reported in total on our Consolidated Statements of Income and decreased operating income by $115 million in 2014 compared to $123 million in 2013. This decrease in expense of $8 million was due primarily to lower share-based compensation costs ($7 million) and transaction expenses related to our timberland acquisition from WestRock Company in 2013 ($4 million) offset in part by higher wage costs ($3 million). The decrease in share-based compensation costs was primarily a result of fair value adjustments associated with our value management plan. Interest Expense, net. In December 2013, we issued an $860 million installment note to MWV CDLM in connection with the acquisition of certain timberland assets. Our effective net interest rate on this note is approximately 4.5%. Also during 2013, we paid off our remaining Private Debt ($260 million), paid down $225 million of our term credit agreement and made pre-payments of approximately $24 million of principal on our Public Debt. As a result of the above transactions, interest expense, net of interest income, increased $25 million, or 18%, to $166 million in 2014 compared to $141 million in 2013. This increase was due primarily to interest expense on our $860 PLUM CREEK 2015 FORM 10-K | 53 PART II / ITEM 7 million installment note payable ($35 million), offset by a reduction in interest expense as a result of the debt repayments in 2013 ($10 million). Loss on Extinguishment of Debt. During 2013, we prepaid approximately $10 million of principal of Private Debt, $24 million of principal of Public Debt and $225 million of principal of the term credit agreement. These prepayments resulted in a $4 million loss. Provision (Benefit) for Income Taxes. The provision for income taxes was $8 million for income taxes in 2014 compared to a benefit for income taxes of $1 million in 2013. This $9 million increase in expense for income taxes was due primarily to higher earnings from real estate sales by our taxable REIT subsidiaries ($3 million), higher earnings from harvesting and log selling operations conducted by our taxable REIT subsidiaries ($3 million) and higher earnings from our manufacturing businesses ($2 million). Real estate sales are made by both our taxable REIT subsidiaries and various wholly-owned subsidiaries of our REIT depending upon the nature and characteristics of the timberlands being sold. Earnings increased for our harvesting and log selling operations due primarily to higher harvest volumes following our timberland acquisition from WestRock Company in December 2013. Higher earnings for our manufacturing businesses were due primarily to gains for insurance recoveries recognized during 2014 related to our MDF facility. See Note 20 of the Notes to Consolidated Financial Statements. Financial Condition and Liquidity Our cash flows from operations are impacted by the cyclical nature of the forest products industry and by general economic conditions in the United States, including interest rate levels and availability of financing. We generate cash primarily from sales of delivered logs and standing timber, sales of our finished manufactured wood products, and sales of our timberlands. Our principal cash requirements are primarily for: • expenditures for logging and hauling of logs, • employee compensation and related benefits, • purchases of logs, fiber and other raw materials used in our manufacturing facilities, • reforestation, silviculture, road construction and road maintenance on our timberlands, and • energy and operating expenditures to run our manufacturing facilities. Our Resources and Manufacturing Segments have significant uses of cash, and as a result, our operating income (excluding depletion and depreciation) approximates these Segments' operating cash flows. In contrast, our cash outflows in our Real Estate Segment are very small, and as a result, our revenues from this Segment approximate operating cash flows. In our Energy and Natural Resources Segment, cash may be received in upfront payments but revenues will be recognized over several reporting periods (quarters or years). We have summarized our sources and uses of cash in a table later in this section. Net cash provided by operating activities for 2015 was $463 million compared to $457 million for 2014. This increase of $6 million was due primarily to higher proceeds from real estate sales ($26 million) and a positive working capital change ($20 million), offset in part by lower earnings before depletion and depreciation by our Resources and Manufacturing Segments ($45 million). We also prepare annual Segment comparisons of Adjusted EBITDA, which is a supplemental non-GAAP measure of operating performance and liquidity. Adjusted EBITDA for 2015 was $579 million compared to Adjusted EBITDA of $605 million for 2014. See Performance and Liquidity Measures (Non-GAAP Measures) later in this section. We ended 2015 with a strong balance sheet; we had a cash balance of $88 million and availability on our line of credit of $280 million. PLUM CREEK 2015 FORM 10-K | 54 PART II / ITEM 7 Cash Flow The following table summarizes total cash flows for operating, investing and financing activities for the years ended December 31 (in millions): Cash Flows from Operating Activities (2015). Net cash provided by operating activities for the year ended December 31, 2015 totaled $463 million compared to $457 million for 2014. This increase of $6 million was due primarily to higher proceeds from real estate sales ($26 million) and a positive working capital change ($20 million), offset in part by lower operating income from both of our Resources and Manufacturing Segments ($45 million). See Results of Operations for a discussion of factors impacting our operating income for our Resources and Manufacturing Segments and proceeds for our Real Estate Segment. Working capital was favorably impacted due primarily to changes in our outstanding accounts receivable balances ($15 million) and our inventory balances ($10 million). During 2014, our accounts receivable balance increased due primarily to improving prices for nearly all of the products we sell and higher product sales due to recent acquisitions, whereas during 2015 our accounts receivable balance decreased due primarily to the deferral of southern sawlog sales as a result of weak markets. At December 31, 2013, our inventory balance was unusually low due primarily to harsh weather conditions which limited log deliveries, whereas inventories were restored to normal levels as of December 31, 2014, but were lower again at December 31, 2015 due to the closure of our Idaho remanufacturing facility. Cash Flows from Operating Activities (2014). Net cash provided by operating activities for the year ended December 31, 2014 totaled $457 million compared to $404 million in 2013. The increase of $53 million was due primarily to improved earnings before depletion from our Resources and Energy and Natural Resources Segments ($67 million) and lower expenditures for the purchase of timber deeds ($18 million), offset in part by higher payments for interest expense ($25 million) and an increase in pension contributions ($9 million). See Results of Operations for a discussion of factors impacting operating income for our Resources and Energy and Natural Resources Segments and for a discussion of changes in interest expense. In March 2013, the company acquired, for $18 million, approximately 0.9 million tons of standing timber under a timber deed that expires in 2020. No timber deeds were acquired in 2014 or 2015. The volume acquired under a timber deed, along with future growth, is harvested over the term of the deed. The timber deed purchase price has been reflected in our Consolidated Statements of Cash Flows as an outflow under Cash Provided by Operating Activities. Capital Expenditures. Capital expenditures were as follows for the years ended December 31 (in millions): Capital expenditures for 2015 (excluding timberland acquisitions) were $84 million and include approximately $68 million for our timberlands, $8 million for our manufacturing facilities, $2 million for our real estate development projects, and $6 million for investments in information technology. The timberland expenditures are primarily for reforestation and other expenditures associated with the planting and growing of trees. Approximately 55% of planned capital expenditures in 2015 were discretionary, primarily expenditures for silviculture. Capital expenditures at our manufacturing facilities consist primarily of expenditures to sustain operating activities. Expenditures for Real Estate Development are included in Other Operating Activities, net on the Consolidated Statements of Cash Flows. Assuming PLUM CREEK 2015 FORM 10-K | 55 PART II / ITEM 7 the merger with Weyerhaeuser is consummated (expected to close on February 19, 2016) future capital expenditures will be at the discretion of Weyerhaeuser's management. During 2014, we incurred a fire loss at our MDF facility. Included in 2014 capital expenditures above are approximately $12 million of capital expenditures that we incurred to rebuild or replace the damaged building and equipment. The majority of the capital expenditures for the MDF fire loss were spent in 2014 and there were no significant costs in 2015 for this project. Timberland Acquisitions. During 2015, we acquired approximately 7,000 acres of timberlands located in Maine for $7 million. The purchase was funded with cash and has been accounted for as an asset acquisition. There were no significant timberland acquisitions in 2014. During 2013, we acquired approximately 501,000 acres of timberlands in Alabama, Georgia, South Carolina, Virginia, and West Virginia from WestRock Company (formerly MeadWestvaco Corporation) for $869 million. This acquisition was accounted for as a business combination. Also during 2013, we acquired approximately 50,000 acres of timberlands primarily located in Georgia and Alabama for a total of $81 million. These purchases of $81 million were financed primarily from the company's line of credit and have been accounted for as asset acquisitions. Real Estate Development Ventures. In connection with the timberland acquisition from WestRock Company the company and WestRock Company formed a limited liability company (MWV-Charleston Land Partners, LLC or “MWV-CLP”). Plum Creek contributed cash to MWV-CLP and WestRock Company contributed real estate development properties, which consisted of both residential and commercial properties currently under development (“Class A Properties”) and high-value development lands (“Class B Properties”). Plum Creek contributed $12 million in exchange for a 5% interest in Class A Properties and $140 million in exchange for a 50% interest in Class B Properties. WestRock Company contributed 22,000 acres of Class A Properties with an agreed upon value of $252 million in exchange for a 95% interest in Class A Properties and 87,000 acres of Class B Properties with an agreed upon value of $279 million in exchange for a 50% interest in Class B Properties. During 2015, the company’s ownership interest in the Class A Properties decreased to 3% from 4% at December 31, 2014, due to capital calls by MWV-CLP for which the company declined to participate. Plum Creek has agreed to make additional capital contributions to MWV-CLP with respect to the Class B Properties through the year 2020, with minimum required contributions of $4 million during 2016. Minerals. In connection with the timberland acquisition from WestRock Company in 2013, the company acquired certain proven and probable coal reserves valued at $50 million, along with related surface lease intangibles valued at $7 million. Mineral Rights Acquisitions. In September 2013, we acquired mineral rights in approximately 255 million tons of aggregate reserves at four quarries in Georgia for approximately $156 million. We are entitled to an overriding royalty in connection with the gross proceeds from the sale of crushed stone from these quarries. The purchase was financed from our line of credit and has been accounted for as an asset acquisition. Future Cash Requirements. If the merger with Weyerhaeuser is not consummated, cash required to meet our future financial needs will be significant. We do not have any scheduled debt principal payments in 2016. PLUM CREEK 2015 FORM 10-K | 56 PART II / ITEM 7 Sources and Uses of Cash. The following table summarizes our sources and uses of cash for the years ended December 31 (in millions): (A) Calculated from the Consolidated Statements of Cash Flows by adding Depreciation, Depletion and Amortization, Basis of Real Estate Sold, Earnings from Unconsolidated Entities, Loss on Extinguishment of Debt, Deferred Income Taxes, Realized Gains from Sale of Marketable Securities and Other Operating Activities (excluding Expenditures for Real Estate Development - see discussion in Footnote D below) to Net Income. (B) In 2013 we acquired timberland, minerals and wind power leases from WestRock Company along with acquiring an equity interest in approximately 109,000 acres of high-value rural and development quality lands. The total purchase price for the WestRock Company assets was approximately $1.1 billion, which consisted of $226 million in cash ($221 million in cash after considering post-closing adjustments) and an installment note payable of $860 million. The table above includes the $860 million as an Increase in Debt Obligations and as part of the Acquisition of MeadWestvaco Timberland Assets. In our Consolidated Statements of Cash Flows, these amounts are presented as Non-Cash Investing and Financing Activities. (C) From the Consolidated Statements of Cash Flows, Other Investing Activities and Other Financing Activities. (D) Capital Expenditures include Real Estate Development costs (see Capital Expenditures section above for calculation). Expenditures for Real Estate Development are included in Other Operating Activities, net on the Consolidated Statements of Cash Flows. PLUM CREEK 2015 FORM 10-K | 57 PART II / ITEM 7 For 2014, Capital Expenditures in the table above are presented net of $10 million of insurance recoveries received to rebuild / replace the building and equipment damaged by the fire at our MDF facility in 2014. (E) Calculated from the Consolidated Statements of Cash Flows by adding Investments in Assets Held in Grantor Trust and Sales of Marketable Securities Held in Grantor Trust. Borrowings Debt Financing. We strive to maintain a balance sheet that provides the financial flexibility to pursue our strategic objectives. In order to maintain this financial flexibility, our objective is to maintain an investment grade credit rating. This is reflected in our moderate use of debt, established access to credit markets and no material covenant restrictions in our debt agreements that would prevent us from prudently using debt capital. All of our borrowings, except for the Note Payable to Timberland Venture, are made by Plum Creek Timberlands, L.P., the company's wholly-owned operating partnership (“the Partnership”). Furthermore, all of the outstanding indebtedness of the Partnership is unsecured. Line of Credit. On December 28, 2015, we amended our $700 million revolving line of credit agreement that matures on January 15, 2019, increasing the borrowing capacity to $800 million. Subject to customary covenants, the line of credit allows for borrowings from time to time up to $800 million, including up to $60 million of standby letters of credit. Borrowings on the line of credit fluctuate daily based on cash needs. The interest rate on the line of credit is currently LIBOR plus 1.25%, including the facility fee. This rate can range from LIBOR plus 1% to LIBOR plus 2% depending on our debt ratings. The weighted-average interest rate for the borrowings on the line of credit was 1.63% and 1.34% as of December 31, 2015 and December 31, 2014, respectively. As of December 31, 2015, we had $519 million of borrowings and $1 million of standby letters of credit outstanding; $280 million remained available for borrowing under our line of credit. As of January 5, 2016, $85 million of the borrowings under our line of credit was repaid. Term Credit Agreement. The company has a $225 million term credit agreement that matures on April 3, 2019. The interest rate on the term credit agreement was 1.92% and 1.67% as of December 31, 2015 and 2014, respectively. The interest rate on the term credit agreement is based on LIBOR plus 1.50%. After giving effect to patronage distributions, the effective net interest rate on the term loan was approximately 1% as of both December 31, 2015 and 2014. See "Patronage" below. The term loan agreement is subject to covenants that are substantially the same as those of our revolving line of credit. The term credit agreement allows for prepayment of the borrowings at any time prior to the maturity date without premium or penalty. Senior Notes. As of December 31, 2015, the company had publicly issued and outstanding approximately $894 million aggregate principal amount of Senior Notes (“Public Debt”). The Public Debt is issued by the Partnership and is fully and unconditionally guaranteed by Plum Creek Timber Company, Inc. This amount includes $569 million of 4.70% Public Debt which matures in 2021 and $325 million of 3.25% Public Debt which matures in 2023. The Senior Notes are redeemable prior to maturity; however, they are subject to a premium on redemption, which is based upon interest rates of U.S. Treasury securities having similar average maturities. The premium that would have been due upon early retirement approximated $91 million at December 31, 2015 and $114 million at December 31, 2014. Plum Creek Timber Company, Inc. and the Partnership have filed a shelf registration statement with the Securities and Exchange Commission. Under the shelf registration statement, Plum Creek Timber Company, Inc., from time to time, may offer and sell any combination of preferred stock, common stock, depositary shares, warrants and guarantees, and the Partnership may from time to time, offer and sell debt securities. During 2013, the company repaid all of its privately placed borrowings with various lenders ("Private Debt"). See "Debt Principal Payments" below for a discussion of these payments. Installment Note Payable. The company has an $860 million installment note payable to MWV Community Development and Land Management, LLC ("MWV CDLM"), which was issued in connection with the acquisition of PLUM CREEK 2015 FORM 10-K | 58 PART II / ITEM 7 certain timberland assets. Following the acquisition, MWV CDLM pledged the installment note to certain banks in the farm credit system. The annual interest rate on the installment note is fixed at 5.207%. After giving effect to patronage distributions, the company's effective net interest rate on the installment note was approximately 4.5% as of December 31, 2015 and December 31, 2014. See “Patronage” below. During the ten-year term of the note, interest is paid semi-annually with the principal due upon maturity. The installment note matures on December 6, 2023, but may be extended at the request of the holder if the company at the time of the request intends to refinance all or a portion of the installment note for a term of five years or more. The installment note is generally not redeemable prior to maturity except in certain limited circumstances and could be subject to a premium on redemption. The installment note is subject to covenants similar to those of our revolving line of credit and term credit agreement. Note Payable to Timberland Venture. The company has a $783 million note payable to a timberland venture (a related party). The annual interest rate on the note payable is fixed at 7.375%. During the ten-year term of the note, interest is paid quarterly with the principal due upon maturity. The note matures on October 1, 2018 but may be extended until October 1, 2020 at the election of Plum Creek. The note is not redeemable prior to maturity. The note is structurally subordinated to all other indebtedness of the company at December 31, 2015. See Note 17 of the Notes to Consolidated Financial Statements. Patronage. The company receives patronage refunds under the term credit agreement and the installment note payable. Patronage refunds are distributions of profits from banks in the farm credit system, which are cooperatives that are required to distribute profits to their members. Patronage distributions, which are made in either cash or stock, are received in the year after they were earned. The company earned approximately $8 million of patronage during both 2015 and 2014. Patronage refunds are recorded as a reduction to interest expense in the year earned. Debt Principal Payments. The table below summarizes the debt principal payments made for the years ended December 31 (in millions): During 2015, we refinanced our $439 million 5.875% Senior Notes on our Line of Credit. The Line of Credit had a weighted-average interest rate of 1.63% at December 31, 2015. During 2013, the company prepaid approximately $10 million of principal of Private Debt, $24 million of principal of Public Debt and $225 million of principal of the term credit agreement. These prepayments resulted in a $4 million loss. The $4 million loss is classified as Loss on Extinguishment of Debt in the Consolidated Statements of Income. Debt Covenants. Our Senior Notes, Term Credit Agreement, Line of Credit and Installment Note Payable contain various restrictive covenants, none of which are expected to materially impact the financing of our ongoing operations. We are in compliance with all of our borrowing agreement covenants as of December 31, 2015. Our Term Credit Agreement, Line of Credit and Installment Note Payable require that we maintain certain interest coverage and maximum leverage ratios. We have no covenants and restrictions associated with changes in our debt ratings. Our Term Credit Agreement, Line of Credit and Installment Note Payable each contain a covenant restricting our ability to make any restricted payments, which includes dividend payments, if we are in default under our debt agreements. Furthermore, there are no material covenants associated with our Note Payable to Timberland Venture, and this indebtedness is not considered in computing any of our debt covenants since the debt is an obligation of Plum Creek Timber Company, Inc. and not the Partnership. PLUM CREEK 2015 FORM 10-K | 59 PART II / ITEM 7 Equity Dividends. On November 3, 2015, the Board of Directors declared a dividend of $0.44 per share, or approximately $77 million, that was paid on November 30, 2015 to stockholders of record on November 13, 2015. The primary factors considered by the Board in declaring the dividend amount were current quarter and full year cash flow and operating results, as measured by Funds from Operations (defined as net income plus non-cash charges for depletion, depreciation and amortization, and the cost basis of land sales), along with the amount of cash on hand. In addition, the Board also considers the following factors when determining dividends: the company's capital requirements; economic conditions; tax considerations; borrowing capacity; changes in the prices of, and demand for, our products; changes in our ability to sell timberlands at attractive prices; and the appropriate timing of timber harvests, acquisition and divestiture opportunities, stock repurchases, debt repayment and other means by which the company could deliver value to its stockholders. Assuming the merger with Weyerhaeuser is consummated (expected to close on February 19, 2016) future dividends will be at the discretion of Weyerhaeuser's Board of Directors. The merger with Weyerhaeuser is expected to become effective so Plum Creek stockholders will become Weyerhaeuser shareholders of record in time to receive the upcoming Weyerhaeuser cash dividend. This dividend is payable on March 18, 2016, to shareholders of record of Weyerhaeuser common shares at the close of business on March 8, 2016. Share Repurchases. Plum Creek's Board of Directors has authorized a common stock repurchase program that may be increased from time to time at the Board of Directors' discretion. Share repurchases after November 6, 2015 are generally restricted under the terms of the Merger Agreement. For the year ended December 31, 2015, we repurchased 2.5 million shares of common stock at a total cost of $100 million, or an average cost per share of $40.30. See Note 12 of the Notes to Consolidated Financial Statements. Other Information Accounting Standards Issued and Not Yet Implemented. Consolidation. In February 2015, the Financial Accounting Standards Board (FASB) issued ASU No. 2015-02, Amendments to the Consolidation Analysis (Topic 810). The new standard is effective for reporting periods beginning after December 15, 2015 and early adoption is permitted. The new standard seeks to improve specific areas of the consolidation guidance and reduce the number of consolidation models. Specific changes relate to how reporting entities evaluate whether (1) they should consolidate limited partnerships and similar entities, (2) fees paid to a decision maker or service provider are variable interests in a variable interests entity (VIE), and (3) variable interests in a VIE held by related parties of the reporting entity requires the reporting entity to consolidate the VIE. The company believes the adoption of this standard will not have a material impact on its financial position, results of operations or cash flows. Revenue from Contracts with Customers. In May 2014, the FASB issued Accounting Standards Update (ASU) No. 2014-09, Revenue from Contracts with Customers (Topic 606). The new standard is effective for reporting periods beginning after December 15, 2016 and early adoption is not permitted. The comprehensive new standard will supersede existing revenue recognition guidance, including industry-specific requirements, and require revenue to be recognized when promised goods or services are transferred to customers in amounts that reflect the consideration to which the company expects to be entitled in exchange for those goods or services. Adoption of the new rules could affect the timing of revenue recognition for certain transactions. In July 2015, the FASB deferred the effective date of the standard by one year, and as such, the standard will now be effective for Plum Creek in the first quarter of 2018; however, entities are allowed to adopt one year earlier if they choose (i.e., the original effective date). The guidance permits two implementation approaches: (1) a retrospective application of the new standard with restatement of prior years; or (2) a modified retrospective basis whereby the new standard would be applied to new contracts and existing contracts with remaining performance obligations as of the effective date, with a cumulative catch-up adjustment recorded to beginning retained earnings. The company is currently evaluating the impact that adoption of this standard will have on our consolidated financial statements and disclosures, and the implementation approach to be used. PLUM CREEK 2015 FORM 10-K | 60 PART II / ITEM 7 Performance and Liquidity Measures (Non-GAAP Measures) For a discussion of the factors impacting our operating performance, see the discussion included in this Item under Results of Operations. For a discussion of the factors impacting our liquidity, see the discussion included previously in Item 7 under Financial Condition and Liquidity. We have included the following Non-GAAP measurements because we believe these are commonly used by investors, lenders and rating agencies to assess our financial performance. Adjusted EBITDA. We define Adjusted EBITDA as earnings from continuing operations, excluding Equity Earnings from the Timberland Venture, and before interest expense (including any gains or losses from extinguishment of debt), taxes, depreciation, depletion, amortization, and basis in real estate sold. In addition to including Equity Earnings or Loss from Real Estate Development Ventures in Adjusted EBITDA, we also include, as an add back to Operating Income for the Other Segment, our proportional share of depreciation, depletion, amortization, and basis in real estate sold from this equity method investment. Adjusted EBITDA is not considered a measure of financial performance under U.S. generally accepted accounting principles (U.S. GAAP) and the items excluded from Adjusted EBITDA are significant components of our consolidated financial statements. We present Adjusted EBITDA as a supplemental performance measure because we believe it facilitates operating performance comparisons from period to period, and each business segment’s contribution to that performance, by eliminating non-cash charges to earnings, which can vary significantly by business segment. These non-cash charges include timber depletion, depreciation of fixed assets and the basis in real estate sold. We also use Adjusted EBITDA as a supplemental liquidity measure because we believe it is useful in measuring our ability to generate cash. In addition, we believe Adjusted EBITDA is commonly used by investors, lenders and rating agencies to assess our financial performance. The following table compares Adjusted EBITDA by segment for the years ended December 31 (in millions): PLUM CREEK 2015 FORM 10-K | 61 PART II / ITEM 7 The following schedules provide a reconciliation of Adjusted EBITDA to net income and net cash from operating activities, the most directly comparable U.S. GAAP performance and liquidity measures, for the years ended December 31 (in millions): (1) Includes Equity Earnings from Real Estate Development Ventures ($6 million) in Operating Income for the Other Segment, along with our proportional share of depreciation, depletion, amortization ($1 million), and basis in real estate sold ($18 million) from this equity method investment. (2) Includes reconciling items not allocated to segments for financial reporting purposes. PLUM CREEK 2015 FORM 10-K | 62 PART II / ITEM 7 (1) Includes Equity Earnings from Real Estate Development Ventures ($3 million) in Operating Income for the Other Segment, along with our proportional share of depreciation, depletion, amortization ($2 million), and basis in real estate sold ($13 million) from this equity method investment. (2) Includes reconciling items not allocated to segments for financial reporting purposes. PLUM CREEK 2015 FORM 10-K | 63 PART II / ITEM 7 (1) Includes a $4 million loss due to forest fire damages in the Northern Resources Segment. (2) Includes reconciling items not allocated to segments for financial reporting purposes. PLUM CREEK 2015 FORM 10-K | 64 PART II /

<s>[INST] This Report contains forwardlooking statements within the meaning of the Private Litigation Reform Act of 1995. Some of the forwardlooking statements can be identified by the use of forwardlooking words such as “believes,” “expects,” “may,” “will,” “should,” “seeks,” “approximately,” “intends,” “plans,” “estimates,” “projects,” “strategy,” or “anticipates,” or the negative of those words or other comparable terminology. Forwardlooking statements involve inherent risks and uncertainties. A number of important factors could cause actual results to differ materially from those described in the forwardlooking statements, including those factors described in “Risk Factors” under Item 1A in this Form 10K. Some factors include changes in governmental, legislative and environmental restrictions, catastrophic losses from fires, floods, windstorms, earthquakes, volcanic eruptions, insect infestations or diseases, as well as changes in economic conditions and competition in our domestic and export markets and other factors described from time to time in our filings with the Securities and Exchange Commission. In addition, factors that could cause our actual results to differ from those contemplated by our projected, forecasted, estimated or budgeted results as reflected in forwardlooking statements relating to our operations and business include, but are not limited to: the failure to meet our expectations with respect to our likely future performance; an unanticipated reduction in the demand for timber products and/or an unanticipated increase in supply of timber products; an unanticipated reduction in demand for higher and better use or nonstrategic timberlands; our failure to make strategic acquisitions or to integrate any such acquisitions effectively or, conversely, our failure to make strategic divestitures; and our failure to qualify as a real estate investment trust, or REIT. It is likely that if one or more of the risks materializes, or if one or more assumptions prove to be incorrect, the current expectations of Plum Creek and its management will not be realized. Forwardlooking statements speak only as of the date made, and neither Plum Creek nor its management undertakes any obligation to update or revise any forwardlooking statements. Organization of the Company In management’s discussion and analysis of financial condition and results of operations (Item 7 of this form), when we refer to “Plum Creek,” “the company,” “we,” “us,” or “our,” we mean Plum Creek Timber Company, Inc. and its consolidated subsidiaries. References to Notes to Consolidated Financial Statements refer to the Notes to the Consolidated Financial Statements of Plum Creek Timber Company, Inc. included in Item 8 of this Form 10K. Plum Creek Timber Company, Inc., a Delaware Corporation and a real estate investment trust, or “REIT”, for federal income tax purposes, is the parent company of Plum Creek Timberlands, L.P., a Delaware Limited Partnership (the “Operating Partnership” or “Partnership”), and Plum Creek Ventures I, LLC, a Delaware Limited Liability Company (“PC Ventures”). Plum Creek conducts substantially all of its activities through the Operating Partnership and various whollyowned subsidiaries of the Operating Partnership. The Operating Partnership has borrowed and has currently outstanding $2.5 billion principal amount of debt, including $894 million of publicly issued notes. PC Ventures has borrowed and has currently outstanding $783 million in principal amount of debt (“the Note Payable to Timberland Venture”) from an entity (“the Timberland Venture”) in which a subsidiary of the Operating Partnership has a common and preferred equity interest. See Note 17 of the Notes to Consolidated Financial Statements. PC Ventures used the proceeds from the borrowing to make a $783 million capital contribution to the Operating Partnership in exchange for a preferred equity interest in the Operating Partnership. PC Ventures has no other activities and the Operating Partnership has no ownership interest in PC Ventures. The Note Payable to Timberland Venture is an obligation of PC Ventures and not an obligation of the Operating Partnership. Therefore, any discussion of the Note Payable to Timberland Venture below is not applicable to the PLUM C [/INST] Negative. </s>

TOLL BROTHERS INC

2015-12-21

2015-10-31

ITEM 7. MANAGEMENT’S DISCUSSION AND ANALYSIS OF FINANCIAL CONDITION AND RESULTS OF OPERATIONS (“MD&A”) This discussion and analysis is based on, should be read together with, and is qualified in its entirety by, the consolidated financial statements and notes thereto included in Item 15(a)1 of this Form 10-K, beginning at page. It also should be read in conjunction with the disclosure under “Forward-Looking Statements” in Part 1 of this Form 10-K. When this report uses the words “we,” “us,” “our,” and the “Company,” they refer to Toll Brothers, Inc. and its subsidiaries, unless the context otherwise requires. References herein to fiscal year refer to our fiscal years ended or ending October 31. Unless otherwise stated in this report, net contracts signed represents a number or value equal to the gross number or value of contracts signed during the relevant period, less the number or value of contracts canceled during the relevant period, which includes contracts that were signed during the relevant period and in prior periods. OVERVIEW Our Business We design, build, market, and arrange financing for detached and attached homes in luxury residential communities. We cater to move-up, empty-nester, active-adult, age-qualified, and second-home buyers in the United States (“Traditional Home Building Product”). We also build and sell homes in urban infill markets through Toll Brothers City Living® (“City Living”). At October 31, 2015, we were operating in 19 states. In the five years ended October 31, 2015, we delivered 21,003 homes from 571 communities, including 5,525 homes from 352 communities in fiscal 2015. We are developing several land parcels for master planned communities in which we intend to build homes on a portion of the lots and sell the remaining lots to other builders. Two of these master planned communities are being developed 100% by us, and the remaining communities are being developed through joint ventures with other builders or financial partners. Over the past several years, we have acquired control of a number of land parcels as for-rent apartment projects, including two student housing sites, totaling approximately 7,450 units. These projects, which are located in the metro Boston to metro Washington, D.C. corridor, and Atlanta, are being developed or will be developed with partners under the brand names Toll Brothers Apartment Living, Toll Brothers Campus Living and Toll Brothers Realty Trust (the “Trust”). In February 2014, we acquired the home building business of Shapell Industries, Inc., a Delaware corporation (“Shapell”), for $1.49 billion in cash, net of cash acquired. Prior to the acquisition, Shapell designed, constructed, and marketed single-family detached and attached homes and developed land in master planned communities and neighborhoods throughout coastal Northern and Southern California. See “Acquisition” below for more information. In fiscal 2010, we formed Gibraltar Capital and Asset Management, LLC (“Gibraltar”) to invest in distressed real estate opportunities. Gibraltar focuses primarily on residential loans and properties, from unimproved land to partially and fully improved developments, as well as commercial opportunities. We operate our own land development, architectural, engineering, mortgage, title, landscaping, security monitoring, lumber distribution, house component assembly, and manufacturing operations. In addition, in certain markets, we develop land for sale to other builders, often through joint venture structures with other builders or with financial partners. We also develop, own, and operate golf courses and country clubs, which generally are associated with several of our master planned communities. We have investments in various unconsolidated entities. We have investments in joint ventures (i) to develop land for the joint venture participants and for sale to outside builders (“Land Development Joint Ventures”); (ii) to develop for-sale homes (“Home Building Joint Ventures”); (iii) to develop luxury for-rent residential apartments, commercial space and a hotel (“Rental Property Joint Ventures”); and (iv) to invest in a portfolio of distressed loans and real estate (“Structured Asset Joint Venture”). Financial Highlights In fiscal 2015, we recognized $4.17 billion of revenues and net income of $363.2 million, as compared to $3.91 billion of revenues and net income of $340.0 million in fiscal 2014. In fiscal 2015 and 2014, the value of net contracts signed was $4.96 billion (5,910 homes) and $3.90 billion (5,271 homes), respectively. The value of our backlog at October 31, 2015 was $3.50 billion (4,064 homes), as compared to our backlog at October 31, 2014 of $2.72 billion (3,679 homes). At October 31, 2015, we had $929.0 million of cash, cash equivalents, and marketable securities on hand and approximately $566.1 million for borrowing available under our $1.035 billion revolving credit facility (“Credit Facility”) that matures in August 2018. At October 31, 2015, we had $350.0 million of outstanding borrowings under the Credit Facility and had outstanding letters of credit of approximately $118.9 million. At October 31, 2015, our total equity and our debt to total capitalization ratio were $4.23 billion and 0.47 to 1:00, respectively, Acquisition On February 4, 2014, we completed our acquisition of Shapell Industries, Inc. (“Shapell”) pursuant to the Purchase and Sale Agreement (the “Purchase Agreement”) dated November 6, 2013, with Shapell Investment Properties, Inc. (“SIPI”). We acquired all of the equity interests in Shapell from SIPI for $1.49 billion net of cash acquired (the “Acquisition”). We acquired the single-family residential real property development business of Shapell, including a portfolio of approximately 4,950 home sites in California, some of which we have sold to other builders. The Acquisition provides us with a premier California land portfolio, including 11 active selling communities as of the acquisition date, in affluent, high-growth markets: the San Francisco Bay area, metro Los Angeles, Orange County, and the Carlsbad market. As part of the Acquisition, we assumed contracts to deliver 126 homes with an aggregate value of approximately $105.3 million. The Shapell operations have been fully integrated into our operations. We did not acquire the apartment and commercial rental properties owned and operated by Shapell (the “Shapell Commercial Properties”) or Shapell’s mortgage lending activities relating to its home building operations. Accordingly, the Purchase Agreement provides that SIPI will indemnify us for any loss arising out of or resulting from, among other things, (i) any liability (other than environmental losses, subject to certain exceptions) related to the Shapell Commercial Properties, and (ii) any liability (other than environmental losses, subject to certain exceptions) to the extent related to Shapell Mortgage, Inc. See Note 2, “Acquisition” of our consolidated financial statements for further details. Our Business Environment and Current Outlook We believe that, in fiscal 2012, the housing market began to recover from the significant slowdown that started in the fourth quarter of our fiscal year ended October 31, 2005. During fiscal 2012 and the first nine months of fiscal 2013, we saw a strong recovery in the number and value of new sales contracts signed. Beginning in the fourth quarter of fiscal 2013, we experienced a leveling in demand that continued through the second quarter of fiscal 2014, and was followed by a decline in demand in the third quarter of fiscal 2014. Since the third quarter of fiscal 2014, we have seen a strengthening in customer demand. In fiscal 2015, we signed 5,910 contracts with an aggregate value of $4.96 billion, compared to 5,271 contracts with an aggregate value of $3.90 billion in fiscal 2014. We are optimistic that the strengthening in customer demand will continue for the foreseeable future. We believe that, as the national economy improves and as the millennial generation comes of age, pent-up demand for homes will begin to be released. We believe that the demographics of the move-up, empty-nester, active-adult, age-qualified, and second-home upscale markets will provide us with the potential for growth in the coming decade. According to the U.S. Census Bureau (“Census Bureau”), the number of households earning $100,000 or more (in constant 2014 dollars) at September 2015 stood at 30.8 million, or approximately 24.7% of all U.S. households. This group has grown at three times the rate of increase of all U.S. households since 1980. According to Harvard University’s 2015 report, “The State of the Nation’s Housing,” demographic forces are likely to drive the addition of just under 1.2 million new households per year during the next decade. Housing starts, which encompass the units needed for household formations, second homes, and the replacement of obsolete or demolished units, have not kept pace with this projected household growth. According to the Census Bureau’s October 2015 New Residential Sales Report, new home inventory stands at a supply of just 5.5 months, based on current sales paces. If demand and pace increase significantly, the supply of 5.5 months could quickly be drawn down. During the period 1970 through 2007, total housing starts in the United States averaged approximately 1.6 million per year, while during the period 2008 through 2014, total housing starts averaged approximately 0.8 million per year according to the Census Bureau. We continue to believe that many of our communities are in desirable locations that are difficult to replace and in markets where approvals have been increasingly difficult to achieve. We believe that many of these communities have substantial embedded value that may be realized in the future as the housing recovery strengthens. Competitive Landscape The home building business is highly competitive and fragmented. We compete with numerous home builders of varying sizes, ranging from local to national in scope, some of which have greater sales and financial resources than we do. Sales of existing homes, whether by a homeowner or by a financial institution that has acquired a home through a foreclosure, also provide competition. We compete primarily on the basis of price, location, design, quality, service, and reputation. We also believe our financial stability, relative to many others in our industry, is a favorable competitive factor as more home buyers focus on builder solvency. In addition, there are fewer and more selective lenders serving our industry as compared to prior years and we believe that these lenders gravitate to the home building companies that offer them the greatest security, the strongest balance sheets, and the broadest array of potential business opportunities. Land Acquisition and Development Our business is subject to many risks, because of the extended length of time that it takes to obtain the necessary approvals on a property, complete the land improvements on it, and deliver a home after a home buyer signs an agreement of sale. In certain cases, we attempt to reduce some of these risks by utilizing one or more of the following methods: controlling land for future development through options (also referred to herein as “land purchase contracts” or “option and purchase agreements”), which enable us to obtain necessary governmental approvals before acquiring title to the land; generally commencing construction of a detached home only after executing an agreement of sale and receiving a substantial down payment from the buyer; and using subcontractors to perform home construction and land development work on a fixed-price basis. During fiscal 2015 and 2014, we acquired control of approximately 2,611 home sites (net of options terminated and home sites sold) and, approximately 3,936 home sites (net of options terminated and home sites sold), respectively. At October 31, 2015, we controlled approximately 44,253 home sites, as compared to approximately 47,167 home sites at October 31, 2014, and 48,628 home sites at October 31, 2013. In addition, at October 31, 2015, we expect to purchase approximately 3,600 additional home sites from several land development joint ventures in which we have an interest, at prices not yet determined. Of the approximately 44,253 total home sites that we owned or controlled through options at October 31, 2015, we owned approximately 35,872 and controlled approximately 8,381 through options. Of the 44,253 home sites, approximately 16,505 were substantially improved. In addition, at October 31, 2015, our Land Development Joint Ventures owned approximately 12,000 home sites (including 378 home sites included in the 8,381 controlled through options), and our Homebuilding Joint Ventures owned approximately 500 home sites. At October 31, 2015, we were selling from 288 communities, compared to 263 communities at October 31, 2014, and 232 communities at October 31, 2013. Customer Mortgage Financing We maintain relationships with a widely diversified group of mortgage financial institutions, many of which are among the largest in the industry. We believe that regional and community banks continue to recognize the long-term value in creating relationships with high-quality, affluent customers such as our home buyers, and these banks continue to provide such customers with financing. We believe that our home buyers generally are, and should continue to be, better able to secure mortgages due to their typically lower loan-to-value ratios and attractive credit profiles, as compared to the average home buyer. Nevertheless, in recent years, tightened credit standards have shrunk the pool of potential home buyers and hindered accessibility of or eliminated certain loan products previously available to our home buyers. Our home buyers continue to face stricter mortgage underwriting guidelines, higher down payment requirements, and narrower appraisal guidelines than in the past. In addition, some of our home buyers continue to find it more difficult to sell their existing homes as prospective buyers of their homes may face difficulties obtaining a mortgage. In addition, other potential buyers may have little or negative equity in their existing homes and may not be able or willing to purchase a larger or more expensive home. Toll Brothers Apartment Living/Toll Brothers Campus Living/Toll Brothers Realty Trust Over the past several years, we acquired control of a number of land parcels as for-rent apartment projects, including two student housing sites. At October 31, 2015, we controlled 20 land parcels as for-rent apartment projects containing approximately 7,450 units. These projects, which are located in the metro Boston to metro Washington, D.C. corridor and Atlanta, are being developed or will be developed with partners under the brand names Toll Brothers Apartment Living, Toll Brothers Campus Living and the Trust. A number of these sites were acquired by us as part of a larger purchase or were originally acquired to be developed as for-sale homes. At October 31, 2015, we had approximately 1,450 units in for-rent apartment projects that were occupied or ready for occupancy, 1,100 units in the lease-up stage, 1,400 units under active development, and 3,500 units in the planning stage. Of the 7,450 units at October 31, 2015, 3,950 were owned by joint ventures in which we have an interest; approximately 1,450 were owned by us; 1,700 were under contract to be purchased by us; and 350 were under a letter of intent. CONTRACTS AND BACKLOG The aggregate value of net sales contracts signed increased 27.2% in fiscal 2015, as compared to fiscal 2014, and 7.2% in fiscal 2014, as compared to fiscal 2013. The value of net sales contracts signed was $4.96 billion (5,910 homes) in fiscal 2015, $3.90 billion (5,271 homes) in fiscal 2014, and $3.63 billion (5,294 homes) in fiscal 2013. The increase in the aggregate value of net contracts signed in fiscal 2015, as compared to fiscal 2014, was the result of a 13.4% increase in the average value of each contract signed, and a 12.1% increase in the number of net contracts signed. The increase in the average value of each contract signed in fiscal 2015, as compared to fiscal 2014, was due primarily to a change in mix of contracts signed to more expensive areas and/or higher priced products and price increases.The increase in the number of net contracts signed in fiscal 2015, as compared to fiscal 2014, was primarily due to the continued recovery in the U.S. housing market in fiscal 2015. The demand we saw in fiscal 2015 has continued into the first quarter of fiscal 2016. In fiscal 2014, we signed 328 contracts at communities we acquired from Shapell. Excluding the net contracts signed at the communities acquired in the Acquisition, net contracts signed declined 6.6% in fiscal 2014 as compared to fiscal 2013. The decline in units was due to an overall softening of demand in fiscal 2014. Beginning in the fourth quarter of fiscal 2013, we experienced a leveling in demand that continued through the second quarter of fiscal 2014, declined in the third quarter of fiscal 2014 and strengthened in the fourth quarter of fiscal 2014. Fiscal 2014’s fourth-quarter, net signed contracts of 1,282 units rose 10%, compared to fiscal 2013’s fourth-quarter net signed contracts of 1,163 units. Backlog consists of homes under contract but not yet delivered to our home buyers (“backlog”). The value of our backlog at October 31, 2015, 2014, and 2013 was $3.50 billion (4,064 homes), $2.72 billion (3,679 homes), and $2.63 billion (3,679 homes), respectively. Approximately 96% of the homes in backlog at October 31, 2015 are expected to be delivered by October 31, 2016. The 28.8% increase in the value of homes in backlog at October 31, 2015, as compared to October 31, 2014, was due to a 27.2% increase in the value of net contracts signed in fiscal 2015, as compared to fiscal 2014, and the higher backlog at the beginning of fiscal 2015, as compared to the beginning of fiscal 2014, offset, in part, by a 6.6% increase in the aggregate value of our deliveries in fiscal 2015, as compared to the aggregate value of deliveries in fiscal 2014. The 3.4% increase in the value of homes in backlog at October 31, 2014, as compared to October 31, 2013, was due to the higher backlog at the beginning of fiscal 2014, as compared to the beginning of fiscal 2013, an increase in the value of net contracts signed in fiscal 2014, as compared to fiscal 2013, and backlog acquired in the Shapell acquisition, offset, in part, by the increase in the aggregate value of our deliveries in fiscal 2014, as compared to the aggregate value of deliveries in fiscal 2013. For more information regarding revenues, net contracts signed, and backlog by geographic segment, see “Segments” in this MD&A. CRITICAL ACCOUNTING POLICIES We believe the following critical accounting policies reflect the more significant judgments and estimates used in the preparation of our consolidated financial statements. Inventory Inventory is stated at cost unless an impairment exists, in which case it is written down to fair value in accordance with U.S. generally accepted accounting principles (“GAAP”). In addition to direct land acquisition, land development, and home construction costs, costs also include interest, real estate taxes, and direct overhead related to development and construction, which are capitalized to inventory during periods beginning with the commencement of development and ending with the completion of construction. For those communities that have been temporarily closed, no additional capitalized interest is allocated to the community’s inventory until it reopens, and other carrying costs are expensed as incurred. Once a parcel of land has been approved for development and we open the community, it can typically take four or more years to fully develop, sell, and deliver all the homes in that community. Longer or shorter time periods are possible depending on the number of home sites in a community and the sales and delivery pace of the homes in a community. Our master planned communities, consisting of several smaller communities, may take up to 10 years or more to complete. Because our inventory is considered a long-lived asset under GAAP, we are required to regularly review the carrying value of each of our communities and write down the value of those communities when we believe the values are not recoverable. Operating Communities: When the profitability of an operating community deteriorates, the sales pace declines significantly, or some other factor indicates a possible impairment in the recoverability of the asset, the asset is reviewed for impairment by comparing the estimated future undiscounted cash flow for the community to its carrying value. If the estimated future undiscounted cash flow is less than the community’s carrying value, the carrying value is written down to its estimated fair value. Estimated fair value is primarily determined by discounting the estimated future cash flow of each community. The impairment is charged to cost of revenues in the period in which the impairment is determined. In estimating the future undiscounted cash flow of a community, we use various estimates such as (i) the expected sales pace in a community, based upon general economic conditions that will have a short-term or long-term impact on the market in which the community is located and on competition within the market, including the number of home sites available and pricing and incentives being offered in other communities owned by us or by other builders; (ii) the expected sales prices and sales incentives to be offered in a community; (iii) costs expended to date and expected to be incurred in the future, including, but not limited to, land and land development costs, home construction costs, interest costs, and overhead costs; (iv) alternative product offerings that may be offered in a community that will have an impact on sales pace, sales price, building cost, or the number of homes that can be built in a particular community; and (v) alternative uses for the property, such as the possibility of a sale of the entire community to another builder or the sale of individual home sites. Future Communities: We evaluate all land held for future communities or future sections of operating communities, whether owned or optioned, to determine whether or not we expect to proceed with the development of the land as originally contemplated. This evaluation encompasses the same types of estimates used for operating communities described above, as well as an evaluation of the regulatory environment in which the land is located and the estimated probability of obtaining the necessary approvals, the estimated time and cost it will take to obtain those approvals, and the possible concessions that will be required to be given in order to obtain them. Concessions may include cash payments to fund improvements to public places such as parks and streets, dedication of a portion of the property for use by the public or as open space, or a reduction in the density or size of the homes to be built. Based upon this review, we decide (i) as to land under contract to be purchased, whether the contract will likely be terminated or renegotiated, and (ii) as to land we own, whether the land will likely be developed as contemplated or in an alternative manner, or should be sold. We then further determine whether costs that have been capitalized to the community are recoverable or should be written off. The write-off is charged to cost of revenues in the period in which the need for the write-off is determined. The estimates used in the determination of the estimated cash flows and fair value of both current and future communities are based on factors known to us at the time such estimates are made and our expectations of future operations and economic conditions. Should the estimates or expectations used in determining estimated fair value deteriorate in the future, we may be required to recognize additional impairment charges and write-offs related to current and future communities. We provided for inventory impairment charges and the expensing of costs that we believed not to be recoverable in each of the three fiscal years ended October 31, 2015, 2014, and 2013, as shown in the table below (amounts in thousands): The table below provides, for the periods indicated, the number of operating communities that we reviewed for potential impairment, the number of operating communities in which we recognized impairment charges, the amount of impairment charges recognized, and, as of the end of the period indicated, the fair value of those communities, net of impairment charges ($ amounts in thousands): Income Taxes - Valuation Allowance Significant judgment is applied in assessing the realizability of deferred tax assets. In accordance with GAAP, a valuation allowance is established against a deferred tax asset if, based on the available evidence, it is more likely than not that such asset will not be realized. The realization of a deferred tax asset ultimately depends on the existence of sufficient taxable income in either the carryback or carryforward periods under tax law. We assess the need for valuation allowances for deferred tax assets based on GAAP’s “more-likely-than-not” realization threshold criteria. In our assessment, appropriate consideration is given to all positive and negative evidence related to the realization of the deferred tax assets. Forming a conclusion that a valuation allowance is not needed is difficult when there is significant negative evidence such as cumulative losses in recent years. This assessment considers, among other matters, the nature, consistency, and magnitude of current and cumulative income and losses, forecasts of future profitability, the duration of statutory carryback or carryforward periods, our experience with operating loss and tax credit carryforwards being used before expiration, and tax planning alternatives. Our assessment of the need for a valuation allowance on our deferred tax assets includes assessing the likely future tax consequences of events that have been recognized in our consolidated financial statements or tax returns. Changes in existing tax laws or rates could affect our actual tax results, and our future business results may affect the amount of our deferred tax liabilities or the valuation of our deferred tax assets over time. Our accounting for deferred tax assets represents our best estimate of future events. Due to uncertainties in the estimation process, particularly with respect to changes in facts and circumstances in future reporting periods (carryforward period assumptions), actual results could differ from the estimates used in our analysis. Our assumptions require significant judgment because the residential home building industry is cyclical and is highly sensitive to changes in economic conditions. If our results of operations are less than projected and there is insufficient objectively verifiable positive evidence to support the more-likely-than-not realization of our deferred tax assets, a valuation allowance would be required to reduce or eliminate our deferred tax assets. Our deferred tax assets consist principally of the recognition of losses primarily driven by inventory impairments and impairments of investments in unconsolidated entities. In accordance with GAAP, we assess whether a valuation allowance should be established based on our determination of whether it was more likely than not that some portion or all of the deferred tax assets would not be realized. At October 31, 2015 and 2014, we determined that it was more-likely-than-not that our deferred assets would be realized for federal purposes. Accordingly, at October 31, 2015 and 2014, we did not record any valuation allowances against our federal deferred tax assets. We file tax returns in the various states in which we do business. Each state has its own statutes regarding the use of tax loss carryforwards. Some of the states in which we do business do not allow for the carryforward of losses, while others allow for carryforwards for five years to 20 years. For state tax purposes, due to past and projected losses in certain jurisdictions where we do not have carryback potential and/or cannot sufficiently forecast future taxable income, we recognized net cumulative valuation allowances against our state deferred tax assets at October 31, 2015 and 2014. During fiscal 2015, 2014, and 2013, due to improved actual and/or operating results, we reversed $16.3 million, $13.3 million, and $4.6 million of state deferred tax asset valuation allowance, respectively. In addition, we establish valuation allowances for newly created deferred tax assets in certain jurisdictions where it is more-likely-than-not that the deferred tax asset would not be realized. During fiscal 2015, 2014, and 2013, we recognized new valuation allowances of $3.7 million, $1.3 million, and $3.2 million, respectively. We will continue to review our deferred tax assets in accordance with ASC 740. The valuation allowance at October 31, 2015 of $31.1 million relates to deferred tax assets in states that had not met the “more-likely-than-not” realization threshold criteria. Revenue and Cost Recognition Revenues and cost of revenues from home sales are recorded at the time each home is delivered and title and possession are transferred to the buyer. For our standard attached and detached homes, land, land development, and related costs, both incurred and estimated to be incurred in the future, are amortized to the cost of homes closed based upon the total number of homes to be constructed in each community. Any changes resulting from a change in the estimated number of homes to be constructed or in the estimated costs subsequent to the commencement of delivery of homes are allocated to the remaining undelivered homes in the community. Home construction and related costs are charged to the cost of homes closed under the specific identification method. For our master planned communities, the estimated land, common area development, and related costs, including the cost of golf courses, net of their estimated residual value, are allocated to individual communities within a master planned community on a relative sales value basis. Any changes resulting from a change in the estimated number of homes to be constructed or in the estimated costs are allocated to the remaining home sites in each of the communities of the master planned community. For high-rise/mid-rise projects, land, land development, construction, and related costs, both incurred and estimated to be incurred in the future, are generally amortized to the cost of units closed based upon an estimated relative sales value of the units closed to the total estimated sales value. Any changes resulting from a change in the estimated total costs or revenues of the project are allocated to the remaining units to be delivered. Forfeited customer deposits: Forfeited customer deposits are recognized in other income-net in our Consolidated Statements of Operations and Comprehensive Income in the period in which we determine that the customer will not complete the purchase of the home and we have the right to retain the deposit. Sales Incentives: In order to promote sales of our homes, we grant our home buyers sales incentives from time-to-time. These incentives will vary by type of incentive and by amount on a community-by-community and home-by-home basis. Incentives that impact the value of the home or the sales price paid, such as special or additional options, are generally reflected as a reduction in sales revenues. Incentives that we pay to an outside party, such as paying some or all of a home buyer’s closing costs, are recorded as an additional cost of revenues. Incentives are recognized at the time the home is delivered to the home buyer and we receive the sales proceeds. Warranty and Self-Insurance Warranty: We provide all of our home buyers with a limited warranty as to workmanship and mechanical equipment. We also provide many of our home buyers with a limited 10-year warranty as to structural integrity. We accrue for expected warranty costs at the time each home is closed and title and possession are transferred to the home buyer. Warranty costs are accrued based upon historical experience. Adjustments to our warranty liabilities related to homes delivered in prior years are recorded in the period in which a change in our estimate occurs. Self-Insurance: We maintain, and require the majority of our subcontractors to maintain, general liability insurance (including construction defect and bodily injury coverage) and workers’ compensation insurance. These insurance policies protect us against a portion of our risk of loss from claims related to our home building activities, subject to certain self-insured retentions, deductibles and other coverage limits (“self-insured liability”). We also provide general liability insurance for our subcontractors in Arizona, California, Nevada and Washington, where eligible subcontractors are enrolled as insureds under our general liability insurance policies in each community in which they perform work. For those enrolled subcontractors, we absorb their general liability associated with the work performed on our homes within the applicable community as part of our overall general liability insurance and our self-insurance through our captive insurance subsidiary. We record expenses and liabilities based on the estimated costs required to cover our self-insured liability and the estimated costs of potential claims and claim adjustment expenses that are above our coverage limits or that are not covered by our insurance policies. These estimated costs are based on an analysis of our historical claims and industry data, and include an estimate of claims incurred but not yet reported (“IBNR”). We engage a third-party actuary that uses our historical claim and expense data, input from our internal legal and risk management groups, as well as industry data, to estimate our liabilities related to unpaid claims, IBNR associated with the risks that we are assuming for our self-insured liability and other required costs to administer current and expected claims. These estimates are subject to uncertainty due to a variety of factors, the most significant being the long period of time between the delivery of a home to a home buyer and when a structural warranty or construction defect claim is made, and the ultimate resolution of the claim. Though state regulations vary, construction defect claims are reported and resolved over a prolonged period of time, which can extend for 10 years or longer. As a result, the majority of the estimated liability relates to IBNR. Adjustments to our liabilities related to homes delivered in prior years are recorded in the period in which a change in our estimate occurs. The projection of losses related to these liabilities requires actuarial assumptions that are subject to variability due to uncertainties regarding construction defect claims relative to our markets and the types of product we build, insurance industry practices and legal or regulatory actions and/or interpretations, among other factors. Key assumptions used in these estimates include claim frequencies, severities and settlement patterns, which can occur over an extended period of time. In addition, changes in the frequency and severity of reported claims and the estimates to settle claims can impact the trends and assumptions used in the actuarial analysis, which could be material to our consolidated financial statements. Due to the degree of judgment required, the potential for variability in these underlying assumptions, our actual future costs could differ from those estimated, and the difference could be material to our consolidated financial statements. OFF-BALANCE SHEET ARRANGEMENTS We also operate through a number of joint ventures. These joint ventures (i) develop land for the joint venture participants and for sale to outside builders (“Land Development Joint Ventures”); (ii) develop for-sale homes (“Home Building Joint Ventures”); (iii) develop luxury for-rent residential apartments, commercial space and a hotel (“Rental Property Joint Ventures”); and (iv) invest in a portfolio of distressed loans and real estate (“Structured Asset Joint Venture”). We earn construction and management fee income from many of these joint ventures. Our investments in these entities are accounted for using the equity method of accounting. We are a party to several joint ventures with unrelated parties to develop and sell land that is owned by the joint venture. We recognize our proportionate share of the earnings from the sale of home sites to other builders, including our joint venture partners. We do not recognize earnings from the home sites we purchase from these ventures, but reduce our cost basis in the home sites by our share of the earnings from those home sites. At October 31, 2015, we had investments in these entities of $412.9 million, and were committed to invest or advance up to an additional $195.6 million to these entities if they require additional funding. At October 31, 2015, we had an understanding to acquire 378 home sites from one of these Land Development Joint Ventures for an estimated aggregate purchase price of $136.3 million. In addition, we expect to purchase approximately 3,600 additional home sites from several joint ventures in which we have interests; the purchase price of these home sites will be determined at a future date. We invested in a joint venture in which we have a 50% voting interest to develop 400 Park Avenue South, a high-rise luxury for-sale/rental project in New York City. Pursuant to the terms of the joint venture agreement, with the completion of the construction of the building’s structure in the third quarter of fiscal 2015, we acquired, with no additional consideration due from us, ownership of the top 18 floors of the building to sell, for our own account, luxury condominium units. Our partner received ownership of the lower floors containing residential rental units and retail space, with no additional consideration due from them. Upon our acquisition of the top 18 floors of the building, we transferred our investment of $132.3 million in this joint venture from “Investments in unconsolidated entities” on our Consolidated Balance Sheets to “Inventory.” The unconsolidated entities in which we have investments generally finance their activities with a combination of partner equity and debt financing. In some instances, we and our partners have guaranteed debt of certain unconsolidated entities. These guarantees may include any or all of the following: (i) project completion guarantees, including any cost overruns; (ii) repayment guarantees, generally covering a percentage of the outstanding loan; (iii) guarantees of indemnities provided to the lender by the unconsolidated entity with regard to environmental matters; (iv) a hazardous material indemnity that holds the lender harmless for any liability it may suffer from the threat or presence of any hazardous or toxic substances at or near the property covered by a loan; and (v) indemnification of the lender from “bad boy acts” of the unconsolidated entity. In some instances, the guarantees provided in connection with loans to an unconsolidated entity are joint and several. In these situations, we generally have a reimbursement agreement with our partner that provides that neither party is responsible for more than its proportionate share or agreed-upon share of the guarantee; however, if the joint venture partner does not have adequate financial resources to meet its obligations under the reimbursement agreement, we may be liable for more than our proportionate share. We believe that as of October 31, 2015, in the event we become legally obligated to perform under a guarantee of the obligation of an unconsolidated entity due to a triggering event, the collateral should be sufficient to repay a significant portion of the obligation. If it is not, we and our partners would need to contribute additional capital to the venture. At October 31, 2015, the unconsolidated entities that have guarantees related to debt had loan commitments aggregating $980.2 million and had borrowed an aggregate of $514.3 million. We estimate that our maximum potential exposure under these guarantees, if the full amount of the loan commitments were borrowed, would be $980.2 million, without taking into account any recoveries from the underlying collateral or any reimbursement from our partners. Based on the amounts borrowed at October 31, 2015, our maximum potential exposure under these guarantees is estimated to be $514.3 million, without taking into account any recoveries from the underlying collateral or any reimbursement from our partners. In addition, we have guaranteed approximately $10.3 million of ground lease payments and insurance deductibles for three joint ventures. For more information regarding these joint ventures, see Note 4, “Investments in Unconsolidated Entities” in the Notes to Consolidated Financial Statements in this Form 10-K. The trends, uncertainties or other factors that negatively impact our business and the industry in general also impact the unconsolidated entities in which we have investments. We review each of our investments on a quarterly basis for indicators of impairment. A series of operating losses of an investee, the inability to recover our invested capital, or other factors may indicate that a loss in value of our investment in the unconsolidated entity has occurred. If a loss exists, we further review to determine if the loss is other than temporary, in which case we write down the investment to its fair value. The evaluation of our investment in unconsolidated entities entails a detailed cash flow analysis using many estimates including but not limited to, expected sales pace, expected sales prices, expected incentives, costs incurred and anticipated, sufficiency of financing and capital, competition, market conditions and anticipated cash receipts, in order to determine projected future distributions. Each of the unconsolidated entities evaluates its inventory in a similar manner. In addition, for rental properties, we review rental trends, expected future expenses, and expected future cash flows to determine estimated fair values of the properties. See “Critical Accounting Policies - Inventory” contained in this MD&A for more detailed disclosure on our evaluation of inventory. If a valuation adjustment is recorded by an unconsolidated entity related to its assets, our proportionate share is reflected in income from unconsolidated entities with a corresponding decrease to our investment in unconsolidated entities. Based upon our evaluation of the fair value of our investments in unconsolidated entities, we determined that no impairments of our investments occurred in fiscal 2015, 2014 and 2013. RESULTS OF OPERATIONS The following table compares certain items in our Consolidated Statements of Operations and Comprehensive Income for fiscal 2015, 2014, and 2013 ($ amounts in millions): Note: Amounts may not add due to rounding. FISCAL 2015 COMPARED TO FISCAL 2014 REVENUES AND COST OF REVENUES Revenues in fiscal 2015 were higher than those for fiscal 2014 by approximately $259.6 million, or 6.6%. This increase was attributable to a 4.2% increase in the average price of the homes delivered and a 2.4% increase in the number of homes delivered. In fiscal 2015, we delivered 5,525 homes with a value of $4.17 billion, as compared to 5,397 homes in fiscal 2014 with a value of $3.91 billion. The increase in the number of homes delivered was principally due to a greater number of homes being sold and delivered in fiscal 2015, as compared to fiscal 2014. The increase in the average price of homes delivered was primarily attributable to a shift in the number of homes delivered to more expensive areas and/or products and increased selling prices of homes delivered in fiscal 2015, as compared to fiscal 2014. Cost of revenues as a percentage of revenues was 78.4% in fiscal 2015, as compared to 78.8% in fiscal 2014. In fiscal 2015 and 2014, we recognized inventory impairment charges of $35.7 million and $20.7 million, respectively. In addition, in fiscal 2015 and 2014 we recognized charges related to warranty and litigation, net of other reversals, of $11.0 million and $24.0 million, respectively. (See Note 7, “Accrued Expenses,” in the Notes to the Consolidated Financial Statements for more information on the warranty and litigation related charges). Cost of revenues as a percentage of revenues, excluding impairments and charges related to warranty and litigation, net of other reversals, was 77.3% of revenues in fiscal 2015, as compared to 77.6% in fiscal 2014. The decrease in cost of revenues as a percentage of revenues, excluding inventory impairment charges and charges related warranty and litigation, net of other reversals, in fiscal 2015, as compared to fiscal 2014, was due primarily to a change in product mix/areas to higher-margin areas, increased prices of homes delivered in fiscal 2015, as compared to fiscal 2014, and the lower impact of the application of purchase accounting from the homes delivered from the Acquisition in fiscal 2015, as compared to fiscal 2014. These decreases were offset, in part, by increased construction costs. In fiscal 2015, inventory write-offs of $22.3 million were attributable to operating communities, $12.6 million were attributable to land owned for future communities, and $0.8 million were attributable to land controlled for future communities. Inventory write-offs in fiscal 2014 of $17.6 million were attributable to operating communities and $3.1 million were attributable to land controlled for future communities. Interest cost in fiscal 2015 was $142.9 million or 3.4% of revenues, as compared to $137.5 million or 3.5% of revenues in fiscal 2014. SELLING, GENERAL AND ADMINISTRATIVE EXPENSES (“SG&A”) SG&A increased by $22.6 million in fiscal 2015, as compared to fiscal 2014. As a percentage of revenues, SG&A decreased to 10.9% in fiscal 2015, from 11.1% in fiscal 2014. Fiscal 2014 SG&A includes $6.1 million of expenses incurred in the Acquisition. The dollar increase in SG&A costs, excluding the acquisition costs, was due primarily to increased compensation costs due to our increased number of employees, and increased sales and marketing costs. The higher sales and marketing costs were the result of the increased spending on advertising and increased operating costs due to the increased number of selling communities that we had in fiscal 2015, as compared to fiscal 2014. INCOME FROM UNCONSOLIDATED ENTITIES We recognize our proportionate share of the earnings and losses from the various unconsolidated entities in which we have an investment. Many of our unconsolidated entities are land development projects or high-rise/mid-rise condominium construction projects, which do not generate revenues and earnings for a number of years during the development of the property. Once development is complete, these unconsolidated entities will generally, over a relatively short period of time, generate revenues and earnings until all of the assets of the entity are sold. Because there is not a steady flow of revenues and earnings from these entities, the earnings recognized from these entities will vary significantly from quarter to quarter and year to year. In fiscal 2015, we recognized $21.1 million of income from unconsolidated entities, as compared to $41.1 million in fiscal 2014. The decrease in income from unconsolidated entities was due primarily to our recognition of a $23.5 million gain representing our share of the gain on the sale by Toll Brothers Realty Trust II (“Trust II”) of substantially all of its assets to an unrelated party in December 2013 and a $12.0 million distribution from the Trust in April 2014 due to the refinancing of one of the Trust’s apartment properties. This was offset, in part, by higher income realized from several of our Land Development Joint Ventures and one Home Building Joint Venture in fiscal 2015, as compared to fiscal 2014. The higher income from these joint ventures was attributable primarily to higher sales activity and/or price increases in fiscal 2015, as compared to fiscal 2014. OTHER INCOME - NET The table below provides the components of “Other Income - net” for the years ended October 31, 2015 and 2014 (amounts in thousands): In fiscal 2015, our security monitoring business recognized an $8.1 million gain from a bulk sale of security monitoring accounts, which is included in income from ancillary businesses above. The decrease in income from Gibraltar’s operations in fiscal 2015, as compared to fiscal 2014, was primarily due to a reduction in gains recognized from the disposition of real estate owned (“REO”) and from the acquisition of REO through foreclosure. The increase in management fee income in fiscal 2015, as compared to fiscal 2014, was primarily due to the increase in activity from the unconsolidated entities that we manage. The decrease in income from land sales was due to fewer land parcels being available for sale in fiscal 2015, as compared to fiscal 2014. INCOME BEFORE INCOME TAXES In fiscal 2015, we reported income before income taxes of $535.6 million, as compared to $504.6 million in fiscal 2014. INCOME TAX PROVISION We recognized a $172.4 million income tax provision in fiscal 2015. The tax provision in fiscal 2015 included the reversal of $16.3 million of state deferred tax asset valuation allowances and the recording of $3.7 million of new state tax deferred asset valuation allowances. See “Critical Accounting Policies - Income Taxes - Valuation Allowance” in this MD&A for information regarding the reversal of valuation allowances against our net deferred tax assets. Excluding the changes in the deferred tax valuation allowances, we recognized a $185.0 million tax provision in fiscal 2015. Based upon the federal statutory rate of 35%, our federal tax provision would have been $187.4 million. The difference between our tax provision recognized, excluding the changes in the deferred tax valuation allowance, and the tax provision based on the federal statutory rate was due mainly to the reversal of $15.3 million of previously accrued tax provisions on uncertain tax positions that were no longer necessary due to the expiration of the statute of limitations and settlements with certain taxing jurisdictions; a $12.3 million tax benefit from the utilization of domestic production activities deductions; and $7.8 million of other permanent deductions; offset, in part, by the recognition of a $21.9 million provision for state income taxes; the recognition of a $3.2 million provision for uncertain tax positions taken; $2.6 million of accrued interest and penalties for previously accrued taxes on uncertain tax positions; and $5.3 million of other differences. We recognized a $164.6 million income tax provision in fiscal 2014. The tax provision in fiscal 2014 included the reversal of $13.3 million of state deferred tax asset valuation allowances and the recording of $1.3 million of new state tax deferred asset valuation allowances. Excluding the changes in the deferred tax valuation allowances, we recognized a $176.5 million tax provision in fiscal 2014. Based upon the federal statutory rate of 35%, our federal tax provision would have been $176.6 million. The difference between our tax provision recognized, excluding the changes in the deferred tax valuation allowance, and the tax provision based on the federal statutory rate was due principally to the reversal of $11.0 million of previously accrued tax provisions on uncertain tax positions that were no longer necessary due to the expiration of the statute of limitations and the settlement of state income tax audits; a $14.8 million tax benefit from our utilization of domestic production activities deductions; and a $6.2 million tax benefit related to other miscellaneous permanent deductions, offset, in part, by a $23.8 million provision for state income taxes; the recognition of a $5.7 million provision for uncertain tax positions taken; and $1.8 million of accrued interest and penalties for previously accrued taxes on uncertain tax positions. FISCAL 2014 COMPARED TO FISCAL 2013 REVENUES AND COST OF REVENUES Revenues in fiscal 2014 were higher than those for fiscal 2013 by approximately $1.24 billion, or 46.3%. This increase was attributable to a 29.0% increase in the number of homes delivered and a 13.4% increase in the average price of the homes delivered. In fiscal 2014, we delivered 5,397 homes with a value of $3.91 billion, as compared to 4,184 homes in fiscal 2013 with a value of $2.67 billion. The increase in the number of homes delivered in fiscal 2014, as compared to fiscal 2013, was primarily due to the 43.2% higher number of homes in backlog at the beginning of fiscal 2014, as compared to the beginning of fiscal 2013, and the backlog of homes acquired from Shapell in February 2014. The increase in the average price of homes delivered in fiscal 2014, as compared to fiscal 2013, was primarily attributable to a shift in the number of homes delivered to more expensive areas and/or products in fiscal 2014. Cost of revenues as a percentage of revenues was 78.8% in fiscal 2014, as compared to 79.8% in fiscal 2013. We recognized inventory impairment charges and write-offs of $20.7 million and $32.0 million in charges related to warranty and litigation in fiscal 2014 (See Note 7, “Accrued Expenses”, in the Notes to the Consolidated Financial Statements for more information on the warranty and litigation related charges). In fiscal 2013, we recognized inventory impairment charges and write-offs of $4.5 million. Cost of revenues as a percentage of revenues, excluding impairments and charges related to warranty and litigation, was 77.4% of revenues in fiscal 2014, as compared to 79.6% in fiscal 2013. The decrease in cost of revenues as a percentage of revenues, excluding inventory impairment charges and charges related warranty and litigation, in fiscal 2014, as compared to fiscal 2013, was due primarily to lower cost of land, construction and interest costs in fiscal 2014, as compared to fiscal 2013; offset, in part, by the impact on costs in fiscal 2014 from the application of purchase accounting on the homes delivered from the Acquisition. The lower cost of revenues as a percentage of revenues was the result of price increases in the October 31, 2013 backlog that exceeded cost increases on the homes delivered, and a change in product mix to higher margin communities. Interest cost in fiscal 2014 was $137.5 million or 3.5% of revenues, as compared to $112.3 million or 4.2% of revenues in fiscal 2013. SELLING, GENERAL AND ADMINISTRATIVE EXPENSES (“SG&A”) SG&A increased by $92.6 million in fiscal 2014, as compared to fiscal 2013. As a percentage of revenues, SG&A was 11.1% in fiscal 2014, as compared to 12.7% in fiscal 2013. The amounts for fiscal 2014 and 2013 include $6.1 million and $1.4 million of expenses incurred in connection with the Acquisition, respectively. The decline in SG&A, excluding the acquisition costs, as a percentage of revenues, was due to SG&A spending increasing by 25.4% while revenues increased 46.3%. The dollar increase in SG&A costs, excluding the acquisition costs, was due primarily to increased compensation costs due to our increased number of employees and higher sales commissions, increased sales and marketing costs, and increased insurance costs. The higher sales commissions and a portion of the increased marketing costs were the result of the increase in the number of homes delivered and the increased sales revenues in fiscal 2014 over fiscal 2013. INCOME FROM UNCONSOLIDATED ENTITIES We are a participant in several unconsolidated entities. We recognize our proportionate share of the earnings and losses from these entities. Many of our unconsolidated entities are land development projects or high-rise/mid-rise condominium construction projects and do not generate revenues and earnings for a number of years during the development of the property. Once development is complete, these unconsolidated entities will generally, over a relatively short period of time, generate revenues and earnings until all of the assets of the entity are sold. Because there is not a steady flow of revenues and earnings from these entities, the earnings recognized from these entities will vary significantly from quarter to quarter and year to year. In fiscal 2014, we recognized $41.1 million of income from unconsolidated entities, as compared to $14.4 million in fiscal 2013. The $26.7 million increase in income from unconsolidated entities in fiscal 2014, as compared to fiscal 2013, was due primarily to our recognition of a $23.5 million gain, representing our share of the gain on the sale by Trust II of substantially all of its assets to an unrelated party in December 2013, a $12.0 million distribution from the Trust in April 2014 due to the refinancing of one of the Trust’s apartment properties, and an increase in income from one of our home building joint ventures due to increased activity in fiscal 2014 as compared to fiscal 2013. These increases were offset, in part, by lower income realized from Gibraltar’s Structured Asset Joint Venture, lower income from our land development joint ventures due to decreased activity from these joint ventures in fiscal 2014 as compared to fiscal 2013, and a settlement of litigation at one of our unconsolidated entities resulting in a charge to our earnings of $2.6 million in the fourth quarter of fiscal 2014. OTHER INCOME - NET Other income - net includes the gains and losses from our ancillary businesses, income from Gibraltar, interest income, management fee income, retained customer deposits, income/losses on land sales, and other miscellaneous items. In fiscal 2014 and 2013, other income - net was $66.2 million and $52.2 million, respectively. Fiscal 2013 other income-net includes $13.2 million of income from the previously disclosed settlement of derivative litigation. Excluding these settlement proceeds, the increase in other income - net in fiscal 2014, as compared to fiscal 2013, was due to a $21.1 million increase in earnings from land sales, a $4.2 million increase in income from our Gibraltar operations, and a $4.4 million increase in management fee income in fiscal 2014, as compared to fiscal 2013. These increases were offset, in part, by lower interest income and miscellaneous income in fiscal 2014, as compared to fiscal 2013. The increase in income from land sales was due to our sale of land to reduce land concentration and outstanding borrowings as a result of the Acquisition. The increase in management fee income is the result of the increase in activity in the various joint ventures in which we have investments. INCOME BEFORE INCOME TAXES In fiscal 2014, we reported income before income taxes of $504.6 million, as compared to $267.7 million in fiscal 2013. INCOME TAX PROVISION We recognized a $164.6 million income tax provision in fiscal 2014. The tax provision in fiscal 2014 included the reversal of $13.3 million of state deferred tax asset valuation allowances and the recording of $1.3 million of new state tax deferred asset valuation allowances. See “Critical Accounting Policies - Income Taxes - Valuation Allowance” in this MD&A for information regarding the reversal of valuation allowances against our net deferred tax assets. Excluding the changes in the deferred tax valuation allowances, we recognized a $176.5 million tax provision in fiscal 2014. Based upon the federal statutory rate of 35%, our federal tax provision would have been $176.6 million. Our tax provision, excluding the changes in the deferred tax valuation allowance, included the recognition of a $23.8 million provision for state income taxes, the recognition of a $5.7 million provision for uncertain tax positions taken; and $1.8 million of accrued interest and penalties for previously accrued taxes on uncertain tax positions, offset, in part, by the reversal of $11.0 million of previously accrued tax provisions on uncertain tax positions that were no longer necessary due to the expiration of the statute of limitations and the settlement of state income tax audits; a $14.8 million tax benefit from our utilization of domestic production activities deductions; and a $6.2 million tax benefit related to other miscellaneous permanent deductions. We recognized an income tax provision of $97.1 million in fiscal 2013. The tax provision in fiscal 2013 included the reversal of $4.6 million of state deferred tax asset valuation allowances and the recording of $3.2 million of new state tax deferred asset valuation allowances. Excluding the changes in the deferred tax valuation allowances, we recognized a $98.4 million tax provision in fiscal 2013. Based upon the federal statutory rate of 35%, our federal tax provision would have been $93.7 million. The difference between the tax provision recognized and the tax provision based on the federal statutory rate was due primarily to an $11.4 million provision for state income taxes and $3.7 million of accrued interest and penalties, offset, in part, by the reversal of $5.6 million of previously accrued taxes and related interest. The reversal of previously accrued taxes and related interest on uncertain tax positions is due primarily to the expiration of the statute of limitations on these items. CAPITAL RESOURCES AND LIQUIDITY Funding for our business has been, and continues to be, provided principally by cash flow from operating activities before inventory additions, unsecured bank borrowings, and the public debt and equity markets. At October 31, 2015, we had $929.0 million of cash, cash equivalents, and marketable securities on hand and approximately $566.1 million available for borrowing under our Credit Facility. Cash provided by operating activities during fiscal 2015 was $60.2 million. It was generated primarily from $494.8 million of net income before stock-based compensation, depreciation and amortization, inventory impairments and write-offs, and deferred taxes; a $46.5 million increase in customer deposits; and an increase of $28.7 million in accounts payable and accrued expenses; offset, in part, by the net purchase of $352.0 million of inventory; a $65.5 million decrease in income taxes payable; a $55.6 million increase in receivables, prepaid expenses, and other assets; and an increase of $21.4 million in mortgage loans originated, net of the sale of mortgage loans to outside investors. Cash used in our investing activities during fiscal 2015 was $52.8 million. The cash used in investing activities was primarily related to $123.9 million used to fund investments in unconsolidated entities, $9.4 million for the purchase of property and equipment, offset, in part, by $77.4 million of cash received as returns on our investments in unconsolidated entities, foreclosed real estate, and distressed loans. We generated $325.3 million of cash from financing activities in fiscal 2015, primarily from the issuance of $350.0 million of 4.875% Senior Notes due 2025; $350.0 million of borrowing under our Credit Facility; and $39.5 million from the proceeds of our stock-based benefit plans, offset, in part, by the repayment of $300.0 million of senior notes; the repurchase of $56.9 million of our common stock; and the repayment of $55.0 million of other loans payable, net of new borrowings. At October 31, 2014, we had $598.3 million of cash, cash equivalents, and marketable securities on hand and approximately $940.2 million available for borrowing under our $1.035 billion revolving credit facility, which extends to August 2018. Cash provided by operating activities during fiscal 2014 was $313.2 million. It was generated primarily from $440.9 million of net income before stock-based compensation, depreciation and amortization, inventory impairments and write-offs, and deferred taxes; an $82.1 million increase in accounts payable and accrued expenses; and a $52.4 million increase in income taxes payable; offset, in part, by the net purchase of $272.0 million of inventory. Cash used in our investing activities during fiscal 2014 was $1.45 billion. The cash used in investing activities was primarily related to the $1.49 billion used to acquire Shapell, $113.0 million used to fund investments in unconsolidated entities, $15.1 million for the purchase of property and equipment, offset, in part, by $127.0 million of cash received as returns on our investments in unconsolidated entities, distressed loans, and foreclosed real estate, and $40.2 million of sales of marketable securities. We generated $952.2 million of cash from financing activities in fiscal 2014, primarily from the issuance of 7.2 million shares of our common stock in November 2013 that raised $220.4 million; $595.3 million from the issuance in November 2013 of $350.0 million of 4.0% Senior Notes due 2018 and $250.0 million of 5.625% Senior Notes due 2024; the borrowing of $500.0 million under a five-year term loan from a syndicate of eleven banks; and $28.4 million from the proceeds of our stock-based benefit plans, offset, in part, by the repayment of $268.0 million of our 4.95% Senior Notes in March 2014; the repurchase of $90.8 million of our common stock; and the repayment of $40.8 million of other loans payable, net of new borrowings. At October 31, 2013, we had $825.5 million of cash, cash equivalents, and marketable securities on hand and approximately $958.4 million available under our $1.035 billion revolving credit facility. Cash used in operating activities during fiscal 2013 was $569.0 million primarily for the acquisition of inventory; the origination of mortgage loans, net of sales to outside investors; and the purchase of commercial property for development, offset, in part, by pretax income from operations, an increase in our accounts payable and accrued expenses, an increase in customer deposits, and a decrease in restricted cash. In fiscal 2013, cash provided by our investing activities was $332.7 million, including $417.8 million of sales and redemptions of marketable securities, and $97.2 million of cash received as returns on our investments in unconsolidated entities, distressed loans, and foreclosed real estate. The cash provided by investing activities was offset, in part, by $36.2 million of purchases of marketable securities, $93.4 million of investments in unconsolidated entities, $26.2 million of investments in distressed loans and foreclosed real estate, and $26.6 million in purchases of property and equipment. We generated $230.4 million of cash from financing activities in fiscal 2013, primarily from the issuance of $400 million of 4.375% Senior Notes due 2023, $24.4 million from the proceeds of our stock-based benefit plans, and a tax benefit of $15.8 million from our stock-based compensation plans. The cash provided by financing activities was offset, in part, by the repayment at maturity of $59.1 million of our 6.875% Senior Notes in November 2012; the repayment at maturity of $104.8 million of our 5.95% Senior Notes in September 2013; $31.0 million of loans payable repayments, net of new borrowings; and $15.4 million for the repurchase of our common stock. In general, our cash flow from operating activities assumes that, as each home is delivered, we will purchase a home site to replace it. Because we own a supply of several years of home sites, we do not need to buy home sites immediately to replace those that we deliver. In addition, we generally do not begin construction of our detached homes until we have a signed contract with the home buyer. Should our business remain at its current level or decline, we believe that our inventory levels would decrease as we complete and deliver the homes under construction but do not commence construction of as many new homes, as we complete the improvements on the land we already own, and as we sell and deliver the speculative homes that we have currently in inventory, resulting in additional cash flow from operations. In addition, we might delay or curtail our acquisition of additional land, as we did during the period April 2006 through January 2010, which would further reduce our inventory levels and cash needs. At October 31, 2015, we owned or controlled through options 44,253 home sites, as compared to 47,167 at October 31, 2014; 48,628 at October 31, 2013; and 91,200 at April 30, 2006, the high point of our home sites owned and controlled. Of the 44,253 home sites owned or controlled through options at October 31, 2015, we owned 35,872. Of our owned home sites at October 31, 2015, significant improvements were completed on approximately 16,505 of them. In February 2014, we acquired all of the equity interests in Shapell, consisting of Shapell’s single-family residential real property development business, including a portfolio of approximately 4,950 home sites in California. See “Overview - Acquisition” in this MD&A for more information about the Shapell acquisition. At October 31, 2015, the aggregate purchase price of land parcels under option and purchase agreements was approximately $1.22 billion (including $136.3 million of land to be acquired from joint ventures in which we have invested). Of the $1.22 billion of land purchase commitments, we had paid or deposited $79.1 million and, if we acquire all of these land parcels, we will be required to pay an additional $1.14 billion. The purchases of these land parcels are scheduled over the next several years. We have additional land parcels under option that have been excluded from the aforementioned aggregate purchase amounts since we do not believe that we will complete the purchase of these land parcels and no additional funds will be required from us to terminate these contracts. During the past several years, we have made a number of investments in unconsolidated entities related to the acquisition and development of land for future home sites, the construction of luxury for-sale condominiums, and for-rent apartments. Our investment activities related to investments in and distributions of investments from unconsolidated entities are contained in the Consolidated Statements of Cash Flows under “Cash flow (used in) provided by investing activities.” At October 31, 2015, we had investments in these entities of $412.9 million, and were committed to invest or advance up to an additional $195.6 million to these entities if they require additional funding. In August 2013, we entered into a $1.035 billion revolving credit facility with a syndicate of banks, which extends to August 2018. At October 31, 2015, we had $350.0 million of borrowings under the credit facility and had outstanding letters of credit of approximately $118.9 million. At October 31, 2015, interest was payable on borrowings under our credit facility at a rate per annum of 1.70% (subject to adjustment based upon our debt rating and leverage ratios) above the Eurodollar rate or at other specified variable rates as selected by us from time to time. We are obligated to pay an undrawn commitment fee of 0.25% (subject to adjustment based upon our debt rating and leverage ratios) based on the average daily unused amount of the credit facility. Under the terms of the credit facility, we are not permitted to allow our maximum leverage ratio (as defined in the credit agreement) to exceed 1.75 to 1.00, and we are required to maintain a minimum tangible net worth (as defined in the credit agreement) of approximately $2.64 billion at October 31, 2015. At October 31, 2015, our leverage ratio was approximately 0.68 to 1.00, and our tangible net worth was approximately $4.19 billion. At October 31, 2015, based upon the minimum tangible net worth requirement, our ability to pay dividends was limited to an aggregate amount of approximately $1.56 billion or the repurchase of our common stock of approximately $1.97 billion. We believe that we will have adequate resources and sufficient access to the capital markets and external financing sources to continue to fund our current operations and meet our contractual obligations. Due to the uncertainties in the economy and for home builders in general, we cannot be certain that we will be able to replace existing financing or find sources of additional financing in the future. INFLATION The long-term impact of inflation on us is manifested in increased costs for land, land development, construction, and overhead. We generally enter into contracts to acquire land a significant period of time before development and sales efforts begin. Accordingly, to the extent land acquisition costs are fixed, subsequent increases or decreases in the sales prices of homes will affect our profits. Because the sales price of each of our homes is fixed at the time a buyer enters into a contract to purchase a home and because we generally contract to sell our homes before we begin construction, any inflation of costs in excess of those anticipated may result in lower gross margins. We generally attempt to minimize that effect by entering into fixed-price contracts with our subcontractors and material suppliers for specified periods of time, which generally do not exceed one year. In general, housing demand is adversely affected by increases in interest rates and housing costs. Interest rates, the length of time that land remains in inventory, and the proportion of inventory that is financed affect our interest costs. If we are unable to raise sales prices enough to compensate for higher costs, or if mortgage interest rates increase significantly, affecting prospective buyers’ ability to adequately finance home purchases, our revenues, gross margins, and net income could be adversely affected. Increases in sales prices, whether the result of inflation or demand, may affect the ability of prospective buyers to afford new homes. CONTRACTUAL OBLIGATIONS The following table summarizes our estimated contractual payment obligations at October 31, 2015 (amounts in millions): (a) Amounts include estimated annual interest payments until maturity of the debt. Of the amounts indicated, $2.7 billion of the senior notes, $1.00 billion of loans payable, and $100.0 million of the mortgage company loan facility were recorded on the October 31, 2015 Consolidated Balance Sheet. In addition, the thereafter amount includes $287.5 million principal amount of 0.5% Exchangeable Senior Notes due 2032 (the “0.5% Exchangeable Senior Notes”). The 0.5% Exchangeable Senior Notes are exchangeable into shares of our common stock at an exchange rate of 20.3749 shares per $1,000 principal amount of notes, corresponding to an initial exchange price of approximately $49.08 per share of common stock. Holders of the 0.5% Exchangeable Senior Notes will have the right to require Toll Brothers Finance Corp. to repurchase their notes for cash equal to 100% of their principal amount, plus accrued but unpaid interest, on each of December 15, 2017, September 15, 2022, and September 15, 2027. We will have the right to redeem the 0.5% Exchangeable Senior Notes on or after September 15, 2017, for cash equal to 100% of their principal amount, plus accrued but unpaid interest. (b) Amounts represent our expected acquisition of land under purchase agreements and the estimated remaining amount of the contractual obligation for land development agreements secured by letters of credit and surety bonds. (c) Amounts represent our obligations under our deferred compensation plan, supplemental executive retirement plans and our 401(k) salary deferral savings plans. Of the total amount indicated, $61.6 million was recorded on the October 31, 2015 Consolidated Balance Sheet. SEGMENTS We operate in two segments: Traditional Home Building and City Living, our urban development division. Within Traditional Home Building, we operate in five geographic segments around the United States: (1) the North, consisting of Connecticut, Illinois, Massachusetts, Michigan, Minnesota, New Jersey, and New York; (2) the Mid-Atlantic, consisting of Delaware, Maryland, Pennsylvania, and Virginia; (3) the South, consisting of Florida, North Carolina, and Texas; (4) the West, consisting of Arizona, Colorado, Nevada, and Washington, and (5) California. Due to the increase in our assets and operations in California, it is now presented as a separate geographic segment; it was previously included in West geographic segment. Prior year amounts presented below have been reclassified to conform to the fiscal 2015 presentation. The following tables summarize information related to revenues, net contracts signed, and income (loss) before income taxes by segment for fiscal years 2015, 2014, and 2013. Information related to backlog and assets by segment at October 31, 2015 and 2014, has also been provided. Units Delivered and Revenues ($ amounts in millions): Net Contracts Signed ($ amounts in millions): Backlog at October 31 ($ amounts in millions): Income (Loss) Before Income Taxes ($ amounts in millions): “Corporate and other” is comprised principally of general corporate expenses such as the offices of our executive officers; the corporate finance, accounting, audit, tax, human resources, risk management, information technology, marketing, and legal groups; interest income; income from our ancillary businesses, including Gibraltar; and income from a number of our unconsolidated entities. Total Assets ($ amounts in millions): “Corporate and other” is comprised principally of cash and cash equivalents, marketable securities, restricted cash, deferred tax assets, and the assets of our Gibraltar investments, manufacturing facilities, and mortgage subsidiary. FISCAL 2015 COMPARED TO FISCAL 2014 Traditional Homebuilding North Revenues in fiscal 2015 were higher than those in fiscal 2014 by $39.5 million, or 6.0%. The increase in revenues was attributable to a 4.4% increase in the average price of the homes delivered and a 1.4% increase in the number of homes delivered. The increase in the average price of homes delivered was primarily attributable to a shift in the number of homes delivered to more expensive areas and/or products and increases in selling prices of homes delivered in fiscal 2015, as compared to fiscal 2014. The value of net contracts signed during fiscal 2015 increased by $92.0 million, or 13.8%. The increase was due to a 9.4% increase in the number of net contracts signed and a 4.0% increase in the average value of each net contract. The increase in the number of net contracts signed was mainly due to improved market conditions in Michigan and New Jersey. The increase in the average sales price of net contracts signed was principally attributable to a shift in the number of contracts signed to more expensive areas and/or products and increases in base selling prices in fiscal 2015, as compared to fiscal 2014. In fiscal 2015, we reported income before income taxes of $59.2 million, as compared to $57.0 million in fiscal 2014. This increase in income was primarily attributable to higher earnings from the increased revenues and lower cost of revenues as a percent of revenues, excluding impairment, in fiscal 2015, as compared to fiscal 2014, offset, in part, by higher inventory impairment charges, higher SG&A costs, and lower earnings from land sales in fiscal 2015, as compared to fiscal 2014. We recognized inventory impairment charges of $15.0 million and $9.1 million in fiscal 2015 and 2014, respectively. The decrease in cost of revenues as a percent of revenues, excluding impairments, was mainly due to a change in product mix/areas to higher margin areas in fiscal 2015, as compared to fiscal 2014. Mid-Atlantic Revenues in fiscal 2015 were higher than those in fiscal 2014 by $28.0 million, or 3.4%. The increase in revenues was primarily attributable to a 3.9% increase in the number of homes delivered. The increase in the number of homes delivered was mainly due to a greater number of homes being sold and delivered in fiscal 2015, as compared to fiscal 2014. The value of net contracts signed during fiscal 2015 increased by $80.8 million, or 10.6%, from fiscal 2014. The increase was due to an 8.4% increase in the number of net contracts signed and a 2.0% increase in the average value of each net contract. The increase in the number of net contracts signed was primarily due to an increase in demand in Pennsylvania and Virginia, offset, in part, by a decrease in the number of net contracts signed in Maryland. The increase in the average sales price of net contracts signed was mainly due to a shift in the number of contracts signed to more expensive areas and/or products and increases in base selling prices in fiscal 2015, as compared to fiscal 2014. We reported income before income taxes in fiscal 2015 and 2014 of $69.1 million and $79.0 million, respectively. The decrease in income before income taxes was primarily due to higher impairment charges, higher SG&A costs, and a $2.8 million decrease in earnings from land sales in fiscal 2015, as compared to fiscal 2014. These decreases were partially offset by higher earnings from increased revenues and lower charges for stucco-related repairs in communities located in Pennsylvania and Delaware in fiscal 2015, as compared to fiscal 2014. Inventory impairment charges, in fiscal 2015 and 2014, were $19.5 million and $9.1 million, respectively. The earnings from land sales in fiscal 2014 mainly represented previously deferred gains on our initial sales of properties to Trust II. In fiscal 2015 and 2014, we recognized $14.7 million and $25.0 million, respectively, in charges for stucco-related repairs. See Note 7, “Accrued Expenses,” in the Notes to the Consolidated Financial Statements for more information on the stucco-related charges. South Revenues in fiscal 2015 were higher than those in fiscal 2014 by $55.8 million, or 6.7%. This increase was attributable to a 9.3% increase in the average price of the homes delivered, offset, in part, by a 2.4% decrease in the number of homes delivered. The increase in the average price of the homes delivered was mainly due to a shift in the number of homes delivered to more expensive areas and/or products in fiscal 2015, as compared to fiscal 2014. The decrease in the number of homes delivered was principally due to a lower number of homes being sold and delivered in fiscal 2015, as compared to fiscal 2014. In fiscal 2015, the value of net contracts signed decreased by $47.9 million, or 5.4%, as compared to fiscal 2014. The decrease was attributable to a 14.5% decrease in the number of net contracts signed, offset, in part, by a 10.6% increase in the average value of each contract signed. The decrease in the number of net contracts signed was principally due to decreased demand. The increase in the average sales price of net contracts signed was mainly due to a shift in the number of contracts signed to more expensive areas and/or products and increases in base selling prices, primarily in Florida and Texas, in fiscal 2015 as compared to fiscal 2014. We reported income before income taxes of $153.0 million in fiscal 2015, as compared to $113.6 million in fiscal 2014. The increase in income before income taxes was primarily due to higher earnings from the increased revenues, lower cost of revenues as a percent of revenues, and an $8.5 million increase in earnings from our investments in unconsolidated entities, in fiscal 2015, as compared to fiscal 2014. These increases were partially offset by higher SG&A costs in fiscal 2015, as compared to fiscal 2014. The decrease in cost of revenues as a percentage of revenue was due mainly to a change in product mix/areas to higher margin areas in fiscal 2015, as compared to fiscal 2014. West Revenues in fiscal 2015 were higher than those in fiscal 2014 by $147.4 million, or 28.5%. The increase in revenues was attributable to increases of 22.1% and 5.2% in the number and average price of homes delivered, respectively. The increase in the number of homes delivered was primarily due to a higher backlog at October 31, 2014, as compared to October 31, 2013, and to a greater number of homes being sold and delivered in fiscal 2015, as compared to fiscal 2014. The increase in the average price of the homes delivered was mainly due to a shift in the number of homes delivered to more expensive products and/or locations and increases in selling prices of homes delivered in fiscal 2015, as compared to fiscal 2014. The value of net contracts signed during fiscal 2015 increased $228.0 million, or 36.9%, as compared to fiscal 2014. This increase was due to a 28.4% increase in the number of net contracts signed and a 6.6% increase in the average value of each contract signed. The increase in the number of net contracts signed was mainly due to an increase in selling communities in Arizona, Nevada, and Washington in fiscal 2015, as compared to fiscal 2014. The increase in the average sales price of net contracts signed was primarily due to a shift in the number of contracts signed to more expensive areas and/or products and increases in base selling prices in fiscal 2015, as compared to fiscal 2014. In fiscal 2015, we reported income before income taxes of $106.4 million, as compared to $78.8 million in fiscal 2014. The increase in income before income taxes was principally due to higher earnings from increased revenues in fiscal 2015, as compared to fiscal 2014, offset, in part, by higher SG&A costs in fiscal 2015, as compared to fiscal 2014. California Revenues in fiscal 2015 were lower than those in fiscal 2014 by $45.8 million, or 5.8%. The decrease in revenues was principally attributable to a 6.2% decrease in the number of homes delivered. The decrease in the number of homes delivered was mainly due to a decrease in the number of communities in California where we were delivering homes. The value of net contracts signed during fiscal 2015 increased $649.0 million, or 93.5%, as compared to fiscal 2014. This increase was due to increases of 57.0% and 23.3% in the number of net contracts signed and in the average value of each contract signed, respectively. The increase in the number of net contracts signed was mainly due to increased demand, an increase in the number of selling communities, and fiscal 2015 having 12 months of sales activity at communities we acquired through the Acquisition, as compared to nine months in fiscal 2014. The increase in the average sales price of net contracts signed was principally due to a shift in the number of contracts signed to more expensive areas and/or products and increases in selling prices. In fiscal 2015, we reported income before income taxes of $139.1 million, as compared to $157.5 million in fiscal 2014. The decrease in income before income taxes was mainly due to lower earnings from decreased revenues and a $10.3 million decrease in earnings from land sales in fiscal 2015, as compared to fiscal 2014, offset, in part, by a $4.8 million increase in earnings from our investments in unconsolidated entities and the lower impact of the application of purchase accounting from the homes delivered from the Acquisition in fiscal 2015, as compared to fiscal 2014. City Living Revenues in fiscal 2015 were higher than those in fiscal 2014 by $34.7 million, or 12.3%. The increase in revenues was attributable to a 35.5% increase in the average price of the homes delivered, offset, in part, by a 17.0% decrease in the number of homes delivered. The increase in the average price of homes delivered was principally due to closings in fiscal 2015 at high-rise buildings located in New York City, where average prices were higher than in other City Living locations. The decrease in the number of homes delivered was mainly due to a lower backlog at October 31, 2014, as compared to October 31, 2013. The value of net contracts signed during fiscal 2015 increased by $57.2 million, or 21.2%, as compared to fiscal 2014. This increase was attributable to a 34.7% increase in the average value of net contracts signed, partially offset by a decrease of a 10.0% in the number of net contracts signed. The increase in the average value of net contracts signed was principally due to a shift in the number of net contracts signed from the Philadelphia, Pennsylvania market to the metro New York City market, where the average value of each contract signed is higher. The decrease in the number of net contracts signed was mainly due to slower demand in the first three months of fiscal 2015 and to a decline in the number of net contracts signed in Philadelphia, Pennsylvania, due to lower product availability. In fiscal 2015, we reported income before income taxes of $124.3 million, as compared to $104.6 million in fiscal 2014. This increase in income was primarily attributable to higher earnings from increased revenues in fiscal 2015, as compared to fiscal 2014, $3.6 million of earnings from the sale of commercial space at one of our high-rise buildings in New York City in fiscal 2015, and a charge of $2.6 million to our earnings due to a settled litigation at one of our unconsolidated entities in fiscal 2014, partially offset by higher SG&A costs in fiscal 2015, as compared to 2014. Other In fiscal 2015 and 2014, corporate and other loss before income taxes was $115.5 million and $85.9 million, respectively. The increase in the loss before income taxes was principally due to a decrease in income from unconsolidated entities from $42.0 million in fiscal 2014 to $5.7 million in fiscal 2015, decreased income from our Gibraltar operations, and higher SG&A costs in fiscal 2015, as compared to fiscal 2014, offset, in part, by an increase of $12.9 million in income from ancillary businesses in fiscal 2015, as compared to fiscal 2014. The decrease in income from unconsolidated entities was due primarily to our recognition of a $23.5 million gain representing our share of the gain on the sale by Trust II of substantially all of its assets to an unrelated party in December 2013 and a $12.0 million distribution from the Trust in April 2014 due to the refinancing of one of the Trust’s apartment properties. The increase in income from ancillary businesses was mainly due to the recognition of an $8.1 million gain from a bulk sale of security monitoring accounts by our home security monitoring business in fiscal 2015. FISCAL 2014 COMPARED TO FISCAL 2013 Traditional Home Building North Revenues in fiscal 2014 were higher than those in fiscal 2013 by $177.7 million, or 36.6%. The increase in revenues was primarily attributable to a 27.0% increase in the number of homes delivered and an increase of 7.6% in the average selling price of the homes delivered. The increase in the number of homes delivered in fiscal 2014, as compared to fiscal 2013, was primarily due to a higher backlog at October 31, 2013, as compared to October 31, 2012. The increase in the average price of homes delivered in fiscal 2014, as compared to fiscal 2013, was primarily attributable to a shift in the number of homes delivered to more expensive areas and/or products in fiscal 2014. The value of net contracts signed in fiscal 2014 was $664.8 million, a 4.7% decrease from the $697.5 million of net contracts signed during fiscal 2013. This 4.7% decrease was primarily due to a 13.1% decrease in the number of net contracts signed, offset, in part, by a 9.7% increase in the average value of each net contract. The decrease in the number of net contracts signed was primarily due to weakening in demand driven by uncertainty in the economy and world events, fragile consumer confidence and reduced affordability, and an extended period of limited real personal income growth. The increase in the average sales price of net contracts signed in fiscal 2014, as compared to fiscal 2013, was primarily attributable to a shift in the number of contracts signed to more expensive areas and/or products in fiscal 2014. In fiscal 2014, we reported income before income taxes of $57.0 million, as compared to $32.7 million in fiscal 2013. This increase in income was primarily attributable to higher earnings from the increased revenues and $3.1 million of earnings from land sales in fiscal 2014, offset, in part, by higher inventory impairment charges and higher SG&A in fiscal 2014, as compared to fiscal 2013. We recognized inventory impairment charges of $9.1 million and $1.8 million in fiscal 2014 and 2013, respectively. The increase in SG&A was due primarily to increased compensation, sales, and marketing costs, primarily due to the increase in the number of homes delivered. Mid-Atlantic Revenues in fiscal 2014 were higher than those in fiscal 2013 by $164.4 million, or 25.2%. The increase in revenues was primarily attributable to a 12.7% increase in the number of homes delivered and an 11.0% increase in the average selling price of the homes delivered. The increase in the number of homes delivered in fiscal 2014, as compared to fiscal 2013, was primarily due to a higher backlog at October 31, 2013, as compared to October 31, 2012, primarily in Maryland, Pennsylvania, and Virginia. The increase in the average price of homes delivered in fiscal 2014, as compared to fiscal 2013, was primarily attributable to a shift in the number of homes delivered to more expensive areas and/or products in fiscal 2014. The value of net contracts signed during fiscal 2014 decreased by $87.4 million, or 10.3%, from fiscal 2013. The decrease was due to a 13.7% decrease in the number of net contracts signed, partially offset by a 4.0% increase in the average value of each net contract. The decrease in the number of net contracts signed was primarily due to a decrease in the number of selling communities in Pennsylvania and a weakening in demand driven by uncertainty in the economy and world events, fragile consumer confidence and reduced affordability, and an extended period of limited real personal income growth. The increase in the average sales price of net contracts signed was primarily due to a shift in the number of contracts signed to more expensive areas and/or products in fiscal 2014. We reported income before income taxes in fiscal 2014 and 2013 of $79.0 million and $79.8 million, respectively. The decrease in income before income taxes was primarily due to $25.0 million in charges for stucco-related repairs in communities located in Pennsylvania and Delaware, higher impairment charges, and higher SG&A costs in fiscal 2014, as compared to fiscal 2013, offset, in part, by higher earnings from the increased revenues and $2.9 million of earnings from land sales in fiscal 2014. The earnings from land sales in fiscal 2014 represent previously deferred gains on our initial sales of properties to Trust II. Inventory impairment charges, in fiscal 2014 and 2013, were $9.1 million and $0.5 million, respectively. South Revenues in fiscal 2014 were higher than those in fiscal 2013 by $195.2 million, or 30.4%. This increase was attributable to an 18.3% increase in the number of homes delivered and a 10.3% increase in the average price of the homes delivered. The increase in the number of homes delivered in fiscal 2014, as compared to fiscal 2013, was primarily due to a higher backlog at October 31, 2013, as compared to October 31, 2012. The increase in the average price of the homes delivered in fiscal 2014, as compared to fiscal 2013, was primarily attributable to a shift in the number of homes delivered to more expensive areas and/or products in fiscal 2014. In fiscal 2014, the value of net contracts signed increased by $54.8 million, or 6.6%, as compared to fiscal 2013. The increase was attributable to a 7.8% increase in the average value of net contracts signed, offset, in part, by a 1.1% decrease in the number of net contracts signed. The increase in the average sales price of net contracts signed was primarily due to a shift in the number of contracts signed to more expensive areas and/or products in fiscal 2014. The decrease in the number of net contracts signed in fiscal 2014, as compared to fiscal 2013, was primarily due to decreased demand in North Carolina, partially offset by increases in the number of net contracts signed in Texas. We reported income before income taxes of $113.6 million in fiscal 2014, as compared to $67.9 million in fiscal 2013. The increase in income before income taxes was primarily due to higher earnings from the increased revenues, lower cost of revenues as a percent of revenues, and higher earnings from land sales, partially offset by higher SG&A costs, in fiscal 2014 as compared to fiscal 2013. The decrease in cost of revenues as a percentage of revenue in fiscal 2014, as compared to fiscal 2013, was due primarily to a change in product mix/areas to higher margin areas, lower interest, and increased prices in fiscal 2014, as compared to fiscal 2013. Earnings from land sales increased from $1.4 million in fiscal 2013 to $5.2 million in fiscal 2014. West Revenues in fiscal 2014 were higher than those in fiscal 2013 by $148.2 million, or 40.0%. The increase in revenues was attributable to a 24.7% increase in the number of homes delivered and a 12.4% increase in the average price of the homes delivered. The increase in the number of homes delivered was primarily due to a higher backlog at October 31, 2013, as compared to October 31, 2012. The increase in the average price of the homes delivered was primarily due to a shift in the number of homes delivered to more expensive products and/or locations in fiscal 2014. The value of net contracts signed during fiscal 2014 increased $157.2 million, or 34.1%, as compared to fiscal 2013. This increase was due to a 24.3% increase in the number of net contracts signed and a 7.9% increase in the average value of each net contract signed. The increase in the number of net contracts signed was primarily due to an increase in selling communities in Colorado and Nevada in fiscal 2014, as compared to fiscal 2013. The increase in the average sales price of net contracts signed was primarily due to a shift in the number of contracts signed to more expensive areas and/or products. In fiscal 2014, we reported income before income taxes of $78.8 million, as compared to $42.7 million in fiscal 2013. The increase in income before income taxes was primarily due to higher earnings from increased revenues and lower cost of revenues as a percentage of revenues, offset, in part, by higher SG&A costs in fiscal 2014, as compared to fiscal 2013. The decrease in cost of revenues as a percentage of revenues in fiscal 2014 was primarily due to a shift in the number of homes delivered to better margin products and/or locations and lower interest. California Revenues in fiscal 2014 were higher than those in fiscal 2013 by $441.1 million, or 124.4%. The increase in revenues was attributable to a 100.0% increase in the number of homes delivered and a 12.0% increase in the average price of the homes delivered. The increase in the number of homes delivered was primarily due to the delivery of 334 homes in communities acquired from Shapell in the period from February 4, 2014 to October 31, 2014 and a higher backlog at October 31, 2013, as compared to October 31, 2012. The increase in the average price of the homes delivered was primarily due to a shift in the number of homes delivered to more expensive products and/or locations in fiscal 2014. The value of net contracts signed during fiscal 2014 increased $188.6 million, or 37.3%, as compared to fiscal 2013. This increase was due to a 55.1% increase in the number of net contracts signed, offset, in part, by an 11.5% decrease in the average value of each net contract signed. In fiscal 2014, we signed 328 contracts with a value of $311.8 million at communities we acquired from Shapell. Excluding these Shapell communities, the value of net contracts signed during fiscal 2014 decreased $123.2 million, or 24.4%, as compared to fiscal 2013. The decrease in the value of net contracts signed, excluding Shapell, was due to a decrease of 24.5% in the number of net contracts signed. The decrease in the number of net contracts signed, excluding Shapell, was primarily due to a reduction of available inventory in fiscal 2014, as compared to fiscal 2013. In fiscal 2014, we reported income before income taxes of $157.5 million, as compared to $68.6 million in fiscal 2013. The increase in income before income taxes was primarily due to higher earnings from increased revenues and $11.7 million of earnings from land sales in fiscal 2014, as compared to $0.4 million in fiscal 2013, offset, in part, by higher cost of revenues as a percentage of revenues and higher SG&A costs in fiscal 2014, which includes $6.1 million of expenses incurred in the Shapell acquisition. The increase in cost of revenues as a percentage of revenues in fiscal 2014 was primarily due to a shift in the number of homes delivered to lower margin products and/or locations and the impact of purchase accounting on the homes delivered in fiscal 2014 from the Acquisition. City Living Revenues in fiscal 2014 were higher than those in fiscal 2013 by $110.7 million, or 64.9%. The increase in revenues was primarily attributable to a 92.7% increase in the number of homes delivered, offset, in part, by a decrease of 14.5% in the average selling price of the homes delivered. The increase in the number of homes delivered in fiscal 2014, as compared to fiscal 2013, was primarily due to an increase in homes delivered in the New Jersey and New York urban markets, which was primarily attributable to higher backlog at October 31, 2013, as compared to October 31, 2012. The decrease in the average price of homes delivered in fiscal 2014, as compared to fiscal 2013, was primarily attributable to a shift in the number of homes delivered to less expensive products and/or locations. The value of net contracts signed in fiscal 2014 was $269.2 million, a 6.2% decrease from the $287.1 million of net contracts signed during fiscal 2013. This decrease was primarily due to a 25.3% decrease in the number of net contracts signed, offset, in part, by a 25.5% increase in the average value of each net contract. The decrease in the number of net contracts signed was primarily due to the commencement of sales at two of our high-rise buildings located in the New York and New Jersey urban markets in the second quarter of fiscal 2013 where sales were high during the initial opening period. The increase in the average sales price of net contracts signed was primarily due to the opening of two high-rise buildings located in Manhattan and the sale of the final unit at The Touraine, a high-rise building located in Manhattan, which had higher selling prices than other City Living locations. In fiscal 2014, we reported income before income taxes of $104.6 million, as compared to $53.3 million in fiscal 2013. This increase in income was primarily attributable to higher earnings from increased revenues and lower cost of revenues as a percentage of revenues in fiscal 2014, as compared to fiscal 2013, partially offset by a decrease in earnings from unconsolidated entities and higher SG&A in fiscal 2014, as compared to 2013. Cost of revenues as a percentage of revenues was 58.5% and 65.7% in fiscal 2014 and 2013, respectively. Earnings from unconsolidated entities decreased from income of $1.2 million in fiscal 2013 to a loss of $3.6 million in fiscal 2014. The decrease in cost of revenues as a percentage of revenue in fiscal 2014, as compared to fiscal 2013, was primarily due to the increase in the number of homes delivered at two of our high-rise buildings located in the New York and New Jersey urban markets, which had better margins than other City Living locations. The decrease in income from unconsolidated entities was due principally to a settled litigation at one of our unconsolidated entities resulting in a charge to our earnings of $2.6 million in the fourth quarter of fiscal 2014. Other In fiscal 2014 and 2013, corporate and other loss before income taxes was $85.9 million and $77.3 million, respectively. The increase in the loss in fiscal 2014, as compared to fiscal 2013, was primarily due to $13.2 million of income in fiscal 2013 from the settlement of litigation and higher SG&A in fiscal 2014, as compared to fiscal 2013, offset, in part, by an increase in earnings from unconsolidated entities from $9.6 million in fiscal 2013 to $42.0 million in fiscal 2014, and increased income from our Gibraltar operations in fiscal 2014, as compared to fiscal 2013. The increase in SG&A costs was due primarily to increased compensation costs due to our increased number of employees and higher insurance costs. The increase in income from unconsolidated entities was due primarily to our recognition of a $23.5 million gain representing our share of the gain on the sale by Trust II of substantially all of its assets to an unrelated party in December 2013 and a $12.0 million distribution from the Trust in April 2014 due to the refinancing of one of the Trust’s apartment properties. The increase attributable to the Trust and Trust II gains was partially offset by lower income realized from Gibraltar’s Structured Asset Joint Venture.

<s>[INST] When this report uses the words “we,” “us,” “our,” and the “Company,” they refer to Toll Brothers, Inc. and its subsidiaries, unless the context otherwise requires. References herein to fiscal year refer to our fiscal years ended or ending October 31. Unless otherwise stated in this report, net contracts signed represents a number or value equal to the gross number or value of contracts signed during the relevant period, less the number or value of contracts canceled during the relevant period, which includes contracts that were signed during the relevant period and in prior periods. OVERVIEW Our Business We design, build, market, and arrange financing for detached and attached homes in luxury residential communities. We cater to moveup, emptynester, activeadult, agequalified, and secondhome buyers in the United States (“Traditional Home Building Product”). We also build and sell homes in urban infill markets through Toll Brothers City Living® (“City Living”). At October 31, 2015, we were operating in 19 states. In the five years ended October 31, 2015, we delivered 21,003 homes from 571 communities, including 5,525 homes from 352 communities in fiscal 2015. We are developing several land parcels for master planned communities in which we intend to build homes on a portion of the lots and sell the remaining lots to other builders. Two of these master planned communities are being developed 100% by us, and the remaining communities are being developed through joint ventures with other builders or financial partners. Over the past several years, we have acquired control of a number of land parcels as forrent apartment projects, including two student housing sites, totaling approximately 7,450 units. These projects, which are located in the metro Boston to metro Washington, D.C. corridor, and Atlanta, are being developed or will be developed with partners under the brand names Toll Brothers Apartment Living, Toll Brothers Campus Living and Toll Brothers Realty Trust (the “Trust”). In February 2014, we acquired the home building business of Shapell Industries, Inc., a Delaware corporation (“Shapell”), for $1.49 billion in cash, net of cash acquired. Prior to the acquisition, Shapell designed, constructed, and marketed singlefamily detached and attached homes and developed land in master planned communities and neighborhoods throughout coastal Northern and Southern California. See “Acquisition” below for more information. In fiscal 2010, we formed Gibraltar Capital and Asset Management, LLC (“Gibraltar”) to invest in distressed real estate opportunities. Gibraltar focuses primarily on residential loans and properties, from unimproved land to partially and fully improved developments, as well as commercial opportunities. We operate our own land development, architectural, engineering, mortgage, title, landscaping, security monitoring, lumber distribution, house component assembly, and manufacturing operations. In addition, in certain markets, we develop land for sale to other builders, often through joint venture structures with other builders or with financial partners. We also develop, own, and operate golf courses and country clubs, which generally are associated with several of our master planned communities. We have investments in various unconsolidated entities. We have investments in joint ventures (i) to develop land for the joint venture participants and for sale to outside builders (“Land Development Joint Ventures”); (ii) to develop forsale homes (“Home Building Joint Ventures”); (iii) to develop luxury forrent residential apartments, commercial space and a hotel (“Rental Property Joint Ventures”); and (iv) to invest in a portfolio of distressed loans and real estate (“Structured Asset Joint Venture”). Financial Highlights In fiscal 2015, we recognized $4.17 billion of revenues and net income of $363.2 million, as compared to $3.91 billion of revenues and net income of $340.0 million in fiscal 2014. In fiscal 2015 and 2014, the value of net contracts signed was $4.96 billion (5,910 homes) and $3. [/INST] Positive. </s>

TOLL BROTHERS INC

2016-12-23

2016-10-31

ITEM 7. MANAGEMENT’S DISCUSSION AND ANALYSIS OF FINANCIAL CONDITION AND RESULTS OF OPERATIONS (“MD&A”) This discussion and analysis is based on, should be read together with, and is qualified in its entirety by, the consolidated financial statements and notes thereto included in Item 15(a)1 of this Form 10-K, beginning at page. It also should be read in conjunction with the disclosure under “Forward-Looking Statements” in Part 1 of this Form 10-K. When this report uses the words “we,” “us,” “our,” and the “Company,” they refer to Toll Brothers, Inc. and its subsidiaries, unless the context otherwise requires. References herein to fiscal year refer to our fiscal years ended or ending October 31. Unless otherwise stated in this report, net contracts signed represents a number or value equal to the gross number or value of contracts signed during the relevant period, less the number or value of contracts canceled during the relevant period, which includes contracts that were signed during the relevant period and in prior periods. Backlog consists of homes under contract but not yet delivered to our home buyers (“backlog”). OVERVIEW Our Business We design, build, market, sell, and arrange financing for detached and attached homes in luxury residential communities. We cater to move-up, empty-nester, active-adult, age-qualified, and second-home buyers in the United States (“Traditional Home Building Product”). We also build and sell homes in urban infill markets through Toll Brothers City Living® (“City Living”). At October 31, 2016, we were operating in 19 states. In the five years ended October 31, 2016, we delivered 24,490 homes from 621 communities, including 6,098 homes from 377 communities in fiscal 2016. In February 2014, we acquired the home building business of Shapell Industries, Inc., a Delaware corporation (“Shapell”), and in November 2016, we acquired substantially all of the assets and operations of Coleman Real Estate Holdings, LLC (“Coleman”). See “Acquisitions” below for more information. We are developing several land parcels for master planned communities in which we intend to build homes on a portion of the lots and sell the remaining lots to other builders. Two of these master planned communities are being developed 100% by us, and the remaining communities are being developed through joint ventures with other builders or financial partners. In addition to our residential for-sale business, we also develop and operate for-rent apartments through joint ventures. See the section entitled “Toll Brothers Apartment Living/Toll Brothers Campus Living/Toll Brothers Realty Trust” below. We operate our own land development, architectural, engineering, mortgage, title, landscaping, security monitoring, lumber distribution, house component assembly, and manufacturing operations. In addition, in certain markets, we develop land for sale to other builders, often through joint venture structures with other builders or with financial partners. We also develop, own, and operate golf courses and country clubs, which generally are associated with several of our master planned communities. We have investments in various unconsolidated entities. We have investments in joint ventures (i) to develop land for the joint venture participants and for sale to outside builders (“Land Development Joint Ventures”); (ii) to develop for-sale homes (“Home Building Joint Ventures”); (iii) to develop luxury for-rent residential apartments, commercial space and a hotel (“Rental Property Joint Ventures”); and (iv) to invest in distressed loans and real estate and provide financing for residential builders and developers for the acquisition and development of land and home sites (“Gibraltar Joint Ventures”). Financial Highlights In fiscal 2016, we recognized $5.17 billion of revenues and net income of $382.1 million, as compared to $4.17 billion of revenues and net income of $363.2 million in fiscal 2015. In fiscal 2016 and 2015, the value of net contracts signed was $5.65 billion (6,719 homes) and $4.96 billion (5,910 homes), respectively. The value of our backlog at October 31, 2016 was $3.98 billion (4,685 homes), as compared to our backlog at October 31, 2015 of $3.50 billion (4,064 homes). At October 31, 2016, we had $633.7 million of cash and cash equivalents on hand and approximately $961.8 million for borrowing available under our $1.295 billion revolving credit facility (“New Credit Facility”) that matures in May 2021. At October 31, 2016, we had $250.0 million of outstanding borrowings under the New Credit Facility and had outstanding letters of credit of approximately $83.2 million. At October 31, 2016, our total equity and our debt to total capitalization ratio were $4.24 billion and 0.47 to 1:00, respectively, Acquisitions Shapell Industries, Inc. On February 4, 2014, we completed our acquisition of Shapell pursuant to the Purchase and Sale Agreement (the “Purchase Agreement”) dated November 6, 2013 with Shapell Investment Properties, Inc. (“SIPI”). We acquired all of the equity interests in Shapell from SIPI on February 4, 2014 for $1.49 billion, net of cash acquired (the “Acquisition”). We acquired the single-family residential real property development business of Shapell, including a portfolio of approximately 4,950 home sites in California, some of which we have sold to other builders. The Acquisition provided us with a premier California land portfolio including 11 active selling communities, as of the Acquisition date, in affluent, high-growth markets: the San Francisco Bay area, metro Los Angeles, Orange County, and the Carlsbad market. As part of the Acquisition, we assumed contracts to deliver 126 homes with an aggregate value of approximately $105.3 million. The Shapell operations have been fully integrated into our operations. Coleman Real Estate Holdings, LLC In October 2016, we entered into an agreement to acquire substantially all of the assets and operations of Coleman. In November 2016, we completed the acquisition of Coleman for approximately $85.2 million in cash. The assets acquired were primarily inventory, including approximately 1,750 home sites owned or controlled through land purchase agreements. As part of the acquisition, we assumed contracts to deliver 128 homes with an aggregate value of $38.8 million. The average price of the undelivered homes at the date of acquisition was approximately $303,000. Our selling community count increased by 15 communities at the acquisition date. See Note 2, “Acquisitions,” in the Notes to Consolidated Financial Statements in this Form 10-K for additional information regarding these acquisitions. Our Business Environment and Current Outlook Since the third quarter of fiscal 2014 through the end of fiscal 2016, we saw a general strengthening in customer demand. In fiscal 2016, we signed 6,719 contracts with an aggregate value of $5.65 billion, compared to 5,910 contracts with an aggregate value of $4.96 billion in fiscal 2015, and 5,271 contracts with an aggregate value of $3.90 billion in fiscal 2014. We are optimistic that the strengthening in customer demand will continue for the foreseeable future. We believe that, as the national economy continues to improve and as the millennial generation comes of age, pent-up demand for homes will continue to be released. According to the U.S. Census Bureau (“Census Bureau”), the number of households earning $100,000 or more (in constant 2015 dollars) at September 2016 stood at 33.2 million, or approximately 26.4% of all U.S. households. This group has grown at three times the rate of increase of all U.S. households since 1980. According to Harvard University’s 2016 report, “The State of the Nation’s Housing,” demographic forces are likely to drive the addition of just under 1.3 million new households per year during the next decade. Housing starts, which encompass the units needed for household formations, second homes, and the replacement of obsolete or demolished units, have not kept pace with this projected household growth. According to the Census Bureau’s October 2016 New Residential Sales Report, new home inventory stands at a supply of just 5.2 months, based on current sales paces. If demand and pace increase significantly, the supply of 5.2 months could quickly be drawn down. During the period 1970 through 2007, total housing starts in the United States averaged approximately 1.6 million per year, while during the period 2008 through 2015, total housing starts averaged approximately 0.81 million per year according to the Census Bureau. We continue to believe that many of our communities are in desirable locations that are difficult to replace and in markets where approvals have been increasingly difficult to achieve. We believe that many of these communities have substantial embedded value that may be realized in the future as the housing recovery strengthens. Competitive Landscape The home building business is highly competitive and fragmented. We compete with numerous home builders of varying sizes, ranging from local to national in scope, some of which have greater sales and financial resources than we do. Sales of existing homes, whether by a homeowner or by a financial institution that has acquired a home through a foreclosure, also provide competition. We compete primarily on the basis of price, location, design, quality, service, and reputation. We believe our financial stability, relative to many others in our industry, is a favorable competitive factor as more home buyers focus on builder solvency. In addition, there are fewer and more selective lenders serving our industry as compared to prior years and we believe that these lenders gravitate to the home building companies that offer them the greatest security, the strongest balance sheets, and the broadest array of potential business opportunities. Land Acquisition and Development Our business is subject to many risks, because of the extended length of time that it takes to obtain the necessary approvals on a property, complete the land improvements on it, and deliver a home after a home buyer signs an agreement of sale. In certain cases, we attempt to reduce some of these risks by utilizing one or more of the following methods: controlling land for future development through options (also referred to herein as “land purchase contracts” or “option and purchase agreements”), which enable us to obtain necessary governmental approvals before acquiring title to the land; generally commencing construction of a detached home only after executing an agreement of sale and receiving a substantial down payment from the buyer; and using subcontractors to perform home construction and land development work on a fixed-price basis. During fiscal 2016 and 2015, we acquired control of approximately 10,682 home sites (net of options terminated and home sites sold) and, approximately 2,611 home sites (net of options terminated and home sites sold), respectively. At October 31, 2016, we controlled approximately 48,837 home sites, as compared to approximately 44,253 home sites at October 31, 2015, and 47,167 home sites at October 31, 2014. In addition, at October 31, 2016, we expect to purchase approximately 3,600 additional home sites from several land development joint ventures in which we have an interest, at prices not yet determined. Of the approximately 48,837 total home sites that we owned or controlled through options at October 31, 2016, we owned approximately 34,137 and controlled approximately 14,700 through options. Of the 48,837 home sites, approximately 17,065 were substantially improved. The 14,700 home sites controlled through options includes the 1,750 home sites owned or controlled by Coleman. In addition, at October 31, 2016, our Land Development Joint Ventures owned approximately 11,400 home sites (including 240 home sites included in the 14,700 controlled through options), and our Homebuilding Joint Ventures owned approximately 400 home sites. At October 31, 2016, we were selling from 310 communities, compared to 288 communities at October 31, 2015, and 263 communities at October 31, 2014. Customer Mortgage Financing We maintain relationships with a widely diversified group of mortgage financial institutions, many of which are among the largest in the industry. We believe that regional and community banks continue to recognize the long-term value in creating relationships with high-quality, affluent customers such as our home buyers, and these banks continue to provide such customers with financing. We believe that our home buyers generally are, and should continue to be, better able to secure mortgages due to their typically lower loan-to-value ratios and attractive credit profiles, as compared to the average home buyer. Toll Brothers Apartment Living/Toll Brothers Campus Living/Toll Brothers Realty Trust In addition to our residential for-sale business, we also develop and operate for-rent apartments through joint ventures. At October 31, 2016, we controlled 28 land parcels as for-rent apartment projects containing approximately 9,600 units. These projects, which are located in the metro Boston to metro Washington, D.C. corridor; Atlanta, Georgia; Dallas, Texas; and Fremont, California are being operated, are being developed or will be developed with partners under the brand names Toll Brothers Apartment Living, Toll Brothers Campus Living and Toll Brothers Realty Trust (the “Trust”). At October 31, 2016, we had approximately 2,950 units in for-rent apartment projects that were occupied or ready for occupancy, 600 units in the lease-up stage, 900 units under active development, and 5,150 units in the planning stage. Of the 9,600 units at October 31, 2016, 4,850 were owned by joint ventures in which we have an interest; approximately 1,600 were owned by us; 2,850 were under contract to be purchased by us; and 300 were under a letter of intent. CONTRACTS AND BACKLOG The aggregate value of net sales contracts signed increased 14.0% in fiscal 2016, as compared to fiscal 2015, and 27.2% in fiscal 2015, as compared to fiscal 2014. The value of net sales contracts signed was $5.65 billion (6,719 homes) in fiscal 2016, $4.96 billion (5,910 homes) in fiscal 2015, and $3.90 billion (5,271 homes) in fiscal 2014. The increase in the aggregate value of net contracts signed in fiscal 2016, as compared to fiscal 2015, was the result of a 13.7% increase in the number of net contracts signed. The increase in the number of net contracts signed in fiscal 2016, as compared to fiscal 2015, was primarily due to the continued recovery in the U.S. housing market in fiscal 2016. The value of our backlog at October 31, 2016, 2015, and 2014 was $3.98 billion (4,685 homes), $3.50 billion (4,064 homes), and $2.72 billion (3,679 homes), respectively. Approximately 97% of the homes in backlog at October 31, 2016 are expected to be delivered by October 31, 2017. The 13.7% increase in the value of homes in backlog at October 31, 2016, as compared to October 31, 2015, was primarily due to a 14.0% increase in the value of net contracts signed in fiscal 2016, as compared to fiscal 2015, and the higher backlog at the beginning of fiscal 2016, as compared to the beginning of fiscal 2015, offset, in part, by a 23.9% increase in the aggregate value of our deliveries in fiscal 2016, as compared to the aggregate value of deliveries in fiscal 2015. The 28.8% increase in the value of homes in backlog at October 31, 2015, as compared to October 31, 2014, was due to a 27.2% increase in the value of net contracts signed in fiscal 2015, as compared to fiscal 2014, and the higher backlog at the beginning of fiscal 2015, as compared to the beginning of fiscal 2014, offset, in part, by a 6.6% increase in the aggregate value of our deliveries in fiscal 2015, as compared to the aggregate value of deliveries in fiscal 2014. For more information regarding revenues, net contracts signed, and backlog by geographic segment, see “Segments” in this MD&A. CRITICAL ACCOUNTING POLICIES We believe the following critical accounting policies reflect the more significant judgments and estimates used in the preparation of our consolidated financial statements. Inventory Inventory is stated at cost unless an impairment exists, in which case it is written down to fair value in accordance with U.S. generally accepted accounting principles (“GAAP”). In addition to direct land acquisition, land development, and home construction costs, costs also include interest, real estate taxes, and direct overhead related to development and construction, which are capitalized to inventory during periods beginning with the commencement of development and ending with the completion of construction. For those communities that have been temporarily closed, no additional capitalized interest is allocated to the community’s inventory until it reopens, and other carrying costs are expensed as incurred. Once a parcel of land has been approved for development and we open the community, it can typically take four or more years to fully develop, sell, and deliver all the homes in that community. Longer or shorter time periods are possible depending on the number of home sites in a community and the sales and delivery pace of the homes in a community. Our master planned communities, consisting of several smaller communities, may take up to 10 years or more to complete. Because our inventory is considered a long-lived asset under GAAP, we are required to regularly review the carrying value of each of our communities and write down the value of those communities when we believe the values are not recoverable. Operating Communities: When the profitability of an operating community deteriorates, the sales pace declines significantly, or some other factor indicates a possible impairment in the recoverability of the asset, the asset is reviewed for impairment by comparing the estimated future undiscounted cash flow for the community to its carrying value. If the estimated future undiscounted cash flow is less than the community’s carrying value, the carrying value is written down to its estimated fair value. Estimated fair value is primarily determined by discounting the estimated future cash flow of each community. The impairment is charged to cost of revenues in the period in which the impairment is determined. In estimating the future undiscounted cash flow of a community, we use various estimates such as (i) the expected sales pace in a community, based upon general economic conditions that will have a short-term or long-term impact on the market in which the community is located and on competition within the market, including the number of home sites available and pricing and incentives being offered in other communities owned by us or by other builders; (ii) the expected sales prices and sales incentives to be offered in a community; (iii) costs expended to date and expected to be incurred in the future, including, but not limited to, land and land development costs, home construction, interest, and overhead costs; (iv) alternative product offerings that may be offered in a community that will have an impact on sales pace, sales price, building cost, or the number of homes that can be built in a particular community; and (v) alternative uses for the property, such as the possibility of a sale of the entire community to another builder or the sale of individual home sites. Future Communities: We evaluate all land held for future communities or future sections of operating communities, whether owned or optioned, to determine whether or not we expect to proceed with the development of the land as originally contemplated. This evaluation encompasses the same types of estimates used for operating communities described above, as well as an evaluation of the regulatory environment in which the land is located and the estimated probability of obtaining the necessary approvals, the estimated time and cost it will take to obtain those approvals, and the possible concessions that will be required to be given in order to obtain them. Concessions may include cash payments to fund improvements to public places such as parks and streets, dedication of a portion of the property for use by the public or as open space, or a reduction in the density or size of the homes to be built. Based upon this review, we decide (i) as to land under contract to be purchased, whether the contract will likely be terminated or renegotiated, and (ii) as to land we own, whether the land will likely be developed as contemplated or in an alternative manner, or should be sold. We then further determine whether costs that have been capitalized to the community are recoverable or should be written off. The write-off is charged to cost of revenues in the period in which the need for the write-off is determined. The estimates used in the determination of the estimated cash flows and fair value of both current and future communities are based on factors known to us at the time such estimates are made and our expectations of future operations and economic conditions. Should the estimates or expectations used in determining estimated fair value deteriorate in the future, we may be required to recognize additional impairment charges and write-offs related to current and future communities and such amounts could be material. We provided for inventory impairment charges and the expensing of costs that we believed not to be recoverable in each of the three fiscal years ended October 31, 2016, 2015, and 2014, as shown in the table below (amounts in thousands): The table below provides, for the periods indicated, the number of operating communities that we reviewed for potential impairment, the number of operating communities in which we recognized impairment charges, the amount of impairment charges recognized, and, as of the end of the period indicated, the fair value of those communities, net of impairment charges ($ amounts in thousands): Income Taxes - Valuation Allowance Significant judgment is applied in assessing the realizability of deferred tax assets. In accordance with GAAP, a valuation allowance is established against a deferred tax asset if, based on the available evidence, it is more likely than not that such asset will not be realized. The realization of a deferred tax asset ultimately depends on the existence of sufficient taxable income in either the carryback or carryforward periods under tax law. We assess the need for valuation allowances for deferred tax assets based on GAAP’s “more-likely-than-not” realization threshold criteria. In our assessment, appropriate consideration is given to all positive and negative evidence related to the realization of the deferred tax assets. Forming a conclusion that a valuation allowance is not needed is difficult when there is significant negative evidence such as cumulative losses in recent years. This assessment considers, among other matters, the nature, consistency, and magnitude of current and cumulative income and losses, forecasts of future profitability, the duration of statutory carryback or carryforward periods, our experience with operating loss and tax credit carryforwards being used before expiration, and tax planning alternatives. Our assessment of the need for a valuation allowance on our deferred tax assets includes assessing the likely future tax consequences of events that have been recognized in our consolidated financial statements or tax returns. Changes in existing tax laws or rates could affect our actual tax results, and our future business results may affect the amount of our deferred tax liabilities or the valuation of our deferred tax assets over time. Our accounting for deferred tax assets represents our best estimate of future events. Due to uncertainties in the estimation process, particularly with respect to changes in facts and circumstances in future reporting periods (carryforward period assumptions), actual results could differ from the estimates used in our analysis. Our assumptions require significant judgment because the residential home building industry is cyclical and is highly sensitive to changes in economic conditions. If our results of operations are less than projected and there is insufficient objectively verifiable positive evidence to support the more-likely-than-not realization of our deferred tax assets, a valuation allowance would be required to reduce or eliminate our deferred tax assets. Our deferred tax assets consist principally of the recognition of losses primarily driven by accrued expenses, inventory impairments, and impairments of investments in unconsolidated entities. In accordance with GAAP, we assess whether a valuation allowance should be established based on our determination of whether it was more likely than not that some portion or all of the deferred tax assets would not be realized. At October 31, 2016 and 2015, we determined that it was more-likely-than-not that our deferred assets would be realized for federal purposes. Accordingly, at October 31, 2016 and 2015, we did not record any valuation allowances against our federal deferred tax assets. We file tax returns in the various states in which we do business. Each state has its own statutes regarding the use of tax loss carryforwards. Some of the states in which we do business do not allow for the carryforward of losses, while others allow for carryforwards for five years to 20 years. For state tax purposes, due to past and projected losses in certain jurisdictions where we do not have carryback potential and/or cannot sufficiently forecast future taxable income, we recognized net cumulative valuation allowances against our state deferred tax assets at October 31, 2016 and 2015. During fiscal 2015, and 2014, due to improved actual and/or operating results, we reversed $16.3 million and $13.3 million of state deferred tax asset valuation allowances, respectively. During fiscal 2016, no state deferred tax asset valuation allowances were reversed. In addition, we establish valuation allowances for newly created deferred tax assets in certain jurisdictions where it is more-likely-than-not that the deferred tax asset would not be realized. During fiscal 2016, 2015, and 2014, we recognized new valuation allowances of $1.0 million, $3.7 million, and $1.3 million, respectively. The valuation allowance at October 31, 2016 of $32.2 million relates to deferred tax assets in states that had not met the more-likely-than-not realization threshold criteria. Revenue and Cost Recognition Revenues and cost of revenues from home sales are recorded at the time each home is delivered and title and possession are transferred to the buyer. For our standard attached and detached homes, land, land development, and related costs, both incurred and estimated to be incurred in the future, are amortized to the cost of homes closed based upon the total number of homes to be constructed in each community. Any changes resulting from a change in the estimated number of homes to be constructed or in the estimated costs subsequent to the commencement of delivery of homes are allocated to the remaining undelivered homes in the community. Home construction and related costs are charged to the cost of homes closed under the specific identification method. For our master planned communities, the estimated land, common area development, and related costs, including the cost of golf courses, net of their estimated residual value, are allocated to individual communities within a master planned community on a relative sales value basis. Any changes resulting from a change in the estimated number of homes to be constructed or in the estimated costs are allocated to the remaining home sites in each of the communities of the master planned community. For high-rise/mid-rise projects, land, land development, construction, and related costs, both incurred and estimated to be incurred in the future, are generally amortized to the cost of units closed based upon an estimated relative sales value of the units closed to the total estimated sales value. Any changes resulting from a change in the estimated total costs or revenues of the project are allocated to the remaining units to be delivered. Forfeited customer deposits: Forfeited customer deposits are recognized in other income-net in our Consolidated Statements of Operations and Comprehensive Income in the period in which we determine that the customer will not complete the purchase of the home and we have the right to retain the deposit. Sales Incentives: In order to promote sales of our homes, we grant our home buyers sales incentives from time to time. These incentives will vary by type of incentive and by amount on a community-by-community and home-by-home basis. Incentives that impact the value of the home or the sales price paid, such as special or additional options, are generally reflected as a reduction in sales revenues. Incentives that we pay to an outside party, such as paying some or all of a home buyer’s closing costs, are recorded as an additional cost of revenues. Incentives are recognized at the time the home is delivered to the home buyer and we receive the sales proceeds. Warranty and Self-Insurance Warranty: We provide all of our home buyers with a limited warranty as to workmanship and mechanical equipment. We also provide many of our home buyers with a limited 10-year warranty as to structural integrity. We accrue for expected warranty costs at the time each home is closed and title and possession are transferred to the home buyer. Warranty costs are accrued based upon historical experience. Adjustments to our warranty liabilities related to homes delivered in prior years are recorded in the period in which a change in our estimate occurs. Over the past several years, we have had a significant number of warranty claims related primarily to older homes built in Pennsylvania and Delaware. See Note 6 - “Accrued Expenses” in Item 15(a)1 of this Form 10-K for additional information regarding these warranty charges. Self-Insurance: We maintain, and require the majority of our subcontractors to maintain, general liability insurance (including construction defect and bodily injury coverage) and workers’ compensation insurance. These insurance policies protect us against a portion of our risk of loss from claims related to our home building activities, subject to certain self-insured retentions, deductibles and other coverage limits (“self-insured liability”). We also provide general liability insurance for our subcontractors in Arizona, California, Nevada, Washington, and certain areas of Texas, where eligible subcontractors are enrolled as insureds under our general liability insurance policies in each community in which they perform work. For those enrolled subcontractors, we absorb their general liability associated with the work performed on our homes within the applicable community as part of our overall general liability insurance and our self-insurance through our captive insurance subsidiary. We record expenses and liabilities based on the estimated costs required to cover our self-insured liability and the estimated costs of potential claims and claim adjustment expenses that are above our coverage limits or that are not covered by our insurance policies. These estimated costs are based on an analysis of our historical claims and industry data, and include an estimate of claims incurred but not yet reported (“IBNR”). We engage a third-party actuary that uses our historical claim and expense data, input from our internal legal and risk management groups, as well as industry data, to estimate our liabilities related to unpaid claims, IBNR associated with the risks that we are assuming for our self-insured liability and other required costs to administer current and expected claims. These estimates are subject to uncertainty due to a variety of factors, the most significant being the long period of time between the delivery of a home to a home buyer and when a structural warranty or construction defect claim is made, and the ultimate resolution of the claim. Though state regulations vary, construction defect claims are reported and resolved over a prolonged period of time, which can extend for 10 years or longer. As a result, the majority of the estimated liability relates to IBNR. Adjustments to our liabilities related to homes delivered in prior years are recorded in the period in which a change in our estimate occurs. The projection of losses related to these liabilities requires actuarial assumptions that are subject to variability due to uncertainties regarding construction defect claims relative to our markets and the types of product we build, insurance industry practices and legal or regulatory actions and/or interpretations, among other factors. Key assumptions used in these estimates include claim frequencies, severities and settlement patterns, which can occur over an extended period of time. In addition, changes in the frequency and severity of reported claims and the estimates to settle claims can impact the trends and assumptions used in the actuarial analysis, which could be material to our consolidated financial statements. Due to the degree of judgment required, the potential for variability in these underlying assumptions, our actual future costs could differ from those estimated, and the difference could be material to our consolidated financial statements. OFF-BALANCE SHEET ARRANGEMENTS We also operate through a number of joint ventures. These joint ventures (i) develop land for the joint venture participants and for sale to outside builders (“Land Development Joint Ventures”); (ii) develop for-sale homes (“Home Building Joint Ventures”); (iii) develop luxury for-rent residential apartments, commercial space and a hotel (“Rental Property Joint Ventures”); and (iv) invest in distressed loans and real estate and provide financing for residential builders and developers for the acquisition and development of land and home sites (“Gibraltar Joint Ventures”). We earn construction and management fee income from many of these joint ventures. Our investments in these entities are accounted for using the equity method of accounting. We are a party to several joint ventures with unrelated parties to develop and sell land that is owned by the joint ventures. We recognize our proportionate share of the earnings from the sale of home sites to other builders, including our joint venture partners. We do not recognize earnings from the home sites we purchase from these ventures at the time of our purchase; instead, our cost basis in the home sites is reduced by our share of the earnings realized by the joint venture from those home sites. At October 31, 2016, we had investments in these entities of $496.4 million, and were committed to invest or advance up to an additional $273.8 million to these entities if they require additional funding. At October 31, 2016, we had agreed to terms for the acquisition of 240 home sites from two Land Development Joint Ventures for an estimated aggregate purchase price of $79.2 million. In addition, we expect to purchase approximately 3,600 additional home sites over a number of years from several joint ventures in which we have interests; the purchase price of these home sites will be determined at a future date. The unconsolidated entities in which we have investments generally finance their activities with a combination of partner equity and debt financing. In some instances, we and our partners have guaranteed debt of certain unconsolidated entities. These guarantees may include any or all of the following: (i) project completion guarantees, including any cost overruns; (ii) repayment guarantees, generally covering a percentage of the outstanding loan; (iii) carry cost guarantees, which cover costs such as interest. real estate taxes, and insurance; (iv) an environmental indemnity provided to the lender that holds the lender harmless from and against losses arising from the discharge of hazardous materials from the property and non-compliance with applicable environmental laws; and (v) indemnification of the lender from “bad boy acts” of the unconsolidated entity. In some instances, the guarantees provided in connection with loans to an unconsolidated entity are joint and several. In these situations, we generally have a reimbursement agreement with our partner that provides that neither party is responsible for more than its proportionate share or agreed-upon share of the guarantee; however, if the joint venture partner does not have adequate financial resources to meet its obligations under the reimbursement agreement, we may be liable for more than our proportionate share. We believe that as of October 31, 2016, in the event we become legally obligated to perform under a guarantee of the obligation of an unconsolidated entity due to a triggering event, the collateral should be sufficient to repay a significant portion of the obligation. If it is not, we and our partners would need to contribute additional capital to the venture. At October 31, 2016, the unconsolidated entities that have guarantees related to debt had loan commitments aggregating $875.7 million and had borrowed an aggregate of $576.0 million. We estimate that our maximum potential exposure under these guarantees, if the full amount of the loan commitments were borrowed, would be $875.7 million, without taking into account any recoveries from the underlying collateral or any reimbursement from our partners. Of this maximum potential exposure, $87.0 million is related to repayment and carry cost guarantees. Based on the amounts borrowed at October 31, 2016, our maximum potential exposure under these guarantees is estimated to be $576.0 million, without taking into account any recoveries from the underlying collateral or any reimbursement from our partners. Of the estimated $576.0 million, $61.5 million is related to repayment and carry cost guarantees. In addition, we have guaranteed approximately $4.3 million of ground lease payments and insurance deductibles for three joint ventures. For more information regarding these joint ventures, see Note 4, “Investments in Unconsolidated Entities” in the Notes to Consolidated Financial Statements in this Form 10-K. The trends, uncertainties or other factors that negatively impact our business and the industry in general also impact the unconsolidated entities in which we have investments. We review each of our investments on a quarterly basis for indicators of impairment. A series of operating losses of an investee, the inability to recover our invested capital, or other factors may indicate that a loss in value of our investment in the unconsolidated entity has occurred. If a loss exists, we further review to determine if the loss is other than temporary, in which case we write down the investment to its fair value. The evaluation of our investment in unconsolidated entities entails a detailed cash flow analysis using many estimates including but not limited to, expected sales pace, expected sales prices, expected incentives, costs incurred and anticipated, sufficiency of financing and capital, competition, market conditions and anticipated cash receipts, in order to determine projected future distributions. Each of the unconsolidated entities evaluates its inventory in a similar manner. In addition, for rental properties, we review rental trends, expected future expenses, and expected future cash flows to determine estimated fair values of the properties. See “Critical Accounting Policies - Inventory” contained in this MD&A for more detailed disclosure on our evaluation of inventory. If a valuation adjustment is recorded by an unconsolidated entity related to its assets, our proportionate share is reflected in income from unconsolidated entities with a corresponding decrease to our investment in unconsolidated entities. Based upon our evaluation of the fair value of our investments in unconsolidated entities, we determined that no impairments of our investments occurred in fiscal 2016, 2015 and 2014. RESULTS OF OPERATIONS The following table compares certain items in our Consolidated Statements of Operations and Comprehensive Income and other supplemental information for fiscal 2016, 2015, and 2014 ($ amounts in millions, unless otherwise stated). For more information regarding results of operations by operating segment, see “Segments” in this MD&A. Note: Amounts may not add due to rounding. FISCAL 2016 COMPARED TO FISCAL 2015 REVENUES AND COST OF REVENUES The increase in revenues in fiscal 2016, as compared to fiscal 2015, was primarily attributable to a 12.3% increase in the average price of the homes delivered due to a shift in the number of homes delivered to more expensive areas and/or higher-priced products and a 10.4% increase in the number of homes delivered primarily due to a higher backlog at October 31, 2015, as compared to October 31, 2014. Cost of revenues as a percentage of revenues in fiscal 2016 was 80.2%, as compared to 78.4% in fiscal 2015. The increase in the fiscal 2016 percentage was primarily due to the recognition in fiscal 2016 of $125.6 million (2.4% of revenues) of warranty charges primarily related to older homes built in Pennsylvania and Delaware, as compared to $14.7 million (0.4% of revenues) in fiscal 2015 and slightly higher land and construction costs as a percentage of revenues in homes delivered in fiscal 2016, as compared to fiscal 2015. These increased costs were offset, in part, by lower interest expense and inventory impairment and write-offs as a percentage of revenues in fiscal 2016, as compared to fiscal 2015. See Note 6 - “Accrued Expenses” in Item 15(a)1 of this Form 10-K for additional information regarding these warranty charges. Interest cost in fiscal 2016 was $160.3 million or 3.1% of revenues, as compared to $142.9 million or 3.4% of revenues in fiscal 2015. We recognized inventory impairments and write-offs of $13.8 million or 0.3% of revenues and $35.7 million or 0.9% of revenues in fiscal 2016 and fiscal 2015, respectively. SELLING, GENERAL AND ADMINISTRATIVE EXPENSES (“SG&A”) SG&A spending increased by $80.3 million but declined as a percentage of revenues in fiscal 2016, as compared to fiscal 2015. The decrease in SG&A as a percentage of revenues in the fiscal 2016 period was due to SG&A spending increasing by 17.6% while revenues increased 23.9% from the fiscal 2015 period. The dollar increase in SG&A was due primarily to increased compensation costs due to a higher number of employees and increased sales and marketing costs. The higher sales and marketing costs were the result of the increased number of homes closed and increased number of selling communities that we had in fiscal 2016, as compared to fiscal 2015. INCOME FROM UNCONSOLIDATED ENTITIES We recognize our proportionate share of the earnings and losses from the various unconsolidated entities in which we have an investment. Many of our unconsolidated entities are land development projects or high-rise/mid-rise condominium construction projects, which do not generate revenues and earnings for a number of years during the development of the property. Once development is complete, these unconsolidated entities will generally, over a relatively short period of time, generate revenues and earnings until all of the assets of the entity are sold. Because there is not a steady flow of revenues and earnings from these entities, the earnings recognized from these entities will vary significantly from quarter to quarter and year to year. In fiscal 2016, we recognized $40.7 million of income from unconsolidated entities, as compared to $21.1 million in fiscal 2015. The increase in income from unconsolidated entities in fiscal 2016, as compared to fiscal 2015, was due mainly to higher earnings from two of our City Living Home Building Joint Ventures, a $4.9 million gain recognized related to the sale of our ownership interests in one of our joint ventures located in New Jersey, and to the recognition of a $2.9 million recovery in fiscal 2016 of previously incurred charges related to a joint venture located in Nevada, offset, in part, by lower income from our Land Development Joint Ventures. OTHER INCOME - NET The table below provides the components of “Other Income - net” for the years ended October 31, 2016 and 2015 (amounts in thousands): In fiscal 2016 and fiscal 2015, our security monitoring business recognized gains of $1.6 million and $8.1 million, respectively, from a bulk sale of security monitoring accounts in fiscal 2015, which is included in income from ancillary businesses above. The decline in income from Gibraltar Capital and Asset Management, LLC (“Gibraltar”) was due primarily from the continuing monetization of its assets offset, in part by a $1.3 million gain in fiscal 2016 from the sale of a 76% interest in certain assets of Gibraltar. See Note 4, “Investments in Unconsolidated Entities - Gibraltar Joint Ventures” of this Form 10-K for additional information on this transaction. INCOME BEFORE INCOME TAXES In fiscal 2016, we reported income before income taxes of $589.0 million, as compared to $535.6 million in fiscal 2015. INCOME TAX PROVISION We recognized a $206.9 million income tax provision in fiscal 2016. Based upon the federal statutory rate of 35%, our federal tax provision would have been $206.2 million. The difference between our tax provision recognized and the tax provision based on the federal statutory rate was due mainly to the recognition of a $27.0 million provision for state income taxes; the recognition of a $2.1 million provision for uncertain tax positions taken; $2.0 million of accrued interest and penalties for previously accrued taxes on uncertain tax positions; and $3.9 million of other differences; offset by a $16.9 million tax benefit from the utilization of the domestic production activities deduction; the reversal of $11.2 million of previously accrued tax provisions on uncertain tax positions that were no longer necessary due to the expiration of the statute of limitations and settlements with certain taxing jurisdictions; and $7.0 million of other permanent deductions. We recognized a $172.4 million income tax provision in fiscal 2015. Based upon the federal statutory rate of 35%, our federal tax provision would have been $187.4 million. The difference between our tax provision recognized and the tax provision based on the federal statutory rate was due principally to the reversal of $15.3 million of previously accrued tax provisions on uncertain tax positions that were no longer necessary due to the expiration of the statute of limitations and the settlements with certain taxing jurisdictions; a $12.3 million tax benefit from our utilization of the domestic production activities deduction; a benefit of $12.6 million from the reversal of state deferred tax asset valuation allowances, net of $3.7 million of new state deferred tax asset valuation allowances recognized; and $7.8 million of other permanent deductions; offset, in part, by the recognition of a $21.9 million provision for state income taxes; the recognition of a $3.2 million provision for uncertain tax positions taken; $2.6 million of accrued interest and penalties for previously accrued taxes on uncertain tax positions; and $5.3 million of other differences. FISCAL 2015 COMPARED TO FISCAL 2014 REVENUES AND COST OF REVENUES Revenues in fiscal 2015 were higher than those for fiscal 2014 by approximately $259.6 million, or 6.6%. This increase was attributable to a 4.2% increase in the average price of the homes delivered and a 2.4% increase in the number of homes delivered. In fiscal 2015, we delivered 5,525 homes with a value of $4.17 billion, as compared to 5,397 homes in fiscal 2014 with a value of $3.91 billion. The increase in the number of homes delivered was principally due to a greater number of homes being sold and delivered in fiscal 2015, as compared to fiscal 2014. The increase in the average price of homes delivered was primarily attributable to a shift in the number of homes delivered to more expensive areas and/or products and increased selling prices of homes delivered in fiscal 2015, as compared to fiscal 2014. Cost of revenues as a percentage of revenues was 78.4% in fiscal 2015, as compared to 78.8% in fiscal 2014.The decrease in cost of revenues in fiscal 2015 as a percentage of revenues, as compared to fiscal 2014, was due primarily to a change in product mix/areas to higher-margin areas, increased prices of homes delivered in fiscal 2015, as compared to fiscal 2014, the lower charge recognized for warranty and litigation in fiscal 2015, as compared to fiscal 2014, and the lower impact of the application of purchase accounting from the homes delivered from the Acquisition in fiscal 2015, as compared to fiscal 2014. These decreases were offset, in part, by increased construction costs and higher higher inventory impairment charges and write-offs in fiscal 2015, as compared to fiscal 2014. In fiscal 2015 and 2014, we recognized inventory impairment charges of $35.7 million or 0.9% of revenues and $20.7 million or 0.5% of revenues, respectively. In addition, in fiscal 2015 and 2014, we recognized charges related to warranty and litigation, net of other reversals, of $11.0 million and $24.0 million, respectively. See Note 6 - “Accrued Expenses” in Item 15(a)1 of this Form 10-K for additional information regarding these warranty charges. Interest cost in fiscal 2015 was $142.9 million or 3.4% of revenues, as compared to $137.5 million or 3.5% of revenues in fiscal 2014. SELLING, GENERAL AND ADMINISTRATIVE EXPENSES (“SG&A”) SG&A increased by $22.6 million in fiscal 2015, as compared to fiscal 2014. As a percentage of revenues, SG&A decreased to 10.9% in fiscal 2015, from 11.1% in fiscal 2014. Fiscal 2014 SG&A includes $6.1 million of expenses incurred in the Acquisition. The dollar increase in SG&A costs, excluding the acquisition costs, was due primarily to increased compensation costs due to our increased number of employees, and increased sales and marketing costs. The higher sales and marketing costs were the result of the increased spending on advertising and increased operating costs due to the increased number of selling communities that we had in fiscal 2015, as compared to fiscal 2014. INCOME FROM UNCONSOLIDATED ENTITIES We recognize our proportionate share of the earnings and losses from the various unconsolidated entities in which we have an investment. Many of our unconsolidated entities are land development projects or high-rise/mid-rise condominium construction projects, which do not generate revenues and earnings for a number of years during the development of the property. Once development is complete, these unconsolidated entities will generally, over a relatively short period of time, generate revenues and earnings until all of the assets of the entity are sold. Because there is not a steady flow of revenues and earnings from these entities, the earnings recognized from these entities will vary significantly from quarter to quarter and year to year. In fiscal 2015, we recognized $21.1 million of income from unconsolidated entities, as compared to $41.1 million in fiscal 2014. The decrease in income from unconsolidated entities was due primarily to our recognition of a $23.5 million gain representing our share of the gain on the sale by a Rental Property Joint Venture of substantially all of its assets in December 2013 and a $12.0 million distribution from the Trust in April 2014 due to the refinancing of one of the Trust’s apartment properties. This was offset, in part, by higher income realized from several of our Land Development Joint Ventures and one Home Building Joint Venture in fiscal 2015, as compared to fiscal 2014. The higher income from these joint ventures was attributable primarily to higher sales activity and/or price increases in fiscal 2015, as compared to fiscal 2014. OTHER INCOME - NET The table below provides the components of “Other Income - net” for the years ended October 31, 2015 and 2014 (amounts in thousands): In fiscal 2015, our security monitoring business recognized an $8.1 million gain from a bulk sale of security monitoring accounts, which is included in income from ancillary businesses above. The decrease in income from Gibraltar’s operations in fiscal 2015, as compared to fiscal 2014, was primarily due to a reduction in gains recognized from the disposition of real estate owned (“REO”) and from the acquisition of REO through foreclosure. The increase in management fee income in fiscal 2015, as compared to fiscal 2014, was primarily due to the increase in activity from the unconsolidated entities that we manage. The decrease in income from land sales was due to fewer land parcels being available for sale in fiscal 2015, as compared to fiscal 2014. INCOME BEFORE INCOME TAXES In fiscal 2015, we reported income before income taxes of $535.6 million, as compared to $504.6 million in fiscal 2014. INCOME TAX PROVISION We recognized a $172.4 million income tax provision in fiscal 2015. Based upon the federal statutory rate of 35%, our federal tax provision would have been $187.4 million. The difference between our tax provision recognized and the tax provision based on the federal statutory rate was due mainly to the reversal of $15.3 million of previously accrued tax provisions on uncertain tax positions that were no longer necessary due to the expiration of the statute of limitations and settlements with certain taxing jurisdictions; a $12.3 million tax benefit from the utilization of the domestic production activities deduction; a benefit of $12.6 million from the reversal of state deferred tax asset valuation allowances, net of $3.7 million of new state deferred tax asset valuation allowances recognized; and $7.8 million of other permanent deductions; offset, in part, by the recognition of a $21.9 million provision for state income taxes; the recognition of a $3.2 million provision for uncertain tax positions taken; $2.6 million of accrued interest and penalties for previously accrued taxes on uncertain tax positions; and $5.3 million of other differences. We recognized a $164.6 million income tax provision in fiscal 2014. Based upon the federal statutory rate of 35%, our federal tax provision would have been $176.6 million. The difference between our tax provision recognized, excluding the changes in the deferred tax valuation allowance, and the tax provision based on the federal statutory rate was due principally to the reversal of $11.0 million of previously accrued tax provisions on uncertain tax positions that were no longer necessary due to the expiration of the statute of limitations and the settlement of state income tax audits; a $14.8 million tax benefit from our utilization of domestic production activities deductions; a $12.3 million tax benefit from our utilization of the domestic production activities deduction; a benefit of $12.0 million from the reversal of state deferred tax asset valuation allowances, net of $1.3 million of new state deferred tax asset valuation allowances recognized; and a $6.2 million tax benefit related to other miscellaneous permanent deductions, offset, in part, by a $23.8 million provision for state income taxes; the recognition of a $5.7 million provision for uncertain tax positions taken; and $1.8 million of accrued interest and penalties for previously accrued taxes on uncertain tax positions. CAPITAL RESOURCES AND LIQUIDITY Funding for our business has been, and continues to be, provided principally by cash flow from operating activities before inventory additions, unsecured bank borrowings, and the public debt and equity markets. At October 31, 2016, we had $633.7 million of cash and cash equivalents on hand and approximately $961.8 million available for borrowing under our New Credit Facility. Cash provided by operating activities during fiscal 2016 was $148.8 million. It was generated primarily from $382.1 million of net income plus $26.7 million of stock-based compensation, $23.1 million of depreciation and amortization, $13.8 million of inventory impairments and write-offs, and $19.3 million of deferred taxes; an increase of $524.6 million in accounts payable and accrued expenses; a $27.8 million increase in customer deposits; and a $6.0 million increase in income taxes payable; offset, in part, by the net purchase of $391.2 million of inventory; a $307.4 million increase in receivables, prepaid expenses, and other assets; and an increase of $124.9 million in mortgage loans originated, net of the sale of mortgage loans to outside investors. Cash provided by investing activities during fiscal 2016 was $8.2 million. The cash provided by investing activities was primarily related to $97.4 million of cash received as returns on our investments in unconsolidated entities, foreclosed real estate, and distressed loans and $10.0 million of proceeds from the the sale of marketable securities, offset, in part, by $69.7 million used to fund investments in unconsolidated entities and $28.4 million for the purchase of property and equipment. We used $442.3 million of cash from financing activities in fiscal 2016, primarily for the repurchase of $392.8 million of our common stock; the repayment of $100.0 million from our credit facilities, net of new borrowing under them; and the repayment of $69.0 million of other loans payable, net of new borrowings, offset, in part, by $110.0 million of new borrowings under our mortgage company loan facility, net of repayments. At October 31, 2015, we had $929.0 million of cash, cash equivalents, and marketable securities on hand and approximately $566.1 million available for borrowing under our $1.035 billion revolving credit facility (“Credit Facility”). Cash provided by operating activities during fiscal 2015 was $60.2 million. It was generated primarily from $363.2 million of net income plus $22.9 million of stock-based compensation, $23.6 million of depreciation and amortization, $35.7 million of inventory impairments and write-offs, and $62.1 million of deferred taxes; a $46.5 million increase in customer deposits; and an increase of $28.7 million in accounts payable and accrued expenses; offset, in part, by the net purchase of $352.0 million of inventory; a $65.5 million decrease in income taxes payable; a $55.6 million increase in receivables, prepaid expenses, and other assets; and an increase of $21.4 million in mortgage loans originated, net of the sale of mortgage loans to outside investors. Cash used in our investing activities during fiscal 2015 was $52.8 million. The cash used in investing activities was primarily related to $123.9 million used to fund investments in unconsolidated entities, $9.4 million for the purchase of property and equipment, offset, in part, by $77.4 million of cash received as returns on our investments in unconsolidated entities, foreclosed real estate, and distressed loans. We generated $325.3 million of cash from financing activities in fiscal 2015, primarily from the issuance of $350.0 million of 4.875% Senior Notes due 2025; $350.0 million of borrowing under our Credit Facility; and $39.5 million from the proceeds of our stock-based benefit plans, offset, in part, by the repayment of $300.0 million of senior notes; the repurchase of $56.9 million of our common stock; and the repayment of $55.0 million of other loans payable, net of new borrowings. At October 31, 2014, we had $598.3 million of cash, cash equivalents, and marketable securities on hand and approximately $940.2 million available for borrowing under our Credit Facility. Cash provided by operating activities during fiscal 2014 was $313.2 million. It was generated primarily from $340.0 million of net income plus $21.7 million of stock-based compensation, $23.0 million of depreciation and amortization, $20.7 million of inventory impairments and write-offs, and $47.4 million of deferred taxes; an $82.1 million increase in accounts payable and accrued expenses; and a $52.4 million increase in income taxes payable; offset, in part, by the net purchase of $272.0 million of inventory. Cash used in our investing activities during fiscal 2014 was $1.45 billion. The cash used in investing activities was primarily related to the $1.49 billion used to acquire Shapell; $113.0 million used to fund investments in unconsolidated entities; $15.1 million for the purchase of property and equipment; offset, in part, by $127.0 million of cash received as returns on our investments in unconsolidated entities, distressed loans, and foreclosed real estate, and $40.2 million of sales of marketable securities. We generated $952.2 million of cash from financing activities in fiscal 2014, primarily from the issuance of 7.2 million shares of our common stock in November 2013 that raised $220.4 million; $595.3 million from the issuance in November 2013 of $350.0 million of 4.0% Senior Notes due 2018 and $250.0 million of 5.625% Senior Notes due 2024; the borrowing of $500.0 million under a five-year term loan from a syndicate of eleven banks; and $28.4 million from the proceeds of our stock-based benefit plans, offset, in part, by the repayment of $268.0 million of our 4.95% Senior Notes in March 2014; the repurchase of $90.8 million of our common stock; and the repayment of $40.8 million of other loans payable, net of new borrowings. In general, our cash flow from operating activities assumes that, as each home is delivered, we will purchase a home site to replace it. Because we own a supply of several years of home sites, we do not need to buy home sites immediately to replace those that we deliver. In addition, we generally do not begin construction of our detached homes until we have a signed contract with the home buyer. Should our business decline, we believe that our inventory levels would decrease as we complete and deliver the homes under construction but do not commence construction of as many new homes, as we complete the improvements on the land we already own, and as we sell and deliver the speculative homes that we have currently in inventory, resulting in additional cash flow from operations. In addition, we might delay or curtail our acquisition of additional land, as we did during the period April 2006 through January 2010, which would further reduce our inventory levels and cash needs. At October 31, 2016, we owned or controlled through options 48,837 home sites, as compared to 44,253 at October 31, 2015; and 47,167 at October 31, 2014. Of the 48,837 home sites owned or controlled through options at October 31, 2016, we owned 34,137. Of our owned home sites at October 31, 2016, significant improvements were completed on approximately 17,065 of them. In February 2014, we acquired all of the equity interests in Shapell, consisting of Shapell’s single-family residential real property development business, including a portfolio of approximately 4,950 home sites in California. For more information regarding the Shapell acquisition, see Note 2, “Acquisitions” in the Notes to Consolidated Financial Statements in this Form 10-K. At October 31, 2016, the aggregate purchase price of land parcels under option and purchase agreements was approximately $1.62 billion (including $79.2 million of land to be acquired from joint ventures in which we have invested). Of the $1.62 billion of land purchase commitments, we had paid or deposited $65.3 million and, if we acquire all of these land parcels, we will be required to pay an additional $1.56 billion. The purchases of these land parcels are scheduled over the next several years. We have additional land parcels under option that have been excluded from the aforementioned aggregate purchase amounts since we do not believe that we will complete the purchase of these land parcels and no additional funds will be required from us to terminate these contracts. During the past several years, we have made a number of investments in unconsolidated entities related to the acquisition and development of land for future home sites, the construction of luxury for-sale condominiums, and for-rent apartments. Our investment activities related to investments in and distributions of investments from unconsolidated entities are contained in the Consolidated Statements of Cash Flows under “Net cash provided by (used in) investing activities,” At October 31, 2016, we had investments in these entities of $496.4 million, and were committed to invest or advance up to an additional $273.8 million to these entities if they require additional funding. On May 19, 2016, we entered into a new $1.215 billion (subsequently increased to $1.295 billion), five-year, unsecured New Credit Facility and terminated our $1.035 billion Credit Facility that was scheduled to terminate on August 1, 2018. Under the terms of the New Credit Facility, our maximum leverage ratio (as defined in the credit agreement) may not exceed 1.75 to 1.00 and we are required to maintain a minimum tangible net worth (as defined in the credit agreement) of no less than approximately $2.60 billion. Under the terms of the New Credit Facility, at October 31, 2016, our leverage ratio was approximately 0.71 to 1.00 and our tangible net worth was approximately $4.18 billion. Based upon the minimum tangible net worth requirement, our ability to repurchase our common stock was limited to approximately $2.13 billion as of October 31, 2016. At October 31, 2016, we had $250.0 million of outstanding borrowings under the New Credit Facility and had outstanding letters of credit of approximately $83.2 million. We believe that we will have adequate resources and sufficient access to the capital markets and external financing sources to continue to fund our current operations and meet our contractual obligations. Due to the uncertainties in the economy and for home builders in general, we cannot be certain that we will be able to replace existing financing or find sources of additional financing in the future. INFLATION The long-term impact of inflation on us is manifested in increased costs for land, land development, construction, and overhead. We generally enter into contracts to acquire land a significant period of time before development and sales efforts begin. Accordingly, to the extent land acquisition costs are fixed, subsequent increases or decreases in the sales prices of homes will affect our profits. Because the sales price of each of our homes is fixed at the time a buyer enters into a contract to purchase a home and because we generally contract to sell our homes before we begin construction, any inflation of costs in excess of those anticipated may result in lower gross margins. We generally attempt to minimize that effect by entering into fixed-price contracts with our subcontractors and material suppliers for specified periods of time, which generally do not exceed one year. In general, housing demand is adversely affected by increases in interest rates and housing costs. Interest rates, the length of time that land remains in inventory, and the proportion of inventory that is financed affect our interest costs. If we are unable to raise sales prices enough to compensate for higher costs, or if mortgage interest rates increase significantly, affecting prospective buyers’ ability to adequately finance home purchases, our revenues, gross margins, and net income could be adversely affected. Increases in sales prices, whether the result of inflation or demand, may affect the ability of prospective buyers to afford new homes. CONTRACTUAL OBLIGATIONS The following table summarizes our estimated contractual payment obligations at October 31, 2016 (amounts in millions): (a) Amounts include estimated annual interest payments until maturity of the debt. Of the amounts indicated, $2.7 billion of the senior notes, $871.1 million of loans payable, and $210.0 million of the mortgage company loan facility were recorded on the October 31, 2016 Consolidated Balance Sheet. In addition, the 2018 - 2019 amount includes $287.5 million principal amount of 0.5% Exchangeable Senior Notes due 2032 (the “0.5% Exchangeable Senior Notes”). The 0.5% Exchangeable Senior Notes are exchangeable into shares of our common stock at an exchange rate of 20.3749 shares per $1,000 principal amount of notes, corresponding to an initial exchange price of approximately $49.08 per share of common stock. Holders of the 0.5% Exchangeable Senior Notes will have the right to require Toll Brothers Finance Corp. to repurchase their notes for cash equal to 100% of their principal amount, plus accrued but unpaid interest, on each of December 15, 2017, September 15, 2022, and September 15, 2027. We will have the right to redeem the 0.5% Exchangeable Senior Notes on or after September 15, 2017, for cash equal to 100% of their principal amount, plus accrued but unpaid interest. (b) Amounts represent our expected acquisition of land under purchase agreements, the estimated remaining amount of the contractual obligation for land development agreements secured by letters of credit and surety bonds and $85.2 million for the acquisition of Coleman in November 2016. (c) Amounts represent our obligations under our deferred compensation plan, supplemental executive retirement plans and our 401(k) salary deferral savings plans. Of the total amount indicated, $68.4 million was recorded on the October 31, 2016 Consolidated Balance Sheet. SEGMENTS We operate in two segments: Traditional Home Building and City Living, our urban development division. Within Traditional Home Building, we operate in five geographic segments around the United States: (1) the North, consisting of Connecticut, Illinois, Massachusetts, Michigan, Minnesota, New Jersey, and New York; (2) the Mid-Atlantic, consisting of Delaware, Maryland, Pennsylvania, and Virginia; (3) the South, consisting of Florida, North Carolina, and Texas; (4) the West, consisting of Arizona, Colorado, Nevada, and Washington, and (5) California. The following tables summarize information related to revenues, net contracts signed, and income (loss) before income taxes by segment for fiscal years 2016, 2015, and 2014. Information related to backlog and assets by segment at October 31, 2016 and 2015, has also been provided. Units Delivered and Revenues: Net Contracts Signed: Backlog at October 31: Income (Loss) Before Income Taxes ($ amounts in millions): “Corporate and other” is comprised principally of general corporate expenses such as the offices of our executive officers; the corporate finance, accounting, audit, tax, human resources, risk management, information technology, marketing, and legal groups; interest income; income from our ancillary businesses, including Gibraltar; and income from a number of our unconsolidated entities. Total Assets ($ amounts in millions): “Corporate and other” is comprised principally of cash and cash equivalents, marketable securities, restricted cash and investments, deferred tax assets, investments in our Rental Property Joint Ventures, expected recoveries from insurance carriers and suppliers, our Gibraltar investments, manufacturing facilities, and mortgage and title subsidiaries. FISCAL 2016 COMPARED TO FISCAL 2015 Traditional Homebuilding North The increase in the average price of homes delivered in fiscal 2016, as compared to fiscal 2015, was primarily attributable to a shift in the number of homes delivered to more expensive areas and/or products and increases in selling prices of homes delivered in fiscal 2016, as compared to fiscal 2015. The increase in the number of homes delivered in fiscal 2016, as compared to fiscal 2015, was mainly due to increases in the number of homes closed in Michigan and New Jersey, partially offset by a decrease in the number of homes closed in Illinois. The increase in the number of homes closed in New Jersey was primarily due to higher backlog conversion in the fiscal 2016 period, as compared to the fiscal 2015 period. In Michigan, the increase was principally due to an increase in the number of homes in backlog as of October 31, 2015, as compared to the number of homes in backlog at October 31, 2014. The increase in the number of net contracts signed in fiscal 2016, as compared to fiscal 2015, was mainly due to improved market conditions in Michigan, New York, and New Jersey, offset, in part by decreases in Connecticut and Illinois where demand has declined, and in Massachusetts due to a decrease in the number of selling communities. The increase in the average sales price of net contracts signed was principally attributable to a shift in the number of contracts signed to more expensive areas and/or products and increases in base selling prices in fiscal 2016, as compared to fiscal 2015. The 30% increase in income before income taxes in fiscal 2016, as compared to fiscal 2015, was principally attributable to higher earnings from increased revenues and lower inventory impairment charges, offset, in part, by higher cost of revenues, excluding inventory impairment charges, as a percentage of revenues, and higher SG&A costs. During our review of communities for impairment in fiscal 2016 and 2015, primarily due to a lack of improvement and/or a decrease in customer demand as a result of weaker than expected market conditions, we determined that the pricing assumptions used in prior impairment reviews for three operating communities (two located in Connecticut and one in suburban New York) in fiscal 2016, and two operating communities (one located in suburban New York and one located in New Jersey) in fiscal 2015, needed to be reduced. As a result of these reductions in expected sales prices, we determined that these communities were impaired. Accordingly, the carrying values of these communities were written down to their estimated fair values resulting in charges to income before taxes of $7.3 million and $13.9 million in fiscal 2016 and fiscal 2015, respectively. Total inventory impairment charges for fiscal 2016 and fiscal 2015 were $7.6 million and $15.0 million, respectively. The increase in the cost of revenues, excluding inventory impairment charges, as a percentage of revenues, was primarily due to a change in product mix/areas to lower-margin areas. Mid-Atlantic The increase in the number of homes delivered in fiscal 2016, as compared to fiscal 2015, was mainly due to a greater number of homes being sold and delivered in fiscal 2016, as compared to fiscal 2015. The increase in the number of net contracts signed in fiscal 2016, as compared to fiscal 2015, was primarily attributable to increases in demand in Pennsylvania, Maryland, and Virginia and to an increase in the number of selling communities in Pennsylvania and Maryland. The loss before income taxes in fiscal 2016, as compared to income before income taxes in fiscal 2015, was mainly due to $125.6 million of warranty charges, primarily related to older homes built in Pennsylvania and Delaware, in fiscal 2016, as compared to $14.7 million in fiscal 2015. and higher SG&A costs, offset, in part, by lower inventory impairment charges and higher earnings from increased revenues. See Note 6 - “Accrued Expenses” in Item 15(a)1 of this Form 10-K for additional information regarding these warranty charges. Inventory impairment charges were $2.1 million, as compared to $19.5 million in fiscal 2016 and fiscal 2015, respectively. The impairment charges in fiscal 2016 primarily related to a land purchase contract in Delaware where we were unable to obtain the required approvals to proceed with our development of the underlying property. Accordingly, we terminated the contract and wrote off costs incurred. In fiscal 2015, due to the weakness in certain housing markets in Maryland and West Virginia, we decided to sell or look for alternate uses for two parcels of land rather than develop them as previously intended. The carrying values of these communities were written down to their estimated fair values resulting in charges to income before taxes of $11.9 million. We sold one parcel of land during the fourth quarter of fiscal 2015. In addition, during our review of operating communities for impairment in fiscal 2015, primarily due to a lack of improvement and/or a decrease in customer demand as a result of weaker than expected market conditions, we determined that the pricing assumptions used in prior impairment reviews for one operating community located in Virginia needed to be reduced. As a result of this reduction in expected sales prices, we determined that this community was impaired. Accordingly, the carrying value of this community was written down to its estimated fair value resulting in a charge to income before taxes in fiscal 2015 of $3.1 million. South The decrease in the number of homes delivered in fiscal 2016, as compared to fiscal 2015, was principally due a decrease in the number of homes in backlog as of October 31, 2015, as compared to the number of homes in backlog at October 31, 2014. The increase in the average price of the homes delivered in fiscal 2016, as compared to fiscal 2015, was primarily attributable to a shift in the number of homes delivered to more expensive areas and/or products. The increase in the number of net contracts signed in fiscal 2016, as compared to fiscal 2015, was mainly due to increases in demand in the Raleigh, North Carolina and the Dallas, Texas markets, and an increase in selling communities in Florida. The decreases in the average value of each contract signed in fiscal 2016, as compared to fiscal 2015, was mainly due to a shift in the number of contracts signed to less expensive areas and/or products. The decrease in income before income taxes in fiscal 2016, as compared to fiscal 2015, was principally due to higher cost of revenues, as a percentage of revenues, lower earnings from decreased revenues, and higher SG&A costs in fiscal 2016, as compared to fiscal 2015. The increase in the cost of revenues, as a percentage of revenues, was primarily due to a change in product mix/areas to lower-margin areas and higher inventory impairment charges. Inventory impairment charges were $3.3 million and $0.7 million in fiscal 2016 and fiscal 2015, respectively. In fiscal 2016, we decided to sell or look for alternate uses for a partially improved land parcel in North Carolina rather than develop it as previously intended. The carrying value of this community was written down to its estimated fair values resulting in a charge to income before taxes of $2.0 million. West The increase in the number of homes delivered in fiscal 2016, as compared to fiscal 2015, was primarily due to a higher backlog at October 31, 2015, as compared to October 31, 2014. The increase in the average price of the homes delivered was mainly due to a shift in the number of homes delivered to more expensive products and/or locations and increases in selling prices of homes delivered in fiscal 2016, as compared to fiscal 2015. The increase in the number of net contracts signed in fiscal 2016, as compared to fiscal 2015, was principally due to increases in the number of selling communities in Colorado and the Las Vegas, Nevada market and increased demand in Colorado and Arizona. The increase in income before income taxes in fiscal 2016, as compared to fiscal 2015, was due mainly to higher earnings from the increased revenues and a $2.9 million recovery in fiscal 2016 of previously incurred charges related to a joint venture located in Nevada partially offset by higher cost of revenues, as a percentage of revenues, and higher SG&A costs. The increase in cost of revenues, as a percentage of revenues, was primarily due to a shift in the number of homes delivered to lower-margin products and/or locations. California The increase in the number of homes delivered in fiscal 2016, as compared to fiscal 2015, was principally due to an increase in the number of homes in backlog as of October 31, 2015, as compared to October 31, 2014. The increase in the average price of homes delivered in fiscal 2016, as compared to fiscal 2015, was primarily due to a shift in the number of homes delivered to more expensive areas and/or products and increased selling prices of homes delivered. The decrease in the number of net contracts signed in fiscal 2016, as compared to fiscal 2015, was due primarily to (1) a temporary lack of inventory, primarily in northern California, as we are transitioning between a number of communities that are selling out, and thus have limited inventory, and the opening of new communities and (2) reduced demand resulting from our decision to increase prices in a number of communities with large backlogs to maximize the value of our inventory. Fiscal 2016 was negatively impacted by the continued reduction in demand in our Porter Ranch master planned community in Southern California due to a natural gas leak on unaffiliated land approximately one mile away. In mid-February 2016, the State of California announced that the leak had been permanently sealed. Recent testing has verified that air quality is back to normal levels and, therefore, we are optimistic that operations will gradually return to normal at our Porter Ranch master planned community. The increase in the average sales price of net contracts signed in fiscal 2016, as compared to fiscal 2015, was principally due to a shift in the number of contracts signed to more expensive areas and/or products and increases in selling prices. The increase in income before income taxes in fiscal 2016, as compared to fiscal 2015, was due mainly to higher earnings from increased revenues and lower cost of revenues, as a percentage of revenues. This increase was partially offset by higher SG&A costs. The decrease in cost of revenues, as a percentage of revenues, was primarily due to a shift in the number of homes delivered to higher-margin products and/or locations and increased selling prices of homes delivered. City Living The decrease in the number of homes delivered in fiscal 2016, as compared to fiscal 2015, was principally due to the delivery of homes at one community located in Philadelphia, Pennsylvania, which commenced delivering homes in the third quarter of fiscal 2015 and delivered all homes by October 31, 2015. The increase in the average price of homes delivered in fiscal 2016, as compared to fiscal 2015, was primarily due to a shift in the number of homes delivered from the Philadelphia, Pennsylvania market to the metro New York City market, where average selling prices were higher. The increase in the average sales price of net contracts signed in fiscal 2016, as compared to fiscal 2015, was principally due to a shift in the number of net contracts signed in the Philadelphia, Pennsylvania market to the metro New York City market, where the average value of each contract is higher, and increases in selling prices. The decrease in income before income taxes in fiscal 2016, as compared to fiscal 2015, was mainly due to higher cost of revenues, as a percentage of revenues, lower earnings from decreased revenues, and higher SG&A costs, offset, in part, by higher earnings from our Home Building Joint Ventures. The increase in cost of revenues, as a percentage of revenues, was mainly due to a shift in the number of homes delivered to buildings with lower margins in fiscal 2016, as compared to fiscal 2015. The increase in earnings from our Home Building Joint Ventures was principally due to the commencement of closing in the fourth quarter of fiscal 2016 at two buildings located in New York City. Other The increase in the loss before income taxes in fiscal 2016, as compared to fiscal 2015, was principally attributable to higher SG&A costs in the fiscal 2016 period, as compared to the fiscal 2015 period, a gain of $1.6 million recognized in the fiscal 2016 period, as compared to $8.1 million in the fiscal 2015 period, from a bulk sale of security monitoring accounts by our home security monitoring business in the fiscal 2015 period, and lower earnings from Gibraltar in the fiscal 2016 period, as compared to the fiscal 2015 period. The increase in SG&A costs was due primarily to increased compensation costs due to our increased number of employees. These increases to the loss before income taxes were partially offset by a $4.9 million gain recognized related to the sale of our ownership interests in one of our joint ventures located in New Jersey in the fiscal 2016 period. FISCAL 2015 COMPARED TO FISCAL 2014 Traditional Home Building North The increase in the average price of homes delivered in fiscal 2015, as compared to fiscal 2014, was primarily attributable to a shift in the number of homes delivered to more expensive areas and/or products and increases in selling prices of homes delivered in fiscal 2015, as compared to fiscal 2014. The increase in the number of net contracts signed in fiscal 2015, as compared to fiscal 2014, was mainly due to improved market conditions in Michigan and New Jersey. The increase in the average sales price of net contracts signed was principally attributable to a shift in the number of contracts signed to more expensive areas and/or products and increases in base selling prices in fiscal 2015, as compared to fiscal 2014. The 4% increase in income in fiscal 2015, as compared to fiscal 2014, was primarily attributable to higher earnings from the increased revenues and lower cost of revenues as a percent of revenues, excluding impairment, offset, in part, by higher inventory impairment charges, higher SG&A costs, and lower earnings from land sales in fiscal 2015, as compared to fiscal 2014. We recognized inventory impairment charges of $15.0 million and $9.1 million in fiscal 2015 and 2014, respectively. The decrease in cost of revenues as a percent of revenues, excluding impairments, was mainly due to a change in product mix/areas to higher margin areas in fiscal 2015, as compared to fiscal 2014. Mid-Atlantic The increase in the number of homes delivered in fiscal 2015, as compared to fiscal 2014, was mainly due to a greater number of homes being sold and delivered in fiscal 2015, as compared to fiscal 2014. The increase in the number of net contracts signed in fiscal 2015, as compared to fiscal 2014, was primarily due to an increase in demand in Pennsylvania and Virginia, offset, in part, by a decrease in the number of net contracts signed in Maryland. The increase in the average sales price of net contracts signed was mainly due to a shift in the number of contracts signed to more expensive areas and/or products and increases in base selling prices in fiscal 2015, as compared to fiscal 2014. The 13% decrease in income before income taxes in fiscal 2015, as compared to fiscal 2014, was primarily due to higher impairment charges, higher SG&A costs, and a $2.8 million decrease in earnings from land sales in fiscal 2015, as compared to fiscal 2014. These decreases were partially offset by higher earnings from increased revenues and lower warranty charges, primarily for older homes built in communities located in Pennsylvania and Delaware, in fiscal 2015, as compared to fiscal 2014. Inventory impairment charges, in fiscal 2015 and 2014, were $19.5 million and $9.1 million, respectively. The earnings from land sales in fiscal 2014 mainly represented previously deferred gains on our initial sales of properties to a Rental Property Joint Venture, which sold substanitally of of its assets in fiscal 2014. In fiscal 2015 and 2014, we recognized $14.7 million and $25.0 million, respectively, in charges for the aforementioned warranty repairs. See Note 6 - “Accrued Expenses” in Item 15(a)1 of this Form 10-K for additional information regarding these warranty charges. South The increase in the average price of the homes delivered in fiscal 2015, as compared to fiscal 2014, was mainly due to a shift in the number of homes delivered to more expensive areas and/or products. The decrease in the number of homes delivered was principally due to a lower number of homes being sold and delivered in fiscal 2015, as compared to fiscal 2014. The decrease in the number of net contracts signed in fiscal 2015, as compared to fiscal 2014, was principally due to decreased demand. The increase in the average sales price of net contracts signed was mainly due to a shift in the number of contracts signed to more expensive areas and/or products and increases in base selling prices, primarily in Florida and Texas, in fiscal 2015 as compared to fiscal 2014. The 35% increase in income before income taxes in fiscal 2015, as compared to fiscal 2014, was primarily due to higher earnings from the increased revenues, lower cost of revenues as a percent of revenues, and an $8.5 million increase in earnings from our investments in unconsolidated entities, in fiscal 2015, as compared to fiscal 2014. These increases were partially offset by higher SG&A costs in fiscal 2015, as compared to fiscal 2014. The decrease in cost of revenues as a percentage of revenue was due mainly to a change in product mix/areas to higher margin areas in fiscal 2015, as compared to fiscal 2014. West The increase in the number of homes delivered in fiscal 2015, as compared to fiscal 2014, was primarily due to a higher backlog at October 31, 2014, as compared to October 31, 2013, and to a greater number of homes being sold and delivered in fiscal 2015, as compared to fiscal 2014. The increase in the average price of the homes delivered was mainly due to a shift in the number of homes delivered to more expensive products and/or locations and increases in selling prices of homes delivered in fiscal 2015, as compared to fiscal 2014. The increase in the number of net contracts signed in fiscal 2015, as compared to fiscal 2014, was mainly due to an increase in selling communities in Arizona, Nevada, and Washington. The increase in the average sales price of net contracts signed was primarily due to a shift in the number of contracts signed to more expensive areas and/or products and increases in base selling prices in fiscal 2015, as compared to fiscal 2014. The 35% increase in income before income taxes in fiscal 2015, as compared to fiscal 2014, was principally due to higher earnings from increased revenues in fiscal 2015, as compared to fiscal 2014, offset, in part, by higher SG&A costs in fiscal 2015, as compared to fiscal 2014. California The decrease in the number of homes delivered in fiscal 2015, as compared to fiscal 2014, was mainly due to a decrease in the number of communities in California where we were delivering homes. The increase in the number of net contracts signed in fiscal 2015, as compared to fiscal 2014, was mainly due to increased demand, an increase in the number of selling communities, and fiscal 2015 having 12 months of sales activity at communities we acquired through the Acquisition, as compared to nine months in fiscal 2014. The increase in the average sales price of net contracts signed in fiscal 2015, as compared to fiscal 2014, was principally due to a shift in the number of contracts signed to more expensive areas and/or products and increases in selling prices. The 12% decrease in income before income taxes in fiscal 2015, as compared to fiscal 2014, was mainly due to lower earnings from decreased revenues and a $10.3 million decrease in earnings from land sales in fiscal 2015, as compared to fiscal 2014, offset, in part, by a $4.8 million increase in earnings from our investments in unconsolidated entities and the lower impact of the application of purchase accounting from the homes delivered from the Acquisition in fiscal 2015, as compared to fiscal 2014. City Living The increase in the average price of homes delivered in fiscal 2015, as compared to fiscal 2014, was principally due to closings in fiscal 2015 at high-rise buildings located in New York City, where average prices were higher than in other City Living locations. The decrease in the number of homes delivered in fiscal 2015, as compared to fiscal 2014, was mainly due to a lower backlog at October 31, 2014, as compared to October 31, 2013. The increase in the average value of net contracts signed in fiscal 2015, as compared to fiscal 2014, was principally due to a shift in the number of net contracts signed from the Philadelphia, Pennsylvania market to the metro New York City market, where the average value of each contract signed is higher. The decrease in the number of net contracts signed was mainly due to slower demand in the first three months of fiscal 2015 and to a decline in the number of net contracts signed in Philadelphia, Pennsylvania, due to lower product availability. The 19% increase in income in fiscal 2015, as compared to fiscal 2014, was primarily attributable to higher earnings from increased revenues in fiscal 2015, as compared to fiscal 2014, $3.6 million of earnings from the sale of commercial space at one of our high-rise buildings in New York City in fiscal 2015, and a charge of $2.6 million to our earnings due to a settled litigation at one of our unconsolidated entities in fiscal 2014, partially offset by higher SG&A costs in fiscal 2015, as compared to 2014. Other The increase in the loss before income taxes in fiscal 2015, as compared to fiscal 2014, was principally due to a decrease in income from unconsolidated entities from $42.0 million in fiscal 2014 to $5.7 million in fiscal 2015, decreased income from our Gibraltar operations, and higher SG&A costs in fiscal 2015, as compared to fiscal 2014, offset, in part, by an increase of $12.9 million in income from ancillary businesses in fiscal 2015, as compared to fiscal 2014. The decrease in income from unconsolidated entities was due primarily to our recognition of a $23.5 million gain representing our share of the gain on the sale by a Rental Property Joint venture, which sold substantially all of its assets in December 2013 and a $12.0 million distribution from the Trust in April 2014 due to the refinancing of one of the Trust’s apartment properties. The increase in income from ancillary businesses was mainly due to the recognition of an $8.1 million gain from a bulk sale of security monitoring accounts by our home security monitoring business in fiscal 2015.

<s>[INST] When this report uses the words “we,” “us,” “our,” and the “Company,” they refer to Toll Brothers, Inc. and its subsidiaries, unless the context otherwise requires. References herein to fiscal year refer to our fiscal years ended or ending October 31. Unless otherwise stated in this report, net contracts signed represents a number or value equal to the gross number or value of contracts signed during the relevant period, less the number or value of contracts canceled during the relevant period, which includes contracts that were signed during the relevant period and in prior periods. Backlog consists of homes under contract but not yet delivered to our home buyers (“backlog”). OVERVIEW Our Business We design, build, market, sell, and arrange financing for detached and attached homes in luxury residential communities. We cater to moveup, emptynester, activeadult, agequalified, and secondhome buyers in the United States (“Traditional Home Building Product”). We also build and sell homes in urban infill markets through Toll Brothers City Living® (“City Living”). At October 31, 2016, we were operating in 19 states. In the five years ended October 31, 2016, we delivered 24,490 homes from 621 communities, including 6,098 homes from 377 communities in fiscal 2016. In February 2014, we acquired the home building business of Shapell Industries, Inc., a Delaware corporation (“Shapell”), and in November 2016, we acquired substantially all of the assets and operations of Coleman Real Estate Holdings, LLC (“Coleman”). See “Acquisitions” below for more information. We are developing several land parcels for master planned communities in which we intend to build homes on a portion of the lots and sell the remaining lots to other builders. Two of these master planned communities are being developed 100% by us, and the remaining communities are being developed through joint ventures with other builders or financial partners. In addition to our residential forsale business, we also develop and operate forrent apartments through joint ventures. See the section entitled “Toll Brothers Apartment Living/Toll Brothers Campus Living/Toll Brothers Realty Trust” below. We operate our own land development, architectural, engineering, mortgage, title, landscaping, security monitoring, lumber distribution, house component assembly, and manufacturing operations. In addition, in certain markets, we develop land for sale to other builders, often through joint venture structures with other builders or with financial partners. We also develop, own, and operate golf courses and country clubs, which generally are associated with several of our master planned communities. We have investments in various unconsolidated entities. We have investments in joint ventures (i) to develop land for the joint venture participants and for sale to outside builders (“Land Development Joint Ventures”); (ii) to develop forsale homes (“Home Building Joint Ventures”); (iii) to develop luxury forrent residential apartments, commercial space and a hotel (“Rental Property Joint Ventures”); and (iv) to invest in distressed loans and real estate and provide financing for residential builders and developers for the acquisition and development of land and home sites (“Gibraltar Joint Ventures”). Financial Highlights In fiscal 2016, we recognized $5.17 billion of revenues and net income of $382.1 million, as compared to $4.17 billion of revenues and net income of $363.2 million in fiscal 2015. In fiscal 2016 and 2015, the value of net contracts signed was $5.65 billion (6,719 homes) and $4.96 billion (5,910 homes), respectively. The value of our backlog at October 31, 2016 was $3.98 billion (4,685 homes), as compared to our backlog at October 31, 2015 of $3.50 billion (4,064 homes). At October 31, 2016, we had $633.7 million of cash and cash equivalents on hand and [/INST] Positive. </s>

TOLL BROTHERS INC

2017-12-21

2017-10-31

ITEM 7. MANAGEMENT’S DISCUSSION AND ANALYSIS OF FINANCIAL CONDITION AND RESULTS OF OPERATIONS (“MD&A”) This discussion and analysis is based on, should be read together with, and is qualified in its entirety by, the Consolidated Financial Statements and Notes thereto in Item 15(a)1 of this Form 10-K, beginning at page. It also should be read in conjunction with the disclosure under “Forward-Looking Statements” in Part I of this Form 10-K. When this report uses the words “we,” “us,” “our,” and the “Company,” they refer to Toll Brothers, Inc. and its subsidiaries, unless the context otherwise requires. References herein to fiscal year refer to our fiscal years ended or ending October 31. Unless otherwise stated in this report, net contracts signed represents a number or value equal to the gross number or value of contracts signed during the relevant period, less the number or value of contracts canceled during the relevant period, which includes contracts that were signed during the relevant period and in prior periods. Backlog consists of homes under contract but not yet delivered to our home buyers (“backlog”). OVERVIEW Our Business We design, build, market, sell, and arrange financing for detached and attached homes in luxury residential communities. We cater to move-up, empty-nester, active-adult, and second-home buyers in the United States (“Traditional Home Building Product”). We also build and sell homes in urban infill markets through Toll Brothers City Living® (“City Living”). At October 31, 2017, we were operating in 20 states. In the five years ended October 31, 2017, we delivered 28,355 homes from 676 communities, including 7,151 homes from 407 communities in fiscal 2017. In November 2016, we acquired substantially all of the assets and operations of Coleman Real Estate Holdings, LLC (“Coleman”). See “Acquisition” below for more information. We are developing several land parcels for master planned communities in which we intend to build homes on a portion of the lots and sell the remaining lots to other builders. Two of these master planned communities are being developed 100% by us, and the remaining communities are being developed through joint ventures with other builders or financial partners. In addition to our residential for-sale business, we also develop and operate for-rent apartments through joint ventures. See the section entitled “Toll Brothers Apartment Living/Toll Brothers Campus Living/Toll Brothers Realty Trust” below. We operate our own land development, architectural, engineering, mortgage, title, landscaping, security monitoring, lumber distribution, house component assembly, and manufacturing operations. In addition, in certain markets, we develop land for sale to other builders, often through joint venture structures with other builders or with financial partners. We also develop, own, and operate golf courses and country clubs, which generally are associated with several of our master planned communities. We have investments in various unconsolidated entities. We have investments in joint ventures (i) to develop land for the joint venture participants and for sale to outside builders (“Land Development Joint Ventures”); (ii) to develop for-sale homes (“Home Building Joint Ventures”); (iii) to develop luxury for-rent residential apartments, commercial space and a hotel (“Rental Property Joint Ventures”); and (iv) to invest in distressed loans and real estate and provide financing and land banking for residential builders and developers for the acquisition and development of land and home sites (“Gibraltar Joint Ventures”). Financial Highlights In fiscal 2017, we recognized $5.82 billion of revenues and net income of $535.5 million, as compared to $5.17 billion of revenues and net income of $382.1 million in fiscal 2016. In fiscal 2017 and 2016, the value of net contracts signed was $6.83 billion (8,175 homes) and $5.65 billion (6,719 homes), respectively. The value of our backlog at October 31, 2017 was $5.06 billion (5,851 homes), as compared to our backlog at October 31, 2016 of $3.98 billion (4,685 homes). At October 31, 2017, we had $712.8 million of cash and cash equivalents on hand and approximately $1.15 billion available for borrowing under our $1.295 billion revolving credit facility (the “Credit Facility”) that matures in May 2021. At October 31, 2017, we had no outstanding borrowings under the Credit Facility and had outstanding letters of credit of approximately $140.1 million. In February 2017, our Board of Directors approved the initiation of quarterly cash dividends to shareholders. During fiscal 2017, we paid a quarterly cash dividend of $0.08 per share on each of April 28, 2017, July 28, 2017 and October 27, 2017. In December 2016, we declared a quarterly cash dividend of $0.08 which will be paid on January 26, 2018 to shareholders of record on the close of business on January 12, 2018. At October 31, 2017, our total equity and our debt to total capitalization ratio were $4.54 billion and 0.42 to 1:00, respectively. Acquisition In October 2016, we entered into an agreement to acquire substantially all of the assets and operations of Coleman. In November 2016, we completed the acquisition of Coleman for approximately $83.1 million in cash. The assets acquired were primarily inventory, including approximately 1,750 home sites owned or controlled through land purchase agreements. As part of the acquisition, we assumed contracts to deliver 128 homes with an aggregate value of $38.8 million. The average price of the undelivered homes at the date of acquisition was approximately $303,000. Our selling community count increased by 15 communities at the acquisition date. Our Business Environment and Current Outlook The current housing market continues to strengthen and grow. We believe that solid and improving demand for homes, low interest rates, the limited supply of resale and new homes, and the financial strength of the affluent buyers that we target are driving our growth. Our buyers are further benefiting from a solid employment picture, strong consumer confidence, a robust stock market, and increasing equity in their existing homes. In fiscal 2017, the value and number of signed contracts increased 20.9% and 21.7%, respectively, as compared to fiscal 2016; and increased 37.8% and 38.3%, respectively, as compared to fiscal 2015. In fiscal 2017, we signed 8,175 contracts with an aggregate value of $6.83 billion, compared to 6,719 contracts with an aggregate value of $5.65 billion in fiscal 2016, and 5,910 contracts with an aggregate value of $4.96 billion in fiscal 2015. We believe that, as the national economy continues to improve and as the millennial generation comes of age, pent-up demand for homes will continue to be released. We believe we are also benefiting from the appeal and national recognition of our brand and a lack of large scale competition in the affordable end of the luxury new home market. Our home designs and our customization program differentiate us within our segment of the luxury home market. The breadth of products we offer enables us to appeal to a wide range of demographic groups, including affluent move-up, empty-nester and millennial buyers, which we believe is also fueling demand for our homes. We continue to believe that many of our communities are in desirable locations that are difficult to replace and that many of these communities have substantial embedded value that may be realized in the future as the housing recovery strengthens. The supply of new and existing homes continues to trail the growth in population and households. We believe that in certain markets, the new home market continues to have significant pent-up demand. We are producing strong results even with industry-wide home production levels still well below historical norms. We believe that, as the national economy continues to improve and as the millennial generation comes of age, pent-up demand for homes will continue to be released. We expect that this increase in demand will drive production of new homes to address the existing deficit in housing supply compared to projected household growth. According to the U.S. Census Bureau (“Census Bureau”), the number of households earning $100,000 or more (in constant 2016 dollars) at September 2017 stood at 35.0 million, or approximately 27.7% of all U.S. households. This group has grown at three times the rate of increase of all U.S. households since 1980. According to Harvard University’s 2017 report, “The State of the Nation’s Housing,” demographic forces are likely to drive the addition of approximately 1.36 million new households per year from 2015 to 2025. Housing starts, which encompass the units needed for household formations, second homes, and the replacement of obsolete or demolished units, have not kept pace with this projected household growth. According to the Census Bureau’s October 2017 New Residential Sales Report, new home inventory stands at a supply of just 5.0 months, based on current sales paces. If demand and pace increase significantly, the supply of 5.0 months could quickly be drawn down. During the period 1970 through 2007, total housing starts in the United States averaged approximately 1.6 million per year, while during the period 2008 through 2016, total housing starts averaged approximately 0.85 million per year according to the Census Bureau. Additionally, the median age of housing stock in the United States has increased from 25 years to 39 years over the last three decades, thus expanding the market for replacement homes. We continue to believe that many of our communities are in desirable locations that are difficult to replace and in markets where approvals have been increasingly difficult to achieve. We believe that many of these communities have substantial embedded value that may be realized in the future as the housing recovery strengthens. Tax Reform In December 2017, Congress passed a federal tax reform bill. If signed into law by the President, this bill will change many longstanding foreign and domestic corporate and individual tax rules, as well as rules pertaining to the taxation of employee compensation and benefits. The legislation includes significant changes impacting domestic corporate taxpayers. We are currently evaluating the impact such changes would have on our consolidated financial statements and disclosures but preliminarily believe, if signed, it will significantly decrease our effective tax rate. Defective Floor Joists In July 2017, one of our lumber suppliers publicly announced a floor joist recall. We believe that these floor joists were present in approximately 350 homes that had been built or were under construction in our North and West geographic segments. Of the approximately 350 affected homes, eight of them had already been delivered to home buyers at the time the joist recall was announced. After the joist recall was announced, 34 home buyers canceled their contracts and 17 home buyers transferred their contracts to another home site. At October 31, 2017, there were approximately 270 affected homes in backlog. The supplier has committed to us that it will absorb the costs associated with the remediation of the defective floor joists. This work has been completed in most of the affected homes. We expect to deliver the remaining homes in fiscal 2018. We do not believe the resolution of this issue will be material to our results of operations, liquidity, or our financial condition. Competitive Landscape The home building business is highly competitive and fragmented. We compete with numerous home builders of varying sizes, ranging from local to national in scope, some of which have greater sales and financial resources than we do. Sales of existing homes, whether by a homeowner or by a financial institution that has acquired a home through a foreclosure, also provide competition. We compete primarily based on price, location, design, quality, service, and reputation. We believe our financial stability, relative to many others in our industry, is a favorable competitive factor as more home buyers focus on builder solvency. In addition, there are fewer and more selective lenders serving our industry as compared to prior years and we believe that these lenders gravitate to the home building companies that offer them the greatest security, the strongest balance sheets, and the broadest array of potential business opportunities. Land Acquisition and Development Our business is subject to many risks, because of the extended length of time that it takes to obtain the necessary approvals on a property, complete the land improvements on it, and deliver a home after a home buyer signs an agreement of sale. In certain cases, we attempt to reduce some of these risks by utilizing one or more of the following methods: controlling land for future development through options (also referred to herein as “land purchase contracts” or “option and purchase agreements”), which enable us to obtain necessary governmental approvals before acquiring title to the land; generally commencing construction of a detached home only after executing an agreement of sale and receiving a substantial down payment from the buyer; and using subcontractors to perform home construction and land development work on a fixed-price basis. During fiscal 2017 and 2016, we acquired control of approximately 6,600 home sites (net of options terminated and home sites sold) and, approximately 10,700 home sites (net of options terminated and home sites sold), respectively. At October 31, 2017, we controlled approximately 48,300 home sites, as compared to approximately 48,800 home sites at October 31, 2016, and approximately 44,300 home sites at October 31, 2015. In addition, at October 31, 2017, we expect to purchase approximately 3,100 additional home sites from several land development joint ventures in which we have an interest, at prices not yet determined. Of the approximately 48,300 total home sites that we owned or controlled through options at October 31, 2017, we owned approximately 31,300 and controlled approximately 17,000 through options. Of the 48,300 home sites, approximately 17,200 were substantially improved. In addition, at October 31, 2017, our Land Development Joint Ventures owned approximately 10,200 home sites (including 347 home sites included in the 17,000 controlled through options), and our Home Building Joint Ventures owned approximately 400 home sites. At October 31, 2017, we were selling from 305 communities, compared to 310 communities at October 31, 2016, and 288 communities at October 31, 2015. Customer Mortgage Financing We maintain relationships with a widely-diversified group of mortgage financial institutions, many of which are among the largest in the industry. We believe that regional and community banks continue to recognize the long-term value in creating relationships with high-quality, affluent customers such as our home buyers, and these banks continue to provide such customers with financing. We believe that our home buyers generally are, and should continue to be, well-positioned to secure mortgages due to their typically lower loan-to-value ratios and attractive credit profiles, as compared to the average home buyer. Toll Brothers Apartment Living/Toll Brothers Campus Living/Toll Brothers Realty Trust In addition to our residential for-sale business, we also develop and operate for-rent apartments through joint ventures. At October 31, 2017, we or joint ventures in which we have an interest controlled 43 land parcels as for-rent apartment projects containing approximately 14,450 units. These projects, which are located in the metro Boston to metro Washington, D.C. corridor; Atlanta, Georgia; Dallas, Texas; and Fremont, California are being operated, are being developed or will be developed with partners under the brand names Toll Brothers Apartment Living, Toll Brothers Campus Living and Toll Brothers Realty Trust. At October 31, 2017, we had approximately 3,200 units in for-rent apartment projects that were occupied or ready for occupancy, 750 units in the lease-up stage, 2,000 units under active development, and 8,500 units in the planning stage. Of the 14,450 units at October 31, 2017, 5,200 were owned by joint ventures in which we have an interest; approximately 2,550 were owned by us; 6,500 were under contract to be purchased by us; and 200 were under a letter of intent. CONTRACTS AND BACKLOG The aggregate value of net sales contracts signed increased 20.9% in fiscal 2017, as compared to fiscal 2016, and 14.0% in fiscal 2016, as compared to fiscal 2015. The value of net sales contracts signed was $6.83 billion (8,175 homes) in fiscal 2017, $5.65 billion (6,719 homes) in fiscal 2016, and $4.96 billion (5,910 homes) in fiscal 2015. The increase in the aggregate value of net contracts signed in fiscal 2017, as compared to fiscal 2016, and fiscal 2016, as compared to fiscal 2015 was due to increases in the number of net contracts signed in each period. The increase in the number of net contracts signed in each period was primarily due to the continued recovery in the U.S. housing market. The value of our backlog at October 31, 2017, 2016, and 2015 was $5.06 billion (5,851 homes), $3.98 billion (4,685 homes), and $3.50 billion (4,064 homes), respectively. Approximately 97% of the homes in backlog at October 31, 2017 are expected to be delivered by October 31, 2018. The 27.0% increase in the value of homes in backlog at October 31, 2017, as compared to October 31, 2016, was primarily due to a 20.9% increase in the value of net contracts signed in fiscal 2017, as compared to fiscal 2016, and a 13.7% higher backlog at the beginning of fiscal 2017, as compared to the beginning of fiscal 2016, offset, in part, by a 12.5% increase in the aggregate value of our deliveries in fiscal 2017, as compared to the aggregate value of deliveries in fiscal 2016. The 13.7% increase in the value of homes in backlog at October 31, 2016, as compared to October 31, 2015, was primarily due to a 14.0% increase in the value of net contracts signed in fiscal 2016, as compared to fiscal 2015, and a 28.8% higher backlog at the beginning of fiscal 2016, as compared to the beginning of fiscal 2015, offset, in part, by a 23.9% increase in the aggregate value of our deliveries in fiscal 2016, as compared to the aggregate value of deliveries in fiscal 2015. For more information regarding revenues, net contracts signed, and backlog by geographic segment, see “Segments” in this MD&A. CRITICAL ACCOUNTING POLICIES We believe the following critical accounting policies reflect the more significant judgments and estimates used in the preparation of our consolidated financial statements. Inventory Inventory is stated at cost unless an impairment exists, in which case it is written down to fair value in accordance with U.S. generally accepted accounting principles (“GAAP”). In addition to direct land acquisition, land development, and home construction costs, costs also include interest, real estate taxes, and direct overhead related to development and construction, which are capitalized to inventory during periods beginning with the commencement of development and ending with the completion of construction. For those communities that have been temporarily closed, no additional capitalized interest is allocated to the community’s inventory until it reopens, and other carrying costs are expensed as incurred. Once a parcel of land has been approved for development and we open the community, it can typically take four or more years to fully develop, sell, and deliver all the homes in that community. Longer or shorter time periods are possible depending on the number of home sites in a community and the sales and delivery pace of the homes in a community. Our master planned communities, consisting of several smaller communities, may take up to 10 years or more to complete. Because our inventory is considered a long-lived asset under GAAP, we are required to regularly review the carrying value of each of our communities and write down the value of those communities when we believe the values are not recoverable. Operating Communities: When the profitability of an operating community deteriorates, the sales pace declines significantly, or some other factor indicates a possible impairment in the recoverability of the asset, the asset is reviewed for impairment by comparing the estimated future undiscounted cash flow for the community to its carrying value. If the estimated future undiscounted cash flow is less than the community’s carrying value, the carrying value is written down to its estimated fair value. Estimated fair value is primarily determined by discounting the estimated future cash flow of each community. The impairment is charged to cost of revenues in the period in which the impairment is determined. In estimating the future undiscounted cash flow of a community, we use various estimates such as (i) the expected sales pace in a community, based upon general economic conditions that will have a short-term or long-term impact on the market in which the community is located and on competition within the market, including the number of home sites available and pricing and incentives being offered in other communities owned by us or by other builders; (ii) the expected sales prices and sales incentives to be offered in a community; (iii) costs expended to date and expected to be incurred in the future, including, but not limited to, land and land development costs, home construction, interest, and overhead costs; (iv) alternative product offerings that may be offered in a community that will have an impact on sales pace, sales price, building cost, or the number of homes that can be built in a particular community; and (v) alternative uses for the property, such as the possibility of a sale of the entire community to another builder or the sale of individual home sites. Future Communities: We evaluate all land held for future communities or future sections of operating communities, whether owned or optioned, to determine whether or not we expect to proceed with the development of the land as originally contemplated. This evaluation encompasses the same types of estimates used for operating communities described above, as well as an evaluation of the regulatory environment in which the land is located and the estimated probability of obtaining the necessary approvals, the estimated time and cost it will take to obtain those approvals, and the possible concessions that may be required to be given in order to obtain them. Concessions may include cash payments to fund improvements to public places such as parks and streets, dedication of a portion of the property for use by the public or as open space, or a reduction in the density or size of the homes to be built. Based upon this review, we decide (i) as to land under contract to be purchased, whether the contract will likely be terminated or renegotiated, and (ii) as to land we own, whether the land will likely be developed as contemplated or in an alternative manner, or should be sold. We then further determine whether costs that have been capitalized to the community are recoverable or should be written off. The write-off is charged to cost of revenues in the period in which the need for the write-off is determined. The estimates used in the determination of the estimated cash flows and fair value of both current and future communities are based on factors known to us at the time such estimates are made and our expectations of future operations and economic conditions. Should the estimates or expectations used in determining estimated fair value deteriorate in the future, we may be required to recognize additional impairment charges and write-offs related to current and future communities and such amounts could be material. We provided for inventory impairment charges and the expensing of costs that we believed not to be recoverable in each of the three fiscal years ended October 31, 2017, 2016, and 2015, as shown in the table below (amounts in thousands): The table below provides, for the periods indicated, the number of operating communities that we reviewed for potential impairment, the number of operating communities in which we recognized impairment charges, the amount of impairment charges recognized, and, as of the end of the period indicated, the fair value of those communities, net of impairment charges ($ amounts in thousands): Income Taxes - Valuation Allowance Significant judgment is applied in assessing the realizability of deferred tax assets. In accordance with GAAP, a valuation allowance is established against a deferred tax asset if, based on the available evidence, it is more likely than not that such asset will not be realized. The realization of a deferred tax asset ultimately depends on the existence of sufficient taxable income in either the carryback or carryforward periods under tax law. We assess the need for valuation allowances for deferred tax assets based on GAAP’s “more-likely-than-not” realization threshold criteria. In our assessment, appropriate consideration is given to all positive and negative evidence related to the realization of the deferred tax assets. Forming a conclusion that a valuation allowance is not needed is difficult when there is significant negative evidence such as cumulative losses in recent years. This assessment considers, among other matters, the nature, consistency, and magnitude of current and cumulative income and losses, forecasts of future profitability, the duration of statutory carryback or carryforward periods, our experience with operating loss and tax credit carryforwards being used before expiration, and tax planning alternatives. Our assessment of the need for a valuation allowance on our deferred tax assets includes assessing the likely future tax consequences of events that have been recognized in our consolidated financial statements or tax returns. Changes in existing tax laws or rates could affect our actual tax results, and our future business results may affect the amount of our deferred tax liabilities or the valuation of our deferred tax assets over time. Our accounting for deferred tax assets represents our best estimate of future events. Due to uncertainties in the estimation process, particularly with respect to changes in facts and circumstances in future reporting periods (carryforward period assumptions), actual results could differ from the estimates used in our analysis. Our assumptions require significant judgment because the residential home building industry is cyclical and is highly sensitive to changes in economic conditions. If our results of operations are less than projected and there is insufficient objectively verifiable positive evidence to support the more-likely-than-not realization of our deferred tax assets, a valuation allowance would be required to reduce or eliminate our deferred tax assets. Our deferred tax assets consist principally of the recognition of losses primarily driven by accrued expenses, inventory impairments, and impairments of investments in unconsolidated entities. In accordance with GAAP, we assess whether a valuation allowance should be established based on our determination of whether it was more likely than not that some portion or all of the deferred tax assets would not be realized. We file tax returns in the various states in which we do business. Each state has its own statutes regarding the use of tax loss carryforwards. Some of the states in which we do business do not allow for the carryforward of losses, while others allow for carryforwards for five years to 20 years. For state tax purposes, we establish valuation allowances for deferred tax assets in certain jurisdictions where it is more-likely-than-not that the deferred tax asset would not be realized. Due to past and projected losses in certain jurisdictions where we did not have carryback potential and/or could not sufficiently forecast future taxable income, we recognized a net cumulative valuation allowance against out state deferred tax assets at October 31, 2016. During fiscal 2016, and 2015, we recognized new valuation allowances of $1.0 million, and $3.7 million, respectively. We did not recognize any new valuation allowances in fiscal 2017. During fiscal 2017 and 2015, due to improved operating results, we reversed $32.2 million and $16.3 million of state deferred tax asset valuation allowances, respectively. No state deferred tax asset valuation allowances were reversed in fiscal 2016. Revenue and Cost Recognition Revenues and cost of revenues from home sales are recorded at the time each home is delivered and title and possession are transferred to the buyer. For our standard attached and detached homes, land, land development, and related costs, both incurred and estimated to be incurred in the future, are amortized to the cost of homes closed based upon the total number of homes to be constructed in each community. Any changes resulting from a change in the estimated number of homes to be constructed or in the estimated costs subsequent to the commencement of delivery of homes are allocated to the remaining undelivered homes in the community. Home construction and related costs are charged to the cost of homes closed under the specific identification method. For our master planned communities, the estimated land, common area development, and related costs, including the cost of golf courses, net of their estimated residual value, are allocated to individual communities within a master planned community on a relative sales value basis. Any changes resulting from a change in the estimated number of homes to be constructed or in the estimated costs are allocated to the remaining home sites in each of the communities of the master planned community. For high-rise/mid-rise projects, land, land development, construction, and related costs, both incurred and estimated to be incurred in the future, are generally amortized to the cost of units closed based upon an estimated relative sales value of the units closed to the total estimated sales value. Any changes resulting from a change in the estimated total costs or revenues of the project are allocated to the remaining units to be delivered. Forfeited Customer Deposits: Forfeited customer deposits are recognized in “Other income-net” in our Consolidated Statements of Operations and Comprehensive Income in the period in which we determine that the customer will not complete the purchase of the home and we have the right to retain the deposit. Sales Incentives: In order to promote sales of our homes, we grant our home buyers sales incentives from time to time. These incentives will vary by type of incentive and by amount on a community-by-community and home-by-home basis. Incentives that impact the value of the home or the sales price paid, such as special or additional options, are generally reflected as a reduction in sales revenues. Incentives that we pay to an outside party, such as paying some or all of a home buyer’s closing costs, are recorded as an additional cost of revenues. Incentives are recognized at the time the home is delivered to the home buyer and we receive the sales proceeds. Warranty and Self-Insurance Warranty: We provide all of our home buyers with a limited warranty as to workmanship and mechanical equipment. We also provide many of our home buyers with a limited 10-year warranty as to structural integrity. We accrue for expected warranty costs at the time each home is closed and title and possession are transferred to the home buyer. Warranty costs are accrued based upon historical experience. Adjustments to our warranty liabilities related to homes delivered in prior years are recorded in the period in which a change in our estimate occurs. Over the past several years, we have had a significant number of warranty claims related primarily to homes built in Pennsylvania and Delaware. See Note 7 - “Accrued Expenses” in Item 15(a)1 of this Form 10-K for additional information regarding these warranty charges. Self-Insurance: We maintain, and require the majority of our subcontractors to maintain, general liability insurance (including construction defect and bodily injury coverage) and workers’ compensation insurance. These insurance policies protect us against a portion of our risk of loss from claims related to our home building activities, subject to certain self-insured retentions, deductibles and other coverage limits (“self-insured liability”). We also provide general liability insurance for our subcontractors in Arizona, California, Colorado, Nevada, Washington, and certain areas of Texas, where eligible subcontractors are enrolled as insureds under our general liability insurance policies in each community in which they perform work. For those enrolled subcontractors, we absorb their general liability associated with the work performed on our homes within the applicable community as part of our overall general liability insurance and our self-insurance through our captive insurance subsidiary. We record expenses and liabilities based on the estimated costs required to cover our self-insured liability and the estimated costs of potential claims and claim adjustment expenses that are above our coverage limits or that are not covered by our insurance policies. These estimated costs are based on an analysis of our historical claims and industry data, and include an estimate of claims incurred but not yet reported (“IBNR”). We engage a third-party actuary that uses our historical claim and expense data, input from our internal legal and risk management groups, as well as industry data, to estimate our liabilities related to unpaid claims, IBNR associated with the risks that we are assuming for our self-insured liability and other required costs to administer current and expected claims. These estimates are subject to uncertainty due to a variety of factors, the most significant being the long period of time between the delivery of a home to a home buyer and when a structural warranty or construction defect claim is made, and the ultimate resolution of the claim. Though state regulations vary, construction defect claims are reported and resolved over a prolonged period of time, which can extend for 10 years or longer. As a result, the majority of the estimated liability relates to IBNR. Adjustments to our liabilities related to homes delivered in prior years are recorded in the period in which a change in our estimate occurs. The projection of losses related to these liabilities requires actuarial assumptions that are subject to variability due to uncertainties regarding construction defect claims relative to our markets and the types of product we build, insurance industry practices and legal or regulatory actions and/or interpretations, among other factors. Key assumptions used in these estimates include claim frequencies, severities and settlement patterns, which can occur over an extended period of time. In addition, changes in the frequency and severity of reported claims and the estimates to settle claims can impact the trends and assumptions used in the actuarial analysis, which could be material to our consolidated financial statements. Due to the degree of judgment required, the potential for variability in these underlying assumptions, our actual future costs could differ from those estimated, and the difference could be material to our consolidated financial statements. OFF-BALANCE SHEET ARRANGEMENTS We also operate through a number of joint ventures. We earn construction and management fee income from many of these joint ventures. Our investments in these entities are accounted for using the equity method of accounting. We are a party to several joint ventures with unrelated parties to develop and sell land that is owned by the joint ventures. We recognize our proportionate share of the earnings from the sale of home sites to other builders, including our joint venture partners. We do not recognize earnings from the home sites we purchase from these ventures at the time of our purchase; instead, our cost basis in the home sites is reduced by our share of the earnings realized by the joint venture from those home sites. At October 31, 2017, we had investments in these entities of $481.8 million, and were committed to invest or advance up to an additional $52.5 million to these entities if they require additional funding. At October 31, 2017, we had agreed to terms for the acquisition of 347 home sites from two Land Development Joint Ventures for an estimated aggregate purchase price of $248.8 million. In addition, we expect to purchase approximately 3,100 additional home sites over a number of years from several joint ventures in which we have interests; the purchase price of these home sites will be determined at a future date. The unconsolidated entities in which we have investments generally finance their activities with a combination of partner equity and debt financing. In some instances, we and our partners have guaranteed debt of certain unconsolidated entities. These guarantees may include any or all of the following: (i) project completion guarantees, including any cost overruns; (ii) repayment guarantees, generally covering a percentage of the outstanding loan; (iii) carry cost guarantees, which cover costs such as interest. real estate taxes, and insurance; (iv) an environmental indemnity provided to the lender that holds the lender harmless from and against losses arising from the discharge of hazardous materials from the property and non-compliance with applicable environmental laws; and (v) indemnification of the lender from “bad boy acts” of the unconsolidated entity. In some instances, the guarantees provided in connection with loans to an unconsolidated entity are joint and several. In these situations, we generally have a reimbursement agreement with our partner that provides that neither party is responsible for more than its proportionate share or agreed-upon share of the guarantee; however, if the joint venture partner does not have adequate financial resources to meet its obligations under the reimbursement agreement, we may be liable for more than our proportionate share. We believe that as of October 31, 2017, in the event we become legally obligated to perform under a guarantee of the obligation of an unconsolidated entity due to a triggering event, the collateral should be sufficient to repay all or a significant portion of the obligation. If it is not, we and our partners would need to contribute additional capital to the entity. At October 31, 2017, we had guaranteed the debt of certain unconsolidated entities with loan commitments aggregating $1.2 billion, of which, if the full amount of the debt obligations were borrowed, we estimate $291.9 million to be our maximum exposure related to repayment and carry cost guarantees. At October 31, 2017, the unconsolidated entities had borrowed an aggregate of $747.7 million, of which we estimate $228.9 million to be our maximum exposure related to repayment and carry cost guarantees. These maximum exposure estimates do not take into account any recoveries from the underlying collateral or any reimbursement from our partners. For more information regarding these joint ventures, see Note 4, “Investments in Unconsolidated Entities” in the Notes to Consolidated Financial Statements in this Form 10-K. The trends, uncertainties or other factors that negatively impact our business and the industry in general also impact the unconsolidated entities in which we have investments. We review each of our investments on a quarterly basis for indicators of impairment. A series of operating losses of an investee, the inability to recover our invested capital, or other factors may indicate that a loss in value of our investment in the unconsolidated entity has occurred. If a loss exists, we further review to determine if the loss is other than temporary, in which case we write down the investment to its fair value. The evaluation of our investment in unconsolidated entities entails a detailed cash flow analysis using many estimates including but not limited to, expected sales pace, expected sales prices, expected incentives, costs incurred and anticipated, sufficiency of financing and capital, competition, market conditions and anticipated cash receipts, in order to determine projected future distributions. Each of the unconsolidated entities evaluates its inventory in a similar manner. In addition, for our unconsolidated entities that own, develop, and manage for-rent residential apartments, we review rental trends, expected future expenses, and expected future cash flows to determine estimated fair values of the properties. See “Critical Accounting Policies - Inventory” contained in this MD&A for more detailed disclosure on our evaluation of inventory. If a valuation adjustment is recorded by an unconsolidated entity related to its assets, our proportionate share is reflected in income from unconsolidated entities with a corresponding decrease to our investment in unconsolidated entities. Based upon our evaluation of the fair value of our investments in unconsolidated entities, we recognized an impairment charge in connection with one Land Development Joint Venture of $2.0 million in fiscal 2017. We determined that no impairments of our investments occurred in fiscal 2016 or 2015. RESULTS OF OPERATIONS The following table compares certain items in our Consolidated Statements of Operations and Comprehensive Income and other supplemental information for fiscal 2017, 2016, and 2015 ($ amounts in millions, unless otherwise stated). For more information regarding results of operations by operating segment, see “Segments” in this MD&A. * $ amounts in thousands. Note: Amounts may not add due to rounding. FISCAL 2017 COMPARED TO FISCAL 2016 REVENUES AND COST OF REVENUES The increase in revenues in fiscal 2017, as compared to fiscal 2016, was mainly attributable to a 17.3% increase in the number of homes delivered primarily due to a higher backlog at October 31, 2016, as compared to October 31, 2015, offset, in part, by a 4.1% decrease in the average price of the homes delivered. The decrease in the average delivered price was due to the impact of lower priced products delivered from communities acquired in our purchase of Coleman in November 2016 and a shift in the number of homes delivered to less expensive areas and/or products in the fiscal 2017 period, as compared to the fiscal 2016 period. Cost of revenues, as a percentage of revenues, in fiscal 2017 was 78.5%, as compared to 80.2% in fiscal 2016. The decrease in fiscal 2017, as compared to fiscal 2016, was primarily due to the recognition in fiscal 2016 of $125.6 million (2.4% of revenues) of warranty charges primarily related to homes built in Pennsylvania and Delaware; a $6.0 million benefit in fiscal 2017 from the reversal of an accrual for offsite improvements at a completed community that was no longer required; state reimbursements of $4.7 million in fiscal 2017 for previously expensed environmental clean-up costs; and lower interest expense in the fiscal 2017 period, as compared to the fiscal 2016 period. These decreases were offset, in part, by a shift in the number of homes delivered to lower-margin buildings in our City Living segment; the impact of purchase accounting for the homes sold from communities acquired in our purchase of Coleman; higher material and labor costs; and a higher number of closings from lower-margin communities in our Traditional Home Building segment. See Note 7 - “Accrued Expenses” in Item 15(a)1 of this Form 10-K for additional information regarding these warranty charges. Interest cost in fiscal 2017 was $172.8 million or 3.0% of revenues, as compared to $160.3 million or 3.1% of revenues in fiscal 2016. We recognized inventory impairments and write-offs of $14.8 million or 0.3% of revenues and $13.8 million or 0.3% of revenues in fiscal 2017 and fiscal 2016, respectively. SELLING, GENERAL AND ADMINISTRATIVE EXPENSES (“SG&A”) SG&A spending increased by $72.4 million in fiscal 2017, as compared to fiscal 2016. As a percentage of revenues, SG&A increased to 10.5% in fiscal 2017 from 10.4% in fiscal 2016. The dollar increase in SG&A was due primarily to increased compensation costs due to a higher number of employees; increased sales and marketing costs; and increased spending on our upgrading of computer software. The higher sales and marketing costs were the result of the increased spending on advertising, higher model operating costs due to the increase in the average number of selling communities, and the increased number of homes delivered. The increased number of employees was due primarily to the overall increase in our business in fiscal 2017, as compared to fiscal 2016. The increase in SG&A as a percentage of revenues in the fiscal 2017 period was due to SG&A spending increasing by 13.5% while revenues increased 12.5% from the fiscal 2016 period. INCOME FROM UNCONSOLIDATED ENTITIES We recognize our proportionate share of the earnings and losses from the various unconsolidated entities in which we have an investment. Many of our unconsolidated entities are land development projects, high-rise/mid-rise condominium construction projects, or for-rent apartments projects, which do not generate revenues and earnings for a number of years during the development of the property. Once development is complete for land development projects and high-rise/mid-rise condominium construction projects, these unconsolidated entities will generally, over a relatively short period of time, generate revenues and earnings until all of the assets of the entity are sold. Further, once for-rent apartments projects are complete and stabilized, we may monetize a portion of these projects through a recapitalization, resulting in income. Because there is not a steady flow of revenues and earnings from these entities, the earnings recognized from these entities will vary significantly from quarter to quarter and year to year. The increase in income from unconsolidated entities in fiscal 2017, as compared to fiscal 2016, was due mainly to higher income recognized in fiscal 2017, as compared to fiscal 2016, from an increase in homes delivered at condominium projects and the sale of portions of our ownership interests in a number of our joint ventures. We recognized $111.8 million of income from our Home Building, Rental Property, and Land Development Joint Ventures in fiscal 2017, as compared to $38.4 million of income in fiscal 2016. The increase in our income realized from these joint ventures was primarily attributable to $72.1 million of income realized from two of our Home Building Joint Ventures located in New York City, as compared to $12.9 million from these Home Building Joint Ventures in fiscal 2016, and $26.7 million of gains recognized in fiscal 2017 on the sale of 50% of our ownership interests in two of our Rental Property Joint Ventures located in Jersey City, New Jersey and the suburbs of Philadelphia, Pennsylvania; offset, in part, by a decrease in the number of lots delivered at one of our Land Development Joint Ventures in fiscal 2017 as compared to fiscal 2016 and a $4.9 million gain, in fiscal 2016, from the sale of our ownership interests in one of our joint ventures located in New Jersey. OTHER INCOME - NET The table below provides the components of “Other Income - net” for the years ended October 31, 2017 and 2016 (amounts in thousands): Management fee income from home building unconsolidated entities presented above primarily represents fees earned by our City Living and home building operations. In addition, in fiscal 2017 and 2016, our apartment living operations earned fees from unconsolidated entities of $6.2 million and $6.1 million, respectively; fees earned by our apartment living operations are included in income from ancillary businesses. In fiscal 2016, our security monitoring business recognized a gain of $1.6 million from a bulk sale of security monitoring accounts in fiscal 2015, which is included in income from ancillary businesses above. The decline in income from Gibraltar was due primarily from the continuing monetization of its assets and a $1.3 million gain in fiscal 2016 from the sale of a 76% interest in certain assets of Gibraltar. See Note 4, “Investments in Unconsolidated Entities - Gibraltar Joint Ventures” of this Form 10-K for additional information on this transaction. INCOME BEFORE INCOME TAXES In fiscal 2017, we reported income before income taxes of $814.3 million or 14.0% of revenues, as compared to $589.0 million, or 11.4% of revenues in fiscal 2016. INCOME TAX PROVISION We recognized a $278.8 million income tax provision in fiscal 2017. Based upon the federal statutory rate of 35%, our federal tax provision would have been $285.0 million. The difference between the tax provision recognized and the tax provision based on the federal statutory rate was due mainly to a $32.2 million benefit from the reversal of state deferred tax asset valuation allowances; a $12.8 million tax benefit from the utilization of the domestic production activities deduction; the reversal of $4.0 million of previously accrued tax provisions on uncertain tax positions that were no longer necessary due to the expiration of the statute of limitations and settlements with certain taxing jurisdictions; and $1.5 million of other permanent differences. These benefits were offset, in part, by the recognition of a $34.7 million provision for state income taxes; $1.0 million of accrued interest and penalties for previously accrued taxes on uncertain tax positions; and $8.6 million of other differences. We recognized a $206.9 million income tax provision in fiscal 2016. Based upon the federal statutory rate of 35%, our federal tax provision would have been $206.2 million. The difference between our tax provision recognized and the tax provision based on the federal statutory rate was due mainly to the recognition of a $27.0 million provision for state income taxes; the recognition of a $2.1 million provision for uncertain tax positions taken; $2.0 million of accrued interest and penalties for previously accrued taxes on uncertain tax positions; and $3.9 million of other differences; offset by a $16.9 million tax benefit from the utilization of the domestic production activities deduction; the reversal of $11.2 million of previously accrued tax provisions on uncertain tax positions that were no longer necessary due to the expiration of the statute of limitations and settlements with certain taxing jurisdictions; and $7.0 million of other permanent deductions. FISCAL 2016 COMPARED TO FISCAL 2015 REVENUES AND COST OF REVENUES The increase in revenues in fiscal 2016, as compared to fiscal 2015, was primarily attributable to a 12.3% increase in the average price of the homes delivered due to a shift in the number of homes delivered to more expensive areas and/or higher-priced products and a 10.4% increase in the number of homes delivered primarily due to a higher backlog at October 31, 2015, as compared to October 31, 2014. Cost of revenues as a percentage of revenues in fiscal 2016 was 80.2%, as compared to 78.4% in fiscal 2015. The increase in the fiscal 2016 percentage was primarily due to the recognition in fiscal 2016 of $125.6 million (2.4% of revenues) of warranty charges primarily related to homes built in Pennsylvania and Delaware, as compared to $14.7 million (0.4% of revenues) in fiscal 2015 and slightly higher land and construction costs as a percentage of revenues in homes delivered in fiscal 2016, as compared to fiscal 2015. These increased costs were offset, in part, by lower interest expense and inventory impairment and write-offs as a percentage of revenues in fiscal 2016, as compared to fiscal 2015. See Note 7 - “Accrued Expenses” in Item 15(a)1 of this Form 10-K for additional information regarding these warranty charges. Interest cost in fiscal 2016 was $160.3 million or 3.1% of revenues, as compared to $142.9 million or 3.4% of revenues in fiscal 2015. We recognized inventory impairments and write-offs of $13.8 million or 0.3% of revenues and $35.7 million or 0.9% of revenues in fiscal 2016 and fiscal 2015, respectively. SELLING, GENERAL AND ADMINISTRATIVE EXPENSES (“SG&A”) SG&A spending increased by $80.3 million but declined as a percentage of revenues in fiscal 2016, as compared to fiscal 2015. The decrease in SG&A as a percentage of revenues in the fiscal 2016 period was due to SG&A spending increasing by 17.6% while revenues increased 23.9% from the fiscal 2015 period. The dollar increase in SG&A was due primarily to increased compensation costs due to a higher number of employees and increased sales and marketing costs. The higher sales and marketing costs were the result of the increased number of homes closed and increased number of selling communities that we had in fiscal 2016, as compared to fiscal 2015. INCOME FROM UNCONSOLIDATED ENTITIES We recognize our proportionate share of the earnings and losses from the various unconsolidated entities in which we have an investment. Many of our unconsolidated entities are land development projects, high-rise/mid-rise condominium construction projects, or for-rent apartment projects, which do not generate revenues and earnings for a number of years during the development of the property. Once development is complete for land development projects and high-rise/mid-rise condominium construction projects, these unconsolidated entities will generally, over a relatively short period of time, generate revenues and earnings until all of the assets of the entity are sold. Further, once for-rent apartments projects are complete and stabilized, we may monetize a portion of these projects through a recapitalization, resulting in income. Because there is not a steady flow of revenues and earnings from these entities, the earnings recognized from these entities will vary significantly from quarter to quarter and year to year. In fiscal 2016, we recognized $40.7 million of income from unconsolidated entities, as compared to $21.1 million in fiscal 2015. The increase in income from unconsolidated entities in fiscal 2016, as compared to fiscal 2015, was due mainly to higher earnings from two of our City Living Home Building Joint Ventures, a $4.9 million gain recognized related to the sale of our ownership interests in one of our joint ventures located in New Jersey, and to the recognition of a $2.9 million recovery in fiscal 2016 of previously incurred charges related to a joint venture located in Nevada, offset, in part, by lower income from our Land Development Joint Ventures. OTHER INCOME - NET The table below provides the components of “Other Income - net” for the years ended October 31, 2016 and 2015 (amounts in thousands): Management fee income from unconsolidated entities presented above primarily represents fees earned by our City Living and home building operations. In addition, in fiscal 2016 and 2015, our apartment living operations earned fees from unconsolidated entities of $6.1 million and $5.7 million, respectively; fees earned by our apartment living operations are included in income from ancillary businesses. In fiscal 2016 and fiscal 2015, our security monitoring business recognized gains of $1.6 million and $8.1 million, respectively, from a bulk sale of security monitoring accounts in fiscal 2015, which is included in income from ancillary businesses above. The decline in income from Gibraltar was due primarily from the continuing monetization of its assets offset, in part by a $1.3 million gain in fiscal 2016 from the sale of a 76% interest in certain assets of Gibraltar. See Note 4, “Investments in Unconsolidated Entities - Gibraltar Joint Ventures” in Item 15(a)1 of this Form 10-K for additional information on this transaction. INCOME BEFORE INCOME TAXES In fiscal 2016, we reported income before income taxes of $589.0 million, as compared to $535.6 million in fiscal 2015. INCOME TAX PROVISION We recognized a $206.9 million income tax provision in fiscal 2016. Based upon the federal statutory rate of 35%, our federal tax provision would have been $206.2 million. The difference between our tax provision recognized and the tax provision based on the federal statutory rate was due mainly to the recognition of a $27.0 million provision for state income taxes; the recognition of a $2.1 million provision for uncertain tax positions taken; $2.0 million of accrued interest and penalties for previously accrued taxes on uncertain tax positions; and $3.9 million of other differences; offset by a $16.9 million tax benefit from the utilization of the domestic production activities deduction; the reversal of $11.2 million of previously accrued tax provisions on uncertain tax positions that were no longer necessary due to the expiration of the statute of limitations and settlements with certain taxing jurisdictions; and $7.0 million of other permanent deductions. We recognized a $172.4 million income tax provision in fiscal 2015. Based upon the federal statutory rate of 35%, our federal tax provision would have been $187.4 million. The difference between our tax provision recognized and the tax provision based on the federal statutory rate was due principally to the reversal of $15.3 million of previously accrued tax provisions on uncertain tax positions that were no longer necessary due to the expiration of the statute of limitations and the settlements with certain taxing jurisdictions; a $12.3 million tax benefit from our utilization of the domestic production activities deduction; a benefit of $12.6 million from the reversal of state deferred tax asset valuation allowances, net of $3.7 million of new state deferred tax asset valuation allowances recognized; and $7.8 million of other permanent deductions; offset, in part, by the recognition of a $21.9 million provision for state income taxes; the recognition of a $3.2 million provision for uncertain tax positions taken; $2.6 million of accrued interest and penalties for previously accrued taxes on uncertain tax positions; and $5.3 million of other differences. CAPITAL RESOURCES AND LIQUIDITY Funding for our business has been, and continues to be, provided principally by cash flow from operating activities before inventory additions, unsecured bank borrowings, and the public debt and equity markets. At October 31, 2017, we had $712.8 million of cash and cash equivalents on hand and approximately $1.15 billion available for borrowing under our Credit Facility. Cash provided by operating activities during fiscal 2017 was $959.7 million. It was generated primarily from $535.5 million of net income plus $28.5 million of stock-based compensation, $25.4 million of depreciation and amortization, $14.8 million of inventory impairments and write-offs; a net deferred tax provision of $185.7 million; a $129.7 million decrease in inventory; a decrease of $114.9 million in mortgage loans held for sale; and a $38.0 million increase in customer deposits; offset, in part, by a decrease of $140.5 million in accounts payable and accrued expenses. Cash used in investing activities during fiscal 2017 was $7.7 million. The cash used in investing activities was primarily related to $122.3 million used to fund investments in unconsolidated entities, $83.1 million used for the acquisition of Coleman, and $28.9 million for the purchase of property and equipment, offset, in part, by $209.3 million of cash received as returns on our investments in unconsolidated entities, foreclosed real estate, and distressed loans, and $18.0 million from net sales of restricted investments. In February 2017, our Board of Directors approved the initiation of quarterly cash dividends to shareholders. During fiscal 2017, we paid a quarterly cash dividend of $0.08 per share on each of April 28, 2017, July 28, 2017 and October 27, 2017. The payment of dividends is within the discretion of our Board of Directors and any decision to pay dividends in the future will depend upon an evaluation of a number of factors, including our results of operations, our capital requirements, our operating and financial condition, and any contractual limitations then in effect. We used $872.9 million of cash from financing activities in fiscal 2017, primarily for the repayment of $687.5 million of senior notes; the repurchase of $290.9 million of our common stock; the repayment of $250.0 million on our Credit Facility, net of new borrowings under it; the repayment of $89.9 million on our mortgage company loan facility, net of new borrowings; the repayment of $42.9 million of other loans payable, net of new borrowings; and payment of $38.6 million of dividends on our common stock, offset, in part, by the net proceeds of $455.5 million from the issuance of $450.0 million aggregate principal amount of 4.875% Senior Notes due 2027, and the proceeds of $66.0 million from our stock-based benefit plans. At October 31, 2016, we had $633.7 million of cash and cash equivalents on hand and approximately $961.8 million available for borrowing under our Credit Facility. Cash provided by operating activities during fiscal 2016 was $148.8 million. It was generated primarily from $382.1 million of net income plus $26.7 million of stock-based compensation, $23.1 million of depreciation and amortization, $13.8 million of inventory impairments and write-offs, and $19.3 million of deferred taxes; an increase of $524.6 million in accounts payable and accrued expenses; a $27.8 million increase in customer deposits; and a $6.0 million increase in income taxes payable; offset, in part, by the net purchase of $391.2 million of inventory; a $307.4 million increase in receivables, prepaid expenses, and other assets; and an increase of $124.9 million in mortgage loans originated, net of the sale of mortgage loans to outside investors. Cash provided by investing activities during fiscal 2016 was $8.2 million. The cash provided by investing activities was primarily related to $97.4 million of cash received as returns on our investments in unconsolidated entities, foreclosed real estate, and distressed loans and $10.0 million of proceeds from the sale of marketable securities, offset, in part, by $69.7 million used to fund investments in unconsolidated entities and $28.4 million for the purchase of property and equipment. We used $442.3 million of cash from financing activities in fiscal 2016, primarily for the repurchase of $392.8 million of our common stock; the repayment of $100.0 million from our credit facilities, net of new borrowing under them; and the repayment of $69.0 million of other loans payable, net of new borrowings, offset, in part, by $110.0 million of new borrowings under our mortgage company loan facility, net of repayments. At October 31, 2015, we had $929.0 million of cash, cash equivalents, and marketable securities on hand and approximately $566.1 million available for borrowing under our $1.035 billion revolving credit facility (“Previous Credit Facility”). Cash provided by operating activities during fiscal 2015 was $60.2 million. It was generated primarily from $363.2 million of net income plus $22.9 million of stock-based compensation, $23.6 million of depreciation and amortization, $35.7 million of inventory impairments and write-offs, and $62.1 million of deferred taxes; a $46.5 million increase in customer deposits; and an increase of $28.7 million in accounts payable and accrued expenses; offset, in part, by the net purchase of $352.0 million of inventory; a $65.5 million decrease in income taxes payable; a $55.6 million increase in receivables, prepaid expenses, and other assets; and an increase of $21.4 million in mortgage loans originated, net of the sale of mortgage loans to outside investors. Cash used in our investing activities during fiscal 2015 was $52.8 million. The cash used in investing activities was primarily related to $123.9 million used to fund investments in unconsolidated entities, $9.4 million for the purchase of property and equipment, offset, in part, by $77.4 million of cash received as returns on our investments in unconsolidated entities, foreclosed real estate, and distressed loans. We generated $325.3 million of cash from financing activities in fiscal 2015, primarily from the issuance of $350.0 million of 4.875% Senior Notes due 2025; $350.0 million of borrowing under our Previous Credit Facility; and $39.5 million from the proceeds of our stock-based benefit plans, offset, in part, by the repayment of $300.0 million of senior notes; the repurchase of $56.9 million of our common stock; and the repayment of $55.0 million of other loans payable, net of new borrowings. In general, our cash flow from operating activities assumes that, as each home is delivered, we will purchase a home site to replace it. Because we own a supply of several years of home sites, we do not need to buy home sites immediately to replace those that we deliver. In addition, we generally do not begin construction of our detached homes until we have a signed contract with the home buyer. Should our business remain at its current level or decline, we believe that our inventory levels would decrease as we complete and deliver the homes under construction but do not commence construction of as many new homes, as we complete the improvements on the land we already own, and as we sell and deliver the speculative homes that are currently in inventory, resulting in additional cash flow from operations. In addition, we might delay, decrease, or curtail our acquisition of additional land, as we did during the period from April 2006 through January 2010, which would further reduce our inventory levels and cash needs. At October 31, 2017, we owned or controlled through options approximately 48,300 home sites, as compared to approximately 48,800 at October 31, 2016; and approximately 44,300 at October 31, 2015. Of the approximately 48,300 home sites owned or controlled through options at October 31, 2017, we owned approximately 31,300. Of our owned home sites at October 31, 2017, significant improvements were completed on approximately 17,200 of them. At October 31, 2017, the aggregate purchase price of land parcels under option and purchase agreements was approximately $2.24 billion (including $248.8 million of land to be acquired from joint ventures in which we have invested). Of the $2.24 billion of land purchase commitments, we had paid or deposited $97.7 million and, if we acquire all of these land parcels, we will be required to pay an additional $2.14 billion. The purchases of these land parcels are scheduled over the next several years. In addition, we expect to purchase approximately 3,100 additional home sites over a number of years from several joint ventures in which we have interests. We have additional land parcels under option that have been excluded from the aforementioned aggregate purchase amounts since we do not believe that we will complete the purchase of these land parcels and no additional funds will be required from us to terminate these contracts. During the past several years, we have made a number of investments in unconsolidated entities related to the acquisition and development of land for future home sites, the construction of luxury for-sale condominiums, and for-rent apartments. Our investment activities related to investments in and distributions of investments from unconsolidated entities are contained in the Consolidated Statements of Cash Flows under “Net cash (used in) provided by investing activities,” At October 31, 2017, we had investments in these entities of $481.8 million, and were committed to invest or advance up to an additional $52.5 million to these entities if they require additional funding. At October 31, 2017, we had purchase commitments to acquire land for apartment developments of approximately $230.1 million, of which we had outstanding deposits in the amount of $11.9 million. We intend to develop these apartment projects in joint ventures with unrelated parties in the future. We have a $1.295 billion Credit Facility that is scheduled to expire in May 2021. Under the terms of the Credit Facility, our maximum leverage ratio (as defined in the credit agreement) may not exceed 1.75 to 1.00 and we are required to maintain a minimum tangible net worth (as defined in the credit agreement) of no less than approximately $2.63 billion. Under the terms of the Credit Facility, at October 31, 2017, our leverage ratio was approximately 0.58 to 1.00 and our tangible net worth was approximately $4.49 billion. Based upon the minimum tangible net worth requirement, our ability to repurchase our common stock was limited to approximately $2.29 billion as of October 31, 2017. At October 31, 2017, we had no outstanding borrowings under the Credit Facility and had outstanding letters of credit of approximately $140.1 million. Subsequent to October 31, 2017, we borrowed $150.0 million under the Credit Facility. We believe that we will have adequate resources and sufficient access to the capital markets and external financing sources to continue to fund our current operations and meet our contractual obligations. Due to the uncertainties in the economy and for home builders in general, we cannot be certain that we will be able to replace existing financing or find sources of additional financing in the future. INFLATION The long-term impact of inflation on us is manifested in increased costs for land, land development, construction, and overhead. We generally enter into contracts to acquire land a significant period of time before development and sales efforts begin. Accordingly, to the extent land acquisition costs are fixed, subsequent increases or decreases in the sales prices of homes will affect our profits. Because the sales price of each of our homes is fixed at the time a buyer enters into a contract to purchase a home and because we generally contract to sell our homes before we begin construction, any inflation of costs in excess of those anticipated may result in lower gross margins. We generally attempt to minimize that effect by entering into fixed-price contracts with our subcontractors and material suppliers for specified periods of time, which generally do not exceed one year. In general, housing demand is adversely affected by increases in interest rates and housing costs. Interest rates, the length of time that land remains in inventory, and the proportion of inventory that is financed affect our interest costs. If we are unable to raise sales prices enough to compensate for higher costs, or if mortgage interest rates increase significantly, affecting prospective buyers’ ability to adequately finance home purchases, our revenues, gross margins, and net income could be adversely affected. Increases in sales prices, whether the result of inflation or demand, may affect the ability of prospective buyers to afford new homes. CONTRACTUAL OBLIGATIONS The following table summarizes our estimated contractual payment obligations at October 31, 2017 (amounts in millions): (a) Amounts include estimated annual interest payments until maturity of the debt. Of the amounts indicated, $2.5 billion of the senior notes, $637.4 million of loans payable, $120.1 million of the mortgage company loan facility, and $36.0 million of accrued interest were recorded on our October 31, 2017 Consolidated Balance Sheet. (b) Amounts represent our expected acquisition of land under purchase agreements and the estimated remaining amount of the contractual obligation for land development agreements secured by letters of credit and surety bonds. (c) Amounts represent our obligations under our deferred compensation plan, supplemental executive retirement plans and our 401(k) salary deferral savings plans. Of the total amount indicated, $67.4 million was recorded on our October 31, 2017 Consolidated Balance Sheet. SEGMENTS We operate in two segments: Traditional Home Building and City Living, our urban development division. Within Traditional Home Building, we operate in five geographic segments around the United States: (1) the North, consisting of Connecticut, Illinois, Massachusetts, Michigan, Minnesota, New Jersey, and New York; (2) the Mid-Atlantic, consisting of Delaware, Maryland, Pennsylvania, and Virginia; (3) the South, consisting of Florida, North Carolina, and Texas; (4) the West, consisting of Arizona, Colorado, Idaho, Nevada, and Washington, and (5) California. The following tables summarize information related to revenues, net contracts signed, and income (loss) before income taxes by segment for fiscal years 2017, 2016, and 2015. Information related to backlog and assets by segment at October 31, 2017 and 2016, has also been provided. Units Delivered and Revenues: Net Contracts Signed: Backlog at October 31: Income (Loss) Before Income Taxes ($ amounts in millions): “Corporate and other” is comprised principally of general corporate expenses such as the offices of our executive officers; the corporate finance, accounting, audit, tax, human resources, risk management, information technology, marketing, and legal groups; interest income; income from certain of our ancillary businesses, including Gibraltar; and income from a number of our unconsolidated entities. Total Assets ($ amounts in millions): “Corporate and other” is comprised principally of cash and cash equivalents, restricted cash and investments, deferred tax assets, investments in our Rental Property Joint Ventures, expected recoveries from insurance carriers and suppliers, our Gibraltar investments, manufacturing facilities, and mortgage and title subsidiaries. FISCAL 2017 COMPARED TO FISCAL 2016 Traditional Home Building North The decrease in the number of homes delivered in fiscal 2017, as compared to fiscal 2016, was mainly due to the defective floor joists issue. The decrease in the average price of homes delivered in fiscal 2017, as compared to fiscal 2016, was primarily attributable to a shift in the number of homes delivered to less expensive areas and/or products in fiscal 2017, as compared to fiscal 2016. For additional information regarding the defective floor joists issue, see “Overview - Defective Floor Joists” in this MD&A. The increase in the number of net contracts signed in fiscal 2017, as compared to fiscal 2016, was mainly due to improved market conditions in Connecticut, Michigan, New York, and New Jersey, offset, in part by a decrease in the number of selling communities and a decrease in Massachusetts where demand has declined. The decrease in the average sales price of net contracts signed in fiscal 2017, as compared to fiscal 2016, was principally attributable to a shift in the number of contracts signed to less expensive areas and/or products in fiscal 2017, as compared to fiscal 2016, particularly in Michigan, where we had a significant increase in the number of contracts signed in multifamily and active-adult communities. The decrease in income before income taxes in fiscal 2017, as compared to fiscal 2016, was principally attributable to lower earnings from decreased revenues and higher cost of revenues, as a percentage of revenues in fiscal 2017, as compared to fiscal 2016. The increase in the cost of revenues, as a percentage of revenues, was primarily due to a change in product mix/areas to lower-margin areas and higher material and labor costs in fiscal 2017, as compared to fiscal 2016. Mid-Atlantic The increase in the number of homes delivered in fiscal 2017, as compared to fiscal 2016, was mainly due to an increase in the number of homes closed in the region, which was attributable to an increase in the number of homes in backlog in those markets at October 31, 2016, as compared to the number of homes in backlog at October 31, 2015. The decrease in the average price of homes delivered in fiscal 2017, as compared to fiscal 2016, was primarily due to a shift in the number of homes delivered to less expensive areas and/or products in fiscal 2017, as compared to fiscal 2016. The increase in the number of net contracts signed in fiscal 2017, as compared to fiscal 2016, was principally due to increases in demand in fiscal 2017, as compared to fiscal 2016. The increase in income before income taxes in fiscal 2017, as compared to the loss before income taxes in fiscal 2016, was mainly due to $125.6 million of warranty charges recognized, primarily related to homes built in Pennsylvania and Delaware in fiscal 2016; higher earnings from increased revenues; and a $6.0 million benefit from the reversal of an accrual for offsite improvements at a completed community that was no longer required. These increases were partially offset by higher inventory impairment charges; a $2.0 million impairment charge we recognized on one of our Land Development Joint Ventures in fiscal 2017; and higher SG&A costs. See Note 7 - “Accrued Expenses” in Item 15(a)1 of this Form 10-K for additional information regarding these warranty charges. Inventory impairment charges were $6.9 million in fiscal 2017, as compared to $2.1 million in fiscal 2016. In fiscal 2017, during our review of operating communities for impairment, primarily due to a decrease in customer demand as a result of weaker than expected market conditions in certain communities, we determined that the pricing assumptions used in prior impairment reviews for two operating communities located in Maryland needed to be reduced. As a result of these reductions in expected sales prices, we determined that these communities were impaired. Accordingly, the carrying value of these communities were written down to their estimated fair value resulting in charges to income before income taxes of $5.4 million in fiscal 2017. The impairment charges in fiscal 2016 primarily related to a land purchase contract in Delaware where we were unable to obtain the required approvals to proceed with our development of the underlying property. Accordingly, we terminated the contract and wrote off our costs incurred. Further in fiscal 2017, during our evaluation of our investments in unconsolidated entities, we determined that the development cost assumptions used in prior impairment reviews for one Land Development Joint Venture located in Maryland needed to be increased. As a result of these cost increases, we determined that our investment in this joint venture was impaired and we concluded that the impairment was other than temporary. Accordingly, we wrote down the carrying value of our investment in this joint venture to its estimated fair value resulting in a charge to income before income taxes of $2.0 million in fiscal 2017. South The increase in the number of homes delivered in fiscal 2017, as compared to fiscal 2016, was mainly due to an increase in the number of homes closed in Florida and North Carolina which was attributable to an increase in the number of homes in backlog as of October 31, 2016, as compared to the number of homes in backlog at October 31, 2015. The decrease in the average price of homes delivered in fiscal 2017, as compared to fiscal 2016, was primarily due to a shift in the number of homes delivered to less expensive areas and/or products in fiscal 2017, as compared to fiscal 2016. The increase in the number of net contracts signed in fiscal 2017, as compared to fiscal 2016, was mainly due to an increase in the number of selling communities in fiscal 2017, as compared to fiscal 2016. The decrease in income before income taxes in fiscal 2017, as compared to fiscal 2016, was principally due to a higher cost of revenues, as a percentage of revenues, higher SG&A costs, lower income earned from our investments in unconsolidated entities, and decreased earnings from land sales in Texas, offset, in part, by higher earnings from increased revenues. The increase in cost of revenues, as a percentage of revenues, in fiscal 2017, as compared to fiscal 2016, was primarily due to a shift in the number of homes delivered to lower-margin products and/or locations in fiscal 2017, as compared to fiscal 2016. The higher SG&A costs in fiscal 2017, as compared to fiscal 2016, were principally due to the increase in the number of selling communities. The decrease in income earned from our investments in unconsolidated entities in fiscal 2017, as compared to fiscal 2016, was primarily related to a $1.4 million charge in fiscal 2017 for amenity construction repairs at one of our Home Building Joint Ventures. West The increase in the number of homes delivered in fiscal 2017, as compared to fiscal 2016, was mainly due to the delivery of 342 homes in the Boise market, in fiscal 2017 and an increase in the number of homes in backlog at October 31, 2016, as compared to the number of homes in backlog at October 31, 2015. The decrease in the average delivered price of homes delivered in fiscal 2017, as compared to fiscal 2016, was primarily due to deliveries of homes in the Boise market, where the average prices of homes delivered in fiscal 2017 was $315,000. Excluding the closings in the Boise market, the average price of homes delivered in fiscal 2017 increased 5%, as compared to fiscal 2016, which was mainly due to a shift in the number of homes delivered to more expensive areas and/or products in fiscal 2017, as compared to fiscal 2016. The increase in the number of net contracts signed in fiscal 2017, as compared to fiscal 2016, was principally due to the 458 contracts we signed in the Boise market during fiscal 2017; increases in demand primarily in Nevada and Arizona; and an increase in the number of selling communities in Nevada. These increases were offset, in part, by lower demand and a decrease in selling communities in Colorado and Washington. The net contracts signed in the Boise market also reduced our average contracted price for fiscal 2017, as compared to fiscal 2016. Excluding contracts signed in the Boise market, the average value of each contract signed in fiscal 2017, increased by 2%, as compared to fiscal 2016. The increase in income before income taxes in fiscal 2017, as compared to fiscal 2016, was due mainly to higher earnings from the increased revenues in fiscal 2017, as compared to fiscal 2016. California The increase in the number of homes delivered in fiscal 2017, as compared to fiscal 2016, was mainly due to an increase in the number of homes sold and settled in fiscal 2017, as compared to fiscal 2016, offset, in part, by a decrease in the number of homes in backlog at October 31, 2016, as compared to the number of homes in backlog at October 31, 2015. The increase in the average price of homes delivered in fiscal 2017, as compared to fiscal 2016, was primarily due to a shift in the number of homes delivered to more expensive areas and/or products and increased selling prices of homes delivered in fiscal 2017, as compared to fiscal 2016. The increase in the number of net contracts signed in fiscal 2017, as compared to fiscal 2016, was due mainly to an increase in demand and an increase in the average number of selling communities in our southern California markets in fiscal 2017, as compared to fiscal 2016. The increase in income before income taxes in fiscal 2017, as compared to fiscal 2016, was primarily due to higher earnings from the increased revenues, offset, in part, by higher SG&A, as a percent of revenues. City Living The increase in the number of homes delivered in fiscal 2017, as compared to fiscal 2016, was principally due to the commencement of deliveries in fiscal 2017 at three buildings (located in Hoboken, New Jersey; New York City; and Bethesda, Maryland). These increases were partially offset by a decrease in closings at one building, located in New York City, where there were fewer available units remaining in fiscal 2017, as compared to fiscal 2016, and at a community located in Philadelphia, Pennsylvania, which settled out in fiscal 2016. The decrease in the average price of homes delivered in fiscal 2017, as compared to fiscal 2016, was primarily due to a shift in the number of homes delivered to less expensive buildings in fiscal 2017, as compared to fiscal 2016. The increase in the number of net contracts signed in fiscal 2017, as compared to fiscal 2016, was primarily due to strong sales at a building located in Jersey City, New Jersey, which opened in the third quarter of fiscal 2017. This increase was partially offset by a decrease at a building located in Hoboken, New Jersey which benefited from strong sales in fiscal 2016 due to its opening in the fourth quarter of fiscal 2015 and a decrease at a building in New York City, where there were fewer available units remaining in fiscal 2017, as compared to fiscal 2016. The decrease in the average sales price of net contracts signed in fiscal 2017, as compared to fiscal 2016, was principally due to a shift to less expensive buildings in fiscal 2017, as compared to fiscal 2016. The increase in income before income taxes in fiscal 2017, as compared to fiscal 2016, was mainly due to a $60.2 million increase in earnings from our investments in unconsolidated entities; higher earnings from increased revenues; and state reimbursement of $4.7 million of previously expensed environmental clean-up costs received in the fiscal 2017 period, offset, in part, by a shift in the number of homes delivered to buildings with a lower margin. In fiscal 2017 and 2016, mainly due to the commencement of deliveries from two City Living Home Building Joint Ventures in the fourth quarter of fiscal 2016, we recognized $73.1 million and $12.9 million in earnings, respectively, from our investments in unconsolidated entities. The tables below provide information related to deliveries and revenues and net contracts signed by our City Living Home Building Joint Ventures, for the periods indicated, and the related backlog for the dates indicated ($ amounts in millions): Other In fiscal 2017 and 2016, loss before income taxes was $146.8 million and $140.8 million, respectively. The increase in the loss before income taxes in fiscal 2017, as compared to fiscal 2016, was principally attributable to higher SG&A costs; a $4.9 million gain recognized in fiscal 2016 from the sale of our ownership interest in one of our joint ventures located in New Jersey; lower earnings from Gibraltar; losses incurred by a one of our Rental Property Joint Ventures which commenced operations of a hotel in February 2017; and a gain of $1.6 million recognized in the fiscal 2016 period, from a bulk sale of security monitoring accounts by our home security monitoring business in fiscal 2015. These increases were partially offset by gains of $26.7 million in fiscal 2017 related to the sales of 50% of our ownership interests in two of our Rental Property Joint Ventures located in Jersey City, New Jersey and the suburbs of Philadelphia, Pennsylvania. The increase in SG&A costs in fiscal 2017, as compared to fiscal 2016, was due to increased compensation costs, due to our increased number of employees related to our increased business activity and increased spending on upgrading our computer software. FISCAL 2016 COMPARED TO FISCAL 2015 Traditional Home Building North The increase in the average price of homes delivered in fiscal 2016, as compared to fiscal 2015, was primarily attributable to a shift in the number of homes delivered to more expensive areas and/or products and increases in selling prices of homes delivered in fiscal 2016, as compared to fiscal 2015. The increase in the number of homes delivered in fiscal 2016, as compared to fiscal 2015, was mainly due to increases in the number of homes closed in Michigan and New Jersey, partially offset by a decrease in the number of homes closed in Illinois. The increase in the number of homes closed in New Jersey was primarily due to higher backlog conversion in the fiscal 2016 period, as compared to the fiscal 2015 period. In Michigan, the increase was principally due to an increase in the number of homes in backlog as of October 31, 2015, as compared to the number of homes in backlog at October 31, 2014. The increase in the number of net contracts signed in fiscal 2016, as compared to fiscal 2015, was mainly due to improved market conditions in Michigan, New York, and New Jersey, offset, in part by decreases in Connecticut and Illinois where demand has declined, and in Massachusetts due to a decrease in the number of selling communities. The increase in the average sales price of net contracts signed was principally attributable to a shift in the number of contracts signed to more expensive areas and/or products and increases in base selling prices in fiscal 2016, as compared to fiscal 2015. The 30% increase in income before income taxes in fiscal 2016, as compared to fiscal 2015, was principally attributable to higher earnings from increased revenues and lower inventory impairment charges, offset, in part, by higher cost of revenues, excluding inventory impairment charges, as a percentage of revenues, and higher SG&A costs. During our review of communities for impairment in fiscal 2016 and 2015, primarily due to a lack of improvement and/or a decrease in customer demand as a result of weaker than expected market conditions, we determined that the pricing assumptions used in prior impairment reviews for three operating communities (two located in Connecticut and one in suburban New York) in fiscal 2016, and two operating communities (one located in suburban New York and one located in New Jersey) in fiscal 2015, needed to be reduced. As a result of these reductions in expected sales prices, we determined that these communities were impaired. Accordingly, the carrying values of these communities were written down to their estimated fair values resulting in charges to income before income taxes of $7.3 million and $13.9 million in fiscal 2016 and fiscal 2015, respectively. Total inventory impairment charges for fiscal 2016 and fiscal 2015 were $7.6 million and $15.0 million, respectively. The increase in the cost of revenues, excluding inventory impairment charges, as a percentage of revenues, was primarily due to a change in product mix/areas to lower-margin areas. Mid-Atlantic The increase in the number of homes delivered in fiscal 2016, as compared to fiscal 2015, was mainly due to a greater number of homes being sold and delivered in fiscal 2016, as compared to fiscal 2015. The increase in the number of net contracts signed in fiscal 2016, as compared to fiscal 2015, was primarily attributable to increases in demand in Pennsylvania, Maryland, and Virginia and to an increase in the number of selling communities in Pennsylvania and Maryland. The loss before income taxes in fiscal 2016, as compared to income before income taxes in fiscal 2015, was mainly due to $125.6 million of warranty charges, primarily related to homes built in Pennsylvania and Delaware, in fiscal 2016, as compared to $14.7 million in fiscal 2015. and higher SG&A costs, offset, in part, by lower inventory impairment charges and higher earnings from increased revenues. See Note 7 - “Accrued Expenses” in Item 15(a)1 of this Form 10-K for additional information regarding these warranty charges. Inventory impairment charges were $2.1 million, as compared to $19.5 million in fiscal 2016 and fiscal 2015, respectively. The impairment charges in fiscal 2016 primarily related to a land purchase contract in Delaware where we were unable to obtain the required approvals to proceed with our development of the underlying property. Accordingly, we terminated the contract and wrote off costs incurred. In fiscal 2015, due to the weakness in certain housing markets in Maryland and West Virginia, we decided to sell or look for alternate uses for two parcels of land rather than develop them as previously intended. The carrying values of these communities were written down to their estimated fair values resulting in charges to income before income taxes of $11.9 million. We sold one parcel of land during the fourth quarter of fiscal 2015. In addition, during our review of operating communities for impairment in fiscal 2015, primarily due to a lack of improvement and/or a decrease in customer demand as a result of weaker than expected market conditions, we determined that the pricing assumptions used in prior impairment reviews for one operating community located in Virginia needed to be reduced. As a result of this reduction in expected sales prices, we determined that this community was impaired. Accordingly, the carrying value of this community was written down to its estimated fair value resulting in a charge to income before income taxes in fiscal 2015 of $3.1 million. South The decrease in the number of homes delivered in fiscal 2016, as compared to fiscal 2015, was principally due a decrease in the number of homes in backlog as of October 31, 2015, as compared to the number of homes in backlog at October 31, 2014. The increase in the average price of the homes delivered in fiscal 2016, as compared to fiscal 2015, was primarily attributable to a shift in the number of homes delivered to more expensive areas and/or products. The increase in the number of net contracts signed in fiscal 2016, as compared to fiscal 2015, was mainly due to increases in demand in the Raleigh, North Carolina and the Dallas, Texas markets, and an increase in selling communities in Florida. The decrease in the average value of each contract signed in fiscal 2016, as compared to fiscal 2015, was mainly due to a shift in the number of contracts signed to less expensive areas and/or products. The decrease in income before income taxes in fiscal 2016, as compared to fiscal 2015, was principally due to higher cost of revenues, as a percentage of revenues, lower earnings from decreased revenues, and higher SG&A costs in fiscal 2016, as compared to fiscal 2015. The increase in the cost of revenues, as a percentage of revenues, was primarily due to a change in product mix/areas to lower-margin areas and higher inventory impairment charges. Inventory impairment charges were $3.3 million and $0.7 million in fiscal 2016 and fiscal 2015, respectively. In fiscal 2016, we decided to sell or look for alternate uses for a partially improved land parcel in North Carolina rather than develop it as previously intended. The carrying value of this community was written down to its estimated fair values resulting in a charge to income before income taxes of $2.0 million. West The increase in the number of homes delivered in fiscal 2016, as compared to fiscal 2015, was primarily due to a higher backlog at October 31, 2015, as compared to October 31, 2014. The increase in the average price of the homes delivered was mainly due to a shift in the number of homes delivered to more expensive products and/or locations and increases in selling prices of homes delivered in fiscal 2016, as compared to fiscal 2015. The increase in the number of net contracts signed in fiscal 2016, as compared to fiscal 2015, was principally due to increases in the number of selling communities in Colorado and the Las Vegas, Nevada market and increased demand in Colorado and Arizona. The increase in income before income taxes in fiscal 2016, as compared to fiscal 2015, was due mainly to higher earnings from the increased revenues and a $2.9 million recovery in fiscal 2016 of previously incurred charges related to a joint venture located in Nevada partially offset by higher cost of revenues, as a percentage of revenues, and higher SG&A costs. The increase in cost of revenues, as a percentage of revenues, was primarily due to a shift in the number of homes delivered to lower-margin products and/or locations. California The increase in the number of homes delivered in fiscal 2016, as compared to fiscal 2015, was principally due to an increase in the number of homes in backlog as of October 31, 2015, as compared to October 31, 2014. The increase in the average price of homes delivered in fiscal 2016, as compared to fiscal 2015, was primarily due to a shift in the number of homes delivered to more expensive areas and/or products and increased selling prices of homes delivered. The decrease in the number of net contracts signed in fiscal 2016, as compared to fiscal 2015, was due primarily to (1) a temporary lack of inventory, primarily in northern California, as we are transitioning between a number of communities that are selling out, and thus have limited inventory, and the opening of new communities and (2) reduced demand resulting from our decision to increase prices in a number of communities with large backlogs to maximize the value of our inventory. Fiscal 2016 was negatively impacted by the continued reduction in demand in our Porter Ranch master planned community in Southern California due to a natural gas leak on unaffiliated land approximately one mile away. In mid-February 2016, the State of California announced that the leak had been permanently sealed. Recent testing has verified that air quality is back to normal levels and, therefore, we are optimistic that operations will gradually return to normal at our Porter Ranch master planned community. The increase in the average sales price of net contracts signed in fiscal 2016, as compared to fiscal 2015, was principally due to a shift in the number of contracts signed to more expensive areas and/or products and increases in selling prices. The increase in income before income taxes in fiscal 2016, as compared to fiscal 2015, was due mainly to higher earnings from increased revenues and lower cost of revenues, as a percentage of revenues. This increase was partially offset by higher SG&A costs. The decrease in cost of revenues, as a percentage of revenues, was primarily due to a shift in the number of homes delivered to higher-margin products and/or locations and increased selling prices of homes delivered. City Living The decrease in the number of homes delivered in fiscal 2016, as compared to fiscal 2015, was principally due to the delivery of homes at one community located in Philadelphia, Pennsylvania, which commenced delivering homes in the third quarter of fiscal 2015 and delivered all homes by October 31, 2015. The increase in the average price of homes delivered in fiscal 2016, as compared to fiscal 2015, was primarily due to a shift in the number of homes delivered from the Philadelphia, Pennsylvania market to the metro New York City market, where average selling prices were higher. The increase in the average sales price of net contracts signed in fiscal 2016, as compared to fiscal 2015, was principally due to a shift in the number of net contracts signed in the Philadelphia, Pennsylvania market to the metro New York City market, where the average value of each contract is higher, and increases in selling prices. The decrease in income before income taxes in fiscal 2016, as compared to fiscal 2015, was mainly due to higher cost of revenues, as a percentage of revenues, lower earnings from decreased revenues, and higher SG&A costs, offset, in part, by higher earnings from our Home Building Joint Ventures. The increase in cost of revenues, as a percentage of revenues, was mainly due to a shift in the number of homes delivered to buildings with lower margins in fiscal 2016, as compared to fiscal 2015. The increase in earnings from our Home Building Joint Ventures was principally due to the commencement of closing in the fourth quarter of fiscal 2016 at two buildings located in New York City. Other In fiscal 2016 and 2015, loss before income taxes was $140.8 million and $115.5 million, respectively. The increase in the loss before income taxes in fiscal 2016, as compared to fiscal 2015, was principally attributable to higher SG&A costs in the fiscal 2016 period, as compared to the fiscal 2015 period, a gain of $1.6 million recognized in the fiscal 2016 period, as compared to $8.1 million in the fiscal 2015 period, from a bulk sale of security monitoring accounts by our home security monitoring business in the fiscal 2015 period, and lower earnings from Gibraltar in the fiscal 2016 period, as compared to the fiscal 2015 period. The increase in SG&A costs was due primarily to increased compensation costs due to our increased number of employees. These increases to the loss before income taxes were partially offset by a $4.9 million gain recognized related to the sale of our ownership interests in one of our joint ventures located in New Jersey in the fiscal 2016 period.

<s>[INST] When this report uses the words “we,” “us,” “our,” and the “Company,” they refer to Toll Brothers, Inc. and its subsidiaries, unless the context otherwise requires. References herein to fiscal year refer to our fiscal years ended or ending October 31. Unless otherwise stated in this report, net contracts signed represents a number or value equal to the gross number or value of contracts signed during the relevant period, less the number or value of contracts canceled during the relevant period, which includes contracts that were signed during the relevant period and in prior periods. Backlog consists of homes under contract but not yet delivered to our home buyers (“backlog”). OVERVIEW Our Business We design, build, market, sell, and arrange financing for detached and attached homes in luxury residential communities. We cater to moveup, emptynester, activeadult, and secondhome buyers in the United States (“Traditional Home Building Product”). We also build and sell homes in urban infill markets through Toll Brothers City Living® (“City Living”). At October 31, 2017, we were operating in 20 states. In the five years ended October 31, 2017, we delivered 28,355 homes from 676 communities, including 7,151 homes from 407 communities in fiscal 2017. In November 2016, we acquired substantially all of the assets and operations of Coleman Real Estate Holdings, LLC (“Coleman”). See “Acquisition” below for more information. We are developing several land parcels for master planned communities in which we intend to build homes on a portion of the lots and sell the remaining lots to other builders. Two of these master planned communities are being developed 100% by us, and the remaining communities are being developed through joint ventures with other builders or financial partners. In addition to our residential forsale business, we also develop and operate forrent apartments through joint ventures. See the section entitled “Toll Brothers Apartment Living/Toll Brothers Campus Living/Toll Brothers Realty Trust” below. We operate our own land development, architectural, engineering, mortgage, title, landscaping, security monitoring, lumber distribution, house component assembly, and manufacturing operations. In addition, in certain markets, we develop land for sale to other builders, often through joint venture structures with other builders or with financial partners. We also develop, own, and operate golf courses and country clubs, which generally are associated with several of our master planned communities. We have investments in various unconsolidated entities. We have investments in joint ventures (i) to develop land for the joint venture participants and for sale to outside builders (“Land Development Joint Ventures”); (ii) to develop forsale homes (“Home Building Joint Ventures”); (iii) to develop luxury forrent residential apartments, commercial space and a hotel (“Rental Property Joint Ventures”); and (iv) to invest in distressed loans and real estate and provide financing and land banking for residential builders and developers for the acquisition and development of land and home sites (“Gibraltar Joint Ventures”). Financial Highlights In fiscal 2017, we recognized $5.82 billion of revenues and net income of $535.5 million, as compared to $5.17 billion of revenues and net income of $382.1 million in fiscal 2016. In fiscal 2017 and 2016, the value of net contracts signed was $6.83 billion (8,175 homes) and $5.65 billion (6,719 homes), respectively. The value of our backlog at October 31, 2017 was $5.06 billion (5,851 homes), as compared to our backlog at October 31, 2016 of $3.98 billion (4,685 homes). At October 31, 2017, we had $712.8 million of cash and cash equivalents on hand and approximately $1.15 billion available for borrowing under our $1.295 billion revolving credit facility (the “Credit Facility”) that matures in [/INST] Negative. </s>

TOLL BROTHERS INC

2018-12-20

2018-10-31

ITEM 7. MANAGEMENT’S DISCUSSION AND ANALYSIS OF FINANCIAL CONDITION AND RESULTS OF OPERATIONS (“MD&A”) This discussion and analysis is based on, should be read together with, and is qualified in its entirety by, the Consolidated Financial Statements and Notes thereto in Item 15(a)1 of this Form 10-K, beginning at page. It also should be read in conjunction with the disclosure under “Forward-Looking Statements” in Part I of this Form 10-K. When this report uses the words “we,” “us,” “our,” and the “Company,” they refer to Toll Brothers, Inc. and its subsidiaries, unless the context otherwise requires. References herein to fiscal year refer to our fiscal years ended or ending October 31. Unless otherwise stated in this report, net contracts signed represents a number or value equal to the gross number or value of contracts signed during the relevant period, less the number or value of contracts canceled during the relevant period, which includes contracts that were signed during the relevant period and in prior periods. Backlog consists of homes under contract but not yet delivered to our home buyers (“backlog”). OVERVIEW Our Business We design, build, market, sell, and arrange financing for detached and attached homes in luxury residential communities. We cater to move-up, empty-nester, active-adult, and second-home buyers in the United States (“Traditional Home Building Product”). We also build and sell homes in urban infill markets through Toll Brothers City Living (“City Living”). At October 31, 2018, we were operating in 19 states, as well as in the District of Columbia. In the five years ended October 31, 2018, we delivered 32,436 homes from 683 communities, including 8,265 homes from 415 communities in fiscal 2018. At October 31, 2018, we had 638 communities containing approximately 53,400 home sites that we owned or controlled through options. We are developing several land parcels for master planned communities in which we intend to build homes on a portion of the lots and sell the remaining lots to other builders. Two of these master planned communities are being developed 100% by us, and the remaining communities are being developed through joint ventures with other builders or financial partners. In addition to our residential for-sale business, we also develop and operate for-rent apartments through joint ventures. See the section entitled “Toll Brothers Apartment Living/Toll Brothers Campus Living” below. We operate our own architectural, engineering, mortgage, title, land development and land sale, golf course development and management, and landscaping subsidiaries. We also operate our own security company, TBI Smart Home Solutions, which provides homeowners with home automation and technology options. In addition, we operate our own lumber distribution, house component assembly, and manufacturing operations. We have investments in various unconsolidated entities. We have investments in joint ventures (i) to develop land for the joint venture participants and for sale to outside builders (“Land Development Joint Ventures”); (ii) to develop for-sale homes (“Home Building Joint Ventures”); (iii) to develop luxury for-rent residential apartments, commercial space and a hotel (“Rental Property Joint Ventures”); and (iv) to invest in distressed loans and real estate and provide financing and land banking for residential builders and developers for the acquisition and development of land and home sites (“Gibraltar Joint Ventures”). Financial Highlights In fiscal 2018, we recognized $7.14 billion of revenues and net income of $748.2 million, as compared to $5.82 billion of revenues and net income of $535.5 million in fiscal 2017. In fiscal 2018 and 2017, the value of net contracts signed was $7.60 billion (8,519 homes) and $6.83 billion (8,175 homes), respectively. The value of our backlog at October 31, 2018 was $5.52 billion (6,105 homes), as compared to our backlog at October 31, 2017 of $5.06 billion (5,851 homes). At October 31, 2018, we had $1.18 billion of cash and cash equivalents and approximately $1.13 billion available for borrowing under our $1.295 billion revolving credit facility (the “Revolving Credit Facility”) that matures in May 2021. At October 31, 2018, we had no outstanding borrowings under the Revolving Credit Facility and had outstanding letters of credit of approximately $165.4 million. In February 2017, our Board of Directors approved the initiation of quarterly cash dividends to shareholders. During fiscal 2018 and 2017, we paid aggregate cash dividends of $0.41 and $0.24 per share, respectively, to our shareholders. In December 2018, we declared a quarterly cash dividend of $0.11 which will be paid on January 25, 2019 to shareholders of record on the close of business on January 11, 2019. At October 31, 2018, our total equity and our debt to total capitalization ratio were $4.77 billion and 0.44 to 1:00, respectively. Acquisition In November 2016, we acquired substantially all of the assets and operations of Coleman for approximately $83.1 million in cash. The assets acquired were primarily inventory, including approximately 1,750 home sites owned or controlled through land purchase agreements. As part of the acquisition, we assumed contracts to deliver 128 homes with an aggregate value of $38.8 million. The average price of the undelivered homes at the date of acquisition was approximately $303,000. Our selling community count increased by 15 communities at the acquisition date. Our Business Environment and Current Outlook In fiscal 2018, we signed 8,519 contracts for the sale of Traditional Home Building Product and City Living units with an aggregate value of $7.60 billion, compared to 8,175 contracts with an aggregate value of $6.83 billion in fiscal 2017, and 6,719 contracts with an aggregate value of $5.65 billion in fiscal 2016. Although we experienced strong order growth in the first nine months of fiscal 2018, in our fourth quarter, we experienced a moderation in demand as compared to the prior year. In the three months ended October 31, 2018, the value and number of contracts signed declined 15% and 13%, respectively, as compared to the three months ended October 31, 2017. In November through mid-December 2018, we experienced further softening in demand. We believe this decline in demand is due to the cumulative impact of rising interest rates, increased prices, and a shift in buyer sentiment. According to the U.S. Census Bureau (“Census Bureau”), the number of households earning $100,000 or more (in constant 2017 dollars) at September 2018 stood at 37.3 million, or approximately 29.2% of all U.S. households. This group has grown at 2.5 times the rate of increase of all U.S. households since 1980. According to Harvard University’s 2018 report, “The State of the Nation’s Housing,” demographic forces are likely to drive the addition of approximately 1.2 million new households per year from 2017 to 2027. Housing starts, which encompass the units needed for household formations, second homes, and the replacement of obsolete or demolished units, have not kept pace with this projected household growth or the aging of existing homes. According to the Census Bureau’s October 2018 New Residential Sales Report, new home inventory stands at a supply of just 7.4 months, based on current sales paces. If demand increases significantly, the supply of 7.4 months will quickly be drawn down. During the period 1970 through 2007, total housing starts in the United States averaged approximately 1.6 million per year, while during the period 2008 through 2017, total housing starts averaged approximately 0.89 million per year according to the Census Bureau. Additionally, the median age of housing stock in the United States has increased from 25 years to 40 years over the last three decades, thus expanding the market for replacement homes. We continue to believe that many of our communities are in desirable locations that are difficult to replace and in markets where approvals have been increasingly difficult to achieve. We believe that many of these communities have substantial embedded value that may be realized in the future. Tax Reform On December 22, 2017, the Tax Cuts and Jobs Act (the “Tax Act”) was enacted into law, which changed many longstanding foreign and domestic corporate and individual tax rules, as well as rules pertaining to the deductibility of employee compensation and benefits. These changes include: (i) reducing the corporate income tax rate from 35% to 21% for tax years beginning after December 31, 2017; (ii) eliminating the corporate alternative minimum tax; (iii) changing rules related to uses and limitations of net operating loss carryforwards created in tax years beginning after December 31, 2017; (iv) repeal of the domestic production activities deduction for tax years beginning after December 31, 2017; and (v) establishing new limits on the federal tax deductions individual taxpayers may take as a result of mortgage loan interest payments, and state and local tax payments, including real estate taxes. As required under accounting rules, we remeasured our net deferred tax liability for the tax law change, which resulted in an income tax benefit of $35.5 million in fiscal 2018. See Note 8, “Income Taxes” in Notes to Condensed Consolidated Financial Statements in Item 15(a)1 of this Form 10-K for additional information regarding the impact of the Tax Act. Defective Floor Joists In July 2017, one of our lumber suppliers publicly announced a floor joist recall. We believe that these floor joists were present in approximately 350 of our homes that had been built or were under construction in our North and West geographic segments. Of the approximately 350 affected homes, eight of them had already been delivered to home buyers at the time the joist recall was announced. After the joist recall was announced, 39 home buyers canceled their contracts and 20 home buyers transferred their contracts to another home site. The remediation of the defective floor joists has been completed for all affected homes. We began delivering these homes in the first quarter of fiscal 2018 and delivered substantially all of these homes in fiscal 2018. The supplier has reimbursed us for all costs associated with the remediation of the defective floor joists. Competitive Landscape The home building business is highly competitive and fragmented. We compete with numerous home builders of varying sizes, ranging from local to national in scope, some of which have greater sales and financial resources than we do. Sales of existing homes, whether by a homeowner or by a financial institution that has acquired a home through a foreclosure, also provide competition. We compete primarily based on price, location, design, quality, service, and reputation. We believe our financial stability, relative to many others in our industry, provides us with a competitive advantage. Land Acquisition and Development Our business is subject to many risks, because of the extended length of time that it takes to obtain the necessary approvals on a property, complete the land improvements on it, and deliver a home after a home buyer signs an agreement of sale. In certain cases, we attempt to reduce some of these risks by utilizing one or more of the following methods: controlling land for future development through options, which enable us to obtain necessary governmental approvals before acquiring title to the land; generally commencing construction of a detached home only after executing an agreement of sale and receiving a substantial down payment from the buyer; and using subcontractors to perform home construction and land development work on a fixed-price basis. During fiscal 2018 and 2017, we acquired control of approximately 13,400 and 6,600 home sites, respectively, net of options terminated and home sites sold. At October 31, 2018, we controlled approximately 53,400 home sites, as compared to approximately 48,300 home sites at October 31, 2017, and approximately 48,800 home sites at October 31, 2016. In addition, at October 31, 2018, we expect to purchase approximately 2,700 additional home sites from several land development joint ventures in which we have an interest, at prices not yet determined. Of the approximately 53,400 total home sites that we owned or controlled through options at October 31, 2018, we owned approximately 32,500 and controlled approximately 20,900 through options. Of the 53,400 home sites, approximately 16,900 were substantially improved. In addition, at October 31, 2018, our Land Development Joint Ventures owned approximately 10,700 home sites (including 169 home sites included in the 20,900 controlled through options), and our Home Building Joint Ventures owned approximately 300 home sites. At October 31, 2018, we were selling from 315 communities, compared to 305 communities at October 31, 2017, and 310 communities at October 31, 2016. Customer Mortgage Financing We maintain relationships with a widely-diversified group of mortgage financial institutions, many of which are among the largest in the industry. We believe that regional and community banks continue to recognize the long-term value in creating relationships with high-quality, affluent customers such as our home buyers, and these banks continue to provide these customers with financing. We believe that our home buyers generally are, and should continue to be, well-positioned to secure mortgages due to their typically lower loan-to-value ratios and attractive credit profiles, as compared to the average home buyer. Toll Brothers Apartment Living/Toll Brothers Campus Living In addition to our residential for-sale business, we also develop and operate for-rent apartments through joint ventures. At October 31, 2018, we or joint ventures in which we have an interest controlled 44 land parcels as for-rent apartment projects containing approximately 15,400 units. These projects, which are located in the metro Boston to metro Washington, D.C. corridor; Los Angeles, San Francisco, San Diego and Fremont, California; Atlanta, Georgia; Dallas, Texas; and Phoenix, Arizona are being operated, are being developed or will be developed with partners under the brand names Toll Brothers Apartment Living and Toll Brothers Campus Living. In fiscal 2018, three of our Rental Property Joint Ventures sold their assets to unrelated parties for $477.5 million. These joint ventures had owned, developed, and operated multifamily rental properties located in suburban Washington, D.C. and Westborough, Massachusetts, and a student housing community in College Park, Maryland. From our investment in these joint ventures, we received cash of $79.1 million and recognized gains from these sales of $67.2 million in fiscal 2018, which is included in “Income from unconsolidated entities” in our Consolidated Statement of Operations and Comprehensive Income included in Item 15(a)1 of this Form 10-K. At October 31, 2018, we had approximately 1,750 units in for-rent apartment projects that were occupied or ready for occupancy, 1,400 units in the lease-up stage, 4,150 units under active development, and 8,100 units in the planning stage. Of the 15,400 units at October 31, 2018, 5,950 were owned by joint ventures in which we have an interest; approximately 3,000 were owned by us; and 6,450 were under contract to be purchased by us. CONTRACTS AND BACKLOG The aggregate value of net sales contracts signed increased 11.4% in fiscal 2018, as compared to fiscal 2017, and 20.9% in fiscal 2017, as compared to fiscal 2016. The value of net sales contracts signed was $7.60 billion (8,519 homes) in fiscal 2018, $6.83 billion (8,175 homes) in fiscal 2017, and $5.65 billion (6,719 homes) in fiscal 2016. The increase in the aggregate value of net contracts signed in fiscal 2018, as compared to fiscal 2017, was due to increases in the number of net contracts signed and average value of each contract signed of 4% and 7%, respectively. The increase in the aggregate value of net contracts signed in fiscal 2017, as compared to fiscal 2016 was due mainly to an increase in the number of net contracts signed. The increases in the number of net contracts signed in each period was primarily due to increased demand. The increase in average price of net contracts signed in fiscal 2018, as compared to fiscal 2017, was principally due to a shift in the number of contracts signed to more expensive areas and/or products and price increases in fiscal 2018, as compared to fiscal 2017. The value of our backlog at October 31, 2018, 2017, and 2016 was $5.52 billion (6,105 homes), $5.06 billion (5,851 homes), and $3.98 billion (4,685 homes), respectively. Approximately 96% of the homes in backlog at October 31, 2018 are expected to be delivered by October 31, 2019. The 9.1% increase in the value of homes in backlog at October 31, 2018, as compared to October 31, 2017, was due to our signing net contracts with a value of $7.60 billion in fiscal 2018, offset, in part, by home deliveries with an aggregate value of $7.14 billion in fiscal 2018. The 27.0% increase in the value of homes in backlog at October 31, 2017, as compared to October 31, 2016, was primarily due to our signing net contracts with a value of $6.83 billion in fiscal 2017, offset, in part, by home deliveries with an aggregate value of $5.82 billion in fiscal 2017. For more information regarding revenues, net contracts signed, and backlog by geographic segment, see “Segments” in this MD&A. CRITICAL ACCOUNTING POLICIES We believe the following critical accounting policies reflect the more significant judgments and estimates used in the preparation of our consolidated financial statements. Inventory Inventory is stated at cost unless an impairment exists, in which case it is written down to fair value in accordance with U.S. generally accepted accounting principles (“GAAP”). In addition to direct land acquisition, land development, and home construction costs, costs also include interest, real estate taxes, and direct overhead related to development and construction, which are capitalized to inventory during periods beginning with the commencement of development and ending with the completion of construction. For those communities that have been temporarily closed, no additional capitalized interest is allocated to the community’s inventory until it reopens, and other carrying costs are expensed as incurred. Once a parcel of land has been approved for development and we open the community, it can typically take four or more years to fully develop, sell, and deliver all the homes in that community. Longer or shorter time periods are possible depending on the number of home sites in a community and the sales and delivery pace of the homes in a community. Our master planned communities, consisting of several smaller communities, may take up to 10 years or more to complete. Because our inventory is considered a long-lived asset under GAAP, we are required to regularly review the carrying value of each of our communities and write down the value of those communities when we believe the values are not recoverable. Operating Communities: When the profitability of an operating community deteriorates, the sales pace declines significantly, or some other factor indicates a possible impairment in the recoverability of the asset, the asset is reviewed for impairment by comparing the estimated future undiscounted cash flow for the community to its carrying value. If the estimated future undiscounted cash flow is less than the community’s carrying value, the carrying value is written down to its estimated fair value. Estimated fair value is primarily determined by discounting the estimated future cash flow of each community. The impairment is charged to cost of revenues in the period in which the impairment is determined. In estimating the future undiscounted cash flow of a community, we use various estimates such as (i) the expected sales pace in a community, based upon general economic conditions that will have a short-term or long-term impact on the market in which the community is located and on competition within the market, including the number of home sites available and pricing and incentives being offered in other communities owned by us or by other builders; (ii) the expected sales prices and sales incentives to be offered in a community; (iii) costs expended to date and expected to be incurred in the future, including, but not limited to, land and land development costs, home construction, interest, and overhead costs; (iv) alternative product offerings that may be offered in a community that will have an impact on sales pace, sales price, building cost, or the number of homes that can be built in a particular community; and (v) alternative uses for the property, such as the possibility of a sale of the entire community to another builder or the sale of individual home sites. Future Communities: We evaluate all land held for future communities or future sections of operating communities, whether owned or optioned, to determine whether or not we expect to proceed with the development of the land as originally contemplated. This evaluation encompasses the same types of estimates used for operating communities described above, as well as an evaluation of the regulatory environment in which the land is located and the estimated probability of obtaining the necessary approvals, the estimated time and cost it will take to obtain those approvals, and the possible concessions that may be required to be given in order to obtain them. Concessions may include cash payments to fund improvements to public places such as parks and streets, dedication of a portion of the property for use by the public or as open space, or a reduction in the density or size of the homes to be built. Based upon this review, we decide (i) as to land under contract to be purchased, whether the contract will likely be terminated or renegotiated, and (ii) as to land we own, whether the land will likely be developed as contemplated or in an alternative manner, or should be sold. We then further determine whether costs that have been capitalized to the community are recoverable or should be written off. The write-off is charged to cost of revenues in the period in which the need for the write-off is determined. The estimates used in the determination of the estimated cash flows and fair value of both current and future communities are based on factors known to us at the time such estimates are made and our expectations of future operations and economic conditions. Should the estimates or expectations used in determining estimated fair value deteriorate in the future, we may be required to recognize additional impairment charges and write-offs related to current and future communities and such amounts could be material. We provided for inventory impairment charges and the expensing of costs that we believed not to be recoverable in each of the three fiscal years ended October 31, 2018, 2017, and 2016, as shown in the table below (amounts in thousands): The table below provides, for the periods indicated, the number of operating communities that we reviewed for potential impairment, the number of operating communities in which we recognized impairment charges, the amount of impairment charges recognized, and, as of the end of the period indicated, the fair value of those communities, net of impairment charges ($ amounts in thousands): Income Taxes - Valuation Allowance We assess the need for valuation allowances for deferred tax assets in each period based on whether it is more-likely-than-not that some portion of the deferred tax asset would not be realized. If, based on the available evidence, it is more-likely-than-not that such asset will not be realized, a valuation allowance is established against a deferred tax asset. The realization of a deferred tax asset ultimately depends on the existence of sufficient taxable income in either the carryback or carryforward periods under tax law. This assessment considers, among other matters, the nature, consistency, and magnitude of current and cumulative income and losses; forecasts of future profitability; the duration of statutory carryback or carryforward periods; our experience with operating loss and tax credit carryforwards being used before expiration; tax planning alternatives; and outlooks for the U.S. housing industry and broader economy. Changes in existing tax laws or rates could also affect our actual tax results. Due to uncertainties in the estimation process, particularly with respect to changes in facts and circumstances in future reporting periods, actual results could differ from the estimates used in our assessment that could have a material impact on our consolidated results of operations or financial position. As a result of the enactment of the Tax Act into law, we remeasured our net deferred tax liability for the tax law change, which resulted in an income tax benefit of $35.5 million in fiscal 2018. See Note 8, “Income Taxes” in Notes to Consolidated Financial Statements in Item 15(a)1 of this Form 10-K for additional information regarding the impact of the Tax Act. Our deferred tax assets consist principally of timing of deductibility of accrued expenses, inventory impairments, inventory valuation differences, state tax net operating loss carryforwards, and stock-based compensation expense. In accordance with GAAP, we assess whether a valuation allowance should be established based on our determination of whether it was more likely than not that some portion or all of the deferred tax assets would not be realized. We file tax returns in the various states in which we do business. Each state has its own statutes regarding the use of tax loss carryforwards. Some of the states in which we do business do not allow for the carryforward of losses, while others allow for carryforwards for five years to 20 years. For state tax purposes, we establish valuation allowances for deferred tax assets in certain jurisdictions where it is more-likely-than-not that the deferred tax asset would not be realized. Due to past and projected losses in certain jurisdictions where we did not have carryback potential and/or could not sufficiently forecast future taxable income, we had recorded a net cumulative valuation allowance against our state deferred tax assets at October 31, 2016. During fiscal 2016, we recognized new valuation allowances of $1.0 million. We did not recognize any new valuation allowances in fiscal 2018 and 2017. During fiscal 2017, due to improved operating results, we reversed $32.2 million of state deferred tax asset valuation allowances. No state deferred tax asset valuation allowances were reversed in fiscal 2018 and 2016. Revenue and Cost Recognition Revenues and cost of revenues from home sales are recorded at the time each home is delivered and title and possession are transferred to the buyer. For our standard attached and detached homes, land, land development, and related costs, both incurred and estimated to be incurred in the future, are amortized to the cost of homes closed based upon the total number of homes to be constructed in each community. Any changes resulting from a change in the estimated number of homes to be constructed or in the estimated costs subsequent to the commencement of delivery of homes are allocated to the remaining undelivered homes in the community. Home construction and related costs are charged to the cost of homes closed under the specific identification method. For our master planned communities, the estimated land, common area development, and related costs, including the cost of golf courses, net of their estimated residual value, are allocated to individual communities within a master planned community on a relative sales value basis. Any changes resulting from a change in the estimated number of homes to be constructed or in the estimated costs are allocated to the remaining home sites in each of the communities of the master planned community. For high-rise/mid-rise projects, land, land development, construction, and related costs, both incurred and estimated to be incurred in the future, are generally amortized to the cost of units closed based upon an estimated relative sales value of the units closed to the total estimated sales value. Any changes resulting from a change in the estimated total costs or revenues of the project are allocated to the remaining units to be delivered. Forfeited Customer Deposits: Forfeited customer deposits are recognized in “Other income-net” in our Consolidated Statements of Operations and Comprehensive Income in the period in which we determine that the customer will not complete the purchase of the home and we have the right to retain the deposit. Sales Incentives: In order to promote sales of our homes, we grant our home buyers sales incentives from time to time. These incentives will vary by type of incentive and by amount on a community-by-community and home-by-home basis. Incentives that impact the value of the home or the sales price paid, such as special or additional options, are generally reflected as a reduction in sales revenues. Incentives that we pay to an outside party, such as paying some or all of a home buyer’s closing costs, are recorded as an additional cost of revenues. Incentives are recognized at the time the home is delivered to the home buyer and we receive the sales proceeds. On November 1, 2018, we adopted Accounting Standards Update ASU No. 2014-09, “Revenue from Contracts with Customers” (“ASU 2014-09”), which supersedes the revenue recognition requirements in Accounting Standards Codification Topic 605, “Revenue Recognition,” and most industry-specific guidance. See Note 1, “Significant Accounting Policies” in Notes to Consolidated Financial Statements in Item 15(a)1 of this Form 10-K for additional information regarding the impact of the adoption of ASU 2014-09. Warranty and Self-Insurance Warranty: We provide all of our home buyers with a limited warranty as to workmanship and mechanical equipment. We also provide many of our home buyers with a limited 10-year warranty as to structural integrity. We accrue for expected warranty costs at the time each home is closed and title and possession are transferred to the home buyer. Warranty costs are accrued based upon historical experience. Adjustments to our warranty liabilities related to homes delivered in prior years are recorded in the period in which a change in our estimate occurs. Over the past several years, we have had a significant number of warranty claims related primarily to homes built in Pennsylvania and Delaware. See Note 7 - “Accrued Expenses” in Item 15(a)1 of this Form 10-K for additional information regarding these warranty charges. Self-Insurance: We maintain, and require the majority of our subcontractors to maintain, general liability insurance (including construction defect and bodily injury coverage) and workers’ compensation insurance. These insurance policies protect us against a portion of our risk of loss from claims related to our home building activities, subject to certain self-insured retentions, deductibles and other coverage limits (“self-insured liability”). We also provide general liability insurance for our subcontractors in Arizona, California, Colorado, Nevada, Washington, and certain areas of Texas, where eligible subcontractors are enrolled as insureds under our general liability insurance policies in each community in which they perform work. For those enrolled subcontractors, we absorb their general liability associated with the work performed on our homes within the applicable community as part of our overall general liability insurance and our self-insurance through our captive insurance subsidiary. We record expenses and liabilities based on the estimated costs required to cover our self-insured liability and the estimated costs of potential claims and claim adjustment expenses that are not covered by our insurance policies. These estimated costs are based on an analysis of our historical claims and industry data, and include an estimate of claims incurred but not yet reported (“IBNR”). We engage a third-party actuary that uses our historical claim and expense data, input from our internal legal and risk management groups, as well as industry data, to estimate our liabilities related to unpaid claims, IBNR associated with the risks that we are assuming for our self-insured liability and other required costs to administer current and expected claims. These estimates are subject to uncertainty due to a variety of factors, the most significant being the long period of time between the delivery of a home to a home buyer and when a structural warranty or construction defect claim is made, and the ultimate resolution of the claim. Though state regulations vary, construction defect claims are reported and resolved over a prolonged period of time, which can extend for 10 years or longer. As a result, the majority of the estimated liability relates to IBNR. Adjustments to our liabilities related to homes delivered in prior years are recorded in the period in which a change in our estimate occurs. The projection of losses related to these liabilities requires actuarial assumptions that are subject to variability due to uncertainties regarding construction defect claims relative to our markets and the types of product we build, insurance industry practices and legal or regulatory actions and/or interpretations, among other factors. Key assumptions used in these estimates include claim frequencies, severities and settlement patterns, which can occur over an extended period of time. In addition, changes in the frequency and severity of reported claims and the estimates to settle claims can impact the trends and assumptions used in the actuarial analysis, which could be material to our consolidated financial statements. Due to the degree of judgment required, and the potential for variability in these underlying assumptions, our actual future costs could differ from those estimated, and the difference could be material to our consolidated financial statements. OFF-BALANCE SHEET ARRANGEMENTS We also operate through a number of joint ventures. We earn construction and management fee income from many of these joint ventures. Our investments in these entities are generally accounted for using the equity method of accounting. We are a party to several joint ventures with unrelated parties to develop and sell land that is owned by the joint ventures. We recognize our proportionate share of the earnings from the sale of home sites to other builders, including our joint venture partners. We do not recognize earnings from the home sites we purchase from these ventures at the time of our purchase; instead, our cost basis in the home sites is reduced by our share of the earnings realized by the joint venture from those home sites. At October 31, 2018, we had investments in these entities of $431.8 million, and were committed to invest or advance up to an additional $39.5 million to these entities if they require additional funding. At October 31, 2018, we had agreed to terms for the acquisition of 169 home sites from two Land Development Joint Ventures for an estimated aggregate purchase price of $128.2 million. In addition, we expect to purchase approximately 2,700 additional home sites over a number of years from several of these joint ventures; the purchase price of these home sites will be determined at a future date. The unconsolidated entities in which we have investments generally finance their activities with a combination of partner equity and debt financing. In some instances, we and our partners have guaranteed debt of certain unconsolidated entities. These guarantees may include any or all of the following: (i) project completion guarantees, including any cost overruns; (ii) repayment guarantees, generally covering a percentage of the outstanding loan; (iii) carry cost guarantees, which cover costs such as interest. real estate taxes, and insurance; (iv) an environmental indemnity provided to the lender that holds the lender harmless from and against losses arising from the discharge of hazardous materials from the property and non-compliance with applicable environmental laws; and (v) indemnification of the lender from “bad boy acts” of the unconsolidated entity. In some instances, the guarantees provided in connection with loans to an unconsolidated entity are joint and several. In these situations, we generally have a reimbursement agreement with our partner that provides that neither party is responsible for more than its proportionate share or agreed-upon share of the guarantee; however, if the joint venture partner does not have adequate financial resources to meet its obligations under the reimbursement agreement, we may be liable for more than our proportionate share. We believe that as of October 31, 2018, in the event we become legally obligated to perform under a guarantee of the obligation of an unconsolidated entity due to a triggering event, the collateral should be sufficient to repay all or a significant portion of the obligation. If it is not, we and our partners would need to contribute additional capital to the entity. At October 31, 2018, we had guaranteed the debt of certain unconsolidated entities with loan commitments aggregating $1.34 billion, of which, if the full amount of the debt obligations were borrowed, we estimate $294.7 million to be our maximum exposure related to repayment and carry cost guarantees. At October 31, 2018, the unconsolidated entities had borrowed an aggregate of $1.06 billion, of which we estimate $254.7 million to be our maximum exposure related to repayment and carry cost guarantees. These maximum exposure estimates do not take into account any recoveries from the underlying collateral or any reimbursement from our partners. For more information regarding these joint ventures, see Note 4, “Investments in Unconsolidated Entities” in the Notes to Consolidated Financial Statements in Item 15(a)1 of this Form 10-K. The trends, uncertainties or other factors that negatively impact our business and the industry in general also impact the unconsolidated entities in which we have investments. We review each of our investments on a quarterly basis for indicators of impairment. A series of operating losses of an investee, the inability to recover our invested capital, or other factors may indicate that a loss in value of our investment in the unconsolidated entity has occurred. If a loss exists, we further review to determine if the loss is other than temporary, in which case we write down the investment to its fair value. The evaluation of our investment in unconsolidated entities entails a detailed cash flow analysis using many estimates including but not limited to, expected sales pace, expected sales prices, expected incentives, costs incurred and anticipated, sufficiency of financing and capital, competition, market conditions and anticipated cash receipts, in order to determine projected future distributions. Each of the unconsolidated entities evaluates its inventory in a similar manner. In addition, for our unconsolidated entities that own, develop, and manage for-rent residential apartments, we review rental trends, expected future expenses, and expected future cash flows to determine estimated fair values of the properties. See “Critical Accounting Policies - Inventory” contained in this MD&A for more detailed disclosure on our evaluation of inventory. If a valuation adjustment is recorded by an unconsolidated entity related to its assets, our proportionate share is reflected in income from unconsolidated entities with a corresponding decrease to our investment in unconsolidated entities. Based upon our evaluation of the fair value of our investments in unconsolidated entities, we recognized charges in connection with two Land Development Joint Ventures of $6.0 million in fiscal 2018 and $2.0 million in fiscal 2017 at one Land Development Joint Venture. We determined that no impairments of our investments occurred in fiscal 2016. RESULTS OF OPERATIONS The following table compares certain items in our Consolidated Statements of Operations and Comprehensive Income and other supplemental information for fiscal 2018, 2017, and 2016 ($ amounts in millions, unless otherwise stated). For more information regarding results of operations by operating segment, see “Segments” in this MD&A. * $ amounts in thousands. Note: Amounts may not add due to rounding. FISCAL 2018 COMPARED TO FISCAL 2017 REVENUES AND COST OF REVENUES The increase in revenues in fiscal 2018, as compared to fiscal 2017, was mainly attributable to a 16% increase in the number of homes delivered primarily due to a higher backlog at October 31, 2017, as compared to October 31, 2016, and a 6% increase in the average price of the homes delivered. The increase in the average delivered home price was mainly due to an increase in the number of homes delivered in California, where home prices were higher; a shift in the number of homes delivered to more expensive areas and/or products in California and City Living; and price increases in the fiscal 2018 period, as compared to the fiscal 2017 period. These increases were partially offset by an increase in deliveries of lower priced products primarily in Massachusetts and Michigan and an increase in deliveries in Idaho, where average delivered home prices were lower than the Company average. Cost of revenues, as a percentage of revenues, in fiscal 2018 was 79.4%, as compared to 78.5% in fiscal 2017. The increase in fiscal 2018, as compared to fiscal 2017, was primarily due to higher material and labor costs; a higher number of closings in attached home communities (including active-adult), where cost of revenues are higher than our Company average; higher inventory impairment charges; a $6.0 million benefit in fiscal 2017 from the reversal of an accrual for offsite improvements at a completed community that was no longer required; and state reimbursements of $4.7 million in fiscal 2017 for previously expensed environmental clean-up costs. These increases were, offset, in part, by an increase in revenues generated in California, where cost of revenues, as a percentage of revenues, were lower than the Company average; price increases; recovery of approximately $9.7 million from litigation settlements in fiscal 2018; a $7.0 million benefit in fiscal 2018 from the reversal of an accrual related to an indemnification obligation related to the Shapell acquisition that has expired; and lower interest expense in fiscal 2018, as compared to fiscal 2017. Interest cost in fiscal 2018 was $190.7 million or 2.7% of revenues, as compared to $172.8 million or 3.0% of revenues in fiscal 2017. We recognized inventory impairments and write-offs of $35.2 million or 0.5% of revenues and $14.8 million or 0.3% of revenues in fiscal 2018 and fiscal 2017, respectively. SELLING, GENERAL AND ADMINISTRATIVE EXPENSES (“SG&A”) SG&A spending increased by $78.5 million in fiscal 2018, as compared to fiscal 2017. As a percentage of revenues, SG&A was 9.6% and 10.4% in fiscal 2018 and 2017, respectively. The dollar increase in SG&A was due primarily to increased compensation costs due to a higher number of employees; increased sales and marketing costs; and increased consulting fees related to implementation of process improvements. The higher sales and marketing costs were the result of the increased number of homes delivered, increased spending on advertising, and higher design studio operating costs. The increased number of employees was due primarily to the overall increase in our business in fiscal 2018, as compared to fiscal 2017. The decrease in SG&A as a percentage of revenues in the fiscal 2018 period was due to SG&A spending increasing by 13% while revenues increased 23% from the fiscal 2017 period. INCOME FROM UNCONSOLIDATED ENTITIES We recognize our proportionate share of the earnings and losses from the various unconsolidated entities in which we have an investment. Many of our unconsolidated entities are land development projects, high-rise/mid-rise condominium construction projects, or for-rent apartments projects, which do not generate revenues and earnings for a number of years during the development of the property. Once development is complete for land development projects and high-rise/mid-rise condominium construction projects, these unconsolidated entities will generally, over a relatively short period of time, generate revenues and earnings until all of the assets of the entity are sold. Further, once for-rent apartments projects are complete and stabilized, we may monetize a portion of these projects through a recapitalization or a sale of all or a portion of our ownership interest in the joint venture, resulting in income. Because there is not a steady flow of revenues and earnings from these entities, the earnings recognized from these entities will vary significantly from quarter to quarter and year to year. The decrease in income from unconsolidated entities from $116.1 million in fiscal 2017 to $85.2 million in fiscal 2018, was due mainly to lower income from two of our Home Building Joint Ventures located in New York, New York, where the fiscal 2017 period benefited from the commencement of deliveries in the fourth quarter of fiscal 2016; $26.7 million of gains recognized in fiscal 2017 on the sale of 50% of our ownership interests in two of our Rental Property Joint Ventures located in Jersey City, New Jersey and the suburbs of Philadelphia, Pennsylvania; and $6.0 million of charges we recognized on two of our Land Development Joint Ventures in fiscal 2018, as compared to a $2.0 million impairment charge recognized on one of these joint ventures in fiscal 2017. These decreases were partially offset by $67.2 million of gains recognized in fiscal 2018 from asset sales by three of our Rental Property Joint Ventures located in College Park, Maryland, Herndon, Virginia, and Westborough, Massachusetts. OTHER INCOME - NET The table below provides the components of “Other Income - net” for the years ended October 31, 2018 and 2017 (amounts in thousands): The increase in income from ancillary businesses in fiscal 2018, as compared to fiscal 2017, was mainly due a $10.7 million gain from a bulk sale of security monitoring accounts by our home control solutions business. This increase was partially offset by a $3.5 million write-down of a commercial property operated by Toll Brothers Apartment Living. Management fee income from home building unconsolidated entities presented above primarily represents fees earned by our City Living and home building operations. In addition, in fiscal 2018 and 2017, our apartment living operations earned fees from unconsolidated entities of $7.5 million and $6.2 million, respectively; fees earned by our apartment living operations are included in income from ancillary businesses. The increase in other in fiscal 2018, as compared to fiscal 2017, was principally due to higher interest income and retained customer deposits in fiscal 2018, as compared to fiscal 2017. INCOME BEFORE INCOME TAXES In fiscal 2018, we reported income before income taxes of $933.9 million or 13.1% of revenues, as compared to $814.3 million, or 14.0% of revenues in fiscal 2017. INCOME TAX PROVISION We recognized a $185.8 million income tax provision in fiscal 2018. Based upon the blended federal statutory rate of 23.3% for fiscal 2018, our federal tax provision would have been $217.9 million. The difference between the tax provision recognized and the tax provision based on the federal statutory rate was mainly due to tax law changes of $38.7 million; a benefit of $18.2 million related to the utilization of domestic production activities deductions; the reversal of $4.7 million of previously accrued tax provisions on uncertain tax positions that were no longer necessary due to the expiration of the statute of limitations and settlements with certain taxing jurisdictions; a benefit of $4.2 million from excess tax benefits related to stock-based compensation; and $15.2 million of permanent and other differences, offset, in part, by the provision for state income taxes of $47.1 million. See Note 8, “Income Taxes” in Item 15(a)1 of this Form 10-K for additional information regarding the impact of the Tax Act. We recognized a $278.8 million income tax provision in fiscal 2017. Based upon the federal statutory rate of 35%, our federal tax provision would have been $285.0 million. The difference between the tax provision recognized and the tax provision based on the federal statutory rate was due mainly to a $32.2 million benefit from the reversal of state deferred tax asset valuation allowances; a $12.8 million tax benefit from the utilization of the domestic production activities deduction; the reversal of $4.0 million of previously accrued tax provisions on uncertain tax positions that were no longer necessary due to the expiration of the statute of limitations and settlements with certain taxing jurisdictions; and $1.5 million of other permanent differences. These benefits were, offset, in part, by the recognition of a $34.7 million provision for state income taxes; $1.0 million of accrued interest and penalties for previously accrued taxes on uncertain tax positions; and $8.6 million of other differences. FISCAL 2017 COMPARED TO FISCAL 2016 REVENUES AND COST OF REVENUES The increase in revenues in fiscal 2017, as compared to fiscal 2016, was mainly attributable to a 17.3% increase in the number of homes delivered primarily due to a higher backlog at October 31, 2016, as compared to October 31, 2015, offset, in part, by a 4.1% decrease in the average price of the homes delivered. The decrease in the average delivered price was due to the impact of lower priced products delivered from communities acquired in our purchase of Coleman in November 2016 and a shift in the number of homes delivered to less expensive areas and/or products in the fiscal 2017 period, as compared to the fiscal 2016 period. Cost of revenues, as a percentage of revenues, in fiscal 2017 was 78.5%, as compared to 80.2% in fiscal 2016. The decrease in fiscal 2017, as compared to fiscal 2016, was primarily due to the recognition in fiscal 2016 of $125.6 million (2.4% of revenues) of warranty charges primarily related to homes built in Pennsylvania and Delaware; a $6.0 million benefit in fiscal 2017 from the reversal of an accrual for offsite improvements at a completed community that was no longer required; state reimbursements of $4.7 million in fiscal 2017 for previously expensed environmental clean-up costs; and lower interest expense in the fiscal 2017 period, as compared to the fiscal 2016 period. These decreases were, offset, in part, by a shift in the number of homes delivered to lower-margin buildings in our City Living segment; the impact of purchase accounting for the homes sold from communities acquired in our purchase of Coleman; higher material and labor costs; and a higher number of closings from lower-margin communities in our Traditional Home Building segment. See Note 7 - “Accrued Expenses” in Item 15(a)1 of this Form 10-K for additional information regarding these warranty charges. Interest cost in fiscal 2017 was $172.8 million or 3.0% of revenues, as compared to $160.3 million or 3.1% of revenues in fiscal 2016. We recognized inventory impairments and write-offs of $14.8 million or 0.3% of revenues and $13.8 million or 0.3% of revenues in fiscal 2017 and fiscal 2016, respectively. SELLING, GENERAL AND ADMINISTRATIVE EXPENSES (“SG&A”) SG&A spending increased by $72.5 million in fiscal 2017, as compared to fiscal 2016. As a percentage of revenues, SG&A increased to 10.4% in fiscal 2017 from 10.3% in fiscal 2016. The dollar increase in SG&A was due primarily to increased compensation costs due to a higher number of employees; increased sales and marketing costs; and increased spending on our upgrading of computer software. The higher sales and marketing costs were the result of the increased spending on advertising, higher model operating costs due to the increase in the average number of selling communities, and the increased number of homes delivered. The increased number of employees was due primarily to the overall increase in our business in fiscal 2017, as compared to fiscal 2016. The increase in SG&A as a percentage of revenues in the fiscal 2017 period was due to SG&A spending increasing by 13.6% while revenues increased 12.5% from the fiscal 2016 period. INCOME FROM UNCONSOLIDATED ENTITIES The increase in income from unconsolidated entities in fiscal 2017, as compared to fiscal 2016, was due mainly to higher income recognized in fiscal 2017, as compared to fiscal 2016, from an increase in homes delivered at condominium projects and the sale of portions of our ownership interests in a number of our joint ventures. We recognized $111.8 million of income from our Home Building, Rental Property, and Land Development Joint Ventures in fiscal 2017, as compared to $38.4 million of income in fiscal 2016. The increase in our income realized from these joint ventures was primarily attributable to $72.1 million of income realized from two of our Home Building Joint Ventures located in New York City, as compared to $12.9 million from these Home Building Joint Ventures in fiscal 2016, and $26.7 million of gains recognized in fiscal 2017 on the sale of 50% of our ownership interests in two of our Rental Property Joint Ventures located in Jersey City, New Jersey and the suburbs of Philadelphia, Pennsylvania; offset, in part, by a decrease in the number of lots delivered at one of our Land Development Joint Ventures in fiscal 2017 as compared to fiscal 2016 and a $4.9 million gain, in fiscal 2016, from the sale of our ownership interests in one of our joint ventures located in New Jersey. OTHER INCOME - NET The table below provides the components of “Other Income - net” for the years ended October 31, 2017 and 2016 (amounts in thousands): Management fee income from home building unconsolidated entities presented above primarily represents fees earned by our City Living and home building operations. In addition, in fiscal 2017 and 2016, our apartment living operations earned fees from unconsolidated entities of $6.2 million and $6.1 million, respectively; fees earned by our apartment living operations are included in income from ancillary businesses. In fiscal 2016, our security monitoring business recognized a gain of $1.6 million from a bulk sale of security monitoring accounts in fiscal 2015, which is included in income from ancillary businesses above. The decline in income from Gibraltar was due primarily from the continuing monetization of its assets and a $1.3 million gain in fiscal 2016 from the sale of a 76% interest in certain assets of Gibraltar. See Note 4, “Investments in Unconsolidated Entities - Gibraltar Joint Ventures” in Item 15(a)1 of this Form 10-K for additional information on this transaction. INCOME BEFORE INCOME TAXES In fiscal 2017, we reported income before income taxes of $814.3 million or 14.0% of revenues, as compared to $589.0 million, or 11.4% of revenues in fiscal 2016. INCOME TAX PROVISION We recognized a $278.8 million income tax provision in fiscal 2017. Based upon the federal statutory rate of 35%, our federal tax provision would have been $285.0 million. The difference between the tax provision recognized and the tax provision based on the federal statutory rate was due mainly to a $32.2 million benefit from the reversal of state deferred tax asset valuation allowances; a $12.8 million tax benefit from the utilization of the domestic production activities deduction; the reversal of $4.0 million of previously accrued tax provisions on uncertain tax positions that were no longer necessary due to the expiration of the statute of limitations and settlements with certain taxing jurisdictions; and $1.5 million of other permanent differences. These benefits were offset, in part, by the recognition of a $34.7 million provision for state income taxes; $1.0 million of accrued interest and penalties for previously accrued taxes on uncertain tax positions; and $8.6 million of other differences. We recognized a $206.9 million income tax provision in fiscal 2016. Based upon the federal statutory rate of 35%, our federal tax provision would have been $206.2 million. The difference between our tax provision recognized and the tax provision based on the federal statutory rate was due mainly to the recognition of a $27.0 million provision for state income taxes; the recognition of a $2.1 million provision for uncertain tax positions taken; $2.0 million of accrued interest and penalties for previously accrued taxes on uncertain tax positions; and $3.9 million of other differences; offset by a $16.9 million tax benefit from the utilization of the domestic production activities deduction; the reversal of $11.2 million of previously accrued tax provisions on uncertain tax positions that were no longer necessary due to the expiration of the statute of limitations and settlements with certain taxing jurisdictions; and $7.0 million of other permanent deductions. CAPITAL RESOURCES AND LIQUIDITY Funding for our business has been, and continues to be, provided principally by cash flow from operating activities before inventory additions, unsecured bank borrowings, and the public debt and equity markets. Fiscal 2018 At October 31, 2018, we had $1.18 billion of cash and cash equivalents and approximately $1.13 billion available for borrowing under our Revolving Credit Facility. Cash provided by operating activities during fiscal 2018 was $602.4 million. It was generated primarily from $748.2 million of net income plus $28.3 million of stock-based compensation, $25.3 million of depreciation and amortization, $35.2 million of inventory impairments and write-offs; and an increase of $57.9 million in accounts payable and accrued expenses; offset, in part, by a $143.6 million increase in inventory; an increase of $85.4 million in receivables, prepaid assets, and other assets; an increase of $38.9 million in mortgage loans held for sale; and a net deferred tax benefit of $21.9 million. Cash provided by investing activities during fiscal 2018 was $81.3 million. The cash generated by investing activities was primarily related to $138.0 million of cash received as returns on our investments in unconsolidated entities, foreclosed real estate, and distressed loans, offset, in part, by $28.2 million for the purchase of property and equipment and $27.5 million used to fund investments in unconsolidated entities. We used $214.3 million of cash from financing activities in fiscal 2018, primarily for repurchase of $503.2 million of our common stock; the repayment of $92.7 million of other loans payable, net of new borrowings; and payment of $61.7 million of dividends on our common stock, offset, in part, by the net proceeds of $396.5 million from the issuance of $400.0 million aggregate principal amount of 4.35% Senior Notes due 2028, the borrowings of $29.9 million on our mortgage company loan facility, net of new borrowings; and the proceeds of $13.4 million from our stock-based benefit plans. Fiscal 2017 At October 31, 2017, we had $712.8 million of cash and cash equivalents on hand and approximately $1.15 billion available for borrowing under our Revolving Credit Facility. Cash provided by operating activities during fiscal 2017 was $965.0 million. It was generated primarily from $535.5 million of net income plus $28.5 million of stock-based compensation, $25.4 million of depreciation and amortization, $14.8 million of inventory impairments and write-offs; a net deferred tax provision of $185.7 million; a $129.7 million decrease in inventory; a decrease of $114.9 million in mortgage loans held for sale; and a $38.0 million increase in customer deposits; offset, in part, by a decrease of $140.5 million in accounts payable and accrued expenses. Cash used in investing activities during fiscal 2017 was $7.7 million. The cash used in investing activities was primarily related to $122.3 million used to fund investments in unconsolidated entities, $83.1 million used for the acquisition of Coleman, and $28.9 million for the purchase of property and equipment, offset, in part, by $209.3 million of cash received as returns on our investments in unconsolidated entities, foreclosed real estate, and distressed loans, and $18.0 million from net sales of restricted investments. We used $878.2 million of cash from financing activities in fiscal 2017, primarily for the repayment of $687.5 million of senior notes; the repurchase of $290.9 million of our common stock; the repayment of $250.0 million on our Revolving Credit Facility, net of new borrowings under it; the repayment of $89.9 million on our mortgage company loan facility, net of new borrowings; the repayment of $42.9 million of other loans payable, net of new borrowings; and payment of $38.6 million of dividends on our common stock, offset, in part, by the net proceeds of $455.5 million from the issuance of $450.0 million aggregate principal amount of 4.875% Senior Notes due 2027, and the proceeds of $66.0 million from our stock-based benefit plans. Fiscal 2016 At October 31, 2016, we had $633.7 million of cash and cash equivalents on hand and approximately $961.8 million available for borrowing under our Revolving Credit Facility. Cash provided by operating activities during fiscal 2016 was $150.9 million. It was generated primarily from $382.1 million of net income plus $26.7 million of stock-based compensation, $23.1 million of depreciation and amortization, $13.8 million of inventory impairments and write-offs, and $19.3 million of deferred taxes; an increase of $524.6 million in accounts payable and accrued expenses; a $27.8 million increase in customer deposits; and a $6.0 million increase in income taxes payable; offset, in part, by the net purchase of $391.2 million of inventory; a $307.4 million increase in receivables, prepaid expenses, and other assets; and an increase of $124.9 million in mortgage loans originated, net of the sale of mortgage loans to outside investors. Cash provided by investing activities during fiscal 2016 was $8.2 million. The cash provided by investing activities was primarily related to $97.4 million of cash received as returns on our investments in unconsolidated entities, foreclosed real estate, and distressed loans and $10.0 million of proceeds from the sale of marketable securities, offset, in part, by $69.7 million used to fund investments in unconsolidated entities and $28.4 million for the purchase of property and equipment. We used $444.4 million of cash from financing activities in fiscal 2016, primarily for the repurchase of $392.8 million of our common stock; the repayment of $100.0 million from our credit facilities, net of new borrowing under them; and the repayment of $69.0 million of other loans payable, net of new borrowings, offset, in part, by $110.0 million of new borrowings under our mortgage company loan facility, net of repayments. Other In general, our cash flow from operating activities assumes that, as each home is delivered, we will purchase a home site to replace it. Because we own a supply of several years of home sites, we do not need to buy home sites immediately to replace those that we deliver. In addition, we generally do not begin construction of our detached homes until we have a signed contract with the home buyer. Should our business remain at its current level or decline, we believe that our inventory levels would decrease as we complete and deliver the homes under construction but do not commence construction of as many new homes, as we complete the improvements on the land we already own, and as we sell and deliver the speculative homes that are currently in inventory, resulting in additional cash flow from operations. In addition, we might delay, decrease, or curtail our acquisition of additional land, which would further reduce our inventory levels and cash needs. At October 31, 2018, we owned or controlled through options approximately 53,400 home sites, as compared to approximately 48,300 at October 31, 2017; and approximately 48,800 at October 31, 2016. Of the approximately 53,400 home sites owned or controlled through options at October 31, 2018, we owned approximately 32,500. Of our owned home sites at October 31, 2018, significant improvements were completed on approximately 16,900 of them. At October 31, 2018, the aggregate purchase price of land parcels under option and purchase agreements was approximately $2.53 billion (including $128.2 million of land to be acquired from joint ventures in which we have invested). Of the $2.53 billion of land purchase commitments, we had paid or deposited $168.4 million and, if we acquire all of these land parcels, we will be required to pay an additional $2.29 billion. The purchases of these land parcels are scheduled over the next several years. In addition, we expect to purchase approximately 2,700 additional home sites over a number of years from several of these joint ventures. We have additional land parcels under option that have been excluded from the aforementioned aggregate purchase amounts since we do not believe that we will complete the purchase of these land parcels and no additional funds will be required from us to terminate these contracts. During the past several years, we have made a number of investments in unconsolidated entities related to the acquisition and development of land for future home sites, the construction of luxury for-sale condominiums, and for-rent apartments. Our investment activities related to investments in and distributions of investments from unconsolidated entities are contained in the Consolidated Statements of Cash Flows under “Net cash provided by (used in) investing activities,” At October 31, 2018, we had investments in these entities of $431.8 million, and were committed to invest or advance up to an additional $39.5 million to these entities if they require additional funding. At October 31, 2018, we had purchase commitments to acquire land for apartment developments of approximately $272.6 million, of which we had outstanding deposits in the amount of $13.2 million. We intend to develop these apartment projects in joint ventures with unrelated parties in the future. We have a $1.295 billion Revolving Credit Facility that is scheduled to expire in May 2021. Under the terms of the Revolving Credit Facility, our maximum leverage ratio (as defined in the credit agreement) may not exceed 1.75 to 1.00 and we are required to maintain a minimum tangible net worth (as defined in the credit agreement) of no less than approximately $2.50 billion. Under the terms of the Revolving Credit Facility, at October 31, 2018, our leverage ratio was approximately 0.54 to 1.00 and our tangible net worth was approximately $4.72 billion. Based upon the minimum tangible net worth requirement, our ability to repurchase our common stock was limited to approximately $2.41 billion as of October 31, 2018. At October 31, 2018, we had no outstanding borrowings under the Revolving Credit Facility and had outstanding letters of credit of approximately $165.4 million. On October 31, 2018, we had a $500.0 million, five-year senior unsecured term loan facility (the “Term Loan Facility”) with a syndicate of banks which was scheduled to mature in August 2021. On November 1, 2018, we entered into an amendment to the Term Loan Facility to, among other things, (i) increase the size of the outstanding term loan to $800 million; (ii) extend the maturity date to November 1, 2023, with no principal payments being required before the maturity date; (iii) provide an accordion feature under which we may, subject to certain conditions set forth in the agreement, increase the Term Loan Facility up to a maximum aggregate amount of $1.0 billion; (iv) revise certain provisions to reduce the interest rate applicable on outstanding borrowings, and (v) modify certain provisions relating to existing financial maintenance and negative covenants. We believe that we will have adequate resources and sufficient access to the capital markets and external financing sources to continue to fund our current operations and meet our contractual obligations. Due to the uncertainties in the economy and for home builders in general, we cannot be certain that we will be able to replace existing financing or find sources of additional financing in the future. INFLATION The long-term impact of inflation on us is manifested in increased costs for land, land development, construction, and overhead. We generally enter into contracts to acquire land a significant period of time before development and sales efforts begin. Accordingly, to the extent land acquisition costs are fixed, subsequent increases or decreases in the sales prices of homes will affect our profits. Because the sales price of each of our homes is fixed at the time a buyer enters into a contract to purchase a home and because we generally contract to sell our homes before we begin construction, any inflation of costs in excess of those anticipated may result in lower gross margins. We generally attempt to minimize that effect by entering into fixed-price contracts with our subcontractors and material suppliers for specified periods of time, which generally do not exceed one year. In general, housing demand is adversely affected by increases in interest rates and housing costs. Interest rates, the length of time that land remains in inventory, and the proportion of inventory that is financed affect our interest costs. If we are unable to raise sales prices enough to compensate for higher costs, or if mortgage interest rates increase significantly, affecting prospective buyers’ ability to adequately finance home purchases, our revenues, gross margins, and net income could be adversely affected. Increases in sales prices, whether the result of inflation or demand, may affect the ability of prospective buyers to afford new homes. CONTRACTUAL OBLIGATIONS The following table summarizes our estimated contractual payment obligations at October 31, 2018 (amounts in millions): (a) Amounts include estimated annual interest payments until maturity of the debt. Of the amounts indicated, $2.9 billion of the senior notes, $686.8 million of loans payable, $150.0 million of the mortgage company loan facility, and $40.3 million of accrued interest were recorded on our October 31, 2018 Consolidated Balance Sheet. (b) The 2020 - 2021 column above includes $500.0 million for the maturity of the Term Loan Facility. On November 1, 2018, we amended the Term Loan Facility to, among other things, increase the size of the outstanding term loan from $500.0 million to $800.0 million and extend the maturity date to November 1, 2023. (c) In December 2018, we amended the mortgage company warehousing agreement to, among other things, extend the maturity date to December 6, 2019. (d) In December 2018, we signed a 16-year lease agreement to lease approximately 163,000 square feet of office space for our new corporate headquarters. The terms of the lease require annual minimum lease payments starting at $2.8 million which escalate throughout the lease term. Payments under this lease are not included in the table above. (e) Amounts represent our expected acquisition of land under purchase agreements and the estimated remaining amount of the contractual obligation for land development agreements secured by letters of credit and surety bonds. Of the total amount indicated, $40.1 million was recorded on our October 31, 2018 Consolidated Balance Sheet. (f) Amounts represent our obligations under our deferred compensation plan, supplemental executive retirement plans and our 401(k) salary deferral savings plans. Of the total amount indicated, $68.6 million was recorded on our October 31, 2018 Consolidated Balance Sheet. SEGMENTS We operate in two segments: Traditional Home Building and City Living, our urban development division. Within Traditional Home Building, we operate in five geographic segments around the United States: (1) the North, consisting of Connecticut, Illinois, Massachusetts, Michigan, New Jersey, and New York; (2) the Mid-Atlantic, consisting of Delaware, Maryland, Pennsylvania, and Virginia; (3) the South, consisting of Florida, North Carolina, and Texas; (4) the West, consisting of Arizona, Colorado, Idaho, Nevada, and Washington, and (5) California. In fiscal 2018, we acquired land and commenced development activities in the Salt Lake City, Utah and Portland, Oregon markets. We expect to open communities in these markets in fiscal 2019. In fiscal 2018, we discontinued the sale of homes in Minnesota. Our operations in Minnesota were immaterial to the North geographic segment. The following tables summarize information related to revenues, net contracts signed, and income (loss) before income taxes by segment for fiscal years 2018, 2017, and 2016. Information related to backlog and assets by segment at October 31, 2018 and 2017, has also been provided. Units Delivered and Revenues: Net Contracts Signed: Backlog at October 31: Income (Loss) Before Income Taxes ($ amounts in millions): “Corporate and other” is comprised principally of general corporate expenses such as the offices of our executive officers; the corporate finance, accounting, audit, tax, human resources, risk management, information technology, marketing, and legal groups; interest income; income from certain of our ancillary businesses, including Gibraltar; and income from our Rental Property Joint Ventures and Gibraltar Joint Ventures. Total Assets ($ amounts in millions): “Corporate and other” is comprised principally of cash and cash equivalents, restricted cash, deferred tax assets, investments in our Rental Property Joint Ventures, expected recoveries from insurance carriers and suppliers, our Gibraltar investments and operations, manufacturing facilities, and our mortgage and title subsidiaries. FISCAL 2018 COMPARED TO FISCAL 2017 Traditional Home Building North The increase in the number of homes delivered in fiscal 2018, as compared to fiscal 2017, was mainly due to increases in the number of homes closed in Michigan, New Jersey, and New York, which were attributable to the increased number of homes in backlog in those markets at October 31, 2017, as compared to the number of homes in backlog at October 31, 2016. In addition, revenue in fiscal 2017 was impacted by the defective floor joists issue that is further discussed in “Overview - Defective Floor Joists” in this MD&A. The decrease in the average price of homes delivered in fiscal 2018, as compared to fiscal 2017, was mainly due to a shift in the number of homes delivered to less expensive areas and/or products in fiscal 2018, as compared to fiscal 2017, particularly in Massachusetts and Michigan. The decrease in the number of net contracts signed in fiscal 2018, as compared to fiscal 2017, was mainly due to a decrease in the average number of selling communities in the fiscal 2018 periods, as compared to the fiscal 2017 periods. The increase in the average sales price of net contracts signed in fiscal 2018, as compared to fiscal 2017, was principally attributable to shifts in the number of contracts signed to more expensive areas and/or products in fiscal 2018, as compared to fiscal 2017, particularly in Michigan and New Jersey. The increase in income before income taxes in fiscal 2018, as compared to fiscal 2017, was principally attributable to higher earnings from increased revenues, offset, in part, by higher cost of revenues, as a percentage of revenues in fiscal 2018, as compared to fiscal 2017. The increase in the cost of revenues, as a percentage of revenues, was primarily due to higher inventory impairment charges, a shift in product mix/areas to lower-margin areas, and higher material and labor costs in fiscal 2018, as compared to fiscal 2017. Inventory impairment charges were $19.7 million in fiscal 2018, as compared to $6.5 million in fiscal 2017. During fiscal 2018, we determined that the pricing assumptions used in prior impairment reviews for one operating community located in Connecticut needed to be reduced, primarily due to a lack of improvement and/or a decrease in customer demand as a result of weaker than expected market conditions. As a result of this reduction in expected sales prices, we determined that this community was impaired. Accordingly, the carrying value of this community was written down to its estimated fair value resulting in a charge to income before income taxes of $12.0 million in fiscal 2018. In addition, during fiscal 2018, primarily due to a lack of improvement and/or a decrease in customer demand, we decided to sell the remaining lots in bulk sales in two communities, located in Illinois and Minnesota, rather than sell and construct homes as previously intended. The carrying values of these communities were written down to their estimated fair values resulting in a charge to income before income taxes of $4.4 million in fiscal 2018. Mid-Atlantic The increase in the number of homes delivered in fiscal 2018, as compared to fiscal 2017, was mainly due to an increase in the number of homes closed in Pennsylvania and Maryland, which was attributable to an increase in the number of homes in backlog in those markets at October 31, 2017, as compared to the number of homes in backlog at October 31, 2016. The increase in the average price of homes delivered in fiscal 2018, as compared to fiscal 2017, was primarily due to a shift in the number of homes delivered to more expensive areas and/or products in fiscal 2018, as compared to fiscal 2017. The decrease in the number of net contracts signed in fiscal 2018, as compared to fiscal 2017, was principally due to a decrease in the average number of selling communities partially offset by an increase in demand in fiscal 2018, as compared to fiscal 2017. The decrease in income before income taxes in fiscal 2018, as compared to fiscal 2017, was mainly due to increases in cost of revenues, as a percent of revenues, and a higher impairment charge recognized on one of our Land Development Joint Ventures in fiscal 2018, as compared to fiscal 2017. These decreases were partially offset by higher earnings from increased revenues. The increase in cost of revenues, as a percentage of revenues, was mainly due to increased material and labor costs; a $6.0 million benefit in fiscal 2017 from the reversal of an accrual for offsite improvements at a completed community that was no longer required; and higher inventory impairment charges in fiscal 2018, as compared to fiscal 2017. In fiscal 2018, inventory impairment charges were $9.8 million, as compared to $6.9 million in fiscal 2017. In fiscal 2018, we decided to sell a portion of the lots in a bulk sale in one community located in Maryland, primarily due to increases in site costs and a lack of improvement in customer demand as a result of weaker than expected market conditions. The carrying value of this community was written down to its estimated fair value resulting in a charge to income before income taxes in fiscal 2018 of $6.7 million. During fiscal 2017, we determined that the pricing assumptions used in prior impairment reviews for one operating community located in Maryland needed to be reduced primarily due to a lack of improvement and/or a decrease in customer demand as a result of weaker than expected market conditions. As a result of this reduction in expected sales prices, we determined that this community was impaired. Accordingly, the carrying value of this community was written down in fiscal 2017 to its estimated fair value resulting in a charge to income before taxes of $3.9 million. In fiscal 2018 and 2017, we recognized impairment charges of $4.0 million and $2.0 million, respectively, related to one Land Development Joint Venture located in Maryland. In fiscal 2017, we determined that we should increase the development costs assumptions used in prior impairment reviews of this joint venture. As a result of these cost increases, we determined that our investment in this joint venture was impaired and we concluded that the impairment was other than temporary. Accordingly, the carrying value of our investment in this joint venture was written down to its estimated fair value resulting in a charge to income before taxes of $2.0 million in fiscal 2017. Further, in the third quarter of fiscal 2018, we and our partner decided to sell the land in this joint venture rather than continue development and sell finished lots as previously intended, primarily due to continued cost increases and reduced demand in that market. We determined that our investment in this joint venture was further impaired and we concluded that the impairment was other than temporary. Accordingly, the carrying value of our investment in this joint venture was written down to its estimated fair value resulting in a charge to income before taxes of $4.0 million in fiscal 2018. South The increase in the number of homes delivered in fiscal 2018, as compared to fiscal 2017, was mainly due to the increased number of homes in backlog as of October 31, 2017, as compared to the number of homes in backlog at October 31, 2016. The increase in the number of net contracts signed in fiscal 2018, as compared to fiscal 2017, was mainly due to an increase in demand, offset, in part, by a decrease in the average number of selling communities in fiscal 2018, as compared to fiscal 2017. The decrease in income before income taxes in fiscal 2018, as compared to fiscal 2017, was principally due to a higher cost of revenues, as a percentage of revenues, offset, in part, by higher earnings from increased revenues. The increase in cost of revenues, as a percentage of revenues, in fiscal 2018, as compared to fiscal 2017, was primarily due to higher material and labor costs in fiscal 2018, as compared to fiscal 2017. West The increase in the number of homes delivered in fiscal 2018, as compared to fiscal 2017, was mainly due to the increased number of homes in backlog at October 31, 2017, as compared to the number of homes in backlog at October 31, 2016. The increase in the average delivered price of homes delivered in fiscal 2018, as compared to fiscal 2017, was primarily due to a shift in the number of homes delivered to more expensive areas and/or products and price increases in fiscal 2018, as compared to fiscal 2017, offset, in part, by an increase in deliveries in Idaho, where average delivered home prices are lower than our Company average, in fiscal 2018, as compared to fiscal 2017. The increase in the number of net contracts signed in fiscal 2018, as compared to fiscal 2017, was principally due to an increase in demand partially offset by a decrease in the average number of selling communities in fiscal 2018, as compared to fiscal 2017. The increase in the average value of each contract signed in fiscal 2018, as compared to fiscal 2017, was mainly due to a shift in the number of contracts signed to more expensive areas and/or products and price increases in fiscal 2018, as compared to fiscal 2017. The increase in income before income taxes in fiscal 2018, as compared to fiscal 2017, was due mainly to higher earnings from increased revenues in fiscal 2018, as compared to fiscal 2017. California The increase in the number of homes delivered in fiscal 2018, as compared to fiscal 2017, was mainly due to to the increased number of homes in backlog at October 31, 2017, as compared to the number of homes in backlog at October 31, 2016. The increase in the average price of homes delivered in fiscal 2018, as compared to fiscal 2017, was primarily due to a shift in the number of homes delivered to more expensive areas and/or products and increased selling prices of homes delivered in fiscal 2018, as compared to fiscal 2017. The increase in the number of net contracts signed in fiscal 2018, as compared to fiscal 2017, was due mainly to an increase in the average number of selling communities in Northern California, offset, in part, by a decrease in demand in Southern California. The increase in the average value of each contract signed in fiscal 2018, as compared to fiscal 2017, was mainly due to a shift in the number of contracts signed to more expensive areas and/or products and increased selling prices in fiscal 2018, as compared to fiscal 2017. The increase in income before income taxes in fiscal 2018, as compared to fiscal 2017, was primarily due to higher earnings from the increased revenues in fiscal 2018, as compared to fiscal 2017, and a $7.0 million benefit in fiscal 2018 from the reversal of an accrual related to an indemnification obligation related to the Shapell acquisition that has expired. City Living The decrease in the number of homes delivered in fiscal 2018, as compared to fiscal 2017, was principally due to the commencement of deliveries in fiscal 2017 at three buildings (located in Hoboken, New Jersey; New York City; and Bethesda, Maryland). These decreases were partially offset by closings at one building, located in Hoboken, New Jersey, where deliveries commenced in fiscal 2018. The increase in the average price of homes delivered in fiscal 2018, as compared to fiscal 2017, was primarily due to a shift in the number of homes delivered to more expensive buildings in fiscal 2018, as compared to fiscal 2017. In fiscal 2018, 37% of the units delivered were located in New York, New York, where home prices were higher, as compared to 21% in fiscal 2017. The decrease in the number of net contracts signed in fiscal 2018, as compared to fiscal 2017, was primarily due to a reduction of available inventory and a decrease in demand in fiscal 2018, as compared to fiscal 2017. The increase in the average sales price of net contracts signed in fiscal 2018, as compared to fiscal 2017, was principally due to a shift to sales in more expensive buildings in fiscal 2018, as compared to fiscal 2017. The decrease in income before income taxes in fiscal 2018, as compared to fiscal 2017, was mainly due to a decrease in earnings from our investments in unconsolidated entities; lower earnings from decreased revenues; a shift in the number of homes delivered to buildings with lower margins in fiscal 2018, as compared to fiscal 2017; $4.7 million recognized in connection with a previously deferred gain in fiscal 2017; and a state reimbursement of $4.7 million of previously expensed environmental clean-up costs received in fiscal 2017. In fiscal 2018, earnings from our investments in unconsolidated entities were $6.9 million, as compared to $73.1 million in fiscal 2017. Fiscal 2017 benefited from the commencement of deliveries from two Home Building Joint Ventures in the fourth quarter of fiscal 2016. The tables below provide information related to deliveries and revenues and net contracts signed by our Home Building Joint Ventures, for the periods indicated, and the related backlog for the dates indicated ($ amounts in millions): Corporate and other In fiscal 2018 and 2017, loss before income taxes was $109.2 million and $146.8 million, respectively. The decrease in the loss before income taxes in fiscal 2018, as compared to fiscal 2017, was principally attributable to a $42.1 million increase in earnings from our investments in unconsolidated entities and higher income earned by our ancillary businesses in fiscal 2018, as compared to fiscal 2017, offset, in part, by higher SG&A costs. The increase in earnings from our investments in unconsolidated entities in fiscal 2018, as compared to fiscal 2017, was mainly due to $67.2 million of gains recognized in fiscal 2018 from asset sales by three of our Rental Property Joint Ventures located in College Park, Maryland, Herndon, Virginia, and Westborough, Massachusetts, partially offset by $26.7 million of gains recognized in fiscal 2017 related to the sale of 50% of our ownership interests in two of our Rental Property Joint Ventures located in Jersey City, New Jersey, and the suburbs of Philadelphia, Pennsylvania. The increase in SG&A costs in fiscal 2018, as compared to fiscal 2017, was due primarily to increased compensation costs due to our increased number of employees primarily related to our increased business activity. FISCAL 2017 COMPARED TO FISCAL 2016 Traditional Home Building North The decrease in the number of homes delivered in fiscal 2017, as compared to fiscal 2016, was mainly due to the defective floor joists issue. The decrease in the average price of homes delivered in fiscal 2017, as compared to fiscal 2016, was primarily attributable to a shift in the number of homes delivered to less expensive areas and/or products in fiscal 2017, as compared to fiscal 2016. For additional information regarding the defective floor joists issue, see “Overview - Defective Floor Joists” in this MD&A. The increase in the number of net contracts signed in fiscal 2017, as compared to fiscal 2016, was mainly due to improved market conditions in Connecticut, Michigan, New York, and New Jersey, offset, in part, by a decrease in the number of selling communities and a decrease in Massachusetts where demand has declined. The decrease in the average sales price of net contracts signed in fiscal 2017, as compared to fiscal 2016, was principally attributable to a shift in the number of contracts signed to less expensive areas and/or products in fiscal 2017, as compared to fiscal 2016, particularly in Michigan, where we had a significant increase in the number of contracts signed in multifamily and active-adult communities. The decrease in income before income taxes in fiscal 2017, as compared to fiscal 2016, was principally attributable to lower earnings from decreased revenues and higher cost of revenues, as a percentage of revenues in fiscal 2017, as compared to fiscal 2016. The increase in the cost of revenues, as a percentage of revenues, was primarily due to a change in product mix/areas to lower-margin areas and higher material and labor costs in fiscal 2017, as compared to fiscal 2016. Mid-Atlantic The increase in the number of homes delivered in fiscal 2017, as compared to fiscal 2016, was mainly due to an increase in the number of homes closed in the region, which was attributable to an increase in the number of homes in backlog in those markets at October 31, 2016, as compared to the number of homes in backlog at October 31, 2015. The decrease in the average price of homes delivered in fiscal 2017, as compared to fiscal 2016, was primarily due to a shift in the number of homes delivered to less expensive areas and/or products in fiscal 2017, as compared to fiscal 2016. The increase in the number of net contracts signed in fiscal 2017, as compared to fiscal 2016, was principally due to increases in demand in fiscal 2017, as compared to fiscal 2016. The increase in income before income taxes in fiscal 2017, as compared to the loss before income taxes in fiscal 2016, was mainly due to $125.6 million of warranty charges recognized, primarily related to homes built in Pennsylvania and Delaware in fiscal 2016; higher earnings from increased revenues; and a $6.0 million benefit from the reversal of an accrual for offsite improvements at a completed community that was no longer required. These increases were partially offset by higher inventory impairment charges; a $2.0 million impairment charge we recognized on one of our Land Development Joint Ventures in fiscal 2017; and higher SG&A costs. See Note 7 - “Accrued Expenses” in Item 15(a)1 of this Form 10-K for additional information regarding these warranty charges. Inventory impairment charges were $6.9 million in fiscal 2017, as compared to $2.1 million in fiscal 2016. In fiscal 2017, during our review of operating communities for impairment, primarily due to a decrease in customer demand as a result of weaker than expected market conditions in certain communities, we determined that the pricing assumptions used in prior impairment reviews for two operating communities located in Maryland needed to be reduced. As a result of these reductions in expected sales prices, we determined that these communities were impaired. Accordingly, the carrying value of these communities were written down to their estimated fair value resulting in charges to income before income taxes of $5.4 million in fiscal 2017. The impairment charges in fiscal 2016 primarily related to a land purchase contract in Delaware where we were unable to obtain the required approvals to proceed with our development of the underlying property. Accordingly, we terminated the contract and wrote off our costs incurred. Further in fiscal 2017, during our evaluation of our investments in unconsolidated entities, we determined that the development cost assumptions used in prior impairment reviews for one Land Development Joint Venture located in Maryland needed to be increased. As a result of these cost increases, we determined that our investment in this joint venture was impaired and we concluded that the impairment was other than temporary. Accordingly, we wrote down the carrying value of our investment in this joint venture to its estimated fair value resulting in a charge to income before income taxes of $2.0 million in fiscal 2017. South The increase in the number of homes delivered in fiscal 2017, as compared to fiscal 2016, was mainly due to an increase in the number of homes closed in Florida and North Carolina which was attributable to an increase in the number of homes in backlog as of October 31, 2016, as compared to the number of homes in backlog at October 31, 2015. The decrease in the average price of homes delivered in fiscal 2017, as compared to fiscal 2016, was primarily due to a shift in the number of homes delivered to less expensive areas and/or products in fiscal 2017, as compared to fiscal 2016. The increase in the number of net contracts signed in fiscal 2017, as compared to fiscal 2016, was mainly due to an increase in the number of selling communities in fiscal 2017, as compared to fiscal 2016. The decrease in income before income taxes in fiscal 2017, as compared to fiscal 2016, was principally due to a higher cost of revenues, as a percentage of revenues, higher SG&A costs, lower income earned from our investments in unconsolidated entities, and decreased earnings from land sales in Texas, offset, in part, by higher earnings from increased revenues. The increase in cost of revenues, as a percentage of revenues, in fiscal 2017, as compared to fiscal 2016, was primarily due to a shift in the number of homes delivered to lower-margin products and/or locations in fiscal 2017, as compared to fiscal 2016. The higher SG&A costs in fiscal 2017, as compared to fiscal 2016, were principally due to the increase in the number of selling communities. The decrease in income earned from our investments in unconsolidated entities in fiscal 2017, as compared to fiscal 2016, was primarily related to a $1.4 million charge in fiscal 2017 for amenity construction repairs at one of our Home Building Joint Ventures. West The increase in the number of homes delivered in fiscal 2017, as compared to fiscal 2016, was mainly due to the delivery of 342 homes in the Boise market, in fiscal 2017 and an increase in the number of homes in backlog at October 31, 2016, as compared to the number of homes in backlog at October 31, 2015. The decrease in the average delivered price of homes delivered in fiscal 2017, as compared to fiscal 2016, was primarily due to deliveries of homes in the Boise market, where the average prices of homes delivered in fiscal 2017 was $315,000. Excluding the closings in the Boise market, the average price of homes delivered in fiscal 2017 increased 5%, as compared to fiscal 2016, which was mainly due to a shift in the number of homes delivered to more expensive areas and/or products in fiscal 2017, as compared to fiscal 2016. The increase in the number of net contracts signed in fiscal 2017, as compared to fiscal 2016, was principally due to the 458 contracts we signed in the Boise market during fiscal 2017; increases in demand primarily in Nevada and Arizona; and an increase in the number of selling communities in Nevada. These increases were, offset, in part, by lower demand and a decrease in selling communities in Colorado and Washington. The net contracts signed in the Boise market also reduced our average contracted price for fiscal 2017, as compared to fiscal 2016. Excluding contracts signed in the Boise market, the average value of each contract signed in fiscal 2017, increased by 2%, as compared to fiscal 2016. The increase in income before income taxes in fiscal 2017, as compared to fiscal 2016, was due mainly to higher earnings from the increased revenues in fiscal 2017, as compared to fiscal 2016. California The increase in the number of homes delivered in fiscal 2017, as compared to fiscal 2016, was mainly due to an increase in the number of homes sold and settled in fiscal 2017, as compared to fiscal 2016, offset, in part, by a decrease in the number of homes in backlog at October 31, 2016, as compared to the number of homes in backlog at October 31, 2015. The increase in the average price of homes delivered in fiscal 2017, as compared to fiscal 2016, was primarily due to a shift in the number of homes delivered to more expensive areas and/or products and increased selling prices of homes delivered in fiscal 2017, as compared to fiscal 2016. The increase in the number of net contracts signed in fiscal 2017, as compared to fiscal 2016, was due mainly to an increase in demand and an increase in the average number of selling communities in our southern California markets in fiscal 2017, as compared to fiscal 2016. The increase in income before income taxes in fiscal 2017, as compared to fiscal 2016, was primarily due to higher earnings from the increased revenues, offset, in part, by higher SG&A, as a percent of revenues. City Living The increase in the number of homes delivered in fiscal 2017, as compared to fiscal 2016, was principally due to the commencement of deliveries in fiscal 2017 at three buildings (located in Hoboken, New Jersey; New York City; and Bethesda, Maryland). These increases were partially offset by a decrease in closings at one building, located in New York City, where there were fewer available units remaining in fiscal 2017, as compared to fiscal 2016, and at a community located in Philadelphia, Pennsylvania, which settled out in fiscal 2016. The decrease in the average price of homes delivered in fiscal 2017, as compared to fiscal 2016, was primarily due to a shift in the number of homes delivered to less expensive buildings in fiscal 2017, as compared to fiscal 2016. The increase in the number of net contracts signed in fiscal 2017, as compared to fiscal 2016, was primarily due to strong sales at a building located in Jersey City, New Jersey, which opened in the third quarter of fiscal 2017. This increase was partially offset by a decrease at a building located in Hoboken, New Jersey which benefited from strong sales in fiscal 2016 due to its opening in the fourth quarter of fiscal 2015 and a decrease at a building in New York City, where there were fewer available units remaining in fiscal 2017, as compared to fiscal 2016. The decrease in the average sales price of net contracts signed in fiscal 2017, as compared to fiscal 2016, was principally due to a shift to less expensive buildings in fiscal 2017, as compared to fiscal 2016. The increase in income before income taxes in fiscal 2017, as compared to fiscal 2016, was mainly due to a $60.2 million increase in earnings from our investments in unconsolidated entities; higher earnings from increased revenues; and state reimbursement of $4.7 million of previously expensed environmental clean-up costs received in the fiscal 2017 period, offset, in part, by a shift in the number of homes delivered to buildings with a lower margin. In fiscal 2017 and 2016, mainly due to the commencement of deliveries from two City Living Home Building Joint Ventures in the fourth quarter of fiscal 2016, we recognized $73.1 million and $12.9 million in earnings, respectively, from our investments in unconsolidated entities. The tables below provide information related to deliveries and revenues and net contracts signed by our City Living Home Building Joint Ventures, for the periods indicated, and the related backlog for the dates indicated ($ amounts in millions): Corporate and other In fiscal 2017 and 2016, loss before income taxes was $146.8 million and $140.8 million, respectively. The increase in the loss before income taxes in fiscal 2017, as compared to fiscal 2016, was principally attributable to higher SG&A costs; a $4.9 million gain recognized in fiscal 2016 from the sale of our ownership interest in one of our joint ventures located in New Jersey; lower earnings from Gibraltar; losses incurred by a one of our Rental Property Joint Ventures which commenced operations of a hotel in February 2017; and a gain of $1.6 million recognized in the fiscal 2016 period, from a bulk sale of security monitoring accounts by our home security monitoring business in fiscal 2015. These increases were partially offset by gains of $26.7 million in fiscal 2017 related to the sales of 50% of our ownership interests in two of our Rental Property Joint Ventures located in Jersey City, New Jersey and the suburbs of Philadelphia, Pennsylvania. The increase in SG&A costs in fiscal 2017, as compared to fiscal 2016, was due to increased compensation costs, due to our increased number of employees related to our increased business activity and increased spending on upgrading our computer software.

<s>[INST] When this report uses the words “we,” “us,” “our,” and the “Company,” they refer to Toll Brothers, Inc. and its subsidiaries, unless the context otherwise requires. References herein to fiscal year refer to our fiscal years ended or ending October 31. Unless otherwise stated in this report, net contracts signed represents a number or value equal to the gross number or value of contracts signed during the relevant period, less the number or value of contracts canceled during the relevant period, which includes contracts that were signed during the relevant period and in prior periods. Backlog consists of homes under contract but not yet delivered to our home buyers (“backlog”). OVERVIEW Our Business We design, build, market, sell, and arrange financing for detached and attached homes in luxury residential communities. We cater to moveup, emptynester, activeadult, and secondhome buyers in the United States (“Traditional Home Building Product”). We also build and sell homes in urban infill markets through Toll Brothers City Living (“City Living”). At October 31, 2018, we were operating in 19 states, as well as in the District of Columbia. In the five years ended October 31, 2018, we delivered 32,436 homes from 683 communities, including 8,265 homes from 415 communities in fiscal 2018. At October 31, 2018, we had 638 communities containing approximately 53,400 home sites that we owned or controlled through options. We are developing several land parcels for master planned communities in which we intend to build homes on a portion of the lots and sell the remaining lots to other builders. Two of these master planned communities are being developed 100% by us, and the remaining communities are being developed through joint ventures with other builders or financial partners. In addition to our residential forsale business, we also develop and operate forrent apartments through joint ventures. See the section entitled “Toll Brothers Apartment Living/Toll Brothers Campus Living” below. We operate our own architectural, engineering, mortgage, title, land development and land sale, golf course development and management, and landscaping subsidiaries. We also operate our own security company, TBI Smart Home Solutions, which provides homeowners with home automation and technology options. In addition, we operate our own lumber distribution, house component assembly, and manufacturing operations. We have investments in various unconsolidated entities. We have investments in joint ventures (i) to develop land for the joint venture participants and for sale to outside builders (“Land Development Joint Ventures”); (ii) to develop forsale homes (“Home Building Joint Ventures”); (iii) to develop luxury forrent residential apartments, commercial space and a hotel (“Rental Property Joint Ventures”); and (iv) to invest in distressed loans and real estate and provide financing and land banking for residential builders and developers for the acquisition and development of land and home sites (“Gibraltar Joint Ventures”). Financial Highlights In fiscal 2018, we recognized $7.14 billion of revenues and net income of $748.2 million, as compared to $5.82 billion of revenues and net income of $535.5 million in fiscal 2017. In fiscal 2018 and 2017, the value of net contracts signed was $7.60 billion (8,519 homes) and $6.83 billion (8,175 homes), respectively. The value of our backlog at October 31, 2018 was $5.52 billion (6,105 homes), as compared to our backlog at October 31, 2017 of $5.06 billion (5,851 homes). At October 31, 2018, we had $1.18 billion of cash and cash equivalents and approximately $1.13 billion available for borrowing under our $1.295 billion revolving credit facility (the “Revolving Credit Facility”) that matures in May 2021. At October 31, 2018, we [/INST] Positive. </s>

Toll Brothers, Inc.

2019-12-26

2019-10-31

ITEM 7. MANAGEMENT’S DISCUSSION AND ANALYSIS OF FINANCIAL CONDITION AND RESULTS OF OPERATIONS (“MD&A”) This discussion and analysis is based on, should be read together with, and is qualified in its entirety by, the Consolidated Financial Statements and Notes thereto in Item 15(a)1 of this Form 10-K, beginning at page. It also should be read in conjunction with the disclosure under “Forward-Looking Statements” in Part I of this Form 10-K. When this report uses the words “we,” “us,” “our,” and the “Company,” they refer to Toll Brothers, Inc. and its subsidiaries, unless the context otherwise requires. References herein to fiscal year refer to our fiscal years ended or ending October 31. Unless otherwise stated in this report, net contracts signed represents a number or value equal to the gross number or value of contracts signed during the relevant period, less the number or value of contracts canceled during the relevant period, which includes contracts that were signed during the relevant period and in prior periods. Backlog consists of homes under contract but not yet delivered to our home buyers (“backlog”). Backlog conversion represents the percentage of homes delivered in the period from backlog at the beginning of the period (“backlog conversion”). This discussion and analysis does not address certain items in respect of fiscal 2017 in reliance on amendments to disclosure requirements adopted by the SEC in 2019. A discussion and analysis of fiscal 2017 may be found in Item 7. Management’s Discussion and Analysis of Financial Condition and Results of Operations of our Annual Report on Form 10-K for the fiscal year ended October 31, 2018, filed with the SEC on December 20, 2018. OVERVIEW Our Business We design, build, market, sell, and arrange financing for an array of luxury residential single-family detached, attached home, master planned resort-style golf, and urban low-, mid-, and high-rise communities, principally on land we develop and improve, as we continue to pursue our strategy of broadening our product lines, price points and geographic footprint. We cater to luxury first-time, move-up, empty-nester, active-adult, affordable luxury and second-home buyers in the United States (“Traditional Home Building Product”), as well as urban and suburban renters. We also design, build, market, and sell urban low-, mid-, and high-rise condominiums through Toll Brothers City Living® (“City Living”). At October 31, 2019, we were operating in 23 states, as well as in the District of Columbia. In the five years ended October 31, 2019, we delivered 35,146 homes from 724 communities, including 8,107 homes from 426 communities in fiscal 2019. At October 31, 2019, we had 715 communities containing approximately 59,200 home sites that we owned or controlled through options. We are developing several land parcels for master planned communities in which we intend to build homes on a portion of the lots and sell the remaining lots to other builders. Two of these master planned communities are being developed 100% by us, and the remaining communities are being developed through joint ventures with other builders or financial partners. In addition to our residential for-sale business, we also develop and operate for-rent apartments through joint ventures. See the section entitled “Toll Brothers Apartment Living/Toll Brothers Campus Living” below. We operate our own architectural, engineering, mortgage, title, land development, golf course development, and landscaping subsidiaries. We also operate our own security company, TBI Smart Home Solutions, which provides homeowners with home automation and a full range of technology options. In addition, we operate our own lumber distribution, house component assembly, and manufacturing operations. We have investments in various unconsolidated entities. We have investments in joint ventures (i) to develop land for the joint venture participants and for sale to outside builders (“Land Development Joint Ventures”); (ii) to develop for-sale homes (“Home Building Joint Ventures”); (iii) to develop luxury for-rent residential apartments, commercial space and a hotel (“Rental Property Joint Ventures”); and (iv) to invest in distressed loans and real estate and provide financing and land banking for residential builders and developers for the acquisition and development of land and home sites (“Gibraltar Joint Ventures”). Financial Highlights In fiscal 2019, we recognized $7.08 billion of home sales revenues and net income of $590.0 million, as compared to $7.14 billion of revenues and net income of $748.2 million in fiscal 2018. In fiscal 2019 and 2018, the value of net contracts signed was $6.71 billion (8,075 homes) and $7.60 billion (8,519 homes), respectively. The value of our backlog at October 31, 2019 was $5.26 billion (6,266 homes), as compared to our backlog at October 31, 2018 of $5.52 billion (6,105 homes). At October 31, 2019, we had $1.29 billion of cash and cash equivalents and approximately $1.73 billion available for borrowing under our $1.905 billion revolving credit facility (the “Revolving Credit Facility”) that matures in November 2024. At October 31, 2019, we had no outstanding borrowings under the Revolving Credit Facility and had outstanding letters of credit of approximately $177.9 million. In fiscal 2017, our Board of Directors approved the initiation of quarterly cash dividends to shareholders. During fiscal 2019 and 2018, we paid aggregate cash dividends of $0.44 and $0.41 per share, respectively, to our shareholders. In December 2019, we declared a quarterly cash dividend of $0.11 which will be paid on January 24, 2020 to shareholders of record on the close of business on January 10, 2020. At October 31, 2019, our total equity and our debt to total capitalization ratio were $5.12 billion and 0.44 to 1.00, respectively. Acquisitions As part of our strategy to expand our geographic footprint and product offerings, in fiscal 2019, we acquired substantially all of the assets and operations of Sharp Residential, LLC (“Sharp”) and Sabal Homes LLC (“Sabal”), for approximately $92.8 million and $69.6 million, respectively, in cash. Sharp operates in metropolitan Atlanta, Georgia; Sabal operates in the Charleston, Greenville, and Myrtle Beach, South Carolina markets. The assets acquired, based on our preliminary purchase price allocations, was primarily inventory, including approximately 2,550 home sites owned or controlled through land purchase agreements. In connection with these acquisitions, we assumed contracts to deliver 204 homes with an aggregate value of $96.1 million. The average price of undelivered homes at the dates of acquisitions was approximately $471,100. As a result of these acquisitions, our selling community count increased by 22 communities. Our Business Environment and Current Outlook Over the past several years, sales prices for both new and resale homes have generally increased, which has reduced housing affordability in many markets, including in California, where we have a significant presence. In addition, late in fiscal 2018 and in the first half of fiscal 2019, interest rates on mortgage loans increased. These conditions resulted in a moderation in demand for our homes late in fiscal 2018 into fiscal 2019, as well as margin compression on contracts signed during this period. Late in the spring of 2019, market conditions improved as interest rates on mortgage loans decreased and as home builders increased sales incentives to improve sales pace. Buyer demand for our homes steadily improved throughout the year, and, in the three months ended October 31, 2019, the number of contracts we signed had increased 18% in units and 12% in dollars compared to the three months ended October 31, 2018. For full year fiscal 2019, we signed 8,075 contracts for the sale of Traditional Home Building Product and City Living units with an aggregate value of $6.71 billion, compared to 8,519 contracts with an aggregate value of $7.60 billion in fiscal 2018. As we enter fiscal 2020, we continue to see solid economic fundamentals underlying the housing market, as consumer confidence has been healthy, household formations have been strong, and there continues to be a limited supply of homes across most of our markets. As the nation's leading builder of luxury homes, we remain committed to meeting the demands of our discerning customers, who continue to pursue distinctive, high-quality homes in desirable locations. At the same time, we are strategically focused on broadening our portfolio through targeted expansion in high-potential markets and product-line diversification that includes increasing our presence in more affordable luxury communities. With a supportive economy as a backdrop, we expect this strategy to improve revenue growth and capital efficiency as we increase community count and seek to deliver more units with more rapid cycle times. Tax Reform On December 22, 2017, the Tax Cuts and Jobs Act (the “Tax Act”) was enacted into law, which changed many longstanding foreign and domestic corporate and individual tax rules, as well as rules pertaining to the deductibility of employee compensation and benefits. These changes include: (i) reducing the corporate income tax rate from 35% to 21% for tax years beginning after December 31, 2017; (ii) eliminating the corporate alternative minimum tax; (iii) changing rules related to uses and limitations of net operating loss carryforwards created in tax years beginning after December 31, 2017; (iv) repeal of the domestic production activities deduction for tax years beginning after December 31, 2017; and (v) establishing new limits on the federal tax deductions individual taxpayers may take as a result of mortgage loan interest payments, and state and local tax payments, including real estate taxes. As required under accounting rules, we remeasured our net deferred tax liability for the tax law change, which resulted in an income tax benefit of $35.5 million in fiscal 2018. See Note 8, “Income Taxes” in Notes to Condensed Consolidated Financial Statements in Item 15(a)1 of this Form 10-K for additional information regarding the impact of the Tax Act. Competitive Landscape The home building business is highly competitive and fragmented. We compete with numerous home builders of varying sizes, ranging from local to national in scope, some of which have greater sales and financial resources than we do. Sales of existing homes, whether by a homeowner or by a financial institution that has acquired a home through a foreclosure, also provide competition. We compete primarily based on price, location, design, quality, service, and reputation. We believe our financial stability, relative to many others in our industry, provides us with a competitive advantage. Land Acquisition and Development Our business is subject to many risks because of the extended length of time that it takes to obtain the necessary approvals on a property, complete the land improvements on it, and deliver a home after a home buyer signs an agreement of sale. In certain cases, we attempt to reduce some of these risks and improve our capital efficiency by utilizing one or more of the following methods: controlling land for future development through options, which enable us to obtain necessary governmental approvals before acquiring title to the land; generally commencing construction of a detached home only after executing an agreement of sale and receiving a substantial down payment from the buyer; and using subcontractors to perform home construction and land development work on a fixed-price basis. During fiscal 2019 and 2018, we acquired control of approximately 13,900 and 13,400 home sites, respectively, net of options terminated and home sites sold. At October 31, 2019, we controlled approximately 59,200 home sites, as compared to approximately 53,400 home sites at October 31, 2018, and approximately 48,300 home sites at October 31, 2017. In addition, at October 31, 2019, we expect to purchase approximately 2,500 additional home sites from several land development joint ventures in which we have an interest, at prices not yet determined. Of the approximately 59,200 total home sites that we owned or controlled through options at October 31, 2019, we owned approximately 36,600 and controlled approximately 22,600 through options. Of the 59,200 home sites, approximately 16,800 were substantially improved. In addition, at October 31, 2019, our Land Development Joint Ventures owned approximately 10,100 home sites (including 130 home sites included in the 22,600 controlled through options), and our Home Building Joint Ventures owned approximately 100 home sites. At October 31, 2019, we were selling from 333 communities, compared to 315 communities at October 31, 2018, and 305 communities at October 31, 2017. Customer Mortgage Financing We maintain relationships with a widely-diversified group of mortgage financial institutions, many of which are among the largest in the industry. We believe that regional and community banks continue to recognize the long-term value in creating relationships with high-quality, affluent customers such as our home buyers, and these banks continue to provide these customers with financing. We believe that our home buyers generally are, and should continue to be, well-positioned to secure mortgages due to their typically lower loan-to-value ratios and attractive credit profiles, as compared to the average home buyer. Toll Brothers Apartment Living/Toll Brothers Campus Living In addition to our residential for-sale business, we also develop and operate for-rent apartments through joint ventures. At October 31, 2019, we or joint ventures in which we have an interest controlled 56 land parcels as for-rent apartment projects containing approximately 18,300 units. These projects, which are located in multiple metropolitan areas throughout the country, are being operated, are being developed or will be developed with partners under the brand names Toll Brothers Apartment Living and Toll Brothers Campus Living. In fiscal 2019, one of our Rental Property Joint Ventures, located in located in Phoenixville, Pennsylvania, sold its assets to an unrelated party for $77.8 million. From our investment in this joint venture, we received cash of $7.4 million and recognized a gain from this sale of $3.8 million in fiscal 2019. In fiscal 2018, three of our Rental Property Joint Ventures sold their assets to unrelated parties for $477.5 million. These joint ventures had owned, developed, and operated multifamily rental properties located in suburban Washington, D.C. and Westborough, Massachusetts, and a student housing community in College Park, Maryland. From our investment in these joint ventures, we received cash of $79.1 million and recognized gains from these sales of $67.2 million in fiscal 2018. The gains recognized from these sales are included in “Income from unconsolidated entities” in our Consolidated Statement of Operations and Comprehensive Income included in Item 15(a)1 of this Form 10-K. At October 31, 2019, we had approximately 2,000 units in for-rent apartment projects that were occupied or ready for occupancy, 1,700 units in the lease-up stage, 8,400 units in the design phase or under development, and 6,200 units in the planning stage. Of the 18,300 units at October 31, 2019, 7,700 were owned by joint ventures in which we have an interest; approximately 4,400 were owned by us; and 6,200 were under contract to be purchased by us. CONTRACTS AND BACKLOG The aggregate value of net sales contracts signed decreased 11.7% in fiscal 2019, as compared to fiscal 2018. The value of net sales contracts signed was $6.71 billion (8,075 homes) in fiscal 2019 and $7.60 billion (8,519 homes) in fiscal 2018. The decrease in the aggregate value of net contracts signed in fiscal 2019, as compared to fiscal 2018, was due to decreases in the number of net contracts signed and average value of each contract signed of 5% and 7%, respectively. The decrease in the number of net contracts signed in fiscal 2019, as compared to fiscal 2018, was primarily due to decreased demand and a lack of inventory in certain locations in fiscal 2019, as compared to fiscal 2018, offset, in part, by an increase in the average number of selling communities and contracts signed in the metropolitan Atlanta, Georgia market and several markets in South Carolina in fiscal 2019 from the Sharp and Sabal acquisitions. The decrease in average price of net contracts signed in fiscal 2019, as compared to fiscal 2018, was principally due to a shift in the number of contracts signed to less expensive areas and/or products resulting in part from our strategy to broaden of our geographic footprint, product types and price points in fiscal 2019. The value of our backlog at October 31, 2019, 2018, and 2017 was $5.26 billion (6,266 homes), $5.52 billion (6,105 homes), and $5.06 billion (5,851 homes), respectively. Approximately 93% of the homes in backlog at October 31, 2019 are expected to be delivered by October 31, 2020. The 4.8% decrease in the value of homes in backlog at October 31, 2019, as compared to October 31, 2018, was due to home deliveries with an aggregate value of $7.08 billion in fiscal 2019, offset, in part, by our signing net contracts with a value of $6.71 billion in fiscal 2019. For more information regarding revenues, net contracts signed, and backlog by geographic segment, see “Segments” in this MD&A. CRITICAL ACCOUNTING POLICIES We believe the following critical accounting policies reflect the more significant judgments and estimates used in the preparation of our consolidated financial statements. Inventory Inventory is stated at cost unless an impairment exists, in which case it is written down to fair value in accordance with U.S. generally accepted accounting principles (“GAAP”). In addition to direct land acquisition, land development, and home construction costs, costs also include interest, real estate taxes, and direct overhead related to development and construction, which are capitalized to inventory during periods beginning with the commencement of development and ending with the completion of construction. For those communities that have been temporarily closed, no additional capitalized interest is allocated to the community’s inventory until it reopens, and other carrying costs are expensed as incurred. Once a parcel of land has been approved for development and we open the community, it can typically take four or more years to fully develop, sell, and deliver all the homes in that community. Longer or shorter time periods are possible depending on the number of home sites in a community and the sales and delivery pace of the homes in a community. Our master planned communities, consisting of several smaller communities, may take up to 10 years or more to complete. Because our inventory is considered a long-lived asset under GAAP, we are required to regularly review the carrying value of each of our communities and write down the value of those communities when we believe the values are not recoverable. Operating Communities: When the profitability of an operating community deteriorates, the sales pace declines significantly, or some other factor indicates a possible impairment in the recoverability of the asset, the asset is reviewed for impairment by comparing the estimated future undiscounted cash flow for the community to its carrying value. If the estimated future undiscounted cash flow is less than the community’s carrying value, the carrying value is written down to its estimated fair value. Estimated fair value is primarily determined by discounting the estimated future cash flow of each community. The impairment is charged to cost of home sales revenues in the period in which the impairment is determined. In estimating the future undiscounted cash flow of a community, we use various estimates such as (i) the expected sales pace in a community, based upon general economic conditions that will have a short-term or long-term impact on the market in which the community is located and on competition within the market, including the number of home sites available and pricing and incentives being offered in other communities owned by us or by other builders; (ii) the expected sales prices and sales incentives to be offered in a community; (iii) costs expended to date and expected to be incurred in the future, including, but not limited to, land and land development costs, home construction, interest, and overhead costs; (iv) alternative product offerings that may be offered in a community that will have an impact on sales pace, sales price, building cost, or the number of homes that can be built in a particular community; and (v) alternative uses for the property, such as the possibility of a sale of the entire community to another builder or the sale of individual home sites. Future Communities: We evaluate all land held for future communities or future sections of operating communities, whether owned or optioned, to determine whether or not we expect to proceed with the development of the land as originally contemplated. This evaluation encompasses the same types of estimates used for operating communities described above, as well as an evaluation of the regulatory environment in which the land is located and the estimated probability of obtaining the necessary approvals, the estimated time and cost it will take to obtain those approvals, and the possible concessions that may be required to be given in order to obtain them. Concessions may include cash payments to fund improvements to public places such as parks and streets, dedication of a portion of the property for use by the public or as open space, or a reduction in the density or size of the homes to be built. Based upon this review, we decide (i) as to land under contract to be purchased, whether the contract will likely be terminated or renegotiated, and (ii) as to land we own, whether the land will likely be developed as contemplated or in an alternative manner, or should be sold. We then further determine whether costs that have been capitalized to the community are recoverable or should be written off. The write-off is charged to cost of home sales revenues in the period in which the need for the write-off is determined. The estimates used in the determination of the estimated cash flows and fair value of both current and future communities are based on factors known to us at the time such estimates are made and our expectations of future operations and economic conditions. Should the estimates or expectations used in determining estimated fair value deteriorate in the future, we may be required to recognize additional impairment charges and write-offs related to current and future communities and such amounts could be material. We provided for inventory impairment charges and the expensing of costs that we believed not to be recoverable in each of the three fiscal years ended October 31, 2019, 2018, and 2017, as shown in the table below (amounts in thousands): The table below provides, for the periods indicated, the number of operating communities that we reviewed for potential impairment, the number of operating communities in which we recognized impairment charges, the amount of impairment charges recognized, and, as of the end of the period indicated, the fair value of those communities, net of impairment charges ($ amounts in thousands): Income Taxes - Valuation Allowance We assess the need for valuation allowances for deferred tax assets in each period based on whether it is more-likely-than-not that some portion of the deferred tax asset would not be realized. If, based on the available evidence, it is more-likely-than-not that such asset will not be realized, a valuation allowance is established against a deferred tax asset. The realization of a deferred tax asset ultimately depends on the existence of sufficient taxable income in either the carryback or carryforward periods under tax law. This assessment considers, among other matters, the nature, consistency, and magnitude of current and cumulative income and losses; forecasts of future profitability; the duration of statutory carryback or carryforward periods; our experience with operating loss and tax credit carryforwards being used before expiration; tax planning alternatives; and outlooks for the U.S. housing industry and broader economy. Changes in existing tax laws or rates could also affect our actual tax results. Due to uncertainties in the estimation process, particularly with respect to changes in facts and circumstances in future reporting periods, actual results could differ from the estimates used in our assessment that could have a material impact on our consolidated results of operations or financial position. Our deferred tax assets consist principally of the timing of deductibility of accrued expenses, inventory impairments, inventory valuation differences, state tax net operating loss carryforwards, and stock-based compensation expense. In accordance with GAAP, we assess whether a valuation allowance should be established based on our determination of whether it was more likely than not that some portion or all of the deferred tax assets would not be realized. At October 31, 2019 and 2018, we determined that it was more-likely-than-not that our deferred tax assets would be realized. Accordingly, at October 31, 2019 and 2018, we did not have valuation allowances recorded against our federal or state deferred tax assets. During fiscal 2017, we reversed the remaining $32.2 million of state deferred tax valuation allowances. We file tax returns in the various states in which we do business. Each state has its own statutes regarding the use of tax loss carryforwards. Some of the states in which we do business do not allow for the carryforward of losses, while others allow for carryforwards for five years to 20 years. Revenue and Cost Recognition Home sales revenues and cost recognition: Revenues and cost of revenues from home sales are recognized at the time each home is delivered and title and possession are transferred to the buyer. For the majority of our home closings, our performance obligation to deliver a home is satisfied in less than one year from the date a binding sale agreement is signed. For our standard attached and detached homes, land, land development, and related costs, both incurred and estimated to be incurred in the future, are amortized to the cost of homes closed based upon the total number of homes to be constructed in each community. Any changes resulting from a change in the estimated number of homes to be constructed or in the estimated costs subsequent to the commencement of delivery of homes are allocated to the remaining undelivered homes in the community. Home construction and related costs are charged to the cost of homes closed under the specific identification method. For our master planned communities, the estimated land, common area development, and related costs, including the cost of golf courses, net of their estimated residual value, are allocated to individual communities within a master planned community on a relative sales value basis. Any changes resulting from a change in the estimated number of homes to be constructed or in the estimated costs are allocated to the remaining home sites in each of the communities of the master planned community. For high-rise/mid-rise projects, land, land development, construction, and related costs, both incurred and estimated to be incurred in the future, are generally amortized to the cost of units closed based upon an estimated relative sales value of the units closed to the total estimated sales value. Any changes resulting from a change in the estimated total costs or revenues of the project are allocated to the remaining units to be delivered. Forfeited Customer Deposits: Forfeited customer deposits are recognized in “Home sales revenues” in our Consolidated Statements of Operations and Comprehensive Income in the period in which we determine that the customer will not complete the purchase of the home and we have the right to retain the deposit. Sales Incentives: In order to promote sales of our homes, we may offer our home buyers sales incentives. These incentives will vary by type of incentive and by amount on a community-by-community and home-by-home basis. Incentives are reflected as a reduction in home sales revenues. Incentives are recognized at the time the home is delivered to the home buyer and we receive the sales proceeds. On November 1, 2018, we adopted Accounting Standards Codification (“ASC”) Topic 606 “Revenue from Contracts with Customers” (“ASC 606”), which supersedes the revenue recognition requirements in Accounting Standards Codification Topic 605, “Revenue Recognition,” and most industry-specific guidance. See Note 1, “Significant Accounting Policies” in Notes to Consolidated Financial Statements in Item 15(a)1 of this Form 10-K for additional information regarding the impact of the adoption of ASC 606. Warranty and Self-Insurance Warranty: We provide all of our home buyers with a limited warranty as to workmanship and mechanical equipment. We also provide many of our home buyers with a limited 10-year warranty as to structural integrity. We accrue for expected warranty costs at the time each home is closed and title and possession are transferred to the home buyer. Warranty costs are accrued based upon historical experience. Adjustments to our warranty liabilities related to homes delivered in prior years are recorded in the period in which a change in our estimate occurs. Over the past several years, we have had a significant number of warranty claims related primarily to homes built in Pennsylvania and Delaware. See Note 7 - “Accrued Expenses” in Item 15(a)1 of this Form 10-K for additional information regarding these warranty charges. Self-Insurance: We maintain, and require the majority of our subcontractors to maintain, general liability insurance (including construction defect and bodily injury coverage) and workers’ compensation insurance. These insurance policies protect us against a portion of our risk of loss from claims related to our home building activities, subject to certain self-insured retentions, deductibles and other coverage limits (“self-insured liability”). We also provide general liability insurance for our subcontractors in Arizona, California, Colorado, Nevada, Washington, and certain areas of Texas, where eligible subcontractors are enrolled as insureds under our general liability insurance policies in each community in which they perform work. For those enrolled subcontractors, we absorb their general liability associated with the work performed on our homes within the applicable community as part of our overall general liability insurance and our self-insurance through our captive insurance subsidiary. We record expenses and liabilities based on the estimated costs required to cover our self-insured liability and the estimated costs of potential claims and claim adjustment expenses that are not covered by our insurance policies. These estimated costs are based on an analysis of our historical claims and industry data, and include an estimate of claims incurred but not yet reported (“IBNR”). We engage a third-party actuary that uses our historical claim and expense data, input from our internal legal and risk management groups, as well as industry data, to estimate our liabilities related to unpaid claims, IBNR associated with the risks that we are assuming for our self-insured liability and other required costs to administer current and expected claims. These estimates are subject to uncertainty due to a variety of factors, the most significant being the long period of time between the delivery of a home to a home buyer and when a structural warranty or construction defect claim is made, and the ultimate resolution of the claim. Though state regulations vary, construction defect claims are reported and resolved over a prolonged period of time, which can extend for 10 years or longer. As a result, the majority of the estimated liability relates to IBNR. Adjustments to our liabilities related to homes delivered in prior years are recorded in the period in which a change in our estimate occurs. The projection of losses related to these liabilities requires actuarial assumptions that are subject to variability due to uncertainties regarding construction defect claims relative to our markets and the types of product we build, insurance industry practices and legal or regulatory actions and/or interpretations, among other factors. Key assumptions used in these estimates include claim frequencies, severities and settlement patterns, which can occur over an extended period of time. In addition, changes in the frequency and severity of reported claims and the estimates to settle claims can impact the trends and assumptions used in the actuarial analysis, which could be material to our consolidated financial statements. Due to the degree of judgment required, and the potential for variability in these underlying assumptions, our actual future costs could differ from those estimated, and the difference could be material to our consolidated financial statements. OFF-BALANCE SHEET ARRANGEMENTS We also operate through a number of joint ventures. We earn construction and management fee income from many of these joint ventures. Our investments in these entities are generally accounted for using the equity method of accounting. We are a party to several joint ventures with unrelated parties to develop and sell land that is owned by the joint ventures. We recognize our proportionate share of the earnings from the sale of home sites to other builders, including our joint venture partners. We do not recognize earnings from the home sites we purchase from these ventures at the time of our purchase; instead, our cost basis in the home sites is reduced by our share of the earnings realized by the joint venture from those home sites. At October 31, 2019, we had investments in these entities of $366.3 million, and were committed to invest or advance up to an additional $38.8 million to these entities if they require additional funding. At October 31, 2019, we had agreed to terms for the acquisition of 130 home sites from one Land Development Joint Ventures for an estimated aggregate purchase price of $10.8 million. In addition, we expect to purchase approximately 2,500 additional home sites over a number of years from several of these joint ventures; the purchase price of these home sites will be determined at a future date. The unconsolidated entities in which we have investments generally finance their activities with a combination of partner equity and debt financing. In some instances, we and our partners have guaranteed debt of certain unconsolidated entities. These guarantees may include any or all of the following: (i) project completion guarantees, including any cost overruns; (ii) repayment guarantees, generally covering a percentage of the outstanding loan; (iii) carry cost guarantees, which cover costs such as interest. real estate taxes, and insurance; (iv) an environmental indemnity provided to the lender that holds the lender harmless from and against losses arising from the discharge of hazardous materials from the property and non-compliance with applicable environmental laws; and (v) indemnification of the lender from “bad boy acts” of the unconsolidated entity. In some instances, the guarantees provided in connection with loans to an unconsolidated entity are joint and several. In these situations, we generally have a reimbursement agreement with our partner that provides that neither party is responsible for more than its proportionate share or agreed-upon share of the guarantee; however, if the joint venture partner does not have adequate financial resources to meet its obligations under the reimbursement agreement, we may be liable for more than our proportionate share. We believe that as of October 31, 2019, in the event we become legally obligated to perform under a guarantee of the obligation of an unconsolidated entity due to a triggering event, the collateral should be sufficient to repay all or a significant portion of the obligation. If it is not, we and our partners would need to contribute additional capital to the entity. At October 31, 2019, we had guaranteed the debt of certain unconsolidated entities with loan commitments aggregating $1.53 billion, of which, if the full amount of the debt obligations were borrowed, we estimate $299.1 million to be our maximum exposure related to repayment and carry cost guarantees. At October 31, 2019, the unconsolidated entities had borrowed an aggregate of $1.14 billion, of which we estimate $239.6 million to be our maximum exposure related to repayment and carry cost guarantees. These maximum exposure estimates do not take into account any recoveries from the underlying collateral or any reimbursement from our partners. For more information regarding these joint ventures, see Note 4, “Investments in Unconsolidated Entities” in the Notes to Consolidated Financial Statements in Item 15(a)1 of this Form 10-K. The trends, uncertainties or other factors that impact our business and the industry in general also impact the unconsolidated entities in which we have investments. We review each of our investments on a quarterly basis for indicators of impairment. A series of operating losses of an investee, the inability to recover our invested capital, or other factors may indicate that a loss in value of our investment in the unconsolidated entity has occurred. If a loss exists, we further review to determine if the loss is other than temporary, in which case we write down the investment to its fair value. The evaluation of our investment in unconsolidated entities entails a detailed cash flow analysis using many estimates including but not limited to, expected sales pace, expected sales prices, expected incentives, costs incurred and anticipated, sufficiency of financing and capital, competition, market conditions and anticipated cash receipts, in order to determine projected future distributions. Each of the unconsolidated entities evaluates its inventory in a similar manner. In addition, for our unconsolidated entities that own, develop, and manage for-rent residential apartments, we review rental trends, expected future expenses, and expected future cash flows to determine estimated fair values of the properties. See “Critical Accounting Policies - Inventory” contained in this MD&A for more detailed disclosure on our evaluation of inventory. If a valuation adjustment is recorded by an unconsolidated entity related to its assets, our proportionate share is reflected in income from unconsolidated entities with a corresponding decrease to our investment in unconsolidated entities. Based upon our evaluation of the fair value of our investments in unconsolidated entities, we recognized charges in connection with one Land Development Joint Venture of $1.0 million in fiscal 2019; two Land Development Joint Ventures of $6.0 million in fiscal 2018; and $2.0 million in fiscal 2017 at one Land Development Joint Venture. RESULTS OF OPERATIONS The following table compares certain items in our Consolidated Statements of Operations and Comprehensive Income and other supplemental information for fiscal 2019 and 2018 ($ amounts in millions, unless otherwise stated). For more information regarding results of operations by operating segment, see “Segments” in this MD&A. (1) On November 1, 2018, we adopted ASC 606. Upon adoption, land sale activity is presented as part of income from operations where previously it was included in "Other income - net." In fiscal 2018, we recognized land sales revenues and land sales cost of revenues of $134.3 million and $128.0 million, respectively. Further, retained customer deposits, which totaled $13.2 million in fiscal 2019, are included in “Home sales revenue” where previously they were included in “Other income - net.” In fiscal 2018, retained customer deposits were $8.9 million. Prior periods are not restated. (2) $ amounts in thousands. Note: Amounts may not add due to rounding. FISCAL 2019 COMPARED TO FISCAL 2018 HOME SALES REVENUES AND HOME SALES COST OF REVENUES The decrease in home sales revenues in fiscal 2019, as compared to fiscal 2018, was attributable to a 2% decrease in the number of homes delivered, offset, in part, by a 1% increase in the average price of the homes delivered. The decrease in the number of homes delivered was primarily due to a moderation in demand, particularly in California, which we experienced beginning in the fourth quarter of fiscal 2018 through the third quarter of fiscal 2019. This decrease was partially offset by contracts we signed in the metropolitan Atlanta, Georgia market and several markets in South Carolina in fiscal 2019 from the Sharp and Sabal acquisitions and an increase in the number of selling communities, primarily in our South and West regions, in fiscal 2019, as compared to fiscal 2018. The increase in the average delivered home price was mainly due to price increases in homes delivered in California and the West region and a shift in the number of homes delivered to more expensive areas and/or products in California, New Jersey, Virginia, and the West region in fiscal 2019, as compared to fiscal 2018. These increases were partially offset by a shift in the number of homes delivered to less expensive areas in City Living in fiscal 2019, as compared to fiscal 2018 and a decrease in the number of homes delivered in California where home prices were higher, in fiscal 2019, as compared to fiscal 2018. Home sales cost of revenues, as a percentage of homes sales revenues, in fiscal 2019 was 80.2%, as compared to 79.4% in fiscal 2018. The increase in fiscal 2019 was primarily due to higher land, land development, material and labor costs; a shift in the mix of our home sales revenues to lower margin products/areas; the recovery of approximately $9.7 million from litigation settlements in fiscal 2018; a $7.0 million benefit in fiscal 2018 from the reversal of an accrual related to an indemnification obligation related to the Shapell acquisition that expired; and higher inventory impairment charges in fiscal 2019, as compared to fiscal 2018. These increases were offset, in part, by a state reimbursement of previously expensed environmental clean-up costs received in fiscal 2019; a benefit in fiscal 2019 from the reversal of accruals for certain Home Owners Associations (“HOA”) turnovers that were no longer required; price increases in homes delivered in California and the West region; and lower interest expense in fiscal 2019 compared to fiscal 2018. Interest cost in fiscal 2019 was $185.0 million or 2.6% of home sales revenues, as compared to $190.7 million or 2.7% of home sales revenues in fiscal 2018. We recognized inventory impairments and write-offs of $42.4 million or 0.6% of home sales revenues and $35.2 million or 0.5% of home sales revenues in fiscal 2019 and fiscal 2018, respectively. LAND SALES REVENUES AND LAND SALES COST OF REVENUES Our revenues from land sales generally consist of the following: (1) land sales to joint ventures in which we retain an interest; (2) lot sales to third-party builders within our master planned communities; and (3) bulk land sales to third parties of land we have decided no longer meets our development criteria. In fiscal 2019, we recognized a gain of $9.3 million from the sale of land to two newly formed Rental Property Joint Ventures in which we have interests of 25%. Prior to the adoption of ASC 606, land sales activity was reported within “Other income - net” in our Condensed Consolidated Statements of Operations and Comprehensive Income. In fiscal 2018, we recognized land sales revenues and land sales cost of revenues of $134.3 million and $128.0 million, respectively. SELLING, GENERAL AND ADMINISTRATIVE EXPENSES (“SG&A”) SG&A spending increased by $50.5 million in fiscal 2019 compared to fiscal 2018. As a percentage of home sales revenues, SG&A was 10.4% and 9.6% in fiscal 2019 and 2018, respectively. The dollar increase in SG&A was due primarily to increased compensation costs due to a higher number of employees and normal compensation increases, increased sales and marketing costs, and costs related to the implementation of new enterprise information technology systems. The higher sales and marketing costs were the result of the increased number of selling communities, increased spending on advertising, and higher design studio operating costs. The increased number of employees was due primarily to the increase in the number of current and future selling communities. INCOME FROM UNCONSOLIDATED ENTITIES We recognize our proportionate share of the earnings and losses from the various unconsolidated entities in which we have an investment. Many of our unconsolidated entities are land development projects, high-rise/mid-rise condominium construction projects, or for-rent apartments projects, which do not generate revenues and earnings for a number of years during the development of the property. Once development is complete for land development projects and high-rise/mid-rise condominium construction projects, these unconsolidated entities will generally, over a relatively short period of time, generate revenues and earnings until all of the assets of the entity are sold. Further, once for-rent apartments projects are complete and stabilized, we may monetize a portion of these projects through a recapitalization or a sale of all or a portion of our ownership interest in the joint venture, resulting in an income producing event. Because of the long development periods associated with these entities, the earnings recognized from these entities may vary significantly from quarter to quarter and year to year. The decrease in income from unconsolidated entities from $85.2 million in fiscal 2018 to $24.9 million in fiscal 2019, was due mainly to $67.2 million of gains recognized in fiscal 2018 from asset sales by three of our Rental Property Joint Ventures located in College Park, Maryland, Herndon, Virginia, and Westborough, Massachusetts, and an increase in losses in several Rental Property Join Ventures related to the commencement of operations and lease up activities in fiscal 2019, as compared to fiscal 2018. These decreases were offset, in part, by a $3.8 million gain recognized in fiscal 2019 from an asset sale by one of our Rental Property Joint Ventures located in Phoenixville, Pennsylvania; higher earnings from two of our Home Building Joint Ventures; and a $3.0 million decrease in impairment charges recognized in fiscal 2019 as compared to fiscal 2018. OTHER INCOME - NET The table below provides the components of “Other Income - net” for the years ended October 31, 2019 and 2018 (amounts in thousands): As a result of our adoption of ASC 606 on November 1, 2018, land sale activity is presented as part of income from operations where previously it was included in “Other income - net.” In addition, retained customer deposits are included in “Home sales revenue” where previously they were included in “Other income - net.” Prior periods are not restated. See Note 1, “Significant Accounting Policies - Recent Accounting Pronouncements” in Notes to Consolidated Financial Statements in this Form 10-K for additional information regarding the adoption of ASC 606. The increase in income from ancillary businesses in fiscal 2019, as compared to fiscal 2018, was mainly due to gains recognized of $35.1 million from the sale of seven golf clubs in fiscal 2019 and lower losses incurred in our apartment living operations in fiscal 2019, as compared to fiscal 2018, partially offset by a $10.7 million gain from a bulk sale of security monitoring accounts by our home control solutions business in fiscal 2018. Management fee income from home building unconsolidated entities presented above primarily represents fees earned by our City Living and Traditional Home Building operations. In addition, in fiscal 2019 and 2018, our apartment living operations earned fees from unconsolidated entities of $11.9 million and $7.5 million, respectively. Fees earned by our apartment living operations are included in income from ancillary businesses. The increase in “other” in fiscal 2019 was principally due to higher interest income earned in fiscal 2019 compared to fiscal 2018, offset, in part, by $2.6 million received in fiscal 2018 from the resolution of a matter involving defective floor joists. INCOME BEFORE INCOME TAXES In fiscal 2019, we reported income before income taxes of $787.2 million or 10.9% of revenues, as compared to $933.9 million, or 13.1% of revenues in fiscal 2018. INCOME TAX PROVISION We recognized a $197.2 million income tax provision in fiscal 2019. Based upon the federal statutory rate of 21.0% for fiscal 2019, our federal tax provision would have been $165.3 million. The difference between the tax provision recognized and the tax provision based on the federal statutory rate was mainly due to the provision for state income taxes of $37.9 million and an increase in unrecognized tax benefits of $2.2 million, offset, in part, by the reversal of $5.3 million of previously accrued tax provisions on uncertain tax positions that were no longer necessary due to the expiration of the statute of limitations and a benefit of $2.1 million from excess tax benefits related to stock-based compensation. We recognized a $185.8 million income tax provision in fiscal 2018. Based upon the blended federal statutory rate of 23.3% for fiscal 2018, our federal tax provision would have been $217.9 million. The difference between the tax provision recognized and the tax provision based on the federal statutory rate was mainly due to tax law changes of $38.7 million; a benefit of $18.2 million related to the utilization of domestic production activities deductions; the reversal of $4.7 million of previously accrued tax provisions on uncertain tax positions that were no longer necessary due to the expiration of the statute of limitations and settlements with certain taxing jurisdictions; a benefit of $4.2 million from excess tax benefits related to stock-based compensation; and $15.2 million of permanent and other differences, which primarily relates to the recognition of Section 45L energy credits and tax planning transactions that benefited the Company’s state net operating loss carryforwards, offset, in part, by the provision for state income taxes of $47.1 million. See Note 8, “Income Taxes” in Item 15(a)1 of this Form 10-K for additional information regarding the impact of the Tax Act. CAPITAL RESOURCES AND LIQUIDITY Funding for our business has been, and continues to be, provided principally by cash flow from operating activities before inventory additions, unsecured bank borrowings, and the public debt markets. Fiscal 2019 At October 31, 2019, we had $1.29 billion of cash and cash equivalents and approximately $1.73 billion available for borrowing under our Revolving Credit Facility. Cash provided by operating activities during fiscal 2019 was $437.7 million. It was generated primarily from $590.0 million of net income plus $26.2 million of stock-based compensation, $72.1 million of depreciation and amortization, $42.4 million of inventory impairments and write-offs, and a net deferred tax benefit of $102.8 million; offset, in part, by a $40.2 million increase in inventory; an increase of $185.3 million in receivables, prepaid assets, and other assets; an increase of $45.6 million in mortgage loans held for sale; and a decrease of $64.5 million in accounts payable and accrued expenses. Cash used in investing activities during fiscal 2019 was $75.9 million, primarily related to $162.4 million used to acquired Sharp and Sabal; $87.0 million for the purchase of property and equipment; and $56.6 million used to fund investments in unconsolidated entities. This activity was offset, in part, by $151.1 million of cash received as returns on our investments in unconsolidated entities, foreclosed real estate, and distressed loans and proceeds of $79.6 million of cash received from sales of golf club properties and an office buildings in several separate transactions with unrelated third parties. We used $258.5 million of cash from financing activities in fiscal 2019, primarily for the repayment of $600.0 million of senior notes; the repurchase of $233.5 million of our common stock; and payment of $63.6 million of dividends on our common stock, offset, in part, by the net proceeds of $396.4 million from the issuance of $400.0 million aggregate principal amount of 3.80% Senior Notes due 2029; borrowings of $227.4 million of other loans payable, net of new repayments; and the proceeds of $17.4 million from our stock-based benefit plans. Fiscal 2018 At October 31, 2018, we had $1.18 billion of cash and cash equivalents on hand and approximately $1.13 billion available for borrowing under our Revolving Credit Facility. Cash provided by operating activities during fiscal 2018 was $588.2 million. It was generated primarily from $748.2 million of net income plus $28.3 million of stock-based compensation, $25.3 million of depreciation and amortization, $35.2 million of inventory impairments and write-offs; and an increase of $57.9 million in accounts payable and accrued expenses; offset, in part, by a $143.6 million increase in inventory; an increase of $99.6 million in receivables, prepaid assets, and other assets; an increase of $38.9 million in mortgage loans held for sale; and a net deferred tax benefit of $21.9 million. Cash provided by investing activities during fiscal 2018 was $81.3 million. The cash generated by investing activities was primarily related to $138.0 million of cash received as returns on our investments in unconsolidated entities, foreclosed real estate, and distressed loans, offset, in part, by $28.2 million for the purchase of property and equipment and $27.5 million used to fund investments in unconsolidated entities. We used $214.3 million of cash from financing activities in fiscal 2018, primarily for repurchase of $503.2 million of our common stock; the repayment of $89.2 million of other loans payable, net of new borrowings; and payment of $61.7 million of dividends on our common stock, offset, in part, by the net proceeds of $396.5 million from the issuance of $400.0 million aggregate principal amount of 4.35% Senior Notes due 2028, the borrowings of $29.9 million on our mortgage company loan facility, net of new borrowings; and the proceeds of $13.4 million from our stock-based benefit plans. Other In general, our cash flow from operating activities assumes that, as each home is delivered, we will purchase a home site to replace it. Because we own a supply of several years of home sites, we do not need to buy home sites immediately to replace those that we deliver. In addition, we generally do not begin construction of our detached homes until we have a signed contract with the home buyer. Should our business decline, we believe that our inventory levels would decrease as we complete and deliver the homes under construction but do not commence construction of as many new homes, as we complete the improvements on the land we already own, and as we sell and deliver the speculative homes that are currently in inventory, resulting in additional cash flow from operations. In addition, we might delay, decrease, or curtail our acquisition of additional land, which would further reduce our inventory levels and cash needs. At October 31, 2019, we owned or controlled through options approximately 59,200 home sites, as compared to approximately 53,400 at October 31, 2018; and approximately 48,300 at October 31, 2017. Of the approximately 59,200 home sites owned or controlled through options at October 31, 2019, we owned approximately 36,600. Of our owned home sites at October 31, 2019, significant improvements were completed on approximately 16,800 of them. At October 31, 2019, the aggregate purchase price of land parcels under option and purchase agreements was approximately $2.36 billion (including $10.8 million of land to be acquired from joint ventures in which we have invested). Of the $2.36 billion of land purchase commitments, we had paid or deposited $168.8 million and, if we acquire all of these land parcels, we will be required to pay an additional $2.19 billion. The purchases of these land parcels are scheduled over the next several years. In addition, we expect to purchase approximately 2,500 additional home sites over a number of years from several of these joint ventures. We have additional land parcels under option that have been excluded from the aforementioned aggregate purchase amounts since we do not believe that we will complete the purchase of these land parcels and no additional funds will be required from us to terminate these contracts. During the past several years, we have made a number of investments in unconsolidated entities related to the acquisition and development of land for future home sites, the construction of luxury for-sale condominiums, and for-rent apartments. Our investment activities related to investments in and distributions of investments from unconsolidated entities are contained in the Consolidated Statements of Cash Flows under “Net cash (used in) provided by investing activities,” At October 31, 2019, we had investments in these entities of $366.3 million, and were committed to invest or advance up to an additional $38.8 million to these entities if they require additional funding. At October 31, 2019, we had purchase commitments to acquire land for apartment developments of approximately $280.2 million, of which we had outstanding deposits in the amount of $13.7 million. We intend to develop these apartment projects in joint ventures with unrelated parties in the future. On October 31, 2019, we amended and restated our existing $1.295 billion Revolving Credit Agreement, dated as of May 19, 2016, to, among other things: (i) increase the aggregate revolving credit commitments under the Revolving Credit Facility from $1.295 billion to $1.905 billion; (ii) extend the Revolving Credit Facility termination date from May 19, 2021 to November 1, 2024; (iii) modify the pricing for outstanding commitments, borrowings and letters of credit under the facility, as set forth in the pricing schedule that is attached to the Revolving Credit Facility; (iv) modify the accordion feature to permit the aggregate revolving credit commitments under the Revolving Credit Facility to be increased to up to $2.5 billion, subject to certain conditions and availability of bank commitments; and (iv) modify certain provisions relating to financial maintenance and negative covenants. Under the terms of the amended and restated Revolving Credit Facility, our maximum leverage ratio (as defined in the credit agreement) may not exceed 1.75 to 1.00 and we are required to maintain a minimum tangible net worth (as defined in the credit agreement) of no less than approximately $2.70 billion. Under the terms of the Revolving Credit Facility, at October 31, 2019, our leverage ratio was approximately 0.50 to 1.00 and our tangible net worth was approximately $5.02 billion. Based upon the minimum tangible net worth requirement, our ability to repurchase our common stock was limited to approximately $3.53 billion as of October 31, 2019. At October 31, 2019, we had no outstanding borrowings under the Revolving Credit Facility and had outstanding letters of credit of approximately $177.9 million. On October 31, 2018, we had a $800.0 million, five-year senior unsecured term loan facility (the “Term Loan Facility”) with a syndicate of banks. On October 31, 2019, we entered into an amendment to the Term Loan Facility to, among other things, extend the maturity date from November 1, 2023 to November 1, 2024, with no principal payments being required before the maturity date. We believe that we will have adequate resources and sufficient access to the capital markets and external financing sources to continue to fund our current operations and meet our contractual obligations. Due to the uncertainties in the economy and for home builders in general, we cannot be certain that we will be able to replace existing financing or find sources of additional financing in the future. INFLATION The long-term impact of inflation on us is manifested in increased costs for land, land development, construction, and overhead. We generally enter into contracts to acquire land a significant period of time before development and sales efforts begin. Accordingly, to the extent land acquisition costs are fixed, subsequent increases or decreases in the sales prices of homes will affect our profits. Because the sales price of each of our homes is fixed at the time a buyer enters into a contract to purchase a home and because we generally contract to sell our homes before we begin construction, any inflation of costs in excess of those anticipated may result in lower gross margins. We generally attempt to minimize that effect by entering into fixed-price contracts with our subcontractors and material suppliers for specified periods of time, which generally do not exceed one year. In general, housing demand is adversely affected by increases in interest rates and housing costs. Interest rates, the length of time that land remains in inventory, and the proportion of inventory that is financed affect our interest costs. If we are unable to raise sales prices enough to compensate for higher costs, or if mortgage interest rates increase significantly, affecting prospective buyers’ ability to adequately finance home purchases, our home sales revenues, gross margins, and net income could be adversely affected. Increases in sales prices, whether the result of inflation or demand, may affect the ability of prospective buyers to afford new homes. CONTRACTUAL OBLIGATIONS The following table summarizes our estimated contractual payment obligations at October 31, 2019 (amounts in millions): (a) Amounts include estimated annual interest payments until maturity of the debt. Of the amounts indicated, $2.66 billion of the senior notes, $1.11 billion of loans payable, $150.0 million of the mortgage company loan facility, and $31.3 million of accrued interest were recorded on our October 31, 2019 Consolidated Balance Sheet. (b) In December 2019, we amended the mortgage company warehousing agreement to, among other things, extend the maturity date to December 4, 2020. (c) Amounts represent our expected acquisition of land under purchase agreements and the estimated remaining amount of the contractual obligation for land development agreements secured by letters of credit and surety bonds. Of the total amount indicated, $14.6 million was recorded on our October 31, 2019 Consolidated Balance Sheet. (d) Amounts represent our obligations under our deferred compensation plan, supplemental executive retirement plans and our 401(k) salary deferral savings plans. Of the total amount indicated, $82.7 million was recorded on our October 31, 2019 Consolidated Balance Sheet. SEGMENTS We operate in two segments: Traditional Home Building and City Living, our urban development division. Within Traditional Home Building, we operate in five geographic segments around the United States: (1) the North, consisting of Connecticut, Illinois, Massachusetts, Michigan, New Jersey, and New York; (2) the Mid-Atlantic, consisting of Delaware, Maryland, Pennsylvania, and Virginia; (3) the South, consisting of Florida, Georgia, North Carolina, South Carolina, and Texas; (4) the West, consisting of Arizona, Colorado, Idaho, Nevada, Oregon, Utah, and Washington, and (5) California. The following tables summarize information related to revenues, net contracts signed, and income (loss) before income taxes by segment for fiscal years 2019, 2018, and 2017. Information related to backlog and assets by segment at October 31, 2019 and 2018, has also been provided. Units Delivered and Revenues: Net Contracts Signed: Backlog at October 31: Income (Loss) Before Income Taxes ($ amounts in millions): “Corporate and other” is comprised principally of general corporate expenses such as our executive officers; the corporate finance, accounting, audit, tax, human resources, risk management, information technology, marketing, and legal groups; interest income; income from certain of our ancillary businesses, including Gibraltar; and income from our Rental Property Joint Ventures and Gibraltar Joint Ventures. Total Assets ($ amounts in millions): “Corporate and other” is comprised principally of cash and cash equivalents, restricted cash, income taxes receivable, investments in properties held for rental apartments, expected recoveries from insurance carriers and suppliers, our Gibraltar investments and operations, manufacturing facilities, and our mortgage and title subsidiaries. Traditional Home Building North The decrease in the number of homes delivered in fiscal 2019 was mainly due to a decrease in the number of homes in backlog at October 31, 2018, as compared to the number of homes in backlog at October 31, 2017. The increase in the average price of homes delivered in fiscal 2019 was due primarily to a shift in the number of homes delivered to more expensive areas and/or products in fiscal 2019, as compared to fiscal 2018, particularly in Michigan and New Jersey. The decrease in the number of net contracts signed in fiscal 2019, as compared to fiscal 2018, was principally due to a decrease in demand in fiscal 2019, as compared to fiscal 2018. The decrease in income before income taxes in fiscal 2019 was principally attributable to lower home sales cost of revenues, as a percentage of home sale revenues, offset, in part, by lower earnings from decreased home sales revenues and higher SG&A costs in fiscal 2019, as compared to fiscal 2018. The decrease in home sales cost of revenues, as a percentage of home sales revenues, in fiscal 2019 was primarily due to a shift in product mix/areas to higher-margin areas and lower inventory impairment charges in fiscal 2019, as compared to fiscal 2018. Inventory impairment charges were $17.5 million in fiscal 2019, as compared to $19.7 million in fiscal 2018. During fiscal 2019, we determined that the pricing assumptions used in prior impairment reviews for one operating community located in Illinois needed to be reduced primarily because weaker-than-expected market conditions drove a lack of improvement and/or a decrease in customer demand for homes in the community. As a result of the reduction in expected sales prices, we determined that this community was impaired. Accordingly, the carrying value was written down in the fiscal 2019 period to its estimated fair value, which resulted in a charge to income before income taxes of $6.6 million. In addition, with respect to two communities located in Illinois, we decided to sell their remaining lots in bulk sales rather than sell and construct homes. As a result, the carrying values of these communities were written down to their estimated fair values, which resulted in a charge to income before income taxes of $4.9 million in fiscal 2019. During fiscal 2018, we determined that the pricing assumptions used in prior impairment reviews for one operating community located in Connecticut needed to be reduced, primarily due to a lack of improvement and/or a decrease in customer demand as a result of weaker than expected market conditions. As a result of the reduction in expected sales prices, we determined that this community was impaired. Accordingly, its carrying value was written down to its estimated fair value, which resulted in a charge to income before income taxes of $12.0 million in fiscal 2018. In addition, with respect to two communities located in Illinois and Minnesota, we decided to sell their remaining lots in bulk sales rather than sell and construct homes. As a result, the carrying values of these communities were written down to their estimated fair values, which resulted in a charge to income before income taxes of $4.4 million in fiscal 2018. Mid-Atlantic The decrease in the number of homes delivered in fiscal 2019 was mainly due to lower backlog conversion in fiscal 2019, as compared to fiscal 2018. The increase in the average price of homes delivered in fiscal 2019 was primarily due to a shift in the number of homes delivered to more expensive areas and/or products in fiscal 2019, as compared to fiscal 2018. The decrease in the number of net contracts signed in fiscal 2019 was principally due to a decrease in the average number of selling communities in fiscal 2019, as compared to fiscal 2018. The increase in the average value of each contract signed in fiscal 2019 was mainly due to shifts in the number of contracts signed to more expensive areas and/or products in fiscal 2019, as compared to fiscal 2018. The decrease in income before income taxes in fiscal 2019 was mainly due to increases in home sales costs of revenues, as a percentage of home sale revenues; lower earnings on decreased home sales revenues; and increases in SG&A costs in fiscal 2019, as compared to fiscal 2018. This decrease was partially offset by a $4.0 million impairment charge recognized in fiscal 2018 related to one Land Development Joint Venture located in Maryland. The increase in home sales costs of revenues, as a percentage of home sale revenues, in fiscal 2019 was primarily due to higher material and labor costs in fiscal 2019, as compared to fiscal 2018. Inventory impairment charges were $8.5 million and $9.8 million in fiscal 2019 and 2018, respectively. During our review of operating communities for impairment in fiscal 2019, we determined that the pricing assumptions used in prior impairment reviews for two operating communities located in Pennsylvania needed to be reduced primarily because weaker-than-expected market conditions drove a lack of improvement and/or a decrease in customer demand for homes in the community. As a result of the reduction in expected sales prices, we determined that these communities were impaired. Accordingly, the carrying value of these communities were written down to their estimated fair values, which resulted in a charge to income before income taxes of $8.0 million in fiscal 2019. In fiscal 2018, we decided to sell a portion of the lots in a bulk sale in one community located in Maryland, primarily due to increases in site costs and a lack of improvement in customer demand as a result of weaker than expected market conditions. The carrying value of this community was written down to its estimated fair value resulting in a charge to income before income taxes in fiscal 2018 of $6.7 million. South The increase in the number of homes delivered in fiscal 2019 was mainly due to the delivery of 137 homes in metropolitan Atlanta, Georgia and several markets in South Carolina from the Sharp and Sabal acquisitions; an increase in the number of homes in backlog at October 31, 2018, as compared to the number of homes in backlog at October 31, 2017; and higher backlog conversion in fiscal 2019, as compared to fiscal 2018. The decrease in the average price of homes delivered in fiscal 2019 was primarily due to a shift in the number of homes delivered to less expensive areas and/or products in fiscal 2019, as compared to fiscal 2018. The increase in the number of net contracts signed in fiscal 2019 was mainly due to contracts we signed in the metropolitan Atlanta, Georgia market and several markets in South Carolina in fiscal 2019 and an increase in the number of selling communities, primarily in Florida, in fiscal 2019, as compared to fiscal 2018, offset, in part, by decreased demand. The decrease in the average value of each contract signed in fiscal 2019 was mainly due to shifts in the number of contracts signed to less expensive areas and/or products in fiscal 2019, as compared to fiscal 2018. The increase in income before income taxes in fiscal 2019 was principally due to higher earnings from increased home sales revenues, offset, in part, by higher cost of home sales revenues, as a percentage of home sales revenues. The increase in home sales cost of revenues, as a percentage of home sales revenues, in fiscal 2019 was primarily due to higher material and labor costs and a shift in product mix/areas to lower-margin areas in fiscal 2019, as compared to fiscal 2018. Inventory impairment charges were $9.5 million and $3.8 million in fiscal 2019 and 2018, respectively. During fiscal 2019, we decided to sell the remaining lots in a bulk sale in one community located in Texas rather than sell and construct homes, primarily due to a lack of improvement and/or a decrease in customer demand. As a result, the carrying value of this community was written down to its estimated fair value, which resulted in a charge to income before income taxes of $1.5 million in fiscal 2019. In addition, we terminated three purchase agreements to acquire land parcels in Texas and forfeited the deposit balances outstanding. We wrote off the deposits resulting in a charges to income before income taxes of $4.2 million in fiscal 2019. West The decrease in the number of homes delivered in fiscal 2019 was mainly due to lower backlog conversion in fiscal 2019, as compared to fiscal 2018. The increase in the average price of homes delivered in fiscal 2019 was primarily due to a shift in the number of homes delivered to more expensive areas and/or products and price increases in fiscal 2019, as compared to fiscal 2018. The increase in the number of net contracts signed in fiscal 2019 was principally due to an increase in the average number of selling communities in fiscal 2019, as compared to fiscal 2018, and an increase in demand, primarily in the fourth quarter of fiscal 2019. The increase in the average value of each contract signed in fiscal 2019 was mainly due to a shift in the number of contracts signed to more expensive areas and/or products in fiscal 2019, as compared to fiscal 2018. The decrease in income before income taxes in fiscal 2019 was due mainly to higher SG&A costs; higher home sales cost of revenues, as a percentage of home sales revenues; and lower earnings from decreased revenues, in fiscal 2019, as compared to fiscal 2018. The increase in home sales cost of revenues, as a percentage of home sales revenues, was primarily due to a shift in product mix/areas to lower-margin areas in fiscal 2019, as compared to fiscal 2018. California The decrease in the number of homes delivered in fiscal 2019 was mainly due to lower backlog conversion in fiscal 2019, as compared to fiscal 2018, offset, in part, by the increased number of homes in backlog at October 31, 2018, as compared to the number of homes in backlog at October 31, 2017. The increase in the average price of homes delivered in 2019 was primarily due to a shift in the number of homes delivered to more expensive areas and/or products and increased selling prices of homes delivered in fiscal 2019, as compared to fiscal 2018. The decrease in the number of net contracts signed in fiscal 2019 was principally due to a decrease in demand and reduced availability of lots in fiscal 2019, as compared to fiscal 2018. The increase in the average value of each contract signed in fiscal 2019 was mainly due to a shift in the number of contracts signed to more expensive areas and/or products in fiscal 2019, as compared to fiscal 2018. The decrease in income before income taxes in fiscal 2019 was primarily due to lower earnings from the decreased home sales revenues and higher home sales cost of revenues, as a percentage of home sales revenues, in fiscal 2019, as compared to fiscal 2018, partially offset by lower SG&A costs in fiscal 2019. The increase in home sales cost of revenues, as a percentage of home sales revenues, was primarily due to a shift in product mix/areas to lower-margin areas in fiscal 2019, as compared to fiscal 2018, and a $7.0 million benefit in fiscal 2018 from the reversal of an accrual related to the Shapell acquisition that has expired. City Living The increase in the number of homes delivered in fiscal 2019 was mainly attributable to homes delivered at a building located in Jersey City, New Jersey, which commenced deliveries in the fourth quarter of fiscal 2018. The decrease in the average price of homes delivered in fiscal 2019 was primarily due to a shift in the number of homes delivered to less expensive buildings in fiscal 2019, as compared to fiscal 2018, offset, in part, by the delivery of two homes in fiscal 2019 in a building located in New York City, New York, where the average price was $13.6 million. In fiscal 2019 and 2018, 7% and 37%, respectively, of the units delivered were located in New York City, where average home prices were higher. The decrease in the number of net contracts signed in fiscal 2019 was primarily due to a decrease in demand. The decrease in the average sales price of net contracts signed in fiscal 2019, as compared to fiscal 2018, was principally due to a shift to less expensive units in fiscal 2019, as compared to fiscal 2018, offset, in part, by the sale of two home in fiscal 2019 period in a building located in New York City, New York, where the average price was $13.6 million. The decrease in income before income taxes in fiscal 2019 was mainly due to lower earnings from decreased home sales revenues and a decrease in earnings from our investments in unconsolidated entities, in fiscal 2019, as compared to fiscal 2018. This decrease was partially offset by lower home sales cost of revenues, as a percentage of home sale revenues, in fiscal 2019. The lower home sales cost of revenues, as a percentage of home sale revenues, in fiscal 2019 was due primarily to a shift in the number of homes delivered to buildings with higher margins; a state reimbursement of previously expensed environmental clean-up costs received in fiscal 2019; a benefit in fiscal 2019 from the reversal of accruals for certain HOA turnovers that were no longer required; and lower interest costs in fiscal 2019, as compared to fiscal 2018. These decreases were offset, in part, by impairment charges of $4.8 million in fiscal 2019. As a result of decreased demand, we wrote down the carrying value of units in two buildings, located in Maryland and New York, New York, to their estimated fair value, which resulted in impairment charges of $4.8 million in fiscal 2019. In fiscal 2019, earnings from our investments in unconsolidated entities decreased $2.8 million as compared to fiscal 2018. This decrease was primarily due a shift in the number of homes delivered to buildings with lower margins and a shift in the number of homes delivered in joint ventures where our ownership percentage was lower in fiscal 2019, as compared to fiscal 2018. The tables below provide information related to deliveries, home sales revenues and net contracts signed by our City Living Home Building Joint Ventures, for the periods indicated, and the related backlog for the dates indicated ($ amounts in millions): Corporate and other In fiscal 2019 and 2018, loss before income taxes was $143.9 million and $109.2 million, respectively. The increase in the loss before income taxes in fiscal 2019 was principally attributable to $67.2 million of gains recognized in fiscal 2018 from asset sales by our Rental Property Joint Ventures located in College Park, Maryland, Herndon, Virginia, and Westborough, Massachusetts; a $10.7 million gain from a bulk sale of security monitoring accounts by our home control solutions business in fiscal 2018; an increase in losses in several Rental Property Joint Ventures due to the commencement of operations and lease up activities in fiscal 2019; and higher SG&A costs in fiscal 2019 compared to fiscal 2018. These increases were partially offset by gains recognized of $35.1 million from the sale of seven golf clubs in fiscal 2019; a $9.3 million gain recognized from the sales of land to newly formed Rental Property Joint Ventures in fiscal 2019; a $3.8 million gain recognized in fiscal 2019 from an asset sale by a Rental Property Joint Venture in Phoenixville, Pennsylvania; and higher interest income in fiscal 2019.

<s>[INST] When this report uses the words “we,” “us,” “our,” and the “Company,” they refer to Toll Brothers, Inc. and its subsidiaries, unless the context otherwise requires. References herein to fiscal year refer to our fiscal years ended or ending October 31. Unless otherwise stated in this report, net contracts signed represents a number or value equal to the gross number or value of contracts signed during the relevant period, less the number or value of contracts canceled during the relevant period, which includes contracts that were signed during the relevant period and in prior periods. Backlog consists of homes under contract but not yet delivered to our home buyers (“backlog”). Backlog conversion represents the percentage of homes delivered in the period from backlog at the beginning of the period (“backlog conversion”). This discussion and analysis does not address certain items in respect of fiscal 2017 in reliance on amendments to disclosure requirements adopted by the SEC in 2019. A discussion and analysis of fiscal 2017 may be found in Item 7. Management’s Discussion and Analysis of Financial Condition and Results of Operations of our Annual Report on Form 10K for the fiscal year ended October 31, 2018, filed with the SEC on December 20, 2018. OVERVIEW Our Business We design, build, market, sell, and arrange financing for an array of luxury residential singlefamily detached, attached home, master planned resortstyle golf, and urban low, mid, and highrise communities, principally on land we develop and improve, as we continue to pursue our strategy of broadening our product lines, price points and geographic footprint. We cater to luxury firsttime, moveup, emptynester, activeadult, affordable luxury and secondhome buyers in the United States (“Traditional Home Building Product”), as well as urban and suburban renters. We also design, build, market, and sell urban low, mid, and highrise condominiums through Toll Brothers City Living® (“City Living”). At October 31, 2019, we were operating in 23 states, as well as in the District of Columbia. In the five years ended October 31, 2019, we delivered 35,146 homes from 724 communities, including 8,107 homes from 426 communities in fiscal 2019. At October 31, 2019, we had 715 communities containing approximately 59,200 home sites that we owned or controlled through options. We are developing several land parcels for master planned communities in which we intend to build homes on a portion of the lots and sell the remaining lots to other builders. Two of these master planned communities are being developed 100% by us, and the remaining communities are being developed through joint ventures with other builders or financial partners. In addition to our residential forsale business, we also develop and operate forrent apartments through joint ventures. See the section entitled “Toll Brothers Apartment Living/Toll Brothers Campus Living” below. We operate our own architectural, engineering, mortgage, title, land development, golf course development, and landscaping subsidiaries. We also operate our own security company, TBI Smart Home Solutions, which provides homeowners with home automation and a full range of technology options. In addition, we operate our own lumber distribution, house component assembly, and manufacturing operations. We have investments in various unconsolidated entities. We have investments in joint ventures (i) to develop land for the joint venture participants and for sale to outside builders (“Land Development Joint Ventures”); (ii) to develop forsale homes (“Home Building Joint Ventures”); (iii) to develop luxury forrent residential apartments, commercial space and a hotel (“Rental Property Joint Ventures”); and (iv) to invest in distressed loans and real estate and provide financing and land banking for residential builders and developers for the acquisition and development of land and home sites (“Gibraltar Joint Ventures”). Financial Highlights In fiscal 2019, we recognized $7.08 billion of home sales revenues and net income of $590.0 [/INST] Negative. </s>

SHENANDOAH TELECOMMUNICATIONS CO/VA/

2015-02-27

2014-12-31

ITEM 7. MANAGEMENT'S DISCUSSION AND ANALYSIS OF FINANCIAL CONDITION AND RESULTS OF OPERATIONS This annual report contains forward-looking statements within the meaning of Section 27A of the Securities Act of 1933 and Section 21E of the Securities Exchange Act of 1934, including statements regarding our expectations, hopes, intentions, or strategies regarding the future. These statements are subject to certain risks and uncertainties that could cause actual results to differ materially from those anticipated in the forward-looking statements. Factors that might cause such a difference include those discussed in this report under “Business-Competition” and “Risk Factors.” The Company undertakes no obligation to publicly revise these forward-looking statements to reflect subsequent events or circumstances, except as required by law. General Overview. Shenandoah Telecommunications Company is a diversified telecommunications company providing both regulated and unregulated telecommunications services through its wholly owned subsidiaries. These subsidiaries provide wireless personal communications services (as a Sprint PCS affiliate), local exchange telephone services, video, internet and data services, long distance services, fiber optics facilities, and leased tower facilities. The Company has three reportable segments, which the Company operates and manages as strategic business units organized by lines of business: (1) Wireless, (2) Cable, and (3) Wireline. * The Wireless segment provides digital wireless service as a Sprint PCS Affiliate to a portion of a four-state area covering the region from Harrisburg, York and Altoona, Pennsylvania, to Harrisonburg, Virginia. In this area, the Company is the exclusive provider of wireless mobility communications network products and services on the 800 and 1900 MHz bands under the Sprint brand. This segment also owns cell site towers built on leased land, and leases space on these towers to both affiliates and non-affiliated service providers. * The Cable segment provides video, internet and voice services in franchise areas in portions of Virginia, West Virginia and western Maryland, and leases fiber optic facilities throughout its service area. It does not include video, internet and voice services provided to customers in Shenandoah County, Virginia. * The Wireline segment provides regulated and unregulated voice services, DSL internet access, and long distance access services throughout Shenandoah County and portions of Rockingham, Frederick, Warren and Augusta counties, Virginia. The segment also provides video services in portions of Shenandoah County, and leases fiber optic facilities throughout the northern Shenandoah Valley of Virginia, northern Virginia and adjacent areas along the Interstate 81 corridor through West Virginia, Maryland and portions of Pennsylvania. A fourth segment, Other, primarily includes Shenandoah Telecommunications Company, the parent holding company. Significant Transactions The 2014, 2013 and 2012 financial results of the Company reflected several significant transactions. These transactions should be noted in understanding the financial results of the Company for 2014, 2013 and 2012. Segment Restructuring Effective for fiscal year 2014, the Company updated segment presentations to reflect two changes. First, in late 2013, the Company restructured its management team to primarily align its organization with its operating segments (Wireless, Cable and Wireline), rather than on a functional basis (sales and marketing, operations and engineering). As part of this restructuring, the Company determined that the operations associated with its video product offered in Shenandoah County, Virginia, would be included in the Wireline segment. The video services offered in Shenandoah County share much of the network which the regulated telephone company uses to serve its customers. These services had previously been included in the Cable segment. Second, primarily as a result of the restructuring described above, the Company’s allocations of certain shared general and administrative expenses were updated to reflect how the senior management team makes financial decisions and manages resources. Since the Vice Presidents managing the operating segments do not directly control these expenses, the Company has chosen to record these at the holding company. As a result, certain costs, including finance and accounting, executive management, legal, human resources, and IT management are now recorded to the Other segment as corporate costs. In this way, segment performance presents a clearer picture of the trends in an individual segment’s profitability. The 2013 and 2012 results have been adjusted to conform to the 2014 presentation. Network Vision In February 2012, the Company amended its Management Agreement with Sprint in connection with the Company’s commitment to build a 4G LTE network in the Company’s service area. Replacement of base stations began in May 2012, proceeded slowly through that August, and accelerated that fall. During 2012, the Company completed upgrades to 200 base stations, and during 2013, completed upgrades to substantially all of its 526 total base stations. Based upon the initial timetable and revisions, the Company determined that changes to the remaining depreciable lives for base stations and certain other assets were required, adding $8.4 million of additional depreciation expense to 2012’s results and $3.4 million to 2013. The 4G LTE base stations require either fiber or microwave backhaul. Accordingly, the Company replaced the copper-based T1 circuits it previously had with fiber and microwave technology. In addition to incurring the costs to install the new backhaul facilities, the Company incurred duplicate network costs during the replacement period for each base station, and higher monthly costs of the higher capacity circuits (though much less expensive per megabit of capacity) following the upgrade. However, the additional capacity of the new fiber-based backhaul facilities will delay the need to further upgrade its capacity to accommodate additional network traffic. During 2013, based upon Company projections, the Company determined that microwave equipment used to backhaul wireless traffic from approximately 150 of its cell sites would be inadequate to carry its traffic by 2016, and accordingly, reduced the remaining useful life of this class of assets. As of December 31, 2014, the Company expects to replace microwave backhaul facilities that it deployed at approximately 100 of its cell sites with fiber-based backhaul facilities in 2015 or 2016. Revision of Prepaid Cost Pass-throughs In July 2010, the Company executed an amendment to its Management Agreement with Sprint to allow the Company to participate in Sprint’s prepaid wireless offerings. The amendment specified that the revenue and cost per unit (per average subscriber or per gross addition or upgrade, as defined) as determined by Sprint on a national basis would be passed through to the Company. In December 2012, Sprint determined it had incorrectly calculated certain cost pass-throughs from inception of the Company’s participation, and reimbursed the Company for $11.8 million to correct its errors from July 2010 through September 2012. The Company recognized this receipt as a reduction of expenses in the quarter and year ended December 31, 2012. Approximately $6.1 million of this adjustment related to miscalculations of costs incurred in 2010 and 2011. Goodwill Impairment During 2012, the Company determined that the fair value of the Company’s then-configured Cable segment had declined during the year, and that the goodwill had become impaired. As a result the Company recorded an $11.0 million write-down of Cable segment in December of 2012. Factors contributing to these determinations included weak economic conditions, underperformance relative to market operating margins and penetration levels, and continued capital spending to upgrade the last remaining markets, improve the customer experience, and combat subscriber loss. In conjunction with the Segment Restructuring discussed above, $3.3 million of the write-down is now presented in the 2012 results of the Wireline Segment. Critical Accounting Policies The Company relies on the use of estimates and makes assumptions that affect its financial condition and operating results. These estimates and assumptions are based on historical results and trends as well as the Company's forecasts as to how these might change in the future. The most critical accounting policies that materially affect the Company's results of operations include the following: Revenue Recognition The Company recognizes revenue when persuasive evidence of an arrangement exists, services have been rendered or products have been delivered, the price to the buyer is fixed and determinable and collectability is reasonably assured. Revenues are recognized by the Company based on the various types of transactions generating the revenue. For services, revenue is recognized as the services are performed. For equipment sales, revenue is recognized when the sales transaction is complete. Under the Sprint Management Agreement, postpaid wireless service revenues are reported net of an 8% Management Fee and, since its imposition effective January 1, 2007, a Net Service Fee retained by Sprint. Initially set at 8.8%, the Net Service Fee increased to 12% during 2010 and to 14%, the maximum allowed, in August 2013. Prepaid wireless service revenues are reported net of a 6% Management Fee. Allowance for Doubtful Accounts Estimates are used in determining the allowance for doubtful accounts and are based on historical collection and write-off experience, current trends, credit policies, and the analysis of the accounts receivable by aging category. In determining these estimates, the Company compares historical write-offs in relation to the estimated period in which the subscriber was originally billed. The Company also looks at the historical average length of time that elapses between the original billing date and the date of write-off and the financial position of its larger customers in determining the adequacy of the allowance for doubtful accounts. From this information, the Company assigns specific amounts to the aging categories. The Company provides an allowance for all receivables over 60 days old and partial allowances for all other receivables. The Company does not carry an allowance for receivables related to Sprint PCS customers. In accordance with the terms of the affiliate contract with Sprint, the Company receives payment from Sprint for the monthly net billings to PCS customers in weekly installments over the following four or five weeks. Income Taxes Income taxes are accounted for under the asset and liability method. Deferred tax assets and liabilities are recognized for the future tax consequences attributable to differences between financial statement carrying amounts of existing assets and liabilities and their respective tax bases. Deferred tax assets and liabilities are measured using enacted tax rates expected to apply to taxable income in the years in which those temporary differences are expected to be recovered or settled. The effect on deferred tax assets and liabilities of a change in tax rates is recognized in income in the period that includes the enactment date. The Company evaluates the recoverability of deferred tax assets generated on a state-by-state basis from net operating losses apportioned to that state. Management uses a more likely than not threshold to make the determination if a valuation allowance is warranted for tax assets in each state. Management evaluates the effective rate of taxes based on apportionment factors, the Company’s operating results, and the various state income tax rates. Leases The Company recognizes rent expense on a straight-line basis over the initial lease term and renewal periods that are reasonably assured at the inception of the lease. In light of the Company’s investment in each leased site, including acquisition costs and leasehold improvements, the Company includes the exercise of certain renewal options in the recording of operating leases. Where the Company is the lessor, the Company recognizes revenue on a straight line basis over the non-cancelable term of the lease. Long-lived Assets The Company views the determination of the carrying value of long-lived assets as a critical accounting estimate since the Company must determine an estimated economic useful life in order to properly amortize or depreciate long-lived assets and because the Company must consider if the value of any long-lived assets have been impaired, requiring adjustment to the carrying value. Economic useful life is the duration of time the asset is expected to be productively employed by us, which may be less than its physical life. The Company’s assumptions on obsolescence, technological advances, and other factors affect the determination of estimated economic useful life. The estimated economic useful life of an asset is monitored to determine if it continues to be appropriate in light of changes in business circumstances. For example, technological advances may result in a shorter estimated useful life than originally anticipated. In such a case, the Company would depreciate the remaining net book value of the asset over the new estimated remaining life, increasing depreciation expense on a prospective basis. During 2013, based upon Company projections, the Company determined that microwave equipment used to backhaul wireless traffic from approximately 150 of its cell sites would be inadequate to carry its traffic by 2016, and accordingly, reduced the remaining useful life of this class of assets. Additional depreciation expense was $1.2 million in 2014 and was not significant in 2013. Intangible Assets Cable franchises, included in Intangible assets, net, provide us with the non-exclusive right to provide video services in a specified area. While some cable franchises are issued for a fixed time (generally 10 years), renewals of cable franchises have occurred routinely and at nominal cost. Moreover, we have determined that there are currently no legal, regulatory, contractual, competitive, economic or other factors that limit the useful lives of our cable franchises. Cable franchise rights and other intangible assets with indefinite lives are not amortized but are tested at least annually for impairment. The testing is performed on the value as of November 30 each year, and is generally composed of comparing the book value of the assets to their estimated fair value. Cable franchises are tested for impairment on an aggregate basis, consistent with the management of the Cable segment as a whole, utilizing a greenfield valuation approach. It is the Company’s practice to engage an independent appraiser to prepare these fair value analyses. Intangible assets that have finite useful lives are amortized over their useful lives. Acquired subscriber base assets are amortized using accelerated amortization methods over the expected period in which those relationships are expected to contribute to our future cash flows. Other finite-lived intangible assets are generally amortized using the straight-line method of amortization. Other The Company does not have any unrecorded off-balance sheet transactions or arrangements; however, the Company has significant commitments under operating leases. Results of Continuing Operations 2014 Compared to 2013 Consolidated Results The Company’s consolidated results from continuing operations for the years ended December 31, 2014 and 2013 are summarized as follows: Operating revenues Operating revenues increased $18.0 million, or 5.8%, in 2014 over 2013. Wireless segment revenues increased $9.3 million compared to 2013. The Wireless revenue growth included an increase in net postpaid service revenues of $5.0 million, driven by 4.7% year-over-year growth in average postpaid subscribers. In addition, net prepaid service revenues grew $3.2 million, or 7.9%, due to 4.9% growth in average prepaid subscribers and higher average revenue per subscriber in 2014 over 2013. Cable segment revenues increased $8.7 million. Cable service revenues grew $5.3 million due to a 6.4% increase in average revenue generating units compared to the 2013 period and to customers selecting higher-priced digital TV and higher-speed data packages. Cable equipment revenues increased $2.3 million due to a change in January 2014 of charging customers separately for their first set top box, which previously had been included in the service fee. Additionally, customer use of digital converter boxes grew as the Company converted markets to all-digital signals. Growth in fiber lease revenue contributed $0.6 million to the year-over-year increase of Cable segment revenue. Wireline segment revenue increased $3.6 million, primarily due to growth in facility lease revenues from new contracts with affiliates and third parties. Operating expenses Total operating expenses increased $11.5 million in 2014 compared to 2013. Cost of goods and services sold increased $4.6 million, including increases of $3.3 million in Cable segment video programming costs and $1.7 million in network maintenance costs. Disposal costs increased $1.6 million, as the Company disposed of obsolete equipment that had been taken out of service while upgrading the cable and wireline networks. The increase in disposal costs was offset by reductions in network costs, driven primarily by lower third party backhaul expenses along with an increase in network engineering labor capitalized to projects. Selling, general and administrative expenses increased $1.7 million, due to higher personnel costs, partially offset by lower advertising and bad debt expenses. Depreciation and amortization expense increased $5.2 million, primarily due to completion of the Network Vision and cable network upgrade projects. Income tax expense The Company’s effective tax rate decreased from 40.2% in 2013 to 39.5% in 2014. The 2013 period included $0.5 million in unfavorable adjustments from finalizing the estimated effects of restructuring entities during 2012. The 2014 period included $0.2 million in favorable adjustments to estimates made for the 2013 federal and state returns filed in September 2014. The Company anticipates that its effective tax rate will be approximately 39.5% in 2015. Net income Net income increased $4.3 million, or 14.5%, in 2014 from 2013, reflecting growth in subscriber counts and revenue per subscriber in the Wireless segment, partially offset by increases in operating expenses incurred in support of this growth. Wireless The Company’s Wireless segment provides digital wireless service to a portion of a four-state area covering the region from Harrisburg, York and Altoona, Pennsylvania, to Harrisonburg, Virginia, through Shenandoah Personal Communications, LLC (“PCS”), a Sprint PCS Affiliate. This segment also leases land on which it builds Company-owned cell towers, which it leases to affiliated and non-affiliated wireless service providers, throughout the same four-state area described above, through Shenandoah Mobile, LLC (“Mobile”). PCS receives revenues from Sprint for subscribers that obtain service in PCS’s network coverage area. PCS relies on Sprint to provide timely, accurate and complete information to record the appropriate revenue for each financial period. Postpaid revenues received from Sprint are recorded net of certain fees retained by Sprint. These fees totaled 20% of net postpaid billed revenue, as defined, during 2012 and through July 31, 2013. Based upon an analysis of the balance of payments between Sprint and Shentel, effective August 1, 2013, Sprint increased the net service fee to 14%, bringing the total fee retained by Sprint to 22%. During the first quarter of 2012, the Company entered into agreements with Sprint and Alcatel-Lucent to begin adding 4G LTE service to the Company’s Wireless network. The 4G service uses base station equipment acquired from Alcatel-Lucent in conjunction with Sprint’s wireless network upgrade plan known as Network Vision. The Company offers prepaid wireless products and services in its PCS network coverage area. Sprint retains a 6% Management Fee on prepaid revenues. Prepaid revenues received from Sprint are reported net of the cost of this fee. Other fees charged on a per unit basis are separately recorded as expenses according to the nature of the expense. The Company pays handset subsidies to Sprint for the difference between the selling price of prepaid handsets and their cost, in aggregate and as a net cost included in cost of goods sold. The revenue and expense components reported to us by Sprint are based on Sprint’s national averages for prepaid services, rather than being specifically determined by customers assigned to our geographic service areas. During 2014, the Company’s PCS stores began participating in Sprint’s postpaid handset financing programs, whereby Sprint enters into a financing agreement with the subscriber and the subscriber receives a handset from Sprint. The equipment revenue from the subscriber and the handset expense are Sprint’s responsibility and are not recorded by the Company. The following tables show selected operating statistics of the Wireless segment as of the dates shown: 1) POPS refers to the estimated population of a given geographic area and is based on information purchased from third party sources. Market POPS are those within a market area which the Company is authorized to serve under its Sprint PCS affiliate agreements, and Covered POPS are those covered by the Company’s network. Covered POPS increased in 2014 primarily as a result of the Company’s deployment of the 800 megahertz spectrum at existing cell sites. 2) The decrease from December 31, 2013 is primarily a result of termination of Sprint iDEN leases associated with the former Nextel network. 3) PCS Average Monthly Retail Churn is the average of the monthly subscriber turnover, or churn, calculations for the period. Operating revenues Wireless service revenue increased $8.2 million, or 4.5%, for 2014 over 2013. Net postpaid service revenues increased $5.0 million, or 3.5%, driven by 4.7% year-over-year growth in average postpaid subscribers. As stated above, the net service fee increased from 12% of net billed revenues to 14% on August 1, 2013, reducing net postpaid service revenue by $2.1 million, or approximately $0.3 million per month. Net prepaid service revenues grew $3.2 million, or 7.9%. Average prepaid subscribers increased 4.9% in 2014 over 2013, with changes in the mix of subscribers accounting for the remainder of the increase in prepaid service revenues. The decrease in tower lease revenue resulted from the termination of Sprint iDEN leases associated with the former Nextel network. Equipment revenue increased due to growth in accessories sales and lower discounts on handset sales. Other revenue increased, as the prior year period included a $0.8 million unfavorable adjustment to straight-line rent accruals related to the termination of iDEN leases. Operating expenses Cost of goods and services increased $0.3 million, or 0.4%, in 2014 from 2013. Network costs increased $1.1 million, driven by increases in rent and backhaul expenses associated with the Network Vision project. Maintenance expense grew $1.0 million due to increases in maintenance contracts that support the upgraded wireless network. Cost of services declined by $0.8 million, driven by lower costs to support WiMax subscribers and prepaid “top-up” services. Cost of goods declined due to a one-time $0.4 million gain related to actual disposal costs for the Network Vision project being less than previously accrued. Handset costs declined $0.3 million as a lower volume of subsidized handsets, driven by the start of installment handset sales in 2014, was partially offset by higher handset costs. Selling, general and administrative costs increased $0.4 million, or 1.1%, in 2014 over 2013 primarily due to the additional retail store personnel to support subscriber growth. Depreciation and amortization increased $2.9 million, or 10.4%, in 2014 over 2013, following completion of Network Vision upgrades. Cable The Cable segment provides video, internet and voice services in franchise areas in portions of Virginia, West Virginia and western Maryland, and leases fiber optic facilities throughout its service area. It does not include video, internet and voice services provided to customers in Shenandoah County, Virginia. The following table shows selected operating statistics of the Cable segment as of the dates shown: 1) Homes and businesses are considered passed (“homes passed”) if we can connect them to our distribution system without further extending the transmission lines. Homes passed is an estimate based upon the best available information. 2) Customer relationships represent the number of customers who receive at least one of our services. 3) Generally, a dwelling or commercial unit with one or more television sets connected to our distribution system counts as one video customer. Where services are provided on a bulk basis, such as to hotels, universities and some multi-dwelling units, the revenue charged to the customer is divided by the rate for comparable service in the local market to determine the number of customer equivalents included in the customer counts shown above. 4) Penetration is calculated by dividing the number of customers by the number of homes passed or available homes, as appropriate. 5) Digital video penetration is calculated by dividing the number of digital video customers by total video customers. Digital video customers are video customers who receive any level of video service via digital transmission. A dwelling with one or more digital set-top boxes or digital adapters counts as one digital video customer. 6) Homes and businesses are considered available (“available homes”) if we can connect them to our distribution system without further extending the transmission lines and if we offer the service in that area. 7) Revenue generating units are the sum of video, voice and high-speed internet customers. 8) Fiber miles are measured by taking the number of fiber strands in a cable and multiplying that number by the route distance. For example, a 10 mile route with 144 fiber strands would equal 1,440 fiber miles. Fiber counts were revised following a review of fiber records in the fourth quarter of 2014. Operating revenues Cable segment service revenue increased $5.3 million, or 8.1%, due to a 6.4% increase in average revenue generating units, a video rate increase in January 2014, and customers selecting higher-priced digital TV services and higher-speed data access packages. Growth in equipment and other revenue was driven primarily by a $2.3 million increase in equipment rents, due to a change in January 2014 of charging customers separately for their first set top box, which previously had been included in the service fee. Additionally, customer use of digital converter boxes grew as the Company converted markets to all-digital signals. Facility lease revenue grew $0.6 million due to new contracts with third parties. Installation revenue increased $0.2 million. Operating expenses Cable segment cost of goods and services increased $6.2 million, or 13.6%, in 2014 over 2013. Video programming costs increased $3.3 million as the impact of rising rates per subscriber outpaced declining video subscriber counts. Asset disposal costs increased $1.4 million, as the Company disposed of obsolete equipment that was removed from service while upgrading the network. Maintenance costs increased $0.7 million to support network growth and personnel costs increased $0.5 million. Selling, general and administrative expenses grew $0.5 million against the prior year as increases in costs related to customer service and administrative functions were partially offset by reductions of $0.3 million in marketing and selling expense and $0.1 million in bad debt expense. The increase in depreciation and amortization expense consists of $3.1 million of higher depreciation expense related to network upgrades, offset by lower amortization on the customer base intangible asset recorded when the cable markets were acquired. The amortization of this asset declines on the anniversary of the acquisitions. Wireline The Wireline segment provides regulated and unregulated voice services, DSL internet access, and long distance access services throughout Shenandoah County and portions of Rockingham, Frederick, Warren and Augusta counties in Virginia. The segment also provides video services in portions of Shenandoah County, and leases fiber optic facilities throughout the northern Shenandoah Valley of Virginia, northern Virginia and adjacent areas along the Interstate 81 corridor through West Virginia, Maryland and portions of Pennsylvania. 1) Fiber miles are measured by taking the number of fiber strands in a cable and multiplying that number by the route distance. For example, a 10 mile route with 144 fiber strands would equal 1,440 fiber miles. Fiber counts were revised following a review of fiber records in the fourth quarter of 2014. Operating revenues Total operating revenues in 2014 increased $3.6 million over 2013. Increases in service revenue resulted primarily from increases in revenues to provide broadband services. The decrease in access revenue is the result of 2013 changes in certain intrastate access charges. Facility lease revenue grew $3.7 million due to additional leasing of fiber backhaul facilities to new and existing customers. Other revenue decreased $0.3 million due to the conclusion of billings for transition services to buyers of Converged Services’ properties. Operating expenses Operating expenses overall increased $2.1 million, or 4.6%, for 2014 over 2013. The increase in cost of goods and services resulted primarily from a $2.3 million increase in costs to provide the additional facilities to support the growth in facilities lease revenues described above. The disposal of obsolete and out of service assets resulted in an additional $0.5 million increase in costs. These increases were partially offset by a $0.9 million increase in labor capitalized to projects. 2013 Compared to 2012 Consolidated Results The Company’s consolidated results from continuing operations for the years ended December 31, 2013 and 2012 are summarized as follows: Operating revenues Operating revenues increased $20.9 million, or 7.2%, in 2013 over 2012, primarily due to an increase of $18.5 million in the Wireless segment and $5.0 million in the Cable segment. The increase in the Wireless segment resulted from increases in postpaid service revenues of $11.1 million and $8.9 million in prepaid service revenues. The postpaid revenues grew as a result of a 4.1% increase in subscribers during the year, and incremental data fees charged to customers with smartphones. The prepaid service revenues grew as a result of improved product mix and a 6.9% increase in prepaid customers during 2013. The Cable segment revenues grew primarily due to revenue generating unit growth of 11.7% and 22.2% in high speed data and voice service, respectively. The growth in revenue described above was partially offset by a $2.0 million increase in affiliated revenue, which is eliminated in consolidation. Operating expenses During the fourth quarter of 2012, the Company received $11.8 million from Sprint to reduce cost allocations relating to our participation in Sprint’s prepaid program beginning in July 2010 and continuing through September 30, 2012. The expense reduction reduced costs of goods and services sold by $8.4 million and selling, general and administrative expenses by $3.4 million, and reflected the recalculation of certain expenses, costs per gross addition (including the cost of handsets) and cash cost per user, associated with the program. Had Sprint calculated these costs consistently in previous years, $6.1 million of the $11.8 million would have been recorded in 2010 and 2011. Adjusting for the effect of the prepaid wireless expense reduction discussed above, operating expenses decreased $6.0 million compared to the 2012 period. Cable segment operating expenses decreased $6.3 million, due to a $7.7 million write-off of goodwill in 2012, partially offset by 2013 growth in network costs, programming costs, and costs for customer service. The adjusted Wireless segment accounted for a year over year increase of $5.6 million, principally due to increased costs to add and maintain prepaid subscribers and growth in rent and maintenance expenses associated with the rollout of LTE coverage. These Wireless segment increases were partially offset by a decrease in depreciation expense due to less accelerated depreciation on assets to be replaced by Network Vision in the current year. Wireline segment operating expenses decreased $3.2 million, due to a $3.3 million write-off of goodwill in 2012. Other income (expense) The change in other income (expense) was driven by activity in patronage income and interest expense in 2013 over 2012. Other income increased $0.8 million primarily due to higher patronage income, resulting from the changes to the Company’s banking arrangements in 2012. Interest expense grew $1.4 million in 2013 as a result of higher outstanding debt balances, and was partially offset by the 2012 write-off of $0.8 million of unamortized loan costs. Income tax expense The Company’s effective tax rate on income from continuing operations decreased from 42.0% in 2012 to 40.2% in 2013 principally due to changes undertaken in 2012 to simplify the Company’s corporate structure that reduced the impact of state taxes on the Company’s overall effective tax rate. Net income from continuing operations Net income from continuing operations increased $13.0 million in 2013 from 2012, primarily as a result of the 2012 goodwill impairment, the continued growth in the Wireless and Cable segments and the decrease in the effective tax rate. Wireless Operating revenues Wireless service revenue increased $20.0 million, or 12.3%, for 2013 over 2012. Net postpaid service revenues increased $11.1 million, driven by a $7.3 million increase in data fees and a 4.1% increase in subscribers during 2013. The net service fee retained by Sprint increased from 12% of net billed revenues to 14% on August 1, 2013, reducing net postpaid service revenue by $1.2 million, or approximately $0.2 million per month. Net prepaid service revenues grew $8.9 million, or 28.3%, due to improved product mix and 12.9% growth in average prepaid subscribers during 2013. The increase in tower lease revenue resulted primarily from rent increases related to tenants installing 4G equipment on our towers. The decrease in net equipment revenue resulted primarily from higher promotional activity during the current year. The decrease in other revenue primarily resulted from a $0.8 million adjustment to straight-line rent accruals related to termination of Sprint iDEN leases at a small number of sites and from a $0.5 million decline in federal Universal Service Fund (“USF”) revenue from Sprint. Operating expenses During the fourth quarter of 2012, the Company received $11.8 million from Sprint to correct errors in its cost allocations relating to our participation in Sprint’s prepaid program beginning in July 2010 and continuing through September 30, 2012. The expense reduction reflected the recalculation of certain expenses, including the cost of handsets, costs per gross addition and cash cost per user, associated with the program. The expense reductions for 2010 and 2011 lowered total operating expenses in 2012 by $6.1 million. Cost of goods and services Costs of goods and services increased $9.1 million, or 14.2%, in 2013 from 2012. After adjusting for the effect of the prepaid wireless expense reduction discussed above, cost of goods and services increased $4.8 million, or 7.1%, in 2013 from 2012. Costs of the expanded network coverage and roll-out of LTE coverage resulted in a $2.6 million increase in network costs, including a $3.2 million increase in rent expense, partially offset by lower backhaul expenses. Cost of goods and services related to prepaid customers increased $1.8 million, or 16.1%, in 2013 over 2012 primarily due to a 17.5% increase in the number of subsidized handsets sold. Maintenance expense increased $0.8 million due to increases in maintenance contracts that support the upgraded wireless network. Selling, general and administrative Selling, general and administrative costs increased $5.5 million, or 20.3%, in 2013 from 2012. After adjusting for the effect of the prepaid wireless expense reduction discussed above, selling, general and administrative expenses increased $3.7 million, or 12.5%, in 2013 from 2012. Costs associated with supporting the existing prepaid subscriber base increased $2.2 million due to a 12.9% increase in average prepaid subscribers and a 13.7% increase in average cost per subscriber. Costs to add new prepaid subscribers increased $1.2 million in 2013 due to a 17.5% increase in gross additions and upgrades over 2012. Commissions, advertising and professional services expenses associated with postpaid activities, increased $0.4 million in 2013 from 2012 levels. Depreciation and amortization Depreciation and amortization decreased $3.5 million in 2013 from 2012. Accelerated depreciation on assets to be replaced by Network Vision upgrades decreased from $8.4 million in the prior year to $3.4 million in 2013. The decrease in accelerated depreciation was partially offset by a 2012 favorable adjustment of $0.9 million related to asset retirement obligations associated with the upgrades. Cable Operating revenues The Cable segment service revenues increased $4.4 million in 2013 over 2012. High speed data access revenue increased $3.5 million due to an 11.7% increase in revenue generating units, while voice revenue increased $1.0 million due to a 22.2% increase in revenue generating units. Video revenue was flat, as revenue increases from video price increases and customers shifting to higher-priced digital TV packages were offset by a 3.5% decline in revenue generating units. Equipment and other revenues increased $0.6 million, or 6.3%, due to $1.1 million of increases in revenue from sales of fiber optic services and in a variety of ancillary revenues such as installation fees, advertising revenues, and other fees billed to customers. The increases were partially offset by a $0.5 million decline in revenue from modems and converters. Operating expenses Cable segment cost of goods and services increased due to $0.8 million of additional network costs to support the expansion of network capacity. Cable content cost increased $0.6 million as the impact of rising rates per subscriber outpaced declining video subscriber counts. Network maintenance costs declined $0.1 million from a prior year that included $0.8 million of storm damage costs. The Cable segment recorded a $7.7 million impairment of goodwill in the fourth quarter of 2012. Selling, general and administrative expenses increased principally due to costs for customer service and general administrative functions. The decrease in depreciation and amortization expense consists of $2.0 million lower amortization on the customer base intangible asset recorded when the cable markets were acquired. The amortization of this asset declines on the anniversary of the acquisitions. The cost reduction was partially offset by higher depreciation expense on assets placed in service. Wireline Operating revenues Operating revenues decreased $0.6 million, or 1.1%, in 2013 from 2012. The increase in service revenue resulted primarily from contracts to provide internet access to third parties. The decrease in access revenues resulted from a $0.5 million reversal of previously recorded revenues as a result of settling a billing dispute, along with changes to certain intrastate access charges. Facility lease revenue increased due to the addition of affiliate and non-affiliated leased circuits for fiber to the tower, to support voice services in the acquired cable markets, as well as service contracts to other customers. Other revenue decreased due to the conclusion of billings for transition services to buyers of Converged Services’ properties (coupled with a corresponding decrease in costs of goods and services mentioned below). Operating expenses Operating expenses overall decreased $3.2 million, or 6.6%, in 2013, compared to 2012. In the fourth quarter of 2012, the Wireline segment recorded a $3.3 million impairment of goodwill related to its legacy cable business. The decrease in cost of goods and services resulted from the conclusion of costs to provide service to the new owners of transitioning Converged Services properties. Partially offsetting the decrease were the costs to provide services to PCS, Shenandoah Cable and other customers, related to the increases in revenue shown above. The increase in depreciation resulted from additions to switch and circuit equipment in support of fiber and other service contract revenue increases as discussed above. The increase in selling, general and administrative expenses resulted from increased bad debt charges and operating taxes, partially offset by lower customer service costs, each of which was less than $0.2 million. Non-GAAP Financial Measure In managing our business and assessing our financial performance, management supplements the information provided by financial statement measures prepared in accordance with GAAP with adjusted OIBDA, which is considered a “non-GAAP financial measure” under SEC rules. Adjusted OIBDA is defined by us as operating income (loss) before depreciation and amortization, adjusted to exclude the effects of: certain non-recurring transactions; impairment of assets; gains and losses on asset sales; and share based compensation expense. Adjusted OIBDA should not be construed as an alternative to operating income as determined in accordance with GAAP as a measure of operating performance. In a capital-intensive industry such as telecommunications, management believes that adjusted OIBDA and the associated percentage margin calculations are meaningful measures of our operating performance. We use adjusted OIBDA as a supplemental performance measure because management believes it facilitates comparisons of our operating performance from period to period and comparisons of our operating performance to that of other companies by excluding potential differences caused by the age and book depreciation of fixed assets (affecting relative depreciation expenses) as well as the other items described above for which additional adjustments were made. In the future, management expects that the Company may again report adjusted OIBDA excluding these items and may incur expenses similar to these excluded items. Accordingly, the exclusion of these and other similar items from our non-GAAP presentation should not be interpreted as implying these items are non-recurring, infrequent or unusual. While depreciation and amortization are considered operating costs under generally accepted accounting principles, these expenses primarily represent the current period allocation of costs associated with long-lived assets acquired or constructed in prior periods, and accordingly may obscure underlying operating trends for some purposes. By isolating the effects of these expenses and other items that vary from period to period without any correlation to our underlying performance, or that vary widely among similar companies, management believes adjusted OIBDA facilitates internal comparisons of our historical operating performance, which are used by management for business planning purposes, and also facilitates comparisons of our performance relative to that of our competitors. In addition, we believe that adjusted OIBDA and similar measures are widely used by investors and financial analysts as measures of our financial performance over time, and to compare our financial performance with that of other companies in our industry. Adjusted OIBDA has limitations as an analytical tool, and should not be considered in isolation or as a substitute for analysis of our results as reported under GAAP. These limitations include the following: · it does not reflect capital expenditures; · many of the assets being depreciated and amortized will have to be replaced in the future and adjusted OIBDA does not reflect cash requirements for such replacements; · it does not reflect costs associated with share-based awards exchanged for employee services; · it does not reflect interest expense necessary to service interest or principal payments on indebtedness; · it does not reflect gains, losses or dividends on investments; · it does not reflect expenses incurred for the payment of income taxes; and · other companies, including companies in our industry, may calculate adjusted OIBDA differently than we do, limiting its usefulness as a comparative measure. In light of these limitations, management considers adjusted OIBDA as a financial performance measure that supplements but does not replace the information reflected in our GAAP results. The following table shows adjusted OIBDA for the years ended December 31, 2014, 2013 and 2012: The following table reconciles adjusted OIBDA to operating income, which we consider to be the most directly comparable GAAP financial measure, for the years ended December 31, 2014, 2013 and 2012: The following tables reconcile adjusted OIBDA to operating income by major segment for the years ended December 31, 2014, 2013 and 2012: Financial Condition, Liquidity and Capital Resources The Company has four principal sources of funds available to meet the financing needs of its operations, capital projects, debt service, investments and potential dividends. These sources include cash flows from operations, existing balances of cash and cash equivalents, the liquidation of investments and borrowings. Management routinely considers the alternatives available to determine what mix of sources are best suited for the long-term benefit of the Company. Sources and Uses of Cash. The Company generated $115.0 million of net cash from operations in 2014, a $20.7 million increase from $94.3 million in 2013, which was a $2.7 million decrease from 2012. The increase in 2014 over 2013 was primarily due to an increase in operating income before depreciation and amortization. The decrease in 2013 over 2012 was primarily due to the increase in income taxes paid, partially offset by the changes in net income and the non-cash components of expenses, principally goodwill impairment and deferred income taxes. During 2014, the Company utilized $67.6 million in net investing activities, including $68.2 million invested in capital assets, offset by proceeds from sales of assets. During 2013, the Company utilized $116.6 million in investing activities. Plant and equipment purchases in 2014, 2013 and 2012 totaled $68.2 million, $117.0 million and $89.1 million, respectively. Capital expenditures in 2014 supported projects across all segments, including wireless network capacity and coverage enhancements, cable plant expansion and upgrades, and wireline fiber builds. Expenditures in 2013 and 2012 primarily supported the upgrade of PCS base stations in conjunction with the Network Vision project, as well as expansion of capacity on other PCS base stations and other related spending. Cable system upgrades to acquired systems were completed in 2013. The Company received $3.8 million in cash proceeds from sales of service contracts and assets in our discontinued Converged Services unit during 2012. Financing activities utilized $16.8 million in 2014, as the Company paid cash dividends totaling $10.8 million and made $5.8 million of principal payments on long-term debt. The increase in dividends paid in the current year over 2013 was due to an increase in the per share dividend rate from $0.36 to $0.47. Financing activities utilized $10.5 million in 2013, principally due to $8.2 million in dividends paid to shareholders and $2.0 million in principal repayments under our loan agreements. Financing activities provided $42.2 million in 2012, as the Company refinanced its credit agreement and expanded the term loan to support the expected spending associated with the Network Vision project. Indebtedness. As of December 31, 2014, the Company’s indebtedness totaled $224.3 million, with an annualized effective interest rate of approximately 3.40% after considering the impact of the interest rate swap contract. The balance consists of the Term Loan Facility at a variable rate (2.67% as of December 31, 2014) that resets monthly based on one month LIBOR plus a base rate of 2.50% currently. The Term Loan Facility requires quarterly principal repayments of $5.75 million, which began on December 31, 2014 and will continue until the remaining expected balance of approximately $120.75 million is due at maturity on September 30, 2019. The Company’s credit agreement includes a Revolver Facility that provides for $50 million in availability for future capital expenditures and general corporate needs. In addition, the credit agreement permits the Company to enter into one or more Incremental Term Loan Facilities in the aggregate principal amount not to exceed $100 million subject to compliance with certain covenants. At December 31, 2014, no draw had been made under the Revolver Facility and the Company had not entered into any Incremental Term Loan Facility. When and if a draw is made, the maturity date and interest rate options would be substantially identical to the Term Loan Facility, though the margin on principal drawn on the revolver is 0.25% less than the corresponding margin on term loans. If the interest rate on an Incremental Term Loan Facility is more than 0.25% greater than the rate on the existing outstanding balances, the interest rate on the existing debt would reset at the same rate as the Incremental Term Loan Facility. Repayment provisions would be agreed to at the time of each draw under the Incremental Term Loan Facility. The Company is subject to certain financial covenants measured on a trailing twelve month basis each calendar quarter unless otherwise specified. These covenants include: · a limitation on the Company’s total leverage ratio, defined as indebtedness divided by earnings before interest, taxes, depreciation and amortization, or EBITDA, of less than or equal to 2.50 to 1.00 through March 31, 2015, and 2.00 to 1.00 thereafter; · a minimum debt service coverage ratio, defined as EBITDA divided by the sum of all scheduled principal payments on the Term Loans and regularly scheduled principal payments on other indebtedness plus cash interest expense, greater than 2.50 to 1.00 at all times; · a minimum equity to assets ratio, defined as consolidated total assets minus consolidated total liabilities, divided by consolidated total assets, of at least 0.325 to 1.00 through December 31, 2014, and at least 0.35 to 1.00 thereafter, measured at each fiscal quarter end. As of December 31, 2014, the Company was in compliance with the financial covenants in its credit agreements, and ratios at December 31, 2014 were as follows: Contractual Commitments. The Company is obligated to make future payments under various contracts it has entered into, primarily amounts pursuant to its long-term debt facility, and non-cancelable operating lease agreements for retail space, tower space and cell sites. Expected future minimum contractual cash obligations for the next five years and in the aggregate at December 31, 2014, are as follows: Payments due by periods 1) Includes principal payments and estimated interest payments on the Term Loan Facility based upon outstanding balances and rates in effect at December 31, 2014. 2) Represents the maximum interest payments we are obligated to make under our derivative agreement. Assumes no receipts from the counterparty to our derivative agreement. 3) Amounts include payments over reasonably assured renewals. See Note 13 to the consolidated financial statements appearing elsewhere in this report for additional information. 4) Represents open purchase orders at December 31, 2014. The Company has no other off-balance sheet arrangements and has not entered into any transactions involving unconsolidated, limited purpose entities or commodity contracts. Capital Commitments. The Company spent $68.2 million on capital projects in 2014, down from $117.0 million spent in 2013 and $89.1 million spent in 2012. Capital expenditures in 2014 supported projects across all segments, including wireless network capacity and coverage enhancements, cable plant expansion and upgrades, and wireline fiber builds. The Company incurred significant capital spending in 2013 and 2012 to upgrade its PCS network as part of Sprint’s Network Vision upgrade project. Capital expenditures budgeted for 2015 total $74.8 million. The 2015 budget includes $24.3 million on the Wireless segment for network capacity and coverage enhancements and new retail stores; $21.8 million for Cable segment extension and upgrade of outside plant and investment in customer premise equipment; $20.9 million on the Wireline segment budget for on-going spending to expand and upgrade our fiber networks; and $7.8 million for IT and other back office projects in the Other segment. The Company believes that cash on hand and cash flow from operations (and if necessary, borrowings available under the Company’s existing credit facilities) will provide sufficient cash to enable the Company to fund its planned capital expenditures, make scheduled principal and interest payments, meet its other cash requirements and maintain compliance with the terms of its financing agreements for at least the next 12 months. Thereafter, capital expenditures will likely continue to be required to provide increased capacity to meet the Company’s expected growth in demand for its products and services. The actual amount and timing of the Company’s future capital requirements may differ materially from the Company’s estimate depending on the demand for its products, new market developments and opportunities and general economic opportunities. The Company’s cash flows from operations could be adversely affected by events outside the Company’s control, including, without limitation, changes in overall economic conditions, regulatory requirements, changes in technologies, availability of labor resources and capital, changes in the Company’s relationship with Sprint, and other conditions. The Wireless segment's operations are dependent upon Sprint’s ability to execute certain functions such as billing, customer care, and collections; the subsidiary’s ability to develop and implement successful marketing programs, and the subsidiary’s ability to effectively and economically manage other operating activities under the Company's agreements with Sprint. The Company's ability to continue to attract and maintain a sufficient customer base is also critical to the Company’s ability to maintain a positive cash flow from operations. The foregoing events individually or collectively could affect the Company’s results. Recently Issued Accounting Standards On May 28, 2014, the FASB issued Accounting Standards Update (“ASU”) No. 2014-09, Revenue from Contracts with Customers, which requires an entity to recognize the amount of revenue to which it expects to be entitled for the transfer of promised goods or services to customers. The ASU will replace most existing revenue recognition guidance in U.S. GAAP when it becomes effective. The new standard is effective for the Company on January 1, 2017. Early application is not permitted. The standard permits the use of either the retrospective or cumulative effect transition method. The Company is evaluating the effect that ASU 2014-09 will have on its consolidated financial statements and related disclosures. The Company has not yet selected a transition method nor has it determined the effect of the standard on its ongoing financial reporting.

<s>[INST] General Overview. Shenandoah Telecommunications Company is a diversified telecommunications company providing both regulated and unregulated telecommunications services through its wholly owned subsidiaries. These subsidiaries provide wireless personal communications services (as a Sprint PCS affiliate), local exchange telephone services, video, internet and data services, long distance services, fiber optics facilities, and leased tower facilities. The Company has three reportable segments, which the Company operates and manages as strategic business units organized by lines of business: (1) Wireless, (2) Cable, and (3) Wireline. * The Wireless segment provides digital wireless service as a Sprint PCS Affiliate to a portion of a fourstate area covering the region from Harrisburg, York and Altoona, Pennsylvania, to Harrisonburg, Virginia. In this area, the Company is the exclusive provider of wireless mobility communications network products and services on the 800 and 1900 MHz bands under the Sprint brand. This segment also owns cell site towers built on leased land, and leases space on these towers to both affiliates and nonaffiliated service providers. * The Cable segment provides video, internet and voice services in franchise areas in portions of Virginia, West Virginia and western Maryland, and leases fiber optic facilities throughout its service area. It does not include video, internet and voice services provided to customers in Shenandoah County, Virginia. * The Wireline segment provides regulated and unregulated voice services, DSL internet access, and long distance access services throughout Shenandoah County and portions of Rockingham, Frederick, Warren and Augusta counties, Virginia. The segment also provides video services in portions of Shenandoah County, and leases fiber optic facilities throughout the northern Shenandoah Valley of Virginia, northern Virginia and adjacent areas along the Interstate 81 corridor through West Virginia, Maryland and portions of Pennsylvania. A fourth segment, Other, primarily includes Shenandoah Telecommunications Company, the parent holding company. Significant Transactions The 2014, 2013 and 2012 financial results of the Company reflected several significant transactions. These transactions should be noted in understanding the financial results of the Company for 2014, 2013 and 2012. Segment Restructuring Effective for fiscal year 2014, the Company updated segment presentations to reflect two changes. First, in late 2013, the Company restructured its management team to primarily align its organization with its operating segments (Wireless, Cable and Wireline), rather than on a functional basis (sales and marketing, operations and engineering). As part of this restructuring, the Company determined that the operations associated with its video product offered in Shenandoah County, Virginia, would be included in the Wireline segment. The video services offered in Shenandoah County share much of the network which the regulated telephone company uses to serve its customers. These services had previously been included in the Cable segment. Second, primarily as a result of the restructuring described above, the Company’s allocations of certain shared general and administrative expenses were updated to reflect how the senior management team makes financial decisions and manages resources. Since the Vice Presidents managing the operating segments do not directly control these expenses, the Company has chosen to record these at the holding company. As a result, certain costs, including finance and accounting, executive management, legal, human resources, and IT management are now recorded to the Other segment as corporate costs. In this way, segment performance presents a clearer picture of the trends in an individual segment’s profitability. The 2013 and 2012 results have been adjusted to conform to the 2014 presentation. Network Vision In February 2012, the Company amended its Management Agreement with Sprint in connection with the Company’s commitment to build a 4G LTE network in the Company’s service area. Replacement of base stations began in May 2012, proceeded slowly through that August, and accelerated that fall. During 2012, the Company completed upgrades to 200 base stations, and during 2013, completed upgrades to substantially all of its 526 total base stations. Based upon the initial timetable and revisions, the Company determined that changes to the remaining depreciable [/INST] Negative. </s>

SHENANDOAH TELECOMMUNICATIONS CO/VA/

2016-02-26

2015-12-31

ITEM 7. MANAGEMENT'S DISCUSSION AND ANALYSIS OF FINANCIAL CONDITION AND RESULTS OF OPERATIONS This annual report contains forward-looking statements within the meaning of Section 27A of the Securities Act of 1933 and Section 21E of the Securities Exchange Act of 1934, including statements regarding our expectations, hopes, intentions, or strategies regarding the future. These statements are subject to certain risks and uncertainties that could cause actual results to differ materially from those anticipated in the forward-looking statements. Factors that might cause such a difference include those discussed in this report under “Business-Competition” and “Risk Factors.” The Company undertakes no obligation to publicly revise these forward-looking statements to reflect subsequent events or circumstances, except as required by law. General Overview. Shenandoah Telecommunications Company is a diversified telecommunications company providing both regulated and unregulated telecommunications services through its wholly owned subsidiaries. These subsidiaries provide wireless personal communications services (as a Sprint PCS affiliate), local exchange telephone services, video, internet and data services, long distance services, fiber optics facilities, and leased tower facilities. The Company has three reportable segments, which the Company operates and manages as strategic business units organized by lines of business: (1) Wireless, (2) Cable, and (3) Wireline. * The Wireless segment provides digital wireless service as a Sprint PCS Affiliate to a portion of a four-state area covering the region from Harrisburg, York and Altoona, Pennsylvania, to Harrisonburg, Virginia. In this area, the Company is the exclusive provider of wireless mobility communications network products and services on the 800 MHz, 1900 MHz and 2.5 GHz bands under the Sprint brand. This segment also owns cell site towers built on leased land, and leases space on these towers to both affiliates and non-affiliated service providers. * The Cable segment provides video, internet and voice services in franchise areas in portions of Virginia, West Virginia and western Maryland, and leases fiber optic facilities throughout its service area. It does not include video, internet and voice services provided to customers in Shenandoah County, Virginia. * The Wireline segment provides regulated and unregulated voice services, DSL internet access, and long distance access services throughout Shenandoah County and portions of Rockingham, Frederick, Warren and Augusta counties, Virginia. The segment also provides video services in portions of Shenandoah County, and leases fiber optic facilities throughout the northern Shenandoah Valley of Virginia, northern Virginia and adjacent areas along the Interstate 81 corridor through West Virginia, Maryland and portions of Pennsylvania. A fourth segment, Other, primarily includes Shenandoah Telecommunications Company, the parent holding company. Significant Transactions The 2015, 2014 and 2013 financial results of the Company reflected several significant transactions. These transactions should be noted in understanding the financial results of the Company for 2015, 2014 and 2013. Pending Acquisition of nTelos and Related Transactions On August 10, 2015, we entered into the Merger Agreement with Merger Sub and nTelos, pursuant to which, subject to certain conditions, at the effective time of the Merger, Merger Sub will merge with and into nTelos, with nTelos surviving the Merger as our wholly-owned subsidiary. Under the terms of the Merger Agreement, which has been approved by the stockholders of nTelos and unanimously approved by the boards of directors of the Company and nTelos, at the effective time of the Merger, each share of nTelos common stock, par value $0.01 per share, of nTelos (“nTelos Common Stock”) issued and outstanding immediately prior to the effective time of the Merger (other than shares held by us, nTelos and any subsidiaries (which will be cancelled) and shares owned by stockholders who properly exercised and perfected a demand for appraisal rights under Delaware law), will be converted into the right to receive the Merger Consideration. This results in a total equity value of nTelos of approximately $208 million, after including shares and other equity-based awards expected to vest on change of control. In accordance with the Merger Agreement, we will repay all existing indebtedness of nTelos as of the closing of the Merger, which was approximately $520 million as of December 31, 2015. The completion of the Merger is subject to the satisfaction or waiver of certain conditions, including the approval of the transaction by the FCC and the consummation of the Sprint Transactions. We expect the Merger to close at the end of the first quarter, or the early part of the second quarter, of 2016. On February 26, 2016, we entered into a letter agreement with nTelos pursuant to which the parties agreed to extend the date after which either we or nTelos may terminate the Merger Agreement, from February 29, 2016 to June 28, 2016, as permitted by the Merger Agreement. While the parties believe that closing will occur at the end of the first quarter or early in the second quarter, the purpose of the extension is to allow the parties additional time to satisfy certain conditions in order to complete the Merger, which would not have been satisfied by the end of February 29, 2016 date. In connection with the execution of the Merger Agreement, on August 10, 2015, PCS and SprintCom entered into the Master Agreement and, along with certain affiliates of Sprint, entered into the Affiliate Addendum. The closing of the Sprint Transactions will occur simultaneously with, and are conditioned upon, the consummation of the Merger. Once the Merger and the Sprint Transactions are completed, we will implement comprehensive integration activities for nTelos customers. As part of that process, nTelos customers will be migrated to Sprint and Sprint’s billing platforms. As migration planning has progressed since the date of the Merger Agreement and Master Agreement, certain of our past assumptions about the migration have materially changed. We now expect that the migration process could extend through 2017. This extended migration process will result in us incurring additional one-time costs associated with, among other things, maintaining the nTelos core network, providing additional customer care and, in certain circumstances, customer device replacement. We expect that the aggregate amount of non-recurring costs associated with the Merger and the Sprint Transactions could be as much as twice the amount of our previous estimates. We are in discussions with Sprint on potential ways to mitigate the incremental costs associated with the extended migration process. Network Vision In February 2012, the Company amended its Management Agreement with Sprint in connection with the Company’s commitment to build a 4G LTE network in the Company’s service area. Replacement of base stations began in May 2012, proceeded slowly through that August, and accelerated that fall. During 2012, the Company completed upgrades to 200 base stations, and during 2013, completed upgrades to substantially all of its 526 total base stations. Based upon the initial timetable and revisions, the Company determined that changes to the remaining depreciable lives for base stations and certain other assets were required, adding $3.2 million of additional depreciation expense to 2013’s results. The 4G LTE base stations require either fiber or microwave backhaul. Accordingly, the Company replaced the copper-based T1 circuits it previously had or leased with fiber and microwave technology. In addition to incurring the costs to install the new backhaul facilities, the Company incurred duplicate network costs during the replacement period for each base station, early termination fees, and higher monthly costs of the higher capacity circuits (though much less expensive per megabit of capacity) following the upgrade. However, the additional capacity of the new fiber-based backhaul facilities will delay the need to further upgrade its capacity to accommodate additional network traffic. During 2013, based upon Company projections, the Company determined that microwave equipment used to backhaul wireless traffic from approximately 150 of its cell sites would be inadequate to carry its traffic by 2016, and accordingly, reduced the remaining useful life of this class of assets. Critical Accounting Policies The Company relies on the use of estimates and makes assumptions that affect its financial condition and operating results. These estimates and assumptions are based on historical results and trends as well as the Company's forecasts as to how these might change in the future. The most critical accounting policies that materially affect the Company's results of operations include the following: Revenue Recognition The Company recognizes revenue when persuasive evidence of an arrangement exists, services have been rendered or products have been delivered, the price to the buyer is fixed and determinable and collectability is reasonably assured. Revenues are recognized by the Company based on the various types of transactions generating the revenue. For services, revenue is recognized as the services are performed. For equipment sales, revenue is recognized when the sales transaction is complete. Under the Sprint Management Agreement, postpaid wireless service revenues are reported net of an 8% Management Fee and, since its imposition effective January 1, 2007, a Net Service Fee retained by Sprint. Initially set at 8.8%, the Net Service Fee increased to 12% during 2010 and to 14%, the maximum allowed, in August 2013. Prepaid wireless service revenues are reported net of a 6% Management Fee. Allowance for Doubtful Accounts Estimates are used in determining the allowance for doubtful accounts and are based on historical collection and write-off experience, current trends, credit policies, and the analysis of the accounts receivable by aging category. In determining these estimates, the Company compares historical write-offs in relation to the estimated period in which the subscriber was originally billed. The Company also looks at the historical average length of time that elapses between the original billing date and the date of write-off and the financial position of its larger customers in determining the adequacy of the allowance for doubtful accounts. From this information, the Company assigns specific amounts to be applied against the outstanding receivables. The Company does not carry an allowance for receivables related to Sprint PCS customers. In accordance with the terms of the affiliate contract with Sprint, the Company receives payment from Sprint for the monthly net billings to PCS customers in weekly installments over the following four or five weeks. Income Taxes Income taxes are accounted for under the asset and liability method. Deferred tax assets and liabilities are recognized for the future tax consequences attributable to differences between financial statement carrying amounts of existing assets and liabilities and their respective tax bases. Deferred tax assets and liabilities are measured using enacted tax rates expected to apply to taxable income in the years in which those temporary differences are expected to be recovered or settled. The effect on deferred tax assets and liabilities of a change in tax rates is recognized in income in the period that includes the enactment date. The Company evaluates the recoverability of deferred tax assets generated on a state-by-state basis from net operating losses apportioned to that state. Management uses a more likely than not threshold to make the determination if a valuation allowance is warranted for tax assets in each state. Management evaluates the effective rate of taxes based on apportionment factors, the Company’s operating results, and the various state income tax rates. Leases The Company recognizes rent expense on a straight-line basis over the initial lease term and renewal periods that are reasonably assured at the inception of the lease. In light of the Company’s investment in each leased site, including acquisition costs and leasehold improvements, the Company includes the exercise of certain renewal options in the recording of operating leases. Where the Company is the lessor, the Company recognizes revenue on a straight line basis over the non-cancelable term of the lease. Long-lived Assets The Company views the determination of the carrying value of long-lived assets as a significant accounting estimate since the Company must determine an estimated economic useful life in order to properly amortize or depreciate long-lived assets and because the Company must consider if the value of any long-lived assets have been impaired, requiring adjustment to the carrying value. Economic useful life is the duration of time the asset is expected to be productively employed by us, which may be less than its physical life. The Company’s assumptions on obsolescence, technological advances, and other factors affect the determination of estimated economic useful life. The estimated economic useful life of an asset is monitored to determine if it continues to be appropriate in light of changes in business circumstances. For example, technological advances may result in a shorter estimated useful life than originally anticipated. In such a case, the Company would depreciate the remaining net book value of the asset over the new estimated remaining life, increasing depreciation expense on a prospective basis. During 2013, based upon Company projections, the Company determined that microwave equipment used to backhaul wireless traffic from approximately 150 of its cell sites would be inadequate to carry its traffic by 2016, and accordingly, reduced the remaining useful life of this class of assets. Additional depreciation expense was $1.2 million in 2014 and was not significant in 2013. Intangible Assets Cable franchises, included in Intangible assets, net, provide us with the non-exclusive right to provide video services in a specified area. While some cable franchises are issued for a fixed time (generally 10 years), renewals of cable franchises have occurred routinely and at nominal cost. Moreover, we have determined that there are currently no legal, regulatory, contractual, competitive, economic or other factors that limit the useful lives of our cable franchises. Cable franchise rights and other intangible assets with indefinite lives are not amortized but are tested at least annually for impairment. The testing is performed on the value as of November 30 each year, and is generally composed of comparing the book value of the assets to their estimated fair value. Cable franchises are tested for impairment on an aggregate basis, consistent with the management of the Cable segment as a whole, utilizing a greenfield valuation approach. It is the Company’s practice to engage an independent appraiser to prepare these fair value analyses. Intangible assets that have finite useful lives are amortized over their useful lives. Acquired subscriber base assets are amortized using accelerated amortization methods over the expected period in which those relationships are expected to contribute to our future cash flows. Other finite-lived intangible assets are generally amortized using the straight-line method of amortization. Other The Company does not have any unrecorded off-balance sheet transactions or arrangements; however, the Company has significant commitments under operating leases. Results of Continuing Operations 2015 Compared to 2014 Consolidated Results The Company’s consolidated results from continuing operations for the years ended December 31, 2015 and 2014 are summarized as follows: Operating revenues Operating revenues increased $15.5 million, or 4.8%. Cable segment revenue grew $13.1 million, primarily as a result of a 5.4% growth in average subscriber counts and an increase in revenue per subscriber. Wireless segment revenues increased $1.3 million compared to 2014. Net prepaid service revenue increased $4.3 million, primarily due to 4.5% growth in average prepaid subscribers over 2014 and higher average revenue per subscriber due to improvements in product mix. Net postpaid service revenues decreased $2.7 million as a 6.7% increase in average postpaid subscribers was more than offset by lower revenue service plans associated with handset financing and leasing programs. Wireline segment revenue increased $4.4 million, led by growth in carrier access fees, fiber revenues, and internet service revenues. Affiliate revenues increased $3.3 million. Affiliate revenues are eliminated from the consolidated totals shown in the table above. Operating expenses Total operating expenses increased $3.4 million, or 1.3%, in 2015 compared to 2014. Cost of goods and services sold decreased $8.4 million, primarily due to an $11.8 million decrease in PCS postpaid and prepaid handset costs, partially offset by a $4.1 million increase in cable programming and retransmission consent costs. Selling, general and administrative expenses increased $7.0 million, driven by $3.5 million of expenses associated with the pending acquisition of nTelos and by a $1.8 million increase to support growth of the wireless prepaid business. Depreciation and amortization expense increased $4.8 million, due to a one-time unfavorable adjustment of $2.0 million cumulative impact of additional depreciation on certain assets placed into service in one year and closed out in the fixed asset system in a subsequent year, and to ongoing projects to expand and upgrade the wireless, cable and fiber networks. Other Expense, net Interest expense decreased $0.8 million in 2015 from 2014. The decrease resulted from a combination of lower outstanding balances due to principal paydowns in 2015, as well as a decrease in the base rate of 0.25% effective May of 2015 due to improvements in the Company’s leverage ratio. Each of these factors contributed approximately $0.4 million to the decrease. The reduction in interest expense was partially offset by reduced gains from investments in 2015. Income tax expense The Company’s effective tax rate increased from 39.5% in 2014 to 40.4% in 2015. The increase is primarily attributable to the non-deductible costs for tax purposes related to the pending acquisition of nTelos. Net income Net income increased $7.0 million, or 20.6%, in 2015 from 2014. Growth in subscriber counts in the Wireless and Cable segments, along with a decrease in cost of goods and services sold in the Wireless segment contributed to the increase, but were partially offset by expenses related to the pending acquisition of nTelos and the unfavorable adjustment to depreciation expense. Wireless The Company’s Wireless segment provides digital wireless service to a portion of a four-state area covering the region from Harrisburg, York and Altoona, Pennsylvania, to Harrisonburg, Virginia, through Shenandoah Personal Communications, LLC (“PCS”), a Sprint PCS Affiliate. Through Shenandoah Mobile, LLC (“Mobile”), this segment also leases land on which it builds Company-owned cell towers, which it leases to affiliated and non-affiliated wireless service providers, throughout the same four-state area described above. PCS receives revenues from Sprint for subscribers that obtain service in PCS’s network coverage area. PCS relies on Sprint to provide timely, accurate and complete information to record the appropriate revenue for each financial period. Postpaid revenues received from Sprint are recorded net of certain fees retained by Sprint. These fees total 22% of postpaid net billed revenue (gross customer billings net of credits and adjustments to customer accounts, and write-offs of uncollectible accounts), as defined by the Affiliate Agreement with Sprint. The Company offers prepaid wireless products and services in its PCS network coverage area. Sprint retains a Management Fee equal to 6% of prepaid customer billings. Prepaid revenues received from Sprint are reported net of the cost of this fee. Other fees charged on a per unit basis are separately recorded as expenses according to the nature of the expense. The Company pays handset subsidies to Sprint for the difference between the selling price of prepaid handsets and their cost, recorded as a net cost in cost of goods sold. The revenue and expense components reported to us by Sprint are based on Sprint’s national averages for prepaid services, rather than being specifically determined by customers assigned to our geographic service areas. In April 2014, the Company’s PCS stores began participating in Sprint’s postpaid handset financing programs, whereby Sprint enters into a financing agreement with the subscriber and the subscriber receives a handset from Sprint. In these instances, the equipment revenue from the subscriber and the handset expense are Sprint’s responsibility and are not recorded by the Company. In the fourth quarter of 2015, approximately 77% of postpaid gross additions through Company channels involved a handset financing plan. All else being equal, the service plans for these subscribers generate less monthly service revenue compared to plans with a subsidized handset. The following tables show selected operating statistics of the Wireless segment as of the dates shown: 1) POPS refers to the estimated population of a given geographic area and is based on information purchased from third party sources. Market POPS are those within a market area which the Company is authorized to serve under its Sprint PCS affiliate agreements, and Covered POPS are those covered by the Company’s network. Covered POPS increased in 2014 primarily as a result of the Company’s deployment of the 800 megahertz spectrum at existing cell sites. 2) The decrease from December 31, 2013 to December 31, 2014 is primarily a result of termination of Sprint iDEN leases associated with the former Nextel network. 3) PCS Average Monthly Retail Churn is the average of the monthly subscriber turnover, or churn, calculations for the period. Operating revenues Wireless service revenue increased $1.6 million, or 0.8%, in 2015 over 2014. Net prepaid service revenues grew $4.3 million, or 9.9%, due to 4.5% growth in average prepaid subscribers over 2014 and higher average revenue per subscriber due to improvements in product mix. Net postpaid service revenues decreased $2.7 million. Average postpaid subscribers increased 6.7% in 2015 over the 2014 period, but the increase was more than offset by promotional discounts and a switch to lower revenue service plans associated with handset financing and leasing plans. Under these programs, the Company receives less service revenue from the subscriber, while the equipment revenue from the subscriber and the handset expense become Sprint’s responsibility and are not recorded by the Company. The decreases in service revenues are currently more than offset by a decrease in handset expense within cost of goods and services. Tower lease revenue increased primarily as a result of amendments to existing leases, as third party co-locators add 4G capabilities to our towers. Equipment revenue decreased due primarily to a lower volume of subsidized handset sales, partially offset by lower discounts on those sales. Operating expenses Cost of goods and services decreased $9.7 million, or 13.3%, in 2015 from 2014. Postpaid handset costs decreased $10.9 million, as handset expenses associated with financing and leasing plans are Sprint’s responsibility and are not recorded by the Company. Prepaid handset costs decreased $1.0 million, driven by year-over-year declines in both the volume and average cost of handsets. Network costs increased $1.9 million, due to a decrease in labor capitalized to projects and to increases in rent and power expenses for cell sites and towers. Additionally, the prior year period included a $0.4 million gain on disposal of 3G equipment. Selling, general and administrative costs increased $2.6 million, or 7.9%, in 2015 over 2014. Costs to support the prepaid wireless business increased $1.8 million, driven by subscriber growth, product mix, and higher general and administrative costs. Personnel costs increased $0.7 million due to the addition of new retail stores. Advertising expenses increased $0.6 million. Property taxes increased $0.5 million due to a prior year refund and a higher tax basis in network assets as a result of recent upgrades. The increases were partially offset by a $1.1 million decline in third party commissions expense due to lower volume of commissionable handsets activated through dealer channels. Depreciation and amortization increased $3.3 million, or 10.6%, in 2015 over 2014, following completion of Network Vision upgrades. Cable The Cable segment provides video, internet and voice services in franchise areas in portions of Virginia, West Virginia and western Maryland, and leases fiber optic facilities throughout its service area. It does not include video, internet and voice services provided to customers in Shenandoah County, Virginia. The following table shows selected operating statistics of the Cable segment as of the dates shown: 1) Homes and businesses are considered passed (“homes passed”) if we can connect them to our distribution system without further extending the transmission lines. Homes passed is an estimate based upon the best available information. 2) Customer relationships represent the number of customers who receive at least one of our services. 3) Generally, a dwelling or commercial unit with one or more television sets connected to our distribution system counts as one video customer. Where services are provided on a bulk basis, such as to hotels, universities and some multi-dwelling units, the revenue charged to the customer is divided by the rate for comparable service in the local market to determine the number of customer equivalents included in the customer counts shown above. 4) Penetration is calculated by dividing the number of customers by the number of homes passed or available homes, as appropriate. 5) Digital video penetration is calculated by dividing the number of digital video customers by total video customers. Digital video customers are video customers who receive any level of video service via digital transmission. A dwelling with one or more digital set-top boxes or digital adapters counts as one digital video customer. 6) Homes and businesses are considered available (“available homes”) if we can connect them to our distribution system without further extending the transmission lines and if we offer the service in that area. 7) Revenue generating units are the sum of video, voice and high-speed internet customers. 8) Fiber miles are measured by taking the number of fiber strands in a cable and multiplying that number by the route distance. For example, a 10 mile route with 144 fiber strands would equal 1,440 fiber miles. (1) Prior year service and other revenue amounts have been recast to conform to the current year presentation of video and internet equipment revenues being included in service revenue rather than other revenue. Operating revenues Cable segment service revenue increased $11.8 million, or 15.3%. Internet service revenue increased $8.5 million, or 29.7%, due to a 9.7% increase in average internet subscribers, along with an improved product mix as customers upgraded to higher-speed plans with higher monthly recurring charges. Video revenue, including retransmission consent fee surcharges, increased $4.0 million driven by video rate increases in January 2015. Voice revenue increased $1.2 million due to 16.7% growth in average voice revenue generating units. These increases were partially offset by a $1.9 million increase in bundle discounts. Other revenue grew $1.3 million, primarily due to new fiber contracts and higher installation revenue. Operating expenses Cable segment cost of goods and services increased $2.6 million, or 5.1%, in 2015 over 2014. Video programming costs, including retransmission consent fees, increased $4.1 million as the impact of rising rates per subscriber outpaced declining video subscriber counts. Network costs grew $0.7 million, primarily due to $0.4 million increase in the Universal Service fees mandated by the U.S. government in the current year. The increases were offset by a $1.5 million decrease in disposal costs following a $1.6 million disposal of obsolete equipment in 2014, along with a $1.0 million decrease in maintenance expense following a multi-year project to upgrade cable network infrastructure. Selling, general and administrative expenses decreased $0.1 million against the prior year as declines in marketing and customer service costs were largely offset by growth in administrative and operating tax expenses. Wireline The Wireline segment provides regulated and unregulated voice services, DSL and broadband internet access, and long distance access services throughout Shenandoah County and portions of Rockingham, Frederick, Warren and Augusta counties in Virginia. The segment also provides video services in portions of Shenandoah County, and leases fiber optic facilities throughout the northern Shenandoah Valley of Virginia, northern Virginia and adjacent areas along the Interstate 81 corridor through West Virginia, Maryland and portions of Pennsylvania. 1) Effective October 1, 2015, the Company launched cable modem services on its cable plant, and ceased the requirement that a customer have a telephone access line to purchase DSL service. 2) The Wireline segment’s video service passes approximately 16,000 homes. 3) 2015 total includes 420 customers served via the coaxial cable network. 4) Fiber miles are measured by taking the number of fiber strands in a cable and multiplying that number by the route distance. For example, a 10 mile route with 144 fiber strands would equal 1,440 fiber miles. (1) Prior year categories of access revenue and facilities lease revenue have been combined into the new category of carrier access and fiber revenue to conform to current year presentation. Additionally, set-top box revenues included in other revenue in the prior year are now presented within service revenue. Operating revenues Total operating revenues in 2015 increased $4.4 million, or 7.0%, over 2014. Carrier access and fiber revenues grew $3.1 million as growth in affiliate and non-affiliate fiber contracts were partially offset by favorable Universal Service program adjustments that were recorded in the first quarter of 2014. Internet service revenue grew $1.2 million as customers upgraded to higher-speed plans. Operating expenses Operating expenses overall increased $3.7 million, or 7.8%, in 2015, compared to 2014. The increase in cost of goods and services resulted primarily from a $2.1 million increase in costs to support affiliate fiber routes. The increase was partially offset by a $0.6 million decrease in affiliate and non-affiliate line costs. Sales, general and administrative expenses increased as a result of growth in sales and customer service support teams. Depreciation expense grew $1.5 million as a result of continued investment in the construction of fiber facilities. The current year total includes an unfavorable adjustment of $0.4 million related to assets placed into service in one year and closed out in the fixed asset system in a subsequent year. 2014 Compared to 2013 Consolidated Results The Company’s consolidated results from continuing operations for the years ended December 31, 2014 and 2013 are summarized as follows: Operating revenues Operating revenues increased $18.0 million, or 5.8%, in 2014 over 2013. Wireless segment revenues increased $9.3 million compared to 2013. The Wireless revenue growth included an increase in net postpaid service revenues of $5.0 million, driven by 4.7% year-over-year growth in average postpaid subscribers. In addition, net prepaid service revenues grew $3.2 million, or 7.9%, due to 4.9% growth in average prepaid subscribers and higher average revenue per subscriber in 2014 over 2013. Cable segment revenues increased $8.7 million. Cable service revenues grew $5.3 million due to a 6.4% increase in average revenue generating units compared to the 2013 period, a video rate increase in early 2014, and to customers selecting higher-priced digital TV and higher-speed data packages. Cable equipment revenues increased $2.3 million due to a change in January 2014 of charging customers separately for their first set top box, which previously had been included in the service fee. Additionally, customer use of digital converter boxes grew as the Company converted markets to all-digital signals. Growth in fiber lease revenue contributed $0.6 million to the year-over-year increase of Cable segment revenue. Wireline segment revenue increased $3.6 million, primarily due to growth in facility lease revenues from new contracts with affiliates and third parties. Operating expenses Total operating expenses increased $11.5 million in 2014 compared to 2013. Cost of goods and services sold increased $4.6 million, including increases of $3.3 million in Cable segment video programming costs and $1.7 million in network maintenance costs. Disposal costs increased $1.6 million, as the Company disposed of obsolete equipment that had been taken out of service while upgrading the cable and wireline networks. The increase in disposal costs was offset by reductions in network costs, driven primarily by lower third party backhaul expenses along with an increase in network engineering labor capitalized to projects. Selling, general and administrative expenses increased $1.7 million, due to higher personnel costs, partially offset by lower advertising and bad debt expenses. Depreciation and amortization expense increased $5.2 million, primarily due to completion of the Network Vision and cable network upgrade projects. Income tax expense The Company’s effective tax rate decreased from 40.2% in 2013 to 39.5% in 2014. The 2013 period included $0.5 million in unfavorable adjustments from finalizing the estimated effects of restructuring entities during 2012. The 2014 period included $0.2 million in favorable adjustments to estimates made for the 2013 federal and state returns filed in September 2014. Net income Net income increased $4.3 million, or 14.5%, in 2014 from 2013, reflecting growth in subscriber counts and revenue per subscriber in the Wireless segment, partially offset by increases in operating expenses incurred in support of this growth. Wireless Operating revenues Wireless service revenue increased $8.2 million, or 4.5%, for 2014 over 2013. Net postpaid service revenues increased $5.0 million, or 3.5%, driven by 4.7% year-over-year growth in average postpaid subscribers. The net service fee increased from 12% of net billed revenues to 14% on August 1, 2013, reducing net postpaid service revenue by $2.1 million, or approximately $0.3 million per month. Net prepaid service revenues grew $3.2 million, or 7.9%. Average prepaid subscribers increased 4.9% in 2014 over 2013, with changes in the mix of subscribers accounting for the remainder of the increase in prepaid service revenues. The decrease in tower lease revenue resulted from the termination of Sprint iDEN leases associated with the former Nextel network. Equipment revenue increased due to growth in accessories sales and lower discounts on handset sales. Other revenue increased, as the prior year period included a $0.8 million unfavorable adjustment to straight-line rent accruals related to the termination of iDEN leases. Operating expenses Cost of goods and services increased $0.3 million, or 0.4%, in 2014 from 2013. Network costs increased $1.1 million, driven by increases in rent and backhaul expenses associated with the Network Vision project. Maintenance expense grew $1.0 million due to increases in maintenance contracts that support the upgraded wireless network. Cost of services declined by $0.8 million, driven by lower costs to support WiMax subscribers and prepaid “top-up” services. Cost of goods declined due to a one-time $0.4 million gain related to actual disposal costs for the Network Vision project being less than previously accrued. Handset costs declined $0.3 million as a lower volume of subsidized handsets, driven by the start of installment handset sales in 2014, was partially offset by higher handset costs. Selling, general and administrative costs increased $0.4 million, or 1.1%, in 2014 over 2013 primarily due to the additional retail store personnel to support subscriber growth. Depreciation and amortization increased $2.9 million, or 10.4%, in 2014 over 2013, following completion of Network Vision upgrades. Cable (1) Prior year service and other revenue amounts have been recast to conform to the current year presentation of video and internet equipment revenues being included in service revenue rather than other revenue. Operating revenues Cable revenue increased $8.7 million, or 11.4% in 2014 over 2013. Cable service revenue increased $7.4 million, or 10.6%, due to a 6.4% increase in average revenue generating units, a video rate increase in January 2014, customers selecting higher-priced digital TV services and higher-speed data access packages, and increases in equipment rents. Other revenue increased by $1.3 million, due to increases in facility lease revenue, which grew $0.7 million due to new contracts with third parties, while all other revenues increased $0.6 million from 2013 to 2014. Operating expenses Cable segment cost of goods and services increased $6.2 million, or 13.6%, in 2014 over 2013. Video programming costs increased $3.3 million as the impact of rising rates per subscriber outpaced declining video subscriber counts. Asset disposal costs increased $1.4 million, as the Company disposed of obsolete equipment that was removed from service while upgrading the network. Maintenance costs increased $0.7 million to support network growth and personnel costs increased $0.5 million. Selling, general and administrative expenses grew $0.5 million against the prior year as increases in costs related to customer service and administrative functions were partially offset by reductions of $0.3 million in marketing and selling expense and $0.1 million in bad debt expense. The increase in depreciation and amortization expense consists of $3.1 million of higher depreciation expense related to network upgrades, offset by lower amortization on the customer base intangible asset recorded when the cable markets were acquired. The amortization of this asset declines on the anniversary of the acquisitions. Wireline (1) Prior year categories of access revenue and facilities lease revenue have been combined into the new category of carrier access and fiber revenue to conform to current year presentation. Additionally, set-top box revenues included in other revenue in the prior year are now presented within service revenue Operating revenues Total operating revenues in 2014 increased $3.6 million over 2013. Increases in service revenue resulted primarily from increases in revenues to provide broadband services. Carrier access and fiber revenue grew $2.9 million due to additional leasing of fiber backhaul facilities to new and existing customers, offset by a decrease in revenues as a result of 2013 changes in certain intrastate access charges. Other revenue decreased $0.1 million due in part to the conclusion of billings for transition services to buyers of Converged Services’ properties. Operating expenses Operating expenses overall increased $2.1 million, or 4.6%, for 2014 over 2013. The increase in cost of goods and services resulted primarily from a $2.3 million increase in costs to provide the additional facilities to support the growth in facilities lease revenues described above. The disposal of obsolete and out of service assets resulted in an additional $0.5 million increase in costs. These increases were partially offset by a $0.9 million increase in labor capitalized to projects. Non-GAAP Financial Measure In managing our business and assessing our financial performance, management supplements the information provided by financial statement measures prepared in accordance with GAAP with adjusted OIBDA, which is considered a “non-GAAP financial measure” under SEC rules. Adjusted OIBDA is defined by us as operating income (loss) before depreciation and amortization, adjusted to exclude the effects of: certain non-recurring transactions; impairment of assets; gains and losses on asset sales; and share based compensation expense. Adjusted OIBDA should not be construed as an alternative to operating income as determined in accordance with GAAP as a measure of operating performance. In a capital-intensive industry such as telecommunications, management believes that adjusted OIBDA and the associated percentage margin calculations are meaningful measures of our operating performance. We use adjusted OIBDA as a supplemental performance measure because management believes it facilitates comparisons of our operating performance from period to period and comparisons of our operating performance to that of other companies by excluding potential differences caused by the age and book depreciation of fixed assets (affecting relative depreciation expenses) as well as the other items described above for which additional adjustments were made. In the future, management expects that the Company may again report adjusted OIBDA excluding these items and may incur expenses similar to these excluded items. Accordingly, the exclusion of these and other similar items from our non-GAAP presentation should not be interpreted as implying these items are non-recurring, infrequent or unusual. While depreciation and amortization are considered operating costs under generally accepted accounting principles, these expenses primarily represent the current period allocation of costs associated with long-lived assets acquired or constructed in prior periods, and accordingly may obscure underlying operating trends for some purposes. By isolating the effects of these expenses and other items that vary from period to period without any correlation to our underlying performance, or that vary widely among similar companies, management believes adjusted OIBDA facilitates internal comparisons of our historical operating performance, which are used by management for business planning purposes, and also facilitates comparisons of our performance relative to that of our competitors. In addition, we believe that adjusted OIBDA and similar measures are widely used by investors and financial analysts as measures of our financial performance over time, and to compare our financial performance with that of other companies in our industry. Adjusted OIBDA has limitations as an analytical tool, and should not be considered in isolation or as a substitute for analysis of our results as reported under GAAP. These limitations include the following: · it does not reflect capital expenditures; · many of the assets being depreciated and amortized will have to be replaced in the future and adjusted OIBDA does not reflect cash requirements for such replacements; · it does not reflect costs associated with share-based awards exchanged for employee services; · it does not reflect interest expense necessary to service interest or principal payments on indebtedness; · it does not reflect gains, losses or dividends on investments; · it does not reflect expenses incurred for the payment of income taxes; and · other companies, including companies in our industry, may calculate adjusted OIBDA differently than we do, limiting its usefulness as a comparative measure. In light of these limitations, management considers adjusted OIBDA as a financial performance measure that supplements but does not replace the information reflected in our GAAP results. The following table shows adjusted OIBDA for the years ended December 31, 2015, 2014 and 2013: The following table reconciles adjusted OIBDA to operating income, which we consider to be the most directly comparable GAAP financial measure, for the years ended December 31, 2015, 2014 and 2013: The following tables reconcile adjusted OIBDA to operating income by major segment for the years ended December 31, 2015, 2014 and 2013: Financial Condition, Liquidity and Capital Resources The Company has four principal sources of funds available to meet the financing needs of its operations, capital projects, debt service, investments and potential dividends. These sources include cash flows from operations, existing balances of cash and cash equivalents, the liquidation of investments and borrowings. Management routinely considers the alternatives available to determine what mix of sources are best suited for the long-term benefit of the Company. Sources and Uses of Cash. The Company generated $119.3 million of net cash from operations in 2015, an increase from $115.0 million in 2014, which was a $20.7 million increase from 2013. The increases were primarily due to increases in operating income before depreciation and amortization. During 2015, the Company utilized $69.3 million in net investing activities, including $69.7 million invested in capital assets, partially offset by proceeds from sales of assets. During 2014, the Company utilized $67.6 million in net investing activities. Plant and equipment purchases in 2015, 2014 and 2013 totaled $69.7 million, $68.2 million and $117.0 million, respectively. Capital expenditures in 2015 supported projects across all segments, including wireless network capacity and coverage enhancements, new retail stores, cable segment extensions and investment in customer premises equipment, and expansion and upgrade of our fiber networks. Expenditures in 2014 also supported projects across all segments, including wireless network capacity and coverage enhancements, cable plant expansion and upgrades, and wireline fiber builds. Expenditures in 2013 primarily supported the upgrade of PCS base stations in conjunction with the Network Vision project, as well as expansion of capacity on other PCS base stations and other related spending. Cable system upgrades to acquired systems were completed in 2013. Financing activities utilized $42.2 million in 2015 as the Company made $23.0 million in principal payments on long-term debt, paid cash dividends totaling $11.1 million and paid $7.9 million in debt issuance fees related to the pending nTelos acquisition. Financing activities utilized $16.8 million in 2014, principally due to $10.8 million in cash dividends paid to shareholders and $5.8 million of principal repayments on long-term debt. Financing activities utilized $10.5 million in 2013, principally due to $8.2 million in dividends paid to shareholders and $2.0 million in principal repayments under our loan agreements. Indebtedness. As of December 31, 2015, the Company’s indebtedness totaled $201.3 million, with an annualized effective interest rate of approximately 3.21% after considering the impact of the interest rate swap contract. The balance consists of the Term Loan Facility at a variable rate (2.67% as of December 31, 2015) that resets monthly based on one month LIBOR plus a base rate of 2.25% currently. The Term Loan Facility requires quarterly principal repayments of $5.75 million, which began on December 31, 2014 and will continue until the remaining expected balance of approximately $120.75 million is due at maturity on September 30, 2019. The Company’s credit agreement includes a Revolver Facility that provides for $50 million in availability for future capital expenditures and general corporate needs. In addition, the credit agreement permits the Company to enter into one or more Incremental Term Loan Facilities in the aggregate principal amount not to exceed $100 million subject to compliance with certain covenants. At December 31, 2015, no draw had been made under the Revolver Facility and the Company had not entered into any Incremental Term Loan Facility. When and if a draw is made, the maturity date and interest rate options would be substantially identical to the Term Loan Facility, though the margin on principal drawn on the revolver is 0.25% less than the corresponding margin on term loans. If the interest rate on an Incremental Term Loan Facility is more than 0.25% greater than the rate on the existing outstanding balances, the interest rate on the existing debt would reset at the same rate as the Incremental Term Loan Facility. Repayment provisions would be agreed to at the time of each draw under the Incremental Term Loan Facility. The Company is subject to certain financial covenants measured on a trailing twelve month basis each calendar quarter unless otherwise specified. These covenants include: · a limitation on the Company’s total leverage ratio, defined as indebtedness divided by earnings before interest, taxes, depreciation and amortization, or EBITDA, of less than or equal to 2.00 to 1.00 thereafter; · a minimum debt service coverage ratio, defined as EBITDA divided by the sum of all scheduled principal payments on the Term Loans and regularly scheduled principal payments on other indebtedness plus cash interest expense, greater than 2.50 to 1.00 at all times; · a minimum equity to assets ratio, defined as consolidated total assets minus consolidated total liabilities, divided by consolidated total assets, of at least 0.35 to 1.00 thereafter, measured at each fiscal quarter end. As of December 31, 2015, the Company was in compliance with the financial covenants in its credit agreements, and ratios at December 31, 2015 were as follows: Contractual Commitments. The Company is obligated to make future payments under various contracts it has entered into, primarily amounts pursuant to its long-term debt facility, and non-cancelable operating lease agreements for retail space, tower space and cell sites. Expected future minimum contractual cash obligations for the next five years and in the aggregate at December 31, 2015, are as follows: Payments due by periods 1) Includes principal payments and estimated interest payments on the Term Loan Facility based upon outstanding balances and rates in effect at December 31, 2015. 2) Represents the maximum interest payments we are obligated to make under our derivative agreement. Assumes no receipts from the counterparty to our derivative agreement. 3) Amounts include payments over reasonably assured renewals. See Note 12 to the consolidated financial statements appearing elsewhere in this report for additional information. 4) Represents open purchase orders at December 31, 2015. 5) Represents estimated costs to complete the financing arrangements that will be due and payable regardless of whether the transaction closes. Additionally, if the deal closes, the Company expects to incur approximately $15 million in transaction related expenses; if the deal does not close, the Company can expect to incur $25 million in a break-up fee. The Company has no other off-balance sheet arrangements and has not entered into any transactions involving unconsolidated, limited purpose entities or commodity contracts. Capital Commitments. The Company spent $69.7 million on capital projects in 2015, up from $68.2 million spent in 2014 and $117.0 million spent in 2013. Capital expenditures in 2015 and 2014 supported projects across all segments, including wireless network capacity and coverage enhancements, cable plant expansion and upgrades, and wireline fiber builds. The Company incurred significant capital spending in 2013 related to the PCS network upgrade as part of Sprint’s Network Vision upgrade project. Capital expenditures budgeted for 2016 totaled $229.4 million, including $134.2 million on the Wireless segment for upgrades and expansion of the nTelos wireless network. Due primarily to the delay in closing the nTelos merger, the Company now expects that capital expenditures for 2016 will be $10.9 million lower, or $218.5 million, with $120.3 million in the Wireless segment relating to the nTelos wireless network. In addition, $21.2 million is budgeted for information technology upgrades, new and renovated buildings and other projects, $24.2 million for additional network capacity, and $36.4 million for network expansion including new fiber routes, new cell towers, and cable market expansion. Approximately $13.1 million of the budget is success-based, and will be scaled back if not supported by customer growth. The Company believes that, excluding the impacts of the pending nTelos acquisition, cash on hand and cash flow from operations (and if necessary, borrowings available under the Company’s existing credit facilities) will provide sufficient cash to enable the Company to fund its planned capital expenditures, make scheduled principal and interest payments, meet its other cash requirements and maintain compliance with the terms of its existing financing agreements for at least the next 12 months. Thereafter, capital expenditures will likely continue to be required to provide increased capacity to meet the Company’s expected growth in demand for its products and services. The actual amount and timing of the Company’s future capital requirements may differ materially from the Company’s estimate depending on the demand for its products, new market developments and opportunities and general economic opportunities. The Company’s cash flows from operations could be adversely affected by events outside the Company’s control, including, without limitation, changes in overall economic conditions, regulatory requirements, changes in technologies, availability of labor resources and capital, changes in the Company’s relationship with Sprint, and other conditions. The Wireless segment's operations are dependent upon Sprint’s ability to execute certain functions such as billing, customer care, and collections; the subsidiary’s ability to develop and implement successful marketing programs, and the subsidiary’s ability to effectively and economically manage other operating activities under the Company's agreements with Sprint. The Company's ability to continue to attract and maintain a sufficient customer base is also critical to the Company’s ability to maintain a positive cash flow from operations. The foregoing events individually or collectively could affect the Company’s results. Merger-Related Financing Transaction. In connection with the Merger and the Sprint Transactions, on December 18, 2015, we entered into a credit agreement (the “New Credit Agreement”) with various banks and other financial institutions party thereto (the “Lenders”) and CoBank, ACB, as administrative agent for the Lenders. The New Credit Agreement provides for three facilities: (i) a five-year revolving credit facility of up to $75 million, (ii) a five-year term loan facility of up to $485 million and (iii) a seven-year term loan facility of up to $400 million (collectively, the “Facilities”), which we expect to use to pay the Merger Consideration, to finance the network upgrades required by the Sprint Transactions, to refinance, in full, all indebtedness outstanding under our existing credit agreement, to repay all existing indebtedness of nTelos, to pay fees and expenses in connection with the Merger and for working capital, capital expenditures and other corporate purposes of us and our subsidiaries (and, following the consummation of the Merger, of nTelos and its subsidiaries). We will be the borrower under the New Credit Agreement. The availability of the Facilities is subject to the satisfaction or waiver of certain conditions set forth in the New Credit Agreement, including, among other things, the consummation of the Merger on or before June 28, 2016. The commitments of the Lenders with respect to the Facilities will terminate if the consummation of the Merger and the initial funding of the Facilities does not occur on or prior to June 28, 2016. Subsequent to the closing of the Merger, the Company’s future requirements for debt service will increase, due to incremental interest on the larger outstanding loan balances, and increased amortization requirements to pay down the loan balances, compared to the terms of our existing debt arrangements. Recently Issued Accounting Standards In May 2014, the FASB issued Accounting Standards Update (“ASU”) No. 2014-09, “Revenue from Contracts with Customers”, which requires an entity to recognize the amount of revenue to which it expects to be entitled for the transfer of promised goods or services to customers. The ASU will replace most existing revenue recognition guidance in U.S. GAAP when it becomes effective. In August 2015, the FASB issued ASU No. 2015-14, delaying the effective date of ASU 2014-09. As amended, the new standard is effective for the Company on January 1, 2018. Early application is not permitted. The standard permits the use of either the retrospective or cumulative effect transition method. The Company is evaluating the effect that ASU 2014-09 will have on its consolidated financial statements and related disclosures. The Company has not yet selected a transition method nor has it determined the effect of the standard on its ongoing financial reporting. In February 2015, the FASB issued ASU No. 2015-2, “Consolidation (Topic 820): Amendments to the Consolidation Analysis”. The ASU provides a revised consolidation model for all reporting entities to use in evaluating whether they should consolidate certain legal entities. All legal entities will be subject to reevaluation under this revised consolidation model. The revised consolidation model, among other things, (i) modifies the evaluation of whether limited partnerships and similar legal entities are VIEs or voting interest entities, (ii) eliminates the presumption that a general partner should consolidate a limited partnership, and (iii) modifies the consolidation analysis of reporting entities that are involved with VIEs through fee arrangements and related party relationships. ASU 2015-2 is effective for fiscal years, and interim reporting periods within those fiscal years, beginning after September 1, 2016 (fiscal 2017). The Company is still evaluating what impact, if any, this ASU will have on the Company’s consolidated financial position, results of operations or cash flows. In April 2015, the FASB issued ASU No. 2015-03, “Simplifying the Presentation of Debt Issuance Costs”, which requires that debt issuance costs related to a recognized debt liability be presented in the balance sheet as a direct deduction from the carrying amount of that debt liability, consistent with debt discounts. This ASU requires retrospective adoption and will be effective for the Company beginning on January 1, 2016. Early adoption is permitted. The Company has not elected to early adopt and does not expect this adoption to have a material impact on its consolidated financial statements. In November 2015, the FASB issued ASU No. 2015-17, “Balance Sheet Classification of Deferred Taxes”, to simplify the presentation of deferred income taxes by requiring deferred tax assets and liabilities to be classified as noncurrent on the balance sheet. The amendments in this update are effective for financial statements issued for annual periods beginning after December 15, 2016. Early adoption is permitted. The Company will not elect to early adopt and does not expect this adoption to have a material impact on its consolidated financial statements. In addition to the updates outlined above, FASB has issued other Accounting Standards Updates that were reviewed by management and determined to have a minimal impact on the financial statements. The Company will continue to evaluate the impact of all updates as they are released.

<s>[INST] General Overview. Shenandoah Telecommunications Company is a diversified telecommunications company providing both regulated and unregulated telecommunications services through its wholly owned subsidiaries. These subsidiaries provide wireless personal communications services (as a Sprint PCS affiliate), local exchange telephone services, video, internet and data services, long distance services, fiber optics facilities, and leased tower facilities. The Company has three reportable segments, which the Company operates and manages as strategic business units organized by lines of business: (1) Wireless, (2) Cable, and (3) Wireline. * The Wireless segment provides digital wireless service as a Sprint PCS Affiliate to a portion of a fourstate area covering the region from Harrisburg, York and Altoona, Pennsylvania, to Harrisonburg, Virginia. In this area, the Company is the exclusive provider of wireless mobility communications network products and services on the 800 MHz, 1900 MHz and 2.5 GHz bands under the Sprint brand. This segment also owns cell site towers built on leased land, and leases space on these towers to both affiliates and nonaffiliated service providers. * The Cable segment provides video, internet and voice services in franchise areas in portions of Virginia, West Virginia and western Maryland, and leases fiber optic facilities throughout its service area. It does not include video, internet and voice services provided to customers in Shenandoah County, Virginia. * The Wireline segment provides regulated and unregulated voice services, DSL internet access, and long distance access services throughout Shenandoah County and portions of Rockingham, Frederick, Warren and Augusta counties, Virginia. The segment also provides video services in portions of Shenandoah County, and leases fiber optic facilities throughout the northern Shenandoah Valley of Virginia, northern Virginia and adjacent areas along the Interstate 81 corridor through West Virginia, Maryland and portions of Pennsylvania. A fourth segment, Other, primarily includes Shenandoah Telecommunications Company, the parent holding company. Significant Transactions The 2015, 2014 and 2013 financial results of the Company reflected several significant transactions. These transactions should be noted in understanding the financial results of the Company for 2015, 2014 and 2013. Pending Acquisition of nTelos and Related Transactions On August 10, 2015, we entered into the Merger Agreement with Merger Sub and nTelos, pursuant to which, subject to certain conditions, at the effective time of the Merger, Merger Sub will merge with and into nTelos, with nTelos surviving the Merger as our whollyowned subsidiary. Under the terms of the Merger Agreement, which has been approved by the stockholders of nTelos and unanimously approved by the boards of directors of the Company and nTelos, at the effective time of the Merger, each share of nTelos common stock, par value $0.01 per share, of nTelos (“nTelos Common Stock”) issued and outstanding immediately prior to the effective time of the Merger (other than shares held by us, nTelos and any subsidiaries (which will be cancelled) and shares owned by stockholders who properly exercised and perfected a demand for appraisal rights under Delaware law), will be converted into the right to receive the Merger Consideration. This results in a total equity value of nTelos of approximately $208 million, after including shares and other equitybased awards expected to vest on change of control. In accordance with the Merger Agreement, we will repay all existing indebtedness of nTelos as of the closing of the Merger, which was approximately $520 million as of December 31, 2015. The completion of the Merger is subject to the satisfaction or waiver of certain conditions, including the approval of the transaction by the FCC and the consummation of the Sprint Transactions. We expect the Merger to close at the end of the first quarter, or the early part of the second quarter, of 2016. On February 26, 2016, we entered into a letter agreement with nTelos pursuant to which the parties agreed to [/INST] Positive. </s>

SHENANDOAH TELECOMMUNICATIONS CO/VA/

2017-03-23

2016-12-31

ITEM 7. MANAGEMENT'S DISCUSSION AND ANALYSIS OF FINANCIAL CONDITION AND RESULTS OF OPERATIONS This annual report contains forward-looking statements within the meaning of Section 27A of the Securities Act of 1933 and Section 21E of the Securities Exchange Act of 1934, including statements regarding our expectations, hopes, intentions, or strategies regarding the future. These statements are subject to certain risks and uncertainties that could cause actual results to differ materially from those anticipated in the forward-looking statements. Factors that might cause such a difference include those discussed in this report under “Business-Competition” and “Risk Factors.” The Company undertakes no obligation to publicly revise these forward-looking statements to reflect subsequent events or circumstances, except as required by law. General Overview. Shenandoah Telecommunications Company is a diversified telecommunications company providing both regulated and unregulated telecommunications services through its wholly owned subsidiaries. These subsidiaries provide wireless personal communications services (as a Sprint PCS affiliate), local exchange telephone services, video, internet and data services, long distance services, fiber optics facilities and leased tower facilities. We have three reportable segments, which we operate and manage as strategic business units organized by lines of business: (1) Wireless, (2) Cable and (3) Wireline. * The Wireless segment has historically provided digital wireless service as a Sprint PCS Affiliate to a portion of a four-state area covering the region from Harrisburg, York and Altoona, Pennsylvania, to Harrisonburg, Virginia. Following the acquisition of nTelos, the Company’s wireless service area expanded to include south-central and western Virginia, West Virginia, and small portions of Kentucky and Ohio. In these areas, we are the exclusive provider of Sprint-branded wireless mobility communications network products and services on the 800 MHz, 1900 MHz and 2.5 GHz spectrum bands. This segment also owns cell site towers built on leased land, and leases space on these towers to both affiliates and non-affiliated service providers. * The Cable segment provides video, internet and voice services in franchise areas in portions of Virginia, West Virginia and western Maryland, and leases fiber optic facilities throughout its service area. It does not include video, internet and voice services provided to customers in Shenandoah County, Virginia. * The Wireline segment provides regulated and unregulated voice services, DSL internet access and long distance access services throughout Shenandoah County and portions of Rockingham, Frederick, Warren and Augusta counties, Virginia. The segment also provides video and cable modem internet access services in portions of Shenandoah County, and leases fiber optic facilities throughout the northern Shenandoah Valley of Virginia, northern Virginia and adjacent areas along the Interstate 81 corridor through West Virginia, Maryland and portions of central and southern Pennsylvania. A fourth segment, Other, primarily includes Shenandoah Telecommunications Company, the parent holding company, and includes corporate costs of executive management, information technology, legal, finance and human resources. This segment also includes certain acquisition and integration costs primarily consisting of severance accruals for short-term nTelos employees to be separated as integration activities wind down and transaction related expenses such as investment advisor, legal and other professional fees. Acquisition of nTelos and Exchange with Sprint: On May 6, 2016, we completed our previously announced acquisition of NTELOS Holdings Corp. (“nTelos”) for $667.8 million, net of cash acquired. The purchase price was financed by a credit facility arranged by CoBank, ACB. We have included the operations of nTelos for financial reporting purposes for periods subsequent to the acquisition. Immediately after acquiring nTelos, we exchanged spectrum licenses valued at $198.2 million, and customer based contract rights valued at $206.7 million, acquired from nTelos with Sprint, and received an expansion of our affiliate service territory to include most of the service area served by nTelos, valued at $284.1 million, as well as customer based contract rights, valued at $120.9 million, relating to nTelos’ and Sprint’s legacy customers in the our affiliate service territory. The value of the affiliate agreement expansion is based on changes to the amended affiliate agreement that include an increase in the price to be paid by Sprint from 80% to 90% of the entire business value of PCS if the affiliate agreement is not renewed and an extension of the affiliate agreement with Sprint by five years to 2029. Also included in the value is the expanded territory in the nTelos service area and the accompanying right to serve all future Sprint customers in the expanded territory, our commitment to upgrade certain coverage and capacity in the newly acquired service area, the waiver of a portion of the management fee charged by Sprint, as well as other items defined in the amended affiliate agreement. The Company expects to incur a total of approximately $90 million of integration and acquisition expenses associated with this transaction, excluding approximately $23.0 million of debt issuance costs. In connection with the acquisition, the Company also chose to proactively migrate former nTelos customers to devices that can interact with the Sprint billing and network systems. Expected costs also include the nTelos back office staff and support functions until the nTelos legacy customers are migrated to the Sprint billing platform; cost of the handsets to be provided to nTelos legacy customers as they migrate to the Sprint billing platform; severance costs for back office and other former nTelos employees who will not be retained permanently; and transaction related fees. We have incurred $54.7 million of these costs in the year ended December 31, 2016. These costs include $1.3 million reflected in cost of goods and services and $11.1 million reflected in selling, general and administrative costs in the year ended December 31, 2016. Critical Accounting Policies The Company relies on the use of estimates and makes assumptions that affect its financial condition and operating results. These estimates and assumptions are based on historical results and trends as well as the Company's forecasts as to how these might change in the future. The most critical accounting policies that materially affect the Company's results of operations include the following: Revenue Recognition The Company recognizes revenue when persuasive evidence of an arrangement exists, services have been rendered or products have been delivered, the price to the buyer is fixed and determinable and collectability is reasonably assured. Revenues are recognized by the Company based on the various types of transactions generating the revenue. For services, revenue is recognized as the services are performed. For equipment sales, revenue is recognized when the sales transaction is complete. Under the Sprint Management Agreement, postpaid wireless service revenues are reported net of an 8% Management Fee and an 8.6% Net Service Fee, retained by Sprint. Prepaid wireless service revenues are reported net of a 6% Management Fee retained by Sprint. Under our amended affiliate agreement, Sprint agreed to waive the management fee, which is historically presented as a contra-revenue by us, for a period of approximately six years. The impact of Sprint’s waiver of the management fee over the approximate six-year period is reflected as an increase in revenue, offset by the non-cash adjustment to recognize this impact on a straight-line basis over the remaining initial contract term of approximately 14 years. Allowance for Doubtful Accounts Estimates are used in determining the allowance for doubtful accounts and are based on historical collection and write-off experience, current trends, credit policies, and the analysis of the accounts receivable by aging category. In determining these estimates, the Company compares historical write-offs in relation to the estimated period in which the subscriber was originally billed. The Company also looks at the historical average length of time that elapses between the original billing date and the date of write-off and the financial position of its larger customers in determining the adequacy of the allowance for doubtful accounts. From this information, the Company assigns specific amounts to be applied against the outstanding receivables. The Company does not carry an allowance for receivables related to Sprint PCS customers. In accordance with the terms of the affiliate contract with Sprint, the Company receives payment from Sprint for the monthly net billings to PCS customers in weekly installments over the following four or five weeks. Inventories The Company's inventories consist primarily of items held for resale such as devices and accessories. The Company values its inventory at the lower of cost or market. Inventory cost is computed on an average cost basis. Market value is determined by reviewing current replacement cost, marketability and obsolescence. Income Taxes Income taxes are accounted for under the asset and liability method. Deferred tax assets and liabilities are recognized for the future tax consequences attributable to differences between financial statement carrying amounts of existing assets and liabilities and their respective tax bases. Deferred tax assets and liabilities are measured using enacted tax rates expected to apply to taxable income in the years in which those temporary differences are expected to be recovered or settled. The effect on deferred tax assets and liabilities of a change in tax rates is recognized in income in the period that includes the enactment date. The Company evaluates the recoverability of deferred tax assets generated on a state-by-state basis from net operating losses apportioned to that state. Management uses a more likely than not threshold to make the determination if a valuation allowance is warranted for tax assets in each state. Management evaluates the effective rate of taxes based on apportionment factors, the Company’s operating results, and the various state income tax rates. Leases The Company recognizes rent expense on a straight-line basis over the initial lease term and renewal periods that are reasonably assured at the inception of the lease. In light of the Company’s investment in each leased site, including acquisition costs and leasehold improvements, the Company includes the exercise of certain renewal options in the recording of operating leases. Where the Company is the lessor, the Company recognizes revenue on a straight line basis over the non-cancelable term of the lease. Long-lived Assets The Company views the determination of the carrying value of long-lived assets as a significant accounting estimate since the Company must determine an estimated economic useful life in order to properly amortize or depreciate long-lived assets and because the Company must consider if the value of any long-lived assets have been impaired, requiring adjustment to the carrying value. Economic useful life is the duration of time the asset is expected to be productively employed by us, which may be less than its physical life. The Company’s assumptions on obsolescence, technological advances, and other factors affect the determination of estimated economic useful life. The estimated economic useful life of an asset is monitored to determine if it continues to be appropriate in light of changes in business circumstances. For example, technological advances may result in a shorter estimated useful life than originally anticipated. In such a case, the Company would depreciate the remaining net book value of the asset over the new estimated remaining life, increasing depreciation expense on a prospective basis. During 2016, based upon recent activity, the Company determined that the antennas deployed at its cell sites would require replacement earlier than previously expected, and accordingly, reduced the remaining useful life of this class of assets. Additional depreciation expense was $0.1 million in 2016 and is expected to be $0.6 million higher in 2017. Intangible Assets Cable franchises, included in Intangible assets, net, provide us with the non-exclusive right to provide video services in a specified area. While some cable franchises are issued for a fixed time (generally 10 years), renewals of cable franchises have occurred routinely and at nominal cost. Moreover, we have determined that there are currently no legal, regulatory, contractual, competitive, economic or other factors that limit the useful lives of our cable franchises. Cable franchise rights and other intangible assets with indefinite lives are not amortized but are tested at least annually for impairment. The testing is performed on the value as of November 1 each year, and is generally composed of comparing the book value of the assets to their estimated fair value. Cable franchises are tested for impairment on an aggregate basis, consistent with the management of the Cable segment as a whole, utilizing a greenfield valuation approach. It is the Company’s practice to engage an independent appraiser to prepare these fair value analyses. Intangible assets that have finite useful lives are amortized over their useful lives. Acquired subscriber base assets are amortized using accelerated amortization methods over the expected period in which those relationships are expected to contribute to our future cash flows. Other finite-lived intangible assets, including the affiliate expansion asset, are generally amortized using the straight-line method of amortization. The initial establishment of many intangible assets, as well as subsequent impairment tests for intangibles with indefinite lives, is generally dependent upon forecasts and projections of future activity, and such estimates can be subjective and variable over time as market conditions and operating results change. Other The Company does not have any unrecorded off-balance sheet transactions or arrangements; however, the Company has significant commitments under operating leases. Goodwill Goodwill is not amortized but is tested for impairment on at least an annual basis. Impairment testing is required more often than annually if an event or circumstance indicates that impairment is more likely than not to have occurred. In conducting our annual impairment testing, we may first perform a qualitative assessment of whether it is more likely than not that a reporting unit’s fair value is less than its carrying amount. If not, no further goodwill impairment testing is required. If it is more likely than not that a reporting unit’s fair value is less than its carrying amount, or if we elect not to perform a qualitative assessment of a reporting unit, we then compare the fair value of the reporting unit to the related net book value. If the net book value of a reporting unit exceeds its fair value, an impairment loss is measured and recognized. We elected not to perform the qualitative assessment and performed a quantitative test comparing the fair value with the carrying amounts and concluded that no impairment existed as of October 1. Pension Benefits and Retirement Benefits Other Than Pensions Through our acquisition of nTelos, we assumed nTelos’ non-contributory defined benefit pension plan (“Pension Plan”) covering all employees who met eligibility requirements and were employed by nTelos prior to October 1, 2003. The Pension Plan was closed to nTelos employees hired on or after October 1, 2003. Pension benefits vest after five years of plan service and are based on years of service and an average of the five highest consecutive years of compensation subject to certain reductions if the employee retires before reaching age 65 and elects to receive the benefit prior to age 65. Effective December 31, 2012, nTelos froze future benefit accruals. We use updated mortality tables published by the Society of Actuaries that predict increasing life expectancies in the United States. IRC Sections 412 and 430 and Sections 302 and 303 of the Employee Retirement Income Security Act of 1974, as amended establish minimum funding requirements for defined benefit pension plans. The minimum required contribution is generally equal to the target normal cost plus the shortfall amortization installments for the current plan year and each of the six preceding plan years less any calculated credit balance. If plan assets (less calculated credits) are equal to or exceed the funding target, the minimum required contribution is the target normal cost reduced by the excess funding, but not below zero. Our policy is to make contributions to stay at or above the threshold required in order to prevent benefit restrictions and related additional notice requirements and is intended to provide not only for benefits based on service to date, but also for those expected to be earned in the future. We also assumed two qualified nonpension postretirement benefit plans that provide certain health care and life benefits for nTelos retired employees that meet eligibility requirements. The health care plan is contributory, with participants’ contributions adjusted annually. The life insurance plan also is contributory. These obligations, along with all of the pension plans and other postretirement benefit plans, are obligations assumed by us. Eligibility for the life insurance plan is restricted to active pension participants age 50-64 as of January 5, 1994. Neither plan is eligible to employees hired after April 1993. The accounting for the plans anticipates that we will maintain a consistent level of cost sharing for the benefits with the retirees. Our share of the projected costs of benefits that will be paid after retirement is generally being accrued by charges to expense over the eligible employees’ service periods to the dates they are fully eligible for benefits. We record annual amounts relating to the Pension Plan and postretirement benefit plans based on calculations that incorporate various actuarial and other assumptions, including discount rates, mortality, assumed rates of return, turnover rates and health care cost trend rates. We review our assumptions on an annual basis and make modifications to the assumptions based on current rates and trend when it is appropriate to do so. We recognize gains and losses on pension and postretirement plan assets and obligations immediately in our operating results. These gains and losses are measured annually at December 31 and accordingly will be recorded during the fourth quarter, unless earlier re-measurements are required. Results of Continuing Operations 2016 Compared to 2015 Consolidated Results The Company’s consolidated results from continuing operations for the years ended December 31, 2016 and 2015 are summarized as follows: Operating revenues Operating revenues increased $192.8 million, or 56.3%, primarily as a result of the nTelos acquisition. Wireless segment revenues increased $179.9 million compared to 2015; this increase was almost entirely due to the acquisition of nTelos on May 6, 2016, combined with the reduction in the Net Service Fee charged by Sprint related to separate settlement of certain revenues and expenses. Cable segment revenue grew $11.1 million, primarily as a result of a 6.3% growth in average subscriber counts and an increase in revenue per subscriber. Wireline segment revenue increased $7.6 million, led by growth in carrier access fees, fiber revenues and internet service revenues. Affiliate revenues increased $5.8 million. Affiliate revenues are eliminated from the consolidated totals shown in the table above. Operating expenses Total operating expenses increased $244.4 million, or 91.0%, in 2016 compared to 2015. Wireless segment operating expenses increased $228.7 million while operating expenses in the Other segment increased $13.4 million, both largely due to the acquisition of nTelos. Cable and Wireline segment operating expenses increased $4.6 million and $3.4 million, respectively. Cost of goods and services sold increased $72.2 million, selling, general and administrative expenses increased $60.5 million, depreciation and amortization increased $73.0 million, and acquisition, integration and migration costs increased $38.7 million. Other Expense, net Non-operating income increased $2.5 million due to increased patronage income related to higher outstanding balances on our CoBank borrowings and interest accrued on handset finance ("EIP") loans acquired with nTelos. Interest expense increased $17.7 million in 2016 from 2015. The increase resulted primarily from higher outstanding balances due to borrowings to finance and support the nTelos acquisition, as well as slightly higher base rates on the new debt, increases in LIBOR during 2016, increased notional principal subject to interest rate swaps, and amortization of the fees and costs incurred to complete the new debt package. Income tax expense The Company’s effective tax rate increased from 40.4% in 2015 to 146.0% in 2016. The increase is primarily attributable to the changes in blended state rates applied to basis differences caused by the nTelos acquisition and the Company's legal entity restructuring that combined the nTelos legal entities into the Company's PCS subsidiary. Additionally, the rate was impacted by the adoption of ASU 2016-09 relating to stock compensation and non-deductible transaction costs incurred during 2016 related to the nTelos acquisition. The impact of these items on the effective tax rate is magnified by the near break-even level of income before taxes. Net income Net income decreased $41.8 million, or 102.2%, in 2016 from 2015. Increases in depreciation and amortization expenses resulting from the acquisition of nTelos, costs related to the acquisition including acquisition, integration and migration costs, (including those in cost of goods and services sold and selling, general and administrative expenses), and higher interest expense on the increased outstanding debt, offset the positive impact of revenues from new customers less new operating expenses resulting from the nTelos acquisition. Wireless Our Wireless segment historically provided digital wireless service to a portion of a four-state area covering the region from Harrisburg, York and Altoona, Pennsylvania, to Harrisonburg, Virginia, through Shenandoah Personal Communications, LLC (“PCS”), a Sprint PCS Affiliate. Following the recent acquisition of nTelos, our wireless service territory expanded to include south-central and western Virginia, West Virginia, and small portions of Kentucky and Ohio. Through Shenandoah Mobile, LLC (“Mobile”), this segment also leases land on which it builds Company-owned cell towers, which it leases to affiliates and non-affiliated wireless service providers, throughout the same four-state area described above. PCS receives revenues from Sprint for subscribers that obtain service in PCS’s network coverage area. PCS relies on Sprint to provide timely, accurate and complete information to record the appropriate revenue for each financial period. Postpaid revenues received from Sprint are recorded net of certain fees retained by Sprint. Through December 31, 2015, these fees totaled 22% of postpaid net billed revenue (gross customer billings net of credits and adjustments to customer accounts, and write-offs of uncollectible accounts), as defined by the Affiliate Agreement with Sprint. Effective January 1, 2016, the fees charged by Sprint declined to 16.6%, and certain revenue and expense items previously included in these fees became separately settled. The 16.6% fee consisted of a Management Fee of 8% and a Net Service Fee of 8.6%. We also offer prepaid wireless products and services in our PCS network coverage area. Sprint retains a Management Fee equal to 6% of prepaid customer billings. Prepaid revenues received from Sprint are reported net of the cost of this fee. Other fees charged on a per unit basis are separately recorded as expenses according to the nature of the expense. We pay handset subsidies to Sprint for the difference between the selling price of prepaid handsets and their cost, recorded as a net cost in cost of goods sold. The revenue and expense components reported to us by Sprint are based on Sprint’s national averages for prepaid services, rather than being specifically determined by customers assigned to our geographic service areas. In connection with the nTelos acquisition and Sprint transactions, Sprint agreed to waive the Management Fees charged on both postpaid and prepaid revenues, up to $4.2 million per month, until the total amount waived reaches $252 million. This is expected to take about six years. The benefit of the fee waivers is being recognized over a straight-line period through the end of the initial term of the Management Agreement, November 30, 2029. The following tables show selected operating statistics of the Wireless segment as of the dates shown: The changes from December 31, 2015 to December 31, 2016 shown above include the following amounts acquired in the nTelos acquisition and the exchange with Sprint on May 6, 2016: 1) POPS refers to the estimated population of a given geographic area and is based on information purchased from third party sources. Market POPS are those within a market area which we are authorized to serve under our Sprint PCS affiliate agreements, and Covered POPS are those covered by our network. 2) PCS Average Monthly Retail Churn is the average of the monthly subscriber turnover, or churn, calculations for the period. 3) Net of approximately 160 overlap cell sites we intend to shut down in coming months. 4) Prepaid losses include 24,348 subscribers purged from customer counts as a result of a one-time reduction of the length of time a customer is inactive before eliminating them from the customer counts. During the twelve months ended December 31, 2016, 5,248 former nTelos prepaid subscribers switched to postpaid subscribers as they migrated to the Sprint back-office platforms. Service Revenues (1) Postpaid net billings are defined under the terms of the affiliate contract with Sprint to be the gross billings to customers within our service territory less billing credits and adjustments and allocated write-offs of uncollectible accounts. Operating revenues Wireless service revenue increased $167.0 million, or 86.6%, in 2016 over 2015, primarily due to the nTelos acquisition. Net postpaid billings increased $129.4 million, or 69.9%, as average subscribers increased 89.2% and average billing rates dropped by 11% primarily due to new customers and upgrading existing customers moving to lower cost service plans that don't include a subsidized phone. Net prepaid billings increased $31.6 million, or 61.8%, due to 53.1% growth in average prepaid subscribers over 2015 and higher average revenue per subscriber due to improvements in product mix. Effective January 1, 2016, the fees retained by Sprint, and deducted from postpaid revenues, decreased from 22.0% to 16.6%, and certain revenue and expense items became settled separately. As a result, despite the growth in net postpaid billings, the net service fee dropped by $2.9 million or 11.4%. Travel and other revenues, now separately settled, increased $17.1 million. Tower lease revenue increased primarily as a result of amendments to existing leases, as third party co-locators add 4G capabilities to our towers, and rents associated with the towers acquired in the nTelos acquisition. Equipment revenue increased due primarily to separately settled national device revenues passed to us by Sprint, as well as expanded activity due to the nTelos acquisition. Operating expenses Cost of goods and services increased $69.5 million, or 109.4%, in 2016 from 2015. Postpaid handset costs decreased $0.6 million. Prepaid handset costs increased $4.3 million. Network costs increased $47.5 million, while maintenance costs increased $8.7 million. These increases are primarily attributable to the expanded activities and service territory as a result of the nTelos acquisition. Separately settled national handset costs added $4.6 million to 2016's cost of goods and services. Selling, general and administrative costs increased $60.1 million, or 167.8%, in 2016 over 2015. National channel sales commissions, which we began separately settling with Sprint effective January 1, 2016, added $22.4 million to the current year expense. Expenses associated with prepaid wireless programs increased $3.5 million in 2016 from 2015. Personnel costs increased $20.9 million due to the addition of new retail stores and the need to support the nTelos billing platform and sales and customer service activities for customers prior to migration. Advertising expenses increased $5.5 million, while property taxes increased $1.8 million, both due to the nTelos acquisition. Acquisition, integration and migration costs of $25.9 million included $18.3 million in handset costs for customers to migrate to the Sprint back office and billing platform, $4.9 million in costs to shutdown overlapping cell sites and replace older backhaul circuits with Ethernet circuits to support increased data volumes at upgraded sites, and $2.7 million in incremental staff to support migration efforts in the stores. Depreciation and amortization increased $73.2 million, or 212.7%, in 2016 over 2015, reflecting the tangible and intangible assets acquired in the nTelos acquisition. Cable The Cable segment provides video, internet and voice services in franchise areas in portions of Virginia, West Virginia and western Maryland, and leases fiber optic facilities throughout its service area. It does not include video, internet and voice services provided to customers in Shenandoah County, Virginia, which are included in the Wireline segment. On January 1, 2016, we acquired the assets of Colane Cable Company. With the acquisition, we received 3,299 video customers, 1,405 high-speed internet customers, and 302 voice customers. These customers are included in the December 31, 2016 totals shown below. The following table shows selected operating statistics of the Cable segment as of the dates shown: 1) Homes and businesses are considered passed (“homes passed”) if we can connect them to our distribution system without further extending the transmission lines. Homes passed is an estimate based upon the best available information. 2) Customer relationships represent the number of customers who receive at least one of our services. 3) Generally, a dwelling or commercial unit with one or more television sets connected to our distribution system counts as one video customer. Where services are provided on a bulk basis, such as to hotels and some multi-dwelling units, the revenue charged to the customer is divided by the rate for comparable service in the local market to determine the number of customer equivalents included in the customer counts shown above. During the first quarter of 2016, we modified the way we count subscribers when a commercial customer upgrades its internet service via a fiber contract. We retroactively applied the new count methodology to prior periods, and applied similar logic to certain bulk customers; the net result was reductions in internet subscriber counts of 559 and 673 subscribers to December 31, 2015, and December 31, 2014 totals, respectively. 4) Penetration is calculated by dividing the number of customers by the number of homes passed or available homes, as appropriate. 5) Digital video penetration is calculated by dividing the number of digital video customers by total video customers. Digital video customers are video customers who receive any level of video service via digital transmission. A dwelling with one or more digital set-top boxes or digital adapters counts as one digital video customer. 6) Homes and businesses are considered available (“available homes”) if we can connect them to our distribution system without further extending the transmission lines and if we offer the service in that area. 7) Revenue generating units are the sum of video, voice and high-speed internet customers. 8) Total Fiber Miles are measured by taking the number of fiber strands in a cable and multiplying that number by the route distance. For example, a 10 mile route with 144 fiber strands would equal 1,440 fiber miles. Operating revenues Cable segment service revenue increased $10.1 million, or 11.3% in 2016 from 2015. Internet service revenue increased $9.0 million, or 23.4%, due to an 8.9% increase in average internet subscribers, along with an improved product mix as new and existing customers increasingly move to higher-speed plans with higher monthly recurring charges. Video revenue, including retransmission consent fee surcharges, increased $2.5 million driven by video rate increases in January 2016, offsetting higher programming costs. Voice revenue increased $0.8 million due to 8.4% growth in average voice revenue generating units. These increases were partially offset by a $2.3 million increase in bundle discounts. Other revenue grew $1.0 million, primarily due to new fiber contracts. Operating expenses Cable segment cost of goods and services increased $4.0 million, or 7.3%, in 2016 over 2015. Video programming costs, including retransmission consent fees, increased $1.2 million as the impact of rising rates per subscriber outpaced declining video subscriber counts. Network costs grew $0.7 million, primarily due to $0.5 million in increased line costs and pole rents. Maintenance costs increased $0.9 million. Depreciation expense increased $0.8 million, partly as a result of assets acquired in the Colane acquisition, and new assets placed in service. Wireline The Wireline segment provides regulated and unregulated voice services, DSL internet access, cable modem and long distance access services throughout Shenandoah County and portions of Rockingham, Frederick, Warren and Augusta counties, Virginia. The segment also provides video and cable modem internet access services in portions of Shenandoah County, and leases fiber optic facilities throughout the northern Shenandoah Valley of Virginia, northern Virginia and adjacent areas along the Interstate 81 corridor through West Virginia, Maryland and portions of Pennsylvania. 1) Effective October 1, 2015, we launched cable modem services on our cable plant, and ceased the requirement that a customer have a telephone access line to purchase internet service. 2) The Wireline segment’s video service passes approximately 16,000 homes. 3) December 2016 and December 2015 totals include 1,072 and 420 customers, respectively, served via the coaxial cable network. During first quarter 2016, we modified the way we count subscribers when a commercial customer upgrades its internet service via a fiber contract. We retroactively applied the new count methodology to prior periods and the net result was increases in internet subscriber counts of 804 and 352 subscribers to December 31, 2015 and December 31, 2014 totals, respectively. 4) Total Fiber Miles are measured by taking the number of fiber strands in a cable and multiplying that number by the route distance. For example, a 10 mile route with 144 fiber strands would equal 1,440 fiber miles. Operating revenues Total operating revenues in 2016 increased $7.6 million, or 11.2%, over 2015. Carrier access and fiber revenues for affiliate fiber contracts grew by $4.9 million in 2016 while non-affiliate fiber contracts grew by $2.3 million. Internet service revenue grew $1.9 million as customers upgraded to higher-speed plans, while voice revenues declined $1.0 million as customers eliminate landline telephone services, and promotional discounts increased $0.9 million. Operating expenses Operating expenses overall increased $3.4 million, or 6.7%, in 2016, compared to 2015. The increase in cost of goods and services resulted primarily from a $3.4 million increase in costs to support affiliate fiber routes, and $1.2 million increase in affiliate costs to support internet revenue services. 2015 Compared to 2014 Consolidated Results The Company’s consolidated results from continuing operations for the years ended December 31, 2015 and 2014 are summarized as follows: Operating revenues Operating revenues increased $15.5 million, or 4.8%. Cable segment revenue grew $13.1 million, primarily as a result of a 5.4% growth in average subscriber counts and an increase in revenue per subscriber. Wireless segment revenues increased $1.3 million compared to 2014. Net prepaid service revenue increased $4.3 million, primarily due to 4.5% growth in average prepaid subscribers over 2014 and higher average revenue per subscriber due to improvements in product mix. Net postpaid service revenues decreased $2.7 million as a 6.7% increase in average postpaid subscribers was more than offset by lower revenue service plans associated with handset financing and leasing programs. Wireline segment revenue increased $4.4 million, led by growth in carrier access fees, fiber revenues, and internet service revenues. Affiliate revenues increased $3.3 million. Affiliate revenues are eliminated from the consolidated totals shown in the table above. Operating expenses Total operating expenses increased $3.4 million, or 1.3%, in 2015 compared to 2014. Cost of goods and services sold decreased $8.4 million, primarily due to an $11.8 million decrease in PCS postpaid and prepaid handset costs, partially offset by a $4.1 million increase in cable programming and retransmission consent costs. Selling, general and administrative expenses increased $3.4 million, driven primarily by a $1.8 million increase to support growth of the wireless prepaid business. Depreciation and amortization expense increased $4.8 million, due to a one-time unfavorable adjustment of $2.0 million cumulative impact of additional depreciation on certain assets placed into service in one year and closed out in the fixed asset system in a subsequent year, and to ongoing projects to expand and upgrade the wireless, cable and fiber networks. Other Expense, net Interest expense decreased $0.8 million in 2015 from 2014. The decrease resulted from a combination of lower outstanding balances due to principal paydowns in 2015, as well as a decrease in the base rate of 0.25% effective May of 2015 due to improvements in the Company’s leverage ratio. Each of these factors contributed approximately $0.4 million to the decrease. The reduction in interest expense was partially offset by reduced gains from investments in 2015. Income tax expense The Company’s effective tax rate increased from 39.5% in 2014 to 40.4% in 2015. The increase is primarily attributable to the non-deductible costs for tax purposes related to the pending acquisition of nTelos. Net income Net income increased $7.0 million, or 20.6%, in 2015 from 2014. Growth in subscriber counts in the Wireless and Cable segments, along with a decrease in cost of goods and services sold in the Wireless segment contributed to the increase, but were partially offset by expenses related to the pending acquisition of nTelos and the unfavorable adjustment to depreciation expense. Wireless Operating revenues Wireless service revenue increased $1.6 million, or 0.8%, in 2015 over 2014. Net prepaid service revenues grew $4.3 million, or 9.9%, due to 4.5% growth in average prepaid subscribers over 2014 and higher average revenue per subscriber due to improvements in product mix. Net postpaid service revenues decreased $2.7 million. Average postpaid subscribers increased 6.7% in 2015 over the 2014 period, but the increase was more than offset by promotional discounts and a switch to lower revenue service plans associated with handset financing and leasing plans. Under these programs, the Company receives less service revenue from the subscriber, while the equipment revenue from the subscriber and the handset expense become Sprint’s responsibility and are not recorded by the Company. The decreases in service revenues are currently more than offset by a decrease in handset expense within cost of goods and services. Tower lease revenue increased primarily as a result of amendments to existing leases, as third party co-locators add 4G capabilities to our towers. Equipment revenue decreased due primarily to a lower volume of subsidized handset sales, partially offset by lower discounts on those sales. Operating expenses Cost of goods and services decreased $9.7 million, or 13.3%, in 2015 from 2014. Postpaid handset costs decreased $10.9 million, as handset expenses associated with financing and leasing plans are Sprint’s responsibility and are not recorded by the Company. Prepaid handset costs decreased $1.0 million, driven by year-over-year declines in both the volume and average cost of handsets. Network costs increased $1.9 million, due to a decrease in labor capitalized to projects and to increases in rent and power expenses for cell sites and towers. Additionally, the prior year period included a $0.4 million gain on disposal of 3G equipment. Selling, general and administrative costs increased $2.6 million, or 7.9%, in 2015 over 2014. Costs to support the prepaid wireless business increased $1.8 million, driven by subscriber growth, product mix, and higher general and administrative costs. Personnel costs increased $0.7 million due to the addition of new retail stores. Advertising expenses increased $0.6 million. Property taxes increased $0.5 million due to a prior year refund and a higher tax basis in network assets as a result of recent upgrades. The increases were partially offset by a $1.1 million decline in third party commissions expense due to lower volume of commissionable handsets activated through dealer channels. Depreciation and amortization increased $3.3 million, or 10.6%, in 2015 over 2014, following completion of Network Vision upgrades. Cable (1) Prior year service and other revenue amounts have been recast to conform to the current year presentation of video and internet equipment revenues being included in service revenue rather than other revenue. Operating revenues Cable segment service revenue increased $11.8 million, or 15.3%. Internet service revenue increased $8.5 million, or 29.7%, due to a 9.7% increase in average internet subscribers, along with an improved product mix as customers upgraded to higher-speed plans with higher monthly recurring charges. Video revenue, including retransmission consent fee surcharges, increased $4.0 million driven by video rate increases in January 2015. Voice revenue increased $1.2 million due to 16.7% growth in average voice revenue generating units. These increases were partially offset by a $1.9 million increase in bundle discounts. Other revenue grew $1.3 million, primarily due to new fiber contracts and higher installation revenue. Operating expenses Cable segment cost of goods and services increased $2.6 million, or 5.1%, in 2015 over 2014. Video programming costs, including retransmission consent fees, increased $4.1 million as the impact of rising rates per subscriber outpaced declining video subscriber counts. Network costs grew $0.7 million, primarily due to $0.4 million increase in the Universal Service fees mandated by the U.S. government in the current year. The increases were offset by a $1.5 million decrease in disposal costs following a $1.6 million disposal of obsolete equipment in 2014, along with a $1.0 million decrease in maintenance expense following a multi-year project to upgrade cable network infrastructure. Selling, general and administrative expenses decreased $0.1 million against the prior year as declines in marketing and customer service costs were largely offset by growth in administrative and operating tax expenses. Wireline (1) Prior year categories of access revenue and facilities lease revenue have been combined into the new category of carrier access and fiber revenue to conform to current year presentation. Additionally, set-top box revenues included in other revenue in the prior year are now presented within service revenue Operating revenues Total operating revenues in 2015 increased $4.4 million, or 7.0%, over 2014. Carrier access and fiber revenues grew $3.1 million as growth in affiliate and non-affiliate fiber contracts were partially offset by favorable Universal Service program adjustments that were recorded in the first quarter of 2014. Internet service revenue grew $1.2 million as customers upgraded to higher-speed plans. Operating expenses Operating expenses overall increased $3.7 million, or 7.8%, in 2015, compared to 2014. The increase in cost of goods and services resulted primarily from a $2.1 million increase in costs to support affiliate fiber routes. The increase was partially offset by a $0.6 million decrease in affiliate and non-affiliate line costs. Sales, general and administrative expenses increased as a result of growth in sales and customer service support teams. Depreciation expense grew $1.5 million as a result of continued investment in the construction of fiber facilities. The current year total includes an unfavorable adjustment of $0.4 million related to assets placed into service in one year and closed out in the fixed asset system in a subsequent year. Non-GAAP Financial Measure In managing our business and assessing our financial performance, management supplements the information provided by financial statement measures prepared in accordance with GAAP with Adjusted OIBDA and Continuing OIBDA, which are considered “non-GAAP financial measures” under SEC rules. Adjusted OIBDA is defined by us as operating income (loss) before depreciation and amortization, adjusted to exclude the effects of: certain non-recurring transactions; impairment of assets; gains and losses on asset sales; straight-line adjustments for the waived management fee by Sprint; amortization of the affiliate contract expansion intangible reflected as a contra revenue; actuarial gains and losses on pension and other post-retirement benefit plans; and share-based compensation expense. Adjusted OIBDA should not be construed as an alternative to operating income as determined in accordance with GAAP as a measure of operating performance. Continuing OIBDA is defined by us as Adjusted OIBDA, less the benefit received from the waived management fee by Sprint over the next approximately six-year period, showing Sprint's support for our acquisition and our commitments to enhance the network. In a capital-intensive industry such as telecommunications, management believes that Adjusted OIBDA and Continuing OIBDA and the associated percentage margin calculations are meaningful measures of our operating performance. We use Adjusted OIBDA and Continuing OIBDA as supplemental performance measures because management believes they facilitate comparisons of our operating performance from period to period and comparisons of our operating performance to that of other companies by excluding potential differences caused by the age and book depreciation of fixed assets (affecting relative depreciation expenses) as well as the other items described above for which additional adjustments were made. In the future, management expects that the Company may again report Adjusted OIBDA and Continuing OIBDA excluding these items and may incur expenses similar to these excluded items. Accordingly, the exclusion of these and other similar items from our non-GAAP presentation should not be interpreted as implying these items are non-recurring, infrequent or unusual. While depreciation and amortization are considered operating costs under generally accepted accounting principles, these expenses primarily represent the current period allocation of costs associated with long-lived assets acquired or constructed in prior periods, and accordingly may obscure underlying operating trends for some purposes. By isolating the effects of these expenses and other items that vary from period to period without any correlation to our underlying performance, or that vary widely among similar companies, management believes Adjusted OIBDA and Continuing OIBDA facilitates internal comparisons of our historical operating performance, which are used by management for business planning purposes, and also facilitates comparisons of our performance relative to that of our competitors. In addition, we believe that Adjusted OIBDA and Continuing OIBDA and similar measures are widely used by investors and financial analysts as measures of our financial performance over time, and to compare our financial performance with that of other companies in our industry. Adjusted OIBDA and Continuing OIBDA have limitations as an analytical tool, and should not be considered in isolation or as a substitute for analysis of our results as reported under GAAP. These limitations include the following: • they do not reflect capital expenditures; • many of the assets being depreciated and amortized will have to be replaced in the future and Adjusted OIBDA and Continuing OIBDA do not reflect cash requirements for such replacements; • they do not reflect costs associated with share-based awards exchanged for employee services; • they do not reflect interest expense necessary to service interest or principal payments on indebtedness; • they do not reflect gains, losses or dividends on investments; • they do not reflect expenses incurred for the payment of income taxes; and • other companies, including companies in our industry, may calculate Adjusted OIBDA and Continuing OIBDA differently than we do, limiting its usefulness as a comparative measure. In light of these limitations, management considers Adjusted OIBDA and Continuing OIBDA as a financial performance measure that supplements but does not replace the information reflected in our GAAP results. The following table shows Adjusted OIBDA and Continuing OIBDA for the years ended December 31, 2016, 2015 and 2014: The following table reconciles Adjusted OIBDA and Continuing OIBDA to operating income, which we consider to be the most directly comparable GAAP financial measure, for the years ended December 31, 2016, 2015 and 2014: (1) Once former nTelos customers migrate to the Sprint backoffice, the Company incurs certain postpaid fees retained by Sprint and prepaid costs passed to us by Sprint that would offset a portion of these savings. For the year ended December 31, 2016, these offsets were estimated at $4.6 million. The following tables reconcile Adjusted OIBDA and Continuing OIBDA to operating income by major segment for the years ended December 31, 2016, 2015 and 2014: Financial Condition, Liquidity and Capital Resources The Company has four principal sources of funds available to meet the financing needs of its operations, capital projects, debt service, investments and potential dividends. These sources include cash flows from operations, existing balances of cash and cash equivalents, the liquidation of investments and borrowings. Management routinely considers the alternatives available to determine what mix of sources are best suited for the long-term benefit of the Company. Sources and Uses of Cash. The Company generated $161.5 million of net cash from operations in 2016, an increase from $119.3 million in 2015, which was a $4.3 million increase from 2014. The increases were primarily due to increases in operating income before depreciation and amortization. During 2016, the Company utilized $820.0 million in net investing activities, including $657.4 million invested in acquisitions of nTelos and Colane. Plant and equipment purchases in 2016, 2015 and 2014 totaled $173.2 million, $69.7 million and $68.2 million, respectively. Capital expenditures in 2016 primarily supported wireless network upgrades and capacity and coverage enhancements as a result of the nTelos acquisition, as well as retail store remodeling, cable segment extensions and investment in customer premises equipment, and expansion and upgrade of our fiber networks. Capital expenditures in 2015 supported projects across all segments, including wireless network capacity and coverage enhancements, new retail stores, cable segment extensions and investment in customer premises equipment, and expansion and upgrade of our fiber networks. Expenditures in 2014 also supported projects across all segments, including wireless network capacity and coverage enhancements, cable plant expansion and upgrades, and wireline fiber builds. Financing activities provided $617.9 million in 2016 as the Company borrowed $860 million to fund the nTelos acquisition and related activities, repaid debt totaling $213.8 million, and paid $14.9 million to enter into the new debt financing arrangement to acquire nTelos. The Company also paid cash dividends totaling $11.7 million. Financing activities utilized $42.2 million in 2015 as the Company made $23.0 million in principal payments on long-term debt, paid cash dividends totaling $11.1 million and paid $7.9 million in debt issuance fees related to the pending nTelos acquisition. Financing activities utilized $16.8 million in 2014, principally due to $10.8 million in cash dividends paid to shareholders and $5.8 million of principal repayments on long-term debt. Indebtedness. As of December 31, 2016, the Company’s gross indebtedness totaled $847.9 million, with an annualized effective interest rate of approximately 3.83% after considering the impact of the interest rate swap contract. The balance consists of the Term Loan A-1 at a variable rate (3.52% as of December 31, 2016) that resets monthly based on one month LIBOR plus a base rate of 2.75% currently, and a Term Loan A-2 at a variable rate (3.77% as of December 31, 2016) that resets monthly based on one month LIBOR plus a base rate of 3.00% currently. The Term Loan A-1 requires quarterly principal repayments of $6.1 million through June 30, 2017, increasing to $12.1 million quarterly through June 2020, with further increases at that time through maturity in 2021. The Term Loan A-2 requires quarterly principal payments of $10.0 million beginning September 30, 2018 through March 31, 2023, with the remaining balance due June 30, 2023. The Company’s credit agreement includes a Revolver Facility that provides for $75 million in availability for future capital expenditures and general corporate needs, and $25 million available under the Term Loan A-2 as a delayed draw term loan. In addition, the credit agreement permits the Company to enter into one or more Incremental Term Loan Facilities in the aggregate principal amount not to exceed $150 million subject to compliance with certain covenants. At December 31, 2016, no draw had been made under the Revolver Facility and the Company had not entered into any Incremental Term Loan Facility. When and if a draw is made, the maturity date and interest rate options would be substantially identical to the Term Loan Facility, though the margin on principal drawn on the revolver is 0.25% less than the corresponding margin on term loans. If the interest rate on an Incremental Term Loan Facility is more than 0.25% greater than the rate on the existing outstanding balances, the interest rate on the existing debt would reset at the same rate as the Incremental Term Loan Facility. Repayment provisions would be agreed to at the time of each draw under the Incremental Term Loan Facility. The Company is subject to certain financial covenants measured on a trailing twelve month basis each calendar quarter unless otherwise specified. These covenants include: • a limitation on the Company’s total leverage ratio, defined as indebtedness divided by earnings before interest, taxes, depreciation and amortization, or EBITDA, of less than or equal to 3.75 to 1.00 through December 30, 2018, then 3.25 to 1.00 through December 30, 2019, and 3.00 to 1.00 thereafter; • a minimum debt service coverage ratio, defined as EBITDA divided by the sum of all scheduled principal payments on the Term Loans and regularly scheduled principal payments on other indebtedness plus cash interest expense, greater than 2.00 to 1.00 at all times; • a minimum liquidity balance, defined as availability under the Revolver Facility plus unrestricted cash and cash equivalents on deposit in a deposit account for which a control agreement has been delivered to the administrative agent under the 2016 credit agreement, of greater than $25 million at all times. As of December 31, 2016, the Company was in compliance with the financial covenants in its credit agreements, and ratios at December 31, 2016 were as follows: Contractual Commitments. The Company is obligated to make future payments under various contracts it has entered into, primarily amounts pursuant to its long-term debt facility, and non-cancelable operating lease agreements for retail space, tower space and cell sites. Expected future minimum contractual cash obligations for the next five years and in the aggregate at December 31, 2016, are as follows: Payments due by periods 1) Includes principal payments and estimated interest payments on the Term Loan Facility based upon outstanding balances and rates in effect at December 31, 2016. 2) Represents the maximum interest payments we are obligated to make under our derivative agreements. Assumes no receipts from the counterparty to our derivative agreements. 3) Amounts include payments over reasonably assured renewals. See Note 14 to the consolidated financial statements appearing elsewhere in this report for additional information. 4) Represents open purchase orders at December 31, 2016. Other long-term liabilities have been omitted from the table above due to uncertainty of the timing of payments, combined with the absence of historical trending to be used as a predictor of such payments. The Company has no other off-balance sheet arrangements and has not entered into any transactions involving unconsolidated, limited purpose entities or commodity contracts. Capital Commitments. The Company spent $173.2 million on capital projects in 2016, up from $69.7 million spent in 2015 and $68.2 million spent in 2014. Capital expenditures in 2016 primarily supported cell site upgrades and coverage and capacity expansions in the wireless segment following the nTelos acquisition, as well as cable plant expansion and upgrades and wireline segment fiber builds. Capital expenditures in 2015 and 2014 supported projects across all segments, including wireless network capacity and coverage enhancements, cable plant expansion and upgrades, and wireline fiber builds. Capital expenditures budgeted for 2017 totaled $152.3 million, including $99.2 million in the Wireless segment primarily for upgrades and expansion of the nTelos wireless network. In addition, $25.8 million is budgeted primarily for cable network expansion including new fiber routes and cable market expansion, $18.9 million in Wireline projects including fiber builds in Pennsylvania and other areas, and $8.2 million primarily for IT projects. We believe that cash on hand, cash flow from operations and borrowings expected to be available under our existing credit facilities will provide sufficient cash to enable us to fund planned capital expenditures, make scheduled principal and interest payments, meet our other cash requirements and maintain compliance with the terms of our financing agreements for at least the next twelve months. Thereafter, capital expenditures will likely continue to be required to continue planned capital upgrades to the acquired wireless network and provide increased capacity to meet our expected growth in demand for our products and services. The actual amount and timing of our future capital requirements may differ materially from our estimate depending on the demand for our products and new market developments and opportunities. Our cash flows from operations could be adversely affected by events outside our control, including, without limitation, changes in overall economic conditions, regulatory requirements, changes in technologies, demand for our products, availability of labor resources and capital, changes in our relationship with Sprint, and other conditions. The Wireless segment’s operations are dependent upon Sprint’s ability to execute certain functions such as billing, customer care, and collections; our ability to develop and implement successful marketing programs and new products and services; and our ability to effectively and economically manage other operating activities under our agreements with Sprint. Our ability to attract and maintain a sufficient customer base, particularly in the acquired cable markets, is also critical to our ability to maintain a positive cash flow from operations. The foregoing events individually or collectively could affect our results. Recently Issued Accounting Standards In May 2014, the FASB issued ASU No. 2014-09, “Revenue from Contracts with Customers”, which requires an entity to recognize the amount of revenue to which it expects to be entitled for the transfer of promised goods or services to customers. The ASU will replace most existing revenue recognition guidance in U.S. GAAP when it becomes effective. In August 2015, the FASB issued ASU No. 2015-14, delaying the effective date of ASU 2014-09. Three other amendments have been issued during 2016 modifying the original ASU. As amended, the new standard is effective for the Company on January 1, 2018, using either a retrospective basis or a modified retrospective basis with early adoption permitted, but not earlier than the original effective date beginning after December 15, 2016. We have formed a project team to evaluate and implement the new standard. As part of our work to date, we have begun contract review and documentation. We currently plan to adopt this guidance using the modified retrospective transition approach, which would result in an adjustment to retained earnings for the cumulative effect, if any, of applying this standard. Additionally, this guidance requires us to provide additional disclosures of the amount by which each financial statement line item is affected in the current reporting period during 2018 as compared to the guidance that was in effect before the change. We continue to assess the impact this new standard will have on our financial position, results of operations and cash flows. In July 2015, the FASB issued ASU No. 2015-11, "Inventory: Simplifying the Measurement of Inventory", which changes the measurement principle for inventory from the lower of cost or market to lower of cost and net realizable value. The ASU also eliminates the requirement for these entities to consider replacement cost or net realizable value less an approximately normal profit margin when measuring inventory. This guidance is effective for fiscal years and interim periods beginning after December 15, 2016. We are currently in the process of evaluating the impact of adoption of the ASU on our financial statements. In February 2016, the FASB issued ASU No. 2016-02, “Leases”, which requires the recognition of lease assets and lease liabilities by lessees for those leases classified as operating leases under previous generally accepted accounting principles. This change will result in an increase to recorded assets and liabilities on lessees’ financial statements, as well as changes in the categorization of rental costs, from rent expense to interest and depreciation expense. Other effects may occur depending on the types of leases and the specific terms of them utilized by particular lessees. The ASU is effective for us on January 1, 2019, and early application is permitted. Modified retrospective application is required. We are currently evaluating the ASU, but expect that it will have a material impact on our consolidated financial statements. In January 2017, the FASB issued ASU 2017-01, “Business Combinations: Clarifying the Definition of a Business”. The standard clarifies the definition of a business to assist entities with evaluating whether transactions should be accounted for as acquisitions (or disposals) of assets or businesses. The ASU will become effective for us on January 1, 2018. We are currently evaluating the impact of this ASU on our consolidated financial statements. In January 2017, the FASB issued ASU 2017-04, “Intangibles - Goodwill and Other (Topic 350): Simplifying the Test for Goodwill Impairment.” The standard eliminates the requirement to measure the implied fair value of goodwill by assigning the fair value of a reporting unit to all assets and liabilities within that unit (“the Step 2 test”) from the goodwill impairment test. Instead, if the carrying amount of a reporting unit exceeds its fair value, an impairment loss is recognized in an amount equal to that excess, limited by the amount of goodwill in that reporting unit. The standard will become effective for us beginning January 1, 2020 and must be applied to any annual or interim goodwill impairment assessments after that date. Early adoption is permitted. We are currently in the process of evaluating the standard, but expect that it will not have a material impact on our consolidated financial statements. In addition to the updates outlined above, FASB has issued other Accounting Standards Updates that were reviewed by management and determined to have a minimal impact on the financial statements. We will continue to evaluate the impact of all updates as they are released.

<s>[INST] This annual report contains forwardlooking statements within the meaning of Section 27A of the Securities Act of 1933 and Section 21E of the Securities Exchange Act of 1934, including statements regarding our expectations, hopes, intentions, or strategies regarding the future. These statements are subject to certain risks and uncertainties that could cause actual results to differ materially from those anticipated in the forwardlooking statements. Factors that might cause such a difference include those discussed in this report under “BusinessCompetition” and “Risk Factors.” The Company undertakes no obligation to publicly revise these forwardlooking statements to reflect subsequent events or circumstances, except as required by law. General Overview. Shenandoah Telecommunications Company is a diversified telecommunications company providing both regulated and unregulated telecommunications services through its wholly owned subsidiaries. These subsidiaries provide wireless personal communications services (as a Sprint PCS affiliate), local exchange telephone services, video, internet and data services, long distance services, fiber optics facilities and leased tower facilities. We have three reportable segments, which we operate and manage as strategic business units organized by lines of business: (1) Wireless, (2) Cable and (3) Wireline. * The Wireless segment has historically provided digital wireless service as a Sprint PCS Affiliate to a portion of a fourstate area covering the region from Harrisburg, York and Altoona, Pennsylvania, to Harrisonburg, Virginia. Following the acquisition of nTelos, the Company’s wireless service area expanded to include southcentral and western Virginia, West Virginia, and small portions of Kentucky and Ohio. In these areas, we are the exclusive provider of Sprintbranded wireless mobility communications network products and services on the 800 MHz, 1900 MHz and 2.5 GHz spectrum bands. This segment also owns cell site towers built on leased land, and leases space on these towers to both affiliates and nonaffiliated service providers. * The Cable segment provides video, internet and voice services in franchise areas in portions of Virginia, West Virginia and western Maryland, and leases fiber optic facilities throughout its service area. It does not include video, internet and voice services provided to customers in Shenandoah County, Virginia. * The Wireline segment provides regulated and unregulated voice services, DSL internet access and long distance access services throughout Shenandoah County and portions of Rockingham, Frederick, Warren and Augusta counties, Virginia. The segment also provides video and cable modem internet access services in portions of Shenandoah County, and leases fiber optic facilities throughout the northern Shenandoah Valley of Virginia, northern Virginia and adjacent areas along the Interstate 81 corridor through West Virginia, Maryland and portions of central and southern Pennsylvania. A fourth segment, Other, primarily includes Shenandoah Telecommunications Company, the parent holding company, and includes corporate costs of executive management, information technology, legal, finance and human resources. This segment also includes certain acquisition and integration costs primarily consisting of severance accruals for shortterm nTelos employees to be separated as integration activities wind down and transaction related expenses such as investment advisor, legal and other professional fees. Acquisition of nTelos and Exchange with Sprint: On May 6, 2016, we completed our previously announced acquisition of NTELOS Holdings Corp. (“nTelos”) for $667.8 million, net of cash acquired. The purchase price was financed by a credit facility arranged by CoBank, ACB. We have included the operations of nTelos for financial reporting purposes for periods subsequent to the acquisition. Immediately after acquiring nTelos, we exchanged spectrum licenses valued at $198.2 million, and customer based contract rights valued at $206.7 million, acquired from nTelos with Sprint, and received an expansion of our affiliate service territory to include most of the service area served by nTelos, valued at $284.1 million, as well as customer based contract rights, valued at $120.9 million, relating to nTelos’ and Sprint’s legacy customers in the our affiliate service territory. The value of the affiliate agreement expansion is based on changes to the amended affiliate agreement that include an [/INST] Positive. </s>

SHENANDOAH TELECOMMUNICATIONS CO/VA/

2018-03-15

2017-12-31

ITEM 7. MANAGEMENT'S DISCUSSION AND ANALYSIS OF FINANCIAL CONDITION AND RESULTS OF OPERATIONS This annual report contains forward-looking statements within the meaning of Section 27A of the Securities Act of 1933 and Section 21E of the Securities Exchange Act of 1934, including statements regarding our expectations, intentions, or strategies regarding the future. These statements are subject to certain risks and uncertainties that could cause actual results to differ materially from those anticipated in the forward-looking statements. Factors that might cause such a difference include those discussed in this report under Item 1, “Business” and Item 1A, “Risk Factors.” The Company undertakes no obligation to publicly revise these forward-looking statements to reflect subsequent events or circumstances, except as required by law. You should read the following discussion and analysis of our financial condition and results of operations in conjunction with our "Selected Financial Data" and our consolidated financial statements and notes thereto appearing elsewhere in this Annual Report on Form 10-K. General Overview. Shenandoah Telecommunications Company, (the "Company", "we", "our", or "us"), is a diversified telecommunications company providing integrated voice, video and data communication services including both regulated and unregulated telecommunications services through its wholly owned subsidiaries. These subsidiaries provide wireless personal communications services, as a Sprint PCS affiliate, and local exchange telephone services, video, internet and data services, long distance services, fiber optics facilities and leased tower facilities. We organize and strategically manage our operations under the Company's reportable segments that include: Wireless, Cable, Wireline, and Other. See Note 16, Segment Reporting, included with the notes to our consolidated financial statements for further information regarding our segments. The following provides a description of the operations within our segments: • Wireless provides digital wireless mobile service as a Sprint PCS Affiliate to a portion of a multi-state area covering large portions of central and western Virginia, south-central Pennsylvania, West Virginia, and portions of Maryland, North Carolina, Kentucky, Tennessee and Ohio, "our wireless network coverage area". In these areas, we are the exclusive provider of Sprint-branded wireless mobility communications network products and services on the 800 MHz, 1900 MHz and 2.5 GHz spectrum bands. Wireless also owns 192 cell site towers built on leased and owned land, and leases space on these towers to both affiliates and non-affiliated third party wireless service providers. • Cable provides video, internet and voice services in franchise areas in portions of Virginia, West Virginia and western Maryland, and leases fiber optic facilities throughout its service area. • Wireline provides regulated and unregulated voice services, DSL internet access and long distance access services throughout Shenandoah County and portions of Rockingham, Frederick, Warren and Augusta counties, Virginia. The segment also provides video, DSL and cable modem internet access services in Shenandoah County, and leases fiber optic facilities throughout the northern Shenandoah Valley of Virginia, northern Virginia and adjacent areas along the Interstate 81 corridor through West Virginia, Maryland and portions of central and southern Pennsylvania. • Additionally, our Other operations are represented by Shenandoah Telecommunications Company, the parent holding company, that provides investing and management services to the Company's subsidiaries. Recent Developments Credit Facility Modification: On February 16, 2018, the Company, entered into a Second Amendment to Credit Agreement (the “Second Amendment”) with CoBank, ACB, as administrative agent of its Credit Agreement, described more fully in Note 13, Long-Term Debt, and the various financial institutions party thereto (the “Lenders”), which modifies the Credit Agreement by (i) reducing the interest rate paid by the Company by approximately 50 basis points with respect to certain loans made by the Lenders to the Company under the Credit Agreement, and (ii) allowing the Company to make charitable contributions to Shentel Foundation, a Virginia nonstock corporation, of up to $1.5 million in any fiscal year. Sprint Territory Expansion: Effective February 1, 2018, we signed the Expansion Agreement with Sprint to expand our wireless service area to include certain areas in Kentucky, Pennsylvania, Tennessee, Virginia and West Virginia, (the “Expansion Area”), effectively adding a population (POPs) of approximately 1.1 million in Lancaster County, PA, central Virginia, southwest Virginia, southern West Virginia, and eastern Kentucky. The agreement includes certain network build out requirements in the Expansion Area, and the ability to utilize Sprint’s spectrum in the Expansion Area along with certain other amendments to the Affiliate Agreements. Pursuant to the Expansion Agreement, Sprint agreed to, among other things, transition the provision of network coverage in the Expansion Area from Sprint to us. The Expansion Agreement required us to make a one-time payment of $60.0 million to Sprint for the right to service the Expansion Area pursuant to the Affiliate Agreements plus an additional payment of up to $5.0 million for certain equipment at the Sprint cell sites in the Expansion Area for maximum potential consideration of $65.0 million. A post-closing reconciliation to validate Sprint subscribers in the Expansion Area identified 59,097 Sprint subscribers in the Expansion Area instead of the 66,822 originally identified, which resulted in an $8 million reduction in purchase price. A map of our territory, reflecting the new expansion area, is provided below: United States Tax Reform: In December 2017, the Tax Cuts and Jobs Act (the “2017 Tax Act”) was enacted. The 2017 Tax Act represents major tax reform legislation that, among other provisions, reduces the U.S. corporate tax rate. Certain income tax effects of the 2017 Tax Act, including approximately $53.4 million of non-cash tax benefits recorded principally due to the revaluation of our net deferred tax liabilities, are reflected in our financial results in accordance with Accounting Standards Codification (ASC) Topic 740, "Income Taxes", in the reporting period in which the 2017 Tax Act became law. See Note 15, Income Taxes, included with the notes to our consolidated financial statements for further information on the financial statement impact of the 2017 Tax Act. Other Events Sprint Territory Expansion: Parkersburg - On April 6, 2017, we completed the expansion of our affiliate service territory, under our agreements with Sprint, to include certain areas in North Carolina, Kentucky, Maryland, Ohio and West Virginia effectively adding approximately 500 thousand POPs in the Parkersburg, WV and Cumberland, MD areas. The expanded territory includes the Parkersburg, WV, Huntington, WV, and Cumberland, MD, basic trading areas, (the "Parkersburg Expansion Area"). Acquisition of nTelos and Exchange with Sprint: On May 6, 2016, we completed the acquisition of NTELOS Holdings Corp. (“nTelos”) for $667.8 million, net of cash acquired. The purchase price was financed by a credit facility arranged by CoBank, ACB. We have included the operations of nTelos for financial reporting purposes for periods subsequent to the acquisition. For additional information regarding the acquisition of nTelos, please refer to Note 3, Business Combinations and Acquisitions, included with the consolidated financial statements. Acquisition, Integration and Migration Expenses Update: Since the acquisition of nTelos occurred, the Company incurred a total of approximately $75.7 million of acquisition, integration and migration expenses associated with this transaction, excluding approximately $23.0 million of debt issuance costs. Such costs included support of back-office staff and support functions required while the nTelos legacy customers were migrated to the Sprint billing platform; cost of the handsets that were provided to nTelos legacy customers as they migrated to the Sprint billing platform; severance costs for back-office and other former nTelos employees who were not retained permanently; and transaction related fees. We incurred $17.5 million of these costs during the year ended December 31, 2017. These costs include $1.8 million reflected in cost of goods and services and $4.7 million reflected in selling, general and administrative costs in the year ended December 31, 2017. Results of Operations In addition to the description of the components of our operations provided below please refer to the descriptions of our Critical Accounting Policies, included within this section, and to Note 2, Summary of Significant Accounting Policies, included within the notes to our consolidated financial statements, for additional information. Revenue We earn revenue primarily through the sale of our wireless network telecommunications services, cable and wireline services that include video, internet, voice, and data services. We also lease space on our cell site towers and our fiber network. Our revenue is primarily driven by the number of Sprint subscribers that utilize our wireless network as well as the number of our customers that subscribe to our cable and wireline services, our ability to retain our customers and the contractually negotiated price of such services. Operating Expenses Our operating expenses consist primarily of cost of goods and services, selling, general and administrative, acquisition, integration and migration expense related to the nTelos acquisition, and depreciation and amortization expenses, described as follows: Cost of Goods and Services - Cost of goods and services consists primarily of network-related costs attributable to the operation of our wireless, cable and wireline networks, including network costs, site costs for telecommunications equipment, and maintenance expenses, the cost of handsets for our Wireless subscribers, programming costs for our Cable operations, and expenses for employees who provide direct contractual services to our clients, including salaries, benefits, discretionary incentive compensation, employment taxes, and equity compensation costs. Our cost of goods and services also included certain network and network maintenance related expenses incurred to integrate the acquired nTelos network. Cost of goods and services does not include allocated amounts for occupancy expense and depreciation and amortization. Overall, we expect cost of goods and services to grow as we expand our network to capitalize on expansion opportunities in our market, which will require us to add additional staff, enter into additional tower and ground leases, and incur additional backhaul and electric network expenses. Selling, General and Administrative - Our selling, general and administrative expense consists primarily of employee-related expenses, including salaries, benefits, commissions, discretionary incentive compensation, employment taxes, and equity compensation costs for our employees engaged in the administration of sales, sales support, business development, marketing, management information systems, administration, human resources, finance, legal, and executive management. Selling, general and administrative expense also includes occupancy expenses including rent, utilities, communications, and facilities maintenance, professional fees, consulting fees, insurance, travel, and other expenses. Our selling, general and administrative expense also included certain general expenses, such as severance, incurred to integrate the acquisition of nTelos with our infrastructure. Our sales and marketing expense excludes any allocation of depreciation and amortization. We expect our selling, general and administrative expenses to increase, including the hiring of additional sales and sales support personnel as we strategically invest to expand our business, both organically and in our newly-acquired Sprint Expansion Areas. Acquisition, Integration and Migration - Our acquisition, integration and migration expense consisted primarily of costs required to migrate subscribers acquired in the May 2016 acquisition of nTelos to the Sprint billing and network systems, costs required to integrate the acquired nTelos administrative and operational support functions, severance costs for former nTelos employees who were not retained, transaction related fees; and gains or losses associated with the disposal of certain property. We completed the migration of nTelos subscribers to the Sprint network during 2017 and have incurred additional expenses related to integration activities. Depreciation and Amortization Expense - Our depreciation and amortization expense consists primarily of depreciation of fixed assets, and amortization of acquisition-related intangible assets. We expect our depreciation and amortization expense to increase as we expand our networks organically and through acquisitions. Other Income (Expense) Our other income (expense) consists primarily of interest expense, net gain (loss) on investments, and net non-operating income (loss), described as follows: Interest Expense - Interest expense represents interest incurred on our Credit Facilities (as defined below, under the heading Financial Condition, Liquidity and Capital Resources-Debt, and in Note 13, Long-Term Debt). We expect our interest expense to fluctuate in proportion to the outstanding principal balance of the Credit Facilities and the prevailing LIBOR interest rate. Gain (Loss) on Investments, net - Net gain (loss) on investments, consists of gains and losses realized as changes occur in the value of the assets and obligation underlying Company’s Supplemental Executive Retirement Plan ("SERP") retirement plan occur. We expect our net gain (loss) on investments, to fluctuate in proportion to the prevailing market conditions as they relate to our SERP assets and obligations. Non-Operating Income (Loss), net - Net non-operating income (loss), primarily represents interest and dividends earned from our investments, including our patronage arrangement that is connected to our credit facility. We expect our interest income to fluctuate in proportion to the amount of funds we invest and the continuation of the patronage arrangement. Income Tax Expense (Benefit) Our provision for income taxes consists of federal and state income taxes in the United States, and the provisional effect of the 2017 Tax Act, including deferred income taxes reflecting the net tax effects of temporary differences between the carrying amounts of assets and liabilities for financial reporting purposes and the amounts used for income tax purposes, and excess tax benefits or deficiencies derived from exercises of stock options and vesting of restricted stock. We expect that in the near-term our effective tax rate may fluctuate due to the effect of the 2017 Tax Act and the recognition of excess tax benefits and tax deficiencies associated with the exercise of stock options or the vesting of restricted stock. Excluding discrete items impacting the effective tax rate, we are expecting our long-term tax rate to more closely reflect the applicable federal and statutory rates. Refer to Note 15, Income Taxes, included with the notes to our consolidated financial statements for additional information concerning income taxes and the effects of the 2017 Tax Act. Results of Continuing Operations 2017 Compared with 2016 Consolidated Results The Company’s consolidated results from continuing operations are summarized as follows: Years Ended December 31, Change (in thousands) $ % Operating revenues $ 611,991 $ 535,288 $ 76,703 14.3 Operating expenses 565,481 512,762 52,719 10.3 Operating income 46,510 22,526 23,984 106.5 Other income (expense) (33,253 ) (20,581 ) (12,672 ) (61.6 ) Income tax expense (benefit) (53,133 ) 2,840 (55,973 ) (1,970.9 ) Net income (loss) $ 66,390 $ (895 ) $ 67,285 7,517.9 Operating revenues Operating revenues increased approximately $76.7 million, or 14.3%, in 2017 compared with 2016. Wireless segment revenues increased $66.3 million compared with 2016; this increase was primarily due to the expansion of our Wireless network coverage area through our 2016 acquisition of nTelos. Cable segment revenue grew approximately $10.4 million, primarily as a result of a 1.2% growth in average revenue generating units and a 8.3% increase in revenue per subscriber. Wireline segment revenue increased approximately $4.3 million, led by growth in carrier access fees, fiber revenues and internet service revenues. Operating expenses Total operating expenses increased approximately $52.7 million, or 10.3%, in 2017 compared with 2016. Wireless operating expenses increased approximately $58.4 million primarily due to our 2016 acquisition of nTelos that resulted in additional network costs required to support our expanded Wireless network, while operating expenses in our Other operations decreased approximately $6.8 million, primarily due to the completion of integration activities associated with the acquisition of nTelos. Cable and Wireline operating expenses increased approximately $1.6 million and $3.8 million, respectively. Within consolidated operating expenses, cost of goods and services sold increased approximately $18.0 million, selling, general and administrative expenses increased approximately $32.6 million, depreciation and amortization increased approximately $33.3 million, primarily due to our 2016 acquisition of nTelos. Increases in operating expenses were offset by a decrease in acquisition, integration and migration costs of approximately $31.2 million as a result of the completion of integration and migration activities related to the acquisition of nTelos. Other income (expense) Other income (expense) increased approximately $12.7 million or 61.6% in 2017 compared with 2016, primarily due to an increase in interest expense due to borrowings, related to our acquisition of nTelos, under our credit facility that were outstanding for the full year 2017. Income tax expense (benefit) The Company’s effective tax rate decreased from an expense of 146.0% in 2016 to a benefit of 400.8% in 2017. The decrease is primarily attributable to the changes in federal tax regulations related to the 2017 Tax Act that was enacted during December 2017 and non-deductible transactions costs incurred in 2016. We are expecting our long-term tax rate to more closely reflect the applicable federal and statutory rates offset for any excess tax benefits or shortfalls related to vesting or exercise of equity awards. We recognized an income tax benefit of approximately $53.1 million for the year ended December 31, 2017. This includes a one-time non-cash decrease of approximately $53.4 million in our net deferred tax liabilities as a result of the remeasurement of our deferred tax assets and liabilities as of December 31, 2017 to reflect the reduction in the U.S. corporate income tax rate from 35 percent to 21 percent. The 2017 Tax Act also provides immediate expensing for certain qualified assets acquired and placed into service after September 27, 2017 as well as prospective changes beginning in 2018, including acceleration of tax revenue recognition, additional limitations on deductibility executive compensation and limitations on the deductibility of interest. Refer to Note 15, Income Taxes, included with the notes to our consolidated financial statements for additional information concerning income taxes. Wireless Wireless earns postpaid and prepaid revenues from Sprint for their subscribers that use our Wireless network service in our Wireless network coverage area net of both recurring and non-recurring customer credits, account write offs and other billing adjustments. Postpaid revenues received from Sprint are recorded net of an 8% Management Fee and an 8.6% Net Service Fee that is retained by Sprint. Prepaid wireless products and service revenues received from Sprint are recorded net of a 6% Management Fee that is retained by Sprint. We incur other prepaid fees that are charged on a per unit basis that are separately recorded as expenses. Under our amended affiliate agreement, Sprint agreed to waive the Management Fees charged on both postpaid and prepaid revenues, up to approximately $4.2 million per month, until the total amount waived reaches approximately $255.6 million, which is expected to occur in 2022. The cash flow savings of the waived management fee waiver has been incorporated into the fair value of the affiliate contract expansion intangible, which is reduced, in part, as credits are received from Sprint. See Note 3, Business Combinations and Acquisitions, to our consolidated financial statements for further information. The following tables indicate selected operating statistics of Wireless, including Sprint subscribers, as of the dates shown: December 31, 2017 (4) December 31, 2016 (5) (6) December 31, 2015 Retail PCS Subscribers - Postpaid 736,597 722,562 312,512 Retail PCS Subscribers - Prepaid (1) 225,822 206,672 129,855 PCS Market POPS (000) (2) 5,942 5,536 2,433 PCS Covered POPS (000) (2) 5,272 4,807 2,224 CDMA Base Stations (sites) 1,623 1,467 Towers Owned Non-affiliate Cell Site Leases Gross PCS Subscriber Additions - Postpaid 173,871 132,593 77,067 Net PCS Subscriber Additions - Postpaid 14,035 5,085 24,645 PCS Average Monthly Retail Churn % - Postpaid (3) 2.04 % 1.84 % 1.47 % Gross PCS Subscriber Additions - Prepaid (1) 151,926 102,352 79,628 Net PCS Subscriber Additions (Losses) - Prepaid (1) 19,150 (58,643 ) 2,097 PCS Average Monthly Retail Churn % - Prepaid (1) 5.07 % 6.72 % 4.93 % _______________________________________________________ 1) Prepaid subscribers reported in the December 2016 and subsequent periods include the impact of a change in how long an inactive customer is included in the customer counts. This policy change effectively reduced prepaid customers by approximately 24 thousand. As of September 2017, the Company is no longer including Lifeline subscribers to be consistent with Sprint's policy. Historical customer counts have been adjusted accordingly. 2) "POPS" refers to the estimated population of a given geographic area. Market POPS are those within a market area which we are authorized to serve under our Sprint PCS affiliate agreements, and Covered POPS are those covered by our network. As of December 31, 2017, the data source for POPS is U.S. census data. Historical periods previously referred to other third party population data and have been recast to refer to U.S. census data. 3) PCS Average Monthly Retail Churn - Postpaid is the average of the monthly subscriber turnover, calculated for the period. 4) December 31, 2017 includes Parkersburg Expansion Area. 5) December 31, 2016 includes the acquired nTelos Area. 6) 2016 Net addition figures exclude the impact of the nTelos acquisition. The operating statistics shown above include the following: December 31, 2017 December 31, 2016 Parkersburg Expansion Area (3) nTelos Area (4) PCS Subscribers - Postpaid (1) 19,067 404,965 PCS Subscribers - Prepaid (1) 5,962 154,944 Acquired PCS Market POPS (000) 3,099 Acquired PCS Covered POPS (000) 2,298 Acquired CDMA Base Stations (sites) (2) - Towers - Non-affiliate Cell Site Leases - _______________________________________________________ 1) Represents Sprint's subscribers, including prepaid Lifeline, as of the acquisition date in the acquired territory. 2) As of December 31, 2017 we have shut down 107 overlap sites associated with the nTelos area. 3) Acquired on April 6, 2017. 4) Acquired on May 6, 2016. Wireless Operating Income Years Ended December 31, Change (in thousands) $ % Wireless operating revenues Wireless service revenue $ 431,184 $ 359,769 $ 71,415 19.9 Tower lease revenue 11,604 11,279 2.9 Equipment revenue 9,467 10,674 (1,207 ) (11.3 ) Other revenue 2,823 7,031 (4,208 ) (59.8 ) Total Wireless operating revenues $ 455,078 $ 388,753 $ 66,325 17.1 Wireless operating expenses Cost of goods and services 152,279 133,113 19,166 14.4 Selling, general and administrative 118,257 95,851 22,406 23.4 Acquisition, integration and migration expenses 10,793 25,927 (15,134 ) (58.4 ) Depreciation and amortization 139,610 107,621 31,989 29.7 Total Wireless operating expenses 420,939 362,512 58,427 16.1 Wireless operating income $ 34,139 $ 26,241 $ 7,898 30.1 Wireless Service Revenues Years Ended December 31, Change (in thousands) $ % Wireless Service Revenues Postpaid net billings (1) $ 372,237 $ 314,579 $ 57,658 18.3 Management fee (29,857 ) (25,543 ) (4,314 ) (16.9 ) Net Service fee (30,751 ) (22,953 ) (7,798 ) (34.0 ) 311,629 266,083 45,546 17.1 Prepaid net billings (2) 103,161 80,056 23,105 28.9 Sprint management fee (6,189 ) (4,960 ) (1,229 ) (24.8 ) 96,972 75,096 21,876 29.1 Travel and other revenues (2) 22,583 18,590 3,993 21.5 Total Wireless Service Revenues $ 431,184 $ 359,769 $ 71,415 19.9 ________________________________ 1) Postpaid net billings are defined under the terms of the affiliate contract with Sprint to be the gross billings to customers within our wireless network coverage area less billing credits and adjustments and allocated write-offs of uncollectible accounts. 2) The Company is no longer including Lifeline subscribers to be consistent with Sprint. The above table reflects the reclassification of the related Assurance Wireless prepaid revenue from prepaid gross billings to travel and other revenues for both years shown. Operating revenues Wireless service revenue increased approximately $71.4 million, or 19.9%, in 2017 compared with 2016, primarily due subscriber growth related to the expansion of our wireless network coverage area that was driven by our 2016 acquisition of nTelos and was offset by a decline in revenue per subscriber as a higher percentage of Sprint's postpaid customer base moved from higher revenue subsidized phone price plans to lower phone price plans associated with leased and installment sales. Postpaid net billings increased approximately $57.7 million, or 18.3%, as Postpaid Retail PCS Subscribers increased 1.9% primarily due to new subscribers from nTelos. Prepaid net billings increased $23.1 million, or 28.9%, due to 9.3% growth in Prepaid Retail PCS Subscribers and higher average revenue per subscriber due to improvements in product mix. Travel and other revenues increased $4.0 million due to a full year of travel revenue in the former nTelos service area compared to eight months in 2016. Equipment revenue decreased approximately $1.2 million or 11.3%, driven by a decline in handset sales as more subscribers are leasing their handsets directly from Sprint and as of August 2017 the Company is no longer being compensated for accessory sales through Sprint's national retailer channel. Other revenue decreased $4.2 million, or 59.8%, in 2017 compared with the same period in 2016 primarily due to the migration of the nTelos subscribers to the Sprint billing platform and corresponding reduction in regulatory recovery revenues that we billed the subscribers from the former nTelos platform prior to their migration. Operating expenses Cost of goods and services increased approximately $19.2 million, or 14.4%, in 2017 compared with 2016 due to the expansion of our network as a result of our 2016 acquisition of nTelos. Network costs increased $22.7 million, while maintenance costs increased $2.8 million and are both primarily attributable to a full year of nTelos and the expansion of our network and wireless network coverage area. Handset costs decreased approximately $7.0 million due to the completion of the migration of nTelos subscribers to the Sprint platform. Selling, general and administrative costs increased approximately $22.4 million, or 23.4%, in 2017 compared with 2016 primarily due to the expansion of our network as a result of our 2016 acquisition of nTelos. Expenses associated with prepaid wireless programs increased approximately $14.1 million in 2017 compared with 2016 as a result of the nTelos acquisition. Advertising and sales expenses increased $13.2 million as a result of our marketing campaigns aimed at POPS in our expanded wireless network coverage area. Integration costs classified as selling, general and administrative, associated with our acquisition of nTelos decreased approximately $3.8 million as a result of the 2017 completion of our migration and integration efforts. Customer service costs also decreased by approximately $1.1 million compared to 2016. Acquisition, integration and migration expenses decreased approximately $15.1 million as we completed the migration of subscribers from the nTelos billing platform to the Sprint network and billing platform. Depreciation and amortization increased $32.0 million, or 29.7%, in 2017 over 2016, reflecting the tangible and intangible assets acquired in the nTelos acquisition. Cable On January 1, 2016, we acquired the assets of Colane Cable Company. With the acquisition, we received 3,299 video customers, 1,405 high-speed internet customers, and 302 voice customers. These customers are included in the December 31, 2016 totals shown below. The following tables indicate selected operating statistics of the Cable operations as of the dates shown: December 31, 2017 December 31, 2016 December 31, 2015 Homes Passed (1) 184,910 184,710 172,538 Customer Relationships (2) Video users 44,269 48,512 48,184 Non-video customers 33,559 28,854 24,550 Total customer relationships 77,828 77,366 72,734 Video Users (3) 46,613 50,618 50,215 Penetration (4) 25.2 % 27.4 % 29.1 % Digital video penetration (5) 76.2 % 77.4 % 77.9 % High-speed Internet Available Homes (6) 184,910 183,826 172,538 Users (3) 63,918 60,495 55,131 Penetration (4) 34.6 % 32.9 % 32.0 % Voice Available Homes (6) 182,379 181,089 169,801 Users (3) 22,555 21,352 20,166 Penetration (4) 12.4 % 11.8 % 11.9 % Total Revenue Generating Units (7) 133,086 132,465 125,512 Fiber Route Miles 3,356 3,137 2,844 Total Fiber Miles (8) 122,011 92,615 76,949 Average Revenue Generating Units 132,759 131,218 124,054 ________________________________ 1) Homes and businesses are considered passed (“homes passed”) if we can connect them to our distribution system without further extending the transmission lines. Homes passed is an estimate based upon the best available information. 2) Customer relationships represent the number of billed customers who receive at least one of our services. 3) Generally, a dwelling or commercial unit with one or more television sets connected to our distribution system counts as one video customer. Where services are provided on a bulk basis, such as to hotels and some multi-dwelling units, the revenue charged to the customer is divided by the rate for comparable service in the local market to determine the number of customer equivalents included in the customer counts shown above. During the first quarter of 2016, we modified the way we count subscribers when a commercial customer upgrades its internet service via a fiber contract. We retroactively applied the new count methodology to prior periods, and applied similar logic to certain bulk customers; the net result was a reduction in internet subscriber counts of 559 subscribers at December 31, 2015. 4) Penetration is calculated by dividing the number of users by the number of homes passed or available homes, as appropriate. 5) Digital video penetration is calculated by dividing the number of digital video users by total video users. Digital video users are video customers who receive any level of video service via digital transmission. A dwelling with one or more digital set-top boxes or digital adapters counts as one digital video user. 6) Homes and businesses are considered available (“available homes”) if we can connect them to our distribution system without further extending the transmission lines and if we offer the service in that area. 7) Revenue generating units are the sum of video, voice and high-speed internet users. 8) Total Fiber Miles are measured by taking the number of fiber strands in a cable and multiplying that number by the route distance. For example, a 10 mile route with 144 fiber strands would equal 1,440 fiber miles. Cable Operating Income Years Ended December 31, Change (in thousands) $ % Cable operating revenues Service revenue $ 107,338 $ 99,070 $ 8,268 8.3 Other revenue 11,824 9,664 2,160 22.4 Total Cable operating revenues $ 119,162 $ 108,734 $ 10,428 9.6 Cable operating expenses Cost of goods and services 59,349 58,581 1.3 Selling, general and administrative 19,999 19,248 3.9 Depreciation and amortization 23,968 23,908 0.3 Total Cable operating expenses 103,316 101,737 1,579 1.6 Cable operating income $ 15,846 $ 6,997 $ 8,849 126.5 Operating revenues Cable service revenue increased $8.3 million, or 8.3% in 2017 compared with 2016. Internet service revenue increased approximately $6.3 million, or 13.8%, due to a 5.7% increase in internet subscribers, along with an improved product mix as new and existing customers increasingly move to higher-speed plans with higher monthly recurring charges. Video revenue, including retransmission consent fee surcharges, decreased approximately $0.3 million primarily related to a reduction in our video customers that was driven by video rate increases in 2017 required to offset higher programming costs. Voice revenue increased approximately $0.4 million due to 5.6% growth in voice revenue customers. A reduction of promotional discounts offered during 2017 also resulted in an increase in Cable operating revenues of approximately $2.0 million. Other revenue grew approximately $2.2 million, primarily due to the addition of new fiber contracts in 2017. Operating expenses Cable cost of goods and services increased $0.8 million, or 1.3%, in 2017 compared with 2016 primarily as a result of growth in our network costs as a result of increases in line costs and pole rents. Wireline The following table includes selected operating statistics of the Wireline operations as of the dates shown: December 31, 2017 December 31, 2016 December 31, 2015 Telephone Access Lines (1) 17,933 18,443 20,252 Long Distance Subscribers 9,078 9,149 9,476 Video Customers (2) 5,019 5,264 5,356 DSL and Cable Modem Subscribers (3) 14,665 14,314 13,890 Fiber Route Miles 2,073 1,971 1,736 Total Fiber Miles (4) 154,165 142,230 123,891 ________________________________ 1) Effective October 1, 2015, we launched cable modem services on our cable plant, and ceased the requirement that a customer have a telephone access line to purchase internet service. 2) Wireline's video service passes approximately 16,500 homes. 3) December 2017, 2016 and 2015 totals include 2,105 and 1,072 and 420 customers, respectively, served via the coaxial cable network. During 2016, we modified the way we count subscribers when a commercial customer upgrades its internet service via a fiber contract. We retroactively applied the new count methodology to prior periods and the net result was an increase in internet subscriber counts of 804 subscribers to December 31, 2015. 4) Total Fiber Miles are measured by taking the number of fiber strands in a cable and multiplying that number by the route distance. For example, a 10 mile route with 144 fiber strands would equal 1,440 fiber miles. Wireline Operating Income Years Ended December 31, Change (in thousands) $ % Wireline operating revenues Service revenue $ 22,645 $ 21,917 $ 3.3 Carrier access and fiber revenues 53,078 49,532 3,546 7.2 Other revenue 3,530 3,525 0.1 Total Wireline operating revenues $ 79,253 $ 74,974 $ 4,279 5.7 Wireline operating expenses Cost of goods and services 38,536 36,259 2,277 6.3 Selling, general and administrative 6,923 6,474 6.9 Depreciation and amortization 12,829 11,717 1,112 9.5 Total Wireline operating expenses 58,288 54,450 3,838 7.0 Wireline operating income $ 20,965 $ 20,524 $ 2.1 Operating revenues Total Wireline operating revenues in 2017 increased approximately $4.3 million, or 5.7%, compared with 2016. New carrier access and fiber revenue contracts became effective during 2017 for third party and affiliate fiber contracts resulting in growth of $3.5 million or 7.2% in 2017. Internet service revenue grew approximately $0.8 million as customers upgraded to higher-speed plans, while voice revenues declined approximately $0.4 million as customers discontinue landline telephone services. Operating expenses Total Wireline operating expenses increased approximately $3.8 million, or 7.0%, in 2017, compared with 2016 and included increases of approximately $2.3 million cost of goods and services related to higher network costs required to support our expanding affiliate fiber routes, $0.4 million increase in selling, general and administrative to support our investment in customer service personnel and infrastructure required to support our growth, and $1.1 million in additional depreciation related to our network assets. 2016 Compared with 2015 Consolidated Results The Company’s consolidated results from continuing operations are summarized as follows: Years Ended December 31, Change $ % (in thousands) Operating revenues $ 535,288 $ 342,485 $ 192,803 56.3 Operating expenses 512,762 268,399 244,363 91.0 Operating income 22,526 74,086 (51,560 ) (69.6 ) Other expense, net 20,581 5,496 15,085 274.5 Income tax expense 2,840 27,726 (24,886 ) (89.8 ) Net income $ (895 ) $ 40,864 $ (41,759 ) (102.2 ) Operating revenues Operating revenues increased $192.8 million, or 56.3%, primarily as a result of the nTelos acquisition. Wireless revenues increased $179.9 million compared to 2015; this increase was almost entirely due to the acquisition of nTelos on May 6, 2016, combined with the reduction in the Net Service Fee charged by Sprint related to separate settlement of certain revenues and expenses. Cable revenue grew $11.1 million, primarily as a result of a 6.3% growth in average subscriber counts and an increase in revenue per subscriber. Wireline revenue increased $7.6 million, led by growth in carrier access fees, fiber revenues and internet service revenues. Operating expenses Total operating expenses increased $244.4 million, or 91.0%, in 2016 compared to 2015. Wireless operating expenses increased $228.7 million while operating expenses in the Other operations increased $13.4 million, both largely due to the acquisition of nTelos. Cable and Wireline operating expenses increased $4.6 million and $3.4 million, respectively. Cost of goods and services sold increased $72.2 million, selling, general and administrative expenses increased $60.5 million, depreciation and amortization increased $73.0 million, and acquisition, integration and migration costs increased $38.7 million. Other expense, net Non-operating income increased $2.5 million due to increased patronage income related to higher outstanding balances on our CoBank borrowings and interest accrued on handset finance equipment installment plans loans acquired with nTelos. Interest expense increased $17.7 million in 2016 from 2015. The increase resulted primarily from higher outstanding balances due to borrowings to finance and support the nTelos acquisition, as well as slightly higher base rates on the new debt, increases in LIBOR during 2016, increased notional principal subject to interest rate swaps, and amortization of the fees and costs incurred to complete the new debt package. Income tax expense The Company’s effective tax rate increased from 40.4% in 2015 to 146.0% in 2016. The increase is primarily attributable to the changes in blended state rates applied to basis differences caused by the nTelos acquisition and the Company's legal entity restructuring that combined the nTelos legal entities into the Company's PCS subsidiary. Additionally, the rate was impacted by the adoption of ASU 2016-09 relating to stock compensation and non-deductible transaction costs incurred during 2016 related to the nTelos acquisition. The impact of these items on the effective tax rate is magnified by the near break-even level of income before taxes. Net income Net income decreased $41.8 million, or 102.2%, in 2016 from 2015. Increases in depreciation and amortization expenses resulting from the acquisition of nTelos, costs related to the acquisition including acquisition, integration and migration costs, (including those in cost of goods and services sold and selling, general and administrative expenses), and higher interest expense on the increased outstanding debt, offset the positive impact of revenues from new customers less new operating expenses resulting from the nTelos acquisition. Wireless Years Ended December 31, Change (in thousands) $ % Wireless operating revenues Wireless service revenue $ 359,769 $ 192,752 $ 167,017 86.6 Tower lease revenue 11,279 10,505 7.4 Equipment revenue 10,674 5,175 5,499 106.3 Other revenue 7,031 6,662 NM Total Wireless operating revenues $ 388,753 $ 208,801 $ 179,952 86.2 Segment operating expenses Cost of goods and services 133,113 63,570 69,543 109.4 Selling, general and administrative 95,851 35,792 60,059 167.8 Acquisition, integration and migration expenses 25,927 - 25,927 NM Depreciation and amortization 107,621 34,416 73,205 212.7 Total Wireless operating expenses 362,512 133,778 228,734 171.0 Wireless operating income $ 26,241 $ 75,023 $ (48,782 ) (65.0 ) Operating revenues Wireless service revenue increased $167.0 million, or 86.6%, in 2016 over 2015, primarily due to the nTelos acquisition. Net postpaid billings increased $129.4 million, or 69.9%, as average subscribers increased 89.2% and average billing rates dropped by 11% primarily due to new customers and upgrading existing customers moving to lower cost service plans that don't include a subsidized phone. Net prepaid billings to Sprint subscribers increased $31.6 million, or 61.8%, due to 53.1% growth in average prepaid subscribers over 2015 and higher average revenue per subscriber due to improvements in product mix. Effective January 1, 2016, the fees retained by Sprint, and deducted from postpaid revenues, decreased from 22.0% to 16.6%, and certain revenue and expense items became settled separately. As a result, despite the growth in net postpaid billings, the net service fee dropped by $2.9 million or 11.4%. Travel and other revenues, now separately settled, increased $17.1 million. Tower lease revenue increased primarily as a result of amendments to existing leases, as third party co-locators add 4G capabilities to our towers, and rents associated with the towers acquired in the nTelos acquisition. Equipment revenue increased due primarily to separately settled national device revenues passed to us by Sprint, as well as expanded activity due to the nTelos acquisition. Operating expenses Cost of goods and services increased $69.5 million, or 109.4%, in 2016 from 2015. Postpaid handset costs decreased $0.6 million. Prepaid handset costs increased $4.3 million. Network costs increased $47.5 million, while maintenance costs increased $8.7 million. These increases are primarily attributable to the expanded activities and service territory as a result of the nTelos acquisition. Separately settled national handset costs added $4.6 million to 2016's cost of goods and services. Selling, general and administrative costs increased $60.1 million, or 167.8%, in 2016 over 2015. National channel sales commissions, which we began separately settling with Sprint effective January 1, 2016, added $22.4 million to the current year expense. Expenses associated with prepaid wireless programs increased $3.5 million in 2016 from 2015. Personnel costs increased $20.9 million due to the addition of new retail stores and the need to support the nTelos billing platform and sales and customer service activities for customers prior to migration. Advertising expenses increased $5.5 million, while property taxes increased $1.8 million, both due to the nTelos acquisition. Acquisition, integration and migration costs of $25.9 million included $18.3 million in handset costs for subscribers to migrate to the Sprint back office and billing platform, $4.9 million in costs to shutdown overlapping cell sites and replace older backhaul circuits with Ethernet circuits to support increased data volumes at upgraded sites, and $2.7 million in incremental staff to support migration efforts in the stores. Depreciation and amortization increased $73.2 million, or 212.7%, in 2016 over 2015, reflecting the tangible and intangible assets acquired in the nTelos acquisition. Cable Years Ended December 31, Change (in thousands) $ % Cable operating revenues Service revenue $ 99,070 $ 88,980 $ 10,090 11.3 Other revenue 9,664 8,642 1,022 11.8 Total Cable operating revenues $ 108,734 $ 97,622 $ 11,112 11.4 Cable operating expenses Cost of goods and services 58,581 54,611 3,970 7.3 Selling, general and administrative 19,248 19,412 (164 ) (0.8 ) Depreciation and amortization 23,908 23,097 3.5 Total Cable operating expenses 101,737 97,120 4,617 4.8 Cable operating income $ 6,997 $ $ 6,495 1293.8 Operating revenues Cable service revenue increased $10.1 million, or 11.3% in 2016 from 2015. Internet service revenue increased $9.0 million, or 23.4%, due to an 8.9% increase in average internet subscribers, along with an improved product mix as new and existing customers increasingly move to higher-speed plans with higher monthly recurring charges. Video revenue, including retransmission consent fee surcharges, increased $2.5 million driven by video rate increases in January 2016, offsetting higher programming costs. Voice revenue increased $0.8 million due to 8.4% growth in average voice revenue generating units. These increases were partially offset by a $2.3 million increase in bundle discounts. Other revenue grew $1.0 million, primarily due to new fiber contracts. Operating expenses Cable segment cost of goods and services increased $4.0 million, or 7.3%, in 2016 over 2015. Video programming costs, including retransmission consent fees, increased $1.2 million as the impact of rising rates per subscriber outpaced declining video subscriber counts. Network costs grew $0.7 million, primarily due to $0.5 million in increased line costs and pole rents. Maintenance costs increased $0.9 million. Depreciation expense increased $0.8 million, partly as a result of assets acquired in the Colane acquisition, and new assets placed in service. Wireline Years Ended December 31, Change (in thousands) $ % Wireline operating revenues Service revenue $ 21,917 $ 21,880 $ 0.2 Carrier access and fiber revenues 49,532 42,303 7,229 17.1 Other revenue 3,525 3,237 8.9 Total Wireline operating revenues $ 74,974 $ 67,420 $ 7,554 11.2 Wireline operating expenses Cost of goods and services 36,259 31,668 4,591 14.5 Selling, general and administrative 6,474 6,612 (138 ) (2.1 ) Depreciation and amortization 11,717 12,736 (1,019 ) (8.0 ) Total Wireline operating expenses 54,450 51,016 3,434 6.7 Wireline operating income $ 20,524 $ 16,404 $ 4,120 25.1 Operating revenues Total Wireline operating revenues in 2016 increased $7.6 million, or 11.2%, over 2015. Carrier access and fiber revenues for affiliate fiber services grew by $4.9 million in 2016 while non-affiliate fiber revenue grew by $2.3 million. Internet service revenue grew $1.9 million as customers upgraded to higher-speed plans, while voice revenues declined $1.0 million as customers eliminate landline telephone services, and promotional discounts increased $0.9 million. Operating expenses Total Wireline operating expenses increased $3.4 million, or 6.7%, in 2016, compared to 2015. The increase in cost of goods and services resulted primarily from a $3.4 million increase in costs to support affiliate fiber routes, and a $1.2 million increase in affiliate costs to support internet revenue services. Non-GAAP Financial Measures In managing our business and assessing our financial performance, management supplements the information provided by the financial statement measures prepared in accordance with GAAP with Adjusted OIBDA and Continuing OIBDA, which are considered “non-GAAP financial measures” under SEC rules. Adjusted OIBDA is defined as operating income (loss) before depreciation and amortization, adjusted to exclude the effects of: certain non-recurring transactions; impairment of assets; gains and losses on asset sales; actuarial gains and losses on pension and other post-retirement benefit plans; and share-based compensation expense, and adjusted to include the benefit received from the waived management fee by Sprint. Continuing OIBDA is defined as Adjusted OIBDA, less the benefit received from the waived management fee by Sprint. Adjusted OIBDA and Continuing OIBDA should not be construed as an alternative to operating income as determined in accordance with GAAP as a measure of operating performance. In a capital-intensive industry such as telecommunications, management believes that Adjusted OIBDA and Continuing OIBDA and the associated percentage margin calculations are meaningful measures of our operating performance. We use Adjusted OIBDA and Continuing OIBDA as supplemental performance measures because management believes these measures facilitate comparisons of our operating performance from period to period and comparisons of our operating performance to that of our peers and other companies by excluding potential differences caused by the age and book depreciation of fixed assets (affecting relative depreciation expenses) as well as the other items described above for which additional adjustments were made. In the future, management expects that the Company may again report Adjusted OIBDA and Continuing OIBDA excluding these items and may incur expenses similar to these excluded items. Accordingly, the exclusion of these and other similar items from our non-GAAP presentation should not be interpreted as implying these items are non-recurring, infrequent or unusual. While depreciation and amortization are considered operating costs under generally accepted accounting principles, these expenses primarily represent the current period allocation of costs associated with long-lived assets acquired or constructed in prior periods, and accordingly may obscure underlying operating trends for some purposes. By isolating the effects of these expenses and other items that vary from period to period without any correlation to our underlying performance, or that vary widely among similar companies, management believes Adjusted OIBDA and Continuing OIBDA facilitates internal comparisons of our historical operating performance, which are used by management for business planning purposes, and also facilitates comparisons of our performance relative to that of our competitors. In addition, we believe that Adjusted OIBDA and Continuing OIBDA and similar measures are widely used by investors and financial analysts as measures of our financial performance over time, and to compare our financial performance with that of other companies in our industry. Adjusted OIBDA and Continuing OIBDA have limitations as an analytical tool, and should not be considered in isolation or as a substitute for analysis of our results as reported under GAAP. These limitations include the following: • they do not reflect capital expenditures; • many of the assets being depreciated and amortized will have to be replaced in the future and Adjusted OIBDA and Continuing OIBDA do not reflect cash requirements for such replacements; • they do not reflect costs associated with share-based awards exchanged for employee services; • they do not reflect interest expense necessary to service interest or principal payments on indebtedness; • they do not reflect gains, losses or dividends on investments; • they do not reflect expenses incurred for the payment of income taxes; and • other companies, including companies in our industry, may calculate Adjusted OIBDA and Continuing OIBDA differently than we do, limiting its usefulness as a comparative measure. In light of these limitations, management considers Adjusted OIBDA and Continuing OIBDA as a financial performance measure that supplements but does not replace the information reflected in our GAAP results. The following tables reconcile Adjusted OIBDA and Continuing OIBDA to operating income, which we consider to be the most directly comparable GAAP financial measure: Year Ended December 31, 2017 (in thousands) Wireless Cable Wireline Other Consolidated Operating income $ 34,139 $ 15,846 $ 20,965 $ (24,440 ) $ 46,510 Plus depreciation and amortization 139,610 23,968 12,829 177,007 Plus (gain) loss on asset sales (243 ) Plus share based compensation expense 1,579 3,580 Plus the benefit received from the waived management fee (1) 36,056 - - - 36,056 Plus amortization of intangibles netted in rent expense 1,528 - - - 1,528 Plus temporary back office costs to support the billing operations through migration (2) 6,459 - - 6,460 Less actuarial gains on pension plans - - - (1,387 ) (1,387 ) Plus integration and acquisition related expenses 10,793 - - 11,030 Adjusted OIBDA 230,378 40,487 34,257 (24,220 ) 280,902 Less waived management fee (36,056 ) - - - (36,056 ) Continuing OIBDA $ 194,322 $ 40,487 $ 34,257 $ (24,220 ) $ 244,846 Year Ended December 31, 2016 (in thousands) Wireless Cable Wireline Other Consolidated Operating income $ 26,241 $ 6,997 $ 20,524 $ (31,236 ) $ 22,526 Plus depreciation and amortization 107,621 23,908 11,717 143,685 Plus (gain) loss on asset sales (131 ) (27 ) (47 ) (49 ) Plus share based compensation expense 1,309 3,021 Plus the benefit received from the waived management fee (1) 24,596 - - - 24,596 Plus amortization of intangibles netted in rent expense - - - Plus temporary back office costs to support the billing operations through migration (2) 13,843 - - - 13,843 Less actuarial gains on pension plans - - - (4,460 ) (4,460 ) Plus integration and acquisition related expenses 25,927 - - 16,305 42,232 Adjusted OIBDA 200,134 31,817 32,561 (18,390 ) 246,122 Less waived management fee (24,596 ) - - - (24,596 ) Continuing OIBDA $ 175,538 $ 31,817 $ 32,561 $ (18,390 ) $ 221,526 Year Ended December 31, 2015 (in thousands) Wireless Cable Wireline Other Consolidated Operating income $ 75,023 $ $ 16,404 $ (17,843 ) $ 74,086 Plus depreciation and amortization 34,416 23,097 12,736 70,702 Plus (gain) loss on asset sales (41 ) Plus share based compensation expense 2,333 Plus the benefit received from the waived management fee (1) - - - - - Plus amortization of intangibles netted in rent expense - - - - - Plus temporary back office costs to support the billing operations through migration (2) - - - - - Less actuarial gains on pension plans - - - - - Plus integration and acquisition related expenses - - - 3,546 3,546 Adjusted OIBDA 110,055 24,455 29,717 (13,325 ) 150,902 Less waived management fee - - - - - Continuing OIBDA $ 110,055 $ 24,455 $ 29,717 $ (13,325 ) $ 150,902 ________________________________ 1) Under our amended affiliate agreement, Sprint agreed to waive the Management Fees charged on both postpaid and prepaid revenues, up to $4.2 million per month, until the total amount waived reaches approximately $255.6 million, which is expected to occur in 2022. 2) Once former nTelos customers migrate to the Sprint back office, the Company incurs certain postpaid fees retained by Sprint and prepaid costs passed to us by Sprint that would offset a portion of these savings. Financial Condition, Liquidity and Capital Resources Sources and Uses of Cash: Primary sources of cash include existing balances of cash and cash equivalents, cash flows from operations, and borrowings from our credit facility. Cash generated from such sources has been sufficient to fund our growth and strategic initiatives, fund our capital projects, service our debt and issue our annual dividend. As of December 31, 2017, our cash and cash equivalents totaled approximately $78.6 million, compared with approximately $36.2 million as of December 31, 2016. All cash held by the Company is domiciled in the United States. We expect to utilize approximately $15 million of existing availability under our credit facilities during the first quarter of 2018 to fund the continued expansion of our Wireless operations and our relationship with Sprint. The Company generated approximately $222.9 million of net cash from operations in 2017, an increase from approximately $161.5 million compared with 2016, which was an increase from $119.3 million in 2015. The increases were primarily due to the continued expansion of our wireless network coverage. During 2017, the Company utilized $151.5 million in net investing activities. Plant and equipment purchases in 2017, 2016 and 2015 totaled $146.5 million, $173.2 million and $69.7 million, respectively. Capital expenditures in 2017 primarily supported the expansion of our wireless network. Capital expenditures in 2016 primarily supported wireless network upgrades and capacity and coverage enhancements as a result of the nTelos acquisition, as well as retail store remodeling, cable segment extensions and investment in customer premises equipment, and expansion and upgrade of our fiber networks. Capital expenditures in 2015 supported projects across all segments, including wireless network capacity and coverage enhancements, new retail stores, cable segment extensions and investment in customer premises equipment, and expansion and upgrade of our fiber networks. Financing activities utilized approximately $29.0 million in 2017 as the Company repaid debt totaling $36.4 million, borrowed $25.0 million to fund the strategic expansion initiatives, paid dividends of $12.3 million, and provided cash payments for taxes related to equity awards of $5.4 million. Financing activities provided $617.9 million in 2016 as the Company borrowed $860.0 million to fund the nTelos acquisition and related activities, repaid debt totaling $201.7 million, paid $14.9 million to enter into the new debt financing arrangement to acquire nTelos and repaid $12.1 million of principal on the new debt financing arrangement. The Company also paid cash dividends totaling $11.7 million. Financing activities utilized $42.2 million in 2015 as the Company made $23.0 million in principal payments on long-term debt, paid cash dividends totaling $11.1 million and paid $7.9 million in debt issuance fees related to the pending nTelos acquisition. Indebtedness. As of December 31, 2017, the Company’s gross indebtedness totaled $836.5 million, with an estimated annualized effective interest rate of 4.23%, inclusive of the impact of the interest rate swap contract. The balance consists of the Term Loan A-1 at a variable rate (1.57% as of December 31, 2017) that resets monthly based on one month LIBOR plus a base rate of 2.75% currently, and a Term Loan A-2 at a variable rate (1.57% as of December 31, 2017) that resets monthly based on one month LIBOR plus a base rate of 3.00% currently. The Term Loan A-1 requires quarterly principal repayments of $12.1 million quarterly through June 2020, with further increases at that time through maturity in 2021. The Term Loan A-2 requires quarterly principal payments of $10.0 million beginning September 30, 2018 through March 31, 2023, with the remaining balance due June 30, 2023. The 2016 credit agreement also included $75 million available under the Term Loan A-2 as a delayed draw term loan, and as of December 2016, the Company drew $50 million under this portion of the agreement and in January 2017 the Company drew the remaining $25 million. Additionally, the 2016 credit agreement includes a $75 million Revolver Facility and permits the Company to enter into one or more Incremental Term Loan Facilities not to exceed $150 million in the aggregate. At December 31, 2017, no draw had been made under the Revolver Facility and the Company had not entered into any Incremental Loan Facility. When and if a draw is made on the Revolver, the maturity date and interest rate options would be substantially identical to the Term Loan Facility, though the margin on principal drawn on the revolver is 0.25% less than the corresponding margin on term loans. If the interest rate on an Incremental Term Loan Facility is more than 0.25% greater than the rate on the existing outstanding balances, the interest rate on the existing debt would reset at the same rate as the Incremental Term Loan Facility. Repayment provisions would be agreed to at the time of each draw under the Incremental Term Loan Facility. The Company is subject to certain financial covenants measured on a trailing twelve month basis each calendar quarter unless otherwise specified. These covenants include: • a limitation on the Company’s total leverage ratio, defined as indebtedness divided by earnings before interest, taxes, depreciation and amortization, or EBITDA, of less than or equal to 3.75 to 1.00 from the closing date through December 30, 2018, then 3.25 to 1.00 through December 30, 2019, and 3.00 to 1.00 thereafter; • a minimum debt service coverage ratio, defined as EBITDA minus certain cash taxes divided by the sum of all scheduled principal payments on the Term Loans and other indebtedness plus cash interest expense, greater than 2.00 to 1.00; • the Company must maintain a minimum liquidity balance, defined as availability under the revolver facility plus unrestricted cash and cash equivalents on deposit in a deposit account for which a control agreement has been delivered to the administrative agent under the 2016 credit agreement, of greater than $25 million at all times. As of December 31, 2017, the Company was in compliance with the financial covenants in its credit agreements, and ratios at December 31, 2017 were as follows: Actual Covenant Requirement Total Leverage Ratio 2.93 3.75 or Lower Debt Service Coverage Ratio 3.73 2.00 or Higher Minimum Liquidity Balance (in millions) $ 151.9 $25 million or Higher Contractual Commitments. The Company is obligated to make future payments under various contracts it has entered into, primarily amounts pursuant to its long-term debt facility, and non-cancelable operating lease agreements for retail space, tower space and cell sites. Expected future minimum contractual cash payments, excluding the effects of time value, on contractual obligations, by period are summarized as follows: Payments due by periods (in thousands) Total Less than 1 year 1-3 years 3-5 years More than 5 years Long-term debt principal (1) $ 836,500 $ 68,500 $ 189,125 $ 358,875 $ 220,000 Interest on long-term debt (1) 132,369 36,223 61,291 29,984 4,871 “Pay-fixed” obligations (2) 17,465 4,771 8,131 3,932 Operating leases (3) 483,268 52,527 104,410 104,886 221,445 Purchase obligations (4) 49,807 37,433 12,374 - - Total $ 1,519,409 $ 199,454 $ 375,331 $ 497,677 $ 446,947 ________________________________ (1) Includes principal payments and estimated interest payments on the Term Loan Facility based upon outstanding balances and rates in effect at December 31, 2017. (2) Represents the maximum interest payments we are obligated to make under our derivative agreements. Assumes no receipts from the counterparty to our derivative agreements. (3) Our existing operating lease agreements may provide us with the option to renew. Our future operating lease obligations would change if we entered into additional operating lease agreements and if we exercised renewal options. (4) Represents open purchase orders at December 31, 2017. Contractual commitments represent future cash payments and liabilities that are required under contractual agreements with third parties, and exclude purchase orders for goods and services. The contractual commitment amounts in the table above are associated with agreements that are legally binding and enforceable, and that specify all significant terms, including fixed or minimum services to be used, fixed, minimum or variable price provisions and the approximate timing of the transaction. Other long-term liabilities have been omitted from the table above due to uncertainty of the timing of payments, refer to Note 11, Accrued Liabilities, included with the notes to our consolidated financial statements for additional information. The Company has no other off-balance sheet arrangements and has not entered into any transactions involving unconsolidated, limited purpose entities or commodity contracts. Capital Commitments. The Company spent $146.5 million on capital projects in 2017, down from $173.2 million in 2016 and up from $69.7 million in 2015. Capital expenditures in 2017 were primarily related to upgrades of the former nTelos sites and additional cell sites to expand coverage in the former nTelos territory, network and cable market expansion, fiber builds and information technology projects. Capital expenditures in 2016 primarily supported cell site upgrades and coverage and capacity expansions in the wireless segment following the nTelos acquisition, as well as cable plant expansion and upgrades and wireline segment fiber builds. Capital expenditures in 2015 supported projects across all segments, including wireless network capacity and coverage enhancements, cable plant expansion and upgrades, and wireline fiber builds, necessary to support our continued expansion. Capital expenditures budgeted for 2018 are expected to be approximately $163 million, including $103 million in the Wireless segment primarily for upgrades and expansion of the nTelos wireless network. In addition, $29 million is budgeted primarily for cable network expansion including new fiber routes and cable market expansion, $22 million in Wireline projects including fiber builds in Pennsylvania and other areas, and $9 million primarily for IT projects. We believe that cash on hand, cash flow from operations and borrowings expected to be available under our existing credit facilities will provide sufficient cash to enable us to fund planned capital expenditures, make scheduled principal and interest payments, meet our other cash requirements and maintain compliance with the terms of our financing agreements for at least the next twelve months. There can be no assurance that we will continue to generate cash flows at or above current levels or that we will be able to maintain our ability to borrow under our credit facilities. Thereafter, capital expenditures will likely be required to continue planned capital upgrades to the acquired wireless network and provide increased capacity to meet our expected growth in demand for our products and services. The actual amount and timing of our future capital requirements may differ materially from our estimate depending on the demand for our products, new market developments and expansion opportunities. Our cash flows from operations could be adversely affected by events outside our control, including, without limitation, changes in overall economic conditions, regulatory requirements, changes in technologies, demand for our products, availability of labor resources and capital, changes in our relationship with Sprint, and other conditions. The Wireless segment’s operations are dependent upon Sprint’s ability to execute certain functions such as billing, customer care, and collections; our ability to develop and implement successful marketing programs and new products and services; and our ability to effectively and economically manage other operating activities under our agreements with Sprint. Our ability to attract and maintain a sufficient customer base, particularly in the acquired cable markets, is also critical to our ability to maintain a positive cash flow from operations. The foregoing events individually or collectively could affect our results. Critical Accounting Policies We prepare our consolidated financial statements in accordance with U.S. generally accepted accounting principles ("GAAP"). The preparation of these consolidated financial statements requires us to make estimates and assumptions that affect our reported amounts of assets, liabilities, revenue and expenses, as well as related disclosures. To the extent that there are material differences between these estimates and actual results, our financial condition or operating results would be affected. We base our estimates on past experience and other assumptions that we believe are reasonable under the circumstances, and we evaluate these estimates on an ongoing basis. We refer to accounting estimates of this type as critical accounting policies and estimates, which we discuss further below. Our significant accounting policies are described in Note 2, Summary of Significant Accounting Policies, of the notes to our audited consolidated financial statements. The following are the accounting policies that we believe involve a greater degree of judgment and complexity and are the most critical to aid in fully understanding and evaluating our consolidated financial condition and results of operations. Revenue Recognition We recognize revenue when persuasive evidence of an arrangement exists, services have been rendered or products have been delivered, the price to the buyer is fixed and determinable and collectability is reasonably assured. Revenues are recognized based on the various types of transactions generating the revenue. For services, revenue is recognized as the services are performed. For equipment sales, revenue is recognized when the sales transaction is complete. Under the Sprint Management Agreement, postpaid wireless service revenues are reported net of an 8% Management Fee and an 8.6% Net Service Fee, retained by Sprint. Prepaid wireless service revenues are reported net of a 6% Management Fee retained by Sprint. For information related to our adoption of Accounting Standards Update ("ASU") 2014-09, (Topic 606) "Revenue from Contracts with Customers", see Note 2, Summary of Significant Accounting Policies, in the notes to the consolidated financial statements in this Annual Report on Form 10-K , under the heading “Adoption of New Accounting Principles”. Income Taxes We account for income taxes under the asset and liability method. Deferred tax assets and liabilities are recognized for the future tax consequences attributable to differences between financial statement carrying amounts of existing assets and liabilities and their respective tax bases. Deferred tax assets and liabilities are measured using enacted tax rates expected to apply to taxable income in the years in which those temporary differences are expected to be recovered or settled. The effect on deferred tax assets and liabilities of a change in tax rates is recognized in income in the period that includes the enactment date. We make estimates, assumptions and judgments to determine our provision for income taxes and also for deferred tax assets and liabilities and any valuation allowances recorded against our deferred tax assets. We evaluate the recoverability of deferred tax assets and liabilities and, to the extent we believe that recovery is not likely, we establish a valuation allowance. We evaluate the effective rate of taxes based on apportionment factors, actual operating results, and the various applicable state income tax rates. We have adopted ASC 740-10, "Accounting for Uncertainty in Income Taxes", that prescribes a recognition threshold of more-likely- than-not, and a measurement attribute for all tax positions taken or expected to be taken on a tax return, in order for those positions to be recognized in the financial statements. We continually review tax laws, regulations and related guidance in order to properly record any uncertain tax liability positions. We adjust these reserves in light of changing facts and circumstances. We have adopted ASU 2016-09, "Compensation - Stock Compensation", which modified income tax consequences for several aspects of share-based payment awards. Excess tax benefits and tax deficiencies for share-based payments are now included in our tax provision expense rather than additional-paid-in-capital. Variability of tax consequences arising from excess tax benefits and tax deficiencies may result due to fluctuations in our stock price and the volume of our employees' equity awards that are exercised or vest. Refer to Note 15, Income Taxes, included with the notes to our consolidated financial statements for additional information concerning income taxes. Goodwill and Indefinite-lived Intangible Assets Goodwill represents the excess of acquisition costs over the fair value of tangible net assets and identifiable intangible assets of the businesses acquired. Cable franchise rights, included in indefinite-lived intangible assets provide us with the non-exclusive right to provide video services in a specified area. While some cable franchises are issued for a fixed time (generally 10 years), renewals of cable franchises have occurred routinely and at nominal cost. Moreover, we have determined that there are currently no legal, regulatory, contractual, competitive, economic or other factors that limit the useful lives of our cable franchises and as a result we account for cable franchise rights as an indefinite lived intangible asset. Goodwill and indefinite-lived intangible assets are not amortized, but rather, are subject to impairment testing annually, in the fourth quarter, or whenever events or changes in circumstances indicate that the carrying amount may not be fully recoverable. A qualitative evaluation of our reporting units is utilized to determine whether it is necessary to perform a quantitative two-step impairment test. If it is more likely than not that the fair value of a reporting unit is less than its carrying amount, we would be required to perform a two-step quantitative test. If the carrying value of the reporting unit's net assets exceeds the fair value of the reporting unit, then an impairment loss is recorded. Our 2017 impairment tests were based on the operating segment structure, where each operating segment was also considered a reporting unit. During the fourth quarter of 2017 we performed a qualitative assessment for our reporting units that were assigned goodwill. During this assessment, qualitative factors were first assessed to determine whether it was more likely than not that the fair value of the reporting units were less than their carrying amounts. Qualitative factors that were considered included, but were not limited to, macroeconomic conditions, industry and market conditions, company specific events, changes in circumstances, after tax cash flows and market capitalization trends. Based on our annual impairment evaluations performed during 2017 and 2016, we concluded that there were no indicators of impairment and therefore it was more likely than not that the fair value of the goodwill exceeded its carrying amount, for each reporting unit, and cable franchise rights exceeded its fair value. Refer to Note 2, Summary of Significant Accounting Policies, and Note 9, Goodwill and Intangible Assets, included with the notes to our consolidated financial statements for additional information concerning goodwill. Finite-lived Intangible Assets On an annual basis, or whenever events or changes in circumstances require otherwise, we review our finite-lived intangible assets for impairment. Intangible assets are included in our annual impairment testing and in the event we identify impairment, the intangible assets are written down to their fair values. Intangible assets typically have finite useful lives that are amortized over their useful lives and primarily consist of affiliate contract expansion, acquired subscribers-cable, and off market leases. Affiliate contract expansion and acquired subscribers-cable intangibles are amortized over the period in which those relationships are expected to contribute to our future cash flows and are also reduced by management fee waiver credits received from Sprint in connection with the 2017 non-monetary exchange. Other finite-lived intangible assets, are generally amortized using the straight-line method of amortization. Such finite-lived intangible assets are subject to the impairment provisions of ASC 360, where impairment is recognized and measured only if there are events and circumstances that indicate that the carrying amount may not be recoverable. The carrying amount is not recoverable if it exceeds the sum of the undiscounted cash flows expected to result from the use of the asset group. An impairment loss is recorded if after determining that it is not recoverable, the carrying amount exceeds the fair value of the asset. Finite-lived intangible assets and liabilities are being amortized over the following periods: Useful Life Affiliate contract expansion 4 - 14 years Favorable and unfavorable leases - wireless 1 - 28 years Acquired subscribers - cable 3 - 10 years Other intangibles 15 - 20 years There were no impairment charges on intangible assets for the years ended December 31, 2017, or 2016. Business Combinations Business combinations, including purchased intangible assets, are accounted for at fair value. Acquisition costs are expensed as incurred and recorded in acquisition, integration and migration expenses. The fair value amount assigned to assets acquired and liabilities assumed is based on an exit price from a market participant's viewpoint, and utilizes data such as discounted cash flow analysis and replacement cost models. Recently Issued Accounting Standards Recently issued accounting standards and their expected impact, if any, are discussed in Note 2, Summary of Significant Accounting Policies, of the notes to our consolidated financial statements.

<s>[INST] This annual report contains forwardlooking statements within the meaning of Section 27A of the Securities Act of 1933 and Section 21E of the Securities Exchange Act of 1934, including statements regarding our expectations, intentions, or strategies regarding the future. These statements are subject to certain risks and uncertainties that could cause actual results to differ materially from those anticipated in the forwardlooking statements. Factors that might cause such a difference include those discussed in this report under Item 1, “Business” and Item 1A, “Risk Factors.” The Company undertakes no obligation to publicly revise these forwardlooking statements to reflect subsequent events or circumstances, except as required by law. You should read the following discussion and analysis of our financial condition and results of operations in conjunction with our "Selected Financial Data" and our consolidated financial statements and notes thereto appearing elsewhere in this Annual Report on Form 10K. General Overview. Shenandoah Telecommunications Company, (the "Company", "we", "our", or "us"), is a diversified telecommunications company providing integrated voice, video and data communication services including both regulated and unregulated telecommunications services through its wholly owned subsidiaries. These subsidiaries provide wireless personal communications services, as a Sprint PCS affiliate, and local exchange telephone services, video, internet and data services, long distance services, fiber optics facilities and leased tower facilities. We organize and strategically manage our operations under the Company's reportable segments that include: Wireless, Cable, Wireline, and Other. See Note 16, Segment Reporting, included with the notes to our consolidated financial statements for further information regarding our segments. The following provides a description of the operations within our segments: Wireless provides digital wireless mobile service as a Sprint PCS Affiliate to a portion of a multistate area covering large portions of central and western Virginia, southcentral Pennsylvania, West Virginia, and portions of Maryland, North Carolina, Kentucky, Tennessee and Ohio, "our wireless network coverage area". In these areas, we are the exclusive provider of Sprintbranded wireless mobility communications network products and services on the 800 MHz, 1900 MHz and 2.5 GHz spectrum bands. Wireless also owns 192 cell site towers built on leased and owned land, and leases space on these towers to both affiliates and nonaffiliated third party wireless service providers. Cable provides video, internet and voice services in franchise areas in portions of Virginia, West Virginia and western Maryland, and leases fiber optic facilities throughout its service area. Wireline provides regulated and unregulated voice services, DSL internet access and long distance access services throughout Shenandoah County and portions of Rockingham, Frederick, Warren and Augusta counties, Virginia. The segment also provides video, DSL and cable modem internet access services in Shenandoah County, and leases fiber optic facilities throughout the northern Shenandoah Valley of Virginia, northern Virginia and adjacent areas along the Interstate 81 corridor through West Virginia, Maryland and portions of central and southern Pennsylvania. Additionally, our Other operations are represented by Shenandoah Telecommunications Company, the parent holding company, that provides investing and management services to the Company's subsidiaries. Recent Developments Credit Facility Modification: On February 16, 2018, the Company, entered into a Second Amendment to Credit Agreement (the “Second Amendment”) with CoBank, ACB, as administrative agent of its Credit Agreement, described more fully in Note 13, LongTerm Debt, and the various financial institutions party thereto (the “Lenders”), which modifies the Credit Agreement by (i) reducing the interest rate paid by the Company by approximately 50 basis points with respect to certain loans made by the Lenders to the Company under the Credit Agreement, and (ii) allowing the Company to make charitable contributions to Shentel Foundation, a Virginia nonstock corporation, of up to $1.5 million in any fiscal year. Sprint Territory Expansion: Effective February 1, 2018, we signed the Expansion Agreement with Sprint to expand our wireless service area to include certain areas in Kentucky, Pennsylvania, Tennessee, Virginia and West Virginia, (the “Expansion Area [/INST] Positive. </s>

SHENANDOAH TELECOMMUNICATIONS CO/VA/

2019-02-28

2018-12-31

ITEM 7. MANAGEMENT'S DISCUSSION AND ANALYSIS OF FINANCIAL CONDITION AND RESULTS OF OPERATIONS This annual report contains forward-looking statements within the meaning of Section 27A of the Securities Act of 1933 and Section 21E of the Securities Exchange Act of 1934, including statements regarding our expectations, intentions, or strategies regarding the future. These statements are subject to certain risks and uncertainties that could cause actual results to differ materially from those anticipated in the forward-looking statements. The Company undertakes no obligation to publicly revise these forward-looking statements to reflect subsequent events or circumstances, except as required by law. The following discussion and analysis of our financial condition and results of operations should be read in conjunction with Part II, Item 6 "Selected Financial Data" and our consolidated financial statements and notes thereto appearing elsewhere in this Annual Report on Form 10-K. Overview Shenandoah Telecommunications Company and its subsidiaries, (the "Company", "we", "our", or "us"), provide wireless personal communication service ("PCS") under the Sprint brand, and telephone service, cable television, unregulated communications equipment sales and services, and internet access under the Shentel brand. In addition, the Company operates an interstate fiber optic network and leases its owned cell site towers to both affiliates and non-affiliated third-party wireless service providers. The Company's reportable segments include: Wireless, Cable, Wireline, and Other. See Note 17, Segment Reporting, included with the notes to our consolidated financial statements for further information regarding our segments. The following provides a description of the operations within our segments: • Wireless provides digital wireless mobile service as a Sprint PCS Affiliate in a multi-state area covering large portions of central and western Virginia, south-central Pennsylvania, West Virginia, and portions of Maryland, North Carolina, Kentucky, and Ohio, "our wireless network coverage area". In these areas, we are the exclusive provider of Sprint-branded wireless mobility communications network products and services on the 800 MHz, 1900 MHz and 2.5 GHz spectrum bands. Wireless also owns 208 cell site towers built on leased and owned land, and leases space on these towers to both affiliates and non-affiliated third party wireless service providers. • Cable provides video, broadband and voice services in franchise areas in portions of Virginia, West Virginia, and western Maryland, and leases fiber optic facilities throughout its service area. • Wireline provides regulated and unregulated voice services, internet broadband, long distance access services, and leases fiber optic facilities throughout portions of Virginia, West Virginia, Maryland, and Pennsylvania. • Additionally, our Other operations are represented by Shenandoah Telecommunications Company, the parent holding company, that provides investing and management services to the Company's subsidiaries. Basis of Presentation The Company adopted ASU No. 2014-09, Revenue from Contracts with Customers (“Topic 606”), effective January 1, 2018, using the modified retrospective method as discussed in Note 3, Revenue from Contracts with Customers. The following tables identify the impact of applying Topic 606 to the Company for the year ended December 31, 2018: Year Ended December 31, 2018 Topic 606 Impact - CONSOLIDATED ($ in thousands, except per share amounts) Prior to Adoption of Topic 606 Changes in Presentation (1) Equipment Revenue (2) Deferred Costs (3) As Reported 12/31/2018 Service revenue and other $ 632,340 $ (86,637 ) $ - $ 16,753 $ 562,456 Equipment revenue 8,298 - 60,100 - 68,398 Total operating revenue 640,638 (86,637 ) 60,100 16,753 630,854 Cost of services 193,860 - - 194,022 Cost of goods sold 28,377 (24,518 ) 60,100 - 63,959 Selling, general & administrative 175,753 (62,119 ) - (412 ) 113,222 Depreciation and amortization 166,405 - - - 166,405 Total operating expenses 564,395 (86,637 ) 60,100 (250 ) 537,608 Operating income (loss) 76,243 - - 17,003 93,246 Other income (expense) (31,134 ) - - - (31,134 ) Income tax expense (benefit) 10,926 - - 4,591 15,517 Net income (loss) $ 34,183 $ - $ - $ 12,412 $ 46,595 Earnings (loss) per share Basic $ 0.69 $ 0.25 $ 0.94 Diluted $ 0.68 $ 0.25 $ 0.93 Weighted average shares outstanding, basic 49,542 49,542 Weighted average shares outstanding, diluted 50,063 50,063 ______________________________________________________ (1) Amounts payable to Sprint for the reimbursement of costs incurred by Sprint in their national sales channel for commissions and device costs for both postpaid and prepaid, and to provide on-going support to their prepaid customers in our territory were historically recorded as expense when incurred. Under Topic 606, these amounts represent consideration payable to our customer, Sprint, and are recorded as a reduction of revenue. In 2017, these amounts were approximately $44.8 million for the postpaid national commissions, previously recorded in selling, general and administrative, $18.7 million for national device costs previously recorded in cost of goods and services, and $16.9 million for the on-going service to Sprint's prepaid customers, previously recorded in selling, general and administrative. (2) Costs incurred by the Company for the sale of devices under Sprint’s device financing and lease programs were previously recorded net against revenue. Under Topic 606, the revenue and related costs from device sales are recorded gross. These amounts were approximately $63.8 million in 2017. (3) Amounts payable to Sprint for the reimbursement of costs incurred by Sprint in their national sales channel for commissions and device costs, which historically have been expensed when incurred and presented net of revenue, are deferred and amortized against revenue over the expected period of benefit of approximately 21 to 53 months. In Cable and Wireline, installation revenues are recognized over a period of approximately 10-11 months. The deferred balance as of December 31, 2018 is approximately $75.8 million and is classified on the balance sheet as current and non-current assets, as applicable. Recent Developments Big Sandy Broadband, Inc. Acquisition: Effective February 28, 2019, the Company completed its acquisition of the assets of Big Sandy Broadband, Inc., ("Big Sandy"). Big Sandy has served Eastern Kentucky for 56 years and is the leading provider of cable television, telephone, and broadband services in Johnson and Floyd counties. All customary closing conditions have been satisfied. The acquisition of Big Sandy furthers Shentel's strategy to expand the Company's cable segment with the addition of quality networks in contiguous markets. Big Sandy adds approximately 4,747 customers to Shentel's expanding Cable segment. Credit Facility Modification: On November 9, 2018, the Company entered into an Amended and Restated Credit Agreement (the “amended 2016 credit agreement”) with various financial institutions (the “Lenders”) and CoBank, ACB, as administrative agent for the Lenders. These amendments resulted in several changes for the Company. The amended 2016 credit agreement reduced near term principal payments, extended the maturity of both Term Loan A-1 and A-2, allowed access to the Revolver for an extended period of time, and reduced the applicable base interest rate by 75 basis points. It also shifted $108.8 million in principal from Term Loan A-1 to Term Loan A-2. See Note 14, Long-Term Debt for additional information. Sprint Territory Expansion: Effective February 1, 2018, we signed the Expansion Agreement with Sprint to expand our wireless network coverage area to include certain portions of Kentucky, Pennsylvania, Virginia and West Virginia, (the “Expansion Area”), effectively adding a population (POPs) of approximately 1.1 million. The agreement includes certain network build out requirements, and the ability to utilize Sprint’s spectrum in the Expansion Area along with certain other amendments to the Affiliate Agreements. Pursuant to the Expansion Agreement, Sprint agreed to transition the provision of network coverage in the Expansion Area to us. The Expansion Agreement required a payment of $52.0 million to Sprint for the right to service the Expansion Area pursuant to the Affiliate Agreements plus an additional payment of up to $5.0 million after acceptance of certain equipment at the Sprint cell sites in the Expansion Area. A map of our territory, reflecting the new Expansion Area, is provided below: Other Events United States Tax Reform: In December 2017, the Tax Cuts and Jobs Act (the “2017 Tax Act”) was enacted. The 2017 Tax Act represented major tax reform legislation that, among other provisions, reduced the U.S. corporate income tax rate from 35 percent to 21 percent. Certain income tax effects of the 2017 Tax Act, included approximately $0.8 million and $53.4 million of one-time non-cash tax benefits that were recorded in 2018 and 2017, respectively, principally due to the revaluation of our net deferred tax liabilities. See Note 16, Income Taxes, included with the notes to our consolidated financial statements for further information on the financial statement impact of the 2017 Tax Act. Sprint Territory Expansion: Parkersburg - On April 6, 2017, we completed the expansion of our affiliate service territory, under our agreements with Sprint, to include certain areas in North Carolina, Kentucky, Maryland, Ohio and West Virginia effectively adding approximately 500 thousand POPs in the Parkersburg, WV and Cumberland, MD areas. The expanded territory includes the Parkersburg, WV, Huntington, WV, and Cumberland, MD, basic trading areas, (the "Parkersburg Expansion Area"). Acquisition of nTelos and Exchange with Sprint: On May 6, 2016, we completed the acquisition of NTELOS Holdings Corp. (“nTelos”) for $667.8 million, net of cash acquired. The purchase price was financed by a credit facility arranged by CoBank, ACB. We have included the operations of nTelos for financial reporting purposes for periods subsequent to the acquisition. For additional information regarding the acquisition of nTelos, please refer to Note 4, Acquisitions, included with the consolidated financial statements. Results of Operations Revenue We earn revenue primarily through the sale of our wireless, cable and wireline telecommunications services that include video, broadband, voice, and data services. We also lease space on our cell site towers and our fiber network. Our revenue is primarily driven by the number of Sprint subscribers that utilize our wireless network as well as the number of our customers that subscribe to our cable and wireline services, our ability to retain our customers and the contractually negotiated price of such services. Operating Expenses Our operating expenses consist primarily of cost of services, cost of goods sold, selling, general and administrative, acquisition, integration and migration expense related to the nTelos acquisition, and depreciation and amortization expenses, described as follows: Cost of Services - Cost of services consists primarily of network-related costs attributable to the operation of our wireless, cable and wireline networks, including network costs, site costs for telecommunications equipment, and maintenance expenses, programming costs for our Cable operations, and expenses for employees who provide direct contractual services to our clients, including salaries, benefits, discretionary incentive compensation, employment taxes, and equity compensation costs. In 2017 and 2016 our cost of services also included network and maintenance related expenses incurred to integrate nTelos. Cost of services does not include allocated amounts for occupancy expense and depreciation and amortization. Overall, we expect cost of services to grow as we expand our network to capitalize on expansion opportunities in our market, which will require us to add additional staff, enter into additional tower and ground leases, and incur additional backhaul and network expenses. Cost of Goods Sold - Cost of goods sold consists primarily of the cost of handsets and accessories for our Wireless subscribers. It excludes any allocation of depreciation and amortization. We expect cost of goods sold to grow as we expand our network to capitalize on growth of the subscriber base. Selling, General and Administrative - Our selling, general and administrative expense consists primarily of employee-related expenses, including salaries, benefits, commissions, discretionary incentive compensation, employment taxes, and equity compensation costs for our employees engaged in the administration of sales, sales support, business development, marketing, management information systems, administration, human resources, finance, legal, and executive management. Selling, general and administrative expense also includes occupancy expenses including rent, utilities, communications, and facilities maintenance, professional fees, consulting fees, insurance, travel, and other expenses. In 2017 and 2016 our selling, general and administrative expense also included certain general expenses, such as severance, incurred to integrate nTelos. Our sales and marketing expense excludes any allocation of depreciation and amortization. We expect our selling, general and administrative expenses to increase as we strategically invest in our sales support organization to expand our business, both organically and in our newly-acquired Sprint Expansion Areas. Acquisition, Integration and Migration - Our acquisition, integration and migration expense consisted primarily of costs required to migrate subscribers acquired in the May 2016 acquisition of nTelos to the Sprint billing and network systems, costs required to integrate the acquired nTelos administrative and operational support functions, severance costs for former nTelos employees who were not retained, transaction related fees; and gains or losses associated with the disposal of certain property. We completed the migration of nTelos subscribers to the Sprint network during 2017. Depreciation and Amortization Expense - Our depreciation and amortization expense consists primarily of depreciation of fixed assets, and amortization of acquisition-related intangible assets. We expect our depreciation and amortization expense to increase as we expand our networks organically and through acquisitions. Other Income (Expense) Our other income (expense) consists primarily of interest expense, net gain (loss) on investments, and net non-operating income (loss), described as follows: Interest Expense - Interest expense represents interest incurred on our Credit Facilities (as defined below, under the heading Financial Condition, Liquidity and Capital Resources, and in Note 14, Long-Term Debt). We expect our interest expense to fluctuate in proportion to the outstanding principal balance of the Credit Facilities and the prevailing London Interbank Offered Rate ("LIBOR") interest rate. Gain (Loss) on Investments, net - Net gain (loss) on investments, consists of gains and losses realized as changes occur in the value of the assets and obligation underlying the Company’s Supplemental Executive Retirement Plan ("SERP") retirement plan. We expect our net gain (loss) on investments to fluctuate in proportion to the prevailing market conditions as they relate to our SERP assets and obligations. Non-Operating Income (Loss), net - Net non-operating income (loss), primarily represents interest and dividends earned from our investments, including our patronage arrangement that is connected to our Credit Facility. We expect our non-operating income (loss) to fluctuate in proportion to the amount of funds we invest and the continuation of the patronage arrangement. Income Tax Expense (Benefit) Our provision for income taxes consists of federal and state income taxes in the United States, and the effect of the 2017 Tax Act, including deferred income taxes reflecting the net tax effects of temporary differences between the carrying amounts of assets and liabilities for financial reporting purposes and the amounts used for income tax purposes, and excess tax benefits or shortfalls derived from exercises of stock options and vesting of restricted stock. We expect that in the near-term our effective tax rate may fluctuate due to the effect of the 2017 Tax Act and the recognition of excess tax benefits and tax shortfalls associated with the exercise of stock options or the vesting of restricted stock. Excluding discrete items impacting the effective tax rate, we expect our long-term tax rate to reflect the applicable federal and state statutory rates. Refer to Note 16, Income Taxes, included with the notes to our consolidated financial statements for additional information concerning income taxes and the effects of the 2017 Tax Act. Results of Operations 2018 Compared with 2017 The Company’s consolidated results from operations are summarized as follows: Year Ended December 31, Change ($ in thousands) % of Revenue % of Revenue $ % Operating revenue $ 630,854 100.0 $ 611,991 100.0 18,863 3.1 Operating expenses 537,608 85.2 565,481 92.4 (27,873 ) (4.9 ) Operating income (loss) 93,246 14.8 46,510 7.6 46,736 100.5 Interest expense (34,847 ) (5.5 ) (38,237 ) (6.2 ) (3,390 ) (8.9 ) Other income (expense), net 3,713 0.6 4,984 0.8 (1,271 ) (25.5 ) Income (loss) before taxes 62,112 9.8 13,257 2.2 48,855 368.5 Income tax expense (benefit) 15,517 2.5 (53,133 ) (8.7 ) 68,650 129.2 Net income (loss) $ 46,595 7.4 $ 66,390 10.9 (19,795 ) (29.8 ) Operating revenue Operating revenue increased approximately $18.9 million, or 3.1%, in 2018 compared with 2017. Excluding the impact of adopting Topic 606, operating revenue increased approximately $28.6 million, or 4.7%, driven by the Wireless and Cable operations. Operating expenses Operating expenses decreased approximately $27.9 million, or 4.9%, in 2018 compared with 2017. Excluding the impact of adopting Topic 606, operating expenses decreased approximately $1.1 million, or 0.2%, primarily due to the absence of acquisition, integration and migration costs related to the completion of the transformation of the nTelos network in 2017 as well as lower depreciation and amortization costs due to the retirement of assets acquired with nTelos, partially offset by increased costs necessary to support our continued growth and expansion. Interest expense Interest expense decreased approximately $3.4 million, or 8.9%, in 2018 compared with 2017. The decrease in interest expense was primarily attributable to the 2018 amendments to the Credit Facility Agreement that reduced the applicable base interest rate by 75 basis points, partially offset by the effect of increases in the LIBOR. Other income (expense), net Other income, net decreased approximately $1.3 million, or 25.5%, in 2018 compared with 2017. The decrease was primarily attributable to a reduction in interest income related to the former nTelos equipment installment plan. The integration of the acquired nTelos business was completed during 2017. Income tax expense (benefit) Income tax expense increased $68.7 million from a $53.1 million benefit in 2017 to a $15.5 million expense in 2018. The increase was primarily attributable to growth in our income before taxes during 2018 and the one-time non-cash tax benefit of $53.4 million recorded in 2017 as a result of the reduction in the U.S. corporate income tax rate from 35% to 21% as the 2017 Tax Act became effective. The Company's effective tax rate increased from a benefit of 400.8% in 2017 to an expense of 25.0% in 2018. Refer to Note 16, Income Taxes for additional information concerning income taxes. 2017 Compared with 2016 The Company’s consolidated results from operations are summarized as follows: Year Ended December 31, Change ($ in thousands) % of Revenue % of Revenue $ % Operating revenue $ 611,991 100.0 $ 535,288 100.0 76,703 14.3 Operating expenses 565,481 92.4 512,762 95.8 52,719 10.3 Operating income (loss) 46,510 7.6 22,526 4.2 23,984 106.5 Other income (expense), net (33,253 ) (5.4 ) (20,581 ) (3.8 ) 12,672 61.6 Income (loss) before taxes 13,257 2.2 1,945 0.4 11,312 581.6 Income tax expense (benefit) (53,133 ) (8.7 ) 2,840 0.5 (55,973 ) (1,970.9 ) Net income (loss) $ 66,390 10.8 $ (895 ) (0.2 ) 67,285 7,517.9 Operating revenues Operating revenues increased approximately $76.7 million, or 14.3%, in 2017 compared with 2016. Wireless segment revenues increased $66.3 million compared with 2016; this increase was primarily due to the expansion of our Wireless network coverage area through our 2016 acquisition of nTelos. Cable segment revenue grew approximately $10.4 million, primarily as a result of a 1.2% growth in average revenue generating units and a 8.3% increase in revenue per subscriber. Wireline segment revenue increased approximately $4.3 million, led by growth in carrier access fees, fiber revenues and internet service revenues. Operating expenses Total operating expenses increased approximately $52.7 million, or 10.3%, in 2017 compared with 2016. Wireless operating expenses increased approximately $58.4 million primarily due to our 2016 acquisition of nTelos that resulted in additional network costs required to support our expanded Wireless network, while operating expenses in our Other operations decreased approximately $6.8 million, primarily due to the completion of integration activities associated with the acquisition of nTelos. Cable and Wireline operating expenses increased approximately $1.6 million and $3.8 million, respectively. Within consolidated operating expenses, cost of goods and services sold increased approximately $18.0 million, selling, general and administrative expenses increased approximately $32.6 million, depreciation and amortization increased approximately $33.3 million, primarily due to our 2016 acquisition of nTelos. Increases in operating expenses were offset by a decrease in acquisition, integration and migration costs of approximately $31.2 million as a result of the completion of integration and migration activities related to the acquisition of nTelos. Other income (expense) Other expense increased approximately $12.7 million or 61.6% in 2017 compared with 2016, primarily due to an increase in interest expense due to borrowings, related to our acquisition of nTelos, under our credit facility that were outstanding for the full year 2017. Income tax expense (benefit) The Company’s effective tax rate decreased from an expense of 146.0% in 2016 to a benefit of 400.8% in 2017. The decrease is primarily attributable to the changes in federal tax regulations related to the 2017 Tax Act that was enacted during December 2017 and non-deductible transactions costs incurred in 2016. We are expecting our long-term tax rate to more closely reflect the applicable federal and statutory rates offset for any excess tax benefits or shortfalls related to vesting or exercise of equity awards. We recognized an income tax benefit of approximately $53.1 million for the year ended December 31, 2017. This includes a one-time non-cash decrease of approximately $53.4 million in our net deferred tax liabilities as a result of the remeasurement of our deferred tax assets and liabilities as of December 31, 2017 to reflect the reduction in the U.S. corporate income tax rate from 35 percent to 21 percent. The 2017 Tax Act also provides immediate expensing for certain qualified assets acquired and placed into service after September 27, 2017 as well as prospective changes beginning in 2018, including acceleration of tax revenue recognition, additional limitations on deductibility executive compensation and limitations on the deductibility of interest. Wireless Wireless earns postpaid, prepaid and wholesale revenues from Sprint for their subscribers that use our Wireless network service in our Wireless network coverage area. The Company's wireless revenue is variable based on billed revenues to Sprint's customers in the Sprint Affiliate Area less applicable fees retained by Sprint. Sprint retains an 8% Management Fee and an 8.6% Net Service Fee on postpaid revenues and a 6% Management Fee on prepaid wireless revenues. For postpaid, the Company is also charged for the costs of subsidized handsets sold through Sprint's national channels as well as commissions paid by Sprint to third-party resellers in our service territory. Sprint also charges the Company separately to acquire and support prepaid customers. These charges are calculated based on Sprint's national averages for its prepaid programs, and are billed per user or per gross additional customer, as appropriate. Under our amended affiliate agreement, Sprint agreed to waive the Management Fees charged on both postpaid and prepaid revenues, up to approximately $4.2 million per month, until the total amount waived reaches approximately $255.6 million, which is expected to occur in 2022. The cash flow savings of the waived management fee waiver have been incorporated into the fair value of the affiliate contract expansion intangible, which is reduced, in part, as credits are received from Sprint. The following table identifies the impact of Topic 606 on the Company's Wireless operations for the year ended December 31, 2018: Year Ended December 31, 2018 Topic 606 Impact - WIRELESS ($ in thousands) Prior to Adoption of Topic 606 Changes in Presentation (1) Equipment Revenue (2) Deferred Costs (3) As Reported 12/31/2018 Service revenue $ 450,735 $ (86,637 ) $ - $ 16,720 $ 380,818 Equipment revenue 7,410 - 60,100 - 67,510 Tower and other revenue 14,327 - - - 14,327 Total operating revenue 472,472 (86,637 ) 60,100 16,720 462,655 Cost of services 131,166 - - - 131,166 Cost of goods sold 28,001 (24,518 ) 60,100 - 63,583 Selling, general & administrative 109,657 (62,119 ) - - 47,538 Depreciation and amortization 127,521 - - - 127,521 Total operating expenses 396,345 (86,637 ) 60,100 - 369,808 Operating income (loss) $ 76,127 $ - $ - $ 16,720 $ 92,847 ______________________________________________________ (1) Amounts payable to Sprint for the reimbursement of costs incurred by Sprint in their national sales channel for commissions and device costs for both postpaid and prepaid, and to provide on-going support to their prepaid customers in our territory were historically recorded as expense when incurred. Under Topic 606, these amounts represent consideration payable to our customer, Sprint, and are recorded as a reduction of revenue. In 2017, these amounts were approximately $44.8 million for the postpaid national commissions, previously recorded in selling, general and administrative, $18.7 million for national device costs previously recorded in cost of goods and services, and $16.9 million for the on-going service to Sprint's prepaid customers, previously recorded in selling, general and administrative. (2) Costs incurred by the Company for the sale of devices under Sprint’s device financing and lease programs were previously recorded net against revenue. Under Topic 606, the revenue and related costs from device sales are recorded gross. These amounts were approximately $63.8 million in 2017. (3) Amounts payable to Sprint for the reimbursement of costs incurred by Sprint in their national sales channel for commissions and device costs, which historically have been expensed when incurred and presented net of revenue, are deferred and amortized against revenue over the expected period of benefit of approximately 21 to 53 months. The deferred balance as of December 31, 2018 is approximately $75.8 million and is classified on the balance sheet as current and non-current assets, as applicable. The following tables indicate selected operating statistics of Wireless, including Sprint subscribers: December 31, 2018 (3) December 31, 2017 (4) December 31, 2016 (5) Postpaid: Retail PCS subscribers - postpaid 795,176 736,597 722,562 Gross PCS subscriber additions - postpaid 190,334 173,871 132,593 Net PCS subscriber additions (losses) - postpaid 58,579 14,035 5,085 PCS average monthly retail churn % - postpaid 1.82 % 2.04 % 1.84 % Prepaid: Retail PCS subscribers - prepaid (1) 258,704 225,822 206,672 Gross PCS subscriber additions - prepaid (1) 150,662 151,926 102,352 Net PCS subscriber additions (losses) - prepaid (1) 32,882 19,150 (58,643 ) PCS average monthly retail churn % - prepaid (1) 4.45 % 5.07 % 6.72 % PCS market POPS (000) (2) 7,023 5,942 5,536 PCS covered POP (000) (2) 6,109 5,272 4,807 CDMA base stations (sites) 1,853 1,623 1,467 Towers owned Non-affiliate cell site leases _______________________________________________________ (1) As of September 2017, the Company is no longer including Lifeline subscribers to be consistent with Sprint's policy. Historical customer counts have been adjusted accordingly. (2) "POPS" refers to the estimated population of a given geographic area. Market POPS are those within a market area which we are authorized to serve under our Sprint PCS affiliate agreements, and Covered POPS are those covered by our network. The data source for POPS is U.S. census data. Historical periods previously referred to other third party population data and have been recast to refer to U.S. census data. (3) Beginning February 1, 2018 includes Richmond Expansion Area except for gross PCS subscriber additions. (4) Beginning April 6, 2017 includes Parkersburg Expansion Area except for gross PCS subscriber additions. (5) Beginning May 6, 2016 includes acquired nTelos Area except for gross PCS subscriber additions. The subscriber statistics shown above, excluding gross additions, include the following: February 1, April 6, May 6, Expansion Area Expansion Area nTelos Area PCS subscribers - postpaid 38,343 19,067 404,965 PCS subscribers - prepaid (1) 15,691 4,517 154,944 Acquired PCS market POPS (000) 1,082 3,099 Acquired PCS covered POPS (000) 2,298 Acquired CDMA base stations (sites) (2) - Towers - - Non-affiliate cell site leases - - _______________________________________________________ (1) Excludes Lifeline subscribers. (2) As of December 31, 2018 we have shut down 107 overlap sites associated with the nTelos Area. 2018 Compared with 2017 Wireless results from operations are summarized as follows: Year Ended December 31, Change ($ in thousands) % of Revenue % of Revenue $ % Wireless operating revenue Wireless service revenue $ 380,818 82.3 $ 431,184 94.7 (50,366 ) (11.7 ) Tower lease revenue 11,622 2.5 11,604 2.5 0.2 Equipment revenue 67,510 14.6 9,467 2.1 58,043 613.1 Other revenue 2,705 0.6 2,823 0.7 (118 ) (4.2 ) Total wireless operating revenue 462,655 100.0 455,078 100.0 7,577 1.7 Wireless operating expenses Cost of services 131,166 28.4 129,626 28.5 1,540 1.2 Cost of goods sold 63,583 13.7 22,653 5.0 40,930 180.7 Selling, general and administrative 47,538 10.3 118,257 26.0 (70,719 ) (59.8 ) Acquisition, integration and migration expenses - - 10,793 2.4 (10,793 ) (100.0 ) Depreciation and amortization 127,521 27.6 139,610 30.7 (12,089 ) (8.7 ) Total wireless operating expenses 369,808 79.9 420,939 92.5 (51,131 ) (12.1 ) Wireless operating income (loss) $ 92,847 20.1 $ 34,139 7.5 58,708 172.0 Operating revenue Wireless operating revenue increased approximately $7.6 million, or 1.7%, in 2018 compared with 2017. Excluding the impact of Topic 606, wireless operating revenue increased approximately $17.4 million, or 3.8%. This increase was driven by growth in postpaid and prepaid PCS subscribers, improvements in average monthly churn, and was partially offset by a decline in postpaid average revenue per subscriber primarily related to promotions and discounts. As a result of the adoption of Topic 606 in 2018, wireless service revenue was reduced by approximately $86.6 million of costs payable to Sprint, our customer, related to the reimbursement to Sprint for costs incurred in their national sales channel for commissions and device costs for both postpaid and prepaid, and to provide ongoing support to their prepaid customers in our territory. Commissions, device costs and costs for ongoing support of Sprint's prepaid customers were previously recorded as operating expenses. Additionally, we recorded $60.1 million of equipment revenue and cost of goods sold for the sale of devices under Sprint’s device financing and lease programs. Prior to the adoption of Topic 606, equipment costs were presented net of equipment revenue. The table below provides additional detail for Wireless service revenue. Year Ended December 31, Change ($ in thousands) $ % Wireless service revenue: Postpaid billings (1) $ 383,235 $ 372,237 10,998 3.0 Amortization of deferred contract and other costs (3) (18,742 ) - 18,742 100.0 Management fee (30,749 ) (29,857 ) 3.0 Net service fee (32,969 ) (30,751 ) 2,218 7.2 Total postpaid service revenue 300,775 311,629 (10,854 ) (3.5 ) Prepaid billings (2) 111,462 103,161 8,301 8.0 Amortization of deferred contract and other costs (3) (52,846 ) - 52,846 100.0 Sprint management fee (7,014 ) (6,189 ) 13.3 Total prepaid service revenue 51,602 96,972 (45,370 ) (46.8 ) Travel and other revenue (2) 28,441 22,583 5,858 25.9 Total service revenue $ 380,818 $ 431,184 (50,366 ) (11.7 ) _______________________________________________________ (1) Postpaid net billings are defined under the terms of the affiliate contract with Sprint to be the gross billings to customers within our wireless network coverage area less billing credits and adjustments and allocated write-offs of uncollectible accounts. (2) The Company includes Lifeline subscribers revenue within travel and other revenue to be consistent with Sprint. The above table reflects the reclassification of the related Assurance Wireless prepaid revenue from prepaid gross billings to travel and other revenue. (3) Due to the adoption of Topic 606, costs reimbursed to Sprint for commission and acquisition cost incurred in their national sales channel are recorded as a reduction of revenue and amortized over the period of benefit. Additionally, costs reimbursed to Sprint for the support of their prepaid customer base are recorded as a reduction of revenue. These costs were previously recorded in cost of goods sold, and selling, general and administrative. The decline in postpaid service revenue during 2018 was primarily the result of the adoption of Topic 606. Excluding the impact of adopting Topic 606, postpaid service revenue increased approximately $6.2 million or 2.0%, primarily due to growth of approximately 58.6 thousand postpaid PCS retail subscribers and an improvement in postpaid PCS average monthly retail churn, partially offset by a decline in average revenue per subscriber. The growth in our postpaid PCS retail subscribers includes approximately 38.3 thousand acquired with the Richmond Expansion Area. Postpaid service revenue was further reduced by approximately $2.2 million due to an increase in net service fee as nTelos subscribers were migrated to Sprint’s billing and back-office systems. The migration of these subscribers resulted in the elimination of costs to operate the nTelos back-office systems which were recorded in selling, general and administrative. The decline in prepaid service revenue during 2018, was primarily the result of the adoption of Topic 606. Excluding the impact of adopting Topic 606, prepaid service revenue increased approximately $7.5 million or 7.7% due to growth of approximately 32.9 thousand prepaid PCS retail subscribers, improvements in prepaid PCS average monthly retail churn and average revenue per subscriber. The growth in our prepaid PCS retail subscribers includes approximately 15.7 thousand subscribers acquired with the Richmond Expansion Area. Travel and other revenue increased $5.9 million, or 25.9%, in 2018 compared with 2017, primarily due to Lifeline subscribers acquired through our expansion events. Cost of services Cost of services increased approximately $1.5 million, or 1.2%, in 2018 compared with 2017, primarily due to the expansion of our network and wireless network coverage area and was partially offset by repricing Wireless backhaul circuits to market rates and migrating Wireless voice traffic from traditional circuit-switched facilities to more cost effective VoIP facilities. Cost of goods sold Cost of goods sold increased approximately $40.9 million, or 180.7%, in 2018 compared with 2017. The increase in costs of goods sold was primarily the result of the reclassification of approximately $60.1 million of expenses for equipment costs, which were previously classified as reductions of revenue, and was partially offset by $24.5 million of costs incurred for subsidy loss reimbursements that are now presented within revenue, driven by the adoption of Topic 606. Excluding the impact of the adoption of Topic 606, cost of goods sold increased approximately $5.3 million, or 23.6% due to an increase in equipment costs primarily related to prepaid handsets. Selling, general and administrative Selling, general and administrative costs decreased approximately $70.7 million, or 59.8%, in 2018 compared with 2017. The decrease in selling, general and administrative was primarily attributable to the reclassification of approximately $62.1 million of commissions and subscriber acquisition costs to reductions of revenue as required by the adoption of Topic 606. Excluding the impact of Topic 606, selling, general and administrative costs decreased approximately $8.6 million, or 7.3% primarily due to a reduction of back-office expenses required to support former nTelos subscribers that migrated to the Sprint back-office during 2017. Acquisition, integration and migration expenses Acquisition and integration costs were not incurred during 2018, as the completion of integration and migration activities related to the acquisition of nTelos was completed during 2017. Depreciation and amortization Depreciation and amortization decreased approximately $12.1 million, or 8.7%, in 2018 compared with 2017, primarily due to the retirement of assets acquired in the nTelos acquisition. 2017 Compared with 2016 Wireless results from operations are summarized as follows: Year Ended December 31, Change ($ in thousands) % of Revenue % of Revenue $ % Wireless operating revenue Wireless service revenue $ 431,184 94.7 $ 359,769 92.5 71,415 19.9 Tower lease revenue 11,604 2.5 11,279 2.9 2.9 Equipment revenue 9,467 2.1 10,674 2.7 (1,207 ) (11.3 ) Other revenue 2,823 0.7 7,031 1.9 (4,208 ) (59.8 ) Total wireless operating revenue 455,078 100.0 388,753 100.0 66,325 17.1 Wireless operating expenses Cost of goods and services 152,279 33.5 133,113 34.2 19,166 14.4 Selling, general and administrative 118,257 26.0 95,851 24.7 22,406 23.4 Acquisition, integration and migration expenses 10,793 2.4 25,927 6.7 (15,134 ) (58.4 ) Depreciation and amortization 139,610 30.7 107,621 27.7 31,989 29.7 Total wireless operating expenses 420,939 92.5 362,512 93.2 58,427 16.1 Wireless operating income (loss) $ 34,139 7.5 $ 26,241 6.8 7,898 30.1 Operating revenue Wireless service revenue increased approximately $71.4 million, or 19.9%, in 2017 compared with 2016, primarily due subscriber growth related to the expansion of our wireless network coverage area that was driven by our 2016 acquisition of nTelos and was offset by a decline in revenue per subscriber as a higher percentage of Sprint's postpaid customer base moved from higher revenue subsidized phone price plans to lower phone price plans associated with leased and installment sales. Postpaid net billings increased approximately $57.7 million, or 18.3%, as Postpaid Retail PCS Subscribers increased 1.9% primarily due to new subscribers from nTelos. Prepaid net billings increased $23.1 million, or 28.9%, due to 9.3% growth in Prepaid Retail PCS Subscribers and higher average revenue per subscriber due to improvements in product mix. Travel and other revenues increased $4.0 million due to a full year of travel revenue in the former nTelos service area compared to eight months in 2016. Equipment revenue decreased approximately $1.2 million or 11.3%, driven by a decline in handset sales as more subscribers are leasing their handsets directly from Sprint, and as of August 2017, the Company is no longer being compensated for accessory sales through Sprint's national retailer channel. Other revenue decreased $4.2 million, or 59.8%, in 2017 compared with the same period in 2016 primarily due to the migration of the nTelos subscribers to the Sprint billing platform and corresponding reduction in regulatory recovery revenues that we billed the subscribers from the former nTelos platform prior to their migration. The table below provides additional detail for Wireless service revenue. Year Ended December 31, Change ($ in thousands) $ % Wireless service revenue: Postpaid billings (1) $ 372,237 $ 314,579 57,658 18.3 Management fee (29,857 ) (25,543 ) 4,314 16.9 Net service fee (30,751 ) (22,953 ) 7,798 34.0 Total postpaid service revenue 311,629 266,083 45,546 17.1 Prepaid billings (2) 103,161 80,056 23,105 28.9 Sprint management fee (6,189 ) (4,960 ) 1,229 24.8 Total prepaid service revenue 96,972 75,096 21,876 29.1 Travel and other revenue (2) 22,583 18,590 3,993 21.5 Total service revenue $ 431,184 $ 359,769 71,415 19.9 ________________________________ 1) Postpaid net billings are defined under the terms of the affiliate contract with Sprint to be the gross billings to customers within our wireless network coverage area less billing credits and adjustments and allocated write-offs of uncollectible accounts. 2) The Company is no longer including Lifeline subscribers to be consistent with Sprint. The above table reflects the reclassification of the related Assurance Wireless prepaid revenue from prepaid gross billings to travel and other revenues for both years shown. Cost of goods and services Cost of goods and services increased approximately $19.2 million, or 14.4%, in 2017 compared with 2016 due to the expansion of our network as a result of our 2016 acquisition of nTelos. Network costs increased $22.7 million, while maintenance costs increased $2.8 million and are both primarily attributable to a full year of nTelos and the expansion of our network and wireless network coverage area. Handset costs decreased approximately $7.0 million due to the completion of the migration of nTelos subscribers to the Sprint platform. Selling, general and administrative Selling, general and administrative costs increased approximately $22.4 million, or 23.4%, in 2017 compared with 2016 primarily due to the expansion of our network as a result of our 2016 acquisition of nTelos. Expenses associated with prepaid wireless programs increased approximately $14.1 million in 2017 compared with 2016 as a result of the nTelos acquisition. Advertising and sales expenses increased $13.2 million as a result of our marketing campaigns aimed at POPS in our expanded wireless network coverage area. Integration costs classified as selling, general and administrative, associated with our acquisition of nTelos decreased approximately $3.8 million as a result of the 2017 completion of our migration and integration efforts. Customer service costs also decreased by approximately $1.1 million compared to 2016. Acquisition, integration and migration expenses Acquisition, integration and migration expenses decreased approximately $15.1 million as we completed the migration of subscribers from the nTelos billing platform to the Sprint network and billing platform. Depreciation and amortization Depreciation and amortization increased $32.0 million, or 29.7%, in 2017 over 2016, reflecting the amortization of tangible and intangible assets acquired in the nTelos acquisition. Cable Cable provides video, broadband and voice services in franchise areas in portions of Virginia, West Virginia and western Maryland, and leases fiber optic facilities throughout its service area. It does not include video, broadband and voice services provided to customers in Shenandoah County, Virginia, which are included in Wireline. The following table indicates selected operating statistics of Cable: December 31, 2018 December 31, 2017 December 31, 2016 Homes passed (1) 185,133 184,910 184,710 Customer relationships (2) Video users 41,269 44,269 48,512 Non-video customers 38,845 33,559 28,854 Total customer relationships 80,114 77,828 77,366 Video Customers (3) 43,600 46,613 50,618 Penetration (4) 23.6 % 25.2 % 27.4 % Digital video penetration (5) 78.8 % 76.2 % 77.4 % Broadband Available homes (6) 185,133 184,910 183,826 Users (3) 68,179 63,918 60,495 Penetration (4) 36.8 % 34.6 % 32.9 % Voice Available homes (6) 185,133 182,379 181,089 Users (3) 23,366 22,555 21,352 Penetration (4) 12.6 % 12.4 % 11.8 % Total revenue generating units (7) 135,145 133,086 132,465 Fiber route miles 3,514 3,356 3,137 Total fiber miles (8) 138,648 122,011 92,615 Average revenue generating units 133,109 132,759 131,218 _______________________________________________________ (1) Homes and businesses are considered passed (“homes passed”) if we can connect them to our distribution system without further extending the transmission lines. Homes passed is an estimate based upon the best available information. (2) Customer relationships represent the number of billed customers who receive at least one of our services. (3) Generally, a dwelling or commercial unit with one or more television sets connected to our distribution system counts as one video customer. Where services are provided on a bulk basis, such as to hotels and some multi-dwelling units, the revenue charged to the customer is divided by the rate for comparable service in the local market to determine the number of customer equivalents included in the customer counts shown above. (4) Penetration is calculated by dividing the number of users by the number of homes passed or available homes, as appropriate. (5) Digital video penetration is calculated by dividing the number of digital video users by total video users. Digital video users are video customers who receive any level of video service via digital transmission. A dwelling with one or more digital set-top boxes or digital adapters counts as one digital video user. (6) Homes and businesses are considered available (“available homes”) if we can connect them to our distribution system without further extending the transmission lines and if we offer the service in that area. (7) Revenue generating units are the sum of video, voice and high-speed internet users. (8) Total fiber miles are measured by taking the number of fiber strands in a cable and multiplying that number by the route distance. For example, a 10 mile route with 144 fiber strands would equal 1,440 fiber miles. 2018 Compared with 2017 Cable results from operations are summarized as follows: Year Ended December 31, Change ($ in thousands) % of Revenue % of Revenue $ % Cable operating revenue Service revenue $ 114,917 89.1 $ 107,338 90.1 7,579 7.1 Equipment revenue 0.5 0.6 (29 ) (4.0 ) Other revenue 13,291 10.4 11,100 9.3 2,191 19.7 Total cable operating revenue 128,903 100.0 119,162 100.0 9,741 8.2 Cable operating expenses Cost of services 59,935 46.5 59,335 49.8 1.0 Cost of goods sold 0.2 - 2,007.1 Selling, general, and administrative 20,274 15.7 19,999 16.8 1.4 Depreciation and amortization 24,644 19.1 23,968 20.1 2.8 Total cable operating expenses 105,148 81.6 103,316 86.7 1,832 1.8 Cable operating income (loss) $ 23,755 18.4 $ 15,846 13.3 7,909 49.9 Service revenue Service revenue increased approximately $7.6 million, or 7.1%, in 2018 compared with 2017, primarily due to growth in our broadband and voice subscribers, video rate increases, and our customers selecting or upgrading to higher-speed data access packages. Other revenue Other revenue increased approximately $2.2 million, or 19.7%, in 2018 compared with 2017, primarily due to new fiber contracts and installation services that were driven by growth in our customer base. Operating expenses Operating expenses increased approximately $1.8 million, or 1.8%, in 2018 compared with 2017 due primarily to our investment in infrastructure necessary to support the growth of the cable and fiber networks. The impact of the adoption of Topic 606, which deferred incremental commission and installation costs over the life of the customer, did not have a significant impact on operating expenses. 2017 Compared with 2016 Cable results from operations are summarized as follows: Year Ended December 31, Change ($ in thousands) % of Revenue % of Revenue $ % Cable operating revenue Service revenue $ 107,338 90.1 $ 99,070 91.1 8,268 8.3 Other revenue 11,824 9.9 9,664 8.9 2,160 22.4 Total cable operating revenue 119,162 100.0 108,734 100.0 10,428 9.6 Cable operating expenses Cost of goods and services 59,349 49.8 58,581 53.9 1.3 Selling, general, and administrative 19,999 16.8 19,248 17.7 3.9 Depreciation and amortization 23,968 20.1 23,908 22.0 0.3 Total cable operating expenses 103,316 86.7 101,737 93.6 1,579 1.6 Cable operating income (loss) $ 15,846 13.3 $ 6,997 6.4 8,849 126.5 Operating revenue Cable service revenue increased $8.3 million, or 8.3% in 2017 compared with 2016. Internet service revenue increased approximately $6.3 million, or 13.8%, due to a 5.7% increase in internet subscribers, along with an improved product mix as new and existing customers increasingly move to higher-speed plans with higher monthly recurring charges. Video revenue, including retransmission consent fee surcharges, decreased approximately $0.3 million primarily related to a reduction in our video customers that was driven by video rate increases in 2017 required to offset higher programming costs. Voice revenue increased approximately $0.4 million due to 5.6% growth in voice revenue customers. A reduction of promotional discounts offered during 2017 also resulted in an increase in Cable operating revenues of approximately $2.0 million. Other revenue grew approximately $2.2 million, primarily due to the addition of new fiber contracts in 2017. Operating expenses Cable cost of goods and services increased $0.8 million, or 1.3%, in 2017 compared with 2016 primarily as a result of growth in our network costs as a result of increases in line costs and pole rents. Wireline The following table includes selected operating statistics of the Wireline operations as of the dates shown: December 31, 2018 December 31, 2017 December 31, 2016 Long distance subscribers 9,452 9,078 9,149 Video customers (1) 4,742 5,019 5,264 Broadband customers 14,464 14,353 14,314 Fiber route miles 2,127 2,073 1,971 Total fiber miles (2) 161,552 154,165 142,230 ________________________________ 1) Wireline's video service passes approximately 16,500 homes. 2) Fiber Miles are measured by taking the number of fiber strands in a cable and multiplying that number by the route distance. For example, a 10 mile route with 144 fiber strands would equal 1,440 fiber miles. 2018 Compared with 2017 Wireline results from operations are summarized as follows: Year Ended December 31, Change ($ in thousands) % of Revenue % of Revenue $ % Wireline operating revenue Service revenue $ 23,274 30.2 $ 22,645 28.6 2.8 Carrier access and fiber revenue 50,438 65.4 53,078 67.0 (2,640 ) (5.0 ) Equipment revenue 0.3 0.2 52.0 Other revenue 3,237 4.1 3,403 4.2 (166 ) (4.9 ) Total wireline operating revenue 77,142 100.0 79,253 100.0 (2,111 ) (2.7 ) Wireline operating expenses Cost of services 38,056 49.3 38,417 48.5 (361 ) (0.9 ) Costs of goods sold 0.1 0.2 (38 ) (31.9 ) Selling, general, and administrative 7,467 9.7 6,923 8.7 7.9 Depreciation and amortization 13,673 17.7 12,829 16.2 6.6 Total wireline operating expenses 59,277 76.8 58,288 73.5 1.7 Wireline operating income (loss) $ 17,865 23.2 $ 20,965 26.5 (3,100 ) (14.8 ) Operating revenue Wireline operating revenue decreased approximately $2.1 million, or 2.7%, in 2018 compared with 2017. The decline in operating revenue was primarily attributable to repricing Wireless backhaul circuits to market rates and migrating Wireless voice traffic from traditional circuit-switched facilities to more cost effective VoIP facilities. Operating expenses Total Wireline operating expenses increased approximately $1.0 million, or 1.7%, in 2018, compared with 2017. The increase in total Wireline operating expenses was primarily attributable to the expansion of the underlying network assets and investments in infrastructure necessary to support the growth in our fiber network. 2017 Compared with 2016 Wireline results from operations are summarized as follows: Year Ended December 31, Change ($ in thousands) % of Revenue % of Revenue $ % Wireline operating revenue Service revenue $ 22,645 28.6 $ 21,917 29.2 3.3 Carrier access and fiber revenue 53,078 67.0 49,532 66.1 3,546 7.2 Other revenue 3,530 4.4 3,525 4.7 0.1 Total wireline operating revenue 79,253 100.0 74,974 100.0 4,279 5.7 Wireline operating expenses Costs of goods and services 38,536 48.6 36,259 48.4 2,277 6.3 Selling, general, and administrative 6,923 8.7 6,474 8.6 6.9 Depreciation and amortization 12,829 16.2 11,717 15.6 1,112 9.5 Total wireline operating expenses 58,288 73.5 54,450 72.6 3,838 7.0 Wireline operating income (loss) $ 20,965 26.5 $ 20,524 27.4 2.1 Operating revenue Total Wireline operating revenue in 2017 increased approximately $4.3 million, or 5.7%, compared with 2016. New carrier access and fiber revenue contracts became effective during 2017 for third party and affiliate fiber contracts resulting in growth of $3.5 million or 7.2% in 2017. Internet service revenue grew approximately $0.8 million as customers upgraded to higher-speed plans, while voice revenues declined approximately $0.4 million as customers discontinue landline telephone services. Operating expenses Total Wireline operating expenses increased approximately $3.8 million, or 7.0%, in 2017, compared with 2016 and included increases of approximately $2.3 million cost of goods and services related to higher network costs required to support our expanding affiliate fiber routes, $0.4 million increase in selling, general and administrative to support our investment in customer service personnel and infrastructure required to support our growth, and $1.1 million in additional depreciation related to our network assets. Non-GAAP Financial Measures In managing our business and assessing our financial performance, management supplements the information provided by the financial statement measures prepared in accordance with GAAP with Adjusted OIBDA and Continuing OIBDA, which are considered “non-GAAP financial measures” under SEC rules. Adjusted OIBDA is defined as operating income (loss) before depreciation and amortization, adjusted to exclude the effects of: certain non-recurring transactions; impairment of assets; gains and losses on asset sales; actuarial gains and losses on pension and other post-retirement benefit plans; and share-based compensation expense, amortization of deferred costs related to the impacts of the adoption of Topic 606, and adjusted to include the benefit received from the waived management fee by Sprint. Continuing OIBDA is defined as Adjusted OIBDA, less the benefit received from the waived management fee by Sprint. Adjusted OIBDA and Continuing OIBDA should not be construed as an alternative to operating income as determined in accordance with GAAP as a measure of operating performance. In a capital-intensive industry such as telecommunications, management believes that Adjusted OIBDA and Continuing OIBDA and the associated percentage margin calculations are meaningful measures of our operating performance. We use Adjusted OIBDA and Continuing OIBDA as supplemental performance measures because management believes these measures facilitate comparisons of our operating performance from period to period and comparisons of our operating performance to that of our peers and other companies by excluding potential differences caused by the age and book depreciation of fixed assets (affecting relative depreciation expenses) as well as the other items described above for which additional adjustments were made. In the future, management expects that the Company may again report Adjusted OIBDA and Continuing OIBDA excluding these items and may incur expenses similar to these excluded items. Accordingly, the exclusion of these and other similar items from our non-GAAP presentation should not be interpreted as implying these items are non-recurring, infrequent or unusual. While depreciation and amortization are considered operating costs under generally accepted accounting principles, these expenses primarily represent the current period allocation of costs associated with long-lived assets acquired or constructed in prior periods, and accordingly may obscure underlying operating trends for some purposes. By isolating the effects of these expenses and other items that vary from period to period without any correlation to our underlying performance, or that vary widely among similar companies, management believes Adjusted OIBDA and Continuing OIBDA facilitates internal comparisons of our historical operating performance, which are used by management for business planning purposes, and also facilitates comparisons of our performance relative to that of our competitors. In addition, we believe that Adjusted OIBDA and Continuing OIBDA and similar measures are widely used by investors and financial analysts as measures of our financial performance over time, and to compare our financial performance with that of other companies in our industry. Adjusted OIBDA and Continuing OIBDA have limitations as an analytical tool, and should not be considered in isolation or as a substitute for analysis of our results as reported under GAAP. These limitations include, but are not limited to, the following: • they do not reflect capital expenditures; • they do not reflect the impacts of adoption of Topic 606; • many of the assets being depreciated and amortized will have to be replaced in the future and Adjusted OIBDA and Continuing OIBDA do not reflect cash requirements for such replacements; • they do not reflect costs associated with share-based awards exchanged for employee services; • they do not reflect interest expense necessary to service interest or principal payments on indebtedness; • they do not reflect gains, losses or dividends on investments; • they do not reflect expenses incurred for the payment of income taxes; and • other companies, including companies in our industry, may calculate Adjusted OIBDA and Continuing OIBDA differently than we do, limiting its usefulness as a comparative measure. In light of these limitations, management considers Adjusted OIBDA and Continuing OIBDA as a financial performance measure that supplements but does not replace the information reflected in our GAAP results. The adoption of the new revenue standard did not impact Adjusted OIBDA. The following tables reconcile Adjusted OIBDA and Continuing OIBDA to operating income, which we consider to be the most directly comparable GAAP financial measure: Year Ended December 31, 2018 (in thousands) Wireless Cable Wireline Other Consolidated Operating income $ 92,847 $ 23,755 $ 17,865 $ (41,221 ) $ 93,246 Impact of ASC topic 606 (15,048 ) (74 ) (197 ) - (15,319 ) Depreciation and amortization 127,521 24,644 13,673 166,405 Share-based compensation expense - - - 4,959 4,959 Benefit received from the waived management fee (1) 37,763 - - - 37,763 Amortization of intangibles netted in rent expense - - - Actuarial (gains) losses on pension plans - - - (1,688 ) (1,688 ) Adjusted OIBDA 243,425 48,325 31,341 (37,383 ) 285,708 Waived management fee (37,763 ) - - - (37,763 ) Continuing OIBDA $ 205,662 $ 48,325 $ 31,341 $ (37,383 ) $ 247,945 Year Ended December 31, 2017 (in thousands) Wireless Cable Wireline Other Consolidated Operating income $ 34,139 $ 15,846 $ 20,965 $ (24,440 ) $ 46,510 Depreciation and amortization 139,610 23,968 12,829 177,007 (Gain) loss on asset sales (243 ) Share-based compensation expense 1,579 3,580 Benefit received from the waived management fee (1) 36,056 - - - 36,056 Amortization of intangibles netted in rent expense 1,528 - - - 1,528 Temporary back-office costs to support the billing operations through migration (2) 6,459 - - 6,460 Actuarial gains on pension plans - - - (1,387 ) (1,387 ) Integration and acquisition related expenses, and other 10,793 - - 11,030 Adjusted OIBDA 230,378 40,487 34,257 (24,220 ) 280,902 Waived management fee (36,056 ) - - - (36,056 ) Continuing OIBDA $ 194,322 $ 40,487 $ 34,257 $ (24,220 ) $ 244,846 Year Ended December 31, 2016 (in thousands) Wireless Cable Wireline Other Consolidated Operating income $ 26,241 $ 6,997 $ 20,524 $ (31,236 ) $ 22,526 Depreciation and amortization 107,621 23,908 11,717 143,685 (Gain) loss on asset sales (131 ) (27 ) (47 ) (49 ) Share-based compensation expense 1,309 3,021 Benefit received from the waived management fee (1) 24,596 - - - 24,596 Amortization of intangibles netted in rent expense - - - Temporary back-office costs to support the billing operations through migration (2) 13,843 - - - 13,843 Actuarial gains on pension plans - - - (4,460 ) (4,460 ) Integration and acquisition related expenses, and other 25,927 - - 16,305 42,232 Adjusted OIBDA 200,134 31,817 32,561 (18,390 ) 246,122 Waived management fee (24,596 ) - - - (24,596 ) Continuing OIBDA $ 175,538 $ 31,817 $ 32,561 $ (18,390 ) $ 221,526 ________________________________ 1) Under our amended affiliate agreement, Sprint agreed to waive the Management Fees charged on both postpaid and prepaid revenues, up to $4.2 million per month, until the total amount waived reaches approximately $255.6 million, which is expected to occur in 2022. 2) Represents back-office expenses required to support former nTelos subscribers that migrated to Sprint back-office systems. Financial Condition, Liquidity and Capital Resources Sources and Uses of Cash: Primary sources of cash include existing balances of cash and cash equivalents, cash flows from operations, and borrowings from our credit facility. Cash generated from such sources has been sufficient to fund our growth and strategic initiatives, fund our capital projects, service our debt and issue our annual dividend. As of December 31, 2018, our cash and cash equivalents totaled approximately $85.1 million, compared with approximately $78.6 million as of December 31, 2017. All cash held by the Company is domiciled in the United States. The Company generated $265.6 million of net cash from operations in 2018, a 19.2% increase over the prior year. In 2017, the Company generated $222.9 million of net cash from operations, representing an approximate 38% improvement from the $161.5 million provided in 2016. The increases were primarily due to the continued expansion of our wireless network coverage area consistent with the growth of the wireless subscriber base and corresponding revenue. During 2018, the Company utilized $187.8 million in net investing activities. Plant and equipment purchases in 2018, 2017 and 2016 totaled $136.6 million, $146.5 million and $173.2 million, respectively. Over the past three years, capital expenditures were primarily focused on supporting and upgrading the expansion of our wireless and fiber networks. Additionally, capital expenditures supported cell site upgrades, cable network expansion and upgrades, Wireline fiber builds and retail store remodels. Financing activities utilized approximately $71.3 million in 2018 as the Company repaid debt totaling $51.3 million, paid dividends of $12.9 million, and provided cash payments for taxes related to equity awards of $3.2 million in 2018. In 2017, financing activities utilized approximately $29.0 million as the Company repaid debt totaling $36.4 million, borrowed $25.0 million to fund strategic expansion initiatives, paid cash dividends of $12.3 million, and provided cash payments for taxes related to equity awards of $5.4 million. Financing activities provided $617.9 million in 2016 as the Company borrowed $860.0 million to fund the nTelos acquisition and related activities, repaid debt totaling $213.8 million (including $12.1 million of principal on the new debt financing agreement), and paid $14.9 million to enter into the new debt financing arrangement to acquire nTelos. The Company also paid cash dividends totaling $11.7 million. Indebtedness: As of December 31, 2018, the Company’s gross indebtedness totaled $785.2 million, with an estimated annualized effective interest rate of 3.97% after considering the impact of the interest rate swap contracts and unamortized loan costs. The balance consisted of Term Loan A-1 at a variable rate (4.27% as of December 31, 2018) that resets monthly based on one month LIBOR plus a margin of 1.75% currently, and Term Loan A-2 at a variable rate (4.52% as of December 31, 2018) that resets monthly based on one month LIBOR plus a margin of 2.00% currently. The Company amended its 2016 credit agreement effective November 9, 2018 and this credit facility modification reduced near term principal payments, extended the maturity of both Term Loan A-1 and A-2, allowed access to the Revolver for an extended period of time, and reduced the applicable base interest rate by 75 basis points. It also shifted $108.8 million in principal from Term Loan A-1 to Term Loan A-2. The amended Term Loan A-1 requires quarterly principal repayments of approximately $3.6 million, which began on December 31, 2018 through September 30, 2019, increasing to $7.3 million quarterly from December 31, 2019 through September 30, 2022; then increasing to $10.9 million quarterly from December 31, 2022 through September 30, 2023, with the remaining balance due November 8, 2023. The amended Term Loan A-2 requires quarterly principal repayments of approximately $1.2 million beginning on December 31, 2018 through September 30, 2025, with the remaining balance due November 8, 2025. At December 31, 2018, $75 million was available under the Revolver Facility. Under the amended 2016 credit agreement, the Company has access to the Revolver through 2023. The Company is subject to certain financial covenants measured on a trailing twelve month basis each calendar quarter unless otherwise specified. These covenants include: • a limitation on the Company’s total leverage ratio, defined as indebtedness divided by earnings before interest, taxes, depreciation and amortization, or EBITDA, of less than or equal to 3.50 to 1.00 from December 31, 2018 through December 31, 2019, then 3.25 to 1.00 through December 31, 2021, and 3.00 to 1.00 thereafter; • a minimum debt service coverage ratio, defined as EBITDA minus certain cash taxes divided by the sum of all scheduled principal payments on the Term Loans and other indebtedness plus cash interest expense, greater than or equal to 2.00 to 1.00; • the Company must maintain a minimum liquidity balance, defined as availability under the revolver facility plus unrestricted cash and cash equivalents on deposit in a deposit account for which a control agreement has been delivered to the administrative agent under the 2016 credit agreement, of greater than $25 million at all times. As of December 31, 2018, the Company was in compliance with the financial covenants in its credit agreements and ratios were as follows: Actual Covenant Requirement Total leverage ratio 2.54 3.50 or Lower Debt service coverage ratio 3.63 2.00 or Higher Minimum liquidity balance (in millions) $ 159.0 $25.0 or Higher Contractual Commitments: The Company is obligated to make future payments under various contracts it has entered into, primarily amounts pursuant to its long-term debt facility, and non-cancelable operating lease agreements for retail space, tower space and cell sites. Expected future minimum contractual cash payments, excluding the effects of time value, on contractual obligations, by period are summarized as follows: Payments due by periods: (in thousands) Total Less than 1 year 1-3 years 4-5 years More than 5 years Long-term debt principal (1) $ 785,236 $ 23,197 $ 68,244 $ 221,198 $ 472,597 Interest on long-term debt (1) 198,295 34,474 65,004 58,215 40,602 "Pay-fixed" obligations (2) 12,695 4,312 6,300 2,083 - Operating leases (3) 425,544 55,050 104,423 97,573 168,498 Purchase obligations (4) 38,252 24,463 13,789 - - Total $ 1,460,022 $ 141,496 $ 257,760 $ 379,069 $ 681,697 ________________________________ (1) Includes principal payments and estimated interest payments on the Term Loan Facility based upon outstanding balances and rates in effect at December 31, 2018. (2) Represents the maximum interest payments we are obligated to make under our derivative agreements. Assumes no receipts from the counterparty to our derivative agreements. (3) Our existing operating lease agreements may provide us with the option to renew. Our future operating lease obligations would change if we entered into additional operating lease agreements and if we exercised renewal options. (4) Represents open purchase orders at December 31, 2018. Contractual commitments represent future cash payments and liabilities that are required under contractual agreements with third parties, and exclude purchase orders for goods and services. The contractual commitment amounts in the table above are associated with agreements that are legally binding and enforceable, and that specify all significant terms, including fixed or minimum services to be used, fixed, minimum or variable price provisions and the approximate timing of the transaction. Other long-term liabilities have been omitted from the table above due to uncertainty of the timing of payments, refer to Note 12, Other Assets and Accrued Liabilities, included with the notes to our consolidated financial statements for additional information. The Company has no other off-balance sheet arrangements and has not entered into any transactions involving unconsolidated, limited purpose entities or commodity contracts. Capital Commitments: The Company spent $136.6 million on capital projects in 2018, down from $146.5 million in 2017 and down from $173.2 million in 2016. Capital expenditures in 2018 were primarily for upgrades to the recently acquired expansion areas, continued expansion of coverage in the former nTelos territory, network and cable market expansion, and for fiber builds and increased Wireline capacity projects. Capital expenditures in 2017 were primarily related to upgrades of the former nTelos sites and additional cell sites to expand coverage in that territory, network and cable market expansion, fiber builds and information technology projects. Capital expenditures in 2016 primarily supported cell site upgrades and coverage and capacity expansions in the wireless segment following the nTelos acquisition, as well as cable network expansion and upgrades and wireline segment fiber builds. Capital expenditures budgeted for 2019 are expected to be approximately $147.4 million, including $64.1 million in the Wireless segment primarily for wireless network capacity improvements. In addition, $52.9 million is budgeted primarily for cable network expansion including new fiber routes and cable market expansion, $20.5 million in Wireline projects including expansion of the fiber network, and $9.9 million primarily for IT projects and other. We believe that cash on hand, cash flow from operations and borrowings expected to be available under our existing credit facilities will provide sufficient cash to enable us to fund planned capital expenditures, make scheduled principal and interest payments, meet our other cash requirements and maintain compliance with the terms of our financing agreements for at least the next twelve months. There can be no assurance that we will continue to generate cash flows at or above current levels or that we will be able to maintain our ability to borrow under our credit facilities. Thereafter, capital expenditures will likely be required to continue planned capital upgrades to the acquired wireless network and provide increased capacity to meet our expected growth in demand for our products and services. The actual amount and timing of our future capital requirements may differ materially from our estimate depending on the demand for our products, new market developments and expansion opportunities. Our cash flows from operations could be adversely affected by events outside our control, including, without limitation, changes in overall economic conditions, regulatory requirements, changes in technologies, demand for our products, availability of labor resources and capital, changes in our relationship with Sprint, and other conditions. The Wireless segment’s operations are dependent upon Sprint’s ability to execute certain functions such as billing, customer care, and collections; our ability to develop and implement successful marketing programs and new products and services; and our ability to effectively and economically manage other operating activities under our agreements with Sprint. Our ability to attract and maintain a sufficient customer base, particularly in the acquired cable markets, is also critical to our ability to maintain a positive cash flow from operations. The foregoing events individually or collectively could affect our results. Critical Accounting Policies We prepare our consolidated financial statements in accordance with U.S. generally accepted accounting principles ("GAAP"). The preparation of these consolidated financial statements requires us to make estimates and assumptions that affect our reported amounts of assets, liabilities, revenue and expenses, as well as related disclosures. To the extent that there are material differences between these estimates and actual results, our financial condition or operating results would be affected. We base our estimates on past experience and other assumptions that we believe are reasonable under the circumstances, and we evaluate these estimates on an ongoing basis. We refer to accounting estimates of this type as critical accounting policies and estimates, which we discuss further below. Our significant accounting policies are described in Note 2, Summary of Significant Accounting Policies, in our consolidated financial statements. The following are the accounting policies that we believe involve a greater degree of judgment and complexity and are the most critical to aid in fully understanding and evaluating our consolidated financial condition and results of operations. Revenue Recognition Refer to Note 3, Revenue from Contracts with Customers for details of the Company's 2018 revenue recognition policy. For the years ended December 31, 2017 and 2016, the Company recognized revenue when persuasive evidence of an arrangement existed, services were rendered or products were delivered, the price to the buyer was fixed and determinable and collectability was reasonably assured. Revenue was recognized based on the various types of transactions generating the revenue. For services, revenue was recognized as the services were performed. For equipment sales, revenue was recognized when the sales transaction was complete. Income Taxes We account for income taxes under the asset and liability method. Deferred tax assets and liabilities are recognized for the future tax consequences attributable to differences between financial statement carrying amounts of existing assets and liabilities and their respective tax bases. Deferred tax assets and liabilities are measured using enacted tax rates expected to apply to taxable income in the years in which those temporary differences are expected to be recovered or settled. The effect on deferred tax assets and liabilities of a change in tax rates is recognized in income in the period that includes the enactment date. We make estimates, assumptions and judgments to determine our provision for income taxes and also for deferred tax assets and liabilities and any valuation allowances recorded against our deferred tax assets. We evaluate the recoverability of deferred tax assets and liabilities and, to the extent we believe that recovery is not likely, we establish a valuation allowance. We evaluate the effective rate of taxes based on apportionment factors, actual operating results, and the various applicable state income tax rates. ASC 740-10, Accounting for Uncertainty in Income Taxes, prescribes a recognition threshold of more-likely- than-not, and a measurement attribute for all tax positions taken or expected to be taken on a tax return, in order for those positions to be recognized in the financial statements. We continually review tax laws, regulations and related guidance in order to properly record any uncertain tax liability positions. We adjust these reserves in light of changing facts and circumstances. We have adopted ASU 2016-09, Compensation - Stock Compensation, which modified income tax consequences for several aspects of share-based payment awards. Excess tax benefits and tax shortfalls for share-based payments are now included in our tax provision expense rather than additional-paid-in-capital. Variability of tax consequences arising from excess tax benefits and tax shortfalls may result due to fluctuations in our stock price and the volume of our employees' equity awards that are exercised or vest. Refer to Note 16, Income Taxes, included with the notes to our consolidated financial statements for additional information concerning income taxes. Goodwill and Indefinite-lived Intangible Assets Goodwill represents the excess of acquisition costs over the fair value of tangible net assets and identifiable intangible assets of the businesses acquired. Cable franchise rights, included in indefinite-lived intangible assets provide us with the non-exclusive right to provide video services in a specified area. While some cable franchises are issued for a fixed time (generally 10 years), renewals of cable franchises have occurred routinely and at nominal cost. Moreover, we have determined that there are currently no legal, regulatory, contractual, competitive, economic or other factors that limit the useful lives of our cable franchises and as a result we account for cable franchise rights as an indefinite lived intangible asset. Goodwill and indefinite-lived intangible assets are not amortized, but rather, are subject to impairment testing annually, in the fourth quarter, or whenever events or changes in circumstances indicate that the carrying amount may not be fully recoverable. A qualitative evaluation of our reporting units is utilized to determine whether it is necessary to perform a quantitative two-step impairment test. If it is more likely than not that the fair value of a reporting unit is less than its carrying amount, we would be required to perform a two-step quantitative test. If the carrying value of the reporting unit's net assets exceeds the fair value of the reporting unit, then an impairment loss is recorded. Our 2018 impairment tests were based on the operating segment structure, where each operating segment was also considered a reporting unit. During the fourth quarter of 2018 we performed a qualitative assessment for our reporting units that were assigned goodwill. During this assessment, qualitative factors were first assessed to determine whether it was more likely than not that the fair value of the reporting units were less than their carrying amounts. Qualitative factors that were considered included, but were not limited to, macroeconomic conditions, industry and market conditions, company specific events, changes in circumstances, after tax cash flows and market capitalization trends. Based on our annual qualitative impairment evaluations performed during 2018 and 2017, we concluded that there were no indicators of impairment and therefore it was more likely than not that the fair value of the goodwill exceeded its carrying amount, for each reporting unit, and cable franchise rights exceeded its fair value. Refer to Note 2, Summary of Significant Accounting Policies, and Note 10, Goodwill and Intangible Assets, included in our consolidated financial statements for additional information concerning goodwill. Finite-lived Intangible Assets On an annual basis, or whenever events or changes in circumstances require otherwise, we review our finite-lived intangible assets for impairment. Intangible assets are included in our annual impairment testing and in the event we identify impairment, the intangible assets are written down to their fair values. Intangible assets typically have finite useful lives that are amortized over their useful lives and primarily consist of affiliate contract expansion, acquired subscribers-cable, and off market leases. Affiliate contract expansion and acquired subscribers-cable intangibles are amortized over the period in which those relationships are expected to contribute to our future cash flows and are also reduced by management fee waiver credits received from Sprint in connection with the 2017 non-monetary exchange. Other finite-lived intangible assets, are generally amortized using the straight-line method of amortization. Such finite-lived intangible assets are subject to the impairment provisions of ASC 360, Property, Plant and Equipment, where impairment is recognized and measured only if there are events and circumstances that indicate that the carrying amount may not be recoverable. The carrying amount is not recoverable if it exceeds the sum of the undiscounted cash flows expected to result from the use of the asset group. An impairment loss is recorded if after determining that it is not recoverable, the carrying amount exceeds the fair value of the asset. Finite-lived intangible assets and liabilities are being amortized over the following estimated useful lives that were established on the dates acquired: Estimated Useful Life Affiliate contract expansion 4 - 14 years Favorable and unfavorable leases - wireless 1 - 28 years Acquired subscribers - cable 3 - 10 years Other intangibles 15 - 20 years There were no impairment charges on intangible assets for the years ended December 31, 2018, 2017 or 2016. Business Combinations Business combinations, including purchased intangible assets, are accounted for at fair value. Acquisition costs are expensed as incurred and recorded in acquisition, integration and migration expenses. The fair value amount assigned to assets acquired and liabilities assumed is based on an exit price from a market participant's viewpoint, and utilizes data such as discounted cash flow analysis and replacement cost models. Recently Issued Accounting Standards Recently issued accounting standards and their expected impact, if any, are discussed in Note 2, Summary of Significant Accounting Policies, of the notes to our consolidated financial statements.

<s>[INST] This annual report contains forwardlooking statements within the meaning of Section 27A of the Securities Act of 1933 and Section 21E of the Securities Exchange Act of 1934, including statements regarding our expectations, intentions, or strategies regarding the future. These statements are subject to certain risks and uncertainties that could cause actual results to differ materially from those anticipated in the forwardlooking statements. The Company undertakes no obligation to publicly revise these forwardlooking statements to reflect subsequent events or circumstances, except as required by law. The following discussion and analysis of our financial condition and results of operations should be read in conjunction with Part II, Item 6 "Selected Financial Data" and our consolidated financial statements and notes thereto appearing elsewhere in this Annual Report on Form 10K. Overview Shenandoah Telecommunications Company and its subsidiaries, (the "Company", "we", "our", or "us"), provide wireless personal communication service ("PCS") under the Sprint brand, and telephone service, cable television, unregulated communications equipment sales and services, and internet access under the Shentel brand. In addition, the Company operates an interstate fiber optic network and leases its owned cell site towers to both affiliates and nonaffiliated thirdparty wireless service providers. The Company's reportable segments include: Wireless, Cable, Wireline, and Other. See Note 17, Segment Reporting, included with the notes to our consolidated financial statements for further information regarding our segments. The following provides a description of the operations within our segments: Wireless provides digital wireless mobile service as a Sprint PCS Affiliate in a multistate area covering large portions of central and western Virginia, southcentral Pennsylvania, West Virginia, and portions of Maryland, North Carolina, Kentucky, and Ohio, "our wireless network coverage area". In these areas, we are the exclusive provider of Sprintbranded wireless mobility communications network products and services on the 800 MHz, 1900 MHz and 2.5 GHz spectrum bands. Wireless also owns 208 cell site towers built on leased and owned land, and leases space on these towers to both affiliates and nonaffiliated third party wireless service providers. Cable provides video, broadband and voice services in franchise areas in portions of Virginia, West Virginia, and western Maryland, and leases fiber optic facilities throughout its service area. Wireline provides regulated and unregulated voice services, internet broadband, long distance access services, and leases fiber optic facilities throughout portions of Virginia, West Virginia, Maryland, and Pennsylvania. Additionally, our Other operations are represented by Shenandoah Telecommunications Company, the parent holding company, that provides investing and management services to the Company's subsidiaries. Basis of Presentation The Company adopted ASU No. 201409, Revenue from Contracts with Customers (“Topic 606”), effective January 1, 2018, using the modified retrospective method as discussed in Note 3, Revenue from Contracts with Customers. The following tables identify the impact of applying Topic 606 to the Company for the year ended December 31, 2018: Year Ended December 31, 2018 Topic 606 Impact CONSOLIDATED ($ in thousands, except per share amounts) Prior to Adoption of Topic 606 Changes in Presentation (1) Equipment Revenue (2) Deferred Costs (3) As Reported 12/31/2018 Service revenue and other $ 632,340 $ (86,637 ) $ $ 16,753 $ 562,456 Equipment revenue 8,298 60,100 68,398 Total operating revenue 640,638 (86,637 ) 60,100 16,753 630,854 Cost of services 193,860 194,022 Cost of goods sold 28,377 (24,51 [/INST] Positive. </s>

SHENANDOAH TELECOMMUNICATIONS CO/VA/

2020-02-26

2019-12-31

ITEM 7. MANAGEMENT'S DISCUSSION AND ANALYSIS OF FINANCIAL CONDITION AND RESULTS OF OPERATIONS You should read the following discussion and analysis of our financial condition and results of operations in conjunction with our “Selected Financial Data” and our consolidated financial statements and notes thereto appearing elsewhere in this Annual Report on Form 10-K. In addition to historical consolidated financial information, the following discussion and analysis may contain forward-looking statements that involve risks, uncertainties and assumptions. Our actual results could differ materially from those anticipated by forward-looking statements as a result of many factors. We discuss factors that we believe could cause or contribute to these differences below and elsewhere in this Annual Report on Form 10-K, including those set forth under “Part I. Cautionary Statement Regarding Forward-Looking Statements” and “Part I. Item 1A. Risk Factors”. Overview Shenandoah Telecommunications Company (“Shentel”, “we”, “our”, “us”, or the “Company”), is a provider of a comprehensive range of wireless and broadband communications products and services in the Mid-Atlantic portion of the United States. Management’s Discussion and Analysis is organized around our reporting segments. Refer to Item 1 above for our description of our reporting segments and a description of their respective business activities. Also see Note 14, Segment Reporting, in our consolidated financial statements for additional information. 2019 Developments Glo Fiber: During the second quarter of 2019, we initiated the deployment of our new fiber-to-the-home service, which is marketed by our Broadband segment under the Glo Fiber brand. Glo Fiber leverages our existing, robust fiber network and commercial customer base to target certain residential areas in markets within our region. We launched service in Harrisonburg, Virginia during the fourth quarter of 2019. During 2019, we recognized $19 thousand in revenue and incurred $2.9 million of operating expense. We expect to continue to incur operating losses in a new market for approximately the first two years from the launch of service. Big Sandy Broadband, Inc. Acquisition: On February 28, 2019, the Company paid $10.0 million to acquire the assets of Big Sandy Broadband, Inc. ("Big Sandy"), a small regional provider of cable television, telephone and high speed internet services in eastern Kentucky. Other Events Sprint Affiliate Area Expansion: Effective February 1, 2018, we signed the expansion agreement with Sprint to expand our wireless network coverage area to include certain portions of Kentucky, Pennsylvania, Virginia and West Virginia, (the “Expansion Area”), effectively adding a population (POPs) of approximately 1.1 million. The agreement includes certain network build out requirements, and the ability to utilize Sprint’s spectrum in the Expansion Area along with certain other amendments to the Affiliate Agreements. Pursuant to the expansion agreement, Sprint agreed to transition the provision of network coverage in the Expansion Area to us. The expansion agreement required a payment of $52.0 million to Sprint for the right to service the Expansion Area pursuant to the Affiliate Agreements plus an additional payment of up to $5.0 million after acceptance of certain equipment at the Sprint cell sites in the Expansion Area. A map of our territory, reflecting the new Expansion Area, is provided below: Results of Operations Revenue As described in Item 1, Business we earn revenue primarily through our provision of wireless network services to Sprint under our affiliate agreement, as well as from our provision of broadband services that include fiber, internet, video, voice, and data services. We also lease colocation space on our owned cell towers to external wireless carriers. Our Wireless segment revenue is fully variable and based upon the number of Sprint subscribers that utilize our wireless network, and their respective rate plans with Sprint. Our Broadband segment revenue is driven primarily by the number of our customers that subscribe to our broadband services, and their selection from our respective rate plans. Our Tower segment revenue is driven primarily by the number of cell towers that we own, and our ability to secure colocation leases from wireless carriers. Operating Expenses Our operating expenses consist primarily of cost of services, cost of goods sold, selling, general and administrative, acquisition, integration and migration expense in 2017 related to the 2016 acquisition of nTelos, and depreciation and amortization expenses. Other Income (Expense) Our other income (expense) consists primarily of interest expense and other income. Our other income primarily represents interest and dividends earned from our investments, including patronage income that is connected with our CoBank loan agreements. Income Tax Expense Income tax expense consists of federal and state income taxes in the United States. 2019 Compared with 2018 Results of Operations The Company’s consolidated results from operations are summarized as follows: Year Ended December 31, Change ($ in thousands) % of Revenue % of Revenue $ % Revenue $ 633,906 100.0 $ 630,854 100.0 3,052 0.5 Operating expenses 536,860 84.7 537,608 85.2 (748 ) (0.1 ) Operating income 97,046 15.3 93,246 14.8 3,800 4.1 Interest expense (29,468 ) (4.6 ) (34,847 ) (5.5 ) (5,379 ) (15.4 ) Other income 3,461 0.5 3,713 0.6 (252 ) (6.8 ) Income before taxes 71,039 11.2 62,112 9.8 8,927 14.4 Income tax expense 16,104 2.5 15,517 2.5 3.8 Net income $ 54,935 8.7 $ 46,595 7.4 8,340 17.9 Revenue Revenue increased approximately $3.1 million, or 0.5%, in 2019 compared with 2018, driven primarily by Broadband revenue growth of $10.8 million partially offset by Wireless revenue decline of $7.1 million. The Wireless segment recognized $12 million in lower travel revenue in 2019 compared to 2018 due to the ongoing dispute with Sprint over resetting of the travel fee. Refer to the discussion of the results of operations for the Wireless and Broadband segments, included within this annual report, for additional information. Operating expenses Operating expenses decreased approximately $0.7 million, or 0.1%, in 2019 compared with 2018. The decrease was primarily due to a decline in Wireless depreciation and amortization expense as certain assets acquired from nTelos became fully depreciated. Interest expense Interest expense decreased approximately $5.4 million, or 15.4%, in 2019 compared with 2018. The decrease in interest expense was primarily attributable to the reduction of the applicable base interest rate by 75 basis points and principal repayments on our Credit Facility term loans, combined with the effect of year-over-year declines in LIBOR. Other income Other income decreased approximately $0.3 million, or 6.8%, in 2019 compared with 2018. The decrease was primarily due to a decline in the actuarial value of our retirement plan obligations. Income tax expense Income tax expense increased approximately $0.6 million, or 3.8%, compared with 2018. The increase was primarily driven by the increase in our income before taxes. Wireless Wireless earns postpaid, prepaid and wholesale revenues from Sprint for their subscribers that use our Wireless network service in our Wireless network coverage area. The Company's wireless revenue is variable based on billed revenues to Sprint's customers in the Sprint Affiliate Area less applicable fees retained by Sprint. Sprint retains an 8% Management Fee and an 8.6% Net Service Fee on postpaid revenues and a 6% Management Fee on prepaid wireless revenues. For postpaid, the Company is also charged for the costs of subsidized handsets sold through Sprint's national channels as well as commissions paid by Sprint to third-party dealers in our Sprint Affiliate Area. Sprint also charges the Company separately to acquire and support prepaid customers. These charges are calculated based on Sprint's national averages for its prepaid programs, and are billed per user or per gross additional customer, as appropriate. The following tables indicate selected operating statistics of Wireless, including Sprint subscribers: December 31, December 31, 2018 (2) December 31, 2017 (3) Postpaid: Retail PCS total subscribers 844,194 795,176 736,597 Retail PCS phone subscribers 740,958 723,455 678,096 Retail PCS connected device subscribers 103,236 71,721 58,501 Gross PCS total subscriber additions 235,953 190,334 173,871 Gross PCS phone additions 174,237 156,601 150,210 Gross PCS connected device additions 61,716 33,733 23,661 Net PCS total subscriber additions (losses) 49,018 20,236 (5,032 ) Net PCS phone additions (losses) 19,846 12,310 (1,414 ) Net PCS connected device additions (losses) 29,172 7,926 (3,618 ) PCS monthly retail total churn % 1.92 % 1.82 % 2.04 % PCS monthly phone churn % 1.77 % 1.69 % 1.88 % PCS monthly connected device churn % 3.21 % 3.35 % 3.96 % Prepaid: Retail PCS subscribers 274,012 258,704 225,822 Gross PCS subscriber additions 152,098 150,662 151,926 Net PCS subscriber additions 15,308 17,191 14,633 PCS monthly retail churn % 4.26 % 4.45 % 5.07 % PCS market POPS (000) (1) 7,227 7,023 5,942 PCS covered POP (000) (1) 6,324 6,109 5,272 Macro base stations (cell sites) 1,960 1,853 1,623 _______________________________________________________ (1) "POPS" refers to the estimated population of a given geographic area. Market POPS are those within a market area which we are authorized to serve under our Sprint PCS affiliate agreements, and Covered POPS are those covered by our network. The data source for POPS is U.S. census data. Historical periods previously referred to other third party population data and have been recast to refer to U.S. census data. (2) Acquired the Richmond Expansion Area on February 1, 2018 with market POPs of 1,082,000 and covered POPs of 602,000. 2018 net adds results exclude 38,343 postpaid and 15,691 prepaid subscribers acquired. (3) Acquired the Parkersburg Expansion Area on April 6, 2017 with market POPs of 511,000 and covered POPs of 244,000. 2017 net adds results exclude 19,067 postpaid and 4,517 prepaid subscribers acquired. Wireless results from operations are summarized as follows: Year Ended December 31, Change ($ in thousands) % of Revenue % of Revenue $ % Wireless revenue: Gross postpaid billings $ 410,532 92.6 $ 405,101 89.9 5,431 1.3 Allocated bad debt (20,428 ) (4.6 ) (21,866 ) (4.9 ) (1,438 ) (6.6 ) Amortization of contract asset and other (23,337 ) (5.3 ) (18,742 ) (4.2 ) 4,595 24.5 Sprint management and net service fee (64,736 ) (14.6 ) (63,718 ) (14.1 ) 1,018 1.6 Total postpaid service revenue 302,031 68.1 300,775 66.8 1,256 0.4 Gross prepaid billings 121,604 27.4 111,462 24.7 10,142 9.1 Amortization of contract asset and other (60,435 ) (13.6 ) (52,846 ) (11.7 ) 7,589 14.4 Sprint management fee (7,629 ) (1.7 ) (7,014 ) (1.6 ) 8.8 Total prepaid service revenue 53,540 12.1 51,602 11.5 1,938 3.8 Travel and other 20,160 4.5 30,572 6.8 (10,412 ) (34.1 ) Wireless service revenue and other 375,731 84.7 382,949 85.0 (7,218 ) (1.9 ) Equipment revenue 67,659 15.3 67,510 15.0 0.2 Total wireless revenue 443,390 100.0 450,459 100.0 (7,069 ) (1.6 ) Wireless operating expenses: Cost of services 131,745 29.7 127,045 28.2 4,700 3.7 Cost of goods sold 65,148 14.7 63,583 14.1 1,565 2.5 Selling, general and administrative 42,225 9.5 46,760 10.4 (4,535 ) (9.7 ) Depreciation and amortization 115,731 26.1 125,067 27.8 (9,336 ) (7.5 ) Total wireless operating expenses 354,849 80.0 362,455 80.5 (7,606 ) (2.1 ) Wireless operating income $ 88,541 20.0 $ 88,004 19.5 0.6 Revenue Under our affiliate agreement with Sprint, we have historically earned and recognized monthly revenue of $1.5 million for providing service to Sprint customers who pass through our network area. While we continue to provide these services to Sprint, the agreed upon payments were suspended by Sprint on April 30, 2019. Accordingly, we have ceased recognizing revenue for the services provided after that date until a new prospective fee can be agreed. We have triggered the final dispute resolution option with Sprint which we expect will lead to a resolution for travel fee revenue in the second quarter of 2020. Wireless revenue decreased approximately $7.1 million, or 1.6%, in 2019 compared with 2018. The decrease was primarily attributable to the aforementioned $12.0 million decline in travel revenue, partially offset by $3.2 million increase in postpaid and prepaid revenue from approximately 6% growth in subscribers and $1.6 million increase in roaming and MVNO revenues. Cost of services Cost of services increased approximately $4.7 million, or 3.7%, in 2019 compared with 2018, primarily due to higher cell site rent expense related to our network expansion, partially offset by continued network optimization and construction of fiber to our towers which results in more cost effective backhaul circuits. Cost of goods sold Cost of goods sold increased approximately $1.6 million, or 2.5%, in 2019 compared with 2018 due to higher volume of equipment sales. Selling, general and administrative Selling, general and administrative costs decreased approximately $4.5 million, or 9.7%, in 2019 compared with 2018 primarily due to reduced sales and use and property tax expense of $2.0 million from favorable settlements during 2019. Lower marketing and advertising expenses of approximately $1.8 million, and a $0.7 million decline in store rent expense as we transition stores to Sprint's dealer network also contributed to the overall decrease. Depreciation and amortization Depreciation and amortization decreased approximately $9.3 million, or 7.5%, in 2019 compared with 2018. Amortization expense declined primarily because our Sprint affiliate contract expansion asset is amortized under an accelerated method that declines over time. Depreciation expense also declined as certain assets acquired from nTelos in 2016 became fully depreciated. Broadband Our Broadband segment provides broadband, video and voice services to residential and commercial customers in portions of Virginia, West Virginia, Maryland, and Kentucky, via fiber optic and hybrid fiber coaxial (“HFC”) cable. The Broadband segment also leases dark fiber and provides Ethernet and Wavelength fiber optic services to enterprise and wholesale customers throughout the entirety of our service area. The Broadband segment also provides voice and digital subscriber line (“DSL”) telephone services to customers in Virginia’s Shenandoah County as a Rural Local Exchange Carrier (“RLEC”). These integrated networks are connected by an approximately 6,000 fiber route mile network. This fiber optic network also supports our Wireless segment operations and these intercompany transactions are reported at their market value. The following table indicates selected operating statistics of Broadband: December 31, December 31, 2018 December 31, 2017 Broadband homes passed (1) 208,298 201,633 201,410 Broadband customer relationships (2) 100,890 95,328 93,162 Video: RGUs (3) 53,673 58,672 62,964 Penetration (4) 25.8 % 29.1 % 31.3 % Digital video penetration (5) 95.0 % 78.8 % 76.2 % Broadband: RGUs (3) 84,045 75,389 68,379 Penetration (4) 40.3 % 37.4 % 34.0 % Voice: RGUs (3) 31,380 29,474 24,138 Penetration (4) 16.2 % 15.9 % 13.1 % Total Cable and Glo Fiber RGUs 169,098 163,535 155,481 RLEC homes passed 25,846 26,782 26,707 RLEC customer relationships (2) 10,306 11,226 12,319 RLEC RGUs: Data RLEC 7,797 9,104 11,409 Penetration (4) 30.2 % 34.0 % 42.7 % Voice RLEC 14,332 15,698 16,930 Penetration (4) 55.5 % 58.6 % 63.4 % Total RLEC RGUs 22,129 24,802 28,339 Total RGUs 191,227 188,337 183,820 Fiber route miles 6,139 5,641 5,429 Total fiber miles (6) 320,444 300,200 276,176 _______________________________________________________ (1) Homes and businesses are considered passed (“homes passed”) if we can connect them to our distribution system without further extending the transmission lines. Homes passed is an estimate based upon the best available information. Homes passed have access to video, broadband and voice services. (2) Customer relationships represent the number of billed customers who receive at least one of our services. (3) As of September 30, 2019, the Company revised its methodology for counting RGUs associated with hotels, multiple dwelling units ("MDUs") and certain commercial customers. We now count each dwelling or unit of service as a separate RGU. Prior year information has been recast to reflect our revised methodology. Previously we counted RGUs on an equivalent basis consistent with carriage fee practices. (4) Penetration is calculated by dividing the number of users by the number of homes passed or available homes, as appropriate. (5) Digital video penetration is calculated by dividing the number of digital video users by total video users. Digital video users are video customers who receive any level of video service via digital transmission. A dwelling with one or more digital set-top boxes or digital adapters counts as one digital video user. (6) Total fiber miles are measured by taking the number of fiber strands in a cable and multiplying that number by the route distance. For example, a 10 mile route with 144 fiber strands would equal 1,440 fiber miles. Broadband results from operations are summarized as follows: Year Ended December 31, Change ($ in thousands) % of Revenue % of Revenue $ % Broadband revenue Cable, residential and SMB $ 134,187 69.2 $ 124,072 67.8 10,115 8.2 Fiber, enterprise and wholesale 27,714 14.3 24,439 13.3 3,275 13.4 Rural local exchange carrier 22,966 11.8 26,196 14.3 (3,230 ) (12.3 ) Equipment and other 9,077 4.7 8,413 4.6 7.9 Total broadband revenue 193,944 100.0 183,120 100.0 % 10,824 5.9 Broadband operating expenses Cost of services 76,674 39.5 75,066 41.0 1,608 2.1 Cost of goods sold 0.4 0.2 103.7 Selling, general, and administrative 32,679 16.8 27,741 15.1 4,938 17.8 Depreciation and amortization 41,304 21.3 38,317 20.9 2,987 7.8 Total broadband operating expenses 151,423 78.1 141,500 77.3 9,923 7.0 Broadband operating income $ 42,521 21.9 $ 41,620 22.7 2.2 Cable, residential and small and medium business (SMB) revenue Cable, residential and SMB revenue increased in 2019 approximately $10.1 million, or 8.2%, primarily driven by data revenue growth of $7.6 million from an increase in broadband penetration, video revenue growth of $1.0 million from an increase in ARPU to pass through higher programming costs, and voice revenue growth of $0.9 million from growth in SMB voice RGUs. Fiber, enterprise and wholesale revenue Fiber, enterprise and wholesale revenue increased in 2019 approximately $3.3 million, or 13.4%, from a combination of 425 new enterprise connections and intercompany backhaul revenue growth. Rural local exchange carrier revenue RLEC revenue decreased approximately $3.2 million, or 12.3%, compared with 2018 due to a decline in residential subscribers and enterprise TDM circuits. Cost of services Cost of services increased approximately $1.6 million, or 2.1%, in 2019 compared with 2018. Maintenance costs for our larger network drove $1.1 million of this increase, while a $0.6 million increase in programming and retransmission costs drove the rest. Cost of goods sold Cost of goods sold increased approximately $0.4 million on higher volume, consistent with the $0.3 million increase in Broadband equipment revenue. Selling, general and administrative Selling, general and administrative expense increased $4.9 million or 17.8% compared with 2018 primarily due to $2.5 million of expenses incurred in the launch of Glo Fiber, $1.5 million in payroll increases and $0.8 million in higher advertising and commissions. Depreciation and amortization Depreciation and amortization increased $3.0 million or 7.8%, compared with 2018, primarily due to the expansion of our broadband network footprint. Tower Our Tower segment owns 225 cell towers and leases colocation space on those towers to our Wireless segment, as well as to other wireless communications providers. Substantially all of our owned towers are built on ground that we lease from the respective landlords. The colocation space that we lease to our Wireless segment is priced at our estimate of fair market value, which updates from time to time based upon our observation of the market. The following table indicates selected operating statistics of the Tower segment: December 31, December 31, December 31, Towers owned Tenants (1) Average tenants per tower 1.8 1.8 1.9 _______________________________________________________ (1) Includes 201, 174 and 171 intercompany tenants for our Wireless segment as of December 31, 2019, 2018 and 2017, respectively. Tower results from operations are summarized as follows: Year Ended December 31, Change ($ in thousands) % of Revenue % of Revenue $ % Tower revenue $ 12,984 100.0 $ 12,196 100.0 % 6.5 Tower operating expenses 7,085 54.6 7,353 60.3 (268 ) (3.6 ) Tower operating income $ 5,899 45.4 $ 4,843 39.7 1,056 21.8 Revenue Revenue increased approximately $0.8 million, or 6.5%, in 2019 compared with 2018. This increase was due to 10.1% increase in tenants and 2.5% increase in the lease rate. Operating expenses Operating expenses were comparable with the prior year. 2018 Compared with 2017 Results of Operations The Company’s consolidated results from operations are summarized as follows: Year Ended December 31, Change ($ in thousands) % of Revenue % of Revenue $ % Revenue $ 630,854 100.0 $ 611,991 100.0 18,863 3.1 Operating expenses 537,608 85.2 565,481 92.4 (27,873 ) (4.9 ) Operating income 93,246 14.8 46,510 7.6 46,736 100.5 Interest expense (34,847 ) (5.5 ) (38,237 ) (6.2 ) (3,390 ) (8.9 ) Other income 3,713 0.6 4,984 0.8 (1,271 ) (25.5 ) Income before taxes 62,112 9.8 13,257 2.2 48,855 368.5 Income tax expense (benefit) 15,517 2.5 (53,133 ) (8.7 ) 68,650 129.2 Net income $ 46,595 7.4 $ 66,390 10.9 (19,795 ) (29.8 ) The Company adopted ASC 606-Revenue from Contracts with Customers, (“ASC 606”) effective January 1, 2018, using the modified retrospective method as discussed in Note 3, Revenue from Contracts with Customers. The following table identifies the impact of applying ASC 606 to the Company for the year ended December 31, 2018: Year Ended December 31, 2018 ASC 606 Impact - CONSOLIDATED ($ in thousands, except per share amounts) Prior to Adoption of ASC 606 Changes in Presentation (1) Equipment Revenue (2) Deferred Costs (3) As Reported 12/31/18 Service revenue and other $ 632,340 $ (86,637 ) $ - $ 16,753 $ 562,456 Equipment revenue 8,298 - 60,100 - 68,398 Total revenue 640,638 (86,637 ) 60,100 16,753 630,854 Cost of services 193,860 - - 194,022 Cost of goods sold 28,377 (24,518 ) 60,100 - 63,959 Selling, general & administrative 175,753 (62,119 ) - (412 ) 113,222 Depreciation and amortization 166,405 - - - 166,405 Total operating expenses 564,395 (86,637 ) 60,100 (250 ) 537,608 Operating income 76,243 - - 17,003 93,246 Other expense (31,134 ) - - - (31,134 ) Income tax expense 10,926 - - 4,591 15,517 Net income $ 34,183 $ - $ - $ 12,412 $ 46,595 Earnings per share Basic $ 0.69 $ 0.25 $ 0.94 Diluted $ 0.68 $ 0.25 $ 0.93 Weighted average shares outstanding, basic 49,542 49,542 Weighted average shares outstanding, diluted 50,063 50,063 ______________________________________________________ (1) Amounts payable to Sprint for the reimbursement of costs incurred by Sprint in their national sales channel for commissions and device costs for both postpaid and prepaid, and to provide on-going support to their prepaid customers in our territory were historically recorded as expense when incurred. Under ASC 606, these amounts represent consideration payable to our customer, Sprint, and are recorded as a reduction of revenue. In 2017, these amounts were approximately $44.8 million for the postpaid national commissions, previously recorded in selling, general and administrative, $18.7 million for national device costs previously recorded in cost of goods and services, and $16.9 million for the on-going service to Sprint's prepaid customers, previously recorded in selling, general and administrative. (2) Costs incurred by the Company for the sale of devices under Sprint’s device financing and lease programs were previously recorded net against revenue. Under ASC 606, the revenue and related costs from device sales are recorded gross. These amounts were approximately $63.8 million in 2017. (3) Amounts payable to Sprint for the reimbursement of costs incurred by Sprint in their national sales channel for commissions and device costs, which historically have been expensed when incurred and presented net of revenue, are deferred and amortized against revenue over the expected period of benefit of approximately 21 to 53 months. In Broadband, installation revenues are recognized over a period of approximately 10-11 months. The deferred balance as of December 31, 2018 was approximately $75.8 million and was classified on the balance sheet as current and non-current assets, as applicable. Revenue Revenue increased approximately $18.9 million, or 3.1%, in 2018 compared with 2017. Excluding the impact of adopting ASC 606, revenue increased approximately $28.6 million, or 4.7%, driven by the Wireless and Broadband operations. Operating expenses Operating expenses decreased approximately $27.9 million, or 4.9%, in 2018 compared with 2017. Excluding the impact of adopting ASC 606, operating expenses decreased approximately $1.1 million, or 0.2%, primarily due to the absence of acquisition, integration and migration costs related to the completion of the transformation of the nTelos network in 2017 as well as lower depreciation and amortization costs due to the retirement of assets acquired with nTelos, partially offset by increased costs necessary to support our continued growth and expansion. Interest expense Interest expense decreased approximately $3.4 million, or 8.9%, in 2018 compared with 2017. The decrease in interest expense was primarily attributable to the 2018 amendments to the Credit Facility Agreement that reduced the applicable base interest rate by 75 basis points, partially offset by the effect of increases in the LIBOR. Other income Other income decreased approximately $1.3 million, or 25.5%, in 2018 compared with 2017. The decrease was primarily attributable to a reduction in interest income related to the former nTelos equipment installment plan. The integration of the acquired nTelos business was completed during 2017. Income tax expense (benefit) Income tax expense increased $68.7 million from a $53.1 million benefit in 2017 to a $15.5 million expense in 2018. The increase was primarily attributable to growth in our income before taxes during 2018 and the one-time non-cash tax benefit of $53.4 million recorded in 2017 as a result of the reduction in the U.S. corporate income tax rate from 35% to 21% as the 2017 Tax Act became effective. The Company's effective tax rate increased from a benefit of 400.8% in 2017 to an expense of 25.0% in 2018. See Note 11, Income Taxes for additional information. Wireless The following table identifies the impact of ASC 606 on the Company's Wireless operations for the year ended December 31, 2018: Year Ended December 31, 2018 ASC 606 Impact - WIRELESS ($ in thousands) Prior to Adoption of ASC 606 Changes in Presentation (1) Equipment Revenue (2) Deferred Costs (3) As Reported 12/31/2018 Service revenue $ 450,735 $ (86,637 ) $ - $ 16,720 $ 380,818 Equipment revenue 7,410 - 60,100 - 67,510 Other revenue 2,131 - - - 2,131 Total revenue 460,276 (86,637 ) 60,100 16,720 450,459 Cost of services 127,045 - - - 127,045 Cost of goods sold 28,001 (24,518 ) 60,100 - 63,583 Selling, general & administrative 108,879 (62,119 ) - - 46,760 Depreciation and amortization 125,067 - - - 125,067 Total operating expenses 388,992 (86,637 ) 60,100 - 362,455 Operating income $ 71,284 $ - $ - $ 16,720 $ 88,004 ______________________________________________________ (1) Amounts payable to Sprint for the reimbursement of costs incurred by Sprint in their national sales channel for commissions and device costs for both postpaid and prepaid, and to provide on-going support to their prepaid customers in our territory were historically recorded as expense when incurred. Under ASC 606, these amounts represent consideration payable to our customer, Sprint, and are recorded as a reduction of revenue. In 2017, these amounts were approximately $44.8 million for the postpaid national commissions, previously recorded in selling, general and administrative, $18.7 million for national device costs previously recorded in cost of goods and services, and $16.9 million for the on-going service to Sprint's prepaid customers, previously recorded in selling, general and administrative. (2) Costs incurred by the Company for the sale of devices under Sprint’s device financing and lease programs were previously recorded net against revenue. Under ASC 606, the revenue and related costs from device sales are recorded gross. These amounts were approximately $63.8 million in 2017. (3) Amounts payable to Sprint for the reimbursement of costs incurred by Sprint in their national sales channel for commissions and device costs, which historically have been expensed when incurred and presented net of revenue, are deferred and amortized against revenue over the expected period of benefit of approximately 21 to 53 months. In Broadband, installation revenues are recognized over a period of approximately 10-11 months. The deferred balance as of December 31, 2018 was approximately $75.8 million and was classified on the balance sheet as current and non-current assets, as applicable. Wireless results from operations are summarized as follows: Year Ended December 31, Change ($ in thousands) % of Revenue % of Revenue $ % Wireless revenue: Gross postpaid billings $ 405,101 89.9 $ 393,571 88.8 11,530 2.9 Allocated bad debt (21,866 ) (4.9 ) (21,334 ) (4.8 ) 2.5 Amortization of contract asset and other (1) (18,742 ) (4.2 ) - - 18,742 100.0 Sprint management and net service fee (63,718 ) (14.1 ) (60,608 ) (13.7 ) 3,110 5.1 Total postpaid service revenue 300,775 66.8 311,629 70.3 (10,854 ) (3.5 ) Prepaid billings (2) 111,462 24.7 103,161 23.3 8,301 8.0 Amortization of contract asset and other (1) (52,846 ) (11.7 ) - - 52,846 100.0 Sprint management fee (7,014 ) (1.6 ) (6,189 ) (1.4 ) 13.3 Total prepaid service revenue 51,602 11.5 96,972 21.9 (45,370 ) (46.8 ) Travel and other (2) 30,572 6.8 24,981 5.6 (267,000 ) (11.1 ) Wireless service revenue and other 382,949 85.0 433,582 97.9 (50,633 ) (11.7 ) Equipment revenue 67,510 15.0 9,467 2.1 58,043 613.1 Total wireless revenue 450,459 100.0 443,049 100.0 7,410 1.7 Wireless operating expenses: Cost of services 127,045 28.2 125,785 28.4 1,260 1.0 Cost of goods sold 63,583 14.1 22,653 5.1 40,930 180.7 Selling, general and administrative 46,760 10.4 117,561 26.5 (70,801 ) (60.2 ) Acquisition, integration and migration expenses - - 10,793 2.4 (10,793 ) (100.0 ) Depreciation and amortization 125,067 27.8 137,725 31.1 (12,658 ) (9.2 ) Total wireless operating expenses 362,455 80.5 414,517 93.6 (52,062 ) (12.6 ) Wireless operating income $ 88,004 19.5 $ 28,532 6.4 59,472 208.4 _______________________________________________________ (1) Due to the adoption of ASC 606, costs reimbursed to Sprint for commission and acquisition cost incurred in their national sales channel are recorded as a reduction of revenue and amortized over the period of benefit. Additionally, costs reimbursed to Sprint for the support of their prepaid customer base are recorded as a reduction of revenue. These costs were previously recorded in cost of goods sold, and selling, general and administrative. (2) The Company includes Lifeline subscribers revenue within travel and other revenue to be consistent with Sprint. The above table reflects the reclassification of the related Assurance Wireless prepaid revenue from prepaid gross billings to travel and other revenue. Revenue Wireless revenue increased approximately $7.4 million, or 1.7%, in 2018 compared with 2017. Excluding the impact of ASC 606, wireless revenue increased approximately $17.2 million, or 3.9%. This increase was driven by growth in postpaid and prepaid PCS subscribers, improvements in average monthly churn, and was partially offset by a decline in postpaid average revenue per subscriber primarily related to promotions and discounts. As a result of the adoption of ASC 606 in 2018, wireless service revenue was reduced by approximately $86.6 million of costs payable to Sprint, our customer, related to the reimbursement to Sprint for costs incurred in their national sales channel for commissions and device costs for both postpaid and prepaid, and to provide ongoing support to their prepaid customers in our territory. Commissions, device costs and costs for ongoing support of Sprint's prepaid customers were previously recorded as operating expenses. Additionally, we recorded $60.1 million of equipment revenue and cost of goods sold for the sale of devices under Sprint’s device financing and lease programs. Prior to the adoption of ASC 606, equipment costs were presented net of equipment revenue. Cost of services Cost of services increased approximately $1.3 million, or 1.0%, in 2018 compared with 2017, primarily due to the expansion of our network and wireless network coverage area and was partially offset by repricing Wireless backhaul circuits to market rates and migrating Wireless voice traffic from traditional circuit-switched facilities to more cost effective VoIP facilities. Cost of goods sold Cost of goods sold increased approximately $40.9 million, or 180.7%, in 2018 compared with 2017. The increase in costs of goods sold was primarily the result of the reclassification of approximately $60.1 million of expenses for equipment costs, which were previously classified as reductions of revenue, and was partially offset by $24.5 million of costs incurred for subsidy loss reimbursements that are now presented within revenue, driven by the adoption of ASC 606. Excluding the impact of the adoption of ASC 606, cost of goods sold increased approximately $5.3 million, or 23.6% due to an increase in equipment costs primarily related to prepaid handsets. Selling, general and administrative Selling, general and administrative costs decreased approximately $70.8 million, or 60.2%, in 2018 compared with 2017. The decrease in selling, general and administrative was primarily attributable to the reclassification of approximately $62.1 million of commissions and subscriber acquisition costs to reductions of revenue as required by the adoption of ASC 606. Excluding the impact of ASC 606, selling, general and administrative costs decreased approximately $8.7 million, or 7.4% primarily due to a reduction of back-office expenses required to support former nTelos subscribers that migrated to the Sprint back-office during 2017. Acquisition, integration and migration expenses Acquisition and integration costs were not incurred during 2018, as the completion of integration and migration activities related to the acquisition of nTelos was completed during 2017. Depreciation and amortization Depreciation and amortization decreased approximately $12.7 million, or 9.2%, in 2018 compared with 2017, primarily due to the retirement of assets acquired in the nTelos acquisition. Broadband Broadband results from operations are summarized as follows: Year Ended December 31, Change ($ in thousands) % of Revenue % of Revenue $ % Broadband revenue Cable residential and SMB $ 124,072 67.8 $ 114,122 65.6 9,950 8.7 Fiber, enterprise and wholesale 24,439 13.3 24,795 14.3 (356 ) (1.4 ) Rural local exchange carrier 26,196 14.3 26,813 15.4 (617 ) (2.3 ) Equipment and other 8,413 4.6 8,251 4.7 2.0 Total broadband revenue 183,120 100.0 173,981 100.0 % 9,139 5.3 Broadband operating expenses Cost of services 75,066 41.0 73,331 42.1 1,735 2.4 Cost of goods sold 0.2 0.1 182.7 Selling, general, and administrative 27,741 15.1 26,909 15.5 3.1 Depreciation and amortization 38,317 20.9 36,797 21.2 1,520 4.1 Total broadband operating expenses 141,500 77.3 137,170 78.8 4,330 3.2 Broadband operating income $ 41,620 22.7 $ 36,811 21.2 4,809 13.1 Revenue Revenue increased in 2018 approximately $9.1 million, or 5.3%, compared with 2017. The increase, driven by cable, residential and SMB, was primarily due to growth in our broadband and voice subscribers, video rate increases, and our customers selecting or upgrading to higher-speed data access packages. Fiber, enterprise and wholesale revenue declined $0.4 million due primarily to repricing intercompany backhaul circuits to our Wireless segment to market rates. RLEC revenue decreased approximately $0.6 million, or 2.3%, compared with 2017 due to a decline in residential subscribers. Operating expenses Operating expenses increased approximately $4.3 million, or 3.2%, in 2018 compared with 2017, primarily attributable to higher expenses associated with maintaining our growing network and expanding subscriber base. Tower Tower results from operations are summarized as follows: Year Ended December 31, Change ($ in thousands) % of Revenue % of Revenue $ % Tower revenue $ 12,196 100.0 $ 12,029 100.0 1.4 Tower operating expenses 7,353 60.3 6,422 53.4 14.5 Tower operating income $ 4,843 39.7 $ 5,607 46.6 (764 ) (13.6 ) Revenue Revenue was comparable with the prior period. Operating expenses Operating expenses increased $0.9 million, or 14.5%, in 2018 compared with 2017, driven by the addition of 16 new tower sites, resulting in higher cost of services and depreciation expense. Non-GAAP Financial Measures Adjusted OIBDA Adjusted OIBDA represents Operating income before depreciation, amortization of intangible assets, stock-based compensation and certain other items of revenue, expense, gain or loss not reflective of our operating performance, which may or may not be recurring in nature. Adjusted OIBDA is a non-GAAP financial measure that we use to evaluate our operating performance in comparison to our competitors. Management believes that analysts and investors use Adjusted OIBDA as a supplemental measure of operating performance to facilitate comparisons with other telecommunications companies. This measure isolates and evaluates operating performance by excluding the cost of financing (e.g., interest expense), as well as the non-cash depreciation and amortization of past capital investments, non-cash share-based compensation expense, and certain other items of revenue, expense, gain or loss not reflective of our operating performance, which may or may not be recurring in nature. Adjusted OIBDA has limitations as an analytical tool and should not be considered in isolation or as a substitute for operating income, net income or any other measure of financial performance reported in accordance with U.S. Generally Accepted Accounting Principles (“GAAP”). The following tables reconcile Adjusted OIBDA to operating income, which we consider to be the most directly comparable GAAP financial measure: Year Ended December 31, 2019 (in thousands) Wireless Broadband Tower Corporate Consolidated Operating income $ 88,541 $ 42,521 $ 5,899 $ (39,915 ) $ 97,046 Depreciation 96,094 40,831 2,025 139,543 Amortization of intangible assets 20,062 - - 20,535 OIBDA 204,697 83,825 7,924 (39,322 ) 257,124 Share-based compensation expense - - - 3,817 3,817 Adjusted OIBDA $ 204,697 $ 83,825 $ 7,924 $ (35,505 ) $ 260,941 Year Ended December 31, 2018 (in thousands) Wireless Broadband Tower Corporate Consolidated Operating income $ 88,004 $ 41,620 $ 4,843 $ (41,221 ) $ 93,246 Depreciation 100,950 38,140 2,454 142,111 Amortization of intangible assets 24,117 - - 24,294 OIBDA 213,071 79,937 7,297 (40,654 ) 259,651 Share-based compensation expense - - - 4,959 4,959 Adjusted OIBDA $ 213,071 $ 79,937 $ 7,297 $ (35,695 ) $ 264,610 Year Ended December 31, 2017 (in thousands) Wireless Broadband Tower Corporate Consolidated Operating income $ 28,532 $ 36,811 $ 5,607 $ (24,440 ) $ 46,510 Depreciation 112,559 36,019 1,885 151,063 Amortization of intangible assets 25,166 - - 25,944 OIBDA 166,257 73,608 7,492 (23,840 ) 223,517 Share-based compensation expense 1,555 1,300 3,580 Adjusted OIBDA $ 167,812 $ 74,908 $ 7,516 $ (23,139 ) $ 227,097 Financial Condition, Liquidity and Capital Resources Sources and Uses of Cash: Our principal sources of liquidity are our cash and cash equivalents, cash generated from operations, and proceeds available under our Credit Facility. As of December 31, 2019 our cash and cash equivalents totaled $101.7 million and the availability under our revolving line of credit was $75.0 million, for total available liquidity of $176.7 million. The Company generated approximately $259.1 million of net cash from operations in 2019, representing a decrease of $6.5 million or 2.4%, compared with 2018, primarily driven by: • $11.0 million as the result of a decline in working capital, partially offset by • a $8.3 million increase in net income. Net cash used in investing activities decreased $22.5 million in 2019, compared with 2018 due to the following: • $42.0 million decline in acquisitions. In 2019, the Company acquired Big Sandy Broadband, Inc. for $10.0 million, whereas in 2018 the Company paid $52.0 million to Sprint in order to expand our affiliate area and to acquire certain network assets. • $16.7 million to purchase FCC spectrum licenses for use in the Broadband segment's fixed wireless initiative; and • $2.2 million increase in capital expenditures due primarily to Broadband segment's $19.0 million investment in Glo Fiber and fixed wireless, partially offset by lower wireless and tower capital expenditures. We expect our investments in our networks and infrastructure to expand in support of our continued growth. Net cash used in financing activities increased $5.9 million, or 8.3%, in 2019 primarily driven by: • $7.2 million used to repurchase 200,410 shares of our common stock under the repurchase plan that we initiated in 2019 • $1.9 million increase in principal repayments on our term loans • $1.1 million increase in our annual dividend distribution, and offset by • $4.0 million decrease in cash used for financing activities because debt issuance costs that we paid in 2018 did not recur. Indebtedness: As of December 31, 2019, the Company’s indebtedness totaled approximately $720.1 million, net of unamortized loan fees of $11.9 million, with an annualized overall weighted average interest rate of approximately 3.26%. Refer to Note 9, Long-Term Debt for information about the Company's Credit Facility and financial covenants. Borrowing Capacity: As of December 31, 2019, the Company’s outstanding debt principal, under the Credit Facility, totaled $732.0 million, with an estimated annualized effective interest rate of 3.3% after considering the impact of the interest rate swap contracts and unamortized loan costs. As of December 31, 2019, we were in compliance with the financial covenants in our Credit Facility agreement. We expect cash flow from operations and our principal sources of funding will be sufficient to meet our anticipated liquidity needs for business operations for the next twelve months, as well as our longer term liquidity needs. There can be no assurance that we will continue to generate cash flows at or above current levels or that we will be able to maintain our ability to borrow under our credit facilities. Thereafter, capital expenditures will likely be required to continue planned capital upgrades to the acquired wireless network and provide increased capacity to meet our expected growth in demand for our products and services. The actual amount and timing of our future capital requirements may differ materially from our estimate depending on the demand for our products and services, new market developments and expansion opportunities. Our cash flows from operations could be adversely affected by events outside our control, including, without limitation, changes in overall economic conditions, regulatory requirements, changes in technologies, demand for our products and services, availability of labor resources and capital, changes in our relationship with Sprint, and other conditions. The Wireless segment’s operations are dependent upon Sprint’s ability to execute certain functions such as billing, customer care, and collections; our ability to develop and implement successful marketing programs and new products and services; and our ability to effectively and economically manage other operating activities under our agreements with Sprint. Our ability to attract and maintain a sufficient customer base, particularly in our Broadband markets, is also critical to our ability to maintain a positive cash flow from operations. The foregoing events individually or collectively could affect our results. Contractual Commitments: The Company is obligated to make future payments under various contracts it has entered into, primarily amounts pursuant to its long-term debt facility, and reasonably certain operating lease agreements for retail space, tower space and cell sites. Expected future minimum contractual cash payments, excluding the effects of time value, on contractual obligations, by period are summarized as follows: Payments due by periods: (in thousands) Total Less than 1 year 1-3 years 4-5 years More than 5 years Long-term debt principal (1) $ 732,040 $ 34,122 $ 71,886 $ 177,503 $ 448,529 Interest on long-term debt (1) 119,273 24,207 45,098 35,830 14,138 "Pay-fixed" obligations (2) 8,514 3,830 4,052 - Leases (3) 497,322 59,964 129,676 116,293 191,389 Purchase obligations (4) 19,405 19,308 - - Spectrum payments (5) 2,759 2,219 Total $ 1,379,313 $ 141,539 $ 251,025 $ 330,474 $ 656,275 ________________________________ (1) Includes principal payments and estimated interest payments on the Term Loan Facility based upon outstanding balances and rates in effect at December 31, 2019. (2) Represents the maximum interest payments we are obligated to make under our derivative agreements. Assumes no receipts from the counterparty to our derivative agreements. (3) Our existing lease agreements may provide us with the option to renew. Our future lease obligations would change if we entered into additional lease agreements and if we exercised renewal options. Amounts provided above represent undiscounted rent payments. (4) Represents open purchase orders at December 31, 2019. (5) Represents expected payments for our spectrum license renewals, which are routinely granted by the FCC. Contractual commitments represent future cash payments and liabilities that are required under contractual agreements with third parties, and exclude purchase orders for goods and services. The contractual commitment amounts in the table above are associated with agreements that are legally binding and enforceable, and that specify all significant terms, including fixed or minimum services to be used, fixed, minimum or variable price provisions and the approximate timing of the transaction. Other long-term liabilities have been omitted from the table above due to uncertainty of the timing of payments, refer to Note 7, Other Assets and Accrued Liabilities, included with the notes to our consolidated financial statements for additional information. The Company has no other off-balance sheet arrangements and has not entered into any transactions involving unconsolidated, limited purpose entities or commodity contracts. Capital Commitments: The Company spent $138.8 million on capital projects in 2019, up from $136.6 million in 2018 and down from $146.5 million in 2017. The $2.2 million increase in capital expenditures from 2018 to 2019 was due primarily to Broadband segment's $19.0 million investment in Glo Fiber and fixed wireless, partially offset by lower wireless and tower capital expenditures. The decline of $9.8 million of capital expenditures from 2017 to 2018 was due to the completion of the nTelos network upgrade and expansion. Critical Accounting Policies We prepare our consolidated financial statements in accordance with U.S. generally accepted accounting principles ("GAAP"). The preparation of these consolidated financial statements requires us to make estimates and assumptions that affect our reported amounts of assets, liabilities, revenue and expenses, as well as related disclosures. To the extent that there are material differences between these estimates and actual results, our financial condition or operating results would be affected. We base our estimates on past experience and other assumptions that we believe are reasonable under the circumstances, and we evaluate these estimates on an ongoing basis. We refer to accounting estimates of this type as critical accounting policies and estimates, which we discuss further below. Our significant accounting policies are described in Note 2, Summary of Significant Accounting Policies in our consolidated financial statements. The following are the accounting policies that we believe involve a greater degree of judgment and complexity and are the most critical to aid in fully understanding and evaluating our consolidated financial condition and results of operations. Revenue Recognition Our Wireless segment is a Sprint affiliate, which is a unique business model that is governed by the terms of our affiliate agreement with Sprint, and which requires accounting judgment. Under the terms of our affiliate agreement, we are the exclusive provider to build and operate a portion of Sprint’s nationwide wireless network in a contiguous portion of the Mid-Atlantic states and are licensed to use Sprint’s trademark and FCC spectrum licenses in this Sprint Affiliate Area. In return, we receive a substantial portion of Sprint’s net billings to its subscribers in our Sprint Affiliate Area. Our revenue from this agreement is fully variable and thus our economic risks and rewards under this model are very similar to those of any other wireless carrier. Accordingly, management and the users of our financial statements routinely model our Wireless service revenue based on a “look through” to Sprint’s subscriber counts and average revenue per user in our Sprint Affiliate Area. Accordingly, we report these subscriber metrics within the Management’s Discussion & Analysis section of this document. When we adopted ASC 606, Revenue from Contracts with Customers, using the modified retrospective method on January 1, 2018, we concluded that Sprint is our customer, rather than Sprint's subscribers. Our performance obligation to Sprint under this arrangement is to provide Sprint a series of continuous network access services. All of our consideration for this performance obligation is variable based upon Sprint’s net billings to its subscribers who either originated in, or otherwise use our network in the Affiliate Area, less applicable fees retained by Sprint. Our variable revenue from those subscriber billings is further reduced by customer credits, allocated bad debt expense, and management and service fees. In the case of Sprint’s prepaid subscribers, our revenue represents the subscriber’s bill reduced by costs to acquire and support those subscribers, based upon national averages from Sprint’s prepaid programs, and a management fee. We also reimburse Sprint for the cost of subsidized handsets that Sprint sells through its national channel in our Sprint Affiliate Area. Similarly, we also reimburse Sprint for commissions that Sprint pays to third-party dealers in our Sprint Affiliate Area. These reimbursements to Sprint represent consideration payable to a customer, and are thus recorded as a contract asset and then amortized as a reduction of revenue over the estimated life of Sprint's relationship with its subscriber. Our Wireless segment also sells cell phones and other equipment to Sprint, who in-turn immediately re-sells the equipment to their subscriber, generally under Sprint's equipment financing plan. Shentel is the principal in these transactions, as we control and bear the risk of ownership of the inventory prior to sale. Accordingly, our equipment revenue and cost of equipment sold are presented gross. We have historically paid certain amounts in order to expand and enhance our rights under the Sprint affiliate agreement and recorded those amounts as an asset. Amounts paid in connection with an acquisition of a business are presented as amortization expense in our income statement. Amounts paid to Sprint outside of an acquisition are accounted for as consideration paid to a customer with amortization presented as a reduction of Service and other revenue in our consolidated statements of comprehensive income. Our Broadband segment provides broadband, video and voice services to residential and commercial customers in portions of Virginia, West Virginia, Maryland, and Kentucky, via fiber optic and hybrid fiber coaxial (“HFC”) cable. The Broadband segment also provides voice and digital subscriber line (“DSL”) telephone services to customers in Virginia’s Shenandoah County as a Rural Local Exchange Carrier (“RLEC”). These contracts are generally cancellable at the customer’s discretion without penalty at any time. We allocate the total transaction price in these transactions based upon the standalone selling price of each distinct good or service. We generally recognize these revenues over time as customers simultaneously receive and consume the benefits of the service, with the exception of equipment sales and home wiring, which are recognized as revenue at a point in time when control transfers and when installation is complete, respectively. Installation fees are allocated to services and are recognized ratably over the longer of the contract term or the period in which the unrecognized fee remains material to the contract, which we estimate to be about one year. Additionally, the Company incurs commission and installation costs related to in-house and third-party vendors which are capitalized and amortized over the expected weighted average customer life which is approximately four years. Our Broadband segment also provides Ethernet and Wavelength fiber optic services to enterprise and carrier customers under capacity agreements, and the related revenue is recognized over time under ASC 606. The Broadband segment also leases dedicated fiber optic strands to customers as part of “dark fiber” agreements, which are accounted for as leases under ASC 842 Leases. Our Tower segment leases space on owned cell towers to our Wireless segment, and to other wireless carriers. Revenue from these leases is accounted for under ASC 842. Recently Issued Accounting Standards Recently issued accounting standards and their expected impact, if any, are discussed in Note 2, Summary of Significant Accounting Policies in our consolidated financial statements.

<s>[INST] You should read the following discussion and analysis of our financial condition and results of operations in conjunction with our “Selected Financial Data” and our consolidated financial statements and notes thereto appearing elsewhere in this Annual Report on Form 10K. In addition to historical consolidated financial information, the following discussion and analysis may contain forwardlooking statements that involve risks, uncertainties and assumptions. Our actual results could differ materially from those anticipated by forwardlooking statements as a result of many factors. We discuss factors that we believe could cause or contribute to these differences below and elsewhere in this Annual Report on Form 10K, including those set forth under “Part I. Cautionary Statement Regarding ForwardLooking Statements” and “Part I. Item 1A. Risk Factors”. Overview Shenandoah Telecommunications Company (“Shentel”, “we”, “our”, “us”, or the “Company”), is a provider of a comprehensive range of wireless and broadband communications products and services in the MidAtlantic portion of the United States. Management’s Discussion and Analysis is organized around our reporting segments. Refer to Item 1 above for our description of our reporting segments and a description of their respective business activities. Also see Note 14, Segment Reporting, in our consolidated financial statements for additional information. 2019 Developments Glo Fiber: During the second quarter of 2019, we initiated the deployment of our new fibertothehome service, which is marketed by our Broadband segment under the Glo Fiber brand. Glo Fiber leverages our existing, robust fiber network and commercial customer base to target certain residential areas in markets within our region. We launched service in Harrisonburg, Virginia during the fourth quarter of 2019. During 2019, we recognized $19 thousand in revenue and incurred $2.9 million of operating expense. We expect to continue to incur operating losses in a new market for approximately the first two years from the launch of service. Big Sandy Broadband, Inc. Acquisition: On February 28, 2019, the Company paid $10.0 million to acquire the assets of Big Sandy Broadband, Inc. ("Big Sandy"), a small regional provider of cable television, telephone and high speed internet services in eastern Kentucky. Other Events Sprint Affiliate Area Expansion: Effective February 1, 2018, we signed the expansion agreement with Sprint to expand our wireless network coverage area to include certain portions of Kentucky, Pennsylvania, Virginia and West Virginia, (the “Expansion Area”), effectively adding a population (POPs) of approximately 1.1 million. The agreement includes certain network build out requirements, and the ability to utilize Sprint’s spectrum in the Expansion Area along with certain other amendments to the Affiliate Agreements. Pursuant to the expansion agreement, Sprint agreed to transition the provision of network coverage in the Expansion Area to us. The expansion agreement required a payment of $52.0 million to Sprint for the right to service the Expansion Area pursuant to the Affiliate Agreements plus an additional payment of up to $5.0 million after acceptance of certain equipment at the Sprint cell sites in the Expansion Area. A map of our territory, reflecting the new Expansion Area, is provided below: Results of Operations Revenue As described in Item 1, Business we earn revenue primarily through our provision of wireless network services to Sprint under our affiliate agreement, as well as from our provision of broadband services that include fiber, internet, video, voice, and data services. We also lease colocation space on our owned cell towers to external wireless carriers. Our Wireless segment revenue is fully variable and based upon the number of Sprint subscribers that utilize our wireless network, and their respective rate plans with Sprint. Our Broadband segment revenue is driven primarily by the number of our customers that subscribe to our broadband services, and their selection from our respective rate plans. Our Tower segment revenue is driven primarily by the number of cell towers that we own, and our ability to secure colocation leases from wireless carriers. Operating Expenses Our operating expenses consist primarily of cost of services, cost of goods sold, selling, general and administrative, acquisition, integration and migration expense in 2017 related to the 2016 acquisition of nTelos, and depreciation and amortization [/INST] Positive. </s>

COSTCO WHOLESALE CORP /NEW

2015-10-14

2015-08-30

Item 7 - Management’s Discussion and Analysis of Financial Condition and Results of Operations (amounts in millions, except per share, share, membership fee, and warehouse count data) OVERVIEW We believe that the most important driver of our profitability is sales growth, particularly comparable warehouse sales (comparable sales) growth. We define comparable sales as sales from warehouses open for more than one year, including remodels, relocations and expansions, as well as online sales related to websites operating for more than one year. Comparable sales growth is achieved through increasing shopping frequency from new and existing members and the amount they spend on each visit (average ticket). Sales comparisons can also be particularly influenced by certain factors that are beyond our control: fluctuations in currency exchange rates (with respect to the consolidation of the results of our international operations); and changes in the cost of gasoline and associated competitive conditions (primarily impacting our U.S. and Canadian operations). The higher our comparable sales exclusive of these items, the more we can leverage certain of our selling, general and administrative expenses, reducing them as a percentage of sales and enhancing profitability. Generating comparable sales growth is foremost a question of making available to our members the right merchandise at the right prices, a skill that we believe we have repeatedly demonstrated over the long term. Another substantial factor in sales growth is the health of the economies in which we do business, especially the United States. Sales growth and gross margins are also impacted by our competition, which is vigorous and widespread, across a wide range of global, national and regional wholesalers and retailers. While we cannot control or reliably predict general economic health or changes in competition, we believe that we have been successful historically in adapting our business to these changes, such as through adjustments to our pricing and to our merchandise mix, including increasing the penetration of our private label items. Our philosophy is to provide our members with quality goods and services at the most competitive prices. We do not focus in the short term on maximizing prices charged, but instead seek to maintain what we believe is a perception among our members of our “pricing authority” - consistently providing the most competitive values. Our investments in merchandise pricing can, from time to time, include reducing prices on merchandise to drive sales or meet competition and holding prices steady despite cost increases instead of passing the increases on to our members, all negatively impacting near-term gross margin as a percentage of net sales (gross margin percentage). We believe that our gasoline business draws members but it generally has a significantly lower gross margin percentage relative to our non-gasoline business. A higher penetration of gasoline sales will generally lower our gross margin percentage. Rapidly changing gasoline prices may significantly impact our near-term net sales growth. Generally, rising gasoline prices benefit net sales growth which, given the higher sales base, negatively impacts our gross margin percentage but decreases our selling, general and administrative expenses as a percentage of net sales. A decline in gasoline prices has the inverse effect. We also achieve sales growth by opening new warehouses. As our warehouse base grows, available and desirable potential sites become more difficult to secure, and square footage growth becomes a comparatively less substantial component of growth. The negative aspects of such growth, however, including lower initial operating profitability relative to existing warehouses and cannibalization of sales at existing warehouses when openings occur in existing markets, are increasingly less significant relative to the results of our total operations. Our rate of square footage growth is higher in foreign markets, due to the smaller base in those markets, and we expect that to continue. Our online business growth both domestically and internationally has also increased our sales. Our membership format is an integral part of our business model and has a significant effect on our profitability. This format is designed to reinforce member loyalty and provide continuing fee revenue. The extent to which we achieve growth in our membership base, increase penetration of our Executive members, and sustain high renewal rates, materially influences our profitability. Our financial performance depends heavily on our ability to control costs. While we believe that we have achieved successes in this area historically, some significant costs are partially outside our control, most particularly health care and utility expenses. With respect to expenses relating to the compensation of our Item 7 - Management’s Discussion and Analysis of Financial Condition and Results of Operations (amounts in millions, except per share, share, membership fee, and warehouse count data) (Continued) employees, our philosophy is not to seek to minimize the wages and benefits that they earn. Rather, we believe that achieving our longer-term objectives of reducing employee turnover and enhancing employee satisfaction requires maintaining compensation levels that are better than the industry average for much of our workforce. This may cause us, for example, to absorb costs that other employers might seek to pass through to their workforces. Because our business is operated on very low margins, modest changes in various items in the income statement, particularly gross margin and selling, general and administrative expenses, can have substantial impacts on net income. Our operating model is generally the same across our U.S., Canada, and Other International operating segments (see Note 11 to the consolidated financial statements included in Item 8 of this Report). Certain countries in the Other International segment have relatively higher rates of square footage growth, lower wages and benefit costs as a percentage of country sales, and/or less or no direct membership warehouse competition. Additionally, we operate our lower-margin gasoline business in the U.S., Canada, Australia, U.K., and Japan. In discussions of our consolidated operating results, we refer to the impact of changes in foreign currencies relative to the U.S. dollar, which are references to the differences between the foreign-exchange rates we use to convert the financial results of our international operations from local currencies into U.S. dollars for financial reporting purposes. This impact of foreign-exchange rate changes is calculated based on the difference between the current period's currency exchange rates and the comparable prior-year period's currency exchange rates. We also refer to the impact of changes in gasoline prices on our net sales. This impact is calculated based on the difference between the current period's average gasoline price per gallon sold and the comparable prior-year period's average gasoline price per gallon sold. Our fiscal year ends on the Sunday closest to August 31. Fiscal years 2015, 2014 and 2013 were 52-week fiscal years ending on August 30, 2015, August 31, 2014 and September 1, 2013, respectively. Certain percentages presented are calculated using actual results prior to rounding. Unless otherwise noted, references to net income relate to net income attributable to Costco. Highlights for fiscal year 2015 included: • We opened 23 net new warehouses in 2015, 12 in the U.S., one in Canada, and 10 in our Other International segment, compared to 29 net new warehouses in 2014; • Net sales increased 3% to $113,666, driven by sales at new warehouses opened in 2014 and 2015, and a 1% increase in comparable sales. Net and comparable sales results were negatively impacted by changes in all foreign currencies relative to the U.S. dollar and decreases in the price of gasoline; • Membership fee revenue increased 4% to $2,533, primarily due to membership sign-ups at existing and new warehouses and executive membership upgrades, partially offset by the negative impact of changes in all foreign currencies relative to the U.S. dollar; • Gross margin as a percentage of net sales increased 43 basis points, primarily from the impact of gasoline price deflation on net sales as well as higher gross margins in our gasoline business; • Selling, general and administrative (SG&A) expenses as a percentage of net sales increased 18 basis points; • Net income increased to $2,377, or $5.37 per diluted share compared to $2,058, or $4.65 per diluted share in 2014. The current year results were positively impacted by a $57 tax benefit, or $0.13 per diluted share, in connection with the special cash dividend paid to the Company's 401(k) Plan participants; • Changes in foreign currencies relative to the U.S. dollar adversely impacted diluted earnings per share by $0.28, primarily due to changes in the Canadian dollar; • In February 2015, we issued $1,000 in aggregate principal amount of Senior Notes, which partially funded a special cash dividend of $5.00 per share paid in February 2015 (approximately $2,201); and • The Board of Directors approved an increase in the quarterly cash dividend from $0.355 to $0.40 per share in April 2015. Item 7 - Management’s Discussion and Analysis of Financial Condition and Results of Operations (amounts in millions, except per share, share, membership fee, and warehouse count data) (Continued) RESULTS OF OPERATIONS Net Sales 2015 vs. 2014 Net Sales Net sales increased $3,454 or 3% during 2015. This was attributable to sales at new warehouses opened in 2014 and 2015 and a 1% increase in comparable warehouse sales. Changes in foreign currencies relative to the U.S. dollar negatively impacted net sales by approximately $3,344, or 303 basis points, compared to 2014. The negative impact was attributable to all foreign countries in which we operate, predominantly Canada of $2,027, Mexico of $385, and Japan of $368. Changes in gasoline prices negatively impacted net sales by approximately $2,902, or 263 basis points, due to a 22% decrease in the average sales price per gallon. Comparable Sales Comparable sales increased 1% during 2015 and was positively impacted by an increase in shopping frequency partially offset by a decrease in the average ticket. The average ticket and comparable sales results were negatively impacted by changes in foreign currencies relative to the U.S. dollar and a decrease in gasoline prices. The increase in comparable sales also includes the negative impact of cannibalization (established warehouses losing sales to our newly opened locations). Item 7 - Management’s Discussion and Analysis of Financial Condition and Results of Operations (amounts in millions, except per share, share, membership fee, and warehouse count data) (Continued) 2014 vs. 2013 Net Sales Net sales increased $7,342 or 7% during 2014. This was attributable to a 4% increase in comparable warehouse sales, and sales at warehouses opened in 2013 and 2014. Changes in foreign currencies negatively impacted net sales by approximately $1,336, or 130 basis points, compared to 2013. The negative impact was primarily due to the Canadian dollar of approximately $1,140 and the Japanese yen of approximately $311. Changes in gasoline prices negatively impacted net sales by approximately $364, or 35 basis points, due to a 3% decrease in the average sales price per gallon. Comparable Sales Comparable sales increased 4% during 2014 and were primarily impacted by an increase in shopping frequency. Changes in foreign currencies relative to the U.S. dollar and gasoline prices negatively impacted comparable sales results, including the average ticket during 2014. The increase in comparable sales also includes the negative impact of cannibalization (established warehouses losing sales to our newly opened locations), primarily in our Other International operations. Membership Fees 2015 vs. 2014 Membership fees increased 4% in 2015. This increase was primarily due to membership sign-ups at existing and new warehouses and increased number of upgrades to our higher-fee Executive Membership program. These increases were partially offset by changes in foreign currencies relative to the U.S. dollar, which negatively impacted membership fees by approximately $76 in 2015. Our member renewal rates are currently 91% in the U.S. and Canada and 88% worldwide. 2014 vs. 2013 Membership fees increased 6% in 2014. This increase was primarily due to membership sign-ups at existing and new warehouses and increased number of upgrades to our higher-fee Executive Membership program. The raising of our membership fees in fiscal 2012 positively impacted 2014 and 2013 by $9 and $119, respectively. These increases were partially offset by changes in foreign currencies relative to the U.S. dollar, which negatively impacted membership fees by approximately $35 in 2014. Item 7 - Management’s Discussion and Analysis of Financial Condition and Results of Operations (amounts in millions, except per share, share, membership fee, and warehouse count data) (Continued) Gross Margin 2015 vs. 2014 During 2015, the gross margin of our combined core merchandise categories (food and sundries, hardlines, softlines and fresh foods), when expressed as a percentage of core merchandise sales (rather than total net sales), increased five basis points, primarily due to increases in softlines and food and sundries, partially offset by a decrease in fresh foods. This measure eliminates the impact of changes in sales penetration and gross margins from our warehouse ancillary and other businesses. Our gross margin percentage increased 43 basis points compared to 2014 and most of the improvement was derived from the impact of gasoline price deflation on net sales. Excluding this impact, gross margin as a percentage of adjusted net sales was 10.81%, an increase of 15 basis points from the prior year. This increase is predominantly due to: an increase in our warehouse ancillary and other business gross margin of 23 basis points, due primarily to our gasoline business; partially offset by a negative contribution from core merchandise categories of 12 basis points, as a result of a decrease in their sales penetration. A LIFO benefit in 2015 compared to a charge in 2014 positively contributed five basis points. The LIFO benefit resulted largely from lower costs for gasoline. Changes in foreign currencies relative to the U.S. dollar negatively impacted gross margin by approximately $359 in 2015. Gross margin on a segment basis, when expressed as a percentage of the segment's own sales (segment gross margin percentage), increased in our U.S. operations, primarily due to our gasoline business, food and sundries merchandise category and the LIFO benefit discussed above. The segment gross margin percentage in our Canadian operations decreased, primarily in hardlines and softlines. The segment gross margin percentage in our Other International operations decreased, primarily in food and sundries. 2014 vs. 2013 During 2014, the gross margin of our combined core merchandise categories, when expressed as a percentage of core merchandise sales, increased seven basis points, primarily due to increases in our softlines and food and sundries categories, partially offset by a decrease in hardlines. Fresh foods also had a positive impact as a result of higher sales penetration. Our gross margin percentage increased four basis points compared to 2013 and most of the improvement was derived from the impact of gasoline price deflation on net sales. Excluding this impact, gross margin as a percentage of adjusted net sales was 10.63%, an increase of one basis point from the prior year. This increase is predominantly due to warehouse ancillary and other business gross margin of six basis points, which was largely offset by five basis points due to a LIFO charge in 2014 compared to a benefit in 2013. The LIFO charge resulted from higher costs for our merchandise inventories, primarily our foods and fresh foods categories. Changes in foreign currencies relative to the U.S. dollar negatively impacted gross margin by approximately $151 in 2014. Gross margin on a segment basis, when expressed as a percentage of the segment's own sales, increased in our U.S. operations, primarily due to our softlines and food and sundries categories, partially offset by a decrease in hardlines and the LIFO charge discussed above. The segment gross margin percentage in our Canadian operations decreased, primarily due to decreases in hardlines and food and sundries, partially offset by an increase in fresh foods. The segment gross margin percentage in our Other International operations increased, primarily due to fresh foods. Item 7 - Management’s Discussion and Analysis of Financial Condition and Results of Operations (amounts in millions, except per share, share, membership fee, and warehouse count data) (Continued) Selling, General and Administrative Expenses 2015 vs. 2014 SG&A expenses as a percentage of net sales increased 18 basis points, mostly due to the negative impact of gasoline price deflation on net sales. Excluding this impact, SG&A expenses as a percentage of adjusted net sales were 9.82%, an improvement of seven basis points. This was due to lower warehouse operating costs of 16 basis points, primarily from improvements in payroll expenses in our core business as a result of leveraging increased sales. This improvement was partially offset by higher central operating costs of five basis points, predominantly due to increased depreciation and service contract costs associated with our information systems modernization projects that were placed into service during the year, primarily incurred by our U.S. operations. Our investment in modernizing our information systems is ongoing. Higher stock compensation expense also negatively impacted our SG&A expenses by four basis points, due to an appreciation in the trading price of our stock at the time of grant. Changes in foreign currencies relative to the U.S. dollar decreased our SG&A expenses by approximately $282 in 2015. 2014 vs. 2013 SG&A expenses as a percentage of net sales increased seven basis points. Excluding the effect of gasoline price deflation on net sales, SG&A expenses as a percentage of adjusted net sales were 9.86%, an increase of four basis points. This increase was largely due to an increase in central operating costs of three basis points primarily due to continued investment in modernizing our information systems, primarily incurred by our U.S. operations. Stock compensation expense was also higher by two basis points due to accelerated vesting for long service and appreciation in the trading price of our stock at the time of grant, despite a 14% reduction in the average number of restricted stock units (RSUs) granted to each participant. Warehouse operating costs were lower by one basis point, primarily resulting from improvements in payroll in our Canadian operations as a result of leveraging increased sales, partially offset by increases in employee benefit costs, primarily health care, in our U.S. operations. Changes in foreign currencies relative to the U.S. dollar decreased our SG&A expenses by $119 in 2014. Preopening Expenses _______________ (1) Includes one relocation and the conversion of an existing warehouse to a business center in 2015. (2) Includes one relocation in 2015. Preopening expenses include costs for startup operations related to new warehouses, development in new international markets, and expansions at existing warehouses. Preopening expenses vary due to the number of warehouse openings, the timing of the opening relative to our year-end, whether the warehouse is owned or leased, and whether the opening is in an existing, new, or international market. Item 7 - Management’s Discussion and Analysis of Financial Condition and Results of Operations (amounts in millions, except per share, share, membership fee, and warehouse count data) (Continued) Interest Expense Interest expense in 2015 primarily relates to $1,100 of 5.5% Senior Notes issued in fiscal 2007, $3,500 of Senior Notes issued in December 2012, and $1,000 of Senior Notes issued in February 2015 (described in further detail under the heading “Cash Flows from Financing Activities” and in Note 4 to the consolidated financial statements included in Item 8 of this Report). Interest Income and Other, Net 2015 vs. 2014 The increase in net foreign-currency transaction gains was primarily attributable to favorable mark-to-market adjustments for forward foreign exchange contracts compared to the prior year. See Derivatives and Foreign Currency sections in Note 1 to the consolidated financial statements included in Item 8 of this Report. The increase was also attributable to net gains on the revaluation or settlement of monetary assets and liabilities during the year. 2014 vs. 2013 The increase in interest income in 2014 was primarily driven by higher average cash, cash equivalents, and short-term investments balances, primarily in our U.S. operations. The decrease in net foreign-currency transaction gains was primarily attributable to the revaluation or settlement of monetary assets and monetary liabilities during the year, primarily our Japanese subsidiary's U.S. dollar-denominated payables. Provision for Income Taxes Our provision for income taxes in 2015 and 2013 were favorably impacted by net tax benefits of $68 and $77, respectively, primarily due to tax benefits recorded in connection with special cash dividends paid to employees through our 401(K) Retirement Plan. Dividends paid on these shares are deductible for U.S. income tax purposes. There was no similar special cash dividend in 2014. Item 7 - Management’s Discussion and Analysis of Financial Condition and Results of Operations (amounts in millions, except per share, share, membership fee, and warehouse count data) (Continued) LIQUIDITY AND CAPITAL RESOURCES The following table summarizes our significant sources and uses of cash and cash equivalents: Our primary sources of liquidity are cash flows generated from warehouse operations, cash and cash equivalents and short-term investment balances. Cash and cash equivalents and short-term investments were $6,419 and $7,315 at the end of 2015 and 2014, respectively. Of these balances, approximately $1,243 and $1,383 at the end of 2015 and 2014, respectively, represented debit and credit card receivables, primarily related to sales in the last week of our fiscal year. Cash and cash equivalents were negatively impacted by changes in exchange rates by $418 and $11, respectively. We have not provided for U.S. deferred taxes on cumulative undistributed earnings of certain non-U.S. consolidated subsidiaries because our subsidiaries have invested or will invest the undistributed earnings indefinitely, or the earnings if repatriated would not result in a deferred tax liability. This includes the remaining undistributed earnings of our Canadian operations that management maintains are indefinitely reinvested, or could be repatriated without resulting in a deferred tax liability. Deferred taxes are recorded for earnings of our foreign operations when we determine that such earnings are no longer indefinitely reinvested. During 2015, we repatriated a portion of the earnings in our Canadian operations that in 2014 were no longer considered indefinitely reinvested. In the fourth quarter of 2015, we changed our position regarding an additional portion of the undistributed earnings of our Canadian operations, which are no longer considered indefinitely reinvested. Current exchange rates compared to historical rates when these earnings were generated resulted in an immaterial U.S. tax benefit, which was recorded at the end of 2015. Management believes that our cash position and operating cash flows will be sufficient to meet our liquidity and capital requirements for the foreseeable future. We believe that our U.S. current and projected asset position is sufficient to meet our U.S. liquidity requirements and have no current plans to repatriate for use in the U.S. cash and cash equivalents and short-term investments held by these non-U.S. consolidated subsidiaries whose earnings are considered indefinitely reinvested. Cash and cash equivalents and short-term investments held at these subsidiaries and considered to be indefinitely reinvested totaled $1,196 at August 30, 2015. Cash Flows from Operating Activities Net cash provided by operating activities totaled $4,285 in 2015 compared to $3,984 in 2014. Our cash flow provided by operations is primarily derived from net sales and membership fees. Our cash flow used in operations generally consists of payments to our merchandise vendors, warehouse operating costs including payroll and employee benefits, credit card processing fees, and utilities. Cash used in operations also includes payments for income taxes. The increase in net cash provided by operating activities for 2015 when compared to 2014 was primarily due to stronger earnings. Cash Flows from Investing Activities Net cash used in investing activities totaled $2,480 in 2015 compared to $2,093 in 2014. Our cash flow used in investing activities is primarily related to funding our warehouse expansion and remodeling activities. Net cash flows from investing activities also includes purchases and maturities of short-term investments. Capital Expenditure Plans We opened 23 new warehouses, relocated two warehouses, and converted an existing warehouse to a business center in 2015 and plan to open up to 32 new warehouses in 2016 and relocate up to five Item 7 - Management’s Discussion and Analysis of Financial Condition and Results of Operations (amounts in millions, except per share, share, membership fee, and warehouse count data) (Continued) warehouses. Our primary requirement for capital is acquiring land, buildings, and equipment for new and remodeled warehouses. To a lesser extent, capital is required for initial warehouse operations, the modernization of our information systems, and working capital. In 2015 we spent $2,393 on capital expenditures, and it is our current intention to spend approximately $2,800 to $3,000 during fiscal 2016. These expenditures are expected to be financed with cash from operations, existing cash and cash equivalents, and short-term investments. There can be no assurance that current expectations will be realized and plans are subject to change upon further review of our capital expenditure needs. Cash Flows from Financing Activities Net cash used in financing activities totaled $2,324 in 2015 compared to $786 in 2014. The primary uses of cash in 2015 were dividend payments of $2,865, which includes a $5.00 per share special cash dividend, repurchases of common stock, and payment of withholding taxes on stock-based awards. Net cash used in financing activities was partially offset by the issuance of $1,000 in Senior Notes. In February 2015, we issued $1,000 in aggregate principal amount of Senior Notes as follows: $500 of 1.75% Senior Notes due February 15, 2020, and $500 of 2.25% Senior Notes due February 15, 2022. The proceeds were used to pay a portion of the special cash dividend on February 27, 2015. Stock Repurchase Programs In April 2015, our Board of Directors authorized a new share repurchase program in the amount of $4,000, which expires in April 2019. This authorization revoked previously authorized but unused amounts, totaling $2,528. During 2015 and 2014, we repurchased 3,456,000 and 2,915,000 shares of common stock, at an average price of $142.87 and $114.45, totaling approximately $494 and $334, respectively. The remaining amount available to be purchased under our approved plan was $3,699 at the end of 2015. Purchases are made from time-to-time, as conditions warrant, in the open market or in block purchases and pursuant to plans under SEC Rule 10b5-1. Repurchased shares are retired, in accordance with the Washington Business Corporation Act. Dividends Our cash dividends paid in 2015 totaled $6.51 per share, as compared to $1.33 per share in 2014. In April 2015, our Board of Directors increased our quarterly cash dividend from $0.355 to $0.40 per share. Additionally, in 2015, our Board of Directors declared and paid a special cash dividend of $5.00 per share, totaling approximately $2,201. Bank Credit Facilities and Commercial Paper Programs We maintain bank credit facilities for working capital and general corporate purposes. At August 30, 2015, we had borrowing capacity within these facilities of $407, of which $337 was maintained by our international operations. Of the $337, $153 is guaranteed by the Company. There were no outstanding short-term borrowings under the bank credit facilities at the end of 2015 and 2014. The Company has letter of credit facilities, for commercial and standby letters of credit, totaling $149. The outstanding commitments under these facilities at the end of 2015 totaled $90, including $89 in standby letters of credit with expiration dates within one year. The bank credit facilities have various expiration dates, all within one year, and we generally intend to renew these facilities prior to their expiration. The amount of borrowings available at any time under our bank credit facilities is reduced by the amount of standby and commercial letters of credit then outstanding. Item 7 - Management’s Discussion and Analysis of Financial Condition and Results of Operations (amounts in millions, except per share, share, membership fee, and warehouse count data) (Continued) Contractual Obligations As of August 30, 2015, our commitments to make future payments under contractual obligations were as follows: _______________ (1) Includes contractual interest payments. (2) Includes only open merchandise purchase orders. (3) Operating lease obligations exclude amounts for common area maintenance, taxes, and insurance and have been reduced by $131 to reflect sub-lease income. (4) Includes build-to-suit lease obligations and contractual interest payments. (5) The amounts exclude certain services negotiated at the individual warehouse or regional level that are not significant and generally contain clauses allowing for cancellation without significant penalty. (6) Includes $54 in asset retirement obligations, and $54 in deferred compensation obligations. The total amount excludes $103 of non-current unrecognized tax contingencies and $22 of other obligations due to uncertainty regarding the timing of future cash payments. Off-Balance Sheet Arrangements We have no off-balance sheet arrangements that in the opinion of management have had, or are reasonably likely to have, a material current or future effect on our financial condition or consolidated financial statements. Critical Accounting Estimates The preparation of our consolidated financial statements in accordance with U.S. generally accepted accounting principles (U.S. GAAP) requires that we make estimates and judgments including those related to revenue recognition, merchandise inventory valuation, impairment of long-lived assets, insurance/self-insurance liabilities, and income taxes. We base our estimates on historical experience and on assumptions that we believe to be reasonable and we continue to review and evaluate these statements. For further information on significant accounting policies, see discussion in Note 1 to the consolidated financial statements included in Item 8 of this Report. Revenue Recognition We generally recognize sales, which include shipping fees where applicable, net of returns, at the time the member takes possession of merchandise or receives services. When we collect payment from customers prior to the transfer of ownership of merchandise or the performance of services, the amount is generally recorded as deferred sales in the consolidated balance sheets until the sale or service is completed. We provide for estimated sales returns based on historical trends and reduce sales and merchandise costs Item 7 - Management’s Discussion and Analysis of Financial Condition and Results of Operations (amounts in millions, except per share, share, membership fee, and warehouse count data) (Continued) accordingly. Our sales returns reserve is based on an estimate of the net realizable value of merchandise inventories to be returned. Amounts collected from members for sales and value added taxes are recorded on a net basis. We evaluate whether it is appropriate to record the gross amount of merchandise sales and related costs or a net amount. Generally, when we are the primary obligor, subject to inventory risk, have latitude in establishing prices and selecting suppliers, influence product or service specifications, or have several but not all of these indicators, revenue is recorded on a gross basis. If we are not the primary obligor and do not possess other indicators of gross reporting as noted above, we record a net amount, which is reflected in net sales. We record related shipping fees on a gross basis. We account for membership fee revenue, net of refunds, on a deferred basis, whereby revenue is recognized ratably over one-year. Our Executive members qualify for a 2% reward on qualified purchases (up to a maximum reward of approximately $750 per year), which can be redeemed only at Costco warehouses. We account for this reward as a reduction in sales. The sales reduction and corresponding liability are computed after giving effect to the estimated impact of non-redemptions based on historical data. Merchandise Inventories Merchandise inventories are valued at the lower of cost or market, as determined primarily by the retail inventory method, and are stated using the last-in, first-out (LIFO) method for substantially all U.S. merchandise inventories. We record an adjustment each quarter, if necessary, for the estimated effect of inflation or deflation, and these estimates are adjusted to actual results determined at year-end. We believe the LIFO method more fairly presents the results of operations by more closely matching current costs with current revenues. Merchandise inventories for all foreign operations are primarily valued by the retail inventory method and are stated using the first-in, first-out (FIFO) method. We provide for estimated inventory losses (shrink) between physical inventory counts as a percentage of net sales. The provision is adjusted periodically to reflect results of the actual physical inventory counts, which generally occur in the second and fourth quarters of the year. Inventory cost, where appropriate, is reduced by estimates of vendor rebates when earned or as we progress toward earning those rebates, provided they are probable and reasonably estimable. Other consideration received from vendors is generally recorded as a reduction of merchandise costs upon completion of contractual milestones, terms of agreement, or other systematic and rational approaches. Impairment of Long-Lived Assets We evaluate our long-lived assets for impairment on an annual basis, when relocating or closing a facility, or when events or changes in circumstances occur that may indicate the carrying amount of the asset group, generally an individual warehouse, may not be fully recoverable. Our judgments are based on existing market and operational conditions. Future events could cause us to conclude that impairment factors exist, requiring a downward adjustment of these assets to their then-current fair value. Insurance/Self-Insurance Liabilities We use a combination of insurance and self-insurance mechanisms, including for certain risks, a wholly-owned captive insurance subsidiary and participation in a reinsurance program, to provide for potential liabilities for workers’ compensation, general liability, property damage, directors’ and officers’ liability, vehicle liability, and employee health care benefits. Liabilities associated with the risks that we retain are not discounted and are estimated, in part, by considering historical claims experience, demographic factors, severity factors and other actuarial assumptions. The estimated accruals for these liabilities could be significantly affected if future occurrences and claims differ from these assumptions and historical trends. Income Taxes The determination of our provision for income taxes requires significant judgment, the use of estimates, and the interpretation and application of complex tax laws. Significant judgment is required in assessing the Item 7 - Management’s Discussion and Analysis of Financial Condition and Results of Operations (amounts in millions, except per share, share, membership fee, and warehouse count data) (Continued) timing and amounts of deductible and taxable items and the probability of sustaining uncertain tax positions. The benefits associated with uncertain tax positions are recorded in our consolidated financial statements only after determining a more-likely-than-not probability that the positions will withstand challenge from tax authorities. Additionally, certain of our cumulative foreign undistributed earnings are considered indefinitely reinvested. These earnings would be subject to U.S. income tax if we changed our position and could result in a U.S. deferred tax liability. When facts and circumstances change, we reassess these positions and record any changes in the consolidated financial statements as appropriate. Recent Accounting Pronouncements See Note 1 to the consolidated financial statements included in Item 8 of this Report for a detailed description of recent accounting pronouncements.

<s>[INST] We believe that the most important driver of our profitability is sales growth, particularly comparable warehouse sales (comparable sales) growth. We define comparable sales as sales from warehouses open for more than one year, including remodels, relocations and expansions, as well as online sales related to websites operating for more than one year. Comparable sales growth is achieved through increasing shopping frequency from new and existing members and the amount they spend on each visit (average ticket). Sales comparisons can also be particularly influenced by certain factors that are beyond our control: fluctuations in currency exchange rates (with respect to the consolidation of the results of our international operations); and changes in the cost of gasoline and associated competitive conditions (primarily impacting our U.S. and Canadian operations). The higher our comparable sales exclusive of these items, the more we can leverage certain of our selling, general and administrative expenses, reducing them as a percentage of sales and enhancing profitability. Generating comparable sales growth is foremost a question of making available to our members the right merchandise at the right prices, a skill that we believe we have repeatedly demonstrated over the long term. Another substantial factor in sales growth is the health of the economies in which we do business, especially the United States. Sales growth and gross margins are also impacted by our competition, which is vigorous and widespread, across a wide range of global, national and regional wholesalers and retailers. While we cannot control or reliably predict general economic health or changes in competition, we believe that we have been successful historically in adapting our business to these changes, such as through adjustments to our pricing and to our merchandise mix, including increasing the penetration of our private label items. Our philosophy is to provide our members with quality goods and services at the most competitive prices. We do not focus in the short term on maximizing prices charged, but instead seek to maintain what we believe is a perception among our members of our “pricing authority” consistently providing the most competitive values. Our investments in merchandise pricing can, from time to time, include reducing prices on merchandise to drive sales or meet competition and holding prices steady despite cost increases instead of passing the increases on to our members, all negatively impacting nearterm gross margin as a percentage of net sales (gross margin percentage). We believe that our gasoline business draws members but it generally has a significantly lower gross margin percentage relative to our nongasoline business. A higher penetration of gasoline sales will generally lower our gross margin percentage. Rapidly changing gasoline prices may significantly impact our nearterm net sales growth. Generally, rising gasoline prices benefit net sales growth which, given the higher sales base, negatively impacts our gross margin percentage but decreases our selling, general and administrative expenses as a percentage of net sales. A decline in gasoline prices has the inverse effect. We also achieve sales growth by opening new warehouses. As our warehouse base grows, available and desirable potential sites become more difficult to secure, and square footage growth becomes a comparatively less substantial component of growth. The negative aspects of such growth, however, including lower initial operating profitability relative to existing warehouses and cannibalization of sales at existing warehouses when openings occur in existing markets, are increasingly less significant relative to the results of our total operations. Our rate of square footage growth is higher in foreign markets, due to the smaller base in those markets, and we expect that to continue. Our online business growth both domestically and internationally has also increased our sales. Our membership format is an integral part of our business model and has a significant effect on our profitability. This format is designed to reinforce member loyalty and provide continuing fee revenue. The extent to which we achieve growth in our membership base, increase penetration of our Executive members, and sustain high renewal rates, materially influences our profitability. Our financial performance depends heavily on our ability to control costs. While we believe that we have achieved successes in this area historically, some significant costs are partially outside our control, most particularly health care and utility expenses. With respect to expenses relating to the compensation of our Item 7 Management’s Discussion and Analysis of Financial Condition and Results of Operations (amounts in millions, except per share, share, membership fee, and warehouse count data) (Continued) employees, our philosophy is not to seek to minimize the [/INST] Negative. </s>

COSTCO WHOLESALE CORP /NEW

2016-10-12

2016-08-28

Item 7 - Management’s Discussion and Analysis of Financial Condition and Results of Operations (amounts in millions, except per share, share, membership fee, and warehouse count data) OVERVIEW We believe that the most important driver of our profitability is sales growth, particularly comparable sales growth. We define comparable sales as sales from warehouses open for more than one year, including remodels, relocations and expansions, as well as online sales related to websites operating for more than one year. Comparable sales growth is achieved through increasing shopping frequency from new and existing members and the amount they spend on each visit (average ticket). Sales comparisons can also be particularly influenced by certain factors that are beyond our control: fluctuations in currency exchange rates (with respect to the consolidation of the results of our international operations); and changes in the cost of gasoline and associated competitive conditions (primarily impacting our U.S. and Canadian operations). The higher our comparable sales exclusive of these items, the more we can leverage certain of our selling, general and administrative expenses, reducing them as a percentage of sales and enhancing profitability. Generating comparable sales growth is foremost a question of making available to our members the right merchandise at the right prices, a skill that we believe we have repeatedly demonstrated over the long term. Another substantial factor in sales growth is the health of the economies in which we do business, especially the United States. Sales growth and gross margins are also impacted by our competition, which is vigorous and widespread, across a wide range of global, national and regional wholesalers and retailers. While we cannot control or reliably predict general economic health or changes in competition, we believe that we have been successful historically in adapting our business to these changes, such as through adjustments to our pricing and to our merchandise mix, including increasing the penetration of our private label items. Our philosophy is to provide our members with quality goods and services at the most competitive prices. We do not focus in the short term on maximizing prices charged, but instead seek to maintain what we believe is a perception among our members of our “pricing authority” - consistently providing the most competitive values. Our investments in merchandise pricing can, from time to time, include reducing prices on merchandise to drive sales or meet competition and holding prices steady despite cost increases instead of passing the increases on to our members, all negatively impacting near-term gross margin as a percentage of net sales (gross margin percentage). We believe that our gasoline business draws members but it generally has a significantly lower gross margin percentage relative to our non-gasoline business. A higher penetration of gasoline sales will generally lower our gross margin percentage. Rapidly changing gasoline prices may significantly impact our near-term net sales growth. Generally, rising gasoline prices benefit net sales growth which, given the higher sales base, negatively impacts our gross margin percentage but decreases our selling, general and administrative expenses as a percentage of net sales. A decline in gasoline prices has the inverse effect. We also achieve sales growth by opening new warehouses. As our warehouse base grows, available and desirable potential sites become more difficult to secure, and square footage growth becomes a comparatively less substantial component of growth. The negative aspects of such growth, however, including lower initial operating profitability relative to existing warehouses and cannibalization of sales at existing warehouses when openings occur in existing markets, are increasingly less significant relative to the results of our total operations. Our rate of square footage growth is generally higher in foreign markets, due to the smaller base in those markets, and we expect that to continue. Our online business growth both domestically and internationally has also increased our sales. Our membership format is an integral part of our business model and has a significant effect on our profitability. This format is designed to reinforce member loyalty and provide continuing fee revenue. The extent to which we achieve growth in our membership base, increase penetration of our Executive members, and sustain high renewal rates, materially influences our profitability. Our financial performance depends heavily on our ability to control costs. While we believe that we have achieved successes in this area historically, some significant costs are partially outside our control, most particularly health care and utility expenses. With respect to expenses relating to the compensation of our employees, our philosophy is not to seek to minimize their wages and benefits. Rather, we believe that Item 7 - Management’s Discussion and Analysis of Financial Condition and Results of Operations (amounts in millions, except per share, share, membership fee, and warehouse count data) (Continued) achieving our longer-term objectives of reducing employee turnover and enhancing employee satisfaction requires maintaining compensation levels that are better than the industry average for much of our workforce. This may cause us, for example, to absorb costs that other employers might seek to pass through to their workforces. Because our business is operated on very low margins, modest changes in various items in the income statement, particularly merchandise costs and selling, general and administrative expenses, can have substantial impacts on net income. Our operating model is generally the same across our U.S., Canada, and Other International operating segments (see Note 11 to the consolidated financial statements included in Item 8 of this Report). Certain countries in the Other International segment have relatively higher rates of square footage growth, lower wages and benefit costs as a percentage of country sales, and/or less or no direct membership warehouse competition. Additionally, we operate our lower-margin gasoline business in all countries except Mexico, Korea, and Taiwan. In discussions of our consolidated operating results, we refer to the impact of changes in foreign currencies relative to the U.S. dollar, which are references to the differences between the foreign-exchange rates we use to convert the financial results of our international operations from local currencies into U.S. dollars for financial reporting purposes. This impact of foreign-exchange rate changes is calculated based on the difference between the current period's currency exchange rates and that of the comparable prior period. The impact of changes in gasoline prices on net sales is calculated based on the difference between the current period's average price per gallon sold and that of the comparable prior period. Our fiscal year ends on the Sunday closest to August 31. Fiscal years 2016, 2015 and 2014 were 52-week fiscal years ending on August 28, 2016, August 30, 2015 and August 31, 2014, respectively. Certain percentages presented are calculated using actual results prior to rounding. Unless otherwise noted, references to net income relate to net income attributable to Costco. Highlights for fiscal year 2016 included: • We opened 29 net new warehouses in 2016, 21 in the U.S., two in Canada, and six in our Other International segment, compared to 23 net new warehouses in 2015; • Net sales increased 2% to $116,073, driven by sales at new warehouses opened in 2015 and 2016, while comparable sales were flat. Net and comparable sales results were negatively impacted by changes in most foreign currencies relative to the U.S. dollar and decreases in the price of gasoline; • Membership fee revenue increased 4% to $2,646, primarily due to membership sign-ups at existing and new warehouses and executive membership upgrades, partially offset by the negative impact of changes in most foreign currencies relative to the U.S. dollar; • Gross margin percentage increased 26 basis points, primarily from the impact of gasoline price deflation on net sales; • Selling, general and administrative (SG&A) expenses as a percentage of net sales increased 33 basis points, largely driven by the impact of gasoline price deflation on net sales; • Net income decreased 1% to $2,350, or $5.33 per diluted share compared to $2,377, or $5.37 per diluted share in 2015. The 2015 results were positively impacted by a $57 tax benefit, or $0.13 per diluted share, in connection with the special cash dividend paid to the Company's 401(k) Plan participants; • Changes in foreign currencies relative to the U.S. dollar adversely impacted diluted earnings per share by $0.24, largely driven by changes in the Canadian dollar and Mexican peso; • In December 2015, we paid the outstanding principal balance and associated interest on the 0.65% Senior Notes of approximately $1,204, from our cash and cash equivalents and short-term investments; • The Board of Directors approved an increase in the quarterly cash dividend from $0.40 to $0.45 per share in April 2016; and • In June 2016, we transitioned to our new Citibank-Visa exclusive co-branded credit card in the U.S. (described in further detail in Item 9B of this Report). Item 7 - Management’s Discussion and Analysis of Financial Condition and Results of Operations (amounts in millions, except per share, share, membership fee, and warehouse count data) (Continued) RESULTS OF OPERATIONS Net Sales 2016 vs. 2015 Net Sales Net sales increased $2,407 or 2% during 2016. This was attributable to sales at new warehouses opened in 2015 and 2016. Comparable sales were flat. Changes in foreign currencies relative to the U.S. dollar negatively impacted net sales by approximately $2,690, or 237 basis points, compared to 2015. The negative impact was attributable to most foreign countries in which we operate, predominantly Canada of $1,646, Mexico of $550, and UK of $224. Changes in gasoline prices negatively impacted net sales by approximately $2,194, or 193 basis points, due to a 19% decrease in the average sales price per gallon. Comparable Sales Comparable sales were flat during 2016 and were positively impacted by an increase in shopping frequency offset by a decrease in the average ticket. The average ticket and comparable sales results were negatively impacted by changes in foreign currencies relative to the U.S. dollar and a decrease in gasoline prices. Changes in comparable sales also includes the negative impact of cannibalization (established warehouses losing sales to our newly opened locations). 2015 vs. 2014 Net Sales Net sales increased $3,454 or 3% during 2015. This was attributable to sales at new warehouses opened in 2014 and 2015 and a 1% increase in comparable sales. Changes in foreign currencies relative to the U.S. dollar negatively impacted net sales by approximately $3,344, or 303 basis points, compared to 2014. The negative impact was attributable to all foreign countries in which we operate, predominantly Canada of Item 7 - Management’s Discussion and Analysis of Financial Condition and Results of Operations (amounts in millions, except per share, share, membership fee, and warehouse count data) (Continued) $2,027, Mexico of $385, and Japan of $368. Changes in gasoline prices negatively impacted net sales by approximately $2,902, or 263 basis points, due to a 22% decrease in the average sales price per gallon. Comparable Sales Comparable sales increased 1% during 2015 and were positively impacted by an increase in shopping frequency partially offset by a decrease in the average ticket. The average ticket and comparable sales results were negatively impacted by changes in foreign currencies relative to the U.S. dollar and a decrease in gasoline prices. Changes in comparable sales also includes the negative impact of cannibalization. Membership Fees 2016 vs. 2015 The increase in membership fees was primarily due to membership sign-ups at existing and new warehouses and increased number of upgrades to our higher-fee Executive Membership program. These increases were partially offset by changes in foreign currencies relative to the U.S. dollar, which negatively impacted membership fees by approximately $52 in 2016. At the end of 2016, our member renewal rates were 90% in the U.S. and Canada and 88% worldwide. 2015 vs. 2014 Membership fees increased 4% in 2015. This increase was primarily due to membership sign-ups at existing and new warehouses and increased number of upgrades to our higher-fee Executive Membership program. These increases were partially offset by changes in foreign currencies relative to the U.S. dollar, which negatively impacted membership fees by approximately $76 in 2015. Gross Margin 2016 vs. 2015 The gross margin of our core merchandise categories (food and sundries, hardlines, softlines and fresh foods), when expressed as a percentage of core merchandise sales (rather than total net sales), increased 13 basis points, primarily due to increases in these categories other than fresh foods. This measure eliminates the impact of changes in sales penetration and gross margins from our warehouse ancillary and other businesses. Total gross margin percentage increased 26 basis points compared to 2015. Excluding the impact of gasoline price deflation on net sales, gross margin as a percentage of adjusted net sales was 11.14%, an increase of five basis points. A larger LIFO benefit in 2016 compared to 2015 positively contributed three basis points. The LIFO benefit resulted largely from lower costs for merchandise inventories, primarily in food and sundries and gasoline. Our core merchandise categories positively contributed one basis point, primarily due to an Item 7 - Management’s Discussion and Analysis of Financial Condition and Results of Operations (amounts in millions, except per share, share, membership fee, and warehouse count data) (Continued) increase in hardlines, partially offset by food and sundries due to a decrease in sales penetration. Warehouse ancillary and other business gross margin positively contributed one basis point, primarily due to hearing aids and e-commerce businesses, partially offset by our gasoline business. Changes in foreign currencies relative to the U.S. dollar negatively impacted gross margin by approximately $286 in 2016. Gross margin on a segment basis, when expressed as a percentage of the segment's own sales and excluding the impact of gasoline price deflation on net sales (segment gross margin percentage), increased in our U.S. operations, predominately due to a positive contribution from our core merchandise categories, primarily hardlines and softlines, and the LIFO benefit discussed above. The segment gross margin percentage in our Canadian operations decreased, primarily due to a decrease in all core merchandise categories, except hardlines, partially offset by increases in warehouse ancillary and other businesses, primarily pharmacy and e-commerce businesses. The segment gross margin percentage in Other International operations decreased in all merchandise categories, except fresh foods, which was higher. 2015 vs. 2014 The gross margin of our core merchandise categories (food and sundries, hardlines, softlines and fresh foods), when expressed as a percentage of core merchandise sales, increased five basis points, primarily due to increases in softlines and food and sundries, partially offset by a decrease in fresh foods. Our gross margin percentage increased 43 basis points compared to 2014 and most of the improvement was derived from the impact of gasoline price deflation on net sales. Excluding this impact, gross margin as a percentage of adjusted net sales was 10.81%, an increase of 15 basis points from the prior year. This increase was predominantly due to: an increase in our warehouse ancillary and other business gross margin of 23 basis points, due primarily to our gasoline business; partially offset by a negative contribution from core merchandise categories of 12 basis points, as a result of a decrease in their sales penetration. A LIFO benefit in 2015 compared to a charge in 2014 positively contributed five basis points. The LIFO benefit resulted largely from lower costs of gasoline. Changes in foreign currencies relative to the U.S. dollar negatively impacted gross margin by approximately $359 in 2015. Segment gross margin percentage increased in our U.S. operations, primarily due to our gasoline business and the LIFO benefit discussed above. The segment gross margin percentage in our Canadian operations decreased across our core merchandise categories. The segment gross margin percentage in our Other International operations decreased, primarily in food and sundries. Selling, General and Administrative Expenses 2016 vs. 2015 SG&A expenses as a percentage of net sales increased 33 basis points compared to 2015. Excluding the negative impact of gasoline price deflation on net sales, SG&A expenses as a percentage of adjusted net sales were 10.20%, an increase of 13 basis points. This was largely due to: higher central operating costs of six basis points, predominantly due to costs associated with our information systems modernization, including increased depreciation for projects placed in service, incurred by our U.S. operations; and higher stock compensation expense of four basis points, due to appreciation in the trading price of our stock at the time of grant. Our investment in modernizing our information systems is ongoing and expected to continue to negatively impact SG&A expenses. Charges for non-recurring legal and regulatory matters during 2016 negatively impacted SG&A expenses by two basis points. Our warehouse operating costs were higher by one basis point due to higher payroll and employee benefit costs, primarily health care, in our U.S. operations. This increase was partially offset by lower payroll expense as a percentage of net sales in our Canadian Item 7 - Management’s Discussion and Analysis of Financial Condition and Results of Operations (amounts in millions, except per share, share, membership fee, and warehouse count data) (Continued) operations. Changes in foreign currencies relative to the U.S. dollar decreased our SG&A expenses by approximately $211 in 2016. 2015 vs. 2014 SG&A expenses as a percentage of net sales increased 18 basis points, mostly due to the negative impact of gasoline price deflation on net sales. Excluding this impact, SG&A expenses as a percentage of adjusted net sales were 9.82%, an improvement of seven basis points. This was due to lower warehouse operating costs of 16 basis points, primarily from improvements in payroll expenses in our core business as a result of leveraging increased sales. This improvement was partially offset by higher central operating costs of five basis points, predominantly due to increased depreciation and service contract costs associated with our information systems modernization projects that were placed into service during the year, primarily incurred by our U.S. operations. Higher stock compensation expense also negatively impacted our SG&A expenses by four basis points, due to an appreciation in the trading price of our stock at the time of grant. Changes in foreign currencies relative to the U.S. dollar decreased our SG&A expenses by approximately $282 in 2015. Preopening Expenses Preopening expenses include costs for startup operations related to new warehouses, including relocations, development in new international markets, and expansions at existing warehouses. Preopening expenses vary due to the number of warehouse openings, the timing of the opening relative to our year-end, whether the warehouse is owned or leased, and whether the opening is in an existing, new, or international market. Interest Expense Interest expense in 2016 primarily relates to Senior Notes issued by the Company (described in further detail under the heading “Cash Flows from Financing Activities” and in Note 4 to the consolidated financial statements included in Item 8 of this Report). The increase in interest expense is primarily due to the Senior Notes issued in February 2015. Item 7 - Management’s Discussion and Analysis of Financial Condition and Results of Operations (amounts in millions, except per share, share, membership fee, and warehouse count data) (Continued) Interest Income and Other, Net 2016 vs. 2015 The decrease in interest income in 2016 is attributable to lower average cash and investment balances, due in part to the payment of the outstanding principal balance and interest on the 0.65% Senior Notes in the second quarter of 2016 (see discussion in Item 8, Note 4 of this Report). Foreign-currency transaction gains, net include mark-to-market adjustments for forward foreign-exchange contracts and the revaluation or settlement of monetary assets and liabilities by our Canadian and Other International operations. See Derivatives and Foreign Currency sections in Item 8, Note 1 of this Report. 2015 vs. 2014 The increase in net foreign-currency transaction gains was primarily attributable to favorable mark-to-market adjustments for forward foreign exchange contracts compared to the prior year. The increase was also attributable to net gains on the revaluation or settlement of monetary assets and liabilities during the year. Provision for Income Taxes In 2015, our provision was favorably impacted by net tax benefits of $68, primarily due to a tax benefit recorded in connection with a special cash dividend paid to employees through our 401(K) Retirement Plan. Dividends paid on these shares are deductible for U.S. income tax purposes. LIQUIDITY AND CAPITAL RESOURCES The following table summarizes our significant sources and uses of cash and cash equivalents: Our primary sources of liquidity are cash flows generated from warehouse operations, cash and cash equivalents and short-term investments. Cash and cash equivalents and short-term investments were $4,729 and $6,419 at the end of 2016 and 2015, respectively. Of these balances, approximately $1,071 and $1,243 at the end of 2016 and 2015, respectively, represented unsettled credit and debit card receivables. These receivables generally settle within one week. Cash and cash equivalents were positively impacted by changes in exchange rates by $50 in 2016 and negatively impacted by $418 and $11 in 2015 and 2014, respectively. We have not provided for U.S. deferred taxes on cumulative undistributed earnings of certain non-U.S. consolidated subsidiaries, including the remaining undistributed earnings of our Canadian operations, because our subsidiaries have invested or will invest the undistributed earnings indefinitely, or the earnings, Item 7 - Management’s Discussion and Analysis of Financial Condition and Results of Operations (amounts in millions, except per share, share, membership fee, and warehouse count data) (Continued) if repatriated would not result in an adverse tax consequence. Although we have historically asserted that certain non-U.S. undistributed earnings will be permanently reinvested, we may repatriate such earnings to the extent we can do so without an adverse tax consequence. If we determine that such earnings are no longer indefinitely reinvested, deferred taxes, to the extent required and applicable, are recorded at that time. During 2016, we repatriated the earnings in our Canadian operations that in 2015 were no longer considered indefinitely reinvested. Subsequent to the end of the fiscal year, we determined that a portion of the undistributed earnings in our Canadian operations could be repatriated without adverse tax consequences. Accordingly, we no longer consider that portion to be indefinitely reinvested. Management believes that our cash position and operating cash flows will be sufficient to meet our liquidity and capital requirements for the foreseeable future. We believe that our U.S. current and projected asset position is sufficient to meet our U.S. liquidity requirements and have no current plans to repatriate for use in the U.S. cash and cash equivalents and short-term investments held by these non-U.S. consolidated subsidiaries whose earnings are considered indefinitely reinvested. Cash and cash equivalents and short-term investments held at these subsidiaries with earnings considered to be indefinitely reinvested totaled $1,535 at August 28, 2016. Cash Flows from Operating Activities Net cash provided by operating activities totaled $3,292 in 2016, compared to $4,285 in 2015. Our cash flow provided by operations is primarily derived from net sales and membership fees. Cash flow used in operations generally consists of payments to our merchandise vendors, warehouse operating costs including payroll and employee benefits, credit and debit card processing fees, and utilities. Cash used in operations also includes payments for income taxes. The decrease in net cash provided by operating activities for 2016 when compared to 2015 was primarily due to accelerated vendor payments of approximately $1,700 made in the last week of fiscal 2016, in advance of implementing our modernized accounting system at the beginning of fiscal 2017. Cash Flows from Investing Activities Net cash used in investing activities totaled $2,345 in 2016 compared to $2,480 in 2015. Cash flow used in investing activities is primarily related to funding warehouse expansion and remodeling activities. Net cash flows from investing activities also included purchases and maturities of short-term investments. Capital Expenditure Plans We opened 29 new warehouses and relocated four warehouses in 2016 and plan to open up to 31 new warehouses and relocate up to three warehouses in 2017. Our primary requirement for capital is acquiring land, buildings, and equipment for new and remodeled warehouses. To a lesser extent, capital is required for initial warehouse operations, the modernization of our information systems, and working capital. In 2016 we spent $2,649 on capital expenditures, and it is our current intention to spend approximately $2,600 to $2,800 during fiscal 2017. These expenditures are expected to be financed with cash from operations, existing cash and cash equivalents, and short-term investments. There can be no assurance that current expectations will be realized and plans are subject to change upon further review of our capital expenditure needs. Cash Flows from Financing Activities Net cash used in financing activities totaled $2,419 in 2016 compared to $2,324 in 2015. The primary uses of cash in 2016 were related to the $1,200 repayment of our 0.65% Senior Notes in December 2015, dividend payments of $746, repurchases of common stock, and payment of withholding taxes on stock-based awards. Net cash used in financing activities in 2015 included a $5.00 per share special cash dividend, totaling approximately $2,201, partially offset by the issuance of $1,000 in Senior Notes. Item 7 - Management’s Discussion and Analysis of Financial Condition and Results of Operations (amounts in millions, except per share, share, membership fee, and warehouse count data) (Continued) In March 2016, our Japanese subsidiary issued approximately $103 of 0.63% Guaranteed Senior Notes through a private placement. Additionally, in June 2016, our Japanese subsidiary issued approximately $93 of zero percent Guaranteed Senior Notes through a private placement. Interest on both issuances are payable semi-annually, and principal is due in March 2026 and June 2021, respectively. Stock Repurchase Programs During 2016 and 2015, we repurchased 3,184,000 and 3,456,000 shares of common stock, at an average price of $149.90 and $142.87, totaling approximately $477 and $494, respectively. The remaining amount available to be purchased under our approved plan was $3,222 at the end of 2016. Purchases are made from time-to-time, as conditions warrant, in the open market or in block purchases and pursuant to plans under SEC Rule 10b5-1. Repurchased shares are retired, in accordance with the Washington Business Corporation Act. Dividends Cash dividends paid in 2016 totaled $1.70 per share, as compared to $6.51 per share in 2015, which included a special cash dividend of $5.00 per share. In April 2016, our Board of Directors increased our quarterly cash dividend from $0.40 to $0.45 per share. Bank Credit Facilities and Commercial Paper Programs We maintain bank credit facilities for working capital and general corporate purposes. At August 28, 2016, we had borrowing capacity within these facilities of $429, of which $358 was maintained by our international operations. Of the $358, $177 is guaranteed by the Company. There were no outstanding short-term borrowings under the bank credit facilities at the end of 2016 and 2015. The Company has letter of credit facilities, for commercial and standby letters of credit, totaling $153. The outstanding commitments under these facilities at the end of 2016 totaled $96, including $94 in standby letters of credit with expiration dates within one year. The bank credit facilities have various expiration dates, all within one year, and we generally intend to renew these facilities prior to their expiration. The amount of borrowings available at any time under our bank credit facilities is reduced by the amount of standby and commercial letters of credit then outstanding. Item 7 - Management’s Discussion and Analysis of Financial Condition and Results of Operations (amounts in millions, except per share, share, membership fee, and warehouse count data) (Continued) Contractual Obligations As of August 28, 2016, our commitments to make future payments under contractual obligations were as follows: _______________ (1) Includes only open merchandise purchase orders. (2) Includes contractual interest payments and excludes deferred issuance costs. (3) Operating lease obligations exclude amounts for common area maintenance, taxes, and insurance and have been reduced by $129 to reflect sub-lease income. (4) Includes build-to-suit lease obligations and contractual interest payments. (5) The amounts exclude certain services negotiated at the individual warehouse or regional level that are not significant and generally contain clauses allowing for cancellation without significant penalty. (6) Includes $64 in asset retirement obligations, and $62 in deferred compensation obligations. The total amount excludes $51 of non-current unrecognized tax contingencies and $29 of other obligations due to uncertainty regarding the timing of future cash payments. Off-Balance Sheet Arrangements In the opinion of management, we have no off-balance sheet arrangements, that have had, or are reasonably likely to have, a material current or future effect on our financial condition or financial statements other than the operating leases included in the table above and discussed in Note 1 and Note 5 to the consolidated financial statements included in Item 8 of this Report. Critical Accounting Estimates The preparation of our consolidated financial statements in accordance with U.S. generally accepted accounting principles (U.S. GAAP) requires that we make estimates and judgments, including those related to revenue recognition, merchandise inventory valuation, impairment of long-lived assets, insurance/self-insurance liabilities, and income taxes. We base our estimates on historical experience and on assumptions that we believe to be reasonable, and we continue to review and evaluate these statements. For further information on significant accounting policies, see discussion in Note 1 to the consolidated financial statements included in Item 8 of this Report. Revenue Recognition We generally recognize sales, which include shipping fees where applicable, net of returns, at the time the member takes possession of merchandise or receives services. When we collect payment from members prior to the transfer of ownership of merchandise or the performance of services, the amount is generally Item 7 - Management’s Discussion and Analysis of Financial Condition and Results of Operations (amounts in millions, except per share, share, membership fee, and warehouse count data) (Continued) recorded as deferred sales in the consolidated balance sheets until the sale or service is completed. We provide for estimated sales returns based on historical trends and reduce sales and merchandise costs accordingly. Our sales returns reserve is based on an estimate of the net realizable value of merchandise inventories to be returned. Amounts collected from members for sales and value added taxes are recorded on a net basis. We evaluate whether it is appropriate to record the gross amount of merchandise sales and related costs or a net amount. Generally, when we are the primary obligor, subject to inventory risk, have latitude in establishing prices and selecting suppliers, influence product or service specifications, or have several but not all of these indicators, revenue is recorded on a gross basis. If we are not the primary obligor and do not possess other indicators of gross reporting as noted above, we record a net amount, which is reflected in net sales. We record related shipping fees on a gross basis. We account for membership fee revenue, net of refunds, on a deferred basis, whereby revenue is recognized ratably over one year. Our Executive members qualify for a 2% reward on qualified purchases (up to a maximum reward of approximately $750 per year in the U.S. and Canada and varies in our Other International operations), which can be redeemed only at Costco warehouses. We account for this reward as a reduction in sales. The sales reduction and corresponding liability are computed after giving effect to the estimated impact of non-redemptions based on historical data. Merchandise Inventories Merchandise inventories are valued at the lower of cost or market, as determined primarily by the retail inventory method, and are stated using the last-in, first-out (LIFO) method for substantially all U.S. merchandise inventories. Merchandise inventories for all foreign operations are primarily valued by the retail inventory method and are stated using the first-in, first-out (FIFO) method. We record an adjustment each quarter, if necessary, for the estimated effect of inflation or deflation, and these estimates are adjusted to actual results determined at year-end. We believe the LIFO method more fairly presents the results of operations by more closely matching current costs with current revenues. We provide for estimated inventory losses (shrink) between physical inventory counts as a percentage of net sales. The provision is adjusted to reflect results of the actual physical inventory counts, which generally occur in the second and fourth quarters of the year. Inventory cost, where appropriate, is reduced by estimates of vendor rebates when earned or as we progress toward earning those rebates, provided they are probable and reasonably estimable. Other consideration received from vendors is generally recorded as a reduction of merchandise costs upon completion of contractual milestones, terms of agreement, or other systematic approaches. Impairment of Long-Lived Assets We evaluate our long-lived assets for impairment on an annual basis, when relocating or closing a facility, or when events or changes in circumstances occur that may indicate the carrying amount of the asset group, generally an individual warehouse, may not be fully recoverable. Our judgments are based on existing market and operational conditions. Future events could cause us to conclude that impairment factors exist, requiring a downward adjustment of these assets to their then-current fair value. Insurance/Self-Insurance Liabilities We use a combination of insurance and self-insurance mechanisms, including for certain risks, a wholly-owned captive insurance subsidiary and participation in a reinsurance program, to provide for potential liabilities for workers’ compensation, general liability, property damage, directors’ and officers’ liability, vehicle liability, and employee health care benefits. Liabilities associated with the risks that we retain are not discounted and are estimated, in part, by considering historical claims experience, demographic factors, severity factors and other actuarial assumptions. The estimated accruals for these liabilities could be significantly affected if future occurrences and claims differ from these assumptions and historical trends. Item 7 - Management’s Discussion and Analysis of Financial Condition and Results of Operations (amounts in millions, except per share, share, membership fee, and warehouse count data) (Continued) Income Taxes The determination of our provision for income taxes requires significant judgment, the use of estimates, and the interpretation and application of complex tax laws. Significant judgment is required in assessing the timing and amounts of deductible and taxable items and the probability of sustaining uncertain tax positions. The benefits associated with uncertain tax positions are recorded in our consolidated financial statements only after determining a more-likely-than-not probability that the positions will withstand challenge from tax authorities. When facts and circumstances change, we reassess these positions and record any changes in the consolidated financial statements as appropriate. Additionally, our cumulative foreign undistributed earnings were considered indefinitely reinvested as of August 28, 2016. These earnings would be subject to U.S. income tax if we changed our position and could result in a U.S. deferred tax liability. Although we have historically asserted that certain non-U.S. undistributed earnings will be permanently reinvested, we may repatriate such earnings to the extent we can do so without an adverse tax consequence. Recent Accounting Pronouncements See Note 1 to the consolidated financial statements included in Item 8 of this Report for a detailed description of recent accounting pronouncements.

<s>[INST] We believe that the most important driver of our profitability is sales growth, particularly comparable sales growth. We define comparable sales as sales from warehouses open for more than one year, including remodels, relocations and expansions, as well as online sales related to websites operating for more than one year. Comparable sales growth is achieved through increasing shopping frequency from new and existing members and the amount they spend on each visit (average ticket). Sales comparisons can also be particularly influenced by certain factors that are beyond our control: fluctuations in currency exchange rates (with respect to the consolidation of the results of our international operations); and changes in the cost of gasoline and associated competitive conditions (primarily impacting our U.S. and Canadian operations). The higher our comparable sales exclusive of these items, the more we can leverage certain of our selling, general and administrative expenses, reducing them as a percentage of sales and enhancing profitability. Generating comparable sales growth is foremost a question of making available to our members the right merchandise at the right prices, a skill that we believe we have repeatedly demonstrated over the long term. Another substantial factor in sales growth is the health of the economies in which we do business, especially the United States. Sales growth and gross margins are also impacted by our competition, which is vigorous and widespread, across a wide range of global, national and regional wholesalers and retailers. While we cannot control or reliably predict general economic health or changes in competition, we believe that we have been successful historically in adapting our business to these changes, such as through adjustments to our pricing and to our merchandise mix, including increasing the penetration of our private label items. Our philosophy is to provide our members with quality goods and services at the most competitive prices. We do not focus in the short term on maximizing prices charged, but instead seek to maintain what we believe is a perception among our members of our “pricing authority” consistently providing the most competitive values. Our investments in merchandise pricing can, from time to time, include reducing prices on merchandise to drive sales or meet competition and holding prices steady despite cost increases instead of passing the increases on to our members, all negatively impacting nearterm gross margin as a percentage of net sales (gross margin percentage). We believe that our gasoline business draws members but it generally has a significantly lower gross margin percentage relative to our nongasoline business. A higher penetration of gasoline sales will generally lower our gross margin percentage. Rapidly changing gasoline prices may significantly impact our nearterm net sales growth. Generally, rising gasoline prices benefit net sales growth which, given the higher sales base, negatively impacts our gross margin percentage but decreases our selling, general and administrative expenses as a percentage of net sales. A decline in gasoline prices has the inverse effect. We also achieve sales growth by opening new warehouses. As our warehouse base grows, available and desirable potential sites become more difficult to secure, and square footage growth becomes a comparatively less substantial component of growth. The negative aspects of such growth, however, including lower initial operating profitability relative to existing warehouses and cannibalization of sales at existing warehouses when openings occur in existing markets, are increasingly less significant relative to the results of our total operations. Our rate of square footage growth is generally higher in foreign markets, due to the smaller base in those markets, and we expect that to continue. Our online business growth both domestically and internationally has also increased our sales. Our membership format is an integral part of our business model and has a significant effect on our profitability. This format is designed to reinforce member loyalty and provide continuing fee revenue. The extent to which we achieve growth in our membership base, increase penetration of our Executive members, and sustain high renewal rates, materially influences our profitability. Our financial performance depends heavily on our ability to control costs. While we believe that we have achieved successes in this area historically, some significant costs are partially outside our control, most particularly health care and utility expenses. With respect to expenses relating to the compensation of our employees, our philosophy is not to seek to minimize their wages and benefits. Rather, we believe that Item 7 Management’s Discussion and Analysis of Financial Condition and Results of Operations (amounts in millions, except per share, share, membership fee, and warehouse count data) (Continued) [/INST] Negative. </s>

COSTCO WHOLESALE CORP /NEW

2017-10-18

2017-09-03

Item 7 - Management’s Discussion and Analysis of Financial Condition and Results of Operations (amounts in millions, except per share, share, membership fee, and warehouse count data) OVERVIEW We believe that the most important driver of our profitability is sales growth, particularly comparable sales growth. We define comparable sales as sales from warehouses open for more than one year, including remodels, relocations and expansions, as well as online sales related to e-commerce websites operating for more than one year. Comparable sales growth is achieved through increasing shopping frequency from new and existing members and the amount they spend on each visit (average ticket). Sales comparisons can also be particularly influenced by certain factors that are beyond our control: fluctuations in currency exchange rates (with respect to the consolidation of the results of our international operations); and changes in the cost of gasoline and associated competitive conditions (primarily impacting our U.S. and Canadian operations). The higher our comparable sales exclusive of these items, the more we can leverage certain of our selling, general and administrative expenses, reducing them as a percentage of sales and enhancing profitability. Generating comparable sales growth is foremost a question of making available to our members the right merchandise at the right prices, a skill that we believe we have repeatedly demonstrated over the long term. Another substantial factor in sales growth is the health of the economies in which we do business, especially the United States. Sales growth and gross margins are also impacted by our competition, which is vigorous and widespread, across a wide range of global, national and regional wholesalers and retailers. While we cannot control or reliably predict general economic health or changes in competition, we believe that we have been successful historically in adapting our business to these changes, such as through adjustments to our pricing and to our merchandise mix, including increasing the penetration of our private label items. Our philosophy is to provide our members with quality goods and services at the most competitive prices. We do not focus in the short term on maximizing prices charged, but instead seek to maintain what we believe is a perception among our members of our “pricing authority” - consistently providing the most competitive values. Our investments in merchandise pricing can, from time to time, include reducing prices on merchandise to drive sales or meet competition and holding prices steady despite cost increases instead of passing the increases on to our members, all negatively impacting near-term gross margin as a percentage of net sales (gross margin percentage). We believe that our gasoline business draws members but it generally has a significantly lower gross margin percentage relative to our non-gasoline business. A higher penetration of gasoline sales will generally lower our gross margin percentage. Rapidly changing gasoline prices may significantly impact our near-term net sales growth. Generally, rising gasoline prices benefit net sales growth which, given the higher sales base, negatively impacts our gross margin percentage but decreases our selling, general and administrative (SG&A) expenses as a percentage of net sales. A decline in gasoline prices has the inverse effect. We operate our lower-margin gasoline business in all countries except Korea and France. We also achieve sales growth by opening new warehouses. As our warehouse base grows, available and desirable potential sites become more difficult to secure, and square footage growth becomes a comparatively less substantial component of growth. The negative aspects of such growth, however, including lower initial operating profitability relative to existing warehouses and cannibalization of sales at existing warehouses when openings occur in existing markets, are increasingly less significant relative to the results of our total operations. Our rate of square footage growth is generally higher in foreign markets, due to the smaller base in those markets, and we expect that to continue. Our e-commerce business growth both domestically and internationally has also increased our sales. Our membership format is an integral part of our business model and has a significant effect on our profitability. This format is designed to reinforce member loyalty and provide continuing fee revenue. The extent to which we achieve growth in our membership base, increase penetration of our Executive members, and sustain high renewal rates, materially influences our profitability. Our financial performance depends heavily on our ability to control costs. While we believe that we have achieved successes in this area historically, some significant costs are partially outside our control, most Item 7 - Management’s Discussion and Analysis of Financial Condition and Results of Operations (amounts in millions, except per share, share, membership fee, and warehouse count data) (Continued) particularly health care and utility expenses. With respect to expenses relating to the compensation of our employees, our philosophy is not to seek to minimize their wages and benefits. Rather, we believe that achieving our longer-term objectives of reducing employee turnover and enhancing employee satisfaction requires maintaining compensation levels that are better than the industry average for much of our workforce. This may cause us, for example, to absorb costs that other employers might seek to pass through to their workforces. Because our business is operated on very low gross margins, modest changes in various items in the income statement, particularly merchandise costs and SG&A expenses, can have substantial impacts on net income. Our operating model is generally the same across our U.S., Canada, and Other International operating segments (see Note 11 to the consolidated financial statements included in Item 8 of this Report). Certain countries in the Other International segment have relatively higher rates of square footage growth, lower wages and benefit costs as a percentage of country sales, and/or less or no direct membership warehouse competition. In discussions of our consolidated operating results, we refer to the impact of changes in foreign currencies relative to the U.S. dollar, which are references to the differences between the foreign-exchange rates we use to convert the financial results of our international operations from local currencies into U.S. dollars for financial reporting purposes. This impact of foreign-exchange rate changes is calculated based on the difference between the current period's currency exchange rates and that of the comparable prior period. The impact of changes in gasoline prices on net sales is calculated based on the difference between the current period's average price per gallon sold and that of the comparable prior period. Our fiscal year ends on the Sunday closest to August 31. Fiscal year 2017 was a 53-week fiscal year ending on September 3, 2017, while 2016 and 2015 were 52-week fiscal years ending on August 28, 2016, and August 30, 2015, respectively. Certain percentages presented are calculated using actual results prior to rounding. Unless otherwise noted, references to net income relate to net income attributable to Costco. Highlights for fiscal year 2017 included: • We opened 26 net new warehouses in 2017: 13 in the U.S., six in Canada, and seven in our Other International segment, compared to 29 net new warehouses in 2016; • Net sales increased 9% to $126,172, driven by a 4% increase in comparable sales, sales at new warehouses opened in 2016 and 2017, and the benefit of one additional week of sales in 2017; • Membership fee revenue increased 8% to $2,853, primarily due to membership sign-ups at existing and new warehouses, an extra week of membership fees in 2017, the annual fee increase, and executive membership upgrades; • Gross margin percentage decreased two basis points; • SG&A expenses as a percentage of net sales decreased 14 basis points, driven by lower costs associated with the co-branded credit card arrangement in the U.S.; • Net income increased 14% to $2,679, or $6.08 per diluted share compared to $2,350, or $5.33 per diluted share in 2016. The 2017 results were positively impacted by a $82 tax benefit, or $0.19 per diluted share, in connection with the special cash dividend paid to the Company's 401(k) Plan participants and other net benefits of approximately $51, or $0.07 per diluted share, for non-recurring net legal and other matters; • In 2017, we re-paid long-term debt totaling $2,200 representing the aggregate principal balances of the 5.5% and 1.125% Senior Notes; we issued $3,800 in aggregate principal amount of Senior Notes which funded a special cash dividend of $7.00 per share paid in May 2017 (approximately $3,100); and • In April 2017, the Board of Directors approved an increase in the quarterly cash dividend from $0.45 to $0.50 per share. Item 7 - Management’s Discussion and Analysis of Financial Condition and Results of Operations (amounts in millions, except per share, share, membership fee, and warehouse count data) (Continued) RESULTS OF OPERATIONS Net Sales 2017 vs. 2016 Net Sales Net sales increased $10,099 or 9% during 2017, primarily due to a 4% increase in comparable sales, new warehouses opened in 2016 and 2017, and the benefit of one additional week of sales in 2017. Changes in gasoline prices positively impacted net sales by approximately $785, or 68 basis points, due to an 8% increase in the average sales price per gallon. Changes in foreign currencies relative to the U.S. dollar negatively impacted net sales by approximately $295, or 25 basis points, compared to 2016. The negative impact was driven by Other International operations, partially offset by positive impacts attributable to our Canadian operations. Comparable Sales Comparable sales increased 4% during 2017 and were positively impacted by an increase in shopping frequency and, to a lesser extent, an increased average ticket. The average ticket and comparable sales results were positively impacted by an increase in gasoline prices, offset by decreases in foreign currencies relative to the U.S. dollar. Changes in comparable sales includes the negative impact of cannibalization (established warehouses losing sales to our newly opened locations). 2016 vs. 2015 Net Sales Net sales increased $2,407 or 2% during 2016. This was attributable to sales at new warehouses opened in 2015 and 2016. Comparable sales were flat. Changes in foreign currencies relative to the U.S. dollar negatively impacted net sales by approximately $2,690, or 237 basis points, compared to 2015. The negative impact was primarily attributable to our Canadian operations and within certain of our Other International Item 7 - Management’s Discussion and Analysis of Financial Condition and Results of Operations (amounts in millions, except per share, share, membership fee, and warehouse count data) (Continued) operations. Changes in gasoline prices negatively impacted net sales by approximately $2,194, or 193 basis points, due to a 19% decrease in the average sales price per gallon. Comparable Sales Comparable sales were flat during 2016, with an increase in shopping frequency offset by a decrease in the average ticket. The average ticket and comparable sales results were negatively impacted by changes in foreign currencies relative to the U.S. dollar and a decrease in gasoline prices. Changes in comparable sales includes the negative impact of cannibalization (established warehouses losing sales to our newly opened locations). Membership Fees 2017 vs. 2016 The increase in membership fees was primarily due to membership sign-ups at existing and new warehouses, an extra week of membership fee revenue, the annual fee increase (discussed below), and an increased number of upgrades to our higher-fee Executive Membership program. At the end of 2017, our member renewal rates were 90% in the U.S. and Canada and 87% worldwide. In the first fiscal quarter of 2017, we increased our annual membership fees in certain of our Other International operations. Effective June 1, 2017, we also increased our annual membership fees in the U.S. and Canada for Gold Star (individual), Business and Business add-on by $5 to $60 and for Executive Membership from$110 to $120 (annual membership fee of $60, plus the Executive upgrade of $60); and the maximum 2% reward associated with Executive Membership increased from $750 to $1,000 annually. We account for membership fee revenue on a deferred basis, recognized ratably over the one-year membership period. These fee increases had a positive impact on membership fee revenues during 2017 of approximately $23 and will positively impact the next several quarters. We expect these increases to positively impact membership fee revenue by approximately $175 in fiscal 2018. 2016 vs. 2015 The increase in membership fees was primarily due to membership sign-ups at existing and new warehouses and increased upgrades to our higher-fee Executive Membership program. These increases were partially offset by changes in foreign currencies relative to the U.S. dollar, which negatively impacted fees by approximately $52 in 2016. Item 7 - Management’s Discussion and Analysis of Financial Condition and Results of Operations (amounts in millions, except per share, share, membership fee, and warehouse count data) (Continued) Gross Margin 2017 vs. 2016 The gross margin of our core merchandise categories (food and sundries, hardlines, softlines and fresh foods), when expressed as a percentage of core merchandise sales (rather than total net sales), increased eight basis points due to increases in these categories other than fresh foods. This measure eliminates the impact of changes in sales penetration and gross margins from our warehouse ancillary and other businesses. Total gross margin percentage decreased two basis points compared to 2016. Excluding the impact of gasoline price inflation on net sales, gross margin as a percentage of adjusted net sales was 11.40%, an increase of five basis points. This increase was primarily due to amounts earned under the co-branded credit card arrangement in the U.S. of 15 basis points and a benefit of three basis points from non-recurring legal settlements and other matters. The improvement in terms in our current co-brand agreement as compared to the prior co-brand arrangement led to substantial year over year benefits in fiscal 2017. Changes of comparable magnitude will not occur in subsequent years. These increases were partially offset by a six basis point decrease in our core merchandise categories, primarily due to food and sundries as a result of a decrease in sales penetration. The gross margin percentage was also negatively impacted by five basis points due to a LIFO benefit in 2016 and one basis point in warehouse ancillary and other businesses. Changes in foreign currencies relative to the U.S. dollar had an immaterial impact on gross margin in 2017. Gross margin on a segment basis, when expressed as a percentage of the segment's own sales and excluding the impact of changes in gasoline prices on net sales (segment gross margin percentage), increased in our U.S. operations, due to amounts earned under the co-branded credit card arrangement and non-recurring legal settlements and other matters as discussed above. These increases were partially offset by a decrease in core merchandise categories, predominantly food and sundries as a result of a decrease in sales penetration, and a LIFO benefit in 2016. The segment gross margin percentage in our Canadian operations increased, primarily due to increases in warehouse ancillary and other businesses, primarily our pharmacy business, partially offset by a decrease in our core merchandise categories, largely fresh foods. The segment gross margin percentage increased in our Other International operations due to increases across all core merchandise categories, except fresh foods. 2016 vs. 2015 The gross margin of our core merchandise categories, when expressed as a percentage of core merchandise sales, increased 13 basis points, primarily due to increases in these categories other than fresh foods. Total gross margin percentage increased 26 basis points compared to 2015. Excluding the impact of gasoline price deflation on net sales, gross margin as a percentage of adjusted net sales was 11.14%, an increase of five basis points. A larger LIFO benefit in 2016 compared to 2015 positively contributed three basis points. The LIFO benefit resulted largely from lower costs for merchandise inventories, primarily in food and sundries and gasoline. Our core merchandise categories positively contributed one basis point, primarily due to an increase in hardlines, partially offset by food and sundries due to a decrease in sales penetration. Warehouse ancillary and other business gross margin positively contributed one basis point, primarily due to hearing aids and e-commerce businesses, partially offset by our gasoline business. Changes in foreign currencies relative to the U.S. dollar negatively impacted gross margin by approximately $286 in 2016. Item 7 - Management’s Discussion and Analysis of Financial Condition and Results of Operations (amounts in millions, except per share, share, membership fee, and warehouse count data) (Continued) Segment gross margin percentage increased in our U.S. operations predominantly due to a positive contribution from our core merchandise categories, primarily hardlines and softlines, and the LIFO benefit discussed above. The segment gross margin percentage in our Canadian operations decreased, primarily due to a decrease in all core merchandise categories, except hardlines, partially offset by increases in warehouse ancillary and other businesses, primarily pharmacy and e-commerce businesses. The segment gross margin percentage in Other International operations decreased in all merchandise categories, except fresh foods, which was higher. Selling, General and Administrative Expenses 2017 vs. 2016 SG&A expenses as a percentage of net sales decreased 14 basis points compared to 2016. Excluding the impact of gasoline price inflation on net sales, SG&A expenses as a percentage of adjusted net sales was 10.33%, a decrease of seven basis points. Operating costs related to warehouses, ancillary, and other businesses, which includes e-commerce and travel, were lower by nine basis points, primarily due to lower costs associated with the co-branded credit card arrangement in the U.S. of 18 basis points. The improvement in terms in our current co-brand agreement as compared to the prior co-brand arrangement led to substantial year over year benefits in fiscal 2017. Changes of comparable magnitude will not occur in subsequent years. This was partially offset by higher payroll and employee benefit expenses of 11 basis points, primarily in our U.S. operations. Central operating costs were higher by one basis point, primarily due to increased costs associated with our information systems modernization, including increased depreciation for projects placed in service, incurred by our U.S. operations. Stock compensation expense was also higher by one basis point. Changes in foreign currencies relative to the U.S. dollar had an immaterial impact in 2017. 2016 vs. 2015 SG&A expenses as a percentage of net sales increased 33 basis points compared to 2015. Excluding the negative impact of gasoline price deflation on net sales, SG&A expenses as a percentage of adjusted net sales were 10.20%, an increase of 13 basis points. This was largely due to: higher central operating costs of six basis points, predominantly due to costs associated with our information systems modernization, including increased depreciation for projects placed in service, incurred by our U.S. operations; and higher stock compensation expense of four basis points, due to appreciation in the trading price of our stock at the time of grant. Charges for non-recurring legal and regulatory matters during 2016 negatively impacted SG&A expenses by two basis points. Operating costs related to warehouses, ancillary, and other businesses, which includes e-commerce and travel, were higher by one basis point due to higher payroll and employee benefit costs, primarily health care, in our U.S. operations. This increase was partially offset by lower payroll expense as a percentage of net sales in our Canadian operations. Changes in foreign currencies relative to the U.S. dollar decreased our SG&A expenses by approximately $211 in 2016. Preopening Expenses Item 7 - Management’s Discussion and Analysis of Financial Condition and Results of Operations (amounts in millions, except per share, share, membership fee, and warehouse count data) (Continued) Preopening expenses include costs for startup operations related to new warehouses, including relocations, development in new international markets, and expansions at existing warehouses. In 2017, we entered into two new international markets, Iceland and France. Preopening expenses vary due to the number of warehouse openings, the timing of the opening relative to our year-end, whether the warehouse is owned or leased, and whether the opening is in an existing, new, or international market. Interest Expense Interest expense primarily relates to Senior Notes issued by the Company (described in further detail under the heading “Cash Flows from Financing Activities” and in Note 4 to the consolidated financial statements included in Item 8 of this Report). Interest Income and Other, Net 2017 vs. 2016 Foreign-currency transaction gains (losses), net include the revaluation or settlement of monetary assets and liabilities and mark-to-market adjustments for forward foreign-exchange contracts by our Canadian and Other International operations. See Derivatives and Foreign Currency sections in Item 8, Note 1 of this Report. 2016 vs. 2015 The decrease in interest income in 2016 is attributable to lower average cash and investment balances, due in part to the payment of the outstanding principal balance and interest on the 0.65% Senior Notes in the second quarter of 2016. Provision for Income Taxes In 2017 and 2015, our provision was favorably impacted by net tax benefits of $104 and $68, respectively, primarily due to tax benefits recorded in connection with the May 2017 and February 2015 special cash dividends paid to employees through our 401(K) Retirement Plan of $82 and $57, respectively. These dividends are deductible for U.S. income tax purposes. Item 7 - Management’s Discussion and Analysis of Financial Condition and Results of Operations (amounts in millions, except per share, share, membership fee, and warehouse count data) (Continued) LIQUIDITY AND CAPITAL RESOURCES The following table summarizes our significant sources and uses of cash and cash equivalents: Our primary sources of liquidity are cash flows generated from warehouse operations, cash and cash equivalents and short-term investments. Cash and cash equivalents and short-term investments were $5,779 and $4,729 at the end of 2017 and 2016, respectively. Of these balances, approximately $1,255 and $1,071 represented unsettled credit and debit card receivables, respectively. These receivables generally settle within four days. Cash and cash equivalents were positively impacted by changes in exchange rates of $25 and $50 in 2017 and 2016, respectfully, and negatively impacted by $418 in 2015. We have not provided for U.S. deferred taxes on cumulative undistributed earnings of certain non-U.S. consolidated subsidiaries, including the remaining undistributed earnings of our Canadian operations, because our subsidiaries have invested or will invest the undistributed earnings indefinitely, or the earnings if repatriated would not result in an adverse tax consequence. Although we have historically asserted that certain non-U.S. undistributed earnings will be permanently reinvested, we may repatriate such earnings to the extent we can do so without an adverse tax consequence. If we determine that such earnings are no longer indefinitely reinvested, deferred taxes, to the extent required and applicable, are recorded at that time. During 2017, we changed our position regarding an additional portion of the undistributed earnings of our Canadian operations, as we determined such earnings could be repatriated without adverse tax consequences. Subsequent to the end of 2017, we repatriated a portion of our undistributed earnings in our Canadian operations without adverse tax consequences. Management believes that our cash position and operating cash flows will be sufficient to meet our liquidity and capital requirements for the foreseeable future. We believe that our U.S. current and projected asset position is sufficient to meet our U.S. liquidity requirements and have no current plans to repatriate for use in the U.S. cash and cash equivalents and short-term investments held by non-U.S. consolidated subsidiaries whose earnings are considered indefinitely reinvested. Cash and cash equivalents and short-term investments held at these subsidiaries with earnings considered to be indefinitely reinvested totaled $1,463 at September 3, 2017. Cash Flows from Operating Activities Net cash provided by operating activities totaled $6,726 in 2017, compared to $3,292 in 2016. Our cash flow provided by operations is primarily derived from net sales and membership fees. Cash flow used in operations generally consists of payments to our merchandise vendors, warehouse operating costs including payroll and employee benefits, utilities, and credit and debit card processing fees. Cash used in operations also includes payments for income taxes. The increase in net cash provided by operating activities for 2017 when compared to 2016 was primarily due to accelerated vendor payments of approximately $1,700 made in the last week of fiscal 2016, in advance of implementing our modernized accounting system. Cash Flows from Investing Activities Net cash used in investing activities totaled $2,366 in 2017, compared to $2,345 in 2016. Cash flow used in investing activities is primarily related to funding warehouse expansion and remodeling. Net cash flows from investing activities also includes purchases and maturities of short-term investments. Item 7 - Management’s Discussion and Analysis of Financial Condition and Results of Operations (amounts in millions, except per share, share, membership fee, and warehouse count data) (Continued) Capital Expenditure Plans Our primary requirement for capital is acquiring land, buildings, and equipment for new and remodeled warehouses. To a lesser extent, capital is required for initial warehouse operations, our information systems, and working capital. We opened 26 new warehouses and relocated 2 warehouses in 2017 and plan to open up to 24 new warehouses and relocate up to six warehouses in 2018. In 2017 we spent $2,502 on capital expenditures, and it is our current intention to spend approximately $2,500 to $2,700 during fiscal 2018. These expenditures are expected to be financed with cash from operations, existing cash and cash equivalents, and short-term investments. There can be no assurance that current expectations will be realized and plans are subject to change upon further review of our capital expenditure needs. Cash Flows from Financing Activities Net cash used in financing activities totaled $3,218 in 2017, compared to $2,419 in 2016. The primary uses of cash in 2017 were related to dividend payments, predominantly the special dividend paid in May 2017, and the repayments of debt totaling $2,200 representing the aggregate principal balances of the 5.5% and 1.125% Senior Notes. Net cash used in financing activities in 2016 includes a $1,200 repayment of our 0.65% Senior Notes in December 2015. In May 2017, we issued $3,800 in aggregate principal amount of Senior Notes. The proceeds received were net of a discount and used to pay the special cash dividend and a portion of the redemption of the 1.125% Senior Notes. Stock Repurchase Programs During 2017 and 2016, we repurchased 2,998,000 and 3,184,000 shares of common stock, at average prices of $157.87 and $149.90, totaling approximately $473 and $477, respectively. The remaining amount available to be purchased under our approved plan was $2,749 at the end of 2017. These amounts may differ from the stock repurchase balances in the accompanying consolidated statements of cash flows due to changes in unsettled stock repurchases at the end of each fiscal year. Purchases are made from time-to-time, as conditions warrant, in the open market or in block purchases and pursuant to plans under SEC Rule 10b5-1. Repurchased shares are retired, in accordance with the Washington Business Corporation Act. Dividends Cash dividends paid in 2017 totaled $8.90 per share, which included a special cash dividend of $7.00 per share, as compared to $1.70 per share in 2016. In April 2017, our Board of Directors increased our quarterly cash dividend from $0.45 to $0.50 per share. Bank Credit Facilities and Commercial Paper Programs We maintain bank credit facilities for working capital and general corporate purposes. At September 3, 2017, we had borrowing capacity under these facilities of $833, including a $400 revolving line of credit entered into by our U.S. operations in June 2017 with an expiration date of one year. The Company currently has no plans to draw upon the new revolving line of credit. Our international operations maintain $349 of the total borrowing capacity under bank credit facilities, of which $166 is guaranteed by the Company. There were no outstanding short-term borrowings under the bank credit facilities at the end of 2017 and 2016. The Company has letter of credit facilities, for commercial and standby letters of credit, totaling $181. The outstanding standby letters of credit under these facilities at the end of 2017 totaled $103 and expire within one year. The bank credit facilities have various expiration dates, all within one year, and we generally intend to renew these facilities prior to their expiration. The amount of borrowings available at any time under our bank credit facilities is reduced by the amount of standby and commercial letters of credit then outstanding. Item 7 - Management’s Discussion and Analysis of Financial Condition and Results of Operations (amounts in millions, except per share, share, membership fee, and warehouse count data) (Continued) Contractual Obligations At September 3, 2017, our commitments to make future payments under contractual obligations were as follows: _______________ (1) Includes only open merchandise purchase orders. (2) Includes contractual interest payments and excludes deferred issuance costs. (3) Operating lease obligations exclude amounts for common area maintenance, taxes, and insurance and have been reduced by $112 to reflect sub-lease income. (4) Includes build-to-suit lease obligations and contractual interest payments. (5) The amounts exclude certain services negotiated at the individual warehouse or regional level that are not significant and generally contain clauses allowing for cancellation without significant penalty. (6) Includes asset retirement obligations, deferred compensation obligations and current liabilities for unrecognized tax contingencies. The total amount excludes $35 of non-current unrecognized tax contingencies and $29 of other obligations due to uncertainty regarding the timing of future cash payments. Off-Balance Sheet Arrangements In the opinion of management, we have no off-balance sheet arrangements that have had, or are reasonably likely to have, a material current or future effect on our financial condition or financial statements other than operating leases, included in the table above and discussed in Note 1 and Note 5 to the consolidated financial statements included in Item 8 of this Report. Critical Accounting Estimates The preparation of our consolidated financial statements in accordance with U.S. generally accepted accounting principles (U.S. GAAP) requires that we make estimates and judgments, including those related to revenue recognition, merchandise inventory valuation, impairment of long-lived assets, insurance/self-insurance liabilities, and income taxes. We base our estimates on historical experience and on assumptions that we believe to be reasonable, and we continue to review and evaluate these estimates. For further information on significant accounting policies, see discussion in Note 1 to the consolidated financial statements included in Item 8 of this Report. Item 7 - Management’s Discussion and Analysis of Financial Condition and Results of Operations (amounts in millions, except per share, share, membership fee, and warehouse count data) (Continued) Revenue Recognition We generally recognize sales, which includes gross shipping fees where applicable, net of returns, at the time the member takes possession of merchandise or receives services. When we collect payment from members prior to the transfer of ownership of merchandise or the performance of services, the amount is generally recorded as deferred sales in the consolidated balance sheets until the sale or service is completed. We provide for estimated sales returns based on historical trends and reduce sales and merchandise costs accordingly. Our sales returns reserve is based on an estimate of the net realizable value of merchandise inventories to be returned. Amounts collected from members for sales and value added taxes are recorded on a net basis. We evaluate whether it is appropriate to record the gross amount of merchandise sales and related costs or a net amount. Generally, when we are the primary obligor, subject to inventory risk, have latitude in establishing prices and selecting suppliers, influence product or service specifications, or have several but not all of these indicators, revenue is recorded on a gross basis. If we are not the primary obligor and do not possess other indicators of gross reporting as noted above, we record a net amount, which is reflected in net sales. We account for membership fee revenue, net of refunds, on a deferred basis, whereby revenue is recognized ratably over one year. Our Executive members qualify for a 2% reward on qualified purchases (up to a maximum reward of approximately $1,000 per year in the U.S. and Canada and varies in our Other International operations), which can be redeemed only at Costco warehouses. We account for this reward as a reduction in sales. The sales reduction and corresponding liability are computed after giving effect to the estimated impact of non-redemptions, based on historical data. Merchandise Inventories Merchandise inventories are stated at the lower of cost or market. U.S. merchandise inventories are valued by the cost method of accounting, using the last-in, first-out (LIFO) basis. The Company believes the LIFO method more fairly presents the results of operations by more closely matching current costs with current revenues. The Company records an adjustment each quarter, if necessary, for the projected annual effect of inflation or deflation, and these estimates are adjusted to actual results determined at year-end, after actual inflation rates and inventory levels for the year have been determined. Canadian and Other International merchandise inventories are predominantly valued using the cost and retail inventory methods, respectively, using the first-in, first-out (FIFO) basis. We provide for estimated inventory shrinkage between physical inventory counts as a percentage of net sales. The provision is adjusted to reflect results of the actual physical inventory counts, which generally occur in the second and fourth quarters. Inventory cost, where appropriate, is reduced by estimates of vendor rebates when earned or as we progress toward earning those rebates, provided they are probable and reasonably estimable. Other consideration received from vendors is generally recorded as a reduction of merchandise costs upon completion of contractual milestones, terms of agreement, or using other systematic approaches. Impairment of Long-Lived Assets We evaluate our long-lived assets for impairment on an annual basis, when relocating or closing a facility, or when events or changes in circumstances occur that may indicate the carrying amount may not be fully recoverable. Our judgments are based on existing market and operational conditions. Future events could cause us to conclude that impairment factors exist, requiring a downward adjustment of these assets to their then-current fair value. Item 7 - Management’s Discussion and Analysis of Financial Condition and Results of Operations (amounts in millions, except per share, share, membership fee, and warehouse count data) (Continued) Insurance/Self-Insurance Liabilities We are predominantly self-insured, with insurance coverage for certain catastrophic risks, for employee health care benefits, workers’ compensation, general liability, property damage, directors’ and officers’ liability, vehicle liability, and inventory loss. We use different mechanisms including a wholly-owned captive insurance subsidiary and participate in a reinsurance program. Liabilities associated with the risks that we retain are not discounted and are estimated, in part, by considering historical claims experience, demographic factors, severity factors and other actuarial assumptions. The estimated accruals for these liabilities could be significantly affected if future occurrences and claims differ from these assumptions and historical trends. Income Taxes The determination of our provision for income taxes requires significant judgment, the use of estimates, and the interpretation and application of complex tax laws. Significant judgment also is required in assessing the timing and amounts of deductible and taxable items and the probability of sustaining uncertain tax positions. The benefits associated with uncertain tax positions are recorded only after determining a more-likely-than-not probability that the positions will withstand challenge from tax authorities. When facts and circumstances change, we reassess these positions and record any changes in the consolidated financial statements as appropriate. Our cumulative foreign undistributed earnings, except the additional portion of earnings in Canada, were considered indefinitely reinvested as of September 3, 2017. These earnings would be subject to U.S. income tax if we changed our position and could result in a U.S. deferred tax liability. Although we have historically asserted that certain non-U.S. undistributed earnings will be permanently reinvested, we may repatriate such earnings to the extent we can do so without an adverse tax consequence. Recent Accounting Pronouncements See Note 1 to the consolidated financial statements included in Item 8 of this Report for a detailed description of recent accounting pronouncements.

<s>[INST] We believe that the most important driver of our profitability is sales growth, particularly comparable sales growth. We define comparable sales as sales from warehouses open for more than one year, including remodels, relocations and expansions, as well as online sales related to ecommerce websites operating for more than one year. Comparable sales growth is achieved through increasing shopping frequency from new and existing members and the amount they spend on each visit (average ticket). Sales comparisons can also be particularly influenced by certain factors that are beyond our control: fluctuations in currency exchange rates (with respect to the consolidation of the results of our international operations); and changes in the cost of gasoline and associated competitive conditions (primarily impacting our U.S. and Canadian operations). The higher our comparable sales exclusive of these items, the more we can leverage certain of our selling, general and administrative expenses, reducing them as a percentage of sales and enhancing profitability. Generating comparable sales growth is foremost a question of making available to our members the right merchandise at the right prices, a skill that we believe we have repeatedly demonstrated over the long term. Another substantial factor in sales growth is the health of the economies in which we do business, especially the United States. Sales growth and gross margins are also impacted by our competition, which is vigorous and widespread, across a wide range of global, national and regional wholesalers and retailers. While we cannot control or reliably predict general economic health or changes in competition, we believe that we have been successful historically in adapting our business to these changes, such as through adjustments to our pricing and to our merchandise mix, including increasing the penetration of our private label items. Our philosophy is to provide our members with quality goods and services at the most competitive prices. We do not focus in the short term on maximizing prices charged, but instead seek to maintain what we believe is a perception among our members of our “pricing authority” consistently providing the most competitive values. Our investments in merchandise pricing can, from time to time, include reducing prices on merchandise to drive sales or meet competition and holding prices steady despite cost increases instead of passing the increases on to our members, all negatively impacting nearterm gross margin as a percentage of net sales (gross margin percentage). We believe that our gasoline business draws members but it generally has a significantly lower gross margin percentage relative to our nongasoline business. A higher penetration of gasoline sales will generally lower our gross margin percentage. Rapidly changing gasoline prices may significantly impact our nearterm net sales growth. Generally, rising gasoline prices benefit net sales growth which, given the higher sales base, negatively impacts our gross margin percentage but decreases our selling, general and administrative (SG&A) expenses as a percentage of net sales. A decline in gasoline prices has the inverse effect. We operate our lowermargin gasoline business in all countries except Korea and France. We also achieve sales growth by opening new warehouses. As our warehouse base grows, available and desirable potential sites become more difficult to secure, and square footage growth becomes a comparatively less substantial component of growth. The negative aspects of such growth, however, including lower initial operating profitability relative to existing warehouses and cannibalization of sales at existing warehouses when openings occur in existing markets, are increasingly less significant relative to the results of our total operations. Our rate of square footage growth is generally higher in foreign markets, due to the smaller base in those markets, and we expect that to continue. Our ecommerce business growth both domestically and internationally has also increased our sales. Our membership format is an integral part of our business model and has a significant effect on our profitability. This format is designed to reinforce member loyalty and provide continuing fee revenue. The extent to which we achieve growth in our membership base, increase penetration of our Executive members, and sustain high renewal rates, materially influences our profitability. Our financial performance depends heavily on our ability to control costs. While we believe that we have achieved successes in this area historically, some significant costs are partially outside our control, most Item 7 Management’s Discussion and Analysis of Financial Condition and Results of Operations (amounts in millions, except per share, share, membership fee, and warehouse count data) (Continued) particularly health care and utility expenses. With respect to expenses relating to [/INST] Negative. </s>

COSTCO WHOLESALE CORP /NEW

2018-10-26

2018-09-02

Item 7 - Management's Discussion and Analysis of Financial Conditions and Results of Operations (amounts in millions, except per share, share, membership fee, and warehouse count data) Overview We believe that the most important driver of our profitability is sales growth, particularly comparable warehouse sales (comparable sales) growth. We define comparable sales as sales from warehouses open for more than one year, including remodels, relocations and expansions, as well as online sales related to e-commerce websites operating for more than one year. Comparable sales growth is achieved through increasing shopping frequency from new and existing members and the amount they spend on each visit (average ticket). Sales comparisons can also be particularly influenced by certain factors that are beyond our control: fluctuations in currency exchange rates (with respect to the consolidation of the results of our international operations); and changes in the cost of gasoline and associated competitive conditions. The higher our comparable sales exclusive of these items, the more we can leverage certain of our selling, general and administrative expenses, reducing them as a percentage of sales and enhancing profitability. Generating comparable sales growth is foremost a question of making available to our members the right merchandise at the right prices, a skill that we believe we have repeatedly demonstrated over the long term. Another substantial factor in sales growth is the health of the economies in which we do business, including the effects of inflation or deflation, especially the United States. Sales growth and gross margins are also impacted by our competition, which is vigorous and widespread, across a wide range of global, national and regional wholesalers and retailers, including those with e-commerce operations. While we cannot control or reliably predict general economic health or changes in competition, we believe that we have been successful historically in adapting our business to these changes, such as through adjustments to our pricing and to our merchandise mix, including increasing the penetration of our private label items, and through our online offerings. Our philosophy is to provide our members with quality goods and services at competitive prices. We do not focus in the short term on maximizing prices charged, but instead seek to maintain what we believe is a perception among our members of our “pricing authority” on quality goods - consistently providing the most competitive values. Our investments in merchandise pricing can, from time to time, include reducing prices on merchandise to drive sales or meet competition and holding prices steady despite cost increases instead of passing the increases on to our members, all negatively impacting near-term gross margin as a percentage of net sales (gross margin percentage). We believe that our gasoline business draws members but it generally has a significantly lower gross margin percentage relative to our non-gasoline business. A higher penetration of gasoline sales will generally lower our gross margin percentage. Rapidly changing gasoline prices may significantly impact our near-term net sales growth. Generally, rising gasoline prices benefit net sales growth which, given the higher sales base, negatively impacts our gross margin percentage but decreases our selling, general and administrative (SG&A) expenses as a percentage of net sales. A decline in gasoline prices has the inverse effect. We also achieve sales growth by opening new warehouses. As our warehouse base grows, available and desirable potential sites become more difficult to secure, and square footage growth becomes a comparatively less substantial component of growth. The negative aspects of such growth, however, including lower initial operating profitability relative to existing warehouses and cannibalization of sales at existing warehouses when openings occur in existing markets, are continuing to decline in significance as they relate to the results of our total operations. Our rate of square footage growth is generally higher in foreign markets, due to the smaller base in those markets, and we expect that to continue. Our e-commerce business growth, domestically and internationally, has also increased our sales. Our membership format is an integral part of our business and has a significant effect on our profitability. This format is designed to reinforce member loyalty and provide continuing fee revenue. The extent to which we achieve growth in our membership base, increase the penetration of our Executive members, and sustain high renewal rates, materially influences our profitability. Our paid membership growth rate may be adversely impacted when warehouse openings occur in existing markets. Our financial performance depends heavily on our ability to control costs. While we believe that we have achieved successes in this area, some significant costs are partially outside our control, most particularly health care and utility expenses. With respect to expenses relating to the compensation of our employees, our philosophy is not to seek to minimize their wages and benefits. Rather, we believe that achieving our longer-term objectives of reducing employee turnover and enhancing employee satisfaction requires maintaining compensation levels that are better than the industry average for much of our workforce. This may cause us, for example, to absorb costs that other employers might seek to pass through to their workforces. Because our business is operated on very low margins, modest changes in various items in the income statement, particularly merchandise costs and selling, general and administrative expenses, can have substantial impacts on net income. Our operating model is generally the same across our U.S., Canada, and Other International operating segments (see Note 11 to the consolidated financial statements included in Item 8 of this Report). Certain countries in the Other International segment have relatively higher rates of square footage growth, lower wages and benefits costs as a percentage of country sales, and/or less or no direct membership warehouse competition. In discussions of our consolidated operating results, we refer to the impact of changes in foreign currencies relative to the U.S. dollar, which are references to the differences between the foreign-exchange rates we use to convert the financial results of our international operations from local currencies into U.S. dollars for financial reporting purposes. This impact of foreign-exchange rate changes is calculated based on the difference between the current period's currency exchange rates and that of the comparable prior period. The impact of changes in gasoline prices on net sales is calculated based on the difference between the current period's average price per gallon sold and that of the comparable prior period. Our fiscal year ends on the Sunday closest to August 31. Fiscal year 2018 and 2016 were 52-week fiscal years ending on September 2, 2018 and August 28, 2016, respectively, and 2017 was a 53-week fiscal year ending on September 3, 2017. Certain percentages presented are calculated using actual results prior to rounding. Unless otherwise noted, references to net income relate to net income attributable to Costco. Highlights for fiscal year 2018 included: • We opened 25 new warehouses, including 4 relocations, in 2018: 13 net new locations in the U.S., three in Canada, and five in our Other International segment, compared to 28 new warehouses, including 2 relocations in 2017; • Net sales increased 10% to 138,434 driven by a 9% increase in comparable sales and sales at new warehouses opened in 2017 and 2018, partially offset by one additional week of sales in 2017; • Membership fee revenue increased 10% to $3,142, primarily due to the annual fee increase in the U.S. and Canada in June 2017, and membership sign-ups at existing and new warehouses; • Gross margin percentage decreased 29 basis points due to the impact of gasoline price inflation on net sales and a shift in sales penetration to certain lower margin warehouse ancillary businesses from our core merchandise categories; • Selling, general & administrative (SG&A) expenses as a percentage of net sales decreased 24 basis points, due to the impact of gasoline price inflation and leveraging increased sales; • The effective tax rate in 2018 was 28.4% and was favorably impacted by the 2017 Tax Act and net tax benefits of $57. The effective tax rate in 2017 was 32.8% and was favorably impacted by net tax benefits of $104; • Net income increased 17% to $3,134, or $7.09 per diluted share compared to $2,679, or $6.08 per diluted share in 2017; and • In April 2018, the Board of Directors approved an increase in the quarterly cash dividend from $0.50 to $0.57 per share. Results of operations Net Sales 2018 vs. 2017 Net Sales Net sales increased $12,262 or 10% during 2018, primarily due to a 9% increase in comparable sales and sales at new warehouses opened in 2017 and 2018, partially offset by the impact of one additional week of sales in 2017. Changes in gasoline prices positively impacted net sales by approximately $2,267, or 180 basis points, due to a 19% increase in the average sales price per gallon. Changes in foreign currencies relative to the U.S. dollar positively impacted net sales by approximately $1,156, or 92 basis points, compared to 2017. The positive impact was driven by both our Canadian and Other International operations. Comparable Sales Comparable sales increased 9% during 2018 and were positively impacted by increases in both shopping frequency and the average ticket. The average ticket and comparable sales results were positively impacted by an increase in gasoline prices and exchange rates in foreign currencies relative to the U.S. dollar. Changes in comparable sales includes the negative impact of cannibalization (established warehouses losing sales to our newly opened locations). 2017 vs. 2016 Net Sales Net sales increased $10,099 or 9% during 2017, primarily due to a 4% increase in comparable sales, new warehouses opened in 2016 and 2017, and the benefit of one additional week of sales in 2017. Changes in gasoline prices positively impacted net sales by approximately $785, or 68 basis points, due to an 8% increase in the average sales price per gallon. Changes in foreign currencies relative to the U.S. dollar negatively impacted net sales by approximately $295, or 25 basis points, compared to 2016. The negative impact was driven by Other International operations, partially offset by positive impacts attributable to our Canadian operations. Comparable Sales Comparable sales increased 4% during 2017 and were positively impacted by an increase in shopping frequency and, to a lesser extent, an increased average ticket. The average ticket and comparable sales results were positively impacted by an increase in gasoline prices, offset by decreases in foreign currencies relative to the U.S. dollar. Changes in comparable sales includes the negative impact of cannibalization. Membership Fees 2018 vs. 2017 The increase in membership fees was primarily due to the annual fee increase and membership sign-ups at existing and new warehouses. These increases were partially offset by the impact of one additional week of membership fees in 2017. At the end of 2018, our member renewal rates were 90% in the U.S. and Canada and 88% worldwide. As reported in fiscal 2017, we increased our annual membership fees in the U.S. and Canada and in certain of our Other International operations. We account for membership fee revenue on a deferred basis, recognized ratably over the one-year membership period. These fee increases had a positive impact of approximately $178 in fiscal 2018 and will positively impact fiscal 2019, primarily the first two quarters, by approximately $70. 2017 vs. 2016 The increase in membership fees was primarily due to membership sign-ups at existing and new warehouses, an extra week of membership fee revenue, the annual fee increase, and an increased number of upgrades to our higher-fee Executive Membership program. Fee increases had a positive impact on membership fee revenues during 2017 of approximately $23. Gross Margin 2018 vs. 2017 The gross margin of our core merchandise categories (food and sundries, hardlines, softlines and fresh foods), when expressed as a percentage of core merchandise sales (rather than total net sales), increased one basis point primarily due to increases in food and sundries and hardlines partially offset by decreases in fresh foods and softlines. This measure eliminates the impact of changes in sales penetration and gross margins from our warehouse ancillary and other businesses. Total gross margin percentage decreased 29 basis points compared to 2017. Excluding the impact of gasoline price inflation on net sales, gross margin as a percentage of adjusted net sales was 11.22%, a decrease of 11 basis points. This decrease was primarily due to a shift in sales penetration to certain lower margin warehouse ancillary and other businesses, which contributed to a 13 basis point decrease in our core merchandise categories, except hardlines which was flat. Gross margin percentage was also negatively impacted by 10 basis points due to a non-recurring legal settlement benefiting 2017 and costs related to our centralized return centers in the U.S. These decreases were partially offset by a 13 basis point increase in our warehouse ancillary and other businesses, predominantly our gasoline business. Changes in foreign currencies relative to the U.S. dollar positively impacted gross margin by approximately $124 in 2018. The segment gross margin percentage, when expressed as a percentage of the segment's own sales and excluding the impact of changes in gasoline prices on net sales (segment gross margin percentage), decreased in our U.S. operations, predominantly in our core merchandise categories, and as a result of the non-recurring legal settlement in 2017, and the costs related to our centralized return centers mentioned above. The segment gross margin percentage in our Canadian operations increased, due to warehouse ancillary and other businesses, primarily our gasoline business. The segment gross margin percentage in our Other International operations decreased, predominantly in food and sundries and softlines, partially offset by an increase in our gasoline business. 2017 vs. 2016 The gross margin of our core merchandise categories, when expressed as a percentage of core merchandise sales, increased eight basis points due to increases in these categories other than fresh foods. Total gross margin percentage decreased two basis points compared to 2016. Excluding the impact of gasoline price inflation on net sales, gross margin as a percentage of adjusted net sales was 11.40%, an increase of five basis points. This increase was primarily due to amounts earned under the co-branded credit card arrangement in the U.S. of 15 basis points and a benefit of three basis points from non-recurring legal settlements and other matters. The improvement in terms in our current co-brand agreement as compared to the prior co-brand arrangement led to substantial year over year benefits in fiscal 2017. These increases were partially offset by a six basis point decrease in our core merchandise categories, primarily due to food and sundries as a result of a decrease in sales penetration. The gross margin percentage was also negatively impacted by five basis points due to a LIFO benefit in 2016 and one basis point in warehouse ancillary and other businesses. Changes in foreign currencies relative to the U.S. dollar had an immaterial impact on gross margin in 2017. Gross margin on a segment basis, when expressed as a percentage of the segment's own sales and excluding the impact of changes in gasoline prices on net sales, increased in our U.S. operations, due to amounts earned under the co-branded credit card arrangement and non-recurring legal settlements and other matters as discussed above. These increases were partially offset by a decrease in core merchandise categories, predominantly food and sundries as a result of a decrease in sales penetration, and a LIFO benefit in 2016. The segment gross margin percentage in our Canadian operations increased, primarily due to increases in warehouse ancillary and other businesses, primarily our pharmacy business, partially offset by a decrease in our core merchandise categories, largely fresh foods. The segment gross margin percentage increased in our Other International operations due to increases across all core merchandise categories, except fresh foods. Selling, General and Administrative Expenses 2018 vs. 2017 SG&A expenses as a percentage of net sales decreased 24 basis points compared to 2017. Excluding the impact of gasoline price inflation on net sales, SG&A expenses as a percentage of adjusted net sales was 10.19%, a decrease of seven basis points. Operating costs related to warehouses, ancillary, and other businesses, which includes e-commerce and travel, were lower by six basis points, predominantly in our U.S. and Other International operations, due to leveraging increased sales. Charges related to certain non-recurring legal and other matters in 2017 positively impacted SG&A expense by two basis points. Stock compensation expense was also lower by one basis point. Central operating costs were higher by two basis points. Changes in foreign currencies relative to the U.S. dollar increased our SG&A expenses by approximately $98 in 2018. Effective in June 2018, a portion of the savings generated from the Tax Cuts and Jobs Act (the “2017 Tax Act”) were used to increase wages for the majority of our U.S. hourly employees. The impact in fiscal 2018 was two basis points and the estimated annualized pre-tax cost of these increases is approximately $120. 2017 vs. 2016 SG&A expenses as a percentage of net sales decreased 14 basis points compared to 2016. Excluding the impact of gasoline price inflation on net sales, SG&A expenses as a percentage of adjusted net sales was 10.33%, a decrease of seven basis points. Operating costs related to warehouses, ancillary, and other businesses, were lower by nine basis points, primarily due to lower costs associated with the co-branded credit card arrangement in the U.S. of 18 basis points. The improvement in terms in our current co-brand agreement as compared to the prior co-brand arrangement led to substantial year over year benefits in fiscal 2017. This was partially offset by higher payroll and employee benefit expenses of 11 basis points, primarily in our U.S. operations. Central operating costs were higher by one basis point, primarily due to increased costs associated with our information systems modernization, including increased depreciation for projects placed in service, incurred by our U.S. operations. Stock compensation expense was also higher by one basis point. Preopening Preopening expenses include costs for startup operations related to new warehouses and relocations, developments in new international markets, new manufacturing and distribution facilities, and expansions at existing warehouses. Preopening expenses vary due to the number of warehouse openings, the timing of the opening relative to our year-end, whether the warehouse is owned or leased, and whether the opening is in an existing, new, or international market. In 2017, we entered into two new international markets, Iceland and France. Interest Expense Interest expense primarily relates to Senior Notes issued by the Company. In May 2017, we issued $3,800 in aggregate principal amount of Senior Notes. In March and June 2017, we repaid $2,200 in total outstanding principal of the 5.5% and 1.125% Senior Notes, respectively. Interest Income and Other, Net 2018 vs. 2017 The increase in interest income in 2018 as compared to 2017 was primarily due to higher interest rates earned on higher average cash and investment balances. Foreign-currency transaction gains (losses), net include the revaluation or settlement of monetary assets and liabilities and mark-to-market adjustments for forward foreign-exchange contracts by our Canadian and Other International operations. In 2018, the increase was primarily due to a strengthening U.S. dollar relative to certain foreign currencies on forward foreign-exchange contracts. See Derivatives and Foreign Currency sections in Item 8, Note 1 of this Report. 2017 vs. 2016 Foreign-currency transaction gains (losses), net include the revaluation or settlement of monetary assets and liabilities and mark-to-market adjustments for forward foreign-exchange contracts by our Canadian and Other International operations. Provision for Income Taxes Our effective tax rate for 2018 was favorably impacted by the 2017 Tax Act, which included a reduction in the U.S. federal corporate rate from 35% to 21%. Due to the timing of our fiscal year relative to the effective date of the rate change, our U.S. corporate rate for 2018 resulted in a blended rate of 25.6%. Other impacts from the 2017 Tax Act consisted of tax expense of $142 for the estimated tax on deemed repatriation of unremitted earnings and $43 for the reduction in foreign tax credits and other immaterial items, largely offset by a tax benefit of $166 for the provisional remeasurement of certain deferred tax liabilities. In 2018, we also recognized net tax benefits of $76, which was largely driven by the adoption of an accounting standard related to stock-based compensation and other immaterial net benefits. In 2017, our provision was favorably impacted by net tax benefits of $104, primarily due to a tax benefit recorded in connection with the May 2017 special dividend paid to employees through our 401(k) retirement plan of $82. This dividend was deductible for U.S. income tax purposes. LIQUIDITY AND CAPITAL RESOURCES The following table summarizes our significant sources and uses of cash and cash equivalents: Our primary sources of liquidity are cash flows generated from warehouse operations, cash and cash equivalents, and short-term investments. Cash and cash equivalents and short-term investments were $7,259 and $5,779 at the end of 2018 and 2017, respectively. Of these balances, approximately $1,348 and $1,255 represented unsettled credit and debit card receivables, respectively. These receivables generally settle within four days. Cash and cash equivalents were negatively impacted by a change in exchange rates of $37 in 2018 and positively impacted by $25 and $50 in 2017 and 2016, respectively. Management believes that our cash position and operating cash flows will be sufficient to meet our liquidity and capital requirements for the foreseeable future. While we believe that our U.S. current and projected asset position is sufficient to meet our U.S. liquidity requirements, beginning in the second quarter of fiscal 2018, we no longer consider current fiscal year and future earnings of our non-U.S. consolidated subsidiaries to be permanently reinvested. We recorded the estimated incremental foreign withholding (net of available foreign tax credits) and state income taxes payable on current fiscal year earnings assuming a hypothetical repatriation to the U.S. We continue to consider undistributed earnings of certain non-U.S. consolidated subsidiaries prior to fiscal 2018 to be indefinitely reinvested and have not provided for withholding or state taxes. In fiscal 2018, we recorded a one-time charge of $142 for the estimated tax on deemed repatriation of unremitted earnings under the 2017 Tax Act. The 2017 Tax Act provides for the payment of the federal tax over an eight-year period. Because of the availability of foreign tax credits, the amount payable is $97, of which $89 is classified as long-term and included in other liabilities on our consolidated balance sheet. Cash Flows from Operating Activities Net cash provided by operating activities totaled $5,774 in 2018, compared to $6,726 in 2017. Our cash flow provided by operations is primarily derived from net sales and membership fees. Cash flow used in operations generally consists of payments to our merchandise vendors, warehouse operating costs including payroll and employee benefits, utilities, and credit and debit card processing fees. Cash used in operations also includes payments for income taxes. The decrease in net cash provided by operating activities for 2018 when compared to 2017 was primarily due to accelerated vendor payments of approximately $1,700 made in the last week of fiscal 2016, which positively impacted cash flows in 2017. Cash Flows from Investing Activities Net cash used in investing activities totaled $2,947 in 2018, compared to $2,366 in 2017, and primarily related to capital expenditures. Net cash flows from investing activities also includes maturities and purchases of short-term investments. Capital Expenditures We opened 21 net new warehouses and relocated 4 warehouses in 2018 and plan to open approximately 20 net new warehouses and relocate up to 4 warehouses in 2019. Our primary requirement for capital is acquiring land, buildings, and equipment for new and remodeled warehouses. Capital is also required for information systems, manufacturing and distribution facilities, initial warehouse operations and working capital. In 2018, we spent $2,969 on capital expenditures, and it is our current intention to spend approximately $2,800 to $3,100 during fiscal 2019. These expenditures are expected to be financed with cash from operations, existing cash and cash equivalents, and short-term investments. There can be no assurance that current expectations will be realized and plans are subject to change upon further review of our capital expenditure needs. Cash Flows from Financing Activities Net cash used in financing activities totaled $1,281 in 2018, compared to $3,218 in 2017. The primary uses of cash in 2018 were related to dividend payments and repurchases of common stock. Net cash used in financing activities in 2017 primarily related to dividend payments, predominantly the special dividend paid in May 2017, and the repayments of debt totaling $2,200 representing the aggregate principal balances of the 5.5% and 1.125% Senior Notes. In May 2017, we issued $3,800 in aggregate principal amount of Senior Notes. The proceeds received were net of a discount and used to pay the special dividend and a portion of the redemption of the 1.125% Senior Notes. Stock Repurchase Programs During 2018 and 2017, we repurchased 1,756,000 and 2,998,000 shares of common stock, at average prices of $183.13 and $157.87, totaling approximately $322 and $473, respectively. The remaining amount available to be purchased under our approved plan was $2,427 at the end of 2018. These amounts may differ from the stock repurchase balances in the accompanying consolidated statements of cash flows due to changes in unsettled stock repurchases at the end of each fiscal year. Purchases are made from time-to-time, as conditions warrant, in the open market or in block purchases and pursuant to plans under SEC Rule 10b5-1. Repurchased shares are retired, in accordance with the Washington Business Corporation Act. Dividends Cash dividends declared in 2018 totaled $2.14 per share, as compared to $8.90 per share in 2017, which included a special cash dividend of $7.00 per share. In April 2018, our Board of Directors increased our quarterly cash dividend from $0.50 to $0.57 per share. Subsequent to the end of 2018, our Board of Directors declared a quarterly cash dividend in the amount of $0.57 per share, which is payable on November 23, 2018. Bank Credit Facilities and Commercial Paper Programs We maintain bank credit facilities for working capital and general corporate purposes. At September 2, 2018, we had borrowing capacity under these facilities of $857, including a $400 revolving line of credit renewed by the U.S., which expires in June 2019. The Company currently has no plans to draw upon this facility. Our international operations maintain $344 of the total borrowing capacity under bank credit facilities, of which $163 is guaranteed by the Company. There were no outstanding short-term borrowings under the bank credit facilities at the end of 2018 and 2017. The Company has letter of credit facilities, for commercial and standby letters of credit, totaling $220. The outstanding standby letters of credit under these facilities at the end of 2018 totaled $149 and expire within one year. The bank credit facilities and commercial paper programs have various expiration dates, all within one year, and we generally intend to renew these facilities. The amount of borrowings available at any time under our bank credit facilities is reduced by the amount of standby and commercial letters of credit then outstanding. Contractual Obligations At September 2, 2018, our commitments to make future payments under contractual obligations were as follows: _______________ (1) Includes only open merchandise purchase orders. (2) Includes contractual interest payments and excludes deferred issuance costs. (3) Excludes common area maintenance, taxes, and insurance and have been reduced by $105 related to sub-lease income. (4) Includes build-to-suit lease obligations and contractual interest payments. (5) Excludes certain services negotiated at the individual warehouse or regional level that are not significant and generally contain clauses allowing for cancellation without significant penalty. (6) Includes asset retirement obligations, deferred compensation obligations and current liabilities for unrecognized tax contingencies. The total amount excludes $36 of non-current unrecognized tax contingencies and $30 of other obligations due to uncertainty regarding the timing of future cash payments. Off-Balance Sheet Arrangements In the opinion of management, we have no off-balance sheet arrangements that have had, or are reasonably likely to have, a material current or future effect on our financial condition or financial statements other than operating leases, included in the table above and discussed in Note 1 and Note 5 to the consolidated financial statements included in Item 8 of this Report. Critical Accounting Estimates The preparation of our consolidated financial statements in accordance with U.S. generally accepted accounting principles (U.S. GAAP) requires that we make estimates and assumptions that affect the reported amounts of assets and liabilities and the disclosure of contingent assets and liabilities at the date of the financial statements and the reported amounts of revenues and expenses during the reporting period. We base our estimates on historical experience and on assumptions that we believe to be reasonable, and we continue to review and evaluate these estimates. For further information on significant accounting policies, see discussion in Note 1 to the consolidated financial statements included in Item 8 of this Report. Insurance/Self-Insurance Liabilities The Company is predominantly self-insured for employee health-care benefits, workers’ compensation, general liability, property damage, directors’ and officers’ liability, vehicle liability, and inventory loss. Insurance coverage is maintained in certain instances to limit the exposure arising from catastrophic events. We use different mechanisms, including a wholly-owned captive insurance subsidiary and participate in a reinsurance program. Liabilities associated with the risks that we retain are not discounted and are estimated by using historical claims experience, demographic factors, severity factors and other actuarial assumptions. The costs of claims are highly unpredictable and can fluctuate as a result of inflation rates, regulatory or legal changes, and unforeseen developments in claims of an extended nature. While we believe our estimates are reasonable and provide for a certain degree of coverage to account for these variables, actual claims and costs could differ significantly from recorded liabilities. Historically, adjustments to our estimates have not been material. Income Taxes The determination of our provision for income taxes requires significant judgment, the use of estimates, and the interpretation and application of complex tax laws. Significant judgment also is required in assessing the timing and amounts of deductible and taxable items and the probability of sustaining uncertain tax positions. The benefits associated with uncertain tax positions are recorded only after determining a more-likely-than-not probability that the positions will withstand challenge from tax authorities. When facts and circumstances change, we reassess these positions and record any changes in the consolidated financial statements as appropriate. In December 2017, the 2017 Tax Act was signed into law and our effective tax rate for fiscal 2018 reflects the provisional impact (see Note 8 to our Consolidated Financial Statements). Recent Accounting Pronouncements See Note 1 to the consolidated financial statements included in Item 8 of this Report for a detailed description of recent accounting pronouncements.

<s>[INST] We believe that the most important driver of our profitability is sales growth, particularly comparable warehouse sales (comparable sales) growth. We define comparable sales as sales from warehouses open for more than one year, including remodels, relocations and expansions, as well as online sales related to ecommerce websites operating for more than one year. Comparable sales growth is achieved through increasing shopping frequency from new and existing members and the amount they spend on each visit (average ticket). Sales comparisons can also be particularly influenced by certain factors that are beyond our control: fluctuations in currency exchange rates (with respect to the consolidation of the results of our international operations); and changes in the cost of gasoline and associated competitive conditions. The higher our comparable sales exclusive of these items, the more we can leverage certain of our selling, general and administrative expenses, reducing them as a percentage of sales and enhancing profitability. Generating comparable sales growth is foremost a question of making available to our members the right merchandise at the right prices, a skill that we believe we have repeatedly demonstrated over the long term. Another substantial factor in sales growth is the health of the economies in which we do business, including the effects of inflation or deflation, especially the United States. Sales growth and gross margins are also impacted by our competition, which is vigorous and widespread, across a wide range of global, national and regional wholesalers and retailers, including those with ecommerce operations. While we cannot control or reliably predict general economic health or changes in competition, we believe that we have been successful historically in adapting our business to these changes, such as through adjustments to our pricing and to our merchandise mix, including increasing the penetration of our private label items, and through our online offerings. Our philosophy is to provide our members with quality goods and services at competitive prices. We do not focus in the short term on maximizing prices charged, but instead seek to maintain what we believe is a perception among our members of our “pricing authority” on quality goods consistently providing the most competitive values. Our investments in merchandise pricing can, from time to time, include reducing prices on merchandise to drive sales or meet competition and holding prices steady despite cost increases instead of passing the increases on to our members, all negatively impacting nearterm gross margin as a percentage of net sales (gross margin percentage). We believe that our gasoline business draws members but it generally has a significantly lower gross margin percentage relative to our nongasoline business. A higher penetration of gasoline sales will generally lower our gross margin percentage. Rapidly changing gasoline prices may significantly impact our nearterm net sales growth. Generally, rising gasoline prices benefit net sales growth which, given the higher sales base, negatively impacts our gross margin percentage but decreases our selling, general and administrative (SG&A) expenses as a percentage of net sales. A decline in gasoline prices has the inverse effect. We also achieve sales growth by opening new warehouses. As our warehouse base grows, available and desirable potential sites become more difficult to secure, and square footage growth becomes a comparatively less substantial component of growth. The negative aspects of such growth, however, including lower initial operating profitability relative to existing warehouses and cannibalization of sales at existing warehouses when openings occur in existing markets, are continuing to decline in significance as they relate to the results of our total operations. Our rate of square footage growth is generally higher in foreign markets, due to the smaller base in those markets, and we expect that to continue. Our ecommerce business growth, domestically and internationally, has also increased our sales. Our membership format is an integral part of our business and has a significant effect on our profitability. This format is designed to reinforce member loyalty and provide continuing fee revenue. The extent to which we achieve growth in our membership base, increase the penetration of our Executive members, and sustain high renewal rates, materially influences our profitability. Our paid membership growth rate may be adversely impacted when warehouse openings occur in existing markets. Our financial performance depends heavily on our ability to control costs. While we believe that we have achieved successes in this area, some significant costs are partially outside our control, most particularly health care and utility expenses. With respect to expenses relating to the compensation of our employees, our philosophy is not to seek to minimize their wages and benefits. R [/INST] Positive. </s>

COSTCO WHOLESALE CORP /NEW

2019-10-11

2019-09-01

Item 7 - Management's Discussion and Analysis of Financial Conditions and Results of Operations (amounts in millions, except per share, share, membership fee, and warehouse count data) Overview We believe that the most important driver of our profitability is sales growth, particularly comparable sales growth. We define comparable sales as sales from warehouses open for more than one year, including remodels, relocations and expansions, and sales related to e-commerce websites operating for more than one year. Comparable sales growth is achieved through increasing shopping frequency from new and existing members and the amount they spend on each visit (average ticket). Sales comparisons can also be particularly influenced by certain factors that are beyond our control: fluctuations in currency exchange rates (with respect to the consolidation of the results of our international operations); changes in the cost of gasoline and associated competitive conditions; and changes from the revenue recognition standard. The higher our comparable sales exclusive of these items, the more we can leverage certain of our selling, general and administrative expenses, reducing them as a percentage of sales and enhancing profitability. Generating comparable sales growth is foremost a question of making available to our members the right merchandise at the right prices, a skill that we believe we have repeatedly demonstrated over the long term. Another substantial factor in sales growth is the health of the economies in which we do business, including the effects of inflation or deflation, especially the United States. Sales growth and gross margins are also impacted by our competition, which is vigorous and widespread, across a wide range of global, national and regional wholesalers and retailers, including those with e-commerce operations. While we cannot control or reliably predict general economic health or changes in competition, we believe that we have been successful historically in adapting our business to these changes, such as through adjustments to our pricing and to our merchandise mix, including increasing the penetration of our private-label items, and through online offerings. Our philosophy is to provide our members with quality goods and services at competitive prices. We do not focus in the short term on maximizing prices charged, but instead seek to maintain what we believe is a perception among our members of our “pricing authority” on quality goods - consistently providing the most competitive values. Our investments in merchandise pricing may include reducing prices on merchandise to drive sales or meet competition and holding prices steady despite cost increases instead of passing the increases on to our members, all negatively impacting gross margin as a percentage of net sales (gross margin percentage). We believe that our gasoline business draws members but it generally has a significantly lower gross margin percentage relative to our non-gasoline business. A higher penetration of gasoline sales will generally lower our gross margin percentage. Rapidly changing gasoline prices may significantly impact our near-term net sales growth. Generally, rising gasoline prices benefit net sales growth which, given the higher sales base, negatively impacts our gross margin percentage but decreases our selling, general and administrative (SG&A) expenses as a percentage of net sales. A decline in gasoline prices has the inverse effect. Additionally, actions in various countries, particularly China and the United States, have created uncertainty with respect to how tariffs will affect the costs of some of our merchandise. The degree of our exposure is dependent on (among other things) the type of goods, rates imposed, and timing of the tariffs. The impact to our net sales and gross margin will be influenced in part by our merchandising and pricing strategies in response to cost increases. While these potential impacts are uncertain, they could have an adverse impact on our results. We also achieve sales growth by opening new warehouses. As our warehouse base grows, available and desirable sites become more difficult to secure, and square footage growth becomes a comparatively less substantial component of growth. The negative aspects of such growth, however, including lower initial operating profitability relative to existing warehouses and cannibalization of sales at existing warehouses when openings occur in existing markets, are continuing to decline in significance as they relate to the results of our total operations. Our rate of square footage growth is generally higher in foreign markets, due to the smaller base in those markets, and we expect that to continue. Our e-commerce business growth, domestically and internationally, has also increased our sales. The membership format is an integral part of our business and has a significant effect on our profitability. This format is designed to reinforce member loyalty and provide continuing fee revenue. The extent to which we achieve growth in our membership base, increase the penetration of our Executive members, and sustain high renewal rates materially influences our profitability. Our paid membership growth rate may be adversely impacted when warehouse openings occur in existing markets as compared to new markets. Our financial performance depends heavily on controlling costs. While we believe that we have achieved successes in this area, some significant costs are partially outside our control, most particularly health care and utility expenses. With respect to the compensation of our employees, our philosophy is not to seek to minimize their wages and benefits. Rather, we believe that achieving our longer-term objectives of reducing employee turnover and enhancing employee satisfaction requires maintaining compensation levels that are better than the industry average for much of our workforce. This may cause us, for example, to absorb costs that other employers might seek to pass through to their workforces. Because our business is operated on very low margins, modest changes in various items in the consolidated statements of income, particularly merchandise costs and selling, general and administrative expenses, can have substantial impacts on net income. Our operating model is generally the same across our U.S., Canada, and Other International operating segments (see Note 11 to the consolidated financial statements included in Item 8 of this Report). Certain countries in the Other International segment have relatively higher rates of square footage growth, lower wages and benefits costs as a percentage of country sales, and/or less or no direct membership warehouse competition. In discussions of our consolidated operating results, we refer to the impact of changes in foreign currencies relative to the U.S. dollar, which are references to the differences between the foreign-exchange rates we use to convert the financial results of our international operations from local currencies into U.S. dollars for financial reporting purposes. This impact of foreign-exchange rate changes is calculated based on the difference between the current period's currency exchange rates and that of the comparable prior period. The impact of changes in gasoline prices on net sales is calculated based on the difference between the current period's average price per gallon sold and that of the comparable prior period. Our fiscal year ends on the Sunday closest to August 31. References to 2019 and 2018 relate to the 52-week fiscal years ended September 1, 2019, and September 2, 2018, respectively. References to 2017 relate to the 53-week fiscal year ended September 3, 2017. Certain percentages presented are calculated using actual results prior to rounding. Unless otherwise noted, references to net income relate to net income attributable to Costco. Highlights for 2019 included: • We opened 25 new warehouses, including 5 relocations: 16 net new locations in the U.S. and 4 in our Other International segment, including our first warehouse in China, compared to 25 new warehouses, including 4 relocations in 2018; • Net sales increased 8% to $149,351 driven by a 6% increase in comparable sales and sales at new warehouses opened in 2018 and 2019; • Membership fee revenue increased 7% to $3,352, primarily due to membership sign-ups at existing and new warehouses and the annual fee increase in the U.S. and Canada in June 2017. • Gross margin percentage decreased two basis points. Excluding the impact of the new revenue recognition standard on net sales, gross margin as a percentage of adjusted net sales increased eight basis points; • Selling, general & administrative (SG&A) expenses as a percentage of net sales increased two basis points. Excluding the impact of the new revenue recognition standard on net sales, SG&A as a percentage of adjusted net sales increased 11 basis points, primarily related to a $123 charge for a product tax assessment; • Effective March 2019, starting and supervisor wages were increased and paid bonding leave was made available for hourly employees in the U.S. and Canada. The estimated annualized pre-tax cost of these increases is approximately $50-$60; • The effective tax rate in 2019 was 22.3% compared to 28.4% in 2018. Both years were favorably impacted by the Tax Cuts and Jobs Act (2017 Tax Act) and other net tax benefits; • Net income increased 17% to $3,659, or $8.26 per diluted share compared to $3,134, or $7.09 per diluted share in 2018; and • In April 2019, the Board of Directors approved an increase in the quarterly cash dividend from $0.57 to $0.65 per share and authorized a new share repurchase program in the amount of $4,000. Results of operations Net Sales _______________ (1) Excluding the impact of the revenue recognition standard for the year ended September 1, 2019. See Note 1 in Item 8. Net Sales Net sales increased $10,917 or 8% during 2019, primarily due to a 6% increase in comparable sales and sales at new warehouses opened in 2018 and 2019. Changes in foreign currencies relative to the U.S. dollar negatively impacted net sales by approximately $1,463, or 106 basis points, compared to 2018, attributable to our Canadian and Other International Operations. The revenue recognition standard positively impacted net sales by $1,332, or 96 basis points. Changes in gasoline prices did not have a material impact on net sales. Comparable Sales Comparable sales increased 6% during 2019 and were positively impacted by increases in both shopping frequency and average ticket. Comparable sales were negatively impacted by cannibalization (established warehouses losing sales to our newly opened locations). Membership Fees The increase in membership fees was primarily due to membership sign-ups at existing and new warehouses and the annual fee increase. Changes in foreign currencies relative to the U.S. dollar negatively impacted membership fees by approximately $30 in 2019. At the end of 2019, our member renewal rates were 91% in the U.S. and Canada and 88% worldwide. As reported in 2017, we increased our annual membership fees in the U.S. and Canada and in certain of our Other International operations. We account for membership fee revenue on a deferred basis, recognized ratably over the one-year membership period. These fee increases had a positive impact of approximately $178 in 2018 and positively impacted 2019, primarily the first two quarters, by approximately $73. Gross Margin The gross margin of our core merchandise categories (food and sundries, hardlines, softlines and fresh foods), when expressed as a percentage of core merchandise sales (rather than total net sales), increased seven basis points primarily due to increases in food and sundries and fresh foods partially offset by decreases in softlines and hardlines. This measure eliminates the impact of changes in sales penetration and gross margins from our warehouse ancillary and other businesses. Total gross margin percentage decreased two basis points compared to 2018. Excluding the impact of the revenue recognition standard on net sales, gross margin as a percentage of adjusted net sales was 11.12%, an increase of eight basis points. This increase was primarily due to a 19 basis point increase in our warehouse ancillary and other businesses, predominantly our gasoline business. This increase was partially offset by decreases of four basis points in our core merchandise categories, four basis points due to an adjustment to our estimate of breakage on rewards earned under our co-branded credit card program and three basis points due to increased spending by members under the Executive Membership 2% reward program. Changes in foreign currencies relative to the U.S. dollar negatively impacted gross margin by approximately $155 in 2019. The segment gross margin percentage, when expressed as a percentage of the segment's own sales and excluding the impact of changes in gasoline prices on net sales (segment gross margin percentage), increased in our U.S. operations, predominantly in our warehouse ancillary and other businesses, primarily our gasoline business. This increase was partially offset by decreases in our core merchandise categories and the breakage adjustment noted above. The segment gross margin percentage in our Canadian operations decreased predominantly in hardlines and softlines and certain of our warehouse ancillary and other businesses, partially offset by an increase in fresh foods. The segment gross margin percentage in our Other International operations decreased primarily in our core merchandise categories and due to the introduction of the Executive Membership 2% reward program in Korea. This decrease was partially offset by an increase in our gasoline business. Selling, General and Administrative Expenses SG&A expenses as a percentage of net sales increased two basis points compared to 2018. Excluding the impact of the revenue recognition standard on net sales, SG&A expenses as a percentage of adjusted net sales were 10.13%, an increase of 11 basis points. This increase is largely due to a $123 charge, or eight basis points, recorded in the U.S. related to a product tax assessment. Central operating costs were higher by two basis points and stock compensation expense was higher by one basis point. Operating costs as a percent of adjusted net sales related to warehouses, ancillary, and other businesses, which includes e-commerce and travel, were flat despite the wage increases and bonding leave benefits for U.S. and Canadian hourly employees effective in March 2019. Changes in foreign currencies relative to the U.S. dollar positively impacted SG&A expenses by approximately $124 in 2019. Preopening Preopening expenses include costs for startup operations related to new warehouses and relocations, developments in new international markets, new manufacturing and distribution facilities, and expansions at existing warehouses. Preopening expenses vary due to the number of warehouse and facility openings, the timing of the opening relative to our year-end, whether a warehouse is owned or leased, and whether openings are in an existing, new, or international market. In 2019, we opened our first warehouse in China. Subsequent to year end, operations commenced at our new poultry processing plant. Interest Expense Interest expense primarily relates to Senior Notes issued by the Company. Interest expense decreased in 2019 largely due to an increase in capitalized interest associated with our new poultry processing plant. Interest Income and Other, Net The increase in interest income in 2019 was primarily due to higher interest rates earned on higher average cash and investment balances. Foreign-currency transaction gains (losses), net include the revaluation and settlement of monetary assets and liabilities and mark-to-market adjustments for forward foreign-exchange contracts by our Canadian and Other International operations. See Derivatives and Foreign Currency sections in Item 8, Note 1 of this Report. Provision for Income Taxes Our effective tax rate for 2019 was favorably impacted by the reduction in the U.S. federal corporate tax rate in December 2017 from 35% to 21%, which was in effect for all of 2019, and compared to a higher blended rate effective for 2018. Net discrete tax benefits of $221 in 2019 included a benefit of $59 related to the stock-based compensation accounting standard adopted in the first quarter of 2018. This also included a tax benefit of $105 related to U.S. taxation of deemed foreign dividends, offset by losses of foreign tax credits, which impacted the effective tax rate. The tax rate for 2019 was 26.9%, excluding the net discrete tax benefits. LIQUIDITY AND CAPITAL RESOURCES The following table summarizes our significant sources and uses of cash and cash equivalents: Our primary sources of liquidity are cash flows generated from warehouse operations, cash and cash equivalents, and short-term investments. Cash and cash equivalents and short-term investments were $9,444 and $7,259 at the end of 2019 and 2018, respectively. Of these balances, unsettled credit and debit card receivables represented approximately $1,434 and $1,348 at the end of 2019 and 2018, respectively. These receivables generally settle within four days. Cash and cash equivalents were negatively impacted by a change in exchange rates of $15 and $37 in 2019 and 2018, respectively, and positively impacted by $25 in 2017. Management believes that our cash position and operating cash flows will be sufficient to meet our liquidity and capital requirements for the foreseeable future. We believe that our U.S. current and projected asset position is sufficient to meet our U.S. liquidity requirements. We no longer consider earnings after 2017 of our non-U.S. consolidated subsidiaries to be indefinitely reinvested. Cash Flows from Operating Activities Net cash provided by operating activities totaled $6,356 in 2019, compared to $5,774 in 2018. Our cash flow provided by operations is primarily derived from net sales and membership fees. Cash flow used in operations generally consists of payments to our merchandise suppliers, warehouse operating costs, including payroll and employee benefits, utilities, and credit and debit card processing fees. Cash used in operations also includes payments for income taxes. Changes in our net investment in merchandise inventories (the difference between merchandise inventories and accounts payable) is impacted by several factors, including how fast inventory is sold, payment terms with our suppliers, and the amount of payables paid early to obtain discounts from our suppliers. Cash Flows from Investing Activities Net cash used in investing activities totaled $2,865 in 2019, compared to $2,947 in 2018, and primarily related to capital expenditures. Net cash flows from investing activities also includes maturities and purchases of short-term investments. Capital Expenditures Our primary requirement for capital is acquiring land, buildings, and equipment for new and remodeled warehouses. Capital is also required for information systems, manufacturing and distribution facilities, initial warehouse operations and working capital. In 2019, we spent $2,998 on capital expenditures, and it is our current intention to spend approximately $3,000 to $3,200 during fiscal 2020. These expenditures are expected to be financed with cash from operations, existing cash and cash equivalents, and short-term investments. We opened 25 new warehouses, including five relocations, in 2019, and plan to open approximately 22 additional new warehouses, including three relocations, in 2020. There can be no assurance that current expectations will be realized and plans are subject to change upon further review of our capital expenditure needs. Cash Flows from Financing Activities Net cash used in financing activities totaled $1,147 in 2019, compared to $1,281 in 2018. Cash flows used in financing activities primarily related to the payment of dividends, withholding taxes on stock-based awards, and repurchases of common stock. Dividends totaling $1,038 were paid during 2019, of which $250 related to the dividend declared in August 2018. In August 2019, approximately $200 and $100 of Guaranteed Senior Notes were issued by our Japanese subsidiary at fixed interest rates of 0.28% and 0.42%, respectively. Stock Repurchase Programs In April 2019, the Board of Directors authorized a new share repurchase program in the amount of $4,000, which expires in April 2023. This authorization revoked previously authorized but unused amounts, totaling $2,237. During 2019 and 2018, we repurchased 1,097,000 and 1,756,000 shares of common stock, at average prices of $225.16 and $183.13, respectively, totaling approximately $247 and $322, respectively. The remaining amount available to be purchased under our approved plan was $3,943 at the end of 2019. These amounts may differ from the stock repurchase balances in the accompanying consolidated statements of cash flows due to changes in unsettled stock repurchases at the end of each fiscal year. Purchases are made from time-to-time, as conditions warrant, in the open market or in block purchases and pursuant to plans under SEC Rule 10b5-1. Repurchased shares are retired, in accordance with the Washington Business Corporation Act. Dividends Cash dividends declared in 2019 totaled $2.44 per share, as compared to $2.14 per share in 2018. In April 2019, the Board of Directors increased our quarterly cash dividend from $0.57 to $0.65 per share. In August 2019, the Board of Directors declared a quarterly cash dividend in the amount of $0.65 per share, which was paid subsequent to the end of 2019. Bank Credit Facilities and Commercial Paper Programs We maintain bank credit facilities for working capital and general corporate purposes. At September 1, 2019, we had borrowing capacity under these facilities of $865, including a $400 revolving line of credit, which expires in June 2020. The Company currently has no plans to draw upon this facility. Our international operations maintain $355 of the total borrowing capacity under bank credit facilities, of which $150 is guaranteed by the Company. There were no outstanding short-term borrowings under the bank credit facilities at the end of 2019 and 2018. The Company has letter of credit facilities, for commercial and standby letters of credit, totaling $219. The outstanding commitments under these facilities at the end of 2019 totaled $145, most of which were standby letters of credit with expiration dates within one year. The bank credit facilities have various expiration dates, most of which are within one year, and we generally intend to renew these facilities. The amount of borrowings available at any time under our bank credit facilities is reduced by the amount of standby and commercial letters of credit outstanding. Contractual Obligations At September 1, 2019, our commitments to make future payments under contractual obligations were as follows: _______________ (1) Includes only open merchandise purchase orders. (2) Includes contractual interest payments and excludes deferred issuance costs. (3) Excludes common area maintenance, taxes, and insurance and have been reduced by $105 related to sub-lease income. (4) Includes build-to-suit lease obligations and contractual interest payments. (5) Excludes certain services negotiated at the individual warehouse or regional level that are not significant and generally contain clauses allowing for cancellation without significant penalty. (6) Includes asset retirement obligations and deferred compensation obligations. The amount excludes $27 of non-current unrecognized tax contingencies and $36 of other obligations due to uncertainty regarding the timing of future cash payments. Off-Balance Sheet Arrangements In the opinion of management, we have no off-balance sheet arrangements that have had or are reasonably likely to have a material current or future effect on our financial condition or financial statements, other than operating leases, included in the table above and discussed in Note 1 and Note 5 to the consolidated financial statements included in Item 8 of this Report. Critical Accounting Estimates The preparation of our consolidated financial statements in accordance with U.S. generally accepted accounting principles (U.S. GAAP) requires that we make estimates and assumptions that affect the reported amounts of assets and liabilities and the disclosure of contingent assets and liabilities at the date of the financial statements and the reported amounts of revenues and expenses during the reporting period. We base our estimates on historical experience and on assumptions that we believe to be reasonable, and we continue to review and evaluate these estimates. For further information on significant accounting policies, see discussion in Note 1 to the consolidated financial statements included in Item 8 of this Report. Insurance/Self-insurance Liabilities The Company is predominantly self-insured for employee health-care benefits, workers’ compensation, general liability, property damage, directors’ and officers’ liability, vehicle liability, and inventory loss. Insurance coverage is maintained in certain instances to seek to limit exposures arising from very large losses. We use different risk management mechanisms, including a wholly-owned captive insurance subsidiary, and participate in a reinsurance program. Liabilities associated with the risks that we retain are not discounted and are estimated by using historical claims experience, demographic factors, severity factors, and other actuarial assumptions. The costs of claims are highly unpredictable and can fluctuate as a result of inflation rates, regulatory or legal changes, and unforeseen developments in claims over time. While we believe our estimates are reasonable and provide for a certain degree of coverage to account for these variables, actual claims and costs could differ significantly from recorded liabilities. Historically, adjustments to our estimates have not been material. Income Taxes The determination of our provision for income taxes requires significant judgment, the use of estimates, and the interpretation and application of complex tax laws. Significant judgment also is required in assessing the timing and amounts of deductible and taxable items and the probability of sustaining uncertain tax positions. The benefits associated with uncertain tax positions are recorded only after determining a more-likely-than-not probability that the positions will withstand challenge from tax authorities. When facts and circumstances change, we reassess these positions and record any changes in the consolidated financial statements as appropriate. The 2017 Tax Act includes various provisions that significantly altered U.S. tax law, many of which impact our business (see Note 8 to the consolidated financial statements for further discussion). Recent Accounting Pronouncements See Note 1 to the consolidated financial statements included in Item 8 of this Report for a detailed description of recent accounting pronouncements.

<s>[INST] We believe that the most important driver of our profitability is sales growth, particularly comparable sales growth. We define comparable sales as sales from warehouses open for more than one year, including remodels, relocations and expansions, and sales related to ecommerce websites operating for more than one year. Comparable sales growth is achieved through increasing shopping frequency from new and existing members and the amount they spend on each visit (average ticket). Sales comparisons can also be particularly influenced by certain factors that are beyond our control: fluctuations in currency exchange rates (with respect to the consolidation of the results of our international operations); changes in the cost of gasoline and associated competitive conditions; and changes from the revenue recognition standard. The higher our comparable sales exclusive of these items, the more we can leverage certain of our selling, general and administrative expenses, reducing them as a percentage of sales and enhancing profitability. Generating comparable sales growth is foremost a question of making available to our members the right merchandise at the right prices, a skill that we believe we have repeatedly demonstrated over the long term. Another substantial factor in sales growth is the health of the economies in which we do business, including the effects of inflation or deflation, especially the United States. Sales growth and gross margins are also impacted by our competition, which is vigorous and widespread, across a wide range of global, national and regional wholesalers and retailers, including those with ecommerce operations. While we cannot control or reliably predict general economic health or changes in competition, we believe that we have been successful historically in adapting our business to these changes, such as through adjustments to our pricing and to our merchandise mix, including increasing the penetration of our privatelabel items, and through online offerings. Our philosophy is to provide our members with quality goods and services at competitive prices. We do not focus in the short term on maximizing prices charged, but instead seek to maintain what we believe is a perception among our members of our “pricing authority” on quality goods consistently providing the most competitive values. Our investments in merchandise pricing may include reducing prices on merchandise to drive sales or meet competition and holding prices steady despite cost increases instead of passing the increases on to our members, all negatively impacting gross margin as a percentage of net sales (gross margin percentage). We believe that our gasoline business draws members but it generally has a significantly lower gross margin percentage relative to our nongasoline business. A higher penetration of gasoline sales will generally lower our gross margin percentage. Rapidly changing gasoline prices may significantly impact our nearterm net sales growth. Generally, rising gasoline prices benefit net sales growth which, given the higher sales base, negatively impacts our gross margin percentage but decreases our selling, general and administrative (SG&A) expenses as a percentage of net sales. A decline in gasoline prices has the inverse effect. Additionally, actions in various countries, particularly China and the United States, have created uncertainty with respect to how tariffs will affect the costs of some of our merchandise. The degree of our exposure is dependent on (among other things) the type of goods, rates imposed, and timing of the tariffs. The impact to our net sales and gross margin will be influenced in part by our merchandising and pricing strategies in response to cost increases. While these potential impacts are uncertain, they could have an adverse impact on our results. We also achieve sales growth by opening new warehouses. As our warehouse base grows, available and desirable sites become more difficult to secure, and square footage growth becomes a comparatively less substantial component of growth. The negative aspects of such growth, however, including lower initial operating profitability relative to existing warehouses and cannibalization of sales at existing warehouses when openings occur in existing markets, are continuing to decline in significance as they relate to the results of our total operations. Our rate of square footage growth is generally higher in foreign markets, due to the smaller base in those markets, and we expect that to continue. Our ecommerce business growth, domestically and internationally, has also increased our sales. The membership format is an integral part of our business and has a significant effect on our profitability. This format is designed to reinforce member loyalty and provide continuing fee revenue. The extent to which we achieve growth in our membership base, increase the penetration of our Executive members, and sustain high renewal rates materially influences our [/INST] Negative. </s>

TORO CO

2015-12-23

2015-10-31

ITEM 7. MANAGEMENT'S DISCUSSION AND ANALYSIS OF FINANCIAL CONDITION AND RESULTS OF OPERATIONS This Management's Discussion and Analysis ("MD&A") provides material historical and prospective disclosures intended to enable investors and other readers to assess our financial condition and results of operations. Statements that are not historical are forward-looking and involve risks and uncertainties, including those discussed in Part I, Item 1A, "Risk Factors" and elsewhere in this report. These risks could cause our actual results to differ materially from any future performance suggested below. OVERVIEW We design, manufacture, and market professional turf maintenance equipment and services, turf irrigation systems, landscaping equipment and lighting, agricultural micro-irrigation systems, rental and specialty construction equipment, and residential yard and snow thrower products. Beginning in fiscal 2015 with our acquisition of BOSS®, we also design, manufacture, and market professional snow and ice management products. We sell our products worldwide through a network of distributors, dealers, hardware retailers, home centers, mass retailers, and over the Internet. Our businesses are organized into three reportable business segments: Professional, Residential, and Distribution. Our Distribution segment, which consists of our company-owned domestic distributorships, has been combined with our corporate activities and is shown as "Other." We strive to provide innovative, well-built, and dependable products supported by an extensive service network. A significant portion of our revenues has historically been, and we expect will continue to be, attributable to new and enhanced products. We define new products as those introduced in the current and previous two fiscal years. Summary of Fiscal 2015 Results In fiscal 2015, we achieved record net sales of $2,390.9 million and net earnings growth of 15.9 percent. Our fiscal 2015 results included the following items of significance: • On November 14, 2014, during the first quarter of fiscal 2015, we acquired substantially all of the assets of the BOSS professional snow and ice management business of privately held Northern Star Industries, Inc. BOSS designs, manufactures, markets, and sells a broad line of snowplows, salt and sand spreaders, and related parts and accessories for light and medium duty trucks, ATVs, UTVs, skid steers, and front-end loaders. Through this acquisition, we added another professional contractor brand; a portfolio of counter-seasonal equipment; manufacturing and distribution facilities located in Iron Mountain, Michigan; and a distribution network for these products. • Net sales for fiscal 2015 increased by 10.0 percent compared to fiscal 2014 to a record of $2,390.9 million. The acquisition of the BOSS business resulted in incremental net sales of $128.5 million for fiscal 2015. Additionally, the sales increase was primarily attributable to the successful introduction of new and enhanced products and increased sales of landscape contractor equipment and specialty construction products, partially offset by lower irrigation product sales. Unfavorable foreign currency exchange rate fluctuations decreased our net sales by approximately $47 million for fiscal 2015. • Professional segment net sales, which represented 69 percent of our total consolidated net sales in fiscal 2015, grew 11.0 percent in fiscal 2015 compared to fiscal 2014. The acquisition of the BOSS business resulted in incremental net sales of $128.5 million for fiscal 2015 for the professional segment. Shipments also increased due to the successful introduction of new and enhanced products, and continued growth and demand for our landscape contractor and specialty equipment products. However, sales of irrigation products were down primarily due to unfavorable weather conditions in key markets. • Our residential segment net sales increased 7.9 percent in fiscal 2015 compared to fiscal 2014 primarily due to strong shipments and demand for our newly introduced zero-turn radius riding and walk power mower products and expanded product placement. However, residential segment net sales in Australia were down due to unfavorable foreign currency exchange rate changes. • International net sales for fiscal 2015 decreased by 1.9 percent compared to fiscal 2014 due to changes in foreign currency exchange rates that reduced our total net sales by approximately $47 million in fiscal 2015. International net sales comprised 25.5 percent of our total consolidated net sales in fiscal 2015 compared to 28.7 percent in fiscal 2014 and 30.1 percent in fiscal 2013. These declines were primarily the result of foreign currency exchange rate changes. In addition, we experienced a decline in fiscal 2015 due to the acquisition of the BOSS business as such products are sold primarily in domestic markets. • Fiscal 2015 net earnings of $201.6 million increased 15.9 percent compared to fiscal 2014, and diluted net earnings per share increased 17.5 percent to $3.55 in fiscal 2015 compared to $3.02 in fiscal 2014. • Gross margin was 35.0 percent in fiscal 2015, a decrease of 60 basis points from 35.6 percent in fiscal 2014. This decline was mainly the result of unfavorable foreign currency exchange rate changes. • Although selling, general, and administrative ("SG&A") expense was up 5.2 percent in fiscal 2015 compared to fiscal 2014, SG&A expense as a percentage of net sales in fiscal 2015 was down 100 basis points to 22.5 percent compared to 23.5 percent in fiscal 2014, reflecting further leveraging of our SG&A costs over higher sales volumes. • Receivables increased by 11.9 percent as of the end of fiscal 2015 compared to the end of fiscal 2014 as a result of higher sales volumes and incremental receivables from the acquisition of the BOSS business. Our inventory levels were up by 21.8 percent as of the end of fiscal 2015 compared to the end of fiscal 2014 mainly due to incremental inventory from the acquisition of the BOSS business, higher snow thrower product inventory, and increased inventory levels of certain residential segment and landscape contractor equipment products. Additionally, average inventory levels during fiscal 2015 compared to fiscal 2014 were up as we built inventory in anticipation of strong demand for new products, including products impacted by the continued phase-in of applicable Tier 4 diesel engine emission requirements and other regulations in Europe, as well as incremental inventory from the acquisition of the BOSS business. Average net working capital (accounts receivable plus inventory less trade payables) as a percent of net sales was 16.0 percent as of the end of fiscal 2015 compared to 15.1 percent as of the end of fiscal 2014. Our domestic field inventory levels were up as of the end of fiscal 2015 compared to the end of fiscal 2014 due, in part, to strong shipments of new products and anticipated retail demand for our products in fiscal 2016. • We continued our history of paying quarterly cash dividends in fiscal 2015. We increased our fiscal 2015 quarterly cash dividend by 25 percent to $0.25 per share compared to our quarterly cash dividend in fiscal 2014 of $0.20 per share. • Our stock repurchase program returned $107 million to our shareholders during fiscal 2015, which reduced our number of shares outstanding. This reduction resulted in a benefit to our diluted net earnings per share of $0.05 per share in fiscal 2015 compared to fiscal 2014. Destination PRIME Our current multi-year initiative, "Destination PRIME," began our journey into our second century. Similar to our previous Destination 2014 initiative, this three-year initiative is intended to help us drive revenue and earnings growth and further improve productivity, while also continuing our century-long commitment to innovation, relationships, and excellence. Through our Destination PRIME initiative, we will strive to achieve our goals by pursuing a progression of milestones for organic revenue growth, operating earnings, and working capital. Organic Revenue Growth. We intend to pursue strategic growth of our existing businesses and product categories with an annual organic revenue growth goal. The organic revenue growth goal of our Destination PRIME initiative is to achieve at least five percent organic revenue growth each fiscal year of this initiative. We define organic revenue growth as the increase in net sales, less net sales from acquisitions that occurred in the prior twelve-month period. In fiscal 2015, we fell short of this goal by achieving 4.1 percent organic revenue growth. Operating Earnings Growth. The operating earnings goal is to raise operating earnings as a percentage of net sales to 13 percent or higher by the end of fiscal 2017. In fiscal 2015, we made progress towards this goal as we realized 12.5 percent of operating earnings as a percentage of net sales. Working Capital. The working capital goal of our Destination PRIME initiative is to drive down average net working capital as a percentage of net sales to 13 percent or lower by the end of fiscal 2017. In fiscal 2015, our average net working capital as a percentage of net sales was 16.0 percent. Outlook for Fiscal 2016 As we move into fiscal 2016, we intend to build on the positive momentum from fiscal 2015 and continue with our commitment to providing an array of innovative products and services to customers around the world. We expect to focus on capitalizing market opportunities and driving profitability with investments aimed at generating customer demand and gaining market share. We believe our fiscal 2016 financial performance will include, among many others, the following main factors: • We anticipate fiscal 2016 net sales in our professional segment to increase compared to fiscal 2015 due, in part, to the momentum of demand generated by the positive reception of our landscape contractor equipment products introduced in fiscal 2015, as well as continued growth in the landscape contractor market. We also expect continued growth in the rental equipment market and strong demand for new rental and specialty construction equipment products. Sales in the golf and grounds and irrigation markets are expected to slightly increase in fiscal 2016 as compared to fiscal 2015, as we also anticipate continued positive customer response generated from new products. Precision irrigation products remain a long-term focus for us as continued market growth and demand for efficient watering solutions is expected to drive demand for our products. We expect our increased manufacturing capacity and infrastructure that expanded our market presence for micro-irrigation products to contribute to our anticipated sales growth of micro-irrigation products in fiscal 2016. We also expect our residential segment net sales in fiscal 2016 to be similar to our sales volumes in fiscal 2015 as we anticipate positive momentum to continue in fiscal 2016 from new products released in fiscal 2015. • We intend to continue to focus on our international markets to grow revenues, and our long-term goal is for our international sales to comprise a larger percentage of our total consolidated net sales. We plan to continue investing in new products with a worldwide focus and leverage our infrastructure around the world, connecting us more closely to our customers and increasing our global presence. However, uncertainty with the economies of key international markets is expected to linger into fiscal 2016, which may hamper our international net sales growth. We expect international net sales to be slightly up in fiscal 2016 compared to fiscal 2015 unless foreign currency exchange rates further decline, which could adversely affect our international net sales in fiscal 2016. • We expect net earnings and diluted net earnings per share to be up in fiscal 2016 compared to fiscal 2015, driven mainly by our anticipated sales growth, improvement in our gross margin rate, and continued leveraging of our SG&A costs. Additionally, we anticipate a further reduction in our diluted shares outstanding due to anticipated continued repurchases of our common stock. • As announced on December 3, 2015, our Board of Directors increased our fiscal 2016 first quarter cash dividend by 20 percent to $0.30 per share compared to the quarterly cash dividend paid in the first quarter of fiscal 2015 and authorized the repurchase of up to an additional 4,000,000 shares of our common stock in open-market or in privately negotiated transactions. • In fiscal 2015, our average net working capital was higher than our expectations. Therefore, in fiscal 2016, we plan to place increased emphasis on improving asset utilization with a focus on reducing the amount of working capital in the supply chain. We anticipate our average net working capital as a percentage of net sales in fiscal 2016 to decrease as compared to fiscal 2015, in part, as we continue to transition certain receivables to our Red Iron joint venture. Additionally, we also anticipate average inventory levels to be lower in fiscal 2016 compared to fiscal 2015. RESULTS OF OPERATIONS Fiscal 2015 net earnings were $201.6 million compared to $173.9 million in fiscal 2014, an increase of 15.9 percent. Fiscal 2015 diluted net earnings per share were $3.55, an increase of 17.5 percent from $3.02 per share in fiscal 2014. The primary factors contributing to the net earnings improvement were higher net sales, leveraging fixed SG&A costs over higher sales volumes, and a decrease in our effective tax rate. However, these improvements were partially offset by a decline in our gross margin rate and an increase in interest expense. Our net earnings per diluted share were also benefited by $0.05 per share in fiscal 2015 compared to fiscal 2014 as a result of reduced shares outstanding from repurchases of our common stock. Fiscal 2014 net earnings were $173.9 million compared to $154.8 million in fiscal 2013, an increase of 12.3 percent. Fiscal 2014 diluted net earnings per share were $3.02, an increase of 15.3 percent from $2.62 per share in fiscal 2013. The primary factors contributing to the net earnings improvement were higher net sales, a slight increase in gross profit, and leveraging fixed SG&A costs over higher sales volumes. However, these increases were partially offset by a reduction in other income and a higher effective tax rate. Our net earnings per diluted share were also benefited by $0.08 per share in fiscal 2014 compared to fiscal 2013 as a result of reduced shares outstanding from repurchases of our common stock. The following table summarizes our results of operations as a percentage of our consolidated net sales. Fiscal 2015 Compared With Fiscal 2014 Net Sales. Worldwide net sales in fiscal 2015 were $2,390.9 million compared to $2,172.7 million in fiscal 2014, an increase of 10.0 percent. This net sales change was attributable to the following factors: • Increased sales of professional segment products driven by the acquisition of the BOSS business resulted in incremental net sales of $128.5 million for fiscal 2015. In addition, our professional segment net sales were positively impacted by higher shipments of landscape contractor and specialty equipment products due to continued market growth and increased demand for our innovative product offerings and newly introduced products. However, sales of irrigation products were down primarily due to unfavorable weather conditions in key markets, and sales of micro-irrigation products were lower due to unfavorable foreign currency exchange rates and continued adverse political and economic conditions in key international markets. • Increased sales of residential segment products due to strong shipments and demand for our newly introduced zero-turn radius riding and walk power mower products and expanded product placement. However, residential segment net sales in Australia were down due to unfavorable foreign currency exchange rate changes. • Our overall net sales in international markets slightly decreased by 1.9 percent in fiscal 2015 compared to fiscal 2014 due to unfavorable foreign currency exchange rate fluctuations that reduced our total net sales by approximately $47 million in fiscal 2015. Gross Margin. Gross margin represents gross profit (net sales less cost of sales) as a percentage of net sales. See Note 1 of the Notes to Consolidated Financial Statements, in the section entitled "Cost of Sales," for a description of expenses included in cost of sales. Gross margin decreased by 60 basis points to 35.0 percent in fiscal 2015 from 35.6 percent in fiscal 2014. This decline was mainly the result of the following factors: • Unfavorable foreign currency exchange rate movements. • Purchase accounting impact of the incremental charge for the sale of inventory that was written-up to fair value as a result of the acquisition of the BOSS business. Somewhat offsetting those negative factors were: • Improved price realization. • Costs for a supplier component rework issue that impacted certain walk power mowers in fiscal 2014 that was not repeated in fiscal 2015. Selling, General, and Administrative Expense. SG&A expense increased $26.7 million, or 5.2 percent, in fiscal 2015 compared to fiscal 2014. See Note 1 of the Notes to Consolidated Financial Statements, in the section entitled "Selling, General, and Administrative Expense," for a description of expenses included in SG&A expense. SG&A expense rate represents SG&A expense as a percentage of net sales. SG&A expense rate in fiscal 2015 decreased 100 basis points to 22.5 percent compared to 23.5 percent in fiscal 2014 due to fixed SG&A costs spread over higher sales volumes. However, the increase in SG&A expense of $26.7 million was driven mainly by the following factors: • Incremental SG&A expense of $19 million from the BOSS business. • Increased administrative expenses of $7 million. • Continued investments in engineering and new product development that resulted in higher expense of $2 million. Interest Expense. Interest expense for fiscal 2015 increased $3.3 million compared to fiscal 2014 due to higher levels of debt as a result of borrowings that were used to pay the purchase price for the BOSS business. Other Income, Net. Other income, net consists mainly of our proportionate share of income or losses from equity investments (affiliates), currency exchange rate gains and losses, litigation settlements and recoveries, interest income, and retail financing revenue. Other income for fiscal 2015 was $10.7 million compared to $8.7 million in fiscal 2014, an increase of $2.0 million. This increase in other income, net was primarily due to higher earnings from our equity investment in Red Iron of $1.1 million and lower foreign currency exchange rate losses of $0.7 million in fiscal 2015 compared to fiscal 2014. Provision for Income Taxes. The effective tax rate for fiscal 2015 was 30.7 percent compared to 32.2 percent in fiscal 2014. The decrease in the effective tax rate was attributable to the benefit in the first quarter of fiscal 2015 for the retroactive re-enactment of the federal research credit for calendar 2014 and higher earnings in lower tax jurisdictions. Based on information available as of this filing, including the permanent extension of the federal research credit, we anticipate our fiscal 2016 tax rate to be slightly lower than our fiscal 2015 tax rate. Fiscal 2014 Compared With Fiscal 2013 Net Sales. Worldwide net sales in fiscal 2014 were $2,172.7 million compared to $2,041.4 million in fiscal 2013, an increase of 6.4 percent. This net sales improvement was attributable to the following factors: • Increased sales of professional segment products due to strong demand for landscape contractor equipment, demand for our drip irrigation solutions in agricultural markets, and the successful introduction of new and enhanced products that were well received by customers, including products in the golf market and rental and specialty construction equipment market. Additionally, improved price realization, as well as incremental sales from acquisitions of $2.8 million, contributed to our net sales growth in fiscal 2014.• Increased sales of residential segment products due to strong shipments and demand for snow thrower products and parts as a result of heavy snow falls during the 2013-2014 snow season in key markets and strong preseason demand for the 2014-2015 snow season. Additionally, higher shipments and demand for our zero-turn radius riding mowers and increased sales of electric trimmers and blowers contributed to our sales growth. However, residential segment net sales in Australia were down due to unfavorable weather conditions and foreign currency exchange rate changes.• Our overall net sales in international markets slightly increased by 1.2 percent in fiscal 2014 compared to fiscal 2013. However, changes in foreign currency exchange rates reduced our total net sales by approximately $5 million in fiscal 2014. Gross Margin. Gross margin slightly increased by 10 basis points to 35.6 percent in fiscal 2014 from 35.5 percent in fiscal 2013. This improvement was mainly the result of the following factors: • Improved price realization. • Cost reduction efforts from productivity and process improvement initiatives. Somewhat offsetting those positive factors were: • Lower proportion of professional segment sales that carry higher average gross margins than our residential segment. • Unfavorable foreign currency exchange rate movements. • Slightly higher prices paid for commodities in fiscal 2014 compared to fiscal 2013, mainly for steel and resins. • Costs for a supplier component rework issue that impacted certain walk power mowers. Selling, General, and Administrative Expense. SG&A expense increased $16.0 million, or 3.2 percent, in fiscal 2014 compared to fiscal 2013. SG&A expense rate in fiscal 2014 decreased 70 basis points to 23.5 percent compared to 24.2 percent in fiscal 2013 due to fixed SG&A costs spread over higher sales volumes. However, the increase in SG&A expense of $16.0 million was driven mainly by the following factors: • Increased sales and marketing expense of $6 million. • Investments in engineering and new product development that resulted in higher expense of $5 million. • Higher incentive compensation expense of $4 million as a result of improved financial performance. • Incremental costs from acquisitions of approximately $2 million. Somewhat offsetting those increases in SG&A expense was a decline in product liability expense of $2 million from favorable claims experience. Interest Expense. Interest expense for fiscal 2014 decreased by 4.8 percent compared to fiscal 2013 as a result of higher capitalized interest from capital projects. Other Income, Net. Other income for fiscal 2014 was $8.7 million compared to $12.3 million in fiscal 2013, a decrease of $3.5 million. This decrease in other income, net was primarily due to recovery for a litigation settlement of $3 million in fiscal 2013 that was not duplicated in fiscal 2014 and higher foreign currency exchange rate losses of $0.3 million in fiscal 2014 compared to fiscal 2013. Provision for Income Taxes. The effective tax rate for fiscal 2014 was 32.2 percent compared to 31.7 percent in fiscal 2013. The increase in the effective tax rate was attributable to the benefit in fiscal 2013 for the retroactive reenactment of the domestic research tax credit, which expired on December 31, 2013. This increase was partially offset by a discrete benefit relating to the change in tax accounting method filed that allowed us to recoup basis for previously disposed assets and changes in the mix of international earnings. PERFORMANCE BY BUSINESS SEGMENT As more fully described in Note 12 of the Notes to Consolidated Financial Statements, we operate in three reportable business segments: Professional, Residential, and Distribution. Our Distribution segment, which consists of our company-owned domestic distributorships, has been combined with our corporate activities and is shown as "Other." Operating earnings for our Professional and Residential segments are defined as earnings from operations plus other income, net. Operating loss for the Other segment includes earnings (loss) from our wholly owned domestic distribution companies, corporate activities, other income, and interest expense. The following information provides perspective on our business segments' net sales and operating results. Professional Professional segment net sales represented 69 percent of consolidated net sales for fiscal 2015, 68 percent for fiscal 2014, and 70 percent for fiscal 2013. The following table shows the professional segment net sales, operating earnings, and operating earnings as a percent of net sales. Net Sales. Worldwide net sales for the professional segment in fiscal 2015 were up by 11.0 percent compared to fiscal 2014 primarily as a result of the following factors: • Incremental sales from the acquisition of the BOSS business of $128.5 million. • Higher shipments of landscape contractor equipment, including new and enhanced products, as contractors continued to invest in turf maintenance equipment. • Increased sales driven by strong demand and market growth for rental and specialty construction equipment, as well as positive customer response for new products we introduced in that market. Somewhat offsetting those positive factors were: • Unfavorable foreign currency exchange rate fluctuations. • A decline in sales of irrigation products due to unfavorable weather conditions in key markets. • Lower sales of micro-irrigation products due to unfavorable foreign currency exchange rate fluctuations and continued adverse political and economic conditions in key international markets. Our domestic field inventory levels of our professional segment products were higher as of the end of fiscal 2015 compared to the end of fiscal 2014 due, in part, to strong sales from new product introductions and anticipated retail demand. Worldwide net sales for the professional segment in fiscal 2014 were up by 3.7 percent compared to fiscal 2013 primarily as a result of the following factors: • Strong sales and demand for landscape contractor equipment, including new and enhanced products, as contractors invested in turf maintenance equipment. • Higher global sales of our micro-irrigation products from market growth and demand for more efficient watering solutions for agriculture. • Increased golf product sales mainly due to the successful introduction of new and enhanced products, such as our new INFINITY® sprinklers, that were well received by customers, as well as new international golf course projects. • Increased sales and demand for rental and specialty construction equipment, including products that we introduced under the Toro brand. • Improved price realization and incremental sales of $2.8 million from acquisitions. Operating Earnings. Operating earnings for the professional segment in fiscal 2015 increased 11.5 percent compared to fiscal 2014 primarily due to higher sales volumes. Expressed as a percentage of net sales, professional segment operating margins slightly increased by 10 basis points to 18.8 percent in fiscal 2015 compared to 18.7 percent in fiscal 2014. The following factors impacted professional segment operating earnings as a percentage of net sales for fiscal 2015: • Lower gross margin in fiscal 2015 compared to fiscal 2014 mainly due to unfavorable foreign currency exchange rate movements and the purchase accounting impact for the acquisition of the BOSS business, as previously discussed. • A decline in SG&A expense rate in fiscal 2015 compared to fiscal 2014 due to further leveraging fixed SG&A costs over higher sales volumes. Operating earnings for the professional segment in fiscal 2014 increased 8.6 percent compared to fiscal 2013 primarily due to higher sales volumes and an improvement in gross margin. Expressed as a percentage of net sales, professional segment operating margins increased 80 basis points to 18.7 percent in fiscal 2014 compared to 17.9 percent in fiscal 2013. The following factors impacted professional segment operating earnings as a percentage of net sales for fiscal 2014: • Higher gross margin in fiscal 2014 compared to fiscal 2013 as a result of improved price realization and cost reduction efforts. • A decline in SG&A expense rate in fiscal 2014 compared to fiscal 2013 due to leveraging fixed SG&A costs over higher sales volumes. Residential Residential segment net sales represented 30 percent of consolidated net sales for fiscal 2015, 31 percent for fiscal 2014, and 29 percent for fiscal 2013. The following table shows the residential segment net sales, operating earnings, and operating earnings as a percent of net sales. Net Sales. Worldwide net sales for the residential segment in fiscal 2015 were up by 7.9 percent compared to fiscal 2014 primarily as a result of the following factors: • Increased shipments driven by strong retail demand and additional product placement for our new platform of zero-turn radius riding mowers. • Higher sales of walk power mowers due to enhanced product placement and increased demand for our product offerings, including our new all-wheel drive model. Somewhat offsetting the increase in residential segment net sales was a decline in sales in Australia from unfavorable foreign currency exchange rate fluctuations. Our domestic field inventory levels of our residential segment products were higher as of the end of fiscal 2015 compared to the end of fiscal 2014 due to the introduction of new products and anticipated retail demand for those new products. Additionally, field inventory levels of snow thrower products were up as a result of anticipated strong retail demand for the 2015-2016 winter season. Worldwide net sales for the residential segment in fiscal 2014 were up by 13.1 percent compared to fiscal 2013 primarily as a result of the following factors: • Strong shipments and demand for snow thrower products and parts as a result of heavy snow falls during the 2013-2014 snow season in key markets and strong preseason demand for the 2014-2015 snow season. • Increased sales and demand of zero-turn radius riding products, including our enhanced products, as customers continued to transition to this mowing platform. • Higher sales of electric handheld products due to additional product placement at mass retailers and favorable weather conditions. • A slight increase in sales of walk power mowers due to the positive customer response to new products and expanded product placement for certain models, which was partially offset by the late arrival of spring weather conditions and a supplier-related rework that hampered sales in fiscal 2014. Somewhat offsetting the increase in residential segment net sales was a decline in sales in Australia from unfavorable weather conditions, as well as unfavorable foreign currency exchange rate fluctuations. Operating Earnings. Operating earnings for the residential segment in fiscal 2015 increased 10.5 percent compared to fiscal 2014. Expressed as a percentage of net sales, residential segment operating margins increased 30 basis points to 11.7 percent in fiscal 2015 compared to 11.4 percent in fiscal 2014. The following factors impacted residential segment operating earnings: • Lower gross margins primarily from unfavorable foreign currency exchange rate fluctuations and increased manufacturing expenses. • Lower SG&A expense rate attributable to further leveraging of fixed SG&A costs over higher sales volumes. Operating earnings for the residential segment in fiscal 2014 increased 24.0 percent compared to fiscal 2013. Expressed as a percentage of net sales, residential segment operating margins increased 100 basis points to 11.4 percent in fiscal 2014 compared to 10.4 percent in fiscal 2013. The following factors impacted residential segment operating earnings: • Slightly lower gross margins from higher commodity prices and costs related to a supplier component rework issue in fiscal 2014, partially offset by production efficiencies on increased sales volumes. • Lower SG&A expense rate attributable to leveraging fixed SG&A costs over higher sales volumes. Other Other segment net sales, which includes our company-owned domestic distributors, represented 1 percent of consolidated net sales for each of fiscal 2015, 2014, and 2013. The following table shows the other segment net sales and operating losses. Net Sales. Net sales for the other segment includes sales from our wholly owned domestic distribution companies less sales from the professional and residential segments to those distribution companies. The other segment net sales in fiscal 2015 were up by $2.8 million compared to fiscal 2014 due to higher sales volumes driven by strong demand for golf and grounds equipment at our company-owned distribution companies. The other segment net sales in fiscal 2014 were up by $0.9 million compared to fiscal 2013 due to higher sales volumes at our company-owned distribution companies. Operating Loss. Operating loss for the other segment in fiscal 2015 increased by 5.3 percent compared to fiscal 2014. This loss increase was primarily attributable to an increase in interest expense and higher administrative expenses. Operating loss for the other segment in fiscal 2014 increased by 7.8 percent compared to fiscal 2013. This loss increase was primarily attributable to higher incentive compensation expense, higher foreign currency exchange rate losses, and recovery for a litigation settlement in fiscal 2013 that was not duplicated in fiscal 2014. FINANCIAL CONDITION Working Capital During fiscal 2015, our average net working capital (accounts receivable plus inventory less trade payables) as a percentage of net sales increased primarily from higher average inventory levels. As of the end of fiscal 2015, our average net working capital increased to 16.0 percent compared to 15.1 percent as of the end of fiscal 2014. The following table highlights several key measures of our working capital performance. The following factors impacted our working capital: • Average net receivables increased by 5.7 percent in fiscal 2015 compared to fiscal 2014 as a result of higher sales volumes and incremental receivables from the acquisition of the BOSS business. Our average days outstanding for receivables decreased to 33.6 days in fiscal 2015 compared to 35.0 days in fiscal 2014. • Average inventories increased by 16.3 percent in fiscal 2015 compared to fiscal 2014. Inventory levels as of the end of fiscal 2015 compared to the end of fiscal 2014 were up by $59.9 million, or 21.8 percent, due to incremental inventory of $17.2 million from the acquisition of the BOSS business, higher inventory levels of snow thrower products in anticipation of strong seasonal demand, and increased inventory of certain residential segment mowers and landscape contractor equipment as we built product earlier compared to last fiscal year. • Average accounts payable increased by 4.7 percent in fiscal 2015 compared to fiscal 2014 mainly due to higher volume of purchases from increased sales and demand in fiscal 2015 compared to fiscal 2014. In fiscal 2016, we plan to place increased emphasis on improving asset utilization with a focus on reducing the amount of working capital in the supply chain. We anticipate our average net working capital as a percentage of net sales in fiscal 2016 to decrease as compared to fiscal 2015 as we continue to transition certain receivables to our Red Iron joint venture. Additionally, we also anticipate average inventory levels to be lower in fiscal 2016 compared to fiscal 2015 due to expected improvements in our supply chain from increased focus and efforts on reducing working capital. Capital Expenditures and Other Long-Term Assets Fiscal 2015 capital expenditures of $56.4 million were lower by $14.8 million compared to fiscal 2014. This decrease was primarily attributable to the construction in fiscal 2014 for our expanded new corporate facility located in Bloomington, Minnesota, partially offset by capital expenditures in fiscal 2015 for the renovation of our original corporate facility to accommodate additional expansion needs for our product development and test capacities. Capital expenditures for fiscal 2016 are planned to be approximately $70 million as we expect to continue the renovation of our original corporate facility to accommodate additional expansion needs for our product development and test capacities. During fiscal 2016, we also plan to invest in new product tooling, new technology in production processes and equipment, replacement production equipment, and investments in new and existing facilities. Long-term assets as of October 31, 2015 were $593.0 million compared to $368.4 million as of October 31, 2014, an increase of $224.6 million. This increase was mainly attributable to the addition of intangible assets and goodwill from the acquisition of the BOSS business. Included in long-term assets as of October 31, 2015 was goodwill in the amount of $195.5 million. Based on our annual impairment analysis, we determined there was no goodwill impairment for any of our reporting units as their related fair values were substantially in excess of their carrying values. Cash Flow Cash flows provided by (used in) operating, investing, and financing activities during the past three fiscal years are shown in the following table. Cash Flows From Operating Activities. Our primary source of funds is cash generated from operations. In fiscal 2015, cash provided by operating activities increased $54.5 million, or 29.9 percent, from fiscal 2014. This increase was mainly due to higher net earnings and a smaller increase in working capital needs, as well as higher accounts payable and accrued liabilities as of the end of fiscal 2015 compared to fiscal 2014. In fiscal 2014, cash provided by operating activities decreased $39.5 million, or 17.8 percent, from fiscal 2013. This decrease was due to cash utilized for increased working capital needs, mainly as a result of an increase in inventory levels and a decline in accounts payable, partially offset by higher net earnings. Cash Flows From Investing Activities. Capital expenditures and acquisitions are a significant use of our capital resources. These investments are intended to enable sales growth in new and expanding markets, help us to meet product demand, and increase our manufacturing efficiencies and capacity. Cash used in investing activities in fiscal 2015 increased $184.6 million from fiscal 2014 due to cash utilized for the acquisition of the BOSS business, partially offset by lower purchases of property, plant, and equipment. Cash used in investing activities in fiscal 2014 increased $20.9 million, or 46.7 percent, from fiscal 2013 mainly due to higher purchases of property, plant, and equipment, including our corporate facility, as previously discussed. Cash Flows From Financing Activities. Cash used in financing activities in fiscal 2015 was $173.4 million compared to cash provided by financing activities of $17.0 million in fiscal 2014. The increase in cash used in financing activities was mainly due to repayments of debt in fiscal 2015 compared to cash received from borrowings of debt in fiscal 2014. Additionally, an increase in cash dividends paid on our common stock and higher amounts of cash utilized for stock repurchases in fiscal 2015 compared to fiscal 2014 contributed to our increase in cash used in financing activities. Cash provided by financing activities was $17.0 million in fiscal 2014 compared to cash used in financing activities of $118.3 million in fiscal 2013. The increase in cash provided by financing activities included an increase in short-term and long-term debt, partially offset by higher amounts of cash paid for dividends and stock repurchases in fiscal 2014 compared to fiscal 2013. Cash and Cash Equivalents. Cash and cash equivalents as of the end of fiscal 2015 were lower by $188.6 million compared to the end of fiscal 2014. In late fiscal 2014, our cash balances reflected the borrowings under our revolving credit facility, including $130.0 million of additional cash received under a term loan that was utilized for the purchase of the BOSS business early in the first quarter of fiscal 2015. Liquidity and Capital Resources Our businesses are seasonally working capital intensive and require funding for purchases of raw materials used in production, replacement parts inventory, payroll and other administrative costs, capital expenditures, establishment of new facilities, expansion and renovation of existing facilities, as well as for financing receivables from customers that are not financed with Red Iron. Our accounts receivable balances historically increase between January and April as a result of typically higher sales volumes and extended payment terms made available to our customers, and typically decrease between May and December when payments are received. We believe that the funds available through existing financing arrangements and forecasted cash flows will be sufficient to provide the necessary capital resources for our anticipated working capital needs, capital expenditures, investments, debt repayments, quarterly cash dividend payments, and stock repurchases for at least the next twelve months. As of October 31, 2015, cash and short-term investments held by our foreign subsidiaries that are not available to fund domestic operations unless repatriated were $61.3 million. We currently do not intend to repatriate this cash held by our foreign subsidiaries; however, if circumstances changed and these funds were needed for our U.S. operations, we would be required to accrue and pay U.S. taxes to repatriate these funds. Determination of the unrecognized deferred tax liability related to these earnings is not practicable because of the complexities with its hypothetical calculation. Seasonal cash requirements are financed from operations, cash on hand, and with short-term financing arrangements, including our $150.0 million unsecured senior five-year revolving credit facility that expires in October 2019. Included in our $150.0 million revolving credit facility is a $20.0 million sublimit for standby letters of credit and a $20.0 million sublimit for swingline loans. At our election, and with the approval of the named borrowers on the revolving credit facility, the aggregate maximum principal amount available under the facility may be increased by an amount up to $100.0 million in aggregate. Funds are available under the revolving credit facility for working capital, capital expenditures, and other lawful purposes, including, but not limited to, acquisitions and stock repurchases. Interest expense on this credit line is determined based on a LIBOR rate (or other rates quoted by the Administrative Agent, Bank of America, N.A.) plus a basis point spread defined in the credit agreement. In addition, our non-U.S. operations maintain unsecured short-term lines of credit in the aggregate amount of approximately $11.1 million. These facilities bear interest at various rates depending on the rates in their respective countries of operation. As of October 31, 2015, we had no outstanding short-term debt under these lines of credit compared to $20.8 million outstanding short-term debt as of October 31, 2014. Our short-term debt outstanding as of October 31, 2014 was due to borrowings under our credit facility for cash required to close the acquisition of the BOSS business early in the first quarter of fiscal 2015. As of October 31, 2015, we had $13.9 million of outstanding letters of credit and $147.2 million of unutilized availability under our credit agreements. Additionally, as of October 31, 2015, we had $378.0 million outstanding in long-term debt that includes $100 million in aggregate principal amount of 7.8% debentures due June 15, 2027, $125.0 million in aggregate principal amount of 6.625% senior notes due May 1, 2037, $30.0 million in aggregate principal amount due to the former owners of the BOSS business, and $123.5 million in an outstanding term loan. The term loan bears interest based on a LIBOR rate (or other rates quoted by the Administrative Agent, Bank of America, N.A.) plus a basis point spread defined in the credit agreement. The term loan can be repaid in part or in full at any time without penalty, but in any event must be paid in full by October 2019. Our revolving and term loan credit facility contains standard covenants, including, without limitation, financial covenants, such as the maintenance of minimum interest coverage and maximum debt to earnings ratios; and negative covenants, which among other things, limit loans and investments, disposition of assets, consolidations and mergers, transactions with affiliates, restricted payments, contingent obligations, liens, and other matters customarily restricted in such agreements. Most of these restrictions are subject to certain minimum thresholds and exceptions. Under the revolving credit facility, we are not limited in the amount for payments of cash dividends and stock repurchases as long as our debt to EBITDA ratio from the previous quarter compliance certificate is less than or equal to 3.25, provided that immediately after giving effect of any such proposed action, no default or event of default would exist. As of October 31, 2015, we were not limited in the amount for payments of cash dividends and stock repurchases. We were in compliance with all covenants related to our credit agreement for our revolving credit facility as of October 31, 2015, and we expect to be in compliance with all covenants during fiscal 2016. If we were out of compliance with any debt covenant required by this credit agreement following the applicable cure period, the banks could terminate their commitments unless we could negotiate a covenant waiver from the banks. In addition, our long-term senior notes, debentures, term loan, and any amounts outstanding under the revolving credit facility could become due and payable if we were unable to obtain a covenant waiver or refinance our short-term debt under our credit agreement. If our credit rating falls below investment grade and/or our average debt to EBITDA ratio rises above 1.50, the basis point spread over LIBOR (or other rates quoted by the Administrative Agent, Bank of America, N.A.) we currently pay on outstanding debt under the credit agreement would increase. However, the credit commitment could not be cancelled by the banks based solely on a ratings downgrade. Our debt rating for long-term unsecured senior, non-credit enhanced debt was unchanged during fiscal 2015 by Standard and Poor's Ratings Group at BBB and by Moody's Investors Service at Baa3. Capital Structure The following table details the components of our total capitalization and debt-to-capitalization ratio. Our debt-to-capitalization ratio decreased in fiscal 2015 compared to fiscal 2014 mainly due to an increase in stockholders' equity from higher net earnings partially offset by an increase in dividends paid and repurchases of our common stock in fiscal 2015 as compared to fiscal 2014. Cash Dividends Each quarter in fiscal 2015, our Board of Directors declared a cash dividend of $0.25 per share, which was a 25 percent increase over our cash dividend of $0.20 per share paid each quarter in fiscal 2014. As announced on December 3, 2015, our Board of Directors increased our fiscal 2016 first quarter cash dividend by 20 percent to $0.30 per share from the quarterly cash dividend paid in the first quarter of fiscal 2015. Share Repurchase Plan During fiscal 2015, we continued repurchasing shares of our common stock in the open market, thereby reducing our shares outstanding. In addition, our repurchase program provided shares for use in connection with our equity compensation plans. As of October 31, 2015, 1,159,314 shares remained available for repurchase under our Board authorization. We expect to continue repurchasing shares of our common stock in fiscal 2016, depending upon market conditions. As announced on December 3, 2015, our Board of Directors authorized the repurchase of up to an additional 4,000,000 shares of our common stock in open-market or in privately negotiated transactions. This repurchase program has no expiration date but may be terminated by the Board at any time. The following table provides information with respect to repurchases of our common stock during the past three fiscal years. 1Does not include shares of our common stock surrendered by employees to satisfy minimum tax withholding obligations upon vesting of restricted stock granted under our stock-based compensation plans. Customer Financing Arrangements Wholesale Financing. We are party to a joint venture with TCFIF, established as Red Iron, the purpose of which is to provide inventory financing, including floor plan and open account receivable financing, to distributors and dealers of our products in the U.S. and select distributors of our products in Canada that enables them to carry representative inventories of our products. Under a separate arrangement, TCFCFC provides inventory financing to dealers of our products in Canada. In late fiscal 2015, Red Iron also began providing inventory financing to a majority of our BOSS distributors and dealers. Under these financing arrangements, down payments are not required and, depending on the finance program for each product line, finance charges are incurred by us, shared between us and the distributor and/or the dealer, or paid by the distributor or dealer. Red Iron retains a security interest in the distributors' and dealers' financed inventories, and those inventories are monitored regularly. Floor plan terms to the distributors and dealers require payment as the equipment, which secures the indebtedness, is sold to customers or when payment terms become due, whichever occurs first. Rates are generally indexed to LIBOR plus a fixed percentage that differs based on whether the financing is for a distributor or dealer. Rates may also vary based on the product that is financed. Red Iron financed $1,430.9 million of new receivables for dealers and distributors during fiscal 2015, of which $367.2 million was outstanding as of October 31, 2015. Some independent international dealers continue to finance their products with a third party financing company. This third party financing company purchased $25.0 million of receivables from us during fiscal 2015, of which $10.6 million was outstanding as of October 31, 2015. We also enter into limited inventory repurchase agreements with third party financing companies and Red Iron for receivables financed by them. As of October 31, 2015, we were contingently liable to repurchase up to a maximum amount of $10.0 million of inventory related to receivables under these financing arrangements. We have repurchased immaterial amounts of inventory from third party financing companies and Red Iron over the past three fiscal years. However, a decline in retail sales or financial difficulties of our distributors or dealers could cause this situation to change and thereby require us to repurchase financed product up to but not exceeding our limited obligation, which could have an adverse effect on our operating results. We continue to provide financing in the form of open account terms to home centers and mass retailers; general line irrigation dealers; international distributors and dealers other than the Canadian distributors and dealers to whom Red Iron provides financing arrangements; micro-irrigation dealers and distributors; government customers; rental companies; and a limited number of BOSS dealers. End-User Financing. We have agreements with third party financing companies to provide lease-financing options to golf course and sports fields and grounds equipment customers in the U.S. and select countries in Europe. The purpose of these agreements is to increase sales by giving buyers of our products alternative financing options when purchasing our products. We have no contingent liabilities for residual value or credit collection risk under these agreements with third party financing companies. From time to time, we enter into agreements where we provide recourse to third party finance companies in the event of default by the customer for lease payments to the third party finance company. Our maximum exposure for credit collection under those arrangements as of October 31, 2015 was $4.6 million. Termination or any material change to the terms of our end-user financing arrangements, availability of credit for our customers, including any delay in securing replacement credit sources, or significant financed product repurchase requirements could have a material adverse impact on our future operating results. Distributor Financing. From time to time, we enter into long-term loan agreements with some distributors. These transactions are used for expansion of the distributors' businesses, acquisitions, refinancing working capital agreements, or facilitation of ownership changes. As of October 31, 2015, we had an outstanding note receivable in the amount of $1.0 million, which is included in other current and long-term assets on our consolidated balance sheet. Off-Balance Sheet Arrangements and Contractual Obligations The following table summarizes our contractual obligations as of October 31, 2015. 1Principal payments in accordance with our credit facilities and long-term debt agreements. 2Interest payments for outstanding long-term debt obligations. Interest on variable rate debt was calculated using the interest rate as of October 31, 2015. 3The unfunded deferred compensation arrangements, covering certain retired management employees, consist primarily of salary and bonus deferrals under our deferred compensation plans. Our estimated distributions in the contractual obligations table are based upon a number of assumptions including termination dates and participant elections. 4Purchase obligations represent contracts or commitments for the purchase of raw materials. 5Operating lease obligations do not include payments to property owners covering real estate taxes and common area maintenance. 6Payment obligation in connection with the renovation of our original corporate facility located at Bloomington, Minnesota. As of October 31, 2015, we also had $16.2 million in outstanding letters of credit issued, including standby letters of credit, during the normal course of business, as required by some vendor contracts. In addition to the contractual obligations described in the foregoing table, we may be obligated for additional net cash outflows related to $5.6 million of unrecognized tax benefits, including interest and penalties. The payment and timing of any such payments is affected by the ultimate resolution of the tax years that are under audit or remain subject to examination by the relevant taxing authorities. Market Risk Due to the nature and scope of our operations, we are subject to exposures that arise from fluctuations in interest rates, foreign currency exchange rates, and commodity prices. We are also exposed to equity market risk pertaining to the trading price of our common stock. Additional information is presented in Part II, Item 7A, "Quantitative and Qualitative Disclosures about Market Risk," and Note 14 of the Notes to Consolidated Financial Statements. Inflation We are subject to the effects of inflation, deflation, and changing prices. During fiscal 2015, we experienced slightly lower average commodity prices compared to the average prices paid for commodities in fiscal 2014. We intend to continue to closely follow prices of commodities and components that affect our product lines, and we anticipate average prices paid for some commodities and components to be equivalent in fiscal 2016 as compared to fiscal 2015. Historically, we have mitigated, and we expect that we would continue to mitigate, commodity price increases, if any, in part, by collaborating with suppliers, reviewing alternative sourcing options, substituting materials, engaging in internal cost reduction efforts, and increasing prices on some of our products, all as appropriate. Acquisitions and Divestiture On November 14, 2014, during the first quarter of fiscal 2015, we acquired substantially all of the assets of the BOSS professional snow and ice management business of privately held Northern Star Industries, Inc. BOSS designs, manufactures, markets, and sells a broad line of snowplows, salt and sand spreaders, and related parts and accessories for light and medium duty trucks, ATVs, UTVs, skid steers, and front-end loaders. The purchase price of this acquisition was $229.5 million. On November 27, 2013, during the first quarter of fiscal 2014, we completed the acquisition of certain assets of a quality value-priced line of outdoor lighting fixtures for the landscape lighting market. The purchase price of this acquisition was $1.2 million. On September 30, 2013, during the fourth quarter of fiscal 2013, we completed the acquisition of certain assets and assumed certain liabilities for a company in China that manufactures water-efficient drip irrigation products, sprinklers, emitters, and filters for agriculture, landscaping, and green house production. The purchase price of this acquisition was $3.5 million. These acquisitions were deemed immaterial based on our consolidated financial condition and results of operations and all acquisitions were accounted for as business combinations. On November 27, 2015, in our first quarter of fiscal 2016, we completed the sale of our Northwestern U.S. distribution company. CRITICAL ACCOUNTING POLICIES AND ESTIMATES In preparing our consolidated financial statements in conformity with U.S. generally accepted accounting principles ("GAAP"), we must make decisions that impact the reported amounts of assets, liabilities, revenues and expenses, and related disclosures. Such decisions include the selection of the appropriate accounting principles to be applied and the assumptions on which to base accounting estimates. In reaching such decisions, we apply judgments based on our understanding and analysis of the relevant circumstances, historical experience, and actuarial valuations. Actual amounts could differ from those estimated at the time the consolidated financial statements are prepared. Our significant accounting policies are described in Note 1 of the Notes to Consolidated Financial Statements. Some of those significant accounting policies require us to make difficult subjective or complex judgments or estimates. An accounting estimate is considered to be critical if it meets both of the following criteria: (i) the estimate requires assumptions about matters that are highly uncertain at the time the accounting estimate is made, and (ii) different estimates reasonably could have been used, or changes in the estimate that are reasonably likely to occur from period to period may have a material impact on the presentation of our financial condition, changes in financial condition, or results of operations. Our critical accounting estimates include the following: Warranty Reserve. Warranty coverage on our products is generally for specified periods of time and on select products' hours of usage, and generally covers parts, labor, and other expenses for non-maintenance repairs. Warranty coverage generally does not cover operator abuse or improper use. At the time of sale, we accrue a warranty reserve by product line for estimated costs in connection with future warranty claims. We also establish reserves for major rework campaigns. The amount of our warranty reserves is based primarily on the estimated number of products under warranty, historical average costs incurred to service warranty claims, the trend in the historical ratio of claims to sales, and the historical length of time between the sale and resulting warranty claim. We periodically assess the adequacy of our warranty reserves based on changes in these factors and record any necessary adjustments if actual claim experience indicates that adjustments are necessary. Actual claims could be higher or lower than amounts estimated, as the number and value of warranty claims can vary due to such factors as performance of new products, significant manufacturing or design defects not discovered until after the product is delivered to customers, product failure rates, and higher or lower than expected service costs for a repair. We believe that analysis of historical trends and knowledge of potential manufacturing or design problems provide sufficient information to establish a reasonable estimate for warranty claims at the time of sale. However, since we cannot predict with certainty future warranty claims or costs associated with servicing those claims, our actual warranty costs may differ from our estimates. An unexpected increase in warranty claims or in the costs associated with servicing those claims would result in an increase in our warranty accrual and a decrease in our net earnings. Sales Promotions and Incentives. At the time of sale to a customer, we record an estimate for sales promotion and incentive costs that are classified as a reduction from gross sales or as a component of SG&A expense. Examples of sales promotion and incentive programs include off-invoice discounts, rebate programs, volume discounts, retail financing support, commissions, and other sales discounts and promotional programs. The estimates for sales promotion and incentive costs are based on the terms of the arrangements with customers, historical payment experience, field inventory levels, volume purchases, and expectations for changes in relevant trends in the future. Actual results may differ from these estimates if competitive factors dictate the need to enhance or reduce sales promotion and incentive accruals or if customer usage and field inventory levels vary from historical trends. Adjustments to sales promotions and incentive accruals are made from time to time as actual usage becomes known in order to properly estimate the amounts necessary to generate consumer demand based on market conditions as of the balance sheet date. Goodwill and Other Intangibles. Identifiable intangible assets are amortized over their useful lives, unless the useful life is determined to be indefinite. The useful life of an identifiable intangible asset is based on an analysis of several factors, including contractual, regulatory or legal obligations, demand, competition, and industry trends. Goodwill and indefinite-life intangible assets are not amortized, but are tested at least annually for impairment and whenever events or changes in circumstances indicate that impairment may have occurred. Our impairment testing for goodwill is performed separately from our impairment testing of indefinite-life intangible assets, and the income approach is utilized for both. We test goodwill for impairment at the reporting unit level. Under the income approach, we calculate the fair value of our reporting units and indefinite-life intangible assets using the present value of future cash flows. Individual indefinite-life intangible assets are tested by comparing the book values of each asset to the estimated fair value. Our estimate of fair value for indefinite-life intangible assets uses projected revenues from our forecasting process, assumed royalty rates, and a discount rate. Assumptions used in our impairment evaluations, such as forecasted growth rates and cost of capital, are consistent with internal projections and operating plans. Materially different assumptions regarding future performance of our businesses or a different weighted-average cost of capital could result in impairment losses or additional amortization expense. In conducting the goodwill impairment test, we first perform a qualitative assessment to determine whether it is more likely than not the fair value of any reporting unit is less than its carrying amount. If we conclude that this is the case, a two-step quantitative test for goodwill impairment is performed. In conducting the initial qualitative assessment, we analyze actual and projected growth trends for net sales, gross margin, and earnings for each reporting unit, as well as historical versus planned performance. Additionally, each reporting unit assesses critical areas that may impact its business, including macroeconomic conditions, market-related exposures, competitive changes, new or discontinued products, changes in key personnel, or any other potential risks to projected financial results. All assumptions used in the qualitative assessment require significant judgment. If performed due to impairment indicators or the amount of time since the last analysis, the quantitative goodwill impairment test is a two-step process. First, we compare the carrying value of a reporting unit, including goodwill, to its fair value. The fair value of each reporting unit is estimated using a discounted cash flow model. Where available, and as appropriate, comparable market multiples and our company's market capitalization are also used to corroborate the results of the discounted cash flow models. If the first step indicates the carrying value exceeds the fair value of the reporting unit, then a second step must be completed in order to determine the amount of goodwill impairment that should be recorded. In the second step, the implied fair value of the reporting unit's goodwill is determined by allocating the reporting unit's fair value to all of its assets and liabilities other than goodwill. The implied fair value of the goodwill that results from the application of this second step is then compared to the carrying amount of the goodwill and an impairment charge is recorded for the difference. Inventory Valuation. We value our inventories at the lower of the cost of inventory or net realizable value, with cost determined by either the last-in, first-out ("LIFO") method for most U.S. inventories or the first-in, first-out ("FIFO") method for all other inventories. We establish reserves for excess, slow moving, and obsolete inventory based on inventory levels, expected product life, and forecasted sales demand. Valuation of inventory can also be affected by significant redesign of existing products or replacement of an existing product by an entirely new generation product. In assessing the ultimate realization of inventories, we are required to make judgments as to future demand requirements compared with inventory levels. Reserve requirements are developed according to our projected demand requirements based on historical demand, competitive factors, and technological and product life cycle changes. It is possible that an increase in our reserve may be required in the future if there is a significant decline in demand for our products and we do not adjust our production schedule accordingly. We also record a reserve for inventory shrinkage. Our inventory shrinkage reserve represents anticipated physical inventory losses that are recorded based on historical loss trends, ongoing cycle-count and periodic testing adjustments, and inventory levels. Though management considers reserve balances adequate and proper, changes in economic conditions in specific markets in which we operate could have an effect on the reserve balances required. Accounts and Notes Receivable Valuation. We value accounts and notes receivable net of an allowance for doubtful accounts. Each fiscal quarter, we prepare an analysis of our ability to collect outstanding receivables that provides a basis for an allowance estimate for doubtful accounts. In doing so, we evaluate the age of our receivables, past collection history, current financial conditions of key customers, and economic conditions. Based on this evaluation, we establish a reserve for specific accounts and notes receivable that we believe are uncollectible, as well as an estimate of uncollectible receivables not specifically known. Deterioration in the financial condition of any key customer, inability of customers to obtain bank credit lines, or a significant slow-down in the economy could have a material negative impact on our ability to collect accounts and notes receivable. We believe that an analysis of historical trends and our current knowledge of potential collection problems provide us with sufficient information to establish a reasonable estimate for an allowance for doubtful accounts. However, since we cannot predict with certainty future changes in the financial stability of our customers or in the general economy, our actual future losses from uncollectible accounts may differ from our estimates. In the event we determined that a smaller or larger uncollectible accounts reserve is appropriate, we would record a credit or charge to SG&A expense in the period that we made such a determination. New Accounting Pronouncements to be Adopted In May 2014, the Financial Accounting Standards Board ("FASB") issued Accounting Standards Update ("ASU") No. 2014-09, Revenue from Contracts with Customers that updates the principles for recognizing revenue. The core principle of the guidance is that an entity should recognize revenue to depict the transfer of promised goods or services to customers in an amount that reflects the consideration to which the entity expects to be entitled to in exchange for those goods or services. The guidance provides a five-step analysis of transactions to determine when and how revenue is recognized. The guidance also requires enhanced disclosures regarding the nature, amount, timing, and uncertainty of revenue and cash flows arising from an entity's contracts with customers. In August 2015, the FASB issued ASU No. 2015-14, Revenue from Contracts with Customers (Topic 606) , which deferred the effective date of this standard by one year. We expect to adopt this guidance on November 1, 2018, as required, based on the new effective date. The guidance permits the use of either a retrospective or cumulative effect transition method. We have not yet selected a transition method and are currently evaluating the impact of the amended guidance on our existing revenue recognition policies and procedures. In February 2015, the FASB issued ASU No. 2015-02, Consolidation (Topic 810), which amends certain requirements for determining whether a variable interest entity must be consolidated. The amended guidance will become effective for us commencing in the first quarter of fiscal 2017. Early adoption is permitted. We anticipate the adoption of this guidance will not have a material impact on our consolidated financial position. In April 2015, the FASB issued ASU No. 2015-03, Interest - Imputation of Interest (Subtopic 835-30): Simplifying the Presentation of Debt Issuance Costs. This guidance requires that debt issuance costs related to a recognized debt liability be presented in the balance sheet as a direct deduction from the carrying amount of the related debt liability. The amended guidance will become effective for us commencing in the first quarter of fiscal 2017. Early adoption is permitted. We anticipate the adoption of this guidance will not have a material impact on our consolidated financial position. In April 2015, the FASB issued ASU No. 2015-05, Customer's Accounting for Fees Paid in a Cloud Computing Arrangement. This amended guidance requires customers to determine whether or not an arrangement contains a software license element. If the arrangement contains a software element, the related fees paid should be accounted for as an acquisition of a software license. If the arrangement does not contain a software license, it is accounted for as a service contract. The amended guidance will become effective for us commencing in the first quarter of fiscal 2017. Early adoption is permitted. We anticipate the adoption of this guidance will not have a material impact on our consolidated financial statements. In July 2015, the FASB issued ASU No. 2015-11, Inventory (Topic 330): Simplifying the Measurement of Inventory. This amended guidance changes the measurement principle for inventory from the lower of cost or market to lower of cost and net realizable value. The amended guidance will become effective for us commencing in the first quarter of fiscal 2018. Early adoption is permitted. We are currently evaluating the impact of this amended guidance on our consolidated financial statements. In November 2015, the FASB issued ASU No. 2015-17, Income Taxes (Topic 740): Balance Sheet Classification of Deferred Taxes. This amended guidance requires an entity to present deferred tax assets and liabilities as noncurrent in the statement of financial position. The amended guidance will become effective for us commencing in the first quarter of fiscal 2018. Early adoption is permitted. We are currently evaluating the impact of this amended guidance on our consolidated financial statements. No other new accounting pronouncement that has been issued but not yet effective for us during fiscal 2015 has had or is expected to have a material impact on our consolidated financial statements.

<s>[INST] OVERVIEW We design, manufacture, and market professional turf maintenance equipment and services, turf irrigation systems, landscaping equipment and lighting, agricultural microirrigation systems, rental and specialty construction equipment, and residential yard and snow thrower products. Beginning in fiscal 2015 with our acquisition of BOSS®, we also design, manufacture, and market professional snow and ice management products. We sell our products worldwide through a network of distributors, dealers, hardware retailers, home centers, mass retailers, and over the Internet. Our businesses are organized into three reportable business segments: Professional, Residential, and Distribution. Our Distribution segment, which consists of our companyowned domestic distributorships, has been combined with our corporate activities and is shown as "Other." We strive to provide innovative, wellbuilt, and dependable products supported by an extensive service network. A significant portion of our revenues has historically been, and we expect will continue to be, attributable to new and enhanced products. We define new products as those introduced in the current and previous two fiscal years. Summary of Fiscal 2015 Results In fiscal 2015, we achieved record net sales of $2,390.9 million and net earnings growth of 15.9 percent. Our fiscal 2015 results included the following items of significance: On November 14, 2014, during the first quarter of fiscal 2015, we acquired substantially all of the assets of the BOSS professional snow and ice management business of privately held Northern Star Industries, Inc. BOSS designs, manufactures, markets, and sells a broad line of snowplows, salt and sand spreaders, and related parts and accessories for light and medium duty trucks, ATVs, UTVs, skid steers, and frontend loaders. Through this acquisition, we added another professional contractor brand; a portfolio of counterseasonal equipment; manufacturing and distribution facilities located in Iron Mountain, Michigan; and a distribution network for these products. Net sales for fiscal 2015 increased by 10.0 percent compared to fiscal 2014 to a record of $2,390.9 million. The acquisition of the BOSS business resulted in incremental net sales of $128.5 million for fiscal 2015. Additionally, the sales increase was primarily attributable to the successful introduction of new and enhanced products and increased sales of landscape contractor equipment and specialty construction products, partially offset by lower irrigation product sales. Unfavorable foreign currency exchange rate fluctuations decreased our net sales by approximately $47 million for fiscal 2015. Professional segment net sales, which represented 69 percent of our total consolidated net sales in fiscal 2015, grew 11.0 percent in fiscal 2015 compared to fiscal 2014. The acquisition of the BOSS business resulted in incremental net sales of $128.5 million for fiscal 2015 for the professional segment. Shipments also increased due to the successful introduction of new and enhanced products, and continued growth and demand for our landscape contractor and specialty equipment products. However, sales of irrigation products were down primarily due to unfavorable weather conditions in key markets. Our residential segment net sales increased 7.9 percent in fiscal 2015 compared to fiscal 2014 primarily due to strong shipments and demand for our newly introduced zeroturn radius riding and walk power mower products and expanded product placement. However, residential segment net sales in Australia were down due to unfavorable foreign currency exchange rate changes. International net sales for fiscal 2015 decreased by 1.9 percent compared to fiscal 2014 due to changes in foreign currency exchange rates that reduced our total net sales by approximately $47 million in fiscal 2015. International net sales comprised 25.5 percent of our total consolidated net sales in fiscal 2015 compared to 28.7 percent in fiscal 2014 and 30.1 percent in fiscal 2013. These declines were primarily the result of foreign currency exchange rate changes. In addition, we experienced a decline in fiscal 2015 due to the acquisition [/INST] Negative. </s>

TORO CO

2016-12-22

2016-10-31

ITEM 7. MANAGEMENT'S DISCUSSION AND ANALYSIS OF FINANCIAL CONDITION AND RESULTS OF OPERATIONS This Management's Discussion and Analysis of Financial Condition and Results of Operations ("MD&A") is intended to provide a reader of our financial statements with a narrative from the perspective of management on our financial condition, results of operations, liquidity and certain other factors that may affect our future results. Unless expressly stated otherwise, the comparisons presented in this MD&A refer to the prior fiscal year. Statements that are not historical are forward-looking and involve risks and uncertainties, including those discussed in Part I, Item 1A, "Risk Factors" and elsewhere in this report. These risks could cause our actual results to differ materially from any future performance suggested below. OVERVIEW The Toro Company is in the business of designing, manufacturing, and marketing professional turf maintenance equipment and services, turf irrigation systems, landscaping equipment and lighting products, snow and ice management products, agricultural micro-irrigation systems, rental and specialty construction equipment, and residential yard and snow thrower products. We sell our products worldwide through a network of distributors, dealers, hardware retailers, home centers, mass retailers, and online. Our businesses are organized into three reportable business segments: Professional, Residential, and Distribution. Our Distribution segment, which consists of our company-owned domestic distributorship, has been combined with our corporate activities and is shown as "Other." We strive to provide innovative, well-built, and dependable products supported by an extensive service network. A significant portion of our net sales has historically been, and we expect will continue to be, attributable to new and enhanced products. We define new products as those introduced in the current and previous two fiscal years. Shares and per share data have been adjusted for all periods presented to reflect the impact of our two-for-one stock split effective September 16, 2016. Summary of Fiscal 2016 Results In fiscal 2016, we achieved net sales of $2,392.2 million and net earnings growth of 14.6 percent. Our fiscal 2016 results included the following items of significance: • Net sales for fiscal 2016 increased by 0.1 percent compared to fiscal 2015 to $2,392.2 million. Foreign currency exchange rate fluctuations negatively impacted our net sales growth by 1.3 percent. The sales increase was primarily attributable to strong demand of our Professional segment products including the successful introduction of new innovative products, primarily offset by lower Residential segment sales driven mainly by decreased pre-season snow products demand. • Professional segment net sales grew 4.0 percent in fiscal 2016 compared to fiscal 2015. Sales increased primarily from strong demand for our golf and landscape contractor equipment, increased product placement of our micro-irrigation products, along with continued growth in our rental and specialty construction businesses. • Residential segment net sales decreased 7.8 percent in fiscal 2016 compared to fiscal 2015, primarily due to lower sales of snow products and decreased shipments of zero-turn radius riding mowers, partially offset by increased shipments of walk power mowers. • International net sales for fiscal 2016 decreased by 5.1 percent compared to fiscal 2015 mainly due to changes in foreign currency exchange rates that reduced our total net sales by approximately $30.6 million in fiscal 2016. International net sales comprised 24.2 percent of our total consolidated net sales in fiscal 2016 compared to 25.5 percent in fiscal 2015 and 28.7 percent in fiscal 2014. These declines were primarily the result of foreign currency exchange rate changes. • Fiscal 2016 net earnings of $231.0 million increased 14.6 percent compared to fiscal 2015, and diluted net earnings per share increased 15.7 percent to $2.06 in fiscal 2016 compared to $1.78 in fiscal 2015. • Gross margin was 36.6 percent in fiscal 2016, an increase of 160 basis points from 35.0 percent in fiscal 2015. This increase was primarily the result of favorable commodity costs and enhanced productivity, as well as favorable segment mix. • Selling, general, and administrative ("SG&A") expense was up 0.6 percent in fiscal 2016 compared to fiscal 2015, or up 10 basis points to 22.6 percent. • Receivables decreased by 7.8 percent as of the end of fiscal 2016 compared to the end of fiscal 2015 primarily as a result of more receivables financed through Red Iron. Our inventory levels were down by 8.2 percent as of the end of fiscal 2016 compared to the end of fiscal 2015 primarily due to focused production planning in the latter half of fiscal 2016. Average net working capital (net accounts receivable plus net inventory less trade payables) as a percent of net sales was 15.9 percent as of the end of fiscal 2016 compared to 16.0 percent as of the end of fiscal 2015. Our domestic field inventory levels were up as of the end of fiscal 2016 compared to the end of fiscal 2015, primarily due to higher levels in the Professional segment with higher retail demand and anticipated strong retail of new products in fiscal 2017. • We continued our history of paying quarterly cash dividends in fiscal 2016. We increased our fiscal 2016 quarterly cash dividend by 20 percent to $0.15 per share compared to our quarterly cash dividend in fiscal 2015 of $0.125 per share. • Our stock repurchase program returned $112.0 million to our shareholders during fiscal 2016, which reduced our number of shares outstanding. This reduction resulted in a benefit to our diluted net earnings per share of $0.03 per share in fiscal 2016 compared to fiscal 2015. Destination PRIME Our current multi-year initiative, "Destination PRIME," began our journey into our second century. Similar to our previous Destination 2014 initiative, this three-year initiative is intended to help us drive revenue and earnings growth and further improve productivity, while also continuing our century-long commitment to innovation, relationships, and excellence. Through our Destination PRIME initiative, we will strive to achieve our goals by pursuing a progression of milestones for organic revenue growth, operating earnings, and working capital. Organic Revenue Growth. We intend to pursue strategic growth of our existing businesses and product categories with an annual organic revenue growth goal. The organic revenue growth goal of our Destination PRIME initiative is to achieve at least five percent organic revenue growth each fiscal year of this initiative. We define organic revenue growth as the increase in net sales, less net sales from acquisitions that occurred in the prior twelve-month period. In both fiscal 2016 and fiscal 2015, we fell short of this goal by achieving 0.1 percent and 4.1 percent organic revenue growth, respectively. Operating Earnings. The operating earnings goal is to raise operating earnings as a percentage of net sales to 13 percent or higher by the end of fiscal 2017. In fiscal 2016, we achieved this goal as we realized 14.0 percent of operating earnings as a percentage of net sales. In fiscal 2015, we realized 12.5 percent of operating earnings as a percentage of net sales. Working Capital. The working capital goal of our Destination PRIME initiative is to drive down average net working capital as a percentage of net sales to 13 percent or lower by the end of fiscal 2017. In fiscal 2016 and fiscal 2015, our average net working capital as a percentage of net sales was 15.9 percent and 16.0 percent, respectively. RESULTS OF OPERATIONS Fiscal 2016 net earnings were $231.0 million compared to $201.6 million in fiscal 2015, an increase of 14.6 percent. Fiscal 2016 diluted net earnings per share were $2.06, an increase of 15.7 percent from $1.78 per share in fiscal 2015. The primary factors contributing to the net earnings increase were gross margin improvement and a decrease in our effective tax rate. However, these improvements were partially offset by an increase in our SG&A expense. Our net earnings per diluted share were also benefited by $0.03 per share in fiscal 2016 compared to fiscal 2015 as a result of reduced shares outstanding from repurchases of our common stock. Fiscal 2015 net earnings were $201.6 million compared to $173.9 million in fiscal 2014, an increase of 15.9 percent. Fiscal 2015 diluted net earnings per share were $1.78, an increase of 17.5 percent from $1.51 per share in fiscal 2014. The primary factors contributing to the net earnings improvement were higher net sales, leveraging fixed SG&A costs over higher sales volumes, and a decrease in our effective tax rate. However, these improvements were partially offset by a decline in our gross margin rate and an increase in interest expense. Our net earnings per diluted share were also benefited by $0.03 per share in fiscal 2015 compared to fiscal 2014 as a result of reduced shares outstanding from repurchases of our common stock. The following table summarizes our results of operations as a percentage of our consolidated net sales. Fiscal 2016 Compared with Fiscal 2015 Net Sales. Worldwide net sales in fiscal 2016 were $2,392.2 million compared to $2,390.9 million in fiscal 2015, an increase of 0.1 percent. This net sales change was attributable to the following factors: • Increased sales of Professional segment products were driven by higher shipments and demand of golf, landscape contractor, and rental and specialty equipment products primarily due to continued market growth and increased demand for our innovative product offerings and the successful introduction of new products. Micro-irrigation and irrigation product sales also increased mainly due to improved product placement and higher project sales. However, sales of snow and ice management products were down primarily due to decreased pre-season demand. • Decreased sales of Residential segment products were mainly driven by lower sales and pre-season retail demand of snow thrower products, decreased shipments of zero-turn radius riding mowers, and unfavorable weather conditions in many of our markets. However, sales of our walk power mowers increased mainly due to strong shipments driven by our innovative product offerings and favorable growing season weather in key markets. • Our overall net sales in international markets decreased by 5.1 percent in fiscal 2016 compared to fiscal 2015 due to unfavorable foreign currency exchange rate fluctuations that reduced our total net sales by approximately $30.6 million in fiscal 2016. Gross Margin. Gross margin represents gross profit (net sales less cost of sales) as a percentage of net sales. See Note 1 of the Notes to Consolidated Financial Statements, in the section entitled "Cost of Sales," for a description of expenses included in cost of sales. Gross margin increased by 160 basis points to 36.6 percent in fiscal 2016 from 35.0 percent in fiscal 2015. This increase was mainly the result of the following factors: • Lower costs to purchase commodities, primarily steel and resin, and productivity improvements. • Segment mix from a higher mix of Professional segment product sales. Somewhat offsetting those positive factors were unfavorable foreign currency exchange rate fluctuations. Selling, General, and Administrative Expense. SG&A expense increased $3.4 million, or 0.6 percent, in fiscal 2016 compared to fiscal 2015. See Note 1 of the Notes to Consolidated Financial Statements, in the section entitled "Selling, General, and Administrative Expense," for a description of expenses included in SG&A expense. SG&A expense rate represents SG&A expense as a percentage of net sales. SG&A expense rate in fiscal 2016 increased 10 basis points to 22.6 percent compared to 22.5 percent in fiscal 2015. The increase in SG&A expense was driven primarily by the following factors: • Continued investments in engineering and new product development that resulted in higher expense of $3.8 million. • Increased warranty expense of $3.1 million driven by higher claims experience for the year. • Higher direct marketing expense of $2.2 million mainly due to increased media spend and paid commissions. Somewhat offsetting those increases were: • Decreased administrative expense of $3.4 million.• Decreased incentive expense of $3.3 million due to actual performance against specified goals. Interest Expense. Interest expense for fiscal 2016 increased $0.6 million compared to fiscal 2015. Other Income, Net. Other income, net consists mainly of our proportionate share of income or losses from equity investments (affiliates), currency exchange rate gains and losses, litigation settlements and recoveries, interest income, and retail financing revenue. Other income for fiscal 2016 was $15.4 million compared to $10.7 million in fiscal 2015, an increase of $4.7 million. The increase in other income, net was primarily due to foreign currency contract exchange gains of $1.8 million, a fiscal 2016 litigation recovery of $1.3 million, and higher earnings from our equity investment in Red Iron of $1.2 million. Provision for Income Taxes. The effective tax rate for fiscal 2016 was 30.1 percent compared to 30.7 percent in fiscal 2015. The decrease was primarily the result of more favorable one-time adjustments related to prior years, and the permanent extension of the federal research credit. Fiscal 2015 Compared with Fiscal 2014 Net Sales. Worldwide net sales in fiscal 2015 were $2,390.9 million compared to $2,172.7 million in fiscal 2014, an increase of 10.0 percent. This net sales change was attributable to the following factors: • Increased sales of Professional segment products driven by the acquisition of the BOSS business which resulted in incremental net sales of $128.5 million for fiscal 2015. In addition, our Professional segment net sales were positively impacted by higher shipments of landscape contractor and rental and specialty equipment products due to continued market growth and increased demand for our innovative product offerings and newly introduced products. However, sales of irrigation products were down primarily due to unfavorable weather conditions in key markets, and sales of micro-irrigation products were lower due to unfavorable foreign currency exchange rates and continued adverse political and economic conditions in key international markets. • Increased sales of Residential segment products due to strong shipments and demand for our newly introduced zero-turn radius riding and walk power mower products and expanded product placement. However, Residential segment net sales in Australia were down due to unfavorable foreign currency exchange rate changes. • Our overall net sales in international markets slightly decreased by 1.9 percent in fiscal 2015 compared to fiscal 2014 due to unfavorable foreign currency exchange rate fluctuations that reduced our total net sales by approximately $47 million in fiscal 2015. Gross Margin. Gross margin decreased by 60 basis points to 35.0 percent in fiscal 2015 from 35.6 percent in fiscal 2014. This decline was mainly the result of the following factors: • Unfavorable foreign currency exchange rate movements. • Purchase accounting impact of the incremental charge for the sale of inventory that was written-up to fair value as a result of the acquisition of the BOSS business. Somewhat offsetting those negative factors were: • Improved price realization. • Costs for a supplier component rework issue that impacted certain walk power mowers in fiscal 2014 that was not repeated in fiscal 2015. Selling, General, and Administrative Expense. SG&A expense increased $26.7 million, or 5.2 percent, in fiscal 2015 compared to fiscal 2014. SG&A expense rate in fiscal 2015 decreased 100 basis points to 22.5 percent compared to 23.5 percent in fiscal 2014 due to fixed SG&A costs spread over higher sales volumes. However, the increase in SG&A expense of $26.7 million was driven mainly by the following factors: • Incremental SG&A expense of $19 million from the BOSS business. • Increased administrative expenses of $7 million. • Investments in engineering and new product development that resulted in higher expense of $2 million. Interest Expense. Interest expense for fiscal 2015 increased $3.3 million compared to fiscal 2014 due to higher levels of debt as a result of borrowings that were used to pay the purchase price for the BOSS business. Other Income, Net. Other income for fiscal 2015 was $10.7 million compared to $8.7 million in fiscal 2014, an increase of $2.0 million. This increase in other income, net was primarily due to higher earnings from our equity investment in Red Iron of $1.1 million and lower foreign currency exchange rate losses of $0.7 million in fiscal 2015 compared to fiscal 2014. Provision for Income Taxes. The effective tax rate for fiscal 2015 was 30.7 percent compared to 32.2 percent in fiscal 2014. The decrease in the effective tax rate was attributable to the benefit in the first quarter of fiscal 2015 for the retroactive re-enactment of the federal research credit for calendar 2014 and higher earnings in lower tax jurisdictions. PERFORMANCE BY BUSINESS SEGMENT As more fully described in Note 12 of the Notes to Consolidated Financial Statements, we operate in three reportable business segments: Professional, Residential, and Distribution. Our Distribution segment, which consists of our company-owned domestic distributorship, has been combined with our corporate activities and is shown as "Other." Operating earnings for our Professional and Residential segments are defined as earnings from operations plus other income, net. Operating loss for the Other segment includes earnings (loss) from our wholly owned domestic distribution companies, corporate activities, other income, and interest expense. The following information provides perspective on our business segments' net sales and operating results. Professional Segment Professional segment net sales represented 71 percent of consolidated net sales for fiscal 2016, 69 percent for fiscal 2015, and 68 percent for fiscal 2014. The following table shows the Professional segment net sales, operating earnings, and operating earnings as a percent of net sales. Net Sales. Worldwide net sales for the Professional segment in fiscal 2016 were up by 4.0 percent compared to fiscal 2015 primarily as a result of the following factors: • Higher shipments of golf equipment and irrigation products, mainly due to demand for our innovative product offerings, the successful introduction of new products, increased golf irrigation projects, and favorable weather conditions. • Increased sales of landscape contractor equipment driven by strong demand of our riding and stand-on mower product lines. • Higher sales of micro-irrigation products which were mainly driven by improved product placement. • Increased sales driven by strong demand and market growth for rental and specialty construction equipment, as well as positive customer response for new products. Somewhat offsetting those positive factors were: • Unfavorable foreign currency exchange rate fluctuations. • A decline in sales of snow and ice management products which was driven mainly from decreased pre-season demand. Our domestic field inventory levels of our Professional segment products were higher as of the end of fiscal 2016 compared to the end of fiscal 2015 due, primarily to anticipated strong shipments of new product introductions and higher retail demand. Worldwide net sales for the Professional segment in fiscal 2015 were up by 11.0 percent compared to fiscal 2014 primarily as a result of the following factors: • Incremental sales from the acquisition of the BOSS business of $128.5 million. • Higher shipments of landscape contractor equipment, including new and enhanced products, as contractors continued to invest in turf maintenance equipment. • Increased sales driven by strong demand and market growth for rental and specialty construction equipment, as well as positive customer response for new products we introduced in that market. Somewhat offsetting those positive factors were: • Unfavorable foreign currency exchange rate fluctuations. • A decline in sales of irrigation products due to unfavorable weather conditions in key markets. • Lower sales of micro-irrigation products due to unfavorable foreign currency exchange rate fluctuations and continued adverse political and economic conditions in key international markets. Operating Earnings. Operating earnings for the Professional segment in fiscal 2016 increased 14.3 percent compared to fiscal 2015, primarily due to higher sales volumes, higher gross margin, and lower SG&A expense. Expressed as a percentage of net sales, Professional segment operating margins increased by 180 basis points to 20.6 percent in fiscal 2016 compared to 18.8 percent in fiscal 2015. The following factors impacted Professional segment operating earnings as a percentage of net sales for fiscal 2016: • Higher gross margin in fiscal 2016 compared to fiscal 2015 mainly due to lower commodity costs and productivity improvements, as well as favorable product mix, partially offset by unfavorable foreign currency exchange rate fluctuations. • A decline in SG&A expense rate in fiscal 2016 compared to fiscal 2015 due to lower administration costs. Operating earnings for the Professional segment in fiscal 2015 increased 11.5 percent compared to fiscal 2014 primarily due to higher sales volumes. Expressed as a percentage of net sales, Professional segment operating margins slightly increased by 10 basis points to 18.8 percent in fiscal 2015 compared to 18.7 percent in fiscal 2014. The following factors impacted Professional segment operating earnings as a percentage of net sales for fiscal 2015: • Lower gross margin in fiscal 2015 compared to fiscal 2014 mainly due to unfavorable foreign currency exchange rate movements and the purchase accounting impact for the acquisition of the BOSS business, as previously discussed. • A decline in SG&A expense rate in fiscal 2015 compared to fiscal 2014 due to further leveraging fixed SG&A costs over higher sales volumes. Residential Segment Residential segment net sales represented 28 percent of consolidated net sales for fiscal 2016, 30 percent for fiscal 2015, and 31 percent for fiscal 2014. The following table shows the Residential segment net sales, operating earnings, and operating earnings as a percent of net sales. Net Sales. Worldwide net sales for the Residential segment in fiscal 2016 were down by 7.8 percent compared to fiscal 2015 primarily as a result of the following factors: • Decreased shipments and lower retail demand of snow products due to low snowfall totals in the 2015/2016 season. • Lower sales of zero-turn radius riding mowers primarily driven by variable weather conditions throughout the year and a slight reduction in retail placement. • Unfavorable weather conditions in many of our markets. Somewhat offsetting the decrease in Residential segment net sales were higher sales of walk power mowers driven by increased demand for our product offerings and strong customer response for our innovative models, including our SMARTSTOW® and all-wheel drive models. Our domestic field inventory levels of our Residential segment products were lower as of the end of fiscal 2016 compared to the end of fiscal 2015 primarily due to decreased pre-season snow thrower product channel demand for the 2016-2017 winter season and inventory sell-through of walk power mowers from a strong fall growing season. Worldwide net sales for the Residential segment in fiscal 2015 were up by 7.9 percent compared to fiscal 2014 primarily as a result of the following factors: • Increased shipments driven by strong retail demand and additional product placement for our new platform of zero-turn radius riding mowers. • Higher sales of walk power mowers due to enhanced product placement and increased demand for our product offerings, including our new all-wheel drive model. Somewhat offsetting the increase in Residential segment net sales was a decline in sales in Australia from unfavorable foreign currency exchange rate fluctuations. Operating Earnings. Operating earnings for the Residential segment in fiscal 2016 decreased 13.3 percent compared to fiscal 2015. Expressed as a percentage of net sales, Residential segment operating margins decreased 70 basis points to 11.0 percent in fiscal 2016 compared to 11.7 percent in fiscal 2015. The following factors impacted Residential segment operating earnings: • Higher gross margin in fiscal 2016 compared to fiscal 2015 mainly due to lower commodity costs and freight expense, partially offset by unfavorable foreign currency exchange rate fluctuations. • Increased SG&A expense rate attributable to lower sales as well as increased engineering, marketing and warehousing expenses. Operating earnings for the Residential segment in fiscal 2015 increased 10.5 percent compared to fiscal 2014. Expressed as a percentage of net sales, Residential segment operating margins increased 30 basis points to 11.7 percent in fiscal 2015 compared to 11.4 percent in fiscal 2014. The following factors impacted Residential segment operating earnings: • Lower gross margins primarily from unfavorable foreign currency exchange rate fluctuations and increased manufacturing expenses. • Lower SG&A expense rate attributable to further leveraging of fixed SG&A costs over higher sales volumes. Other Segment Other segment net sales, which includes our company-owned domestic distributors, represented 1 percent of consolidated net sales for each of fiscal 2016, 2015, and 2014. During the first quarter of fiscal 2016, we sold our Northwestern U.S. distribution company. The following table shows the other segment net sales and operating losses. Net Sales. Net sales for the Other segment includes sales from our wholly owned domestic distribution companies less sales from the Professional and Residential segments to those distribution companies. The Other segment net sales in fiscal 2016 were down $7.8 million compared to fiscal 2015, primarily due to the sale of our Northwestern U.S. distribution company. The Other segment net sales in fiscal 2015 were up by $2.8 million compared to fiscal 2014 due to higher sales volumes driven by strong demand for golf and grounds equipment at our company-owned distribution companies. Operating Loss. Operating loss for the Other segment in fiscal 2016 decreased by 6.5 percent compared to fiscal 2015. This loss decrease was primarily attributable to increased income from our investment in Red Iron and a fiscal 2016 litigation settlement recovery. Operating loss for the Other segment in fiscal 2015 increased by 5.3 percent compared to fiscal 2014. This loss increase was primarily attributable to an increase in interest expense and higher administrative expenses. FINANCIAL CONDITION Working Capital During fiscal 2016, our average net working capital (net accounts receivable plus net inventory less accounts payable) as a percentage of net sales decreased slightly mainly due to lower average net receivables and higher average accounts payable levels. As of the end of fiscal 2016, our average net working capital decreased to 15.9 percent compared to 16.0 percent as of the end of fiscal 2015. The following table highlights several key measures of our working capital performance. The following factors impacted our working capital: • Average net receivables decreased by 6.5 percent in fiscal 2016 compared to fiscal 2015 as more receivables were financed through Red Iron. Our average days outstanding for receivables decreased to 31.4 days in fiscal 2016 compared to 33.6 days in fiscal 2015. • Average inventories increased by 5.3 percent in fiscal 2016 compared to fiscal 2015. Inventory levels as of the end of fiscal 2016 compared to the end of fiscal 2015 were down by $27.5 million, or 8.2 percent, primarily due to efforts to reduce high inventory levels in early fiscal 2016 through focused production planning in the latter half of fiscal 2016. • Average accounts payable increased by 2.9 percent in fiscal 2016 compared to fiscal 2015, mainly due to initiatives to increase days payables outstanding, which included extending payment terms with suppliers. In fiscal 2017, we plan to place increased emphasis on improving asset utilization with a focus on reducing the amount of working capital in the supply chain, adjusting production plans, and maintaining or improving order replenishment and service levels to end users. We anticipate our average net working capital as a percentage of net sales in fiscal 2017 to decrease as compared to fiscal 2016. We plan to place continued importance on managing our average receivables and payables. Additionally, we expect improvements in our average inventory levels primarily driven by increased focus and coordination between our businesses and operations. Capital Expenditures and Other Long-Term Assets Fiscal 2016 capital expenditures of $50.7 million were lower by $5.7 million compared to fiscal 2015. This decrease was primarily attributable to the fiscal 2015 renovation of a portion of our original corporate facility to accommodate additional expansion needs for our product development and test capacities. Capital expenditures for fiscal 2017 are planned to be approximately $65 million as we plan to invest in new product tooling, new technology in production processes and equipment, replacement of production equipment, and investments in new and existing facilities. Long-term assets as of October 31, 2016 were $608.5 million compared to $631.1 million as of October 31, 2015, a decrease of $22.6 million. This decrease was driven mainly by amortization expense of intangible assets and decreases in deferred tax assets. Included in long-term assets as of October 31, 2016 was goodwill in the amount of $194.8 million. Based on our annual impairment analysis, we determined there was no goodwill impairment for any of our reporting units as their related fair values were substantially in excess of their carrying values. Cash Flow Cash flows provided by/(used in) operating, investing, and financing activities during the past three fiscal years are shown in the following table. Cash Flows from Operating Activities. Our primary source of funds is cash generated from operations. In fiscal 2016, cash provided by operating activities increased $125.1 million, or 52.8 percent, from fiscal 2015. This increase was mainly due to lower net receivables as more net receivables were financed through Red Iron and favorable movement in net inventories from focused production planning in the latter half of fiscal 2016. In fiscal 2015, cash provided by operating activities increased $54.5 million, or 29.9 percent, from fiscal 2014. This increase was mainly due to higher net earnings and a smaller increase in working capital needs, as well as higher accounts payable and accrued liabilities. Cash Flows from Investing Activities. Capital expenditures and acquisitions are a significant use of our capital resources. These investments are intended to enable sales growth in new and expanding markets, help us to meet product demand, and increase our manufacturing efficiencies and capacity. Cash used in investing activities in fiscal 2016 decreased $211.2 million from fiscal 2015 due to cash utilized in fiscal 2015 for the acquisition of the BOSS business and lower purchases of property, plant, and equipment, partially offset by increased distributions from our joint venture with Red Iron and proceeds from the sale of our Northwestern distribution company in fiscal 2016. Cash used in investing activities in fiscal 2015 increased $184.6 million from fiscal 2014 due to cash utilized for the acquisition of the BOSS business, partially offset by lower purchases of property, plant, and equipment. Cash Flows from Financing Activities. Cash used in financing activities in fiscal 2016 was $170.4 million compared $173.4 million in fiscal 2015. The decrease in cash used in financing activities was mainly due to favorable benefits from stock-based compensation and less cash utilized for repayments of debt in fiscal 2016 compared fiscal 2015. Partially offsetting this decrease was an increase in cash dividends paid on our common stock and higher amounts of cash utilized for common stock repurchases in fiscal 2016 compared to fiscal 2015. Cash used in financing activities in fiscal 2015 was $173.4 million compared to cash provided by financing activities of $17.0 million in fiscal 2014. The increase in cash used in financing activities was mainly due to repayments of debt in fiscal 2015 compared to cash received from borrowings of debt in fiscal 2014. Additionally, an increase in cash dividends paid on our common stock and higher amounts of cash utilized for stock repurchases in fiscal 2015 compared to fiscal 2014 contributed to the increase in cash used in financing activities. Cash and Cash Equivalents. Cash and cash equivalents as of the end of fiscal 2016 were higher by $147.3 million compared to the end of fiscal 2015. Liquidity and Capital Resources Our businesses are seasonally working capital intensive and require funding for purchases of raw materials used in production, replacement parts inventory, payroll and other administrative costs, capital expenditures, establishment of new facilities, expansion and renovation of existing facilities, as well as for financing receivables from customers that are not financed with Red Iron. Our accounts receivable balances historically increase between January and April as a result of typically higher sales volumes and extended payment terms made available to our customers, and typically decrease between May and December when payments are received. We believe that the funds available through existing financing arrangements and forecasted cash flows will be sufficient to provide the necessary capital resources for our anticipated working capital needs, capital expenditures, investments, debt repayments, quarterly cash dividend payments, and common stock repurchases for at least the next twelve months. As of October 31, 2016, cash and short-term investments held by our foreign subsidiaries that are not available to fund domestic operations unless repatriated were $105.5 million. We currently do not intend to repatriate this cash held by our foreign subsidiaries; however, if circumstances changed and these funds were needed for our U.S. operations, we would be required to accrue and pay U.S. taxes to repatriate these funds. Determination of the unrecognized deferred tax liability related to these earnings is not practicable because of the complexities with its hypothetical calculation. Seasonal cash requirements are financed from operations, cash on hand, and with short-term financing arrangements, including our $150.0 million unsecured senior five-year revolving credit facility that expires in October 2019. Included in our $150.0 million revolving credit facility is a $20.0 million sublimit for standby letters of credit and a $20.0 million sublimit for swingline loans. At our election, and with the approval of the named borrowers on the revolving credit facility and the election of the lenders to fund such increase, the aggregate maximum principal amount available under the facility may be increased by an amount up to $100.0 million in aggregate. Funds are available under the revolving credit facility for working capital, capital expenditures, and other lawful purposes, including, but not limited to, acquisitions and stock repurchases. Interest expense on this credit line is determined based on a LIBOR rate (or other rates quoted by the Administrative Agent, Bank of America, N.A.) plus a basis point spread defined in the credit agreement. In addition, our non-U.S. operations maintain unsecured short-term lines of credit in the aggregate amount of $9.1 million. These facilities bear interest at various rates depending on the rates in their respective countries of operation. As of October 31, 2016 and October 31, 2015 we had no outstanding short-term debt under these lines of credit. As of October 31, 2016, we had $9.0 million of outstanding letters of credit and $150.8 million of unutilized availability under our credit agreements. Additionally, as of October 31, 2016, we had $353.9 million outstanding in long-term debt that includes $100.0 million of 7.8% debentures due June 15, 2027, $123.7 million of 6.625% senior notes due May 1, 2037, $19.7 million due to the former owners of the BOSS business, and $110.5 million in an outstanding term loan. The term loan bears interest based on a LIBOR rate (or other rates quoted by the Administrative Agent, Bank of America, N.A.) plus a basis point spread defined in the credit agreement. The term loan can be repaid in part or in full at any time without penalty, but in any event must be paid in full by October 2019. Our revolving and term loan credit facility contains standard covenants, including, without limitation, financial covenants, such as the maintenance of minimum interest coverage and maximum debt to earnings before interest, tax, depreciation, and amortization ("EBITDA") ratios; and negative covenants, which among other things, limit loans and investments, disposition of assets, consolidations and mergers, transactions with affiliates, restricted payments, contingent obligations, liens, and other matters customarily restricted in such agreements. Most of these restrictions are subject to certain minimum thresholds and exceptions. Under the revolving credit facility, we are not limited in the amount for payments of cash dividends and common stock repurchases as long as our debt to EBITDA ratio from the previous quarter compliance certificate is less than or equal to 3.25, provided that immediately after giving effect of any such proposed action, no default or event of default would exist. As of October 31, 2016, we were not limited in the amount for payments of cash dividends and stock repurchases. We were in compliance with all covenants related to our credit agreement for our revolving credit facility as of October 31, 2016, and we expect to be in compliance with all covenants during fiscal 2017. If we were out of compliance with any covenant required by this credit agreement following the applicable cure period, the banks could terminate their commitments unless we could negotiate a covenant waiver from the banks. In addition, our long-term senior notes, debentures, term loan, and any amounts outstanding under the revolving credit facility could become due and payable if we were unable to obtain a covenant waiver or refinance our short-term debt under our credit agreement. If our credit rating falls below and our debt to EBITDA ratio rises above 1.50, the basis point spread over LIBOR (or other rates quoted by the Administrative Agent, Bank of America, N.A.) we currently pay on outstanding debt under the credit agreement would increase. However, the credit commitment could not be cancelled by the banks based solely on a ratings downgrade. Our debt rating for long-term unsecured senior, non-credit enhanced debt was unchanged during fiscal 2016 by Standard and Poor's Ratings Group at BBB and by Moody's Investors Service at Baa3. Capital Structure The following table details the components of our total capitalization and debt-to-capitalization ratio. Our debt-to-capitalization ratio decreased in fiscal 2016 compared to fiscal 2015 primarily due to an increase in stockholders' equity from higher net earnings and repayments of our long-term debt, partially offset by an increase in dividends paid and repurchases of our common stock in fiscal 2016 as compared to fiscal 2015. Cash Dividends Each quarter in fiscal 2016, our Board of Directors declared a cash dividend of $0.15 per share, which was a 20 percent increase over our cash dividend of $0.125 per share paid each quarter in fiscal 2015. As announced on December 8, 2016, our Board of Directors increased our fiscal 2017 first quarter cash dividend by 16.7 percent to $0.175 per share from the quarterly cash dividend paid in the first quarter of fiscal 2016. Stock Split On August 18, 2016, we announced that our Board of Directors declared a two-for-one stock split of our common stock, effected in the form of a 100 percent stock dividend. The stock split dividend was distributed or paid on September 16, 2016, to stockholders of record as of September 1, 2016. As a result of this action, 54.5 million shares were issued to stockholders of record as of September 1, 2016. The par value of the common stock remains at $1.00 per share and, accordingly, approximately $54.5 million was transferred from retained earnings to common stock. Earnings and dividends declared per share and weighted average shares outstanding are presented in this report after the effect of the 100 percent stock dividend. The two-for-one stock split is reflected in the share amounts in all periods presented in this report. Share Repurchase Plan During fiscal 2016, we continued repurchasing shares of our common stock in the open market, thereby reducing our shares outstanding. In addition, our repurchase program provided shares for use in connection with our equity compensation plans. As of October 31, 2016, 7,692,715 shares remained available for repurchase under our Board authorization. We expect to continue repurchasing shares of our common stock in fiscal 2017, depending upon market conditions. The following table provides information with respect to repurchases of our common stock during the past three fiscal years. 1Share and per share data have been adjusted for all periods presented to reflect the impact of our two-for-one stock split effective September 16, 2016. 2Does not include shares of our common stock surrendered by employees to satisfy minimum tax withholding obligations upon vesting of restricted stock granted under our stock-based compensation plans. Customer Financing Arrangements Wholesale Financing. We are party to a joint venture with TCFIF, established as Red Iron, the primary purpose of which is to provide inventory financing to certain distributors and dealers of our products in the U.S. that enables them to carry representative inventories of our products. Under a separate arrangement, TCFCFC provides inventory financing to dealers of our products in Canada. Under these financing arrangements, down payments are not required and, depending on the finance program for each product line, finance charges are incurred by us, shared between us and the distributor and/or the dealer, or paid by the distributor or dealer. Red Iron retains a security interest in the distributors' and dealers' financed inventories, and those inventories are monitored regularly. Financing terms to the distributors and dealers require payment as the equipment, which secures the indebtedness, is sold to customers or when payment terms become due, whichever occurs first. Rates are generally indexed to LIBOR plus a fixed percentage that differs based on whether the financing is for a distributor or dealer. Rates may also vary based on the product that is financed. Red Iron financed $1,713.6 million of new receivables for dealers and distributors during fiscal 2016, of which $371.1 million was outstanding as of October 31, 2016. Some independent international dealers continue to finance their products with a third-party financing company. This third-party financing company purchased $28.9 million of receivables from us during fiscal 2016, of which $12.3 million was outstanding as of October 31, 2016. We enter into limited inventory repurchase agreements with third party financing companies and Red Iron for receivables financed by them. As of October 31, 2016, we were contingently liable to repurchase up to a maximum amount of $10.4 million of inventory related to receivables under these financing arrangements. We have repurchased immaterial amounts of inventory from third party financing companies and Red Iron over the past three fiscal years. However, a decline in retail sales or financial difficulties of our distributors or dealers could cause this situation to change and thereby require us to repurchase financed product up to but not exceeding our limited obligation, which could have an adverse effect on our operating results. We continue to provide financing in the form of open account terms to home centers and mass retailers; general line irrigation dealers; international distributors and dealers other than the Canadian distributors and dealers to whom Red Iron provides financing arrangements; micro-irrigation dealers and distributors; government customers; and rental companies. End-User Financing. We have agreements with third party financing companies to provide lease-financing options to golf course and sports fields and grounds equipment customers in the U.S. and select countries in Europe. The purpose of these agreements is to increase sales by giving buyers of our products alternative financing options when purchasing our products. We have no contingent liabilities for residual value or credit collection risk under these agreements with third party financing companies. From time to time, we enter into agreements where we provide recourse to third-party finance companies in the event of default by the customer for lease payments to the third-party finance company. Our maximum exposure for credit collection under those arrangements as of October 31, 2016 was $4.9 million. Termination or any material change to the terms of our end-user financing arrangements, availability of credit for our customers, including any delay in securing replacement credit sources, or significant financed product repurchase requirements could have a material adverse impact on our future operating results. Distributor Financing. From time to time, we enter into long-term loan agreements with some distributors. These transactions are used for expansion of the distributors' businesses, acquisitions, refinancing working capital agreements, or facilitation of ownership changes. As of October 31, 2016, we had an outstanding note receivable in the amount of $0.9 million, which is included in other current and long-term assets on our consolidated balance sheet. Off-Balance Sheet Arrangements and Contractual Obligations The following table summarizes our contractual obligations as of October 31, 2016. 1Principal payments in accordance with our credit facilities and long-term debt agreements. 2Interest payments for outstanding long-term debt obligations. Interest on variable rate debt was calculated using the interest rate as of October 31, 2016. 3The unfunded deferred compensation arrangements, covering certain current and retired management employees, consist primarily of salary and bonus deferrals under our deferred compensation plans. Our estimated distributions in the contractual obligations table are based upon a number of assumptions including termination dates and participant elections. 4Purchase obligations represent contracts or commitments for the purchase of raw materials. 5Operating lease obligations do not include payments to property owners covering real estate taxes and common area maintenance. 6Payment obligations in connection with renovations of our corporate facilities located at Bloomington, Minnesota and corporate information technology payment obligations. As of October 31, 2016, we also had $9.0 million in outstanding letters of credit issued, including standby letters of credit and import letters of credit, during the normal course of business, as required by some vendor contracts, as well as $4.9 million in surety bonds, which include workers compensation self-insured bonds. In addition to the contractual obligations described in the preceding table, we may be obligated for additional net cash outflows related to $5.1 million of unrecognized tax benefits, including interest and penalties. The payment and timing of any such payments is affected by the ultimate resolution of the tax years that are under audit or remain subject to examination by the relevant taxing authorities. We have off-balance sheet arrangements with Red Iron, our joint venture with TCFIF, and TCFCFC in which inventory receivables for certain dealers and distributors are financed by Red Iron or TCFCFC. More information regarding the terms and our arrangements with Red Iron and TCFCFC are disclosed herein under Item 7, "Management's Discussion and Analysis of Financial Condition and Results of Operations" and Note 3 of the Notes to Consolidated Financial Statements included in Item 8, "Financial Statements and Supplementary Data." Market Risk Due to the nature and scope of our operations, we are subject to exposures that arise from fluctuations in interest rates, foreign currency exchange rates, and commodity prices. We are also exposed to equity market risk pertaining to the trading price of our common stock. Additional information is presented in Part II, Item 7A, "Quantitative and Qualitative Disclosures about Market Risk," and Note 14 of the Notes to Consolidated Financial Statements. Inflation We are subject to the effects of inflation, deflation, and changing prices. During fiscal 2016, we experienced lower average commodity prices compared to the average prices paid for commodities in fiscal 2015. We intend to continue to closely follow prices of commodities and components that affect our product lines, and we anticipate average prices paid for some commodities and components to be slightly higher in fiscal 2017 as compared to fiscal 2016. Historically, we have mitigated, and we expect that we would continue to mitigate, commodity price increases, if any, in part, by collaborating with suppliers, reviewing alternative sourcing options, substituting materials, engaging in internal cost reduction efforts, and increasing prices on some of our products, all as appropriate. CRITICAL ACCOUNTING POLICIES AND ESTIMATES In preparing our consolidated financial statements in conformity with U.S. generally accepted accounting principles ("GAAP"), we must make decisions that impact the reported amounts of assets, liabilities, revenues and expenses, and related disclosures. Such decisions include the selection of the appropriate accounting principles to be applied and the assumptions on which to base accounting estimates. In reaching such decisions, we apply judgments based on our understanding and analysis of the relevant circumstances, historical experience, and actuarial valuations. Actual amounts could differ from those estimated at the time the consolidated financial statements are prepared. Our significant accounting policies are described in Note 1 of the Notes to Consolidated Financial Statements. Some of those significant accounting policies require us to make difficult subjective or complex judgments or estimates. An accounting estimate is considered to be critical if it meets both of the following criteria: (i) the estimate requires assumptions about matters that are highly uncertain at the time the accounting estimate is made, and (ii) different estimates reasonably could have been used, or changes in the estimate that are reasonably likely to occur from period to period may have a material impact on the presentation of our financial condition, changes in financial condition, or results of operations. Our critical accounting estimates include the following: Warranty Reserve. Warranty coverage on our products is generally for specified periods of time and on select products' hours of usage, and generally covers parts, labor, and other expenses for non-maintenance repairs. Warranty coverage generally does not cover operator abuse or improper use. At the time of sale, we accrue a warranty reserve by product line for estimated costs in connection with future warranty claims. We also establish reserves for major rework campaigns. The amount of our warranty reserves is based primarily on the estimated number of products under warranty, historical average costs incurred to service warranty claims, the trend in the historical ratio of claims to sales, and the historical length of time between the sale and resulting warranty claim. We periodically assess the adequacy of our warranty reserves based on changes in these factors and record any necessary adjustments if actual claim experience indicates that adjustments are necessary. Actual claims could be higher or lower than amounts estimated, as the number and value of warranty claims can vary due to such factors as performance of new products, significant manufacturing or design defects not discovered until after the product is delivered to customers, product failure rates, and higher or lower than expected service costs for a repair. We believe that analysis of historical trends and knowledge of potential manufacturing or design problems provide sufficient information to establish a reasonable estimate for warranty claims at the time of sale. However, since we cannot predict with certainty future warranty claims or costs associated with servicing those claims, our actual warranty costs may differ from our estimates. An unexpected increase in warranty claims or in the costs associated with servicing those claims would result in an increase in our warranty accrual and a decrease in our net earnings. Sales Promotions and Incentives. At the time of sale to a customer, we record an estimate for sales promotion and incentive costs that are classified as a reduction from gross sales or as a component of SG&A expense. Examples of sales promotion and incentive programs include off-invoice discounts, rebate programs, volume discounts, retail financing support, commissions, and other sales discounts and promotional programs. The estimates for sales promotion and incentive costs are based on the terms of the arrangements with customers, historical payment experience, field inventory levels, volume purchases, and expectations for changes in relevant trends in the future. Actual results may differ from these estimates if competitive factors dictate the need to enhance or reduce sales promotion and incentive accruals or if customer usage and field inventory levels vary from historical trends. Adjustments to sales promotions and incentive accruals are made from time to time as actual usage becomes known in order to properly estimate the amounts necessary to generate consumer demand based on market conditions as of the balance sheet date. Goodwill and Other Intangibles. Identifiable intangible assets are amortized over their useful lives, unless the useful life is determined to be indefinite. The useful life of an identifiable intangible asset is based on an analysis of several factors, including contractual, regulatory or legal obligations, demand, competition, and industry trends. Goodwill and indefinite-life intangible assets are not amortized, but are tested at least annually for impairment and whenever events or changes in circumstances indicate that impairment may have occurred. Our impairment testing for goodwill is performed separately from our impairment testing of indefinite-life intangible assets, and the income approach is utilized for both. We test goodwill for impairment at the reporting unit level. Under the income approach, we calculate the fair value of our reporting units and indefinite-life intangible assets using the present value of future cash flows. Individual indefinite-life intangible assets are tested by comparing the book values of each asset to the estimated fair value. Our estimate of fair value for indefinite-life intangible assets uses projected revenues from our forecasting process, assumed royalty rates, and a discount rate. Assumptions used in our impairment evaluations, such as forecasted growth rates and cost of capital, are consistent with internal projections and operating plans. Materially different assumptions regarding future performance of our businesses or a different weighted-average cost of capital could result in impairment losses or additional amortization expense. In conducting the goodwill impairment test, we first perform a qualitative assessment to determine whether it is more likely than not the fair value of any reporting unit is less than its carrying amount. If we conclude that this is the case, a two-step quantitative test for goodwill impairment is performed. In conducting the initial qualitative assessment, we analyze actual and projected growth trends for net sales, gross margin, and earnings for each reporting unit, as well as historical versus planned performance. Additionally, each reporting unit assesses critical areas that may impact its business, including macroeconomic conditions, market-related exposures, competitive changes, new or discontinued products, changes in key personnel, or any other potential risks to projected financial results. All assumptions used in the qualitative assessment require significant judgment. If performed due to impairment indicators or the amount of time since the last analysis, the quantitative goodwill impairment test is a two-step process. First, we compare the carrying value of a reporting unit, including goodwill, to its fair value. The fair value of each reporting unit is estimated using a discounted cash flow model. Where available, and as appropriate, comparable market multiples and our company's market capitalization are also used to corroborate the results of the discounted cash flow models. If the first step indicates the carrying value exceeds the fair value of the reporting unit, then a second step must be completed in order to determine the amount of goodwill impairment that should be recorded. In the second step, the implied fair value of the reporting unit's goodwill is determined by allocating the reporting unit's fair value to all of its assets and liabilities other than goodwill. The implied fair value of the goodwill that results from the application of this second step is then compared to the carrying amount of the goodwill and an impairment charge is recorded for the difference. Inventory Valuation. We value our inventories at the lower of the cost of inventory or net realizable value, with cost determined by either the last-in, first-out ("LIFO") method for most U.S. inventories or the first-in, first-out ("FIFO") method for all other inventories. We establish reserves for excess, slow moving, and obsolete inventory based on inventory levels, expected product life, and forecasted sales demand. Valuation of inventory can also be affected by significant redesign of existing products or replacement of an existing product by an entirely new generation product. In assessing the ultimate realization of inventories, we are required to make judgments as to future demand requirements compared with inventory levels. Reserve requirements are developed according to our projected demand requirements based on historical demand, competitive factors, and technological and product life cycle changes. It is possible that an increase in our reserve may be required in the future if there is a significant decline in demand for our products and we do not adjust our production schedule accordingly. We record a reserve for inventory shrinkage. Our inventory shrinkage reserve represents anticipated physical inventory losses that are recorded based on historical loss trends, ongoing cycle-count and periodic testing adjustments, and inventory levels. Though management considers reserve balances adequate and proper, changes in economic conditions in specific markets in which we operate could have an effect on the reserve balances required for excess, slow moving and obsolete inventory. New Accounting Pronouncements to be Adopted In May 2014, the Financial Accounting Standards Board ("FASB") issued Accounting Standards Update ("ASU") No. 2014-09, Revenue from Contracts with Customers that updates the principles for recognizing revenue. The core principle of the guidance is that an entity should recognize revenue to depict the transfer of promised goods or services to customers in an amount that reflects the consideration to which the entity expects to be entitled to in exchange for those goods or services. The guidance provides a five-step analysis of transactions to determine when and how revenue is recognized. The guidance also requires enhanced disclosures regarding the nature, amount, timing, and uncertainty of revenue and cash flows arising from an entity's contracts with customers. In August 2015, the FASB issued ASU No. 2015-14, Revenue from Contracts with Customers (Topic 606), which deferred the effective date of this standard by one year. We expect to adopt this guidance on November 1, 2018, as required, based on the new effective date. The guidance permits the use of either a retrospective or cumulative effect transition method. We have not yet selected a transition method but plan to select a transition method no later than the fourth quarter of our fiscal 2017. We are currently assessing our contracts with customers and related financial disclosures to evaluate the impact of the amended guidance on our existing revenue recognition policies and procedures. In April 2015, the FASB issued ASU No. 2015-03, Interest - Imputation of Interest (Subtopic 835-30): Simplifying the Presentation of Debt Issuance Costs. This guidance requires that debt issuance costs related to a recognized debt liability be presented in the balance sheet as a direct deduction from the carrying amount of the related debt liability. The amended guidance will become effective for us commencing in the first quarter of fiscal 2017. Early adoption is permitted. We anticipate the adoption of this guidance will not have a material impact on our consolidated financial position. In April 2015, the FASB issued ASU No. 2015-05, Customer's Accounting for Fees Paid in a Cloud Computing Arrangement. This amended guidance requires customers to determine whether or not an arrangement contains a software license element. If the arrangement contains a software element, the related fees paid should be accounted for as an acquisition of a software license. If the arrangement does not contain a software license, it is accounted for as a service contract. The amended guidance will become effective for us commencing in the first quarter of fiscal 2017. Early adoption is permitted. We anticipate the adoption of this guidance will not have a material impact on our consolidated financial statements. In July 2015, the FASB issued ASU No. 2015-11, Inventory (Topic 330): Simplifying the Measurement of Inventory. This amended guidance changes the measurement principle for inventory from the lower of cost or market to lower of cost and net realizable value. The amended guidance will become effective for us commencing in the first quarter of fiscal 2018. Early adoption is permitted. We are currently evaluating the impact of this amended guidance on our consolidated financial statements. In February 2016, the FASB issued ASU 2016-02, Leases, which, among other things, requires lessees to recognize most leases on-balance sheet. The standard requires the recognition of lease assets and lease liabilities by lessees for those leases classified as operating leases under previous GAAP. The amended guidance will become effective for us commencing in the first quarter of fiscal 2020. Entities are required to use a modified retrospective approach, with early adoption permitted. We are reviewing the revised guidance and assessing the impact on our consolidated financial statements. In March 2016, the FASB issued ASU No. 2016-09, Stock-based Compensation: Improvements to Employee Share-based Payment Accounting, which simplifies several aspects of the accounting for share-based payment transactions, including the accounting for income taxes, forfeitures, statutory tax withholding requirements, and statement of cash flow classification. The amended guidance will become effective for us commencing in the first quarter of fiscal 2018. Early adoption is permitted. We plan to early adopt this amended guidance in the first quarter of our fiscal 2017 and are currently evaluating the impact of this new standard on our consolidated financial statements, including the impact on our provision for income taxes on our consolidated income statement. Adoption of this amended guidance will add increased volatility to our provision for income taxes mainly due to timing of stock option exercises, vesting of restricted stock units and common stock price. In August 2016, the FASB issued ASU No. 2016-15, Statement of Cash Flows (Topic 230): Classification of Certain Cash Receipts and Cash Payments, which amends guidance on the classification of certain cash receipts and payments in the statement of cash flows. The amended guidance will become effective for us commencing in the first quarter of fiscal 2019. Early adoption is permitted. We are currently evaluating the impact of this new standard on our consolidated financial statements. In October 2016, the FASB issued ASU No. 2016-16, Income Taxes (Topic 740): Intra-Entity Transfers of Assets Other Than Inventory, which removes the prohibition against the immediate recognition of the current and deferred tax effects of intra-entity transfers of assets other than inventory. The amended guidance will become effective for us commencing in the first quarter of fiscal 2019. Early adoption is permitted. We are currently evaluating the impact of this new standard on our consolidated financial statements. In October 2016, the FASB issued ASU No. 2016-17, Consolidation (Topic 810): Interests Held through Related Parties That Are Under Common Control, which amends guidance on related parties that are under common control. The amended guidance will become effective for us commencing in the first quarter of fiscal 2017. Early adoption is permitted. We are currently evaluating the impact of this new standard on our consolidated financial statements. No other new accounting pronouncement that has been issued but not yet effective for us during fiscal 2016 has had or is expected to have a material impact on our consolidated financial statements.

<s>[INST] OVERVIEW The Toro Company is in the business of designing, manufacturing, and marketing professional turf maintenance equipment and services, turf irrigation systems, landscaping equipment and lighting products, snow and ice management products, agricultural microirrigation systems, rental and specialty construction equipment, and residential yard and snow thrower products. We sell our products worldwide through a network of distributors, dealers, hardware retailers, home centers, mass retailers, and online. Our businesses are organized into three reportable business segments: Professional, Residential, and Distribution. Our Distribution segment, which consists of our companyowned domestic distributorship, has been combined with our corporate activities and is shown as "Other." We strive to provide innovative, wellbuilt, and dependable products supported by an extensive service network. A significant portion of our net sales has historically been, and we expect will continue to be, attributable to new and enhanced products. We define new products as those introduced in the current and previous two fiscal years. Shares and per share data have been adjusted for all periods presented to reflect the impact of our twoforone stock split effective September 16, 2016. Summary of Fiscal 2016 Results In fiscal 2016, we achieved net sales of $2,392.2 million and net earnings growth of 14.6 percent. Our fiscal 2016 results included the following items of significance: Net sales for fiscal 2016 increased by 0.1 percent compared to fiscal 2015 to $2,392.2 million. Foreign currency exchange rate fluctuations negatively impacted our net sales growth by 1.3 percent. The sales increase was primarily attributable to strong demand of our Professional segment products including the successful introduction of new innovative products, primarily offset by lower Residential segment sales driven mainly by decreased preseason snow products demand. Professional segment net sales grew 4.0 percent in fiscal 2016 compared to fiscal 2015. Sales increased primarily from strong demand for our golf and landscape contractor equipment, increased product placement of our microirrigation products, along with continued growth in our rental and specialty construction businesses. Residential segment net sales decreased 7.8 percent in fiscal 2016 compared to fiscal 2015, primarily due to lower sales of snow products and decreased shipments of zeroturn radius riding mowers, partially offset by increased shipments of walk power mowers. International net sales for fiscal 2016 decreased by 5.1 percent compared to fiscal 2015 mainly due to changes in foreign currency exchange rates that reduced our total net sales by approximately $30.6 million in fiscal 2016. International net sales comprised 24.2 percent of our total consolidated net sales in fiscal 2016 compared to 25.5 percent in fiscal 2015 and 28.7 percent in fiscal 2014. These declines were primarily the result of foreign currency exchange rate changes. Fiscal 2016 net earnings of $231.0 million increased 14.6 percent compared to fiscal 2015, and diluted net earnings per share increased 15.7 percent to $2.06 in fiscal 2016 compared to $1.78 in fiscal 2015. Gross margin was 36.6 percent in fiscal 2016, an increase of 160 basis points from 35.0 percent in fiscal 2015. This increase was primarily the result of favorable commodity costs and enhanced productivity, as well as favorable segment mix. Selling, general, and administrative ("SG&A") expense was up 0.6 percent in fiscal 2016 compared to fiscal 2015, or up 10 basis points to 22.6 percent. Receivables decreased by 7.8 percent as of the end of fiscal 2016 compared to the end of fiscal 2015 primarily as a result of more receivables financed through Red Iron. Our inventory levels were down by 8.2 percent as of the end of fiscal 2016 compared to the end of fis [/INST] Positive. </s>

TORO CO

2017-12-22

2017-10-31

ITEM 7. MANAGEMENT'S DISCUSSION AND ANALYSIS OF FINANCIAL CONDITION AND RESULTS OF OPERATIONS This Management's Discussion and Analysis of Financial Condition and Results of Operations ("MD&A") is intended to provide a reader of our financial statements with a narrative from the perspective of management on our financial condition, results of operations, liquidity, and certain other factors that may affect our future results. Unless expressly stated otherwise, the comparisons presented in this MD&A refer to the prior fiscal year. Our MD&A is presented in five sections: • Company Overview • Results of Operations • Business Segments • Financial Position • Critical Accounting Policies and Estimates Statements that are not historical are forward-looking and involve risks and uncertainties, including those discussed in Part I, Item 1A, "Risk Factors" and elsewhere in this report. These risks could cause our actual results to differ materially from any future performance suggested below. COMPANY OVERVIEW The Toro Company is in the business of designing, manufacturing, and marketing professional turf maintenance equipment and services, turf irrigation systems, landscaping equipment and lighting products, snow and ice management products, agricultural micro-irrigation systems, rental and specialty construction equipment, and residential yard and snow thrower products. We sell our products worldwide through a network of distributors, dealers, mass retailers, hardware retailers, home centers, as well as online (direct to end-users). We classify our operations into three reportable business segments: Professional, Residential, and Distribution. Our Distribution segment, which consists of our wholly owned domestic distributorship, has been combined with our corporate activities and elimination of intersegment revenues and expenses and is presented as “Other." We strive to provide innovative, well-built, and dependable products supported by an extensive service network. A significant portion of our net sales has historically been, and we expect will continue to be, attributable to new and enhanced products. We define new products as those introduced in the current and previous two fiscal years. Shares and per share data have been adjusted for prior periods presented to reflect the impact of our two-for-one stock split effective September 16, 2016. Summary of Fiscal 2017 Results In fiscal 2017, we achieved net sales of $2,505.2 million and net earnings growth of 15.9 percent. Our fiscal 2017 results included the following items of significance: • Net sales for fiscal 2017 increased by 4.7 percent to $2,505.2 million when compared to fiscal 2016. The sales increase was primarily attributable to strong demand for our Professional segment products, as well as the successful introduction of new innovative products in the Professional and Residential segments. • Professional segment net sales grew 6.2 percent in fiscal 2017 compared to fiscal 2016. • Residential segment net sales increased 0.6 percent in fiscal 2017 compared to fiscal 2016. • International net sales for fiscal 2017 increased by 5.6 percent compared to fiscal 2016 despite unfavorable foreign currency exchange rate fluctuations. International net sales comprised 24.4 percent of our total consolidated net sales in fiscal 2017 compared to 24.2 percent in fiscal 2016 and 25.5 percent in fiscal 2015. • Fiscal 2017 net earnings of $267.7 million increased 15.9 percent compared to fiscal 2016, and diluted net earnings per share increased 17.0 percent to $2.41 in fiscal 2017 compared to $2.06 in fiscal 2016. • Gross margin was 36.8 percent in fiscal 2017, an increase of 20 basis points from 36.6 percent in fiscal 2016. • Selling, general, and administrative ("SG&A") expense was up 4.7 percent in fiscal 2017 compared to fiscal 2016, or consistent at 22.6 percent as a percentage of net sales. • Receivables increased by 12.1 percent as of the end of fiscal 2017 compared to the end of fiscal 2016. Our inventory levels were up by 7.2 percent as of the end of fiscal 2017 compared to the end of fiscal 2016. • Our field inventory levels were up as of the end of fiscal 2017 compared to the end of fiscal 2016, mainly due to higher Professional segment field inventory levels primarily due to anticipated strong retail demand for early fiscal 2018. • We continued our history of paying quarterly cash dividends in fiscal 2017. We increased our fiscal 2017 quarterly cash dividend by 16.7 percent to $0.175 per share compared to our quarterly cash dividend in fiscal 2016 of $0.15 per share. Please refer to the sections entitled “Results of Operations", "Business Segments", and "Financial Position" included in Part II, Item 7 of this report for additional details concerning our financial results for 2017. Destination PRIME Our multi-year employee initiative, "Destination PRIME," which began with our 2015 fiscal year, continued our journey into our second century. Fiscal 2017 was our final year of this three-year initiative, which was intended to help us drive revenue and earnings growth and further improve productivity, while also continuing our century-long commitment to innovation, relationships, and excellence. Through our Destination PRIME initiative, we strove to achieve organic revenue growth, operating earnings, and working capital goals. Organic Revenue Growth Our organic revenue growth goal was to achieve five percent or more organic revenue growth each fiscal year during this initiative. For purposes of this goal, we defined organic revenue growth as the increase in net sales, less net sales from acquisitions that occurred in the current fiscal year. In fiscal years 2017, 2016, and 2015, we fell short of this goal by achieving 4.2 percent, 0.1 percent, and 4.1 percent organic revenue growth, respectively. Operating Earnings Our operating earnings goal was to raise operating earnings as a percentage of net sales to more than 13 percent by the end of fiscal 2017. We achieved this goal as we realized 14.2 percent of operating earnings as a percentage of net sales by the end of fiscal 2017. Working Capital Our working capital goal was to drive down average net working capital as a percentage of net sales to 13 percent or less by the end of fiscal 2017. We define average net working capital as net accounts receivable plus net inventory, less accounts payable as a percentage of net sales for a twelve month period. Our average net working capital as a percentage of net sales was 13.8 percent at the end of fiscal 2017. New Three-Year Initiative Our new multi-year initiative, "Vision 2020", will focus on driving profitable growth with an emphasis on innovation and serving our customers, which we believe will generate further momentum for the organization. We have set specific goals intended to help us drive organic revenue and operating earnings growth. While there is not a specific goal for working capital in our new Vision 2020 initiative, it is our intent to maintain the progress we made through our previous initiatives and to not lose sight of this important metric. Organic Revenue Growth We intend to pursue strategic growth of our existing businesses and product categories with an organic revenue goal. One of our goals of our new Vision 2020 initiative is to achieve at least five percent or more organic revenue growth each of the three fiscal years of this initiative. For purposes of this goal, we define organic revenue growth as the increase in net sales, less net sales from acquisitions that occurred in the current fiscal year. Operating Earnings Additionally, as part of our new Vision 2020 initiative growth goals, we have set an operating earnings goal to increase operating earnings as a percentage of net sales to 15.5 percent or higher by the end of fiscal 2020. RESULTS OF OPERATIONS The following table summarizes our results of operations as a percentage of our consolidated net sales: Fiscal 2017 Compared with Fiscal 2016 Net Sales Worldwide net sales in fiscal 2017 were $2,505.2 million compared to $2,392.2 million in fiscal 2016, an increase of 4.7 percent. This net sales increase was primarily attributable to the following factors: • Increased sales of Professional segment products were primarily driven from the successful introduction of new products and strong demand for our golf and grounds equipment, successful introduction of new landscape contractor equipment, continued growth in our rental and specialty construction businesses, increased shipments of our snow and ice management products, and our acquisition of the Perrot irrigation business in the first quarter of fiscal 2017. • Increased sales of Residential segment products were primarily due to increased demand for our Pope-branded irrigation products and increased shipments of snow products, partially offset by decreased shipments of zero-turn radius riding mowers. • Net sales in international markets increased by 5.6 percent in fiscal 2017 compared to fiscal 2016, mainly due to strong demand for our golf and grounds equipment, our acquisition of the Perrot irrigation business, and increased demand for our Pope-branded irrigation products, partially offset by fluctuations in foreign currency exchange rates that reduced our total net sales by approximately $3.3 million in fiscal 2017. Gross Margin Gross margin represents gross profit (net sales less cost of sales) as a percentage of net sales. See Note 1 of the Notes to Consolidated Financial Statements, in the section entitled "Cost of Sales," included in Part II, Item 8, "Financial Statements and Supplementary Data" of this report for a description of expenses included in cost of sales. Gross margin increased by 20 basis points to 36.8 percent in fiscal 2017 from 36.6 percent in fiscal 2016. This increase was mainly the result of the following factors: • Favorable operational productivity due to production efficiencies and Lean method initiatives. • Favorable segment mix from a higher mix of Professional segment product sales. Somewhat offsetting those favorable factors were: • Higher costs of commodities, primarily steel and resin. • Higher freight costs. Selling, General, and Administrative Expense SG&A expense increased $25.5 million, or 4.7 percent, in fiscal 2017 compared to fiscal 2016. See Note 1 of the Notes to Consolidated Financial Statements, in the section entitled "Selling, General, and Administrative Expense," included in Part II, Item 8, "Financial Statements and Supplementary Data" of this report for a description of expenses included in SG&A expense. SG&A expense rate represents SG&A expense as a percentage of net sales. The SG&A expense rate in fiscal 2017 stayed consistent with the SG&A expense rate in fiscal 2016 at 22.6 percent. As a percentage of net sales, our SG&A expense rate was mainly impacted by decreased administrative expense primarily due to favorable health care claims experience in fiscal 2017, offset, in large part, by higher incentive expense due to improved company performance in fiscal 2017. Interest Expense Interest expense for fiscal 2017 decreased $0.2 million compared to fiscal 2016. Other Income, Net Other income, net consists mainly of our proportionate share of income or losses from equity investments (from Red Iron), currency exchange rate gains and losses, litigation settlements and recoveries, interest income, dividend income, other income, and retail financing revenue. Other income for fiscal 2017 was $17.2 million compared to $15.4 million in fiscal 2016, an increase of $1.8 million. The increase in other income, net was primarily due to higher income from our equity investment in Red Iron of $2.0 million, foreign currency contract exchange gains of $0.6 million, and higher interest income of $0.5 million, partially offset by a fiscal 2016 litigation recovery that was not repeated in fiscal 2017 of $1.3 million. Provision for Income Taxes The effective tax rate for fiscal 2017 was 24.2 percent compared to 30.1 percent in fiscal 2016. The decrease was primarily the result of the adoption of ASU 2016-09 in fiscal 2017, which resulted in a tax benefit of $19.7 million. Net Earnings Fiscal 2017 net earnings were $267.7 million compared to $231.0 million in fiscal 2016, an increase of 15.9 percent. Fiscal 2017 diluted net earnings per share were $2.41, an increase of 17.0 percent from $2.06 per share in fiscal 2016. The primary factors contributing to the net earnings increase was a lower effective tax rate, mainly driven by the adoption of ASU 2016-09 in fiscal 2017, along with net sales and gross margin improvement. Fiscal 2016 Compared with Fiscal 2015 Net Sales Worldwide net sales in fiscal 2016 were $2,392.2 million compared to $2,390.9 million in fiscal 2015, an increase of 0.1 percent. This net sales increase was primarily attributable to the following factors: • Increased sales of Professional segment products were driven by (i) higher shipments and demand for golf, landscape contractor, and rental and specialty equipment products primarily due to continued market growth and increased demand for our innovative product offerings and the successful introduction of new products, and (ii) our micro-irrigation and irrigation product sales increased mainly due to improved product placement and higher project sales, partially offset by lower sales of snow and ice management products primarily due to decreased pre-season demand. • Decreased sales of Residential segment products were mainly driven by lower sales and pre-season retail demand for snow thrower products, decreased shipments of zero-turn radius riding mowers, and unfavorable weather conditions in many of our markets, partially offset by increased sales of our walk power mowers mainly due to strong shipments driven by our innovative product offerings and favorable growing season weather in key markets. • Net sales in international markets decreased by 5.1 percent in fiscal 2016 compared to fiscal 2015 due to unfavorable foreign currency exchange rate fluctuations that reduced our total net sales by approximately $30.6 million in fiscal 2016. Gross Margin Gross margin increased by 160 basis points to 36.6 percent in fiscal 2016 from 35.0 percent in fiscal 2015. This increase was mainly the result of the following factors: • Lower costs of commodities, primarily steel and resin, and favorable operational productivity. • Favorable segment mix from a higher mix of Professional segment product sales, which generally carry higher gross margins. Somewhat offsetting those positive factors were unfavorable foreign currency exchange rate fluctuations. Selling, General, and Administrative Expense SG&A expense increased $3.4 million, or 0.6 percent, in fiscal 2016 compared to fiscal 2015. SG&A expense rate in fiscal 2016 increased 10 basis points to 22.6 percent compared to 22.5 percent in fiscal 2015. Our SG&A expense rate was primarily impacted by the following factors as a percentage of net sales: • Continued investments in engineering and new product development. • Increased warranty expense driven by higher claims experience for fiscal 2016. Somewhat offsetting those increases were: • Decreased incentive expense due to actual performance against specified goals. • Decreased administrative expense. Interest Expense Interest expense for fiscal 2016 increased $0.6 million compared to fiscal 2015. Other Income, Net Other income for fiscal 2016 was $15.4 million compared to $10.7 million in fiscal 2015, an increase of $4.7 million. The increase in other income, net was primarily due to foreign currency contract exchange gains of $1.8 million, a fiscal 2016 litigation recovery of $1.3 million, and higher earnings from our equity investment in Red Iron of $1.2 million. Provision for Income Taxes The effective tax rate for fiscal 2016 was 30.1 percent compared to 30.7 percent in fiscal 2015. The decrease was primarily the result of more favorable one-time adjustments related to prior years, and the permanent extension of the federal research credit. Net Earnings Fiscal 2016 net earnings were $231.0 million compared to $201.6 million in fiscal 2015, an increase of 14.6 percent. Fiscal 2016 diluted net earnings per share were $2.06, an increase of 15.7 percent from $1.78 per share in fiscal 2015. The primary factors contributing to the net earnings increase were gross margin improvement and a decrease in our effective tax rate. However, these improvements were partially offset by an increase in our SG&A expense. BUSINESS SEGMENTS As more fully described in Note 12 of the Notes to Consolidated Financial Statements, we operate in three reportable business segments: Professional, Residential, and Distribution. Our Distribution segment, which consists of our wholly owned domestic distributorship, has been combined with our corporate activities and is shown as "Other." Operating earnings for our Professional and Residential segments are defined as earnings from operations plus other income, net. Operating loss for the Other segment includes earnings (loss) from our wholly owned domestic distribution company, corporate activities, other income, and interest expense. The following information provides perspective on our business segments' net sales and operating results. Professional Segment Professional segment net sales represented approximately 72 percent of consolidated net sales for fiscal 2017, 71 percent for fiscal 2016, and 69 percent for fiscal 2015. The following table shows the Professional segment net sales, operating earnings, and operating earnings as a percent of net sales: Net Sales Worldwide net sales for the Professional segment in fiscal 2017 were up by 6.2 percent compared to fiscal 2016 primarily as a result of the following factors: • Higher shipments of golf and grounds equipment, primarily due to strong demand for our innovative product offerings. • Higher shipments of landscape contractor equipment, primarily driven by strong demand for new products. • Increased shipments of rental and specialty construction equipment, mainly driven by strong demand, and positive customer response for new products. • Increased sales of snow and ice management products, mainly driven by new product offerings and favorable snowfalls in the first quarter of fiscal 2017. • Increased sales of irrigation products mainly driven by the acquisition of the Perrot business. Somewhat offsetting those increases were unfavorable foreign currency exchange rate fluctuations. Worldwide net sales for the Professional segment in fiscal 2016 were up by 4.0 percent compared to fiscal 2015 primarily as a result of the following factors: • Higher shipments of golf equipment and irrigation products, mainly due to demand for our innovative product offerings, the successful introduction of new products, increased golf irrigation projects, and favorable weather conditions. • Increased sales of landscape contractor equipment driven by strong demand for our riding and stand-on mower product lines. • Higher sales of micro-irrigation products mainly driven by improved product placement. • Increased sales driven by strong demand and market growth for rental and specialty construction equipment, as well as positive customer response for new products. Somewhat offsetting those positive factors were: • Unfavorable foreign currency exchange rate fluctuations. • A decline in sales of snow and ice management products which was driven mainly from decreased pre-season demand. Operating Earnings Operating earnings for the Professional segment in fiscal 2017 increased 7.8 percent compared to fiscal 2016. Expressed as a percentage of net sales, Professional segment operating margins increased by 30 basis points to 20.9 percent in fiscal 2017 compared to 20.6 percent in fiscal 2016. The following factors impacted Professional segment operating earnings as a percentage of net sales for fiscal 2017: • Higher gross margin in fiscal 2017 compared to fiscal 2016 mainly due to favorable operational productivity from production efficiencies and Lean method initiatives, partially offset by higher commodity costs and unfavorable product mix. • A decline in SG&A expense rate in fiscal 2017 compared to fiscal 2016 primarily due to lower administration and engineering expense as a percentage of net sales. Operating earnings for the Professional segment in fiscal 2016 increased 14.3 percent compared to fiscal 2015. Expressed as a percentage of net sales, Professional segment operating margins increased by 180 basis points to 20.6 percent in fiscal 2016 compared to 18.8 percent in fiscal 2015. The following factors impacted Professional segment operating earnings as a percentage of net sales for fiscal 2016: • Higher gross margin in fiscal 2016 compared to fiscal 2015 mainly due to lower commodity costs and productivity improvements, as well as favorable product mix, partially offset by unfavorable foreign currency exchange rate fluctuations. • A decline in SG&A expense rate in fiscal 2016 compared to fiscal 2015 due to a lower administration expense rate. The domestic field inventory levels of our Professional segment products were higher as of the end of fiscal 2017 compared to the end of fiscal 2016, primarily due to anticipated strong retail demand in early fiscal 2018. Residential Segment Residential segment net sales represented approximately 27 percent of consolidated net sales for fiscal 2017, 28 percent for fiscal 2016, and 30 percent for fiscal 2015. The following table shows the Residential segment net sales, operating earnings, and operating earnings as a percent of net sales: Net Sales Worldwide net sales for the Residential segment in fiscal 2017 were up by 0.6 percent compared to fiscal 2016 primarily as a result of the following factors: • Higher sales of Pope-branded irrigation products in Australia mainly due to strong demand and favorable weather conditions. • Increased shipments of snow products mainly driven by favorable snowfalls in the first quarter of fiscal 2017. Somewhat offsetting those increases were: • Lower shipments of our zero-turn radius riding mowers due to lower demand for our steering wheel zero-turn radius mower models and higher demand for our new lines of Professional segment contractor grade zero-turn radius mowers. • Unfavorable foreign currency exchange rate fluctuations. Worldwide net sales for the Residential segment in fiscal 2016 were down by 7.8 percent compared to fiscal 2015 primarily as a result of the following factors: • Decreased shipments and lower retail demand for snow products due to low snowfall totals in the 2015/2016 season. • Lower sales of zero-turn radius riding mowers primarily driven by variable weather conditions throughout the year and a slight reduction in retail placement. • Unfavorable weather conditions in many of our markets. Somewhat offsetting the decrease in Residential segment net sales in fiscal 2016 when compared to fiscal 2015, were higher sales of walk power mowers driven by increased demand for our product offerings and strong customer response for our innovative models, including our SMARTSTOW® and all-wheel drive models. Operating Earnings Operating earnings for the Residential segment in fiscal 2017 increased 1.4 percent compared to fiscal 2016. Expressed as a percentage of net sales, Residential segment operating margins increased 10 basis points to 11.1 percent in fiscal 2017 compared to 11.0 percent in fiscal 2016. The following factors impacted Residential segment operating earnings as a percentage of net sales for fiscal 2017: • Higher gross margin in fiscal 2017 compared to fiscal 2016 mainly due to favorable product mix and favorable operational productivity from production efficiencies, partially offset by higher commodity costs and freight expense. • An increased SG&A expense rate attributable to higher incentive and engineering expense as a percentage of net sales. Operating earnings for the Residential segment in fiscal 2016 decreased 13.3 percent compared to fiscal 2015. Expressed as a percentage of net sales, Residential segment operating margins decreased 70 basis points to 11.0 percent in fiscal 2016 compared to 11.7 percent in fiscal 2015. The following factors impacted Residential segment operating earnings as a percentage of net sales for fiscal 2016: • Higher gross margin in fiscal 2016 compared to fiscal 2015 mainly due to lower commodity costs and freight expense, partially offset by unfavorable foreign currency exchange rate fluctuations. • Increased SG&A expense rate attributable to lower sales as well as increased engineering, marketing and warehousing expenses as a percentage of net sales. The domestic field inventory levels of our Residential segment products as of the end of fiscal 2017 were consistent with the levels of fiscal 2016. Other Segment Other segment net sales, which includes our wholly owned domestic distributor, represented approximately 1 percent of consolidated net sales for each of fiscal 2017, 2016, and 2015. During the first quarter of fiscal 2016, we sold our Northwestern U.S. distribution company. The following table shows the other segment net sales and operating losses: Net Sales Net sales for the Other segment includes sales from our wholly owned domestic distribution company less sales from the Professional and Residential segments to that distribution company. The Other segment net sales in fiscal 2017 were up $2.5 million compared to fiscal 2016, primarily due to strong demand for our golf and grounds equipment that was sold through our wholly owned domestic distribution company. The Other segment net sales in fiscal 2016 were down $7.8 million compared to fiscal 2015, primarily due to the sale of our Northwestern U.S. distribution company in the first quarter of fiscal 2016. Operating Loss Operating loss for the Other segment in fiscal 2017 increased by 6.0 percent compared to fiscal 2016. This loss increase was primarily attributable to higher incentive expense due to improved company performance. Operating loss for the Other segment in fiscal 2016 decreased by 6.5 percent compared to fiscal 2015. This loss decrease was primarily attributable to increased income from our investment in Red Iron and a fiscal 2016 litigation settlement recovery. FINANCIAL POSITION Working Capital We define average net working capital as average net accounts receivable plus net inventory, less accounts payable as a percentage of net sales for a twelve month period. As of the end of fiscal 2017, our average net working capital decreased to 13.8 percent compared to 15.9 percent as of the end of fiscal 2016 mainly due to higher average accounts payable and higher net sales. The following table highlights several key measures of our working capital performance: The following factors impacted our working capital: • Average net receivables increased by 1.3 percent in fiscal 2017 compared to fiscal 2016 due to increased sales in fiscal 2017. Our average days outstanding for receivables decreased to 30.4 days in fiscal 2017 compared to 31.4 days in fiscal 2016. • Average inventories decreased by 2.1 percent in fiscal 2017 compared to fiscal 2016. Inventory levels as of the end of fiscal 2017 compared to the end of fiscal 2016 were up by $22.0 million, or 7.2 percent, primarily due to higher Professional segment forecasted retail demand. • Average accounts payable increased by 14.7 percent in fiscal 2017 compared to fiscal 2016, mainly due to initiatives to manage our payables, which included extending payment terms with suppliers. Capital Expenditures and Other Long-Term Assets Fiscal 2017 capital expenditures of $58.3 million were higher by $7.6 million compared to fiscal 2016. This increase was mainly attributable to fiscal 2017 facilities renovations, replacement of production process equipment, investments in new technology, and expanded capacity. Capital expenditures for fiscal 2018 are expected to be approximately $75 million as we plan to invest in our facilities, new product tooling, new technology in production processes and equipment, replacement of production equipment, and expanded capacity. Long-term assets as of October 31, 2017 were $633.9 million compared to $605.6 million as of October 31, 2016, an increase of $28.3 million. This increase was driven mainly by the acquisition of the Perrot business in the first quarter of fiscal 2017 and an increase in deferred tax assets. Included in long-term assets as of October 31, 2017 was goodwill in the amount of $205.0 million. Based on our annual impairment analysis, we determined there was no goodwill impairment for any of our reporting units as their related fair values were substantially in excess of their carrying values. Cash Flow Cash flows provided by/(used in) operating, investing, and financing activities during the past three fiscal years are shown in the following table: Cash Flows from Operating Activities Our primary source of funds is cash generated from operations. In fiscal 2017, cash provided by operating activities decreased by $23.5 million, or 6.1 percent, from fiscal 2016. This decrease was mainly due to higher net receivables as a result of higher sales, as well as increased net inventories due to higher amounts of inventory purchased to support higher Professional segment forecasted retail demand. This decrease was partially offset by higher net earnings, higher payables due to continued working capital initiatives, and a Red Iron exclusivity incentive payment. In fiscal 2016, cash provided by operating activities increased $134.7 million, or 54.0 percent, from fiscal 2015. This increase was mainly due to lower net receivables as more net receivables were financed through Red Iron and favorable movement in net inventories from focused production planning in the latter half of fiscal 2016. Cash Flows from Investing Activities Capital expenditures and acquisitions are a significant use of our capital resources. These investments are intended to enable sales growth in new and expanding markets, help us to meet product demand, and increase our manufacturing efficiencies and capacity. Cash used in investing activities in fiscal 2017 increased by $34.8 million from fiscal 2016 mainly due to cash utilized for the acquisition of the Perrot business in the first quarter of fiscal 2017 and higher purchases of property, plant, and equipment. Cash used in investing activities in fiscal 2016 decreased $205.6 million from fiscal 2015 due to cash utilized in fiscal 2015 for the acquisition of the BOSS business and lower purchases of property, plant, and equipment, partially offset by proceeds from the sale of our Northwestern distribution company in fiscal 2016. Cash Flows from Financing Activities Cash used in financing activities in fiscal 2017 was $245.3 million compared to $182.9 million in fiscal 2016. The increase in cash used in financing activities was mainly due to more cash used for common stock repurchases, lower proceeds from stock-based compensation, and increased cash dividends paid on our common stock in fiscal 2017 compared to fiscal 2016. Cash used in financing activities in fiscal 2016 was $182.9 million compared to $181.8 million in fiscal 2015. The increase in cash used in financing activities was mainly due to an increase in cash dividends paid on our common stock and higher amounts of cash utilized for common stock repurchases, partially offset by favorable benefits from stock-based compensation and less cash utilized for repayments of debt in fiscal 2016 compared fiscal 2015. Cash and Cash Equivalents Cash and cash equivalents as of the end of fiscal 2017 increased by $36.7 million compared to the end of fiscal 2016. Liquidity and Capital Resources Our businesses are seasonally working capital intensive and require funding for purchases of raw materials used in production, replacement parts inventory, payroll and other administrative costs, capital expenditures, establishment of new facilities, expansion and renovation of existing facilities, as well as for financing receivables from customers that are not financed with Red Iron. Our accounts receivable balances historically increase between January and April as a result of typically higher sales volumes and extended payment terms made available to our customers, and typically decrease between May and December when payments are received. We believe that the funds available through existing financing arrangements and forecasted cash flows will be sufficient to provide the necessary capital resources for our anticipated working capital needs, capital expenditures, investments, debt repayments, quarterly cash dividend payments, and common stock repurchases for at least the next twelve months. As of October 31, 2017, cash and short-term investments held by our foreign subsidiaries that are not available to fund domestic operations unless repatriated were $133.5 million. We currently do not intend to repatriate this cash held by our foreign subsidiaries; however, if circumstances changed and these funds were needed for our U.S. operations, we would be required to accrue and pay U.S. taxes to repatriate these funds. Determination of the unrecognized deferred tax liability related to these earnings is not practicable because of the complexities with its hypothetical calculation. Seasonal cash requirements are financed from operations, cash on hand, and with short-term financing arrangements, including our $150.0 million unsecured senior five-year revolving credit facility that expires in October 2019. Included in our $150.0 million revolving credit facility is a $20.0 million sublimit for standby letters of credit and a $20.0 million sublimit for swingline loans. At our election, and with the approval of the named borrowers on the revolving credit facility and the election of the lenders to fund such increase, the aggregate maximum principal amount available under the facility may be increased by an amount up to $100.0 million. Funds are available under the revolving credit facility for working capital, capital expenditures, and other lawful purposes, including, but not limited to, acquisitions and stock repurchases. Interest expense on this credit line is determined based on a LIBOR rate (or other rates quoted by the Administrative Agent, Bank of America, N.A.) plus a basis point spread defined in the credit agreement. In addition, our non-U.S. operations maintain unsecured short-term lines of credit in the aggregate amount of $9.2 million. These facilities bear interest at various rates depending on the rates in their respective countries of operation. As of October 31, 2017 and October 31, 2016 we had no outstanding short-term debt under these lines of credit. As of October 31, 2017, we had $10.2 million of outstanding letters of credit and $149.0 million of unutilized availability under our credit agreements. Additionally, as of October 31, 2017, we had $331.9 million outstanding in long-term debt that includes $100.0 million of 7.8 percent debentures due June 15, 2027, $123.8 million of 6.625 percent senior notes due May 1, 2037, a $100.8 million term loan, a $10.0 million note due November 14, 2017 to the former owners of the BOSS business, and partially offsetting debt issuance costs and deferred charges of $2.7 million related to our outstanding long-term debt. The term loan bears interest based on a LIBOR rate (or other rates quoted by the Administrative Agent, Bank of America, N.A.) plus a basis point spread defined in the credit agreement. The term loan can be repaid in part or in full at any time without penalty, but in any event must be paid in full by October 2019. Our revolving and term loan credit facility contains standard covenants, including, without limitation, financial covenants, such as the maintenance of minimum interest coverage and maximum debt to EBITDA ratios; and negative covenants, which among other things, limit loans and investments, disposition of assets, consolidations and mergers, transactions with affiliates, restricted payments, contingent obligations, liens, and other matters customarily restricted in such agreements. Most of these restrictions are subject to certain minimum thresholds and exceptions. Under the revolving credit facility, we are not limited in the amount for payments of cash dividends and common stock repurchases as long as our debt to EBITDA ratio from the previous quarter compliance certificate is less than or equal to 3.25, provided that immediately after giving effect of any such proposed action, no default or event of default would exist. As of October 31, 2017, we were not limited in the amount for payments of cash dividends and stock repurchases. We were in compliance with all covenants related to our credit agreement for our revolving credit facility as of October 31, 2017, and we expect to be in compliance with all covenants during fiscal 2018. If we were out of compliance with any covenant required by this credit agreement following the applicable cure period, the banks could terminate their commitments unless we could negotiate a covenant waiver from the banks. In addition, our long-term senior notes, debentures, term loan, and any amounts outstanding under the revolving credit facility could become due and payable if we were unable to obtain a covenant waiver or refinance our short-term debt under our credit agreement. If our credit rating falls below investment grade and/or our average debt to EBITDA ratio rises above 1.50, the basis point spread over LIBOR (or other rates quoted by the Administrative Agent, Bank of America, N.A.) we currently pay on outstanding debt under the credit agreement would increase. However, the credit commitment could not be canceled by the banks based solely on a ratings downgrade. Our debt rating for long-term unsecured senior, non-credit enhanced debt was unchanged during fiscal 2017 by Standard and Poor's Ratings Group at BBB and by Moody's Investors Service at Baa3. Capital Structure The following table details the components of our total capitalization and debt-to-capitalization ratio: Our debt-to-capitalization ratio decreased in fiscal 2017 compared to fiscal 2016 primarily due to an increase in stockholders' equity from higher net earnings, as well as repayments of our long-term debt, partially offset by an increase in dividends paid and repurchases of our common stock in fiscal 2017 as compared to fiscal 2016. Cash Dividends In each quarter of fiscal 2017, our Board of Directors declared a cash dividend of $0.175 per share, which was a 16.7 percent increase over our cash dividend of $0.15 per share paid each quarter in fiscal 2016. As announced on December 7, 2017, our Board of Directors increased our fiscal 2018 first quarter cash dividend by 14.3 percent to $0.20 per share from the quarterly cash dividend paid in the first quarter of fiscal 2017. Share Repurchases During fiscal 2017, we continued to repurchase shares of our common stock in the open market, thereby reducing our total shares outstanding. As of October 31, 2017, 4,981,878 shares remained available for repurchase under our Board authorization. Our repurchase program also provides shares for use in connection with our equity compensation plans. We expect to continue repurchasing shares of our common stock in fiscal 2018, depending upon market conditions. The following table provides information with respect to repurchases of our common stock during the past three fiscal years: Share and per share data have been adjusted for prior year periods presented to reflect the impact of our two-for-one stock split effective September 16, 2016. Customer Financing Arrangements Wholesale Financing We are party to a joint venture with TCFIF, established as Red Iron, the primary purpose of which is to provide inventory financing to certain distributors and dealers of our products in the U.S. that enables them to carry representative inventories of our products. Under a separate arrangement, TCFCFC provides inventory financing to dealers of our products in Canada. Under these financing arrangements, down payments are not required and, depending on the finance program for each product line, finance charges are incurred by us, shared between us and the distributor and/or the dealer, or paid by the distributor or dealer. Red Iron retains a security interest in the distributors' and dealers' financed inventories, and those inventories are monitored regularly. Financing terms to the distributors and dealers require payment as the equipment, which secures the indebtedness, is sold to customers or when payment terms become due, whichever occurs first. Rates are generally indexed to LIBOR plus a fixed percentage that differs based on whether the financing is for a distributor or dealer. Rates may also vary based on the product that is financed. Red Iron financed $1,847.7 million of new receivables for dealers and distributors during fiscal 2017, of which $407.5 million of net receivables were outstanding as of October 31, 2017. Some independent international dealers continue to finance their products with a third-party financing company. This third-party financing company purchased $32.1 million of receivables from us during fiscal 2017, of which $13.1 million was outstanding as of October 31, 2017. We enter into limited inventory repurchase agreements with third party financing companies and Red Iron for receivables financed by them. As of October 31, 2017, we were contingently liable to repurchase up to a maximum amount of $10.7 million of inventory related to receivables under these financing arrangements. We have repurchased immaterial amounts of inventory from third party financing companies and Red Iron over the past three fiscal years. However, a decline in retail sales or financial difficulties of our distributors or dealers could cause this situation to change and thereby require us to repurchase financed product up to but not exceeding our limited obligation, which could have an adverse effect on our operating results. We continue to provide financing in the form of open account terms to home centers and mass retailers; general line irrigation dealers; international distributors and dealers other than the Canadian distributors and dealers to whom Red Iron provides financing arrangements; micro-irrigation dealers and distributors; government customers; and rental companies. End-User Financing We have agreements with third party financing companies to provide lease-financing options to golf course and sports fields and grounds equipment customers in the U.S., Australia, and select countries in Europe. The purpose of these agreements is to increase sales by giving buyers of our products alternative financing options when purchasing our products. We have no contingent liabilities for residual value or credit collection risk under these agreements with third party financing companies. From time to time, we enter into agreements where we provide recourse to third-party finance companies in the event of default by the customer for lease payments to the third-party finance company. Our maximum exposure for credit collection under those arrangements as of October 31, 2017 was $6.6 million. Termination or any material change to the terms of our end-user financing arrangements, availability of credit for our customers, including any delay in securing replacement credit sources, or significant financed product repurchase requirements could have a material adverse impact on our future operating results. Distributor Financing Occasionally, we enter into long-term loan agreements with some distributors. These transactions are used for expansion of the distributors' businesses, acquisitions, refinancing working capital agreements, or facilitation of ownership transitions. As of October 31, 2017, we had outstanding notes receivable in the amount of $1.6 million, which is included in other current and long-term assets on our Consolidated Balance Sheets. Off-Balance Sheet Arrangements and Contractual Obligations The following table summarizes our contractual obligations as of October 31, 2017: Principal payments in accordance with our credit facilities and long-term debt agreements. Interest payments for outstanding long-term debt obligations. Interest on variable rate debt was calculated using the interest rate as of October 31, 2017. The unfunded deferred compensation arrangements, covering certain current and retired management employees, consist primarily of salary and bonus deferrals under our deferred compensation plans. Our estimated distributions in the contractual obligations table are based upon a number of assumptions including termination dates and participant elections. Purchase obligations represent contracts or commitments for the purchase of raw materials. Operating lease obligations do not include payments to property owners covering real estate taxes and common area maintenance. Payment obligations in connection with renovations of our corporate facilities located at Bloomington, Minnesota and corporate information technology payment obligations. As of October 31, 2017, we also had $10.2 million in outstanding letters of credit issued, including standby letters of credit and import letters of credit, during the normal course of business, as required by some vendor contracts, as well as $5.4 million in surety bonds, which include workers compensation self-insured bonds. In addition to the contractual obligations described in the preceding table, we may be obligated for additional net cash outflows related to $2.2 million of unrecognized tax benefits, including interest and penalties. The payment and timing of any such payments is affected by the ultimate resolution of the tax years that are under audit or remain subject to examination by the relevant taxing authorities. We have off-balance sheet arrangements with Red Iron, our joint venture with TCFIF, and TCFCFC in which inventory receivables for certain dealers and distributors are financed by Red Iron or TCFCFC. More information regarding the terms and our arrangements with Red Iron and TCFCFC are disclosed herein under Item 7, "Management's Discussion and Analysis of Financial Condition and Results of Operations" and Note 3 of the Notes to Consolidated Financial Statements included in Item 8, "Financial Statements and Supplementary Data." Market Risk Due to the nature and scope of our operations, we are subject to exposures that arise from fluctuations in interest rates, foreign currency exchange rates, and commodity prices. We are also exposed to equity market risk pertaining to the trading price of our common stock. Additional information is presented in Part II, Item 7A, "Quantitative and Qualitative Disclosures about Market Risk," and Note 14 of the Notes to Consolidated Financial Statements. Inflation We are subject to the effects of inflation, deflation, and changing prices. During fiscal 2017, average prices paid for commodities and components we purchased were higher compared to the average prices paid for commodities and components in fiscal 2016. We intend to continue to closely follow prices of commodities and components that affect our product lines, and we anticipate average prices paid for some commodities and components to be higher in fiscal 2018 as compared to fiscal 2017. Historically, we have mitigated, and we currently expect that we would mitigate, any commodity cost increases, in part, by collaborating with suppliers, reviewing alternative sourcing options, substituting materials, utilization of Lean methods, engaging in internal cost reduction efforts, and increasing prices on some of our products, all as appropriate. CRITICAL ACCOUNTING POLICIES AND ESTIMATES In preparing our Consolidated Financial Statements in conformity with U.S. GAAP, we must make decisions that impact the reported amounts of assets, liabilities, revenues and expenses, and related disclosures. Such decisions include the selection of the appropriate accounting principles to be applied and the assumptions on which to base accounting estimates. In reaching such decisions, we apply judgments based on our understanding and analysis of the relevant circumstances, historical experience, and actuarial valuations. Actual amounts could differ from those estimated at the time the Consolidated Financial Statements are prepared. Our significant accounting policies are described in Note 1 of the Notes to Consolidated Financial Statements. Some of those significant accounting policies require us to make difficult subjective or complex judgments or estimates. An accounting estimate is considered to be critical if it meets both of the following criteria: (i) the estimate requires assumptions about matters that are highly uncertain at the time the accounting estimate is made, and (ii) different estimates reasonably could have been used, or changes in the estimate that are reasonably likely to occur from period to period may have a material impact on the presentation of our financial condition, changes in financial condition, or results of operations. Our critical accounting estimates include the following: Warranty Reserve Warranty coverage on our products is generally for specified periods of time and on select products' hours of usage, and generally covers parts, labor, and other expenses for non-maintenance repairs. Warranty coverage generally does not cover operator abuse or improper use. At the time of sale, we accrue a warranty reserve by product line for estimated costs in connection with future warranty claims. We also establish reserves for major rework campaigns. The amount of our warranty reserves is based primarily on the estimated number of products under warranty, historical average costs incurred to service warranty claims, the trend in the historical ratio of claims to sales, and the historical length of time between the sale and resulting warranty claim. We periodically assess the adequacy of our warranty reserves based on changes in these factors and record any necessary adjustments if actual claim experience indicates that adjustments are necessary. Actual claims could be higher or lower than amounts estimated, as the number and value of warranty claims can vary due to such factors as performance of new products, significant manufacturing or design defects not discovered until after the product is delivered to customers, product failure rates, and higher or lower than expected service costs for a repair. We believe that analysis of historical trends and knowledge of potential manufacturing or design problems provide sufficient information to establish a reasonable estimate for warranty claims at the time of sale. However, since we cannot predict with certainty future warranty claims or costs associated with servicing those claims, our actual warranty costs may differ from our estimates. An unexpected increase in warranty claims or in the costs associated with servicing those claims would result in an increase in our warranty accrual and a decrease in our net earnings. Sales Promotions and Incentives At the time of sale to a customer, we record an estimate for sales promotion and incentive costs that are classified as a reduction from gross sales or as a component of SG&A expense. Examples of significant sales promotions and incentive programs in which the related expense is classified as a reduction from gross sales are as follows: • Off-Invoice Discounts: Our costs for off-invoice discounts represent a reduction in the selling price of our products given at the time of sale. • Rebate Programs: Our rebate programs are generally based on claims submitted from either our direct customers or end-users of our products, depending upon the program. The amount of the rebate varies based on the specific program and is either a dollar amount or a percentage of the purchase price and can also be based on actual retail price as compared to our selling price. • Incentive Discounts: Our costs for incentive discount programs are based on our customers’ purchases of certain quantities or mixes of product during a specified time period which are tracked on an annual basis. • Financing Programs: Our costs for financing programs, namely floor planning and retail financing, represent financing costs associated with programs under which we pay a portion of the interest cost to finance distributor and dealer inventories through third party financing arrangements for a specific period of time. Retail financing is similar to floor planning with the difference being that retail financing programs are offered to end-user customers under which we pay a portion of interest costs on behalf of end-users for financing purchases of our equipment. • Commissions Paid to Home Center Customers: We pay commissions to home center customers as an off-invoice discount. These commissions do not represent any selling effort by the home center customer but rather is a discount from the selling price of the product. Examples of significant sales promotions and incentive programs in which the related expense is classified as a component of selling, general, and administrative expense are as follows: • Commissions Paid to Distributors and Dealers: For certain products, we use a distribution network of dealers and distributors that purchase and take possession of products for sale to the end customer. In addition, we have dealers and distributors that act as sales agents for us on certain products using a direct-selling type model. Under this direct-selling type model, our network of distributors and dealers facilitates a sale directly to the dealer or end-user customer on our behalf. Commissions to distributors and dealers in these instances represent commission payments to sales agents that are also our customers. • Cooperative Advertising: Cooperative advertising programs are based on advertising costs incurred by distributors and dealers for promoting our products. We support a portion of those advertising costs in which claims are submitted by the distributor or dealer along with evidence of the advertising material procured/produced and evidence of the cost incurred in the form of third party invoices or receipts. The estimates for sales promotion and incentive costs are based on the terms of the arrangements with customers, historical payment experience, field inventory levels, volume purchases, and expectations for changes in relevant trends in the future. Actual results may differ from these estimates if competitive factors dictate the need to enhance or reduce sales promotion and incentive accruals or if customer usage and field inventory levels vary from historical trends. Adjustments to sales promotions and incentive accruals are made from time to time as actual usage becomes known in order to properly estimate the amounts necessary to generate consumer demand based on market conditions as of the balance sheet date. Goodwill and Indefinite-Lived Intangible Assets Goodwill and indefinite-lived intangible assets are not amortized, but are tested at least annually for impairment and whenever events or changes in circumstances indicate that impairment may have occurred. We test goodwill and indefinite-lived intangible assets for impairment at the reporting unit level and individual indefinite-lived intangible asset level, respectively. Our impairment testing for goodwill is performed separately from our impairment testing of indefinite-lived intangible assets, but the income approach is utilized for both to determine fair value when a quantitative analysis is required. Under the income approach, we calculate the fair value of our reporting units and indefinite-lived intangible assets using the present value of future cash flows. Assumptions utilized in determining fair value under the income approach, such as forecasted growth rates and weighted-average cost of capital ("WACC"), are consistent with internal projections and operating plans. Materially different assumptions regarding future performance of our businesses or a different WACC rate could result in impairment losses. Individual indefinite-lived intangible assets are tested for impairment by comparing the carrying amounts of the respective asset to its estimated fair value. Our estimate of the fair value for indefinite-lived intangible assets uses projected revenues from our forecasting process, assumed royalty rates, and a discount rate. If the fair value of the indefinite-lived intangible asset is less than its carrying value, an impairment loss is recognized in an amount equal to the excess. In conducting our goodwill impairment test, we first perform a qualitative assessment to determine whether changes in events or circumstances since our most recent quantitative test for goodwill impairment indicate that it is more likely than not that the fair value of a reporting unit is less than its carrying amount. In conducting the initial qualitative assessment, we analyze actual and projected growth trends for net sales, gross margin, and earnings for each reporting unit, as well as historical versus planned performance. Additionally, each reporting unit is assessed for critical areas that may impact its business, including macroeconomic conditions, market-related exposures, competitive changes, new or discontinued products, changes in key personnel, or any other potential risks to projected financial results. All assumptions used in the qualitative assessment require significant judgment. If, after evaluating the weight of the changes in events and circumstances, both positive and negative, we conclude that an impairment may exist, a two-step quantitative test for goodwill impairment is performed. If performed due to identified impairment indicators or the duration of time since the most recent quantitative goodwill impairment test, the quantitative goodwill impairment test is a two-step process. First, we compare the carrying value of a reporting unit, including goodwill, to its fair value. Our estimate of the fair value of our reporting units utilizes various inputs and assumptions, including projected operating results and growth rates from our forecasting process, applicable tax rates and a WACC rate. Where available, and as appropriate, comparable market multiples and our company's market capitalization are also used to corroborate the results of the discounted cash flow models. If the first step indicates the carrying value exceeds the fair value of a reporting unit, then a second step must be completed in order to determine the amount of goodwill impairment that should be recorded. In the second step, the implied fair value of the reporting unit's goodwill is determined by allocating the reporting unit's fair value to all of its assets and liabilities other than goodwill. The implied fair value of the goodwill that results from the application of this second step is then compared to the carrying amount of the goodwill. If the carrying amount of the goodwill exceeds the implied fair value of the goodwill, an impairment loss is recognized in an amount equal to that excess. Inventory Valuation We value our inventories at the lower of the cost of inventory or net realizable value, with cost determined by either the last-in, first-out method for most U.S. inventories or the first-in, first-out method for all other inventories. We establish reserves for excess, slow moving, and obsolete inventory based on inventory levels, expected product life, and forecasted sales demand. Valuation of inventory can also be affected by significant redesign of existing products or replacement of an existing product by an entirely new generation product. In assessing the ultimate realization of inventories, we are required to make judgments as to future demand requirements compared with inventory levels. Reserve requirements are developed according to our projected demand requirements based on historical demand, competitive factors, and technological and product life cycle changes. It is possible that an increase in our reserve may be required in the future if there is a significant decline in demand for our products and we do not adjust our production schedule accordingly. We record a reserve for inventory shrinkage. Our inventory shrinkage reserve represents anticipated physical inventory losses that are recorded based on historical loss trends, ongoing cycle-count and periodic testing adjustments, and inventory levels. Though management considers reserve balances adequate and proper, changes in economic conditions in specific markets in which we operate could have an effect on the reserve balances required for excess, slow moving and obsolete inventory. New Accounting Pronouncements to be Adopted In May 2014, the FASB issued ASU No. 2014-09, Revenue from Contracts with Customers, that updates the principles for recognizing revenue. The core principle of the guidance is that an entity should recognize revenue to depict the transfer of promised goods or services to customers in an amount that reflects the consideration to which the entity expects to be entitled to in exchange for those goods or services. The guidance provides a five-step analysis of transactions to determine when and how revenue is recognized. The guidance also requires enhanced disclosures regarding the nature, amount, timing, and uncertainty of revenue and cash flows arising from an entity’s contracts with customers. In August 2015, the FASB issued ASU No. 2015-14, Revenue from Contracts with Customers (Topic 606), which deferred the effective date of this standard by one year. The guidance permits the use of either a retrospective or cumulative effect transition method. We have elected to use a cumulative effect transition method for adoption of the amended guidance. We expect to adopt this guidance on November 1, 2018, as required, based on the new effective date. We are currently assessing our contracts with customers and developing related financial disclosures in order to evaluate the impact of the amended guidance on our existing revenue recognition policies, procedures, and internal controls. The majority of our revenue arrangements generally consist of a single performance obligation to transfer promised goods or services. While we have not identified any material differences in the amount and timing of revenue recognition related to ASU 2014-09, our evaluation is not complete and, accordingly, we have not yet reached a conclusion on the overall impacts of adopting ASU 2014-09. In July 2015, the FASB issued ASU No. 2015-11, Inventory (Topic 330): Simplifying the Measurement of Inventory. This amended guidance changes the measurement principle for inventory from the lower of cost or market to lower of cost and net realizable value. The amended guidance will become effective for us commencing in the first quarter of fiscal 2018. Early adoption is permitted. We are currently evaluating the impact of this amended guidance on our Consolidated Financial Statements. In February 2016, the FASB issued ASU No. 2016-02, Leases, which, among other things, requires lessees to recognize most leases on-balance sheet. The standard requires the recognition of lease assets and lease liabilities by lessees for those leases classified as operating leases under previous U.S. GAAP. The amended guidance will become effective for us commencing in the first quarter of fiscal 2020. Entities are required to use a modified retrospective approach, with early adoption permitted. We are currently reviewing the revised guidance, assessing our leases, and related impact on our Consolidated Financial Statements. In January 2017, the FASB issued ASU No. 2017-04, Intangibles-Goodwill and Other (Topic 350): Simplifying the Test for Goodwill Impairment, which simplifies the accounting for goodwill impairments by eliminating step 2 from the goodwill impairment test. The amended guidance will become effective for us commencing in the first quarter of fiscal 2021. We are currently evaluating the impact of this new standard on our Consolidated Financial Statements. In May 2017, the FASB issued ASU No. 2017-09, Compensation-Stock Compensation (Topic 718): Scope of Modification Accounting, which provides guidance on the types of changes to the terms or conditions of share-based payment awards to which an entity would be required to apply modification accounting under Topic 718. The amended guidance will become effective for us commencing in the first quarter of fiscal 2019. Early adoption is permitted. We are currently evaluating the impact of this new standard on our Consolidated Financial Statements. In August 2017, the FASB issued ASU No. 2017-12, Derivatives and Hedging (Topic 815): Targeted Improvements to Accounting for Hedging Activities, which amends the hedge accounting recognition and presentation requirements in ASC 815. The amended guidance will become effective for us commencing in the first quarter of fiscal 2020. Early adoption is permitted. We are currently evaluating the impact of this new standard on our Consolidated Financial Statements. No other new accounting pronouncement that has been issued but not yet effective for us during fiscal 2017 has had, or is expected to have, a material impact on our Consolidated Financial Statements.

<s>[INST] Company Overview Results of Operations Business Segments Financial Position Critical Accounting Policies and Estimates Statements that are not historical are forwardlooking and involve risks and uncertainties, including those discussed in Part I, Item 1A, "Risk Factors" and elsewhere in this report. These risks could cause our actual results to differ materially from any future performance suggested below. COMPANY OVERVIEW The Toro Company is in the business of designing, manufacturing, and marketing professional turf maintenance equipment and services, turf irrigation systems, landscaping equipment and lighting products, snow and ice management products, agricultural microirrigation systems, rental and specialty construction equipment, and residential yard and snow thrower products. We sell our products worldwide through a network of distributors, dealers, mass retailers, hardware retailers, home centers, as well as online (direct to endusers). We classify our operations into three reportable business segments: Professional, Residential, and Distribution. Our Distribution segment, which consists of our wholly owned domestic distributorship, has been combined with our corporate activities and elimination of intersegment revenues and expenses and is presented as “Other." We strive to provide innovative, wellbuilt, and dependable products supported by an extensive service network. A significant portion of our net sales has historically been, and we expect will continue to be, attributable to new and enhanced products. We define new products as those introduced in the current and previous two fiscal years. Shares and per share data have been adjusted for prior periods presented to reflect the impact of our twoforone stock split effective September 16, 2016. Summary of Fiscal 2017 Results In fiscal 2017, we achieved net sales of $2,505.2 million and net earnings growth of 15.9 percent. Our fiscal 2017 results included the following items of significance: Net sales for fiscal 2017 increased by 4.7 percent to $2,505.2 million when compared to fiscal 2016. The sales increase was primarily attributable to strong demand for our Professional segment products, as well as the successful introduction of new innovative products in the Professional and Residential segments. Professional segment net sales grew 6.2 percent in fiscal 2017 compared to fiscal 2016. Residential segment net sales increased 0.6 percent in fiscal 2017 compared to fiscal 2016. International net sales for fiscal 2017 increased by 5.6 percent compared to fiscal 2016 despite unfavorable foreign currency exchange rate fluctuations. International net sales comprised 24.4 percent of our total consolidated net sales in fiscal 2017 compared to 24.2 percent in fiscal 2016 and 25.5 percent in fiscal 2015. Fiscal 2017 net earnings of $267.7 million increased 15.9 percent compared to fiscal 2016, and diluted net earnings per share increased 17.0 percent to $2.41 in fiscal 2017 compared to $2.06 in fiscal 2016. Gross margin was 36.8 percent in fiscal 2017, an increase of 20 basis points from 36.6 percent in fiscal 2016. Selling, general, and administrative ("SG&A") expense was up 4.7 percent in fiscal 2017 compared to fiscal 2016, or consistent at 22.6 percent as a percentage of net sales. Receivables increased by 12.1 percent as of the end of fiscal 2017 compared to the end of fiscal 2016. Our inventory levels were up by 7.2 percent as of the end of fiscal 2017 compared to the end of fiscal 2016. Our field inventory levels were up as of the end of fiscal 2017 compared to the end of fiscal 2016, mainly due to higher Professional segment field inventory levels primarily due to anticipated strong retail demand for early [/INST] Negative. </s>

TORO CO

2018-12-21

2018-10-31

ITEM 7. MANAGEMENT'S DISCUSSION AND ANALYSIS OF FINANCIAL CONDITION AND RESULTS OF OPERATIONS This Management's Discussion and Analysis of Financial Condition and Results of Operations ("MD&A") is intended to provide a reader of our financial statements with a narrative from the perspective of management on our financial condition, results of operations, liquidity, and certain other factors that may affect our future results. Unless expressly stated otherwise, the comparisons presented in this MD&A refer to the prior fiscal year. Our MD&A is presented in six sections: • Company Overview • Results of Operations • Business Segments • Financial Position • Non-GAAP Financial Measures • Critical Accounting Policies and Estimates We have provided non-GAAP financial measures, which are not calculated or presented in accordance with accounting principles generally accepted in the United States ("GAAP"), as information supplemental and in addition to the financial measures presented in this report that are calculated and presented in accordance with GAAP. This MD&A contains certain non-GAAP financial measures, consisting of adjusted net earnings, adjusted net earnings per diluted share, and an adjusted effective tax rate as measures of our operating performance. Management believes these measures may be useful in performing meaningful comparisons of past and present operating results, to understand the performance of our ongoing operations, and how management views the business. Reconciliations of adjusted non-GAAP financial measures to the most directly comparable reported GAAP financial measures are included in the section titled "Non-GAAP Financial Measures" within this MD&A. These measures, however, should not be construed as an alternative to any other measure of performance determined in accordance with GAAP. Our net earnings, diluted net earnings per share ("EPS"), and effective tax rate for fiscal year 2016 were not impacted by the effects of U.S. Tax Reform or ASU No. 2016-09, Stock-based Compensation: Improvements to Employee Share-based Payment Accounting, and accordingly, have not been adjusted within the following sections of this MD&A. Statements that are not historical are forward-looking and involve risks and uncertainties, including those discussed in Part I, Item 1A, "Risk Factors" and elsewhere in this report. These risks could cause our actual results to differ materially from any future performance suggested below. COMPANY OVERVIEW The Toro Company is in the business of designing, manufacturing, and marketing professional turf maintenance equipment and services, turf irrigation systems, landscaping equipment and lighting products, snow and ice management products, agricultural irrigation systems, rental and specialty construction equipment, and residential yard and snow thrower products. We sell our products worldwide through a network of distributors, dealers, mass retailers, hardware retailers, home centers, as well as online (direct to end-users). We strive to provide innovative, well-built, and dependable products supported by an extensive service network. A significant portion of our net sales has historically been, and we expect will continue to be, attributable to new and enhanced products. We define new products as those introduced in the current and previous two fiscal years. We classify our operations into two reportable business segments: Professional and Residential. Our remaining activities are presented as "Other" due to their insignificance. These Other activities consist of earnings (loss) from our wholly-owned domestic distribution company, corporate activities, and the elimination of intersegment revenues and expenses. Summary of Fiscal 2018 Results In fiscal 2018, we achieved net sales of $2,618.7 million and net earnings growth of 1.6 percent. Our fiscal 2018 results included the following items of significance: • Net sales for fiscal 2018 increased by 4.5 percent to $2,618.7 million when compared to fiscal 2017. The sales increase was primarily driven by strong demand for our Professional segment products, as well as the successful introduction of new innovative products in the Professional and Residential segments. • Professional segment net sales grew 7.5 percent in fiscal 2018 compared to fiscal 2017. • Residential segment net sales decreased 2.8 percent in fiscal 2018 compared to fiscal 2017. • International net sales for fiscal 2018 increased by 5.1 percent compared to fiscal 2017. Foreign currency exchange rates favorably impacted our international net sales by approximately $12.5 million in fiscal 2018. International net sales comprised 24.6 percent of our total consolidated net sales in fiscal 2018 compared to 24.4 percent in fiscal 2017 and 24.2 percent in fiscal 2016. • Our net earnings were significantly impacted by the provisions of U.S. Tax Reform during fiscal 2018. Fiscal 2018 net earnings of $271.9 million increased 1.6 percent compared to fiscal 2017, and diluted net earnings per share increased 3.7 percent to $2.50 in fiscal 2018 compared to $2.41 in fiscal 2017. Fiscal 2018 non-GAAP adjusted net earnings of $290.1 million increased 17.0 percent compared to fiscal 2017, and non-GAAP adjusted diluted net earnings per share increased 19.7 percent to $2.67 in fiscal 2018 compared to $2.23 in fiscal 2017. • Gross margin was 35.9 percent in fiscal 2018, a decrease of 90 basis points from 36.8 percent in fiscal 2017. • Selling, general, and administrative ("SG&A") expense was 21.7 percent as a percentage of net sales in fiscal 2018, a decrease of 90 basis points from 22.6 percent in fiscal 2017. • Receivables increased by 5.5 percent as of the end of fiscal 2018 compared to the end of fiscal 2017. Our inventory levels were up by 8.9 percent as of the end of fiscal 2018 compared to the end of fiscal 2017. • Our field inventory levels were up as of the end of fiscal 2018 compared to the end of fiscal 2017, mainly due to higher Professional segment field inventory driven by strong channel demand in our landscape contractor, golf and grounds, and rental and specialty construction equipment businesses. • We continued our history of paying quarterly cash dividends in fiscal 2018. We increased our fiscal 2018 quarterly cash dividend by 14.3 percent to $0.20 per share compared to our quarterly cash dividend in fiscal 2017 of $0.175 per share. Please refer to the sections entitled “Results of Operations", "Business Segments", and "Financial Position" included in Part II, Item 7 of this report for additional details concerning our financial results for fiscal 2018. Reconciliations of adjusted non-GAAP financial measures to the most directly comparable reported GAAP financial measures are included in the section titled "Non-GAAP Financial Measures" within this MD&A. Vision 2020 Our current multi-year employee initiative, "Vision 2020", which began with our 2018 fiscal year, focuses on driving profitable growth with an emphasis on innovation and serving our customers, which we believe will generate further momentum for the organization. Through our Vision 2020 initiative, we have set specific goals intended to help us drive organic revenue and operating earnings growth. Organic Revenue Growth We intend to pursue strategic growth of our existing businesses and product categories with an organic revenue goal to achieve at least five percent or more of organic revenue growth in each of the three fiscal years of this initiative. For purposes of this goal, we define organic revenue growth as the increase in net sales, less net sales from acquisitions that occurred in the current fiscal year. In fiscal year 2018, we fell short of this goal by achieving 3.7 percent organic revenue growth. Operating Earnings Additionally, as part of our Vision 2020 initiative growth goals, we have set an operating earnings goal to increase operating earnings as a percentage of net sales to 15.5 percent or higher by the end of fiscal 2020. We are tracking short of this goal as fiscal year 2018 realized 14.2 percent of operating earnings as a percentage of net sales. RESULTS OF OPERATIONS United States Tax Reform On December 22, 2017, the U.S. enacted Public Law No. 115-97 ("Tax Act"), originally introduced as the Tax Cuts and Jobs Act, which significantly modified the Internal Revenue Code. The Tax Act reduced the U.S. federal corporate tax rate from 35.0 percent to 21.0 percent, created a territorial-type tax system with an exemption for foreign dividends, and imposed a one-time deemed repatriation tax on a U.S. company's historical undistributed earnings and profits of foreign affiliates. The tax rate change was effective January 1, 2018, which resulted in a blended U.S. federal statutory tax rate of 23.3 percent for the fiscal year ended October 31, 2018. Among other provisions, the Tax Act also increased expensing for certain business assets, created new taxes on certain foreign sourced earnings, adopted limitations on business interest expense deductions, repealed deductions for income attributable to domestic production activities, and added other anti-base erosion rules. The effective dates for the provisions set forth in the Tax Act vary as to when the provisions will apply to Toro. In response to the Tax Act, the SEC provided guidance by issuing Staff Accounting Bulletin No. 118 ("SAB 118"), which has since been codified by the release of ASU No. 2018-05, Income Taxes (Topic 740): Amendments to SEC Paragraphs Pursuant to SEC Staff Accounting Bulletin No. 118. ASU 2018-05 allows companies to record provisional amounts during a measurement period with respect to the impacts of the Tax Act for which the accounting requirements under Accounting Standards Codification ("ASC") Topic 740 are not complete, but a reasonable estimate has been determined. The measurement period under ASU 2018-05 ends when a company has obtained, prepared, and analyzed the information that was needed in order to complete the accounting requirements under ASC Topic 740, but cannot exceed one year. As of October 31, 2018, we have completed the accounting for the effects of the Tax Act. We have estimated the impacts of the Tax Act on our annual effective tax rate, and have recorded tax expense of $19.3 million for the remeasurement of deferred tax assets and liabilities and tax expense of $13.4 million for the deemed repatriation tax. These tax expense amounts significantly impacted our results of operations for the fiscal year ended October 31, 2018. Please reference the sections below titled "Provision for Income Taxes" and "Net Earnings" within this MD&A for further information regarding the impacts of the Tax Act on Toro for the fiscal year ended October 31, 2018. While we have recorded amounts in fiscal 2018 for the items expected to most significantly impact our Consolidated Financial Statements, many of the provisions of the Tax Act are not effective for us until the fiscal year ending October 31, 2019. Accordingly, we have not yet reached a final conclusion on the overall impacts of the Tax Act. Reconciliations of adjusted non-GAAP financial measures to the most directly comparable reported GAAP financial measures are included in the section titled "Non-GAAP Financial Measures" within this MD&A. Overview The following table summarizes our results of operations as a percentage of our consolidated net sales: Fiscal 2018 Compared with Fiscal 2017 Net Sales Worldwide net sales in fiscal 2018 were $2,618.7 million compared to $2,505.2 million in fiscal 2017, an increase of 4.5 percent. This net sales increase was primarily attributable to the following factors: • Increased sales of Professional segment products, which were primarily driven by strong channel demand and a successful new product introduction for our landscape contractor zero-turn radius riding mowers, continued growth in our golf and grounds businesses, sales of new products as a result of our acquisition of L.T. Rich, strong channel demand for our rental and specialty construction equipment, higher shipments of our snow and ice management products, and incremental sales and strong demand for our Perrot-branded irrigation products. • Decreased sales of Residential segment products were primarily due to unfavorable weather conditions during the key selling seasons for zero-turn radius riding mowers, snow products, walk power mowers, and Pope-branded products. • Net sales in international markets increased by 5.1 percent in fiscal 2018 compared to fiscal 2017, mainly due to strong channel demand for our golf and grounds equipment, higher sales of Perrot-branded irrigation products, increased shipments of Professional segment zero-turn radius riding mowers, and successful product introductions within the Residential and Professional segments. These increases were partially offset by decreased sales of Pope-branded products and Residential segment zero-turn radius riding mowers and walk power mowers due to unfavorable weather conditions during the key selling seasons. Changes in foreign currency exchange rates positively impacted our international net sales by approximately $12.5 million in fiscal 2018. Gross Margin Gross margin represents gross profit (net sales less cost of sales) as a percentage of net sales. See Note 1 of the Notes to Consolidated Financial Statements, in the section entitled "Cost of Sales," included in Part II, Item 8, "Financial Statements and Supplementary Data" of this report for a description of expenses included in cost of sales. Gross margin decreased by 90 basis points to 35.9 percent in fiscal 2018 from 36.8 percent in fiscal 2017. This decrease was mainly the result of the following factors: • Higher costs of commodities, primarily steel and resin. • Higher freight rates. • Manufacturing supply challenges. • Unfavorable impact of import tariffs on purchased raw materials and component parts. Somewhat offsetting those unfavorable factors were: • Cost reduction efforts from productivity and process improvement initiatives. • Net price realization on Professional segment products. • Favorable foreign currency exchange rate fluctuations. • Favorable segment mix from a higher mix of Professional segment product sales. Selling, General, and Administrative Expense SG&A expense increased $2.2 million, or 0.4 percent, in fiscal 2018 compared to fiscal 2017. See Note 1 of the Notes to Consolidated Financial Statements, in the section entitled "Selling, General, and Administrative Expense," included in Part II, Item 8, "Financial Statements and Supplementary Data" of this report for a description of expenses included in SG&A expense. SG&A expense rate represents SG&A expense as a percentage of net sales. The SG&A expense rate in fiscal 2018 was 21.7 percent compared to 22.6 percent in fiscal 2017, a decrease of 90 basis points. As a percentage of net sales, our SG&A expense rate decrease was primarily due to the following factors: • Lower incentive compensation expense due to company performance against our multi-year employee initiative Vision 2020 and annual management incentives. • Leveraging of expenses over higher sales volume, partially offset by increased engineering expense for investments in new product development. Interest Expense Interest expense for fiscal 2018 decreased 0.1 percent compared to fiscal 2017. Other Income, Net Other income, net consists mainly of our proportionate share of income or losses from equity investments (from Red Iron), currency exchange rate gains and losses, litigation settlements and recoveries, interest income, dividend income, other income, and retail financing revenue. Other income for fiscal 2018 was $18.4 million compared to $17.2 million in fiscal 2017, an increase of $1.2 million. The increase in other income, net was primarily due to higher earnings from our equity investment in Red Iron of $1.2 million and higher interest income on marketable securities of $0.9 million. These increases were partially offset by lower gains realized on foreign currency exchange rate fluctuations of $1.0 million. Provision for Income Taxes The effective tax rate for fiscal 2018 was 27.0 percent compared to 24.2 percent in fiscal 2017. The effective tax rate was significantly impacted by the enactment of the Tax Act during fiscal 2018. The increase in the effective tax rate was driven by the remeasurement of deferred tax assets and liabilities, which resulted in a non-cash discrete tax charge of $19.3 million, and the calculation of the deemed repatriation tax, which resulted in a discrete tax charge of $13.4 million, payable over eight years. In addition to these one-time charges resulting from the Tax Act during fiscal 2018, the increase in the effective tax rate was driven by a $5.2 million year-over-year decrease in the benefit of the excess tax deduction for share-based compensation, which includes a $6.1 million unfavorable impact on the benefit due to the reduction in the federal corporate tax rate. These increases were partially offset by a benefit of $30.8 million during fiscal 2018, resulting from the reduction in the federal corporate tax rate on all items other than the excess tax deduction for share-based compensation. The adjusted effective tax rate for fiscal 2018 was 22.1 percent, compared to an adjusted effective tax rate of 29.8 percent in fiscal 2017. The adjusted effective tax rate for fiscal 2018 excludes one-time charges associated with the Tax Act of $32.7 million and a benefit of $14.6 million for the excess tax deduction for share-based compensation. The adjusted effective tax rate for fiscal 2017 excludes the benefit of $19.7 million for the excess tax deduction for share-based compensation. Reconciliations of adjusted non-GAAP financial measures to the most directly comparable reported GAAP financial measures are included in the section titled "Non-GAAP Financial Measures" within this MD&A. Net Earnings Fiscal 2018 net earnings were $271.9 million compared to $267.7 million in fiscal 2017, an increase of 1.6 percent. Fiscal 2018 diluted net earnings per share were $2.50, an increase of 3.7 percent from $2.41 per diluted share in fiscal 2017. Net earnings for fiscal 2018 were significantly impacted by the enactment of the Tax Act. As previously mentioned, the impact from the enactment of the Tax Act was driven by the remeasurement of deferred tax assets and liabilities, which resulted in a non-cash discrete tax charge of $19.3 million, and the calculation of the deemed repatriation tax, which resulted in a discrete tax charge of $13.4 million, payable over eight years. The unfavorable impact of these one-time charges during fiscal 2018 was partially offset by a benefit of $24.7 million resulting from the reduction in the federal corporate tax rate. Adjusted net earnings for fiscal 2018 were $290.1 million, or $2.67 per diluted share, compared to $248.0 million, or $2.23 per diluted share, in fiscal 2017, an increase of 19.7 percent per diluted share. Fiscal 2018 adjusted net earnings excludes one-time charges associated with the Tax Act of $32.7 million, or $0.30 per diluted share, and a benefit of $14.6 million, or $0.13 per diluted share, for the excess tax deduction for share-based compensation. Fiscal 2017 adjusted net earnings excludes a benefit of $19.7 million, or $0.18 per diluted share, for the excess tax deduction for share-based compensation. Reconciliations of adjusted non-GAAP financial measures to the most directly comparable reported GAAP financial measures are included in the section titled "Non-GAAP Financial Measures" within this MD&A. In addition, as a result of reduced shares outstanding from repurchases of our common stock, fiscal 2018 net earnings per diluted share and adjusted net earnings per diluted share were benefited by approximately $0.06 per diluted share. Fiscal 2017 Compared with Fiscal 2016 Net Sales Worldwide net sales in fiscal 2017 were $2,505.2 million compared to $2,392.2 million in fiscal 2016, an increase of 4.7 percent. This net sales increase was primarily attributable to the following factors: • Increased sales of Professional segment products were primarily driven from the successful introduction of new products and strong demand for our golf and grounds equipment, successful introduction of new landscape contractor equipment, continued growth in our rental and specialty construction businesses, increased shipments of our snow and ice management products, and our acquisition of the Perrot irrigation business in the first quarter of fiscal 2017. • Increased sales of Residential segment products were primarily due to increased demand for our Pope-branded irrigation products and increased shipments of snow products, partially offset by decreased shipments of zero-turn radius riding mowers. • Net sales in international markets increased by 5.6 percent in fiscal 2017 compared to fiscal 2016, mainly due to strong demand for our golf and grounds equipment, our acquisition of the Perrot irrigation business, and increased demand for our Pope-branded irrigation products, partially offset by fluctuations in foreign currency exchange rates that reduced our total net sales by approximately $3.3 million in fiscal 2017. Gross Margin Gross margin increased by 20 basis points to 36.8 percent in fiscal 2017 from 36.6 percent in fiscal 2016. This increase was mainly the result of the following factors: • Favorable operational productivity due to production efficiencies and Lean method initiatives. • Favorable segment mix from a higher mix of Professional segment product sales. Somewhat offsetting those favorable factors were higher costs of commodities, primarily steel and resin, and higher freight costs. Selling, General, and Administrative Expense SG&A expense increased $25.5 million, or 4.7 percent, in fiscal 2017 compared to fiscal 2016. The SG&A expense rate in fiscal 2017 stayed consistent with the SG&A expense rate in fiscal 2016 at 22.6 percent. As a percentage of net sales, our SG&A expense rate was mainly impacted by decreased administrative expense primarily due to favorable health care claims experience in fiscal 2017, offset, in large part, by higher incentive expense due to improved company performance in fiscal 2017. Interest Expense Interest expense for fiscal 2017 decreased $0.2 million compared to fiscal 2016. Other Income, Net Other income for fiscal 2017 was $17.2 million compared to $15.4 million in fiscal 2016, an increase of $1.8 million. The increase in other income, net was primarily due to higher income from our equity investment in Red Iron of $2.0 million, foreign currency contract exchange gains of $0.6 million, and higher interest income of $0.5 million, partially offset by a fiscal 2016 litigation recovery that was not repeated in fiscal 2017 of $1.3 million. Provision for Income Taxes The effective tax rate for fiscal 2017 was 24.2 percent compared to 30.1 percent in fiscal 2016. The decrease was primarily the result of the adoption of ASU 2016-09 in fiscal 2017, which resulted in a tax benefit of $19.7 million. The adjusted effective tax rate for fiscal 2017 was 29.8 percent, compared to an unadjusted effective tax rate of 30.1 percent in fiscal 2016. The adjusted effective tax rate for fiscal 2017 excludes the benefit of $19.7 million for the excess tax deduction for share-based compensation. Reconciliations of adjusted non-GAAP financial measures to the most directly comparable reported GAAP financial measures are included in the section titled "Non-GAAP Financial Measures" within this MD&A. Net Earnings Fiscal 2017 net earnings were $267.7 million compared to $231.0 million in fiscal 2016, an increase of 15.9 percent. Fiscal 2017 diluted net earnings per share were $2.41, an increase of 17.0 percent from $2.06 per share in fiscal 2016. The primary factors contributing to the net earnings increase was a lower effective tax rate, mainly driven by the adoption of ASU 2016-09 in fiscal 2017, along with net sales and gross margin improvement. Adjusted net earnings for fiscal 2017 were $248.0 million, or $2.23 per diluted share, compared to unadjusted net earnings of $231.0 million, or $2.06 per diluted share, in fiscal 2016, an increase of 8.3 percent per diluted share. Fiscal 2017 adjusted net earnings excludes a benefit of $19.7 million, or $0.18 per diluted share, for the excess tax deduction for share-based compensation. Reconciliations of adjusted non-GAAP financial measures to the most directly comparable reported GAAP financial measures are included in the section titled "Non-GAAP Financial Measures" within this MD&A. BUSINESS SEGMENTS As more fully described in Note 11 of the Notes to Consolidated Financial Statements, we operate in two reportable business segments: Professional and Residential. Segment earnings for our Professional and Residential segments are defined as earnings from operations plus other income, net. Our remaining activities are presented as "Other" due to their insignificance. Operating loss for our Other activities includes earnings (loss) from our wholly-owned domestic distribution company, corporate activities, other income, and interest expense. Corporate activities include general corporate expenditures (finance, human resources, legal, information services, public relations, and similar activities) and other unallocated corporate assets and liabilities, such as corporate facilities and deferred tax assets and liabilities. The following information provides perspective on our reportable business segments' and Other activities net sales and operating results. Professional Segment Professional segment net sales represented approximately 74 percent of consolidated net sales for fiscal 2018, 72 percent for fiscal 2017, and 71 percent for fiscal 2016. The following table shows the Professional segment net sales, operating earnings, and operating earnings as a percent of net sales: Segment Net Sales Worldwide net sales for the Professional segment in fiscal 2018 were up by 7.5 percent compared to fiscal 2017 primarily as a result of the following factors: • Higher shipments of our landscape contractor zero-turn radius riding mowers driven by strong channel demand and a successful new product introduction for our diesel-powered Exmark Lazer® and Toro Z Master®. • Continued growth in our golf and grounds businesses driven by increased shipments of our Reelmaster®, Groundsmaster®, and Greensmaster® series mowers, as well as increased shipments of Multi Pro® application equipment and Workman® utility vehicles. • Incremental sales of new products within our landscape contractor and snow and ice management businesses as a result of our acquisition of L.T. Rich. • Strong channel demand for our Dingo® TX 1000 compact utility loader within our rental and specialty construction business. • Higher shipments of our snow and ice management products due to strong preseason channel demand. • Increased sales of irrigation products mainly driven by incremental sales and strong demand for Perrot-branded irrigation products, as well as golf project growth. Worldwide net sales for the Professional segment in fiscal 2017 were up by 6.2 percent compared to fiscal 2016 primarily as a result of the following factors: • Higher shipments of golf and grounds equipment, primarily due to strong demand for our innovative product offerings. • Higher shipments of landscape contractor equipment, primarily driven by strong demand for new products. • Increased shipments of rental and specialty construction equipment, mainly driven by strong demand, and positive customer response for new products. • Increased sales of snow and ice management products, mainly driven by new product offerings and favorable snowfalls in the first quarter of fiscal 2017. • Increased sales of irrigation products mainly driven by the acquisition of the Perrot business. Somewhat offsetting those increases for fiscal 2017 were unfavorable foreign currency exchange rate fluctuations. Segment Earnings Operating earnings for the Professional segment in fiscal 2018 increased 5.4 percent compared to fiscal 2017. Expressed as a percentage of net sales, Professional segment operating earnings decreased by 40 basis points to 20.5 percent in fiscal 2018 compared to 20.9 percent in fiscal 2017. The following factors impacted Professional segment operating earnings as a percentage of net sales for fiscal 2018: • Lower gross margin in fiscal 2018 compared to fiscal 2017 mainly due to higher commodity and freight rates, manufacturing supply challenges, and unfavorable product mix, partially offset by net price realization and favorable foreign currency exchange rate fluctuations. • A decline in SG&A expense rate in fiscal 2018 compared to fiscal 2017 primarily due to lower incentive compensation expense and leveraging SG&A expense over higher sales volumes. Operating earnings for the Professional segment in fiscal 2017 increased 7.8 percent compared to fiscal 2016. Expressed as a percentage of net sales, Professional segment operating earnings increased by 30 basis points to 20.9 percent in fiscal 2017 compared to 20.6 percent in fiscal 2016. The following factors impacted Professional segment operating earnings as a percentage of net sales for fiscal 2017: • Higher gross margin in fiscal 2017 compared to fiscal 2016 mainly due to favorable operational productivity from production efficiencies and Lean method initiatives, partially offset by higher commodity costs and unfavorable product mix. • A decline in SG&A expense rate in fiscal 2017 compared to fiscal 2016 primarily due to lower administration and engineering expense as a percentage of net sales. The domestic field inventory levels of our Professional segment products were higher as of the end of fiscal 2018 compared to the end of fiscal 2017, primarily due to higher field inventory for our landscape contractor, golf and grounds, and rental and specialty construction equipment businesses driven by strong channel demand. Residential Segment Residential segment net sales represented approximately 25 percent of consolidated net sales for fiscal 2018, 27 percent for fiscal 2017, and 28 percent for fiscal 2016. The following table shows the Residential segment net sales, operating earnings, and operating earnings as a percent of net sales: Segment Net Sales Worldwide net sales for the Residential segment in fiscal 2018 were down by 2.8 percent compared to fiscal 2017 primarily as a result of the following factors: • Fewer shipments of zero-turn radius riding mowers and walk power mowers driven by unfavorable spring weather conditions in fiscal 2018. • Lower snow product sales due to below average snowfall early in the fiscal 2018 season. • Lower sales of Pope-branded irrigation products in Australia mainly due to unfavorable weather conditions during the fourth quarter of fiscal 2018. These decreases were partially offset by the successful introduction of the redesigned lines of our Hayter-branded walk power mowers and Power Max® HD snow thrower products. Worldwide net sales for the Residential segment in fiscal 2017 were up by 0.6 percent compared to fiscal 2016 primarily as a result of the following factors: • Higher sales of Pope-branded irrigation products in Australia mainly due to strong demand and favorable weather conditions. • Increased shipments of snow products mainly driven by favorable snowfalls in the first quarter of fiscal 2017. Somewhat offsetting those increases were: • Lower shipments of our zero-turn radius riding mowers due to lower demand for our steering wheel zero-turn radius mower models and higher demand for our new lines of Professional segment contractor grade zero-turn radius mowers. • Unfavorable foreign currency exchange rate fluctuations. Segment Earnings Operating earnings for the Residential segment in fiscal 2018 decreased 13.2 percent compared to fiscal 2017. Expressed as a percentage of net sales, Residential segment operating earnings decreased 120 basis points to 9.9 percent in fiscal 2018 compared to 11.1 percent in fiscal 2017. The following factors impacted Residential segment operating earnings as a percentage of net sales for fiscal 2018: • Lower gross margin in fiscal 2018 compared to fiscal 2017 mainly due to higher commodity costs and the unfavorable impact of import tariffs, partially offset by favorable foreign currency exchange rate fluctuations and freight cost reductions efforts. • A slight increase in the SG&A expense rate in fiscal 2018 compared to fiscal 2017 primarily due to fixed SG&A costs over lower sales volume. Operating earnings for the Residential segment in fiscal 2017 increased 1.4 percent compared to fiscal 2016. Expressed as a percentage of net sales, Residential segment operating earnings increased 10 basis points to 11.1 percent in fiscal 2017 compared to 11.0 percent in fiscal 2016. The following factors impacted Residential segment operating earnings as a percentage of net sales for fiscal 2017: • Higher gross margin in fiscal 2017 compared to fiscal 2016 mainly due to favorable product mix and favorable operational productivity from production efficiencies, partially offset by higher commodity costs and freight expense. • An increased SG&A expense rate attributable to higher incentive and engineering expense as a percentage of net sales. The domestic field inventory levels of our Residential segment products as of the end of fiscal 2018 were consistent with the levels of fiscal 2017. Other Activities Net sales for our Other activities, which includes our wholly owned domestic distributor, represented approximately 1 percent of consolidated net sales for each of fiscal 2018, 2017, and 2016. During the first quarter of fiscal 2016, we sold our Northwestern U.S. distribution company. The following table shows the net sales and operating losses for our Other activities: Other Net Sales Net sales for our Other activities includes sales from our wholly owned domestic distribution company less sales from the Professional and Residential segments to that distribution company. Net sales for our Other activities in fiscal 2018 decreased $3.0 million compared to fiscal 2017, primarily due to fewer shipments of our golf and grounds equipment sold through our wholly owned domestic distribution company. Net sales for our Other activities in fiscal 2017 were up $2.5 million compared to fiscal 2016, primarily due to strong demand for our golf and grounds equipment that was sold through our wholly owned domestic distribution company. Other Operating Loss Operating loss for our Other activities in fiscal 2018 decreased by 8.7 percent compared to fiscal 2017. This loss decrease was primarily attributable to lower incentive compensation expense due to company performance against our multi-year employee initiative Vision 2020 and annual management incentives, higher earnings from our equity investment in Red Iron, and higher interest income on marketable securities, partially offset by lower gains realized on foreign currency exchange rate fluctuations. Operating loss for our Other activities in fiscal 2017 increased by 6.0 percent compared to fiscal 2016. This loss increase was primarily attributable to higher incentive expense due to improved company performance. FINANCIAL POSITION Working Capital Our strategy for fiscal 2018 continued to place emphasis on improving asset utilization with a focus on reducing the amount of working capital in the supply chain, adjusting production plans, and maintaining or improving order replenishment and service levels to end-users. We calculate our average net working capital as average net accounts receivable plus average net inventory, less average accounts payable as a percentage of net sales for a twelve month period. As of the end of fiscal 2018, our average net working capital improved to 13.7 percent compared to 13.8 percent as of the end of fiscal 2017 mainly due to higher average accounts payable and higher net sales, partially offset by higher average inventory. The following table highlights several key measures of our working capital performance: The following factors impacted our working capital during fiscal 2018: • Average net receivables increased by 3.0 percent in fiscal 2018 compared to fiscal 2017 due to increased sales in fiscal 2018. Our average days outstanding for receivables decreased to 29.9 days in fiscal 2018 compared to 30.4 days in fiscal 2017. • Average inventories increased by 10.2 percent in fiscal 2018 compared to fiscal 2017. Inventory levels as of the end of fiscal 2018 compared to the end of fiscal 2017 were up by $29.3 million, or 8.9 percent, primarily due to higher Professional segment forecasted retail demand, increased work in process inventory due to supply challenges, and incremental inventory from the acquisition of L.T. Rich. • Average accounts payable increased by 13.4 percent in fiscal 2018 compared to fiscal 2017, mainly due to initiatives to manage our payables, which included extending payment terms with suppliers. Capital Expenditures and Other Long-Term Assets Fiscal 2018 capital expenditures of $90.1 million were $31.8 million higher than fiscal 2017. This increase was mainly attributable to fiscal 2018 facilities renovations, replacement of production process equipment, investments in new technology, and expansion of capacity. Capital expenditures for fiscal 2019 are expected to be approximately $85.0 million as we plan to continue to invest in our facilities, new product tooling, new technology in production processes and equipment, replacement of production equipment, and expansion of capacity. Long-term assets as of October 31, 2018 were $676.3 million compared to $633.9 million as of October 31, 2017, an increase of $42.4 million. This increase was driven mainly by purchases of property, plant, and equipment and the acquisition of L.T. Rich in the second quarter of fiscal 2018, partially offset by decreased deferred income taxes due to the remeasurement required under the Tax Act. Included in long-term assets as of October 31, 2018 was goodwill in the amount of $225.3 million. Based on our annual goodwill impairment analysis, we determined there was no impairment of goodwill during fiscal 2018 for any of our reporting units as the fair values of the reporting units exceeded their carrying values, including goodwill. Cash Flow Cash flows provided by/(used in) operating, investing, and financing activities during the past three fiscal years are shown in the following table: Cash Flows from Operating Activities Our primary source of funds is cash generated from operations. In fiscal 2018, cash provided by operating activities increased by $4.1 million, or 1.1 percent, from fiscal 2017. This increase was mainly driven by higher net earnings, which include the unfavorable non-cash charge related to the remeasurement of deferred income taxes required under the Tax Act. The increase in net earnings was partially offset by increased net inventories due to higher Professional segment forecasted retail demand and increased work in process inventory due to supply challenges and a lower year-over-year benefit from extending accounts payable terms as a component of our working capital initiatives. In fiscal 2017, cash provided by operating activities decreased by $23.5 million, or 6.1 percent, from fiscal 2016. This decrease was mainly due to higher net receivables as a result of higher sales, as well as increased net inventories due to higher amounts of inventory purchased to support higher Professional segment forecasted retail demand. This decrease was partially offset by higher net earnings, higher payables due to continued working capital initiatives, and a Red Iron exclusivity incentive payment. Cash Flows from Investing Activities Capital expenditures and acquisitions are a significant use of our capital resources. These investments are intended to enable sales growth in new and expanding markets, help us to meet product demand, and increase our manufacturing efficiencies and capacity. Cash used in investing activities in fiscal 2018 increased by $44.2 million from fiscal 2017 mainly due to higher purchases of property, plant, and equipment, cash utilized for the acquisition of L.T. Rich in the second quarter of fiscal 2018, and minority investments in unconsolidated entities. Cash used in investing activities in fiscal 2017 increased by $34.8 million from fiscal 2016 mainly due to cash utilized for the acquisition of the Perrot business in the first quarter of fiscal 2017 and higher purchases of property, plant, and equipment. Cash Flows from Financing Activities Cash used in financing activities in fiscal 2018 was $252.1 million compared to $245.3 million in fiscal 2017, an increase of $6.8 million. This increase in cash used in financing activities was mainly due to increased cash dividends paid on our common stock, higher payments of withholding taxes for stock awards, and more cash used for common stock repurchases, partially offset by higher proceeds from the exercise of stock options. Cash used in financing activities in fiscal 2017 was $245.3 million compared to $182.9 million in fiscal 2016. The increase in cash used in financing activities was mainly due to more cash used for common stock repurchases, lower proceeds from stock-based compensation, and increased cash dividends paid on our common stock in fiscal 2017 compared to fiscal 2016. Cash and Cash Equivalents Cash and cash equivalents as of the end of fiscal 2018 decreased by $21.1 million compared to the end of fiscal 2017. Liquidity and Capital Resources Our businesses are seasonally working capital intensive and require funding for purchases of raw materials used in production, replacement parts inventory, payroll and other administrative costs, capital expenditures, establishment of new facilities, expansion and renovation of existing facilities, as well as for financing receivables from customers that are not financed with Red Iron. Our accounts receivable balances historically increase between January and April as a result of typically higher sales volumes and extended payment terms made available to our customers, and typically decrease between May and December when payments are received. We believe that the funds available through existing financing arrangements and forecasted cash flows will be sufficient to provide the necessary capital resources for our anticipated working capital needs, capital expenditures, investments, debt repayments, quarterly cash dividend payments, and common stock repurchases for at least the next twelve months. As of October 31, 2018, cash and cash equivalents held by our foreign subsidiaries were approximately $104.3 million. Notwithstanding the deemed repatriation under the Tax Act and other previously taxed income, we consider that $42.5 million of cash and cash equivalents held by our foreign subsidiaries are intended to be indefinitely reinvested. Should these cash and cash equivalents be distributed in the future in the form of dividends or otherwise, we may be subject to foreign withholding taxes, state income taxes, and/or additional federal taxes for currency fluctuations. At this time, the unrecognized deferred tax liabilities for temporary differences related to our investment in non-U.S. subsidiaries, and any withholding, state, or additional federal taxes upon any future repatriation, are not material and have not been recorded. Seasonal cash requirements are financed from operations, cash on hand, and borrowings under our revolving credit facility, as applicable. In June 2018, we replaced our prior revolving credit facility and term loan, which were scheduled to mature in October 2019, with an unsecured senior five-year revolving credit facility that, among other things, increases our borrowing capacity to $600 million, from $150 million, and expires in June 2023. Included in our $600 million revolving credit facility is a $10 million sublimit for standby letters of credit and a $30 million sublimit for swingline loans. At our election, and with the approval of the named borrowers on the revolving credit facility and the election of the lenders to fund such increase, the aggregate maximum principal amount available under the facility may be increased by an amount up to $300 million. Funds are available under the revolving credit facility for working capital, capital expenditures, and other lawful corporate purposes, including, but not limited to, acquisitions and common stock repurchases, subject in each case to compliance with certain financial covenants described below. Loans under the revolving credit facility (other than swingline loans) bear interest at a variable rate generally based on LIBOR or an alternative variable rate based on the highest of the Bank of America prime rate, the federal funds rate or a rate generally based on LIBOR, in each case subject to an additional basis point spread that is calculated based on the better of the leverage ratio (as measured quarterly and defined as the ratio of (a) total indebtedness to (b) consolidated earnings before interest and taxes plus depreciation and amortization expense) and debt rating of Toro. Swingline loans under the revolving credit facility bear interest at a rate determined by the swingline lender or an alternative variable rate based on the highest of the Bank of America prime rate, the federal funds rate or a rate generally based on LIBOR, in each case subject to an additional basis point spread that is calculated based on the better of the leverage ratio and debt rating of Toro. Interest is payable quarterly in arrears. Our debt rating for long-term unsecured senior, non-credit enhanced debt was unchanged during the fourth quarter of fiscal 2018 by Standard and Poor's Ratings Group at BBB and by Moody's Investors Service at Baa3. If our debt rating falls below investment grade and/or our leverage ratio rises above 1.50, the basis point spread we currently pay on outstanding debt under the revolving credit facility would increase. However, the credit commitment could not be canceled by the banks based solely on a ratings downgrade. Our revolving credit facility contains standard covenants, including, without limitation, financial covenants, such as the maintenance of minimum interest coverage and maximum leverage ratios; and negative covenants, which among other things, limit disposition of assets, consolidations and mergers, restricted payments, liens, and other matters customarily restricted in such agreements. Most of these restrictions are subject to certain minimum thresholds and exceptions. Under the revolving credit facility, we are not limited in the amount for payments of cash dividends and common stock repurchases as long as, both before and after giving pro forma effect to such payments, our leverage ratio from the previous quarter compliance certificate is less than or equal to 3.5 (or, at our option (which we may exercise twice during the term of the facility) after certain acquisitions with aggregate consideration in excess of $75 million, for the first four quarters following the exercise of such option, is less than or equal to 4.0), provided that immediately after giving effect of any such proposed action, no default or event of default would exist. As of October 31, 2018, we were not limited in the amount for payments of cash dividends and common stock repurchases. We were in compliance with all covenants related to the credit agreement for our revolving credit facility as of October 31, 2018, and we expect to be in compliance with all covenants during fiscal 2019. If we were out of compliance with any covenant required by this credit agreement following the applicable cure period, the banks could terminate their commitments unless we could negotiate a covenant waiver from the banks. In addition, our long-term senior notes, debentures, and any amounts outstanding under the revolving credit facility could become due and payable if we were unable to obtain a covenant waiver or refinance our borrowings under our credit agreement. As of October 31, 2018, we had $312.5 million of outstanding long-term debt that includes $100.0 million of 7.8 percent debentures due June 15, 2027, $123.9 million of 6.625 percent senior notes due May 1, 2037, and $91.0 million outstanding under our revolving credit facility. These long-term debt amounts were partially offset by debt issuance costs and deferred charges of $2.3 million related to our outstanding long-term debt. Our revolving credit facility is classified as long-term debt within our Consolidated Balance Sheets as we have the ability to extend the outstanding borrowings under the revolving credit facility for the full-term of the facility and we currently intend to keep the balance outstanding for at least twelve months. In addition to the $91.0 million outstanding under our revolving credit facility as of October 31, 2018, we had $1.5 million outstanding under the sublimit for standby letters of credit as of October 31, 2018 and $507.5 million of unutilized availability under our revolving credit facility. In addition, our domestic and non-U.S. operations maintain import letters of credit in the aggregate amount of approximately $13.5 million. As of October 31, 2018, we had $6.7 million of outstanding import letters of credit. Capital Structure The following table details the components of our total capitalization and debt-to-capitalization ratio: Our debt-to-capitalization ratio decreased in fiscal 2018 compared to fiscal 2017 primarily due to an increase in stockholders' equity from higher net earnings, as well as repayments of our long-term debt, partially offset by repurchases of our common stock and an increase in cash dividends paid on our common stock in fiscal 2018 as compared to fiscal 2017. Cash Dividends In each quarter of fiscal 2018, our Board of Directors declared a common stock cash dividend of $0.20 per share, which was a 14.3 percent increase over our common stock cash dividend of $0.175 per share paid each quarter in fiscal 2017. On December 4, 2018, our Board of Directors increased our fiscal 2019 first quarter common stock cash dividend by 12.5 percent to $0.225 per share from the quarterly common stock cash dividend paid in the first quarter of fiscal 2019. Share Repurchases During fiscal 2018, we continued to repurchase shares of our common stock in the open market, thereby reducing our total shares outstanding. As of October 31, 2018, 2,402,014 shares remained available for repurchase under our Board authorization. Our repurchase program also provides shares for use in connection with our equity compensation plans. We expect to continue repurchasing shares of our common stock in fiscal 2019, depending upon market conditions. The following table provides information with respect to repurchases of our common stock during the past three fiscal years: On December 4, 2018, our Board of Directors authorized the repurchase of up to an additional 5,000,000 shares of common stock in open-market or privately negotiated transactions. This repurchase program has no expiration date but may be terminated by the Board at any time. Customer Financing Arrangements Wholesale Financing We are party to a joint venture with TCFIF, established as Red Iron, the primary purpose of which is to provide inventory financing to certain distributors and dealers of our products in the U.S. that enables them to carry representative inventories of our products. Under a separate arrangement, TCFCFC provides inventory financing to dealers of our products in Canada. Under these financing arrangements, down payments are not required and, depending on the finance program for each product line, finance charges are incurred by us, shared between us and the distributor and/or the dealer, or paid by the distributor or dealer. Red Iron retains a security interest in the distributors' and dealers' financed inventories, and those inventories are monitored regularly. Financing terms to the distributors and dealers require payment as the equipment, which secures the indebtedness, is sold to customers or when payment terms become due, whichever occurs first. Rates are generally indexed to LIBOR plus a fixed percentage that differs based on whether the financing is for a distributor or dealer. Rates may also vary based on the product that is financed. Red Iron financed $1,959.7 million of new receivables for dealers and distributors during fiscal 2018, of which $446.1 million of net receivables were outstanding as of October 31, 2018. Some independent international dealers continue to finance their products with a third-party financing company. This third-party financing company purchased $29.8 million of receivables from us during fiscal 2018, of which $13.0 million was outstanding as of October 31, 2018. We enter into limited inventory repurchase agreements with third party financing companies and Red Iron for receivables financed by them. As of October 31, 2018, we were contingently liable to repurchase up to a maximum amount of $10.5 million of inventory related to receivables under these financing arrangements. We have repurchased immaterial amounts of inventory from third party financing companies and Red Iron over the past three fiscal years. However, a decline in retail sales or financial difficulties of our distributors or dealers could cause this situation to change and thereby require us to repurchase financed product up to but not exceeding our limited obligation, which could have an adverse effect on our operating results. We continue to provide financing in the form of open account terms to home centers and mass retailers; general line irrigation dealers; international distributors and dealers other than the Canadian distributors and dealers to whom Red Iron provides financing arrangements; ag-irrigation dealers and distributors; government customers; and rental companies. End-User Financing We have agreements with third party financing companies to provide lease-financing options to golf course and sports fields and grounds equipment customers in the U.S., Australia, and select countries in Europe. The purpose of these agreements is to provide end-users of our products alternative financing options when purchasing our products. We have no contingent liabilities for residual value or credit collection risk under these agreements with third party financing companies. From time to time, we enter into agreements where we provide recourse to third-party finance companies in the event of default by the customer for lease payments to the third-party finance company. Our maximum exposure for credit collection under those arrangements as of October 31, 2018 was $6.7 million. Termination or any material change to the terms of our end-user financing arrangements, availability of credit for our customers, including any delay in securing replacement credit sources, or significant financed product repurchase requirements could have a material adverse impact on our future operating results. Distributor Financing Occasionally, we enter into long-term loan agreements with some distributors. These transactions are used for expansion of the distributors' businesses, acquisitions, refinancing working capital agreements, or facilitation of ownership transitions. As of October 31, 2018, we had outstanding notes receivable in the amount of $0.8 million, which is included in other current and long-term assets on our Consolidated Balance Sheets. Contractual Obligations We are obligated to make future payments under various existing contracts, such as debt agreements, operating lease agreements, unconditional purchase obligations, and other long-term obligations. The following table summarizes our contractual obligations as of October 31, 2018: Principal payments in accordance with our credit facilities and long-term debt agreements. Interest payments for outstanding long-term debt obligations. Interest on variable rate debt was calculated using the interest rate as of October 31, 2018. The Tax Act imposed a one-time deemed repatriation tax on our historical undistributed earnings and profits of foreign affiliates, payable over eight years. The unfunded deferred compensation arrangements, covering certain current and retired management employees, consist primarily of salary and bonus deferrals under our deferred compensation plans. Our estimated distributions in the contractual obligations table are based upon a number of assumptions, including termination dates and participant elections. Purchase obligations represent contracts or commitments for the purchase of raw materials. Operating lease obligations do not include payments to property owners covering real estate taxes and common area maintenance. Payment obligations in connection with the renovation and expansion of our manufacturing facility located at Tomah, Wisconsin and corporate information technology payment obligations, as well as other miscellaneous contractual obligations. In addition to the contractual obligations described in the preceding table, we may be obligated for additional net cash outflows related to $2.2 million of unrecognized tax benefits, including interest and penalties. The payment and timing of any such payments is affected by the ultimate resolution of the tax years that are under audit or remain subject to examination by the relevant taxing authorities. Off-Balance Sheet Arrangements We have off-balance sheet arrangements relating to our operating lease agreements for certain property, plant, or equipment assets utilized in the normal course of business, such as buildings for manufacturing facilities, office space, distribution centers, and warehouse facilities; land for product testing sites; machinery and equipment for research and development activities, manufacturing and assembly processes, and administrative tasks; and vehicles for sales, marketing and distribution activities. Refer to the section titled "Contractual Obligations" within this MD&A for our future payment obligations under our operating lease agreements. We also have off-balance sheet arrangements with Red Iron, our joint venture with TCFIF, and TCFCFC in which inventory receivables for certain dealers and distributors are financed by Red Iron or TCFCFC. More information regarding the terms and our arrangements with Red Iron and TCFCFC are disclosed herein under Item 7, "Management's Discussion and Analysis of Financial Condition and Results of Operations" and Note 3 of the Notes to Consolidated Financial Statements included in Item 8, "Financial Statements and Supplementary Data." Additionally, we use letters of credit and surety bonds in the ordinary course of business to ensure the performance of contractual obligations, as required under certain contracts. As of October 31, 2018, we had $8.2 million in outstanding letters of credit issued, which include amounts outstanding on our standby letter of credit under our revolving credit facility and import letters of credit. As of October 31, 2018, we did not have an outstanding balance on our surety bonds. Market Risk Due to the nature and scope of our operations, we are subject to exposures that arise from fluctuations in interest rates, foreign currency exchange rates, and commodity costs. We are also exposed to equity market risk pertaining to the trading price of our common stock. Additional information is presented in Part II, Item 7A, "Quantitative and Qualitative Disclosures about Market Risk," and Note 13 of the Notes to Consolidated Financial Statements. Inflation We are subject to the effects of inflation, deflation, and changing prices. During fiscal 2018, the average cost of commodities and components purchased were higher compared to the average cost of commodities and components in fiscal 2017. We strategically work to mitigate the impact of inflation on the cost of commodities and components that affect our product lines; however, we anticipate that the average cost for commodities and components will be higher in fiscal 2019, as compared to fiscal 2018. Historically, we have mitigated, and we currently expect that we would mitigate, any commodity and component cost increases, in part, by collaborating with suppliers, reviewing alternative sourcing options, substituting materials, utilizing Lean methods, engaging in internal cost reduction efforts, and increasing prices on some of our products, all as appropriate. NON-GAAP FINANCIAL MEASURES We have provided non-GAAP financial measures, which are not calculated or presented in accordance with GAAP, as information supplemental and in addition to the most directly comparable financial measures that are calculated and presented in accordance with GAAP. Such non-GAAP financial measures should not be considered superior to, as a substitute for, or as an alternative to, and should be considered in conjunction with, the GAAP financial measures. The non-GAAP financial measures may differ from similar measures used by other companies. The following table provides reconciliations of financial measures calculated and reported in accordance with GAAP as well as adjusted non-GAAP financial measures for the fiscal years ended October 31, 2018 and October 31, 2017. We believe these measures may be useful in performing meaningful comparisons of past and present operating results, to understand the performance of our ongoing operations, and how management views the business. Our net earnings, diluted EPS, and effective tax rate for fiscal year 2016 were not impacted by the effects of U.S. Tax Reform or ASU No. 2016-09, Stock-based Compensation: Improvements to Employee Share-based Payment Accounting, and accordingly, have not been adjusted within the following table. The following is a reconciliation of our net earnings, diluted EPS, and effective tax rate to our adjusted net earnings, adjusted diluted EPS, and adjusted effective tax rate: The actual impact of U.S. tax reform may differ from our estimates, due to, among other things, changes in interpretations and assumptions we have made, guidance that may be issued, and changes in our structure or business model. Signed into law on December 22, 2017, the Tax Act reduced the U.S. federal corporate tax rate from 35.0 percent to 21.0 percent, effective January 1, 2018, resulting in a blended U.S. federal statutory tax rate of 23.3 percent for the fiscal year ended October 31, 2018. This reduction in rate requires the re-measurement of our net deferred taxes as of the date of enactment, which resulted in non-cash charge of $19.3 million during fiscal 2018. The Tax Act imposed a one-time deemed repatriation tax on our historical undistributed earnings and profits of foreign affiliates which resulted in a charge of $13.4 million during fiscal 2018, payable over eight years. In the first quarter of fiscal 2017, we adopted ASU No. 2016-09, Stock-based Compensation: Improvements to Employee Share-based Payment Accounting, which requires that any excess tax deduction for share-based compensation be immediately recorded within income tax expense. We recorded discrete tax benefits of $14.6 million and $19.7 million as excess tax deductions for share-based compensation during fiscal years 2018 and 2017, respectively. The Tax Act reduced the U.S. federal corporate tax rate, which reduced the tax benefit related to share-based compensation by $6.1 million for fiscal 2018. CRITICAL ACCOUNTING POLICIES AND ESTIMATES In preparing our Consolidated Financial Statements in conformity with U.S. GAAP, we must make decisions that impact the reported amounts of assets, liabilities, revenues and expenses, and related disclosures. Such decisions include the selection of the appropriate accounting principles to be applied and the assumptions on which to base accounting estimates. In reaching such decisions, we apply judgments based on our understanding and analysis of the relevant circumstances, historical experience, and actuarial valuations. Actual amounts could differ from those estimated at the time the Consolidated Financial Statements are prepared. Our significant accounting policies are described in Note 1 of the Notes to Consolidated Financial Statements. Some of those significant accounting policies require us to make difficult, subjective, or complex judgments or estimates. An accounting estimate is considered to be critical if it meets both of the following criteria: (i) the estimate requires assumptions about matters that are highly uncertain at the time the accounting estimate is made, and (ii) different estimates reasonably could have been used, or changes in the estimate that are reasonably likely to occur from period to period may have a material impact on the presentation of our financial condition, changes in financial condition, or results of operations. Our critical accounting estimates include the following: Warranty Reserve Warranty coverage on our products is generally for specified periods of time and on select products' hours of usage, and generally covers parts, labor, and other expenses for non-maintenance repairs. Warranty coverage generally does not cover operator abuse or improper use. At the time of sale, we accrue a warranty reserve by product line for estimated costs in connection with future warranty claims. We also establish reserves for major rework campaigns. The amount of our warranty reserves is based primarily on the estimated number of products under warranty, historical average costs incurred to service warranty claims, the trend in the historical ratio of claims to sales, and the historical length of time between the sale and resulting warranty claim. We periodically assess the adequacy of our warranty reserves based on changes in these factors and record any necessary adjustments if actual claim experience indicates that adjustments are necessary. Actual claims could be higher or lower than amounts estimated, as the number and value of warranty claims can vary due to such factors as performance of new products, significant manufacturing or design defects not discovered until after the product is delivered to customers, product failure rates, and higher or lower than expected service costs for a repair. We believe that analysis of historical trends and knowledge of potential manufacturing or design problems provide sufficient information to establish a reasonable estimate for warranty claims at the time of sale. However, since we cannot predict with certainty future warranty claims or costs associated with servicing those claims, our actual warranty costs may differ from our estimates. An unexpected increase in warranty claims or in the costs associated with servicing those claims would result in an increase in our warranty accrual and a decrease in our net earnings. Sales Promotions and Incentives At the time of sale to a customer, we record an estimate for sales promotion and incentive costs that are classified as a reduction from gross sales or as a component of SG&A expense. Examples of significant sales promotions and incentive programs in which the related expense is classified as a reduction from gross sales are as follows: • Off-Invoice Discounts: Our costs for off-invoice discounts represent a reduction in the selling price of our products given at the time of sale. • Rebate Programs: Our rebate programs are generally based on claims submitted from either our direct customers or end-users of our products, depending upon the program. The amount of the rebate varies based on the specific program and is either a dollar amount or a percentage of the purchase price and can also be based on actual retail price as compared to our selling price. • Incentive Discounts: Our costs for incentive discount programs are based on our customers’ purchase or retail sales goals of certain quantities or mixes of product during a specified time period, which are tracked on an annual or quarterly basis depending on the program. • Financing Programs: Our costs for financing programs, namely floor planning and retail financing, represent financing costs associated with programs under which we pay a portion of the interest cost to finance distributor and dealer inventories through third party financing arrangements for a specific period of time. Retail financing is similar to floor planning with the difference being that retail financing programs are offered to end-user customers under which we pay a portion of interest costs on behalf of end-users for financing purchases of our equipment. • Commissions Paid to Home Center Customers: We pay commissions to home center customers as an off-invoice discount. These commissions do not represent any selling effort by the home center customer but rather is a discount from the selling price of the product. Examples of significant sales promotions and incentive programs in which the related expense is classified as a component of selling, general, and administrative expense are as follows: • Commissions Paid to Distributors and Dealers: For certain products, we use a distribution network of dealers and distributors that purchase and take possession of products for sale to the end customer. In addition, we have dealers and distributors that act as sales agents for us on certain products using a direct-selling type model. Under this direct-selling type model, our network of distributors and dealers facilitates a sale directly to the dealer or end-user customer on our behalf. Commissions to distributors and dealers in these instances represent commission payments to sales agents that are also our customers. • Cooperative Advertising: Cooperative advertising programs are based on advertising costs incurred by distributors and dealers for promoting our products. We support a portion of those advertising costs in which claims are submitted by the distributor or dealer along with evidence of the advertising material procured/produced and evidence of the cost incurred in the form of third party invoices or receipts. The estimates for sales promotion and incentive costs are based on the terms of the arrangements with customers, historical payment experience, field inventory levels, volume purchases, and expectations for changes in relevant trends in the future. Actual results may differ from these estimates if competitive factors dictate the need to enhance or reduce sales promotion and incentive accruals or if customer usage and field inventory levels vary from historical trends. Adjustments to sales promotions and incentive accruals are made from time to time as actual usage becomes known in order to properly estimate the amounts necessary to generate consumer demand based on market conditions as of the balance sheet date. Goodwill and Indefinite-Lived Intangible Assets Goodwill and indefinite-lived intangible assets are not amortized, but are tested at least annually for impairment and whenever events or changes in circumstances indicate that impairment may have occurred. We test goodwill for impairment at the reporting unit level and test indefinite-lived intangible assets for impairment at the individual indefinite-lived intangible asset or asset group level, as appropriate. Our impairment testing for goodwill is performed separately from our impairment testing of indefinite-lived intangible assets, but the income approach is utilized for both to determine fair value when a quantitative analysis is required. Under the income approach, we calculate the fair value of our reporting units and indefinite-lived intangible assets using the present value of future cash flows. Assumptions utilized in determining fair value under the income approach, such as forecasted growth rates and weighted-average cost of capital ("WACC"), are consistent with internal projections and operating plans. Materially different assumptions regarding future performance of our businesses or a different WACC rate could result in impairment losses. Individual indefinite-lived intangible assets, or asset groups, are tested for impairment by comparing the carrying amounts of the respective asset, or asset group, to its estimated fair value. Our estimate of the fair value for an indefinite-lived intangible asset, or asset group, uses projected revenues from our forecasting process, assumed royalty rates, and a discount rate. If the fair value of the indefinite-lived intangible asset, or asset group, is less than its carrying value, an impairment loss is recognized in an amount equal to the excess. In conducting our goodwill impairment test, we may elect to first perform a qualitative assessment to determine whether changes in events or circumstances since our most recent quantitative test for goodwill impairment indicate that it is more likely than not that the fair value of a reporting unit is less than its carrying amount. However, we have an unconditional option to bypass the qualitative assessment for any reporting unit and proceed directly to performing the quantitative analysis. If elected, in conducting the initial qualitative assessment, we analyze actual and projected growth trends for net sales, gross margin, and earnings for each reporting unit, as well as historical versus planned performance. Additionally, each reporting unit is assessed for critical areas that may impact its business, including macroeconomic conditions, market-related exposures, competitive changes, new or discontinued products, changes in key personnel, or any other potential risks to projected financial results. All assumptions used in the qualitative assessment require significant judgment. If, after evaluating the weight of the changes in events and circumstances, both positive and negative, we conclude that an impairment may exist, a quantitative test for goodwill impairment is performed. If performed due to identified impairment indicators under the qualitative assessment, the duration of time since the most recent quantitative goodwill impairment test, or our election to bypass the qualitative assessment and move directly to the quantitative analysis, the quantitative goodwill impairment test is a one-step process. In performing the quantitative analysis, we compare the carrying value of a reporting unit, including goodwill, to its fair value. The carrying amount of each reporting unit is determined based on the amount of equity required for the reporting unit's activities, considering the specific assets and liabilities of the reporting unit. We do not assign corporate assets and liabilities to reporting units that do not relate to the operations of the reporting unit or are not considered in determining the fair value of the reporting unit. Our estimate of the fair value of our reporting units utilizes various inputs and assumptions, including projected operating results and growth rates from our forecasting process, applicable tax rates and a WACC rate. Where available, and as appropriate, comparable market multiples and our company's market capitalization are also used to corroborate the results of the discounted cash flow models. If the fair value of the reporting unit exceeds its carrying value, goodwill of the reporting unit is not impaired. If the carrying value of a reporting unit exceeds its fair value, an impairment charge would be recognized for the amount by which the carrying value of the reporting unit exceeds the its fair value, not to exceed the total amount of goodwill allocated to that reporting unit. Inventory Valuation We value our inventories at the lower of the cost of inventory or net realizable value, with cost determined by either the last-in, first-out method for most U.S. inventories or the first-in, first-out method for all other inventories. We establish reserves for excess, slow moving, and obsolete inventory based on inventory levels, expected product life, and forecasted sales demand. Valuation of inventory can also be affected by significant redesign of existing products or replacement of an existing product by an entirely new generation product. In assessing the ultimate realization of inventories, we are required to make judgments as to future demand requirements compared with inventory levels. Reserve requirements are developed according to our projected demand requirements based on historical demand, competitive factors, and technological and product life cycle changes. It is possible that an increase in our reserve may be required in the future if there is a significant decline in demand for our products and we do not adjust our production schedule accordingly. Though management considers reserve balances adequate and proper, changes in economic conditions in specific markets in which we operate could have an effect on the reserve balances required for excess, slow moving and obsolete inventory. Recent Accounting Pronouncements For information regarding recent accounting pronouncements, refer to Note 1 in our Notes to Consolidated Financial Statements in the sections entitled "New Accounting Pronouncements Adopted" and "New Accounting Pronouncements Not Yet Adopted", included in Part II, Item 8, "Financial Statements and Supplementary Data" of this report.

<s>[INST] Company Overview Results of Operations Business Segments Financial Position NonGAAP Financial Measures Critical Accounting Policies and Estimates We have provided nonGAAP financial measures, which are not calculated or presented in accordance with accounting principles generally accepted in the United States ("GAAP"), as information supplemental and in addition to the financial measures presented in this report that are calculated and presented in accordance with GAAP. This MD&A contains certain nonGAAP financial measures, consisting of adjusted net earnings, adjusted net earnings per diluted share, and an adjusted effective tax rate as measures of our operating performance. Management believes these measures may be useful in performing meaningful comparisons of past and present operating results, to understand the performance of our ongoing operations, and how management views the business. Reconciliations of adjusted nonGAAP financial measures to the most directly comparable reported GAAP financial measures are included in the section titled "NonGAAP Financial Measures" within this MD&A. These measures, however, should not be construed as an alternative to any other measure of performance determined in accordance with GAAP. Our net earnings, diluted net earnings per share ("EPS"), and effective tax rate for fiscal year 2016 were not impacted by the effects of U.S. Tax Reform or ASU No. 201609, Stockbased Compensation: Improvements to Employee Sharebased Payment Accounting, and accordingly, have not been adjusted within the following sections of this MD&A. Statements that are not historical are forwardlooking and involve risks and uncertainties, including those discussed in Part I, Item 1A, "Risk Factors" and elsewhere in this report. These risks could cause our actual results to differ materially from any future performance suggested below. COMPANY OVERVIEW The Toro Company is in the business of designing, manufacturing, and marketing professional turf maintenance equipment and services, turf irrigation systems, landscaping equipment and lighting products, snow and ice management products, agricultural irrigation systems, rental and specialty construction equipment, and residential yard and snow thrower products. We sell our products worldwide through a network of distributors, dealers, mass retailers, hardware retailers, home centers, as well as online (direct to endusers). We strive to provide innovative, wellbuilt, and dependable products supported by an extensive service network. A significant portion of our net sales has historically been, and we expect will continue to be, attributable to new and enhanced products. We define new products as those introduced in the current and previous two fiscal years. We classify our operations into two reportable business segments: Professional and Residential. Our remaining activities are presented as "Other" due to their insignificance. These Other activities consist of earnings (loss) from our whollyowned domestic distribution company, corporate activities, and the elimination of intersegment revenues and expenses. Summary of Fiscal 2018 Results In fiscal 2018, we achieved net sales of $2,618.7 million and net earnings growth of 1.6 percent. Our fiscal 2018 results included the following items of significance: Net sales for fiscal 2018 increased by 4.5 percent to $2,618.7 million when compared to fiscal 2017. The sales increase was primarily driven by strong demand for our Professional segment products, as well as the successful introduction of new innovative products in the Professional and Residential segments. Professional segment net sales grew 7.5 percent in fiscal 2018 compared to fiscal 2017. Residential segment net sales decreased 2.8 percent in fiscal 2018 compared to fiscal 2017. International net sales for fiscal 2018 increased by 5.1 percent compared to fiscal 2017. Foreign currency exchange rates favorably impacted our international net sales by approximately $12.5 million in fiscal 2018. International net sales comprised 24.6 percent of our total consolidated net sales in fiscal 2018 compared to 24.4 percent in fiscal 2017 and 24.2 percent in fiscal 2016. Our net earnings were significantly impacted [/INST] Positive. </s>

TORO CO

2019-12-20

2019-10-31

ITEM 7. MANAGEMENT'S DISCUSSION AND ANALYSIS OF FINANCIAL CONDITION AND RESULTS OF OPERATIONS This Management's Discussion and Analysis of Financial Condition and Results of Operations ("MD&A") is intended to provide a reader of our financial statements with a narrative from the perspective of management on our financial condition, results of operations, liquidity, and certain other factors that may affect our future results. Unless expressly stated otherwise, the comparisons presented in this MD&A refer to the year-over-year comparison of changes in our financial condition and results of operations as of and for the fiscal years ended October 31, 2019 and October 31, 2018. Discussion of fiscal 2017 items and the year-over-year comparison of changes in our financial condition and results of operation as of and for the fiscal years ended October 31, 2018 and October 31, 2017 can be found in Part II, Item 7. "Management’s Discussion and Analysis of Financial Condition and Results of Operations" of our Annual Report on Form 10-K for the fiscal year ended October 31, 2018. Our MD&A is presented as follows: • Company Overview • Results of Operations • Business Segments • Financial Position • Non-GAAP Financial Measures • Critical Accounting Policies and Estimates We have provided non-GAAP financial measures, which are not calculated or presented in accordance with accounting principles generally accepted in the United States ("GAAP"), as information supplemental and in addition to the most directly comparable financial measures presented in this report that are calculated and presented in accordance with GAAP. We use these non-GAAP financial measures in making operating decisions because we believe these non-GAAP financial measures provide meaningful supplemental information regarding our core operational performance and provide us with a better understanding of how to allocate resources to both ongoing and prospective business initiatives. Additionally, these non-GAAP financial measures facilitate our internal comparisons to both our historical operating results and to our competitors' operating results by factoring out potential differences caused by charges not related to our regular, ongoing business, including, without limitation, non-cash charges, certain large and unpredictable charges, acquisitions and dispositions, legal settlements, and tax positions. Further, we believe that such non-GAAP financial measures, when considered in conjunction with our Consolidated Financial Statements prepared in accordance with U.S. GAAP, provide investors with useful supplemental financial information to better understand our core operational performance. Reconciliations of adjusted non-GAAP financial measures to the most directly comparable reported GAAP financial measures are included in the section titled "Non-GAAP Financial Measures" within this MD&A. These non-GAAP financial measures, however, should not be considered superior to, as a substitute for, or as an alternative to, and should be considered in conjunction with, the most directly comparable GAAP financial measures. Further, these non-GAAP financial measures may differ from similar measures used by other companies. Statements that are not historical are forward-looking and involve risks and uncertainties, including those discussed in Part I, Item 1A, "Risk Factors" and elsewhere in this report. These risks could cause our actual results to differ materially from any future performance suggested throughout this MD&A. COMPANY OVERVIEW The Toro Company is in the business of designing, manufacturing, and marketing professional turf maintenance equipment and services; turf irrigation systems; landscaping equipment and lighting products; snow and ice management products; agricultural irrigation systems; rental, specialty, and underground construction equipment; and residential yard and snow thrower products. We sell our products worldwide through a network of distributors, dealers, mass retailers, hardware retailers, equipment rental centers, home centers, as well as online (direct to end-users). We strive to provide innovative, well-built, and dependable products supported by an extensive service network. A significant portion of our net sales has historically been, and we expect will continue to be, attributable to new and enhanced products. We define new products as those introduced in the current and previous two fiscal years. We classify our operations into two reportable business segments: Professional and Residential. Our remaining activities are presented as "Other" due to their insignificance. Such Other activities consist of earnings (loss) from our wholly-owned domestic distribution companies, corporate activities, and the elimination of intersegment revenues and expenses. Acquisition of CMW As more fully described in Part I, Item 1, "Business" within the section titled "Acquisition of The Charles Machine Works, Inc." and Note 2, Business Combinations, in the Notes to Consolidated Financial Statements included in Part II, Item 8, "Financial Statements and Supplementary Data," on April 1, 2019, we completed our acquisition of CMW, a privately held Oklahoma corporation. CMW designs, manufactures, and markets a range of professional products to serve the underground construction market, including horizontal directional drills, walk and ride trenchers, compact utility loaders/skid steers, vacuum excavators, asset locators, pipe rehabilitation solutions, and after-market tools. CMW provides innovative product offerings that broadened and strengthened our Professional segment product portfolio and expanded our dealer network, while also providing a complementary geographic manufacturing footprint. The transaction was structured as a merger, pursuant to which a wholly-owned subsidiary of Toro merged with and into CMW, with CMW continuing as the surviving entity and a wholly-owned subsidiary of Toro. As a result of the merger, all of the outstanding equity securities of CMW were canceled and now only represent the right to receive the applicable consideration as described in the merger agreement. At the closing date, we paid preliminary merger consideration of $679.3 million that was subject to customary adjustments based on, among other things, the amount of actual cash, debt, and working capital in the business of CMW at the closing date. During the fourth quarter of fiscal 2019, we finalized such customary adjustments that resulted in an additional $5.7 million of merger consideration being paid and an aggregate merger consideration of $685.0 million ("purchase price"). We funded the purchase price for the acquisition by using a combination of cash proceeds from the issuance of borrowings under our unsecured senior term loan credit agreement and borrowings from our unsecured senior revolving credit facility. For additional information regarding the financing agreements utilized to fund the aggregate merger consideration, refer to the section titled "Financial Position" within this MD&A and Note 6, Indebtedness, in the Notes to Consolidated Financial Statements included in Part II, Item 8, "Financial Statements and Supplementary Data" of this Annual Report on Form 10-K. Summary of Fiscal 2019 Results Our fiscal 2019 results included the following items of significance: • Net sales for fiscal 2019 increased by 19.8 percent to $3,138.1 million when compared to fiscal 2018. The sales increase was primarily driven by incremental sales as a result of our acquisition of CMW, the year-over-year impact of price increases across our Professional and Residential segment product lines, strong channel demand for our Professional segment snow and ice management products and Residential snow thrower products, incremental sales as a result of our acquisition of a Northeastern U.S. distribution company, as well as the successful introduction of innovative new products in the Professional and Residential segments. • Professional segment net sales grew 25.5 percent in fiscal 2019 compared to fiscal 2018. • Residential segment net sales increased 1.0 percent in fiscal 2019 compared to fiscal 2018. • International net sales for fiscal 2019 increased by 12.7 percent compared to fiscal 2018, primarily driven by incremental sales as a result of our acquisition of CMW. Foreign currency exchange rates unfavorably impacted our international net sales by approximately $14.1 million in fiscal 2019. International net sales comprised 23.1 percent of our total consolidated net sales in fiscal 2019 compared to 24.6 percent and 24.4 percent in fiscal 2018 and 2017, respectively. • Gross margin was 33.4 percent in fiscal 2019, a decrease of 250 basis points from 35.9 percent in fiscal 2018. Non-GAAP adjusted gross margin was 35.1 percent in fiscal 2019, a decrease of 80 basis points from 35.9 percent in fiscal 2018. • Selling, general, and administrative ("SG&A") expense was 23.0 percent as a percentage of net sales in fiscal 2019, an increase of 130 basis points from 21.7 percent in fiscal 2018. • Fiscal 2019 net earnings of $274.0 million increased 0.8 percent compared to fiscal 2018, and diluted net earnings per share increased 1.2 percent to $2.53 in fiscal 2019 compared to $2.50 in fiscal 2018. Fiscal 2019 non-GAAP adjusted net earnings were $324.3 million, an increase of 11.8 percent compared to fiscal 2018, and non-GAAP adjusted diluted net earnings per share increased 12.4 percent to $3.00 in fiscal 2019 compared to $2.67 in fiscal 2018. • Our receivables and inventories increased by 39.1 percent and 81.9 percent, respectively, as of the end of fiscal 2019 compared to the end of fiscal 2018, primarily due to incremental receivables and inventories as a result of our acquisition of CMW. • Our field inventory levels were up as of the end of fiscal 2019 compared to the end of fiscal 2018, primarily as a result of higher Professional segment field inventory that was primarily due to incremental field inventory as a result of our acquisition of CMW and higher field inventory for our Professional segment zero-turn riding mowers due to soft retail demand. • We continued our history of paying quarterly cash dividends in fiscal 2019. We increased our fiscal 2019 quarterly cash dividend by 12.5 percent to $0.225 per share compared to our quarterly cash dividend in fiscal 2018 of $0.20 per share. Please refer to the sections entitled “Results of Operations", "Business Segments", and "Financial Position" within this MD&A for more specific disclosures regarding the above items of significance and additional details concerning our financial condition, results of operations, and liquidity for fiscal 2019. Additionally, please refer to the section titled "Non-GAAP Financial Measures" within this MD&A for reconciliations of adjusted non-GAAP financial measures to the most directly comparable reported GAAP financial measures. Vision 2020 Our current multi-year employee initiative, "Vision 2020", which began with our 2018 fiscal year, focuses on driving profitable growth with an emphasis on innovation and serving our customers, which we believe will generate further momentum for the organization. Through the first two fiscal years of our Vision 2020 initiative, we set specific financial goals, which included organic revenue and operating earnings growth. In fiscal year 2019, we fell short of our organic revenue growth and our operating earnings as a percentage of net sales goals by achieving 1.1 percent organic revenue growth and 10.4 percent of operating earnings as a percentage of net sales, respectively. With our transformational acquisition of CMW, we will complete the third and final fiscal year of our Vision 2020 initiative with a revised enterprise-wide performance goal of adjusted operating earnings of $485.0 million, which is intended to help us drive profitable growth as a combined enterprise. RESULTS OF OPERATIONS Overview The following table summarizes our results of operations as a percentage of our consolidated net sales: Net Sales Worldwide net sales in fiscal 2019 were $3,138.1 million compared to $2,618.7 million in fiscal 2018, an increase of 19.8 percent. This net sales increase was primarily attributable to the following factors: • Increased worldwide sales of Professional segment products, which were primarily driven by incremental sales as a result of our acquisition of CMW, the year-over-year impact of price increases across our Professional segment product lines, and strong channel demand for our snow and ice management, landscape contractor, and Toro-branded rental and specialty construction equipment, partially offset by fewer shipments of our irrigation products due to unfavorable weather in key regions. • Increased sales for our Other activities were primarily due to increased shipments of our golf and grounds equipment through our wholly-owned domestic distribution companies driven by our acquisition of a Northeastern U.S. distribution company. • Increased worldwide sales of Residential segment products were primarily due to the year-over-year impact of price increases across our Residential segment product lines, strong retail demand for snow throwers, the successful introduction of new products, and increased parts sales, partially offset by soft retail demand for zero-turn riding mowers and reduced sales of our Pope-branded irrigation products by unfavorable weather conditions. Net sales in international markets increased by 12.7 percent in fiscal 2019 compared to fiscal 2018. This net sales increase was primarily attributable to the following factors: • incremental sales as a result of our acquisition of CMW, • strong channel demand for our golf and grounds equipment, and • strong retail demand for Residential snow thrower products. These international net sales increases were partially offset by the following factors: • decreased sales of Residential and Professional segment zero-turn riding mowers due to soft retail demand, • lower sales of Pope-branded products due to unfavorable weather in key regions, and • changes in foreign currency exchange rates unfavorably impacted our international net sales by approximately $14.1 million in fiscal 2019. Gross Margin Gross margin represents gross profit (net sales less cost of sales) as a percentage of net sales. See Note 1, Summary of Significant Accounting Policies and Related Data, of the Notes to Consolidated Financial Statements, in the section entitled "Cost of Sales," included in Part II, Item 8, "Financial Statements and Supplementary Data" of this Annual Report on Form 10-K for a description of expenses included in cost of sales. Gross margin decreased by 250 basis points to 33.4 percent in fiscal 2019 from 35.9 percent in fiscal 2018. This decrease was mainly the result of the following factors: • the unfavorable impact of higher commodity and tariff costs on purchased raw materials and component parts, • the impact of purchase accounting adjustments related to our acquisition of CMW, • unfavorable product mix, • charges related to the Toro underground wind down, and • supply chain challenges and inclement weather resulting in manufacturing inefficiencies within our Professional segment. Somewhat offsetting those unfavorable gross margin factors were: • improved net price realization driven by price increases across our product lines, • productivity initiatives related to commodities, components, parts, and accessories sourcing, and • lower freight costs due to cost reduction initiatives. Adjusted non-GAAP gross margin decreased 80 basis points to 35.1 percent in fiscal 2019 from 35.9 percent in fiscal 2018. This decrease was mainly the result of the following factors: • the unfavorable impact of higher commodity and tariff costs on purchased raw materials and component parts, • unfavorable product mix, and • supply chain challenges and inclement weather resulting in manufacturing inefficiencies within our Professional segment. Somewhat offsetting those unfavorable adjusted non-GAAP gross margin factors were: • improved net price realization driven by price increases across our product lines, • productivity initiatives related to commodities, components, parts, and accessories sourcing, and • lower freight costs due to cost reduction initiatives. Adjusted non-GAAP gross margin excludes the impact of certain purchase accounting adjustments resulting from our acquisition of CMW, including charges incurred for the take-down of the inventory fair value step-up amount and amortization of the backlog intangible asset, as well as the impact of management actions, including the charges incurred for inventory write-downs, anticipated inventory retail support activities, and accelerated depreciation of fixed assets related to the Toro underground wind down and restructuring charges incurred for our corporate restructuring event. Please refer to the section titled "Non-GAAP Financial Measures" within this MD&A for reconciliations of adjusted non-GAAP financial measures to the most directly comparable reported GAAP financial measures. Selling, General and Administrative Expense SG&A expense increased $155.0 million, or 27.3 percent, in fiscal 2019 compared to fiscal 2018. See Note 1, Summary of Significant Accounting Policies and Related Data, of the Notes to Consolidated Financial Statements, in the section entitled "Selling, General, and Administrative Expense," included in Part II, Item 8, "Financial Statements and Supplementary Data" of this report for a description of expenses included in SG&A expense. SG&A expense rate represents SG&A expense as a percentage of net sales. The SG&A expense rate in fiscal 2019 was 23.0 percent compared to 21.7 percent in fiscal 2018, an unfavorable increase of 130 basis points. As a percentage of net sales, our SG&A expense rate increase was primarily due to the following factors: • the acquisition of CMW, which resulted in incremental administrative, indirect sales and marketing, engineering, warranty, and service expense; integration and acquisition-related expenditures, and higher amortization of other intangible assets; • increased warranty costs in certain of our legacy businesses; and • increased engineering expense for new product development in our legacy businesses. These unfavorable SG&A expense rate factors were partially offset by decreased direct marketing expense in our legacy businesses. Interest Expense Interest expense for fiscal 2019 increased $9.7 million, or 51.0 percent, compared to fiscal 2018. This increase was driven by interest expense incurred on higher outstanding borrowings incurred to fund the purchase price for our acquisition of CMW. Other Income, Net Other income, net consists mainly of our proportionate share of income or losses from our Red Iron joint venture, realized currency exchange rate gains and losses, litigation settlements and/or recoveries, interest income, dividend income, gains or losses recognized on actuarial valuation changes for our pension and post-retirement plans, retail financing revenue, and other miscellaneous income. Refer to Note 16, Other Income, Net, of the Notes to Consolidated Financial Statements, included in Part II, Item 8, "Financial Statements and Supplementary Data" of this Annual Report on Form 10-K for additional information regarding the components of other income, net. Other income, net for fiscal 2019 was $25.9 million compared to $18.4 million in fiscal 2018, an increase of $7.5 million. The increase in other income, net was primarily due to the following factors: • realized gain on actuarial valuation changes for our pension and post-retirement plans of $6.8 million and • higher earnings from our equity investment in Red Iron of $0.8 million. These increases were partially offset by the following factors: • increased legal expense, net of litigation recoveries, of $1.0 million and • the loss on the sale of a used underground construction equipment business of $0.9 million. Provision for Income Taxes The effective tax rate for fiscal 2019 was 14.9 percent compared to 27.0 percent in fiscal 2018. The effective tax rate was significantly impacted by the enactment of the Tax Act during fiscal 2018, including the remeasurement of deferred tax assets and liabilities, which resulted in a non-cash discrete tax charge of $19.3 million, and the calculation of the deemed repatriation tax, which resulted in a discrete tax charge of $13.4 million, payable over eight years. In addition to these one-time charges resulting from the Tax Act, the decrease in the effective tax rate was partially driven by the reduction in the U.S. federal corporate tax rate from a blended rate of 23.3 percent in fiscal 2018 to a rate of 21.0 percent in fiscal 2019. See Note 8, Income Taxes, of the Notes to Consolidated Financial Statements, included in Part II, Item 8, "Financial Statements and Supplementary Data" of this report for further discussion the impacts on US Tax Reform. The adjusted non-GAAP effective tax rate for fiscal 2019 was 19.3 percent, compared to an adjusted non-GAAP effective tax rate of 22.1 percent in fiscal 2018. The decrease in the adjusted non-GAAP effective tax rate was primarily driven by the reduction in the U.S. federal corporate tax rate from a blended rate of 23.3 percent in fiscal 2018 to a rate of 21.0 percent in fiscal 2019. The adjusted non-GAAP effective tax rate excludes costs incurred related to our acquisition of CMW, including integration and transaction costs and certain purchase accounting adjustments; the impact of management actions, including the charges related to the Toro underground wind down, our corporate restructuring event, and the divestiture of a used underground construction equipment business; the tax benefit for the excess tax deduction for share-based compensation; and one-time charges incurred under the Tax Act. Please refer to the section titled "Non-GAAP Financial Measures" within this MD&A for reconciliations of adjusted non-GAAP financial measures to the most directly comparable reported GAAP financial measures. Net Earnings Fiscal 2019 net earnings were $274.0 million compared to $271.9 million in fiscal 2018, an increase of 0.8 percent. Fiscal 2019 diluted net earnings per share were $2.53, an increase of 1.2 percent from $2.50 per diluted share in fiscal 2018. The net earnings increase for fiscal 2019 was primarily due to the following factors: • the significant impact of the one-time charges as a result of the Tax Act on our fiscal 2018 net earnings, • incremental earnings as a result of our acquisition of CMW, • improved net price realization driven by price increases across our product lines, • the reduction in the U.S federal corporate tax rate from a blended rate of 23.3 percent in fiscal 2018 to a rate of 21.0 percent in fiscal 2019, • productivity initiatives related to commodities and component parts sourcing, and • the realized gain on actuarial valuation changes for our pension and post-retirement plans. These increases to net earnings were partially offset by the following factors: • the unfavorable impact of purchase accounting adjustments and integration and acquisition-related expenditures from our CMW acquisition, • higher commodity and tariff costs on purchased raw materials and component parts, • unfavorable product mix, • charges related to the Toro underground wind down, • higher interest expense incurred on outstanding indebtedness, and • charges related to our corporate restructuring event. Non-GAAP adjusted net earnings for fiscal 2019 were $324.3 million, or $3.00 per diluted share, compared to $290.1 million, or $2.67 per diluted share, in fiscal 2018, an increase of 12.4 percent per diluted share. The non-GAAP adjusted net earnings increase for fiscal 2019 was primarily due to the following factors: • incremental earnings as a result of our acquisition of CMW, • improved net price realization driven by price increases across our product lines, • the reduction in the U.S federal corporate tax rate from blended rate of 23.3 percent in fiscal 2018 to a rate of 21.0 percent in fiscal 2019, • productivity initiatives related to commodities and component parts sourcing, and • the realized gain on actuarial valuation changes for our pension and post-retirement plans. These increases to adjusted non-GAAP net earnings were partially offset by the following factors: • higher commodity and tariff costs on purchased raw materials and component parts, • unfavorable product mix, and • higher interest expense incurred on outstanding indebtedness. Adjusted net earnings excludes costs incurred related to our acquisition of CMW, including integration and transaction costs and certain purchase accounting adjustments; the impact of management actions, including the charges related to the Toro underground wind down, our corporate restructuring event, and the divestiture of a used underground construction equipment business; the tax benefit for the excess tax deduction for share-based compensation; and one-time charges incurred under the Tax Act. Please refer to the section titled "Non-GAAP Financial Measures" within this MD&A for reconciliations of adjusted non-GAAP financial measures to the most directly comparable reported GAAP financial measures. Commodity Cost Changes Commodities, components, parts, and accessories purchased for use in our manufacturing process and end-products or to be sold as standalone end-products are subject to the effects of inflation, deflation, changing prices, tariffs, and/or duties. During fiscal 2019, the average cost of commodities, components, parts, and accessories purchased, including the impact of inflation and tariff costs, were higher compared to the average cost of commodities, components, parts, and accessories purchased in fiscal 2018. The increase in the average cost of commodities, components, parts, and accessories had an unfavorable impact on our gross margins during fiscal 2019 as compared to fiscal 2018. We strategically work to mitigate any unfavorable impact as a result of changes in the cost of commodities, components, parts, and accessories that affect our product lines; as a result, we anticipate the costs associated with commodity, components, parts, and accessories in fiscal 2020 to be slightly lower than the average cost of commodities, components, parts, and accessories purchased during fiscal 2019. Historically, we have mitigated, and we currently expect that we would mitigate, any commodity, components, parts, and accessories cost increases, in part, by collaborating with suppliers, reviewing alternative sourcing options, substituting materials, utilizing Lean methods, engaging in internal cost reduction efforts, utilizing tariff exclusions and duty drawback mechanisms, and increasing prices on some of our products, all as appropriate. Further information regarding commodity cost risk is presented in Part II, Item 7A, "Quantitative and Qualitative Disclosures About Market Risk," of this Annual Report on Form 10-K in the section entitled "Commodity Cost Risk". BUSINESS SEGMENTS As more fully described in Note 3, Segment Data, of the Notes to Consolidated Financial Statements included within Part II, Item 8, "Financial Statements and Supplementary Data" of this Annual Report on Form 10-K, we operate in two reportable business segments: Professional and Residential. Segment earnings for our Professional and Residential segments are defined as earnings from operations plus other income, net. Our remaining activities are presented as "Other" due to their insignificance. Operating loss for our Other activities includes earnings (loss) from our wholly-owned domestic distribution companies, corporate activities, other income, and interest expense. Corporate activities include general corporate expenditures (finance, human resources, legal, information services, public relations, business development, and similar activities) and other unallocated corporate assets and liabilities, such as corporate facilities and deferred tax assets and liabilities. The following information provides perspective on our reportable business segments' and Other activities net sales and operating results. Professional Segment Professional segment net sales represented approximately 77.9 percent of consolidated net sales for fiscal 2019, 74.4 percent for fiscal 2018, and 72.3 percent for fiscal 2017. The following table presents our Professional segment's net sales, operating earnings, and operating earnings as a percent of net sales: Segment Net Sales Worldwide net sales for the Professional segment in fiscal 2019 were up by 25.5 percent compared to fiscal 2018 primarily as a result of the following factors: • incremental sales as a result of our acquisition of CMW; • the year-over-year impact of price increases across our Professional segment product lines; • higher shipments of our snow and ice management products due to strong channel and retail demand driven by late snowfalls in key regions during the Spring of 2019, as well as strong sales of the redesigned stand-on Snowrator; • continued growth in our landscape contractor business driven by the successful introduction of the new eXmark-branded Staris stand-on zero-turn riding mower, incremental sales of lawn solution products as a result of our acquisition of L.T. Rich Products, Inc. ("L.T. Rich"), higher parts sales, and strong channel demand for walk-behind and walk-power mowers; and • increased shipments of our rental and specialty construction equipment due to the successful new product introduction of our Dingo TXL 2000 compact utility loader and continued channel demand for our line of Dingo compact utility loaders. Somewhat offsetting those increases were fewer shipments of our irrigation products primarily due to unfavorable weather in key regions resulting in soft retail demand. Segment Earnings Operating earnings for the Professional segment in fiscal 2019 decreased 4.7 percent compared to fiscal 2018. Expressed as a percentage of Professional segment net sales, Professional segment operating earnings decreased by 490 basis points to 15.6 percent in fiscal 2019 compared to 20.5 percent in fiscal 2018. The following factors unfavorably impacted Professional segment operating earnings as a percentage of Professional segment net sales for fiscal 2019: • our acquisition of CMW resulting in charges incurred for purchase accounting adjustments and acquisition-related and integration expenditures; incremental administrative, indirect sales and marketing, engineering, warranty, and service expense; and higher amortization of other intangible assets; • the unfavorable impact of higher commodity and tariff costs on purchased raw materials and component parts; • supply chain challenges and inclement weather resulting in manufacturing inefficiencies; • charges related to the Toro underground wind down; • unfavorable product mix; • increased warranty costs in certain of our legacy businesses; and • increased engineering expense for new product development. Somewhat offsetting these unfavorable factors were the following items: • improved net price realization driven by pricing increases across our Professional segment product lines, • productivity initiatives related to commodities and component parts sourcing, • lower freight costs due to cost reduction initiatives, and • decreased direct marketing expense in our legacy businesses. Residential Segment Residential segment net sales represented approximately 21.1 percent of consolidated net sales for fiscal 2019, 24.9 percent for fiscal 2018, and 26.9 percent for fiscal 2017. The following table presents our Residential segment's net sales, operating earnings, and operating earnings as a percent of net sales: Segment Net Sales Worldwide net sales for the Residential segment in fiscal 2019 were up by 1.0 percent compared to fiscal 2018 primarily as a result of the following factors: • the year-over-year impact of price increases across our Residential segment product lines, • strong retail demand for our snow throwers, including the successful introduction of our line of 60V lithium-ion powered single-stage snow thrower products, • higher shipments of walk power mowers driven by the launch of our 60V lithium-ion powered walk power mowers, and • increased parts sales driven by channel demand. Somewhat offsetting those increases were the following factors: • fewer shipments of zero-turn riding mowers driven by soft retail demand and • reduced sales of our Pope-branded irrigation products driven by unfavorable weather conditions in key regions. Segment Earnings Operating earnings for the Residential segment in fiscal 2019 increased 0.5 percent compared to fiscal 2018. Expressed as a percentage of Residential segment net sales, Residential segment operating earnings were flat as a percent of sales at 9.9 percent in both fiscal 2019 and fiscal 2018. The following factors positively impacted Residential segment operating earnings as a percentage of Residential segment net sales for fiscal 2019: • improved net price realization as a result of pricing increases across our Residential segment product lines, • favorable manufacturing variance, and • lower direct marketing costs. Offsetting these positive factors were the following items: • the unfavorable impact of higher commodity and tariff costs on purchased raw materials and component parts, • unfavorable product mix, • increased warranty cost, and • higher engineering expense for new product development. Other Activities Net sales for our Other activities, which includes sales from our wholly-owned domestic distribution companies less sales from our Professional and Residential business segments to the wholly-owned domestic distribution companies, represented approximately 1.0 percent of consolidated net sales for fiscal 2019, 0.7 percent for fiscal 2018, and 0.8 percent for fiscal 2017. The following table presents net sales and operating losses for our Other activities: Other Net Sales Net sales for our Other activities in fiscal 2019 increased approximately $16.1 million compared to fiscal 2018, primarily due to increased sales of our golf and grounds equipment through our wholly-owned domestic distribution companies driven by our acquisition of a Northeastern U.S. distribution company. Other Operating Loss Operating loss for our Other activities in fiscal 2019 increased by $31.7 million, or 34.4 percent, compared to fiscal 2018. This loss increase was primarily attributable to costs incurred for continued CMW integration efforts, higher interest expense incurred on outstanding indebtedness, charges incurred for our corporate restructuring event, higher incentive compensation expense, and increased legal expense, net of litigation recoveries. The increase in loss was partially offset by the realized gain on actuarial valuation changes for our pension and post-retirement plans and higher Red Iron income. FINANCIAL POSITION Working Capital Our strategy for fiscal 2019 continued to place emphasis on improving asset utilization with a focus on reducing the amount of working capital in the supply chain, adjusting production plans, and maintaining or improving order replenishment and service levels to end-users. We calculate our average net working capital as average net accounts receivable plus average net inventory, less average accounts payable as a percentage of net sales for a twelve month period. As of the end of fiscal 2019, our average net working capital was 16.3 percent compared to 13.7 percent as of the end of fiscal 2018. This capital increase was mainly due to a higher average net inventory and net accounts receivable than the corresponding increase to average net accounts payable as a percentage of net sales due to our acquisition of CMW, as well as higher net inventory balances in our legacy businesses due to lower than forecasted sales in our Professional segment driven by soft retail demand and build-ahead for fiscal 2020 new product introductions in our Residential segment. The following table highlights several key measures of our working capital performance: The following factors impacted our working capital during fiscal 2019: • Average net receivables increased by 23.6 percent in fiscal 2019 compared to fiscal 2018, primarily due to incremental net receivables as a result of our acquisition of CMW. Our average days outstanding for receivables increased to 30.9 days in fiscal 2019 compared to 29.9 days in fiscal 2018. • Average net inventories increased by 38.6 percent in fiscal 2019 compared to fiscal 2018. Inventory levels as of the end of fiscal 2019 compared to the end of fiscal 2018 were up by $293.4 million, or 81.9 percent, primarily due to incremental net inventory as a result of our acquisition of CMW, as well as higher net inventory balances in our legacy businesses due to lower than forecasted sales in our Professional segment driven by soft retail demand and build-ahead for fiscal 2020 new product introductions in our Residential segment. • Average accounts payable increased by 21.7 percent in fiscal 2019 compared to fiscal 2018, mainly due to incremental accounts payable as a result of our acquisition of CMW and negotiating more favorable payment terms with suppliers as a component of our working capital initiatives. Cash Flow Cash flows provided by/(used in) operating, investing, and financing activities during the past three fiscal years are shown in the following table: Cash Flows from Operating Activities Our primary source of funds is cash generated from operations. In fiscal 2019, cash provided by operating activities decreased by $27.4 million, or 7.5 percent, from fiscal 2018. This decrease was mainly driven by more cash utilized for purchases of inventory and a lower year-over-year cash source benefit from extending payment terms with vendors as a component of our working capital initiatives. Somewhat offsetting this decrease was higher net earnings, which includes the unfavorable non-cash take-down of the CMW inventory purchase accounting step-up amount, and lower cash utilized for prepaid taxes. Cash Flows from Investing Activities Capital expenditures and acquisitions are a significant use of our capital resources. These investments are intended to enable sales growth in new and expanding markets, help us meet product demand, and increase our manufacturing efficiencies and capacity. Cash used in investing activities in fiscal 2019 increased by $645.0 million from fiscal 2018 mainly due to more cash utilized for our acquisitions of CMW and a Northeastern U.S. distribution company in fiscal 2019 than the cash utilized for the acquisition of L.T. Rich in fiscal 2018, partially offset by cash proceeds from the sale of a used underground construction equipment business. Cash Flows from Financing Activities Cash provided by financing activities in fiscal 2019 was $299.5 million compared to $252.1 million of cash used in financing activities in fiscal 2018, an increase of $551.6 million. This increase in cash provided by financing activities was mainly due to the cash proceeds as the result of the issuance of indebtedness under our term loan credit agreement and amounts drawn on our revolving credit facility to fund the CMW acquisition and the issuance of our private placement senior notes, reduced cash utilized for purchases of Toro common stock compared to fiscal 2018, and higher cash provided from the exercise of stock options. These sources of cash were partially offset by more cash utilized for repayments of our outstanding indebtedness under our revolving credit facility and term loan credit agreement and more cash utilized for dividend payments on shares of our common stock compared to fiscal 2018. Cash and Cash Equivalents Cash and cash equivalents as of the end of fiscal 2019 decreased by $137.3 million compared to the end of fiscal 2018. As of October 31, 2019, cash and cash equivalents held by our foreign subsidiaries were approximately $97.5 million. We consider that $17.2 million of cash and cash equivalents held by our foreign subsidiaries are intended to be indefinitely reinvested. Should these cash and cash equivalents be distributed in the future in the form of dividends or otherwise, we may be subject to foreign withholding taxes, state income taxes, and/or additional federal taxes for currency fluctuations. As of October 31, 2019, the unrecognized deferred tax liabilities for temporary differences related to our investment in non-U.S. subsidiaries, and any withholding, state, or additional federal taxes upon any future repatriation, are not material and have not been recorded. Capital Expenditures Fiscal 2019 capital expenditures of $92.9 million were $2.8 million higher than fiscal 2018. This increase was mainly attributable to incremental capital expenditures as a result of our acquisition of CMW, as well as continued investment in our facilities, new product tooling, productivity improvements in our manufacturing and distribution processes, and continued replacement of production equipment. Capital expenditures for fiscal 2020 are expected to be approximately $100.0 million as we plan to continue to invest in our facilities, new product tooling, productivity improvements in our manufacturing and distribution processes, and continued replacement of production equipment. Other Long-Term Assets Other long-term assets as of October 31, 2019 were $1,207.7 million compared to $676.3 million as of October 31, 2018, an increase of $531.3 million. This increase was driven mainly by our acquisition of CMW, which resulted in significant increases in other intangible assets; property, plant and equipment; and goodwill. In addition, our other long-term assets increased as a result of purchases of property, plant, and equipment in our legacy businesses. These increases to other long-term assets were partially offset by amortization of intangible assets and the reclassification of our long-term deferred tax assets to long-term deferred tax liabilities as a result of our acquisition of CMW. Included in other long-term assets as of October 31, 2019 was goodwill in the amount of $362.3 million. Based on our annual goodwill impairment analysis, we determined there was no impairment of goodwill during fiscal 2019 for any of our reporting units as the fair values of the reporting units exceeded their carrying values, including goodwill. Liquidity and Capital Resources Our businesses are seasonally working capital intensive and require funding for purchases of raw materials used in production, replacement parts inventory, payroll and other administrative costs, capital expenditures, establishment of new facilities, expansion and renovation of existing facilities, as well as for financing receivables from customers that are not financed with Red Iron or other third-party financial institutions. Our accounts receivable balances historically increase between January and April as a result of typically higher sales volumes and extended payment terms made available to our customers, and typically decrease between May and December when payments are received. We believe that the funds available through existing, and potential future, financing arrangements and forecasted cash flows will be sufficient to provide the necessary capital resources for our anticipated working capital needs, capital expenditures, investments, debt repayments, quarterly cash dividend payments, and common stock repurchases, all as applicable, for at least the next twelve months. Indebtedness As of October 31, 2019, we had $700.8 million of outstanding indebtedness that included $100.0 million of 7.8 percent debentures due June 15, 2027, $123.9 million of 6.625 percent senior notes due May 1, 2037, $100.0 million under our $200.0 million three year unsecured senior term loan facility, $180.0 million under our $300.0 million five year unsecured senior term loan facility, $100.0 million of 3.81 percent Series A Senior Notes, $100.0 million of 3.91 percent Series B Senior Notes, and no outstanding borrowings under our revolving credit facility. The October 31, 2019 outstanding indebtedness amounts were partially offset by debt issuance costs and deferred charges of $3.1 million related to our outstanding indebtedness. As of October 31, 2019, we have reclassified $79.9 million of the remaining outstanding principal balance under the term loan credit agreement, net of the related proportionate share of debt issuance costs, to current portion of long-term debt within the Condensed Consolidated Balance Sheets as we intend to prepay such amount utilizing cash flows from operations within the next twelve months. As of October 31, 2018, we had $312.5 million of outstanding indebtedness that included $100.0 million of 7.8 percent debentures due June 15, 2027, $123.9 million of 6.625 percent senior notes due May 1, 2037, and $91.0 million of outstanding borrowings under our revolving credit facility. The October 31, 2018 outstanding indebtedness amounts were partially offset by debt issuance costs and deferred charges of $2.3 million related to our outstanding indebtedness. As of October 31, 2018, the $91.0 million of outstanding borrowings under our revolving credit facility was classified as long-term debt within our Condensed Consolidated Balance Sheets. Revolving Credit Facility Seasonal cash requirements are financed from operations, cash on hand, and with borrowings under our $600.0 million unsecured senior five-year revolving credit facility that expires in June 2023. Included in our $600.0 million revolving credit facility is a $10.0 million sublimit for standby letters of credit and a $30.0 million sublimit for swingline loans. At our election, and with the approval of the named borrowers on the revolving credit facility and the election of the lenders to fund such increase, the aggregate maximum principal amount available under the facility may be increased by an amount up to $300.0 million. Funds are available under the revolving credit facility for working capital, capital expenditures, and other lawful corporate purposes, including, but not limited to, acquisitions and common stock repurchases, subject in each case to compliance with certain financial covenants described below. Outstanding loans under the revolving credit facility (other than swingline loans), if applicable, bear interest at a variable rate generally based on LIBOR or an alternative variable rate based on the highest of the Bank of America prime rate, the federal funds rate or a rate generally based on LIBOR, in each case subject to an additional basis point spread that is calculated based on the better of the leverage ratio (as measured quarterly and defined as the ratio of total indebtedness to consolidated earnings before interest and taxes plus depreciation and amortization expense) and debt rating of Toro. Swingline loans under the revolving credit facility bear interest at a rate determined by the swingline lender or an alternative variable rate based on the highest of the Bank of America prime rate, the federal funds rate or a rate generally based on LIBOR, in each case subject to an additional basis point spread that is calculated based on the better of the leverage ratio and debt rating of Toro. Interest is payable quarterly in arrears. Our debt rating for long-term unsecured senior, non-credit enhanced debt was unchanged during the fourth quarter of fiscal 2019 by Standard and Poor's Ratings Group at BBB and by Moody's Investors Service at Baa3. If our debt rating falls below investment grade and/or our leverage ratio rises above 1.50, the basis point spread applicable in determining the interest payable on our outstanding debt under the revolving credit facility could increase. However, the credit commitment could not be canceled by the banks based solely on a ratings downgrade. For the fiscal years ended October 31, 2019 and October 31, 2018, we incurred interest expense of approximately $1.9 million and $1.3 million, respectively, on outstanding borrowings under the revolving credit facility. Our revolving credit facility contains customary covenants, including, without limitation, financial covenants, such as the maintenance of minimum interest coverage and maximum leverage ratios; and negative covenants, which among other things, limit disposition of assets, consolidations and mergers, restricted payments, liens, and other matters customarily restricted in such agreements. Most of these restrictions are subject to certain minimum thresholds and exceptions. Under the revolving credit facility, we are not limited in the amount for payments of cash dividends and common stock repurchases as long as, both before and after giving pro forma effect to such payments, our leverage ratio from the previous quarter compliance certificate is less than or equal to 3.5 (or, at our option (which we may exercise twice during the term of the facility) after certain acquisitions with aggregate consideration in excess of $75.0 million, for the first four quarters following the exercise of such option, is less than or equal to 4.0), provided that immediately after giving effect to any such proposed action, no default or event of default would exist. As of October 31, 2019, we were not limited in the amount for payments of cash dividends and common stock repurchases. We were in compliance with all covenants related to the credit agreement for our revolving credit facility as of October 31, 2019, and we expect to be in compliance with all covenants during fiscal 2020. If we were out of compliance with any covenant required by this credit agreement following the applicable cure period, the banks could terminate their commitments unless we could negotiate a covenant waiver from the banks. In addition, our long-term senior notes, debentures, term loan facilities, and any amounts outstanding under the revolving credit facility could become due and payable if we were unable to obtain a covenant waiver or refinance our borrowings under our revolving credit facility. As of October 31, 2019, we had no borrowings under the revolving credit facility but did have $1.9 million outstanding under the sublimit for standby letters of credit, resulting in $598.1 million of unutilized availability under our revolving credit facility. As of October 31, 2018, we had $91.0 million of outstanding borrowings under the revolving credit facility and $1.5 million outstanding under the sublimit for standby letters of credit, resulting in $507.5 million of unutilized availability under our revolving credit facility. Term Loan Credit Agreement In March 2019, we entered into a term loan credit agreement with a syndicate of financial institutions for the purpose of partially funding the purchase price of our acquisition of CMW and the related fees and expenses incurred in connection with such acquisition. The term loan credit agreement provided for a $200.0 million three year unsecured senior term loan facility maturing on April 1, 2022 and a $300.0 million five year unsecured senior term loan facility maturing on April 1, 2024. The funds under both term loan facilities were received on April 1, 2019 in connection with the closing of our acquisition of CMW. There are no scheduled principal amortization payments prior to maturity on the $200.0 million three year unsecured senior term loan facility. For the $300.0 million five year unsecured senior term loan facility, we are required to make quarterly principal amortization payments of 2.5 percent of the original aggregate principal balance beginning with the last business day of the thirteenth calendar quarter ending after April 1, 2019, with the remainder of the unpaid principal balance due at maturity. No principal payments are required during the first three and one quarter (3.25) years of the $300.0 million five year unsecured senior term loan facility. The term loan facilities may be prepaid and terminated at our election at any time without penalty or premium. As of October 31, 2019, we have prepaid $100.0 million and $120.0 million against the outstanding principal balances of the $200.0 million three year unsecured senior term loan facility and $300.0 million five year unsecured senior term loan facility, respectively. Outstanding borrowings under the term loan credit agreement bear interest at a variable rate generally based on LIBOR or an alternative variable rate, based on the highest of the Bank of America prime rate, the federal funds rate, or a rate generally based on LIBOR, in each case subject to an additional basis point spread as defined in the term loan credit agreement. Interest is payable quarterly in arrears. For the fiscal year ended October 31, 2019, we incurred interest expense of approximately $7.5 million on the outstanding borrowings under the term loan credit agreement. The term loan credit agreement contains customary covenants, including, without limitation, financial covenants generally consistent with those applicable under our revolving credit facility, such as the maintenance of minimum interest coverage and maximum leverage ratios; and negative covenants, which among other things, limit disposition of assets, consolidations and mergers, restricted payments, liens, and other matters customarily restricted in such agreements. Most of these restrictions are subject to certain minimum thresholds and exceptions. Under the term loan credit agreement, we are not limited in the amount for payments of cash dividends and common stock repurchases as long as, both before and after giving pro forma effect to such payments, our leverage ratio from the previous quarter compliance certificate is less than or equal to 3.5 (or, at our option (which we may exercise twice during the term of the facility) after certain acquisitions with aggregate consideration in excess of $75.0 million, for the first four quarters following the exercise of such option, is less than or equal to 4.0), provided that immediately after giving effect of any such proposed action, no default or event of default would exist. As of October 31, 2019, we were not limited in the amount for payments of cash dividends and common stock repurchases. We were in compliance with all covenants related to our term loan credit agreement as of October 31, 2019. If we were out of compliance with any covenant required by this term loan credit agreement following the applicable cure period, our term loan facilities, long-term senior notes, debentures, and any amounts outstanding under the revolving credit facility could become due and payable if we were unable to obtain a covenant waiver or refinance our borrowings under our credit agreement. 3.81% Series A and 3.91% Series B Senior Notes On April 30, 2019, we entered into a private placement note purchase agreement with certain purchasers ("holders") pursuant to which we agreed to issue and sell an aggregate principal amount of $100.0 million of 3.81 percent Series A Senior Notes due June 15, 2029 ("Series A Senior Notes") and $100.0 million of 3.91 percent Series B Senior Notes due June 15, 2031 ("Series B Senior Notes" and together with the Series A Senior Notes, the "Senior Notes"). On June 27, 2019, we issued $100.0 million of the Series A Senior Notes and $100.0 million of the Series B Senior Notes pursuant to the private placement note purchase agreement. The Senior Notes are senior unsecured obligations of Toro. Interest on the Senior Notes is payable semiannually on the 15th day of June and December in each year, commencing on December 15, 2019. For the fiscal year ended October 31, 2019, we incurred interest expense of approximately $2.6 million on the outstanding borrowings under the private placement note purchase agreement. No principal is due on the Senior Notes prior to their stated due dates. We have the right to prepay all or a portion of either series of the Senior Notes in amounts equal to not less than 10.0 percent of the principal amount of the Senior Notes then outstanding upon notice to the holders of the series of Senior Notes being prepaid for 100.0 percent of the principal amount prepaid, plus a make-whole premium, as set forth in the private placement note purchase agreement, plus accrued and unpaid interest, if any, to the date of prepayment. In addition, at any time on or after the date that is 90 days prior to the maturity date of the respective series, we have the right to prepay all of the outstanding Senior Note of such series for 100.0 percent of the principal amount so prepaid, plus accrued and unpaid interest, if any, to the date of prepayment. Upon the occurrence of certain change of control events, we are required to offer to prepay all Senior Notes for the principal amount thereof plus accrued and unpaid interest, if any, to the date of prepayment. The private placement note purchase agreement contains customary representations and warranties of Toro, as well as certain customary covenants, including, without limitation, financial covenants, such as the maintenance of minimum interest coverage and maximum leverage ratios, and other covenants, which, among other things, provide limitations on transactions with affiliates, mergers, consolidations and sales of assets, liens and priority debt. Under the private placement note purchase agreement, we are not limited in the amount for payments of cash dividends and common stock repurchases as long as, both before and after giving pro forma effect to such payments, our leverage ratio from the previous quarter compliance certificate is less than or equal to 3.5 (or, at our option (which we may exercise twice during the term of the facility) after certain acquisitions with aggregate consideration in excess of $75.0 million, for the first four quarters following the exercise of such option, is less than or equal to 4.0), provided that immediately after giving effect of any such proposed action, no default or event of default would exist. As of October 31, 2019, we were not limited in the amount for payments of cash dividends and stock repurchases. We were in compliance with all covenants related to the private placement note purchase agreement as of October 31, 2019 and we expect to be in compliance with all covenants during fiscal 2020. If we were out of compliance with any covenant required by this private placement note purchase agreement following the applicable cure period, our term loan facilities, long-term senior notes, debentures, and any amounts outstanding under the revolving credit facility would become due and payable if we were unable to obtain a covenant waiver or refinance our borrowings under our private placement note purchase agreement. Capital Structure The following table details the components of our total capitalization and debt-to-capitalization ratio: Our debt-to-capitalization ratio increased in fiscal 2019 compared to fiscal 2018 primarily due to an increase in long-term debt driven by the issuance of indebtedness under our term loan credit agreement and amounts drawn on our revolving credit facility to fund the CMW acquisition and the issuance of our private placement senior notes, partially offset by repayments of outstanding borrowings on our revolving credit facility and term loan credit agreement. Stockholders' equity also increased in fiscal 2019 compared to fiscal 2018 primarily due to increased net earnings, reduced purchases of Toro common stock, and increased exercises of stock options, partially offset by increased cash dividend payments on shares of our common stock. Cash Dividends In each quarter of fiscal 2019, our Board of Directors declared a common stock cash dividend of $0.225 per share, which was a 12.5 percent increase over our common stock cash dividend of $0.20 per share paid each quarter in fiscal 2018. On December 3, 2019, our Board of Directors increased our fiscal 2020 first quarter common stock cash dividend by 11.1 percent to $0.25 per share from the quarterly common stock cash dividend of $0.225 per share paid in the first quarter of fiscal 2019. Future common stock cash dividends will depend upon our financial condition, capital requirements, results of operations, and other factors deemed relevant by our Board of Directors. Share Repurchases During fiscal 2019, we curtailed repurchasing shares of our common stock under our Board authorized stock repurchase program after our fiscal 2019 first quarter, as we focused on repaying the outstanding borrowings issued to fund the purchase price for our acquisition of CMW. As of October 31, 2019, 7,042,256 shares remained available for repurchase under our Board authorized stock repurchase program. Our Board authorized stock repurchase program provides shares for use in connection with our equity compensation plans. We expect to repurchase shares of our common stock in fiscal 2020, depending on market conditions and other factors. The following table provides information with respect to repurchases of our common stock during the past three fiscal years: Customer Financing Arrangements Wholesale Financing We are party to a joint venture with TCFIF, established as Red Iron, the primary purpose of which is to provide inventory financing to certain distributors and dealers of certain of our products in the U.S. that enables them to carry representative inventories of our products. In addition, TCFCFC provides inventory financing to dealers of certain of our products in Canada. Under these financing arrangements, down payments are not required and, depending on the finance program for each product line, finance charges are incurred by us, shared between us and the distributor and/or the dealer, or paid by the distributor or dealer. Red Iron retains a security interest in the distributors' and dealers' financed inventories, and those inventories are monitored regularly. Financing terms to the distributors and dealers require payment as the equipment, which secures the indebtedness, is sold to customers or when payment terms become due, whichever occurs first. Rates are generally indexed to LIBOR plus a fixed percentage that differs based on whether the financing is for a distributor or dealer. Rates may also vary based on the product that is financed. Red Iron financed $1,924.9 million of new receivables for dealers and distributors during fiscal 2019, of which $486.8 million of net receivables were outstanding as of October 31, 2019. We also have floor plan financing agreements with other third-party financial institutions to provide floor plan financing to certain dealers not financed through Red Iron, which include agreements with third-party financial institutions in the U.S. and internationally as a result of our acquisition of CMW and in Australia. These third-party financing companies financed $235.4 million of receivables for such dealers and distributors during fiscal 2019, of which $148.4 million was outstanding as of October 31, 2019. We entered into a limited inventory repurchase agreement with Red Iron. Under such limited inventory repurchase agreement agreement, we have agreed to repurchase products repossessed by Red Iron and TCFCFC, up to a maximum aggregate amount of $7.5 million in a calendar year. Additionally, as a result of our financing agreements with the separate third-party financial institutions, we have also entered into inventory repurchase agreements with the separate third-party financial institutions, for which we have agreed to repurchase products repossessed by the separate third-party financial institutions. As of October 31, 2019, we were contingently liable to repurchase up to a maximum amount of $133.4 million of inventory related to receivables under these inventory repurchase agreements. Our financial exposure under these inventory repurchase agreements is limited to the difference between the amount paid to Red Iron or other third-party financing institutions for repurchases of inventory and the amount received upon any subsequent resale of the repossessed product. We have repurchased immaterial amounts of inventory pursuant to such arrangements over the past three fiscal years. However, a decline in retail sales or financial difficulties of our distributors or dealers could cause this situation to change and thereby require us to repurchase financed product, which could have an adverse effect on our operating results. We continue to provide financing in the form of open account terms to home centers and mass retailers; general line irrigation dealers; international distributors and dealers other than the Canadian distributors and dealers to whom Red Iron or other third-party financing institutions provide financing arrangements; ag-irrigation dealers and distributors; government customers; and rental companies. End-User Financing We have agreements with third-party financing companies to provide lease-financing options to golf course, sports fields and grounds equipment and underground construction equipment customers in the U.S., Canada, Australia, and select countries in Europe. The purpose of these agreements is to provide end-users of our products alternative financing options when purchasing our products. We have no material contingent liabilities for residual value or credit collection risk under these agreements with third-party financing companies. From time to time, we enter into agreements where we provide recourse to third-party finance companies in the event of default by the customer for lease payments to the third-party finance company. Our maximum exposure for credit collection under those arrangements as of October 31, 2019 was $10.1 million. Termination or any material change to the terms of our end-user financing arrangements, availability of credit for our customers, including any delay in securing replacement credit sources, or significant financed product repurchase requirements could have a material adverse impact on our future operating results. Contractual Obligations We are obligated to make future payments under various existing contracts, such as debt agreements, operating lease agreements, unconditional purchase obligations, and other long-term obligations. The following table summarizes our contractual obligations as of October 31, 2019: Principal payments based on the maturity dates defined in our long-term debt agreements. Interest payments for outstanding long-term debt obligations. Interest on variable rate debt was calculated using the interest rate as of October 31, 2019. Purchase obligations represent contracts or firm commitments for the purchase of commodities, components, parts, and accessories, as well as contracts or firm commitments to purchase property, plant, and equipment, as applicable. Operating lease obligations represent contracts that convey our right to use certain property, plant, or equipment assets in exchange for consideration and do not include payments to property owners covering real estate taxes and common area maintenance. Payment obligations for corporate information technology software and services, as well as other miscellaneous contractual obligations. In addition to the contractual obligations described in the preceding table, we may be obligated for additional net cash outflows related to $2.5 million of unrecognized tax benefits, including interest and penalties. The payment and timing of any such payments is affected by the ultimate resolution of the tax years that are under audit or remain subject to examination by the relevant taxing authorities. Off-Balance Sheet Arrangements We have off-balance sheet arrangements relating to our operating lease agreements for certain property, plant, or equipment assets utilized in the normal course of business, such as buildings for manufacturing facilities, office space, distribution centers, and warehouse facilities; land for product testing sites; machinery and equipment for research and development activities, manufacturing and assembly processes, and administrative tasks; and vehicles for sales, marketing and distribution activities. Refer to the section titled "Contractual Obligations" within this MD&A for our future payment obligations under our operating lease agreements. We also have off-balance sheet arrangements with Red Iron, our joint venture with TCFIF, TCFCFC, and other third-party financial institutions in which inventory receivables for certain dealers and distributors are financed by Red Iron, TCFCFC, or the other third-party financial institutions. Additional information regarding such agreements is disclosed within the section titled "Wholesale Financing" included in Item 7, "Management's Discussion and Analysis of Financial Condition and Results of Operations" and Note 11, Investment in Joint Venture, and Note 12, Commitments and Contingent Liabilities, of the Notes to Consolidated Financial Statements included in Item 8, "Financial Statements and Supplementary Data" of this Annual Report on Form 10-K. Additionally, we use standby letters of credit under our revolving credit facility, import letters of credit, and surety bonds in the ordinary course of business to ensure the performance of contractual obligations, as required under certain contracts. As of October 31, 2019, we had $10.0 million of maximum availability and $1.9 million outstanding under the sublimit for standby letters of credit under our revolving credit facility. As of October 31, 2019, we had $13.3 million of maximum availability and $4.7 million in outstanding import letters of credit issued. As of October 31, 2019, we did not have an outstanding balance on our surety bonds. Market Risk Due to the nature and scope of our operations, we are subject to exposures that arise from fluctuations in interest rates, foreign currency exchange rates, and commodity costs. We are also exposed to equity market risk pertaining to the trading price of our common stock. Additional information regarding such market risks is disclosed in Part II, Item 7A, "Quantitative and Qualitative Disclosures about Market Risk," and Note 13, Financial Instruments, of the Notes to Consolidated Financial Statements within Part II, Item 8, "Financial Statements and Supplementary Data" of this Annual Report on Form 10-K. NON-GAAP FINANCIAL MEASURES We have provided non-GAAP financial measures, which are not calculated or presented in accordance with GAAP, as information supplemental and in addition to the most directly comparable financial measures presented in this Annual Report on Form 10-K that are calculated and presented in accordance with GAAP. We use these non-GAAP financial measures in making operating decisions because we believe these non-GAAP financial measures provide meaningful supplemental information regarding our core operational performance and provide us with a better understanding of how to allocate resources to both ongoing and prospective business initiatives. Additionally, these non-GAAP financial measures facilitate our internal comparisons to both our historical operating results and to our competitors' operating results by factoring out potential differences caused by charges not related to our regular, ongoing business, including, without limitation, non-cash charges, certain large and unpredictable charges, acquisitions and dispositions, legal settlements, and tax positions. Further, we believe that such non-GAAP financial measures, when considered in conjunction with our Consolidated Financial Statements prepared in accordance with U.S. GAAP, provide investors with useful supplemental financial information to better understand our core operational performance. Such non-GAAP financial measures should not be considered superior to, as a substitute for, or as an alternative to, and should be considered in conjunction with, the most directly comparable GAAP financial measures. The non-GAAP financial measures may differ from similar measures used by other companies. The following table provides a reconciliation of financial measures calculated and reported in accordance with GAAP, as well as adjusted non-GAAP financial measures, for the fiscal years ended October 31, 2019 and October 31, 2018: During the second quarter of fiscal 2019, we acquired CMW. Acquisition-related costs represent integration and transaction costs incurred, as well as charges incurred for the take-down of the inventory fair value step-up amount and amortization of the backlog intangible asset resulting from purchase accounting adjustments, related to our acquisition of CMW during the fiscal year ended October 31, 2019. Refer to Note 2, Business Combinations, of the Notes to Consolidated Financial Statements included in Part II, Item 8, "Financial Statements and Supplementary Data" of this Annual Report on Form 10-K for additional information regarding our acquisition of CMW. During the third quarter of fiscal 2019, we announced the wind down our Toro-branded large horizontal directional drill and riding trencher product line. Additionally, during the fourth quarter of fiscal 2019, we incurred charges for a corporate restructuring event and a loss on the divestiture of a used underground construction equipment business. Management actions represent charges incurred during the fiscal year ended October 31, 2019 for the Toro underground wind down, including charges related to the write-down of inventory, anticipated inventory retail support activities, and accelerated depreciation on fixed assets; the corporate restructuring event, including employee severance charges; and the divestiture of a used underground construction equipment business, including the loss on the sale of the business. Refer to Note 7, Management Actions, of the Notes to Consolidated Financial Statements included in Part II, Item 8, "Financial Statements and Supplementary Data" of this Annual Report on Form 10-K for additional information regarding our these management actions. In the first quarter of fiscal 2017, we adopted Accounting Standards Update No. 2016-09, Stock-based Compensation: Improvements to Employee Share-based Payment Accounting, which requires that any excess tax deduction for share-based compensation be immediately recorded within income tax expense. These amounts represent the discrete tax benefits recorded as excess tax deductions for share-based compensation during the fiscal years ended October 31, 2019 and October 31, 2018. Signed into law on December 22, 2017, the Tax Act, reduced the U.S. federal corporate tax rate from 35.0 percent to 21.0 percent, effective January 1, 2018, resulting in a blended U.S. federal statutory tax rate of 23.3 percent for the fiscal year ended October 31, 2018. This reduction in rate required the re-measurement of our net deferred taxes as of the date of enactment. The Tax Act also imposed a one-time deemed repatriation tax on our historical undistributed earnings and profits of foreign affiliates. During the fiscal year ended October 31, 2019, we recorded a tax benefit of $1.0 million related to a prior year true-up of the Tax Act. During the fiscal year ended October 31, 2018, the remeasurement of our net deferred taxes and the one-time deemed repatriation tax resulted in a combined charge of $32.7 million. CRITICAL ACCOUNTING POLICIES AND ESTIMATES In preparing our Consolidated Financial Statements in conformity with U.S. GAAP, we must make decisions that impact the reported amounts of assets, liabilities, revenues and expenses, and related disclosures. Such decisions include the selection of the appropriate accounting principles to be applied and the assumptions on which to base accounting estimates. In reaching such decisions, we apply judgments based on our understanding and analysis of the relevant circumstances, historical experience, and actuarial and other independent external third-party specialist valuations, when applicable. Actual amounts could differ from those estimated at the time the Consolidated Financial Statements are prepared. Our significant accounting policies are described in Note 1 of the Notes to Consolidated Financial Statements. Some of those significant accounting policies require us to make difficult, subjective, or complex judgments or estimates. An accounting estimate is considered to be critical if it meets both of the following criteria: (i) the estimate requires assumptions about matters that are highly uncertain at the time the accounting estimate is made, and (ii) different estimates reasonably could have been used, or changes in the estimate that are reasonably likely to occur from period to period may have a material impact on the presentation of our financial condition, changes in financial condition, or results of operations. Our critical accounting policies and estimates include the following: Warranty Reserve Warranty coverage on our products is generally for specified periods of time and on select products' hours of usage, and generally covers parts, labor, and other expenses for non-maintenance repairs. Warranty coverage generally does not cover operator abuse or improper use. At the time of sale, we accrue a warranty reserve by product line for estimated costs in connection with future warranty claims. We also establish reserves for major rework campaigns. The amount of our warranty reserves is based primarily on the estimated number of products under warranty, historical average costs incurred to service warranty claims, the trend in the historical ratio of claims to sales, and the historical length of time between the sale and resulting warranty claim. We periodically assess the adequacy of our warranty reserves based on changes in these factors and record any necessary adjustments if actual claim experience indicates that adjustments are necessary. Actual claims could be higher or lower than amounts estimated, as the number and value of warranty claims can vary due to such factors as performance of new products, significant manufacturing or design defects not discovered until after the product is delivered to customers, product failure rates, and higher or lower than expected service costs for a repair. We believe that analysis of historical trends and knowledge of potential manufacturing or design problems provide sufficient information to establish a reasonable estimate for warranty claims at the time of sale. However, since we cannot predict with certainty future warranty claims or costs associated with servicing those claims, our actual warranty costs may differ from our estimates. An unexpected increase in warranty claims or in the costs associated with servicing those claims would result in an increase in our warranty accrual and a decrease in our net earnings. Sales Promotions and Incentives At the time of sale, we record an estimate for sales promotion and incentive costs. Our estimates of sales promotion and incentive costs are based on the terms of the arrangements with customers, historical payment experience, field inventory levels, volume purchases, and expectations for changes in relevant trends in the future. The expense of each program is classified as a reduction from gross sales or as a component of selling, general and administrative expense, depending on the nature of the respective program. Examples of significant sales promotions and incentive programs in which the related expense is classified as a reduction from gross sales are as follows: • Off-Invoice Discounts: Our costs for off-invoice discounts represent a reduction in the selling price of our products given at the time of sale. • Rebate Programs: Our rebate programs are generally based on claims submitted from either our direct customers or end-users of our products, depending upon the program. The amount of the rebate varies based on the specific program and is either a dollar amount or a percentage of the purchase price and can also be based on actual retail price as compared to our selling price. • Incentive Discounts: Our costs for incentive discount programs are based on our customers’ purchase or retail sales goals of certain quantities or mixes of product during a specified time period, which are tracked on an annual or quarterly basis depending on the program. • Financing Programs: Our financing programs, consist of wholesale floor plan financing and end-user retail financing. Costs incurred for wholesale floor plan financing programs represent financing costs associated with programs under which we pay a portion of the interest cost to finance distributor and dealer inventories through third-party financing arrangements for a specific period of time. End-user retail financing is similar to floor planning with the difference being that retail financing programs are offered to end-user customers under which we pay a portion of interest costs on behalf of end-users for financing purchases of our equipment. • Commissions Paid to Service Home Centers: We pay commissions to representative agencies to service home centers to ensure appropriate store sets for all Toro product. This estimated expense is recorded at point of sale. In addition, Toro dealers are paid a commission to set up and deliver riding product purchased at certain home centers. Examples of significant sales promotions and incentive programs in which the related expense is classified as a component of selling, general, and administrative expense are as follows: • Commissions Paid to Distributors and Dealers: For certain products, we use a distribution network of dealers and distributors that purchase and take possession of products for sale to the end customer. In addition, we have dealers and distributors that act as sales agents for us on certain products using a direct-selling type model. Under this direct-selling type model, our network of distributors and dealers facilitates a sale directly to the dealer or end-user customer on our behalf. Commissions to distributors and dealers in these instances represent commission payments to sales agents that are also our customers. • Cooperative Advertising: Cooperative advertising programs are based on advertising costs incurred by distributors and dealers for promoting our products. We support a portion of those advertising costs in which claims are submitted by the distributor or dealer along with evidence of the advertising material procured/produced and evidence of the cost incurred in the form of third-party invoices or receipts. Estimates for sales promotion and incentive costs are based on the terms of the arrangements with customers, historical payment experience, field inventory levels, volume purchases, and expectations for changes in relevant trends in the future. Actual results may differ from these estimates if competitive factors dictate the need to enhance or reduce sales promotion and incentive accruals or if customer usage and field inventory levels vary from historical trends. Adjustments to sales promotions and incentive accruals are made from time to time as actual usage becomes known in order to properly estimate the amounts necessary to generate consumer demand based on market conditions as of the balance sheet date. Goodwill and Indefinite-Lived Intangible Assets Goodwill and indefinite-lived intangible assets are not amortized, but are tested at least annually for impairment and whenever events or changes in circumstances indicate that impairment may have occurred. We test goodwill for impairment at the reporting unit level and test indefinite-lived intangible assets for impairment at the individual indefinite-lived intangible asset or asset group level, as appropriate. Our impairment testing for goodwill is performed separately from our impairment testing of indefinite-lived intangible assets, but the income approach is utilized for both to determine fair value when a quantitative analysis is required. Under the income approach, we calculate the fair value of our reporting units and indefinite-lived intangible assets using the present value of future cash flows. Assumptions utilized in determining fair value under the income approach, such as forecasted growth rates and weighted-average cost of capital ("WACC"), are consistent with internal projections and operating plans. Materially different assumptions regarding future performance of our businesses or a different WACC rate could result in impairment losses. Individual indefinite-lived intangible assets, or asset groups, are tested for impairment by comparing the carrying amounts of the respective asset, or asset group, to its estimated fair value. Our estimate of the fair value for an indefinite-lived intangible asset, or asset group, uses projected revenues from our forecasting process, assumed royalty rates, and a discount rate. If the fair value of the indefinite-lived intangible asset, or asset group, is less than its carrying value, an impairment loss is recognized in an amount equal to the excess. In conducting our goodwill impairment test, we may elect to first perform a qualitative assessment to determine whether changes in events or circumstances since our most recent quantitative test for goodwill impairment indicate that it is more likely than not that the fair value of a reporting unit is less than its carrying amount. However, we have an unconditional option to bypass the qualitative assessment for any reporting unit and proceed directly to performing the quantitative analysis. If elected, in conducting the initial qualitative assessment, we analyze actual and projected growth trends for net sales, gross margin, and earnings for each reporting unit, as well as historical versus planned performance. Additionally, each reporting unit is assessed for critical areas that may impact its business, including macroeconomic conditions, market-related exposures, competitive changes, new or discontinued products, changes in key personnel, or any other potential risks to projected financial results. All assumptions used in the qualitative assessment require significant judgment. If, after evaluating the weight of the changes in events and circumstances, both positive and negative, we conclude that an impairment may exist, a quantitative test for goodwill impairment is performed. If performed due to identified impairment indicators under the qualitative assessment, the duration of time since the most recent quantitative goodwill impairment test, or our election to bypass the qualitative assessment and move directly to the quantitative analysis, the quantitative goodwill impairment test is a one-step process. In performing the quantitative analysis, we compare the carrying value of a reporting unit, including goodwill, to its fair value. The carrying amount of each reporting unit is determined based on the amount of equity required for the reporting unit's activities, considering the specific assets and liabilities of the reporting unit. We do not assign corporate assets and liabilities to reporting units that do not relate to the operations of the reporting unit or are not considered in determining the fair value of the reporting unit. Our estimate of the fair value of our reporting units utilizes various inputs and assumptions, including projected operating results and growth rates from our forecasting process, applicable tax rates and a WACC rate. Where available, and as appropriate, comparable market multiples and our company's market capitalization are also used to corroborate the results of the discounted cash flow models. If the fair value of the reporting unit exceeds its carrying value, goodwill of the reporting unit is not impaired. If the carrying value of a reporting unit exceeds its fair value, an impairment charge would be recognized for the amount by which the carrying value of the reporting unit exceeds the its fair value, not to exceed the total amount of goodwill allocated to that reporting unit. Inventory Valuation We value our inventories at the lower of the cost of inventory or net realizable value, with cost determined by either the first-in, first-out method for most U.S. inventories or the last-in, first-out or average cost methods for all other inventories. We establish reserves for excess, slow moving, and obsolete inventory based on inventory levels, expected product life, and forecasted sales demand. Valuation of inventory can also be affected by significant redesign of existing products or replacement of an existing product by an entirely new generation product. In assessing the ultimate realization of inventories, we are required to make judgments as to future demand requirements compared with inventory levels. Reserve requirements are developed according to our projected demand requirements based on historical demand, competitive factors, and technological and product life cycle changes. It is possible that an increase in our reserve may be required in the future if there is a significant decline in demand for our products and we do not adjust our production schedule accordingly. Though management considers reserve balances adequate and proper, changes in economic conditions in specific markets in which we operate could have an effect on the reserve balances required for excess, slow moving and obsolete inventory. Business Combinations We account for the acquisition of a business in accordance with the accounting standards codification guidance for business combinations, whereby the total consideration transferred is allocated to the assets acquired and liabilities assumed, including amounts attributable to non-controlling interests, when applicable, based on their respective estimated fair values as of the date of acquisition. Goodwill represents the excess of consideration transferred over the estimated fair value of the net assets acquired in a business combination. Assigning estimated fair values to the assets acquired and liabilities assumed requires the use of significant estimates, judgments, inputs, and assumptions regarding the fair value of intangibles assets that are separately identifiable from goodwill, inventory, and property, plant, and equipment. Such significant estimates, judgments, inputs, and assumptions include, when applicable, the selection of an appropriate valuation method depending on the nature of the respective asset, such as the income approach, the market or sales comparison approach, or the cost approach; estimating future cash flows based on projected revenues and/or margins that we expect to generate subsequent to an acquisition; applying an appropriate discount rate to estimate the present value of those projected cash flows we expect to generate subsequent to an acquisition; selecting an appropriate royalty rate or estimating a customer attrition or technological obsolescence factor where necessary and appropriate given the nature of the respective asset; assigning the appropriate contributory asset charge where needed; determining an appropriate useful life and the related depreciation or amortization method for the respective asset; and assessing the accuracy and completeness of other historical financial metrics of the acquiree used as standalone inputs or as the basis for determining estimated projected inputs such as margins, customer attrition, and costs to hold and sell product. In determining the estimated fair value of intangible assets that are separately identifiable from goodwill, we typically utilize the income approach, which discounts the projected future cash flows using an appropriate discount rate that reflects the risks associated with the projected cash flows. However, in certain instances, particularly in relation to developed technology or patents, we may utilize the cost approach depending on the nature of the respective intangible asset and the recency of the development or procurement of such technology. In determining the estimated fair value of acquired inventory, we typically utilize the cost approach for raw materials and the sales comparison approach for work in process, finished goods, and service parts. In determining the estimated fair value of acquired property, plant, and equipment, we typically utilize the sales comparison approach or the cost approach depending on the nature of the respective asset and the recency of the construction or procurement of such asset. Estimated fair values of intangible assets that are separately identifiable from goodwill, inventory, and property, plant, and equipment are based on available historical information, future expectations, and assumptions determined to be reasonable but are inherently uncertain with respect to future events, including economic conditions, competition, the useful life of the acquired assets and other factors. We may refine the estimated fair values of assets acquired and liabilities assumed, if necessary, over a period not to exceed one year from the date of acquisition by taking into consideration new information that, if known at the date of acquisition, would have affected the estimated fair values ascribed to the assets acquired and liabilities assumed. Estimates that are sensitive include judgments as to whether information gathered during the measurement period relate to information that was not yet available or whether subsequent developments have occurred that indicate the recognition of other asset or liabilities should be recorded within net earnings. The judgments made in determining the estimated fair value assigned to assets acquired and liabilities assumed, as well as the estimated useful life and depreciation or amortization method of each asset, can materially impact the net earnings of the periods subsequent to an acquisition through depreciation and amortization, and in certain instances through impairment charges, if the asset becomes impaired in the future. During the measurement period, any purchase price allocation changes that impact the carrying value of goodwill will affect any measurement of goodwill impairment taken during the measurement period, if applicable. Recent Accounting Pronouncements For information regarding recent accounting pronouncements, refer to Note 1, Summary of Significant Accounting Policies and Related Data, in our Notes to Consolidated Financial Statements in the sections entitled "New Accounting Pronouncements Adopted" and "New Accounting Pronouncements Not Yet Adopted", included in Part II, Item 8, "Financial Statements and Supplementary Data" of this Annual Report on Form 10-K.

<s>[INST] Our MD&A is presented as follows: Company Overview Results of Operations Business Segments Financial Position NonGAAP Financial Measures Critical Accounting Policies and Estimates We have provided nonGAAP financial measures, which are not calculated or presented in accordance with accounting principles generally accepted in the United States ("GAAP"), as information supplemental and in addition to the most directly comparable financial measures presented in this report that are calculated and presented in accordance with GAAP. We use these nonGAAP financial measures in making operating decisions because we believe these nonGAAP financial measures provide meaningful supplemental information regarding our core operational performance and provide us with a better understanding of how to allocate resources to both ongoing and prospective business initiatives. Additionally, these nonGAAP financial measures facilitate our internal comparisons to both our historical operating results and to our competitors' operating results by factoring out potential differences caused by charges not related to our regular, ongoing business, including, without limitation, noncash charges, certain large and unpredictable charges, acquisitions and dispositions, legal settlements, and tax positions. Further, we believe that such nonGAAP financial measures, when considered in conjunction with our Consolidated Financial Statements prepared in accordance with U.S. GAAP, provide investors with useful supplemental financial information to better understand our core operational performance. Reconciliations of adjusted nonGAAP financial measures to the most directly comparable reported GAAP financial measures are included in the section titled "NonGAAP Financial Measures" within this MD&A. These nonGAAP financial measures, however, should not be considered superior to, as a substitute for, or as an alternative to, and should be considered in conjunction with, the most directly comparable GAAP financial measures. Further, these nonGAAP financial measures may differ from similar measures used by other companies. Statements that are not historical are forwardlooking and involve risks and uncertainties, including those discussed in Part I, Item 1A, "Risk Factors" and elsewhere in this report. These risks could cause our actual results to differ materially from any future performance suggested throughout this MD&A. COMPANY OVERVIEW The Toro Company is in the business of designing, manufacturing, and marketing professional turf maintenance equipment and services; turf irrigation systems; landscaping equipment and lighting products; snow and ice management products; agricultural irrigation systems; rental, specialty, and underground construction equipment; and residential yard and snow thrower products. We sell our products worldwide through a network of distributors, dealers, mass retailers, hardware retailers, equipment rental centers, home centers, as well as online (direct to endusers). We strive to provide innovative, wellbuilt, and dependable products supported by an extensive service network. A significant portion of our net sales has historically been, and we expect will continue to be, attributable to new and enhanced products. We define new products as those introduced in the current and previous two fiscal years. We classify our operations into two reportable business segments: Professional and Residential. Our remaining activities are presented as "Other" due to their insignificance. Such Other activities consist of earnings (loss) from our whollyowned domestic distribution companies, corporate activities, and the elimination of intersegment revenues and expenses. Acquisition of CMW As more fully described in Part I, Item 1, "Business" within the section titled "Acquisition of The Charles Machine Works, Inc." and Note 2, Business Combinations, in the Notes to Consolidated Financial Statements included in Part II, Item 8, "Financial Statements and Supplementary Data," on April 1, 2019, we completed our acquisition of CMW, a privately held Oklahoma corporation. CMW designs, manufactures, and markets a range of professional products to serve the underground construction market, including horizontal directional drills, walk and ride trenchers, compact utility loaders/skid steers, vacuum excavators, asset locators, pipe rehabilitation solutions, and aftermarket tools. CMW provides innovative product offerings that broadened and strengthened our Professional segment product portfolio and expanded our dealer network, while also providing a complementary geographic manufacturing footprint. The transaction was structured as a merger, pursuant to which a whollyowned subsidi [/INST] Positive. </s>

SMITH A O CORP

2015-02-17

2014-12-31

ITEM 7 - MANAGEMENT’S DISCUSSION AND ANALYSIS OF FINANCIAL CONDITION AND RESULTS OF OPERATIONS OVERVIEW Our company is comprised of two reporting segments: North America and Rest of World. Our Rest of World segment is primarily comprised of China, Europe and India. Both segments manufacture and market comprehensive lines of residential and commercial gas, gas tankless and electric water heaters. Both segments primarily manufacture and market in their respective region of the world. Our North America segment also manufactures and globally markets specialty commercial water heating equipment, condensing and non-condensing boilers and water systems tanks. Our Rest of World segment also manufactures and markets water treatment products, primarily for Asia. On August 22, 2011, we sold our electrical products business (EPC) to Regal Beloit Corporation (RBC) for approximately $760 million in cash and approximately 2.83 million shares of RBC common stock valued at $140.6 million as of that date. Due to the sale, EPC has been reflected as a discontinued operation in the accompanying financial statements for all periods presented. In 2014 our North America segment sales were $1,621.7 million and our Rest of World segment sales were $768.3 million. Sales of our products in China grew significantly in 2014. We expect sales in 2015 in China to grow at the rate of approximately two times the rate of China’s gross domestic product (GDP) growth, as we believe overall water heater market growth, geographic expansion, market share gains, growth in water treatment and improved product mix will contribute to our growth. The residential replacement market contributed significantly to 2014 sales in our North America segment. Our 2014 North America residential unit sales grew mid-single digits compared to the prior year and commercial sales showed similar unit growth. We expect both North America residential and commercial water heater industry unit growth to be flat or show modest growth in 2015, due to growth the industry experienced in 2014 in excess of the growth rate of the U.S. GDP and the 2014 fourth quarter pre-buy we believe occurred in advance of a regulatory change requiring increased energy efficiency from residential water heaters. Lochinvar-branded products contributed $275 million to our net sales in 2014, and we expect ten percent sales growth of Lochinvar-branded products in 2015, driven by sales of higher efficiency products and the introduction of new products particularly condensing boilers. Approximately 40 percent of Lochinvar-branded sales consist of residential and commercial water heaters while the remaining 60 percent of Lochinvar-branded sales consist primarily of boilers and related parts. Our stated acquisition strategy includes a number of our water-related strategic initiatives. We will look to continue to grow our core residential and commercial water heating, boiler and water treatment businesses throughout the world. We will also continue to look for opportunities to add to our existing operations in the high growth regions of China and India. Consistent with our stated strategy to expand our core product offering, we acquired Lochinvar in 2011. Lochinvar, one of the leading manufacturers of residential and commercial boilers in the U.S., fit squarely within our stated strategic growth initiative to expand our core water heating business. In 2013, approximately 40 percent of boilers sold in the U.S. were condensing boilers, compared with five percent ten years ago. Our Lochinvar brand is a leading brand of higher efficiency, condensing boilers. We expect the transition in the U.S. to higher efficiency boilers will continue into the foreseeable future. RESULTS OF OPERATIONS Our sales in 2014 were a record $2,356.0 million surpassing 2013 sales of $2,153.8 million by 9.4 percent. The increase in sales was due to higher volumes of water heaters and boilers in the U.S as well as an 18.4 percent increase in sales to $694.0 million of water heaters and water treatment products in China. Our sales in 2013 were higher than 2012 sales of $1,939.3 million by 11.1 percent. The 2013 increase in sales was attributable to higher sales in China and higher volumes of residential and commercial water heaters and boilers in the U.S. Sales of water heaters and water treatment products in China grew 25.3 percent to $586.3 million in 2013 as compared to 2012. Our gross profit margin in 2014 increased to 36.5 percent from 35.9 percent in 2013. The impact of increased sales volumes of water heaters and boilers in the U.S., partially offset by higher material costs in the U.S., as well as higher volumes of water heaters and water treatment products in China contributed to higher gross profit margins in 2014. Our gross profit margin in 2013 increased 2.3 percent from 33.6 percent in 2012. The higher gross profit margin in 2013 was primarily due to the contribution from increased sales volumes of water heaters and boilers in the U.S., lower material costs in the U.S., and higher sales of water heaters and water treatment products in China as well as higher priced product mix as a result of product introductions with higher value features in China. Selling, general and administrative (SG&A) expenses were $47.6 million higher in 2014 than in 2013. The increase in SG&A expenses in 2014 to $572.1 million was primarily due to higher selling and advertising costs in support of increased volumes in North America and China and approximately $9 million of incremental planned enterprise resource planning system (ERP) implementation costs. SG&A expenses were $74.0 million higher in 2013 than in 2012 primarily due to higher selling and advertising expenses in support of increased volumes in North America and China and higher pension expenses in North America. On March 28, 2013, our board of directors approved a plan to transfer residential water heater production from our Fergus, Ontario plant to our other North American facilities. The majority of our production was consolidated in the second quarter of 2013. As a result of the capacity rationalization, we incurred pre-tax restructuring and impairment expenses of $22.0 million in 2013 related to employee severance costs, impairments of assets and equipment relocation costs. These activities are reflected in the “Restructuring, impairment and settlement expenses (income) net” line in the accompanying financial statements. In addition, included in operating earnings in 2013 is a pre-tax gain of $11.0 million resulting from a settlement with a former supplier related to previous overcharges and warranty costs. Operating earnings in 2012 included a pre-tax gain of $3.9 million associated with a legal settlement with a component supplier for our Canadian operations. These gains are also reflected in the “Restructuring, impairment and settlement expenses (income) net” line in the accompanying financial statements. Also included in 2012 operating earnings is a $3.3 million favorable adjustment related to the finalization of an earn-out obligation from our acquisition of Lochinvar. The earn-out adjustment is reflected as “Contingent consideration adjustment” in the accompanying financial statements. Pension expense in 2014 was $28.6 million compared to $27.9 million in 2013 and $13.8 million in 2012. The increases in pension expense in 2014 and 2013 were primarily due to increases in the amortization of unrecognized net actuarial losses in these years in addition to decreases in the expected rate of return on plan assets. Interest expense was $5.7 million in 2014, unchanged from 2013. Interest expense in 2012 was $9.2 million. The higher interest expense in 2012 was due to higher debt levels as a result of the Lochinvar acquisition in 2011. In addition, in 2011 we sold EPC to RBC and received 2.83 million shares of RBC common stock. During 2012 we sold all of our shares of RBC common stock, the net proceeds of which were used to pay down debt in 2012. Other income was $5.2 million in 2014 compared to $3.8 million in 2013. The increase in other income in 2014 is primarily due to higher interest income. Other income of $34.3 million in 2012 was primarily comprised of $27.2 million of pre-tax gains on the sale of the shares of RBC common stock received in the sale of EPC, net of the impact of the RBC share collar described below with most of the remainder of 2012 net other income resulting from interest income on investments resulting from the sale of EPC. We received the RBC common stock in August 2011 under an agreement that we executed in December 2010. The RBC share price appreciated in 2011 during which we entered into an equity collar contract for 50 percent of the shares that we expected to receive to protect a portion of the appreciation. The collar did not qualify for hedge accounting and therefore was adjusted to fair value through earnings from continuing operations. Our effective tax rate was 27.5 percent in 2014, compared with 28.2 percent in 2013 and 30.4 percent in 2012. The rate decline from 2012 to 2013 is primarily due to increased profits in jurisdictions with lower enacted income tax rates than the U.S., principally China. Our 2012 net earnings include discontinued operations after-tax losses of $3.9 million, or $.04 per diluted share, related to the sale of EPC which occurred in 2011. Included in discontinued operations in 2012 was $6.4 million of expense representing the correction of an error primarily due to our calculation of taxes due upon repatriation of undistributed foreign earnings. North America Our North America segment sales were $1,621.7 million in 2014 or $101.7 million higher than sales of $1,520.0 million in 2013. The sales increase in 2014 benefitted from higher volumes of water heaters and boilers in the U.S. which were partially offset by lower water heater sales in Canada, primarily due to a decline in the value of the Canadian dollar of approximately seven percent versus the U.S. dollar. Sales in 2013 were $89.2 million higher than sales of $1,430.8 million in 2012. The sales increase in 2013 was primarily due to higher sales of residential and commercial water heaters and boilers in the U.S. North America operating earnings were $238.7 million in 2014 as compared to operating earnings of $211.9 million and $199.8 million in 2013 and 2012, respectively. Adjusted segment operating earnings were $253.4 million in 2014 as compared to adjusted segment operating earnings of $237.7 million and $197.0 million in 2013 and 2012, respectively. Higher operating earnings and adjusted operating earnings in 2014 were primarily due to higher volumes in the U.S. which were partially offset by higher material costs and approximately $9 million of incremental planned ERP implementation costs. Operating margins were 14.7 percent in 2014 and 13.9 percent in 2013. Adjusted segment operating margins were 15.6 percent in both 2014 and 2013. In 2012, operating margins were 14.0 percent and adjusted operating margins were 13.8 percent. Higher adjusted segment operating margins in 2013 as compared to 2012 were primarily due to higher incremental margins associated with increased volumes of water heaters and boilers in the U.S. as well as lower material costs. Adjusted segment operating earnings in 2014 exclude $14.7 million of pre-tax non-operating pension costs. Adjusted segment operating earnings in 2013 exclude $22.0 million of pre-tax restructuring and impairment charges associated with the transfer of production from Fergus, Ontario, an $11.0 million pre-tax gain on the settlement with a former supplier and $14.8 million of pre-tax non-operating pension costs. Adjusted segment operating earnings in 2012 exclude a pre-tax gain of $3.9 million associated with a legal settlement with a component supplier for our Canadian operations, a $3.3 million favorable adjustment to our estimate of the Lochinvar earn-out obligation and $4.4 million of pre-tax non-operating pension costs. In order to provide improved transparency into the operating results of our business, we are providing non-GAAP measures (adjusted earnings, adjusted earnings per share, adjusted segment operating earnings and adjusted segment operating margins) that exclude certain items as well as non-operating pension costs consisting of interest cost, expected return on plan assets, amortization of actuarial gains (losses) and curtailments. Prior year results are provided on a comparable basis. Reconciliations to measures on a GAAP basis are provided later in this section. We do not plan to provide non-GAAP measures in 2015. Rest of World Sales for our Rest of World segment in 2014 were $768.3 million or $100.3 million higher than sales of $668.0 million in 2013 due to an 18.4 percent increase in sales in China, driven by increased demand for water heaters and water treatment products and higher priced product mix that was partially offset by lower sales in India resulting from weakness in the housing market and the termination of a co-branding relationship with our largest distributor. Sales for our Rest of World segment in 2013 were $125.5 million higher than sales of $542.5 million in 2012 due to increased demand for water heaters and water treatment products in China and market acceptance of our newer, higher value A. O. Smith branded products in China. Rest of World operating earnings were $106.7 million in 2014 compared to operating earnings of $88.0 million and $59.6 million in 2013 and 2012, respectively. Segment operating margins were 13.9 percent in 2014 as compared to 13.2 percent and 11.0 percent in 2013 and 2012, respectively. Higher operating earnings and operating margins in 2014 were due to higher sales of water heaters and water treatment products in China as well as a higher priced product mix as a result of product introductions with higher value features which was partially offset by larger losses in India. Losses in India were $7.5 million in 2014, including approximately $1 million of product development and advertising expenses related to our planned 2015 launch of water treatment products. Higher operating earnings and margins in 2013 as compared to 2012 were due to higher volumes and a more favorable mix of water heaters and water treatment products in China that were partially offset by larger losses in India due to higher costs for new product introductions and brand building as well as devaluation of the Indian rupee. LIQUIDITY AND CAPITAL RESOURCES Our working capital was $713.8 million at December 31, 2014 compared with $614.7 million and $608.3 million at December 31, 2013 and December 31, 2012 respectively. Cash generated by our business in China and sales-related increases in accounts receivable and inventory levels explain the majority of the increase in 2014. Sales-related increases in accounts receivable and inventory levels were partially offset by similar increases in accounts payable, resulting in essentially no change in working capital in 2013 as compared to 2012. As of December 31, 2014, all of the $541.9 million of cash, cash equivalents and marketable securities was held by our foreign subsidiaries. We would incur a cost to repatriate these funds to the U.S. and have an accrual of $50.7 million for the repatriation of a portion of these funds. Operating cash provided by continuing operations during 2014 was $265.7 million compared with $282.2 million during 2013 and $171.8 million during 2012. Higher earnings in 2014 were more than offset by higher outlays for working capital. The improvement in cash flows in 2013 was primarily due to higher earnings from operations and lower outlays for working capital. We expect cash provided by operating activities in 2015 to be between $270 and $280 million. Our capital expenditures were $86.1 million in 2014, $97.7 million in 2013 and $69.9 million in 2012. Included in 2014 capital expenditures was approximately $32 million related to our ERP implementation. Included in 2013 capital expenditures was approximately $45 million in China and India for the construction of a second water heater manufacturing plant in Nanjing, China and to continue the expansion of our manufacturing plant near Bangalore, India. The new plant in China, which opened in October 2013, is projected to add 50 percent more capacity, when fully utilized, to our China water heater operations to meet local demand. We also continue to expand our India plant to accommodate more water heater models, in-source some component manufacturing and meet local demand. Approximately $19 million of expenditures in 2013 related to the implementation of our new ERP system. We are projecting 2015 capital expenditures of between $100 and $110 million and 2015 depreciation and amortization of approximately $66 million. We expect capital spending in 2015 to include approximately $20 million related to our ERP implementation and approximately $30 million related to capacity expansion in China and in the U.S. for Lochinvar branded products to support growth. In December 2012, we completed a $400 million multi-currency five year revolving credit facility with a group of eight banks. The facility has an accordion provision which allows it to be increased up to $500 million if certain conditions (including lender approval) are satisfied. Borrowing rates under the facility are determined by our leverage ratio. The facility requires us to maintain two financial covenants, a leverage ratio test and an interest coverage test, and we were in compliance with the covenants as of December 31, 2014. The facility backs up commercial paper and credit line borrowings, and it expires on December 12, 2017. As a result of the long-term nature of this facility, the commercial paper and credit line borrowings, as well as drawings under the facility are classified as long-term debt. At December 31, 2014, we had available borrowing capacity of $219.5 million under this facility. We believe that the combination of cash, available borrowing capacity and operating cash flow will provide sufficient funds to finance our existing operations for the foreseeable future. Our total debt increased to $223.8 million at December 31, 2014 compared with $191.9 million at December 31, 2013, as our cash flows generated in the U.S were more than offset by our share repurchase activity. As a result, our leverage, as measured by the ratio of total debt to total capitalization, was 13.9 percent at the end of 2014 compared with 12.6 percent at the end of 2013. Our U.S. pension plan continues to meet all funding requirements under ERISA regulations. We were not required to make a contribution to our pension plan in 2014 and we did not make any voluntary contributions. We forecast that we will not be required to make a contribution to the plan in 2015 and we do not plan to make any voluntary contributions in 2015. For further information on our pension plans, see Note 12 of the Notes to Consolidated Financial Statements. During 2014, our board of directors authorized the purchase of an additional 3,500,000 shares of our common stock. In 2014, we repurchased 2,154,783 shares at an average price of $48.19 per share and at a total cost of $103.8 million. At December 31, 2014, a total of 2,497,993 shares remained on the existing repurchase authorization. Depending on factors such as stock price, working capital requirements and alternative investment opportunities, we expect to spend approximately $100 million on stock repurchase activity in 2015. We have paid dividends for 75 consecutive years with payments increasing each of the last 23 years. We paid total dividends of $.60 per share in 2014 compared with $.46 per share in 2013. In January, 2015 we increased our dividend and anticipate paying total dividends of $.76 per share in 2015. Discontinued operations financial information is provided in Note 2 of the Notes to Consolidated Financial Statements. Aggregate Contractual Obligations A summary of our contractual obligations as of December 31, 2014, is as follows: As of December 31, 2014, our liability for uncertain income tax positions was $1.2 million. Due to the high degree of uncertainty regarding timing of potential future cash flows associated with these liabilities, we are unable to make a reasonably reliable estimate of the amount and period in which these liabilities might be paid. We utilize blanket purchase orders to communicate expected annual requirements to many of our suppliers. Requirements under blanket purchase orders generally do not become committed until several weeks prior to our scheduled unit production. The purchase obligation amount presented above represents the value of commitments that we consider firm. Recent Accounting Pronouncements In May 2014, the Financial Accounting Standards Board issued Accounting Standards Codification (ASC) 606-10, Revenue from Contracts with Customers (issued under Accounting Standards Update No. 2014-09). ASC 606-10 will replace all existing revenue recognition guidance when effective. ASC 606-10 is effective for the year beginning January 1, 2017. Either full retrospective adoption or modified retrospective adoption is allowed under ASC 606-10. We are in the process of determining whether the adoption of ASC 606-10 will have an impact on our consolidated financial condition, results of operations or cash flows. Critical Accounting Policies Our accounting policies are described in Note 1 of Notes to Consolidated Financial Statements. Also as disclosed in Note 1, the preparation of financial statements in conformity with accounting principles generally accepted in the U.S. requires the use of estimates and assumptions about future events that affect the amounts reported in the financial statements and accompanying notes. Future events and their effects cannot be determined with absolute certainty. Therefore, the determination of estimates requires the exercise of judgment. Actual results inevitably will differ from those estimates, and such differences may be material to the financial statements. The most significant accounting estimates inherent in the preparation of our financial statements include estimates associated with the evaluation of the impairment of goodwill and indefinite-lived intangible assets, as well as significant estimates used in the determination of liabilities related to warranty activity, product liability, and pensions. Various assumptions and other factors underlie the determination of these significant estimates. The process of determining significant estimates is fact-specific and takes into account factors such as historical experience and trends, and in some cases, actuarial techniques. We monitor these significant factors and adjustments are made when facts and circumstances dictate. Historically, actual results have not significantly deviated from those determined using the estimates described above. Goodwill and Indefinite-lived Intangible Assets In conformity with U.S. GAAP, goodwill and indefinite-lived intangible assets are tested for impairment annually or more frequently if events or changes in circumstances indicate that the assets might be impaired. We perform impairment reviews for our reporting units using a fair-value method based on management’s judgments and assumptions. The fair value represents the estimated amount at which a reporting unit could be bought or sold in a current transaction between willing parties on an arms-length basis. The estimated fair value is then compared with the carrying amount of the reporting unit, including recorded goodwill. We are subject to financial statement risk to the extent that goodwill and indefinite-lived intangible assets become impaired. Any impairment review is, by its nature, highly judgmental as estimates of future sales, earnings and cash flows are utilized to determine fair values. However, we believe that we conduct annual thorough and competent valuations of goodwill and indefinite-lived intangible assets and that there has been no impairment in goodwill or indefinite-lived assets in 2014. Product warranty Our products carry warranties that generally range from one to ten years and are based on terms that are generally accepted in the market. We provide for the estimated cost of product warranty at the time of sale. The product warranty provision is estimated based upon warranty loss experience using actual historical failure rates and estimated costs of product replacement. The variables used in the calculation of the provision are reviewed on a periodic basis. At times, warranty issues may arise which are beyond the scope of our historical experience. We provide for any such warranty issues as they become known and estimable. While our warranty costs have historically been within calculated estimates, it is possible that future warranty costs could differ significantly from those estimates. The allocation of the warranty liability between current and long-term is based on the expected warranty liability to be paid in the next year as determined by historical product failure rates. Product liability Due to the nature of our products, we are subject to product liability claims in the normal course of business. We maintain insurance to reduce our risk. Most insurance coverage includes self-insured retentions that vary by year. In 2014, we maintained a self-insured retention of $7.5 million per occurrence with an aggregate insurance limit of $125.0 million per occurrence. We establish product liability reserves for our self-insured retention portion of any known outstanding matters based on the likelihood of loss and our ability to reasonably estimate such loss. There is inherent uncertainty as to the eventual resolution of unsettled matters due to the unpredictable nature of litigation. We make estimates based on available information and our best judgment after consultation with appropriate advisors and experts. We periodically revise estimates based upon changes to facts or circumstances. We also use an actuary to calculate reserves required for estimated incurred but not reported claims as well as to estimate the effect of adverse development of claims over time. At December 31, 2014 our reserve for product liability was $40.8 million. Pensions We have significant pension benefit costs that are developed from actuarial valuations. The valuations reflect key assumptions regarding, among other things, discount rates, expected return on plan assets, retirement ages, and years of service. Consideration is given to current market conditions, including changes in interest rates in making these assumptions. Our assumption for the expected return on plan assets was 7.75 percent in 2014 compared to 8.00 percent in 2013. The discount rate used to determine net periodic pension costs increased to 4.85 percent in 2014 from 4.05 percent in 2013. For 2015, our expected return on plan assets is 7.75 percent and our discount rate is 4.05 percent. In developing our expected return on plan assets, we evaluate our pension plan’s current and target asset allocation, the expected long-term rates of return of equity and bond indices and the actual historical returns of our pension plan. Our plan’s target allocation to equity managers is approximately 50 percent, with the remainder allocated primarily to bond managers and a small allocation to private equity managers and real estate managers. Our actual asset allocation as of December 31, 2014, was 50 percent to equity managers, 37 percent to bond managers, eight percent to real estate managers, four percent to private equity managers and the remainder in money market instruments. We regularly review our actual asset allocation and periodically rebalance our investments to our targeted allocation when considered appropriate. Our pension plan’s historical ten-year and 25-year compounded annualized returns are 6.9 percent and 9.6 percent, respectively. We believe that with our target allocation and the expected long-term returns of equity and bond indices as well as our actual historical returns, our 7.75 percent expected return on plan assets for 2015 is reasonable. The discount rate assumptions used to determine future pension obligations at December 31, 2014 and 2013 were based on the AonHewitt AA Only Above Median yield curve, which was designed by AonHewitt to provide a means for plan sponsors to value the liabilities of their postretirement benefit plans. The AA Only Above Median curve represents a series of annual discount rates from bonds with AA minimum average rating as rated by Moody’s Investor Service, Standard &Poor’s and Fitch Ratings. We will continue to evaluate our actuarial assumptions at least annually, and we will adjust the assumptions as necessary. We estimate that we will recognize minimal pension expense in 2015 compared to $28.6 million in 2014. We have made changes to our pension plan including closing the plan to new entrants effective January 1, 2010, and the sunset of our plan for the majority of our employees on December 31, 2014 which we believe will significantly decrease pension expense beginning in 2015. Lowering the expected return on plan assets by 25 basis points would increase our net pension expense for 2015 by approximately $1.9 million. Lowering the discount rate by 25 basis points would decrease our 2015 net pension expense by approximately $0.1 million. Non-GAAP Measures We provide non-GAAP measures (adjusted earnings, adjusted earnings per share, and adjusted segment operating earnings) that exclude certain items as well as non-operating pension costs consisting of interest cost, expected return on plan assets, amortization of actuarial gains (losses) and curtailments. We believe that these components of pension cost better reflect ongoing operating related costs of providing pension benefits to our employees. As such, we believe that the measures of adjusted earnings, adjusted earnings per share and adjusted segment operating earnings provide management and investors with a useful measure of our operational results. We have prepared quarterly and annual reconciliations of adjusted earnings, adjusted earnings per share and adjusted segment operating earnings for the years 2012-2014, which have been provided in the Supplemental Financial Data documents posted in the Investor Relations section on our website in addition to the following reconciliations. A. O. SMITH CORPORATION Adjusted Earnings and Adjusted EPS (dollars in millions, except per share data) (unaudited) The following is a reconciliation of earnings and diluted earnings per share (EPS) to adjusted earnings (non-GAAP) and adjusted EPS (non-GAAP): A. O. SMITH CORPORATION Adjusted Segment Operating Earnings (dollars in millions) (unaudited) The following is a reconciliation of segment operating earnings to adjusted segment operating earnings (non-GAAP): Additional information: The following is a reconciliation of diluted earnings per share from continuing operations (GAAP) to diluted Adjusted EPS from continuing operations (non-GAAP). We will not report adjusted EPS for 2015: Outlook As we enter 2015, we continue to expect strong, profitable growth in China, driven by expected continued overall market growth, market share gains, improved product mix and water treatment growth. We expect sales in 2015 in China to grow at the rate of approximately two times the rate of China’s gross domestic product growth. In the U.S. we believe an expected continued transition from non-condensing, lower efficiency boilers to condensing, higher efficiency boilers, as well as continued new product introductions, will allow Lochinvar branded sales to continue the ten percent pace of growth in 2015. We believe residential and commercial water heater volumes in the U.S. will be flat or show modest growth in 2015, as we expect new construction activity to slowly improve. An energy efficiency regulatory change impacting approximately 80 percent of U.S. residential water heaters will become effective April 16, 2015. Our new compliant products are more expensive to manufacture, and we announced an average price increase of approximately 20 percent on these products. We expect some operating inefficiencies and one-time costs in the first half of 2015 as we implement the changeover to the new compliant residential water heater line. Combining all these factors, we expect 2015 sales to increase approximately ten percent from 2014 and 2015 earnings to be in the range of $2.65 to $2.80 per share. OTHER MATTERS Environmental Our operations are governed by a number of federal, foreign, state, local and environmental laws concerning the generation and management of hazardous materials, the discharge of pollutants into the environment and remediation of sites owned by the company or third parties. We have expended financial and managerial resources complying with such laws. Expenditures related to environmental matters were not material in 2014 and are not expected to be material in any single year. We have reserves associated with environmental obligations at various facilities and we believe these reserves are sufficient to cover reasonably anticipated remediation costs. Although we believe that our operations are substantially in compliance with such laws and maintain procedures designed to maintain compliance, there are no assurances that substantial additional costs for compliance will not be incurred in the future. However, since the same laws govern our competitors, we should not be placed at a competitive disadvantage. Market Risk We are exposed to various types of market risks, primarily currency. We monitor our risks in such areas on a continuous basis and generally enter into forward contracts to minimize such exposures for periods of less than one year. We do not engage in speculation in our derivatives strategies. Further discussion regarding derivative instruments is contained in Note 1 of Notes to Consolidated Financial Statements. We enter into foreign currency forward contracts to minimize the effect of fluctuating foreign currencies. At December 31, 2014, we had net foreign currency contracts outstanding of $141.5 million. Assuming a hypothetical ten percent movement in the respective currencies, the potential foreign exchange gain or loss associated with the change in rates would amount to $14.2 million. Gains and losses from our forward contract activities will be offset by gains and losses in the underlying transactions being hedged. Our earnings exposure related to movements in interest rates is primarily derived from outstanding floating-rate debt instruments that are determined by short-term money market rates. At December 31, 2014, we had $180.5 million in outstanding floating-rate debt with a weighted-average interest rate of 1.3 percent at year end. A hypothetical ten percent annual increase or decrease in the year-end average cost of our outstanding floating-rate debt would result in a change in annual pre-tax interest expense of approximately $0.2 million. Forward-Looking Statements This filing contains statements that the company believes are “forward-looking statements” within the meaning of the Private Securities Litigation Reform Act of 1995. Forward-looking statements generally can be identified by the use of words such as “may,” “will,” “expect,” “intend,” “estimate,” “anticipate,” “believe,” “forecast,” “guidance” or words of similar meaning. These forward-looking statements are subject to risks and uncertainties that could cause actual results to differ materially from those anticipated as of the date of this filing. Important factors that could cause actual results to differ materially from these expectations include, among other things, the following: uncertain operating inefficiencies, costs and effects of pricing actions associated with the implementation of the National Appliance Energy Conservation Act update (NAECA III) energy efficiency standard change applicable to U.S. residential water heaters; uncertain cost savings and timeframes associated with the implementation of the new enterprises resources planning system; potential weakening in the high efficiency boiler segment in the U.S.; the ability to execute our acquisition strategy; significant volatility in raw material prices; competitive pressures on the company’s businesses; inability to implement pricing actions; instability in the company’s replacement markets; strength or duration of any recoveries in U.S. residential or commercial construction; a slowdown in the growth of the Chinese economy; foreign currency fluctuations; and adverse general economic conditions and capital market deterioration. Forward-looking statements included in this filing are made only as of the date of this release, and the company is under no obligation to update these statements to reflect subsequent events or circumstances. All subsequent written and oral forward-looking statements attributed to the company, or persons acting on its behalf, are qualified entirely by these cautionary statements.

<s>[INST] Our company is comprised of two reporting segments: North America and Rest of World. Our Rest of World segment is primarily comprised of China, Europe and India. Both segments manufacture and market comprehensive lines of residential and commercial gas, gas tankless and electric water heaters. Both segments primarily manufacture and market in their respective region of the world. Our North America segment also manufactures and globally markets specialty commercial water heating equipment, condensing and noncondensing boilers and water systems tanks. Our Rest of World segment also manufactures and markets water treatment products, primarily for Asia. On August 22, 2011, we sold our electrical products business (EPC) to Regal Beloit Corporation (RBC) for approximately $760 million in cash and approximately 2.83 million shares of RBC common stock valued at $140.6 million as of that date. Due to the sale, EPC has been reflected as a discontinued operation in the accompanying financial statements for all periods presented. In 2014 our North America segment sales were $1,621.7 million and our Rest of World segment sales were $768.3 million. Sales of our products in China grew significantly in 2014. We expect sales in 2015 in China to grow at the rate of approximately two times the rate of China’s gross domestic product (GDP) growth, as we believe overall water heater market growth, geographic expansion, market share gains, growth in water treatment and improved product mix will contribute to our growth. The residential replacement market contributed significantly to 2014 sales in our North America segment. Our 2014 North America residential unit sales grew midsingle digits compared to the prior year and commercial sales showed similar unit growth. We expect both North America residential and commercial water heater industry unit growth to be flat or show modest growth in 2015, due to growth the industry experienced in 2014 in excess of the growth rate of the U.S. GDP and the 2014 fourth quarter prebuy we believe occurred in advance of a regulatory change requiring increased energy efficiency from residential water heaters. Lochinvarbranded products contributed $275 million to our net sales in 2014, and we expect ten percent sales growth of Lochinvarbranded products in 2015, driven by sales of higher efficiency products and the introduction of new products particularly condensing boilers. Approximately 40 percent of Lochinvarbranded sales consist of residential and commercial water heaters while the remaining 60 percent of Lochinvarbranded sales consist primarily of boilers and related parts. Our stated acquisition strategy includes a number of our waterrelated strategic initiatives. We will look to continue to grow our core residential and commercial water heating, boiler and water treatment businesses throughout the world. We will also continue to look for opportunities to add to our existing operations in the high growth regions of China and India. Consistent with our stated strategy to expand our core product offering, we acquired Lochinvar in 2011. Lochinvar, one of the leading manufacturers of residential and commercial boilers in the U.S., fit squarely within our stated strategic growth initiative to expand our core water heating business. In 2013, approximately 40 percent of boilers sold in the U.S. were condensing boilers, compared with five percent ten years ago. Our Lochinvar brand is a leading brand of higher efficiency, condensing boilers. We expect the transition in the U.S. to higher efficiency boilers will continue into the foreseeable future. RESULTS OF OPERATIONS Our sales in 2014 were a record $2,356.0 million surpassing 2013 sales of $2,153.8 million by 9.4 percent. The increase in sales was due to higher volumes of water heaters and boilers in the U.S as well as an 18.4 percent increase in sales to $694.0 million of water heaters and water treatment products in China. Our sales in 2013 were higher than 2012 sales of $1,939.3 million by 11.1 percent. The 2013 increase in sales was attributable to higher sales in China and higher volumes of residential and commercial water heaters and boilers in the U [/INST] Positive. </s>

SMITH A O CORP

2016-02-17

2015-12-31

ITEM 7 - MANAGEMENT’S DISCUSSION AND ANALYSIS OF FINANCIAL CONDITION AND RESULTS OF OPERATIONS OVERVIEW Our company is comprised of two reporting segments: North America and Rest of World. Our Rest of World segment is primarily comprised of China, Europe and India. Both segments manufacture and market comprehensive lines of residential and commercial gas, gas tankless and electric water heaters. Both segments primarily manufacture and market in their respective region of the world. Our North America segment also manufactures and globally markets specialty commercial water heating equipment, condensing and non-condensing boilers and water systems tanks. Primarily for Asia, our Rest of World segment also manufactures and markets water treatment products. We also market in-home air purification products in China. In 2015, our North America segment sales were $1,703.0 million and our Rest of World segment sales were $866.1 million. Sales of our products in China grew significantly in 2015, increasing 13.7 percent over 2014. Excluding the impact from the strengthening U.S. dollar, sales in China increased 16.1 percent in 2015. We expect sales in 2016 in China to grow at a rate of approximately 15 percent in local currency, as we believe overall water heater market growth, geographic expansion, market share gains, growth in water treatment products and air purification products and improved product mix will contribute to our growth. Price increases for residential and commercial water heaters and higher volumes of commercial water heaters and condensing commercial boilers contributed to 2015 sales increases in our North America segment. Partially offsetting these factors was a decline in residential water heater volumes in the U.S. The 13 percent decline in the value of the Canadian dollar against the U.S. dollar during 2015 also negatively impacted sales. We expect North America residential and commercial water heater industry unit to show modest growth in 2016. Lochinvar-branded products contributed $296.0 million to our net sales in 2015, and we expect ten percent sales growth of Lochinvar-branded products in 2016, driven by the U.S. industry transition to higher efficiency products and our introduction of new products; particularly condensing boilers. Approximately 40 percent of Lochinvar-branded product sales consist of residential and commercial water heaters while the remaining 60 percent of Lochinvar-branded product sales consist primarily of boilers and related parts. Our stated acquisition strategy includes a number of our water-related strategic initiatives. We will look to continue to grow our core residential and commercial water heating, boiler and water treatment businesses throughout the world. We will also continue to look for opportunities to add to our existing operations in the high growth regions of China and India demonstrated by our introduction of air purification products in China in 2015. Consistent with our stated strategy to expand our core product offering, we acquired Lochinvar in 2011. Lochinvar, one of the leading manufacturers of residential and commercial boilers in the U.S., fit squarely within our stated strategic growth initiative to expand our core water heating business. In 2013, approximately 40 percent of boilers sold in the U.S. were condensing boilers, compared with five percent in 2003. Our Lochinvar brand is a leading brand of higher efficiency, condensing boilers. We expect the transition in the U.S. to higher efficiency boilers will continue into the foreseeable future. RESULTS OF OPERATIONS Our sales in 2015 were a record $2,536.5 million surpassing 2014 sales of $2,356.0 million by 7.7 percent. Excluding the impact from the strengthening U.S. dollar against the Canadian and Chinese currencies, our sales grew over nine percent in 2015. The increase in sales was due to higher prices in North America, higher sales of Lochinvar-branded products and commercial water heaters in the U.S., as well as continued demand for our water heating and water treatment products in China. Sales in China grew 13.7 percent in 2015. Excluding the impact from the stronger U.S. dollar, China sales increased 16.1 percent in 2015. Our sales in 2014 were higher than 2013 sales of $2,153.8 million by 9.4 percent. The increase in 2014 in sales was attributable to higher volumes of water heaters and boilers in the U.S. and higher sales of water heaters and water treatment products in China. Sales of water heaters and water treatment products in China grew 18.4 percent to $694.0 million in 2014 compared to 2013. Our gross profit margin in 2015 increased to 39.8 percent from 36.5 percent in 2014. The higher margin in 2015 was due to price increases in the U.S. and Canada, higher U.S. sales of commercial boilers and commercial water heaters which have higher margins, lower steel costs and a reduction in pension-related costs. Our gross profit margin in 2014 increased slightly from 35.9 percent in 2013, primarily due to higher volumes of water heaters and boilers in the U.S., partially offset by higher material costs in the U.S., as well as higher volumes of water heaters and water treatment products in the China. Selling, general and administrative (SG&A) expenses were $38.6 million higher in 2015 than in 2014. The increase in SG&A expenses in 2015 to $610.7 million was primarily due to higher selling and engineering costs in support of increased volumes in China as well as higher costs associated with the 2015 launch of air purification products in China which more than offset lower pension costs in the U.S. SG&A expenses were $47.6 million higher in 2014 than in 2013 primarily due to higher selling and advertising costs in support of increased volumes in North America and China and approximately $9 million of incremental enterprise resource planning system (ERP) implementation costs. On March 28, 2013, our Board of Directors approved a plan to transfer residential water heater production from our Fergus, Ontario plant to our other North American facilities. The majority of our production was consolidated in the second quarter of 2013. As a result of the capacity rationalization, we incurred pre-tax restructuring and impairment expenses of $22.0 million in 2013 related to employee severance costs, impairments of assets and equipment relocation costs. In addition, included in operating earnings in 2013 is a pre-tax gain of $11.0 million resulting from a settlement with a former supplier related to previous overcharges and warranty costs. Pension expense in 2015 was $0.1 million compared to $28.6 million in 2014 and $27.9 million in 2013. The significant decrease in pension expense in 2015 compared to prior years was due to the sunset of our pension plan for the majority of our employees on December 31, 2014. In 2015, we began making additional Company contributions to a defined contribution plan in lieu of benefits earned in our pension plan. Interest expense was $7.4 million in 2015 compared to $5.7 million in 2014. Interest expense in 2013 was also $5.7 million. The higher interest expense in 2015 was primarily related to interest rates on term notes in the amount of $75 million issued in January 2015 that were higher than the interest rate on the revolving credit facility that it replaced as well as higher overall debt levels related to share repurchases. Other income was $10.8 million in 2015 compared to $5.2 million in 2014 and $3.8 million in 2013. The increases in other income in 2015 and 2014 were primarily due to higher interest income compared to the preceding year. Our effective tax rate was 29.7 percent in 2015, compared with 27.5 percent in 2014 and 28.2 percent in 2013. The higher effective tax rate in 2015 was primarily due to a change in geographic earnings mix as compared to the prior year. North America Our North America segment sales were $1,703.0 million in 2015 or $81.3 million higher than sales of $1,621.7 million in 2014. The sales increase in 2015 resulted from higher prices in the U.S. and Canada and higher volumes of commercial water heaters and condensing commercial boilers in the U.S., partially offset by lower residential volumes in the U.S. and an unfavorable currency impact in Canada. Sales in 2014 were $101.7 million higher than sales of $1,520.0 million in 2013. The sales increase in 2014 was primarily due to higher volumes of water heaters and boilers in the U.S., which were partially offset by lower water heaters sales in Canada, primarily due to a decline in the value of the Canadian dollar of approximately seven percent versus the U.S. dollar. North America operating earnings were $339.9 million in 2015 compared to operating earnings of $238.7 million and $211.9 million in 2014 and 2013, respectively. Operating margins were 20.0 percent, 14.7 percent and 13.9 percent in 2015, 2014 and 2013, respectively. The significantly higher operating earnings and operating margin in 2015 were primarily due to higher prices in the U.S. and Canada, higher sales of Lochinvar-branded products and commercial water heaters in the U.S., lower steel costs and lower pension costs which more than offset lower residential water heater volumes in the U.S. Higher operating earnings in 2014 compared to 2013 were primarily due to higher volumes in the U.S. which were partially offset by higher material costs and approximately $9 million of incremental ERP implementation costs. Rest of World Sales in our Rest of World segment in 2015 were $866.1 million or $97.8 million higher than sales of $768.3 million in 2014. Sales in China increased approximately $95 million due to higher demand for water heaters, approximately $35 million of incremental sales of water treatment products and approximately $9 million in sales of our newly launched in-home air purification products. Sales in China grew 13.7 percent in 2015. Excluding the impact from the stronger U.S. dollar, China sales increased 16.1 percent in 2015. Sales for our Rest of World segment in 2014 were $100.3 million higher than sales of $668.0 million in 2013 due to an 18.4 percent increase in sales in China, driven by increased demand for water heaters and water treatment products and a higher priced product mix that was partially offset by lower sales in India resulting from weakness in the housing market and the termination of a co-branding relationship with our largest distributor. Rest of World operating earnings were $113.0 million in 2015 compared to operating earnings of $106.7 million and $88.0 million in 2014 and 2013, respectively. Segment operating margins were 13.0 percent in 2015 as compared to 13.9 percent and 13.2 percent in 2014 and 2013, respectively. Higher operating earnings in 2015 were primarily due to higher sales in China and lower steel costs that were partially offset by lower sales of highly profitable commercial water heaters in China, increased SG&A expenses and approximately $1.5 million of higher losses in India as compared to 2014. China earnings were reduced by approximately $2.5 million due to currency translation. Higher selling and engineering costs in China as well as higher SG&A costs associated with the 2015 launch of air purification products were the primary drivers for the decreased operating margin in 2015 as compared to 2014. Higher operating earnings and margins in 2014 as compared to 2013 were due to higher sales of water heaters and water treatment products in China as well as a higher priced product mix as a result of product introductions with higher value features which was partially offset by larger losses in India. Losses in India were $7.5 million in 2014, including approximately $1 million of product development and advertising expenses in advance of our 2015 launch of water treatment products. LIQUIDITY AND CAPITAL RESOURCES Our working capital was $802.1 million at December 31, 2015 compared with $713.8 million and $614.7 million at December 31, 2014 and December 31, 2013, respectively. Cash generated in China and sales-related increases in accounts receivable and inventory levels explain the majority of the increase in both 2015 and 2014. As of December 31, 2015, essentially all of the $645.2 million of cash, cash equivalents and marketable securities were held by our foreign subsidiaries. We would incur a cost to repatriate these funds to the U.S. and have an accrual of $47.9 million for the repatriation of a portion of these funds. Cash provided by operating activities during 2015 was $344.4 million compared with $263.9 million during 2014 and $279.6 million during 2013. The improvement in cash flows in 2015 was primarily due to higher earnings from operations and lower outlays for working capital driven primarily by increases in accounts payable balances in China. Higher earnings in 2014 were more than offset by higher outlays for working capital. We expect cash provided by operating activities in 2016 to be approximately $320 million. Our capital expenditures were $72.7 million in 2015, $86.1 million in 2014 and $97.7 million in 2013. Included in 2015 capital expenditures were approximately $16 million related to our ERP implementation and approximately $19 million related to capacity expansion in China and the U.S. to support growth. Included in 2014 capital expenditures was approximately $31 million related to our ERP implementation. Included in 2013 capital expenditures was approximately $45 million in China and India for the construction of a second water heater manufacturing plant in Nanjing, China and to continue the expansion of our manufacturing plant near Bangalore, India. Also included in 2013 capital expenditures was approximately $19 million related to the ERP implementation. We project 2016 capital expenditures will be between $120 and $130 million and depreciation and amortization expense in 2016 will be approximately $70 million. We expect capital spending in 2016 to include approximately $8 million related to our ERP implementation and approximately $40 million related to the initial phase of a new water treatment manufacturing facility in China as we will outgrow capacity in a leased facility in the next few years. In December 2012, we completed a $400 million multi-currency five year revolving credit facility with a group of eight banks. The facility has an accordion provision which allows it to be increased up to $500 million if certain conditions (including lender approval) are satisfied. Borrowing rates under the facility are determined by our leverage ratio. The facility requires us to maintain two financial covenants, a leverage ratio test and an interest coverage test, and we were in compliance with the covenants as of December 31, 2015. The facility backs up commercial paper and credit line borrowings, and it expires on December 12, 2017. As a result of the long-term nature of this facility, the commercial paper and credit line borrowings, as well as drawings under the facility are classified as long-term debt. At December 31, 2015, we had available borrowing capacity of $253.0 million under this facility. We believe that the combination of cash, available borrowing capacity and operating cash flow will provide sufficient funds to finance our existing operations for the foreseeable future. In January 2015, we issued $75 million of fixed rate term notes to an insurance company. Principal payments commence in 2020 and the notes mature in 2030. The notes have an interest rate of 3.52 percent. We used proceeds of the notes to pay down borrowings under our revolving credit facility. Our total debt increased to $249.0 million at December 31, 2015 compared with $223.8 million at December 31, 2014, as our cash flows generated in the U.S were more than offset by our share repurchase activity. As a result, our leverage, as measured by the ratio of total debt to total capitalization, was 14.7 percent at the end of 2015 compared with 13.9 percent at the end of 2014. Our U.S. pension plan continues to meet all funding requirements under ERISA regulations. We were not required to make a contribution to our pension plan in 2015 and we did not make any voluntary contributions. We forecast that we will not be required to make a contribution to the plan in 2016 and we do not plan to make any voluntary contributions in 2016. For further information on our pension plans, see Note 11 of the Notes to Consolidated Financial Statements. During 2015, our Board of Directors authorized the purchase of an additional 2,000,000 shares of our Common Stock. In 2015, we repurchased 1,908,237 shares at an average price of $67.14 per share and a total cost of $128.1 million. At December 31, 2015, a total of 2,589,756 shares remained on the existing repurchase authorization. Depending on factors such as stock price, working capital requirements and alternative investment opportunities, we expect to spend approximately $150 million on stock repurchase activity in 2016. We have paid dividends for 76 consecutive years with payments increasing each of the last 24 years. We paid total dividends of $0.76 per share in 2015 compared with $0.60 per share in 2014. In January 2016, we increased our dividend by 26 percent and anticipate paying total dividends of $0.96 per share in 2016. Aggregate Contractual Obligations A summary of our contractual obligations as of December 31, 2015, is as follows: As of December 31, 2015, our liability for uncertain income tax positions was $2.6 million. Due to the high degree of uncertainty regarding timing of potential future cash flows associated with these liabilities, we are unable to make a reasonably reliable estimate of the amount and period in which these liabilities might be paid. We utilize blanket purchase orders to communicate expected annual requirements to many of our suppliers. Requirements under blanket purchase orders generally do not become committed until several weeks prior to our scheduled unit production. The purchase obligation amount presented above represents the value of commitments that we consider firm. Recent Accounting Pronouncements In November 2015, the Financial Accounting Standards Board (FASB) amended Accounting Standard Codification (ASC) 740, Income Taxes (issued under Accounting Standards No. (ASN) 2015-17). This amendment requires that deferred tax assets and liabilities be classified as noncurrent in the statement of financial position. The amendment is effective for periods beginning January 1, 2016 and allows for either prospective adoption or retrospective adoption. We expect the adoption of amended ASC 740 to impact the classification of deferred taxes on our consolidated balance sheet. In April 2015, the FASB amended ASC 835-30, Interest - Imputation of Interest (issued under ASN 2015-03). This amendment to ASC 835-30 requires that debt issuance costs related to a recognized debt liability be presented in the balance sheet as a direct deduction from the carrying amount of that debt liability, consistent with debt discounts. The recognition and measurement guidance for debt issuance costs is not affected by this amendment. The amendment is effective for periods beginning January 1, 2016 and requires using a retrospective approach. We do not expect the adoption of amended ASC 835-30 to have a material impact on our consolidated balance sheet. In May 2014, the FASB issued ASC 606-10, Revenue from Contracts with Customers (issued under ASN 2014-09). ASC 606-10 will replace all existing revenue recognition guidance when effective. In July 2015, the FASB approved a one year deferral of the effective date, with application permitted as of the original effective date, or periods beginning January 1, 2017. Either full retrospective adoption or modified retrospective adoption is allowed under ASC 606-10. We are in the process of determining whether the adoption of ASC 606-10 will have an impact on our consolidated financial condition, results of operations or cash flows. Critical Accounting Policies Our accounting policies are described in Note 1 of Notes to Consolidated Financial Statements. Also as disclosed in Note 1, the preparation of financial statements in conformity with accounting principles generally accepted in the U.S. requires the use of estimates and assumptions about future events that affect the amounts reported in the financial statements and accompanying notes. Future events and their effects cannot be determined with absolute certainty. Therefore, the determination of estimates requires the exercise of judgment. Actual results inevitably will differ from those estimates, and such differences may be material to the financial statements. The most significant accounting estimates inherent in the preparation of our financial statements include estimates associated with the evaluation of the impairment of goodwill and indefinite-lived intangible assets, as well as significant estimates used in the determination of liabilities related to warranty activity, product liability and pensions. Various assumptions and other factors underlie the determination of these significant estimates. The process of determining significant estimates is fact-specific and takes into account factors such as historical experience and trends, and in some cases, actuarial techniques. We monitor these significant factors and adjustments are made as facts and circumstances dictate. Historically, actual results have not significantly deviated from those determined using the estimates described above. Goodwill and Indefinite-lived Intangible Assets In conformity with U.S. GAAP, goodwill and indefinite-lived intangible assets are tested for impairment annually or more frequently if events or changes in circumstances indicate that the assets might be impaired. We perform impairment reviews for our reporting units using a fair-value method based on management’s judgments and assumptions. The fair value represents the estimated amount at which a reporting unit could be bought or sold in a current transaction between willing parties on an arm’s-length basis. The estimated fair value is then compared with the carrying amount of the reporting unit, including recorded goodwill. We are subject to financial statement risk to the extent that goodwill and indefinite-lived intangible assets become impaired. Any impairment review is, by its nature, highly judgmental as estimates of future sales, earnings and cash flows are utilized to determine fair values. However, we believe that we conduct annual thorough and competent valuations of goodwill and indefinite-lived intangible assets and that there has been no impairment in goodwill or indefinite-lived assets in 2015. Product warranty Our products carry warranties that generally range from one to ten years and are based on terms that are generally accepted in the market. We provide for the estimated cost of product warranty at the time of sale. The product warranty provision is estimated based upon warranty loss experience using actual historical failure rates and estimated costs of product replacement. The variables used in the calculation of the provision are reviewed on a periodic basis. At times, warranty issues may arise which are beyond the scope of our historical experience. We provide for any such warranty issues as they become known and estimable. While our warranty costs have historically been within calculated estimates, it is possible that future warranty costs could differ significantly from those estimates. The allocation of the warranty liability between current and long-term is based on the expected warranty liability to be paid in the next year as determined by historical product failure rates. Product liability Due to the nature of our products, we are subject to product liability claims in the normal course of business. We maintain insurance to reduce our risk. Most insurance coverage includes self-insured retentions that vary by year. In 2015, we maintained a self-insured retention of $7.5 million per occurrence with an aggregate insurance limit of $125.0 million per occurrence. We establish product liability reserves for our self-insured retention portion of any known outstanding matters based on the likelihood of loss and our ability to reasonably estimate such loss. There is inherent uncertainty as to the eventual resolution of unsettled matters due to the unpredictable nature of litigation. We make estimates based on available information and our best judgment after consultation with appropriate advisors and experts. We periodically revise estimates based upon changes to facts or circumstances. We also use an actuary to calculate reserves required for estimated incurred but not reported claims as well as to estimate the effect of adverse development of claims over time. At December 31, 2015, our reserve for product liability was $38.7 million. Pensions We have significant pension benefit costs that are developed from actuarial valuations. The valuations reflect key assumptions regarding, among other things, discount rates, expected return on plan assets, retirement ages, and years of service. Consideration is given to current market conditions, including changes in interest rates in making these assumptions. Our assumption for the expected return on plan assets was 7.75 percent in 2015 and 2014. The discount rate used to determine net periodic pension costs decreased to 4.05 percent in 2015 from 4.85 percent in 2014. For 2016, our expected return on plan assets is 7.50 percent and our discount rate is 4.40 percent. In developing our expected return on plan assets, we evaluate our pension plan’s current and target asset allocation, the expected long-term rates of return of equity and bond indices and the actual historical returns of our pension plan. Our plan’s target allocation to equity managers is approximately 50 percent, with the remainder allocated primarily to bond managers and a small allocation to private equity managers and real estate managers. Our actual asset allocation as of December 31, 2015, was 47 percent to equity managers, 39 percent to bond managers, nine percent to real estate managers and five percent to private equity managers. We regularly review our actual asset allocation and periodically rebalance our investments to our targeted allocation when considered appropriate. Our pension plan’s historical ten-year and 25-year compounded annualized returns are 6.1 percent and 9.5 percent, respectively. We believe that with our target allocation and the expected long-term returns of equity and bond indices as well as our actual historical returns, our 7.50 percent expected return on plan assets for 2016 is reasonable. The discount rate assumptions used to determine future pension obligations at December 31, 2015 and 2014 were based on the AonHewitt AA Only Above Median yield curve, which was designed by AonHewitt to provide a means for plan sponsors to value the liabilities of their postretirement benefit plans. The AA Only Above Median yield curve represents a series of annual discount rates from bonds with AA minimum average rating as rated by Moody’s Investor Service, Standard &Poor’s and Fitch Ratings. We will continue to evaluate our actuarial assumptions at least annually, and we will adjust the assumptions as necessary. As of December 31, 2015, we changed the method we used to estimate the service and interest components of net periodic pension benefit cost for our pension plan and post-retirement benefit plan. The change will result in an approximate $7 million decrease in the service and interest components in 2016. As a result, we estimate that we will recognize pension income of approximately $7 million in 2016 compared to $0.1 million of pension expense in 2015. We estimate that costs associated with our replacement retirement plan in 2016 will be approximately $6 million, consistent with 2015. We made changes to our pension plan including closing the plan to new entrants effective January 1, 2010, and the sunset of our plan for the majority of our employees on December 31, 2014 which significantly decreased pension expense beginning in 2015. Lowering the expected return on plan assets by 25 basis points would increase our net pension expense for 2015 by approximately $1.8 million. Lowering the discount rate by 25 basis points would decrease our 2015 net pension expense by approximately $0.3 million. Outlook Despite volatile conditions in China, we continue to expect strong, profitable sales growth in China in 2016 at the rate of approximately 15 percent in local currency terms. We continue to experience strong consumer demand for our water heating and water treatment products in China, and our new air purification products have been well received by Chinese consumers. In the U.S. we expect the transition from non-condensing, lower efficiency boilers to condensing, higher efficiency boilers to continue in 2016, which combined with new products, should allow sales growth of Lochinvar-branded products to continue at ten percent. We expect modest growth in commercial and residential water heater volumes in North America driven by modest assumptions for new construction and steady replacement demand. Other income is expected to be approximately $5 million lower in 2016 as compared to 2015 primarily due to expected lower interest rates than last year on cash deposits in China. We anticipate ERP implementation related costs will be approximately $9 million higher or approximately $25 million in 2016 due to the increase in the number of scheduled go-live events in 2016. We also expect our effective tax rate to be between 30.5 percent and 31 percent due to a change in geographic earnings mix. Combining all these factors, we expect sales growth of between nine and ten percent in local currency terms and between seven and eight percent in U.S. dollars in 2016 and earnings to be in the range of $3.40 to $3.55 per share for 2016. OTHER MATTERS Environmental Our operations are governed by a number of federal, foreign, state, local and environmental laws concerning the generation and management of hazardous materials, the discharge of pollutants into the environment and remediation of sites owned by the company or third parties. We have expended financial and managerial resources complying with such laws. Expenditures related to environmental matters were not material in 2015 and we do not expect them to be material in any single year. We have reserves associated with environmental obligations at various facilities and we believe these reserves are sufficient to cover reasonably anticipated remediation costs. Although we believe that our operations are substantially in compliance with such laws and maintain procedures designed to maintain compliance, there are no assurances that substantial additional costs for compliance will not be incurred in the future. However, since the same laws govern our competitors, we should not be placed at a competitive disadvantage. Market Risk We are exposed to various types of market risks, primarily currency. We monitor our risks in such areas on a continuous basis and generally enter into forward contracts to minimize such exposures for periods of less than one year. We do not engage in speculation in our derivatives strategies. Further discussion regarding derivative instruments is contained in Note 1 of Notes to Consolidated Financial Statements. We enter into foreign currency forward contracts to minimize the effect of fluctuating foreign currencies. At December 31, 2015, we had net foreign currency contracts outstanding of $79.8 million. Assuming a hypothetical ten percent movement in the respective currencies, the potential foreign exchange gain or loss associated with the change in rates would amount to $8.0 million. Gains and losses from our forward contract activities will be offset by gains and losses in the underlying transactions being hedged. Our earnings exposure related to movements in interest rates is primarily derived from outstanding floating-rate debt instruments that are determined by short-term money market rates. At December 31, 2015, we had $147.0 million in outstanding floating-rate debt with a weighted-average interest rate of 1.3 percent at year end. A hypothetical ten percent annual increase or decrease in the year-end average cost of our outstanding floating-rate debt would result in a change in annual pre-tax interest expense of approximately $0.2 million. Forward-Looking Statements This filing contains statements that the company believes are “forward-looking statements” within the meaning of the Private Securities Litigation Reform Act of 1995. Forward-looking statements generally can be identified by the use of words such as “may,” “will,” “expect,” “intend,” “estimate,” “anticipate,” “believe,” “forecast,” “guidance” or words of similar meaning. All forward-looking statements are subject to risks and uncertainties that could cause actual results to differ materially from those anticipated as of the date of this filing. Important factors that could cause actual results to differ materially from these expectations include, among other things, the following: a further slowdown in the growth rate of the Chinese economy; potential weakening in the high efficiency boiler segment in the U.S.; significant volatility in raw material prices; inability to implement or maintain pricing actions; potential weakening in U.S. residential or commercial construction or instability in the Company’s replacement markets; uncertain costs, savings and timeframes associated with the implementation of the new enterprises resources planning system; foreign currency fluctuations; the ability to execute our acquisition strategy; competitive pressures on the company’s businesses and adverse general economic conditions and capital market deterioration. Forward-looking statements included in this filing are made only as of the date of this release, and the company is under no obligation to update these statements to reflect subsequent events or circumstances. All subsequent written and oral forward-looking statements attributed to the company, or persons acting on its behalf, are qualified entirely by these cautionary statements.

<s>[INST] Our company is comprised of two reporting segments: North America and Rest of World. Our Rest of World segment is primarily comprised of China, Europe and India. Both segments manufacture and market comprehensive lines of residential and commercial gas, gas tankless and electric water heaters. Both segments primarily manufacture and market in their respective region of the world. Our North America segment also manufactures and globally markets specialty commercial water heating equipment, condensing and noncondensing boilers and water systems tanks. Primarily for Asia, our Rest of World segment also manufactures and markets water treatment products. We also market inhome air purification products in China. In 2015, our North America segment sales were $1,703.0 million and our Rest of World segment sales were $866.1 million. Sales of our products in China grew significantly in 2015, increasing 13.7 percent over 2014. Excluding the impact from the strengthening U.S. dollar, sales in China increased 16.1 percent in 2015. We expect sales in 2016 in China to grow at a rate of approximately 15 percent in local currency, as we believe overall water heater market growth, geographic expansion, market share gains, growth in water treatment products and air purification products and improved product mix will contribute to our growth. Price increases for residential and commercial water heaters and higher volumes of commercial water heaters and condensing commercial boilers contributed to 2015 sales increases in our North America segment. Partially offsetting these factors was a decline in residential water heater volumes in the U.S. The 13 percent decline in the value of the Canadian dollar against the U.S. dollar during 2015 also negatively impacted sales. We expect North America residential and commercial water heater industry unit to show modest growth in 2016. Lochinvarbranded products contributed $296.0 million to our net sales in 2015, and we expect ten percent sales growth of Lochinvarbranded products in 2016, driven by the U.S. industry transition to higher efficiency products and our introduction of new products; particularly condensing boilers. Approximately 40 percent of Lochinvarbranded product sales consist of residential and commercial water heaters while the remaining 60 percent of Lochinvarbranded product sales consist primarily of boilers and related parts. Our stated acquisition strategy includes a number of our waterrelated strategic initiatives. We will look to continue to grow our core residential and commercial water heating, boiler and water treatment businesses throughout the world. We will also continue to look for opportunities to add to our existing operations in the high growth regions of China and India demonstrated by our introduction of air purification products in China in 2015. Consistent with our stated strategy to expand our core product offering, we acquired Lochinvar in 2011. Lochinvar, one of the leading manufacturers of residential and commercial boilers in the U.S., fit squarely within our stated strategic growth initiative to expand our core water heating business. In 2013, approximately 40 percent of boilers sold in the U.S. were condensing boilers, compared with five percent in 2003. Our Lochinvar brand is a leading brand of higher efficiency, condensing boilers. We expect the transition in the U.S. to higher efficiency boilers will continue into the foreseeable future. RESULTS OF OPERATIONS Our sales in 2015 were a record $2,536.5 million surpassing 2014 sales of $2,356.0 million by 7.7 percent. Excluding the impact from the strengthening U.S. dollar against the Canadian and Chinese currencies, our sales grew over nine percent in 2015. The increase in sales was due to higher prices in North America, higher sales of Lochinvarbranded products and commercial water heaters in the U.S., as well as continued demand for our water heating and water treatment products in China. Sales in China grew 13.7 percent in 2015. Excluding the impact from the stronger U.S. dollar, China sales increased 16.1 percent in 2015. Our sales in 2014 were higher than 2013 sales [/INST] Positive. </s>

SMITH A O CORP

2017-02-17

2016-12-31

ITEM 7 - MANAGEMENT’S DISCUSSION AND ANALYSIS OF FINANCIAL CONDITION AND RESULTS OF OPERATIONS OVERVIEW Our company is comprised of two reporting segments: North America and Rest of World. Our Rest of World segment is primarily comprised of China, Europe and India. Both segments manufacture and market comprehensive lines of residential and commercial gas, gas tankless and electric water heaters, as well as water treatment products. Both segments primarily manufacture and market in their respective regions of the world. Our North America segment also manufactures and globally markets specialty commercial water heating equipment, condensing and non-condensing boilers and water systems tanks. Our Rest of World segment also manufactures and markets in-home air purification products in China. In 2016, our North America segment sales were $1,743.2 million and our Rest of World segment sales were $965.6 million. Sales of our products in China grew significantly in 2016, increasing 12.5 percent over 2015. Excluding the impact from the strengthening U.S. dollar, sales in China increased 18.9 percent in 2016. We expect sales in 2017 in China to grow at a rate of approximately 15 percent in local currency, as we believe overall water heater market growth, geographic expansion, market share gains, and growth in water treatment and air purification products will contribute to our growth. Price increases for residential and commercial water heaters and higher volumes of commercial water heaters and boilers contributed to 2016 sales increases in our North America segment. Partially offsetting these factors was a decline in residential water heater volumes in the U.S. We expect our North America residential and commercial water heater industry unit to show modest growth in 2017. Lochinvar-branded products contributed $300.6 million to our net sales in 2016, and we expect over eight percent sales growth of Lochinvar-branded products in 2017, driven by the continuing U.S. industry transition to higher efficiency products and our introduction of new products. Approximately 40 percent of Lochinvar-branded product sales consist of residential and commercial water heaters while the remaining 60 percent of Lochinvar-branded product sales consist primarily of boilers and related parts. Our stated acquisition strategy includes a number of our water-related strategic initiatives. We will look to continue to grow our core residential and commercial water heating, boiler and water treatment businesses throughout the world. We will also continue to look for opportunities to add to our existing operations in the high growth regions demonstrated by our introduction of air purification products in China and water treatment products in India and Vietnam in 2015. Consistent with our stated strategy to expand our core product offering, we acquired Aquasana, Inc. (Aquasana) in August 2016. Aquasana designs, assembles and markets premium performance water treatment products, including whole-house treatment systems, drinking water solutions for at home and on-the-go, and shower filters. Aquasana sells products primarily directly to U.S. consumers through e-commerce, as well as through retail outlets and distributors. With a three year compound annual revenue growth rate of 17 percent as of December 31, 2016, Aqausana fits squarely within our stated strategy to expand our core product offerings to new geographies that present growth opportunities. RESULTS OF OPERATIONS Our sales in 2016 were a record $2,685.9 million surpassing 2015 sales of $2,536.5 million by 5.9 percent. Excluding the impact from the appreciation of the U.S. dollar against the Chinese currency that occurred in 2016, our sales grew approximately eight percent in 2016. The increase in sales in 2016 was primarily due to higher sales in China of water heaters, residential air purification products, as well as 35 percent sales growth of A. O. Smith-branded water treatment products. Sales in China grew 12.5 percent in 2016, and excluding the impact of the appreciation of the U.S. dollar, sales in China increased 18.9 percent in 2016. Our sales in 2016 also benefitted from price increases in the U.S., higher volumes of U.S. boilers and commercial water heaters as well as $18.4 million of sales of Aquasana-branded water treatment products resulting from our acquisition of Aquasana in August 2016. These items more than offset lower volumes of U.S. residential water heaters. Our sales in 2015 were higher than 2014 sales of $2,356.0 million by 7.7 percent. The increase in sales in 2015 was attributable to higher prices in North America, higher sales of Lochinvar-branded products and commercial water heaters in the U.S. as well as strong demand for our water heating and water treatment products in China. Sales of water heaters and water treatment products in China grew 13.7 percent in 2015 compared to 2014. Sales of water heaters and water treatment products in China grew 16.1 percent in 2015 compared to 2014, excluding impact of the appreciation of the U.S. dollar in 2015. Our gross profit margin in 2016 increased to 41.7 percent from 39.8 percent in 2015. The higher margin in 2016 was due to price increases in the U.S., lower material costs in the first half of 2016 and higher sales of boilers and commercial water heaters in the U.S. Our gross profit margin in 2015 increased from 36.5 percent in 2014 primarily due to price increases in the U.S. and Canada, higher U.S. sales of commercial water heaters and boilers, lower steel costs and a reduction in pension-related costs. Selling, general and administrative (SG&A) expenses were $48.2 million higher in 2016 than in 2015. The increase in SG&A expenses in 2016 to $658.9 million was primarily due to higher selling costs supporting our sales efforts in tier 2 and tier 3 cities in China as well as higher advertising costs to support brand building in China. SG&A expenses were $38.6 million higher in 2015 than in 2014 primarily due to higher selling and engineering costs supporting increased volumes in China as well as higher costs associated with the 2015 launch of air purification products in China which more than offset lower pension costs in the U.S. Pension income in 2016 was $6.9 million compared to pension expense of $0.1 million in 2015 and $28.6 million in 2014. As of December 31, 2015, we changed to a more precise method to estimate the service cost and interest components of net periodic benefit cost for our pension and post-retirement plan. The change is the primary reason for the $7.1 million decrease in service and interest costs in 2016 compared to 2015. The significant decrease in pension expense in 2015 compared to 2014 was due to the sunset of our pension plan for the majority of our employees on December 31, 2014. In 2015, we began making additional Company contributions to a defined contribution plan in lieu of benefits earned in our pension plan. Interest expense was $7.3 million in 2016 compared to $7.4 million in 2015 and $5.7 million in 2014. The higher interest expense in 2015 compared to 2014 was primarily related to interest rates on term notes in the amount of $75 million issued in January 2015 that were higher than the interest rate on the revolving credit facility that it replaced as well as higher overall debt levels related to share repurchases. Other income was $9.4 million in 2016 compared to $10.8 million in 2015 and $5.2 million in 2014. The decrease in other income in 2016 compared to 2015 was primarily due to a decrease in interest income caused by lower interest rates in China in 2016. The increase in other income in 2015 compared to 2014 was primarily due to higher interest income resulting from a higher level of marketable securities during the year. Our effective tax rate was 29.4 percent in 2016, compared with 29.7 percent in 2015 and 27.5 percent in 2014. Our lower effective tax rate in 2016 compared to 2015 was primarily due to our adoption of a new accounting standard for share-based compensation that was partially offset by a change in geographic earnings mix. The higher effective tax rate in 2015 compared to 2014 was primarily due to a change in geographic earnings mix. North America Sales in our North America segment sales were $1,743.2 million in 2016 or $40.2 million higher than sales of $1,703.0 million in 2015. The sales increase in 2016 resulted from a full year of U.S. price increases for residential water heaters related to a regulatory change in April 2015, and an August 2016 price increase in the U.S. related to higher steel prices and other cost inflation. Sales in 2016 also benefitted from higher volumes of boilers and commercial water heaters in the U.S. as well as the addition of $18.4 million of sales of water treatment products resulting from our Aquasana acquisition. Lower volumes of U.S. residential water heaters partially offset these benefits. Sales in 2015 were $81.3 million higher than sales of $1,621.7 million in 2014. The sales increase in 2015 resulted from a price increase for residential water heaters in the U.S. due to a regulatory change in April 2015 and higher volumes of commercial water heaters and condensing commercial boilers in the U.S., partially offset by lower residential volumes in the U.S. and a decrease in the translated value of the Canadian dollar during 2015. North America operating earnings were $385.9 million in 2016 compared to operating earnings of $339.9 million and $238.7 million in 2015 and 2014, respectively. Operating margins were 22.1 percent, 20.0 percent and 14.7 percent in 2016, 2015 and 2014, respectively. The higher operating earnings and operating margin in 2016 compared to 2015 were primarily due to pricing actions in the U.S., lower material costs in the first half of 2016 and higher boiler and commercial water heater volumes in the U.S. that were partially offset by lower U.S. residential water heater volumes. The significantly higher operating earnings and operating margin in 2015 compared to 2014 were primarily due to higher prices in the U.S. and Canada, higher sales of Lochinvar-branded products and commercial water heaters in the U.S., lower steel costs and lower pension costs which more than offset lower residential water heater volumes in the U.S. We expect North America operating margin to be between 21.5 and 22.25 percent in 2017, despite the headwind from lower Aquasana margins of almost 50 basis points. Rest of World Sales in our Rest of World segment in 2016 were $965.6 million or $99.5 million higher than sales of $866.1 million in 2015. Sales in China grew 12.5 percent in 2016. Excluding the impact from the appreciation of the U.S. dollar in 2016, sales in China increased 18.9 percent in 2016 driven by higher demand for water heaters, water treatment products and residential air purification products. A. O. Smith-branded water treatment sales in China totaled $148 million in 2016 compared to $110 million in 2015. Sales of in-home air purification products were $26 million in 2016 compared to $9 million in 2015. Sales in 2015 were $97.8 million higher than sales of $768.3 million in 2014 due to higher demand for water heaters, approximately $35 million of incremental sales of water treatment products and approximately $9 million in sales of our newly launched in-home air purification products. Sales in China grew 13.7 percent in 2015. Excluding the impact from the appreciation of the U.S. dollar in 2015, sales in China increased 16.1 percent in 2015. Rest of World operating earnings were $129.1 million in 2016 compared to operating earnings of $113.0 million and $106.7 million in 2015 and 2014, respectively. Segment operating margins were 13.4 percent in 2016 compared to 13.0 percent and 13.9 percent in 2015 and 2014, respectively. Higher operating earnings and operating margin in 2016 compared to 2015 were primarily due to higher sales in China that were partially offset by increased SG&A expenses in China. Higher selling costs in China to support our sales efforts in tier 2 and tier 3 cities and higher advertising costs to support brand building were the primary drivers of higher SG&A expenses. Operating earnings in 2016 were also negatively impacted by almost $8 million due to the appreciation of the U.S. dollar in 2016. Higher operating earnings in 2015 were primarily due to higher sales in China and lower steel costs that were partially offset by lower sales of highly profitable commercial water heaters in China, increased SG&A expenses and approximately $1.5 million of higher losses in India compared to 2014. Earnings in China were reduced by approximately $2.5 million due to the appreciation of the U.S. dollar in 2015. Higher selling and engineering costs in China as well as higher SG&A costs associated with the 2015 launch of air purification products were the primary drivers for decreased operating margins in 2015 as compared to 2014. We expect 2017 operating margin to exceed 14 percent. LIQUIDITY AND CAPITAL RESOURCES Our working capital was $796.4 million at December 31, 2016 compared with $750.1 million and $713.8 million at December 31, 2015 and December 31, 2014, respectively. Cash generated in China and sales-related increases in accounts receivable, inventory and accounts payable levels explain the majority of the increase in 2016 and 2015. As of December 31, 2016, essentially all of our $754.6 million of cash, cash equivalents and marketable securities were held by our foreign subsidiaries. We would incur a cost to repatriate these funds to the U.S. and have an accrual of $42.3 million for the repatriation of a portion of these funds. Cash provided by operating activities during 2016 was $446.6 million compared with $351.7 million during 2015 and $264.0 million during 2014. The increase in cash flows in 2016 was primarily due to higher earnings from operations and lower outlays for working capital. We experienced a series of favorable cash flow impacts in China in the fourth quarter of 2016, including: • A decline in accounts receivable balances from the prior year-end, despite higher fourth quarter sales in 2016. We received a series of unanticipated large customer payments late in the fourth quarter of 2016 and benefitted from improved terms with a few customers, all resulting in lower accounts receivable balances; • An increase in trade payable balances most notably due to higher inventory in advance of the spring festival occurring in China in the last week in January; and • Higher receipts of cash in advance of sales from distribution customers. The improvement in cash flows in 2015 was primarily due to higher earnings from operations and lower outlays for working capital driven primarily by increases in accounts payable balances in China. We expect cash provided by operating activities in 2017 to be approximately $350 million. We expect higher earnings in 2017 to be more than offset by larger outlays for working capital due to the higher than anticipated cash flows in the fourth quarter of 2016. Over the two-year period from 2016 to 2017, we expect to generate operating cash of approximately $800 million, which compares with $616 million of operating cash flows during 2014 to 2015. Our capital expenditures were $80.7 million in 2016, $72.7 million in 2015 and $86.1 million in 2014. We broke ground in 2016 on the construction of a new water treatment and air purification products manufacturing facility in Nanjing, China, to support the expected growth of these products in China. Included in 2016 capital expenditures were approximately $13 million related to capacity expansion in China as well as approximately $11 million related to our enterprise resource planning (ERP) system implementation. Included in 2015 capital expenditures were approximately $16 million related to our ERP implementation and approximately $19 million related to capacity expansion in China and the U.S. to support growth. Included in 2014 capital expenditures was approximately $31 million related to our ERP implementation. We project between $90 and $100 million of capital expenditures in 2017 and depreciation and amortization expense of approximately $70 million. We expect our spending on the manufacturing facility in Nanjing will be approximately $40 million in 2017. In December 2016, we completed a $500 million multi-currency five year revolving credit facility with a group of nine banks. The facility has an accordion provision which allows it to be increased up to $700 million if certain conditions (including lender approval) are satisfied. Borrowing rates under the facility are determined by our leverage ratio. The facility requires us to maintain two financial covenants, a leverage ratio test and an interest coverage test, and we were in compliance with the covenants as of December 31, 2016. The facility backs up commercial paper and credit line borrowings, and it expires on December 15, 2021. As a result of the long-term nature of this facility, the commercial paper and credit line borrowings, as well as drawings under the facility are classified as long-term debt. In November 2016, we issued $45 million of fixed rate term notes in two tranches to two insurance companies. Principal payments commence in 2023 and 2028 and the notes mature in 2029 and 2034, respectively. The notes carry interest rates of 2.87 and 3.10, respectively. We used proceeds of the notes to pay down borrowings under our revolving credit facility. In January 2015, we issued $75 million of fixed rate term notes to an insurance company. Principal payments commence in 2020 and the notes mature in 2030. The notes carry an interest rate of 3.52 percent. We used proceeds of the notes to pay down borrowings under our revolving credit facility. At December 31, 2016, we had available borrowing capacity of $310.8 million under this facility. We believe that the combination of cash, available borrowing capacity and operating cash flow will provide sufficient funds to finance our existing operations for the foreseeable future. Our total debt increased to $323.6 million at December 31, 2016 compared with $249.0 million at December 31, 2015, as our cash flows generated in the U.S were more than offset by our share repurchase activity and our purchase of Aquasana. As a result, our leverage, as measured by the ratio of total debt to total capitalization, was 17.6 percent at the end of 2016 compared with 14.7 percent at the end of 2015. Our U.S. pension plan continues to meet all funding requirements under ERISA regulations. We were not required to make a contribution to our pension plan in 2016 but made a voluntary $30 million contribution due to escalating Pension Benefit Guaranty Corporation insurance premiums. We forecast that we will not be required to make a contribution to the plan in 2017 and we do not plan to make any voluntary contributions in 2017. For further information on our pension plans, see Note 10 of the Notes to Consolidated Financial Statements. During 2016, our Board of Directors authorized the purchase of an additional 3,000,000 shares of our Common Stock. In 2016, we repurchased 3,273,109 shares at an average price of $41.30 per share and a total cost of $135.2 million. A total of 4,906,403 shares remained on the existing repurchase authorization at December 31, 2016. Depending on factors such as stock price, working capital requirements and alternative investment opportunities, such as acquisitions, we expect to spend approximately $135 million on share repurchase activity in 2017 using a 10b5-1 repurchase plan. In addition, we may opportunistically repurchase an additional $65 million of our shares in 2017. We have paid dividends for 77 consecutive years with payments increasing each of the last 25 years. We paid dividends of $0.48 per share in 2016 compared with $0.38 per share in 2015. In January 2017, we increased our dividend by 17 percent and anticipate paying dividends of $0.56 per share in 2017. Aggregate Contractual Obligations A summary of our contractual obligations as of December 31, 2016, is as follows: As of December 31, 2016, our liability for uncertain income tax positions was $4.2 million. Due to the high degree of uncertainty regarding timing of potential future cash flows associated with these liabilities, we are unable to make a reasonably reliable estimate of the amount and period in which these liabilities might be paid. We utilize blanket purchase orders to communicate expected annual requirements to many of our suppliers. Requirements under blanket purchase orders generally do not become committed until several weeks prior to our scheduled unit production. The purchase obligation amount presented above represents the value of commitments that we consider firm. Recent Accounting Pronouncements Refer to Recent Accounting Pronouncements in Note 1 of Notes to Consolidated Financial Statements. Critical Accounting Policies Our accounting policies are described in Note 1 of Notes to Consolidated Financial Statements. Also as disclosed in Note 1, the preparation of financial statements in conformity with accounting principles generally accepted in the U.S. requires the use of estimates and assumptions about future events that affect the amounts reported in the financial statements and accompanying notes. Future events and their effects cannot be determined with absolute certainty. Therefore, the determination of estimates requires the exercise of judgment. Actual results inevitably will differ from those estimates, and such differences may be material to the financial statements. The most significant accounting estimates inherent in the preparation of our financial statements include estimates associated with the evaluation of the impairment of goodwill and indefinite-lived intangible assets, as well as significant estimates used in the determination of liabilities related to warranty activity, product liability and pensions. Various assumptions and other factors underlie the determination of these significant estimates. The process of determining significant estimates is fact-specific and takes into account factors such as historical experience and trends, and in some cases, actuarial techniques. We monitor these significant factors and adjustments are made as facts and circumstances dictate. Historically, actual results have not significantly deviated from those determined using the estimates described above. Goodwill and Indefinite-lived Intangible Assets In conformity with U.S. Generally Accepted Accounting Principles, goodwill and indefinite-lived intangible assets are tested for impairment annually or more frequently if events or changes in circumstances indicate that the assets might be impaired. We perform impairment reviews for our reporting units using a fair-value method based on management’s judgments and assumptions. The fair value represents the estimated amount at which a reporting unit could be bought or sold in a current transaction between willing parties on an arm’s-length basis. The estimated fair value is then compared with the carrying amount of the reporting unit, including recorded goodwill. We are subject to financial statement risk to the extent that goodwill and indefinite-lived intangible assets become impaired. Any impairment review is, by its nature, highly judgmental as estimates of future sales, earnings and cash flows are utilized to determine fair values. However, we believe that we conduct annual thorough and competent valuations of goodwill and indefinite-lived intangible assets and that there has been no impairment in goodwill or indefinite-lived assets in 2016. Product warranty Our products carry warranties that generally range from one to ten years and are based on terms that are generally accepted in the market. We provide for the estimated cost of product warranty at the time of sale. The product warranty provision is estimated based upon warranty loss experience using actual historical failure rates and estimated costs of product replacement. The variables used in the calculation of the provision are reviewed at least annually. At times, warranty issues may arise which are beyond the scope of our historical experience. We provide for any such warranty issues as they become known and estimable. While our warranty costs have historically been within calculated estimates, it is possible that future warranty costs could differ significantly from those estimates. The allocation of the warranty liability between current and long-term is based on the expected warranty liability to be paid in the next year as determined by historical product failure rates. At December 31, 2016, our reserve for product warranties was $140.9 million. Product liability Due to the nature of our products, we are subject to product liability claims in the normal course of business. We maintain insurance to reduce our risk. Most insurance coverage includes self-insured retentions that vary by year. In 2016, we maintained a self-insured retention of $7.5 million per occurrence with an aggregate insurance limit of $125.0 million. We establish product liability reserves for our self-insured retention portion of any known outstanding matters based on the likelihood of loss and our ability to reasonably estimate such loss. There is inherent uncertainty as to the eventual resolution of unsettled matters due to the unpredictable nature of litigation. We make estimates based on available information and our best judgment after consultation with appropriate advisors and experts. We periodically revise estimates based upon changes to facts or circumstances. We also utilize an actuary to calculate reserves required for estimated incurred but not reported claims as well as to estimate the effect of adverse development of claims over time. At December 31, 2016, our reserve for product liability was $38.6 million. Pensions We have significant pension benefit costs that are developed from actuarial valuations. The valuations reflect key assumptions regarding, among other things, discount rates, expected return on plan assets, retirement ages, and years of service. Consideration is given to current market conditions, including changes in interest rates in making these assumptions. Our assumption for the expected return on plan assets was 7.50 percent in 2016 compared to 7.75 percent in 2015. The discount rate used to determine net periodic pension costs increased to 4.40 percent in 2016 from 4.05 percent in 2015. For 2017, our expected return on plan assets is 7.50 percent and our discount rate is 4.15 percent. In developing our expected return on plan assets, we evaluate our pension plan’s current and target asset allocation, the expected long-term rates of return of equity and bond indices and the actual historical returns of our pension plan. Our plan’s target allocation to equity managers is approximately 45 to 55 percent, with the remainder allocated primarily to bond managers, private equity managers and real estate managers. Our actual asset allocation as of December 31, 2016, was 48 percent to equity managers, 37 percent to bond managers, ten percent to real estate managers, four percent to private equity managers and one percent to others. We regularly review our actual asset allocation and periodically rebalance our investments to our targeted allocation when considered appropriate. Our pension plan’s historical ten-year and 25-year compounded annualized returns are 5.7 percent and 9.0 percent, respectively. We believe that with our target allocation and the expected long-term returns of equity and bond indices as well as our actual historical returns, our 7.50 percent expected return on plan assets for 2017 is reasonable. The discount rate assumptions used to determine future pension obligations at December 31, 2016 and 2015 were based on the AonHewitt AA Only Above Median yield curve, which was designed by AonHewitt to provide a means for plan sponsors to value the liabilities of their postretirement benefit plans. The AA Only Above Median yield curve represents a series of annual discount rates from bonds with AA minimum average rating as rated by Moody’s Investor Service, Standard &Poor’s and Fitch Ratings. We will continue to evaluate our actuarial assumptions at least annually, and we will adjust the assumptions as necessary. As of December 31, 2015, we changed the method we used to estimate the service and interest components of net periodic pension benefit cost for our pension plan and post-retirement benefit plan. The change was the primary reason for the $7.1 million decrease in the service and interest components of pension costs in 2016. As a result, we recognized pension income of $6.9 million in 2016 compared to $0.1 million of pension expense in 2015. Costs associated with our replacement retirement plan in 2016 were approximately $6 million, consistent with 2015. We made changes to our pension plan including closing the plan to new entrants effective January 1, 2010, and the sunset of our plan for the majority of our employees on December 31, 2014 which significantly decreased pension expense beginning in 2015. Lowering the expected return on plan assets by 25 basis points would increase our net pension expense for 2017 by approximately $1.9 million. Lowering the discount rate by 25 basis points would decrease our 2017 net pension expense by approximately $0.3 million. Outlook We expect our sales in China will continue to grow at a rate of approximately 15 percent in local currency terms in 2017 led by continued strong sales growth of water heaters, water treatment and air purification products. We project continued declines in the Chinese currency compared to the U.S. dollar resulting in a five percent, or $40 million, headwind in 2017 sales, compared with the average rate in 2016. We expect our sales in the U.S. to grow due to residential water heater industry growth, driven by new construction and expansion of replacement demand, as well as continued growth in sales of our boilers and water treatment products. We expect sales of Lochinvar-branded products to grow over eight percent. We expect sales of Aquasana-branded water treatment products will add an incremental $40 million of sales in 2017. We expect steel prices to continue to be volatile and to be significantly higher than our average cost in 2016. We expect our effective tax rate to be between 29.4 percent and 29.7 percent assuming the current U.S. tax system remains in place. Combining all these factors, we expect sales growth of between eight and 9.5 percent in 2017 and sales growth of between 9.5 and 11 percent measured in local currency in 2017 and earnings to be in the range of $1.98 to $2.08 per share for 2017. This does not include the potential impact of future acquisitions. OTHER MATTERS Environmental Our operations are governed by a number of federal, foreign, state, local and environmental laws concerning the generation and management of hazardous materials, the discharge of pollutants into the environment and remediation of sites owned by the company or third parties. We have expended financial and managerial resources complying with such laws. Expenditures related to environmental matters were not material in 2016 and we do not expect them to be material in any single year. We have reserves associated with environmental obligations at various facilities and we believe these reserves are sufficient to cover reasonably anticipated remediation costs. Although we believe that our operations are substantially in compliance with such laws and maintain procedures designed to maintain compliance, there are no assurances that substantial additional costs for compliance will not be incurred in the future. However, since the same laws govern our competitors, we should not be placed at a competitive disadvantage. Market Risk We are exposed to various types of market risks, primarily currency. We monitor our risks in such areas on a continuous basis and generally enter into forward contracts to minimize such exposures for periods of less than one year. We do not engage in speculation in our derivatives strategies. Further discussion regarding derivative instruments is contained in Note 1 of Notes to Consolidated Financial Statements. We enter into foreign currency forward contracts to minimize the effect of fluctuating foreign currencies. At December 31, 2016, we had net foreign currency contracts outstanding of $102.2 million. Assuming a hypothetical ten percent movement in the respective currencies, the potential foreign exchange gain or loss associated with the change in exchange rates would amount to $10.2 million. However, gains and losses from our forward contracts will be offset by gains and losses in the underlying transactions being hedged. Our earnings exposure related to movements in interest rates is primarily derived from outstanding floating-rate debt instruments that are determined by short-term money market rates. At December 31, 2016, we had $189.2 million in outstanding floating-rate debt with a weighted-average interest rate of 1.5 percent at year end. A hypothetical ten percent annual increase or decrease in the year-end average cost of our outstanding floating-rate debt would result in a change in annual pre-tax interest expense of approximately $0.3 million. Forward-Looking Statements This filing contains statements that the company believes are “forward-looking statements” within the meaning of the Private Securities Litigation Reform Act of 1995. Forward-looking statements generally can be identified by the use of words such as “may,” “will,” “expect,” “intend,” “estimate,” “anticipate,” “believe,” “forecast,” “guidance” or words of similar meaning. All forward-looking statements are subject to risks and uncertainties that could cause actual results to differ materially from those anticipated as of the date of this filing. Important factors that could cause actual results to differ materially from these expectations include, among other things, the following: a further slowdown in the growth rate of the Chinese economy and/or a decline in the growth rate of consumer spending in China; potential weakening in the high efficiency boiler segment in the U.S.; significant volatility in raw material prices; inability of the Company to implement or maintain pricing actions; potential weakening in U.S. residential or commercial construction or instability in the Company’s replacement markets; uncertain costs, savings and timeframes associated with the Company’s new enterprises resources planning system; foreign currency fluctuations; the Company’s ability to execute its acquisition strategy; competitive pressures on the company’s businesses; the impact of potential information technology or data security breaches; changes in government regulations or regulatory requirements; and adverse developments in general economic, political and business conditions in key regions of the world. Forward-looking statements included in this filing are made only as of the date of this release, and the company is under no obligation to update these statements to reflect subsequent events or circumstances. All subsequent written and oral forward-looking statements attributed to the company, or persons acting on its behalf, are qualified entirely by these cautionary statements.

<s>[INST] Our company is comprised of two reporting segments: North America and Rest of World. Our Rest of World segment is primarily comprised of China, Europe and India. Both segments manufacture and market comprehensive lines of residential and commercial gas, gas tankless and electric water heaters, as well as water treatment products. Both segments primarily manufacture and market in their respective regions of the world. Our North America segment also manufactures and globally markets specialty commercial water heating equipment, condensing and noncondensing boilers and water systems tanks. Our Rest of World segment also manufactures and markets inhome air purification products in China. In 2016, our North America segment sales were $1,743.2 million and our Rest of World segment sales were $965.6 million. Sales of our products in China grew significantly in 2016, increasing 12.5 percent over 2015. Excluding the impact from the strengthening U.S. dollar, sales in China increased 18.9 percent in 2016. We expect sales in 2017 in China to grow at a rate of approximately 15 percent in local currency, as we believe overall water heater market growth, geographic expansion, market share gains, and growth in water treatment and air purification products will contribute to our growth. Price increases for residential and commercial water heaters and higher volumes of commercial water heaters and boilers contributed to 2016 sales increases in our North America segment. Partially offsetting these factors was a decline in residential water heater volumes in the U.S. We expect our North America residential and commercial water heater industry unit to show modest growth in 2017. Lochinvarbranded products contributed $300.6 million to our net sales in 2016, and we expect over eight percent sales growth of Lochinvarbranded products in 2017, driven by the continuing U.S. industry transition to higher efficiency products and our introduction of new products. Approximately 40 percent of Lochinvarbranded product sales consist of residential and commercial water heaters while the remaining 60 percent of Lochinvarbranded product sales consist primarily of boilers and related parts. Our stated acquisition strategy includes a number of our waterrelated strategic initiatives. We will look to continue to grow our core residential and commercial water heating, boiler and water treatment businesses throughout the world. We will also continue to look for opportunities to add to our existing operations in the high growth regions demonstrated by our introduction of air purification products in China and water treatment products in India and Vietnam in 2015. Consistent with our stated strategy to expand our core product offering, we acquired Aquasana, Inc. (Aquasana) in August 2016. Aquasana designs, assembles and markets premium performance water treatment products, including wholehouse treatment systems, drinking water solutions for at home and onthego, and shower filters. Aquasana sells products primarily directly to U.S. consumers through ecommerce, as well as through retail outlets and distributors. With a three year compound annual revenue growth rate of 17 percent as of December 31, 2016, Aqausana fits squarely within our stated strategy to expand our core product offerings to new geographies that present growth opportunities. RESULTS OF OPERATIONS Our sales in 2016 were a record $2,685.9 million surpassing 2015 sales of $2,536.5 million by 5.9 percent. Excluding the impact from the appreciation of the U.S. dollar against the Chinese currency that occurred in 2016, our sales grew approximately eight percent in 2016. The increase in sales in 2016 was primarily due to higher sales in China of water heaters, residential air purification products, as well as 35 percent sales growth of A. O. Smithbranded water treatment products. Sales in China grew 12.5 percent in 2016, and excluding the impact of the appreciation of the U.S. dollar, sales in China increased 18.9 percent in 2016. Our sales in 2016 also benefitted from price increases in the U.S., higher volumes of U.S. boilers and commercial water heaters as well as $18.4 million of sales [/INST] Positive. </s>

SMITH A O CORP

2018-02-16

2017-12-31

ITEM 7 - MANAGEMENT’S DISCUSSION AND ANALYSIS OF FINANCIAL CONDITION AND RESULTS OF OPERATIONS OVERVIEW Our company is comprised of two reporting segments: North America and Rest of World. Our Rest of World segment is primarily comprised of China, Europe and India. Both segments manufacture and market comprehensive lines of residential and commercial gas and electric water heaters, boilers and water treatment products. Both segments primarily manufacture and market in their respective regions of the world. Our North America segment also manufactures and markets water systems tanks. Our Rest of World segment also manufactures and markets in-home air purification products in China. In our North America segment, we project our sales in the U.S. will grow in 2018 compared to 2017 due to higher residential water heater and boiler volumes resulting from expected industry-wide new construction growth and expansion of replacement demand. We expect the North America residential water heater industry to have three to 3.5 percent unit growth in 2018. Due to nearly 20 percent unit growth in 2017, partially driven by an anticipated 2018 regulatory change and resulting pre-buy, we expect the North America commercial water heater industry to have a three percent unit decline in 2018. Our sales of boilers grew 13 percent in 2017, and we expect ten percent sales growth in 2018, driven by the continuing U.S. industry transition to higher efficiency products and our introduction of new products. We continued to expand our North America water treatment platform with the acquisition of Hague on September 5, 2017. We expect sales of North America water treatment products to increase by approximately 50 percent in 2018, compared to 2017, primarily due to volume growth and a full year of Hague sales. In our Rest of World segment, we expect China sales to grow in 2018 at a rate of approximately 13 percent, as we believe overall water heater market growth, geographic expansion, market share gains, and growth in water treatment and air purification products will contribute to our growth. In addition, we expect our sales in India to grow over 40 percent in 2018 from approximately $26 million in 2017. Combining all of these factors, we expect total company sales growth of between 8.5 percent to 9.5 percent in 2018. Our stated acquisition strategy includes a number of our water-related strategic initiatives. We will look to continue to grow our core residential and commercial water heating, boiler and water treatment businesses throughout the world. We will also continue to look for opportunities to add to our existing operations in high growth regions demonstrated by our introduction in 2015 of air purification products in China and water treatment products in India and Vietnam. RESULTS OF OPERATIONS Our sales in 2017 were a company record $2,997 million surpassing 2016 sales of $2,686 million by 11.6 percent. The increase in sales in 2017 was primarily due to higher sales in China as well as higher sales of water heaters and boilers in North America. Sales in China grew 15.9 percent to over $1 billion in 2017, and excluding the impact of the appreciation of the U.S. dollar, sales in China increased 17.9 percent in 2017. Our sales in 2016 were higher than 2015 sales of $2,537 million by 5.9 percent. In 2016, excluding the impact from the appreciation of the U.S. dollar against the Chinese currency, our sales grew approximately eight percent. Sales in China grew 12.5 percent in 2016, and excluding the impact of the appreciation of the U.S. dollar, sales in China increased by 18.9 percent in 2016. Our gross profit margin in 2017 decreased to 41.3 percent from 41.7 percent in 2016. The slightly lower margin in 2017 was due to significantly higher steel costs that more than offset pricing actions taken in 2017 in North America and China. Our gross profit margin in 2016 increased from 39.8 percent in 2015 primarily due to price increases in the U.S., lower material costs in the first half of 2016 and higher sales of boilers and commercial water heaters in the U.S. than in 2015. Selling, general and administrative (SG&A) expenses were $59.3 million higher in 2017 than in 2016. The increase in SG&A expenses in 2017 to $718.2 million was primarily due to higher selling and advertising expenses to support increased volumes and brand building in our newer product categories. SG&A expenses were $48.2 million higher in 2016 than in 2015 primarily due to higher selling costs supporting our sales efforts in tier 2 and tier 3 cities in China as well as higher advertising costs to support brand building in China. Pension income in 2017 was $9.1 million compared to $6.9 million in 2016 and $0.1 million of pension expense in 2015. As of December 31, 2015, we changed to what we believe is a more precise method to estimate the service cost and interest components of net periodic benefit cost for our pension and post-retirement plans. The change was the reason for $7.7 million and $7.1 million of decreases in 2017 and 2016, respectively, compared to 2015, in service and interest costs. Interest expense was $10.1 million in 2017 compared to $7.3 million in 2016 and $7.4 million in 2015. The higher interest expense in 2017 compared to 2016 was primarily related to higher interest rates as well as higher overall debt levels primarily due to increased share repurchases and acquisitions completed in 2016 and 2017. Other income was $10.4 million in 2017 compared to $9.4 million in 2016 and $10.8 million in 2015. The increase in other income in 2017 compared to 2016 was primarily due to higher interest income. The decrease in other income in 2016 compared to 2015 was primarily due to a decrease in interest income caused by lower interest rates in China in 2016. Our effective income tax rate was 43.1 percent in 2017, compared with 29.4 percent in 2016 and 29.7 percent in 2015. The significant increase in our effective income tax rate in 2017 compared to previous years was due to provisional one-time charges associated with the U.S. Tax Cuts & Jobs Act (U.S. Tax Reform) of $81.8 million, primarily related to the mandatory repatriation tax on undistributed foreign earnings that we are required to pay over eight years. Excluding the impact of the U.S. Tax Reform provisional one-time charges, our adjusted effective income tax rate was 27.4 percent in 2017. Our adjusted effective income tax rate in 2017 was lower than our effective income tax rate in 2016 primarily due to lower U.S. state income taxes and higher deductions for share-based compensation. Our lower effective income tax rate in 2016 compared to 2015 was primarily due to our adoption of an accounting standard for share-based compensation partially offset by a change in geographic earnings mix. We estimate our annual effective income tax rate for the full year 2018 will be approximately 22.0 to 22.5 percent, significantly lower than previous years due to U.S. Tax Reform. North America Sales in our North America segment were $1,905 million in 2017 or $162 million higher than sales of $1,743 million in 2016. The increase in sales in 2017 compared to 2016 was primarily due to higher volumes of water heaters and boilers, price increases in the U.S. for water heaters largely related to steel cost increases as well as our customer’s pre-buy of commercial water heaters in advance of an anticipated 2018 regulatory change. North America water treatment sales, comprised of Hague, acquired in September 2017 and Aquasana, acquired in August 2016, incrementally added approximately $40 million of sales in 2017. Sales in 2016 were $40 million higher than sales of $1,703 million in 2015. The sales increase in 2016 resulted from a full year of U.S. price increases for residential water heaters related to a regulatory change in April 2015, and a 2016 price increase in the U.S. related to higher steel prices and other cost inflation. Sales in 2016 also benefitted from higher volumes of boilers and commercial water heaters in the U.S. as well as the addition of $18.4 million of sales of water treatment products resulting from our Aquasana acquisition. Lower volumes of U.S. residential water heaters in 2016 compared to 2015 offset these benefits. North America segment earnings were $428.6 million in 2017 compared to segment earnings of $385.9 million and $339.9 million in 2016 and 2015, respectively. Segment margins were 22.5 percent, 22.1 percent and 20.0 percent in 2017, 2016 and 2015, respectively. The higher segment earnings and segment margin in 2017 compared to 2016 were primarily due to higher water heater and boiler volumes and pricing actions which were partially offset by higher steel costs. Segment margin in 2017 also benefitted from lower SG&A expenses as a percent of sales. The higher segment earnings and segment margin in 2016 compared to 2015 were primarily due to pricing actions in the U.S., lower material costs in the first half of 2016 and higher boiler and commercial water heater volumes in the U.S., which were partially offset by lower U.S. residential water heater volumes. We estimate our 2018 North America segment margin will be between 22 and 22.5 percent primarily due to anticipated growth in boiler and residential water heater volumes offset by higher steel costs. Rest of World Sales in our Rest of World segment in 2017 were $1,116 million or $150 million higher than sales of $966 million in 2016. Sales in China grew 15.9 percent to over $1 billion in 2017 due to higher demand for our consumer products, led by water treatment and air purification products and pricing actions primarily due to higher steel and installation costs. Excluding the impact from the appreciation of the U.S. dollar in 2017, sales in China increased 17.9 percent. Water heater and water treatment sales in India increased $8 million, over 40 percent, in 2017 compared to 2016. Sales in our Rest of World segment in 2016 were $100 million higher than sales of $866 million in 2015. Sales in China grew 12.5 percent in 2016. Excluding the impact from the appreciation of the U.S. dollar in 2016, sales in China increased 18.9 percent in 2016 driven by higher demand for water heaters, water treatment products and residential air purification products. Water treatment sales in China totaled $177 million in 2016 compared to $130 million in 2015. Sales of air purification products were $26 million in 2016 compared to $9 million in 2015. Rest of World segment earnings were $149.3 million in 2017 compared to segment earnings of $129.1 million and $113.0 million in 2016 and 2015, respectively. Segment margins were 13.4 percent in 2017 compared to 13.4 percent and 13.0 percent in 2016 and 2015, respectively. Higher segment earnings in 2017 compared to 2016 were primarily due to higher sales in China, which included a price increase, partially offset by higher steel costs, higher fees paid to installers and increased SG&A expenses. Higher SG&A expenses in China were primarily due to the expansion of water treatment and air purification product retail outlets in tier 2 and tier 3 cities, higher advertising expenses related to brand building in our newer product categories and higher water treatment product development engineering costs. Higher segment earnings and segment margin in 2016 compared to 2015 were primarily due to higher sales in China partially offset by increased SG&A expenses in China. Higher selling costs in China to support our sales efforts in tier 2 and tier 3 cities and higher advertising costs to support brand building were the primary drivers of higher SG&A expenses in 2016. Operating earnings in 2016 were also negatively impacted by almost $8 million due to the appreciation of the U.S. dollar in 2016. We expect 2018 Rest of World segment margin to expand 30 to 40 basis points compared to 2017. LIQUIDITY AND CAPITAL RESOURCES Our working capital was $978.3 million at December 31, 2017 compared with $796.4 million and $750.1 million at December 31, 2016 and December 31, 2015, respectively. Cash generation in China and sales-related increases in accounts receivable, and inventory levels explain the majority of the increase in 2017 and 2016. As of December 31, 2017, essentially all of our $820.0 million of cash, cash equivalents and marketable securities were held by our foreign subsidiaries. In December 2017, we recorded provisional one-time charges of $81.8 million primarily associated with the mandatory repatriation tax of undistributed foreign earnings under U.S. Tax Reform. In addition, we had an existing accrual of $38.6 million associated with withholding taxes due upon issuance of foreign dividends. We expect to repatriate approximately $200 million in the first half of 2018 and use the proceeds to repay floating rate debt. Cash provided by operating activities during 2017 was $326.4 million compared with $446.6 million during 2016 and $351.7 million during 2015. The decline in cash flows in 2017 compared to 2016 was primarily due to higher outlays for working capital than the below normal levels experienced in 2016, which more than offset the impact of higher earnings in 2017. The increase in cash flows in 2016 compared to 2015 was primarily due to higher earnings from operations and lower outlays for working capital. We experienced favorable cash flow impacts in China late in the fourth quarter of 2016 primarily from a series of unanticipated large customer payments including customer deposits. Over the two-year period from 2016 to 2017, we generated operating cash of approximately $773 million, which compares with $616 million of operating cash flows during 2014 to 2015. We anticipate cash provided by operating activities to be $475 to $500 million in 2018, compared to $326 million in 2017, due to higher projected earnings and lower outlays for working capital, particularly inventory. Our capital expenditures were $94.2 million in 2017, $80.7 million in 2016 and $72.7 million in 2015. We broke ground in 2016 on the construction of a new water treatment and air purification products manufacturing facility in Nanjing, China, to support the expected growth of these products in China. Included in 2017 capital expenditures were approximately $24 million related to capacity expansion in China. Included in 2016 capital expenditures were approximately $13 million related to capacity expansion in China as well as approximately $11 million related to the continuation of our enterprise resource planning (ERP) system implementation. Included in 2015 capital expenditures were approximately $16 million related to our ERP implementation and approximately $19 million related to capacity expansion in China and the U.S. to support growth. We project approximately $100 million of capital expenditures in 2018, which includes approximately $30 million related to the completion of capacity expansion in China. We project depreciation and amortization expense of approximately $80 million in 2018. In January 2015, we issued $75 million of fixed rate term notes to an insurance company. Principal payments commence in 2020 and the notes mature in 2030. The notes carry an interest rate of 3.52 percent. We used proceeds of the notes to pay down borrowings under our revolving credit facility. In November 2016, we issued $45 million of fixed rate term notes in two tranches to two insurance companies. Principal payments commence in 2023 and 2028 and the notes mature in 2029 and 2034, respectively. The notes carry interest rates of 2.87 and 3.10, respectively. We used proceeds of the notes to pay down borrowings under our revolving credit facility. In December 2016, we completed a $500 million multi-currency five year revolving credit facility with a group of nine banks. The facility has an accordion provision which allows it to be increased up to $700 million if certain conditions (including lender approval) are satisfied. Borrowing rates under the facility are determined by our leverage ratio. The facility requires us to maintain two financial covenants, a leverage ratio test and an interest coverage test, and we were in compliance with the covenants as of December 31, 2017. The facility backs up commercial paper and credit line borrowings, and it expires on December 15, 2021. As a result of the long-term nature of this facility, the commercial paper and credit line borrowings, as well as drawings under the facility are classified as long-term debt. At December 31, 2017, we had available borrowing capacity of $217.1 million under this facility. We believe that our combination of cash, available borrowing capacity and operating cash flow will provide sufficient funds to finance our existing operations for the foreseeable future. Our total debt increased to $410.4 million at December 31, 2017 compared with $323.6 million at December 31, 2016, as our cash flows generated in the U.S were more than offset by our share repurchase activity and our acquisition of Hague. As a result, our leverage, as measured by the ratio of total debt to total capitalization, was 19.9 percent at the end of 2017 compared with 17.6 percent at the end of 2016. Our U.S. pension plan continues to meet all funding requirements under ERISA regulations. We were not required to make a contribution to our pension plan in 2017 but made a voluntary $30 million contribution due to escalating Pension Benefit Guaranty Corporation insurance premiums. We forecast that we will not be required to make a contribution to the plan in 2018, and we do not plan to make any voluntary contributions in 2018. For further information on our pension plans, see Note 10 of the Notes to Consolidated Financial Statements. In 2017, we repurchased 2,533,350 shares at an average price of $54.90 per share and a total cost of $139.1 million. A total of 2,373,053 shares remained on the existing repurchase authorization at December 31, 2017. Depending on factors such as stock price, working capital requirements and alternative investment opportunities, such as acquisitions, we expect to spend approximately $135 million on share repurchase activity in 2018 using a 10b5-1 repurchase plan. In addition, we may opportunistically repurchase our shares in the open market in 2018. We have paid dividends for 78 consecutive years with payments increasing each of the last 26 years. We paid dividends of $0.56 per share in 2017 compared with $0.48 per share in 2016. In January 2018, we increased our dividend by 29 percent and anticipate paying dividends of $0.72 per share in 2018. Aggregate Contractual Obligations A summary of our contractual obligations as of December 31, 2017, is as follows: As of December 31, 2017, our liability for uncertain income tax positions was $6.2 million. Due to the high degree of uncertainty regarding timing of potential future cash flows associated with these liabilities, we are unable to make a reasonably reliable estimate of the amount and period in which these liabilities might be paid. We utilize blanket purchase orders to communicate expected annual requirements to many of our suppliers. Requirements under blanket purchase orders generally do not become committed until several weeks prior to our scheduled unit production. The purchase obligation amount presented above represents the value of commitments that we consider firm. Recent Accounting Pronouncements Refer to Recent Accounting Pronouncements in Note 1 of Notes to Consolidated Financial Statements. Critical Accounting Policies Our accounting policies are described in Note 1 of Notes to Consolidated Financial Statements. Also as disclosed in Note 1, the preparation of financial statements in conformity with accounting principles generally accepted in the U.S. requires the use of estimates and assumptions about future events that affect the amounts reported in the financial statements and accompanying notes. Future events and their effects cannot be determined with absolute certainty. Therefore, the determination of estimates requires the exercise of judgment. Actual results inevitably will differ from those estimates, and such differences may be material to the financial statements. The most significant accounting estimates inherent in the preparation of our financial statements include estimates associated with the evaluation of the impairment of goodwill and indefinite-lived intangible assets, as well as significant estimates used in the determination of liabilities related to warranty activity, product liability and pensions. Various assumptions and other factors underlie the determination of these significant estimates. The process of determining significant estimates is fact-specific and takes into account factors such as historical experience and trends, and in some cases, actuarial techniques. We monitor these significant factors and adjustments are made as facts and circumstances dictate. Historically, actual results have not significantly deviated from those determined using the estimates described above. Goodwill and Indefinite-lived Intangible Assets In conformity with U.S. Generally Accepted Accounting Principles (GAAP), goodwill and indefinite-lived intangible assets are tested for impairment annually or more frequently if events or changes in circumstances indicate that the assets might be impaired. We perform impairment reviews for our reporting units using a fair-value method based on management’s judgments and assumptions. The fair value represents the estimated amount at which a reporting unit could be bought or sold in a current transaction between willing parties on an arm’s-length basis. The estimated fair value is then compared with the carrying amount of the reporting unit, including recorded goodwill. We are subject to financial statement risk to the extent that goodwill and indefinite-lived intangible assets become impaired. Any impairment review is, by its nature, highly judgmental as estimates of future sales, earnings and cash flows are utilized to determine fair values. However, we believe that we conduct thorough and competent annual valuations of goodwill and indefinite-lived intangible assets and that there has been no impairment in goodwill or indefinite-lived assets in 2017. Product warranty Our products carry warranties that generally range from one to ten years and are based on terms that are generally accepted in the market. We provide for the estimated cost of product warranty at the time of sale. The product warranty provision is estimated based upon warranty loss experience using actual historical failure rates and estimated costs of product replacement. The variables used in the calculation of the provision are reviewed at least annually. At times, warranty issues may arise which are beyond the scope of our historical experience. We provide for any such warranty issues as they become known and estimable. While our warranty costs have historically been within calculated estimates, it is possible that future warranty costs could differ significantly from those estimates. The allocation of the warranty liability between current and long-term is based on the expected warranty liability to be paid in the next year as determined by historical product failure rates. At December 31, 2017 and 2016, our reserve for product warranties was $142.4 million and $140.9 million, respectively. Product liability Due to the nature of our products, we are subject to product liability claims in the normal course of business. We maintain insurance to reduce our risk. Most insurance coverage includes self-insured retentions that vary by year. In 2017, we maintained a self-insured retention of $7.5 million per occurrence with an aggregate insurance limit of $125.0 million. We establish product liability reserves for our self-insured retention portion of any known outstanding matters based on the likelihood of loss and our ability to reasonably estimate such loss. There is inherent uncertainty as to the eventual resolution of unsettled matters due to the unpredictable nature of litigation. We make estimates based on available information and our best judgment after consultation with appropriate advisors and experts. We periodically revise estimates based upon changes to facts or circumstances. We also utilize an actuary to calculate reserves required for estimated incurred but not reported claims as well as to estimate the effect of adverse development of claims over time. At December 31, 2017 and 2016, our reserve for product liability was $40.1 million and $38.6 million, respectively. Pensions We have significant pension benefit costs that are developed from actuarial valuations. The valuations reflect key assumptions regarding, among other things, discount rates, expected return on plan assets, retirement ages, and years of service. Consideration is given to current market conditions, including changes in interest rates in making these assumptions. Our assumption for the expected return on plan assets was 7.50 percent in 2017 and 2016. The discount rate used to determine net periodic pension costs decreased to 4.15 percent in 2017 from 4.40 percent in 2016. For 2018, our expected return on plan assets is 7.15 percent and our discount rate is 3.65 percent. In developing our expected return on plan assets, we evaluate our pension plan’s current and target asset allocation, the expected long-term rates of return of equity and bond indices and the actual historical returns of our pension plan. Our plan’s target allocation to equity managers is approximately 45 to 55 percent, with the remainder allocated primarily to bond managers, private equity managers and real estate managers. Our actual asset allocation as of December 31, 2017, was 45 percent to equity managers, 43 percent to bond managers, nine percent to real estate managers, two percent to private equity managers and one percent to others. We regularly review our actual asset allocation and periodically rebalance our investments to our targeted allocation when considered appropriate. Our pension plan’s historical ten-year and 25-year compounded annualized returns are 6.3 percent and 9.2 percent, respectively. We believe that with our target allocation and the expected long-term returns of equity and bond indices as well as our actual historical returns, our 7.15 percent expected return on plan assets for 2018 is reasonable. The discount rate assumptions used to determine future pension obligations at December 31, 2017 and 2016 were based on the AonHewitt AA Only Above Median yield curve, which was designed by AonHewitt to provide a means for plan sponsors to value the liabilities of their postretirement benefit plans. The AA Only Above Median yield curve represents a series of annual discount rates from bonds with AA minimum average rating as rated by Moody’s Investor Service, Standard & Poor’s and Fitch Ratings. We will continue to evaluate our actuarial assumptions at least annually, and we will adjust the assumptions as necessary. We recognized pension income of $9.1 million in 2017 compared to $6.9 million of pension income in 2016 and $0.1 million of pension expense in 2015. As of December 31, 2015, we changed the method we used to estimate the service and interest components of net periodic pension benefit cost for our pension plan and post-retirement benefit plan. Historically, we estimated the service and interest cost components utilizing a single weighted-average discount rate derived from the yield curve used to measure the benefit obligation at the beginning of the period. We elected to utilize an approach that discounts the individual expected cash flows underlying the service cost and interest cost using the applicable spot rates derived from the yield curve used in the determination of the benefit obligation to the relevant projected cash flows. This change was made to provide a more precise measurement of service and interest costs by improving the correlation between the projected benefit cash flows to the corresponding spot yield curve rates. The change was the reason for $7.7 million and $7.1 million decreases in 2017 and 2016, respectively, compared to 2015, in service and interest costs. Costs associated with our replacement retirement plan in 2017 were approximately $6 million, consistent with 2016. We made changes to our pension plan including closing the plan to new entrants effective January 1, 2010, and the sunset of our plan for the majority of our employees on December 31, 2014 which significantly decreased pension expense beginning in 2015. Lowering the expected return on plan assets by 25 basis points would increase our net pension expense for 2017 by approximately $2.0 million. Lowering the discount rate by 25 basis points would decrease our 2017 net pension expense by approximately $0.3 million. Non-GAAP Measures We provide non-GAAP measures (adjusted earnings and adjusted earnings per share) that exclude one-time expenses associated with U.S. Tax Reform. We believe that these non-GAAP measures better reflect our financial performance. As such, we believe that the measures of adjusted earnings and adjusted earnings per share provide management and investors with a useful measure of our results. We have prepared annual reconciliations of adjusted earnings and adjusted earnings per share for 2017. A. O. SMITH CORPORATION Adjusted Earnings and Adjusted EPS (dollars in millions, except per share data) (unaudited) The following is a reconciliation of net earnings and diluted earnings per share (EPS) to adjusted earnings (non-GAAP) and adjusted EPS (non-GAAP): Excluding the impact of U.S. Tax Reform provisional one-time charges, our 2017 adjusted effective income tax rate was 27.4 percent as compared to our effective income tax rate of 43.1 percent in 2017. Outlook We expect our consolidated sales to grow 8.5 to 9.5 percent in 2018. With our organic growth potential and our stable replacement markets, we expect to achieve full-year earnings of between $2.50 and $2.58 per share, which excludes the potential impact from future acquisitions. Our guidance includes the estimated benefit related to our lower projected income tax rate under U.S. Tax Reform. OTHER MATTERS Environmental Our operations are governed by a number of federal, foreign, state, local and environmental laws concerning the generation and management of hazardous materials, the discharge of pollutants into the environment and remediation of sites owned by the company or third parties. We have expended financial and managerial resources complying with such laws. Expenditures related to environmental matters were not material in 2017 and we do not expect them to be material in any single year. We have reserves and available insurance coverage associated with environmental obligations at various facilities and we believe these reserves are sufficient to cover reasonably anticipated remediation costs. Although we believe that our operations are substantially in compliance with such laws and maintain procedures designed to maintain compliance, there are no assurances that substantial additional costs for compliance will not be incurred in the future. However, since the same laws govern our competitors, we should not be placed at a competitive disadvantage. Market Risk We are exposed to various types of market risks, primarily currency. We monitor our risks in such areas on a continuous basis and generally enter into forward contracts to minimize such exposures for periods of less than one year. We do not engage in speculation in our derivatives strategies. Further discussion regarding derivative instruments is contained in Note 1 of Notes to Consolidated Financial Statements. We enter into foreign currency forward contracts to minimize the effect of fluctuating foreign currencies. At December 31, 2017, we had net foreign currency contracts outstanding with notional values of $94.9 million. Assuming a hypothetical ten percent movement in the respective currencies, the potential foreign exchange gain or loss associated with the change in exchange rates would amount to $9.5 million. However, gains and losses from our forward contracts will be offset by gains and losses in the underlying transactions being hedged. Our earnings exposure related to movements in interest rates is primarily derived from outstanding floating-rate debt instruments that are determined by short-term money market rates. At December 31, 2017, we had $282.9 million in outstanding floating-rate debt with a weighted-average interest rate of 2.3 percent at year end. A hypothetical ten percent annual increase or decrease in the year-end average cost of our outstanding floating-rate debt would result in a change in annual pre-tax interest expense of approximately $0.6 million. Forward-Looking Statements This filing contains statements that the company believes are “forward-looking statements” within the meaning of the Private Securities Litigation Reform Act of 1995. Forward-looking statements generally can be identified by the use of words such as “may,” “will,” “expect,” “intend,” “estimate,” “anticipate,” “believe,” “forecast,” “guidance” or words of similar meaning. All forward-looking statements are subject to risks and uncertainties that could cause actual results to differ materially from those anticipated as of the date of this filing. Important factors that could cause actual results to differ materially from these expectations include, among other things, the following: a further slowdown in the growth rate of the Chinese economy and/or a decline in the growth rate of consumer spending in China; potential slower rate of conversion in the high efficiency boiler segment in the U.S.; significant volatility in raw material prices; our inability to implement or maintain pricing actions; potential weakening in U.S. residential or commercial construction or instability in our replacement markets; foreign currency fluctuations; our inability to successfully integrate or achieve our strategic objectives resulting from acquisitions; competitive pressures on our businesses; the impact of potential information technology or data security breaches; changes in government regulations or regulatory requirements; the impact of U.S. Tax Reform for effective income tax rates and one-time expenses under the new law and adverse developments in general economic, political and business conditions in key regions of the world. Forward-looking statements included in this filing are made only as of the date of this release, and the company is under no obligation to update these statements to reflect subsequent events or circumstances. All subsequent written and oral forward-looking statements attributed to the company, or persons acting on its behalf, are qualified entirely by these cautionary statements.

<s>[INST] Our company is comprised of two reporting segments: North America and Rest of World. Our Rest of World segment is primarily comprised of China, Europe and India. Both segments manufacture and market comprehensive lines of residential and commercial gas and electric water heaters, boilers and water treatment products. Both segments primarily manufacture and market in their respective regions of the world. Our North America segment also manufactures and markets water systems tanks. Our Rest of World segment also manufactures and markets inhome air purification products in China. In our North America segment, we project our sales in the U.S. will grow in 2018 compared to 2017 due to higher residential water heater and boiler volumes resulting from expected industrywide new construction growth and expansion of replacement demand. We expect the North America residential water heater industry to have three to 3.5 percent unit growth in 2018. Due to nearly 20 percent unit growth in 2017, partially driven by an anticipated 2018 regulatory change and resulting prebuy, we expect the North America commercial water heater industry to have a three percent unit decline in 2018. Our sales of boilers grew 13 percent in 2017, and we expect ten percent sales growth in 2018, driven by the continuing U.S. industry transition to higher efficiency products and our introduction of new products. We continued to expand our North America water treatment platform with the acquisition of Hague on September 5, 2017. We expect sales of North America water treatment products to increase by approximately 50 percent in 2018, compared to 2017, primarily due to volume growth and a full year of Hague sales. In our Rest of World segment, we expect China sales to grow in 2018 at a rate of approximately 13 percent, as we believe overall water heater market growth, geographic expansion, market share gains, and growth in water treatment and air purification products will contribute to our growth. In addition, we expect our sales in India to grow over 40 percent in 2018 from approximately $26 million in 2017. Combining all of these factors, we expect total company sales growth of between 8.5 percent to 9.5 percent in 2018. Our stated acquisition strategy includes a number of our waterrelated strategic initiatives. We will look to continue to grow our core residential and commercial water heating, boiler and water treatment businesses throughout the world. We will also continue to look for opportunities to add to our existing operations in high growth regions demonstrated by our introduction in 2015 of air purification products in China and water treatment products in India and Vietnam. RESULTS OF OPERATIONS Our sales in 2017 were a company record $2,997 million surpassing 2016 sales of $2,686 million by 11.6 percent. The increase in sales in 2017 was primarily due to higher sales in China as well as higher sales of water heaters and boilers in North America. Sales in China grew 15.9 percent to over $1 billion in 2017, and excluding the impact of the appreciation of the U.S. dollar, sales in China increased 17.9 percent in 2017. Our sales in 2016 were higher than 2015 sales of $2,537 million by 5.9 percent. In 2016, excluding the impact from the appreciation of the U.S. dollar against the Chinese currency, our sales grew approximately eight percent. Sales in China grew 12.5 percent in 2016, and excluding the impact of the appreciation of the U.S. dollar, sales in China increased by 18.9 percent in 2016. Our gross profit margin in 2017 decreased to 41.3 percent from 41.7 percent in 2016. The slightly lower margin in 2017 was due to significantly higher steel costs that more than offset pricing actions taken in 2017 in North America and China. Our gross profit margin in 2016 increased from 39.8 percent in 2015 primarily due to price increases in the U.S., lower material costs in the first half of 2016 and higher sales of boilers and commercial water he [/INST] Positive. </s>